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Part II The Financial Crisis of 2007–2011, 8 The Initial Legal and Regulatory Responses to the Financial Crisis in the UK

Roger Mccormick, Chris Stears

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

Roger McCormick, Chris Stears

From: Oxford Legal Research Library (http://olrl.ouplaw.com). (c) Oxford University Press, 2023. All Rights Reserved. Subscriber: null; date: 07 June 2023

Credit risk — Financial stability — UK Financial Services Authority (FSA)

(p. 105) The Initial Legal and Regulatory Responses to the Financial Crisis in the UK

… in the circumstances in which we found ourselves, where on a Monday night a major bank, integral to our financial system, said that it could not get to the end of the day, I think it would have been an act of economic vandalism not to have stepped in and rescued it. But I think we have to design a framework which makes that very, very much less likely in the future.1

A.  Overview of Legal and Regulatory Responses

8.01  This chapter is concerned with the various laws, regulations and comparable measures that were initially2 passed or proposed in response to the Financial Crisis in the UK, the EU and, to some extent, elsewhere, with a particular focus on the extent to which they may be regarded as having a significant legal risk impact. Legislative and other developments that were largely a response to the Conduct Crisis3 (considered in detail in Part III of this book) are considered in more detail in Chapters 13–16. The measures that have come into effect in the (p. 106) UK are considered in some detail whereas measures that affect only other jurisdictions, are considered, in most cases, in outline only. (In addition to regulatory proposals, there have also been a large number of proposals regarding the taxation of banks, bankers, and bank transactions, of varying degrees of precision. These have been ignored for the purposes of this book.) In addition, the significant volume of case law triggered by the Lehman insolvency is also considered.

8.02  The political context for the changes in law and regulation following the Financial Crisis was charged and, to some extent, reflected a level of mistrust of, and disappointment with, the kind of bank behaviour that came under public scrutiny. According to Kirk and Ross:

Public and political opinion has greatly hardened with the discovery of yet more financial services and banking scandal, involving the interbank lending rate (LIBOR), the mis-selling of payment protection insurance (PPI) and the deceptive sale of interest rate swaps to small businesses. These episodes involved billions of pounds and the real suspicion of white collar fraud. Banks have been implicated in international money laundering on a scale never previously encountered. All of which has augmented the public perception that parts of the banking sector were greedy and riven by dishonest and misleading practice. The question was inevitably, why did the regulators let it get so bad?4

8.03  The public’s awareness of poor behaviour in the financial markets was vastly increased by the Crises and the need for political responses has been pressing. They have generally (but not exclusively) taken the form of legislation. A list of the most significant issues that have given rise to political intervention in response to the Crises, is set out below:

  1. 1)  Restore confidence in the banking system: make bank deposits ‘safe’;

  2. 2)  Avoid recurrence of ‘too big to fail’ scenarios and stop banks being exemplars of ‘private profit’ when things go well but ‘public loss’ when things go badly;

  3. 3)  Curb individual greed of bankers;

  4. 4)  Make it more likely that miscreant bankers will face jail sentences;

  5. 5)  Make senior bankers more directly responsible for misconduct of staff who report to them;

  6. 6)  Bring mis-selling of financial products under control; and

  7. 7)  Bring to an end the unfair treatment of small and medium-sized businesses (SMEs) who get into difficulties.

8.04  There has been a range of political responses to these issues. Various mechanisms have been employed, including (a) direct equity investment by government in failing banks or explicit guarantees of deposits;5 (b) legislation on many different (p. 107) topics, ranging from making banks ‘safer’ to creating new criminal offences;6 (c) significant changes to the regulatory ‘architecture’;7 (d) setting up of new Parliamentary Committees and other political groupings8 to review law, practice, and specific events and issues (and make related recommendations); (e) the appointment of independent commissions to report on policy options;9 (f) the creation of a government-owned development bank to aid the delivery of finance and financial services to small and medium-sized businesses10 and (g) at a more mundane level, exploiting perceptions of the causes of the Crises and various related phenomena for party political purposes and other political advantage. The political issues raised by the Crises have been many and varied, involving not only the immediate concerns suggested by the above list but also hugely important consequential issues: the impact of bank failure or ‘shrinkage’ on employment and taxation revenues; whether or not the UK can remain a leading financial centre (and/or whether its economy is too reliant on financial markets11); whether the regulatory system is fit for purpose; and, at least in the minds of more left-wing commentators, whether there is a need to re-assess whether the ‘capitalist system’ is working properly.

8.05  As regards the first item on the list, the response to the need to ‘make banks safe’ was, of course, when the time came, a matter of great urgency. There was no question of being able to debate political and philosophical questions on the issue of whether it might be right to ‘let a bank fail’ in order to avoid ‘moral hazard’. The insolvency of Lehmans in September 2008 showed how difficult it is to assess the potential consequences of a major failure and there was no political appetite for experimenting with letting a big UK bank fail in (p. 108) the autumn of 2008. It is understood that Royal Bank of Scotland informed the then Chancellor of the Exchequer, Alistair Darling, in the morning of 7 October 2008 (while he was at a meeting in Luxembourg) that it was only a matter of a few hours before they would, in effect, run out of money. The bank’s share price had collapsed and dealing in the shares had been suspended. As Darling recalled in his memoir:

When dealings in a bank’s shares are suspended it is all over. I knew the bank was finished, in the most spectacular way possible. The game was up. If the markets could give up on RBS, one of the largest banks in the world, all bets on Britain’s and the world’s financial system were off.12

8.06  Following government intervention earlier in 2008 to keep Northern Rock and Bank of Scotland alive and to nationalize, or encourage take-overs of struggling building societies, the problems at RBS brought financial, economic, and political issues together in an explosive cocktail. If RBS had failed, others would soon have followed, so a government bail-out (by way of equity injection) was a genuine emergency. A few days after his Luxembourg conversation, Darling authorized the first major government injection of funds into RBS—£37 billion. More was to follow, and more banks and building societies were to need rescue in subsequent months.

8.07  The emergency rescues (and of course the ‘non-rescue’ of Lehman Brothers by the US Government on 6 September 2008) were followed by a spate of legislation in the UK (and elsewhere) designed to make bank rescue easier (and, one hopes, failure less likely). The most fundamental changes, as regards failing banks, were in The Banking (Special Provisions) Act 2008 and the Banking Act 2009 which introduced ‘stabilization’ provisions for what we have come to know as the ‘resolution’ of failing institutions. These involved, for example, the splitting up of banks in difficulty into ‘good banks’ and ‘bad banks’. Other ‘lessons learned’ from the many problems encountered in the UK with the Lehmans insolvency were also addressed in legislation such as the Investment Bank Special Administration Regulations 2011. For good measure, the ‘regulatory architecture’ was overhauled by the Financial Services Act 201213 (which, essentially, moved the UK to a ‘twin peaks’ model and replaced the old Financial Services Authority with the Financial Conduct Authority and the Prudential Regulation Authority). In due course, and following the report of the Vickers Commission,14 and the deliberations of the Parliamentary Banking Standards Commission, legislation was passed to implement the so-called ‘ring-fencing’ or ‘splitting’ of investment banking from commercial and (p. 109) retail banking (and set the framework for the ‘conduct agenda’ triggered by the LIBOR scandal).15

8.08  The politicians, advised by lawyers, insolvency practitioners, and other technicians were now more open to the need to get the ‘legal plumbing’ right in financial services by passing new laws to fix problems than perhaps they had ever been before. Financial law reform was no longer a political backwater with no vote-winning appeal. Public interest in the need for change was only increased when the LIBOR scandal triggered the Conduct Crisis16 and politicians started to take a keen interest, not just in the safety and stability of the financial system but also the ethical and moral culture of banks. Any politician who vociferously stood up against not just bankers’ greed and recklessness but also fraud and deception was only going to win plaudits from the public at large. The key ingredient, however, was to be able to back up the relatively easy criticisms with a sound appreciation of the relevant technical issues and a considered and perceptive approach to the changes in law and practice needed to bring about the desired changes.

8.09  As stated at paragraph 8.02 above, the impact of the LIBOR manipulation scandal was enormous. The public concerns were suddenly switched from ‘bank safety’ to ‘bank conduct’.17 It had been known that bankers had behaved recklessly and foolishly, many of them apparently consumed by greed and self-interest, but the public had not appreciated the extent to which lies, deception and fraud had entered bank culture. The scandal led to the formation of the Parliamentary Commission on Banking Standards (PCBS), a direct political response, and an ongoing saga of major scandals, swingeing fines, and other ‘conduct costs’.18 The legislative response has included a new criminal offence of reckless mismanagement of a bank19 and a new ‘Senior Managers Regime’ under which senior executives in banks are held responsible for regulatory breaches in their areas of responsibility unless they can demonstrate that they took reasonable steps to prevent such breaches—a significant departure from the presumption of having to prove some level of guilt.20

(p. 110) 8.10  A number of legal risk implications arise as a result of the regulatory responses. Some of them are inherent in the nature of the response itself. But, on a more general level, concerns arose in the following areas:

  • •  Whilst national laws can be, and are, passed reasonably swiftly in accordance with a well-understood timetable and consultation process, this is not always the case at international level. The prolonged period between a statement of intention as to a given regulatory change and the time the text of the new measure is available and actually in force creates uncertainty in the markets and a sense of heightened risk.

  • •  Many of the measures were, for various reasons, implemented only as generally worded principles. These tended to be vague and capable of more than one meaning. Sometimes one senses that they are only likely to be tested retrospectively, in the context of a bank that has actually failed, to a greater or lesser extent, at which point practices that had been accepted during profitable times may (with the benefit of hindsight) be condemned by the regulator—because the failure is itself evidence of some kind of breach of regulation (eg, in relation to ‘excessive risk taking’, inappropriate compensation systems or some other governance failure).

  • •  The creation of new agencies with regulatory powers always results in a degree of unpredictability, especially in the case of agencies acting on an international basis with powers that have hitherto simply not existed.

  • •  Where a state decides to ‘go it alone’ on a particular measure, this may, on the one hand, create opportunities for ‘regulatory arbitrage’ but, on the other, may leave market participants with a difficult patchwork of requirements to observe in different countries, each requirement addressing the same issue but in ways that are slightly different in each jurisdiction.

B.  The Banking (Special Provisions) Act 2008 and The Banking Act 2009

8.11  The Banking Act 2009 (generally referred to below as ‘the Act’) was the most important early legislative response in the UK to the issues raised by the Crisis.21 It replaced and extended the Banking (Special Provisions) Act 2008, which was introduced as a temporary, emergency measure in the wake of the Northern Rock crisis (and gave the UK government powers that were in fact used in relation to (p. 111) various troubled financial institutions before the ‘stabilisation’ provisions in the Act came into force (in February 2009)).22 The Act is a ‘portmanteau’ piece of legislation, with provisions covering the following principal areas:

  • •  a new ‘Special Resolution Regime’ which includes powers for the authorities to take action in relation to ‘failing’ financial institutions before they are formally insolvent;

  • •  a new bank insolvency procedure;

  • •  a new bank administration procedure;23

  • •  changes to the Financial Services Compensation Regime;

  • •  provisions giving the Bank of England powers to oversee certain inter-bank payment systems;

  • •  enabling provisions for the Treasury to make new regulations concerning (i) the insolvency of investment banks and (ii) financial collateral arrangements;

  • •  the establishment of a new Bank of England Financial Stability Committee and clarification (and extension) of the Bank’s immunity from legal action; and

  • •  miscellaneous provisions concerned with the issuance of banknotes in Scotland and Northern Ireland.

8.12  The Act is principally concerned with procedures to be followed, and ‘options’ available to the authorities, when banks encounter serious financial difficulties. It is not directly concerned with new regulations designed to make it less likely that the Financial Crisis will be repeated. However, the Act is an important development insofar as it gives the public sector a range of formidable new powers that have an impact on the rights of the citizen and on the risks faced by financial market participants, particularly creditors of, and shareholders in, failing financial institutions. As Hudson puts it:

… the UK Banking Act 2009 is just a play-book which presents the Bank of England with a series of options for crisis management, ensuring that the law will compel others to obey its lawful commands in practice.

It is not the aim of this book to provide a general commentary on the Act but, rather, to focus on those areas that have particular implications for legal risk. We begin with consideration of the Special Resolution Regime.

(1)  The Stabilization Options under the Special Resolution Regime


8.13  Section 1 of the Act provides an ‘overview’ of why the new ‘regime’ has been brought into the law and what it consists of. Its purpose ‘is to address the situation (p. 112) where all or part of the business of a bank has encountered, or is likely to encounter, financial difficulties’. It consists of:

  1. (a)  the three stabilisation options,

  2. (b)  the bank insolvency procedure …, and

  3. (c)  the bank administration procedure.

8.14  It is the stabilization options that have, to date, generated most interest and have the most obvious significance in relation to legal risk. They are considered in Part B(1) of this chapter. The new provisions regarding bank insolvency and administration are considered in Part B(2). These stabilization options (essentially powers24 conferred on the authorities, ie the Bank of England, the Treasury, the FCA or the PRA, depending on the circumstances) all involve transfers of shares (or other securities)25 in, or issued by, banks or the assets and/or liabilities of banks to any of (a) a private sector purchaser (b) a ‘bridge bank’26 or (c) temporary public ownership. The powers are exercisable in respect of ‘banks’ (and, in the case of the power to take into temporary public ownership, holding companies of banks).27 Although ‘banks’ are defined to mean UK institutions28 that are regulated deposit takers and do not include building societies or credit unions, section 84 of the Act applies the stabilization powers to building societies with certain modifications and section 89 gives the Treasury power to make an order that does the same in respect of credit unions. (In this book, we will refer generally to ‘banks’ as covering (or potentially covering) all these entities unless there is a specific context relating to another kind of entity.)

8.15  From the point of view of a shareholder in a bank, a bank’s management or others who have dealings with it, the new law presents, at least at first sight, a somewhat daunting prospect: the possibility of de facto nationalization (albeit with compensation), confiscation or forced change of ownership, giving priority to retail depositors on liquidation of a bank, severe modification of contractual rights and/or transfer of contractual claims and obligations to a party that was not in anyone’s contemplation when the contract was signed. There is even a somewhat extreme ‘change in law’ risk by virtue of the unusual and extensive powers given to the Treasury under section 75 of the Act. From the point of view of the public sector, on the other hand, the Act has many provisions that indicate that if any of these powers are in fact exercised, it will be with extreme reluctance and in the hope that, ultimately, a ‘private sector solution’ can be found. It is not to be (p. 113) regarded, in itself, as an indication of a change of policy, with the UK government suddenly becoming interested in owning and running banks.

The trigger for exercise of stabilization powers

8.16  Not surprisingly, the Act contains a large number of checks and balances (in the form of numerous consultation requirements and the need to have regard to generally framed objectives and a code of practice) that show considerable sensitivity to the potential concerns. The provision relating to the ‘objectives’ of the powers expressly refers to the need to ‘balance’ different considerations; an exercise that lies at the heart of most bank ‘rescue’ operations.

8.17  The first question, however, is: what are the trigger points for the stabilization powers being exercised? There are various series of conditions, the basic ones (and thus the starting point) being set out in section 7, which provides that a stabilization power ‘may be exercised in respect of a bank only if the PRA is satisfied that’ two ‘general conditions’ are met. The first condition is that: ‘the bank is failing, or is likely to fail, to satisfy the threshold conditions’ (within the meaning of section 55B(1) of the Financial Services and Markets Act (FSMA)). The second is that: ‘having regard to the timing and other relevant circumstances it is not reasonably likely that (ignoring stabilisation powers) action will be taken by or in respect of the bank that will enable the bank to satisfy the threshold conditions’. The threshold conditions are set out in FSMA Schedule 6 and include the requirement that the bank has adequate resources and that it is ‘fit and proper’ (as to which the sound and prudent conduct of its affairs will be relevant). In deciding whether or not these conditions are met the PRA is to ignore the impact of any financial assistance provided by the Treasury or the Bank of England.29 There are a number of questions of interpretation that may arise here:

  1. (1)  How will judgements as to the application of the phrase ‘likely to fail’ be made? One would imagine that, given the weight of responsibility attached to the action, the FSA would in practice only invoke this part of the section if it felt that a bank was virtually certain to fail the threshold conditions.

