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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, 3 Legal and Conduct Risk in the London Market

Roger Mccormick, Chris Stears

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

Roger McCormick, Chris Stears

Credit risk — Financial stability

(p. 39) Legal and Conduct Risk in the London Market

The style of financial case law is, in general, as pragmatic as that of the markets it serves.1

3.01  All jurisdictions, of course, present their own distinct legal risk issues but English law, as one of the favoured ‘governing laws’ for financial market documentation and the ‘home law’ for the City of London, is worthy of analysis in its own right in the context of legal risk management. Such analysis is far from a parochial exercise.2 Many of the issues considered in the English courts and the London market have parallels elsewhere. Indeed, it is a feature of the markets that phenomena such as the imposition of sanctions or penalties for various forms of market abuse and other kinds of misconduct frequently arise with near-simultaneity on both sides of the Atlantic. Further, legal issues affecting the wholesale financial markets in London usually affect the markets in the EU as a whole (and vice versa), depending, to some extent, on the degree of ‘harmonization’ achieved. (It is likely that this will continue to be the case notwithstanding Brexit.) It is notable, in this context, that legal projects undertaken by bodies such as the FMLC have often taken place at the same time as parallel projects in other countries.3

3.02  In reviewing how the City of London and the English courts have dealt with legal risk issues, particularly as regards defective documentation risk, we shall see that the establishment, and activities, of the Legal Risk Review Committee, the Financial Law Panel, and the Financial Markets Law Committee have been of crucial (p. 40) importance. Bodies like this are now rightly seen as part of the ‘legal infrastructure’ of the wholesale financial markets. Also—and in a broad legal and conduct risk context—the rules, policies, and practices of the Financial Conduct Authority are of great, and growing, significance. And, following Sir Richard Lambert’s review of banking standards4 and the Fair and Effective Markets Review5 of wholesale market conduct, we now have two highly influential bodies: The Banking Standards Board and the FICC Market Standards Board.6 These bodies do not have strict ‘enforcement’ powers as they do not espouse binding ‘law’ or ‘regulation’. However, they are charged with defining and sustaining good practice standards for the banking and wholesale markets respectively, and to this extent, the work of these bodies will represent norms of behaviour that can be expected in the lawful discharge of duties—whether at common law or when relying on a ‘reasonable precautions and exercised all due diligence’ defence to regulatory action. A bank that chooses to ignore these norms will be taking potentially serious legal risks. With these developments, it is clear that the interaction of law, regulation, and the financial markets at various levels, set against the background of increasingly globalized markets, provides a vital social context to the many technical legal developments. As Jaime Caruana (at the time, the Chairman of BCBS) astutely pointed out, ‘the legal and judicial system must make the rights and responsibilities of both banks and their counterparties clear and enforceable so that banks and borrowers can make the most effective use of collateral, guarantees and other measures to secure credit’.7 Indeed, the importance not only of legal certainty but of managing the legitimate expectations for financial market conduct is reflected in the preamble to each of the FMSB standards and the statement of good practice in which the Board emphasizes the need for guidance to resolve ‘a lack of clarity in the standards of behaviour expected of market participants, or a lack of understanding of the issues relevant to a product or transaction type, or evidence of poor conduct’.8

3.03  The mutual interdependence of the legal profession (including the judiciary) and those who wish to preserve London’s position as one of the leading international (p. 41) financial centres (even after the Financial Crisis) is one of the dominant themes to emerge from this exercise. The financial marketplace can only function properly in an environment which provides a satisfactory level of legal certainty. Although the English courts are not enslaved by the need for commercial efficacy, the development of English case law over more than a hundred years has taken place against a background of consistent judicial awareness of a policy objective that, as far as possible, commercial bargains should be enforceable in accordance with their terms and that a successful marketplace does not welcome legal (or regulatory) ‘surprises’. Even in the (somewhat notorious) case of Hazell v Hammersmith and Fulham London Borough Council,9 the Court of Appeal noted that ‘fundamental fairness and pragmatic good sense … are boasted to infuse’ the common law of England and, more recently, in the course of a judgment which appeared (at least in part) to be intended to address market anxieties about the celebrated dictum of Millett J in Re Charge Card Services Ltd,10 Lord Hoffmann noted that ‘law is fashioned to suit the practicalities of life’.11 This judicial awareness of market pressure has only increased as the City of London has become more open to international competition for its preeminent role as a leading financial centre. As Goode notes:

In a world financial centre such as London it would be surprising indeed if the courts were insensitive to the need to uphold reasonable business practice where not otherwise constrained by rules of positive law. In a major market the consequences of a refusal to accept the market’s perception of the legal nature and incidents of contracts and financial instruments in widespread use could be severe; indeed, in some cases confidence could be seriously undermined … There is therefore considerable scope for the business community to establish law through practice and thus, as it were, pull itself up by its own legal bootstraps.12

3.04  English law has provided a number of examples of law being established through practice in recent years. Mercantile usage or custom has, in any event, always been an important source for English commercial law. An example of the practicality and flexibility that results from this, which is of enormous importance to bankers, can be found in the law relating to negotiable instruments, which expressly recognizes that, although instruments such as bills of exchange, cheques (p. 42) and promissory notes are conferred by statute with the important beneficial characteristics of negotiability, the categories of negotiable instruments are not closed and new instruments can be added to the list which, in a sense, updates itself in line with the custom and practice of the market.13 The law follows, and automatically adjusts to, market practice. Another example can be found in the law relating to the duties of paying banks in connection with letters of credit. The duty of care relating to the inspection of shipping documents is such that although a bank may refuse to pay in the absence of strict compliance, it is protected against claims from its customer as long as it acts reasonably, a test which turns substantially on market practice.14

3.05  Bodies like the FMLC (and its predecessors) are clearly very conscious of the need to act as ‘a bridge to the judiciary to help UK courts remain up to date with developments in financial markets practice’.15 The FMLC, in performing what it describes as its ‘radar’ function, consults regularly and widely with market participants to ensure that it is aware, on a current basis, of any legal issues that are perceived to be adverse to the orderly functioning of the markets. The virtues of English commercial law are seen to be part and parcel of the general ‘invisible export’ effort. They give London a significant ‘edge’ because of the ‘certainty’ qualities of the common law system. In a letter, dated 1 September 2003, addressed to Lord Woolmer (the Chairman of a House of Lords Subcommittee concerned, amongst other things, with the European Commission’s ‘Financial Services Action Plan’)16 Lord Browne-Wilkinson (at that time, the Chairman of the FMLC, and, prior to his retirement, the UK’s senior law lord) observed that ‘wholesale financial markets require, and by their regulators are required to exhibit, an unusually high level of “to-the-minute” and “to-the penny” legal certainty. In English law, business dealings are governed by that part of the common law known as commercial law. English commercial law offers its users the opportunity to achieve a level of legal certainty greater than in almost any other walk of life.’ Similar remarks can be found in an earlier letter17 from Lord Browne-Wilkinson (again, in his capacity as Chairman of the FMLC) to Sir (p. 43) Roger Toulson, the Chairman of the Law Commission, resisting proposals that laws invalidating ‘unfair’ contract terms should be extended (beyond consumer contracts) to, amongst other things, ‘the type of contract which arises in the wholesale financial markets’. Expressing the view that ‘legal certainty is even more important in a commercial environment than fairness’, Lord Browne-Wilkinson drew attention to why the LRRC had been set up in 1991 and its conclusions on the importance of legal certainty, including the following points with regard to the financial markets:

  • •  These markets are an important contributor to the UK’s GNP and foreign earnings.

  • •  They involve huge sums, so that unpredictable legal results could produce huge unexpected losses, leading to market instability.

  • •  The markets are international—they are not locked into the English legal system but are free to choose another, if English law is considered to be unsafe.

  • •  Market participants assume that transactions freely entered into will be upheld as legally valid, unless there is a compelling reason to the contrary which would be reasonably apparent to a prudent and sophisticated person taking whatever advice is appropriate to the transaction in question.

  • •  Markets depend on certainty (including legal certainty). Lack of certainty undermines confidence and the damage can spread far beyond its original cause.18

3.06  Comparable sentiments are frequently echoed in the language used by the judges themselves. For example, in the case of Scandinavian Trading Tanker Co AB v Flota Petrola Ecuatoriana19 Goff LJ noted:

It is of the utmost importance in commercial transactions that, if any particular event occurs, which may affect the parties’ respective rights under a commercial contract, they should know where they stand. The court should so far as possible desist from placing obstacles in the way of either party in ascertaining his legal position, if necessary with the aid of advice from a qualified lawyer, because it may be commercially desirable for action to be taken without delay, action which may be irrevocable and which may have far-reaching consequences. It is for this reason of course that the English courts have time and again asserted the need for certainty in commercial transactions—for the simple reason that the parties to such transactions are entitled to know where they stand, and to act accordingly.

