FINANCIAL SUPERVISION AND CAPITAL ADEQUACY 415

capital, but usually by not more than 10 per cent, depending on the
collateral.
a Specialised lending is where the risk assessment does not depend on a
general assessment of the corporate credit of the borrower, but where
the primary source of repayment is the income generated by, and the
value of particular assets over which the lender has a substantial degree
of control. There are live specialised lending sub-classes:
o Project finance (the lender looks primarily to the revenues gener -
ated by the project).
o Object finance, such as aircraft and ship finance.
o Commodities finance, where the borrower has no independent
capacity to repay the loan.
o Income-producing real estate, where the prospect of repayment
depends primarily on the cash flow generated by the asset such as
rentals and sale proceeds.
0 High-volatility commercial real estate, which includes development

finance and finance for commercial property showing high

volatility.

The risk-weights are higher than those for ordinary corporates. Hence
specialised lending is regarded as riskier.

Credit risk: internal ratings based approach

This approach (which was not available in Basel I) allows banks to use more 25-29
sophisticated risk modelling techniques and their own internal ratings sys-
tems to calculate the capital requirement. Those systems must meet detailed
specified requirements and be approved by the bank's regulator. The intent
is that most significant banks should at least use this approach.
The internal ratings based approach requires application of a statistically
sound method to evaluating the risk-weight of the bank's exposures and the
capital required to support those exposures. The risk components include
measures of:

o probability of default ("PD"). This is the likelihood of default,

• exposure at default ("EAD"). This is the forecast amount of the facility
outstanding on default,
o loss given default ("LGD"). This is the expected losses, and
a effective maturity ("M").

Banking book exposures are categorised into six broad asset classes: (1)
corporate; (2) sovereign; (3) bank; (4) retail; (5) equity; and (6) eligible
purchased receivables. A different risk-weight function is allocated to each
asset class. For corporate exposures (ignoring the small and medium-sized
sector), the risk-weights vary between 14.4 per cent and 238.23 per cent.
Under the foundation approach, the bank provide-, its own estimate of 25 W
probability of default but must then use supervisory estimates of the other
risk components.
 416 )N OF INTERNATIONAL FINANCE
REGULATION

Under the advanced approach, the bank provides its own estimates of all
the risk components.

Corporate governance and oversight for internal ratings based

approach

25-21 In the case of the internal ratings based approach, a bank's rating and
estimation process must be approved by the bank's board of directors (r a
designated committee) and by senior management. They must possess a
general understanding of the risk rating system and a detailed understanding
of the associated management report.
There must be a credit risk control unit that is responsible for the design,
selection, implementation and performance of the internal rating system
which is independent of the origination function, that is, of the bank staff
who handle the transactions with customers.
The system must he reviewed at least annually.

Long-term equity holdings and subordinated debt

25-22 Equities - that is, shares held by an institution on a long-term investment

basis have special risk weights. By contrast, equities held for trading
purposes will generally he held in the trading book and subject to the
trading hook regime: see below. The risk weights can he high. eg 400 per
cent (capital of 32 per 100).
If an CXOSUC is subordinated, the regulatory capital cost will be sig-
nificantly greater than if it was a senior exposure for the every obvious
reason that a subordinated exposure is less likely to get paid. The LGD
value for subordinated and equity exposures is up to double that for senior
exposures.

Retail and small business exposures

25-23 Retail exposures, eg loans to individuals, are approached in an entirely
different way from corporate, bank and sovereign receivables, in that,
instead of each individual borrower being given a credit rating, exposures
are assessed on a portfolio basis lumped together. A diversified retail
portfolio will tend to be treated as a better credit than an equivalent
exposure to a corporate borrower. There are several detailed approaches to
valuing retail portfolios.

Trading book
25-24 The trading book regime applies mainly to investment banks which do not
makc loans hut instead trade in securities. In:;tcad of credit risk, securities
which are held short-term with intent to trade are valued according to their
market value for the purposes of capital requirements.
 FINANCIAL SUPERVISION AND CAPITAL ADEQUACY 417

Operational risk

This is another feature of Basel II not Found in Basel I. Banks have to hold 25-25
capital to cover operational risk. Operational risk is the risk of loss resulting
from inadequate or failed internal processes, people, and systems or from
external events. It includes legal risk but not strategic or reputational risk.

Examples of operational risk Examples of operational risk contemplated 25-26

by Basel If include: internal fraud (intentional non-reporting or position
ismarking, theft, destruction, forgery, bribes, insider dealing on own
account, etc.); external fraud (theft, robbery, fraud, hacking, database
thefts, etc.); losses from and compensation for wrong employment practices
(eg discrimination) and workplace safety; losses resulting from negligent
client product or business conduct (breaches of fiduciary duty, privacy,
confidentiality, disclosure, churning, lender liability, aggressive sales, cus-
tomer non-suitability, anti-trust, market abuse, insider dealing on firm's
account, unlicensed activity, money-laundering, bad advice, etc.); damage to
physical assets for natural disaster, vandalism, terrorism, etc.; business
disruption or system failures; losses from execution, and delivery and pro-
cess management (wrong data entry, missed deadlines, accounting errors,
delivery failures; negligent reporting; incomplete documentation, incorrect
customer records, etc.). A dismal taxonomy of human wickedness and
incompetence, with a less dismal sprinkling of human fallibility to which we
(and our machines) are all prone, and a dash of natural risks to which we are
also prone.

Measurement There are three measurement methodologies: the basic 25-27

indicator approach; the standardised approach; and the advanced mea-
surement approach.
Under both the basic indicator and standardised approaches the calcu-
lation of capital required is crude. It is a percentage of gross income. The
assumption is that the more the income, the more operational risk there is.
Under the standardised approach the income is split into different business
lines and different factors (called beta factors) are applied to each business
line to give a figure for the capital required. This is because some business
lines generate higher operational risk than others. The business lines and
associated beta factors are: corporate finance (18 per cent); trading and sales
(18 per cent); retail banking (1 2 per cent); commercial banking (15 per cent);
payment and settlement (18 per cent); agency services (15 per cent); asset
management (12 per cent); and retail brokerage (12 per cent). So if income is
100 and the percentage is 12, the bank must have 12 capital for operational
risk.
Under the advanced measurement approach, the bank's own risk model is
used to determine capital. In order to develop the risk model a bank must
keep and analyse loss data over a five-year period and be able to show that
their model is statistically sound. The model uses the main categories
exemplified above.
Insurance can be taken into account if it satisfies various eligibility criteria 25-28
(eg rating of insurer, insurance term, independent insurer, minimum can-
cellation period, etc.), but the mitigant is limited to 20 per cent of the total
operational risk charge. There are detailed provisions about the risk models.
 4J8 RFGULA°IION OF IN1°IR NATIONAL FINANCE

The measurement ol operational risk does not replace the expectations for
managing operational risk. See the Basel Committee document of February
2003 "Sound practices for the management and supervision of operational
risk" which sets out 10 principles of risk: management, eg board and Senior
management involvement, independent internal audit, assessments, mor
itoring, reporting, contingency plans, independent evaluation, and public
disclosure.

Conclusions

25-29 As at 2007 it seemed likely that Basel Ii would, in one form or another, be
adopted or he influential in over 100 countries, in practice virtually all those
with a developed banking system. This is a remarkable achievement for
consensus regulation. The Accord offers a level-headed view with few
political compromises.
Basel II is prescriptive, extremely complex and detailed. Some maintain
that bank managements are sufficiently sophisticated to manage their risks
without being told in quite so much detail how they should do it and they do
not need to be micrornanagcd. Increased disclosure and market discipline
underpin prudent bank behaviour. On the other hand, considerable dis-
cretion is given to sophisticated banks so that to that extent the supervisors
recognise that they cannot realistically prescribe all rules for all situations
and that their task is primarily to check that banks are adopting a sound
methodology. Effectively, the Accord represents a consensus on prudent
banking.
The internal ratings based methodology involves a. hank predicting its
likely losses by extrapolating from its past loss record. This, it is said, is like
driving down a road looking in the rear view mirror and is pro-cyclical. In
an economically benign climate, the credit Losses reduce, leading to a lower
capital requirement and increasing the capacity of banks to lend (and the
pressure on them to do so). As soon as the cycle turns down, loan losses lead
to an increase in capital requirement, and a credit crunch. The response
from Basel is that bank managements are sufficiently sophisticated to
understand this and will not therefore act imprudently. The reality is that
prophecy is the most difficult part of banking.
25-30 Minimum capital is insufficient to cope with massive volatile swings in the
business cycle and with cataclysms, but a balance has to be struck. Total
security is not realistic.
The system depends on ratings. Ratings are not available For all bor -
rowers or are limited in some countries.
Some of the rules are rigid. Credit analysis is an art and is highly judg-
mental, involving prophecies not just about the particular borrower, but
also about economic forecasts and unforeseen crises. Compliance with rules
might lead to false sense of security if the rules alone are followed.
25-31 The regime is very costly to implement for both banks and supervisors.
The costs may he too high for small new entrants, thereby limiting com-
petition and raising barriers to entry. But a set of rules is considered
essential to protect big systemically important banks.
The piaying-field is not entirely level because of supervisory discretions
and because of varying national implementation. For example, national
regulators can decide what banks qualify for the more sophisticated
 FINANCIAL SUPERVISION AND CAPITAL ADEQUACY 419

internal-ratings approaches. Complete international harmonisation is diffi-

cu lt to achieve.
The Accord is to some extent "one size fits all". The rules do not take into
a ccount international differences in bankruptcy law, for example. The other
side of the coin is that there is quite enough detail and, in the end, the object
is to stipulate a minimum capital, even though rough and ready or blunt or
crude here and there. This at least is more sensible than tiny extremes of the
mull, the micro, the nano.
Further reading on financial Supervision and Base! LPIF vol 7 chapter 24.
420 REGULATION OF INTERNATIONAL FINANCE

QUESTIONS AND SEMINAR TOPICS

Chapters 20-25
(1) What are the distinctions between financial regulatory regimes and
the ordinary law of contract, agency, tort, and the like?
(2) Do you think that the administrative sanctions imposed by financial
regulatory regimes are effectively criminal sanctions? Do you think
that the protections typically granted to the accused by the criminal
law should also apply to alleged violators of the regulatory regime?
(3) How should one define: (I) banking business, and (2) Securities
business for the purpose of defining the activities which require offi-
cial authorisation?
(4) Analyse critically the policies for and against the typical regulatory
regimes applicable to commercial banks and investment banks and
express your conclusions.
(5) Your client is a newly emerging country which wishes to introduce a
new code regulating its financial markets. Advise your client on the
key important issues which should be COVCICd in the code.
(6) The regulation of the solvency of banks and sccuriies firms is much
more important than the rcgulatit)I1 o the conduct of business
(fiduciary duties, conflicts of interest, etc.) by banks and securities
firms. Discuss.
(7) Do you think that banks and securities firms need different systems of
regulation?
(8) "The conduct of business rules in regulatory codes are no more than
the traditional rules of agency law with a quasi-criminal adminis-
trative sanction." Discuss.
(9) You are the general counsel (chief in-house lawyer) of a large
financial services conglomerate group with businesses in the US and
EU, as well as other countries. The group's business includes inter-
national commercial banking (including arranging and acting as
agent bank in syndicated loans), underwriting securities, dealing in
securities as broker and for the bank's own account, corporate
finance advice and custodianship of securities. The board of directors
is concerned about conflicts of interest. Advise the board on the usual
regulatory requirements and what steps the group should take to
mitigate the risks.
(10) What is a collective investment scheme? Analyse critically how they
are regulated.
(I I) "The regulatory regime is two-tiered: the first more restrictive tier
protects consumers and the second more liberal tier applies only to
sophisticated investors." Give examples of this tiering. Do you think
that the tiering is justified?
 QUESTIONS AND SEMINAR TOPICS 421

(12)"ln practice there is very little material difference as regards liability

for a misleading prospectus in the care of a regulated prospectus for
the issue of securities to the public as compared to the liability for
unregulated prospectuses, such as a prospectus offering securities to
sophisticated investors." Discuss.
(1 3) Review the usual main exemptions for prospectuses exempted from
the regime applying to regulated prospectuses for the issue of secu-
rities to the public and state whether you think that these exemptions
arc justified.
(14)Do you think that underwriters of issues of securities to the public
should he liable to investors for lack of due diligence in relation to
prospectuses for these issues? Give international examples of this
liability.
(15) Which of the following do you think might constitute the adiniiiis-
trativc offence of market abuse under the typical regulatory regime
and why?
A client instructs its broker to buy a large amount of the shares of
a listed company. The broker buys shares for himself before pla-
cing the client's order in the market.
o A bank has granted an option to a dealer whereby the bank has to
pay the dealer to the extent that a stock exchange index of top
shares goes above 1,000. On the option day, the price is hovering
around 1,000. Just before the close of business an employee at the
bank puts in large sell orders to drive down the index.
e A financial journalist buys shares and then recommends them in
her weekly column without disclosing that she has bought the
shares.
® A hedge fund sells a large block of shares short, ie shares which it
does not own, in the meantime borrows the shares in the market to
deliver to the buyer, and then hopes to buy the shares more
cheaply to deliver under the share lending agreement.
o a dealer learns that a hedge fund has a large short position in a
very illiquid share. The dealer buys in most of the outstanding
shares in the market so that the dealer can force the hedge fund to
pay a high price for them.
(16)A salesman of stationery products is waiting in the reception of a
small oil company hoping to he able to sell his company's products to
the small oil company. The managing director of a large oil company
announces himself to the receptionist and meets with the managing
director of the small oil company. The salesman dabbles in the stock
market in his spare time and has heard that the large oil company is
looking for acquisition targets. He immediately buys shares in the
small oil company and tells his girlfriend what he saw. She also buys.
A few days later the large oil company announces an agreed bid for
the small oil company and the shares race up in value.
1)o you think that the salesman and his girlfriend should under the
typical regime he guilty of insider dealing?
(17) Write a critical appraisal of Basel 11.
• • • . -

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 PART 6
SPECIAL TOPICS
 CHAPTER 26

DERIVATIVES I

Introduction
Transactions and background

o "1 sell my cow to you for 10, delivery in one month's time." 26-01
This is a future or forward. I am sure of receiving 10 for my cow.
o "I have the option to sell my cow to you for 10, delivery in one month's
time."
This is an option. I have the right but not the obligation to sell my cow to
you (which 1 will only exercise if cows are worth less than 10).
o "If you pay me amounts equal to the variable floating rate of interest
on the loan I owe to my bank, I will pay you amounts equal to a fixed
rate of 5 per cent on a loan of the same amount."
This is an interest rate swap. The effect is that I have made my interest
obligation fixed and certain rather than floating and unpredictable.
o "You will buy this 100 bond from me for 100 if the issuer defaults on
the bond."
This is a credit derivative. I effectively get a guarantee of my bond.

"Derivatives" is a generic term used to describe futures, options, swaps

and various other similar transactions. They are "derived" from underlying
assets, eg an option to buy a share in the future is a contract derived from
the share (the "underlying"). Most derivative contracts are contracts for
differences--the difference between the agreed future price of an asset on a
future date and the actual market price on that date.
The main objective of derivatives is insurance. One can insure one's home
against fire and one's car against damage in an accident. Similarly one can
insure one's loan against interest rates going sky high like smoke and against
the value of one's equity shares crumpling in a crash. Nobody is allowed to
call the transactions insurance because the insurance business is regulated by
insurance regulators--although there are technical legal differences and
obvious common sense differences separating the insurance business and
derivatives business. They are not called guarantees either, because amongst
other things, US banks are prohibited from issuing guarantees. Instead the
insurance or guarantee aspect is called "hedging".
If insurance is needed, there have to be insurers--derivatives dealers. 26-02
As we shall see, derivatives can also reduce transaction costs, eg the cost
of switching from equities to bonds.
The famous description of derivatives as "toxic weapons of financial mass
destruction" seems rather to reflect the risks applying to any form of
insurance.
 426 Si'IIAI. tOf'I(S

I31e1 history

6-03 Derivatives sprang up mainly because of the volatility of interest rates,

floating currencies, shares, bonds, and commodities, and the need for
"insurance." The main developments were from the 1980s forward, resulting
From the collapse of the Bretton Woods fixed currency parity with the US
dollar and gold in 1971 and the removal of exchange controls in advanced
countries. The most important dealers association is the International
Swaps and Derivatives Association, Inc ISDA. Following prior market
initiatives in the rnid-1980s, the first ISDA main master agreement was in
1987, it was amended in 1992, and the latest version was in 2002. Credit
derivatives emerged in the mid-1990s.
Derivatives have a much longer history. The Chicago Board of Trade
introduced a grains futures contract in 1865. The London Metal Exchange
was founded in 1877. Evidence of derivatives transactions goes back many
centuries to antiquity. Their quite fantastic expansion since 1980 attests to
the twin surge in the role of financial assets and the dismantling of national
barriers to the transkr of these assets.

Amounts

26-04 Derivatives involve very large amounts, a substantial multiple of world

GDP. But derivatives figures often relate to notional amounts, eg the
amount of loans and bonds by reference to which interest swaps are cal-
culated, so they are not actual exposures. Thus the gross amounts of interest
swaps may he 3-5 per cent of the notional amounts. Nevertheless, these
exposures are still very substantial.
In crude orientational terms the percentages according to type of deri-
vative may be around the following:

o Interest rate risk. The largest volume by far--more than 60 per cent.
o Currency risk. Over 20 per cent.

o Equity risk. Perhaps 2 per cent.

o Commodity risk. Less than I per cent.

Credit risk. Perhaps more than 15 per cent.

The interest rate risk is the highest because most businesses have an interest
rate risk, while the others tend to be relevant only to the particular busi-
nesses concerned.
A large proportion of business is transacted in London.
The topic is characterised by confusing jargon, argot and vernacular, a
bewildering range of transactions, and complex impenetrable detail, espe-
cially ­exotics­. But they are simple in outline.
 :-•

DERIVATIVES I 427

Main USt1S

The main users of derivatives are sophisticated investors, especially banks, 26-05
insurers, pension funds, mutual funds, corporates and hedge funds. These
are all sophisticated investors who hold large pools of intangible financial
assets (loans, bonds, shares) whose value they wish to protect, in the same
way that the rest of the world protects their buildings, their houses and their
other tangible possessions.
Dealers who enter into derivatives trades with their customers also hedge
them with other dealers, ie enter into a back-to-back mirror deal matching
the deal with their customer, as in the case of reinsurance.

Derivative transactions
The object of this and following sections is to give some examples of 26-06
transactions to illustrate market deals. There are an enormous range of
transactions and so these examples are intended only to provide orientation
without being. assaulted by the mind-numbing barrage of possible
permutations.

Interest swaps and other interest contracts

Interest swaps An interest swap is a contract whereby each party agrees to 26-07
make periodic payments to the other equal to interest on agreed principal
sums and where the interest is calculated on a different basis.

Example: Float Co and Fixed Co have each borrowed 100 from third
party lenders. Float Co's loan bears floating rate interest at a floating rate
or variable rate (such as the London interbank offered rate between
banks) plus I per cent, and Fixed Co's loan (which is a eurobond issue)
bears fixed interest at 10 per cent. Under the interest swap contract, Fixed
Co pays Float Co periodic amounts equal to the floating rate interest on
100. Float Co pays Fixed Co periodic amounts equal to the fixed rate
interest on 100, plus an extra amount representing Fixed Co's profit. The
payment days are matched so that the reciprocal payments can be netted.

The usual reason for transaction is that Fixed Co is a bank of high credit-
standing which can borrow at a fixed rate, eg by an issue of international
eurobonds, while Float Co is a less creditworthy industrial company which
cannot borrow cheaply (or at all) in the eurobond market.
The reciprocal payments are not actual interest, but amounts equal to
interest calculated on the same notional principal amount. The lenders to
Float Co and Fixed Co are not affected. Float Co and Fixed Co must pay
the lenders actual interest on their respective loans, regardless of whether the
other party makes its swap payments. Thus if Float Co becomes insolvent,
Fixed Co must still pay its bondholders 10 per cent, even though Fixed Co is
no longer receiving swap payments from Float Co.
A bank may he interposed as an intermediary between the swapping
parties, so that each relies on the credit of the bank. The bank charges a fee.
Most swap products are provided by banks. The bank agrees to pay 26-08
 428 SE'IClAL TOPICS

floating rate to it floating rate borrower, and the borrower pays fixed rate to
the hank. The effect is that the bank makes it profit or kiss according to
whether the floating rate is less or more than the fixed rate. The borrower,
however, has the certainty of a fixed rate. The bank is in a better position to
hedge its own exposure with market countcrparties or by its own funding.
Some uses of interest swaps are as follows:

o Project finance. The project company borrows bank loans at a floating

rate. So the project economics are unpredictable. To protect against
this uncertainty, the project company fixes the rate on the floating rate
hank loan: a bank agrees to pay the project company floating in return
for fixed.
o Securitisations. A securitisation vehicle hedgesthe floating rate payable
on the sccuritised receivables. A bank agrees to pay the securitisation
vehicle a floating rate in return for a fixed rate. llence the .sccuritisation
is safer and more predictable for investors.
o Fixed rate bank loans. Banks often raise deposit or other funds at a
floating rate and lend at floating rates. But if the bank wishes to satisfy
it demand for fixed rate loans, it can enter into it swap with a market
counterparty whereby the bank pays the fixed rate it receives on its
fixed rate loans and the co Lill terparty pays floating, SO that hank can
pay floating rate to its funding sources.

26-09 Interest caps Under an interest cap, one party agrees, in return for a fee, to
pay the other party amounts equal to interest above a specified rate on it
notional principal amount.

Example: Float Co issues floating rate notes of 100 and wishes to be sure
that the interest rate will not he more than 10 per cent. In return for a fee
Fixed Co agrees to pay Float Co amounts equal to interest on 100 in
excess of 10 per cent. so that if the rate goes up to II per cent, Fixed Co
will pay Float Co 1 per cent on 100 during the period of the excess.

26-10 Interest floors Under an interest floor, one party agrees, in return for a fee,
to pay the other amounts equal to interest below a specified rate on a
notional principal amount.

Example: Float Co invests in floating rate notes of 100 and wishes to be

sure that the interest rate will not be less than 5 per cent. Fixed Co agrees
to pay Float Co amounts equal to interest on 100 to the extent it is below
5 per cent during the period it is below 5 per cent.

26-11 Interest collars Under an interest collar, one party agrees, in return for a
fee, to pay the other amounts equal to interest above a specified rate on a
notional principal amount over an agreed period, and the other pays the
first party amounts equal to interest below a specified rate.

Example: Fixed Co pays Float Co if rates go over 10 per cent, but Float
Co pays Fixed Co if rates are less than 5 per cent.
 DERIVATIVES I 429

Futures contracts
Example: "I sell my cow to you for 10, delivery in one month's time". 26-12

Terminology A futures contract is a contract under which one party agrees 26-13
to deliver to the other party on a specified future date (the "maturity date")
a specified asset at a price (the "strike price") agreed at the time of the
contract and payable on the maturity date.
The term "forward contract" is often used in relation to private contracts
not transacted through an organised exchange. The origin of the difference
in terminology is that, in the US, off-exchange forward contracts are illegal,
subject to carve-outs, because of problems in regulating them. So on-
exchange forwards were called futures to distinguish them from prohibited
forwards.
A "spot" contract is one which is to be performed, within, eg two days, Ic
the shortest practicable time to arrange settlement.

Assets The asset may be a commodity (grain, oil, metals) or currency or a 26-14
debt or equity security (or a number or basket of securities), or a deposit of
money by way of loan, or any other category of property. One of the most
traded instruments is the currency forward, ie buying or selling a currency
for delivery at a future or "forward" date.

Hedging The effect is to guarantee or "hedge" the price. The hedging party 26-15
protects itself against a loss but also loses the chance to make a profit.

Settlement Futures are usually performed ("settled") by the payment of 26-16

the difference between the strike price and the market price on the fixed
future date, and not by physical delivery and payment in full on that date.
Hence they are called "derivatives" because settlement is not by actual full
performance of the sale or deposit contract but rather by a difference pay -
ment derived from an actual asset and an actual price. The contract is based
on or related to or derived from an ordinary commercial contract.

Examples of futures contracts 26-I 7

Commodity futures: example: In March, Seller sells grain to Buyer for 10

for delivery in September. Seller does so to fix the price of his grain crop in
advance. If in September the market value is nine, Seller makes a profit of
one because he gets 10 from Buyer when the market price is nine. If in
September the market value is 11, Seller has made a loss of one, because
he could have sold his grain crop for 11, instead of 10. But at least Seller
did not take the risk of a loss. Seller has sold a grain future, a commodity
future. He has guaranteed his grain price, ie hedged it.

In a derivatives contract, the parties do not usually contract to deliver grain

and pay for it, but only to pay or receive the difference between the contract
price and the market price on the maturity date. In this case the Seller sells
the grain in the market, and Seller or Buyer pays one to the other. lhc
transaction is "cash-settled" without physical delivery and is not a contract
for the sale of grain. Seller has still hedged his grain price, because he can sell
430 SP[CIAI. TOPICS

his grain at the market price and receive from Buyer any shortfall between
the market price and the contract price. However, in return for the certainty
of guaranteeing the price and hence not making a loss, the Seller has Ior
gone the potential profit.
Commodity futures may also relate to oil, gold, copper or aluminium or
any other commodity.

Currency futures (swaps): example: In March, a Seller in Britain sells

goods to a purchaser in the US in return for $10 for payment in Sep-
tember. The Seller sells the Buyer the $10 for £5 sterling, for delivery in
September when Seller expects to receive the $10 from his US buyer, so as
to he sure that the $10 will be worth £5 and that he does not make it loss
on the sale of goods due to currency fluctuations. If in September the $10
are worth £4, the Seller has ensured that he does not suffer the loss ol £ I.
But if it is worth £6 he has lost a profit of £1. The Seller has bought a
sterling future, or sold a dollar future. He has guaranteed his price, ie
hedged it.

In a derivatives contract, the parties do not normally contract to deliver

the gross amounts of the two currencies, but only to pay or receive the net
difference between the contract price and the market price. They can buy or
sell the actual currency in the foreign exchange market. The transaction is it
contract for differences ("cash-settled") and is not an exchange of gross
currency amounts.

Interest futures: example: In March, a Borrower agrees to borrow lOt)

from a Lender, the borrowing to be made in September for a year a an
interest rate of 5 per cent p.a. The Borrower agrees to do so because he
will need the loan in September and wishes to fix the interest rate in
advance. In September the market interest rate is 7 per cent, so the
Borrower avoids an extra expense of 2. If the rate in September had been
3 per cent, the Borrower would have saved 2 because he could have
borrowed at 3 per cent in the market. The Borrower has guaranteed his
maximum cost of borrowing, ie hedged it, but at the expense of losing the
benefit, of downturns in interest rates. In the jargon, the Borrower has
"sold" an interest rate future even though this is strictly a borrowing
contract, not a sale contract. If he had agreed to lend, he would have
"bought" an interest rate future. He might have wished to lend because he
expected to receive 100 in September and wished to guarantee the interest
rate.

In the derivatives market, this is a contract for differences, ie the Borrower

does not actually borrow the 100 (typically they will borrow from another
lender), but only pays or receives the difference between the contract interest
rate and the market interest rate in September calculated over the agreed
period and on the agreed amount of the loan. The Borrower is still protected
against rises in interest rates, but does not benefit if interest rates fall.
There are often called forward rate agreements. A person who is bor-
rowing a loan can fix their interest rate by buying an interest future in the
market. A person who is lending a loan can do the same.

Stock index futures: example: In March, a Seller agrees to sell the stocks
comprised in a stock market index for 10, delivery in September. The
stock index is made up of a sample basket of shares listed on the
 DERIVATIVES 1 431

e xchange. The Seller wishes to do so because he has a portfolio of stocks

which are roughly the same as those used for the stock exchange index
and thinks their value will go down. If in September, the index is nine,
Seller has made a profit of one. If the value is 11, Seller has lost one
because he could have waited and sold for 11, instead of the agreed price
of 10. Seller has sold a stock exchange index future. He has guaranteed
the value of his portfolio, ie hedged it

In a derivatives contract, the seller does not agree actually to sell the stocks,
but only to pay or receive the difference in price. The transaction is "cash-
settled" without physical delivery of' the stocks against payment of the full
price.

Examples of uses of stock index futures Stock index futures are used for 26-li
hedging and portfolio management.
Thus an investor wishes to invest 100 in shares. They could borrow 100
and buy the shares in which case they will incur interest on the borrowing
and transaction Costs on the shares, eg broker commissions and stamp
duties. Instead they could buy a stock index future and avoid these costs.
Indexes based on the value of a basket of the shares of the largest com-
panies on the leading stock exchange in the world are available. Examples
are S&P 500 (equity shares of 500 US companies listed on the New York
Stock Exchange), the FT-SE 100 (100 UK companies), DAX (30 German
companies), CAC (40 top listed French companies), and Nikkei 225 (225
Japanese companies listed on the Tokyo Stock Exchange).

Options
Example: "1 have the option to sell my cow to you for 10, delivery in a
month's time".

A call option is the right (but not an obligation) to acquire an asset in the 26-19
future at a price (the strike price) fixed when the option is entered into. The
usual effect of a call option is that the seller of the asset has to pay an
increase in price to the buyer (or transfer the asset which has increased in
value).
A put option is the right (but not an obligation) to sell an asset in the
future at a price (the strike price) fixed when the option is entered into. The
usual effect of a put option is that the buyer of the asset has to pay the
decrease in price to the seller (or buy the asset which has decreased in value).
In other words, in a call, you call for the profit or the more profitable
asset. In a put, you put the loss to the counterparty or put away the loss-
making asset. Call the profit, put the loss.
Confusingly, the person who is given the option is typically called the 26-20
"buyer" of the option and the person who grants him the option is called the
"writer" or "seller". These terms are non-legal vernacular. Thus the buyer of
an option is the "buyer" whether or not they have the option to buy or sell
under the contract.
An option is "in the money" (le profitable) it in the case of a put option,
the strike price exceeds the market price. Thus if the strike or contract price
of a currency option is £50 for $100, the option is in the money if the market
 432 SI(IAE. 1OI'j(S

price on the exercise date is £45. Conversely, if the strike price is less than the
market price, the option is "out-of-the money", ic loss-making. In such a
case the option-holder will not exercise the option but let it lapse.
A "European" option is exercisable only on a fixed future date by refer-
ence to prices on that date. An "American" option is exercisable on any day
over the agreed fixed period. A "Bermudian" option -so-called because it is
mid-Atlantic can be exercised on any one of a number of specified days. In
an "Asian-style" option, the price is based on an average price determined
over a number of future dates.

Example: In March, a Seller agrees with it counterparty that Seller will

have the option to sell grain to the counterparty for 100 (the strike price)
for delivery and payment in September. For this he pays a premium of
five to the counterparty. If in September the market price is 90, the Seller
would exercise his option to sell, and would thus make a profit of 10, less
the premium of live. The option is in the money. If the market price is 110
in September, the Seller would not exercise the option but let it lapse. He
has lost his premium of five but could sell his grain for 110 and so make a
net profit of five.

The same applies to options to sell currency, or borrow money (an interest
option) or to sell stocks comprised in a stock exchange index.
The exercise of the option does not result in an actual obligation to
physically deliver the asset against the full price in a derivatives contract, but
rather results in a contract to pay the difference between the strike price and
the market price on the exercise date.

26-21 Risks of buyer and seller The maximum loss that the buyer of an option
can suffer is the loss of their premium. Unlike a futures contract, they are
not committed to buy or sell but have merely the option to do so. Con-
versely, the seller of the option has an unlimited risk because the buyer can,
by exercising his option, insist on performance. Actually, the risk is the drop
in the price of the option to zero in the case of a put (limited risk), but
unlimited in the case of a call because only the sky is the limit to an increase
in price (theoretically). Hence speculators can expose themselves to risks far
greater than a wager: in the case of a wager, the money at risk is just the sum
wagered. Professionals usually hedge this risk by a matching or mirror
transaction in the market, as with reinsurance. The risk they then take is the
insolvency of the hedger or reinsurer.

26-22 Gearing Gearing is the potential of making a large profit out of a small
outlay. A trader can buy 100 of a currency he expects to appreciate. This
costs 100. They risk losing the 100 or part of it. Or he could buy an option to
buy the currency for a premium of 2 per cent. He only risks losing 2 per cent.
So his gearing is 50 (50 x 2 per cent 100) because he can take a bet 50
times the size of spending the full 100.
Thus if the currency goes up to 110, the buyer of the whole 100 makes a
gross profit of 10 per cent on his outlay. The buyer of the option makes a
profit of 500 per cent on his outlay.

6-23 Examoles of uses of options Options are an inexpensive way of investing.

 DERIVATIVES I 433

Example I: An investor who expects a rise in the price of currency or

securities or commodities can buy a call option for the assets for a pre-
mium which will usually be much less than the cost of financing the
purchase of the assets themselves (borrowing costs, brokers commissions,
registration costs, transaction taxes, custody charges). In addition, if the
investor bought the assets, he would be exposed to an unlimited sub-
sequent drop in their value. In the case of an option, he loses only the
premium. The transaction may also be confidential.
Example 2: An investor with a portfolio of equities included in a stock
exchange index of top shares (most stock exchanges include the shares of
[their] largest companies in an index so that one can tell if the top shares
are going up or down) might choose to buy a put option on the index
from a financial institution to protect himself against the value of his
portfolio falling. When the value of his portfolio decreases, there is an
increase in the value of his option. Unless the portfolio matches identi-
cally the shares constituting the index, the hedge would be imperfect.
Nevertheless, the put, if of a sufficient size, offers a degree of protection.
Example 3: A fund manager holding for investors a particular mix of debt
and equity investments may decide to increase the debt investments and
decrease the equity investments in the portfolio, eg because they think
that equities will decline in value. The fund manager can buy a put option
for equity so that if equity prices fall, he is paid the decrease. At the same
time, he buys a call option for bonds, so that if bond prices go up, they arc
paid the increase. The fund manager can replicate the performance of an
altered portfolio without incurring the expense and disruption of selling
any of the underlying investments and buying in others.
Example 4: 'rhe party which may have to deliver the asset under an option
can hedge his risk either by buying the asset at the inception of the
transaction (although often in the case of financial institutions they will
already hold the asset, eg securities) or by entering into a reverse trans-
action with a third party.

A shareholder may agree: not to sell his shares for a lock-up period; does
not wish to sell controlling shares; or does not wish to incur an immediate
capital gain by selling. In each case he can "monetise" his shareholding by
an equity derivative which pays him the value of the shareholding.

Credit derivatives
Example: "You will buy from me this 100 bond for 100 if the issuer 26-24
defaults on the bond"

The parties are similar in broad concept to those in guarantee transactions

but the terminology and transactions are different. A seller of protection
(roughly the "guarantor") agrees to pay the buyer of protection (roughly the
"creditor") an amount if during an agreed period a prescribed credit event
occurs signifying a problem, such as non-payment bankruptcy or insolvency
restructuring or rating downgrade, in relation to a reference obligation
(roughly the "guaranteed" debt) of a reference entity (roughly the 'principal
debtor"). In other words, the seller pays the buyer if the debtor defaults or
the creditworthiness of one of the debtor's loans or bonds declines
 434 SPECIAL TOPICS

materially. For this protection, the buyer pays the seller . a lee, which is
usually paid periodically.
If the credit event occurs, the seller of protection (the party assuming the
credit risk, like a guarantor) typically either pays the buyer of protecti on
(the party who wants the protection like a creditor receiving a guarantee) an
amount equal to the loss in value of the reference obligation attributable to
the credit event or more usually buys the reference obligation or an
equivalent obligation (usually called a deliverable obligation) at its nominal
value—like payment in full under a guarantee by the guarantor followed by
subrogation by the guarantor to the credit it has guaranteed. lithe seller of
protection takes over the reference obligation, the transaction is "physically
settled". If the seller of protection pays the difference in value without
taking over the reference obligation, It is "cash-settled".
The principal types of credit derivative are credit default products, as
outlined above. There are others, such as total return swaps and credit
spread options which are not dealt with here.

26-25 Comparison with guarantees The differences between a credit default swap
and a guarantee include:

o non-payment is not usually the only triggering event. It could be, say, a
rating downgrade or a restructuring (though usually the credit events
are limited to non-payment and bankruptcy, with restructuring as an
occasional third alternative-- -because a work-out is a lesser indication
of serious financial trouble and is less precise in definition);
the buyer of protection need not necessarily hold the reference obli-
gation, so that the protection is divorced from the protected asset,
unlike a guarantee which guarantees a specific debt owed to the ben-
eficiary of the guarantee;
o the transaction might he cash-settled---- -so there is no equivalent of
subrogation; and
o if the transaction is physically settled, the buyer may deliver to the
seller an obligation which is different from the initial obligation which
the buyer holds, ic a substituted subrogation.

26-26 Credit linked note issues In credit-linked note issues the amount which the :
issuer has to pay noteholders depends on the reference obligation--say a
bond of another issuer. Thus if the other issuer defaults on its bond during o ilp

the term of the note issue or becomes insolvent, the note issuer can elect to
redeem the note either by paying the value of the defaulted bond or by
transferring an appropriate number of defaulted bonds to the noteholder. In
the meantime the note issuer pays noteholders interest amounts equivalent
to interest paid on the bonds.
Note that the "guarantee" is "prepaid", ie funded, because the noteholder
pays the note issuer in advance on subscription of the notes. This is similar
to a funded bank loan sub-participation. The issuer has no credit risk on
noteholders because they have paid. Noteholders have a double credit risk---
issuer and reference entity.
Notes are used instead of private contracts because some investors. eg
 DERIVATIVES I 435

mutual funds, by regulation or internal investment policy can invest only in

listed securities.

Synthetic securitisations See para 28 •23. 26-27

Ex amples of uses of credit derivatives A bank can diversify its exposure by 26-28
selling protection without having to make diversifying loans--which would
take time and involve expense. Banks are major participants because their
job is assessing credit risks. Investors can buy exposure by investing in
credit-linked notes. Also if an investor thinks that a security will decline in
value it would traditionally borrow the securities from a securities lender,
sell them and then buy securities in the market--when hopefully they are
cheaper in order to repay the securities lender--this is called "shorting".
Instead of these transactions the investor can simply buy protection in
respect of the securities under a credit derivative so that it is paid if the
securities do fall in value.

Hedging Banks and others can hedge their exposure or risk by buying 26-29
protection. This may free up capital under the capital adequacy regime so as
to make room for further lending without having to raise fresh capital.
Companies with an exposure to a particularly risk country, eg because Of the
funding of a subsidiary in the country, can hedge this exposure by buying
protection in respect of bonds issued by that country--there is a mismatch
between the reference obligation (the sovereign bonds) and the actual
exposure (the inter-company loan). A hedge fund which holds equities in an
industry sector in a particular country can hedge that exposure by buying
protection on a selection of matching reference entities in that sector based
on rating down-grade credit events--again a mismatch.

Trading Market participants can trade in credit derivatives as assets so as 26-30

to earn a profit. Trading increases the liquidity of a market and hence its
capacity to engage in further transactions.

Hedging the hedge

Dealers who enter into derivatives trades with their customers also hedge 26-31
them with other dealers, le enter into a back-to-back mirror deal matching
the deal with their customer, as in the case of reinsurance.

Derivatives markets
Exchanges, OTC and primary markets
There are three principal markets for derivative products: 26-32

o OTC. The "over-the counter" markets are private transactions. The

term probably originally derives from buying groceries in the corner
shop over the counter and was used in the US in the 1870s to describe
the practice of buying shares over bank counters. These deals are
 436 SIEC!AL TOPICS

usually sold by banks. The OTC markets are much bigger than
exchange-traded markets.
o Primary markets. There are the new issues markets for primary offer-
ings of debt securities, eg equity-linked bonds, notes or warrants.
Primary offerings of equity-linked bonds, notes and warrants are
normally hedged with OTC or exchange-traded instruments.
o Exchanges. These are organised securities and commodities exchanges,
including the specialised futures and options markets.

Primary offerings
26-33 These are issues of debt securities, often listed, in the bond market which
carry a derivative feature. The security is said to have an "embedded"
derivative and sometimes these transactions are called "derivative secu-
rities". The main purpose of framing the derivative as a note is that the note
can be listed, thereby increasing the range of investors who can effectively
provide the protection: many institutional investors are limited to investing
listed securities, eg pension funds and mutual funds.

26-34 Examples: index-linked notes Here the interest or redemption amount of

the note bond is calculated by reference to the movements in a specified
index, eg a stock index or a commodity index.
Thus, an issuer issues notes to investors who pay for them. One note has a
principal amount of 10, and the issuer can redeem this note (repay it) by
paying the value of the shares of company x. On the issue of the notes, the
shares are priced at 10. On the maturity date, the shares are priced at eight.
So the issuer can pay eight instead of tO. lion the maturity date, the shares
are priced at 12, the issuer must pay 12, unless otherwise agreed or subject to
a cap.
Often the issuer can, instead of repaying cash, deliver the shares or other
reference asset.
Unlike an OTC or exchange-traded derivative, the noteholder pays the
full amount of the note in advance by way of loan since issuers could not
evaluate the credit of each noteholder in advance. It is as if the noteholder
had accepted a put option and immediately deposited collateral for its
obligations.

26-35 Example: warrants These are warrants attached to bonds or issued on their
own which are linked to an index, a single security or a basket of securities
or to a commodity index. They provide for cash settlement (payment of
differences) by the issuer by reference to levels of an index; prices of an
equity; debt security; a basket of such securities; or in the case of single
security or basket warrants, physical delivery of a security or basket of
securities. Index-linked securities are always cash-settled because it is
impractical to deliver the many shares comprising an index. A warrant is
essentially an option, but the term "warrant" is normally used in the context
of a primary offering. The subscription price for the warrant is equivalent to
ihe pteuiiuiil for the option. Although the holder has the credit risk that the
issuer will fail to perform, the value of the warrant itself is not related to the
credit of the issuer, but rather the external index.
 DERIVATIVE'S I 437

For example, an issuer issues call warrants relating to shares of company

x for an issue price of one. On issue, the agreed exercise price for the shares
is 10. On exercise by the warrant holder, the value- -or settlement price—of
the shares is 12. The holder can call upon the issuer to transfer to the holder
shares worth 12 against payment by the holder of the exercise price of 10.
Alternatively, depending on what is agreed, the issuer pays cash of two
and the warrant-holder uses this to buy the shares, if they so wish. This is
cash settlement. The issuer pays the difference between exercise and settle-
ment price, ie a contract for differences.
The warrant is "in the money", ie profitable to the holder. 26-36
If the shares on exercise are worth eight, than the warrant-holder would
not exercise the warrant to buy shares for 10 which are only worth eight.
The warrant is "out of the money", ie unprofitable.

Issuer hedge The issuer often protects itself against its liability on the 26-37
bonds or warrants by mirror hedging contracts in the OTC or exchange-
traded markets.

Listing As mentioned, the issues are usually listed, eg on the Luxembourg 26-38
Stock Exchange. The purpose of a primary issue which is listed is to enable
certain institutions (eg insurance companies, mutual investment funds,
pension funds) to invest they are often not permitted to invest in unlisted
or OTC investments. Normally the issues are not actually dealt in on the
exchange via members of the exchange but rather through financial
intermediaries.

Covered warrants In the case of a covered warrant the warrant relates to 26-39
existing securities or other property. The term is used to distinguish them
from warrants to subscribe for new securities.

Exchange-traded derivatives

Derivatives in the form of futures and options are traded on numerous 26-40
exchanges around the world, including specialised futures and
options exchanges—there are at least 30 major exchanges.
Exchanges are usually constituted by companies which are ultimately
owned by their members or by financial institutions. Typically all contracts
with the exchange must be between members and the exchange. The
members are traders whose credit-standing, competence and integrity have
been approved by the exchange. Outside investors must contract with a
member who then enters into an identical contract with the exchange.
Under the rules of the exchange the clearing house becomes the coun-
terparty of each party to the original trade. Each trade concluded on the
relevant exchange is first matched (ie the precise deal checked) either elec-
tronically or by the exchange, and then replaced by two trades: (1) one
between one party to the original trade and the clearing house, and (2) a
mirror trade between the clearing house and the other party to the original
trade. The object is to increase mutuality so as to enhance netting: see para
15 04.
 438 SPECIAL TOPICS

26-41 Advantages One may compare the advantages of exchange-traded dcii_

vatives in relation to OTC and primary market derivatives as follows:

o Liquidity. The terms of contracts and size of lots are standardised

leaving only the prices and transaction costs to be settled each time.
Hence liquidity is increased since the contract is more easily saleable
and the exchange facilitates a market. However, many OTC transac-
tions are quite commoditised and have standard documentation in the
interests of speed, to enable participants to hedge by matching trans-
actions in a chain which should, therefore, be on the same terms,
except price. Primary offerings are usually quite liquid with screen-
based quotes available from brokers but are not Liquid if specially
tailored to a specific situation or highly complex.
o Price transparency. Owing to the limitation to products in high demand
and because the exchanges must usually publish the price of trades
immediately, prices are readily ascertainable and are likely to he close
to the market price. OTC transactions do not have this advantage,
although many OTC traders do publish indicative prices. Regulation
typically requires prices to have been reached by fair methods and
there arc bans on insider trading, market manipulation and misuse of
confidential information, so the price is more likely to be the real price,
undistorted by price-rigging.
26-42 Coimterparty risk. The counterparty credit risk is minimised. Traders
do riot have to make a credit assessment of counterpartics since the
clr:iring.house lakes the risk from each trader. It is impracticable for
traders to make credit assessments of countcrpartieS when deals are
done quickly. The exchange's risk is mitigated as follows:
o Each member of the exchange has to provide "margin" (le col-
lateral) to the clearing house to the extent that its contracts are
out.ot-t he- money. The contracts are regularly "marked-to.
market" (le valued at current market prices) to determine the
margin required. Therefore, in theory at least, the clearing house is
not exposed to the credit risk of its members.
o The solvency of the clearing company may be further protected by
initial capital reserves and by guarantees and liquidity facilities
granted by its members.
In OTC transactions, the parties must deal with credit risk themselves,
eg by collateral. In primary offerings, the issuer does not take a credit
risk on noteholders because they pay the amount of the note in
advance.
o Netting mutuality. Since all trades between a trader and the clearing-
house arc mutual, the clearing-house can potentially net the contracts
on the insolvency of the trader, thereby reducing exposures. The
reduction in exposure is much greater than in OTC markets. This
exposure is less relevant in the primary markets. See para 15-04.
26-43 o Close-outs. Contracts of a trader can be easily closed out (assuming
sullicient liquidity in the relevant contract) by simply entering into a
reverse trade. Since the counterparty is the clearing house in each case,
the original and reverse trades are then netted. In contrast the close-out
 DERIVATIVES 1 439

of an OTC transaction generally requires countcrparty consent, which

may not always be forthcoming at an acceptable price. Close-outs are
impracticable with primary offerings.
Close-outs on exchanges are a useful way of fixing a profit or loss.
The participant "closes out" its position by entering into a mirror
reverse contract with the exchange before the settlement date so that
the obligations under the two contracts to deliver and pay can he
netted leaving only the price difference to pay one way or the other.
Example: In March a Seller agrees to sell a Buyer $100 for £50 for
delivery in September. In August the price of $100 for delivery in
September is £45. The Seller then enters into a reverse contract
with the Buyer to sell £45 (the current market price) for $100 for
delivery in September. Hence in September the Seller pays $100
and receives $100, receives £50 and pays £45. They makes a profit
of £5. The effect of the reverse contract is to fix his profit at £5 in
August. If they had waited until September, their $100 may be
been worth £55 in which case, by selling at £50 they would have
made a loss. In practice, many contracts on exchange are "closed-
out" in advance in this way.
o Administration. The clearing-house may administer the matching and
settlement of transactions. In OTC transactions the parties deal with
this themselves. In primary offerings the securities are usually traded
via a clearing and settlement system, such as Euroclear or Clearstrearn.

Disadvantages The disadvantages of exchange-traded derivatives corn- 26-44

pared to OTC and primary market derivatives include:

0 Standardisation. Exchange-traded derivatives are much less flexible

than OTC derivatives because they can only he traded in standard
trading amounts or "lots" and settled at set maturity dates, for
example, only in March, June, September and December in each year,
and because the range of products is limited to those for which there is
the greatest market demand.
o Concentration of risk. There is a substantial concentration of risk on
the central counterparty which is party to all market trades. Hence the
importance of the regulation of exchanges. Protecting an exchange is
an extra cost to its participants.

Other functions of exchanges If a contract is to be physically settled, the 26-45

exchange can assign the delivery notice to a seller member on a random
basis.
The exchange usually maintains market statistics, eg as to volumes.

For questions and seminar topics, see the end of chapter 27.
 CHAPTER 27

DERIVATIVES H

Documentation of derivatives and the ISDA form

Master agreements generally

27-01 In private over-the-counter markets, contracts may be tailored to the

occasion, but usually parties use standard master agreements covering all
transactions between the parties.
Each individual transaction is documented by an exchange of confirma-
tions, ic written memoranda recording the details of the transaction. The
confirmations incorporate the terms of the master agreements. Standard
forms arc commonly used.
By far the most important master form is the ISDA Master Agreement.
There are others, such as forms by national bank associations for domestic
use.
The ISDA Master Agreement can cover all types of transaction in all
markets but not for repos or stock lending -there are master agreements for
these transactions developed by other market associations. The ISDA
nasier agreement is usually subject to New York or English law.

Advantages of standard master agreements

27-02 The advantages of master agreements include:

o Legal safety. The terms have been considered in -depth and so are more
likely to be legally safe and sophisticated. Hence, market confidence.
Party capacity to do deals, corporate authorisations, netting avail-
ability and collateral validity, can be settled in relation to all deals in
advance. There are likely to he more judicial decisions on standard
forms, and therefore more predictability.
a Documentation. There is a massive saving of time and expense com-
pared to documenting each transaction separately. Contract
standardisation is essential in fast-moving markets with huge volumes.
Standardisation discourages non-essential variations.
a Netting. A master agreement can improve the efficacy of netting, enjoy
the benefit of formal legal opinions from the major jurisdictions (as
with ISDA) and receive the approval of regulators for this purpose.
e Familiarity and trading. Many institutions are familiar with the stan-
1ard Therefore, this promotes speed kind liqi.iidity of sale.

a Matching. It is easier to match hack-to-hack transactions because of

stand a rd i sat ion.
 DERIVATIVES II 441

ISDA Master Agreement

ØackgrOUfld This ISDA Master Agreement is probably the most remark- 27-03
able standard form ever devised in view of the immense range of
transactions that it covers, the gigantic amounts which rest on its provisions
and the width of its use by the market. It is a worldwide standard for
international and local deals.
The idea of the ISDA form is to settle the common terms likely to apply
to most transactions and to leave the terms of particular deals to be settled
in dividually in contract entered into on each occasion and evidenced by
"confirmations" agreed by the parties. In order to streamline these con-
firmations, ISDA has produced booklets of definitions to save the parties
having to write things out each time. These definitions range from
mechanics such as a definition of a business day for when payments can be
made to intricate legislation of adjustments to shares which change their
character. They are a financial dictionary of short-hand phrases.
The first ISDA standard appeared in 1987. This was replaced in 1992-
here there were two forms: a multicurrency cross-border form and a single
currency local form. The latter was little used and so the division was
dropped in the 2002 form. This commentary deals only with the 2002 form.
The heritage of the form was the commercial bank term loan agreement 2744
and indeed the overall architecture and the types of clauses will be familiar
to anybody familiar with term loan agreements. Thus it has equivalent of
representations, covenants, events of default and the usual boiler-plate
bespeaking its origin. Crucial differences are that the actual terms of each
deal are contained elsewhere (in the confirmations) so that the master is the
skeleton not the body, that the clauses are reciprocal, eg the events of
default apply to both parties, and that, since it covers a multitude of con-
tracts between the parties, set-off and netting to reduce. exposures are a
central preoccupation.
Set-off and netting are discussed in chapters 14 and 15. Where there are a
series of contracts between the parties, then on the insolvency of one of
them, it is desirable to reduce all the exposures of the non-defaulter to a
single net amount. If a party becomes insolvent the non-defaulting party
must be able to terminate all open contracts, calculate the loss or gain on
each contract and set them off. Cancel, calculate, set-off. For this to be
possible, there must be no insolvency legal prohibition on a party cancelling
contracts or on insolvency set-off.
There are Users Guides published by ISDA and a considerable number of
useful manuals on the detail of the documentation and how to negotiate it.
The master agreement displays a number of options which can be selected
in the schedule. It is also of course possible for the parties to vary the master
via the schedule and they commonly do.