  2. (2)  Similar issues may arise in relation to ‘not reasonably likely’. The reference to ‘having regard to the timing and other relevant circumstances’ brings into play the likely scenario (such as those encountered in the Financial Crisis) of extreme urgency. One can imagine desperate attempts to find a voluntary private sector solution to a troubled bank problem taking place over a weekend against the background of an imperative to be able to present at least some kind of solution to the public before the markets open on Monday morning. At some point a decision may have to be made as to whether or not the state (p. 114) of discussions has got to the point that such a solution is (or is not) ‘reasonably likely’. This may not be an easy call to make but at least the presence of this new power in the authorities’ armoury should help to concentrate the minds of those involved in the negotiations!

  3. (3)  The threshold conditions themselves involve a number of fairly vague concepts. This is not necessarily a bad thing in the context of granting authorization to carry on business in the first place. It may prove to be a more contentious area when the language is considered against the backdrop of, say, potential confiscation. What are ‘adequate resources’, for example, may be a matter for heated debate. Likewise the reference to ‘fit and proper’. One would imagine, however, that the most likely context is one where the bank’s management is in no position to engage in any protracted debate on such matters.

8.18  To some extent, the likelihood of any of the above issues being controversial or otherwise problematic is reduced by the requirement in the Act for the PRA to consult the Bank of England, the Treasury, and the FCA before it determines whether or not the second of the above conditions is satisfied. It seems inconceivable that the PRA would proceed without complete concurrence from the consultees.

Special resolution objectives

8.19  There are further ‘specific conditions’ that apply to specific scenarios. However, before turning to those it is important to note there are also very generally worded ‘special resolution objectives’ set out in section 4 of the Act and the authorities are required to have regard to these in using, or considering using, the stabilization powers (or the bank insolvency and administration procedures). These objectives, therefore, introduce a potential further restraint (although it is specifically stated that they are ‘not relevant’ for the purpose of deciding whether or not the two conditions referred to above have been met).30 The special resolution objectives include:

  1. (1)  to ensure the continuity of banking services in the UK and of critical functions;

  2. (2)  to protect and enhance the stability of the financial system of the UK;

  3. (3)  to protect and enhance public confidence in the stability of the banking systems of the UK;

  4. (4)  to protect depositors;

  5. (5)  to protect public funds;

  6. (6)  to protect client assets (where relevant); and

  7. (7)  to avoid interfering with property rights in contravention of a Convention right (within the meaning of the Human Rights Act 1998).

(p. 115) The code of practice

8.20  An arbitrary use of any of the stabilization powers would be likely to conflict with at least one of the above objectives (particularly the last one). Further reassurance is given by the fact that the Treasury has to issue a code of practice about the use of the powers (and the bank insolvency and administration procedures) under section 5 (1) and, pursuant to section 5(4), ‘the relevant authorities shall have regard to the code’. The version of the code current at the time of writing was published in March 2015.

8.21  The above requirements apply generally to the use of the stabilization powers. There are further specific requirements that apply to specific powers.

The Banking Liaison Panel

8.22  There is a further innovation of the Act that should serve the valuable purpose of limiting the potential for misuse of power or, perhaps more likely, unintended consequences. This is the setting up, pursuant to section 10, of a new ‘Banking Liaison Panel’. This is:

to advise the Treasury about the effect of the special resolution regime on—

  1. (a)  banks

  2. (b)  persons with whom banks do business, and

  3. (c)  the financial markets.31

8.23  More specifically, the panel may advise on the exercise of certain powers to make statutory instruments as well as, to an extent, compensation orders and orders made under section 75,32 the code of practice and ‘anything else referred to the panel by the Treasury.’ The panel must include (amongst others) one or more persons with ‘expertise in law relating to the financial systems of the United Kingdom’ and one or more with expertise in insolvency law and practice. The first members of the panel included representatives of the FMLC and also of the Financial Law Committee of the City of London Law Society. There was also a representative of ISDA, the first such individual being a senior partner in a major City law firm. The panel is, effectively, the successor to the Expert Liaison Group that the government had set up to assist it with some of the technically tricky parts of the legislation as it passed through Parliament. Because of its composition it is well-placed to advise on issues of legal uncertainty and legal risk. The code of practice33 notes that one of the most technically difficult areas of the new legislation, partial property transfers,34 is expected to be an area of ‘particular (p. 116) interest’ to it. The expertise that has been developed over two decades by the successor entities to the original Legal Risk Review Committee, and by professional bodies of City of London financial lawyers, has thus found its way into a body with a statutory footing. The establishment of the Banking Liaison Panel is also at least an implicit recognition that in certain areas of financial law there is merit in the idea, even a necessity, that lawyers with market experience should be consulted by the government from time to time. It is an example of legal risk management at the highest level.

Other provisions

8.24  Sections 15 to 46 of the Banking Act 2009 contain a large number of provisions which, for the purposes of this book, can be regarded as essentially supplementary and administrative (which is not of course to suggest that they are unimportant). Examples include:

  • •  provisions regarding the nature of the legal mechanisms by which shares or property are transferred (a combination of ‘instruments’ and ‘orders’) pursuant to the original exercise of the stabilization powers and also for further transfers (including transfers of shares in a ‘bridge bank’) thereafter,

  • •  provisions to ensure continuity between the original entity and any transferee successor,

  • •  provisions enabling the Bank of England or the Treasury to make changes to the board of directors of a bank, and

  • •  provisions dealing with issues that may arise where some of the property to be transferred is foreign property.

Partial property transfers

8.25  Perhaps the most technically demanding issues arising out of the stabilization powers concern the problems that could arise if a power was exercised to transfer some, but not all, of the property, rights and liabilities of a bank, a so-called ‘partial property transfer’.35 Section 33(2) clearly contemplates that a property transfer instrument may relate to all the property, rights and liabilities of a bank or only to specified property rights and liabilities. Such an instrument might be used, for example, where it was decided to separate bad debts and other assets of dubious quality (often referred to through the Financial Crisis as ‘troubled’ or even ‘toxic’ assets) from the other assets, creating a so-called ‘bad bank’ and ‘good bank’. The use of such an instrument could, however, cause severe difficulties in relation to transactions (of which there are, of course, very many in the financial markets) involving set-off and netting provisions where a counterparty to a bank that is subject to such an instrument has relied on, say, a set-off right that, following the instrument coming into effect, is destroyed (for want (p. 117) of mutuality)36 because its claim has not been transferred (and remains perfectly valid, but against an insolvent institution whose only assets are those that no one else wants) whereas its obligations have been transferred and may now be pursued, free of set-off, by the transferee. Because of the fundamental importance of set-off rights in the financial markets37 it was recognized, in the course of the legislation’s development, that this problem had to be addressed. Otherwise, City law firms, and others, would have felt obliged to include extremely material qualifications in any legal opinions given in relation to a wide range of wholesale market transactions. It would also have become impractical, for the purpose of capital adequacy rules, to measure exposures on a net basis (a practice that assumes set-off rights ‘work’ in insolvency and in relation to which regulators require appropriately worded legal opinions). The solution was found by providing, in sections 47 and 48, that the Treasury may by order (by statutory instrument) do a number of things that prevent partial property transfers having the undesirable effect described above. These include restricting the making of such transfers and imposing conditions on the making of them. More importantly, in the present context, section 48(2) provides that such an order may address particular issues that arise in connection with ‘protected arrangements’. Protected arrangements are defined in section 48(1)(e) to mean:

  • •  security interests

  • •  title transfer collateral arrangements

  • •  set-off arrangements, and

  • •  netting arrangements.

8.26  Set-off arrangements and title transfer collateral arrangements are considered more fully in Chapter 22 but it should be noted that these and the other expressions mentioned above each have their own definitions in section 48(1). The meanings given are not unusual or extended meanings: they are what a market practitioner would expect. The definition of ‘netting arrangements’, however, is of interest because of its complexity and the recognition given to a very particular kind of provision (or range of provisions) now commonly found in market documentation in all the major financial jurisdictions. The definition reads:

… ‘netting arrangements’ are arrangements under which a number of claims or obligations can be converted into a net claim or obligation and include, in particular, ‘close-out’ netting arrangements, under which actual or theoretical debts are calculated during the course of a contract for the purpose of enabling them to be set off against each other or to be converted into a net debt.

8.27  An order was made under section 48(2) that came into force in February 2009. This was the Banking Act 2009 (Restriction of Partial Property Transfers) Order (p. 118) 2009.38 The concern about the effect of partial property transfers on set-off and netting arrangements is addressed in paragraph 3 of the Order. According to paragraph 3(1), a partial property transfer ‘may not provide for the transfer of some, but not all, of the protected rights and liabilities between a particular person (‘P’) under a particular set-off arrangement, netting arrangement or title transfer financial collateral arrangement’.39 Paragraph 3(2) similarly prohibits continuity powers40 terminating or modifying protected rights and liabilities between P and a banking institution.41 Paragraph 3(3) provides that rights and liabilities between P and a banking institution are protected for the purposes of the foregoing ‘if they are rights and liabilities which either P or the banking institution is entitled to set-off or net under a set-off or netting arrangement or title transfer financial collateral arrangement which P has entered into with the banking institution’.42

8.28  Other paragraphs of the Order deal with, for example, situations comparable to those involving set-off or netting described above, where (but for the Order) there would be a risk that secured liabilities might be transferred without the benefit of the security (or, conversely, that the property might be transferred without the liability), and restrictions on the partial transfer of rights and liabilities under ‘capital market arrangements’ or which would affect rights under ‘market contracts’ and certain rules of recognized investment exchanges and clearing houses.


8.29  Sections 49 to 62 deal with the compensation (if any) to be paid to those adversely affected by the exercise of stabilization powers. Depending on the precise powers used, the Treasury is required to make either a ‘compensation scheme order’ or a ‘resolution fund order’. The former is concerned with compensation (to transferors) in the conventional sense. The latter is concerned with establishing a scheme to pay (to transferors) proceeds of disposal of assets transferred in specified circumstances and to a specified extent. ‘Third party compensation orders’ may (p. 119) also be made, providing for compensation to persons other than transferors (eg, counter-parties to transactions with a bank). There are provisions for the appointment of an independent valuer43 and, importantly, the principles of valuation.44 One of the more contentious principles, to date, has been the requirement, set out in section 57(3), that in determining the amount of compensation the valuer ‘must disregard actual or potential financial assistance provided by the Bank of England or the Treasury (disregarding ordinary market assistance provided by the Bank on its usual terms)’. The predecessor of this provision, in the Banking (Special Provisions) Act 2008, gave rise to litigation in relation to the position of the former shareholders in Northern Rock plc. In the case of SRM Global Masters Fund (and others) v Commissioners of H.M. Treasury,45 the Divisional Court46 judgment provides an illustration of what shareholders in a bank might expect if and when the Bank of England is considering whether or not to step in as a lender of last resort (such assistance being described in the report, and below, as ‘LOLR’) and/or stabilization powers47 are exercised. The judgment quotes at length from a lecture given by the then Governor of the Bank, the late Lord (‘Eddie’) George at the London School of Economics in 1993. It was common ground amongst the parties to the litigation that this lecture sets out the correct principles for LOLR. For example, it is important that LOLR is not seen as a guarantee that a bank cannot fail: ‘The possibility of failure is necessary to the health of the financial system, as it is to the efficiency of all other economic activity.’ Lord George went on to discuss what factors the Bank would look at when considering LOLR for a failing bank:

The central bank must at least consider the option of supporting it. The Bank of England frequently does no more than that: we think about support, but we decide against it. There have been nine bank closures since 1987; and the majority of them proved unable to meet all their liabilities. But there are circumstances when we may decide that, were an institution not to meet its obligations as they fell due, that would pose a serious threat to the financial system as a whole.

8.30  LOLR for a failing bank ‘is not designed to give special protection to its depositors, or to safeguard the position of its employees, nor is it based on a wish to help its shareholders or management, who should, indeed expect to be penalised’. Any benefit such parties might derive from LOLR could only come about as a ‘byproduct of meeting our wider objective’. The overriding principle behind LOLR is the safeguarding of the financial system, not any one institution.

(p. 120) 8.31  As is well known, Northern Rock plc (‘NR’) was subject to various LOLR measures (including, it would seem as a landmark precedent, the guarantee by the government of all its deposits) and, ultimately, nationalized under the provisions of the 2008 Act. The judgment contains a helpful summary of the salient facts (or at least those relevant to the decision):

  1. (a)  Northern Rock had a good quality loan book.

  2. (b)  At all relevant times the assets of Northern Rock exceeded its liabilities. It was solvent on a balance sheet basis.

  3. (c)  However, in August or September 2007 it became insolvent in the sense that it could not pay its debts as they fell due.

  4. (d)  Government support for Northern Rock was provided because there was ‘a genuine threat to the stability of the financial system and in order to avoid a disturbance to the wider economy.’ It may also have been provided to protect depositors.

  5. (e)  The loans and guarantees provided for Northern Rock were not gratuitous. A premium rate of interest was payable on the loans, and a fee ‘set at a higher rate than the interest premium’ charged for the guarantee arrangements provided on 9 October and later.

  6. (f)  The loans to Northern Rock provided by the Bank of England were repayable on demand. If repayment had been demanded at any time before nationalization, the company would have been insolvent in that it would have been unable to pay its debts as they fell due.

  7. (g)  The financial support required by Northern Rock was not available from any source other than the government.

  8. (h)  The government may make a profit from the nationalization of Northern Rock in addition to the price paid for the financial support.

8.32  The SRM case (which was a judicial review action) was concerned primarily with the level of compensation paid to the shareholders of NR under the 2008 Act. The Act provided for an independent valuer to determine the valuation and for various assumptions that he had to make in so doing. These included assumptions that any assistance from the authorities had been withdrawn and would not be renewed and (pursuant to an order made under the 2008 Act addressing the NR situation specifically) that the bank was unable to continue as a going concern. The claimants challenged the appropriateness of these assumptions, especially in the context of human rights legislation (specifically, Article 1 of the First Protocol to the European Human Rights Convention). They argued that the valuation should not be built on such assumptions, which led to expropriation without compensation. They also argued that the government was trying to make a profit out of the situation and that the NR problems were due to ‘regulatory failure’.

8.33  The claimants failed in their various claims. It was determined that it was indeed appropriate for the assumptions to be factored into the valuation, NR being, in (p. 121) effect on ‘life support’ from the authorities at the relevant time and thus in an exceptionally precarious position. The following statement of John Kingman, a senior Treasury official, was accepted by the Court:

… the former shareholders are not entitled to be compensated for value created or enhanced by the provision of public financial assistance. If public financial assistance were not excluded in the calculation of value, the Treasury would compensate former shareholders for value which the public provision of financial assistance had created.

8.34  The Court noted that there was no public or private law duty to provide such assistance. Nor were the claimants entitled to any reasonable or legitimate expectation that public financial assistance would be continued. The result of this reasoning was that the compensation, although negligible, was judged to be fair (the assumptions necessarily leading to a very low valuation). ‘Fairness requires that the valuation reflects the relevant facts and the relevant legal obligations of the State.’

8.35  As regards regulatory failure, various statements of Hector Sants48 were quoted, some of which had a ring of mea culpa (on behalf of the FSA) to them but which fell short of any outright confession of guilt. The Court decided that even if there had been regulatory failure it was not a failure in any duty owed to the claimants. (In any event, any such claim, the Court pointed out, would not be relevant to the valuation issue, although it might have supported a claim in damages.)

8.36  The Court also pointed out that, amongst the various classes of claimants, much sympathy might be due to those small shareholders who had held shares for many years but rather less, if any at all, to hedge funds that had only acquired their NR shares after the NR problems were well known and who were, in effect, gambling on there being no nationalization. (It was noted that the market for NR shares remained open from the time its problems became well known (13 September 2007) until the time of the nationalization announcement. During this time the price fluctuated dramatically.)