3.07  Writing extrajudicially in 1984, the same judge also noted, with respect to the judges’ role:

We are there to help businessmen, not to hinder them; we are there to give effect to their transactions, not to frustrate them; we are there to oil the wheels of commerce, not to put a spanner in the works, or even grit in the oil.20

(p. 44) 3.08  However, as Hart has famously observed,21 ‘all rules have a penumbra of uncertainty where the judge must choose between alternatives’. Judges are not mere fact-finders, applying immutable legal rules to the facts that present themselves. They make law on occasions as well. This has considerable advantages as long as the ‘bridge’ between the market and the judges remains strong, not least because commercial courts can sometimes take the opportunity to ‘clear up’ uncertain areas of the law which cannot get the attention of the legislature. But the corollary is that, from time to time, there will be legal uncertainties (for example, pending the hearing of an appeal from a controversial decision) and the resultant risk has to be managed.22

3.09  Although English commercial law can (notwithstanding the Financial Crisis) rightly be seen as a success story in providing a rules and principles system that works very well for rapidly evolving financial and commercial practice, and there are even examples of English law based systems being, in effect, exported to ‘commercial (or financial) law centres’ in countries such as Qatar, it is important that we do not become complacent. In the Financial Times of 27 May 2009, it was reported that, ‘The financial crisis has weakened the world’s embrace of English-style commercial law and dealt a blow to London-based firms’ efforts to expand in leading emerging economies …’ According to Lord Woolf (in an interview given before an important conference in Qatar, where Lord Woolf is the senior judge for the financial centre) there is talk about ‘a general sense of malaise with western standards’ and ‘that goes into the common law system, because it’s very much part of what we have been promoting in China, Japan and Russia.’ Although the perceived ‘failings’ in London’s experience of the Crisis would seem to have been of a regulatory nature rather than of English commercial law generally, the reputational damage spreads easily to the system as a whole.

3.10  The financial markets, even in relatively settled times, are volatile, mobile, and hypersensitive to risk and uncertainty. Legal risk is more likely to be successfully (p. 45) managed if we maintain an effective dialogue amongst legislators, judges, and lawyers in private practice. As we shall see, the management of legal risk is not exclusively a function and responsibility of either the public sector or the private sector acting alone, and open communication amongst all those involved (sometimes on an international basis) is vital if management efforts are to be successful. The importance of effective dialogue has only been reinforced by the advent of globalization, which has accentuated the need for London to compete effectively with other actual and potential financial centres and by the need to respond effectively to the Financial Crisis. As the FSA said (in describing itself): ‘Ultimately, the FSA is all about maintaining confidence in the UK’s financial marketplace for the benefit of everyone.’ This has not changed under the stewardship of the FCA, which continues to engage with its European and global counterparts through standing committees, joint task forces, and board memberships.23 Still, there remains a need to restore confidence, not just maintain it. And that can only be done if a solid legal foundation is preserved and kept up to date.(p. 46)


1  Benjamin, Financial Law (Oxford University Press, 2007) at 1.06.

2  As Wood points out, ‘ … England is only 0.33% of the world’s jurisdictions. It occupies less than 0.01% of the planet’s land mass and has less than 0.75% of the global population. Nevertheless, if we take the world’s most important and biggest international contracts—which are syndicated credits, bond issues and to a lesser extent ISDA master agreements—it may be that somewhere between 40% and 70% of international bond issues are governed by English law and the proportion of international syndicated credits may be the same … English law is the workhorse of international contracts’ (‘English law and legal leadership in the global economy’—a paper given to the Chancery Bar Association, 23 June 2003).

3  See, eg the issues considered in Ch 26 below.

4  The Review recommended the establishment of an independent, albeit industry-sponsored, Banking Standards Review Council (BSRC). The BSRC later became the Banking Standards Board (see, <http://www.bankingstandardsboard.org.uk/what-is-the-bsb/>). At the time of writing, the BSB has focused more on individual ‘competence’ and ‘professionalism’ than on market practice standards.