Summary terms of the ISDA master The following is a summary. 27-05

o Recital. All transactions between the parties are governed by this master
agreement:

o Interpretation. This master and all transactions under it area single

agreement. For the purposes of this connexity clause, see para 14-37.
 442 SI'[(IA L R)I'I( S

o Obligations.
(a) Each party will pay or deliver as specified in each confirmation,
but only if there has been no (potential) event of default or
election to terminate.
(h) A party may change its payment or delivery account by notice
subject to reasonable objection by the other.
(c) Payments in the same currency under the same transaction falling
due on the same day will be netted. For settlement netting, see
para 14 06.
(d) Each party will gross up for taxes which must he deducted from
payments, subject to conditions.
27-06 o Representations. Each party gives representations as to its status,
powers, non-conflict with laws, constitution or contracts, official con-
sents obtained, legal validity, no (potential) events of default or
termination event, no material litigation, accuracy of scheduled
information, tax representations correct, and no agency.
o Agreements. Each party will furnish the agreed information, maintain
authorisations, comply with laws, notify the other if its tax repre-
sentation becomes untrue, and pay stamp taxes.
27-07 o Events of default and termination events. The following are events of
default:
Q failure to pay or deliver,
breach or repudiation of agreement.
default in relation to credit support,
o material misrepresentation,
o default under derivatives transactions hetvicen the parties and their
related parties ot default under borrowings and guarantees of
borrowings. (For this cross-default, see Para 9.03.)
o bankruptcy, and
merger without the new entity assuming the obligations under the
master ("merger without assumption").
27-08 a The following are termination events (they are separated from events
of default because they do not involve defaults, but nevertheless justify
the other party in terminating):
e illegality,
o force majeure (the definitions booklets have further examples, such
as market disruption and exchange controls),
o change of tax law resulting in tax grossing-up or a payment from
which tax has been deducted ("tax event"),
o merger resulting in tax grossing-up or a payment from which tax
has been deducted ("tax event upon merger"), and
o merger, change of control or debt incurrence materially weakening
credit ("credit event upon merger").
7-09 o Early termination and close-out netting.
an event, of default or termination event occurs in relation to one
party, the other party may terminate.
o The relevant party (such as the non-defaulter) calculates the losses
 DERIVATIVES II - 443

and gains on each terminated transaction and sets them off,

together with any amounts which were already due, so that only a
net amount is payable. (For close-out netting, see chapter 14.)
o A non-defaulter has a right to set off other non-agreement sums
against the early termination amount.
o Transfers. Neither party can transfer its rights or obligations
without the consent of the other, subject to exceptions.
o Miscellaneous. Various boiler-plate. Default interest. No change of
contracting offices. Governing law, jurisdiction. Waiver of sovereign
immunity. Definitions.

Schedule 27-10

e Adaptions to events of default and termination events.

o Tax representations.
o Documents to be provided, eg corporate authorities and accounts.
o Miscellaneous.
o Other agreed modifications.

For detailed commentary, see LPIF vol 4 para 12-003. Chapter 12 also
includes a commentary on the documentation of the various types of
derivatives.

Legal aspects of derivatives

This section reviews selected legal aspects of derivatives transactions. 27—I I

Validity of oral contracts

Contracts in the OTC market are often made orally by dealers over the 27-12
telephone. It is usually intended that a binding contract arises immediately,
not when electronic or fax confirmations are exchanged or when more
formal documentation is signed by the parties.
A binding oral contract will usually arise at the time a transaction is
concluded by dealers on the telephone, assuming that there is sufficient
agreement at that time on all the essential terms of the transaction and they
intended that there would be a contract (as is usually the case and is usually
presumed). If there is a fundamental mistake of fact, the contract may be
invalid and usual contract doctrines apply, eg restitution of money paid.
A subsequent e-mail or fax confirmation of the deal simply evidences the
oral agreement, although it could vary or supplement the original terms.
Any variation or supplement would have to be agreed by each party.
The international tendency is to dispense with formalities in commercial
contracts. No writing is required For these transactions under English or
Netherlands law, but guarantees and related obligations must in England be
in writing: see the Statute of Frauds 1677 s 4. In 1994 New York abolished
 4.44 SI'L(IA1-TOPIC'S

the writing requirement in certain cases. Note the adoption Of C-COfllmcrce

statutes in many states.

Capacity

27-13 The powers of corporations to enter into derivatives may not he available if
their corporate charters pre-dated the derivatives markets. Corporate law in
advanced countries provides protections to third parties against ultra vires
transactions, but these may not protect the directors.
Some specialised bodies may not have limited capacity to enter into
derivatives transactions, cg statutory corporations, building societies and
similar savings institutions, insurance companies, municipalities, pension
funds, trusts, mutual funds, charities, and international organisations.
Regulatory restrictions may also limit the capacity of some institutions to
enter into certain types of derivatives contracts in order to reduce insolvency
risks, especially insurance companies and regulated collective investment
schemes.

In Haze/I r Ham,ners,niih and Fulham London Borough Council [1992] 2

AC 1, 1-IL, interest swaps were held to be ultra vires UK local authorities
and therefore void. The municipality had hundreds of swaps, and a
massive loss which rate-payers would have had to pay. This celebrated
case led to the commencement of nearly 200 actions and gave rise to it
number of major cases on the liability of the parties to make restitution
for benefits received under ultra vires contracts. and on the effect of it
mistake of law.

Set-off and netting

27-14 Set-off and netting is at the heart of the reduction of exposures in derivatives
markets and a major preoccupation of master agreements.
In order to reduce exposures set-off and netting must be valid on the
insolvency of the counterparty and must also be valid against interveners,
such as attaching creditors who take over one of the claims.
Set-off is the setting-off of debts. Close-out netting is the cancellation of
open executory contracts, the calculation of losses and gains either way and
the set-off of those losses and gains. Settlement netting is the set-off of
reciprocal delivery obligations of the same asset which fall due for delivery
on the same day.
Set-off and netting are reviewed in chapters 14 and 15.

Margin and collateral

27-15 Derivative transactions may he supported by security, usually called

"margin". For OTC transactions, ISDA has developed standard forms for
providing collateral in the form of investment securities (Credit Support
Annexes). The main exchanges commonly require security.
The collateral is usually in the form of highly-rated debt securities or cash
 DERIVATIVES 11 445

or bank letters of credit, ie very liquid and highly marketable. Most margin
is in the form of a cash deposit--perhaps 75 per cent.
"Initial margin" must be provided at the inception of the transaction to
cover potential risks. "Variation margin" must be provided if market rates
on the transaction would cause a loss to the investor if the transaction were
closed out immediately. Valuing a transaction according to fluctuations in
market rates is known as "marking to market". Margin usually has to be
provided on very short notice, and sometimes several times in the day if
prices are falling rapidly. If a party does not provide margin, the other party
can typically close out the transaction immediately under the terms of the
contract.
Many countries have express Statutes to enhance set-off against cash
deposits, to enhance netting between sale and repurchase transactions, and
to protect collateral in financial markets.

Regulation of derivatives

Regulatory regimes contain rules as to: 27-16

o The authorisation of entities which deal in derivative products so as to

monitor the solvency, competence and honesty of the dealers. In the
EU, dealers in financial derivatives must be authorised.
o The conduct of business by traders, eg suitability of the transaction for
the investor, cooling-off periods, content of financial promotions,
misleading statements, negligent advice, inadequate documentation,
conflicts of interest, risk warnings, disclosure of charges, and segre-
gation of client money and assets. The rules are relaxed for
transactions between sophisticated investors. There is an elaborate
regime covering most of these matters in the Markets in Financial
Instruments Directive 2004 and subsequent implementing legislation.
See chapter 22.
o Promotion of derivatives, by advertisements or offering circulars.
Again, the rules are relaxed for transactions between sophisticated
investors.
a Capital adequacy, ic the amount of capital which authorised institu-
tions must maintain against exposures on derivative contracts so as to
protect the state and investors against systemic risk resulting from an
insolvency, ie ripple, domino or cascade risk and investors against
insolvency losses. The markets on which derivatives are based, eg
securities and commodities markets, are prone to sudden and volatile
price movements so that the value of derivatives contracts can change
very quickly. A change in the underlying market could affect a much
wider range of dealers who have entered into derivatives related to that
market. International capital adequacy rules are based on a version of
the principles promulgated by the Basel Committee on Banking
Supervision, a committee of the BIS. Sec chapter 25.
o Criminal conduct, eg rules against deception, market-rigging, false
markets and insider dealing. Sec chapter 24.
 446 SI'1(tAL IOl'ICS

Some regulation seeks to control speculation SO as to protect unsophisticated

investors and to limit bubbles. This is the territory of anti-gaming laws.

Gaming
27-17 Contracts for differences and swaps may be deemed to be gaming or
wagering contracts which arc void under gaming laws. These were originally
intended to protect individuals, to control speculators and are now out-of-
date. Often the position depends upon whether the parties truly intended a
commercial sale or borrowing contract as opposed to it contract for dif-
ferences and, if it is it contract for differences, whether at least one party had
a legitimate commercial interest to protect, eg hedging, and is not merely
speculating.
Many states have introduced exceptions to gaming laws in order to
facilitate markets (originally stock exchange and commodity markets) and
to remove the threat of nullity. The rationale is either there is a satisfactory
alternative system of protection or the contracts are entered into between
sophisticated institutions who do not need the protection of gaming
legislation.
Countries which have exemptions, notably for contracts on exchanges or
for sophisticated counterparties include: Belgium (1934, 1939); France (1885
legislation exempting futures contracts extended to derivatives 1985, 1993);
Germany (Stock Exchange Act 1896 as amended); Netherlands (1986); and
the United Kingdom -sec the Financial Services and Markets Act 2000,
s 41 If which generally exempts contracts where one party enters into them by
way of business. The Gambling Act 2005 in Britain provides for the licen-
sing of gambling businesses, but exempts businesses regulated by the
Financial Services Authority. In most cases in Britain derivatives transac-
tions will not be a "bet" and will fall outside the Gambling Act. However,
there are many gaps in the international protection.

Insurance regulation
27-18 Insurance business requires official authorisation in most commercial states.
Some derivatives contracts are literally similar to insurance because one
party pays a premium in return for the agreement of the other party to pay
on a future event which may or may not occur. The distinctions are not easy
to draw when faced with the usual black-letter statutory definitions of
insurance, framed prior to the development of derivatives. The consensus
view is that normal derivatives contracts are not strictly insurance.
Apart from the necessary technical explanations, the underlying rationale
for excluding derivatives from insurance company regulation is threefold:
first, derivatives dealers are not within the remedial purpose of the legisla-
tion. Market dealers are not like insurance companies conducting
conventional insurance business with members of the public exposing the
public to long-term risks, eg under life endowment or pension policies.
Secondly, derivatives dealers are regulated by banking or financial services
legulanon. Thirdly, dual authorisation as insurers would cause duplication.
In Britain, insurance business does not require authorisation if it is carried
on solely in the course of and for the purpose of banking business—because
 DIiKIVA1IVES ii - 447

banks are supervised separately. Evidently US insurance regulators do not

consider core derivatives business to be insurance business.

Legal liability

A derivatives trader may incur legal liability if it has duties as adviser to its 27-19
customer, eg because the trader holds itself out as advising the customer.
There may be a duty under the law of agency, contract or tort, but it depends'
on the facts. There will usually also be regulatory duties, eg to non-business
customers, such as private individuals, under the Financial Markets and
Services Act 2000 or equivalent regulatory statute.
There may also be legal liability if a trader misrepresented the market or
benefits or documentation to the customer, who relied on the mis-
representation. Consider the general law of misrepresentation in contract
and tort, especially whether a forecast can be a misrepresentation. Banks
can be liable for negligent misrepresentation: see Hedley Byrne v Heller &
Partners [1964] AC 465 (negligent credit reference).
The English courts are slow to impose implied duties on banks to advise
customers about the prudence of a transaction, ie the customer should take
its own advice. The general rule is that banks are under no duty to advise on
the prudence of a transaction from the customer's point of view, unless the
bank clearly undertook to advise the customer. For English and US case
law, see para 22-05.
Dealers usually endeavour to obtain confirmation from sophisticated 27-20
counterparties to the effect that: (I) the counterparty relies on its own
independent judgement and not on the dealer or on any statements about
the transaction made by the dealer, (2) the counterparty is able to assess the
merits of the transaction, and (3) the dealer is not a fiduciary or adviser to
the counterparty. There is standard language in the ISDA master agreement
in the schedule.
The efficacy of these exclusions depends upon the circumstances and on
contract, tort and statutory rules restricting exculpations. In England, the
Unfair Contract Terms Act 1977 is typical in limiting exclusion clauses in
certain cases--they must be reasonable. Best practice is to check suitability
and to ensure the client has proper independent advice, where appropriate.
Almost invariably, suitability duties will be mandatory under regulatory law
in the case of unsophisticated investors.

Non-legal risks

It is worth tabulating some of the non-legal risks involved in derivatives 27-21

trading, though some of these are legal or mixed risks.

Financial risks

Large exposure if markets move against a party. 27-22

e Collateral insufficient.
 448 SI'tIAI. fOI'ICS

O Liquidity the market will not Lend to a party over-exposed on its

derivatives, especially if the market is in free-Fall.
o Imperfect matching— hence imperfect hedging. Examples arc: payment
date mismatches on interest swaps; mismatch of the actual credit
exposure (loan); and the reference obligation (bond) in credit
(lcriva lives.
o Complex mathematical valuations may give false predictability to what
is essentially a prophecy.

llnsollvettcy risks

27-23 o Counterparty becomes insolvent. Take collateral?

Credit evaluation of firms which have large derivative activities is
difficult, either because the transactions are off-balance sheet or
because values move so quickly that the balance sheet is obsolete.

Regulatory and reputational risks

27--24 o The transaction is not authorised by the regulator. There are sanctions
on contravening dealers, eg criminal or regulatory penalties. civil lia-
bility, and invalidity of transaction.
o Conduct of business rules are contravened. eg a suitability rule, conflict
of, interest, negligent advise.
o Transaction is void gaming.
o Criminal contravention, eg market manipulation, insider dealing, and
market abuse.

4
Operational risks
27-25 o Paperwork not maintained. Wrong completion of schedules or
confirmations.
o Settlement bottlenecks and market disruptions, eg suspension of
trading, emergencies.
o Inadequate monitoring of risks (audit and IT systems).
e Inadequate understanding of transaction (intellectual risk).
® Employee fraud and unauthoriscd dealings.

Further reading: LPIF vol 4 chapters 10 13; Simon Firth, Derivalives Law
and Praclice (Sweet & Maxwell, looseleaf); Schuyler K. Henderson, !Ien
derson on Derivatives (Lex isNexis 2003).
 QUESTIONS AND SEMINAR TOPICS 449

QUESTIONS AND SEMINAR TOPICS

Chapters 27 and 28
(I) You are advising an investment bank which is proposing to sell a [liii
range of derivative products to its large corporate customers. The
bank will not sell these products to its consumer customers. Advise
your client as to the main legal and regulatory risks involved in the
proposal. In what ways can your client try to reduce these risks?
(2) "Derivatives are toxic weapons of financial mass destruction." Do
you think that this statement is justified in relation to the legal risks of
derivatives?
(3) Why do you think the master agreement of the International Swaps
and Derivatives Association master agreement is so successful? How
does it reduce risks in the use of derivatives? Are there some legal
risks which it cannot reduce?
(4) Compare and contrast the principal legal aspects of the three main
markets for derivatives, ie:
exchange-traded derivatives;
• "over the counter" (OTC) derivatives; and
o primary market issues of derivative securities.
(5) Pushy Bank suggests to its customer, which is a large corpore
pension fund, that it will "help it develop a programme" of hediug
against various interest rate risks and that Pushy Bank has "special
expertise in this area". Pushy Bank enters into a complicated interest
rate swap with the pension fund which Pushy Bank said that in its
opinion was "favourable" to the pension fund and "quite safe".- In
fact interest rates move very sharply and the contracts turn out to he
disastrous for the pension fund, but highly profitable for Pushy Bank.
The pension fund had signed a disclaimer with Pushy Bank which
stated that the pension fund relied on its own investigations and was a
sophisticated customer, that Pushy Bank owed it no fiduciary duties
to advise it and was not responsible for any representations made.
The contracts are governed by English law.
The trustees of the pension fund arc potentially liable to compen-
sate the pension fund for their negligence in entering into these
interest swaps and hope to recover damages against Pushy Bank or
alternatively to have the interest swap contracts declared to be void.
You are asked to advise the pension fund trustees. Suggest as many
defences and lines of attack against Pushy Bank that you can think
of, good or bad, to protect the trustees and advise on their likely
success in law.
 C1-IAPTER 28

SECURUHSAT!ONS

What is a securitisation?
Summary of securitisations

28-01 The basic classical transaction is as follows: an owner of receivables (the

originator or seller) sells receivables to a third party (the purchaser or special
purpose company or SPy). The purchaser borrows money to finance
the purchase price and repays the borrowing out of the proceeds of the
receivables bought by it. Hence the traditional securitisation is essentially a
sophisticated form of factoring or discounting of debts.
The transaction may he summarised in more detail as follows:

o An originator of receivables, such as home mortgage loans or con-

sumer credit receivables, sells the receivables to a specially formed
company (SPV) in return for a purchase price payable immediately on
sale. Originators arc typically banks or corporates since these com-
monly OWfl receivables from their activities.
o The SPy finances the purchase price of the receivables by a conven-
tional bond or flOtC issue to sophisticated investors or (unusually) by a
hank loan. The SPy grants security to the investors over the recei-
vables to secure the borrowing.
o The SPV authorises the originator as "servicer" to collect the recei-
vables on behalf of the SPV which uses them to pay principal and
interest on the notes (investing the proceeds in the meantime). The SPV
pays a servicing fee to the servicer.
28-02 o The SPV is usually a thinly-capitalised single-purpose company whose
shares are held by somebody other than the originator, eg charitable
trustees, so that the SPV is not a subsidiary which must be consolidated
on the originator's balance sheet. Since the SPV is a separate legal
entity, the originator is not responsible for its obligations.
o In order to ensure that the receivables are sufficient to repay the
investors on time, there may be various forms of "credit enhance-
ment", eg a third party may give a guarantee to the SPV or the
originator may agree to make a subordinated loan to the SPV, or the
SPy may retain part of the price for the receivables until the notes are
repaid.
o The notes are often rated by a rating agency. Usually the loan has a
hlighcr .;..,.-.LIaLaa
.i............ I.I L-.._ ..l..s...,..kI.-. C ............
a.aLaSJ I%..?(JLttIIa.A(II.. 101 U
a
WILk..t
I...., a..
al.
tUlt LJ LLt
......
aab

natur because the investors look only to the receivables, not the general
credit of the originator.
 S.J(:URITtSATR)NS I 451

• The SPY pays surplus income from the receivables, which is not needed
to repay the notes, to the originator so that the originator takes the
profit. The SPV may pay this profit to the originator as servicing fees
or a high rate of interest on a subordinated note or other means.

One economic effect is that the originator raises money from investors on
the security of the receivables and continues to retain any surplus of the
receivables just as if it had granted a security interest over them. Under a
security interest, the secured creditor must return any surplus not needed for
re payment of the secured loan to the debtor. But in a securitisation the
originator transfers the risk of non-payment of the receivables to the
investors and removes the assets and the loan notes from its balance sheet:
the loan is not a liability of the originator but of the SPy. In the case of a
direct loan to the originator, rather than the SPV, the originator would be
liable to repay the notes if the secured assets were insufficient.
The term securitisation is used because in substance non-marketable 28-03
assets—the receivables- -are converted into marketable assets represented
by securities---the notes: the lenders can sell their notes secured on the
receivables.
It will be seen that the above classic securitisation has flowered into many
different varieties.

Origins of securitisations
The factoring or discounting of receivables by specialist factoring companies 2-04
was well established in the nineteenth century. Companies could sell their
trade receivables to a factor, either on the basis that the factor bore the risk
of non-collecti bill ty or on the basis that the seller guaranteed collectibihty.
These sales were often treated as true sales and not as security interests
and therefore avoided adverse legal rules as to security interests, eg enfor -
cement restrictions and usury. This was so, even though in commercial
substance the sale had a similar commercial effect to a security interest.
Recharactcrisation remains a problem in relation to sccuritisations in some
jurisdictions.
The main difference between factoring and securitisations is that the
factoring companies were not single-purpose companies which issued bonds
secured on the receivables. It is impracticable for multiple lenders to hold
pro rata portions of each receivable. The amounts involved require multiple
lenders. So in a securitisation, the originator sells the receivables to a single
purpose company specially formed for the occasion and this company
finances the purchase of the receivables by an issue of marketable bonds.
Thus the receivables are transferred to a SPy for the lenders, not to the
lenders direct. It is often impracticable for multiple lenders to hold pro rata
portions of each receivable.
Modern securitisations began in the US in the 1970s. Two US govern- 28-05
ment-sponsored agencies, the Federal Home Loan Mortgage Corporation
("Freddie Mae"), established in 1970 and owned by US savings institutions,
and the Federal National Mortgage Association ("Fannie Mae"), estab-
lished iii 1936 and listed on the New Yoik Stock Exchange, would acquile
home mortgages From lending institutions and issue securities backed by
pools of these mortgages. The Governmental National Mortgage
 452 SPECIAL. TOPICS

Association ("Ginnie Mac") guarantees certain securities backed by pools

of home mortgages. US investment banks set up trading departments to deal
with Ginnie Mae paper. Subsequently banks established securitisations for
their own home loans, beginning around 1977 (Bank of America). The first
non-home loan deals were launched in 1985 in the US.
Since then, the growth in securitisations has been dramatic. The two
largest asset classes are home mortgage loans and consumer receivables
(autos, credit card receivables).

Jargon

8-06 A common generic term for securitisations is asset-backed securities (ABS).

Subdivisions include:

o collateralised loan obligations (CLOs): typically where the receivables

are bank loans;
o collateralised bond obligations (CBOs): typically where the receivables
are bonds;
o collateralised debt obligations (CDOs) -a group term for the above
collateralised loan and bond obligations as well as other claims;
O commcrcal mortgage-backed securities (CM BS): the receivables are
loans secured by mortgages of commercial property; and
residential mortgage-hacked securities (RMBS): the receivables are
loans secured by mortgages of residential property; and
o non-performing loans (NPLs): delulted bank loans.

The jargon is short-form financial -vernacular used by practitioners and, like

most slang, can he ephemeral.

Main requirements in summary

8-07 If a securitisation is to be feasible, certain minimum requirements must be
satisfied. These are usually:

e Credit. The receivables must be sufficient to cover the notes issued by

the buyer to finance the purchase price. Any shortfalls or mismatches
must be covered, eg by guarantees or other credit enhancement.
o Saleability. It must be possible for the originator to transfer the
receivables to the buyer without expense or formality or the consent of
the debtors or a serious risk of debtor set-offs.
o True sale. The sale must be treated as a complete and final transfer of
the receivables from the originator to the buyer so that the receivables
are no longer assets of the originator and the financing notes are not a
liability of the originator for the purposes of:
(a) bankruptcy of the originator. The sale must not be revocable on
the bankruptcy of the originator, eg by virtue of fraudulent
 SECURITISA11ONS i 453

preference rates, and the SPV must be treated as a separate legal

entity and not part of the originator (no "bankruptcy
consolidation");
(b) accounting rules applicable to the originator (off balance-sheet);
(c) regulation regulating the originator (capital adequacy); and
(d) the rules regarding security interests, ie the transaction must not
he recharacterised as a security interest granted by the originator.
e The rules determining what is a true sale are different in each case.

Other restrictions It must be possible to set up the transaction without

other burdensome restrictions or expenses, eg under tax laws or securities
regulation.

Typical documents in summary

The usual documents for a classic securitisation are as follows: 28-08

Funding loan documentation (note issue documentation, commercial

paper documentation, offering circular).
a A transfer agreement between the originator and the SPV covering the
following: the sale of existing receivables; the sale of substitute recei-
vables; representations and warranties as to the receivables (validity,
eligibility, no set-offs, status of security, etc.); an obligation on the
originator to repurchase for breach of warranty; and a right to
repurchase in other circumstances, eg the final stump amounts.
o An administration agreement between the originator and the SPV
covering the following: the setting of interest rates; arrears and
enforcement procedures; the investment of SPV surplus cash; termi-
nation on an administrator default; administration fees; liability for
acts or omissions; insurance against error and employee fraud; and
provision for a successor administrator.
• Credit enhancement documents between a credit enhancer and the SPV,
eg a guarantee, letter of credit, surety bond, pool policy, or sub-
ordinated note.
o Security trust deed whereby the SPV creates security in favour of the
trustee over all the SPV's assets (mainly the receivables, the transfer
agreement and the administration agreement) to secure the creditors
providing the funding loan.

Tranching

Tiering or tranching of the notes is extremely common, eg the issue of senior 28-09
and junior notes. Junior notes carry interest at higher rates. The object is to
rca. Li
available r...........i . ...
that, 1flC LIIC first• loss
u1Id1ILL dilu LO C bui uld IU i
t)tJI
.. . IIL
-
by the junior notes, the senior notes can be rated AAA. Junior notes appeal
to speculative investors. The security inteests are ranked.
 454 SI'N('IAL iOIICS

A typical tranching of bonds of 100 with their ratings might be as follows:

93 AAA
3 AA
1 A
I BBB
2 Unrated; retained by originator (the
"equity piece")
l00

The effect is that losses must he 7 per cent before the senior AAA tranche is
prejudiced. Some securitisations have many more hers than this.
These securitisalions provide that the proceeds of the receivables are paid
in a sequential order from senior to junior notes in accordance with a
waterfall clause. It is also stated that: (a) the noteholders have no recourse to
any assets of the SPV other than the collateral, and (h) only the trustee can
enforce, except as otherwise directed by bondholder resolution. The effect,
therefore, is that the noteholders look only to the collateral in the prescribed
order and, if the collateral is inadequate, then they have no claim against the
SPV. This reflects economic realities because the only assets which the SPV
has are charged to the noteholders and, if there is no collateral, then there is
nothing.

Receivables and other securitised assets

2--l0 Theoretically, any kind of asset can he securitised. Common examples arc:
home mortgage loans (the most common historically); commercial property
mortgages; consumer receivables (car, boat and truck loans, credit card
receivables, TV rentals, health care receivables, and telephone charges);
trade receivables; equipment leases, eg aircraft or marine container leases;
bank loans (sovereign debt, project finance loans); bond portfolios; and
government revenues, including delinquent tax receivables. Single debtor
receivables have been securitised.
The number of debtors varies greatly, hut, apart from repackagings of
single issuer bond issues, would often be high. A range of 5,000-10,000
would he usual for home loan mortgages, 20,000 for auto and consumer
loans, and much more for credit card receivables. The number of com-
mercial bank loans to corporate customers might be in the range of 50-100
or more.
Some important differentiating features between these various types of
receivables which impact on the documentation are:

o The assignability of the receivables and requirements for notice of the

sale to the debtors concerned (see below).
o The collectibility of the receivables and whether they are secured, eg
home mortgage loans have better recovery rates than unsecured credit
card receivables (this affects the credit-standing of the purchaser).
o Whether the receivables bear interest and the rate of interest. Thus
trade receivables do not normally bear interest and credit card
 SECURITISATIONS 1 455

receivables normally carry interest only after the first month. The
interest may be fixed or floating, eg bank loans, home loans. The dif-
ference between wholesale market rates and the rate of interest on the
receivables determines the excess spread or margin available to cover
defaults—typically low on bank loans and high on credit card
receivables.
• The standardisation of the documentation covering the receivables (it is
usually too expensive to study them all).
• The life of the receivables. Home mortgage loans often have a nominal
life of 10-25 years, but an average life of five to seven years because of
prepayments. Consumer credit receivables tend to have a life of 30- 90
days so they need to be constantly topped up by fresh sales to the SPV.
The SPV uses the proceeds of repaid receivables to buy new recei-
vables. Trade receivables often have a life of 30 days—but car loans
may have maturities of five years perhaps. Bank loans are typically
prepayable at the option of the borrower, but bonds usually are not.
The payment of non-performing loans (defaulted bank loans) is irre-
gular and often depends on the negotiation of insolvency plans. If the
payment stream is not smooth or is unpredictable, then credit
enhancement will have to be provided to the SPV to compensate for
the volatility, eg a liquidity loan facility.
o Simplicity, eg home mortgage loans are easier to securitise than, say,
complex project finance loans.
o The defences available to obligors. For example, set-offs for defective 28-1 11
goods may weaken trade and consumer debts. The originator may have
maintenance obligations in relation to leases of land or equipment
which, if not performed, may result in set-offs against the receivables
and problems of providing alternative maintenance if the originator
defaults. Consumer protection laws and guidelines may affect credit
card receivables and home loans.
o Diversity of the debtors in respect of the receivables ("granularity").
Diversity Lends to reduce risk.

The criteria for eligible home loan receivables typically relate to the security,
the loan to value ratio, minimum loan size, debtor income multiples, sea-
soning, geographical dispersion, and buildings insurance. There may he an
audit of a sample.
Securitisations of other assets are possible, such as office buildings, stands
of timber and oil and gas properties.

Objectives of originator

The objectives of these transactions to originators fall into three main 28-12
groups: (1) accounting advantages; (2) capital-raising advantages; and (3)
regulatory advantages. Tue conveigelice 01 these thee has been a great
stimulus to the development of the securitisation market from the early
1980s onwards.
 456 SPECIAL TOPICS

Financial accounts
8-13 Sccuritisation can result in an improved balance sheet for the originator as
seller. If accounting rules permit, the seller can raise money without the loan
appearing on its balance sheet and still keep the surplus from the sold
receivables as profit. The cash price received by the originator as seller is
used to pay the seller's liabilities, so the seller has less assets and less
liabilities and hence more borrowing room. Its financial ratios are improved,
eg a debt to equity ratio (gearing). Return on capital is improved, because
the seller has removed the asset and liability from its balance sheet, but still
retains the profit.

Example: The seller has receivables of 1000 and borrowings of 800. The
seller sells 200 of the receivables and uses the proceeds to repay bor-
rowings so that its assets are now 800 and its borrowings 600. The cover of
assets compared to liabilities (leverage or gearing ratio) has increased from
125 per cent to 133 per cent.
The receivables bear interest at 10 per cent and the borrowings at 8 per
cent. Before the sale, the seller has net interest income of 36. After the sale
and repayment, the seller has net interest income of 32 but earns fees of
another 10 for servicing the sold receivables, so that net income is 42.
Before the sale, net income was 3.6 per cent of assets. After (he sale, it is
5.25 per cent of assets• - a dramatic improvement in return on assets.
Before the sale, interest income was 1.6 times interest expense. After the
sale, interest income is 2.2 times interest expense, hence improving the
interest cover ratio so that EBITDA is improved (earnings before interest,
tax, depreciation and amortisation).

28-14 Capital raising

Securitisation frequently has advantages in relation to capital-raising by the
seller.

o Excess spread. The interest received by the SPV on the receivables is

often much greater than the interest which the SPV has to pay note-
holders plus the transaction expenses. The originator ultimately
receives this excess spread by the various methods of profit extraction
discussed at para 2841, assuming that the receivables do not default.
Often the originator will receive this excess spread by holding the most
junior subordinated note issued by the SPV which carries a very high
rate of interest so as to mop up this excess spread. There is an excess
spread because the interest payable to the noteholders is lowered for
the reasons given below in relation to cheaper capital.
o Immediate capital. The seller raises capital immediately, rather than
having to wait for the receivables to be repaid.
28-15 e Cheaper capital. Securitisations may offer cheaper finance compared to
finance raised directly by the seller from banks or the bond market.
This is often because junior tranches of notes bear the first loss so that
the senior tranches can he rated AAA and therefore carry a low rate of
 SECURITISATIONS I 457

interest, because the receivables are of better quality than the seller's
assets generally, because the assets are insulated from the credit of the
seller and because the finance is secured. The strength of the investor's
security is improved by the fact that the SPV enjoys credit enhance-
ment (see below) and is insulated from the credit of the SPV because it
is a separate legal entity. The assets are more marketable because the
non-marketable receivables are converted into marketable debt secu-
rities so that they are accessible to more investors.
Diversification of sources of funds. The seller has access to wider sources
of finance and can therefore diversify. For example, the seller may not
itself have the credit-standing for a bond issue, but the SPV could issue
bonds secured on the receivables which have a higher rating than the
seller. Hence the seller diversifies its sources of funds and is less reliant
on bank borrowings. Funding from international investors replaces
that of domestic banks. Bondholder covenants are typically less
onerous than bank loan agreement covenants.

Other objectives
Other objectives arc: 28-16

o A securitisation avoids the disposal of non-marketable receivables to

third parties to raise cash. A home loan or auto loan may not be
readily saleable except to another company in the same line of business
or a factoring company, and so is illiquid. A securitisation facilitates
the creation of liquid marketable instruments in the form of bonds
secured on the receivables.
o Avoidance of restrictions. Securitisation is effectively secured finance,
but may avoid restrictions in the seller's loan documentation, eg
negative pledges, borrowing restrictions, cross-defaults (assuming the
purchaser is outside the originator's group), because the transaction is
a sale, the funding notes are issued by the SPV and the actual security
over the receivables is granted by the SPV. It is usually inappropriate
for bank originators to grant security over their assets (regulators
usually prohibit this to protect depositors) so this is the only way banks
can raise "secured" money.
o Matched funding. The seller can match assets and liabilities. This is
safer where the receivables are exactly used to repay the funding loan.
There is no mismatch of yields or timing of payment.
Transfer of risk. The seller transfers the risk of the recovery of the
receivables to the investors. The issuer is not liable for any shortfall-
which it would be if it borrowed direct and charged its assets to secure
the borrowing.
o Longer-term financing. The funding of short-term receivables with
medium-term financing enables access to longer-term financing than
banks might offer.
o Fees. The originator can earn fees from the SPy in servicing the
receivables.
 458 SI'I(:iAL Ioii(:S

Regulatory advantages

28-17 The regulatory advantages relate mainly to capital adequacy. In the case of'
banks and other financial institutions (eg building societies), the originator
may have to raise extra capital under supervisory rules in order to support
the receivables. This is avoided or mitigated if the assets are sold. The choice
facing the originator is either to raise capital or sell the assets. However, the
originator keeps the profit (hopefully). See para 28-41.
Securitisations may also avoid lending limits, ie limits on lending to single
obligors or lack of diversification.

Disadvantages of securitisatkrns

28-18 Some disadvantages are:

o Originators tend to transfer their best receivables so the originator's

credit may he weakened. This may afl'ect the originator's ability to
ISSUC its own unsecured bonds, particularly as investors will tend to buy
the secured bonds.
o The transactions arc expensive in terms of the fees of the arrangers,
rating agencies and lawyers.
o Securitisations are very technical ­ .because of regulatory and auditor
insistence that the originator must not he morally obliged to support
the SPV, ic there is it real transfer of the risk of the receivables in
practice.
o The debtors liable on the receivables may object to the change of
creditor from their originator to an SPV controlled in substance by
unknown bondholders and sometimes located in a tax haven country.
This may damage the relationship.

Securitisation structures
Sale to a special purpose vehicle

28-19 This structure- by far the most common--involves a sale of the receivables
by the originator to a special purpose vehicle as explained above.
The purchaser is usually a specially-formed single-purpose company
whose shares are held by charitable trustees or foundations so as to be
independent of the seller and not to be a subsidiary of anybody. The usual
objective is that the purchaser should not be consolidated on the balance
sheet of the seller. The originator is insulated from the insolvency of the
SPV, and the investors in the SPV arc insulated from the insolvency of the
originator.
The SPV s formed as a pubiic coiiipaii y , tu be able to issue securities
non-privately. The minimum capital requirement is an extra cost. The SPV
may he formed in a tax haven jurisdiction.
 SLCURITISATIONS I 459

Offshore SPV locations Ideally the SPV is located in a favourable jur- 28-20
isdictiofl which has low or no taxes (transfers, no withholding on the notes,
a network of double tax treaties so that payments on the receivables are not.
subject to withholding taxes, and no VAT on fees), creditor-friendly
bankruptcy laws and security interests, political and legal stability, efficient
a dministration, low corporate costs, minimum capital requirements, and
streamlined incorporation (no high minimum capital, number of directors),
and minimal director liability (especially for not having stopped business
before the onset of insolvency). Favoured jurisdictions include no-tax jur -
isdictions, such as Cayman, Gibraltar, the British Virgin Islands, Bermuda
and Jersey, and low tax jurisdictions such as Ireland, the Netherlands and
Luxembourg.

Trusts
Under this structure, the receivables are transferred to a trustee which holds 28-21
them first for the benefit of the investors and then for the originator. The
trustee issues pro rata certificates to investors. The originator's share is
subordinated to that of the investors so that the investors have first bite--
the junior share is the excess profit.
A number of jurisdictions- mainly in the Napoleonic group--have leg-
islation which uses the trust concept for a securitisation SPV, eg France and
Argentina, but the use of the trust is less favoured in Anglo-American
jurisdictions, probably because the corporate form is flexible enough in most
cases.

Sub-participations
Under this structure, the seller grants sub-participations in the receivables to 28-22
an SPV, cg because the receivables arc not transferable without debtor
consent. The SPV borrows from investors via a bond issue and uses the
proceeds to place a deposit with the originator. The terms of this deposit are
that the originator must repay the deposit plus interest only if and to the
extent that the originator recovers principal and interest on the recei-
vables—a conduit loan. The originator is a conditional debtor to the SPV.
The effect is that the SPy and hence its investors carry the risk of non-
payment of the receivables, as opposed to the originator, because if the
debtors do not pay the originator, the originator does not have to pay
the deposit to the SPV. A disadvantage is that the investors take a double
credit risk, ie the risk of the receivables and the risk of the originator. The
transaction may not succeed in being off-balance sheet or avoiding capital
adequacy requirements.
The legal technology of sub-participations, widely used for bank loan
transfers, is reviewed in chapter 10.

Synthetic securitisations
A similar effect to a conventional transfer of loans can he achieved by a 28-23
"synthetic securitisation" without having to transfer the loans to an SPV -
460 SPECIAL TOPICS

thcrc might be transfer or confidentiality restrictions and the originator may

wish to preserve its relationship with its borrower.
In overall effect, noteholders insure or guarantee the receivables of the
originator and the originator does not transfer them. This is achieved as
follows:

o The SPV enters into a credit default swap with the originator whereby
the SPV agrees to pay the originator its losses on the originator's loans
(the reference obligations) to its borrowers (the reference entities) if
adverse credit events occur in relation to the loans, eg non-payment by
a borrower, or the insolvency or debt restructuring of a borrower,
under it credit deliult swap effectively like a guarantee or insurance.
Under the credit default swap, the originator pays the SPV an amount
equal to part of the interest to which the originator receives on the
loans to its borrowers and the SPV agrees to pay the originator's losses
on those loans if adverse credit events occur. Stripped of the jargon, the
originator is effectively paying a premium or fee to the SPV in return
for a guarantee or insurance equivalent. For more detail on these credit
derivatives, see para 26-24.
o In order for it to make these loss payments, the SPV issues notes to
investors on terms that, if the SPV has to pay the originator, the
principal amount payable to the noteholders is reduced, first the junior
notes, then the senior. The proceeds of the issue of the notes are
invested by the SPV in safe government bonds or other secure
investments. These bonds may be bought from the originator.
The interest which the SPV must pay to the noteholders is paid out of
interest on these bonds plus the amounts payable by the originator
under its credit default swap out of the interest it receives on the
reference loans concerned—effectively the premium paid by the origi-
nator for this protection.
o The originator has a charge on all the assets of the SPV including the
government bonds in order to secure the obligations of the SPV to the
originator. The noteholders have a second-ranking charge to secure
their notes.
o There are usually several tranches of notes with the riskiest tranche
bearing the first loss so that the senior notes can he highly rated. This
junior piece may he, say, 3 per cent of the whole pool.
e When the SPV has to pay the originator it sells some of the government
bonds. At the end of the transaction it sells all the remaining bonds so
as to pay off the notes.

The result is as if the originator had insured the loans with the SPV and
the SPV had rcinsurcd with the noteholders. The "insurer" or "guarantor"
pays the maximum amount of the insurance or guarantees in advance SO
that there is no credit risk of the failure of the "insurer/guarantor". If
a conditojis tire satsficd We ouigiriati . Will reduce iLN ctfiitai adequacy
requirements because it has transferred the risk on its loans to a highly
credit-worthy entity (the SPV) and so does not need the same risk capital
 SECURITISATIONS 1 461

against them. Effectively, the originator has obtained a cash collateralised

"g uarantee" which may attract a lower weight under capital adequacy rules.
Often the originator is permitted to vary the reference loans and reference 28-24
entities if they comply with certain criteria.
The main difference compared to an ordinary securitisation is that the
o riginator does not receive any funding, only the transfer of risk—"insur -
ance". Hence, the originator does not raise any capital.
The typical synthetic securitisation will be only partially funded by the
notes issued by the SPy. The reference portfolio of the originator may have
a notional amount up to 10 times greater than the principal of the notes so
that the notes only protect 10 per cent of the reference portfolio. This makes
sense because the originator in the circumstances may be unlikely to lose
riore than 10 per cent of its reference portfolio.
The advantages of synthetic securitisations include:

o no actual transfers of assets (restrictions on assignment, need for

borrower consent, bank secrecy, notifications, transfer taxes, avoid-
ance of preferences, separation of collection accounts and payment
records, or damage to customer relationships);
o ease of replenishment or substitution of the protected receivables
without actual transfers; and
0 simpler regulatory criteria for recognising the transfer of risks.

Repackaging of securities

An originator transfers (a portfolio of) bonds to an SPV which issues debt 28-25
securities to investors secured on the bonds. This is a simplified securitisa-
tion because the receivables are simpler.

Managed securitisations

In the typical managed securitisation--usually called managed CDOs-- a 28-26

collateral manager is appointed by the SPy to invest in debt obligations,
such as bonds and home loans, during a specified reinvestment period,
subject to various eligibility criteria, portfolio diversity and quality tests
being satisfied as to those obligations. In synthetic transactions the collateral
manager is more commonly referred to as a portfolio manager. In sub-
stance, these securitisations come very close in concept to ordinary
investment companies where a manager buys and sells investments
according to eligibility criteria, and the shareholders profit or lose according
to the value of the pool—a mutual fund.

Securjtjsatjops of securitisatios

Investors sell their notes made to several SPVs to another SPV. 28-27
 462 - SPF('IAI. iOPI('S

Several originators

28-28 Several originators sell their receivables to a single SPIV, usually because
each batch is too small. The advantages include: pooled expenses, single
operator, and standard documentation.

Legall aspects of We of receivables

Price for sale

28-29 The receivables may he sold at a discount, reflecting the risk that some of
them will he uncollectable and also reflecting the financing cost to the SPV
of funding the purchase. A discount may improve the credit standing of the
SPIV.

Assignability of receivables
28-30 Restrictions of assignment If the consent of debtors is needed to the
assignment of the receivables (because under the terms of the contracts
applying to the receivables, they are personal contracts, or there are con-
tractual prohibitions or because of official guidelines for the protection of
consumers or home-owners) the securitisation is impracticable because of
debtor inertia in replying. There are usually lust too many debtors.
In many jurisdictions a prohibited assignment is invalid as regards the
debtor. The effect is that the debtor can continue to pay the seller. In
English-based jurisdictions, it is probably the case that the seller would hold
these proceeds on trust for the buyer as a super-priority claim if the seller is
insolvent, but only if the proceeds are traceable, eg have not been paid into
an overdrawn account at a bank unaware of the trust. It appears that in
most civil jurisdictions, this trust is not available so that the assignment
would he totally ineffective on the seller's insolvency.
A few states have enacted laws which override restrictions on assignments
(usually any in relation to certain classes of receivables, such as ordinary
commercial receivables) in the interests of improving the marketability of
claims, but at the expense of freedom of contract. Examples are: the United
States, Article 9406 of the UCC accounts; France, CornC 442-6 11 c
(certain commercial contracts); Germany, 1-1GB (commercial code) s 354 (a)
(business receivables).
28—I1 Other factors relevant to assignability are whether bankers confidentiality
is breached, whether the SIN can fix the interest rate, and whether the SPV
can fix a market rate (as opposed to the originator's rate).
Alternatives to assignment might include a trust of the receivables, a trust
of proceeds (of little value), sub-participations (unlikely), or a novation
(consent of debtors required).
In England an assignment contravening an express prohibition on
assignments is void even if the assignee did not know of the restriction: see,
for example, Linden Gardens Trusi Lid v Lenesta Sludge Lid[1993] 3 All ER
417. H L (assigiimco ul ashcsios-iciiiovah contract with non-assignmen(
clause was void).
.1 A ,rrhjhiipd iicTnmpnt is effective as between the assignor and assignee:
 SECURI11SATIONS 1 463

see The Linden Gardens case, it would seem, therefore, that the proceeds
when received by the assignor from the debtor would be bound by a trust in
favour of the assignee even if the assignor is insolvent: consider Barclays
Bank plc v Willowbrook International Ltd [19871 1 FTLR 386; International
Factors Ltd v Rodriguez [1979] 2B 351 (both cases imposed a trust on pro-
ceeds even if the assignee did not know of the restriction: but in neither was
there a prohibition on assignments).
Bank loan agreements sometimes provide that a bank may transfer only
to another bank or financial institution.

In The Argo Fund v Sressar Steel Ltd [2004] EWHC 128, the bank loan
agreement allowed transfers only to a "bank of other financial institu-
tion". A bank assigned the loan to a hedge fund. Held: a hedge fund was a
"financial institution" within the scope of the assignment clause. A
financial institution does not have to be like a hank. It must be concerned
with commercial finance or provide capital to financial markets. It must
be a business entity that regularly makes, purchases or invests in loans,
securities or other financial assets. Since it must be an institution, it must
be an entity of a certain substance and not insubstantial. It follows that if
a borrower wishes to limit assignees to commercial banks which are able
to lend, this would have to be specifically stated.

Assignment clauses often provide that consent is not to be unreasonably

withheld.

In Henry v Charisearch Lid, The Times, September 16, 1998, CA, the
majority of the Court of Appeal held that, where there is a clause requiring
consent, consent not to be unreasonably withheld, it is fatal to the validity
of the assignment that the debtor's consent was not sought. It is irrelevant
that on the facts consent could not have been reasonably withheld.

Restrictions on assignment have been held not to prevent a transfer or trust

of proceeds: see Gregg v Bromley [1912] 3 KB 474 (assignment of proceeds of
non-assignable action for slander); Re Turcan [1888] 40 Ch D 5 (assignment
of proceeds of insurance policy); Russell & Co v Austin Fryers [1909] 25 TLR
414 (assignment of proceeds of non-assignable contract for personal ser -
vices); The Litsion Pride [1985] 1 Lloyds Rep 437 (assignment of proceeds of
insurances). See also, Re Irving, ex p Brett [1877] 7 Ch D 419 (assignment of
dividends received on a proof of debt in bankruptcy of the debtor).
An assignment of proceeds is of little use because it does not carry with it 28-33
all the benefits under the contract. An assignee of proceeds cannot sue for
the debt itself.

In Floor v Shand Construction Lid, The Times, January 8, 1997, a clause

prohibited assignment without consent of a building sub-contract but
permitted the assignment of "any sum which is or may become due and
payable under this sub-contract". This was construed as permitting
assignment of the right to recover sums already due, but not the right to
claim damages or other sums that needed to be established as due and
payable by litigation or arbitration or contractual machinery.

A rcstricton on assignments may be construed so as not to prevent a trust

of the claim. This is because the courts construe restrictions on transfer as
narrowly as possible since the law prefers the Free marketability of' property.
 464 SI'I(1AL TOPICS

In Don King 'Productions Inc v Warren 119991 2 All ER 218, boxers agreed
to transfer their boxing promotion contracts to a partnership. They each
assigned their contracts, but there was a restriction on free assignment il l
some of the contracts. Held: the restriction on assignments did not pre-
vent a trust of the contracts and the court would order the boxer
concerned to hold the contracts on trust for the partnership. The court
considered that, nevertheless, the partnership would not be able to sue on
the contracts even though the partnership had the benefit of them, but this
is considered doubtful and was doubted in the Barbados case mentioned
below.
In Barbados Trust Co Ltd v Bank of Zambia [20071 EWCA Civ 148, an
investor assigned a loan (made to the Bank of Zambia) to a bank. The
assignment was invalid because the investor did not obtain the prior
written consent of the borrower as required by the loan agreement. The
loan agreement prohibited assignments without the prior written consent
of the borrower except that consent was deemed to be given by the
borrower if no reply was received within 15 days of request. The assign-
ment to the bank was made before the end of the 15 days. The borrower
did not reply. The bank therefore had no title. Nevertheless, the bank
declared a trust of the loan in favour of a second investor. Held: the bank
could not transfer any interest by declaration of trust because the bank
had no title. In ohiter remarks the court said that a prohibition on
assignment of the loan would not prevent a declaration of trust, ie a
declaration of trust would he effective to establish the investor as a ben-
ciciary. Subject to qualifications, two members of the court suggested
that, in that case, il the trustee failed to sue when the beneficiary
instructed it to do so, the second investor could sue direct but must join
the trustee in the action.

Lisual practice in the case of trusts of the claims is for the transferor/trustee
to grant the beneficiary a power of attorney to sue, manage and collect.
An absolute assignment which increases the borrower's liability at the
time of the assignment (such as under a tax grossing-up or an increased cost
clause) might he implicitly prohibited: see Tolhur.si v Portland Cement [1902]
2 KB 660.

28-34 Notice to debtors Notice will not normally be given to the debtors because
of the inconvenience and expense, because it is preferable for the originator
to continue collection (the originator has the data and the systems), because
the debtors might be confused by notice of an assignment, and because the
originator wishes to maintain its relationship with its customers.
If no notice is given to the debtors, the effect in some jurisdictions is that
the sale is invalid against attaching creditors of the seller and on the seller's
bankruptcy. This renders the securitisation impractical unless there is a
special exemption. Compulsory "notice to the debtor" prevails in most of
the Napoleonic group (eg France, Italy, Spain), about half the Roman-
Germanic group (Japan, Korea, Scandinavia, but not Germany, Austria,
Switzerland), but not the Anglo-American group. Notice must often be
formal, cg by a court bailiff in France, but informal in Scandinavian
countries, Cg notice on an account statement. There are exceptions to the
"notice to debtor" rule in some of the hostile countries, such as France, Italy
dnd Japan, in oidcr to Ci ourage scearitisations but generally the cXCUIP
tions are restrictive. See para 19-27.
There is conflict between jurisdictions as to whether the requirement for
 SECURIrISATIONS I - 465

n otice should be determined by the law of the location of the debtor con-
cerned or whether it should be determined by the governing law of the loan
or receivable concerned. See para 34-14.
In countries which validate assignments on the insolvency of the seller, 28-35
even though no notice is given to the debtor, the absence of notice has other
effects. Thus:

o The SPV might lose priority if the originator resells or charges the
receivables to a third party: this is prohibited by the transfer agreement
and investors and rating agencies are content to rely on the SPV
complying with this prohibition.
o Debtors can continue to pay the originator. This is not an objection
because the originator usually wishes to continue to collect in any event
and this is the most convenient from the point of view of all parties.
Consider the commingling risk.
o Debtors without notice can continue to acquire new set-offs and
defences. Sec below.
o In the absence of notice, the originator and debtors can vary the terms
of receivables: again one relies on the good faith of the seller.
o It may be necessary to join the originator in an action by the SPV
against debtors (in England only the debtor can waive this, but it is a
procedural technicality).