8.37  The case illustrates a number of legal risk points arising from the Banking Act 2009. First, the stabilization powers brought in by the new legislation do increase the risk of regulatory action that ultimately leads to a confiscatory effect if a bank gets into difficulties; the position of the shareholders in such a case will be extremely weak. Secondly, it would seem that the new powers, at least as regards valuation, are largely ‘human rights claim-proof’ as long as the correct procedures are followed. Thirdly, it is clear that however much we might feel that regulators are to blame for things that might go wrong in the financial world, that will not, of itself, cause a court to invent a duty owed by them to bank shareholders—who will (p. 122) largely have to look to management if they wish to blame someone for their misfortune. It might, however, be wise for regulators to avoid too much angst in public, at least to the extent it looks like an acceptance of blame. Statements of an apologetic nature may well come under the scrutiny of the courts in the event of litigation.

The power to change the law

8.38  The last section in Part 1 of the Act that merits special mention in the context of legal risk is section 75. This is a very unusual piece of legislation (some commentators have termed it a ‘Henry VIII clause’) in that it confers on the Treasury the power ‘by order to amend the law for the purpose of enabling [the stabilisation powers] to be used effectively, having regard to the special resolution objectives’. Such an order (which must be made by statutory instrument) may be made for the general purpose of the exercise of the powers, to facilitate a particular proposed or possible use of a power or ‘in connection with a particular exercise of a power’. As regards the latter purpose, the order:

may make provision which has retrospective effect in so far as the Treasury consider it necessary or desirable for giving effect to the particular exercise of a power under this Act in connection with which the order is made (but in relying on this section the Treasury shall have regard to the fact that it is in the public interest to avoid retrospective legislation).49

8.39  It is hard to imagine a provision that could (at least potentially) be more arbitrary. The Executive is given power by the Legislature not only to amend the law ‘by order’ but also to do so retrospectively. The parenthetical phrase at the end of the subsection is of some comfort; but not much. ‘Amend the law’ is defined by section 75(4) and means—

  1. (a)  disapply or modify the effect of a provision of an enactment (other than a provision made by or under this Act),

  2. (b)  disapply or modify the effect of a rule of law not set out in legislation, or

  3. (c)  amend any provision of an instrument or order made in the exercise of a stabilisation power.

8.40  The Treasury can thus change common law as well as statute law (a point overlooked by the code of practice). There is even a provision50 dispensing with the need (‘if the Treasury think it necessary’) for the statutory instrument to be laid in draft before and approved by Parliament before it comes into effect. In such a case the order comes into effect immediately but lapses if not approved by Parliament within 28 days (although such lapse does not invalidate anything done in reliance on the order in the meantime if neither House has, at the time, declined to approve the order). This is presumably to cater for situations where action is required as a matter of extreme urgency.

(p. 123) 8.41  Two points are made by the code of practice in relation to section 75 that may provide some reassurance:

  1. (1)  We are, again, reminded that the Treasury must ‘have respect for the rule of law and legal certainty’.51

  2. (2)  Paragraph 7.26 notes that the Banking Liaison Panel has a statutory right to advise on the use of the power to change the law; but ‘this does not include a right to provide advice on an exercise of this power that is carried out in connection with or to facilitate a particular use (proposed or actual) of a stabilisation power’.

8.42  The provisions evidently reflect concerns borne out of particular situations experienced during the Financial Crisis when it was felt that the existing law was, for various reasons, deficient and, somehow, obstructed the efforts of the authorities to ‘resolve’ difficult problems that they then had. One assumes that specific issues that fall into this category have been covered by specific provisions in the Act. But there is clearly unease that legal risk for the authorities (in the form of law that ‘gets in the way’ of what they want to do) might reappear if they need to use the new powers and, as a result, the power to change the law (if necessary, virtually, overnight) has been reserved in order to help manage that risk. That such a sweeping power is apparently needed is itself a reflection of both the complexity and the novelty of the legal issues that now tend to be involved in a modern day bank rescue operation.

(2)  Bank Insolvency and Administration


8.43  The Banking Act 2009 introduced new procedures regarding bank insolvency and bank administration.52 The Act also gave the Treasury power to make new regulations regarding the insolvency of investment banks and the current version of those regulations, following recommendations by Peter Bloxham,53 is the Investment Bank Special Administration Regulations 2011,54 as amended by the Investment Bank (Amendment of Definition) and Special Administration (Amendment) Regulations 2017 (referred to below as the ‘Investment Bank Administration Regulations’). The distinction between investment banks and other banks is considered further in paragraph 8.52 below. The following two parts of this chapter are concerned with ‘ordinary’ deposit-taking banks (that is, those that are subject to the special resolution regime) as opposed to investment banks.

(p. 124) 8.44  It is still possible for UK banks55 to be subject to the procedures for insolvency and administration that apply to corporate entities generally but this now seems less likely in practice. This is because section 120 of the Act provides a number of hurdles that would have to be overcome by anyone applying for ‘conventional’ administration or petitioning for a ‘conventional’ winding up, by any bank that wishes to be wound up voluntarily or by anyone wishing to appoint an administrator. Taken together, the effect of the hurdles is that the PRA and the Bank of England must be content that a conventional procedure goes ahead and not be ‘trumped’ by either of them invoking one of the new procedures under the Act. The hurdles are:

  1. (1)  that the PRA and the Bank of England have been notified:

    1. (a)  by any applicant for an administration order, that the application has been made,

    2. (b)  by any petitioner for a winding up order, that the petition has been presented,

    3. (c)  by a bank that proposes a voluntary winding up, that such a resolution may be made, or (as the case may be),

    4. (d)  by any person proposing to appoint an administrator, of the proposed appointment;56 and

  2. (2)  that a copy of the notice to the FSA with the relevant details referred to above has been filed with the court (and made available for public inspection by the court); and

  3. (3)  that (a) two weeks have elapsed since the FSA received the notice referred to above; or (b) both—

    • the FSA has informed the person who gave the notice that it does not intend to apply for a bank insolvency order, and

    • the Bank of England has informed the person who gave the notice that it does not intend to apply for a bank insolvency order or to exercise a stabilisation power; and

  4. (4)  that no application for a bank insolvency order is pending.

8.45  Section 117 also provides that on a petition for winding up or an application for administration the court may instead make a bank insolvency order (but only if the PRA applies for the same with the consent of the FCA or if the Bank of England applies for it). The ‘whip hand’ is thus with the regulators if proposals are afoot to wind up a UK bank or put it into administration. The ‘ultimate (p. 125) weapon’ of the dissatisfied creditor may be taken away from him. However, it is clear that the policy is to give precedence to the position of retail depositors. According to the Explanatory Notes, the principal reason for the new insolvency procedure ‘is to ensure that, where a bank fails, depositors who are eligible claimants under [the FSCC] are paid out promptly’.57 This is understandable, given the need to limit the possibility of public near-panic that accompanied the demise of Northern Rock. However, good news for one class of creditors is bad news for others. We will deal first with the new bank insolvency order and then with the bank administration order.

Bank insolvency order

8.46  Applications for bank insolvency orders (which are orders of the court, appointing a bank liquidator) can only be made by the Bank of England, the PRA or the Secretary of State.58 Three possible grounds for such an application (which must nominate someone to be appointed as bank liquidator) are given in section 96. ‘Ground A’ is that a bank is unable, or likely to become unable, to pay its debts. ‘Ground B’ is that the winding up of the bank would be in the public interest. ‘Ground C’ is that the winding up of the bank would be ‘fair’. The rules that apply for each authority in this context are:

  1. (1)  the Bank of England can only apply if:

    1. (a)  the PRA has informed it that the general conditions for the exercise of stabilization powers (set out in section 7) have been met, and

    2. (b)  the Bank of England is satisfied—

      • that the bank has eligible depositors,59 and

      • that Ground A or C applies;

  2. (2)  the PRA can only apply if—

    1. (a)  the Bank of England consents, and

    2. (b)  the PRA is satisfied that—

      1. (i)  the general conditions referred to above have been satisfied,

      2. (ii)  the bank has eligible depositors, and

      3. (iii)  Ground A or C applies;

  3. (3)  the Secretary of State can only apply if satisfied that the bank has eligible depositors and that Ground B applies.

8.47  The court may make a bank insolvency order on the application of either the Bank of England or the PRA if satisfied that the bank has eligible depositors and that Ground A or C applies and may do so on the application of the Secretary of State if satisfied that the bank has eligible depositors and that Grounds B and C apply. ‘Fairness’ is thus an additional requirement in the case of the public (p. 126) interest ground but not for Ground A (inability to pay debts). ‘Fairness’ is also a ground for making an order in its own right. The Secretary of State is in the driving seat in relation to applications based on public interest. Otherwise, it is the Bank of England (unless the Bank agrees to the PRA taking the lead).

8.48  A bank liquidator has two objectives.60 The first (‘Objective 1’, which takes precedence over the second)61 is ‘to work with the FSCS so as to ensure that as soon as is reasonably practicable each eligible depositor (a) has the relevant account transferred to another financial institution, or (b) receives payment from (or on behalf of) FSCS’. The second is to wind up the affairs of the bank so as to achieve the best result for the bank’s creditors as a whole.

8.49  Sections 100–103 contain provisions relating to the liquidation committee and the powers of the liquidator. Until Objective 1 has been achieved (‘entirely or so far as reasonably practicable’)62 the committee will consist of appointees of the Bank of England, the PRA, the FCA, and the FSCS. When Objective 1 is achieved the committee may pass a full payment resolution and, after that, a meeting of all creditors is called and additional members of the committee can be appointed. The committee is given detailed duties as to recommendations relating to the different aspects of (and options under) Objective 1.63 Many of the liquidator’s powers are incorporated by reference (with modifications) from general insolvency legislation.

Bank administration order

8.50  Whereas the bank insolvency procedure reflects a clear policy change (to give priority to retail depositors on a bank’s liquidation) the new procedures for bank administration are more of a consequential nature: how to deal with the part of a bank’s business that is ‘left behind’ in the so-called ‘residual bank’ when a stabilization power is used to transfer some, but not all, of its assets to a commercial purchaser or a ‘bridge bank’. The Act enables the Bank of England (no one else) to apply to the court for a bank administration order in such a situation as long as the Bank is satisfied that the residual bank cannot pay its debts or is likely to become unable to pay them once such a transfer has been made.64 If the court appoints an administrator, the latter will be ‘able and required to ensure that the non-sold or non-transferred part of the bank … provides services or facilities to enable the commercial purchaser … or the transferee … to operate effectively’.65 In other respects ‘the process is the same as for normal administration under (p. 127) the Insolvency Act 1986, subject to special modifications.’66 The Objectives laid down for the bank administrator in section 137 reflect this. There are procedures for determining when the Objective to support the transferee has been achieved, following which the administrator can concentrate on ‘normal’ administration. If reasonably practicable, this should involve rescue as a going concern but the administrator is able to look at other options if they would achieve a better result for the creditors as a whole.

Investment bank insolvency

8.51  The special resolution regime, set out in the first three Parts of the Act, is not concerned with the insolvency of investment banks as such. The Act does not contain any substantive provisions that address investment bank insolvency, the experiences gained as a result of the insolvency of Lehman Brothers67 (from September 2008 onwards) persuaded the government that modifications to the law in this area would be desirable. Section 233 of the Act accordingly gave the Treasury power to make ‘investment bank insolvency regulations’ and these are embodied in the Investment Bank Administration Regulations.68 (There is also a Special Resolution Regime, put in place by the Financial Services Act 2012, for systemic investment firms to the extent a failure would have a systemic impact on the UK’s financial system.)

8.52  The first question, therefore, is: what is an ‘investment bank’? The definition is framed in section 232 by reference to three conditions. The institution must be incorporated in, or formed under the law of any part of, the UK. It must have permission under Part 4 of FSMA to carry on the regulated activity of:

  1. (a)  safeguarding and administering investments,

  2. (b)  managing an AIF (Alternative Investment Fund) or a UCITS (Undertakings for Investment in Transferable Securities),

  3. (c)  acting as a trustee or depositary of an AIF or a UCITS,

  4. (d)  dealing in investments as principal, or

  5. (e)  dealing in investments as agent.

8.53  Finally, it must hold ‘client assets’. These are defined69 as assets which it has undertaken to hold for a client (whether or not on trust and whether or not the undertaking has been complied with). Apart from this definition of an investment bank, the Treasury is given power to specify that certain classes of institutions (p. 128) fall inside or outside the scope of the relevant provisions and also to specify that certain classes of assets fall inside or outside the definition of client assets. This is a wise precaution. The somewhat nebulous concept of investment banking does not lend itself to an easy, traditional legal definition and the task of definition is, in any event, made harder by the speed with which market practice and convention in this area can change.

8.54  We then move to the question: what is the objective of having a special insolvency regime for investment banks? Section 233(3) supplies a statutory answer. In making any regulations on the topic, the Treasury is required to have regard to the following:

  1. (a)  identifying, protecting and facilitating the return of client assets,

  2. (b)  protecting creditors’ rights,

  3. (c)  ensuring certainty for investment banks, creditors, clients, liquidators and administrators,

  4. (d)  minimizing the disruption of business and markets, and

  5. (e)  maximizing the efficiency and effectiveness of the financial services industry in the United Kingdom.

8.55  The fact that the return of client assets has pride of place tells us something about the nature of the concerns that arose in connection with the Lehmans insolvency. Their former clients had much greater difficulty extracting what they regarded as ‘their property’ from the insolvency process than might have been expected. Accusations were made that the UK insolvency process was not as efficient in this regard as that of other countries (notably, the US). Was there a danger that, if such accusations were true (or simply perceived to be true), the UK would lose some of its competitive edge? The perceptions in the market, and the very real practical difficulties of managing an insolvency of the size of Lehmans, are referred to in the interview with David Ereira contained in Appendix 2.70 This interview reflected the position as at December 2008, shortly after the Lehmans administration started (on 15 September 2008).71 There was already a degree of restlessness amongst creditors at that time, reflected in (unsuccessful) litigation seeking to force the administrators’ hands.72 There was also concern about how contractual documentation may have seriously affected what might otherwise have been property rights of Lehmans’ former clients in ‘client assets’. The Investment Management Association was reported as being ‘furious’ with the (p. 129) FSA because of its perceived failure ‘to protect investors’ leaving them with the problem that ‘when Lehmans folded, institutions that had placed buy and sell orders for cash equities through the firm had no idea where they stood—whether the trades had gone through or not’.73 Many of these issues were commented on in the Consultation Paper, ‘Developing effective resolution arrangements for investment banks’ issued by the Treasury in May 2009 in connection with the possibility of making investment bank insolvency regulations.74 The paper provides a compelling illustration of how concerns over legal risk and legal uncertainty, the protection of the UK’s competitive position in financial markets activity and the need to take full account of regulators’ and practitioners’ views (and the possibility of market-led solutions to problems as opposed to new laws) were beginning to converge when the government considered legislation in the financial markets area. The concerns are now substantially addressed by the Investment Bank Administration Regulations but some consideration of the events that led up to these regulations coming into existence is merited as an illustration of the impact that legal risk can have when unforeseen events occur.

8.56  The opening sentences of the Consultation Paper noted that: ‘The UK, and particularly London, serves as one of the pre-eminent international centres for investment banking and related services. Around half of European investment banking activity takes place through London and, along with New York, London is the global leader for the provision of investment banking services.’ The following paragraph tells us that the ‘UK’s robust and flexible legal and insolvency regimes are two of the most important foundations underpinning the success of the UK financial services sector and its role as an international centre for investment banking’. The Consultation Paper was somewhat less bold and confident as to what it actually proposed, being distinctly exploratory in tone and not containing ‘concrete policy recommendations’.75 The following is a summary of the main points:

  • •  The government formed an expert panel (the ‘Advisory Panel’) to assist it with the issues raised by the consultation. Much of the content of the paper is expressly stated to reflect the panel’s views as well as the government’s (or the government’s after taking the panel’s advice). There were also two smaller ‘working groups’ dealing with issues specifically related to trading, clearing and settlement and the return of client assets.

