Part V Legal and Conduct Risk in Interconnected Financial Markets, 18 The Role of International Institutions in Financial Law Reform
Roger Mccormick, Chris Stears
Roger McCormick, Chris Stears
- International financial system — International monetary conduct
In the 1990s, legal reform as a tool of economic reform was … not restricted to countries of the former communist bloc but became a global phenomenon.1
18.01 The Financial Crisis has added a sense of urgency to the desire, often expressed, for more up-to-date and internationally consistent (and, where appropriate, harmonized) laws to apply to global financial market activity. But it was apparent to market participants and others, well before the Financial Crisis, that law reform at international level was necessary for an increasingly globalizing financial market. The collapse of the Soviet Union, and the opening up of important new markets in former Soviet Union countries, was just one of the spurs for reform. The laws of those countries (which, in many cases, had little or no experience of modern market-based commercial or financial activity) had been ‘marking time’ for most of the 20th century and were inadequate and generally out of date for the kinds of transaction that would be needed in order to implement foreign investment. Other new markets were beginning to open in China, India, parts of Africa and Latin America, and elsewhere. The patchwork of legal systems that came with these new markets presented a challenge to the international banks (and their lawyers) who wanted to replicate transaction structures that had been tried and tested in London and New York. Unsecured syndicated loans were relatively easy to implement as the documentation could largely be governed by (p. 334) English or New York law but as soon as the need for infrastructure financing and asset-backed financing began to develop, which required security over local assets (amongst other things), the problems associated with the local ‘legal infrastructure’ became more pressing and the case for reform built very rapidly. The law relating to security interests, how they are created, over what assets they may be created, who can benefit from them and how they are enforced varies a great deal from jurisdiction to jurisdiction.2 The differences are not always easy to justify in the context of a global marketplace and aspiring members of that marketplace. Further impetus to the reform agenda was added as more and more countries sought to establish markets in the more complex capital market instruments.
18.02 Inconsistency and incompatibility of laws add to the legal risks that have to be managed, make regulation less effective and result in inefficiencies and costs that cause investment in countries that badly need it to be more expensive than it should be. Ideas for financial law reform can come from any number of sources. At the national level, these may include bodies that are specifically tasked with consideration of law reform issues, such as, in the UK, the Law Commission. They may come from the academic community or from trade associations or (perhaps impliedly rather than explicitly) bodies such as the FMLC or the City of London Law Society.
18.03 At international level, the bodies that promote reform tend to be international themselves. They include international financial institutions such as The World Bank3 and EBRD (which is considered in more detail in Section C of this chapter); NGOs; OECD;4 ad hoc groupings of practitioners and academics; trade associations such as ISDA;5 various organs of the EU (concerned, essentially, with harmonization within the EU); and the United Nations Commission on International Trade Law (UNCITRAL) and the International Institute for the Unification of Private Law (UNIDROIT).
18.04 UNCITRAL was created in 1966, by a resolution of the United Nations General Assembly. It was given a general mandate to further the progressive harmonization and unification of international trade law and regards itself (according to its website) as ‘the core legal body of the United Nations system in the field (p. 335) of international trade law’. Its membership consists of some 60 member states elected by the General Assembly and it is structured so as to have representation from the principal economic and legal systems. Further details of its constitution can be found on its website.
18.05 Despite the reference to ‘trade’ in its title, UNCITRAL has undertaken many projects in areas affecting the financial markets, particularly in relation to security interests and insolvency. It is, for example, responsible for the 2001 UN Convention on the Assignment of Receivables in International Trade, whose objectives include (according to UNCITRAL) removing ‘legal obstacles to certain international financing practices, such as asset-based lending, factoring, forfaiting, securitization, refinancing and project financing’. These objectives are achieved by, amongst other things, validating assignments of future receivables and bulk assignments (a persistent conceptual difficulty in many civil law jurisdictions) and partially invalidating ‘no assignment’ clauses (which many lawyers who believe in the primacy of freedom of contract have reservations about, but which is certainly a benefit to receivables financiers who find it impractical to check whether the debts they are buying are subject to assignment restrictions). In 2001, UNCITRAL published a Legislative Guide on Privately Financed Infrastructure Projects (containing recommendations for countries that need to have laws in place to authorize privately financed infrastructure programmes) and, in 2007, published its Legislative Guide on Secured Transactions. This is essentially a guide for states that wish to bring outdated laws on security interests into line with modern international financial market practice and expectations. The work of EBRD in connection with its Model Law on Secured Transactions6 is expressly acknowledged. As the preface to the Guide states:
The Guide is based on the premise that sound secured transactions laws can have significant economic benefits for States that adopt them, including attracting credit from domestic and foreign lenders and other credit providers, promoting the development and growth of domestic businesses (in particular, small and medium-sized enterprises) and generally increasing trade.