In any event, the rating agencies do not object to non-notified (equitable)

assignments if valid, ie they are prepared to assume that originators will not
act fraudulently or with gross negligence.
Other assignments might include assignments of endowment insurance, of
guarantees of the receivables and of any security for the receivables, eg real
property mortgages.
In civil code (but not English-based) jurisdictions, it is often necessary, to
register an assignment of a mortgage or other security interest in any
available asset title register for the asset (land, ships, aircraft, shares, book-
entry securities, intellectual property) in order for the assignment to be
effective on the insolvency of the originator.

Set-offs against receivables

If the debtors in respect of the receivables can set off claims owed by the 28-36
originator to them as against the SPV as assignee and the investors as
security assignees, then the receivables will he diminished and extra credit
enhancement will be required.
For an analysis of this issue, see para 15-10.

Credit enhancement
Main risks If the purchaser issues securities to investors, the solvency of 28-37
the purchaser must be assured. The main potential threat to solvency is that
 466 SII(.IAI. 1019CS

the receivables are not collectible. There are others, such as interest or
payment mismatches.

28-38 Forms of credit enhancement In order to protect the SPV from insolvency,
the structure usually contemplates various forms of credit enhancement. The
enhancement can he internal, such as over-collateralisation by the origina-
tor, or external, such as a guarantee from a third party. Examples arc:

o Guarantees or their equivalent, such as letters of credit, an obligation

to purchase defaulted receivables, irrevocable and unconditional obli-
gations to lend, such as obligations to invest, and top-slice credit
insurance. These must come from a third party, such as a bank or
surety company, if the transaction is to be off the originator's balance
sheet (for the purpose of the accounting and regulatory regime).
o Liquidity facilities. Liquidity facilities are generally designed to smooth
payments because of mismatches, not to make up for defaults. The
facility is provided under an agreement between the lending bank, the
SPV and the security trustee. There are strict capital adequacy reg-
ulatory requirements for these facilities.
28-39 o Subordinated loans or deferred prices. These are the most common
methods. The originator may make a subordinated loan to the SPy,
jUfliOl to the investors and limited in recourse to the available assets—
often called the 'equity piece". The loan must usually be made in
advance to fund the purchase price. Alternatively the originator defers
part of the sale price for the receivables, ie the originator is paid, say,
90 per cent on the sale and the remaining 10 per cent claim is sub-
ordinated to the notes. Hence the investors lend 90 against receivables
nominally worth 100. This is equivalent to over-col lateral isation---the
sale of more receivables than are needed to cover the funding loan or
sale at a discount.
o Guaranteed investment contract between the SPV and a rated bank
whereby the bank agrees, for a fee, to pay a minimum interest rate on
deposits by the SPy of proceeds of the receivables, pending their use
for repayment. This covers mismatches between collections on the
receivables and the repayment of the funding loan.
o Interest swap between the SPV and a (rated) bank whereby the bank,
for a fee, pays floating/fixed to the SPV to cover any fixed/floating
interest mismatch between the receivables and the funding loan, or an
interest rate floor whereby the bank pays any shortfall below a specified
rate.
o Reserve accounts. The surplus and any difference between the interest
on the SPV's bonds and the interest on the receivables is accumulated
in it reserve account of the SPV.

The originator cannot have a right to repurchase surplus receivables for

iluililog u.titse ui die ecactcrisitioi1 nsk (among other things).
In practice, the credit enhancement of the senior notes so that they can he
highly-rated results from the fact that the junior notes bear the first loss.
 sLcuRrnsATloNs 1 467

Profit extraction by originator generally

The originator desires to continue to enjoy the profit from any surplus 28-40
interest from the receivables after the payment of interest to the investors
and the other expenses of the SPy. The profit is usually the difference
between the higher interest rate on the receivables and the lower interest rate
payable by the SPV to investors on the notes plus any surplus receivables, eg
i f the original sale was over-collateralised, plus any credit enhancing cash
reserve fund provided by the originator.
The profit extraction must not prejudice the off-balance sheet treatment
or prejudice the true sale for the purposes of capital adequacy, or lead to
recharactcrisation as security as opposed to true sale for the purposes of
mortgage law.

Methods of profit extraction

The main methods of extracting profits include: 28-41

e The SPV defers part of the price for the receivables payable by the SPV
to the originator until the senior notes payable to the investors have
been paid in full. This is the usual method. The deferred purchase price
is subordinated to the senior and junior notes. A similar result could he
achieved by a subordinated loan by the originator to the SPV or (more
usually) by the originator buying the most junior tranche of the notcs
issued by the SPy- -the "equity piece". The profit is realised by a very
high rate of interest on the deferred purchase price. The holding by a
bank originator of the most junior tranche of the notes will usually he
deducted from its capital required for capital adequacy purposes- a
very adverse result since most ordinary exposures attract 8 per cent as
opposed to a huge multiple of this if there is a straight deduction.
o Servicing fees for the administration of the receivables.

Further reading: LPIF vol 5 chapters 6 and 7.

For questions and seminar lopics, see the end of chapter 29.
 CHAPTER 29

SECURITISATIONS H

True salle requirements generally

29-01 A securitisation must normally be a final true sale if it is to qualify for
favourable treatment. The main aspects of a true sale arc:

• The seller has no liability For the asset, once sold, except normal
warranties for defects. The seller does not guarantee recoverability, or
have a duty to repurchase or to provide additional cash and has no
commercial non-legal "moral" duty in practice to compensate for
shortfalls. If the seller has a liability, then this must be recognised in its
balance sheet and a regulated seller must have capital against it.
• The buyer has exclusive control and dominion over the asset, can sell it,
exchange it, pledge it, does not have to re-sell it to the seller (except for
clean-up of final small amounts), and can itself manage and collect it.
The buyer also takes all the profit from the asset, and does not have to
remit it jO the seller. If the seller retains a degree of control and
dominion, then the asset may still belong to the seller and he available
to its creditors. This principle is a leading characteristic of the concept
of po va Le f)rc)pLrty, but is the most doubtful in the context of secur-
itisations. It IS much more important that the seller has no further
liability.
o The sale is not revocable on the bankruptcy of the buyer, either because
it was a preferential transfer, because the buyer is really part of the
seller, or because the sale was not published, and must not be reachable
by the creditors of the buyer if it were, then in substance the seller still
has the asset. The asset sold must be isolated, insulated, "bankruptcy-
remote" from the bankruptcy of the seller.

The four main interested areas the legal treatment, the accounting treat-
ment, the regulatory treatment, and the treatment by rating agencies/
investors reflect these broad concepts, but differently and with different
emphasis and variations: the rules are extremely detailed.

True sale: recharacterisation of sale as security interest

29-02 The sale of the receivables by the originator to the SPV must not be
recharacterised as security br the purposes of sccurity interest and bank-
ruptcy law.
The question is whether the transaction is recharacterised as a loan by the
SPV to the originator sCücd Oil the receivables which are treated as still
belonging to the originator, as opposed to a true sale of the receivables to
the SIN.
 sE(;URITISATIONS 11 469

if the sale is legally recharacteriscd as security for the purposes of

m ortgage law, the result is usually disastrous.
The assets remain on the balance sheet of the seller and the funding loan is 29-03
a liability of the seller—the whole object of the securitisation will have
failed.
The security becomes subject to the restrictions of the law relating to
security interests. Thus, it may require registration or perfection by filing if it
is not to be void on the insolvency of the seller. The enforcement of the
security may be frozen on the insolvency of the seller. The bankrupt estate
may have a right to use or substitute secured property (France; United
States--but only if the secured creditor is given adequate protection under
BC 1978 s 361; Britain, in relation to floating charges of companies in
administration, although a universal floating charge usually has blocking
powers in the case of securitisations). The security may he subordinated to a
super-priority moratorium loan (US, France). The security given by the SPy
to the investors would be a sub-mortgage limited to the "loan" by the SPV
to the seller. Access by the investors to the receivables might be subject to
potentially restrictive mortgage enforcement procedures. The security may
infringe negative pledges in the originator's credit agreements. The investors
lose insulation from the originator's insolvency, so that a default by the
originator would force the investors to realise their security prematurely.
Most legal systems seek to ensure that transactions which are like a
security interest are subject to the legal rules relating to security interests, in
particular:

o the security interest is publicised so as (1) to protect unsecured cred-

itors, and (2) to protect other purchasers and rnortgagees of the assets
against secret interests disturbing their title;
o the "mortgagee" hands back any surplus to the debtor after realisation
and does not foreclose by taking the property for itself;
the enforcement of the security interest is subject to bankruptcy freezes
under reorganisation laws; and
• other debtor-protective rules, eg formalities.

The main characteristics of a security interest are that the debtor has the 29-4
right to get back the charged collateral if the debtor repays the secured debt
and to receive the surplus proceeds if the creditor enforces and sells the
collateral and that the debtor is liable to repay any shortfall. Hence the chief
factors in considering recharacterisation include:

o Whether the originator's right to repurchase receivables in substance

constitute the mortgagor's right to get back the mortgaged property on
repayment of the loan. The originator usually has the right to
repurchase small remaining amounts at the end of the financing to mop
up the last drops when it is no longer economic to continue. This is not
generally regarded as material.
e Whcthcr "hic cxtraction of profIts by the originator amounts to it lcndc;
accounting to the borrower for the excess of the mortgaged property
over the loan. In it true sale, the purchaser keeps the residual value
 470 srtic,Al. TOPICS

(profit) of the purchased property, but in a mortgage the borrower

receives hack the residual value on repayment of the loan.
o Whether the originator has any liability to pay any shortfall if the
receivables are insufficient.
o Sham, ie the parties carry out the transaction in a different way than
that contemplated by the documents, eg the records refer to a loan and
interest, not a sale price. The parties need to make sure that this does
not happen.
o Collections by the originator, ic whether the continued collection and
managemcnt of the receivables by the originator negates a true sale. In
a true sale, the buyer normally manages the asset because it belongs to
the buyer.

Rccharacterisation is mainly a US risk under UCC Article 9 which covers

security interests in personal property. Article 9 treats a transaction as a
security interest if it has this effect, regardless of its form.
in substance, the US courts adopt the accounting and regulatory sub-
stance-over-form tests -which examine whether the transferor has
transferred the risks and rewards (profits) or whether the transferor keeps
the risks and rewards. The test is elusive and unpredictable when risks and
rewards are shared and the cases cannot be harmonised.
(ariada. most of the provinces, except Quebec, have personal property
scurity star utes based on UCC Article 9.
In England. it properly documented sale of receivables, which is treated by
the pailies as a sale, is not a loan by the buyer to the seller secured on the
.:ccivables requiring registration: even if the buyer has recourse to the seller
[or unpaid receivables, even if the seller has a right of repurchase (cg stub
assets at end), even if the profit is paid to the originator (eg a servicing fee),
even though the seller continues to collect as agent of the purchaser,
and even though the economic effect is similar to a loan secured on the
receivables. Form over substance was established in, for example, Olds
Discount Co Lid v .John Playfair Lid [1938] 3 All ER 275; Re George
Inglejield Ltd [1 933] Ch 1, CA; Lloyds & Scottish Finance Lid v Prentice
(1977) 121 Sol Jo 847; affirmed HL, The Times, March 29, 1979; and Welsh
Development Agency v Export Finance Co Ltd[ 19921 BCC 270, CA; Mahonia
Lid v .JP Morgan Chase Bank [2004] EWHC 1938, [2004] All ER (D) 10. The
English objectives are (I) predictability, and (2) a desire to free transactions
from the historical baggage restricting security interests.
Some other jurisdictions might recharacterise more readily, especially in
the Napoleonic group.
All of the interested parties -investors, rating agencies, accountants and
regulators.- -insist on non-recharacterisation under security law.

True sale: "bankruptcy remoteness" from originator

29406 A securilisation must be insulated and isolated from the insolvency of the
urg;nator, ic he "bankruptcy iFOffi the originator in order to satisfy
all interested parties- -investors, rating agencies, accountants and
regulators.
 SECLJRITISA i UIN. lo

The main req uirerncnts arc:

• The assignment of the receivables must not be void on the insolvency of

the originator because of the absence of notice to the debtors. See para
28-34.
o The SEW must not be consolidated/fused/merged with the originator on
the originator's bankruptcy so that all its assets and liabilities are
merged with those of originator. This piercing of the veil of incor-
poration is different from balance sheet consolidation. If that
happened, then the funding lenders would have to enforce their
security over the receivables prematurely on the insolvency of the
originator and would be subject to the bankruptcy laws applicable to
the originator (freezes, etc.). This is because the merger or fusion would
result in the assets becoming assets of the originator and the funding
loan a liability of the originator. The documents and their imple-
mentation must ensure separateness of the SPV, eg separate officers, no
commingling, separate records, observance of corporate formalities,
disclosure in financial statements, and the like. Bankruptcy con-
solidation is rare and tends to happen only if there is extreme
commingling ignoring separate legal identities. So this is not usually a
serious risk.
o Transfers or payments by the originator to the SPV must not be 29-07
capable of being set aside as a preference or transaction at an under-
value on the bankruptcy of the originator. If set aside, the creditors of
the originator have a claim on the receivables-- -whichcease to be
insulated/remote. This affects mainly the sale itself and any substitu-
tions by the originator--they must not be at an undervalue, it is very
unusual for a sale at full value for cash to he preferential anywhere.
There may be a vulnerable gift element if the sale of the receivables is at
a non-market discount or the recovery by the originator of a deferred
price is illusory.
• There should be no material loss of or delay in the recovery of hinds
collected by the originator as servicing agent, if the originator becomes
insolvent. The documents usually require frequent turnovers to the
SPV, eg every two or three days (consider the commingling risk); or
payments go direct to the SPV's account.

True sale and accounting

This is a swiftly moving field. The usual objective is that the receivables and 29-08
the loan to finance the Spy are not consolidated on the balance sheet of the
originator. Accounting treatment aims at substance over form, and so may
be different from the legal treatment.
If the Spy is a subsidiary or affiliate, it is consolidated on the consolidated
balance sheet of the originator.
If the SPV is consolidated with the originator's group, the effect is dra-
matic. The bond issued by the SPV is treated as a borrowing by the
Originator's group- it is on balance sheet ---which will increase the
 472 SPECIAL TOPICS

originator's gearing ratio (debt: equity), increase debt service and worsen
earnings cover of interest.
9-09 Nevertheless, the originator may stilt benefit from a tower cost of funds,
from favourable capital adequacy treatment, and the shifting of the risk to
the investors. Hence the main adverse impact is on the originator's financial
ratios.
The accounting rules ignore the separate corporate existence of sub-
sidiaries on the theory that parent companies normally do not let
their subsidiaries fail unless they themselves fail and that there is usually
much interconnection and inter-reliance between group companies- -the
group stands or falls as a single entity. Hence the key accounting test is-
who really owns the company? Ownership is a bundle of ideas comprising
control and the risk of losses and rewards. The greater the control and risk
of losses and rewards, the greater the inter-dependency, hence the greater
the need to treat the company as part of the same economic entity.
Hence:

o The SPV must not be a subsidiary of the originator. There may he

special rules for the consolidation of affiliates which are not majority-
owned: this usually leads to the result that the originator cannot have a
significant shareholding in the SPV.
The sale of the receivables must be a true sale, ie the transferor has
tianslcrrccl significantly all of the incidents of ownership of the recei-
vables to the transferee, namely control, the risk of loss and the benefit
of rewards. The problem is that the SPV is often auto-controlled
(brain-dead) or its receivables are managed by the seller, that some
risks remain with the seller and that the seller also wishes to extract
some profit. The main questions are: (a) how much control does the
originator have over the SPy (management, servicing); (h) how much
recourse or risk of toss can he imposed on the seller in the form of
guarantees, repurchase liability, junior loans, reserve accounts, war-
ranty of receivables, prospectus liability, moral commitment and the
like; and (c) how much of the profits can be passed back to the seller
and how, whether by a right to repurchase, servicing fees, subordinated
loan, or the like.

There are detailed international differences in accounting approaches

towards entities which must be consolidated and the degree of transfer of
risks and rewards. The rules are extremely complex.
29-10 In the US, the rules are mainly contained in Financial Accounting
Standard 140. To qualify as a sale, the transferor must (1) surrender control
over the assets so that they are isolated beyond the reach of the transferor
and its creditors, (2) transfer the assets to a qualifying special purpose entity
where the noteholders have the right to pledge or exchange their notes or
certificates, (3) not retain effective control over the assets via a right and
obligation to take back specific assets or a right to unilaterally cause the
holder to return specific assets (apart from a clean-up call which is an ori-
ginator option to buy the receivables), and (4) receive cash proceeds from
the sale as opposed to a note or interest in the assets.
A qualifying special purpose entity is not consolidated in the financial
statements of the seller- To qualify, the entity must (1) be demonstrably
 SECURITISATIONS If 473

distinct from the seller (le it cannot be unilaterally dissolved by the trans-
feror or its affiliates and where at least 10 per cent of the value of its
beneficial interests are held by entities other than the transferor or its
affiliates), (2) have significantly limited permitted activities, (3) only hold
passive financial assets, ie where the entity makes no decisions other than
s ervicing (not, for example, controlling equities), and (4) have limited
powers of disposal of the assets. Consolidation may be required if the
transferor has obligations to support the special purpose entity.
There are other rules for entities which are not qualifying special purpose
entities. These are contained in FASB Interpretation No 46, known as FIN
46 as amended.
The main International Financial Reporting Standards (applicable in the 29—I I
EU) are lAS 27 and lAS 39. lAS 27 requires companies to be consolidated
with a parent if it is "controlled" by the parent. Control is present if the
parent has more than half of the voting power or equivalent powers of
control, eg power hire or fire a majority of the directors. This is supple-
mented by an interpretation of the Standing Interpretations Committee
SIC-12 which consolidates special purpose entities created to accomplish a
narrow or well-defined objective where (in substance) the transferor retains
the majority of the benefits and risks of the entity.
lAS 39 deals with the circumstances when an asset may be considered off-
balance sheet for accounting purposes, ie a true sale. The effect of the rules is
that it is more difficult to achieve off-balance sheet treatment under IFRS.
The EU statistics agency Eurostat has published guidelines on accounting
for securitisations undertaken by EU states, in order to determine whether
the transaction is a government borrowing.

True sale and capital adequacy

General The capital adequacy regime is also subject to rapid change. For 29-12
capital adequacy generally under the Base! II regime, see chapter 25.
There is an extreme emphasis on substance over form. The principles
adopted by the regulatory authorities are similar to the accounting princi-
ples but with a greater emphasis on the transfer of risk as opposed to
the transfer of rewards. In addition, supervisors pay regard to moral obli-
gations to support the SPV because of the special vulnerability of credit
institutions to a loss of business confidence.
For example, disappointed investors may put pressure on the originator
to buy them out on the basis that the receivables were generated and
managed by the originator and so should be its responsibility, or that they
were induced into the deal by an offering circular which in practice was
produced by the originator. Originators may he pressured into supporting
the SPV, though not legally obliged to do so, in order to maintain their
reputation and to preserve their access to future securitisations, especially if
they rely on securitisations as a major form of funding. The regulators pay
special regard to links connecting the SPV with the originator, eg liquidity
provider, servicer, underwriter, dealer, swap counterparty, and provider of
credit enhancement.
If the lest is too stringent, securiUsations are dampened and the ability of 29-13
credit institutions to finance themselves is reduced.
In order to avoid the Base! 11 capital requirements, a bank must have fully
 474 Si'F(:IAi. iOI'R:S

transftrrcd the exposure From its balance sheet for capital adequacy pur-
poses, and it is only then that it does not need to have capital against the
exposure. Hence the choice for a bank which wants to make more loans is
that either it must raise more capital in the market to support the loan or
else it must transfer the loan in a way which satisfies the regulatory
requirements.
Clearly the originator must not guarantee the receivables, even indirectly
and must not he obliged to top-up receivables, to provide improved recei-
vables, or to improve the yield to noteholders if the receivables deteriorate.
If the originator actually does these things, that is permitted, so long as it is
clear that it does not have to and this is made abundantly plain in the
prospectus and the documents.
2-114 Also, there are usually stricter rules For revolving securitisations where
short-term receivables are replenished by the originator, because investors
may put pressure on the originator to hail out the investors by topping-up
the receivables and thereby maintaining the maturity of the notes.
Basel 11 applies only if the notes are stratified into tranches. An example is
where the securitisation company issues senior and junior notes secured on
the pool of receivables where the junior notes are subordinated to the senior.
If the securitisation is not tranched, then it is not within special regime for
securitisations. The reason presumably is the regulators arc primarily con-
cerned with making sure that the riskier junior exposures have a weighting
to reflect the risk.

29- Vi Basel criteria for recognition of traditional securitisations Conditions must

he met ii an originating bank wishes to remove assets From its balance sheet
or reguiatoy purposes. In effect there must he a clean break, a true sale, to
hat the originator is not liable, contractually or morally, to compensate
investors if the vehicle is insolvent. They arc:

o Significant credit risk associated with the securitised exposures has been
transferred to third parties. This means that the originating bank must
not be in any way responsible for losses on the transferred receivables.

o The transferor does not maintain effective or indirect control over the
transferred exposures. A transferor maintains effective control over
the transferred credit risk exposures if it: (I) is able to repurchase
from the transferee the previously transferred exposures in order to
realise their benefits; (2) is obligated to retain the risk of the transferred
exposures, but not (3) if it is merely appointed as servicer in respect of
the assets, as it usually is because it has a relationship with its bor-
rowers. These conditions reflect the idea that If there is to be a true sale
then the transferor must have transferred all of the risks and rewards of
the asset to the transferee who must have complete dominion over the
assets. For example, a buyer who buys a car can use it, sell it, crash it,
or give it away, and the transferor has no responsibility for it at all. The
concept is somewhat theological because what really matters is that the
originator does not have any responsibility for the receivables and it
ought to he irrelevant and indeed beneficial— that it can get the
benefits of them back by a rcpurchasc. The thinking tuay have been
that originators might he tempted to repurchase because of pressures
from the noteholders i( the receivables deteriorated in quality.
 S1'CUR(TISATIONS ii 475

o The assets are effectively legally isolated from the transferor and its
creditors on insolvency, ie through the sale of assets. This means that the
SPy and the transfer of the receivables must be "bankruptcy remote".
o The securities issued confer no rights against the originator, but only a
claim to the underlying assets.
o The transferee is an SPY and beneficial interests in that SPV are freely
transferable.

There are special rules for liquidity facilities and synthetic securitisations.

other rules Outside Base!, national regulators may impose additional 29-16
rules, eg that the originator will:

o have no shareholding in the SPV: hence the use of an "orphan" SPV

with shares held by trustees on discretionary trusts for charities; hence
profits cannot be extracted by dividends;
o not have more than one director on the SPV's board and that the
director must be in a minority;
o not have a right to repurchase the receivables (except the final clean-up
stump);
o not be associated commercially with the SPY, eg by a similar name
which might imply a moral obligation to support the SPY; and
• not have a refinancing risk in practice.

Bank exposures to securitisation vehicles tinder Basel 11 there also is an 29-17

extremely complex separate securitisation framework for determining reg-
ulatory capital required to back bank exposures arising from traditional and
synthetic securitisation structures. Exposures by banks to securitisations,
such as notes issued by the securitisation vehicle, are governed by special
rules, not by the general rules for other classes of exposure. These exposures
include those held by the originator, as where the originator buys notes
issued by the vehicle.
The overall effect is to impose a higher capital requirement on non-
investment grade notes issued by a securitisation vehicle held by a bank than
would be applied to equivalent notes of the same risk category. Where an
exposure is defined as a securitisation exposure, it therefore has a worse
capital treatment than would be the case were it not so defined. If an ori-
ginator holds the most junior subordinated loans (the equity piece), the
amount is often deducted from capital—a risk weight of 1,250 per cent.
The potential liability of the originator for an incorrect prospectus is not
usually counted as a risk for capital adequacy purposes.

Rating of the securities

The securities issued by the SPy must usually be rated by a rating agency to 29-18
sell to investors. eg AA or AAA. The rating agencies are concerned pri-
manly with credit risk of the SVP and hence of the receivables. A high rating
is usually essential to sell bonds in the international bond markets and to
 476 SPECIAL. TOPICS

achieve it reduced interest rate. But some securitisaLions have been rated
speculative grade, as opposed to investment grade, and some not rated at all.
Usually the senior securities are rated as well as the junior securities, but not
the lowest tranche. The rating agency requirements are stringent and affect
the structure.
See the rating symbols at para 20-23.
Rating is both initial and periodical, so that it can be downgraded. A
down-grading of the rating of a credit-enhancer can also down-grade the
rating of the SPV's securities.
29-19 Rating agencies firstly assess the overall soundness, eg the quality of
receivables by audit. Thus in the case of mortgage loans, they will review
loan to value ratios and income multiples and (to determine the likelihood
of deItult by borrowers and the level of loss upon enforcement) the fore-
closure frequency and loss severity, value of the collateral, the ranking of the
mortgages, the efficiency of local enforcement, and the level of enforcement
expenses. Currency is a factor.
They will assess the correlation between the debtors, ie the degree of
homogeneity as opposed to diversification, including geographic and
industry concentrations which might in turn be affected by local misfortunes
or catastrophes, eg the bankruptcy of a major local employer or the intro-
duction of prejudicial local taxes.
l'hcy USC a variety of statistical models for the process, including histor-
ical data and stress testing via a Monte Carlo simulation---basically a "what
W?­ stress testing. Prophecy is difficult. The analysis will determine the level
oIcre(lit enhancement required to achieve the desired rating. The higher the
rating. the worse the assumptions as to default and loss.
29--20 They will also review:

o whether the sale is it true sale for the purposes of the law relating to
security interests;
o the SPV's remoteness from the bankruptcy of the originator (eg true
sale, no preferences or transaction at undervalue, non-consolidation);
o the credit enhancement to cover costs, possible shortfalls on the
receivables and liability risks in respect of the senior rated tranches and
the possibility of debtor set-offs (credit enhancers must have a com-
parable rating with no weak link);
o the risk of a SPV bankruptcy because of other liabilities, ie there must
he no liabilities to third parties outside the transaction (cg no
employees, premises, other business); and
o the sophistication of the systems of the administrator and the feasi-
bility of appointing an alternative servicer if the originator is bankrupt.

In assessing these aspects, they will often assume that the originator
becomes bankrupt immediately after the closing.
Rating agencies assume that there is no fraud in the transaction and that
the parties will comply with their covenants (cg the originator will not
double-sell, the SPV will not double-mortgage) and that warranties of the
nrtg!nalor a to the rcceivab!es arc true.

Further reading: LPIF vol 5 chapter 8.

 QUESTIONS AND SEMINAR TOPICS 477

QUESTIONS AND SEMINAR TOPICS

Chapters 28 and 29
(I) "Securitisations of receivables, such as home loans, are really just a
loan to the originator of the receivables secured on those receivables."
Discuss.
(2) The legal, regulatory and accounting treatment of whether a sccur-
itisation is a true sale are different. In what way are they different and
do you think that they should be the same?
(3) Why do originators securitise receivables when they could much more
simply borrow money secured on their receivables?
(4) Compare a traditional securitisation (involving a sale of receivables to
a special purpose vehicle) with a synthetic securitisation.
(5) You are advising an originator which is arranging a securitisation of
corporate loans made by the originator to its corporate borrowers.
The originator will sell the loans to a special purpose securitisation
vehicle (SPY) and the sale will be financed by bonds issued by the
spy.
o Some of the English law loan agreements between the originator as
lender and its corporate borrowers contain a provision that states
that the originator as lender "shall not assign any of its rights
under this loan agreement". Is there any way that this restriction
could be circumvented so that the securitisation can go ahead?
o There is likely to be a substantial surplus after the bondholders
financing the SPY have been repaid. How would the originator
extract this surplus?
o What techniques could be adopted to ensure that at least some of
the bonds issued by the SPV are rated AAA?
 CHAPTER 30

PAYMENT AND SECURITIES

SETTLEMENT SYSTEMS

Payment systems
Ontiroduction
32-01 The object of' this section is to explain the mechanics of large-value credit
wholesale transfers. These transfers are typically in large amounts, arc
transfers between banks, must be paid within very short periods (minutes),
and usually involve settling large commercial, money market or foreign
exchange transactions. The turnover gets through world GDP every few
days. The actual number of transfers is also gigantic.
The amount of actual coins and notes transferred in terms of value is
probably less than I per cent of the total in the major industrialised C01.111-
tries a negligible amount. Some say that actual cash is on the way out
except for very small purchases and will be replaced by credit cards and
electronic money.
Large wholesale transactions attract systemic risk, in that the collapse of
one large hank could lead to domino or cascadc collapses of other banks
arid the collapse of the whole banking system. A financial shock in one
country could he felt in other countries. OF particular importance is the
concentration of risks in payment systems in a few major banks.

Payment by bank money

32-02 In international financial markets, debtors pay their creditors by "hank
money' A debtor at - ranges for the beneficiary's hank account to be credited
with the amount due. Debtors do not pay by legal tender, eg handing over a
sackful of notes, or by employing it Wells Fargo coach and horses.
The claim of a creditor against its hank constitutes a debtor-creditor
relationship. The hank is the debtor which owes the amount of the deposit
to its customer as the creditor. Any money which was paid into the account
by the creditor can be used by the bank as its own: the hank does not have to
set that money aside in kind nor hold it as custodian for the creditor.

Codes governing international bank transfers

32-03 One country at least (hut not the only one) has codified the law relating to
funds transfers. This is the United States which sets out rules for high
......................i ....................... A...l .r.i ,t..i'
vaa,_i,tac t'ii - iuiit.i
' tytu.ih Iii luLic - r tjj (IlL l._JIljlUl -ill
ill .OIILiIICILtU'

Code. This is a companion to the Electric Funds Transfer Act of' 1978 which
contains consumer protections. Article 4A applies to high volume
 PAYMENT ANt) SECIJRITIES SETTLEMENT SYSTEMS 479

co mmercial payments and does not apply to consumer related transfers

which are covered by EFTA.
The EU Cross-Border Credit Transfers Directive 1997 (97/5/EC) deals
with the transparency and minimum standards for the performance of intra-
Member State cross-border credit transfers of no more than €50,000, ie
largely retail.
In most countries payment systems are governed either by the contracts
between the parties concerned and by ordinary principles of law (especially
agency), which in both cases are overridden by the mandatory provisions of
bankruptcy law.
There are numerous special statutes dealing mainly with the validity of
set-off and netting and security interests in financial markets. The EU Set-
tlement Finality Directive 1998 enhances the safety of payment systems: sec
para 17--55.

Definition of parties to a credit transfer

International usage describes the "originator" as the person who proposcs to 32-04
make a payment, eg typically a debtor such as a borrower, buyer or lessee
(often called "the payer") and the "beneficiary" as the person receiving the
payment, usually the creditor (often called the "payee").
A payment order is a message or instruction to make a payment. Payment
is the conferring of an unconditional claim against a bank in favour of the
creditor. Payment is sometimes referred to as "settlement".

Payment procedures: international transfers

The diagram shows the usual chain in a payment system. This is the basic 32-05
classical model, but has many variations.

Central Bank

Originator's settlement bank L "1 Beneficiary's settlement bank

Originator's Bank I I Beneficiary's bank

Originator I I Beneficiary

An originator as debtor pays a beneficiary as creditor by arranging for a

bank acceptable to the beneficiary to a gree to be liable to the beneficiary for
the amount of the debt, ie debtors commonly pay in bank money (a claim
against a bank), not notes and coin.
 480 SPECIAl.. roi'ic:s
The payment process involves a series of debit and credits, as opposed to
transfers in the sense of assignments. Each step requires an instruction from
one party to the next in the chain.

o The originator instructs the originator's bank to pay the beneficiary at

the beneficiary's bank.

o The originator's bank debits the originator's account.

o [he originator's settlement bank in the country of the currency debits

the account of the originator's bank and agrees with the beneficiary's
settlement bank to he liable for that amount to the beneficiary's set-
tlement bank

o The central bank (either immediately or later in the day) debits the
account of the originator's settlement hank and credits the account of
the beneficiary's settlement bank. This is "central bank money"—.a
claim against the central bank.

o The beneficiary's settlement hank credits the account of the bene-

ficiary's bank, which in turn credits the account of the beneficiary. So
the beneficiary is paid because they now have a claim against a bank
acceptable to the beneficiary.

32--06 When it hank credits an account, it agrees to be liable to the holder of the
account for the amount of the credit. This is payment.
So payments involve reductions of liability up one side of the pyramid,
ricreases of liability down the other, like a runner laboriously losing pounds
up the hi!l and building up energy as the runner leaps down the easy slope
on the other side.
The reason for the settlement banks (sometimes called clearing banks) is
that only it few strong banks are permitted to have accounts at the central
hank in the country of the currency for a variety of historical, commercial
and legal reasons. Central banks do not usually accept every bank as a
customer. The banks are systemically important. They have to have
sophisticated systems. In most cases foreign banks are not permitted (con-
trol, familiarity, credit in a crisis). So all payments must be channelled
through these settlement banks.
32-07 Settlement banks will only accept as payment a claim against the central
bank since this is the most creditworthy credit in the country of the cur-
rency. This is because the central hank can, if it wants to, create as much
money as it needs by simply crediting the accounts of' settlement banks --
lending them money albeit at the risk of devaluing its own currency.
Ranks lower in the chain have to accept the credit of settlement banks
since they do not have accounts at the central hank. These other banks may
well he located in other countries and hence have, say, US dollar accounts
with US settlement banks.
It follows that the claim of it beneficiary against its bank is ultimately
reflected in the country of the currency by a claim by a hank in that currency
against the central hank.
There could he longer or shorter chains of intermediary or correspondent
banks.
 PAYMENT AND SECURITIES SEtTLEMENT SYSTEMS 481

payment at same bank

If the originator and beneficiary both have accounts at the same branch of 32-08
the same bank, then the credit transfer is simply effected by that bank
branch debiting the account of the originator and crediting the account of
the beneficiary. The payment does not involve the central bank.
intrabank transfers form a very high proportion of transfers where there
is a concentration of big banks, eg 30 per cent. These quasi-systems could be
s ystematically important.

Payment contracts
A payment involves three steps: (I) a payment order, (2) the acceptance of 32-09
the payment order, and (3) the debiting or creating of an account. This is
chapter 1 of the law of contract: offer, acceptance to click in the contract,
then closing by doing it—performance.
Wholesale payment orders are paperless--an electronic message sent
between two computers. Payment orders between banks may be transmitted
via the banks' computers themselves or more commonly via Swift, which is a
Belgian co-operative owned by financial institutions.

Regulation of payment systems

Payment systems may be regulated informally--usually by central banks- 32-10
or pursuant to formal statutory regulation providing for the authorisation
of participants and the supervision of the payment system by regulators.
The payment system must have robust rules approved by the regulator.

End of day and real time gross settlement systems

As explained, credit transfers generally go through settlement banks in the 32-11
country of the currency.
The payments clearing system may be operated by an association of
banks, or a bank-owned company as in the United Kingdom, or by the
central bank itself.
o Some of the main examples are the New York Clearing House
Interbank Payment System (Chips) which is the world's largest
payment system, the Target System for euro, the Clearing House
Automated Payment System (Chaps) in London. Target stands for
Trans-European Automated Real-time Gross-settlement Express
Transfer. In the US, Fedwire is used for domestic payments, Chips
for international payments. Japan has the Bank of Japan Financial
Network System (real time) and the Zengin Data Telecommunica-
tions System (for domestic funds transfers in Japan). For the
mechanics of the euro systems, see LPIF vol 4 para 14-036.

Each participating bank agrees to a common contract contained in it rule-

book. Other banks will usually contract with their customers that credit
transfers are subject to the rule-book.
 482 SPECIAL TOPICS

The effect of the triangle shown at para 15-04 is that all payments in the
country of the currency arc channelled through a small number of settle-
ment banks who have accounts with the central hank. The result is a massive
build up of claims between settlement banks with consequent systemic risks
if one of them should fail before settlement between them at the central
bank, ie before the central bank debits one and credits the other.
There are two methods of settling these claims end of day settlement or
real time gross settlement. Most of the large systems are effectively now real
time gross settlement.

2-12 End of day settlement Under an "end of day" settlement system, the
transfer at the central hank from the account of the originator's settlement
hank to the account of the beneficiary's settlement hank takes place at the
end of each day some time during the night. All the commitments to pay
criss-crossing between the settlement banks can then be totalled up and only
net balances transferred: this netting out of payments vastly reduces the
number of actual gross transfers funnelled through to the narrow channel of
the settlement banks which would otherwise have to be made. The gross
amount, of the transfers would otherwise run into billions or trillions of units
of the currency concerned and so the object is to avoid laboriously trans-
ferring each transfer separately in the central bank's accounts if they can all
he netted out and only net balances transferred between the banks
concerned.
However, it will often he ihe case that the ultimate beneficiary will want
the money immediately during the day he/ore the end of day clearing at the
central hank, eg to pay for assets bought or to repay a loan.
Owing to these commercial pressures, the beneficiary's hank may there-
lore agree to credit the beneficiary's account immediately after it receives
notification from the originator's bank of the credit transfer even though at
that point the beneficiary's hank is merely relying on a commitment from
the originator's hank. The credit of the originator's bank may not be suf-
ficient in the eyes of the beneficiary's bank and the beneficiary's bank will
require a claim against the beneficiary's settlement hank in New York in US
dollars.
32-13 For similar commercial reasons, the beneficiary's settlement bank may
agree to commit in advance to pay the beneficiary's bank so that the ben-
eficiary's bank can immediately credit the account of the creditor. Hence the
beneficiary's settlement hank will have an exposure to the originator's set-
tlement bank which is committed to ensure that at the end of the day the
beneficiary settlement hank is paid, ic by the originator's settlement bank
arranging for the central hank to confer a claim for 100 in favour of the
beneficiary's settlement bank.
The fact that all of these banks may become committed before the final
payments by settlement through the central bank in the evening means that
banks have an exposure to each other during the day. This is often called the
"daylight overdraft" and can run into gigantic amounts. The participants
may operate a system of caps which results in either delaying excess payment
orders (resulting in queuing bottlenecks and delaying payments, potentially
leading to customer claims) or collateralising them. There may be loss-
sharing provisions if a hank dciauits, and various principles for excising
insolvent banks.
The end of' day settlement of the claims of the settlement banks against
 PAYMENT AND SECURITIES SETTLEMENT SYSTEMS 483

each other is made at the end of each day by transfer on accounts of the
settlement banks with the central bank in accordance with the procedures
shown in the diagram at para 15-04. The reciprocal amounts owing between
each pair of settlement banks is netted out so as to produce a single bilateral
balance, and the bilateral balances are netted out multilaterally between the
settlement banks (A, B and C in the diagram).
The multilateral set-off is universally void after the commencement of 32-14
insolvency proceedings against a settlement bank, unless validated by special
statute: see para 15-04.
Special legislation applying to Chips in the United States validates the
multilateral netting. There is similar legislation in the EU pursuant to the
Settlement Finality Directive 1998 in Australia, New Zealand, Canada and
elsewhere.

Real time gross settlement As an alternative to periodic clearings, all credit 32-15
transfers could be debited and credited with all the banks (including the
central bank) simultaneously in their gross amount. In other words, when a
payment is made, the account of the originator's settlement bank at the
central bank is debited immediately during the day and the account of the
beneficiary's settlement bank at the central bank is simultaneously credited.
In practice, payments go through the chain in minutes.
The result is that the beneficiary's bank account can be credited at once.
The insolvency risk with regard to end-of-day multilateral settlements is
obviated. This is effectively the system used by US Fedwire, New York
Chips, euro Target and UK Chaps. Chips is mixed: a statute of 1991 vali-
dates the end-of-day multilateral settlement, but banks are required to hold
large balances with the Federal Reserve Bank. Most payment systems are
now real time gross settlement.
The disadvantages are:

o each payment must he processed individually (a disadvantage sub-

stantially reduced by automation),
o the settlement banks must either maintain large balances at the central
bank to cope with sudden large payments or must be able to deposit
liquid and eligible collateral with the central bank to cover any over-
draft allowed by the central bank (central banks do not usually allow
unsecured overdrafts) or must have borrowing facilities with other
banks: all of these options are expensive. End-of-day settlement does
not require intra-day liquidity, and
0 there is a liquidity risk (shortage of cash to cover payments) and
resulting gridlock while waiting for a payment, ie Bank A can't pay
until Bank B pays it, and Bank B can't pay until Bank C pays it, and
Bank C can't pay until Bank A pays it. Computer programmes can
reduce this risk by counting up each party's positions overall.

It would seem much cheaper to validate multilateral netting by statute,

despite the fact that the creditors of the insolvent bank would be prejudiced,
and this is the view taken by many advanced countries.
Real time gross settlement is normally combined with bilateral (mutual)
netting to reduce the intra-day claims and the need for intra-day liquidity.
Some systems operate on the basis of continuous multilateral and bilateral
 484 SPiCIA[. TOPICS

netting of positions with a complex system of queuing. For a survey of

current techniques, see a paper by Committee on Payment and Settlement
Systems, New Developments in Large-Value Payment Systems (May 2005).

Other issues on payment systems

32-16 The other main issues in relation to payment systems include:

o Insolvency revocation. Whether payment orders given to banks as

agents or sub-agents are automatically revoked on the insolvency of
the sender or its principal. It is almost universally the case that final
liquidation proceedings do cancel mandates to pay if not already
performed.
The precise point at which the proceedings revoke all actual pay-
ments made by or on behalf of an insolvent debtor, eg the originator is
insolvent. The key issue is whether this is the actual time of the
insolvency order or at the beginning of the day on which the order is
made and whether the bank is protected if it does not know of the
order. The debiting of an insolvent's account to pay a creditor results
in the payment of a creditor in full out of assets which should be used
for the payment of creditors equally and is a post-commencement
deprivation of assets. Back-dating to zero hour is relatively common
and protections to banks by no means universal.
32 - -f7 Time of payment. The time at which payment is finally made affects the
following questions, amongst others:
o whether the debtor has paid its creditor on time,
o the time from which interest ceases or starts to run on credit bal-
ances or debit balances,
e the ability of the originator to revoke a payment order,
o insolvency of the originator or beneficiary or a bank in the chain.
Thus, if payment has been made to the beneficiary's bank which
then becomes insolvent, the beneficiary has the risk,
o attachments of bank accounts by creditors. Thus a creditor cannot
attach the originator's bank account once it has been debited
pursuant to a payment order,
o freeze orders or embargoes on making payments,
o expropriation orders seizing bank accounts, and
o set-off against bank deposits.

o Liability of banks in the chain for mistakes and forgeries.

a Conflict of laws.

For these, see LPIF vol 4, chapters 15 and 16.

 PAYMENT AND SECURITIES SE'ITLEMENT SYSTEMS 485

Settlement systems for securities

Introduction

Most actively traded investments are held in settlement systems. The final 32-18
investors are not usually direct holders having a direct relationship with the
issuer. Investors use intermediaries to hold the investments for them.
The intermediaries record the investor holdings by credit to an account kept
by the intermediary. Transfers and pledges of the investments are from one
account to another.
This system replaces the earlier methods of custody and transfer of
investments: investors held the securities directly, eg were registered in the
issuer's books, and custodians kept the paper investments in a box in a
vault.

Examples of settlement systems

The world's largest securities depository is the Depository Trust Corpora- 32-19
tion in the US having custody of equity and debt securities worth more than
half world GDP. The actual "trustee" or title-holder is DTC's nominee
Cede & Co. This nominee holds around 75 per cent of all publicly traded
securities in the US.
Euroclear in Brussels and Clcarstrearn in Luxembourg are the main
international securities depositories: they hold securities worth more than
the GDP of all EU countries.
It is obvious, therefore, that these settlement systems are huge holders of
wealth and play a crucial role in modern economies.
The systems diverge greatly in the detail of their operations and rules. The 32-20
object here is to indicate the principles and the main legal issues.
Some book-entry systems are direct holding systems, eg Crest in the UK
and Chess in Australia. For the differences, see LPIF vol 4 para 18-073.

Objectives

The main objectives of these systems are: 32-21

Transfers are between accounts: this avoids transfer risks (seller or

buyer insolvent before delivery or payment), costs, and delays. Security
interests can be recorded in the account, ie the account functions as a
title register, which satisfies the publicity requirement in those jur-
isdictions which require that the security interest be recorded in a
public register for validity against creditors. The location of the
account can determine the validity of the transfer or security interests
for the purposes of conflict of laws.
o Sale-keeping oi the securities. The secuiities are represented by dn
entry in an account as opposed to a negotiable piece of paper which
can get lost or stolen.
 486 SPECIAL TOPICS

o The reduction of paperwork. 'Ihe paperwork involved in direct hold-

ings of securities using paper would bring markets to a halt. The
annual volumes of shares traded substantially exceeds world GDP. Th e
operations can be computerised so that it is not necessary to delive r
paper transfers or certificates evidencing ownership. There is no need
to incur the cost of security printing negotiable instruments such as
bearer bonds transferable by delivery.
32-22 a The intermediary administers the securities on behalf of the investors.
Thus the intermediary collects principal and interest (which the inter-
mediary credits to the investor's cash account) and manages the
securities, eg the exercise of rights, such as voting, conversions
options, and claims.
o Netting of deliveries and payments can take place so as to reduce
exposures and the processing of millions of' transactions. The use of a
central counterparty for netting purposes mutualiscs trades between
participants and further reduces exposures.
o Statute can enhance the finality and priority of transfers in favour of
transierecs: the legislator might be unwilling to do this generally except
in favour of eligible systems which are regulated.
o The efficiency of the system mitigates systemic risk.
o The unity of title via the account avoids problems of priority when the
asset is split into two indicia of ownership—namely, the registered title
and apparent ownership conferred by possession of a certificate.

Obstacles and problems

32-23 The main legal problems include:

o ensuring that in all relevant jurisdictions the holdings by intermediaries

are immune from the private creditors of the intermediary by a trust or
equivalent. Many jurisdictions do not recognise the trust;

o replicating the priority protections available to the holder of a nego-

tiable instrument so that transferees are absolutely sure of getting good
title without the need to investigate the title of the transferor and its
authority to transfer on behalf of its clients; and

o the adoption of a conflict of laws rule that the validity and priority of
transfers is determined by the law of the location of the relevant des-
tination account, not where the issuer or any global security certificate
is situated. For this principle, see para 34-19.

i' - of citstodias
32-24 The basic usual structure has four tiers as follows
 PAYMENT AND SECURITIES SETTLEMENT SYSTEMS 487

Holder of securities
Issuer
I (eg holder of a global bond)

System operator

(eg Euroclear)

System participant
(cg bank or investment dealer)

Investor
(ie the owner of the securities)

For example, an issue of international bearer bonds is typically repre-

sented by a single global bearer bond held by a depository bank which holds
for Euroclear and Clearstrcam who in turn hold for their account-holders
(who are large institutions as participants in the system) who in turn hold
for their clients as ultimate owners.
US registered international bonds and other securities are registered with
a nominee Cede & Co to in New York for the benefit of Depository Trust
Corporation in the US which has accounts for account-holders.
The system is usually governed by rules in a rule-book or manual to which 32-25
system participants agree. This sets out the detail of operations and liabil-
ities of the parties. The relationship between the ultimate investor and its
immediate intermediary is typically covered by a custody agreement between
them.
System operators and intermediaries are usually regulated by an official
regulator.

Enabling statutes

In most advanced jurisdictions settlement systems are sanctioned by statute. 32-26

The objects may be:

o To establish a trust or equivalent so that investors can be protected

against the insolvency of an intermediary. This will be necessary in
jurisdictions which do not recognise the trust.
o To override requirements, particularly pervasive in civil code jur -
isdictions, that an asset must be specified to transfer or pledge it, eg
specifying the certificate number for shares. This would prevent the
fungibility of securities (each is the same as any other if of the same
issue) which is essential to these systems.
o To override requirements, again persuasive in civil code jurisdictions,
that a charge over an investment must for validity against creditors be
 488 SPF(IAI. TOPICS

registered in the issuer's title register For the investments. This register
must be replaced by the account.
o To enhance the protections of purchasers and col lit teral-takers by
replicating negotiability.

Thus there arc special statutes in, for example, Belgium (1967), Luxembourg
(1971), New Zealand (1967), Germany (1937) and Austria (1969), mostly as
amended. One of the most comprehensive codifications is Article 8 of the
American UCC. There is a Unidroit Preliminary Convention on Substantive -
Rules regarding International Securities, March 2006.
The EU Settlement Finality Directive 1998 and the EU Financial Col-
lateral Directive 2002 improve the positions of buyers and chargees in
relation to (amongst other things) the non-revocability of orders and the
validity of transactions initiated after the commencement of insolvency
proceedings. For these, see para 1 7--55.

Eligible system participants and securities

32-27 Usually each permitted participant in the system must be approved, be

officially regulated (because it holds the assets of investors), have a high
credit-rating (because it may receive investor's money on the securities), pay
system fees, have approved computer systems linked to the operator, and
sometimes have an approved bank to make payments on its behalf. All of
the above necessitate large institutions. The result is that small brokers and
retail investors cannot be participants at the top level. In some national
systems, the participant must often he a national or he regulated locally.
Large systems may have thousands of participants.
Typically, therefore, a lay investor must contract with a participant to act
as intermediary on the investor's behalf----a custody agreement. The inves-
tor, therefore, assumes some risks relating to the intermediary, eg failure to
report or collect, or an unauthorised transfer in favour of a protected
purchaser who takes in priority to the ultimate investor free of the beneficial
ownership of the ultimate investor, or the insolvency of an intermediary who
does not hold sufficient securities for all its investors. Hence the need to
ensure that intermediaries are officially regulated. In practice, most investors
are large institutions such as banks, insurance companies, mutual funds and
pension funds.

Immobilisation and dematerialisation of securities

The securities may be dematerialised or immobilised.

32-28 Dematerialisation Here there are no paper certificates at all so there is a

saving of the costs of custodianship and no need to deliver paper on a
transfer or grant of a security interest. The holder's entitlement to the
securities is an entry in a register kept by the system operator. The holder
does not get a physical certificate. In most systems the securities are
dematerialised.
 PAYMENT AND SECURITIES SETTLEMENT SYSTEMS 489

Immobilisation Dematerialisation is usually not favoured with negotiable 32-29

bearer bonds, which normally have to be contained in a physical written
i nstrument in order to be negotiable.
Negotiability must be distinguished from mere transferability or assig-
n ability. The main characteristics of negotiability are that:

• a holder in good faith for value acquires the property in the instrument
and all rights under it free of any defects in title of a prior holder, eg
even if it is stolen;
o the holder acquires it free of defences available to the issuer against the
prior holder, eg set-offs;
o there are no "notice to debtor" requirements to validate the transfer
against creditors of the transferor; and
o a bearer bond is transferable by delivery.

Therefore, a negotiable bond is highly marketable.

Under English law, an instrument may become negotiable by mercantile
usage, ie the market treats them as negotiable by custom. But, unless the
instrument is within the strict definitions in bills of exchange legislation (eg
unconditional, etc.), which eurobonds never are, they must he payable to
bearer. This was established by nineteenth century case law, eg London Joint
Stock Bank v Simmons [1892] AC 201; Edelstein v Schuler [1902] 2 KB 144.
Owing to traditional adherence to the idea of negotiability, negotiable 32-30
eurobonds are represented by a global bearer bond held by a global
depository—usually a major international bank—for the system, eg Euro-
clear or Clearstream, on terms that the investor's interests are represented
by book-entries in the accounts kept by the system operator.
Since the transfers are of interests under a trust or equivalent from
account to account, it is not the negotiable bond which is being transferred.
Accordingly the protections of negotiability must be extended—by statute
or custom—to the interests which are transferred.
In the United States securities are usually immobilised and not dema-
terialised. Thus the Depository Trust Corporation or its nominee holds a
global certificate for the securities concerned. The reason for this is that
most states in the US require securities to be certificated.