  • •  The Advisory Panel is stated to be very representative of different interests. Further, ‘The Government hopes that this open and collaborative policy-making process will lead to robust outcomes which reflect the needs of market (p. 130) participants and secure the public interest in both financial stability and London’s position as a global investment banking hub.’76

  • •  This tone is continued in paragraph 1.35 where it is said that, in the spirit of G20 aspirations and various other initiatives: ‘The Government will seek financial markets, in the UK and internationally, that:

    • •  are open and competitive, meeting the needs of all constituents in society and the wider economy efficiently and fairly;

    • •  enjoy and inspire the trust and confidence of all users, including consumers;

    • •  are subject to stronger regulation that reduces the likelihood of damaging market and institutional failures; and

    • •  have effective mechanisms for dealing with the failure of financial institutions when, nevertheless, they do occur.’

  • •  Two ‘areas of possible difficulty’ are recognized; these are in relation to (i) clearing and settlement of trades and (ii) the return of client assets.

  • •  The UK’s general corporate insolvency regime is described as ‘robust and fit for purpose’.77 It is not accepted that the UK’s insolvency regime for investment banks is comparatively worse than competing jurisdictions; it is, however, recognized that there is a perception issue to be dealt with; ‘misconceptions’ have to be addressed.

  • •  The fact that investment banking is international in its nature imposes restraints on what any one jurisdiction can achieve by itself; not only are investment bank groups comprised of companies in various jurisdictions, they also use custodians and sub-custodians in various different countries; however, there is no EC directive or regulation applying to investment bank insolvency (although certain initiatives are under way).78

  • •  The number of venues where it is possible to execute (and clear and settle) trades in equities and derivatives transactions has increased considerably in recent years and although the increased choice is to be welcomed it has brought with it a degree of complexity; in the event of an insolvency of an institution like Lehmans, it takes some time to work out which trades are subject to which rules and which legal regime; the problems ‘left many counterparties lacking certainty with regard to their outstanding exposures and positions’.79

  • •  The Advisory Panel has noted that investors do not want their risk profile to turn on which of the relevant exchanges and clearing procedures are selected by their broker;80 there is a need for more information, clarity, and guidance in this area; it may also be necessary to address a perceived inequality of bargaining power between investors and brokers.

  • (p. 131) •  Prior to the Lehmans insolvency it may have been the case that clients did not always scrutinize their documentation very carefully because they took the view that the counterparty was ‘too big to fail’.

  • •  A helpful analysis81 of the current position under English law as to the circumstances in which clients have proprietary claims to money and other assets was provided (taking into account the implications of the then recent case of In re Global Trader Europe Limited);82 it was evidently felt that the market (and perhaps the FSA)83 needs a better understanding of the law in this area.

  • •  Indeed the crucial distinction between assets that are subject to ‘rights of use’ (or ‘re-hypothecation’) or are subject to title transfer collateral arrangements and those that clearly remain the client’s property (or subject to a trust in the client’s favour) is explored in some detail; the Lehmans insolvency has underlined the fact that assets in the former categories cease (or may cease) to be the property of the client, the arrangements having the effect of leaving the client with no more than a claim as unsecured creditor (although there may be rights of set-off); the law in this area is in fact, reasonably clear, but there is a ‘transparency problem’; the government identified three objectives in relation to this:

    • •  ‘resolving practical issues through better record keeping and reporting;

    • •  providing information around the segregation and re-hypothecation of assets; and

    • •  establishing legal clarity as to the basis on which assets are held.’84

  • •  Enhanced record keeping may be achieved by market initiatives or by regulation; the kind of information required includes: what assets are being held (and on what basis); by which custodians they are being held (and in which jurisdictions); what rights of set-off exist over them; aggregate value of assets over which a right of use has been exercised and the extent of any liens over assets;85 it may be desirable for details of the record-keeping system to be ‘embedded’ in ‘business information packs’ to be prepared by businesses (while they are still a going concern) to assist insolvency practitioners if, at any time, they have to take over; the ‘business information pack’ is an interesting concept in its own right—a requirement for a business to have a contingency plan for its own failure;86 the potential cost of such arrangements is noted as an issue (p. 132) but the benefits include enabling insolvency practitioners (who, as was the case with Lehmans, may be appointed with as little as twelve hours’ notice) to get to grips with the running of the business as quickly as possible; related proposals (set out in chapter 4 of the paper) are closer to the heart of a (possibly) modified insolvency regime; these include: placing continuity of service obligations on the administrators of firms in insolvency or on other relevant parties; amending insolvency law so that insolvency practitioners have lower exposure to liability (so that they do not feel obliged to behave in an ultra-conservative manner, resulting in unnecessary delays) or giving them special objectives as regards the issues covered in the paper; and establishing new roles for special insolvency office holders.

  • •  Although the government was content that the ‘Lehmans problems’ did not stem from legal uncertainty, it seemed possible that changes to the law would be proposed in the following areas: the use of third party custodians and affiliates for holding client assets and monies; the way in which client money is segregated; arrangements for set-off and liens; the establishment of bar dates to crystallize claims; the ‘regime around re-hypothecation’; the creation of special office-holders or objectives for reconciling client assets as a matter of priority; and the establishment of bankruptcy remote vehicles to establish market-led forms of client asset protection;87 this was a long list of potential reforms in areas of fundamental importance to market operations and in some of those areas the existing law gave London a ‘core competitive advantage’;88 the government was alert to the need to avoid ‘undermining the certainty of English law as it applies to financing transactions utilising mechanisms such as title transfer’.89

8.57  The May 2009 Consultation Paper, and, subsequently, the Bloxham Review, touched on a number of areas that had legal risk implications. These included: being sensitive to the overall need to preserve and improve legal certainty and to give the financial markets the assurance that any uncertainty produced by the consultation exercise itself will be resolved speedily; involving practitioners directly in the process (not merely as respondents to the consultation paper) and thus managing the legal risks implicit in reforming this branch of the law in the most effective way; addressing misconceptions as to the existing law being less satisfactory than is actually the case; and encouraging ‘market-led solutions’ where possible. One of the most complex areas of law considered in the paper related to rights of use and re-hypothecation. The underlying legal issues are considered at greater length in Chapter 22. However, in order to place the discussion of the effect of (p. 133) such provisions in context, an edited version of a typical ‘re-hypothecation’ provision is set out below:

  1. 1.  The Client hereby authorizes the Investment Bank at any time or times to borrow, lend, charge, hypothecate, dispose of or otherwise use for its own purposes any securities which the Client has charged in favour of the Investment Bank as security for its obligations to it (‘Charged Securities’) by transferring such securities to itself or to another person without giving notice of such transfer to the Client.


    1. (a)  a borrowing, lending, disposal or other use, such securities will become the absolute property of the Investment Bank (or other transferee) free from any security created under this Agreement and from any equity, right, title or interest of the Client;

    2. (b)  a charge or hypothecation of any of the Client’s securities, all of those securities, including the Client’s interest in them, will be subject to the charge or other security interest created by such charge or re-hypothecation.

Upon any such borrowing, lending, charge, hypothecation, disposal or use, the Client will have a right against the Investment Bank for the delivery of securities equivalent to those securities.

8.58  As explained in Chapter 22, the ‘title transfer’ concept is now in very wide use in the financial markets and the above clause is an example of how some of its underlying principles are applied to give an investment bank the right to take property that (originally) belonged to its client, transfer it to itself and use it for its own business purposes. In effect, the bank can use its client’s capital for proprietary trading (although there are restrictions on this in the US). The client is left with an unsecured claim as opposed to a property interest if the bank becomes insolvent. Prior to the Lehmans failure this was a risk that many market participants were prepared to take. Following that failure, this is apparently no longer the case. According to an IMF Working Paper by Singh and Aitken, published in March 2009,90 re-hypothecation declined rapidly after the Lehmans failure. This resulted in higher funding costs for financial institutions that had taken advantage of it previously. Forthcoming reforms affecting the ability of certain kinds of banks to engage in proprietary trading will also be relevant in this context.

8.59  As regards ‘client money’ a typical provision (at least prior to the Lehmans insolvency) might read as follows:

Any cash held by the Investment Bank for the Client is received by the Investment Bank with full ownership under a collateral arrangement and is subject to the security created by this Agreement. Accordingly, such cash will not be client money pursuant to the Rules of the FSA and will not have the benefit of any protection conferred by such Rules. Such cash held by the Investment Bank will (p. 134) not be segregated from the money of the Investment Bank or any other counterparty of the Investment Bank and will be held free and clear of all trusts. It is also agreed that the Investment Bank may use such cash in its business and the Client will therefore rank as a general creditor of the Investment Bank in respect of such cash.

8.60  This provision is clear. In fact, both the above provisions should be reasonably clear to the sophisticated investors who are generally supposed to operate in the wholesale financial markets, usually advised by very experienced lawyers. If they agree, in effect, to give up their rights in the manner indicated in these provisions, they take a risk (for which they may receive a reward in the form of better financial terms). They may have thought that the investment bank they were dealing with was ‘too big to fail’. And they may have got this badly wrong. But, even so, it is hard to see how one could argue that they did anything other than take a risk in full knowledge of the possible consequences. One of the issues that now has to be dealt with, however, and which underlies much of the Consultation Paper, is to what extent the law (or some form of ‘market-led’ solution) should step in to protect market participants from such consequences, or at least to make it more likely that they will fully understand the risks they are taking when they agree to such terms.

8.61  The May 2009 Consultation Paper was followed by a further Consultation Paper in December 2009 (‘Establishing resolution arrangements for investment banks’) which developed many of the ideas that were given exposure in the earlier paper and contained firm proposals for legislation. Among the more significant proposals were the following:

  • •  establishing a special resolution regime for investment banks that would involve the return of client assets being given priority;

  • •  giving administrators a ‘special defence’ against liability if they could show that they had acted according to the special administration regime objectives;

  • •  requiring firms to appoint a ‘Business Resolution Officer’ (BRO) at board level who would be responsible (in both ‘business as usual’ and ‘distress situations’) for coordinating and implementing ‘firm-level resolution actions’ such as those mentioned below; the BRO would be a key contact for parties such as the regulator who were concerned about an orderly wind-up of a failing firm’s business and would be responsible for ensuring that the board complied with relevant responsibilities;

  • •  requiring the preparation of ‘Recovery and Resolution Plans’ (RRPs) which would be subject to rules to be made by the FSA; an RRP would, in effect, anticipate a firm’s demise and put in place plans and procedures to reduce or even eliminate the problems that faced the administrators when they took over the running of Lehman’s business; these would, for example, ‘attempt a managed (p. 135) wind-down’ and be ‘based on principles of simplification, rationalization and reconciliation’;91

  • •  requiring firms to produce ‘Business Information Packs’ (BIPs), which would be ‘a contemporaneous and accurate repository of information on the investment firm’s business’; importantly, these would be produced on a ‘legal entity basis’ and the information has to be presented in a clear manner that can easily be understood by someone not familiar with the firm’s business; again, the need to ease the problems faced by Lehmans’ administrators is clearly to the fore; the BIP must ‘allow outside parties to understand quickly how a firm … . manages risk’ and, for example, have details on ‘specific risk management methods including up-to-date details on where the firm is exposed significantly in terms of products, sectors or counterparties’;

  • •  requiring the setting aside of an ‘operational reserve’ ie adequate liquid funds for paying key staff and suppliers in the event of insolvency so that services can be continued;

  • •  (subject to further consideration with the FSA) requiring prominent product warnings in documentation, alerting clients to potential risks in certain kinds of provision (eg, re-hypothecation, placing client money with affiliates) affecting the return of client assets; consideration was also to be given to limiting the ability to transfer client money to jurisdictions with unsatisfactory insolvency regimes and/or making transfers to affiliates generally; the experience of the likely losses flowing from LBIE placing client money with a German affiliate was no doubt influential here;

  • •  establishing ‘bar dates’ for clients claiming a proprietary interest in assets;

  • •  establishing the new office of ‘Client Asset Trustee’ (CAT) to uphold the interest of client money and asset holders together with a ‘Client Asset Agency’ (CAA); the CAT would be an insolvency practitioner specifically concerned with the return of client assets; administrators would remain responsible for dealing with creditors; the CAA would take over some of the FSA’s responsibility in relation to client money and client assets.

8.62  As can readily be seen, the issues associated with investment bank insolvency can be enormously complex. The Investment Bank Administration Regulations, in their latest form (following the Bloxham Review) have taken eight years to go through consultation and become law. It would not be surprising if further changes are proposed in due course as experience develops.

(p. 136) C.  Lehmans UK Litigation

8.63  The Lehmans administration gave rise to a significant number of important issues before the courts.92 These issues included schemes of arrangement, the so-called ‘anti-deprivation’ rule (on insolvency) the ‘return of client assets’ and various issues associated with ‘client money’. According to Mr Justice Briggs (as he then was), the Lehmans litigation:

… imposed unprecedented strains on the legal and regulatory systems of all the countries where its main business was based. Never before has there been an international insolvency on anything approaching such a scale. Never before had the insolvency provisions of international standard form derivative and other agreements been tested against the wholly unexpected insolvency of the banking counterparty, as opposed to that of the customer on the street, for which they were primarily designed. Never before have the numerous internal agreements put in place without any arm’s length bargaining, between companies in the same group, and designed mainly to satisfy regulators, become the arbiters of the innumerable and hugely complex disputes as to who owned the remaining assets when the music stopped, between group companies now at loggerheads under the management of separate office holders, in the interests of different classes of creditors.93

The more significant UK cases are considered in turn below.

8.64  In Re Lehman Brothers International (Europe)94 (heard on 26 October 2009), the Court of Appeal unanimously upheld the decision of Blackburne J that it was not possible to use a scheme of arrangement95 for the purpose of changing property rights of LBIE’s customers (as opposed to the rights of creditors, ie those seeking to enforce claims for money due, in contrast to those seeking the return of their own property). Under the Companies Act 2006, the court has power to sanction a compromise or arrangement proposed between a company and its creditors or any class of creditors when the creditors (or relevant class thereof) have agreed to it, by a majority in number representing 75 per cent in value. Although the Act does not define ‘creditor’ it was, according to Patten LJ ‘… obvious that someone with a purely proprietary claim against the company is not its creditor in any conventional sense of that word’.

8.65  The Court evidently felt some regret that it could not come to a different conclusion as the scheme that had been proposed by the administrators of Lehman (p. 137) represented, on the face of it, a reasonable solution to what had become a very difficult problem. Because of the nature of the Lehman business,96 those who had been left with claims on its insolvency fell into two large categories, represented by those with property claims (the ‘trust estate’) and those with debt claims (‘LBIE’s estate’). The administrators, the Court accepted, were ‘faced with the serious difficulty that, as things stand, they cannot be certain who is entitled to the trust property in their hands’. (The administrators also faced the serious legal risk that they might be held personally responsible for any error in returning property to claimants.) The uncertainties stemmed from three primary causes: ‘a lack of response from clients to enquiries made about the transactions in which they were involved; the inability of the administrators to rely on LBIE’s books and records; and the failure of custodians, depositories and affiliates to provide information about the assets held on behalf of LBIE’. The scheme would have had the effect of replacing the existing property claims with a form of claim on a pooled basis so that claimants asserting entitlements to the same asset would have a proportionate payment out of the securities comprising that asset. They would rank as unsecured creditors as to any shortfall. In the circumstances, the speedier payout that such a scheme would have enabled was almost certainly to the advantage of claimants on the trust estate (although, interestingly, the London Investment Bankers’ Association opposed the scheme) but the court felt that its hands were tied: the claimants on the trust estate were not creditors.