In his commentary on the Guide,7 Spiros Bazinas (a senior legal officer of UNCITRAL) remarked:
… with few exceptions, secured credit law is based on a multiplicity of statutes (or non-statutory rules) that leave gaps, present inconsistencies and, in any case, create legal uncertainty. Uncertainty in this context means credit at a high cost, less or no credit, depending on whether the risk can be reasonably estimated. The effect of this result on the development of businesses in international markets cannot be anything but negative.
(p. 336) 18.06 In 2016, UNCITRAL published its own Model Law on Secured Transactions which, it is stated, addresses the gaps and uncertainties created by the multiplicity of regimes by adopting ‘a unitary approach using one concept for all types of security interest, a functional approach under which the Model Law applies to all types of transaction that fulfil security purposes, such as a secured loan, retention-of-title sale or financial lease, and a comprehensive approach under which the Model Law applies to all types of asset, secured obligation, borrower and lender.’
18.07 UNCITRAL has also published a Model Law on Cross-Border Insolvency (which has been adopted, with some modifications, in the UK),8 a Legislative Guide on Insolvency Law (2004) and a Practice Guide on Cross-Border Insolvency Co-operation (2009).
18.08 UNIDROIT (the International Institute for the Unification of Private Law) is an independent inter-governmental organization (originally set up in 1926 and re-established in 1940) based in Rome. It has 63 member states. According to Article 1 of its statute, the purposes of UNIDROIT are to ‘examine ways of harmonising and coordinating the private law of States and groups of States, and to prepare gradually for the adoption by the States of uniform rules of private law’. To that end, UNIDROIT prepares draft laws and conventions, and undertakes and organizes related studies and conferences. The UNIDROIT Hague and Geneva Securities Conventions are considered in Chapter 26. Another important UNIDROIT convention affecting international financial markets is the 2001 Cape Town Convention on International Interests in Mobile Equipment, together with the related Protocol on Matters specific to Aircraft Equipment.9 An official commentary on this convention and protocol by Professor Sir Roy Goode can be found on the UNIDROIT website (which also has the convention texts). In 2013, UNIDROIT finalized its Principles on the Operation of Close-out Netting Provisions.10
18.09 The EBRD is an international financial institution that supports projects (project finance being its core business) in more than 30 countries, centred on those that formerly comprised the Soviet Union and its various satellite states but also including others, such as Turkey, in the geographical region of Central and (p. 337) Eastern Europe, its neighbours to the East (including Russia) and Central Asia and, more recently, countries in the Southern and Eastern Mediterranean area. The bank is concerned to promote transition to a market economy in its countries of operation. Its ‘Legal Transition’ programme, which is part of its legal department (or ‘Office of the General Counsel’) is concerned with law reform proposals in these countries where reform is likely to make the attraction of foreign investment easier and generally improve access to credit. Its activities fall under the following headings:
• Taking part in international standard setting initiatives.
• Monitoring and analysing the progress of legal transition in its countries of operation and assessing legal risk for investments in those countries.
• Advancing legal reform through ‘outreach’ activities, such as the publication of its journal ‘Law in Transition’.
• Developing and implementing technical assistance projects of various kinds.11
18.10 The focus areas of the Legal Transition Programme have been: capital markets and corporate governance; concessions; judicial capacity and contract enforcement; insolvency; secured transactions; and telecommunications regulatory reform. The bank regularly publishes a journal, ‘Law in Transition’, with news and information about its efforts in this area.
18.11 The Secured Transactions Reform Project, which was initiated in 1992, is a good example of the work carried out by the Legal Transition Programme. When EBRD started its operations (in 1991) it found that the laws of the various countries that comprised ‘its region’ fell a long way short of being conducive to debt or equity investment. After decades under communism, the region needed a radical re-think about the role of law itself alongside the evident, and welcome, change of political direction. Law was no longer simply the instrument by which the state controlled its citizens’ activities, it was now to be seen as something that should facilitate commercial activity in a new, market-based economy. And that commercial activity would, of course, include building up new businesses and improving public infrastructure with the use of a combination of private and public funding, much of which would come from outside the region (including from the bank itself). Debt finance is, of course, not necessarily dependent on the availability of security (or ‘collateral’, to use the term that seems now to be gaining ground) but including collateral in the transaction may well improve the pricing from the borrower’s perspective and, in the case of project finance, it makes it possible to contemplate deals that otherwise might not get done at all. So, as the EBRD region started to look across borders for inward investment, attention focused on how ‘user-friendly’ the region’s laws were for that purpose and, more specifically, what those laws could offer as forms of collateral for foreign (p. 338) creditors. The options available were not particularly appealing. As Emmanuel Maurice, the bank’s General Counsel put it:
The choice of collateral is driven by the circumstances, such as the availability of assets, value and market liquidity. At a minimum, the law should provide such a choice to lenders and borrowers. Yet, in 1992, this was not the case in any of the EBRD’s countries of operations, and is still not the case in too many jurisdictions today.12