Trusts of securities

Each intermediary must hold on trust or equivalent in order to avoid the 32-31
insolvency risk of the holder. Under the trust, the legal, representative or
nominal title to the asset is held by the trustee as title-holder, but the trust
assets belong to the beneficial owner, the investor and are immune from the
private creditors of the trustee (the intermediary). In common law countries
this is not problematic but in most civil countries special legislation is often
needed to permit trusts and also to permit the holding and transfer of non-
identified fungibles.
This holding of title by the trustee is crucial, because it enables the trustee
to manage and sell the asset as the legal holder.
The immunisation of the securities from the private creditors of the
 490 - SI'E(IAI. TOPICS

intermediary is an essential means of reducing risk of major importance in

view of the amounts involved. Intermediaries could be treated like banks
who owe contract debts to depositors and who can use deposited money as
their own, but such a system would vastly magnify the risks in the financial
system and be contrary to the objective of investors that their assets are kept
in sate custody insulated from the custodian's insolvency (though not from a
custodian's fraud or error).
32-32 The effect of trusts is that, if all the intermediaries are insolvent, the
ultimate investor can claim the property direct from the issuer, assuming
that there are no breaks in the chain.
Since there is a chain of intermediaries, there must he a chain of trusts and
sub-trusts. The ultimate investor is the beneficial owner and all those higher
in the tier are representatives who hold a bare nominal title but no own-
ership. Hence the real ownership is swept down through the tiers to the
ultimate investor.
lithe chain of ownership is broken, cg because there is no recognised trust
or the equivalent in the jurisdiction of a higher tier intermediary, the effect is
that the next in line has only a debt claim against that intermediary on the
intermediary's insolvency and, therefore, the ultimate investor will receive
only what the higher tier intermediaries receive as mere creditors on the
insolvency, ie little or nothing.

32-33 Matching of claims in order to maintain the chain of trusts, each inter-
mediary must have a matching claim against its immediate intermediary
upwards for the securities concerned, ie the upwards intermediary must hold
for the next intermediary down a sufficient number of securities to satisfy the
claims against the next intermediary. Since those claims arc not for physical
assets, they cannot be identified by physical segregation or physical ear-
marking, but only by amount or value. In addition, as explained below, the
upper tier intermediaries do not record the identity of the ultimate investors
or the precise amount of each of their holdings and so the matching
amounts are bulk amounts which are not allocated specifically to the ulti-
mate investors. The holdings are defined by amount, not segregation.

32-34 Fungibility Fungibility means that securities of the same issue and issuer
which are in all material respects equivalent are treated as interchangeable
because they are the same. The claim for the issue is one co-owned claim
which is chopped into pieces by mathematical amount or percentage, not by
giving each investor a paper certificate with a number on it.
II' the investments were not fungible, the system operator would have to
hold numbered definitive securities and identify which definitivcs were
allocated to a holder. This would be impracticable. A major object of these
systems is to avoid paper.
The specificity of the intangibles between holders can only be achieved by
identifying portions by amount or percentage. It would be operationally
impracticable to allocate each interest separately and give it a number or
other indicium of identity.
Intermediaries at all levels record holdings separately by each fungible
class ol security. Recording is issue by issue. They record client holdings ot
each issue in their own books.
 PAYMENT AND SECURITIES SETTLEMENT SYSTEMS 491

Example: A participant in a system has an account with the system

operator recording a holding of 100 securities of a particular issue in the
name of the participant. The participant has accounts for 10 brokers each
holding 10 securities. It records these holdings in its own books, 10
securities for client 1, 10 for client 2, etc. Each of these brokers has five
clients and has accounts showing holdings of two securities each. It
records these holdings in its own books, 2 securities for client 1, 2 for
client 2, etc. Each broker must ensure that its account with the participant
has 10 securities. The broker must not reduce that holding without
instructions from its clients, eg to sell. The participant must ensure that its
account with the system operator has 100 securities. The systems operator
does not know that the participant is holding for 10 brokers or who they
are. The participant does not know that each broker is holding for live
clients or who they arc.

Cell structure and no look-through

Although the ultimate investor is the true beneficial owner of the securities, 32-35
the investor can only exercise its rights through the chain of intermediaries:
the investor does not claim directly from the issuer, but can only receive the
economic benefit of the investments and only communicate with the issuer
through the chain. Similarly, the issuer can only distribute to and commu-
nicate with investors through the chain and not directly. There is no look-
through.
Hence all distributions of income and capital are paid by the issuer to the
top tier holder who in turn passes them down. When the ultimate investor
wishes to exercise rights in respect of the securities, such as voting or con-
version or acceptance of a takeover offer, the investor must instruct its
immediate intermediary who passes the instruction up through the tiers to
the top tier holder who instructs the issuer accordingly. Thus there is a pass
down and a pass up, and vice versa, like buckets of water on a circulating
rope into a well. The issuer does not pay the ultimate investor directly and
the ultimate investor does not instruct the issuer direct as to the exercise of
the investor's rights.
The reason for this cell structure is that the issuer or its registrar cannot in
practice record the ultimate holdings and the-top tier holder does not do so
either. So far as the issuer is concerned, the holder of the investments and
the only person entitled to receive distributions and notices and to give
voting and other instructions is the top tier holder. Similarly, the operator of
the system next down in the chain only keeps accounts for its participants,
and does not record who ultimately owns the investments further down.
Upper tier records are omnibus accounts. See the above example. The
reasons for this are:

It would be impracticable for top tier holders to record lower tier

holdings and the system would break down if upper tiers had to record
all the dealings and entitlements of the ultimate investors and to enter
into custody agreements with them. Millions of securities change hands
at the investor level but there are few changes in upper tiers and none
at top tier. The result is that investors delegate management
upstream and the costs are spread amongst the actual users.
 492 s,IcIAI. TOPICS

o It would also be impracticable For ultimate investors.-who might be

ordinary individuals -to he account-holders with the operator of the
system since for this they would have to be approved and regulated
firms with sophisticated electronic systems and eligible for membership
of payment systems to process the payments. Thus in payment systems,
the ultimate users cannot all be account-holders at the central bank but
must deal with their own bank which then processes payments through
the chain of banks up to the central bank and down the other side to
the creditor's bank.
o The ultimate customers may be in different countries and they will wish
to deal with their own local broker, not with participants at a higher
tier in another country.

32-36 Realistically customers round the world can only deal with their Own
intermediary, just as a customer transferring money through a payment
system cannot realistically deal with each member of the chain of banks up
to the central bank and then down the other side of correspondent banks to
the creditor's bank. In addition, customer confidentiality is preserved.
Customers can also tailor their custodian agreements with their own inter -
mediary according to their own requirements, eg investment policies,
reporting and fees. The top tier holder could not conceivably have invest-
ment agreements with millions of ultimate investors and maintain records of
their entitlements and wishes.
Article 8 of the American UCC neatly codifies the rights of the investor as
a bundle of rights, namely:

o the immunity of the assets from the private creditors of the inter-
mediary and a duty of the intermediary to maintain sufficient matching
assets,
o pass through of distributions, such as capital, income and investments
distributed in right of the investments, such as rights issues, bonus
shares, consolidations and stock splits,

pass up of the exercise of rights, such as voting, conversion and the

exercise of warrants and options,

o compliance with the proper orders of the account-holder, such as sales

and pledges, and
o exit from the system, eg by delivery of a definitive paper investment
from the issuer so as to re-establish a direct relationship between the
issuer and the investor if this is what the investor wishes, provided that
it is available in relation to the securities concerned.

Under Article 8, the account-holder can exercise these rights only against its
immediate intermediary—there is no right to leap-frog upwards: see s 8 ­ 503.
English classical trust law similarly honours the cell structure. As between
trustee and beneficiaries, the trustee has the prime right of action. The
trustee is generally under a positive duty to collect the trust property and
to enforce claims. The remedy of the beneficiary is primarily to compel the
trustee to do his duty. See h'ayim v Citibank NA [1987] AC 370. This is in
sham contrast to agency where the prime right of action on contracts
 PAYMENT AND SECURITIES SETTLEMENT SYSTEMS 493.

entered into between a third party and an agent on behalf of his principal
rests ordinarily in the principal and not in the agent. The main difference is
that the beneficiary's remedy is not, as in the UCC, solely limited to action
against the intermediary-trustee. If the trustee fails to act, the beneficiary
can act but must join the trustee in court proceedings. This preserves the
ability of a beneficiary to act if the intermediary fails to do so, but at the cost
of a rupture of the cell structure. This direct action is important if the
immediate intermediary is in breach of duty or insolvent.
The main consequences of this system is that ultimate investors depend 32-37
upon upper tiers performing. The chain is only as strong as its weakest link.
To compensate for this, investors benefit from the efficiencies of the system.
One disadvantage is that there is a possible lack of transparency. Thus the
ultimate investor may have difficulty in discovering whether there is an
upper tier break in the trust chain—either by virtue of the absence of the
trust or because an upper tier intermediary fails to maintain matching
securities--or whether there is an upper tier lien for unpaid fees or whether
upper tier liability for negligence is excluded. The investor may find it dif-
ficult to discover, say, whether the conditions for a set-off are available.
The strict compartmentalisation of the cells is not always observed. For
example, upper tier intermediaries are reluctant to get involved in voting.
Global bearer notes held by the global depository for Euroclear and
Clearstream vest voting rights in the account-holders at the systems. Neither
DTC nor Cede & Co vote: instead they send the issuer an omnibus proxy
assigning consent and voting rights which they may have to account-holders
on the relevant record date so that the account-holders vote direct. A typical
case of voting by bondholders is on an insolvency reorganisation plan.

Cash accounts

Intermediaries will typically maintain cash accounts for the receipt on behalf 32-38
of investors of distributions of interest, dividends, redemption proceeds, sale
and repurchase proceeds, and proceeds in connection with loans secured on
investments and others.
The possible relationships are:

The intermediary deposits the proceeds in its bank account at a third

party bank and holds the benefit of this account on trust for the
account-holder. This confers a property claim in favour of the account-
holders in trust countries. This will be the usual arrangement in the
case of lower tier holders who are non-bank brokers holding for retail
clients.

o The intermediary is only a debtor to the account-holder and holds

nothing in trust. This will typically be the case where the intermediary
is a bank which credits proceeds to an account in the name of the
account-holder. The account-holder takes an unsecured risk on the
intermediary.
 494 SPECIAL iOI'I(:S

Transfers and security interests

32-39 Transfers and identification Each ultimate investor has a partitioned
interest in the global security. They are not held in common as joint
property, as would be the case where two people own a Picasso or a Single
piece of land which they can both use and enjoy in common. Each investor's
interest is usually the same as that of each other investor and interchange.
able, but that does not lead to the result that they are co-owned. People OWfl
cars or washing-machines which are substantially identical. In other words,
the ultimate investor can deal with the property as its own: this segregated
property is not co-owned with the other investors.
As regards transfers, the law for tangible assets, such as goods, often
stipulates that the asset to be transferred must be identified and separated in
order to publicise the delivery of the asset and the passage of beneficial
ownership. The law relating to sales is of limited application because
transfers in these systems are not assignments or sales of an interest: see para
30-41. It is not possible to identify a portion of an interest in a debt claim
except by amount. It cannot be done physically like goods, eg unlike the
labelling or physical segregation of goods, and it cannot be done for
interests in securities, which are pure intangibles. Thus a sale of 10 out of a
debt of 100 requires only that the amount to he sold - the 10 -is specified.
The 10 cannot be physically separated and can only be identified
mathematically.
English law recognises that defining the portion of a claim which is owned
or which is transferred is effective for ownership or transfer, if the bulk is
identified. Thus it trust or sale of tOO bonds of X Corp is ineffective, but a
trust or sale of 100 bonds out of my X Corp holding or 100 bonds of my X
('orp holding recorded with intermediary A is effective.

In Re Harvard Securities Lid [19971 2 BCLC 369, a securities dealer

bought US registered shares on behalf of clients and registered them in the
name of nominee which held in trust for the dealer which told clients that
the dealer held a specified number of shares in trust for the clients. The
dealer did not identify the shares by certificate number because the cer-
tificate was issued globally to the nominee. The dealer became insolvent.
Held: the shares held in trust were sufficiently identified: The cases relating
to the need for segregation of ascertained goods from a bulk to pass title
did not apply: it is not possible to identify a proportion of a debt or other
claim physically.
In Hunter v ti'los.c [1994] I WLR 452, CA, Moss held 950 out of 1000
registered shares of a company. He declared a trust of 5 per cent. of them
in favour of Hunter. Held: the trust was valid and did not fail because of
the absence of certainty (specificity). The cases relating to the need for
segregation of ascertained goods from a bulk to pass title did not apply: it
is not possible to identify a proportion of a debt or other claim, physi-
cally, unlike the labelling or physical segregation of goods.
In Re CA Pacific Finance Ltd [1999] BCLC 494 (Hong Kong), an insol-
vent broker held fungible shares deposited in Hong Kong clearing and
settlement system in trust for clients. Held: the trust was valid.

30-40 In relation to goods, under English law the title to portions of hulk goods
can he transferred if the price is paid: see the Sale of Goods Act 1979 S 20A.
 PAYMENT AND SECURITIES SETTLEMENT SySTEMS 495

This overrides previous English case law on sale of goods which held that
sales of a portion by quantity of bulk grain, gold bullion and wine bottles
did not pass title because of lack of segregation, eg 50 tons out of 500 tons of
grain on a specified ship. See Re Wait [1927] 1 Ch 606 (500 tons of wheat out
of a large bulk on board the ship "Challenger"); Re London Wine Shippers
Ltd (1986) FCC 121 (unsegregated wine bottles in a vault); Re Goldcorp
Exchange Ltd(1995) 1 AC 74 (unsegregated gold bullion). The requirements
to segregate goods in order to pass title to a portion of a bulk is very
common in other jurisdictions (not required in the US under the UCC). But
m the case of debts, one part of a debt is the same as any other and one
cannot identify any part of a debt as being different from another part. So in
English law it has always been possible to transfer, eg half a specified debt,
or 50 out of a debt of 100. See, for example, Re Steel Wing Co (1921) 1 Ch
349 (sale of an "equal half part" of a specified debt). This is probably the
rule in most jurisdictions, ie the "goods" rule for segregation of sales from a
larger physical bulk does not apply to intangibles.
Some jurisdictions require the segregation of customer securities if they
are to benefit from the trust protection. The intermediary must, therefore,
not only specify in its own records the number of securities held for itself
and for each customer, but must also open separate accounts for each
customer in upper tiers, thereby proliferating the number of accounts in
upper tiers and multiplying the complication. Sometimes the only necessary
segregation is between client omnibus accounts and house accounts. As in
bank accounts, the segregation is mathematical by amount.

Mechanics of transfer If both the seller and buyer have accounts at the 30-41
same intermediary, the intermediary simply debits the seller's account and
credits the buyer's account. It is not necessary for there to be any account
changes upstream. Thus in the diagram below, the system operator debits
the seller's account and credits that of the buyer.

The mechanics are different if there is a transfer from one intermediary to

another. The structure is like a splayed-out compass with two legs. The seller
at the foot of the left hand tier wishes to transfer 10 securities to the buyer at
the foot of the right-hand chain. The participant in the left-hand chain
debits 10 from the seller's account and instructs the system operator to debit
10 from the left participant's account and credit those 10 to the right-hand
participant's account who in turn credits 10 in the account it holds for the
buyer.
 496 SPECIAL T()I'ICS

The left-hand participant does not simply debit the seller's account and
credit the buyer nor does the seller sell its claim against its own intermediary
to the buyer, because the buyer does not have a custody contract with the
seller's participant and desires to deal only with its own right-hand parti-
cipant -the participants may also be in different countries.
The transfer is not an assignment of a claim by the owner. It is a form of
novation because the intermediary extinguishes its obligation to one holder
and re-creates it in favour of another—exactly as in credit transfers in a
payment system although there are many variations in both systems. For
transfers in payment systems, see para 30M5.

30-42 Security interests generally Most systems have arrangements whereby

parties can grant security interests over their securities held in the system.
If the pledgor has an account with the operator or a system participant,
the pledgor pledges its claim against the operator or the participant. This
claim is a property interest under a trust or the equivalent.
The pledge may be:

o by transfer of the securities in the pledgor's account to an account in

the name of the pledgee, so that the pledgee appears as the full owner;
o by notation on the pledgor's account that the securities are pledged to
the pledgee or by a pledge account. The pledgor appears as the full
owner but the securities are blocked; and
o by private pledge between plcdgor and pledgee without registration in
the accounts. In some jurisdictions this is ineffective against creditors,
and the pledge is therefore useless. Informal pledges are effective
against creditors in England.

30-43 Perfection of the security interest In English-based jurisdictions the general

rule is that, for validity against creditors, the security interest must be
registered as a charge at the debtor-indexed companies registry in the jur -
isdiction of the debtor's place of incorporation if within one of the heads of
registration, eg the charge: (1) is to secure an issue of debentures, (2) is a
floating charge (possible if the debtor has a right to deal or a right of
substitution), or (3) is a charge on "hook debts"-----thcse are broadly
 PAYMENT AND SECUR1TIES SITFLEMENT SYSTEMS 497

c ommercial receivables. None of these heads of registration is likely to

apply. Otherwise no publicity is required, but a full transfer or notation of
the security interest is useful to protect priorities. The EU Financial Col-
lateral Directive 2002 neuters the above registration in cases where the
Directive applies (financial collateral between eligible parties where the
collateral-taker has possession or control).
Under Article 9 of the UCC, the creditor must perfect either by a UCC
filing or by "control".
In Roman-Germanic and Napoleonic jurisdictions, subject to the EU
Financial Collateral Directive 2002, the usual rule is that the creditor must
either be the account-holder or be registered in a pledge section of the
account or similar. There are many exceptions. Where there is a general
business charge which includes book-entry securities, these charges must
often be registered in a debtor-indexed register.
For publicity generally, see para 19 -18.

Netting and central counterparties Where there are cross-transfers between 30-44
parties, whether on sale or pledge, the securities can be netted, often via a
clearing house as central counterparty, so as to reduce delivery exposures
and costs. The reduction in risk can be very substantial. For these central
counterparties, see para 1 545.
Thus if in the diagram at para I 5--05 sellers agree to sell to buyers in the
lowest tier, the sale obligations result in obligations to transfer from
accounts at the level of the top tier participants having accounts with the
system operator. These obligations are novated to a central counterparty
which on-sells to the participant in the buyer's side of the pyramid, two
mirror contracts instead of one. Since there will be sales in the other
direction, all these obligations can be netted by the central counterparty.
The central counterparty notifies the system operator to transfer securities
from the accounts of net sellers to the central counterparty and then to the
accounts of net buyers.
Similarly, the payment may be routed through a third pyramid of banks,
correspondent banks and settlement banks, from debtor to creditor. If there
is a central counterparty then the central counterparty will have to make
payments.
Some of the participants in these three pyramids could be the same or
they could be subsidiaries of the same financial institution or outsiders.

Payments
If a seller transfers to a buyer on a sale, the ideal is that the seller is paid by a 30-45
final irrevocable credit to its bank account simultaneously with the transfer
of the beneficial ownership of the securities (delivery against payment-•
"DVP"). Otherwise the seller runs the risk that the buyer becomes insolvent
before payment. Some examples of payment systems for securities transfers
are:

Some systems have an assured payment arrangement whereby, for

example, under the rules (as in UK Crest) a settlement batik acting
for the buyer becomes immediately liable to the settlement bank
acting for the seller for the purchase price as soon as the operator
 498 Si1(iAI t()II('S

eflects the hook-entry tiansfr. The result is I fiat the seller then looks to
its own hank and the buyer is discharged. Pa rticipa Ills agree lending
hicilities with their settlement hank.
0 In the case (W both F.uroclear and ( 'learst ream. participants have it cash
account Wit h 1711roclear or Clearst ream. which are banks, and so when
securities are tiansfrred from seller to buyer, the bank simply debits
the buyer's cash account and credits the seller's cash account as an iii-
house transfer. flie result is that payments can be made against the
transfer of' title.

o In sonic systems the payments are iiiatle only sonic (lays after the
ia tisler. 1 fence the seller has the risk of the buyer's insolvency.

1 a lender takes a securdV interest over the securities of' a participant. then
file svsteiii may have synchronised arrangements whereby the pledged
securities arc (a nsfriecf to the lender's account or to a blocked account
simultaiieously with the advance of' the loan. If' not, it is up to the parties to
synchronise.
Under the ideal securities settlement system operated in some countries.
the relevant exchange,the central securities depositary and the financing
bank are linked by a common computer network. Once a trade on the
exchange has been confirmed, the parties, give notices 1)0111 to the securities
settlement system (which debits or credits the appropriate securities
acc )U iitS ) and tot he l)ayiiient system (tha( debit., or cre(hit.s the cash accounts
of the mnterme(Ii:trics involved in the trade) siniultaneouslv so that there is an
gap between delivery and payment. flie functions of the clearing oi'ganisa.
(ion i' llrst 10 match the confirmations dc.'livei'ed to the clearing orgunisation
by flic raders so as to ensure that they con l'ormn . The clearing orga ii sat Ion
acts as a central coutiterparty in order to enhance netting and to guarantee
delivery. The central counterparty may agree to deliver securities or pay
notwithstanding the deLi tilt of a member in order to increase the trust of' the
market in capital markets and to spread the cost of' losses. Some stock
exchanges alternatively have guarantee t'unds which ensure that the settle-
inents of central market transactions are guaranteed SO that in the event of
(lie default ol' an intermediary the guaranteed fund will compensate investors.
']'lie guaranteed fund is funded by the members of' the exchange.

Priorities and replication of negotiability

30-46 In hook-entry systems it is essential to protect the sahty of' transactions by
scraping oIl' prior property interests. Markets cannot operate unless the
principle of the protected holder in due course developed kr negotiable
instruments is upheld. The velocity of' transactions is so high that investi-
gations would normally he impracticable and, given the volumes, it
disruptive claim disturbing finality could have systemic consequences. It
would he very expensive to investigate problems the costs would have to
be passed on and effectively I he system would conic to it halt.
That means that prior property interests titlist he cut oil or overreached,
L ()IUI nud NCCUI ii,y imiieicsls ut the i ighits um bencliciaries under it it
or the rights of' clients as principals acting through a broker as agent it
must be assunied that the broker has a right to sell. Otherwise, the mere Lict
 PAYMENT AN!) SECURITIES SETFLEMENT SYSTEMS 499

that an intermediary or transferee knows that a transferor was a broker

acting for clients (as will often be the case) might require the intermediary or
transferee to check that the client had authorised the transfer. Inter-
mediaries cannot check whether securities represent embezzled profits or
whether a registered secured creditor is entitled to sell.
The effect is that, if purchasers and secured creditors are protected,
investors rely on the integrity and competence of their intermediaries and
those in upper tiers.
A high degree of protection to ultimate investors is afforded by the 30-47
experience and rating of intermediaries, by official regulation of inter -
mediaries and by depositor or investment guarantee schemes. Delinquencies
appear to he few.
As the transfer is not an assignment or sale of property but rather a form
of novation (extinguishment of an obligation to the transferor and its re-
creation in favour of the transferee) the normal priority principle applicable
to a sale of property should apply only by analogy.
The effect of the American UCC Articles 8 and 9 is substantially to
improve the priority protection of collateral-takers and purchasers from an
intermediary if they become account-holders or otherwise obtain control,
unless there is collusion. In most cases, it is irrelevant that the purchaser/
pledgee has notice of a prior advance claim (except in the case of the fraud)
so long as the purchaser/pledgee is the first to obtain control, eg by
becoming registered as the holder of the securities. For the priority of
secured creditors in the US, see LPIF vol 2 para 15-077. The Spanish
Securities Markets Law art 9 provides that a person buying securities is not
liable for any claim for their recovery unless they acted in bad faith or with
gloss negligence at the time of purchase.
The basic English priority rule protects the bona fide purchaser who has
no notice of the prior claimant, gives value and acquires "legal" title.

Further reading on securities settlement systems: LPIF vol 5 chapter 18.

500 SPECIAL TOPICS

QUESTIONS AND SEMINAR TOPICS

(I) What is payment? How are payments made through a payment
system?
(2) Why have the payment systems of most advanced countries moved
over to real time gross settlement as opposed to end-of-day
settlement?
(3) What are the objectives of settlement systems for securities and how
are these objectives met?
(4) What is: (I) a trust; and (2) negotiability, and why are these concepts
essential to book-entry securities settlement systems?
(5) A bondholder in Sweden at the foot of a chain of brokers and banks
holding bonds in Euroclear wishes to pledge the bonds to a broker in
Singapore who is also at the foot of a chain of account-holders
leading up to Euroclear. The broker requires that the bondholder
transfers the bonds into the name of the broker. What are the
mechanics of this transfer? What law do you think that jurisdictions
ought in principle to apply to the validity of the transfer as the pre-
ferred solution, and why?
(6) Read the following excerpt from LPIF vol 7 para 12 -002 headed
"Buying a share":
"When you buy a loaf of bread in the shop, you take the loaf,
hand over some coins and exchange pleasantries. Have a nice
day. Buying a share is not like that.
You order your broker to buy a share and to arrange payment
out of cash left with the broker. The order flutters down gently
like a butterfly on to a polished scale. This is enough to tip a
sensitive balance of gossamer delicacy.
At once a gigantic machine, as dark as night, vast in size,
stretching up to the thunderous clouds, a stupendous machine
with huge cogs and levers, with immense chains and pulleys and
wheels, with conveyors stretching across the world, with belts and
Furnaces and engines, this monstrous machine leaps into life with
a roar, belching smoke and flames and fumes. Once in motion,
nothing can stop it, nothing can interrupt its relentless career as
each interconnecting piece, each rod, each piston, each cog,
sparks oil another in fatalistic progression. Your buy order is
hurled into one bucket amongst thousands of buckets carrying
buy orders for that share and hurtling round on a gigantic wheel
which meshes the cogs of another wheel in a screech of steel, that
other wheel which carries sell orders for that share. As soon as
your buy order matches a seller's order, the seller's share far away
is cranked up on cogs through the tiers of the securities settlement
system, the conveyor climbing with the rasping of chains up into
the darkness, across territories, across countries far beneath, until

it reaches the clangorous control room of the settlement system,

from where it tumbles into a boiling cauldron of other shares
 QUESTIONS AND_SEMI NAR TOPICS 501

with an ear-splitting crack of explosion. A catch unclasps and the

cauldron swoops down on its cables with a whoosh and smashes
against the side of the towering armoured central counterparty
which nets all shares so that only a jet of molten metal squirts
through the other side. The jet spits on to a palette and hisses as it
is douched with water to form a solid iron ball, rolling around on
its palette. Meanwhile the chains and cogs of the share settlement
system are linked by pulleys to the wheels with the bucketed share
orders, linked to the payment system at the foot of which sits
your cash, your cash which is ratcheted up the side of the pay-
ment system in a tumbril, clattering though tiers of banks across
borders, rattling up, up, so high as to he almost invisible. There it
is queued at the central bank on a plate spinning at furious speed,
at once mangled in an instantaneous netting process which cru-
shes prodigious piles of cash from everybody transferring cash
that day, leaving your cash a dense golden ball on its palette,
trembling with energy, almost toppling from its dizzying height
atop the tiers of the payment system. At this point, set off by
sonic hidden piston, a ferocious claw with brass prongs rears up
on a crane ready to grab the collateral if anything goes wrong in
the final act. A tiny spring releases a colossal iron lever whose two
swinging arms with fearsome violence simultaneously smite the
golden cash ball and swipe the iron share ball so that they fly in
long arcs across oceans, across seas, and land at exactly the same
time with a deafening clang into two great steel bowls countries
apart, your account, the seller's account.
The great machine falls silent. A little piece of paper wafts
down on to your polished scale. It reads, 'We have credited your
account with the share you have bought. We are regulated by the
Financial Authority. Please note that we have a lien on your
share for our charges.'"
What processes does this passage describe? How would you design a
system for the sale and purchase of shares so that netting, the transfer
and payment all happened more or less simultaneously?
 L.

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 CHAPTER 31

GOVERNING LAW OF FINANCIAL

CONTRACTS
Introduction

Every legal issue under a contract must be determined in accordance with a 31-01
system of law. An aspect of a contract cannot exist in a legal vacuum.
In England and in most developed countries the parties to a contract may
normally choose the governing law of the contract which will govern many
of its aspects.
The law chosen is that of a jurisdiction, not a sovereign state: there are
seven legal systems in the British Isles of varying degrees of distinctiveness:
England, Scotland (anglicised Roman law), Northern Ireland, Isle of Man,
Jersey, Guernsey, and Alderney/Sark. The last three, which are the Channel
Islands, have an anglicised pre-Napoleonic French legal system. A choice of
"US law" could be any one of 51 jurisdictions.
The law governing a contract is variously called the "governing" law, the 31-02
"applicable" law or the "proper" law. This review will use these terms inter -
changeably. The consensus term is "governing law".
The rules regarding the governing law of financial contracts are settled in
most advanced states. The main current battleground in relation to con-
tracts is not governing law but what courts have jurisdiction.
The main battleground in relation to other conflicts arenas is insolvency
law and also the law relating to property, such as security interests and
trusts—where often the problems happen to coincide with an insolvency.

Factors influencing contract choice of law

Factors which influence the choice of law for a financial contract include: 31-03

non-legal preferences, such as patriotism, tradition, familiarity and

convenience;
' avoidance by the lender of a detailed investigation into an unfamiliar
system of law;
e commercial orientation, stability and predictability of the chosen legal
system;
o application of the agreed terms of contracts without the court imposing
its own view of fairness;
o the desire to coincide the governing law with the law of the enforcing
forum (which may be external)– legal unpredictability may result if the
court is called upon to apply a foreign law with which it is not familiar;
 506 (UNtt RI 01 I AWS

0 tile a hili I y 10 use lawyers WIM have special cx r)C11CncC iii (lie I Ype of
financial contract concerned
0 Ia niwauc: and
0 insulation.

English and New York law

31-04 1 listorical dominance English and New York law enjoy ii dominant posi -
lion as the governing law of* major international financial contracts. these
arc international syndicated bank loans, international bond issues and
derivatives transactions all of which involve colossal amounts.
The reasons For this doniina nec are partly historical In the nineteenth
century Britain was the world's largest economic power, and the United
States was and is the world's largest CcOflOfliiC power, a mantle which it
assumed around 19(X). Financial institutions tend to prefer their home law
and so it was inevitable that countries which gave birth to these banks and
very deep capital markets would see a tendency for those banks and markets
to choose their own law with which they were familiar.
Once a legal system views itself' as international and as being used in
mator commercial and financial transactions, then courts. fudges and leg-
slit toi's tend to see it its their job to ensure that the legal system meets
he req ut rement s of its users. They become aware of their international
tcsponsl hi lilies and the confidence and trust reposed in their stability and
common sense by the international financial community.

31-05 The Delaware factor This tide to a single trusted legal system may he
dubbed the Delaware factor. Although the following figures may not be
particularly precise. it seems that more than 70 per cent of the corporations
listed on the New York Stock Exchange are incorporated in Delaware. In
order to appreciate the magnitude of this concentration in Delaware, these
corporations may well command around 30 per cent of world trade. It does
not matter whether it is 20 per cent or 40 per cent the amounts are
extremely large. There are two basic reasons why this happened. In the first
place the five justices of the Delaware ('ourts of Chancery resolved that their
corporations law would, amongst other things, respect the business judg-
mcnt of the officers if properly considered and would not support populist
big pocket theories of liability. The corporate statue itself', as interpreted by
the Delaware Court of ('hancery. is liberal on such matters as maintenance
of capital- -Tor example, it OOSCS the rule. championed in English-based
countries, preventing a company from giving financial assistance for the
purchase of' its own shares. The state administration of corporations is last,
cheap and efficient.
The second feature of the Delaware Factor is that markets cannot he
bothered with it proliferation of choices: they are content with even a single
option, provided that the chosen option reasonably meets their needs.
There arc many other examples of this character of legal monopoly. For
example:
 GOVERNING LAW OF FINANCIAL CONTRACTS 507

o The Uniform Customs and Practice 600 for Documentary Credits pub-
lished by the International Chamber of Commerce is incorporated in
trade letters of credit almost universally in the world.
o Virtually all international payment messages are communicated
through Swift, which is a bank owned co-operative located in Brussels.
o The CLS Bank incorporated in New York and operating largely in
London is the central netting counterparty of choice for the great bulk
of international foreign exchange transactions.
o Virtually all dematerialised securities on the New York Stock
Exchange are held and cleared through a single settlement system,
namely the Depositary Trust Corporation and its affiliates, and the same
is almost true of international bonds which are held by the interna-
tional securities depositaries Euroclear in Belgium and Clearstream in
Luxembourg.
o The ISDA master agreement is probably used for 90 per cent by volume
of mainstream derivative transactions in the private markets.

In all of these cases the institution or document has a virtual monopoly and
the same is true of legal systems. It is too complicated for markets to
investigate a different legal system on each occasion and so they tend to
gravitate towards legal systems which they are used to and which they can
trust.

Stability and experience Both jurisdictions have high potential stability, as 3146
independent and efficient jurisdictions, and much experience in financial
matters.

In the case 311-07

Predictability of governing law, jurisdictions and deimmunisation
of English law freedom of choice of the governing law was confirmed in
1865 in the case of Peninsula and Oriental Steam Navigation Co v Shand
[1865] LT 461 'this was well before its liberation elsewhere-- -and New York
removed the requirement for connection between the chosen law and New
York law by a statute in the last quarter of the twentieth century. An
English choice of courts coupled with the appointment of an agent for
service of process entitles the parties to their choice as of right in the normal
case and the same is true of New York. Both systems of law gave validity to
express waivers of state immunity---the US in 1976 and the UK in 1978.
Both jurisdictions effectively enable lenders to insulate their contracts from
exchange controls, moratoriums and other prejudicial actions of the state in
which the borrower is located. See para 31-14.

Contract predictability Both jurisdictions have a strong policy in favour of 3148

upholding the bargain of the parties in business contracts freely entered into
without imposing a judicial view of what is fair.
Doctrines which may affect a creditor materially include:

o Good faith. There are differences between the attitude to loan accel-
erations for a minor breach or delay in payment, even though this is an
express event of default. Outside consumerism, the English courts
enforce the bargain of the parties strictly and, if the parties have agreed
 508 (ON I I .I( :1 01 LAWS

that a loan is accelerubic on non-payment in lull on the due date, it is

accelerable even if payment is only a day late or $100 short. It is up to
the business parties to negotiate their own grace periods if they want,
the courts will not substitute their own views of what they think is fair
or reasonable. This is not true in all jurisdictions: courts in some
countries apply concepts of good faith or reasonableness. For state-
ments of the "good faith" doctrine for contracts, see, for example,
France CC art 1134; al 3; Germany BGB s 242; US UCC s 1-203 and
the VS Restatement (Second) of Contracts s 205.
It is true that sudden accelerations like a bolt out of the blue are
unusual, and accelerations of major bank loans or bond issues on
account of a triviality are rare in the author's experience. The ability to
suspend new loans on an event of default is more important. Never-
theless, there are cases where the ability to accelerate quickly could
matter, eg where a debtor seeks to withdraw a deposit from the lender,
and the lender, fearing that the debtor is unable or unwilling to pay,
seeks to accrue a set-off by accelerating the loan and has to hunt for a
technical default. This situation may also arise where a creditor of the
borrower attaches the deposit. Immediate acceleration could also be
important in relation to secured credits and title finance where the
value of the asset is volatile (investment securities) or the asset is liable
to flee, eg an aircraft subject to a finance lease. Any lack of legal
predictability and certainty tends to introduce a sense of unease and a
weakening of bargaining power. Much lies in the perception of pre-
dictability and certainty. The willingness of the courts to enforce the
contract as written--which is usually between parties of equal bar-
gaining power and has been heavily negotiated--is seen as
Fundamental by markets. Legal systems which are accustomed to being
used in market transactions tend to honour this proposition and give
primacy to the policy of giving effect to the parties' agreement, not-
withstanding occasional abuse.

31-09 a The English position may be illustrated by a series of cases on termi-

nation of contracts for a default.

In Shepherd & Cooper Lid v TSB Bank plc [1996] 2 All ER 654, a
bank was entitled by the documentation to accelerate and enforce
a secured loan, immediately on default in payment. The bank sent
in receivers one hour after demanding repayment of £600,000.
Held: the time allowed must be sufficient for the borrower to
arrange mechanics of payment via its bank. But if the borrower
makes it clear that it cannot pay (as in this case), the bank need not
give further time. The appointment of the receivers was valid.
a In The Chikuma (1981) 1 All ER 652, the hire payment for a ship
charter was short by $80 because of bank interest and charges. The
ship owner was held entitled to cancel the charter under a clause
allowing cancellation if payment was not made in full on the due
date.
o In The Laconia (1977) AC 850, an owner forfeited a ship charter
for non-payment of hire on the due date-• payment was a weekend
LOW. The charterparty entitled the shipowner to cancel if hue was
not paid on the due date. Held: the owner was entitled to cancel the
charterparty.
 GOVERNING LAW OF FINANCIAL CONTRACTS 509

In these cases the courts either enforce the contract as written (the
approach of the English courts) or they amend the contract. If they
amend the contract, is the grace period to be 24 hours, three days, one
week or one month? if the creditor fails to divine in advance the view
of the courts, then a creditor taking possession of security could be
liable for very substantial damages and hence increased risk. The view
of the courts is that, if a contracting party wants a grace period, then it
must agree it in the contract and indeed this is commonly done. These
are not situations of an overweaning disparity of bargaining power or
unconscionability.
The "good faith" doctrine may also affect the ability of a lender to
withdraw from negotiations for a loan after committing in principle
under a non-legally binding letter.
Other factors are:
o The upholding of exculpation clauses between sophisticated
counterparties, eg excluding the liability of a manager of a bond
issue or a syndicated loan from misrepresentation, a syndicate
bank agent, bond trustee from duties of due diligence or a deri-
vatives dealer except in the most egregious circumstances such as
an exclusion for fraud. The amounts involved can be gigantic,
could wipe out an institution and are generally uninsurable.
' The absence of out-of-date usury laws and writing requirements.
a Restraint in the imposition of unpredictable lender, or big pocket,
liability, cg for misrepresentation by an issuer in a prospectus or
for abusive credit. See LPIF vol 1, chapter 22.

The five indicators in both cases the underlying legal system is positive on 31-10
five key indicators of financial law discussed in chapter 2. The three major
indicators are insolvency set-off (though with some wobble in the case of
New York by reason of a stay in BC 1978, although the economic effect of
insolvency set-off is maintained), universal corporate security interests, and
the universal trust, each of which plays a major role in financial law. US
insolvency law is more debtor-friendly.

Regulation In regulatory matters it is sometimes said that the US rcg- 31-11

ulatory authorities are more aggressive and the regulatory regime more
intensively punitive. It is also sometimes said that litigation in New York, as
in the whole of the United States, is an adverse factor by virtue of expensive
class actions, jury trials, contingent fees, the fact that the loser does not
necessarily pay the other side's costs and excessive punitive damages, but it
may well be that these litigation adversities, although a feature of the US
legal scene generally, are less of a factor in the type of business disputes we
are concerned with which are heard in the federal courts sitting in New York
as opposed to the state courts.

Conflicting pressures Both jurisdictions are subject to inescapable con- 31-12

flicting pressures. The first is to conform the legal system more to the
expectations of domestic politics which usually means greater emphasis on
debtor interests. The second is ihat both jurisdictions are subject to an
overarching legal order- Federal law in the case of New York and EU law
in the case of England. Just as Delaware had to submit to the Sarbanes-
 519 (:0NFLICr OF LAWS

Oxley Act criminalising director responsibility for financial statements

somewhat more intensely, so must New York how to the Federal regulatory
system and to the Federal Bankruptcy Code which has more debtor-
orientated features compared to English law. Adverse intrusions on English
financial law stemming from EU directives and regulations has not in fact
proved to he particularly material in our field, partly because of UK opt-
outs or because the views of EU Member States in this arena do not differ
substantially from those of Britain. Indeed in some cases the EU view has
vigorously supported financial markets, notably in the case of settlement
finality in clearing systems, set-off and netting in financial markets and the
protection of financial collateral.

31-13 Conclusion There are occasionally protests that the competition between
legal systems leads to a race to the bottom. Another view is that the legal
values of an appropriate measure of freedom and predictability or the
protection of legitimate expectations in financial and corporate law are not a
race to the bottom but rather a race to the top. Corporations on the New
York Stock Exchange do not choose Delaware as the lowest common
denominator but rather as the representative of sound corporate values and
it is unthinkable that these corporations would do otherwise. Similarly
parties frequently choose English or New York law because of their relia-
bility and good sense.
Neither of these two legal systems is by any means perfect and both have
blots. In addition it does not follow that they are the best legal systems. Out
of the 320 or so jurisdictions there are numerous legal systems which offer as
much or more. Despite this obvious reality, the Delaware factor nevertheless
leads to only it few out of the many being chosen since the alternative is too
complicated and expensive.
Whether these legal systems can continue on their chosen course is a
matter for them. History does not stop now and no jurisdiction is entitled to
assume that it is exempt from competition. The muscular power of com-
petition is a salutary Force for improvement.

Insulation
31-4 Objectives Insulation of the loan contract from legal changes in the bor-
rower's country is one of the most important reason for the choice of an
external system of law—it does not matter which law, so long as it is
external. Historically the most common changes of law protecting national
debtors have been: (a) legislation imposing a moratorium on foreign obli-
gations, and (b) exchange controls. The risk may be increased where the
borrower is a state or is state-related or is nationally important. These
interferences often arise either because of political upheavals or because the
state is insolvent--both of which are events against which the private
creditor seeks some defence.
If the borrower's system of law is chosen a lender may be subject to
changes in the local law. This conclusion flows from the rule that the gov-
erning law applying to the agreement is the law as it exists from time to time:
CC Rc IIell;crt Wag & Co Lid [1956] 'it 323. As the House of Lords stated
in Kahier v Midland Bank [1950] AC 24. [I949] 2 All ER 621 "the proper
contrirtiil hnnd"
 GOVERNING LAW OF FINANCIAL CONTRACTS Sill

The point is illustrated by two contrasting English cases.

In Re He/bert Wagg & Co Ltd [1956] Ch 323, a subsequent German

moratorium law required a German borrower to make loan payments
under a loan contract governed by German law to a government agency
in Berlin in German marks instead of in pounds sterling. Held: the Ger-
man law was effective to discharge the borrower. The German
moratorium law arose under a German contract.
On the other hand in National Bank of Greece and Athens S A v Meilis.r
[1958] AC 509, HL, a Greek decree reduced the interest rate on bonds
issued by a Greek bank and subject to English law. Held: the Greek law
was disregarded and the borrower was liable to pay arrears of interest.
The English governing law insulated the contract from changes in Greek
law.

The result is that in England the foreign lender can, by choice of external 31-15
law, have complete certainty in knowing that the borrower's country cannot
unilaterally alter the obligations by a change of local law. The piece of
paper, at least, is inviolate and retains its bargaining power: that piece
of paper, whether a credit agreement or bond or whatever, is all the creditor
has to represent the money and plainly the creditor's position is somewhat
unhappy if that, too, is destroyed.
The US position is similar.

In French v Banco Nacional de Cuba, 23 NY 2d 46, 242 NE 2d 704, 295,

NYS 2d 433 (1968), a New York court denied recovery on Cuban gov-
ernment certificates of indebtedness governed by Cuban law and therefore
subject to a Cuban government decree suspending payment of the
certificates.
On the other hand in Central Hanover Bank & Trust Co v Siemens &
Haiske AG, 15 F Supp 927 (SDNY 1936), a trustee for bondholders
succeeded in a claim on German municipal bonds whose payment in
foreign currency abroad had been blocked by a subsequent German law
which required that they be paid only in German scrip. The bonds were
governed by New York law and were therefore insulated from the Ger-
man law.

The US courts may also insulate if the situs of the claim is outside the
interfering state.

In Allied Bank International v Banco Credito Agricola de Cartago, 757 F

2d 516 (2d Cir 1985), US banks sued nationalised Costa Rican banks on
promissory note loans. Costa Rica, being insolvent, had passed exchange
controls prohibiting the payment of foreign currency debts. Held: the
Costa Rican exchange controls did not affect the debts and the Costa
Rican banks were liable to pay. This was because the debts were payable
in New York and therefore the sit us of the debt was outside the territory
of Costa Rica.

It is not possible by contract to stabilise the law, eg that the governing law is
ihat at ilte titiie of the contract. The fluctuating governing law must still be
ascertained and will apply to this term of the contract. A change in the
governing law will override. A contract can provide that an invalidating
 512 ( UNI'l 1(1 l I AVIS

1. igc ot a w wil l C( )nst ii u (C a ii event oF del a ul t (a L h )ugh (he ciia iige oi law
flight oveiride the ability to recover or the event ol (Icta nIt Itself').

Limits on insulation

-16 Amongst the limits on the insulating effect or the choice or external law are:
There may he no external assets capable of attachment to satisfy a
Judgment against the borrower. If the action were brought locally. (he
local courts might ignore the foreign governing law to the extent that it
conflicted with local overriding law. including the very laws (such as an
exchange control) against which the lender sought to be insuLtie&l. It is
iirelrahle for a creditor to have a legal claim, even if Futile, than no
claim at all.
o An exchange control in the borrower's country may, if that country is
an IMF member, achieve recognition in a kw I ME states under art
VIII 2(h) of the Bretton Woods Agreement: see para 3 1 -25.
Many issues in local insolvency proceedings are governed by local
insolvency law there is a complex split regime. See chapters 33 and
34.

Rome Contract Convention of 1980 and EU Contracts

Regulation

(i- f 7 In Member States of tile European Union most conflicts rules in contract
are governed by the 198() E(' Rome Convention on the Law Applicable to
Contractual Obligations.
The replacement of the Convention by an EU Regulation having direct
Cited was under consideration as at mid-2007. The draft Regulation doeS
not represent a fundamental change of course hut, apart From tidying-up,
there are some significant differences. It is not envisaged that Denmark will
be suhect to the Regulation. Both the UK and Ireland reserved their opt-
Out, this being dependent on (lie final form of (lie Regulation.
The Rome Convention is a treaty between states with the result that its
liii pienienta t ion in national law varies. The Regulation will have direct effect
in all applicable member states without the need for any national imnple-
nientation by statute.
'The Convention and the draft Regulation represent a crystallisation of the
views of a large number of highly sophisticated states with widely divergent
legal traditions and therefore represents advanced thinking at least in its
main lines.

Other conflicts code'

I-IS Other major statements are:

 GOVERNING LAW OF FINANCIAL CONTRACTS 513

o The US Restatement on Conflicts of Laws (1971) produced by the

American Law Institute.
o The Swiss Act on Private International Law of 1987 ("Swiss PILA
1987").
o Codes in codified countries usually contain conflicts rules ranging from
the basic to the elaborate, eg Japan and Turkey, as well as the Bus-
tamente Code applying in a number of Latin American states.

The literature on the subject is huge. Amongst the classic comparative works
are Ernst Rabel, The Conflict of Laws: A Comparative Study (19581964)
and Ole Lando "Private International Law: Contracts" (1977) in Interna-
tional Encyclopaedia of Comparative Law, vol 111, chapter 24. There are
many others.

Choice of law
Free choice Most jurisdictions honour a free choice of law by the parties. 31-19
Thus art 3(1) of the Rome Convention/draft Regulation allows the parties
expressly to choose the applicable law. If no choice is made, the contract is
governed by the laws of the country stipulated by art 4.
Freedom of choice appeared finally in England by 1865: see P&O Navi-
gation Co v Shand [1865] 3 Moo (NS) 272, in Germany in the 1880s, in
France in 1910 and in Switzerland in 1952. Jurisdictions in the United States
were slow as to confer complete freedom of choice, but most states now do
not require reasonable relationship. To set the matter at rest, in 1984 the
New York General Obligations Law was amended to enable parties to
choose New York law for transactions of more than $250,000, whether or
not the contract bears a reasonable relationship to New York: see the NY
General Obligations Law s 5-1401. The UCC is to similar effect: sees 1--301.

Governing law clauses An express selection usually states: "This Agree- 31-20
ment is governed by the law of Sealandia". There is dispute as to whether
the parties can choose public international law, but in England this is
probably valid. -

Summary of scope of governing law

Typically (as under the Rome measures and the US Conflicts Restatement) 31-21
the governing law primarily governs:

o Formal validity, except that commonly a contract is also formally valid

if it complies with the law at the place of contracting and except that
normally contracts governing land must comply with the formalities of
the place where the land is situate. Formalities include such matters as
writing and notarisation.
o The existence and validity of the contract.
Interpretation. This means the methods of interpreting the meaning of
the parties such as rules of construction. Thus in the case of a
 514 (:ONFLI( 1 OF LAWS

Singapore contract, a reFerence to "dollars" must be interpreted in

accordance with Singapore rules of construction--it does not flCCCS-
sarily mean Singapore dollars but could mean US dollars, For example.
o Most aspects of performance.
o The consequences of hrea(;hes, eg damages payable.
o The extinguishing of obligations, including prescription and limitation.

In summary the effect of the rules is that in the case of bank loan
agreements, most aspects will be governed by the governing law. The gov-
erning law will typically govern the meaning and interpretation of the
terms--the conditions precedent, the drawdowns, how interest is calculated,
whether pre-payment is permitted, the meaning of the representations and
warranties, the meaning of the covenants and events of default, the scope of
any restrictions on assignment, whether an acceleration may be immediate if
so provided or whether it is subject to any good faith doctrines or grace
periods, and the liability of a bank for failure to lend.
Similar considerations apply in telation to guarantees. Thus the governing
law should apply to such questions as the extent of the guaranteed liabilities,
whether future liabilities can be guaranteed without specifying them, whe-
ther a waiver or variation of the guaranteed liability or surrender by the
creditor of securities or co-guarantors avoids the guarantee, and whether the
guarantee remains on foot if there is some defect in the underlying obliga-
tion. The governing law should also govern whether the guarantee is to be
characterised as a first demand guarantee payable solely against documents.

Summary of issues not covered by governing law

31-22 The best way to approach the subject of scope of the governing law is to
identify the main issues in our context not covered by the governing law.
These relate to the following (there are others):

Mandatory statutes and public policy of the forum invariably override

the applicable law: see, For example, Rome Convention arts 7(2) and
16, draft Regulation arts 8(2) and 20. This may in England cover, for
exam pie:
o Contracts violating the laws of a friendly foreign state when entered
into, eg tax frauds or loans to finance terrorism. The English
courts will not enforce a contract which is illegal at the place at
which it must be performed (eg where payment must be made) if
the contract is governed by English law.
In Ralli Bros v Cia Naviera Sota y Aznar [1920J 2 KB 287, CA, a
charterer agreed to pay the shipowner freight of50 a ton for jute
carried by sea from Calcutta to Barcelona. The contract was
governed by English law. After the date of the contract, but
before the arrival of the ship, a Spanish decree made it a criminal
n. . ................
. h. .. C1 .. .. .. r...L. r.........
.
. -i
I ii 'u -
O C iC LU pcty k1U tuat i iv i iOu ii lbu iOu jui

owner sued the charterer for the excess over £10 in the English
courts. held: the charterer was not liable for the excess. It was
 GOVERNING LAW OF FINANCIAL CONTRACTS 515

illegal at the place of performance. Note that the illegality arose

after the date of the contract so this was not a contract to break
the laws of a friendly foreign country ab inilio.
In the English case of Libyan Arab Foreign Bank v Bankers Trust
Co [1988] 1 Lloyds Rep 259, the Libyan Bank had a US dollar
deposit with Bankers Trust in London. The US imposed an
embargo on payments to Libyan entities. Held: Bankers Trust
London Branch must pay. The deposit contract was found to be
governed by English law. Although it was customary for US
dollars to be paid in New York through the New York clearing
system, this was not the compulsory place of performance since
Bankers Trust could pay in London and there was no provision
absolutely requiring payments in New York. If payments had
been required to be made in New York, then the court would not
have enforced the contract as being illegal at the place of
performance.
If a contract is not illegal at the place of performance, then it is irre-
levant that it is illegal at the place of incorporation of one of the
parties, eg an exchange control.
o A foreign discriminatory law which otherwise applies to the contract 31-23
but is so oppressive that it should not affect the contract, cg a foreign
law which imposes exchange controls based on race or creed and which
would otherwise modify the contract because it is governed by that
foreign law: see Re Helbert Wagg & Co Lid (1956) Ch 323, 352; Eder v
Kertesz (1960) 26 DLR (2d) 209 (Ont CA);
o Contracts to pay a bribe to a foreign public official to procure a gov-
ernment contract: see Lemenda Trading Co Ltd v African Middle East
Petroleum Co Lid [1988] QB 448.
All of the above are law of the court, ie countries apply their own
law. The question of what states regard as mandatory or public policy
is probably at the edges (except for mandatory economic statutes
like exchange controls), but there could be problems, eg the attitude to
exclusion clauses in contracts and, in Islamic states, the ban on usury.
o Corporate constitution, powers, and authorities. These are typically cov-
ered by the law of the place of incorporation of the company concerned.
o Most property transfers: sales, security interests, trusts, but aspects of 31-24
assignments of claims are covered by the draft Convention art 12, draft
Regulation art 13. The validity of property transfers—usually meaning
the degree of publicity which is required, such as by possession or
control or registration in an asset title registry—is normally covered by
the law of the location of the property, subject to exceptions: see para
34..Ø7
o Corporate amalgamations. Generally a corporate fusion or merger
carried out in accordance with the law of the place of incorporation of
the company concerned will be recognised by the courts in other
countries, provided that there is a universal transfer of assets and
liabilities, not merely a transfer of assets, leaving the liabilities behind.
See, for example, Adams v National Bank of Greece [1961] AC 255
 SI( - ( UNIiI( 1 ()I I.AV'S

Universal fusion) -, con t rast /?c United Railu-ir.v of 11(1%'Wl(I m'I!o1l.ex

[l960) ('h 52. CA.