8.66  In Belmont Park Investments Pty Ltd v BNY Corporate Trustee Services Ltd97 the Supreme Court held that certain provisions in transactions entered into by a Lehmans entity (a special purpose vehicle or ‘SPV’ in a ‘tax friendly jurisdiction’) did not infringe the ‘anti-deprivation’ rule and thus were valid notwithstanding the Lehmans insolvency. The ‘anti-deprivation’ rule is concerned with contractual provisions that purport to take assets out of the estate of an insolvent, for the benefit of a particular counterparty or counter-parties, at the onset of the insolvency—and thus deprive the general body of creditors of the benefit of those assets. (It was common ground amongst the parties before the Court that the rule, if it applied, would apply on liquidation or administration as well as bankruptcy and that, although the SPV was not an English company, (p. 138) the issue should be decided as though it concerned insolvency proceedings in England.)

8.67  In the Court of Appeal, Lord Neuberger MR had quoted from the judgment of Page Wood V-C in Whitmore v Mason98 the following formulation of the rule: ‘no person possessed of property can reserve that property to himself until he shall become bankrupt, and then provide that, in the event of his becoming bankrupt, it shall pass to another and not to his creditors’. The rule is simply stated but has proved difficult to apply in particular cases, not least because of the inconsistent case law99—as the Master of the Rolls acknowledged (‘some of the judgments are a little hard to reconcile’). The judgment of the Master of the Rolls provides a summary of the relevant case law. Some of the ‘easier’ decisions quoted showed that the rule would apply to strike down, for example, a provision that increased the amount repayable by a debtor if he became bankrupt. On the other hand, where A grants to B a limited interest on A’s property (such as a lease or licence) a provision that terminates that interest on B’s bankruptcy is valid and does not infringe the rule.

8.68  The facts concerning the Lehmans transaction that the Court had to consider were complex, although the essential point was not. In the case before the Court, the Lehmans SPV entity had issued Notes to investors and used the proceeds to buy various securities, such as government bonds (the ‘Collateral’). The Collateral was vested in a trust corporation and charged to secure (i) the obligations to the Noteholders and (ii) the obligations to another Lehman company (‘LBSF’) which entered into an agreement (a form of swap) with the SPV under which it paid the SPV amounts equal to what was owed to the Noteholders in return for the SPV paying it an amount equal to the yield on the Collateral. The Collateral became enforceable in the event (which happened) various Lehman entities filed for Chapter 11 bankruptcy in the US. Apart from the agreement for the purchase of the Collateral, the documentation was governed by English law. Under the charging document it was provided that the priority of the two groups of beneficiaries (the Noteholders and the LBSF) changed if (amongst other things) the Chapter 11 filings occurred (each being an Event of Default under the Swap agreement). This provision (commonly known as a ‘flip’ provision) had the effect of disadvantaging LBSF (as against the Noteholders) if, in effect, the Lehmans group got into financial difficulties because the ‘usual’ (non-Event of Default scenario) priority under which proceeds of Collateral went to LBSF before the Noteholders would be reversed. Was such a provision contrary to the anti-deprivation rule?

8.69  The Court of Appeal and the Supreme Court unanimously upheld the ‘flip provision’, holding that the anti-deprivation rule was not infringed. There were a (p. 139) number of reasons for the decision referred to in the various judgments (with the most comprehensive judgment, and analysis of relevant case law, being that of Lord Collins in the Supreme Court). All the judgments laid emphasis on the need to respect ‘party autonomy’ as far as possible, particularly in complex financial transactions. Weight was also placed on the absence of any intention to evade the principles of insolvency law concerned with paru passu distribution and the fact that, as Lord Collins put it:

… this was a complex commercial transaction entered into in good faith.

8.70  In Re Lehman Brothers International (Europe)100 (heard on 6–8 October 2009) Briggs J was asked to consider an application by the LBIE administrators for directions on another of what he termed ‘the many difficult and complex issues arising in the administration of LBIE’. The question concerned cash received by LBIE after the commencement of the administration which derived101 from securities held by it as custodian (or by sub-custodians on its behalf). The securities in question were held pursuant to a Lehmans standard form document known as an ‘International Prime Brokerage Agreement (Charge Version)’ (referred to below as the ‘Charge IPBA’). The essential issue was whether the claims of LBIE’s counterparty (in this case RAB Market Cycles (Master) Fund Limited (referred to below as ‘MCF’)) were proprietary in nature (ie the cash should be treated as trust money) or whether MCF was only an unsecured creditor. (MCF was, in effect, representing the interests of a number of claimants in comparable positions; it had approximately US$50 million at stake on the point itself. The total amount at stake for all claimants in this position stood, apparently, at around $US1.8 billion at the time of the hearing. (For the sake of completeness, it should also be mentioned that the judgment was given on the basis of certain assumed facts.)

8.71  Under the Charge IPBA (in contrast to a comparable document which provided for title transfer collateral)102 it was clear that the property in securities charged to LBIE remained with its customer. What, however, was the position as regards cash received by LBIE in respect of those securities? Here, the language of clause 5.2 of the document (similar to that considered in paragraph 8.59 above) appeared to present a serious problem for the customer:

The parties acknowledge and agree that any cash held by us for you is received by us as collateral with full ownership under a collateral arrangement and is subject to the security interest contained in the Agreement. Accordingly, such cash will not be client money pursuant to the Rules (or any successor provisions thereto) and will not be subject to the protections conferred by the Rules. Such cash held by the Prime Broker will not be segregated from the money of the Prime Broker or any (p. 140) other counterparty of the Prime Broker and will be held free and clear of all trusts. The parties further agree that the Prime Broker will use such cash in the course of its business and the Counterparty will, therefore, rank as a general creditor of the Prime Broker in respect of such cash.

8.72  This provision (when read with the rest of the agreement) tells the customer: ‘As long as the collateral you have given us is comprised of securities then it belongs to you; but as and when any collateral becomes cash, it belongs to us—although we have to account to you for it on the basis of debtor and unsecured creditor.’ And the position of an unsecured creditor in the Lehmans administration was not an enviable one. This had the effect, as Briggs J put it, of causing a customer’s property to ‘leak away into cash, so as to be replaced by a merely unsecured receivable’ unless active steps were taken to manage the portfolio to keep it in the form of securities. Unfortunately, once the administration of LBIE had begun, it would no longer be possible to take such active steps. Requests and instructions from customers regarding their assets were ‘routinely declined’. Further, a customer would not be in a position to prevent moneys in respect of, say, redemption of securities or interest and dividends being paid to LBIE, following which the customer’s proprietary rights would, potentially, ‘disappear’. The provision was thus reasonably workable as long as LBIE continued in business but utterly disastrous (for the customer) once LBIE went into administration—a value-destroying provision on an epic scale. Was there a solution to the problem? Briggs J decided that there was.

8.73  In short, the judge found a way out for MCF by finding an implied term in the contract. He held that the securities charged to LBIE were held by it subject to a trust (notwithstanding that LBIE had been given a ‘right of use’ in the documentation103) which continued after the start of the administration (subject to the charge) and, most importantly, that clause 5.2 did not apply to cash received after the start of the administration. In applying this ‘temporal restriction’ to clause 5.2, Briggs J relied heavily on the restatement of the law on implied terms that can now be found in the Privy Council judgment in Attorney-General of Belize v Belize Telecom Limited104 from which various passages were quoted including:

The need for an implied term not infrequently arises when the draftsman of a complicated instrument has omitted to make express provision for some event because he has not fully thought through the contingencies which might arise, even though it is obvious after a careful consideration of the express terms and the background that only one answer would be consistent with the rest of the instrument.

8.74  In the judgment of Briggs J., ‘that description exactly fits the present case’. The parties could not have realistically intended that the provision would operate post-administration. There was no advantage in that for LBIE itself and (p. 141) certainly none for its customer. Since the result of this approach was that the cash was client money, and it had been segregated, it was, subject to certain qualifications, available for distribution to the relevant claimants. This was a satisfactory outcome—but, in legal risk terms, an uncomfortably close shave. No lawyer drawing up documentation of this kind would intentionally rely on implied terms.

8.75  In Re Lehman Brothers International (Europe)105 Briggs J, at first instance (the case eventually went to the Supreme Court106), was asked to look at a large number of questions relating to rights and duties affecting client money received by LBIE. The case, which, as regards certain questions, became very controversial, proceeded on the basis of an agreed statement of assumed facts (which is set out in the judgment). It was an application by the Lehman administrators that became known as the ‘Client Money Application’ because the issues largely related to the rules about client money and the related statutory trust set out in Chapter 7 of the FSA’s Client Assets Sourcebook (‘CASS 7’) which was itself part of the FSA Handbook. It included rules and other provisions made by the FSA pursuant to powers conferred by FSMA. CASS 7 constituted the UK’s implementation of the requirements of two EU Directives, MiFID and the MiFID implementing Directive.

8.76  The question that, according to Briggs J, lay ‘at the heart of the issues’ before the Court concerned the precise application of the statutory trust imposed on client moneys by CASS 7.7. As the judge said in his opening remarks:

In an ideal world, the flawless operation of the scheme created by the CASS 7 rules would ensure first, that the client’s money could not be used by the firm for its own account and secondly, that upon the firm’s insolvency, the clients would receive back their money in full, (subject only to the proper costs of its distribution) free from any claims of the firm’s creditors under the statutory insolvency scheme. The rules would achieve these twin objectives by ensuring that, promptly upon receipt, client money was held by a firm as trustee, separately and distinctly from the firm’s own money and other assets, and therefore out of reach both of the firm (for the conduct of its business) and of the firm’s administrator or liquidator upon its insolvency (for distribution among its creditors).

8.77  That would be the position in the ideal world. In the ‘imperfect and hugely complex real world occupied by LBIE and its numerous clients’ things looked rather different. The fundamental issue turned on the fact that although CASS 7 required client money to be segregated from ‘house funds’ (ie paid into a different bank account or accounts) LBIE had, to a very significant extent, failed to do this. (At one point, the judge said that LBIE had ‘spectacularly’ failed to comply over a long period.)

(p. 142) 8.78  The failure to segregate was apparently partly due to LBIE assuming that its affiliates’ money could not be client money.107 The amount involved under this head exceeded $US3 billion. (By way of contrast, the amount that LBIE had actually segregated pursuant to CASS 7 was, at the start of the administration, some $US2.16 billion). There were also claims from non-affiliates for significant sums, to some extent based on an alleged failure to recognize they had a proprietary entitlement rather than a mere unsecured creditor position. In addition to problems (or potential problems) stemming from the failure to segregate, there was also the very unfortunate fact that LBIE had deposited around $US1 billion of client money with a German affiliate (Lehman Brothers Bankhaus AG) which had also become insolvent. There was great uncertainty as to how much (if any) of this money might be recovered.

8.79  The judge described the non-achievement of the client money rules’ objectives as being on ‘a truly spectacular scale’ and the result as being a ‘shocking underperformance’. The possible consequences to Lehman customers of its having failed to comply with segregation obligations were that their claims would not be proprietary but only those of unsecured creditors. This was of course a distinction of crucial importance. It seems unlikely that Lehman customers would have fully appreciated the legal risk that, potentially, lay embedded in the language of CASS 7 when it transpired that they were not, after all, in the ‘ideal world’ to which the judge referred. How serious that risk was would depend on how the courts answered the first question to be addressed—and perhaps the most important one of the many that had to be considered: what was the effect of the failure to segregate on the statutory trust (and thus the recovery prospects of affected clients)? To put the question in the language used by the judge: ‘Does the statutory trust created by CASS 7 take effect upon receipt, or only upon the segregation of client money?’ As a first step in considering this question, one should look at the definition of client money and the terms of the statutory trust. Client money is defined (in the Glossary applicable to CASS 7) as ‘… money of any currency that a firm receives or holds for, or on behalf of, a client in the course of, or in connection with, its MiFID business’.108 There are a number of important provisions that qualify the basic rule. (For example, money that becomes properly payable to the firm for its own account ceases to be client money and money that is used for the purposes of collateral within the scope of CASS section 7.2.3R is not client money.) The statutory trust is provided for in CASS 7.7.2. This provides that ‘a firm receives and holds client money as trustee …’ on terms that the provision sets out in detail, essentially providing for distribution to clients (p. 143) in proportion to entitlements after payment of distribution costs. The requirement to segregate client money is in CASS 7.4, which requires it to be placed in an account separate from the firm’s money (although client monies may be held in one or more accounts that commingle client moneys together). Importantly, firms have a choice as to whether they comply with the segregation obligation, in effect, promptly upon receipt (the ‘normal’ approach) or, initially, pay client money into the firm’s (‘house’) account and make a payment to a client money account after a ‘reconciliation’ calculation of net balances between client money and firm money made on a business day109 delay basis (the ‘alternative approach’). LBIE used the alternative approach. Briggs J made the following observation regarding that approach:

The periodic reconciliations and segregations … will inevitably be conducted at a time later than the point of reference to which they relate. Typically the point of reference is close of business, and the reconciliation and segregation are carried out usually during the morning of the following business day. During the period between the point of reference and the actual segregation (or de-segregation) of the amount of money required to bring the segregated accounts into accordance with the client money requirement, further client money will have been received from clients into, or paid to clients out of, the relevant house accounts used for that purpose. It necessarily follows that every reconciliation and segregation conducted under the alternative approach which leads to an increase in the amount segregated reflects the fact that, between the previous point of reference and the point of reference in question, there will have been client money mixed with the firm’s money in house accounts.

8.80  No FSA guidance existed as to the legal consequences of the mixing of monies that followed from the alternative approach. Those who argued that the statutory trust only took effect on segregation placed some reliance on the fact that there was no express restriction in CASS as to what a firm could do with money held in its own account. On the other hand, the literal meaning of CASS 7.7.2 (quoted above) pointed towards the trust applying as soon as money was received. Briggs J held that the ‘on receipt’ view was the correct one and this view was upheld by the Supreme Court. The Global Trader cases,110 which at first sight seemed to point to the other view, were easily distinguishable, since they had been concerned with a firm’s failure to segregate out of its own funds money belonging to a client (not a failure to segregate money received from or on behalf of a client). In such a scenario, until there had been some appropriation of some kind ‘there is simply no identifiable property to which a trust can rationally be attached’. The position was different where money belonging to a client was received by a firm. It seemed counter-intuitive to say that it would cease to be the client’s on being placed in the firm’s account but then become the client’s again when (substitute) (p. 144) money was transferred to client account. The judge also felt that the ‘on receipt’ approach better reflected the objectives of MiFID (of protecting clients’ rights on insolvency, etc). It was also held that, notwithstanding the absence of any express restrictions on what a firm could do with money in its account, there was ‘an obligation to deal with house accounts in such a way that clients’ rights in relation to client money in those accounts are not put at risk, and the client money not used for the firm’s own purposes, pending segregation’. This duty might involve (it was ‘not for the court to specify the precise method’) ensuring that the house account maintains a minimum credit balance equal to the client money deposited in it, avoiding the account being subject to any kind of charge or other security or using ‘group liquidity arrangements of the type used by the Lehman Brothers Group’.

8.81  The decision on this point thus achieved a result that appeared to conform to what one might have regarded as the legitimate expectations of investment bank customers who had taken the language of CASS literally. It also involved the FSA reversing its own position (as reflected in official guidance) that the trust only applied on segregation. The FSA was represented before the Court and its counsel ‘roundly declared to be wrong’ an FSA statement that indicated that the client money had to be in a client bank account for the trust to attach. However, although the judgment is helpful in principle to clients making claims in an investment bank insolvency, arguments to the effect that such clients had some kind of security over unsegregated client money were rejected by the Court and this inevitably leaves them with potentially difficult problems as to how, in practice, they might be able to trace money that has not been segregated. If money is paid into an account that subsequently goes into overdraft or has a zero balance (even temporarily), it then becomes impossible to identify that money, for the purpose of tracing, and the value of the tracing right is lost. As Briggs J acknowledged, it was likely that ‘… it will prove extremely hard for unsegregated clients to [trace], in relation to any failure to segregate their client money over a significant period of time’. The tracing claim would be ‘necessarily limited to the minimum balance on that account between the date of deposit of client money and the date of the claim’. So the practical benefit of the decision for those whose money is wrongly not segregated may prove to be very limited.