18.12 Although there has undoubtedly been progress since 1992, including the publication of EBRD’s ‘Model Law on Secured Transactions’13 as well as various papers setting out ‘guiding principles’ and several surveys, ‘the task is not complete’, according to Maurice. Questions of economics combine with legal questions on the reform agenda. Why, for example, is it that some countries have much ‘deeper’ credit markets than others? Is it because the countries with ‘shallow’ credit markets suffer from inadequacy of information in the system as to risk—a problem to be cured by better institutions to make the information available—or is it more because of inadequate legal protection for creditors in those countries—a problem to be addressed more by law reform that improves creditors’ rights? In the first chapter of a book co-edited by two lawyers (Frederique Dahan and John Simpson) from EBRD’s Law in Transition team, Florencio Lopez-de-Silanes considers these issues in detail. Not surprisingly perhaps, the conclusion is that work needs to be done on both fronts (the diagnoses are not, after all, mutually exclusive). Better information-sharing institutions, such as property registries and credit bureaus, are recommended—as are improvements in creditor rights and the mechanisms for enforcing those rights (including in relation to the court systems themselves). Chapter 2 of the same book, by Thorsten Beck, also looks at policy issues and the options for ‘building efficient and inclusive financial systems’. Many of the points made will now have a particular resonance in the aftermath of the Crisis. For example, Beck observes that:
Given the maturity transformation—using deposits withdrawable at short notice to finance medium to long term loans—and given the limited transparency of financial institutions, banks have been subject to special regulation and supervision not applied to non-financial corporations. Given the put-option character of bank equity, bank shareholders participate only in the upside risk of the bank business and have therefore strong incentives to take too aggressive risks, ignoring sound and prudent risk management. Effective bank regulation and supervision, as well as market discipline exercised by large depositors and creditors, can keep bank owners and managers in check. The question is, as before, what measures are appropriate to take without running the risk of negative effects on financial system depth and breadth.
Financial contracts depend on the certainty of the legal rights of borrowers, creditors and outside investors and the predictability and speed of their fair and impartial enforcement.
18.14 This is important, given that ‘financial contracts consist of an exchange of money today for the promise of money tomorrow’. Thus, if macroeconomic stability is a ‘first building block for an effective financial system’ and a sound informational system is a second, the third ‘crucial pillar’ is comprised of private property rights and enforcement of contracts.
18.15 Dahan and Simpson contribute a chapter to the book14 where they look at two questions:
18.16 The authors are able to draw on the experience of EBRD in the law reform process in its region. The need for the reform to be ‘efficient’ is emphasized. For example, ‘Secured transactions are encouraged because of the economic benefits that can be derived from them and the law is needed first and foremost to enable those economic benefits to be maximised.’ The process of law reform is broken down into four stages: (1) consultation and the decision to reform; (2) designing and passing of legislation; (3) establishing the necessary institutions and implementing mechanisms; and (4) bringing the law into force. The potential traps and pitfalls in each stage are discussed and some useful tips for foreigners providing ‘technical assistance’ are noted. These include: letting local lawyers do the drafting; avoiding the importation of foreign legal concepts; developing an understanding of the local legal tradition; and maintaining objectivity and detachment.
Certainty is a critical element of any sound legal system. A grain of uncertainty in the legal position can have a pervasive and disproportionate effect. Once a banker hears that there is some doubt in the legal robustness of a transaction, he will fast become hesitant. The difficulty is one of measurement. If the legal uncertainty relating to a pledge or a mortgage could be stated, for example, as a 5 per cent chance of proceeds on enforcement being reduced, with the amount of the reduction being on average 20 per cent, the risk would be quantified and it would become easier to manage as there would be relative certainty. But in reality legal opinions cannot (p. 340) be expressed in that way. And the natural reaction to unquantifiable uncertainty is extreme caution. Transparency can often strengthen certainty: for instance easy access for all to information in the land register allows potential mortgage lenders to find out about the property and any other mortgages that may be claimed.
18.18 The need for legal certainty is a global issue in what is still, even after the Crisis, a global market. The difficulties in managing legal risks that flow from that uncertainty are also an ongoing concern. When law is ‘in transition’ itself, this is bound to result in some uncertainty, whether the transition is part of a more general economic reform or part of a drive for worldwide regulatory change. But if, as Dahan and Simpson in the passage quoted above say, legal uncertainty can lead to ‘extreme caution’ this can have a distinctly chilling effect. At the time of writing, many economies are still struggling to recover from the effects, and after-effects, of the Crisis. Impediments to that recovery which add legal uncertainty to economic uncertainty should be eradicated if at all possible. In a world which is still in the process of globalization, the tendency has been for the law to be in a position of playing ‘catch-up’ to the changes that have taken place in the market or in the wider political sphere. This is inevitable. What is important is that the law does in fact ‘catch up’ and achieve a higher level of international consistency and effective implementation15 as soon as possible. Leaving it too long is not only likely to result in inefficiencies but also present risks that are difficult to manage and could, if left unaddressed, present systemic problems.
6 See Section C of this chapter.
10 See, generally, Ch 22.
13 See Rover, Secured Lending in Eastern Europe (Oxford University Press, 2007) Ch 7.