O Corporate insolvency. Sec chapters 33 and 34.

-2 a Exchange controls- art VIII 2(h) of the IMF Agreement. This article was
designed to encourage comity on exchange controls. The article pro-
Vi(ICS as follows:

1xchangc contracts which iiivolvc the currency of any member

and which are contrary to the exchange control regulations of
that member maintained or imposed consistently with this
Agreement shall be unenforceable in the territories of any
member. "
One of the objects was evidently to introduce it prototype of it bank-
ruptcy Freeze or may in the case of insolvent states which had to
introduce exchange controls in order to protect their economics. The
objection to the concept was that it puts it entirely in the hands of' the
states concerned whether they can postpone or discharge their obli-
ga tions provided that the exchange control regulations are consistent
with IMF rules. Nearly all states are members of the IMF. The better
view is that the article applies only if the contract infringes exchange
Controls at the time the con tract is entered into so that the Subsequent
Imposition t)l exchange controls should not i.ouvcrt it valid contract
n to a11 u nen Forcea tile exchange contract.

U--26 a An agreement will not he subject (0 art VIII 2(b) it , it is not an

ecl1angc contract. There is little inteunalioiial harmony. There are
Iwo basic views as to the meaning of this term:
11
I ) The narrow construction that an "exchange contract is it con-
tract to exchange the currency of one country into the currency of
another and so would not catch it loan agreement or bond issue.
This construction enables the courts to side-step the article which
is frequently used by defendants seeking to escape their obliga-
tions. This view is supported by case law in England, the US and
Belgium.
(2) The wide construction that an exchange contract is one which in
any way affects a country's exchange resources, and so would
catch it loan agreement or bond issue, because the country's
exchange resources are affected: the debtor must sell domestic
currency to pay For foreign currency in order to pay the debt.
This view is supported by case law in France, Oerniany and
Luxembourg.
For the international case law, see I .Pl F vol 6 para 3 018.

Procedure. Matters or procedure are covered by the law of the courts,

eg the jurisdiction of the courts, whether the defendant is entitled to
sovereign immunity, evidence and discovery.

Some international convent ions may overrie. There may he CXciuSioii

relation to certain types of contract, such as consumer, employnicilt,
insurance and agency contracts. The Rome Convention (repeated by the
 GOVERNING LAW OF FINANCIAL CONTRACTS 517

draft Regulation) has technical exceptions in relation to negotiable instru-

ments, arbitration and jurisdiction agreements, and trusts.

Applicable law in absence of express choice

Generally Parties to a formal loan agreement, bond issue or derivatives 31-27
contract usually make an express selection of governing law in the instru-
ment itself. Financial trading contracts, such as foreign exchange contracts
and derivatives contracts, are generally contracted under a master agree-
ment which applies to all transactions between the parties and which.
contains an express choice of law, eg the 1SDA master agreement for
derivatives. However, there are occasions when no express choice is made,
eg because the loan is informally documented. Interbank deposit contracts
generally do not state the applicable law. The absence of a choice results in
much unpredictability.

Summary of international rules Municipal rules vary widely in the manner 31-28
of determining the governing law in the absence of an express choice. The
case law is vast, but internationally the main theories can be summarised as
follows:

Tacit or implied choice, eg choice of forum.

(2) Centre of gravity, sometimes called "presumed intention", "sub-
stantial connection", "dominant contacts", or the "most significant
relationship": the flexible English common law position and, prior to
the Rome Convention, the principle followed in most Continental
European states.
(3) Policy interests, notably those promoted initially by American aca-
demic writers, such as "governmental interest analysis" which weighs
the interests of the states concerned in having their own law applied:
see the US Conflicts Restatement; this idea has probably now been
dropped by important US states.
(4) In the absence of a tacit choice, rigid presumptions, such as common
nationality or common residence or the law of place of contracting or
performance (mainly Napoleonic-influenced states).
(5) Rome Convention---mixture of tacit choice, centre of gravity and
presumptions, but mainly centre of gravity; the draft successor
Regulation returns to rigidity in some cases, if the law of the country
where the key party (seller, lender, etc.) has its habitual residence.
(6) Law of the forum, ie the courts apply their own law (non-commercial
jurisdictions, eg Saudi Arabia).

In many commercial jurisdictions, the courts first see whether there is a tacit
choice and, if there is not, they follow one of the other theories, either a
flexible view (such as centre of gravity) or an inflexible rule (such as place of
contracting).
 (:ONILI(T OF LAWS

Torts and restitution

3fl-29 Non-contractual obligations, such as torts and restitution, cover a variety of
claims, notably in our context misrepresentation, negligence, procuring a
breach of contract, breach of fiduciary or similar duty by a trustee or
director, unjust enrichment (such as mistaken payments, embezzlement or
bribes) and the like.
Aside from the usual exceptions (such as public policy, mandatory sta-
tutes and court procedure), the governing law of these obligations is
generally the law where the wrongful act occurred, sometimes with an
override of the most closely connected law on centre of gravity tests. Many
of the tort cases have arisen in relation to guest passenger statutes where
non-residents of a particular state have an accident in the state they are
visiting so the issue arises as to whether one should apply the law of their
home state or the visited state (usually the law of the home state).
The issue is particular relevant in relation to, for example, mis-
representations made in a prospectus for securities which may he targeted at
investors all over the world.
3-30 Another problem area is the liability of directors for breach of duty,
where the conduct may more properly be characterised as an issue for the
constitutional duties of management, governed by the law of the place of
incorporation.
Where the unjust enrichment claim arises Out of a contract or other
instrument, such its atr ust conti act. then the law of the contract may
govern.
In the lIJ there is it proposed regulation on the law applicable to non--
contractual obligations which would havc direct effect in Member States - -
colloquially known as Rome II. The obiec:tvc is to harmonise the choice of
law rules for tort and restitutionary claims across the European Union.
31-31 Some English cases exemplify the current approach.

In Diamond v Bank of London and Montreal Ltd (1979) QB 333, CA, an

employee of a Nassau bank allegedly misrepresented to a London broker
that a sugar purchase was available when the sugar did not exist. The
statements were made in Nassau by telephone and fax. The London
broker acted on them in England. The London broker brought action
against the Nassau bank in England where the Nassau bank had an office.
Field: the applicable law was the law of Nassau because that is where the
messages were received.
In Morin v Bonhams and Brooks Lid [2003) EWCA Civ 1802, a buyer
bought a 1959 Ferrari at an auction in Monaco but the misrepresenta-
tions started in England. The car had severe defects. The law of Monaco
applied since most significant aspects occurred there, mainly the auction.
In Thahir v Periamina [19941 3 Sing LR 257, CA, an employee accepted
bribes in Indonesia and transferred some of them to an associate who
transferred them to Singapore. The employer sought to recover the bribes
in Singapore. Held: the claim was governed by Singapore law as the place
of the enrichment, not by the law of Indonesia. The briber intended to
keep the money in Singapore.
Compare Arab Monetary Fund r Has/urn ji996j I Lloyd's Rep 59, CA.
An employee in Abu Dhabi was employed by the Fund under a contract
governed by Abu Dhabi law. The employee received bribes from a
 GOVERNING LAW OF FINANCiAl. CONTRACTS. 519

contractor in return for arranging for the contractor to receive a con-

struction contract from the Fund governed by Abu Dhabi law. The bribes
were paid into a Swiss bank account and later disbursed by the employee.
The Fund claimed in the English courts to recover the bribe from the
employee. Held: the claim was governed by the law of Abu Dhabi. The
essence of the wrong was the abuse by the contractor of the employee's
contract of employment and of the contractor's relationship with the
Fund. The place of payment of the bribe was not regarded as significant.
In Chase Manhattan Bank NA v Israel-British Bank (London) Ltd [1981]
Ch 105, Chase in New York paid Israel-British, a London hank, twice by
mistake. The payment was made by transfer to an account of Israel-
British with its New York correspondent bank. Chase sued Israel-British
in England for the return of the mistaken payment. Held (it seems): New
York law applied because this is the place where the benefit was
conferred.
In Base Metal Trading v Shamurin [2004] 1 All ER (Comm) 159, CA, two
Russians formed a 50/50 company in Guernsey to trade in Russian
metals. The shareholders fell out and the company alleged that the
remaining shareholder in his capacity as a director had entered into highly
speculative contracts on the London Metals Exchange in breach of his
fiduciary duties to the Guernsey company. The director's contract of
employment was governed by Russian law and all of the instructions for
the metal trading were given from Moscow. Held: in this case the direc-
tor's duties were governed not by the law of his contract of employment
but by the fiduciary duties of directors to the company which were guy-
erned by the law of the place of incorporation of the company. ie
Guernsey. There was considerable discussion in the judgments as to the
relationship between claims in contract in tort (the tort itself occurred in
Russia) and the fiduciary duties of directors. See also Kuwait Oil Tankèr
SAK v Al Bader [2000] 2 All ER (Comm) 271.

Further reading on governing law: LPIF vol 6 chapters 2 and 3. For tort and
restitution, see LPIF vol 6 chapter 11.

For question.s and seminar topics, see the end of chapter 34.
 CHAPTER 32

JUDICIAL JURISDICTION

Jurisdiction generally
llntroduction

32-01 This chapter is concerned with the question of determining the courts which
will have jurisdiction to hear a dispute in a financial setting and to enforce
the terms of financial contracts. The focus here is on personal jurisdiction in
such matters as jurisdiction over contract and torts. Jurisdiction over
property matters, such as the enforcement of security interests, is often
different, as is insolvency jurisdiction. Again, there are different principles
applying to the jurisdiction of courts over crimes and administrative
offences, such as those arising under the regulatory regime.
In practice enforcement jurisdiction in the context of credit contracts
tends not to he greatly used since the preferred method of debt recovery is
by a consensual debt restructuring agreement. It . that fails, the alternative is
either a judicial rescue proceeding or liquidation. Attempts by creditors to
enforce by suit and execution are almost invariably met by insolvency
proceedings, initiated either by the debtor or oiher creditors, which freere
further individual actions SO that one creditor does not get ahead of the
others.
Nevertheless, the availability of court action is a basic sanction. Contracts
without sanctions, even if the sanctions are not used in practice, have no
value.

Purposes of forum selection

32-02 Most major international credit contracts contain a forum selection clause,
so that the general grounds on which courts exercise jurisdiction where there
is no express submission are of less relevance. Thus international syndicated
credit and international eurobond issues invariably contain a forum selec-
tion clause, often English or New York law. This is also true of master
agreements, eg the ISDA master agreement for derivatives.
Inter-bank deposit contracts and (often) contracts for international credit
transfers do not usually contain forum selection clauses.
Forum selection clauses cannot in practice be universal so that the jur-
isdiction of other courts to which an obligor has not expressly submitted
may be relevant, eg if there are local assets. The usual case is that a creditor
seeks to freeze assets of an obligor wherever they are prior to judgment and
so must have jurisdiction for that. The creditor then obtains judgment in the
chosen court and then seeks to enforce it where the assets arc: there must be
jurisdiction for that too.
30-03 Some of the objectives are:
 JUDICIAL JURISDICTION 521

o Additional forum. To provide an additional forum outside the borro-

wer's country. Many international borrowers have worldwide assets.
Other courts may be prepared to enforce foreign judgments locally.
o Insulation. To protect the insulation achieved by the choice of an
external governing law. The application of an external governing law
can to some degree shield the obligations from adverse legislation
introduced by the government of the borrower's country, eg exchange
control or moratorium legislation: see para 31-14. Local courts are
likely to apply the mandatory interfering legislation.
o Forum and governing law. To coincide the forum with the governing 32-04
law. The courts are familiar with their domestic law. No delays or
expense will be involved in calling expert evidence.
A foreign court may not give the governing law the scope that
was intended. Courts almost invariably apply their own rules of private
international law in matters of contract. The rules of the governing law
may be overridden by a mandatory local statute which is directly
applicable to the issue in question or by considerations of public policy.
o Standards of the courts. To choose a court with high standards, nota-
bly: a judiciary experienced in international investment disputes;
impartiality; and commercially-orientated court procedures.
Immunity. Where the borrower is a state or a state-related institution,
then, even if the local courts are prepared to entertain an action against
the home government, it is almost universally true that no enforcement
proceedings will be permitted. The position is different if the action is
brought externally. Most commercial countries (including the United
Kingdom and the United States) are prepared to give effect to express
waivers of immunity from enforcement, thereby allowing attachment
of assets which come within the jurisdiction. Sec para 32-32.
o Miscellaneous. 3245
An express submission greatly enhances the eligibility of a judg-
ment for recognition and enforcement elsewhere.
o The ability of a defendant to complain that a specified court
should not exercise jurisdiction on the grounds of inconvenient
forum is reduced almost to vanishing point.
Where a borrower is domiciled in an EU country a written
agreement to confer jurisdiction on external courts is essential
to contract out of the general rule that, subject to exceptions, the
courts of the borrower's domicile are to have sole jurisdiction.

Jurisdiction clauses

A short-form clause may provide: 32-06

"The borrower agrees that the courts of Sealandia shall have jurisdiction
in connection with this agreement and appoints Service Process Ltd as its
agent in Sealandia for service of process for this purpose. The jurisdiction
of the Sealandia courts does not exclude any other court of competent
 522 CONI:UCT 01: LAWS

jurisdiction. The borrower may not bring proceedings in any other

court."

No express forum selection

32-07 II there is no express choice, then traditionally, the extent of a court's jur-
isdiction is associated with the territory over which the government of the
country concerned has sovereignty so that if the defendant is within the
domain of a court and can be served with due process the court can hear the
action. The state has power over the defendant.
States have developed "long-arm" rules whereby their courts can claim
jurisdiction merely where one of the parties or the transaction has some
connection with the country of the courts, subject to self-imposed restraints
on the exercise of jurisdiction where such exercise would be unjust.
The following rules must be read subject to the EU Judgments Regulation
and the European Judgments Conventions force between European states.
See para 32-I1.

Universal bases of jurisdiction

32-08 Probably all commercial states claim the power to exercise jurisdiction in the
following cases:

o the defendant agreed to submit to the jurisdiction by advance contract

or actually appeared in the action, otherwise than (sometimes) to
Contest jurisdiction;
o the corporate defendant is incorporated locally or has a principal place
of business locally or its "seat" locally. In common law countries, place
of incorporation usually confers jurisdiction; in some Roman-Ger-
manic countries, the "seat" is decisive--usually the principal place of
business or where the central control of the company is exercised; and
o the defendant has a local branch, although sometimes the action is
limited to transactions arising in connection with the branch. In many
countries, local branches must register themselves at the local com-
panies or commercial register and designate a person on whom process
can be served. See, cg the British Companies Act 2006 s 1139.

Summary of long-arm jurisdiction

32-09 More fleeting connections with the forum arc often called the long-arm,
extended, exorbitant, or excessive jurisdiction. Almost invariably in the case
of the long-arm jurisdiction courts have a discretion as to whether or not
they will accept jurisdiction so that jurisdiction is not automatic. This jur -
isdiction is generally exercised on the basis of whether the courts concerned
are the most convenient forum. In many parts of the world, the courts are
quite blow Lu refuse jurisdiction ii technically they have it, even though the
real centre of the action is elsewhere. This is particularly the case in clai-
mant-orientated jurisdictions if the court considers that the plaintiff will
 JUDICIAl. JURISDICTION 523

have a better result in their courts than elsewhere, eg in terms of large

damages awards. The result is a great deal of forum-shopping, exacerbated
where, as in the United States, lawyers can take a substantial cut of the
proceeds of the litigation.
The main heads of discretionary long-arm jurisdiction internationally are:

Transient presence locally of an individual debtor (England, US

states)—the "Heathrow writ".
o The debtor does business locally, eg through a local agent;
In the leading case of International Shoe Co v State of
Washington, 326 US 310, 66 S Ct 154, 90 L Ed (1945), the US
Supreme Court held that a Washington court had jurisdiction
over a Missouri enterprise which had no office in Washington
and entered into no contracts there, but solicited orders through
salesmen there and sold products there. Those activities con-
stituted "doing business" in Washington. The court laid down as
a basic principle of judicial jurisdiction that there must be such
"minimum contracts" with the state of the forum as not to offend
"traditional notions of fair play and substantial justice" (at 316).
The due process clause of the Fourteenth Amendment of the
Constitution prohibits the states from acting through their courts
when they have no judicial jurisdiction and the due process clause
of the Fifth Amendment of the Constitution prohibits the United
States from taking similar action.
o The transaction sued on has local connections, eg was made locally
(England, but not New York), or the contract is expressly or impliedly
governed by local law (England, but not New York--see Hanson v
Denkla, 357 US 235(1958)) or a contract is to be performed there, a
tort was committed there or wrongful acts were done there, or property
is located there or a trust is domiciled there.
o Local nationality of the claimant (France, Luxembourg)—(CC art 14) 32-10
and Italy (subject to reciprocity—(CCP art 4(4)), but not England, not
most US states. This is a typical Napoleonic view;
o Domicile of the claimant, regardless of nationality: Netherlands, (CCP
Art 126(3)) and Belgium (subject to reciprocity in the case of Belgium).
Not England, not most US states.
o Local assets of the defendant, however small— the "toothbrush"
jurisdiction: Germany (ZPO art 25), Austria (para 99(1) of
Jurisdiktionsnormen), Japan, Denmark, South Africa, Sweden--- in fact,
most Roman-Germanic jurisdictions.

In addition, courts exercise long-arm jurisdiction for procedural reasons,

such as where one of the defendants is subject to the jurisdiction and it is
desirable to Join other defendants outside the jurisdiction because they are
closely involved in the main action, Cg guarantors.
Therefore, the main connecting links arc: (1) party, (2) transaction, (3)
assets, and (4) joinder.
 524 CONFIA70F i.cws

European Judgments Regulation

Introduction of EU Judgments Regulation
32-11 The EU Regulation of 2000 on jurisdiction and the recognition and enfor-
ccmcnt of judgments in civil and commercial matters provides for a
simplified and predictable EU-wide recognition and enforcement of judg-
ments in EU Member States on the basis of mutual trust and reflecting a
desire for the free movement of judgments within the EU. Except for
Denmark, it replaced the Brussels Judgments Convention of 1968 (plus the
various accession and other protocols).

32-2 Countries covered The EU Judgments Regulation applies to all 27 EU

Member States (plus Gibraltar (but not in Spain)) and has direct effect
without national implementing legislation:

The Lugano Judgments Convention of 1988 extended the jurisdiction and

enforcement rules of the 1968 Brussels Judgments Convention to Eur-
opean Free Trade Association states: Iceland; Norway; and Switzerland.

The F.LJ Judgments Regulation and the Lugano Convention are in similar,
but not identical form. As at 2007 it was planned to conform Lugano to the
Regulation: this was intended to conic into effect at the end of 2007.

Application of EU Judgments Regulation

32-'3 The EU Regulation applies in the following cases:

o where the defendant is domiciled in a Member State;

o where the rules as to exclusive jurisdiction in art 22 apply—mainly land;
validity of corporate constitutions, dissolutions and decisions of their
origins; and validity of entries in public registers, if in a Member State.
The domicile of the parties is irrelevant in these cases; and
o where the parties have chosen a court, in or outside the EU, by a forum
selection clause complying with art 23. One or more of the parties must
be domiciled in a Member State.

In other cases, courts apply their OWfl rules, eg for non-EU domiciliarics.

Basic principles of the EU Judgments Regulation

32-14 [he EU Judgments Regulation efThcts fundamental changes to normal
jurisdiction bases. The first basic tenet of the Regulation is that, subject to
exceptions, "persons domiciled in a Member State shall, whatever their
nationality, be sued in the courts of that State": see art 2. For a corporation,
ths is usually the ciitrai place of husincss or placc of incorporation. The
second tenet is that, generally speaking. a judgment of a court in a Member
State in accordance with the Regulation is to be enforced universally in the
 JUDICIAL JURISDICTION 525

entire Community, subject only to a public policy exception (eg no fair

trial): see arts 33, 34.
Even if the defendant is domiciled locally, the court will not be able to
assume jurisdiction where:

o another court has exclusive jurisdiction under art 22: see para 32-25;
another court has jurisdiction under a jurisdiction agreement com-
plying with art 23: para 32-27; and
o proceedings have already been commenced in the courts of another
Member State under various alternative heads of jurisdiction, eg those
in arts 5 and 6: see para 32-20.

Non-doiniciliaries are subject to the long-arm rules of each Member State

and judgments on the basis of those rules are enforced in all other states.
The large, group of 30 states (31 including Gibraltar) and the outriders
therefore operates as a monolithic jurisdictional unit with the widest con-
ceivable long-arm jurisdictional rules available to a creditor of a debtor in a
non-Member State, eg Japan or the United States. The UK has Conventions
with Canada and Australia overriding this rule. Although the Member State
where the action is first brought will generally have exclusive jurisdiction,
the position in other Member States can be preserved by the wide avail-
ability of pre-judgment preservation measures, eg the freeze order in
England or the saisie conservatoire in France.
In the case of a Member State domiciliary, where it is desired to confer
jurisdiction on another Member State, the creditor should comply with the
contracting-out provisions of art 23. Again the position in other Member
States can be protected by local preservative measures while the exclusive
action continues in the chosen court.

Overall assessment of the EU Judgments Regulation

The great merits of the Judgments Regulation in terms of litigation are: 32-15

• it restricts forum-shopping;
• it sanctions freedom of contract in choosing an alternative forum;
o it allows Europe-wide preservative arrests regardless of domiciliary;
and
it provides for the virtually automatic recognition and enforcement of
Member State judgments.

The main weaknesses are as follows:

Inconvenient forum. It does not give any flexibility to European courts

to decide whether their jurisdiction or another jurisdiction is a more
convenient forum. This absence of discretion was dramatised in the
following case:
In Owusu v Jackson, Case C-281/02 [2005] ECR 1-1383; [2005] 2
WLR 942, Owusu and Jackson were both domiciled in England.
 526 CON FLICI' OF LAWS

Owusu hired from Jackson a holiday villa in Jamaica. Owusu was

to have access to a private beach nearby. Unfortunately Owusu
seriously injured himself when he struck it hidden obstacle when
swimming from this beach. As a result Owusu was tetraplegic.
Owusu sued Jackson in England (because Jackson was domiciled
in England) and also brought proceedings against a number of
Jamaican companies including the company that owned the
beach and the company that was responsible for its management
and upkeep. The defendants claimed that Jamaica was a more
appropriate forum and asked the English court to stay the pro-
ceedings before it. The accident occurred in Jamaica and almost
all the evidence was there. Held by the European Court: the
English domiciled defendant Jackson could not stay the pro-
ceedings against him in favour of Jamaica. The case was actually
on the 1968 Brussels Convention but will apply also to the
Judgments Regulation. The European Court said that the 1968
Convention precludes a court of a contracting state from
declining the domicile jurisdiction conferred on it by art 2 of that
Convention on the ground that a court of a non-contracting state
would be a more appropriate forum for the trial of the action
even if the jurisdiction of no other contracting state is in issue or
the proceedings have no connecting factors to any other con-
tracting state.
o The result is that if a defendant is domiciled in it Member State then the
courts of that Member Stale have compulsory jurisdiction (apart from
the various exits) even though the action has no other connecting link
with the Member State, even though that Member Stale is a completely
inappropriate forum, and even though the main centre of gravity of the
litigation is elsewhere.
32-16 e Abuse. Litigants can abuse the rule that the court which is first scised
has jurisdiction and all other courts of Member States must decline
jurisdiction. This was sharply brought out in a series of cases where a
party to an exclusive jurisdiction clause defeated the exclusivity by
bringing action in another court contrary to the jurisdiction agreement.
The European Court of Justice has held that the other party has to wait
until the wrongly seised court has declined jurisdiction , which may
take quite some time. This is so even if the violating party was acting in
bad faith. This type of abuse is probably limited by the fact that it is
expected that most EU courts will be alerted to deal with this type of
conduct expeditiously and that breach of jurisdiction agreements have
been held (in England at least) to give rise to an action for damages
against the violator. See Union DLwouni Co Ltd v ZolIer [2001] EWCA
(Si
1755, [2002] 1 WLR 1517.

The problem arises because a principle of the Regulation is that only one
Member State should exercise jurisdiction. Concurrent jurisdictions are
possible, eg where Member States apply different domicile tests or an action
is available in an alternative forum under the rules noted in para 3220, or
the parties have chosen more than one court under art 23. The basic rule is
that the court first seised is to exercise jurisdiction if it is the same cause of
action between the same parties. This is to avoid irreconcilable actions.
 JtJI)ICIfri. JURISDICTION 527

In Turner v Grovit, Case 159/02 (2004) European Court, Paul Turner was
a young solicitor who worked for a company Harada Ltd that came under
the control of Grovit. Turner was sent to work at the office of the group in
Madrid where he discovered that the whole group of companies was using
money deducted for tax from the salaries of employees to pay creditors.
He resigned and succeeded in an action before an English Employment
Tribunal that he had been unfairly and wrongfully dismissed. Grovit then
brought proceedings against Turner in Spain claiming nearly £500,000
damages for his "unjustified departure". Turner brought proceedings
before the English courts for an anti-suit injunction to restrain the
Spanish proceedings. The Court of Appeal found that the Spanish pro-
ceedings had been brought in bad faith and the matter was referred to the
European Court of Justice by the House of Lords. Held by the European
Court of Justice: even in cases of bad faith an anti-suit injunction cannot
he granted with regard to proceedings in another contracting state. An
injunction constitutes an interference with the jurisdiction of the other
court which is incompatible with the system of the Brussels Convention
(in similar terms to the Judgments Regulation). Contracting states must
trust one another.
In Erich Gasser GmbH v MISA T sri [2004] 1 Lloyd's Rep 222, there was
an Austrian jurisdiction agreement; the plaintiff sued in Italy contrary to
the agreement. Held: the Austrian courts were not entitled to find that the
Italian courts had no jurisdiction and could not allow a claim in the
Austrian courts until the Italian courts had declined jurisdiction.
In J P Morgan Europe Ltd v PrimaCom [2005] EWHC 508 (Comm), J P
Morgan led a syndicate of second lien lenders who had advanced €375
million to PrimaCom AG which was a German telecoms company. Pri-
maCom was in financial difficulties and missed an interest payment.
PrimaCom commenced pre-emptive proceedings in Germany in breach of
an exclusive jurisdiction clause in the documentation in favour of Eng-
land. When the lenders subsequently commenced proceedings in England
PrimaCom applied to stay the proceedings under the rule in Gasser. Held:
the English court had to stay the English proceedings notwithstanding a
finding that PrimaCom had deliberately commenced the German pro-
ceedings to delay enforcement action by the lenders. The lenders therefore
had to wait until the German court declined jurisdiction. But JP Morgan
was entitled to preservative orders in the meantime.

The effect of this unsatisfactory situation is that there is a race to the

courthouse door which promotes an adversarial attitude. Lenders have to
get in first and issue proceedings in the chosen jurisdiction at the first sign of
distress from the borrower in order to ensure that they are not pre-empted
by the borrower opening proceedings in another Member State court. This
is the type of situation when it is normally in the interests of all parties to
commence negotiations in order to reach a solution privately instead of
involving the court. Court action, coupled with preservative attachments of
assets, may also spark off events of default in loan agreements and hence a
series of cross-defaults.
 28 ( ( ) NtI .I( 1 Ut I .AWS

Civil and commercial matters: art

32-- 17 The [I.J Judgments Regulation applies only to "civil and commercial mat-
ters'': see art 1. "Civil" excludes claims by and against public bodies acting
in the exercise of public functions, eg regulatory authorities.
'['lie most important express exclusions (in art I ) are (emphasis added):

o "Revenue, customs or administrative matters"

3-18 o "Bankruptcy, proceedings relating to the winding-up of insolvcut

companies or other legal persons, Judicial arrangements, compositions
and analogous proceedings". These arc covered by separate Fumpean
regulations and directives. Solvent winding-ups are within the Reg-
ulation. The bankruptcy exception is construed narrowly. It would not
cover claims by it liquidator to recover debts or claims for misfeasance
by directors or the construction of' it pre-liquidation contract even
hough raised in the winding-up. All of these could arise outside
insolvency proceedings. It wouki cover claims to avoid it preferenceor
a liquidator claim against a director for fraudulent or wrongful trad-
ing, since these are directly insolvency matters. See generally, Gourdain
Nadler, ('use 133/78 119791 ECR 733, where the European Court held
that actions derived directly l'rom the insolvency and in close connec-
tion with insolvency proceedings are within the It.J Insolvency
Regulation and outside the li'erunner to the Judgnients Regulation.
In (lBS AG v O,iii,i ho/hug AG [20001 I WLR 9)6. U BS was the
agent of a syndicate of banks which lent money to it German and
Jersey company secured on shares and on it put option against a
Swiss company, Omni. The documents were governed by English
law with [iiglisl forum selection. U I3S enforced its security and
exercised the option. Omni went into liquidation in Switzerland.
U uS claimed damages For breach of the option, but the liq ui-
dator alleged that the proceeds of' the sale of' the pledged shares
should be deducted and that the issue should be tried in Swit-
i.erla nd. 11(1(1: the claim of' I) BS was within the Lugano
('onvention and should he heard in the English courts as agreed.
'['he issue a rose out of a pre-liquidation arrangement and was not
excluded by the bankruptcy exception in tile Convention since it
did not relate directly to the winking-up of an insolvent company,
even though it was a dispute over a liquidation claim. See also
Oukiet' r (I/ü V('Ili(/e Desiiu, 1.1(1 12005 F.WIIC 872 (Ch) (the
question of which company in insolvency proceedings owns
particular property ttlls within the Judgments Regulation and
not (lie Insolvency Regulation).
1'he issue usually arises because the Iudgments Regulation forces
liquidators to sue at the tloniicile OF the defendant in the normal case.
while the Eli insolvency Reitula non might allow the liquidator to site
in the insolvency forum on the basis that all litigation involving the
debtor is to be removed to i lie i uisol ' e ncv to ruin.
32-19 o Arbitration I a possi 1* k:Nlt I row the rules which is ioi I: kcl to be used
'or ba ii aireenienis and bond issues on account of ' the disadvantages
 JULMCIAI.. J1JRISDIC11ON 529

of arbitration for loan contracts). There is much case law on the scope
of this exclusion. Enforcement of arbitral awards is outside the
Regulation.
o Certain other matters, eg the status or legal capacity of natural persons,
matrimonial property, wills and succession, and social security.

Alternatives to domicile: arts 5, 6, 7 and 24

In some cases a claimant can take proceedings otherwise than at the dorn- 32-20
icile of a debtor, assuming the courts are competent under their normal
jurisdictional rules. In the context of financial transactions, the most
important additional possibilities are set out below, but only if the defen-
dant is domiciled in a Member State.

o Contractual suits: "courts for the place of performance of the obliga-

tion in question", eg the place where payments have to be made. Sec
art 5(1).
o Tort, delict or quasi-delict: "place where the harmful event occurred or 32-21
may occur." See art 5(3). The place "where the harmful event"
occurred gives the claimant the option of choosing the place where the
damage occurred or the place of the event giving rise to it: see Bier v
Mines de Poia,sse d' Alsace, Case 21/76 [19761 ECR 1735. The place of
damage is where the physical damage or actual economic loss is suf-
fered, as opposed to the place of business of the victim. The loss is
often felt at the victim's place of business, but it is not the purpose to
convert this into another jurisdictional option: the statute is funda-
mentally based on suit at the defendant's domicile, not the claimant's
domicile. The place where damage is suffered is not any place where
adverse effects are felt.
In Dumez France v Hessische Landesbank, Case C-280/88, [1990]
ECR 1-49, German subsidiaries of a French parent became
insolvent allegedly as a result of the negligence of German banks
in relation to a property development in Germany. Held: the
damage was suffered in Germany. The French parent could not,
therefore, sue the German banks in France, even though the
parent suffered economic loss in France. See also Marinari v
Lloyd's Bank plc, Case C-364/93 [1995] ECR 1-2719: an Italian
was arrested in England for allegedly dubious notes deposited
with a bank in England. Held: he could not sue the bank in Italy
for the loss of the notes and damage to reputation: the damage
and the event giving rise to it both occurred in England.
In Shevill v Press Alliance, Case C-68/73 [1995] ECR 1-415, the
claimant was established in England, France and Belgium and
was allegedly libelled in a French newspaper with a small circu-
lation in England. Held: the victim could sue either in the country
I the publishcr for all damages caused in all Member States or in,
each country of distribution, but the court could rule only on the
damage suffered in that country.
 530 CONFLICT OF LAWS

Hence, in the case of negligent misrepresentation, the victim m ust

usually sue in the place where the statement originated as opposed to
where the statement is received and relied upon unless the damage was
also suffered there.
In Domicrest v Swiss Bank Corporation [1999] QB 548, an Officer
of a Swiss bank wrongly advised the English agent of an English
company by telephone from Switzerland to England that it would
be safe to release goods to a buyer on receipt of the buyer's
payment orders to the hank. The English company did so, on the
basis that the bank had "said" that the payment orders were
"guaranteed" by the bank, but the Swiss bank refused to honour
the payment orders because it had not been put in funds by the
buyer. The English company sued the Swiss bank in England for
alleged negligent misrepresentation. Held: the English court had
no jurisdiction. The place where the harmful event occurred was
the place where the misstatement was made, ie in Switzerland, ie
where it originated. It was not where it was received and acted
upon. This is so whether the statement is made in writing or oral
or other instantaneous communication. The goods were released
in Switzerland and Italy which was where the damage occurred.
So neither the event giving rise to the damage or the place where
the damage was suffered was in England. However, the English
courts had jurisdiction over the alleged contract of guarantee
because, under the Swiss governing law of the contract, payment
was to be made in London at l)oniicrest's hank so that there was
a contract breach in England, conferring jurisdiction under art
5(1) of the Lugano Convention (similar to art 5(l) of the Judg-
ments Regulation). Sec also London Helicopters Lid I:
Heliporiugal [20061 EWHC 108, [2006) All ER(D) 115.
32-22 o Disputes arising out of the operations of a branch, agency or other
establishment: "courts for the place in which the branch, agency or
other establishment is situated". Sec art 5(5).

GD Trusts: "Where the person to be sued is settlor, trustee or beneficiary

under a trust created by the operation of a statute or by a written
instrument, or created orally and evidenced in writing": where "the
trust is domiciled". See art 5(6). Examples are bondholder trusts, the
trusts created by security settlement systems, unit trusts, custodianship
of investments and the trusts by a securities broker of client assets such
as hank deposits and investments belonging to the client. The head
would not apply to constructive or implied trusts. It applies mainly to
disputes between trustees and beneficiaries, not, for example, the
enforcement by third parties of a trustee contract. The trust instrument
may choose a court under art 23. In England a trust is domiciled where
it has its closest and most real connection.
32-23 o Actions against more than one defendant who is domiciled in a Member
State: "place where any one of them is domiciled", but only lithe
claims are so closely connected that it is expedient to hear and deter -
mine them together to avoid the risk of irreconcilable judgments
reciiliinp from separate proceedings. Sec art 6(1). An example might he
 JUDICIAL JURISDICTION 531

claims by an investor against several underwriters and the directors of

the issuer for a misleading prospectus.
o Third party actions, eg warranties or guarantees: "court seised of the
original proceedings, unless these were instituted solely with the object
of removing [the third party] from the jurisdiction of the court which
would he competent in his case". See art 6(2). This head applies where
the third party is domiciled in another Member State There must be a
connection between the actions against the various defendants of such
a kind that it is expedient to determine the action together to avoid the
risk of irreconcilable judgments resulting from separate proceedings.
o Contracts relating to immoveables: "in matters relating to a contract, if' 32-24
the action may be combined with an action against the same defendant
relating to matters in rem in immoveable property": where "the
property is situated". Art 6(4). This will allow a mortgagee of land to
sue for the mortgage debt in the courts of the state where the mort-
gaged property is situated combined with an action for the enforced
sale of the property.
o Appearance: a court of a Member State where the defendant enters an
appearance has jurisdiction--they have consented. This does not apply
where the appearance was entered to contest the jurisdiction or where
another court has exclusive jurisdiction under art 22. See art 24.

Exclusive jurisdiction: art 22

The courts of a Member State have exclusive jurisdiction in certain cases, 32-25
regardless of whether any of the parties is domiciled in a Member State,
including:

o In rem suits (including tenancies) relating to immoveable property in a

Member State, presumably including mortgage actions. Jurisdiction is
fixed where the property is, subject to an exception for in rem suits
relating to short-term private lettings. See art 22(1).
o The validity of the constitution, the nullity or the dissolution of legal
associations or the decisions of their organs. Jurisdiction is fixed where
the seat is in a Member State.
o The validity of entries in public registers, eg land, company, commer-
cial and ship registers. Jurisdiction is fixed where the register is kept in
a Member State. See art 5(3).
o Other exclusive rules relate to the registration and validity of intellec-
tual property rights (place of registration) and enforcement of
judgments if the judgment has been or is to he enforced in another
Member State (the enforcing court in the Member State concerned).
See arts 22(4) and (5).
 532 CON FLICF OF LAWS

llnstrance, consumer and employment contracts

32-26 There are separate provisions regarding insurance contracts (see arts 8 14),
certain consumer contracts (see arts 15- 17) and individual contracts of
employment (see arts 18-21). Broadly speaking, their effect is that the pol-
icyholder or consumer must be sued in the courts of his or her domicile and
both can sue in the courts of the policyholder's or consumer's domicile (the
employee provisions are similar). The effect is that policy-holders, con-
sumers and employees can use their home courts, subject to qualifications.

Contracting-out: art 23
32-27 Article 23 is fundamentally important since financial agreements often
contract out of the forum of the obligor. Article 23 provides as follows:

1. lithe parties, one or more of whom is domiciled in a Member State,

have agreed that a court or the courts of a Member State are to have
jurisdiction to settle any disputes which have arisen or which may
arise in connection with a particular legal relationship, that court or
those courts shall have jurisdiction. Such jurisdiction shall be
exclusive unless the parties have agreed otherwise. Such an agree-
ment conferring jurisdiction shall be either:•
(a) in writing or evidenced in writing, or
(b) in a trm which accords with practices which the parties have
established between themselves, or
(c) in international trade or commerce, in a form which accords
with a usage of which the parties are or ought 1.0 have been
aware and which in such trade or commerce is widely known to,
and regularly observed by, parties to contracts of the type
involved in the particular trade or commerce concerned.
2. Any communication by electronic means which provides a durable
record of the agreement shall be equivalent to 'writing'.
3. Where such an agreement is concluded by parties, none of whom is
domiciled in a Member State, the courts of other Member States
shall have no jurisdiction over their disputes unless the court or
courts chosen have declined jurisdiction.
4. The court or courts of a Member State on which a trust instrument
has conferred jurisdiction shall have exclusive jurisdiction in any
proceedings brought against a settlor, trustee or beneficiary, if
relations between these persons or their rights or obligations under
the trust are involved.
5. Agreements or provisions of a trust instrument conferring jurisdic-
tion shall have no legal force if they are contrary to the provisions of
Articles 13 [insurance], 17 [consumer contracts] or 21 [employment],
or if the courts whose jurisdiction they purport to exclude have
exclusive jurisdiction by virtue of Article 22 [mainly land, corporate
constitutions, public registers, intellectual property]."

The parties may choose more than one EU court in which neither party is
domiciled: the selection cat) be non-cclusive, subject to the various man-
datory restrictions. They can choose a non-EU jurisdiction.
"ntr4ctinp-nut is subject to the insurance, consumer contract and
 JUDICIAL JURISDICTION 533

employee requirements (arts 8 and 17) and to the exclusive jurisdictions in

art 22.

Further reading on the EU Judgments Regulation: LPIF vol 6 chapter 5.

Other jurisdictional matters

Arbitration
Unlike ordinary commercial contracts, arbitration is almost never used in 32-2
financial contracts, especially bank loan agreements or bond issues. The
main objections are: having nothing to arbitrate; very limited appeals; time
and delays involved in setting up the arbitration tribunal; not necessarily less
expensive; looser procedures, and sometimes decisions are made on the
merits otherwise than in accordance with the strict principles of law. See
LPIF vol 6 chapter 8.

Enforcement of foreign judgments

Most countries are prepared to enforce foreign money judgments subject to 32-29
conditions.
The conditions upon which jurisdictions recognise and enforce a foreign
judgment vary but the principal rules may be summed up as follows:

The foreign court had substantial jurisdiction--long-arm Jurisdiction- is

usually insufficient. An express submission usually is enough: this
underlines the desirability of an express submission to jurisdiction. The
foreign court will not have jurisdiction where another court has
exclusive jurisdiction, for example in relation to actions concerning
land.
o Reciprocity, ie the foreign court would recognise in similar circum-
stances in reverse. There is some international division on this issue.
The US and England do not require reciprocity.
o Due process, meaning due notice, fair trial, no fraud, eg adequate
notice of proceeding and observance of the basic rules of justice. This is
a universal requirement.
o The judgment does not conflict with local public policy. This is a uni- 32-30
versal requirement, but there are differing views of public policy. Most
countries will not enforce US punitive or treble damages awards.
o The judgment is for a liquidated money sum, not cg for an injunction.
Practice differs.
o The judgment is not for foreign taxes, fines or penalties. This is
universal.
G (Often) the judgment is final and conclusive, ic not subject to appeal, or
(if appealable) is enforceable locally. This is a universal requirement,
but there are detailed differences.
 534 CONFLICT 01: LAWS

o The judgment does not conflict with a local judgment on the same cause
of action. This is a universal requirement.

In substance, the two main dividing principles are:

o reciprocity (the Lit-for-tat); and

o review of the merits of the original judgment (Ic a retrial on some
issues- effectively not a recognition).

The enforcement of foreign judgments is unusual in international financial

markets, because proceedings are in fact quite rare and where they take
place they usually end up in a work-out or in an insolvency proceeding.
32-31 There is a network of treaties. The US does not have reciprocal judgment
enforcement treaties with any country, probably because of international
caution about US litigation, particularly punitive damages and class actions.
See LPIF vol 6 chapter 9.

PreJudgment attachments

32-32 Most countries, other than the United States in certain cases, permit a
creditor to provisionally attach assets of a defendant in order to prevent
them from being removed from the jurisdiction. Obviously the defendant is
not involved in thcse proceedings which must he by way of ambush. As a
consequence courts routinely impose reasonably high standards of (us-
closure and proof upon creditors that there arc assets and that they might be
removed and it reasonable prima fade claim. Creditors are liable in damages
to the debtor ii an order is made and it turns out that the order is unjustified
because the creditor's claim is groundless. Usually the creditor must deposit
security for costs. The court must typically he satisfied that the court will
have jurisdiction over the debtor in the main action. The main assets usually
caught are bank deposits.
The English courts will in appropriate cases freeze the assets of a debtor
worldwide, subject to conditions to prevent excessive extra-territoriality.
Of course all courts have measures for enforcing their final judgments by
way of execution and the like. The English courts will not order the
attachment of a debt such as a bank account unless the debt is situated
within their jurisdiction otherwise the party liable on the debt may have to
pay twice.
See LPIF vol 6 chapter 10.

State immunity
32-33 State immunity generally Most advanced states de-immunise actions in
their own courts against foreign states or their political sub-divisions if the
transaction is commercial and also allow pre-judgment attachments of
commercial assets and final enforcement over commercial assets, subject to
c-Ic--ptions for diplomatic property.
A loan or bond issue will generally be regarded as a commercial trans-
action, regardless of whether the proceeds are to be used to finance some
 JUDICIAL JURISDICTION 535

governmental purpose, ic it is the nature of the transaction not the nature of

the purpose of the transaction which must be commercial.
Ironically de-immunisation was achieved in many common law States by
statute, notably the US Foreign Sovereign Immunities Act 1976 and the UK
State Immunity Act 1978, whereas in civil code countries, the de-immuni-
sation has been achieved by case law, eg Belgium, France, Germany and
Switzerland. There is immunity legislation on UK lines in Singapore (1979),
South Africa (1981), Canada (1982), Pakistan (1981) and Australia (1985).
Foreign state-owned corporations will generally enjoy immunity only if they
are carrying out some public or administrative purpose, as opposed to a
commercial trading corporation.
Note that most states, while they may permit a judgment to be given 32-34
against them in their own courts, will almost invariably not permit enfor -
cement against public assets within their own domain.
In the case of the de-immunisation of foreign states, some countries
require some nexus between the country concerned and the transaction sued
upon, eg Switzerland and the US.
Some countries, notably the US and the UK, do not permit the assets of a
foreign central bank to be subject to any enforcement measures unless the
- central bank has expressly waived its immunity. The object of this is to
enable central banks to deposit their foreign reserves in the countries
concerned.

Waiver of immunity In practice it is almost invariably the ease that coin- 32-35
mercial hank loan agreements and international bond issues, as well as
derivatives contracts with sovereign states or their sub-divisions or state-
owned companies, contain express waivers of immunity from jurisdiction,
from pre-judgment attachment and from enforcement. As mentioned,: an
express waiver is required in the US and the UK to de-immunise central
hank property.
A typical short form clause reads as follows:

"The State irrevocably waives all immunity to which it may be or become

entitled in relation to this Agreement, including immunity from jurisdic-
tion, enforcement, prejudgment proceedings, injunctions and all other
legal proceedings and relief, both in respect of itself and its assets, and
consents to such proceedings and relief."

States often exclude: (1) the external property of diplomatic missions, (2)
military property, (3) assets located within their territory and dedicated to a
public or governmental use, and (4) heritage property.
It is believed that these waivers are effective in most advanced commercial
states -this is certainly so in the case of the US and the UK.
For a survey of sovereign immunity generally, particularly when these is 32-36
no express waiver of immunity, see LPIF vol 5 chapter 25.
There is a European Convention on State Immunity of 1972 and also a
UN convention which is unlikely to come into force but which broadly
expresses the international consensus on the matter.

For questions and seminar topics, see the end of chapter 34.
 CHAPTER 33

INSOLVENCY CONFLICT OF LAWS:

GENERAL

!mtrnthctoll1

Reasons for conflicts

33-01 A number of l7actors have led to problems in relation to international

bankruptcy law. One is the sharp division between pro-creditor and pro-
debtor bankruptcy policies. Bankruptcy policies are the fundamental bed-
rock of business law and are adhered to with a fierce intensity so that they
are converted into mandatory rules of public policy.
Some of the main differences are:

o priority creditors, especially local employees and taxes and the bank-
ruptcy ladder;
o the scope and efficiency of security and title finance;
o insolvency set-off;
attitudes towards publicity for property tratislèrs and the trust:
o attitudes to director liability;
o ability to rescind contracts on insolvency and forfeit leases;
o the width of rules annulling preferential transfers; and
o corporate rehabilitation laws which have as their object the rescue of
the debtor and which must therefore curtail creditor rights more sav-
agely than a final liquidation in the interests of the resurrection and
which collide with a final bankruptcy proceeding over the same debtor
elsewhere.

These chapters on conflict of laws are primarily concerned with corporate

bankruptcies, not the bankruptcy of individuals.

Treaties and other harmonisation measures

3342 Considerable progress on mitigating these problems has been achieved by

the EU Insolvency Regulation 2000 applying to all EU States except Den-
mark, the Uricitral Model Law on Cross-Border Insolvency adopted by
many important states including the US, the UK and Japan and by the
unilateral adoption of forward-looking statutes on international insolvency
by leading states, eg Germany. There are also other treaties, notably a
- INSOLVENCY CONFLI(F OF LAWS: GENERAL 537

Nordic treaty in Scandinavia and the Bustamente and Montevideo Codes in

Latin America. Treaties sometimes codify existing trends.

Territorial and universal theories

In ideological terms there are two broad approaches, the territorial and 3343
universal theories:

o Bankruptcy is purely territorial and covers only local assets. Local law
applies.
o Bankruptcy is universal and unified: the only courts which have jur -
isdiction to bankrupt a debtor are the courts of the debtor's domicile or
principal place of business. All creditors must resort to that country.
That country applies its own insolvency law. The bankruptcy applies to
all the debtor's assets globally and not just local assets.

Apart from treaties, in practice most developed states adopt a combination

of these extremes.

Advantages and disadvantages of single forum

The advantages of a single insolvency administration include: 33-04

o it avoids the cost and inefficiency of two competing administrations;

o all creditors are treated equally in accordance with local rules so the
process is simpler;
o all international property is pooled;
• there is a universal restraint on creditor proceedings; and
o creditors dealing with a domiciliary should expect to be governed by
domiciliary law.

The disadvantages often cited arc:

• Local creditors are prejudiced by unexpected adverse foreign insolvency

laws which they could not be expected to investigate;
o local creditors have to incur the cost of going abroad;
• if the creditor's claim is in foreign money, the creditor may be expro-
priated if the creditor has to convert the claim into the local currency
which is depreciating rapidly;
• creditors assets are used to pay foreign taxes or employee claims; and
o local proceedings usually relate to local assets so that it is fair to apply
the law of the closest connection.

The reality is that none of the leading states contemplate only one
bankruptcy at the centre of main interests of the debtor. Generally, the
 538 (ON FLICI OF LAWS

usual pattern For large corporations is that creditors commence the bank-
ruptcy proceedings at the principal place of business where the assets are so
as to protect them From the debtor and from piecemeal attachments. Either
local creditors or the main administrator then commence local proceedings
where there is an establishment or even lesser links. Hence an international
bankruptcy often takes the form of a main bankruptcy at the principal place
of business plus non-main bankruptcies in foreign parts.
33-05 In addition, where a large group is insolvent and the subsidiaries are in ••'
different jurisdictions, the insolvency of each subsidiary will normally have
to he conducted under local insolvency law, potentially with further insol-
vciicjes at the branch offices of these subsidiaries elsewhere.
lIence a major collapse can result in dozens of separate insolvencies, each
with their own local administrator, each operating under different laws, each
competing for assets, and each potentially with a different view as to rescue
or liquidation. The result is inefficiency and enormous cost. The insolvency
of the Bank of Credit and Commerce International in 1991 (still ongoing in
2007) is illustrative of the complications of an international insolvency.

There was a Luxembourg holding company, a Luxembourg principal

operating company with 47 branches and two subsidiaries located in 15
countries. Another principal operating subsidiary had 63 branches loca-
ted in 28 countries. Other subsidiaries and affiliates operated 225 banking
offices in about 30 countries. At the time of the closure BCCI had about
380 offices in nearly 70 countries. Its senior management was located in
Ahu Dhabi. The majority shareholders of the Luxembourg holding
company were the ruler and government of Abu Dhabi and related par-
ties. The Luxembourg regulator filed for a controlled management in
Luxembourg. subsequently converted into a liquidation. Regulators
elsewhere petitioned for winding-ups of branches or subsidiaries, eg in
Britain and Cayman. In New York the superintendent of banks took
possession of the business and property of the Luxembourg main oper -
ating BCCI company in New York available only to local creditors. The
Californian superintendent did the same for Californian assets. The main
liquidators (Touche Ross) proposed a plan pooling the assets of the two
main operating subsidiaries. The pooling was ultimately approved in
Luxembourg, England and Cayman. There was massive litigation around
the world, including criminal proceedings for fraud, especially in New
York (1991), actions against regulators for misfeasance, including the
Bank of England (thrown out in 2005), and much litigation on such
matters as set-oft, especially in England. The bank group was not sys-
temically important and was not a significant participant in payment
systems.