8.82  The case addressed a substantial number of other issues raised by CASS and the need to resolve competing claims in respect of client money. For the purpose of this book, we have concentrated on the central issue of how and when the statutory trust operates. But other questions, notably on the vexed question of how the rules on ‘pooling’ of client money should operate where some money has been segregated and some not, were also before the courts and the final decision of the Supreme Court on these issues has attracted some criticism insofar as it was held that segregated and unsegregated money claims should be pooled for the purpose of claims. This has the potential effect of adversely affecting the claim of a client (p. 145) who has gone to some lengths to ensure his ‘client money’ is segregated since his claim may be ‘diluted’ by claims of clients who had unsegregated money. The case shows that the law in this area is extraordinarily complex: not only did a major international financial institution (presumably with the best legal advice available to it) fail to understand it but, also, even the FSA got the law wrong on the central issue as to when the statutory trust attaches.

8.83  In the case that became known as the ‘Rascals’ case, Re Lehman Brother International (Europe),111 the Courts had to interpret the legal effect of a series of intra-group contracts made by Lehman companies that had been entered into with the dual purpose of (a) enabling one Lehmans entity (LBIE) to operate as the interface (or ‘hub’ company) with the market (or the ‘street’) in relation to a series of wholesale market transactions in securities where other Lehman entities were, commercially if not legally, intended to have the beneficial interest in the securities that were the subject of those transactions and (b) maintaining the best possible regulatory capital treatment for LBIE. The capital question, in a sense, ‘drove’ the structure of the transactions since, if it was documented on the ‘simple’ basis that LBIE acquired securities on behalf of affiliates who owed it unsecured debt for the purchase price, that capital charge on LBIE would have been severe. The Rascals transaction structure was designed, through the use of a very complex series of repo transactions, to put LBIE in the position of having title to the securities itself rather than an unsecured debt. If the arrangement ‘worked’, the other important effect was that LBIE would have the ability to trade the securities with the ‘street’ as beneficial owner. The repos, broadly, operated so as to cause the affiliate, as soon as LBIE had acquired securities for it, to ‘repo’ them ‘back’ to LBIE so that LBIE became the owner with the two resulting inter-company debts being offset against each other. The questions before the courts were concerned, essentially, with who owned what when ‘the music stopped’ (ie when LBIE went into administration). Somewhat ironically, the case was a dispute between LBIE and an affiliate as to who had ownership, with one side to the dispute arguing that the documentation that the Lehmans group had spent much time and money in preparing was ineffective. The Court of Appeal held, in effect that the desired outcome of the documentation was achieved (that is, that LBIE was the beneficial owner) although the legal arguments used to reach this result (relying significantly on a desire to give effect to the parties intentions and estoppel on a question of property law rather than contract) have attracted a certain amount of criticism.112 The facts of the case, which comprise largely an account of the infernally complex documentation, are not easy to follow and the (p. 146) arguments that persuaded the court are somewhat labrynthine. The importance of the case—as regards legal risk—lies not so much in the risks taken by the parties (which were not material as long as none of them became insolvent) but as an example of the English courts’ willingness to go as far as reasonably possible to interpret the combined effect of documentation and the relevant law in a way that gives effect to the evident commercial intentions.

8.84  Another case evidencing such willingness was Lomas v JFB Firth Rixon,113 one of a series of cases114 heard by the Court of Appeal on the interpretation of the 1992 ISDA Master Agreement. The particular clause giving rise to difficulties was section 2 (a) (iii) which, in a provision that ostensibly seemed relatively routine, stated that a party's obligations were subject to the condition precedent that no ‘Event of Default’ or ‘Potential Event of Default’ with respect to the other party has occurred and is continuing. Questions to be decided by the courts related not only to the interpretation of the clause but also if it was valid at all (because of the anti-deprivation principle and the pari passu principle).115 The Court upheld the validity of the clause, holding it to be sound as regards ‘anti-deprivation’ due to it being commercially justifiable and not an attempt to evade the principles of insolvency law (following a similar logic to the arguments in the Belmont case) and, as regards the pari passu issue, holding that there was no relevant asset being unfairly distributed (in contravention of the principle) as the effect of the clause was to suspend a payment obligation owed to the insolvent entity. As regards interpretation, the Court held that the clause operated to suspend the payment obligation until the default ceased to exist. This latter point caused sufficient disquiet in the market for ISDA to publish, in June 2014, an amendment to the provision which enabled the ‘limbo’ effect of the provision to be brought to an end by giving the defaulting party the right to place an end date on the suspension of the payment obligation. These cases are a graphic illustration of the limitations of standard forms—even those with the undoubted stature of the ISDA forms—and provide very real examples of how even the most tried and trusted documentation can come under pressure if an insolvency causes them to be tested in the courts. In the event, the ISDA forms ‘survived’ the test of litigation but few would have predicted that they could come under such exacting examination not only as regards interpretation but even as regards validity.

8.85  The last of the Lehman cases to be considered here, which also illustrates some questionable drafting in standard form documents, is the case that became (p. 147) known as the ‘Extended Liens Case’.116 In this case, heard by Briggs J, the issues turned on a ‘Master Custody Agreement’ (MCA) under which LBIE held as custodian various securities belonging to its customers. Clause 13 of the MCA provided that LBIE should have a ‘general lien’ over the customer’s property (which consisted essentially, of intangible assets held by LBIE as custodian) as security for obligations owed by the customer to LBIE or any of its affiliates. One of the issues to be decided was what exactly the reference to a general lien meant, that is, what kind of security was created? The use of the term ‘lien’ gave rise to some difficulty as, under English law, liens can only apply to tangible property (for example goods being repaired). The court decided that, given the overall context of the document and the powers conferred on LBIE, the security created by the ‘lien’ was in fact a charge … a floating charge. But the court also had to consider the question of whether the security interest was ‘saved’ from any registration requirement by FCA(2). This took the Court into the controversial area of ‘possession’ and ‘control’117 in the context of floating charges that followed from the decision in Gray v GTP Group.118

8.86  In the Gray case, Vos J had decided, in an ex tempore judgment, that a charge over a balance in a bank account could not fall within the scope of FCA(2)119 because the charge (or ‘collateral taker’) did not have the requisite degree of possession or control (one which a collateral taker must have if a security financial collateral arrangement is to qualify to be within the scope of FCA(2)) because possession was not a concept that could be applied to intangibles and also because the chargor could direct how the moneys in question were dealt with (pending crystallization).120 Briggs J came to a similar conclusion, as regards control, with respect to the charge in the Extended Liens case since the chargor retained significant rights in relation to the charged property which were inconsistent with the notion that the collateral taker had control. As regards possession, the judge did not accept that it was impossible for an intangible to be ‘possessed’ although the requirements for possession in this case would seem to involve more than merely having the security transferred to the charge.121

8.87  The Lehman failure also spawned a remarkable document produced by the US court system. On 16 January 2009, the US Bankruptcy Court for the Southern District of New York required the appointment of an Examiner to investigate various issues associated with the failure. The man appointed for the task was Anton (p. 148) Valukas. He delivered his report on 11 March 2010. Valukas looked into a number of aspects of the behaviour of Lehman senior executives and their advisers in the period leading up to the failure and found that, in some cases, there was cause for belief that ‘colorable claims’ might have arisen. Valukas was particularly concerned about the accounting treatment (and non-disclosure) of transactions known as ‘Repo 105’ transactions. According to the Valukas Report these were a variant on standard repo transactions122 in that they involved more than the usual value of securities as a proportion of the capital raised (eg, US$105 of securities would be repo’d for every US$100 raised: hence the name given to the transaction). This, apparently, opened the door to the transactions being accounted for as ‘true sales’ as opposed to financings. Also important for this purpose was the legal question of whether or not the transactions were true sales as a matter of law. If they had been governed by US law, this would not have been the case. But the transactions were governed by English law (with LBIE as the Lehman party) and, since they required the ‘repurchase’ of ‘equivalent’ securities rather than the same securities that were originally transferred, a ‘true sale’ was the correct legal analysis. The net result was that very large sums,123 effectively, disappeared from the Lehman balance sheet at crucial quarter end dates as Lehman entered into these transactions in a manner that ‘straddled’ such dates. This had the effect of flattering the accounting portrayal of Lehman’s leverage, since a bundle of securities that otherwise might have appeared on the balance sheet as financed by a borrowing would be replaced by cash (as raised by the repo) which might be used to repay the borrowing. The Valukas Report found that the transactions had no substance: ‘Repo 105 transactions were not used for a business purpose, but instead for an accounting purpose: to reduce Lehman’s publicly reported net leverage and net balance sheet.’

8.88  Not surprisingly, the publication of the Valukas Report gave rise to something of a furore in the media. The Financial Times reported that it had sent ‘shockwaves through the accounting fraternity’ as it had been critical of Lehmans’ auditors. Its front page headline on 13 March 2010 was: ‘Lehman file rocks Wall St’. There was a certain amount of commentary about the ‘UK law firm’ (Linklaters) that had provided opinions about the Repo 105 transactions, some of it suggesting (incorrectly) that the firm had approved of them in some way (the Financial Times referred to ‘rubberstamped’, ‘signed off’ and ‘deemed legal’ at various points) but the opinions (an example of which is appended to the Valukas Report) are unremarkable in that they simply provide a correct summary of the English law on recharacterization, as relevant to the transactions, as described elsewhere in this book.124 The Financial (p. 149) Times also referred (on 15 March 2010) to the transactions being booked through the UK because of a ‘legal quirk’ but the quirkiness of the affair was surely more a question of accounting and disclosure (particularly US accounting) rather than legal analysis. (It appears that the LBIE accounts presented to the FSA in the UK would have disclosed the transactions whereas the consolidated accounts prepared under US GAAP did not.)125 At the time of writing, it remains to be seen whether any of the ‘colorable claims’ referred to by Valukas will become actual and whether or not they will be successful.

D.  The Landsbanki ‘Freezing Order’

8.89  The financial collapse of various Icelandic banks towards the end of 2008 raised important and urgent issues for the UK government in view of the fact that some of those institutions had businesses located in the UK that had attracted deposits from UK individuals and institutions. Some of these businesses were operated through subsidiaries and some through branches. The subsidiaries were regulated by the FSA and the branches were regulated in Iceland but able to operate in the UK by virtue of the EU ‘passporting’ system (from which Iceland could benefit since it is a member of the EEA). Particular difficulties, with legal risk implications arose in connection with the collapse of Landsbanki (the country’s second largest bank), which operated through a UK branch with the trade name ‘Icesave’. On 7 October 2008 the Icelandic government passed emergency legislation to take over Landsbanki. Concerns were immediately raised in the UK as to whether the Icelandic government would cause Icesave to honour its obligations to UK depositors.126 Conversations between governments were had at the highest level without any mutually satisfactory outcome apparently being achieved. On 8 October 2008 the UK Treasury made an Order (the Landsbanki Freezing Order) under the Anti-terrorism, Crime and Security Act 2001 to freeze all funds that were related to Landsbanki. A number of unintended consequences followed from the making of this Order, with considerable (p. 150) legal uncertainty being created in the financial markets, subsequently reported on in some detail in an FMLC paper produced in May 2009.127 Although the enabling legislation was passed before the Crisis (and the title of the statute, with its references to terrorism, produced a strong reaction from Iceland)128 its use (to make the Order) in the context of the Crisis may fairly be said to be a legislative response to a Crisis phenomenon.

8.90  Much of the legal difficulty stemmed from the extremely broad terms in which the Order was drafted.129 It covered all funds ‘owned held or controlled by’ Landsbanki or ‘related’ to Landsbanki as well as a range of Icelandic institutions, including the Icelandic government and central bank. It contained a range of prohibitions, including a requirement not to ‘deal with’ frozen funds. Although the expression ‘deal with’ was defined in the Order, the definition left a number of important questions unanswered. For example, it was not clear whether the operation of a set-off or close-out netting provision would be caught. (As with many points of interpretation, a licence was subsequently made under the Order permitting this.) The issues are detailed in the FMLC paper. This document also contains some useful guidance for draftsmen of future orders (if they should be required). These include:

  • •  Make the order as narrow and precise as possible (rather than making it very broad, following up with detailed exemptions and licences); precision is needed especially on (a) to whom the order applies (b) the funds or assets covered and (c) the kinds of transactions restricted.

  • •  Try to avoid restricting normal market behaviour (including the exercise of normal contractual rights such as set-off) if this is not within the ‘mischief’ to which the measure is directed.

  • •  Wherever possible, include a ‘sunset clause’ so that the order expires automatically after a given time, unless renewed.

  • •  Set-off and netting should not normally be prevented by an order.

  • •  Disclosure obligations should be proportionate and limited to where a firm holds frozen funds (and the disclosure obligation should be limited to disclosing that information).

(p. 151) E.  The Turner Review and the Initial Response of the FSA

8.91  The UK’s principal regulatory response to the Financial Crisis was, initially at least, set out in the Turner Review. The following is a summary of the main points made in the Review by way of reform proposals and other changes.

  • •  Capital. The Review took the view that the most fundamental changes that were required relate to capital adequacy, liquidity, and accounting. A balance had to be struck between demanding so much extra capital that banks feel constrained from lending in the ordinary course and demanding insufficient extra capital to cure them of their ‘excessive risk taking’ habits. Wherever that balance is struck, the FSA (as it then was) was of the view that the new levels of capital would be ‘significantly higher than that which appeared appropriate in the past’.130 The point was also made that: ‘The future world of banking probably will and should be one of lower average return on equity but significantly lower risk to shareholders as well as to depositors.’131 One of the more striking changes would be to increase considerably (a ‘radical change’) the amount of capital held against trading book exposures. The historically generous treatment of the trading book used to be justified on the basis that the exposures could easily be disposed of. The Financial Crisis showed the weakness of this theory.

  • •  Accounting treatment. The Financial Crisis caused many commentators to question the appropriateness of ‘mark-to-market’ accounting. A sudden crisis in liquidity can cause a market to seize up very quickly: assets that might previously have been held at a fairly high value (while the market still had confidence) might suddenly have to be written down to a nominal value. This can itself create a domino effect, exacerbating an already difficult situation, as more and more institutions feel forced to liquidate positions. However, the FSA did not propose a radical change of this accounting methodology but suggested that it be balanced by a new requirement to hold an ‘Economic Cycle Reserve’. This would attempt to compensate for the pro-cyclicality effect of mark-to-market by establishing a reserve ‘in good times’ to help deal with the series of problems that arise when the cycle moves into ‘bad times’.

  • •  Liquidity. It was acknowledged that liquidity risk management did not receive adequate attention in the period leading up to the Crisis. Certain proposals on the subject were put forward by the FSA in a paper in December 2008132 but the Review went further, proposing a general ‘core funding ratio’ on which debate is encouraged. The policy objectives include the encouragement of: less (p. 152) reliance on short term wholesale funding (including from foreign counterparties); attracting more retail time deposits; and higher quality, more liquid assets (including government debt).

  • •  SIVS and hedge funds, etc. The Review made the statement (surprising only in that it needed to be made) that ‘regulation should focus on economic substance not legal form’.133 As a result, off-balance sheet vehicles, such as SIVs should now be treated as if they were on balance sheet for regulatory purposes. But if SIVs are identified as part of the worrying ‘shadow banking system’, what about hedge funds? The FSA is concerned about any activity that becomes ‘bank-like’ and sufficiently large to have systemic implications. As of 2009, the FSA was not concerned that hedge funds were, in general, sufficiently ‘bank-like’ to justify bank-like, prudential, regulation and, in any event, did not see them as responsible in any way for the Financial Crisis. But regulators need to have power to obtain information about such activities so that they can form a judgement about what, if anything, needs to be done about them as they evolve and to look at the systemic impact of the activity in the aggregate. The Review noted that investment banks evolved rapidly over a period of about 25 years from being institutions with virtually no systemic significance (when they were often called ‘broker-dealers’) to being capable of causing the catastrophic consequences symbolized by the fall of Lehman Brothers. So the emphasis in the future, according to the FSA, should be on being able to access information and impose prudential regulation if ‘bank-like’ roles or other systemic concerns start to emerge.