5  This was a tripartite review of the fixed income, currency and commodities (FICC) markets by HM Treasury, the Bank of England, and the Financial Conduct Authority. The review called for the establishment of an FICC Markets Standards Board that would look to create ‘stronger collective processes for identifying and agreeing standards of good market practice, consistent with regulatory requirements …’ (see, FMSB website at <http://www.fmsb.com>).

6  See Ch 12.

7  Caruana, ‘Making diligent preparations for Basel II’, 22 September 2004, speech delivered to 13th International Conference of Banking Supervisors.

8  See, for example, FMSB, ‘Binary Options Standard, for the Commodities Markets’, Standard #2006-002 (Final November 2016).

9  [1990] 3 All ER 33; see generally Ch 20 below.

10  [1987] Ch 150. The dictum was believed to cast doubt on the ability of a bank to take a charge over money deposited with it; see further Ch 21 below.

11  Morris and ors v Rayners Enterprises Inc, Morris and ors v Agrichemicals Ltd (BCCI No 8) [1998] AC 214 (this case is referred to below as ‘BCCI No 8 ’). In the same case the Court of Appeal was clearly mindful of the potential ‘market impact’ of its decision. In looking at the Charge Card case, the Court noted: ‘It is important that … routine financing arrangements should not be put at risk. If the reasoning in re Charge Card Services Ltd led to the conclusion that charge-backs were invalid or ineffective to give security in the event of that chargor’s insolvency, then that reasoning would be suspect; and if it could not be faulted we would be willing to sacrifice doctrinal purity on the altar of commercial necessity ’ (emphasis added). See further Ch 21 below.

12  Goode, Commercial Law (3rd edn, Penguin, 2004) 159.

13  Examples of instruments that are negotiable as a result of mercantile usage include treasury bills, bearer bonds, share warrants, and negotiable certificates of deposit: see Goode, Commercial Law (3rd edn) 477.

14  See, eg Edward Owen Engineering v Barclays Bank International Ltd [1978] QB 159.

15  See FMLC website: <http://www.fmlc.org>. See also the author’s interview with Lord Woolf (at the time, the Chairman of the FMLC) first published in LFMR Vol. 1 No. 1 at 3 and reproduced in Appendix 1.

16  This plan was launched by the EU in 1999 (following the introduction of the euro) as part of a drive to create a single European financial market. It has, however, met with a number of difficulties in implementation and there remain many areas where there is a distinct lack of harmonization. The commissioner in charge of the EU internal market, Charles McCreevy, is reported as being ‘convinced by the argument of regulatory fatigue’ and has acknowledged that the plan has produced a ‘mountain of legislation’, see Financial Times, 17 January 2005.

17  Dated 20 June 2003.

18  The need to ‘respect … the rule of law and principle of legal certainty’ is also expressly mentioned in the code of practice issued under the Banking Act 2009 (see para 8.41 below).

19  [1983] QB 529, 540.

20  ‘Commercial Contracts and the Commercial Court’ [1984] LMCLQ 382 at 391. The authors are grateful to Andrew McKnight for bringing this passage to their attention.

21  Hart, The Concept of Law (2nd edn, Oxford University Press, 1994) 12. This statement, by a leading academic and barrister, was echoed by the reference by Hoffmann J (as he then was) in Re Brightlife Ltd [1987] Ch 200 to ‘penumbral cases’ when it is difficult to determine whether a security interest is or is not a floating charge (which Hoffmann J did not think could be defined precisely), a question which may turn on ‘whether the degree of deviation from the standard case is enough to make it appropriate to use such a term’.

22  In his Chief Executive’s report, set out in the FLP’s first Annual Report, of October 1994, Colin Bamford points out that: ‘Legal uncertainty can take a number of forms: the law itself may be unsettled; the law may be settled, but of such complexity that it is not generally understood by non-specialist lawyers; or the law, although in itself quite clear, may have consequences and practical effects which are not easy to quantify or evaluate.’ As to sources of legal risk generally, see Ch 25 below.

23  The FCA participates in a range of policy and regulatory fora such as the Investor Protection and Intermediaries Standing Committee, the Commodities Derivatives Task Force, the International Organisation of Securities Commissions, and the International Association of Insurance Supervisors, as well as the Financial Stability Board, the Financial Action Task Force, and the Organisation for Economic Co-operation and Development.