Main and non-main proceedings

33-06 Concurrent proceedings may he either a main proceeding or a non-main

proceeding.
A main proceeding is one opened at the debtor's centre of main inter-
ests -its place of incorporation or seat or principal place of business. A non-
main, ancillary or sccondar proceeding is U11C cotuineuced at a local branch
or establishment or where the debtor has local assets or even some more
transient or tenuous presence. These non-main proceedings may he a full-
 INSOLVENCY CON FLIC.T OF LAWS: GENERAl. 539

blown local proceeding or a restricted local proceeding, eg limited to local

assets or subservient to the main proceeding.
The insolvency jurisdiction of most states allows a local opening if there
are local assets so generally there is jurisdiction to open local non-main
proceedings everywhere where there are assets. Both the EU Insolvency
Regulation and the Uncitral Model Law restrict secondary or non-main
proceedings and restrict the non-main proceeding to local assets. The object
is to strengthen the primacy of the debtor's centre of main interests.
In summary, as very broad generalisations, the main effects, aside from 33-07
treaties and the like, are:

o each set of proceedings applies its OWfl law, eg as to procedure and to

set-off, and its own conflicts of law, cg as to security interests;
o each proceeding pays its own priority creditors first, such as local
employees and taxes;
main proceedings are often entitled to better recognition abroad
compared to non-main proceedings;
e main proceedings theoretically exten4 to global property, but
non-main proceedings often do not, ic they restrict themselves to local
property and regard themselves as ancillary;
creditors can usually prove in both sets of proceedings but dividends in
one jurisdiction are taken into account in the other by a process known
as equalisation or hotchpot;
the co-ordination of the proceedings, for example, as to an overall
reorganisation or liquidating plan, information on claims lodged and
financial information, depends on agreement; and
non-main proceedings often turn over assets to the main proceeding
only after payment of creditors proving locally, such as local priority
creditors and all creditors, both local and foreign, proving locally.
Local proceedings will often exhaust the assets, so there is nothing to
turnover. Turnover may be conditional. Thus an Australian case
allowed a turnover on condition that assets were not used to pay
secured claims which were void locally: see Re Australian Federal Li/e
and Gnl Insurance Co Ltd (193 1 ) VLR 317 (Victoria).

Group insolvencies
It is generally advantageous to be able to propose a rescue plan for an entire 33-08
group, but insolvency law treats each member of a group as a separate legal
entity with its own assets and creditors. Hence each proceeding is separate
and, if the members of the group are in different jurisdictions, different laws
will apply. Hence an overall rescue requires significant co-operation between
administrators which is difficult to achieve.
The position is somewhat ameliorated under the EU Insolvency Reg-
ulation. The courts in many Member States have been prepared to appoint
administrators in respect of foreign subsidiaries of a local parent on the
basis that the subsidiaries were being managed by the parent in each case so
that the centre of main interests of the subsidiaries was in the main country.
 544) (ON FLiCI OF LAWS

EU Insolvency Regulation and Uneitral Model Law

IEU Insolvency Regulation
33- -09 Introduction Council Regulation (EC) No 1346/2000 of May 29, 2000 on
insolvency proceedings sets out a set of insolvency recognition and conflict
of laws rules for the EU, except Denmark. The Regulation is directly
applicable in Member States, ie it applies without the need for any Member
State implementation.
Non-bankruptcy rules on jurisdiction are dealt with mainly by the EU
Judgments Regulation 2000. Contract conflicts of law are covered by the
Rome Convention on applicable contract law 1980 (proposed in 2007 to be
replaced by a Regulation).
The EU Insolvency Regulation acknowledges the fact that as a result of
widely differing substantive laws it is not practical to introduce insolvency
proceedings with universal scope in the entire Community. The result is (1)
not to impose local insolvency law for all issues, especially the difficult
issues, and (2) to allow national proceedings covering only assets situated in
the opening state alongside main insolvency proceedings elsewhere with
universal scope.
The fact the Brussels Judgments Convention was prepared in less than 10
years, but the insolvency Regulation took 40 years, demonstrates that
insolvency is the ultimate collision- --other fields of commercial law are easy
by comparison.

33-10 Eligible proceedings The Regulation applies to all types of insolvency

proceedings, whether liquidation or rescue (unless there is no debtor
divestment), and to all debtors, whether corporate, individual or otherwise,
except certain banks, insurers, securities firms and mutual funds. See art 1.
The applicable insolvency proceedings for each state are listed in Annex A
which is definitive. The English-based receivership of a floating charge is not
included because it is not collcctive-----only a proceeding on behalf of the
creditor concerned.

33-i I Main jurisdiction and recognition The courts of the Member State where
the debtor has its centre of main interests ("Comi")--roughly its principal
office (presumptively hut not necessarily the place of incorporation) -have
jurisdiction to open insolvency proceedings. Sec art 3(1). Effectively the first
court to open has exclusivity, so that then it is not possible to open pro-
ceedings elsewhere in the EU. These are the main proceedings. Those
proceedings are then automatically recognised throughout the EU so that
the freezes on creditors of the opening state apply and the administrator—
called a liquidator even in the case of rescues and definitively listed in Annex
C----can collect EU-wide assets. See arts 16-18. A temporary administrator
appointed between request and order for opening can freeze EU assets in the
interim. See art 38. Court judgments in relation to the course and closure of
the proceedings (eg court confirmation of a composition) must he recog-
rused and enforced throughout the EU in accordance with the procedures
established in the EU Judgments Regulation 2000 --a simple process with-
out obstacles. See art 25.
 INSOLVENCY CONFLICT OF LAWS: GENERAE. 541

In the Eurojood case decided by the European Court of Justice (C-341/04,

ECJ May 2, 2006) followed by the Irish Supreme Court [20061 IESC 41,
an Irish court opened insolvency proceedings over an Irish company,
Eurofood, which was a subsidiary of a bankrupt Italian company, Par
malat. The court appointed a provisional liquidator. Subsequently, the
Italian court purported to open main proceedings in relation to the same
company in Italy. In this leading case the European Court of Justice held
that the location of the company's registered office is key to determining a
debtor's centre of main interest. The presumption that Comi is the
location of its registered office can be rebutted if factors which are both
objective and ascertainable by third parties enable it to be established that
an actual situation exists which is different from locating the debtor's
Comi at its registered office. An example would be a letterbox company
which does not carry on any business in the territory of the member state
in which its registered office is situate. The mere fact that the economic
choices of a subsidiary are or can be controlled by a parent company in
another member state is not enough to rebut the registered office pre-
sumption. Applying this guidance, the Irish Supreme Court held that
Eurofood's centre of main interests was in Ireland. Hence the case dis-
approves decisions that merely being a member of a larger group is
enough to locate the subsidiary at the location of the parent's main
business.
One of the first decisions after the Eurofood case decided by the European
Court of Justice, was the French decision of Eurotunnel (Paris Tribunal of
Commerce, August 2, 2006) in which the Paris court opened safeguard
proceedings in respect of 17 companies in the Eurotunnel group whose
registered offices were situated in different member states across the EU
including France, the UK, Germany and Belgium. The main factors were
that the strategic and operational management of the various Eurotunnel
entities was carried out in Paris and the essential part of Eurotunnel's
business, employees and assets were localised in France. The court gave
primacy to the purposes of the Insolvency Regulation to aim at an effi-
cient and unified administration of insolvencies. This required a single
solution for the financial difficulties which threatened the companies in
the Eurotunnel group. Recital 2 of the Regulation states that the Reg-
ulation has an overriding objective to improve the efficiency and
effectiveness or cross-border insolvency proceedings.

Courts can legitimately come to different decision on the basis of similar

facts because the process involves a weighting. Hence there is a race to the
court-house door.

Public policy A Member State may refuse to recognise and enforce insol- 33-12
veney judgments if manifestly contrary to public policy. See art 26.

Territorial scope The Regulation applies if the debtor's centre of main 33-13
interests is in the EU. If the debtor's centre of main interests is outside the
EU, then each Member State exercises its own jurisdiction outside the
Regulation and recognition by other states depends on their own law apart
from the Regulation. If a debtor is incorporated abroad but has its Comi in
a Member State, then the Regulation applies. Hence a US, Japanese or
Chinese company with its Com] in the EU is subject to the Regulation.
 542 CONFLICT OF LAWS

33-14 Secondary proceedings for establishments lithe debtor's Comi is situate in

a Member State, then parallel secondary proceedings can be opened in
another Member State if the debtor has an establishment there—roughly a
branch which has some permanence. See art 3(2). These secondary pro-
ceedings can normally only be winding-up proceedings (as definitively listed
in Annex I)) and are restricted to assets within the state concerned. Freezes
and composition discharges do not bind external assets. See art 17(2).
The main liquidator has power to influence the secondary proceedings:
the liquidators must communicate and co-operate; creditors can claim in
both proceedings; the main liquidator can propose a rescue plan for the
secondary proceedings, veto a secondary rescue plan (it is therefore possible
to exit a secondary winding-up by a rescue plan controlled by the main
liquidator and note that any secondary plan does not bind external assets
unless the creditors consent) and require a stay of the secondary winding-up,
subject to protection of local creditors; and the secondary liquidator must
turnover any surplus to the main liquidator. See arts 3 1-37. The effect is
that, in the case of companies with establishments elsewhere in the EU, there
can be separate insolvency proceedings at each establishment subject to
dillerent systems of law, but the main liquidator can co-ordinate and control
an overall reorganisation plan covering the debtor's Comi and its branches
(hut not other group companies).
There are technical differences between secondary proceedings according
to whether they are opened before or after the main proceedings.
33-5 In practice, creditors or management may decide to start secondary
proceedings at an establishment ring-fenced from the main proceedings
because, for example: the creditors are tax or social security authorities who
want a local priority; because the rules as to priorities, voidable preferences
or director's liabilities are more favourable to them, or because they want a
home liquidator and home courts.
lithe debtor's Comi is in the EU, then the only other proceedings allowed
in the EU are these secondary proceedings at an establishment it is not
possible to open proceedings in another Member State if there is anything
less than an establishment. Mere assets are not enough. The effect is to limit
proliferation, lithe debtor's Comi is outside the EU, then any proceedings
can be opened anywhere in the EU in accordance with local law, eg pro-
ceedings based on very tenuous connecting links such as the mere presence
of assets locally, however minor.

33-16 Groups In the case of' groups, the effect is that Comi must be established
for each company in the group and hence there could be different insolvency
proceedings subject to different laws for each member of the group. How -
ever, it is often possible to have a single administrator for the whole group
because of the willingness of the courts to treat subsidiaries as having their
Comi in the same country as the parent where it is shown that the parent
runs the subsidiaries, as is often the case. Apart from uniform insolvency
management, the subsidiaries are still treated as separate companies.

33-17 Applicable law The law of the opening state, whether main or secondary,
determines the conditions for the opening of the proceedings, their effect,
their conduct and closure. See art 4. In particular it determines what debtors
can be bankrupted, the assets of the estate, powers of the debtor and
liauidator. set-off (subject to an exception), the effect on contracts and
 INSOLVENCY CONFLICT OF LAWS: GENERAL 543

creditor proceedings, the lodgment and treatment of claims, priorities, the

effect of closure and a discharge by a composition, costs and voidable
preferences ("detrimental acts"). See art 4(2). It probably also determines
director liabilities for not stopping early enough, but probably not other
mismanagement liabilities under corporate law.

Exceptions to opening state applicable law There are major exceptions to 33-18
the uniform application of the insolvency law of the opening state, whether
main or secondary. These relate to:

o third party rights in rem (proprietary rights) in assets situate in other

Member States (mainly security interests including floating charges,
liens, leases, restitution, beneficial interests under trusts, and title rights
recorded in title registers—see art 5),
o set-off (if insolvency set-off is not permitted under the local law, it can
be admitted if the law of the debtor's claim allows set-off—see art 6),
o reservation of title for assets situate in another Member State (see art
7),
o contracts to acquire or use immoveable property (law of the Member
State where the immoveable is--see art 8),
o payment and settlement systems and financial markets (law of the
Member State where the system or market is--see art 9),
o contracts of employment (Member State governing law of the con-
tract- see art 10),
o effects of insolvency proceedings on title registered land, ships, aircraft 33-49
(law of the Member State where the register is—see art Ii),
EU patents and trade marks (includable only in main proceedings, not
secondary—see art 12--this is for technical reasons flowing from EU
Community IP legislation),
o voidable preferences subject to another law and not challengeable
under that law (see art 13),
o post-commencement disposals of title registered property (law of the
place of the register—see art 14), and
o pending lawsuits (law of the relevant Member State court—see art 15).

Miscellaneous There are provisions as to the equalization of claims by 33-20

creditors who claim in more than one insolvency (see art 20), the protection
of post-opening payees and transferees (see art. 24) and other matters. All
EU persons can lodge claims, including tax and social security authorities.
See art 39. Various previous insolvency conventions between Member States
are overridden. See art 44.

Further reading on the EU insolvency Regulation: LP1F vol 6 chapter 22.

EU Bark and surance Insolvency Directives The EU Directive on the 33-21

Reorganisation and Winding up of Credit Institutions 2001/24/EC broadly
establishes a unified system for the reorganisation and winding-up of EU
 544 CONFliCT OF LAWS

banks. Only the home state which authorised the bank (this authorisation is
then passported into other Member States by banking directives) can initiate
reorganisation and winding-up proceedings for a credit institution.
The home state's laws, subject to various exceptions, apply to the bank in its
home state and to all EU branches. The scope of the applicable law is almost
identical to the EU Insolvency Regulation, eg as to set-off. Unlike the EU
Insolvency Regulation, there is no room for local winding-up of local
branches under local law--the whole procedure is centred on the home
state. The home state is determined by the main authorising authority and
there is no need to establish the centre of main interests of the debtor,
as there is in the case of the EU Insolvency Regulation. As with the Reg-
ulation, members of a bank group may be subject to a different legal regime
applicable to each subsidiary.
Unlike the EU Insolvency Regulation, which has direct effect in Member
States without implementing legislation, this Directive had to be imple-
mented by each Member State and SO its application might vary.
Articles 25 -27 are remarkable provisions which, like set-off, effectively
allow the parties to choose their insolvency law for netting, repos and
regulated market transactions. According to recital 26, the Settlement
Finality Directive of 1898 is overriding.

o Article 25 provides: "Netting agreements shall be governed solely by

the law of the contract which governs such agreements."
o Article 26 provides: "Without prejudice to Article 24, repurchase
agreements shall he governed solely by the law of the contract which
govern' such agrccrnents."
o Article 27 provides: "Without prejudice to Article 24, transactions
carried out in the context of a regulated market [defined to include
formal markets, such as stock exchanges] shall be governed solely by
the law of the contract which governs such transactions."

33-22 Article 24 provides: "The enforcement of proprietary rights in instru-

ments or other rights in such instruments the existence or transfer of which
presupposes their recording in a register, an account or a centralised deposit
system held or located in a Member State shall be governed by the law of the
Member State where the register, account, or centralised deposit system in
which those rights are recorded is held or located."
The EU Directive on the Reorganisation and Winding-up of Insurance
Undertakings (2000/17/EC) is in very similar terms to EU Bank Insolvency
2001. Reinsurers are not covered by the Directive.
See LPIF vol 6 para 22.086 for the bank and insurance directives.

Uncitral Model Law on Cross-Border Insolvency

33-23 Introduction The Uncitral Model Law on Cross-Border Insolvency was
adopted in 1997. Unlike a convention or treaty, states can adopt it or change
it so that it is more likely to be accepted. On the other hand, if state:; change
it there is less harmonisation than with a convention.
The Model Law is unilateral and does not require reciprocity from other
 INSOLVENCY CONFLICT OF LAWS: GENERAl.. 545

states: local recognition is available for insolvency proceedings anywhere in

the world.
The scope is more modest than the EU Insolvency Regulation, mainly
because the Model Law does not set out rules of applicable law for insol-
vency questions.
The Model Law does not prevent states from exercising their own 33-24
jurisdictional rules in relation to insolvency, including exorbitant or
ephemeral jurisdiction. Contrast the EU Insolvency Regulation 2000 which
confines jurisdiction to the debtor's centre of main interests in the EU plus
an EU establishment but not for slighter connections.
Subject to local variations, the Model Law has been adopted, for exam-
ple, by the United States (2005), Britain (2006), Japan (2000-previously
strict territoriality), the British Virgin Islands, Eritrea (1998), Mexico
(2000—Mexico has no other insolvency treaties), Montenegro (2002),
Poland (2003), Romania (2003), South Africa (2000), and Spain. Many
other states have either announced that they intend to adopt it or are
considering it, eg Argentina and Australia. Implementing legislation in
Canada and New Zealand was in process in 2007. Mexico and South Africa
require reciprocity.
For details of enacting states, texts and decisions, see hzip://www.unci-
zral.org/en-index.himl.

Recognised proceedings The Law provides for the recognition in the 33-25
enacting state of foreign collective insolvency proceedings (not floating
charge receiverships, not completely self-managed proceedings, not out-of-
court work-outs), whether liquidation or rehabilitation. It is contemplated
that the insolvency of banks, insurers and other entities can be excluded.
The insolvency administrator is called a foreign representative. See art 2.

Main and non-main proceedings The Law divides foreign proceedings into 33-26
main and non-main proceedings. Main proceedings are those commenced at
the debtor's centre of main interests. See art 2. In the absence of proof to the
contrary, the debtor's registered office (or habitual residence in the case of
individuals) is presumed to be the centre of the debtor's main interests. See
art 16(3). Non-main proceedings are those taking place where the debtor has
an establishment- broadly a non-transitory branch. See art 2. A main
insolvency has much better recognition than a non-main insolvency. A
foreign insolvency where there is less than a branch (eg only local assets) is
not entitled to recognition.

Local proceedings After foreign recognition, the enacting state may open 33-27
local proceedings only if there are assets locally-.it need not be a branch.
Scc art 28. The stays in the local proceeding have primacy over the stays in
the foreign proceeding recognised locally so that they could be more or less.
See art 29. The Law does not state what law applies to the local proceedings,
but normally it will be local law, including its conflicts rules.
Foreign creditors have the same rights to commence and participate ill
local proceedings as local creditors. See art 13.
The Law has two central concepis: (I) the degree of recognition of tile
foreign proceeding, and (2) co-operation between courts and representatives
of concurrent proceedings.
 546 CONFLICT OF LAWS

3-28 Recognition In the case of a foreign main proceeding, the foreign pro-
ceeding will be recogniscd if the foreign representative presents certificates of
the foreign commencement. See art 15. The intent is that the local court
should not he ahic to reopen the merits of the foreign commencement, eg
reexamine if the criteria of insolvency were established and whether the
debtor had its centre of main interests in the foreign jurisdiction concerned,
except in the case of a public policy violation. However, there may be room
for the local court to do so since the certificates only create presumptions
(sec art 16) which might he upset Wit is shown that the grounds for it Were
Fully or partially lacking. See art 17(4). The degree of conclusivity accorded
to the decisions of foreign courts therefore depend upon local court dcci-
SIOflS in practice.

33-29 Recognition stays Once a foreign main proceeding is recognised, then three
basic stays come into effect locally: (I) on individual actions and proceed-
ings, (2) on execution against the debtor's assets, and (3) on disposals of the
debtor's assets. See art 20. But a local proceeding may be commenced. See
art 20(4). The scope of the stays can be limited by local law. See art 20(2).
Examples of exempted stays might be the potential stays on security inter -
ests, lease repossessions, reservation of title, other rights in rem, contract
terminations and set-off if indeed caught by the automatic stay.
The scope of the stays are the main battleground of the Model Law and
the most controversial in implementation. The full range of stays would be
dramatically debtor-protective and contrary to the insolvency policies of
most jurisdictions. Many adopting states have adopted their own versions of
the stays.
In the case of all foreign proceedings, whether main or non-main, the
local court can order other relief in addition to the above. Sec art 21.
"Relief" is the term used mainly for stays and freezes, but it is wider, eg local
investigations. The court can Order a turnover of assets to a foreign repre-
sentative if local creditors are adequately protected. See art 2](2).
The Model Law does not expressly allow the foreign representative to
claim local assets, but this is probably implied by virtue of provisions giving
the foreign representative standing in the local courts (see arts 9 and II) and
by the co-operation provisions.

33-30 Co-operation There are general provisions for co-operation between courts
and insolvency representatives, eg communication. See arts 25-30. The
legislator can add to the co-operation list.

33-31 Voidable preferences A foreign representative has procedural capacity to

initiate the avoidance of preferences in the local courts. See art 23. This
provision does not impose the foreign law of voidable preferences or set out
conflicts rules and is solely procedural.

33-32 Equalisation A creditor who receives part payment in a foreign proceeding

must bring this into account in a local proceeding (hotchpot, equalisation).
See art 32.

33-33 Public poiic "lie Model Law dues not prevent the couit Iruiii iclusing to
take action ii manifestly contrary to the public policy of' the enacting state.
See art 6.
 INSOLVENCY CONFLICT OF LAWS: GENERAL 547

Treaties International treaties and other state agreements prevail. See 33-34
art 3.

Applicable law Unlike the EU Insolvency Regulation, the Model Law does 33-35
not set out any rules as to what law is to apply to particular issues, eg assets
of the estate; powers of the debtor and representative, such as debtor-in-
possession; effect on contracts; admissible claims (no rule that foreign tax
and social security claims are admissible); priorities; the effect of a confirmed
plan and discharge; voidable preferences; the treatment of security interests,
liens, leases of land or equipment, proprietary tracing claims, trusts, reser -
vation of title or other rights in rem; set-off -,the effect on public registers;
and post-commencement disposals to good faith third parties. It does not
specify the applicable law for director liabilities for not having stopped early
enough, and the consolidation of group companies.
However, some of the above may be affected by the interpretation of the
stays which the local court implements on recognition, whether mandatory
or discretionary, eg the stay on individual actions and proceedings may
affect the enforcement of security interests and repossession of leased
property and goods sold on reservation of title terms. It is doubtful but
possible that the stays could affect set-off and contract termination clauses,
unless negatived on implementation (as they sometimes are).

Groups Each group company is treated as a separate debtor. Group 33-36

insolvencies might by facilitated by the co-operation provisions.

Procedure Many provisions of the Model Law are concerned with over- 33-37
riding local procedural objections preventing foreign representatives from
having procedural standing locally so that the foreign representative may
collect local assets and with ensuring that the foreign stays on creditors have
local effect. Some are aimed at the blocking powers of local courts on
technical procedural grounds. Thus a foreign representative can apply
locally for recognition (see art 9), so that various stays come into effect, can
commence a local proceeding (see art II), can, after recognition, participate
in a local proceeding, is entitled to local co-operation, and can initiate a
local preference avoidance action (see art 23).

Further reading on the Uncitral Model Law: LPI F vol 6 chapter 23.

Insolvency jurisdiction
Summary of jurisdictional bases 33-38

The main heads of jurisdiction to institute bankruptcy proceedings are:

o Local centre of main interests or incorporation.

o Local establishment or branch.
o Local assets.
o Local business activities.
o Local nationality or residence of the creditor.
 548 CONFLICT OF LAWS

Races for jurisdiction are common. Some creditors may wish to install
their own administrator and run the insolvency in accordance with their
own home rules. Others, such as employees or tax authorities, may wish to
assert their home priorities over local assets. An insolvency administrator at
the debtor's centre of main interests may desire to thwart attempts by
creditors to seize assets locally by imposing an insolvency stay via local
proceedings.
One of the most startling differences between ordinary credit contracts
and bankruptcy cases is that in the case of credit contracts it is possible to
choose the forum with a high degree of liberality by contract selection
clauses, but this is not possible in bankruptcy cases where typically the
forum where the debtor has its centre of main interests or its place of
incorporation in the case of main proceedings or, in the case of ancillary,
secondary or non-main proceedings where it has assets or a branch, has
exclusive jurisdiction and the parties cannot choose their forum. Naturally
parties can select the location of their principal office and place of incor -
poration, but they do so for commercial reasons (proximity to customers
and markets, labour costs, Lax) and rarely take into account the bankruptcy
regime, even though this might influence the cost of credit.

33-39 Long-arm jurisdiction: summary Virtually all developed states permit local
insolvency proceedings at the debtors centre of main interests or place of
incorporation or where there is a local establishment. The question, there-
fore, is whether the courts exercise a long-arm jurisdiction, ic an excessive or
exorbitant jurisdiction, based on some other weaker or fleeting connection
with the forum. The principles stated below are overridden by the EU
Insolvency Regulation 2000 and by treaties where they apply.
The main heads of long-arm bankruptcy jurisdiction are:

o Local assets. The "assets" ground of insolvency jurisdiction (however

small the asset) appears almost universal and applies in countries as
various as Argentina, England (and many English-based countries),
Finland, France, Germany, Sweden and the United States, but perhaps
not in a few exceptional states, eg Denmark, Norway and some Latin
American countries (Bolivia, Honduras), where it seems that a local
branch or establishment is required. Under the EU Insolvency Reg-
ulation, if the debtor's centre of main interests is in the EU, local assets
are not enough--there must be an establishment, as defined.
o Local physical presence (individuals).
o Nationality or residence of the petitioning creditor. The long-arm jur-
isdiction based on the local nationality of the creditor applies in
France. Whether it applies in other Napoleonic jurisdictions should be
investigated. Nationality or residence of the creditor is irrelevant in
probably most other jurisdictions, eg England, Germany and the US.

Sometimes these ephemeral jurisdictional bases are used, not so much as

to collect or preserve local assets (the usual reason), but rather to secure
insolvency jurisdiction over debtors: (l)to investigate their affairs under far-
reaching investigative powers available only on bankruptcy, particularly in
the case of fraud, (2) to recover a Fraudulent preference, (3) to recover an
excess receipt obtained by a creditor in defiance of the main bankruptcy, eg
 INS0LV1N(y CONIL.I(T 01: LAWS: GINERAI.

by virtue of a foreign attachment or repossession, (4) to impose liability on a

director for fraudulent or wrongful trading, or (5) to recover the debtor's
property spirited away by an officer. These remedies may either not be
available or be weaker in the absence of insolvency jurisdiction.
Sometimes a single factor on its own is not enough and several connecting 33-4()
factors are required, and often the courts have a discretion.
In England and many English-based countries the court has long-arm
jurisdiction to wind-up an insolvent foreign company if there are local assets
and also if there are persons (English or foreign) who would benefit from the
winding-up order, even though there are no local assets of the company
itself: there is no point in making a winding-up order to wind-up nothing or
if creditors have no local advantage. The long-arm jurisdiction is discre-
tionary. It is immaterial that the company did not carry on business in
England or that the creditors who stand to benefit are foreign.

In Re A Company (No 00359 of 1987) [1987] 3 WLR 339, a bank lent

US$13m to a Liberian company controlled by Greek interests in order to
enable the company to finance the acquisition of a new ship. Alter
defaults in payments under the loan agreement, the loan was called in.
The bank subsequently obtained judgment in the English courts for the
loan. The company had no assets in England. If an order were made, the
liquidator would seek to recover from the company's directors (some of
whom were resident in England) for fraudulent or wrongful trading.
Those amounts would be available for the company's creditors, including
the bank. Held: the court had jurisdiction if there was a sufficient con-
nection between the case and England and if there was a reasonable
possibility that creditors would benefit from the winding up. The con-
nection with England existed because (in particular) the loan agreement
was entered into and fell to be performed in England and the company
had carried on business in England directly or through agents.
In Stocznia Gdanska v Latreefers [2001] BCC 174, CA, a Latvian shipping
company had used an off-the-shelf Liberian company to enter into certain
shipbuilding contracts with a Polish shipyard. The Liberian company
subsequently defaulted. The Court of Appeal held that there were suffi-
cient points of contact with the English jurisdiction for the English court
to assume jurisdiction to wind up the Liberian company. The default was
under contracts governed by English law and the Liberian company had
been controlled through agents in London. The judgment debt upon
which the insolvency proceedings were based had been created by a
judgment of English courts.
In the Texas case of Re Yukos Oil Co (Southern District of Texas, Feb-
ruary 24, 2005) Yukos was an enormous Russian oil and gas company
and its only US asset was bank deposits transferred to the US to create
jurisdiction a week before petition. The object of the filing in Texas was to
stay the enforced sale in Russia of a Yukos subsidiary for unpaid tax bills.
Held: the court would not exercise jurisdiction over the Russian company
since the US links were too tenuous for a voluntary case filed by the
debtor. The assets had been transferred to create jurisdiction.

Internal jurisdiction

Apart from national jurisdiction, it is also necessary to establish the courts 33-41
which have jurisdiction internally within a country. Federal countries
 550 CONFLICT OF LAWS

typically have provisions (or internal jurisdiction, in the uS, a large pro-
portion of listed companies are incorporated in Delaware and many case
arc bled there, instead of the state of the principal business. in the US, a
corporation can file for bankruptcy in any district in which it has its prin-
cipal place of' business, principal assets or domicile or where an affiliated
firm has already tiled for bankruptcy. See 28 USC s 1409. in Canada, statute
provides for co-operation amongst courts in cases involving more than
one province.

Recognition of foreign insolvency representatives

anll stays
htroduction
33-42 Sometimes the foreign administrator can collect foreign assets locally
without local proceedings, but more often a local court order for recognition
is necessary. The alternative is for the foreign administrator to commence
bankruptcy proceedings locally. These proceedings could either be main or
non-main.
Internationally, there is an increasing tendency to recognise the right of a
Foreign administrator from the bankrupt's main forum to collect local
assets, and an increasing tendency to recognise the freeze on creditor
execution:. although this may be delayed tiuitil local recognition proceedings
are taken. 11 is much less common f'r other stays to he recognised, notably
on sct.-ofl security interests and contract cattccUat;on. Most states will
allow con('uirctIt proceedings to he opened, so that in practice the unilateral
cliorts of the foreign administrator are quickly overtaken by local pro-
ceedings which guillotine further attachments by creditors and transfers by
the debtor of its assets. The effect of the local proceedings is to allow the
local jurisdiction to give effect to its own bankruptcy law.

Summary of recognition of foreign stays and foreign

representative
33-43 The following is a broad summary of the international approaches as to the
recognition of foreign stays and of the right of the foreign representatives to
collect local assets.

33-44 Total non-recognition A few countries arc not prepared to recognise a

bankruptcy at the principal foreign forum or to give it any local effect over
local assets in the absence of a treaty-- -possibly Estonia and Finland. There
must he a local proceeding.

33-45 Full or partial recognition In most countries, the foreign forum's insol-
vency proceedings achieve it measure of local recognition in terms of Foreign
administrator collection and Freezes on creditor execution and debtor dis-
posals (bitt not other stays). with or without local recognition proceediiig.
In order to achieve this recognition, it is generally true that certain basic
conditions are satisfied:
 INSOLVENCY CONFLICT OF LAWS:(ilNERAL 551

o the foreign forum had bankruptcy jurisdiction in the eyes of the local
forum. This generally means that the proceedings must have been
opened at the debtor's centre of main interests or equivalent, so that
usually foreign non-main proceedings are not recognised;
o the foreign decree was final and conclusive;
o the foreign decree does not conflict with the local forum's views of
public policy, eg is not for the collection of foreign taxes or penalties;
o the foreign decree had extraterritorial effect, ic covered global
property;
o local proceedings have not been opened; and
o (sometimes) proof of reciprocity.

Fhe rationale for recognising foreign administrators of a company must he

that they are the persons who now are in control of the company and they
re its managers: jurisdictions ought to look to the law of the place of
incorporation of the debtor to determine the rightful manager.
Provided the local conditions of recognition are met, broadly there are
three degrees of recognition in this group of states where the original
bankruptcy is opened at the centre of the debtor's operations.

o Immediate recognition without proceedings. The local forum rccogniscs

the foreign bankruptcy immediately without formal recognition pro-
ceedings locally. This recognition entitles the foreign insolvency
representative to collect local assets, and it Freezes creditor attachments
of local assets and the powers of the debtor to dispose of local prop-
erty. The effect is to recognise the immediate universality of the foreign
principal bankruptcy so far as property of the estate is concerned. This
is the general rule in English-based states, subject to qualifications.
This principle is also implemented by the EU Insolvency Regulation
applying where the debtor's centre of main interests is in the EU
(except for Denmark).
o Recognition proceedings required. The local forum requires formal 33-46
recognition proceedings before the foreign representative can collect
local assets and this recognition order is not retroactive, so that prior
attachments by creditors of local assets in defiance of the foreign for-
um's freeze and prior dealings with the assets by the debtor are
effective. This is often a serious disadvantage because the exequatur
process is commonly costly and time-consuming, eg six months, so that
in the meantime assets may be dissipated. This is roughly the position
under the Uncitral Model Law and appears to be the case in many
Latin American jurisdictions. The effect is to recognise the universality
of the principal bankruptcy as regards the property of the debtor but
only from the time that the formal local recognition order is made. In
France the local recognition is retroactive.
In Société Kieber v Frics Hansen (Cass civ Ire, February 25, 1986)
a French creditor, Sociêtê Kleber, presented its claims in Danish
bankruptcy proceedings against a Danish company and
attempted at the same time to ensure the recovery of its debts by
 552 CONFLICT OF LAWS

seizing property located in France and having an interim mort-

gage registered over it. It brought an action in France against the
Danish company for payment of its debts and validation of the
interim mortgage. Held: the court rejected the action on the
grounds that the foreign decision, which had been recognised by
French courts, took effect from the date it had been rendered by
the foreign court, subject to public policy considerations. The
Cour de Cassation held that termination of individual proceed-
ings and of registration of securities and rejection of claims for
payment of prior debts were effective in France from the date of
foreign judgement, ic before it had been recognised in France.
33-47 o Recognition limited to asset collection. The foreign forum is not pre-
pared to recognise the bankruptcy at the foreign main forum or to give
it any effect over local assets so that debtor transfers and creditor
attachments are not stayed. The foreign forum may grant the insol-
vency representative powers to collect local property, especially in the
case of it company where the directors no longer have powers of
coiiirol. This may be the position in Scandinavian countries and the
Netherlands.

Further reading on recognition: LPI F vol 6 chapter 20.

i . Jte('.V!/')n.. a,i/ .('Pflh1U!i u;pie.c ..e i/u' ('/1(1 OJ .11d/)k'r 34.

 CHAPTER 34
INSOLVENCY CONFLICT OF LAWS:
PARTICULAR TOPICS
Introduction
This chapter reviews the question of what law will apply to selected insol- 34-0 1
vcncy issues.
The applicable law governing particular issues is codified in the EU
Insolvency Regulation. See para 33-08. The Uncitral Model Law does not
codify applicable law on substantive issues, other than (broadly) the right of
foreign representatives to collect assets and the recognition of certain stays.
Austria, Belgium, Germany and Spain used the European Insolvency
Regulation as the base for their extra-EU conflicts regime instead of the
Uncitral Model Law so as to have a unified set of rules, instead of the
Regulation for the EU and Uncitral for the rest of the world. The UK chose
to split its regime into the EU Regulation for the EU and Uncitral for
everybody else.

Set-off: conflict of laws

Solvent set-off 34-02

The question of whether a claim may be discharged by set-off between

solvent parties should be governed by the law of the claim which the debtor
asserts has been discharged. For England, see Allen v Kemble (1848) 6 Moo
PPC 314, PC. Thus if a depositor claims a deposit and owes a loan to the
bank, the availability to the bank of set-off should be determined by the law
governing the deposit: the bank pays the deposit by using the loan. The
deposit is the claim which the bank as debtor asserts has been discharged by
setting off the loan.
The reason for this choice is that the question of whether a contract claim
has been discharged is typically governed by the law governing that claim.
Set-off is a form of payment of a claim: whether a debtor can pay a claim by
using a debt owed to him by the creditor should be governed by the law of
the claim which the debtor owes and pays by the set-off.
As at early 2007, art 16 of the proposed EU Regulation on Contract
Applicable Law, intended to replace the Rome Convention on
Contract Applicable Law 1980, adopted the above principle by stating that
"Statutory offsetting shall be governed by the law applicable to the obli-
gation in relation to which the right to offset is asscrtcd." •rhis is also be
consistent with the rule adopted by the EU Insolvency Regulation 2000 art 6
for insolvency set-off--see next.
 554 (uNit iCi 01 lAWS

4-40: II ffTLSll vcy C-(tIi

As noted in chapter 14. one group of states permits insolvency set-oil while
nother group does not, except in the case of Coll neXity or current accounts.
ndci the EU Insolvency Regulation 2000 the "conditions under which
set-oil Ella)' he iiivoked is governed by the law of' [he jurisdiction where the
proceedings arc opened. Sec art 4(2)(d ). II that forum disallows the set-oil.
then tile creditor gets the set-oil ''where such set-oil' is permitted by the law
applicable to the insolvent debtor's claiiii' . See art 6(l). It is considered that
this is a reFerence to die Insolvency set-ofT rules of' the governing law, so that
I English law a pplies to the law governing the debt owed to the insolvent
hen insolvency set-oil' is permitted. Since in most developed jurisdictions,
the parties can choose the overning law, this means that effectively the
pill- ties can Freely Colin-act into insolvency set-oil by choosing a system oF
law that allows set-oil. It is considered that the chosen law does not have to
he that of- it Member State. The governing line is the substantive law of' the
jurisdiction concerned, not its conflicts rules.
The rights and obligations of' arties to it payment or settlement system or
to it financial market are governed by the law oF the member state applicable
to that system or market. See art 9.
34-04 tinder the Lincitral Model Law on Cross-Border Insolvency, certain stays
an toma tica liv conic into ellect and the court may order other stays and relict
ii I IS discretion. ei-oll' cOt!ld he ii heeLed by 1 Itese provisions. hut (he detail
depcnds on kw- dl Implementation. 'I he Rn iNtl 11)1 pieiiien tat i Oil dOCS not
permit the Slav to 111cct set-oil, in(l ilic i IS fill pk'nicntatloll iii effect Imports
(lie t.i: SL's alto their exceptions.
Outside I ic Illsokency Regulation and the 1.1 neit ra I lvi odd Law, it
sceUlS to be olteti the case that the haiikruptcv lornni Will apply its own rules
to (lie Availability oh set-oil' on insolvency, including Its rules as to pre-
teren (al build-ups and stays on set-off. This is so ill England: see Re lie!!,
ifci i/or & ('o I.iil (I 894) 10 TER 412, Re llaiik of Credit aiuf C ()flhFJl(f('C
Iniernational SA ( No 10) [1996] 4 All ER 796. Some jurisdictions may defer
to the law of' the maui proceedings or adopt the principle of' the EU
Insolvency Regulation, eg Germany.

34405 Netting and (he cancellation of contracts As discussed in chapter 14. the
netting (IF OCil, eXecutory Or unperFormed contract req uircs three steps: the
cii nccllatloll of tile open contracts on the insolvency of' the countcrparty, the
ci len fat ion of losses and gains either way (su hject to qualifications) and then
the set-oil oF these losses and gains. Hence on the insolvency of a coUfl'
tcrpa rty it must he possible for the solvent party to cancel the contracts
without hindrance under insolvency law, eg there is no nullification of
contract termination clauses. For it discussion of' the insolvency conflicts
position in i'ela ton to the cancellation of' contracts, see pin -a 34-33.

Further reading on set-oft conflicts: I P1 F vol 6 pa ia 13 021.

 INSOLVENCY (1ONFLIc7 OF LAWS: PARTICULAR TOPICS 555

Security interests and title finance

General 34-06

The conflict of laws rules in relation to security interests and title finance
involve a large number of issues, eg the status, powers and authorisations of
the debtor granting the security, formalities, the contractual aspects of
security, the characterisation of the transfer, the degree of publicity and how
it is effected, permissible secured debt, title and priorities, priority against
unsecured creditor executions and methods of enforcement, eg private sale,
receivership, judicial public auction and the like. There are also issues as to
the priority of preferential creditors, the ability to set aside a security interest
as a preference, contract jurisdiction and enforcement jurisdiction.
In principle it is useful to distinguish the arenas as follows:

o Corporate aspects, notably the status of the debtor, its powers and
authorisations. These are usually governed by the law of the place of
incorporation.
o Contract aspects of the security interest, notably the terms of the
secured debt. These tend to be governed by ordinary contract conflict
of laws, usually the governing law of the security agreement.
o Proprietary aspects of the security interest, especially the publicity
needed such as filing or possession by the creditor. These tend to be
governed by the law of the location of the collateral with patchy
exceptions for hook-entry securities (sometimes governing law of the
account as in the US) and contract claims (governing law of the claim).
o Insolvency aspects which are generally governed by the law of the place
of the bankruptcy court administering the proceedings. They will
generally look to the law of the location of the collateral.

Law of the location of assets: principles

Traditionally, the law of the location of the collateral is fundamental in 34-07
determining the proprietary aspects of a security interest. In particular, it is
location which primarily decides whether there has been an effective transfer
of the collateral to the creditor and whether the transfer has been adequately
publicised to unsecured creditors and other third parties dealing with the
asset, such as buyers and pledges of the assets. Publication often decides
validity and priority. There have been major erosions of this comfortable
principle.

Origins of law of location of the collateral The law of the location is ulti- 34-08
matcly grounded on (1) the need for publicity, and (2) national sovereignty.
If an asset is local, the national power can tax it, regulate it, control it,
attach it, expropriate it, and apply its own ideas of succession. Other states
infringe national sovereignty if they apply their own law to transfers of
property located within another nations territory. Since the nation has
control and power over the local asset, it is useless for foreign courts to
apply different rules which they could not in practice enforce over the asset.
 556 (ONI'It(T (H LAWS

They could make orders binding personally on the litigants before them, but
these could he counterrnandcd by the controlling nation.
Publicity is typically considered fundamental to security interests and
indeed to all transfers of property, although the ideology is now doubtful.
The purpose was to permit false wealth and to protect market priorities
against a secret security interest. See para 17-01. Nevertheless, the policy of
publicity is deeply entrenched and underpins why the law of the location of
the assets is normally determinative of both validity and priorities.
It was natural that the people who were most likely to be affected by a
security interest -namely unsecured creditors and those who wanted to buy
the land, goods or take a mortgage or pledge--- would be those on the spot.
In the absence of financial statements and central registration systems, the
best and often the only way of finding out who had an interest in the asset
was by inspecting it physically and enquiring of neighbours in the area or in
the town market-place. It made sense, therefore, that these third parties
should look to the law of the location or situs of the asset to decide their
properly rights.
34-09 When it came to priorities, such as the trumping of unsecured creditors
and whether buyers and mortgagees got good title, what mattered was who
had the apparent ownership, rather than who actually owned the asset,
because third parties inspecting the asset could only rely on what they saw- --
who had possession or apparent title-' and if an owner chose to remain
secret then he would have to bear the consequences. What they saw was
where they saw it.
When the mortgage came to be enforced, it was the local courts who
decided the remedies. If the debtor became bankrupt, the local court took
charge and administered assets within its territorial grasp.

34-10 Problems with the location rule This golden world of safe unity was over-
taken by the realities of modern complication:

® Location is problematic For intangible assets and has to be fictitious. IF

one strips off any paper packaging then the assets are all invisible and it
is necessary to give them a fictitious location. The international con-
sensus for most types of intangible property is to locate the property
where the debtor is or the person against whom the claim is made. This
is because the debtor usually has to hand over money in order to
deliver the asset so that it looks as though the debtor has the property
although the owner of the asset is actually the creditor or shareholder
For chattelised intangibles sometimes they arc located where the
heavily packaged paper happens to be and registered intangibles are
often situated where the register is--this is often in the same jurisdic-
tion as the debtor.
Many assets are constantly on the movc---moveable moveables (ships,
goods being exported, claims against banks, investments). They can
move extremely rapidly from one jurisdiction to another.
o For universal security or any other bulk collateral, it is often imprac-
ticable to investigate the law of the location of each item. This is also
true of an account lot book-ciiti'y secuis.

Ono response was to fix location at a title register, eg obviously for land
 INSOLVENCY CONFLICT OF LAWS: PARTICULAR TOPICS 557

ut also for intellectual property, ships, aircraft, (episodically) automobiles,

nd often for registered investments. Another was the introduction of
ebtor-indexed filing systems for security interests, usually at the place of
icorporation of the debtor. Here, publicity is central and you only have to
)ok in one place. A third, applicable to contract debts, was to substitute the
overning law of the contract debt for the location of the debtor—a freedom
hallenged on the grounds that the parties could now freely decide publicity
r property transfers.

overning law of creation, perfection and priorities

;ummary The general rule is that creation (attachment), perfection (pub- 34-11
city by possession, control, registration on an asset title register, or notice
o obligor) and most priorities which involve competing property transfers,
eing matters of property, are governed by the law of the place where the
ollateral is located.
Priorities relate to such matters as priorities between owners, other
ecured creditors and buyers of the mortgaged assets. Issues such as whether
referential creditors have a special privilege on bankruptcy are pure
ankruptcy matters, governed by bankruptcy conflicts, usually the law of
he forum of the bankruptcy.
Where perfection is by filing in a debtor register, perfection and some
priorities are governed by the law of the place where the filing must take
lace, usually the location of the debtor. The problem with these tiling
ystems is that they often also require filing if the asset is local and the
hargor has a local business, even if no local incorporation and even if the
sset is subsequently moved to the filing jurisdiction.
The object is to protect local creditors. The result is multiple filing or 34-12
,ther perfection according to the location by reason of the view that the job
f governments is to protect their local creditors from secret security
nterests.

In Luckins v Highway Motel (Caernarvon) Ply Lid (1975) 133 CLR 164, a
company located in Victoria, Australia, created a charge over a bus and
filed the charge in Victoria as required by the Victorian filing law. An
unsecured judgment creditor attached the bus in Western Australia, which
also had a filing statute for charges over assets within the jurisdiction
created by foreign companies carrying on business in the state. The bus
company was carrying on business in the state. Held: the charge was void
For non-compliance with the filing requirements in Western Australia. The
court applied its own mandatory statute.
In a Swiss case, a seller retained title to goods delivered to a buyer in
Germany. The retention of title was effective in Germany. The buyer
moved the goods to Switzerland. Held: the retention of title clause was
invalid in Switzerland for lack of registration in a Swiss register: BFE 106
11198.
In NV Slavenhurg 's Bank i , Intercontinental Natural Resources Inc., [1980]
I WLR 1076, a company located in Bermuda charged oil in an oil tank
located in England to a Dutch bank. 'llie company had a branch in
England. The English tiling statute required filing for charges over assets
in England created by foreign companies which had a branch in England,
 558 CONFI.KT 01

whether or not the branch was registered at the companies registry in

England, as required. Held: the charge WS void.
Contrast Century Credit Corpn v J?,chard (1962)34 DLR (2d) 291. A seller
sold a car to a buyer in Quebec but retained title. This was valid under
Quebec law. The buyer took the car to Ontario which required registra-
tion of retention of title clauses, field: the retention of title clause was
valid because the transaction WaS entered into in Quebec.

The long-arm rule is regarded as unsatisfactory and protectionist. The

desire to protect local creditors means that it is necessary to check regis-
tration and filing in all jurisdictions where any of the company's property
may be situated. This is absurd for aircraft and ships and is impracticable
for universal charges created by corporations with many assets in may
difThrent countries --in each case, one would have to check whether there is a
sufficient local business. In addition the location of many assets is constantly
changing. Unsecured creditors dealing with a foreign company can easily
search at the place of incorporation to see whether any charges are tiled and
the idea that they can only be expected to search in their own jurisdiction is
no longer tenable.
In some jurisdictions, perfection and priority in relation to debts and
other contract claims is decided by the governing law of the debt or con-
tract and in relation to book-entry investments, sometimes it is the
governing law of the intermediary's account.
Hence there are three competing principles:

O location of asset: -
O location of debtor (filing statutes); and
o governing law of' the asset (sometimes for contract debts and hook-
entry securities).

34-13 Summary of location rules The following is a summary of' the location
rules.

° It is universally agreed that the location of land is where it is.

o (Almost universally) registered ships and aircraft are located where the
asset title register is situated.
o (Universally) goods are located where they arc, subject to qualifications
For transitory goods. This is also true of' chattelised intangibles, such as
negotiable instruments.
0 As to intangibles, if there is a register or equivalent, such as a share
register or a book entry account in a demateriahised clearing system,
then the tendency is to locate the asset at the register or account. This is
certainly true of registered intellectual property.
o For ordinary contracts, receivables and bank accounts, the consensus
is that these are located where the debtor has its residence, eg a hank
account is located at the branch of the bank where the account is kept,
and a receivable is located where the debtor in respect of the receivable
carrics on its business.
 - INSOLVENCY CONFLICT OF LAWS: PARTICULAR TOPICS 559

There is considerable international variation in the detail. In particular there

are special rules for contract receivables and book-entry securities.
They include receivables, contracts, concessions, shares and other
investments, investments held in book-entry systems, receivables, charter -
parties, insurances, hank deposits and intellectual property rights.

Perfection for contract debts There is much divergence between the degree 34-14
of publicity required to validate a security interest over or assignment of
debts as against the attaching creditors and the insolvency representative of
the obligor liable for the debt. In most of the Napoleonic group, but also in
Japan, Korea, Scandinavia and others, the security is invalid against cred-
itors unless it is notified to the obligor owing the receivable (sometimes in
prescribed form), subject to carve-outs. In most English-based countries,
notice to the obligor is not necessary for validity of the assignment against
creditors of the assignor, but a corporate charge over "book debts" must
normally be filed at the companies registry to be valid on insolvency. Ger-
many requires neither.
Under the EU Insolvency Regulation 2000 for the purposes of insolvency
jurisdiction, claims are deemed to be located in the Member State within the
territory of which third party required to meet has its centre of main
interests. See art 2(g). Under UCC Article 9 there is a hierarchy of five rules
for determining the location of bank accounts---one of these is the express
governing law of the account agreement, which accords with the English
principle that perfection and priorities are determined by the governing law
of the debt which is assigned.
The principles set out below may be affected if there is a filing statute. Sec
para 34-11. Under Article 9 of the UCC there is a mixed system for the
governing law for the perfection of security interests in relation to intangi-
bles-- -sometimes debtor location (filing), sometimes collateral location (best
title or control).
Subject to filing statutes, there is little international agreement as to 34-15
whether publicity by "notice to the obligor" should be determined by the
law governing the debt which is subject to the security, or the law of the
fictional location of the debt, which will often be the law of the obligor's
location.
Outside bankruptcy, the Rome Contracts Convention of 1980 art 12(2)
provides that: "The law governing the right to which the assignment relates
shall determine its assignability, the relationship between the assignor and
the debtor, the conditions under which the assignment can be invoked
against the debtor and any question of whether the debtor's obligations
have been discharged."
In applying art 12 of the Rome Contracts Convention, English law
applies the governing law of the claim assigned to decide whether notice to
the obligor must be given for the validity of the assignment.

In RaJJeisen Zentralbank Oesterreich AG v Five Star General Trading LLC

[2001] QB 825, CA, a shipowner mortgaged a ship and its insurances. A
cargo-owner attached the proceeds of the insurances in France on the
ground that notice of the assignment had not been given to the insurers.
The insurances were governed by English law. Held: the question of
whether notice was necessary for the validity of the assignment was
determined by the law of the contract assigned. Since this was English law
 56() CON ILI(T (fl LAWS

and since English law does not require notice to the obligor For validity of
an assignment, the mortgagee was entitled to the insurances.

