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Legal and Conduct Risk in the Financial Markets, 3rd Edition by McCormick, Roger; Stears, Chris (22nd March 2018)

Part I The General Context, 1 Why Legal and Conduct Risks are Important: A Short History

Roger Mccormick, Chris Stears

From: Legal and Conduct Risk in the Financial Markets (3rd Edition)

Roger McCormick, Chris Stears

Subject(s):
Credit risk — Derivatives — Financial stability

(p. 21) Why Legal and Conduct Risks1 are Important

A Short History

An element of legal uncertainty is inevitable in wholesale financial markets that are international, competitive and innovative.2

1.01  Banks and financial institutions trade, for the most part, in products that are ‘creatures’ of the law rather than tangible goods. Commercial banks, for example, are regulated principally because they accept deposits from the public. Their business is the creation of, and trade in, ‘intangibles’, such as debts and similar obligations, of varying degrees of complexity. These intangibles (unlike tangible property such as land, ships, or aircraft) exist, in law, as ‘things’ (or ‘choses in action’, to use a legal term)3 capable of being owned as property only because we, through our financial dealings with each other, bring them into existence. Trade in goods and other physical ‘things’ frequently involves credit, and so the ordinary trade transaction, which is primarily about something that we can touch and see, also gives rise to things that we cannot touch or see—‘invisibles’ and ‘intangibles’, such as debts and various other kinds of claim. Things that fall into this latter category, which may themselves be owned and traded, owe their existence (and value) to the legal infrastructure that recognizes the intellectual concepts that underpin them. They are the lifeblood of banking business. For a bank, therefore, legal risk, when it threatens the legal validity or nature of an ‘intangible’ asset owned by it or exposes the bank to large claims, is somewhat akin to, say, engineering risk for an aircraft manufacturer, maintenance risk for a railway operator, or fire and earthquake risk for an owner of valuable real estate. In the worst case, the bank may lose a great deal of money, its reputation, possibly the ability to continue in business, and—now most poignant in the context of (p. 22) conduct risk—may even lead to criminal liability for the institution, its directors, or employees. The link between legal risk and reputational risk is very close. In financial markets, the loss of, or severe damage to, reputation can, at the very least, cause the business to lose key mandates and relationships and, at the worst, may cause a swift disintegration of the business itself. Further, a major loss for a bank, if it threatens the bank’s financial survival, frequently causes reverberations around society as a whole. It is indicative of the importance of legal risk that in the ‘War Game’ exercise carried out by the UK regulatory authorities in 2004, to simulate risks to the financial system, the trigger event in the exercise was an imaginary unfavourable decision of the European Court of Justice: a classic example of legal risk.4 The simulation assumed that the ruling of the court ‘created a behind-the-scenes run on banks that were heavily exposed to the property sector’ according to the Financial Times report.

1.02  The recent history of the financial markets, from around the time of the first major UK privatization share issues of the 1980s, has featured a number of significant developments that have tended to bring concern about legal risk, albeit in specific contexts, to the fore. These include the growth of global markets, the arrival of ‘universal’ banks (whose business involves much more than banking, as traditionally understood) and the huge expansion of markets in instruments commonly known as ‘derivatives’ and other highly structured financial products. These products are created, in some cases, as a result of ‘securitization’ transactions whereby loans and other assets which, in the 1970s and 1980s, would generally have been held on an originating bank’s books are converted, in effect, into tradeable securities issued by special purpose vehicles (or SPVs). Such developments have brought benefits but they have also added greatly to the complexity of financial activity. Many argue that they (or, rather, their misuse or misapplication) have been direct contributors to the underlying causes of the Financial Crisis.5 No one would deny that the complexity has led to increased risks of, for example, misunderstanding the nature of the instruments in question or of their economic implications. Their complexity has also increased awareness of legal risk.