  • •  Offshore centres. Whilst the Review does not regard offshore centres as responsible for the Financial Crisis, it was recognized that tighter controls over their operation would be needed if they were to be prevented from becoming an alternative home for activities that the new regime regulates more severely than before.

  • •  CRAs. The need to reform CRA134 governance was acknowledged and the FSA was supportive of the initiatives for supervisory oversight being taken at EU level. It also noted that the EU measures needed to be matched in other important centres.

  • •  Remuneration. The FSA subscribed to the new, post-Financial Crisis philosophy that ‘inappropriate’ remuneration structures (typically, weighting too much pay on bonuses that are triggered by short term phenomena) could act as an incentive to ‘inappropriate’ risk taking.135 Various reforms have followed in this area.

  • (p. 153) •  Netting, clearing and central counterparties in derivatives trading. It was noted that the use of clearing mechanisms using central counterparties in derivatives (particularly CDS) trading would enable multilateral netting and result in a significant reduction in exposures. The FSA supported the various initiatives being taken to set up such systems and various reforms have since been implemented.

  • •  The more ‘intrusive’ and systemic approach to regulation. The FSA promised a ‘fundamental shift’136 in its approach to regulation. This would involve a number of changes in emphasis (many of them with strong echoes of lessons learned from the Northern Rock failure) including: less focus on systems and processes and more on key business outcomes and risks and the sustainability of business models and strategies; as regards ‘approved persons’, more emphasis on technical skills and probity; an increased focus on sectoral phenomena to enable ‘outliers’ to be more easily identified and also to pick up trends across sectors that might have systemic risk implications; and more intensive analysis of information that is relevant to key risks (including, eg, liquidity risk).

  • •  Risk management and governance. The Turner Review, to some extent, anticipated the likely direction of the Walker Review137 (for which the FSA provided the secretariat). Key issues raised by the former were: risk management should be linked to remuneration structures (as indicated above); there should be an improvement in the skill levels and time commitment of non-executive directors and more emphasis on a willingness to stand up to ‘dominant chief executives pursuing aggressive growth strategies’; and ways should be found to improve the ability of shareholders to exert influence over management. There was a specific mention of the possibility that systems going beyond the general Combined Code might be required.

  • •  Separation of ‘classic’ commercial banking (or ‘narrow banking’) from ‘risky trading activities’. This is sometimes referred to (see Chapter 6, Section A above) as separating the utility and casino functions—or, to use US parlance, a return to ‘Glass Steagall’ (the legislation in the US, now repealed, that required separation of commercial from investment banking). The FSA accepted that the ‘theoretical clarity’ of the argument for separation had received much support. The Governor of the Bank of England made his views fairly clear in his Mansion House speech of 17 June 2009 when (commenting also on the undesirability of banks just getting too big) he said:

If some banks are thought to be too big to fail, then, in the words of a celebrated American economist, they are too big. It is not sensible to allow large banks to (p. 154) combine high street retail banking with risky investment banking or funding strategies, and then supply an implicit state guarantee against failure. Something must give. Either those guarantees to retail depositors should be limited to banks that make a narrower range of investments, or banks which pose greater risks to taxpayers and the economy in the event of failure should face higher capital requirements, or we must develop resolution powers such that large and complex financial institutions can be wound down in an orderly manner. Or, perhaps, an element of all three.

  • •  ‘Direct product regulation?’ The old ‘regulatory philosophy’ would never have countenanced direct regulation limiting the ability to develop, and trade in, particular kinds of product. After all, markets are supposed to know best: ‘well managed firms will not develop products that are excessively risky, and … well informed customers will only choose products that serve their needs’.138 This philosophy has been tested to breaking point by the Financial Crisis. The head of Deutsche Bank, Josef Ackermann, famously remarked, in March 2008 that he no longer believed in the market’s ‘self healing power’. Other commentators, at the time, made even more apocalyptic statements about the death of free market capitalism. In the Turner Review, the FSA said that it was no longer a ‘given’ that ‘direct product regulation’ was by definition inappropriate. A ‘debate’ is called for. The following arguments for change (in the context of CDS, cited as ‘a specific example’) are considered:

    • •  CDS contracts are like insurance and in conventional insurance one cannot take out a policy without having an insurable interest; as Soros points out, the current regime can lead to situations where CDS give strong financial incentives to vote against corporate rescue.

    • •  CDS tend to lead to risk being understated in good times and overstated in bad times; they are not good indicators of risk, as has commonly been supposed.

    • •  Because they can lead to volatility, they can also be instrumental in bringing about the defaults that they are supposed to protect against.

    • •  The above factors can be particularly harmful where CDS are taken out against banks, which are especially susceptible to confidence swings in times such as those experienced in the Crisis.

F.  The Walker Review

8.92  It is generally accepted that the principal cause of the Financial Crisis was basic bad management in the banking industry. Huge mistakes were made. How could (p. 155) management have got it so wrong? And what can be done about it? In conventional commercial corporations, the answer to that question might, following strict free market theory, be: ‘nothing, it’s the shareholders’ responsibility to hire and fire managers and not a matter for law or regulation’. But, as we know, banks are different. Bank failure can have systemic consequences. So the management of banks (or their ‘corporate governance’) cannot be a matter left entirely for shareholders. Good corporate governance of banks is not just a ‘nice to have’, it is an essential.

8.93  The question of governance has, inevitably become linked to questions about the so-called ‘bonus culture’ prevalent in financial institutions and is now closely tied to ‘conduct’ questions.139 There is an argument, somewhat overstated at times, that improperly structured bonus schemes encourage excessive risk taking. Not surprisingly, this has risen high up the political agenda for reform. Restricting bankers’ ability to pay themselves bonuses has populist appeal. But another, more obvious, failing in governance revealed by the Financial Crisis was the apparent inability of non-executive directors to stand up to over-dominant chief executives, especially those bent on over-ambitious and risky projects. This version of ‘deference’ even extended, some believed, to the regulators themselves. One of the authors140 commented on the problem in an LFMR Editorial (May 2008) extracts of which are set out below:

On being contrarian

Laws and regulations are not, generally, self-executing. They require application, implementation, enforcement, judgement, sentencing … human intervention at all stages. This, inevitably, results in a degree of discretion and some unevenness and uncertainty in the way laws work in practice. The ‘penumbra of uncertainty’ is a well-known phenomenon and one that we can live with … up to a point. In the financial markets, uncertainty is not welcomed as we all know although, in reality, a fair amount of ‘known unknowns’ is tolerated.

The discretionary area produced by the gap between text and real life practice potentially produces uncertainty but this is often reduced by the application of convention—an accepted understanding of how things are done within (and sometimes outside) the parameters permitted by a rule. Conventions are part of our constitutional and legal structure and they are equally an important part of business and social structures. At one level, we may insist on ‘zero tolerance’ for a particular kind of crime (or, on the other hand, turn a blind eye); at another, indulge a custom that a certain member of the family has prior rights to sit in a particular chair. In business organizations, conventions take many forms and in most cases are essential to the smooth operation of a complex mechanism. But where the business (or a part of the business) is headed by a very powerful individual, on whose continuing involvement the business is seen to have a disproportionate dependence, conventions may start to have a pernicious effect. Suppose, for example, you have just been (p. 156) appointed a non-executive director of a bank. It is your first board meeting and you want to make a good impression. The meeting is chaired reasonably competently but a number of things catch your attention. Some of the papers for consideration only arrived just before the meeting, and then only in electronic form. They were not identified clearly in the agenda, so you are not sure to which item or items they relate or who will speak to them. The Chairman appears to be excessively deferential to the CEO. The CEO politely, but vaguely, answers a question you put to him and starts to show his impatience when you have the nerve to ask for clarification. None of the other non-executives say anything. The minutes arrive several weeks later and make no mention of the issue you raised (which you had thought reasonably important). Should you say anything about your concerns at the next meeting? Will this look like ‘making a fuss’? Making a complaint could seem niggling and petty. Do you bide your time until you no longer feel like a ‘new boy’? How long is that? The convention to ‘go with the flow’ weighs heavily on you—non-executives do not ‘make waves’ in this company. (No wonder they don’t want lawyers on the board!)

And then, a few meetings later, the Chairman tells you it has been decided that it is in the interests of the bank that the CEO succeeds him as Chairman, while hanging on to the CEO role. You are left in no doubt that any opposition to this flouting of ordinary principles of good governance will be met by a threatened resignation of the CEO. The full force of the convention finally hits you: no one says ‘no’ to the CEO. You have so far been lulled by the unspoken application of the convention, and now—with no track record whatsoever of making challenges—you are in a weak position to resist. All the written processes and procedures suggest that the bank is well managed. But, from top to bottom, conventions undermine the text. The CEO lords it over the board, the managers of the various business lines lord it over the legal department and the heavy hitting traders lord it over compliance, since they know that traders who break the rules but still make big profits are smiled upon by senior colleagues who are far more powerful than anyone in compliance. External advisers have long ago given up any pretence of being able (or wanting) to assert any moral suasion on any issue of importance. Where are the controls in substance? As the FSA points out:

The statement that a process exists, or a control is in place, does not indicate that the process is followed all of the time or that the control is 100% effective in delivering the desired outcome.141

It is not difficult to see how convention can undermine a theoretically sound-looking risk control procedure. Whose responsibility is it to check this does not happen? And how is their independence assured? Clearer rules on ‘niggling’ details would have helped a non-executive in the situation described. Their absence left room for discretion which, when dressed up as ‘flexibility’, can seem very appealing—but that in turn opened the door to arbitrary, even dictatorial behaviour. While times are good, no one notices (or, at least, says anything about) the defects in the system. When times are not so good, the defects suddenly seem horribly obvious.

Some element of convention—certainly slackness in process implementation—may have adversely affected the FSA’s own supervision of Northern Rock. The FSA’s summary of its own investigation into the matter remarks (at paragraph 41) that:(p. 157)

One of the themes to emerge from the review has been the apparent ease with which individual members of staff have been able not to comply with established processes …

There is no need for us to add to the criticisms already laid at the FSA’s door over Northern Rock, not least by itself. But the various comments that have been made as to how to avoid making the same errors in the future do draw attention to the need for the regulator to be tough and independent and, here, we think it would serve us all well to stand back for a moment and assess what happened in the wider context.

‘Agile, tough and contrarian’ are three estimable qualities that, according to the Financial Times’ Lex column,142 regulators should possess and the FSA did not have when it was overseeing Northern Rock. Many commentators have rightly pointed out that even if the FSA had done its job better (made notes of meetings and perhaps had a few more of them, for example) it is far from clear that it had enough of these qualities to have told Northern Rock that it had to change its funding arrangements. The problems that we had in the second half of 2007 would therefore still have occurred.

But who, these days (or, certainly, those days), would have the temerity to tell a large financial institution that it had got its business model wrong and that it should fund itself in a more conservative manner? Let’s just park hindsight in a large black box for a moment (thus depriving much contemporary commentary of any real force) and recall where we were in the first half of 2007. Everyone was complaining about ‘over-regulation’ at the slightest provocation. Even Blair, when Prime Minister, had as much as accused the FSA of it. Paradoxically, however, the UK was preening itself as the home of lighter touch regulation (at least when compared to the US) and was riding high as the world’s favourite financial centre. ‘Principles-based’ regulation, ‘risk-based’ regulation, ‘outcomes-based regulation’, etc were all the rage. As though we had invented something new. ‘Rules’ were out, at least at the level of the regulator. Market participants were the best placed to sort out the detail. Those in the ‘industry’ knew best. Even Basel II seemed to back up this thinking. You can imagine the outcry we would have had if the FSA had suddenly decided to buck the trend and be ‘tough’ and ‘contrarian’. Nobody else was in the mood for that. Not lawyers, not accountants, not politicians. All were happily feeding at the trough of the booming financial markets. And the CEOs of the banks themselves? Should we have expected them to ‘think outside the box’ and question where all the financial rocket science was leading their organizations? No chance. As Michael Lewis recently put it, ‘A Wall Street CEO can’t interfere with the new thing on Wall Street because the new thing is the profit centre, and the people who create it are mobile … He isn’t a boss in the conventional sense. He’s a hostage of his cleverest employees.’143 (He might have added that even if he gets fired for his incompetence he may still receive a pay-off sufficient to keep him, his children and his children’s children in the lap of luxury for the rest of their days. So what would be the point of rocking the boat?) …

Whatever happens with the regulatory institutions (and politicians have historically always found it easier to change regulatory systems than the regulations themselves), (p. 158) there is no doubt that, this time, we will be getting more, tougher regulations. The need has been apparent for some time but the political will, and courage, to do anything has only arisen in the aftermath of the Crisis and crunch.144 Capital adequacy, liquidity, conflicts of interest, fuller disclosure of exposures, risk management rules, the ‘securitisation framework’, even the way certain kinds of ‘product’ are bought and sold … you name it, it’s coming …

The banks cannot quit the game (and they seem to be ‘too big to fail’) but the game has to change. They are, for the most part, desperate, needing our (so-called ‘taxpayers’) money for liquidity as well as generous injections of sovereign wealth funds’ cash, and rights issues, for capital. And, to an embarrassing degree that would have been unthinkable a short time ago, they need to develop a better, collective sense of direction. It is no use expecting any one of them, however powerful, to act alone in any kind of reform process; they need to be given substantially new rules that apply across the field. And politicians and others are lining up to tell them what they should be. The banks have lost confidence to the extent that they ‘no longer believe in the market’s self healing power’.145 One of the architects of the merger that created Citigroup now accepts that it was a ‘mistake’. There is also talk of breaking up UBS. Is this the dawn of a new ‘think smaller’ era?

Not that bankers have forgotten how to reward themselves of course. On this question, confidence abounds. One high street bank’s board is pushing for its executive directors to be given a bonus scheme based on four times salary, compared with two and a half times at present. An executive of another major UK bank has, for his efforts last year, just trousered £21 million (that’s twenty one million pounds sterling—incredibly, slightly less than he earned for the previous year). That would pay for a lot of tough, contrarian regulators. How badly do we really want them?

8.94  In February 2009, Sir David Walker was asked by the UK government to conduct a review of corporate governance in UK banks ‘in the light of the experience of critical loss and failure throughout the banking system’. The Walker Review published its final recommendations on 26 November 2009. In the Preface to the Review, the important point is made that:

the fact that different banks operating in the same geography, in the same financial and market environment and under the same regulatory arrangements generated such massively different outcomes can only be fully explained in terms of the differences in the way they were run.

(p. 159) 8.95  The Review goes on to assert that ‘how banks are run is a matter for their boards, that is, of corporate governance’. Corporate governance, it is argued, is largely a matter of behaviour. If corporate governance is to improve, ‘this will require behavioural change in an array of closely related areas in which prescribed standards and processes play a necessary but insufficient part’. This emphasis on behaviour was echoed in the evidence of Group Chief Executive of Barclays, John Varley, to the Treasury Select Committee on 9 February 2010:

Nothing is more important than behaviour; in other words, nothing is more important than culture. A way of thinking about culture is what people do when their boss is not around. Can they be relied upon to make right decisions in terms of compliance and in terms of ethics when their boss is not around? Ultimately, in a large organisation you have to have a reliable compliance system and a reliable system of ethics so that people understand what is good behaviour and what is bad behaviour. That is something that we work on hard.

8.96  Varley also said, in the context of ‘lessons learned’ from the Crisis, that the Barclays board’s increased attention to governance was demonstrated by the fact that in 2008 there were 29 board meetings whereas normally there would have been eight. Further, although a tighter regulatory system was to be welcomed, there was, in Varley’s view, no substitute for three things:

  1. (1)  the culture of a bank being sound;

  2. (2)  the governance structure of a bank, in terms of how the board behaves, being sound; and

  3. (3)  the suppliers of capital to a bank, whether debt or equity, holding the bank to account.