'The position at common law outside the Rome Contracts Convention is

considered to he the same.
34—!6 The Rome Contracts Convention is intended to be replaced by it Reg-
iilation and, as at 2007, it seemed that the Regulation was likely to adopt the
Ra/fris('n principle that the requirement for notice is determined according
to the governing law of the debt assigned so that ii the debt assigned is
governed by English law, notice is not necessary for validity, but if it is
governed by. say, Italian law then it is necessary for validity.
In the case of the French rule requiring formal notification to the obligor
For validity, German and Swiss decisions determined the applicability of this
requirement in accordance with the law of the debt assigned--the same as
the English view. However, under French law, if the obligor who owes the
debt is in France and the assignor becomes bankrupt, the French courts in
pre-Rome Convention decisions insisted on the formal notification so that,
if it was not duly effected, local creditors could attach the debt and ignore
the assignment and the assignment would he invalid on the assignor's
bankruptcy in France. Hence French courts applied the law of the location
of the debt (obligor's place of business) and this may he followed in other
Napoleonic countries. The French position was derived from the Fact that
the notification rule was designed not only to protect unsecured creditors
against false wealth, but also to protect the obligor who owes the receivable.
Its understood that Japan has now adopted the law of the claim assigned to
govern this question.
In many jurisdictions outside the English common law group. if the loan
or other debt which is sold is secured on assets registered in an asset title
register, such as a register for land, ships, aircraft, shares or intellectual
property, then the transfer of the mortgage also has to be registered in the
same register if the transfer of the mortgage is to be effective against cred-
itors of the seller. In principle it is suggested that this question should be
decided by the law of the location of the register concerned, at least in the
case of land.

34-17 Priorities for contract debts Where it debt is successively mortgaged or

assigned, the priorities as between competing assignees ought to be deter-
mined by the governing law of the debt assigned, as opposed to the law of
the location of the debt which is the obligor's place of business. Article 12
of the 1980 Rome Contracts Convention is silent on the matter, but check
the ultimate outcome on the successor Regulation. The application of the
law governing the debt assigned will give the same answer for all parties and
is the law to which parties would naturally look. Hence if a debt is governed
by English law, then the priorities between successive assignees depend upon
the first to give notice to the obligor, assuming that when the second
assignee took his assignment they were not on notice of the previous
assignment.
Article 9 of the UCC establishes that generally the jurisdiction governing
'Ill perfcction has taken iUCC also governs prionty and the effect of
perfection and non-perfection in the case of accounts (le receivables) and
general intangibles (including contracts). As noted, this is generally the filing
 INSOLVENCY (ONFLI('( OF LAWS: PARTICULAR TOPICS 561

jurisdiction for these assets, but the location of the collateral for deposit
accounts may be different.

Investment securities Included in this head are shares and other invest- 34-18
ments, such as listed equities and debt securities. One can exclude fully
negotiable instruments, such as promissory notes and bearer bonds trans-
ferable by delivery, which are chattelised intangibles and for which the
governing location is generally where they are located. Book-entry invest-
ments are a special case: sec below.
The consensus is that both perfection and priorities should be governed
by the law of the location of the collateral, absent a filing statute prescribing
registration or filing at the debtor's location.
Case law in England holds that the location of transferable shares in
companies which are not dematerialised in a hook-entry system is usually
where the company shareholder register is located on which transfers are
recorded or, if there are several registers, the register where the registered
holder would transfer in the ordinary course. The better view (supported by
Canadian authority) is that the place of the incorporation of the issuer
overrides. In practice they are often the same. If the shares are transferred
by delivery of a document, cg because they are bearer shares or order shares
transferable without registration, then there is some English authority that
they are situate where the document is, as is the case with chattelised
intangibles such as negotiable instruments.
Article 9 of the UCC provides that in the case of "investment property"
(as defined), the local law of the jurisdiction in which the debtor is located
(generally place of incorporation) governs whether a security interest in
investment property has been perfected by filing: see s 9-305(c)!. Where
perfection is not claimed by filing (eg because it is claimed by getting the best
title), the local law where the security certificate is located determines
whether a security interest in a certificated security is perfected (these are
generally negotiable instruments) and the local law of the issuer's Jurisdic-
tion governs perfection of an uncertilicated security. These same
jurisdictions govern priority and the effect of perfection or non-perfection.

Book-entry investments Jurisdictions differ widely as to the location of 34-19

dematerialised or immobilised investment kept in hook-entry systems The
preferred view in England is that they are located for the purposes of per-
fection and priorities in the jurisdiction where the destination account is
located. Thus if a broker grants a pledge over book-entry securities in its
accounts with Euroclear in Belgium in favour of a bank which keeps its
hook-entry accounts in the clearing system in Singapore, then one complies
with the perfection requirements under Singapore law.
This principle that one looks to the law of the destination account rather
than the law of where the issuer is situated or where any global bearer bond
is actually held by a custodian is known as the "place of the relevant
intermediary approach". The advantages of this approach are:

0 There is a single law for a whole portfolio or pool of securities held by

the accountholder instead of a different law according to the location
of the issuer for each investment.
o It confers comparative certainty.
 562 - CONFLICT ot: LAWS

o From the practical point of view checking the location of immobilised

hearer bonds or actual certificates, ie where they are actually kept,
would often he impractical because of time, confidentiality between the
tiers of accountholders in a clearing system and for other reasons.

Prima is confirmed by the EU Settlement Finality Directive 1998, by the

EU Financial Collateral Directive 2002, by the EU Directive on the Reor -
ganisation and Winding up of Credit Institutions 2001, by Article 8 of the
US Uniform Commercial Code and by the Hague Convention on Inter-
mediary Securities 2002. The two EU Directives are summarised at para 17
55.
34-20 Both Article 8 and the Hague Convention decide that, lithe parties
expressly choose a governing law for the account, then the "location" is the
jurisdiction of the governing law. In other words there is a shift From
determining perfection and priorities according to some fixed location
to determining these matters according to the governing law between the
custodian and the accountholder.
This is exactly the same trend as is observed in relation to contract debts
where England applies the law governing the debt concerned to the question
of perfection.
Logically, the governing law concerned should he that of the destination
account as opposed to the account from which the transfer is made, because
it is lr the transferee to show that the transfer is publicised, where
necessary.
The adoption of Prima is by no means universal and the law in many
ttrisdictions is in a state of flux. It is quite possible that some jurisdictions
may still apply the law of the location of the issuer, the issuer's registrar, or
the place of any negotiable certificates to this issue.

kisovency conflicts: main issues

34-21 There are a variety of issues which should be determined in accordance with
insolvency conflicts. These include:

o bankruptcy freezes on enforcement in order to aid a rehabilitation;

o the right of the insolvency administrator to sell or to use the collateral;

o the priority of preferential unsecured creditors over the security

interest;

o the right of the insolvency administrator to substitute collateral;

o the ability of the distressed company to trump existing security by a

super-priority moratorium loan; and

o whether the secured creditor is hound by voting on a plan, whether the

secured creditor can vote, and whether (as is usually the case)
the secured creditors form a separate voting class.

In principle the above main issues should be decided by the law of the
location of the collateral. Thus if the collateral is located within the
 INSOLVENCY ('ONI-l.ICF OF LAWS: PA R11CLJI.AR i0I'ICS 563

jurisdiction of the bankruptcy court, the court applies its own rules. If the
collateral is elsewhere, the collateral should he free of the bankruptcy rules.

In Banque Jndosuez v Ferromet [1993] BCLC 112, a US company was in

US Chapter I proceedings. The English court refused to give effect to the
US bankruptcy court's stay on property located in England over which a
bank claimed security. Case law in the Netherlands is to the same effect.

Outside the EU Insolvency Regulation, if there arc English insolvency

proceedings then a secured creditor will not be prevented from enforcing its
security abroad so that the collateral is in effect insulated: see Moor v Anglo
Italian Bank [1879] 10 ChD 681; Minna Craig SS Co v Chartered etc Bank
[1897] I QB 460, 470, CA.
If a foreign jurisdiction declines to give effect to the bankruptcy forum's
freeze, the bankruptcy forum has indirect methods of obtaining a remedy,
namely, equalisation (the creditor cannot prove without bringing his exist-
ing receipts into account), injunction against a creditor who is subject to the
bankruptcy jurisdiction, action for recovery of realisation proceeds against a
creditor who is subject to the jurisdiction, and the imposition of contempt of
court or other penalties. It is considered that equalisation and actions for
recovery would be most unusual where a creditor lawfully enforces a
security interest where the asset is located.

EU Insolvency Regulation Under the EU Insolvency Regulation 2000, 34-22

which applies where the debtor's centre of main interests is in the EU, the
opening of insolvency proceedings in one Member State (whether main or
secondary) does not affect the rights in rem—which includes security
interests--of creditors or third parties in respect of all assets belonging to
the debtor which are situate within the territory of another Member State at
the time of the opening of the proceedings. See art 5. Therefore, collateral
which elsewhere is immune from the Member State bankruptcy proceedings.
If the collateral is in the Member State concerned, it is governed by that
Member State's law under the general terms of art 4(1). There are rules for
the location of the collateral in art 2(g).
Hence a foreign security interest granted pre-commencement is not
affected at all by the bankruptcy proceedings. The result is that the following
rules of any bankruptcy forum would not apply: freezes on enforcement, the
right of the administrator to use the collateral or his exclusive right to sell
the collateral; any right of the administrator to substitute the collateral; any
right of the administrator to raise new loans secured ahead of the collateral;
any reorganisation voting on a plan and the like. The security interest
should not be subject to any prior preferential creditors, such as taxes,
employee benefits and post-commencement costs in the bankruptcy forum.
The result is a split regime. However, security interests are subject to
avoidance as a preference in accordance with the rules of the opening state
(see art 5(4)), unless saved by art 13 which protects foreign transactions.
As to title finance, such as finance leases and repos, the position is similar
as in relation to core security interests. Note that retention of title is gov-
erned by special rules in art 7.
The art 5 exemption immunising collateral iocacd in another Member 34-23
State does not apply to assets outside the Member States, eg in the US or
Japan. In this case Member States apply their own conflicts rules. If the
 564 CONFLICT OF LAWS

debtor's centre of main interests is not in the EU, then Member States also
apply their own conflict rules.
In the case of payment and settlement systems and financial markets one
applies the law of the Member State where the system or market is--see art
9). Note also the immunities from bankruptcy law enforced by the EU
Settlement Finality Directive 1998 and the EU Financial Collateral Direc-
tive 2002. Sec para 1755.

34-24 Uncitral Model Law The Model Law does not set out conflicts rules for
security interests or other property transfers. However, if a foreign pro-
ceeding is recognised locally, then certain stays come into effect
automatically and others can be imposed in the discretion of the court.
Other relief is available. These could affect the enforcement of security
interests. The scope of these intrusions depends upon local implementation.

Further reading on security interest conflicts: LPI F vol 6 chapter 14.

Trusts and other in rem claims

Contract and property aspects of trusts

34-2S The contract aspects of trusts should be distinguished From the property
aspects. Contract covers such matters as: the rights and duties of the trustees
amongst themselves; the powers of the trustees, cg to invest or borrow or
create security interests or to sell the trust assets; the duties of the trustees to
the beneficiaries and the liability of the trustees to the beneficiaries; and
exculpation clauses exonerating the trust from liability. These matters
should be governed by the law selected as applicable to the trust or, in the
absence of an express selection, by the rules relating to applicable law in
the absence of a choice, such as centre of gravity.
Questions relating to the validity and priority of transfers of property
should he governed by the rules applicable to property transfers, usually the
law of the location of the property at the time of the transfer. Property
transfers include outright transfers, eg sales, and also other transfers, such as
security interests. Property transfers will usually also have a contract ele-
ment decided according to contract conflicts rules, eg covenants, warranties,
payments.
The property rules should, for example, apply to: the transfer of property
to the trustee; the transfer of property by the trustee to third parties, eg
whether they take priority if they have notice of the trust; and security
interests granted by the trustee over the trust property.
34-26 The property rules should also apply to the availability of tracing mis-
appropriated trust property as a super-priority remedy against the creditors
of the wrongdoer.
The key issue relating to trusts is whether the trust property is treated as
belonging to the hcnefIciancs and not available to the private creditors of
the trustee. These creditors include execution creditors of the trustee and
creditors on the bankruptcy of the trustee. See chapter 19.
 INSOLVENCY CONFLICT OF LAWS: PARTICULAR TOPICS 565

Elague Trusts Convention 34-27

n the case of those jurisdictions which have implemented the Hague

onvcntion on the law applicable to trusts and on their recognition of
January 10, 1986, the immunity of the assets of the trusts from the private
;reditors of the trustee is decided by the governing law of the trust. The
;ettler may choose the governing law. There are qualifications to this--see
P1F vol 5 para 12-013.
Subject to relatively minor variations, the Hague Trust Convention
pplies in the UK (England, Scotland and Northern Ireland) by virtue of the
ecognition of Trusts Act 1987. Amongst common law jurisdictions, the
-1aguc Convention has also been implemented by (amongst others) Aus-
ralia, Hong Kong, Gibraltar, the Isle of Man, Canada, Bermuda, the
British Virgin Islands, the Turks and Caicos Islands, and Montserrat.
mongst civil code and non-common law jurisdictions, the Convention has
,een implemented by China, Italy, Liechtenstein, Luxembourg, Malta, the
Netherlands, San Marino, Jersey, and Guernsey. The take-up in civil code
urisdictions is therefore slim.

EU insolvency Regulation

Under art 5(1) of the EU Insolvency Regulation 2000 "the opening of 34-28
insolvency proceedings shall not allèct the rights in rem of creditors or third
parties in respect of tangible or intangible, moveable or immoveable
assets- -both specific assets and collections of indefinite assets as a whole
which change from time to time—belonging to the debtor which are situated
within the territory of another Member State at the time of the opening of
proceedings." One of the particular examples of the rights in rem which
benefit from this provisions is "a right in rem to the beneficial use of assets."
See art 5(2)(d). This should include trusts. There are detailed rules in art 2(g)
as to where assets are situated.
The effect of art 5(1) is that the opening of insolvency proceedings do not
affect these rights in rem at all which in our case means that the beneficiaries'
rights would not be affected if the asset concerned is located in another
Member State.
If under the location rules the trust asset happens to he located in the
jurisdiction in which the insolvency proceedings are opened under the EU
regulation, then that jurisdiction will apply its own law: the law of the
opening state determines "the assets which form part of the estate". See art
4(2)(b). This must mean the substantive law of the opening state, not its
conflict rules.
The concept that the immunity of beneficiary assets under a trust should 34-29
be decided by the governing law is underlined by the Hague Convention on
Indirectly Held Securities 2003 and Article 8 of the American UCC, both of
which deal with book-entry securities held in settlement systems—which are
in substance trusts, by whatever name they are called. Both these instru-
ments apply the law of the place of the relevant account to decide such
mailers as the vd 1lidity of transfcrs, and in both cases the parties can decide
the location according to the governing law of the account.
The art 5 exemption does not apply to assets situate outside Member
 566 (ONILi(T 01: LAWS

States. Those assets are completely outside the Regulation: the opening state
should determine the effects of insolvency in accordance with its own con-
fliCt rules, not the Regulation rules. In practice, the law of the location is
predominant in most states in relation to property matters.
Payment and settlement systems are governed by the law of the Member
State where the system or market is -see art 9.

Location of trust assets

34-30 Many jurisdictions may well follow the traditional view that the question of
in rem rights, including rights under a trust, is determined according to the
location of the property, eg land where it is, goods where they arc, intangible
claims, and where the debtor is.
This would he an unfortunate rule when applied to trustees because in the
case of large (rusts with many assets it would not be feasible to track down
the location of all the assets spread around several countries. Even it'll were
feasible, the cost and time of checking local law affirmatively would often be
prohibitive.
Jurisdictions which do follow the location rule should arguably decide the
location of trust assets as being situated at the office of the trustee which
could he in a common law country. This would be consistent with the
location of hank deposit accounts and the international consensus that
intangibles are located where they arc enforced. This ought to apply to
proprietary intangibles as much as it does to debtor-creditor claims. The
bcnchciary's claim under the trust is a different asset from the real asset and
is often classified as it moveable because it is realised in cash, even it'll is land
which is held on trust. This, however, is not settled.
The most sensible approach is to apply the law governing the trust.

Uncitrat Model Law

34-31 The Model Law does not contain any specific rules on applicable law in
relation to trusts or tracing claims.

Tracing

34-32 In English-based jurisdictions, it is commonly possible to trace money or

other property flowing from an embezzlement by it trustee, a mis-
appropriation by a director, by another fiduciary, a bribe, or a
known mistake in payment into commingled hank accounts and other
transformations. If the money is traceable, then the deprived victim can
claim the money or other asset as a priority property claim in the insolvency
of whoever holds the property or other asset. See para 19-13.
The conflicts of laws position is probably similar to that applying to
ordinary consensual trusts, except that the Hague Trusts Convention 1985
applies only to trusts created voluntarily and not to these constructive trusts.
cc ai -L J.
Under the EU Insolvency Regulation, rights in rem include "the right to
demand the assets from, and/or to require restitution by, anyone having
 INSOLVENCY (:ONFLIC:I 01 LAWS: PARTICULAR TOPICS 567

Possession or use of them contrary to the wishes of the party so entitled."

This presumably includes proprietary tracing claims. See art 5(2)(c).

Further reading on trusts and tracing conflicts: LPIF vol 6 chapter 12.

Contracts aid Ileases

Main issues

Some of the main issues in relation to contracts and leases include the 34-33
administrator's rights to abandon or disclaim contracts or leases or to keep
them alive (by overriding contract termination clauses), the rights of
mortgagees or underleases to take over disclaimed property, and the rights
of employees to compensation and to follow the transfer of the business to a
buyer.

EU Insolvency Regulation
Under the Eli Insolvency Regulation 2002, the law of the opening state 34-34
(whether main or secondary) determines "the effects of insolvency pro-
ceedings on current contracts to which the debtor is a party". In the case of
secondary proceedings at establishments in a Member State--which must
normally only be winding-up proceedings- the insolvency effects are
restricted to local assets in all cases. See art 4(2)(e).
There arc exceptions to the forum rules. Thus the "effects of insolvency
proceedings on a contract conferring the right to acquire or make use of
immoveable property shall be governed solely by the law of the Member
State within the territory of which the immoveable property is situated." See
art 8. The "effects of the insolvency proceedings on employment contracts
and relationships shall he governed solely by the law of the Member State
applicable to the contract of employment". See art 10.
By art 9, the effects of insolvency proceedings on rights and obligations of
parties to a payment or settlement system or to a financial market are
governed by the law of the Member State applicable to the system or
market.
As to title finance, such as financial leases and sale and repurchase, see 34-35
chapter IS.

In the Netherlands decision of Tri,n/Esseni (JOR 2006/56, Court of

Hertogenbosch, October 31, 2005) a Dutch registered company had been
placed into administration in England. The Dutch public utility supplier
threatened to disconnect the Dutch company's gas and electricity. Under
art 4(2)(e) of the Regulation the effect of an English administration on
current contracts was to he governed by English law, but freezes on the
cutting off of utility supplies applies in England only to English utility
suppliers. The Dutch court held that the Dutch utility did not have the
right under English law to disconnect the Dutch company since this
would frustrate the purpose of the administration and would be an abuse
of power. The objective of the Regulation is to facilitate the efficient and
effective conclusion of insolvency proceedings, which in this case was to
save the company as a going concern.
 568 CONFLICT OF LAWS

The Eli Settlement Finality Directive 1998 and the EU Financial Col-
lateral Directive 2002 protect contracts within their ambit, eg against
nullification of termination clauses SO as to allow netting.

Uncitral Model Law

34-36 The Model Law does not have specific rules of application for contract
questions, but certain stays either do or can come into effect on the recog -
nition of a foreign proceeding and these might include contract or lease -
cancellations. The precise effect depends on local implementation.

Other principles
34-37 The bankruptcy forum will commonly apply its own rules as to the treat-
ment of contracts and leases. One issue is whether a non-main or ancillary
forum will defer to the rules of the main forum.
If the local Forum does recognise the foreign forum's bankruptcy, then, if
the local forum is England, the English courts apply the governing law of
the contract to questions of rescission, nullification of rescission or forfeiture
clauses, and disclaimer, and not the bankruptcy rules of the foreign forum,
outside an EU case. This is consistent with their attitude to bankruptcy
discharges: see para 3449. lknce if the foreign forum law provides for a
ftrce.l cancellation of the contract. the English should only recognise it if
the governing law of the contract is the foreign forum's law, but not if
governed by some other system of law. If the foreign forum nullifies a
rescission by the counterparty piiruaiil to a clause entitling the counter-
party to do so by providing for a freeze on termination rights, the governing
law should govern. Whether these principles would he reconsidered and in
what circumstances in light of the UK adoption of the Uncitral Model Law
remains to be seen.

Priority unsecured creditors

34-38 In most jurisdictions, certain unsecured creditors rank prior to other
ordinary unsecured creditors: these are mainly costs, tax and employee
claims but include others, such as administrative claims and post-com-
mencement new money.
Generally, the bankruptcy forum applies its own bankruptcy rules to the
prior payment of preferential creditors. This is certainly the rule in England
and the United States. Thus in the US case of Re Florida Peach Corpn, 87
BR 700 (B Ct MD Fla 1988), it was held that the priority ranking of lawyers
fees relating to a Panamanian bankruptcy must be determined by the US
rules in BC 1978 s 507.
As to employees, foreign employees may be relegated to pan passu status,
but consider the detail of local legislation. Foreign taxes are often not
recoverable. If so, the foreign revenue authorities are left to recover out of
local assets in their own Forum. The EU Insolvency Regulation allows
claims by Member State tax and social security authorities. See art 39.
34-39 Under the EU Insolvency Regulation the law of the opening state, whether
 INSOLVENCY CONFLICT OF LAWS: PARTICULAP, TOPICS 369

main or secondary, determines "the rules governing the distribution of

proceeds from the realisation of assets, the ranking of claims and the rights
of creditors who have obtained partial satisfaction after the opening of
insolvency proceedings by virtue of a right in rem or through a set-off". See
art 4(2)(1). Generally, "the law applicable to insolvency proceedings and
their effects shall be that of the Member State within the territory of which
such proceedings are opened", save as otherwise provided in the Regulation.
See art 4(1).
The Uncitral Model Law does not deal with conflicts regarding priorities.
However, art 13(1) provides that foreign creditors are to have the same
rights as local creditors; this is not to affect the ranking of claims (ie foreign
creditors need not be granted priority even if they would have foreign
priority) but are not to be ranked lower than general non-preference claims
unless an equivalent local claim would be subordinated. Sec art 13(2).
Also art 2 1(2) requires that if the foreign representative handles the dis-
tribution of assets, the court must be satisfied that the interests of local
creditors, eg priority creditors, are adequately protected. Local courts arc
unlikely to permit a turnover to a foreign main proceeding unless local
priority creditors are protected.

Avoidance of preferences
Main issues

The issue here is the rules which should govern the avoidance of pre-com- 34-40
mencement transactions as a fraudulent preference or as prejudicial to
creditors. The main conflicting issues are likely to be: (1) whether a trans-
action prejudices creditors (on which there is a substantial international
consensus); (2) the length of the suspect period and whether insolvency must
be proved (on which there is little agreement); (3) the defences, eg in favour
of good faith creditors unaware of the bankruptcy or protecting creditors if
the debtor did not intend to prefer—where again there is little agreement;
and (4) the application of the rules to insiders. See para 6-09.

Foreign preferences

In many countries, the preference rule is not regarded as limited to tern- 34-41
tonal transfers but applies to transfers wherever they are made, eg where the
debtor makes a payment abroad to a creditor abroad within the forum's
suspect period. This is because preferential transfers should be available to
all creditors, local or foreign, as part of the assets. The administrator is left
with the task of reclaiming assets situated abroad and transferred to a
foreign transferee.
If a foreign forum ignores the bankruptcy forum's rules, the bankruptcy
forum is left to indirect means of enloiceineut—equalisation, injunction or
recovery action against a creditor subject to the jurisdiction, and contempt
of court or other penalties.
 570 ('()NFLt(F (j LAWS

Mi llnsolvency Regulat i on

34-42 Under the EU Insolvency Regulation (applying where the debtor's centre of
main interests is in the EU, except Denmark), the state of the opening
(whether main or non-main) determines "the rules relating to the voidness,
voidability or unenforceahility of legal acts dctri mental to all the creditors".
See art 4(2)(m). If the proceeding is a secondary proceeding (an establish-
merit in the EU), then "the effects of those proceedings shall be restricted to
the assets of the debtor situated in the territory of that Member State". See
art 3(2). Secondary proceedings must normally only he winding-up pro-
ceedings. In all cases foreign preferences are exempt if they would not he a
preference under the Mcn-ibcr State law to which they are subject. See art 13.
The EU Settlement Finality Directive 1998 and the EU Financial Col-
lateral Directive 2002 relax preference rules. See para 17-55.

tindtral Model Law

34-43 The Model Law does not contain conflict of law provisions. It merely gives a
foreign representative of a main or non-main proceeding the standing upon
recognition to initiate actions. See art 23(I).

Other pcipks

34-$. A p~ rt thc EU lnsolvcucy Reg nlal lon, 111 England the courts apPlY
Eaghsh prelerence rules to property within England ofa person bankrupt in
liagiand so thai. it may be an advantage to initiate English proceedings.
The English courts have a discretionary power to apply the English
avoidance rules to external transactions, eg a payment by the debtor to a
hank located abroad: see Powdrill v Jiambros Bank (Jersey) [1992] 3 WLR
690, CA (payment by English company to discharge an overdraft at its bank
in Jersey). In Jyske Bank (Gibraltar) Ltd v Spjeldnaes [1999] 2 BCLC 101, it
was held that the court has jurisdiction to set aside a transaction defrauding
creditors, at the suit of a victim of the transaction, even if the company is
foreign, the transaction is governed by foreign law and the transaction
related to foreign land. It was enough that the defendant was subject to
English jurisdiction: no additional connections had to exist.
Courts in Australia have held that their preference sections are not ter-
ritorially limited, eg Re Merchant & Industrial Finance Ltd [1975] Qd R 46
(Queensland liquidator could recover payment made preferentially in New
South Wales).
A US case is indicative of trends.

In the US case of Re Betty French [2006] WL 328 392, February 14, 2006,
(4th Circuit), Betty French of Maryland bought a house in 1976 and gave
it to her children by a deed of gift in 1981. Both her children were US
residents. In order to avoid Bahamian transfer taxes, the children decided
not immediately to record the deed in the Bahamas but they did so in 2000
when Betty French was insolvent. A few months later Betty French hied
for liquidation under Chapter 7. The registration of the deed in 2000 when
Betty French was insolvent was a fraudulent transfer under US law but
 INSOLViNCY CONFLICFOF LAWS: PARTICULAR TOPICS 571

not under Bahamian law where the land was situated. field: US fraudu-
lent preference law applied because the Bankruptcy Code makes it clear
that property of the state is property wherever located so that, but for the
fraudulent transfer, the land in the Bahamas would have been property of
the debtor's estate. In addition, the debtor, the transferees and all but one
of the creditors were based in the US and there were no insolvency pro-
ceedings taking place in the Bahamas so that the US had a stronger
interest than the Bahamas in regulating this transaction. The Bahamas
had comparatively little interest in protecting non-residents so that
applying Bahamian law would withdraw the US Bankruptcy Code pro-
tections from those it is intended to cover while simultaneously failing to
protect any Bahamian residents.

Bankruptcy procedure
Procedural matters should always be governed by the law of the place where 34-45
the bankruptcy proceedings are brought. This will apply to such matters
as the mode of appointment, qualifications and powers of the administrator,
the ability of management to stay in possession, the manner and venue of
petitioning, the time within which proofs must he filed, the establishment
and powers of creditors committees, and costs.
In addition the criteria and the eligible applicants for opening proceedings
is a matter for the bankruptcy forum. Under the EU Insolvency Regulation
these matters would be determined by the law of the opening stale. See art 4.

Reorganisation plans and discharges

Main issues
The main issue here is whether a composition or moratorium or a discharge 34-46
of a creditor effected under a reorganisation plan or the like in a foreign
bankruptcy proceeding will be recognised elsewhere as affecting the claim of
the creditor concerned. Another practical issue is the co-ordination of a plan
where there are several sets of proceedings.
Other procedural matters will normally be a matter for the procedural law
of the bankruptcy forum, eg the permitted scope of a plan, the division of
claimants into classes, voting, court confirmation, and possibly the effect of
non-compliance by the debtor.
Debt/equity conversions and takeover of the debtor will normally be
governed mainly by corporate and regulatory law.

Bankruptcy forum
Generally the bankruptcy forum will apply its own rules as to discharge, 34-47
moratorium or remission as a mandatory bankruptcy policy regardless of'
whether the law governing the debt is home or foreign and regardless of'
whether the creditor is home or foreign.
Thus in England a bankruptcy discharge is effective despite the fact that
the debt may be governed by a foreign law. Similarly an English morator -
ium, eg under a corporate voluntary arrangement or a court-approved
 572 ('ONII.ICT()i LAWS

corporate scheme of arrangement, will he effective in England despite the

fact that the postponed debts were governed by a foreign law.

ll4oca recognition of foreign discharge

34-48 Under the EU Insolvency Regulation 2000, the law of the opening state
(whether a main or secondary proceeding) determines "the conditions for
and the effects of closure of insolvency proceedings, in particular by com-
position" and "creditors' rights after the closure of insolvency proceedings".
Generally. "the law applicable to insolvency proceedings and their effects
shall be that of the Member State within the territory of which such pro-
ceedings are opened", save as otherwise provided in the Regulation. See art
4(1). These provisions override any rule that a foreign moratorium or dis-
charge of' a debt is effective elsewhere, cg in England, only if the debt is
governed by the law of the bankruptcy state.
The Uncitral Model Law does not deal expressly with the recognition of
reorganisation plans and of any modification or discharge of the debtor's
obligations under a confirmed plan.

Recognition of foreign reorganisation plans generally

34-4 In .ncland, recent case law has shown comity as regards the recognition of
iorcuzri reorganisation plans.

1 n Re (thnlilgc Gas 7ranspori (mpvraiion, May 16, 2006, Privy Council

Appeal No. 46 of 2005. an insolvent group of Isle of Man shipping
companies petitioned for relief in New York under Chapter 11 of BC
1978. The New York court approved a reorganisation plan whereby the
assets of the shipping group would he vested in the creditors. The only
assets of the group were five transport vessels owned by five companies
held by the parent company, Navigator. The creditors' plan provided that
the shares in Navigator would be automatically vested in the creditors
committee as interim shareholders in order to enable the creditors to
control the Navigator group and therefore the assets that were held by the
subsidiaries. The New York Bankruptcy Court requested the assistance of
the High Court of Justice of the Isle of Man in giving effect to the
creditors' plan following which the creditors committee petitioned the
High Court for an order vesting the shares of Navigator in their repre-
sentative. A 70 per cent shareholder of Navigator objected on the ground
that the shareholder had never submitted to the jurisdiction of the New
York Bankruptcy Court and therefore an order of that court could not
vest its property rights in the shares of Navigator. Field by the English
Privy Council: the court would give the assistance requested by the New
York court and vest the shares of Navigator in the creditors' repre-
sentative. Exactly the same result as the reorganisation could have been
achieved in the Isle of Man by a scheme of arrangement under the
Companies Act 1931 of the Isle of Man. If there had been a scheme of
arrangement, the court could have sanctioned a scheme in relation to an
insolvent company in which the shareholders had no interest of any value
at all so that there could he a scheme which left them with nothing. The
objecting shareholder had no economic interest in the proceedings so that
an approval of a scheme would not be unfair to the shareholder.
 INSOLVENCY CONFLICT OF LAWS: PARTICULAR TOPICS 573

In England (apart from special the EU Insolvency Regulation) a foreign

ankruptcy discharge is effective only if it is a discharge under the law
;overning the debt. Thus if the debt is governed by the law of the bank-
ruptcy forum effecting the discharge, then England will recognise that
iischarge. lithe debt is governed by English law, England will not recognise
it. Hence the discharged debtor remains liable to pay in the English courts
even though the debtor may have has lost its assets to pay their creditors in
the home forum's bankruptcy proceedings. This principle may now be
affected by the British implementation of the Uncitral Model Law, but
might still apply in jurisdictions influenced by pre-implementation English
law.

In Gardiner v Houghton (1862) 2 B&S 743, a debtor was indebted to it

creditor under a contract governed by the law of Victoria. The debtor was
made bankrupt in Australia and obtained an order of discharge under the
Australian bankruptcy law. Held: the discharge was a good defence to an
action by the creditor against the debtor in England to recover the debt.
In Bartley v Hodges (1861) 1 CBNS 375, the debtor was indebted to a
creditor under a contract governed by English law. The debtor was made
bankrupt in Australia and obtained an order for discharge under the
Australian bankruptcy law. Held: the discharge was not a good defence to
an action by the creditor against the debtor in England to recover the
debt.

The same law rules apply to a foreign moratorium. The matter is gov-
erned by the governing law of the contract arid the moratorium is effective
(or recognised) only if it is effective under the governing law of the contract.

In Gibbs v Société Industrielle des Metaux (1890) 25 QBD 399, CA, a

creditor who carried on business in England agreed under an English
contract to sell copper to a debtor, a French company, carrying on
business in France. The French debtor refused to accept and pay for
copper tendered by the English creditor. Subsequently the debtor was
placed under judicial liquidation in France and, as a result, its liability
was by French law deemed to be discharged. field: the French debtor was
held still liable in damages to the creditor in England because the French
discharge did not operate under the governing law of the contract which
was English law.

The courts may take the opportunity afforded by the British adoption of the
Uncitral Model Law to extend comity in an appropriate case to a foreign
court-confirmed insolvency reorganisation plan.
However, as regards compositions or rehabilitation plans, a creditor who 34-50
claimed or voted in the proceedings ought to be bound by a bankruptcy
composition even though it did not vote in favour, since it must do so in the
knowledge that the composition is intended to bind all creditors. There is
Scottish and Commonwealth authority for the proposition that, if a creditor
who claims that a foreign discharge was not effective, itself participated in
the foreign proceedings, it should not be able to insist that the discharge was
ineffective.
ill Germany, a court gave legal effect in Germany to a discharge of a
Swiss corporation in a Swiss bankruptcy case: see the Decision of May 27,
1993, IX ZR 254/92.
 574 ('ONFLICI OF LAWS

Dhector's llabllty and vefill of iinicorporato

34-51 This issue involves the following questions, amongst others:

o The liability of directors or shadow directors to contribute to the assets

for fraudulent or wrongful trading.
o The liability of the management for failing to call a meeting of
shareholders if more than half the capital is lost or for failing to
petition if the company is insolvent.
o The liability of shareholders for the debts of the company on a strip-
ping of the veil of incorporation or on a consolidation of companies
(substantive consolidation).

See para 5-23.

The EU Insolvency Regulation does not deal specifically with the
applicable law of director liability or the substantive consolidation of
companies. However, art 41(1) provides that 'the law applicable to insol-
vency proceedings and their effects shall be that of the Member State within
the territories of which such proceedings are opened".

In a German decision (10 S 44/05, Regional Court of Kiel, April 20,

2005), an English registered company carried on all its business through it
branch in Germany. A creditor filed an action against the sole director of
the company on the grounds that he had failed to file for the opening of
insolvency proceedings when the company was insolvent, as required by
German corporate law. Held: the English company's centre of main
interests was in Germany and therefore German law governed the
insolvency proceedings and their effects. The provision of German cor -
porate law requiring directors to file compulsorily when the company is
insolvent is an insolvency matter within the Regulation and is not just a
corporate law matter since its purpose was to protect the creditors of an
insolvent company. Accordingly the German director liability rules
applied to this director of the English company.
In the German decision of CoIlin.s & Aikman (71 IN 416/05, Local Court
of Cologne, August 10, 2005), an English court placed a German regis-
tered company into main insolvency proceedings in England. The
German court held that the German directors of the German subsidiary
did not have to comply with the mandatory filing obligations of directors
if a German company is insolvent so as to open secondary proceedings in
Germany. It was enough that proceedings had been opened elsewhere in
another Member State. The main purpose of the compulsory filing lia-
bility was to protect creditors and the public from companies trading
while insolvent and this objective could he met by filing for insolvency in
another Member State.

']'he Uncjtral Model Law is silent on this issue.

A director's personal liability for fraudulent or wrongful trading or for
failure to file for insolvency or for other mismanagement precipitating the
insolvency should be decided by insolvency conflicts. Normally directors'
duties, eg in relation to their fiduciary duties, business judgement, avoidance
of conflicts of interest and the like are normally determined by the law of the
place of incorporation. See Base Metal Trading Lid v Shamurin [2004]
 INSOLVENCY CONFLICT OF LAWS: PARTICULAR 'lOPICS 575

EWCA (Civ 1316; [2005] 1 WLR 1157 (see the facts at para 31 31). This
almost invariably covers such matters are legal status, powers, authorities of
management, capitalisation and the fiduciary duties of management. The
precise boundary between corporate law and the insolvency law remains to
be determined. Thus the giving of a guarantee by a subsidiary of its parent's
debt may be labelled a matter of powers or director fiduciary duties, and
therefore a matter for the law of the place of incorporation under the
internal affairs doctrine, or rather an issue of voidable preference or the
protection of creditors and hence decided by bankruptcy conflicts.
Probably the trend is to regard issues affecting creditors as bankruptcy 34-52
conflicts, not internal affairs.
In England, it has been held that liability for wrongful trading applies also
to directors of foreign companies: see Re A Company (No 00359 of 1987)
[1988] Ch 210 (Liberian company); Re Howard Holdings Inc [1998] BCC 549
(even though there is no such liability under the law of the place of incor-
poration). The court can also disqualify a foreign director of a foreign
company and can order service abroad: see Re Seagull Manufacturing Co
Lid (No 2) [1994] Ch 91.
576 CON FI.ICF OF LAWS

QUESTIONS AND SEMINAR TOPffCS

Chapters 3 1-34
(I) Your client is a bank which is arranging a large international syn-
dicated loan for the Central Bank of Sealandia. The purpose of the
loan is a standby in case the banking system in Sealandia is hit by
foreign currency crisis ---'to smooth out attacks by foreign spec-
ulators on our currency". The borrower has requested the bank to
delete the English governing law clause, the submission to the jur-
isdiction of the English courts, and the waiver of sovereign immunity
clause as being inappropriate for their status. The borrower has also
suggested that all disputes under the loan agreement be submitted to
arbitration in a neutral forum. The Republic of Sealandia has a
history of financial problems, but now has much sounder economic
management. Sealandia is a member of the IMF. The loan is to be
syndicated to major international banks out of London. Advise the
client on the borrower's request.
(2) Analyse whether the principles of the EU Judgments Regulation 2000
would he a suitable model for adoption on a world basis so Far as
financial law is concerned.
() A well-known country wishes to challenge the dominance of English
and New York law as the chosen governing law of most international
financial contracts. You are an international legal consultant. Advise
the country on what features a legal system should have in order to
challenge that dominance.
(4) Why are insolvency conflicts of law so much more controversial than,
say, the rules applying to the governing law of contracts?
(5) Discuss the advantages and disadvantages of giving exclusive insol-
vency jurisdiction to the centre of main interests of a corporation and
then applying the law of that jurisdiction to all insolvency questions.
(6) Compare the EU Insolvency Regulation with the Uncitral Model
Law on Cross-Border Insolvency.
(7) What is the scope of the law of the location of the collateral in
relation to the conflict of laws applicable to security interests? What
issues would you expect not to he governed by the law of the location
ol' the collateral?
() Discuss what law should apply to the following insolvency issues and
give international examples:
o a trust of client securities held by an insolvent broker;
e a rule of insolvency law which prescribes that parties having an
executory contract with the insolvent cannot cancel the contract
merely on the ground of the insolvency;
a fraudulent preference n favour ol a creditor hy in insolvent: and
o a directors liability for the mismanagement of' a company which
leads to its insolvency.
 INDEX
All references are to paragraph number.

Abusive squeezes Assignment

market manipulation, 24-11 see also Syndicated loans
Acquisition finance securitisation
deal structures, 13-15-13-19 notice to debtors, 28--34---28 --35
directors' liabilities, 13-25 restrictions, 28- 30- -28 -33
financial assistance, 13-21 set-off and netting, 15-10
generally, 13-08-13 10 title registration, 19-26 —19-28
guarantees, 13-22- -13-23 Attachments
senior lenders' exit, 13-24 jurisdiction, 32-32
shareholder agreements, 13-26 - 13--28 set-off and netting, 15-10
takeover regulation, 13-11 Authorisation of investment business
taxation, 13-20 conditions, 20-14
Administrative costs generally, 20-13
priorities, 5-12 unauthorised business, 20-15---20 -16
Agents
bond issues, 11-37 Bank depositors
set-off and netting, 15-lO, 15-17 --15-18 priorities, 5-I5
syndicated loans, 9-17 -9-18 Banks
Aircraft finance see also Capital adequacy; Payment
generally, 13 35 systems; Settlement systems;
American common law jurisdictions Syndicated loans
conclusions, 3-05 central banks, 21-10
identity, 3-02 credit
insolvency law indicators, 3--04 advantages, 1-15
legal origins, 3---03 disadvantages, 1- 16
American options role, 1-13--I- 14
generally, 26-20 EU Bank Insolvency Directive, 33--
Anglo-American common law 21-33--22
jurisdictions financial regulation
see American common law Bank for International Settlements,
jurisdictions; English common law 21-13
jurisdictions banking business, 20-18
Applicable law central banks, 21-10
see Governing law investment banks, 20-21
Arbitration multilateral banks, 21-12
jurisdiction, 32 -28 securities businesses distinguished,
Arrangers 20-24
prospectus liability types, 20-17
exclusion of liability, 23-35 World Bank, 21 -12
generally, 23- 19-23-30 intermediaries, 1-22
syndicated loans, 7 -07- -7-09 investment banks, 20-21
Asian options multilateral banks, 21-12
generally, 26-20 purpose, I 13--1-14
Assets risks
see also Financial assets globalisation, I 20
classification, 1-02 introduction, 1 17
578 INI)fX

Banks- coil!. Bond issues- -coil!.

risk s---conI. issue procedure con!.
miscellaneous, 1--19 generally, 11-39---ll 40
mismanagement, 1-2 I global bonds, 11-38
mismatch of assets and liabilities, I - interest hedging agreements, 11 38
18 management agreements, 11 36
securities businesses distinguished, 20 mandate letters, II - 34
24 prospectuses, 11-34
World Bank, 21 12 subscription agreements, II 34-
Basel Banking Supervision Committee 11-35
generally, 21-14 trust deeds, 11-37
Basel 11 capital adequacy listing
see Capital adequacy advantages, I (--42
Beneficiaries' claims convertible bonds. 12-05
see Trusts disadvantages, 1143
Bermudan options generally, 11-41
generally, 26-20 marketing, 11-33
Bond issues medium-term notes
bondholder meetings documentation, 12-- 12
generally, 12 34 generally, 12-1 1
main issues, 12-35 pricing supplements, 12 .13
majority voting, 12-37 preliminary offerings, 11-33
minority protection. 12-38---12 40 private placements, II . 33
regulation, 12 36 prospectuses
bondholder protection, II -30 II -32 content, 11-49
bondholder trustees gencrally. 1134
acceleration. 12-30-- I 2 -31 regulation, 11-46--I 1-48
advantages, 12--18---12--23 rating, 11 -45
disadvantages, 12-25 sovereign issues, 12 41 12- 42
generally, 12-- 17 subordinated capital bonds
immunity of trust property, 12 28 generally, 1214
mandatory requirements, I 2--25 subordination clauses, 12-15
12 26 syndicated loans compared
market practice, 12--27 advance of funds, 11-10
no-action clauses, 12-32----12-33 borrowers, 11-05
secured bonds, 12-23 covenants, 11-18-- 11-25
trust structure, 12-29 currency conversion, Il -Il
bonds with warrants attached, 12-04 default events, 11--26---1 127
bought deals, 11-33 documentation, 11-08
collective action, 12-41 - -12-42 governing law, 11- 29
convertible bonds interest, 1112
advantages of equity-linking, 12 - introduction, II --03
06- 12-07 investors' identity, 11-06
anti-dilution provisions, 12-08 jurisdiction, II- 29
bonds with warrants attached, 12 04 lenders, 11-04
conversion premiums, 12-03 margin protection, 11-15
conversion price, 12 02 modification, 11-28
generally, 12 01 negative pledges, II 20 - 11 - -21
listing, 12-05 offering documents, I l--07
mergers, 12-10 payments, 11-16
spin-offs, 12 10 prepayments, 11-14
takeovers, 12 09 priorities, 11-19
distribution, Ii 33 pro raW sharing, 11-16
domestic issues. II -02 repayments, II 13
generally. I I -Ut stale immunity waiver, I I 29
issue procedure transferability, Il 09
agency agrcemcnts. 11 37 warranties, II 17
 INDEX - 579

Bond issues- emit. Charge-backs

taxation, II 44 set-off and netting distinguished, 14
Buy-backs 10--14-11, 14-13
market manipulation, 24-16 Chinese walls
advantages, 22--31
definition, 22-29
Call options disadvantages, 22--31
generally, 26 -19 insider dealing, 24---39
Capital adequacy jurisdictional examples, 22-32---
Basel Capital Accords, 25-04 22-33
Basel I defects, 25-05 necessity, 22-30
Basel 11 pillars, 25-06 practical steps, 22- 34
conclusions, 25-29- 25-31 Choice of law
credit risk (internal ratings based see Governing law
approach) Churning
corporate governance, 25-21 market manipulation, 24-13
generally, 25-19----25-20 Civil law jurisdictions
credit risk (standardised approach) see Mixed civil/common law
introduction, 25-12 jurisdictions; Napoleonic
off-balance-sheet exposures, 25- jurisdictions; Roman-Germanic
l3-----25--l4 jurisdictions
over-the-counter derivatives, 25-15 Client assets, segregation of
credit risk mitigation see Conduct of business
collateral, 25-17-25-- 18 Close-out netting
generally, 25-16 generally, 14-04
introduction, 25--01--25-02 Codification
long-term equity holdings, 25-22 financial law indicators, 2-19
market discipline, 25-06 Collars
minimum capital interest rate contracts, 26-11
capital, 25-08 Collective investment schemes
introduction, 25 -07 definition, 20-32
overview, 25-06 generally, 20-30--20-31
risk weight, 25-09--25-1() Comity
sophistication, 25-11 financial law indicators, 2-27
Commission
operational risk
conduct of business, 22-12
examples, 25--26
Commodity futures
introduction, 25-25
generally, 26-17
measurement, 25-27--- 25-28
Common law jurisdictions
retail exposure, 25-23
see American common law
risk types, 2503 jurisdictions; English common law
sccuritisation, 29--12 -29-17 jurisdictions; Mixed civil/common
small business exposure, 25-23 law jurisdictions
subordinated exposure, 25-22 Company law
supervisory review, 25-06 financial law indicators, 2- 30 -2-31
trading book regime, 25-24 Conditional debts
Caps set-off and nettingdistingui shed, 14
interest rate contracts, 26 -09 10 --14-12
Carve-outs Conduct of business
preferences, 6--14 see also Financial regulation
Central banks aggregation, 22- It
generally, 21- 10 allocation of orders, 22--11
Central counterparties best execution, 22-08
generally. 30-44 Chinese walls
multilateral [letting, IS-OS- - I advantages, 22 31
Centre of main interests definition, 22 -29
conflict of laws, 33-I1 disadvantages, 22-31
580 INDEX

Conduct of business cunt. Contracts and leases—cont.