(p. 23) 1.03  However, legal risk is not a new phenomenon for banks to deal with. In the 1960s, for example, the English courts were still grappling with questions such as the appropriate definition of a ‘bank’ (the penalty for lending money if you were not a bank being that the loan transaction was unenforceable) and even invented a new tort (of negligent misstatement) that, in the case in question, had specific application to an unreliable banker’s reference.6 These were basic, fundamental issues. It is hard to imagine that the English courts would have to decide today questions as basic as ‘what is a bank?’7 Nevertheless, even as late as the 1980s, case law on questions such as the validity of corporate guarantees was still developing,8 with resultant uncertainty for lending banks. Case law developments on some fairly fundamental issues associated with the kind of security that banks can take for loans to customers still continue9 and the ‘Lehmans cases’ considered in para 8.61 et seq. demonstrate that rules as fundamental as the ‘anti-deprivation rule’ in insolvency are still subject to ongoing review and refinement in the courts (and that the courts in different jurisdictions may have different views on such rules).

1.04  The earlier cases involved and, arguably, exacerbated legal risks for financial institutions, but they did not produce a reaction that compared with the extremely hostile response of the markets to various, more recent, case law developments in the English courts in the late 1980s and early 1990s. What caused the markets to become so much more sensitive about what we started to describe as ‘legal risk’ at that time? Was the reaction caused by the nature of the issues decided by the courts or had something changed in the markets themselves? Was this when we suddenly ‘woke up’ to legal risk? To what extent should we still be worried about it?

1.05  One reaction to the more recent case law, and perhaps the most significant, came from the Bank of England. This was the formation (in April 1991) of a committee, called the Legal Risk Review Committee (LLRC), which, amongst other things, considered whether the state of the law at that time involved too much ‘legal uncertainty’. This short phrase (which is now in common use whenever legal risk is a topic of discussion) related to concerns in the markets which could hardly be more fundamental, ie ‘uncertainty over whether financial transactions freely entered into in the wholesale financial markets might suddenly turn out (p. 24) to be based on shifting legal foundations’.10 Some of the language used in the LRRC’s Final Report11 shows the depth of these concerns. One case, for example, that had been decided shortly before the publication of that report, was described as being ‘of real practical concern to the markets’12 and the ultra vires doctrine (which had featured in another case involving ‘swap’ transactions with a local authority) was described as leading ‘to a denial of legitimate expectations that bargains will be enforced’ and, as a result, ‘damaging to the market’.13 In reviewing the impact of a number of recent cases involving swaps with local authorities, the LRRC was trenchant in its views: ‘There is no doubt that the swaps saga has damaged the reputation of English law. One way or another, it is important to ensure that it does not happen again.’14 As we now learn to live with the aftermath of the Financial Crisis and seek to understand the implications of the Conduct Crisis,15 it is interesting to reflect that, for very different reasons, derivatives (in the form of relatively ‘plain vanilla’ swaps) and technical issues relating to set-off rights featured centre stage in the legal risk world back in the last decade of the last century as much as they do in the early part of the 21st century.16

1.06  Apart from specific law reform proposals, the LRRC felt that one way of achieving its objectives, and ensuring that in the future the interests of the markets were more appropriately taken into account by all concerned, was to set up a new body ‘without precedent either in this country or, as far as we are aware, any other’, under the aegis of the Bank of England, to be a ‘central forum’ for the discussion and resolution of issues of legal uncertainty affecting the wholesale financial markets and services in the UK.17 This recommendation was swiftly implemented, and the body was set up as the Financial Law Panel (FLP).

1.07  The LRRC (and later the FLP) was composed of some of the most senior and respected lawyers and bankers in the land. Its views were representative of the vast majority of City of London practitioners. The concern about legal risk at the beginning of the 1990s was real and widely felt. A decade later, legal risk was still providing much food for thought. For example, in July 2001, the FLP launched a new project ‘to try to bring clarity and consistency to this topic’.18 This initiative took place against a background of growing acceptance of the need (p. 25) for more sophisticated risk management techniques in the management of commercial enterprises. This was evidenced in the UK by requirements such as those of the Combined Code on Corporate Governance, which applies to all listed companies, and involves an annual review by directors of systems of ‘internal control’.19 Throughout the preceding decade, the FLP had issued numerous papers on issues concerned with legal risk, and that work still continues with the activities of its successor body,20 the Financial Markets Law Committee (FMLC). The FSA has also been actively involved in this area, particularly with regard to risk management. In a letter dated 24 August 200421 issued by the FSA to chief executives of life insurance firms and friendly societies, concern is expressed that such firms ‘may not be exercising sufficient management control over legal risk’ and they are urged to ‘look again at their procedures for managing legal risk’.22