Chinese wails—con!. marketability, 2-13
jurisdictional examples, 22-32 22-- termination on insolvency
33 financial law indicators, 2-24
necessity, 22 30 ipso facto clauses, 6-01-6-02
practical steps, 22 -34 jurisdictional survey, 6 -06- -6-08
conflict of interests policies, 6-04--6-06
Chinese walls, 22-29--22--34 right to terminate, 6--03
conglomerates, 22--23 Contractual set-off
European Union, 22-22 generally, 14-09
introduction, 22-21 interveners, 15-I 5--1 5-16
management, 22-26----22-28 Convertible bonds
miscellaneous examples, 22-24 see also Bond issues
secret profits, 22-25 advantages of equity-linking, 12-06
self-dealing, 22-25 12-07
duties of skill, care and diligence, 22 - anti-dilution provisions, 12-08
05- -22-06 bonds with warrants attached, 12-04
excessive mark-ups, 22-09 conversion premiums, 12-03
Front-running, 22-- 10-22--I I conversion price, 12-02
general/regulatory law compared, 22-- generally, 12-01
03 listing, 12-05
generally, 22-01 mergers, 12-10
inducements, 22- 12 spin-offs, 12--1
risk warnings, 22-07 takeovers, 12-09
secret profits, 22-12, 22-25 Corners
segregation of client assets market manipulation, 24--1 1
generally, 22-13-22-15 Corporate governance
Jurisdictional examples, 22-18 --22- credit risk, 25-21
20 Corporate personality
methods, 22 --- 16 see Directors' liabilities
pooled assets, 22- 17 Costs
soft commissions, 22-12 financial law indicators, 2-32
sophisticated investors, 2204 Courts
sources of law, 22--02 see also Judicial reorganisations
suitability of investments, 22-05---22- insolvency management, 6-26-6-27
06 Covered warrants
timely execution, 22-11 derivatives, 26-39
Conflict of interests Credit
see Conduct of business advantages, 1-15
Conflict of laws disadvantages, 1-16
see Governing law; Insolvency (conflict role, 1-13-1-14
of laws); Jurisdiction Credit derivatives
Construction finance credit-linked note issues, 26-26
generally, 13-36 examples, 26-28
Consumer credit agreements generally, 26-24
EU Judgments Regulation, 32-26 guarantees compared, 26-25
secured finance, 16-18 hedging, 26-29
Contract law synthetic securitisation, 26-27
financial law indicators, 2-22 trading, 26--30
Contracts and leases Credit rating
conflict of laws generally, 20-23
EU Insolvency Regulation, 34- 34- securitisation, 29-18-29-20
34-35 Credit risk
main issues, 34-33 see also Capital adequacy
other principles. 34 37 internal ratings based approach
UNCITRAL Model Law on Cross- corporate governance, 25--21
Border insolvency, 34-36 generally, 25-19---25--20
 INDEX 5811

Credit risk con!. Derivatives - --- coni.

mitigation exchanges
collateral, 25-17-25-18 advantages, 26-41---26--43
generally, 25-16 disadvantages, 26-44
standardised approach functions, 26--45
introduction, 25-12 generally, 26-40
off-balance-sheet exposures, 25- futures contracts
13-25-14 assets, 26-14
over-the-counter derivatives, 25-15 commodity futures, 26-17
Credit-linked note issues currency futures, 26-17
derivatives, 26 26 hedging, 26-15
Creditors interest futures, 26-17
directors' duties, 528 --5-30 introduction, 26-12
identity, 4-05- 4-07 settlement, 26- 16
insolvency management, 6-24 stock index futures, 26-17- 26 18
protection, 4-02--4-04 terminology, 26-13
Criminal liability gaming contracts, 27-17
financial regulation, 20-04-20-05 hedging
Cross-border insolvency credit derivatives, 26-29
see Insolvency (conflict of laws) definition, 26-01
Culture futures contracts, 26-15
financial law indicators, 2--21 generally, 26-31
Currency futures issuers, 26-37
generally, 26-17 history, 26-03
Current account set-off insurance regulation, 27 18
generally, 1407 interest rate contracts
Custodians caps, 26-09
settlement systems, 30-24---30-25 collars, 26-11
Iloors, 26-10
swaps, 26-07 26 08
De facto directors introduction, 26-01---26-402
liabilities, 5-42- - 5-43 ISDA Master Agreement
Debtors background, 27-03-27-04
identity, 4 -05- 4-07 summary of terms, 27-05--27 10
insolvency management, 6-25 legal aspects
Deferred creditors capacity, 27- 13
see Subordination collateral, 27--15
Delaware companies gaming contracts, 27-17
governing law, 31-05 insurance regulation, 27-18
Dematerialisation of securities liability, 27-19-27-20
settlement systems, 30-28 margin, 2715
Derivatives oral contracts, 27-12
capacity, 27- 13 regulation, 27-16
collateral, 27-15 set-off and netting, 27-14
credit derivatives margin, 27-15
credit-linked note issues, 26- 26 markets
examples, 26-28 exchanges, 26-40-- 26-45
generally, 26-24 introduction, 26-32
guarantees compared, 26-25 over-the-counter markets, 26-32
hedging, 26- 29 primary markets, 26--33--26-39
synthetic .sccuritisation, 26-27 options
trading, 26 30 call options, 26-19
definition, 26-01 examples, 26-23
documentation gearing, 26-22
USDA Master Agreement, 27 03 generally, 26 i9 2620
27-10 put options, 26- 19
master agreements. 27-01 -27--02 risk. 26­21
582 INDEX

Derivatives- - con!. Enforcement of security interests

oral contracts, 27-12 see Security interests
primary markets English common law jurisdictions
covered warrants, 26-39 conclusions, 3-09
generally, 26-33 identity, 3-06
hedging, 26-37 insolvency law indicators, 3-08
index-linked notes, 26-34 legal origins, 3-07
listing, 26-38 Equipment lease finance
warrants, 26-35--26-36 generally, 13-35
regulation, 27-I 6 Equitable subordination
risk generally, 5-18
financial risk, 27-22 Equity-linked bonds
insolvency risk, 27-23 see Convertible bonds
operational risk, 27-25 Ethical walls
regulatory risk, 27--24 see Chinese walls
reputational risk, 27-24 EU Bank Insolvency Directive
set-off and netting, 27-14 conflict of laws, 33-21-33-22
statistics, 26-04 EU Contracts Regulation
use, 26-OS governing law, 3 1-17
Directors' liabilities EU Financial Collateral Directive
advantages, 5-26 security interests, 17--55, 17 57
conflict of laws, 34--51---34-52 EU Insolvency Regulation
de facto directors, 5-42 -5-43 see also Insolvency (conflict of laws)
disadvantages, 5-27-5-28 centre of main interests, 33-I1
duties to creditors, 5-28---5-30 contracts and leases, 34-34-34-35
failure to call shareholders' meeting, governing law, 33-I 7--33--1 9
5-39 groups of companies. 33-16
failure to petition for insolvency, 5- in rem claims, 34-28---34-29
36-5-38 introduction, 33-09
financial law indicators, 2-26 miscellaneous provisions, 33-20
fraudulent trading, 5-31---5-32 opening state law
governing law, 31-30 exceptions, 33-18 33-19
heads of liability, 5-25 generally, 31- 17
introduction, 5-23-5-24 preferences, 34-42
mismanagement, 5-40----5-41 proceedings covered, 33-10
prospectuses, 23-17 public policy, 33-12
special purpose finance, 13-25 recognition, 33-I1
syndicated loans, 846 secondary proceedings for
wrongful trading, 5-33-5-35 establishments, 33-14----33-1 5
Discharge from insolvency security interests, 34-22----34-23
insolvency forum, 34-47 territorial scope, 33-13
main issues, 34-46 title finance, 34-22-34-23
recognition, 34-48 trusts, 34-28-34-29
reorganisation plans, 34-49 --34-50 EU Insurance Company Insolvency
Due diligence Directive
prospectus liability, 23-30 -23-31 conflict of laws, 33-21--33-22
EU Judgments Regulation
Employees abuse, 32-16
priorities, 5-14 advantages, 32-15
Employment contracts application, 32-13
EU Judgments Regulation, 32-26 basic principles, 32 14
End-of-day settlement systems civil and commercial matters, 32-17-
generally, 30- 11 ---30-- 14 32-19
Enforcement of judgments consumer credit agreements. 32-26
see EU Judgments Regulation; contracting out, 32-27
Jurisdiction disadvantages, 32-15-32- 16
 INDEX 583

FU Judgments Regulation- -corn. Financial law--corn.

domicile indicators----cont.
exceptions, 32--20----32--24 Costs, 2-32
generally, 32-14 criteria, 2-16
employment contracts, 32-26 culture, 2-21
exclusive jurisdiction, 32-25 directors' liabilities, 2-26
generally, 32--I1 financial regulation, 2-29
insurance Contracts, 32-26 generally, 2-09
territorial scope, 32-12 inappropriate indicators, 2-17
EU Settlement Finality Directive insolvency, 2-16
security interests, 17-55----17-56 judicial reorganisations, 2-28
European options
legal and political infrastructure,
generally, 26-20
2-18
Excessive mark-ups
precedent, 2-20
conduct of business, 22-09
Exchanges preferences, 2-25
derivatives security interests, 2-I1
set-off, 2-10
advantages, 26-41----26-43
disadvantages, 26-44 taxation, 2-32
functions, 26-45 tracing, 2- 14
generally. 26-40 trusts, 2-12
financial markets, 20--26--20 28 objectives, 1-24
regulation, 20-29 Financial market carve-outs
Expropriation preferences, 6-14
priorities, 5-20- 5 21 Financial markets
definition, 20-26
Factoring over-the-counter markets
title finance, 18-05 derivatives, 26-32
False markets generally, 20-27
market manipulation, 24--14 primary markets
Finance leasing derivatives, 26-33--26--39
title finance, 18-08--18--09 generally, 20-27
Financial Action Task Force regulation, 20-29
generally, 21-17 retail markets, 20-28
Financial assets secondary markets, 2-027
classification, 1-03 wholesale markets
key features, 1-04 1-06 generally, 2-028
purpose, 1-12 secured finance, 16-16
statistics, 1-07 ­ 1 11 Financial regulation
Financial assistance
see also Capital adequacy; Conduct of
English common law jurisdictions,
business; Prospectuses
13 31
a uthorisation
European Union, 13-33
generally, 13-21, 13-29--- 13 30 conditions, 20 -14
Napoleonic jurisdictions, 13-34 generally, 20-13
Roman-Germanic jurisdictions. 13-34 unauthorised business, 20-15--20-16
United States, 13-32 banks
Financial law Bank for International Settlements,
harmonisation, 3 33- 3--35 21-13
indicators banking business, 20- -18
codification, 2--19 central banks, 21-10
comity, 227 investment banks, 20-21
company law, 2 30 2-31 multilateral banks, 21-12
comparative methodology, 2- 33- - securities businesses distinguished,
2 30 20-24
contract law, 2- 22 types, 20-17
contracts and leases, 2--13. 2-24 World Bank, 21-12
584 INDEX

Financial regulation—con!. Financial regulation--cont.

Basel Banking Supervision settlement systems, 20-22
Committee, 21-14 territorial scope
codification, 20-06-20-08 financial supervision, 21-32
collective investment schemes generally, 21-27---21-29
definition, 20-32 memorandums of understanding,
generally, 20-30-20-31 21-33--21-34
conglomerates, 20-25 prospectuses, 21-30-21-31
credit rating agencies, 20-23 tiering, 21-19
criminal liability, 20-04-20-05 trade associations, 21-18
defects, 21-05-21 -07 United States
deposit-taking institutions, 20- 17 Financial Accounting Standards
EU directives, 21-22--•21-25 Board, 21- 18
Financial Action Task Force, 21 -17 generally, 2 1-21
financial law indicators, 2- 29 World Bank, 2 1-12
financial markets Financial Stability Forum
definition, 20-26 generally, 21-16
over-the-counter markets, 20 --27 Flawed assets
primary markets, 20 27 set-off and netting distinguished, 14
regulation, 20-29 10----14-I 2
retail markets, 20-28 Floating charges
secondary markets, 2-027 see Universal security interests
wholesale markets, 2-028 Floors
Financial Stability Forum, 21-16 interest rate contracts, 26-10
financial supervision, 21-32 Forced trading
general law compared, 20-01 insider dealing, 24-35
heads of regulation, 20-10-20-11 Foreclosure
hedge funds, 20-33 enforcement of security interests, 17
industry associations, 21-18 30
International Accounting Standards Foreign currency debts
Board, 21-18 priorities, 5- 21
International Association of Deposit security interests, 17-13
Insurers, 2148
Foreign taxes
International Financial Reporting
priorities, 5-20
Standards, 21-18
Forfaiting
International Monetary Fund, 2 1-11
title finance, 18-05
International Organisation of
Fraudulent preferences
Securities -Commissions, 2 1-15
introduction, 20-01 insolvency, 6--1 I
investment businesses, 20-21 Fraudulent trading
legislation, 2 1-26 directors' liabilities, 5-3 1-5-32
macroeconomic regulation Front-running
distinguished, 20-12 conduct of business, 22-10----22-11
memorandums of understanding, 21-- Fund set-off
33-21-34 generally, 14-09 -
non-deposit-taking credit institutions, Future debts
20-17 security interests, 17-I1
other fields of regulation, 20-09 Futures contracts
payment systems, 20-22 assets, 26-14
policies, 21 -Ol--21-08 commodity futures, 26-17
purpose, 21-01-21-04 currency futures, 26- 17
regulators, 20-02-20-03 hedging, 26 -15
securities businesses interest futures, 26-17
banks distinguished, 20-24 introduction, 26- 12
definition of securities, 20-20 settlement, 26-16
generally, 20-19 stock index futures, 2617-26-18
investment businesses, 20-21 terminology, 26-I 3
 INDEX 585

;aming contracts Guarantees

derivatives, 27-17 special purpose finance, 13-22-13-23
DP (gross domestic product)
measurement of financial assets, 1-09 Hague Trusts Convention
;earing conflict of laws, 34-27
options, 26--22 Hedge funds
;eneral preferences financial regulation, 20-33
insolvency, 6-13 Hedging
;ifts bond issues, 11-38
preferences, 6-12 derivatives
;lobalisation credit derivatives, 26-29
banks, 1-20 definition, 26-01
overning law futures contracts, 26-I5
see also Insolvency (conflict of laws); generally, 26-31
Jurisdiction issuers, 26-37
absence of express choice, 31--27-3l- Hire purchase
28 title finance, 18-10
choice of law Home loans
contract clauses, 31-20 secured finance, 16-17
factors influencing choice, 31--03
freedom of choice, 31-19 Immobilisation of securities
codes, 31 17---31--18 settlement systems, 30-29---30-30
English and New York law In rem claims
conclusions, 31-13 see Tracing; Trusts
conflicting pressures, 31--12 Independent set-off
Delaware companies, 3105 generally, 14-07
experience, 31-06 Index-linked notes
financial law indicators, 31-10 derivatives, 26-34
historical dominance, 31-04 Industry associations
predictability, 31-07 -31-09 financial regulation, 21--18
regulation, 31 -11 Information memorandums
stability, 31-06 syndicated loans, 7-15
EU Contracts Regulation, 31-17 Insider dealing
factors influencing choice of law, 31 see also Market manipulation
03 definition, 24-17
insulation disclosure of directors' interests, 24-
generally, 31-14---31-15 2!
limitations, 31-16 enforcement, 24-30
introduction, 31-0l--3l-02 exemptions
Rome Convention, 31-17 alternative legitimate reasons, 24
scope, 31-21--31--26 35
torts, 3l-29---3l•-31 buy-backs, 24-16
tracing, 31-29---31--31 Chinese walls, 24-39
Grace periods disclosure in normal course of
enforcement of security interests, 17- duties, 24-26
33--I 7-35 equality of information, 24-36
Gross domestic product forced trading, 24-35
measurement of financial assets, 1--09 managed accounts, 24-38
Groups of companies stabilisation, 24-I5
insolvency stake-building, 24-37
EU Insolvency Regulation, 33-16 takeovers, 24-37
generally, 33-08 territorial scope, 24-40
UNCITRAL Model Law on Cross- general law, 24-19
Border Insolvency, 33-36 inside information
set-off and netting accuracy, 24-27
account pooling, 15-19 materiality, 24-27
cross-guarantees, 15-20-15-22 publication, 24-28
586 INDEX

Insider dealing. --cow. Insider dealing--con!.

insiders, 24-25 judicial reorganisations— cont.
introduction, 24-01 disadvantages, 4-19
listing codes, 24-22 generally, 4-11
negative profits, 24-31 grading of laws, 4-20--4-21
policies, 24-18 jurisdictional survey, 4-22--4-27
practical considerations, 24-41 overlap with other methods, 4-12
sanctions, 24-30 work-outs compared, 4-17
securities covered, 24-29 liquidation
short-swing profits, 24-23 generally, 4-11
sources of law, 24-02 overlap with other methods, 4-12
summary, 24-24 work-outs compared, 4-16
tipping-off, 24-26 management
whistleblowing, 24-03 conclusions, 6-28
Insolvency courts, 6-26-6--27
see also Insolvency (conflict of laws) creditors, 6-24
contract and lease termination debtors' existing management, 6--25
ipso facto clauses, 6-01-6-02 managers' powers, 6-23
jurisdictional survey, 6-06-6-08 potential managers, 6-22
policies, 6-04---6--06 preferences
right to terminate, 6-03 carve-outs, 6-14
debtors and creditors fraudulent preferences, 6-- I I
identity, 4-05--4-07 general preferences, 6-13
protection, 4-02---4-04 gifts, 6-12
directors' liabilities jurisdictional survey, 6-15---6-21
advantages, 5-26 ordinary course of business
de facto directors, 5-42- --5-43 payments, 6- 19
disadvantages, 5-27-- 5-28 policies, 6-09-- -6-10
duties to creditors, 5-28--5 30 security for pre-existing debts,
ía i lure to call shareholders' 6 18
meeting, 5--39 pre-packaging, 4-12
failure to petition for insolvency, 5- priorities
36---5-38 conclusions, 5-22
fraudulent trading, 5--31----5-32 cross-border insolvency, 5-05
heads of liability, 5-25 de facto reversal, 5-04
introduction, 5-23---5-24 expropriation, 5-20---5 21
mismanagement, 5-40 -5-41 introduction, 5-01
wrongful trading, 5-31-5-35 judicial reorganisations, 5-03
effect, 4-01 liquidation, 5-03
effect on legal systems, 4- 08-4-09 preferential creditors, 5 -11-5-I5
finance, 6-29--6-30 secured creditors, 5-07-5 08
importance of laws, 1-23 set-off, 5--09
insolvency law indicators shareholders, 5 19
comity, 2-27 subordination, 5 17 5 18
contracts and leases, 2- 13, 2-24 summary, 5-02
criteria, 2-16 "super priority" creditors, 5--06
directors' liabilities, 2- -26 title finance, 5-07--5--08
generally, 2- 16 trusts, 5- 10
judicial reorganisations, 2-28 unsecured creditors, 5-16
preferences, 2-25 work-outs
security interests, 2 II advantages, 4-13--4--14
set-off, 2-10 disadvantages, 4- 15
tracing, 2-14 generally, 4-11
trusts, 2 12 judicial reorganisations compared,
judicial reorganisations 4 17
advantages, 4 18 liquidation compared, 416
conclusions. 4-28 overlap with other methods, 4- 12
 INDEX 587

Insolvency (conflict of laws) Insolvency (conflict of laws)--cont.

advantages of single forum, 3304 preferences
centre of main interests, 33-11 EU insolvency Regulation, 34-42
contracts and leases foreign preferences, 34-41
EU insolvency Regulation, 34-34--- main issues, 34-40
34-35 other principles, 34-44
main issues, 34 33 UNCITRAL Model Law on Cross-
other principles, 34-37 Border Insolvency, 33-31, 34-43
UNCITRAL Model Law on Cross- preferential creditors, 34-38-34-39
Border Insolvency, 34-36 priorities, 5-05
directors' liabilities, 34-51--34-52 procedure, 34-45
disadvantages of single forum, 33-- reasons for conflicts, 33-01
04----33-05 recognition of insolvency
discharge representatives and stays
insolvency forum, 34-47 asset collection, 33-47
main issues, 34-46 introduction, 3342
recognition, 34-48 non-recognition, 33-44
reorganisation plans, 34-49-34-50 partial recognition, 33-45
EU Bank insolvency Directive, 33- proceedings not required, 33-45
21-33-22 proceedings required, 33-46
EU Insolvency Regulation reorganisation plans
centre of main interests, 33-11 insolvency forum, 34-47
contracts and leases, 34--34--34-35 main issues, 34 46
exceptions to opening state law, 33- recognition, 34-49-34-50
l8--33--19 security interests and title finance
governing law, 33-17-33-19 book-entry investments, 34-19
groups of companies, 33 -16 contract debts, 34-17
introduction, 3309 creation, 34-11-- 34-20
miscellaneous provisions, 33-20 EU Insolvency Regulation, 34-22
opening state law, 33-17-33-19 34-23
preferences, 34-42 generally, 34-06
proceedings covered, 33-10 investment securities, 34-18
public policy, 33-12 location of assets, 34-07-34--10
recognition, 33-11 main issues, 34-21
secondary proceedings for priorities, 34-11---34-20
establishments, 33-14--33-1 5 publicity, 34-11-34-20
security interests, 34-22 --34-23 UNCITRAL Model Law on Cross-
territorial scope, 33-13 Border Insolvency, 34 24
title finance, 34--22---34-23 set-off
trusts, 34 28---34-29 contract termination, 34-05
EU Insurance Company Insolvency insolvent set-off, 34-03-34-05
Directive, 33-21---33-22 solvent set-off, 34-02
groups of companies territorial theory, 33-03
EU Insolvency Regulation, 33-16 treaties, 33-02
generally, 33-08 trusts
UNCITRAL Model Law on Cross- contract law aspects, 34 -25-34-26
Border Insolvency, 33-36 EU Insolvency Regulation, 34-28
harmonisation, 33-02 34-29
jurisdiction Hague Trusts Convention, 3427
bases of jurisdiction, 33-38 location of assets, 34-30
internal jurisdiction, 33-41 property law aspects, 34- 25- -34-26
long-arm jurisdiction, 33-39 -33-40 tracing, 34-32
recognition of insolvency UNCITRAL Model Law on Cross-
representatives and stays, 33- Border Insolvency, 34-31
42- 3-46 UNCITRA!. Model Law on Cross-
main/non-main proceedings, 33- 06 Border Insolvency
33-07 contracts and leases. 34-36
588 INDEX

Insolvency (conflict of laws)--cont. International Organisation of Securities

UNCITRAL Model Law on Cross- Commissions
Border Insolvency—con!. generally, 21-15
co-operation, 33-30 Interveners
equalisation, 33-32 see Set-off and netting
governing law, 33-35 Investment banks
groups of companies, 33-36 generally, 20-21
introduction, 33-23-33-24 Investment business
local proceedings, 33-27 see Conduct of business; Financial
main/non-main proceedings, 33-26 regulation
preferences, 33-31, 34-43 ipso facto clauses
procedure, 33 -37 contract termination, 6-01--6-02
proceedings covered, 33-25 ISDA Master Agreement
public policy, 33-33 derivatives
recognition, 33---28 background, 27-03--- -27-04
security interests, 34-24 summary of terms, 27-05--27-10
stays, 33-29 Islamic jurisdictions
title finance, 34-24 generally, 3-27-3-29
treaties, 33-34
trusts, 34-3 I
Judgments, enforcement of
universal theory, 33-03
see EU Judgments Regulation;
Insolvency set-off
Jurisdiction
see Set-off and netting
Judicial reorganisations
Insurance companies
see also Insolvency
EU Insurance Company Insolvency
Directive, 33 -21---33-22 advantages, 4-18
Insurance contracts conclusions, 4-28
EU Judgments Regulation, 32-26 conflict of laws
Insurance policyholders insolvency forum. 34-47
priorities, 5 15 main issues, 34-46
Interest recognition, 34-49--34--50
subordination, 5-18 disadvantages, 4- 19
syndicated loans, 7-31 --7 -32 financial law indicators, 228
Interest futures generally, 4-I I
generally, 26-17 grading of laws, 4-20--4-21
Interest rate contracts jurisdictional survey, 4-22--4--27
caps, 26-09 overlap with other methods, 4-12
collars, 26-11 priorities, 5-03
floors, 26-10 work-outs compared, 4-17
swaps, 26--07---26 08 Judicial set-off
Internal ratings based approach generally, 14-09
see Credit risk Jurisdiction
International Accounting Standards absence of express choice, 32--07
Board arbitration, 32-28
generally, 21-18 attachments, 32-32
International Association of Deposit bases of jurisdiction
Insurers generally, 32-08
generally, 21 --18 insolvency, 33 -38---33-40
International bonds long-arm jurisdiction, 32 09- -32
see Bond issues 10
International Financial Reporting enforcement of judgments, 32-29- -
Standards 32-31
generally. 21-18 EU Judgments Regulation
International loans abuse, 32-16
see Syndicated loans advantages. 32- I 5
International Monetary Fund application. 32-13
generally. 21-I1 basic principles. 32- 14
 INDEX
589

.lurisiliction-- -e on, Jurisdictions -conL

EU Judgments Regulation -cant. Napoleonic jurisdictions-cont.
civil and commercial matters, 32- legal origins, 3-13
l7-32-l9 OHADA jurisdictions, 3-I1
consumer credit agreements, 32-26 new jurisdictions, 3-30-3-31
contracting out, 32-27 number, 2-01
disadvantages, 32-15---32-16 polarisation, 2-37-2-38
domicile, 32-14 Roman-Germanic jurisdictions
domicile exceptions, 32-20--32-24 conclusions, 3-23
employment contracts, 32-26 identity, 3--17
exclusive jurisdiction, 32-25 insolvency law indicators, 3-22
generally, 32-11 legal origins, 3-20-3-21
insurance contracts, 32- 26 new group, 3-19
territorial scope, 32 -12 traditional group, 3 18
insolvency statistics, 2-07---2-08
bases of jurisdiction, 33-38 transmission of legal systems, 2--05
internal jurisdiction, 33-41 2-06
long-arm jurisdiction, 33-39-33- unallocated jurisdictions, 3-32
40
recognition of foreign insolvency
representatives and stays, 33- Leases
42-33-46 see Contracts and leases
introduction, 32-01 Legal and political infrastructure
jurisdiction clauses financial law indicators, 2-18
form, 32-06 Liquidation
purpose, 32-02-32-05 see also Insolvency
long-arm jurisdiction generally, 4-11
generally, 32-09-32-10 overlap with other methods, 4--12
insolvency, 33-39--33-40 priorities, 5-03
state immunity work-outs compared, 4-16
generally, 32-33- -32-34 Listing
waiver, 32-35--32-36 bond issues
.Jurisdictions advantages, 11 -42
see also under specific subjects convertible bonds, 12 05
American common law jurisdictions disadvantages, 11-43
conclusions, 3-05 generally, 11-41
identity, 3-02 insider dealing, 24-22
insolvency law indicators, 3-04
legal origins, 3-03
definition, 2-02 Macroeconomic regulation
English common law jurisdictions financial regulation distinguished, 20-
conclusions, 1-09 12
identity, 3-06 Managed accounts
insolvency law indicators, 3-08 insider dealing, 24-38
legal origins, 3-07 Management of insolvency
groups, 2-03--2-04 conclusions, 6-28
harmonisation of financial law, 3- courts, 6-26-6-27
33-3-35 creditors, 6-24
identification, 2 01 debtors' existing management, 6-25
Islamic jurisdictions, 3-27- 3-29 managers' powers, 6-23
mixed civil/common law jurisdictions, potential managers, 6-22
3. 24- 3-26 Mandates
Napoleonic jurisdictions bond issues, II -34
conclusions, 3-16 syndicated loans, 7- 05 -7-06
identity, 3 tO _3. 12 Margin
insolvency law indicators, 3 14 derivatives, 27-15
3-15 multilateral netting, 15-09
590 INDEX

Margin—cont. Multilateral netting--conl.

syndicated loans generally, 15-03
bond issues compared, 11-15 margin, 15-09
generally, 7--32 mutuality, 15-01-15-02
protection, 7-35 settlement systems, 15--04----15 -08
Market manipulation Mutual funds
see also Insider dealing see Collective investment schemes
abusive squeezes, 24--Il Mutuality
churning, 24-13 set-off and netting
corners, 24-11 generally, 15-01-15-02
definition, 24-04 multilateral netting, 15-03-15-09
example, 24--05----24-09
exemptions Napoleonic jurisdictions
buy-backs, 24- 16 conclusions, 3-16
stabilisation, 24--1 5 identity, 3-1 0--3- 12
false markets, 24-14 insolvency law indicators, 3-14---
introduction, 24-01 3-15
market timing, 24-12 legal origins, 3-13
sources of law, 24-02 Ol-IADA jurisdictions, 3--I I
whistleblowing, 24-03 Negative pledges
Mark-ups see Syndicated loans
conduct of business, 22-09 Negative profits
Master agreements insider dealing, 24- 31
derivatives Netting
generally, 27--01----27-02 see Set-off and netting
ISDA Master Agreement, 27 -03- New jurisdictions
27-10 new jurisdictions, 3-30- ---3 31
Matching No-action clauses
settlement systems, 30-33 bondholder trustees, 12 32--- 12-33
Medium-term notes syndicated loans, 9- 22
S't? C1v1) Bond ISSLkS Non-deposit-taking credit institutions
documentation, 12-12 financial regulation, 20-17
generally, I 2-Il Non-disclosure in prospectuses
pricing supplements, 12-13 see Prospectus liability
Memorandums of understanding Novation
financial regulation, 21 33-21-34 see Syndicated loans
Mergers
convertible bonds, 12-10 OHADA jurisdictions
Minimum capital see also Napoleonic jurisdictions
see Capital adequacy generally, 3-11
Mismanagement Operational risk
banks, 1-21 capital adequacy
directors' liabilities, 540----5-41 examples, 25-26
Mismatch of assets and liabilities introduction, 25-25
banks, 1-18 measurement, 25-27-25 28
Misrepresentation in prospectuses derivatives, 27-25
see Prospectus liability Options
Mistake call options, 26-19
tracing, 19--16 examples, 26-23
Mixed civil/common law jurisdictions gearing, 26--22
generally, 3-24---3--26 generally, 26-19----26- 20
Money put options, 26- -19
history, 1-12 risk, 26-21
Multilateral banks Oral contracts
generally, 21 -12 derivatives, 27 - 1 2
Multilateral netting Ordinary course of business payments
central counterparties, 15--05 I 5-08 preferences, 6 -19
 INDEX 5911

Over-the-counter markets Preferential creditors

derivatives, 26-32 administrative costs, 5-12.
generally, 20-27 bank depositors, 5--15
conflict of laws, 34-38--34-39
Payment systems employees, 5-14
bank money, 30-02 generally, 5-I1
banks' liabilities, 30- 17 insurance policyholders, 5-15
conflict of laws, 30-17 tax, 5-13
end-of-day settlement systems, 30- Pre-packaging
11-30-14 insolvency, 4-12
financial regulation, 20-22 Primary markets
international transfers derivatives
procedure, 30-05----30-07 covered warrants, 26 .39
regulation, 30-03 generally, 26-33
introduction, 30-01 hedging, 26-37
parties, 30-04 index-linked notes, 26-34
payment contracts, 30-09 listing, 26-38
payment orders, 30-04 warrants, 26-35- -26--36
real-time gross settlement systems, 30- generally, 20-27
11, 30-15 Priorities
regulation, 30-10 conclusions, 5-22
revocation on insolvency, 30-16 cross-border insolvency, 5-05
same bank, 30-08 de facto reversal, 5-04
set-off and netting, 15-04-15-08 expropriation, 5-20--5-21
time of payment, 30-17 foreign currency creditors, 5-21
Perfection of security interests foreign taxes, 5-20
see Publicity for security interests introduction, 5-01
Petitions for insolvency judicial reorganisations, 5 03
directors' failure to file, 5 36-5- 38 liquidation, 5-03
Political and legal infrastructure preferential creditors
financial law indicators, 2-18 administrative costs, 5-12
Possession bank depositors, 5-15
enforcement of security interests, 17-31 employees, 5-14
Precedent generally, 5-- 11
financial law indicators, 2-20 insurance policyholders, 5-15
Pre-existing debts, security for tax, 5-13
preferences, 6-18 secured creditors, 5-07---5-08
Preferences set-off, 5-.09
carve-outs, 6-14 settlement systems, 3"6--30-47
conflict of laws shareholders, 5-19
EU Insolvency Regulation, 34-42 subordination, 5-17-- -5-18
Foreign preferences, 34-41 summary, 5- 02
main issues, 34-40 "super priority" creditors, 5-06
other principles, 34-44 title finance, 5-07---5-08
UNCITRAL Model Law on Cross- trusts, 5-10
Border Insolvency, 33--31, 34-- unsecured creditors, 5-16
43 Private equity finance
financial law indicators, 2-25 deal structures, 13-15--1 3-19
fraudulent preferences, 6- 11 directors' liabilities, 13-25
general preferences, 6-13 financial assistance, 11-21
gifts. 6 12 generally, 13--12--13-14
jurisdictional survey, 6-15---6-21 guarantees, 13.-22--13-23
ordinary course of business payments, senior lenders' exit, 13-24
6-19 shareholder agreements, 13 -26--- 13--28
poitcies, 6 09----6-- 10 taxation, 13 20
security for pre-existing debts. 6 18 Private sale
tracing, 19 16 enforcement of security interests, 17 32
592 INDEX

Project finance Publicity for security interests—con!.

generally, 13 36 Roman-Germanic jurisdictions, 17-10
Proper law settlement systems, 30-43
see Governing law Purchase of own shares
Property finance see Financial assistance
generally, 13-37 Put options
Prospectus liability generally, 26--I9
derivatives, 27-19-27-20
due diligence, 23-30 --23-31 Rating agencies
exclusion of liability see Credit rating
arrangers, 23-35 Real-time gross settlement systems
indemnities from borrowers, 23-- 36 generally, 30-I1, 30-15
regulated prospectuses, 23-34 Receivership
restrictions, 23-37 enforcement of security interests, 17- 31
Joint and several liability, 23- 15 Regulation
liable persons see Financial regulation
arrangers, 23-19-21-30 Regulators
directors, 23--17 generally, 20-02-20-03
experts, 23-- 18 Reorganisations
introduction, 23-14 see Judicial reorganisations
issuers, 23-16 Repos
Joint and several liability, 23-15 title finance, 18-06
underwriters, 23-19-23 30 Restitution
sources of law, 21-1 see Tracing
summary, 23-11-23-13 Retail markets
Prospectuses generally, 20--28
see also Prospectus liability Retainer set-off
bond issues generally, 14--0
contcnt. II- 49 Retention of title
gcueially, 11-34 title finance, 18-03-- 18-04
regulation. I l--46--- I 1-48 Risk mitigation
exemptions, 23--07-- 23-09 see Security interests; Set-off and
form, 23--06 netting; Title finance; Trusts
introduction, 23-01 Roman-Germanic jurisdictions
policies, 23-03 conclusions, 3-23
purpose, 23-02 identity, 3-17
re-sales, 23--09 insolvency law indicators, 3-22
syndicated loans, 7-16 legal origins, 3-20---3-21
territorial scope, 21-30-- 21-31 new group, 3- 19
types, 2304- 23-05 traditional group. 3 18
Public auction Rome Convention
enforcement of security interests, I 7-- governing law, 3 1-17
32 Routine business payments
Publicity for security interests preferences, 6-19
see also Title registration
advantages, I 7-04 Sale
American common law jurisdictions, enforcement of security interests,
17-08 17-32
conflict of laws, 34-1 1-- 34-20 title registration, 19 19
disadvantages, 1705 Sale and leaseback
English common law jurisdictions, title finance, 18--I I
l7--08 Sale and repurchase
generally, 16-24-- 16-26 title finance, 18-06
methods, I? 02 Secondary markets
Napoleonic urisdicuons, 17 09 generally. 2 -027
policies. 17-03 17-05 Secret profits
purpose, 17-01 conduct of business, 22 12. 22-25
 INDEX 593

Secured creditors Securitisation—cont.

priorities, 5-07- -5 08 recharacterisation as security
Securities businesses interests, 29-02-29-05
banks distinguished, 20--24 remoteness from originator
definition of securities, 20-20 insolvency, 29-06-29-07
generally, 20-19 trusts, 28-21
investment businesses, 20-21 Security for pre-existing debts
Securities fraud preferences, 6-18
see Insider dealing; Market Security interests
manipulation see also Title finance
Securities lending advantages, 16-06-16--07
title finance, 18--07 assets, 16 -20---16-22
Securities settlement systems conflict of laws
see Settlement systems book-entry investments, 34-19
Securitisation contract debts, 34-17
advantages creation, 34-11-34-20
accounting, 28-13 EU Insolvency Regulation, 34-22 -
capital raising, 28-14--28-15 34-23
introduction, 28-12 generally, 3446
miscellaneous, 28-16 investment securities, 34-18
regulation, 28-17 location of assets, 34-07-34-10
assets, 28 10-28-11 main issues, 34-21
assignment of receivables priorities, 34-11 - -34-20
notice to debtors, 28-34 -28--35 publicity, 34-11- 34-20
restrictions, 28 30-28-33 UNC1TRAL Model Law on Cross-
capital adequacy, 29 12-29 17 Border Insolvency, 34-24
credit enhancement, 28-37---28-39 debts secured
credit rating, 29-18--29-20
foreign currency debts, 17 13
disadvantages, 28-18
future debts, 17-11
documentation, 28- 08
maturity dates, 17-12
introduction, 28 01- -28-03
maximum amounts, 17-12
managed securitisation, 28-26
miscellaneous restrictions, 17 14
origin, 28--04---28-05
pricing, 28-29 definition, 16 01--16 02
profit extraction, 28-40----28--41 disadvantages, 16-08
receivables, 28 10-28- 11 enforcement on insolvency
recharacterisation as security interests, blocking of administration, 17-48--
29-02----29-05 17-49
repackaging of securities, 28-25 France, 17-51---17-53
requirements, 28-07 main issues, 17-37
sale to special purpose vehicles management of collateral, 17-42--
generally, 28-19 17-43
offshore companies, 28-20 policies, 17-38 17-41
securitisation of securitisations, 28 27 stays, 17-45-17-54
set-off, 28--36 title finance, 17-50
several originators, 28 28 United States, 17-44
sub-participation, 28--22 enforcement outside insolvency
synthetic securitisation foreclosure, 17 -30
credit derivatives, 26-27 grace periods, 17-33- 17-35
generally, 28-23 --28--24 introduction, 17-29
terminology, 28-06 jurisdictional summary, 17-36
tranching, 28-09 possession, 17 31
true sale private sale, 17-32
accounting, 29 08-29 II public auction, 17-32
capital adc4uay, 29 12--29- 11 7 rcccivcrship, 17 31
credit rating, 29--18--29-20 [I.J Financial Collateral Directive,
generally, 29-4)l 17-55, 17-57
594 IN I)IX

Security interests coin. Security interests cont.

EU Settlement Finality Directive, IT universal security interests con!.
55--17 56 English common law jurisdictions,
financial law indicators. 2-I1 16- 32-16-34
main issues, 16-10--I6-1 I Islamic jurisdictions, 16-42
over-collateralisation, 16-- 27 Napoleonic jurisdictions, 16.40 -
overview, 16-03---16-05 16 41
policies, 16-06 - 16 -09 new jurisdictions, 16-42
priorities Roman-Germanic jurisdictions, 16-
conflict of laws, 34-I I--- 34-20 36---16-39
filing, 17-27-17-28 United States, 16 35
policies, 17-21-1726 Segregation of client assets
preferential creditors, 1719- -17-' see Conduct of business
20 Self-dealing
publicity conduct of business, 22-25
advantages, 17-04 Set-off and netting
American common law advantages, 14-14
jurisdictions, 17-08 anti-avoidance, 14-37
conflict of laws, 34 - Ii ---34 20 assignees, 15- 10
disadvantages, 17-05 attaching creditors, I 5--b
English common law jurisdictions, charge-backs distinguished, 14 10
17-08 14-1I, 14-13
generally, 16-24 -16-26 claims owed by insolvent persons, 14
methods, 17-02 25- -14-27
Napoleonic jurisdictions, 17-09 claims owed to insolvent persons, 14-
policies, 17-03-----17--05 28
purpose, 17-01 close-out netting, 14-04
Roman-Germanic jurisdictions. li conditional debts distinguished, 14
I0 0-- 14 12
settlement systems, 30- 43 conflict of laws
scope contract termination, 34-05
generally, 16-23 insolvent set-off, 34--03---34--05
restrictions, 16- 24---16 27 solvent set-off, 34--02
universal security interests, 16-28 contractual set-off
16-43 generally, 14-09
secured finance sectors interveners, 15-15 15-16
consumer credit, 16 -18 current account set-off, 14-07
home loans, 16 17 derivatives, 27-14
introduction, 16-12 disadvantages, 14-I5
public companies, 16-13 financial law indicators, 2-10
small and medium-sized enterprises. flawed assets distinguished, 14 10--
l& 15 14-12
special purpose vehicles, 16-14 floating chargees, 15-10
title finance, 16-19 fund set-off, 14--09
wholesale financial markets, 16-16 generally, 14-03
settlement systems group account pooling
generally, 30-42 cross-guarantees, 15 20 - 15-22
publicity, 30-43 purpose, 15-19
specificity, 16 24 16 26 independent set-off, 14-07
trusts interveners
advantages, 17 16-1717 assignees, 15-10
covenants, 17 IS attaching creditors, IS 10
generally, 17-15 contractual set-off, 15 15 -15--16
security icis iivaiiitg chargecs, ii 10
advantages, 16 28 16 29 general rule, 15 Il--IS 14
 INDEX 595

Set-off and netting -corn. Settlement systems

interveners---cont. cash accounts, 30--38
undisclosed principals, 15-10, 15 cell structure, 30-35-30-37
17-15-18 central counterparties, 30-44
introduction, 14-01----14-02 custodians, 30-24-30-25
judicial set-off, 14-09 dematerialisation of securities, 30-28
jurisdictional survey eligible participants and securities, 30
American common law 27
jurisdictions, 14-18 end-of-day systems, 30-11- ­30-14
English common law jurisdictions, examples, 30-19-30-20
14-18 financial regulation, 20-22
exceptions to prohibitions, 14-24 immobilisation of securities, 30-29
introduction, 14-17 30-30
Islamic jurisdictions, 14-21 introduction, 30-18
jurisdictions permitting set-off, 14- legislative provisions, 30-26
22 multilateral netting, 15--04-15-08
jurisdictions prohibiting set-off, 14- payments, 30-45
23 --14-24 priorities, 30-46-30-47
mixed civil/common law problems, 30-23
jurisdictions, 14-21 purpose, 30--21---30-22
Napoleonic jurisdictions, 14- 20 real-time gross systems, 30-I1, 30--I5
new jurisdictions, 14-21 security interests
generally, 30--42
Roman-Germanic jurisdictions, 14
19 publicity, 30-43
transfer
multilateral netting
central counterparties, 30-44
central counterparties, 15-05-15-
identification, 3039-30-40
08
netting, 30- 44
generally, 15-03
procedure, 30-41
margin, 15-09
security interests, 30-42-30-43
mutuality, 15-01-1502 trusts of securities
settlement systems, 15-04-.-15-08 fungibility, 30--34
mutuality generally, 30-31-30-32
generally, 15-01-15-02 matching, 30-33
multilateral netting, 15-03-15-09 Shadow directors
netting agreements, 14-35- 1436 liabilities, 5-42--5--43
netting statutes, 14-33 -14-34 Shareholder agreements
payment systems, 15--04--15--08 special purpose finance, 13-26 --13-28
policies, 14-14---14--16 Shareholders
priorities, 5-09 priorities, 5-19
retainer set-off, 14-09 Shareholders' meetings
securitisation, 28-36 directors' failure to call, 5-39
settlement netting, 14-06 Sharia
stays, 14-29---14--32 see Islamic jurisdictions
syndicated loans Ship finance
assignment, 10-16 generally, 13-38
generally, 9-29- 9-30 Short-swing profits
negative pledges, 8-13 insider dealing, 24-23
novation, 10-31 Soft commissions
sub-participation, 10-25 conduct of business, 22-12
transaction set-off, 14- 08 Sovereign immunity
types, 14-03-14--09 see State immunity
undisclosed beneficiaries, 15-10 Special purpose finance
undisclosed principals, 15 tO, IS- see also Securilisation; Syndicated
7 5--18 loans
Settlement netting acquisition finance
generally, 406 deal structures, 13--15 -.13-19
596 INDEX

Special purpose finance con!. Stays

acquisition finance--con!. enforcement of security interests, IT.
directors' liabilities, 13-25 45--- 17-54
financial assistance, 13-21 set-off and netting, 14-29--14---32
generally, 13-08--I 3-10 Stock exchanges
guarantees, 13--22--13-23 see Exchanges
senior lenders' exit, 13-24 Stock index futures
shareholder agreements, 13 26-- generally, 26-17-----26--1 8
13-28 Structural subordination
takeover regulation, 13-11 generally, 13-05
taxation, 13-20 Subordinated capital bonds
see also Bond issues
aircraft finance, 13-35
generally, 12-14
common features, 13-02
subordination clauses, 12-15
construction finance, 13-36
Subordination
credit agreements, 13-03 priorities, 5-17-5-I 8
equipment lease finance, 13-35 special purpose finance
financial assistance generally, 13-04
English common law jurisdictions, types, I 3--OS
13-31 structural subordination, 13-05
European Union, 13-33 turnover subordination, 13-05
generally, 13-21, 13-29-13-30 Sub-participation
Napoleonic jurisdictions, 13-34 see also Syndicated loans
Roman-Germanic jurisdictions, 13- securitisation, 28-22
34 "Super priority" creditors
United States, 13-32 generally, 5-06
introduction, 13-01 set-off, 5-09
private equity finance title finance, 5-07 5-08
deal structures, 13-15-13-19 trusts, 5-10
directors' liabilities, 13-25 Swaps
financial assistance, 13-21 interest rate contracts, 26-07--26-08
generally, 13-12-13-14 Syndicated loans
guarantees, 13-22-- 13-23 see also Special purpose finance
senior lenders' exit, 13-24 agents, 9-17-9--18
shareholder agreements, 13 -26-- arrangers' functions, 7-07--7-09
13-28 assignment
taxation, 13-20 appropriation of payments, 10- 18
project finance, 13-36 benefits, 10-14
property finance, 13-37 burdens, 10-15
security agreements, I 3-06---I 3-07 generally, 10-12
ship finance, 13-38 guarantees, 10-17
restrictions in loan agreements, 10 -
subordination
13
generally, 13-04
security, 10-17
types, 13-05 set-off, 10-16
Specificity bilateral loans, 7-03
security interests, 1624 16-26 bond issues compared
title registration, 19-23--19-25 advance of funds, 11-10
Spin-offs borrowers, 11-05
convertible bonds, 12-10 covenants, 11-18-11-25
Stabilisation currency conversion, 11-Il
market manipulation, 24-15 default events, 11-26---11-27
Stake-building documentation, 11-08
market manipulation, 24-37 governing law, 11-29
State immunity interest, 11-12
generally, 32-33---32-34 introduction, 11 --03
waiver, 32-35 -- 32-36 investors' identity, 11 -06
 INDEX 597

Syndicated loans -: -cant. Syndicated loans—cant.

bond issues compared- cant financial terms---cont.
jurisdiction, 11-29 cancellation by borrowers, 7--29
lenders, 11-04 conditions precedent, 7-22-7-23
margin protection, 11-15 default by lenders, 7-24-7-26
modification, 11-28 generally, 7-18
negative pledges, 11-20-11-21 grossing-up, 7-36
offering documents, 11-07 illegality, 7-30
payments, 11- 16 increased costs, 737 : 738
prepayments, 11--14 interest, 7-31-7-32
priorities, 11--19 loan commitments, 7-21
pro rala sharing, 11--16 Loan Market Association forms, 7
repayments, 11-13 19
stale immunity waiver, 11-29 margin protection, 7-35
transferability, 11-09 market disruption, 7-33
covenants payments, 7-34
breach, 8-05 repayments, 7-28--7-29
disposal restrictions, 8-27--8--30 generally, 7-03
financial covenants, 8-31---8--40 governing law, 9-31
generally, 8-01 information memorandums, T-15
information, 8-07 interest, 7-31-7-32
lender liability, 8-06 jurisdiction, 9-31
miscellaneous, 8-41 mandates, 7-05--7-06
negative pledges, 8 -08 8-23 margin
priorities, 8-24-8-26 bond issues compared, 11-15
purpose, 8-02----8-04 generally, 7- 32
dccision-making protection, 7-35
generally, 9-19- 9-20 negative pledges
majority control, 9---21 after-acquired properly!
no-action clauses, 9-22 subsidiaries, 8-16
default events automatic security clauses, 8-23
acceleration, 9-14--9-16 baskets, 8-17
cancellation, 9-14--9-16 debts covered, 8 ­ 11
change of control, 9-10 efficacy, 8-20
cross-default, 9-03-9-05 exclusions, 8-15-8-17
effect of default, 9-01 generally, 8-08
guarantors, 9-12 interpretation, 8-12
material adverse change, 9-06- - -9.- liens, 8-15
09 procuring breach of contract, 8-
sovereign loans, 9 -13 2l--8- 22
subsidiary companies, 9-11 purpose, 8-09
types of default, 9-02 scope, 8-20
wrongful acceleration/cancellation, second-ranking security, 8-19
9-16 security interests covered, 8-10
financial covenants set-off, 8-13
debt-to-earnings ratio, 8-38 sovereign loans, 8-18
dividend restrictions, 8--39 subsidiary companies, 8 ­ 14, 8-16
earnings-to-interest ratio, 8--35-8- - substitution, 8 17
36 title finance, 8-13
finance costs, 8-37 novation
generally, 8--31-8-32 generally, 10 30
leverage ratio, 8-34 guarantees, 10-32
liquidity tests, 8 40 security, 10-32
minimum net worth, 8-33 set-off, 10-31
financial terms parties, 7 -04
agreement to lend, 7-20 payments, 7-14
application of proceeds, 7-27 principles
598 INDEX -

Syndicated loans con!. Synthetic securitisation

principles- -con!. credit derivatives, 26- 27
agency, 7-12 generally, 28-23- -- 28- 24
decision-making, 7-13
introduction, 7 -10 Takeovers
Pro rata sharing, 7-14 convertible bonds, I 2- -09
severality of commitments, 7--I I insider dealing, 24-37
pro raw sharing special purpose finance, 1 3--Il
assignment, 9 26 Taxation
double-dipping, 9- 25 bond issues, II -44
efficacy, 9-28 financial law indicators, 2--32
generally, 9--24 priorities
miscellaneous aspects, 9 27 foreign taxes, 5-20
subrogation, 9 -26 generally, 5-13
prospectus regulation, 7 -16 special purpose finance, I 3--20
repayments, 7 -28--7--29 Term sheets
representations, 7-39---7--40 syndicated loans, 7--05
revolving credit, 7- 20 Tipping-off
sct-off insider dealing, 24- 26
assignment, 10 16 Title finance
generally, 9--29 --9-30 conclusions, 18--I5- 18-16
negative pledges, 8- 13 conflict of laws
novation, 10-31 hook-entry investments, 34-19
sub-participation, 10 -25 contract debts, 34-- 17
state immunity waiver, 9-31 creation, 34-I l---34--20
sub-participation EU Insolvency Regulation, 34 22
benefits. 10-- 23 34-23
burdens, I 0-24 generally, 34 -06
generally, 10 19 Investment securities, 34 18
guarantees, 10- 26 location of assets, 34 07- --34 -tO
management, 10-29 main issues, 34-21
purpose, 10-21 priorities, 34-I1- --34-20
rescheduling, 10-27--10--28 publicity, 34-I I-- -34 20
restrictions in loan agreements, tO 22 UNCITRAL Model Law on Cross-
risk, 10--2() Border Insolvency, 34-24
security, 10-26 enforcement on insolvency, 17-50
set-off, 10 -25 factoring, 18--05
term loans, 7-01--- 7-02 finance leasing, 18--08 - - 18-09
term sheets, 7--05 forfaiting, 18--05
transfer hire purchase, 18-10
accounting treatment, 10-35 introduction, 18-01
assignment, 10-- 12----I0--18 priorities, 5-07--5 -08
borrower protection, 10-04 purpose, 18-12
capital adequacy, 10-33 --10-34 recharacterisation as security interests,
confidentiality, 10-09 18-13
insider dealing, 10-10 retention of title, 18--03---18- -04
introduction, 10-01 sale and leaseback, 18--I I
methods, 10-05 -10 06 sale and repurchase. 18-06
novation, 10-30- 10-- 32 sectors, 18 14
purpose, 10-02 securities lending, 18 07
risk participation, 10--06 types, 18-02
solicitation of participants, 10- II Title registration
sub-participation, 10-19 - 10-29 assignment of contracts and debts,
summary of main points, 10- -07 19-26-- 19 28
10 -08 introduction, 19 -lt
terms, 10 03 sale. 19-19
warranties. 7 -39- 7 40 security interests, 19 21
 INDEX 599

Title registration cont. Trusts-con!.

specificity, 19-23---19--25 objections, 19-03
summary, 19-22 priorities, 5-10
trusts, 19--20 securitisation, 2821
Torts security interests
governing law, 31-29-31-31 advantages, 17-16--17-17
Tracing covenants, 17-18
availability, 19-17 generally, 17-15
conflict of laws, 34- 32 settlement systems
examples, 19-14 fungibility, 30-34
financial law indicators, 2-14 generally, 30-31---30-32
generally, 1913 matching, 30-33
governing law, 31-29 --31-31 title registration, 19-20
mistake, 19-16 tracing
preferences, 19-16 availability, 19-17
unjust enrichment, 19-15-19-16 conflict of laws, 34-32
Trade associations examples, 19-14
financial regulation, 21-18 generally, 19- 13
Transaction set-off mistake, 19-16
generally, 14-08 preferences, 19-16
Transfer of loans unjust enrichment, 19-15-19--16
see Syndicated loans use, 19-07-19-08
True sale Turnover subordination
see Securitisation generally, 13-05
Trusts
advantages, 19-06 Unallocated jurisdictions
bond issues generally, 3-32
acceleration, 12-30-- 12-31 UNCITRAL Mode! Law on Cross-
advantages, 12--18---12-23 Border Insolvency
disadvantages, 12 25 see also Insolvency (conflict of laws)
generally, 12-17 contracts and leases, 34 36
Immunity of trust property, 12-28 co-operation, 33-30
mandatory requirements, 12 25- equalisation, 33-32
12-26 governing law, 33-35
market practice, 12-27 groups of companies, 33-36
no-action clauses, 12-32-12 -33 introduction, 33-23-33-24
secured bonds, 12-23 local proceedings, 33-27
trust deeds, 11-37 main/non-main proceedings, 33 -26
trust structure, 12-29 preferences, 33-31, 34- 43
civil law jurisdictions, 19-04--19 05 procedure, 33-37
conclusions, 19-29 proceedings covered, 33-25
conflict of laws public policy, 33-33
contract law aspects, 34-25---34-26 recognition, 33-28
EU Insolvency Regulation, 34-28- security interests, 34-24
34-29 stays, 33-29
Hague Trusts Convention, 34 -27 title finance, 34-24
location of assets, 34 30 treaties, 33-34
property law aspects, 34- 25---34- 26 trusts, 34-31
tracing, 34-32 Underwriters
UNCITRAL Model Law on Cross- prospectus liability, 23--19 --23-3()
Border Insolvency, 34 -31 Undisclosed beneficiaries
constructive trusts, 19-13 set-off and netting, 15-10
financial law indicators, 2 12 Undisclosed principals
Hague Trusts Convention, 34-27 set-off and netting, 15-10, 15-17 - 15-
introduction, 19-01-19-02 18
jurisdictional survey, 19-09 19 12 Universal security interests
Netherlands, 19 12 advantages, 16 28----16-29
600 INI)FX

Universal security interests---cont. Warrants

disadvantages, 16-30 covered warrants, 26- 39
English common law jurisdictions, generally, 26-35-- -26-36
16-32---16-34 Whistleblowing
Islamic jurisdictions, 16 42 market manipulation, 24-03
Napoleonic jurisdictions, 16-40---16- 41 Wholesale financial markets
new jurisdictions, 16-42 generally, 2 -028
Roman-Germanic jurisdictions, 16- secured finance, 16-16
36-- 16-39 Work-outs
United States, 16-35 see aLvo Insolvency
Unjust enrichment advantages, 4 -13-4-14
tracing, 19-15-- 19- 16 disadvantages, 4-15
Unsecured creditors generally, 4-I I
priorities, 5-16 judicial reorganisations compared. 4
US Financial Accounting Standards 17
Board liquidation compared, 4-16
generally, 21-18 overlap with other methods, 4-12
World Bank
Veil of incorporation generally, 21-42
see Directors' liabilities Wrongful trading
directors' liabilities. 5--33-- 5 35
Wagering contracts
derivatives, 27-17