1.08  Concerns about legal risk in the context of the reliability and ‘user-friendliness’ of English commercial law are not as great now as they were at the time of the formation of the LRRC23 but, as stated above,24 the general topic of legal risk, which is multifaceted (and includes conduct risk), is still very high on the agenda for many financial market participants and regulators in the UK, the EU and the USA, as well as elsewhere. Even in areas where uncertainties or other problems are perhaps more imagined than real it remains important, particularly in the febrile atmosphere that has pervaded the financial markets since the Financial Crisis, that unfounded doubts or anxieties do not take hold in a way that adversely affects market activity. Perceptions of problems, even if misconceived, can sometimes be almost as damaging as the problems themselves.

1.09  This book is not primarily concerned with the causes of the Financial Crisis. However, the events that led up to the Financial Crisis and the various responses of government and others in its early phases do require some consideration insofar (p. 26) as they have a bearing on why the Financial Crisis has had an impact on legal risk including, especially, conduct risk. It is clear that the Financial Crisis, which made society re-examine the fundamentals of what it expects from the financial system, has had such an impact. It has, for example, caused new legislation to be introduced in the UK that affects the rights of shareholders in banks, giving the authorities the right to exercise so-called ‘stabilisation powers’ that can result in the effective confiscation of either their shares or the assets of the banks themselves. Such powers may also have a dramatic impact on the rights of counterparties to transactions with banks. The Financial Crisis has raised concerns about the effectiveness of governance regimes in banks and other financial institutions and, especially, the effectiveness of non-executive directors. Following the LIBOR scandal25 and the onset of the Conduct Crisis, this has spread to questions about the ‘culture’ that operates inside banks and the need to reconsider the relationship between business activity and morality. It has, generally, triggered widespread demands for more effective regulation in a great many areas and a search for better ‘standards’26 to supplement the conventional regulatory regime. On a more technical level, it has demonstrated the inadequacy of the general corporate insolvency regime for dealing with the complex issues that arise when a high profile international financial institution gets into financial difficulties and has raised some issues of particular complexity in the context of the insolvency of investment banks. The combined effect of the changes in the bank insolvency regime in the UK, changes in the approach to governance and the fact that (for the time being at least) several major banks have large public sector shareholders goes to the heart of what kind of legal animal a bank actually is.

1.10  Bank insolvencies triggered by the Financial Crisis have also caused market participants to re-think some of the standard provisions in documentation that had tended to be based on the assumption that the collapse of a bank as well known as, say, Lehman Brothers was, in practice, ‘unthinkable’. The need for such reassessment has been further emphasized by the substantial and extensive new case law that has resulted from the Lehmans collapse. Finally, the various ‘Ponzi’ schemes and other frauds and dubious practices exposed by the Crises have had their own legal and reputational risk consequences both in relation to the litigation that has resulted and also in relation to the impact, direct and indirect, on how the legal responsibilities of those involved in fund management and advisory roles are now viewed and the borderline between such roles and market making and proprietary trading.

1.11  The effects of the Financial Crisis and, in its aftermath, the Conduct Crisis, therefore, require coverage in this book in order to provide both analysis of the new, or newly appreciated, risks and also consider the impact of the Crises on risk (p. 27) management. Risk management in financial institutions must, for example, now take into account the extremely low esteem in which banks and bankers are held. This makes them more likely targets for litigation and regulatory action. They are ‘fair game’, at least for the foreseeable future. This results from perceptions as to the banks’ role in causing the Financial Crisis and also from behaviour, at an individual as well as institutional level, that is, rightly or wrongly, seen as greedy or reckless—or both. Risk managers need to have an understanding of how banks got themselves into this position. To understand fully the effects of the Financial Crisis, and how this led on to the Conduct Crisis, it is necessary to devote some coverage not only to what it has triggered but also to the events and behaviour that caused it to arise in the first place.(p. 28)

Footnotes:

1  As explained in Intro 1.05, legal risk is defined in this book to include conduct risk.

2  From the ‘History’ section of the FMLC website.

3  In more recent times, also referred to as ‘things in action’.

4  This was reported in the Financial Times of 31 March 2009. (There were two articles: ‘Bank’s “war game” was plausible to an almost chilling extent’ and ‘War game saw run on Rock’). One of the striking features of the exercise was that it apparently exposed the weak position of both Northern Rock and HBOS in the event of turbulence in the property markets. Although regulators confirmed that the two banks (which of course later succumbed in the course of the Crisis) were ‘central to the war game’ one of the reasons that it failed to alert them to the forthcoming Financial Crisis was that ‘the exercise was focused on uncovering weak regulatory practices rather than predicting individual bank failure.’

5  In a speech on 14 September 2009, Andrew Haldane, the Executive Director (Stabilisation) of the Bank of England, described some of the problems associated with loan assets becoming tradeable: ‘The desire to make loans a tradeable commodity led to a loss of information, as transactions replaced relationships and quantity trumped quality. Within the space of a decade, banks went from monogamy to speed dating.’

6  See United Dominions Trust Ltd v Kirkwood [1966] 2 QB 431 and Hedley Byrne & Co Ltd v Heller & Partners Ltd [1964] AC 465. Throughout this book the term ‘bank’ is generally used loosely and includes other comparable financial/credit institutions.

7  The courts have, however, recently had to consider the meaning of ‘financial institution’; see The Argo Fund Ltd v Essar Steel Ltd [2005] EWHC 600 (Comm).

8  See eg, Rolled Steel Products (Holdings) Ltd v British Steel Corp [1986] Ch 246. In the 1970s case law was also still developing on the nature of foreign currency (whether or not it was a commodity). See Miliangos v George Frank (Textiles) Ltd [1976] AC 443 and Barclays Bank International Ltd v Levin [1977] 1 Lloyd’s Rep 51.

9  See National Westminster Bank plc v Spectrum Plus Ltd [2005] UKHL 41 (considered in more detail in Ch 28 below) for a famous recent example.

10  See LRRC Final Report, October 1992, para 2.1.

11  Published in October 1992.

12  See LRRC Final Report, para 4.2.7.

13  See LRRC Final Report, App 1, para 1.4.

14  See LRRC Final Report, App 1, para 2.6.

15  See Intro 1.06 et seq and Part III for a discussion of the background to and nature and extent of the ‘Conduct Crisis’. Reference to the ‘Crises’ is to both the ‘Financial Crisis’ and the ‘Conduct Crisis’ as defined in this book.

16  See Chs 14, 15, and 16 below.

17  See LRRC Final Report, paras 4.1.2 and 5.

18  See FLP paper, ‘Legal Risk Assessment’, July 2001. This is now available on the FMLC’s website at <http://www.fmlc.org>.

19  See the Turnbull Report published by the Institute of Chartered Accountants in England and Wales (ICAEW). As regards the corporate governance of banks, see para 8.90 et seq.

20  The FMLC effectively replaced the FLP in 2002. To the surprise, indeed consternation, of some, the FLP apparently had to cease activities because its voluntary funding sources were drying up. Whereas the FLP was set up as an independent body (technically, it was a company limited by guarantee and a subsidiary of the Bank of England), the FMLC is a committee of the Bank of England. The Bank provides facilities for the FMLC to meet and its Secretariat. However, the Bank is keen that it should be independent and that any views it expresses should be understood as its own, and not necessarily those of the Bank.

21  Dated 24 August 2004. In a subsequent letter (17 September 2004) to senior officers of banks the FSA wrote a ‘reminder’ of ‘responsibility to implement appropriate processes and procedures for the effective risk management of conflicts of interest and risks arising from financing transactions’.

22  See also the letter of 17 September from Hector Sants (FSA) to various senior executives regarding legal and reputational risk. (Considered in McCormick: ‘Legal Risk Management and Red Flag Scenarios’ (2006) 02 JIBFL 51).

23  Even in October 1992, the LRRC was able to conclude in its Final Report that English law was as user-friendly to the markets as any other, and better than most.

24  See Intro 1.05.

25  See Ch 10.

26  See Ch 12.