8.97  Walker believed that the best way to encourage the necessary changes is by self-regulation—the use of the Combined Code since this will encourage the relevant people (essentially board members and major shareholders) to feel ‘ownership’. It is not thought that ‘regulatory fiat’ will work. However, although the problems are identified as mainly behavioural, the solutions proposed are mainly structural—the creation of new committees and responsibilities. The more significant proposals are summarized below:

  • •  Non-executive directors (NEDs) of banks146 should be given regular ‘thematic business awareness sessions’ and provided with a ‘substantive personalized approach to induction, training and development to be reviewed annually with the chairman’. The aim, of course, is to improve NEDs’ understanding of complex financial businesses.

  • •  NEDs should have a higher minimum time commitment (30–36 days is suggested for listed entities) and this should be spelt out in a letter of appointment (p. 160) which should be available to shareholders on request; the chairman of a major bank should expect the role to take up around two thirds of his or her time; chairmen (who should be elected annually) should also have board leadership and financial industry credentials.

  • •  The FSA’s supervisory process should look more closely at the balance of the board, taking into account risk strategies of individual businesses; more intensive interviewing by the FSA of prospective NEDs is envisaged.

  • •  NEDs should be encouraged to be more assertive and, generally, more probing and challenging; the chairman should be aware of his or her responsibilities to encourage and facilitate this; the senior independent director should act as a sounding board for the chairman and be an intermediary for relaying concerns of NEDs and shareholders as appropriate.

  • •  Every second or third year the board ‘undertake a formal and rigorous evaluation of its performance’.

  • •  A Code on the Responsibilities of Institutional Investors should be developed; generally, steps should be taken to encourage major shareholders to act like ‘real owners’ of banks.

  • •  Listed banks should have a Board Risk Committee, responsible for ‘oversight and advice to the board on the current risk exposures of the entity and future risk strategy, including strategy for capital and liquidity management, and the embedding and maintenance throughout the entity of a supportive culture in relation to the management of risk alongside established prescriptive rules and procedures’.

  • •  The board should be served by a Chief Risk Officer (CRO) who should be totally independent and have a firm-wide remit; the CRO would report to the Board Risk Committee.

  • •  Particular due diligence responsibilities are ascribed to the Board Risk Committee for strategic acquisitions and disposals.

  • •  There are also various proposals regarding remuneration of employees.

8.98  In a consultation paper issued in January 2010,147 the FSA confirmed that it would play its part in implementing the Walker proposals. The difficulties in regulating behaviour were recognized in a speech by the FSA’s Hector Sants on 12 March 2010:148

My personal view is that if we really do wish to learn lessons from the past, we need to change not just the regulatory rules and supervisory approach, but also the culture and attitudes of both society as a whole, and the management of major financial firms. This will not be easy. A cultural trend can be very widespread and resilient—as has been seen by a return to a ‘business as usual’ mentality. Nevertheless, no culture is inevitable. But changing it is a task that cannot be achieved by policymakers (p. 161) alone—we need to collectively address these issues. From the regulators’ perspective it is probably the case that seeking to set ourselves as a judge of ethics and culture would not be feasible or acceptable. More realistic would be to relate the consequences of culture to regulatory outcomes. However, developing this line of thinking requires much further debate which I would welcome.

8.99  In the evidence of John Varley to the Treasury Select Committee referred to above, it was said that Barclays would implement the Walker proposals and that the bank was already ‘broadly compliant’. While the need to change culture and behaviour—and to inject some form of ethical dimension—is gaining recognition,149 the mechanism for monitoring whether or not this is being done and, if so, how successfully remains elusive.(p. 162)


1  Paul Tucker, Deputy Governor of the Bank of England, in his evidence to the Treasury Select Committee, 26 January 2010.

2  For the most part, in the period 2008–11.

3  For the most part, in the period 2012–17.

4  Jonathan Kirk QC and James Ross, Modern Financial Regulation (Jordan Publishing Limited, 2013) at 1.05.

5  Taxpayer support for the UK bank and banking sector included inter alia the recapitalization of Lloyds Banking Group and the Royal Bank of Scotland and full nationalization of Northern Rock and Bradford & Bingley; financing the Financial Services Compensation Scheme (FSCS) to enable it to guarantee deposits; and lending to insolvent banks to enable those banks to repay the balance of deposits not covered by the FSCS (see National Audit Office reports on taxpayers’ support for UK Banks).

6  See for example, the Banking Act 2009 c.1 UK (concerning the new Special Resolution Regime and stabilization powers, considered below) and the Financial Services (Banking Reform) Act 2013 c.33 UK (on ‘Ring-fencing’ (Part 1), ‘depositor preference’ (Part 2), ‘bail-in’ mechanisms (Part 3), and reforms aimed at bringing about greater ‘individual accountability’ through the introduction of the Senior Managers and Licensing Regime and a new criminal offence for reckless conduct causing an institution to fail (Part 4) considered in Ch 15 below).

7  The Financial Services Act 2012 c.21 UK (considered in Ch 14 below) significantly amended the Financial Services and Markets Act 2000 c.8 UK and the structure of financial regulation in the UK. The previous ‘tripartite regime’ of financial regulation (consisting of HM Treasury, the Bank of England, and the Financial Services Authority) was replaced with the ‘twin peaks’ approach, ceding micro-prudential regulation back to an authority within the Bank of England (the Prudential Regulation Authority), creating the Financial Policy Committee (with responsibility for macro-prudential oversight) and replacing the FSA with the Financial Conduct Authority. See further below.

8  Parliamentary Group for Better Business Banking.

9  Such as The Independent Commission on Banking: The Vickers Report (September 2011) and the UK Government’s response to the report (Cm 8252, December 2011).

10  The British Business Bank plc, is a UK-centric development bank owned by HM Government (reporting into the Department for Business Innovation and Skills).

11  At the time of its rescue, RBS’ balance sheet was almost the same size as the UK’s gross domestic product.

12  See Darling, Back from the Brink (Atlantic Books, 2011) at p 153.

13  See Ch 13.

14  The Independent Commission on Banking, chaired by Sir John Vickers.

15  See the Financial Services (Banking Reform) Act 2013. See Ch 14 and, more generally, Part IV of this book.

16  See Part III of this book. According to Hudson, the LIBOR scandal ‘shocked the regulatory and political establishment to its core’ as the ‘financial crisis and the system's other shortcomings were no longer just a matter of economic theory, but rather this was a matter of simple fraud’. The Law of Finance (2nd edn, Sweet & Maxwell, 2013) at 45–44.

17  See Part III of this book.

18  See n 2 above.

19  For a very perceptive commentary, see The LSE’s Law and Financial Markets Project Briefing 1/13 by Julia Black and David Kershaw: ‘Criminalising Bank Managers’. See also Black’s and Kershaw’s written evidence to the PCBS (11 January 2013).

20  See Ch 15. Objections to this change, typically from the banking industry, have been based on the apparent ‘reversal of the onus of proof’ involved. Less colourfully, this new approach is said to involve a ‘rebuttable presumption’ (that the executive should have prevented the regulatory breach occurring). In their evidence to the PCBS (see n 19 above) Black and Kershaw make the point that there is a regulatory precedent for the ‘rebuttable presumption’ approach in s 40 of the Health & Safety at Work Act 1974.

21  Others have included, eg, various (temporary) measures (taken in a large number of countries in addition to the UK) restricting short-selling shares in financial institutions. This was a (somewhat controversial) response to extremely volatile movements in the market price of such shares when the Crisis was at its peak.

22  See, eg, The Bradford & Bingley plc Transfer of Securities and Property etc. Order 2008, SI 2008/2546.

23  In the scheme of the Act, the new insolvency and administration procedures are part of the SRR.

24  The term used in s 3 and, for the most part, thereafter.

25  These are very broadly defined (s 14) and include a wide range of debt securities. It is perhaps unfortunate that the expression ‘share transfer instrument’ is used throughout the Act.

26  Defined (in s 12) as a ‘company which is wholly or partly owned by the Bank of England’.

27  See s 82.

28  It must be incorporated in, or formed under the law of any part of, the UK. Foreign banks (and their branches in the UK) are not within the scope of the powers.

29  In connection with assistance from the Bank of England, ‘ordinary market assistance offered by the Bank on its usual terms’ is to be disregarded for this purpose (s 7(4)(b)).

30  S 7(7).

31  S 10(1).

32  Compensation orders are considered in para 8.29 below. S 75 contains sweeping powers to change the law and is considered further in para 8.38 below.

33  Para 2.11.

34  See para 8.25.

35  See s 47(1).

36  See Ch 22.

37  See Ch 22.

38  .

39  There are certain exceptions to this provision (defined in para 1 as ‘excluded’ rights and liabilities). These include rights and obligations relating to (i) retail deposits, (ii) contracts entered into ‘otherwise than in the course of carrying on an activity which relates solely to relevant financial instruments’, (iii) damages claims and awards and (iv) subordinated debt.

40  ‘Continuity powers’ are defined by reference to s 64(2) of the Act, which gives the Bank of England broad powers to, eg, cancel and modify arrangements and contracts entered into by a bank, all or part of whose business has been transferred pursuant to the stabilization powers.

41  ‘Banking institution’ is defined in the Order and, apart from banks, includes building societies and holding companies of banks.

42  Para 3(4) deals with a potentially complex situation that may arise where some of the property in question is foreign property (for example, rights and liabilities under a contract with a foreign counterparty and not governed by English law) and ‘may not have been effectively transferred’ by the relevant order or instrument. In such a case an instrument or order that purports to transfer all the protected rights and liabilities shall be treated as having done so effectively (and thus not give rise to a contravention of para 3(1)).

43  S 54.

44  S 57.

45  [2009] EWHC 227 (Admin). Upheld on appeal: [2009] EWCA Civ 788.

46  Stanley Burnton LJ and Silber J.

47  The Special Resolution Objectives set out in the Banking Act 2009 are, in effect, based on the principles applied in the SRM case (ie those set out in the Lord George lecture referred to in the judgment) even though this Act was not in force at the relevant time.

48  The FSA’s CEO.

49  See s 75(3).

50  S 75(8).

51  Para 6.20.

52  These are set out in Parts 2 and 3 of the Act.

53  See ‘Final review of the Investment Bank Special Administration Regulations 2011’ by Peter Bloxham (published January 2014 and available on HM Treasury website). This is referred to below as the ‘Bloxham Review’.

54  SI 2011/245. There is also a set of statutory rules accompanying the regulations that came into force in June 2011; SI 2011/1301.

55  The definition, for the purposes of bank insolvency orders, is contained in s 91 and is the same as that applicable to banks for the purposes of the stabilization powers referred to above. Bank administration orders, by their nature, are only available in respect of a bank with regard to which the Bank of England has exercised, or proposes to exercise a property transfer instrument (pursuant to a stabilization power).

56  See s 120(5).

57  See Explanatory Note at para 241.

58  S 95.

59  These are depositors who are eligible for compensation under the FSCS.

60  These are set out in s 99.

61  Although the liquidator is ‘obliged to begin working towards both objectives immediately upon appointment’: s 99(4).

62  S 100(4) and s 100(5)(a).

63  S 102.

64  See ss 142 and 143.

65  See s 136(c).

66  See s 136(d).

67  In the UK, the administration of Lehman Brothers International (Europe) (LBIE).

68  See n 55.

69  See s 232(4). Para 3.5 of the May 2009 Consultation Paper referred to in para 8.55 of this chapter offers a more helpful explanation: ‘Client assets, as referred to in this paper, are the financial instruments that belong to the clients of an investment firm and are held on their behalf by the firm in the course of its investment business.’

70  See also the Bloxham Review and the changes made to the Investment Bank Administration Regulations made pursuant to it. To take the issue of volume alone, according to the May 2009 Consultation Paper the administrators of Lehman estimated that it had 1.5 million open positions as at the date it entered administration.

71  The relevant orders were made by Henderson J at 7:56 am.

72  See In Re RAB Capital (and others) and Lehman Brothers International (Europe) [2008] EWHC 2335 and In Re Lehman Brothers International (Europe) [2008] EWHC 2869 (Ch).

73  ‘FSA failures in Lehman fallout’ (Hilton) Evening Standard, 28 November 2008. The article concludes that ‘… this whole fiasco is not something that can be ignored. London’s share settlement system should not be vulnerable to this kind of problem. It needs to be sorted out—immediately.’

74  See Ereira, ‘The UK review of resolution procedures for investment banks in difficulties’ LFMR Vol. 3 No. 4 at p 333.

75  See para 1.51.

76  See para 1.33.

77  See para 1.21.

78  See paras 1.46–1.48.

79  See para 2.13.

80  Para 3.5.

81  See para 3.24 et seq.

82  [2009] EWHC 602 (Ch). A client is at risk of being an unsecured creditor only of a regulated entity notwithstanding that entity’s obligation to cause client money to be subject to a statutory trust (under FSA client money rules) if that entity fails to comply with that obligation. (See case note: LFMR Vol. 3 No. 4 at p 381) However, the scope of this principle is considerably (and helpfully) qualified by the later decision of Briggs J in Re Lehman Brothers International (Europe) [2009] EWHC 3228 (Ch).

83  In the second Lehman case referred to in the above footnote, the FSA accepted that its previous interpretation of its own rules on client money and the related statutory trust had been wrong.

84  Para 3.43.

85  See para 3.47.

86  See para 4.2. In his Mansion House speech of 17 June 2009, the Governor of the Bank of England indicated that something of this kind may be appropriate for all regulated banks: ‘a plan for the orderly wind down of its activities was described as being akin to ‘making a will’—as much a part of ‘good housekeeping’ as for ordinary individuals’.

87  See para 3.60.

88  See para 3.76.

89  See para 3.80; see also Ch 22.

90  WP/09/42.

91  This concept has become known as the ‘living will’. The Treasury Select Committee (‘Too important to fail, too important to ignore’ Report of 29 March 2010, at para 150) has commented that: ‘As a general proposition, we consider that if an institution is too complex to prepare for an orderly resolution, it is too complex to operate without imposing unacceptable risks to the states in which it does business. Regulators should take account of any structural difficulties in the preparation of a living will. Living wills, if fully applied, will necessarily lead to the structural reform of banks.’ The ‘living will’ idea may thus achieve some of the changes that those who have been calling for the separation of ‘casino’ and ‘utility’ functions have been calling for.

92  For an excellent summary of the most important Lehmans cases, see the LSE Working Paper, ‘Law after Lehmans’ by Jo Braithwaite (LSE Law, Society and Economy Working Papers 11/2014). (This is referred to below as the ‘Braithwaite paper’).

93  From the Denning Lecture 2012 (Mr Justice Briggs) ‘Has English Law Coped with the Lehmans Collapse’.

94  [2009] EWCA Civ 1161.

95  Under Part 26 of the Companies Act 2006. (Provisions of this kind first appeared in an 1870 statute.)

96  The judgment of Patten LJ notes that ‘Hedge funds do not have substantial back office functions of their own. They therefore require a third party to deal with the trades themselves and thereafter provide custodial and reporting services.’ Lehman would thus hold counterparties’ assets in various capacities, eg, as custodian, as agent or as the recipient of collateral. Further, these assets might be held by Lehman ‘through various depositaries, exchanges, clearing systems and sub-custodians depending on the type of asset and the system through which they were traded’. For further background on the difficulties faced by the administrators, see the interview between the author and David Ereira, reproduced in Appendix 2.

97  [2011] UKSC 38.

98  (1861) 2 J&H 204.

99  Much of the case law dates from the period 1860–1930.

100  [2009] EWHC 2545 (Ch): see commentary by Bridge in LFMR Vol. 4 No. 2 at p 189.

101  The cash may have come in to LBIE in a number of ways, eg, as proceeds of redemption of a security or as income payable in respect of it.

102  See Ch 22.

103  For a critique of this, see the Braithwaite paper at p 12.

104  [2009] UKPC 10.

105  [2009] EWHC 3228 (Ch).

106  [2012] UKSC 6.

107  For the purpose of the case, an assumption was made that affiliates were entitled to have their money segregated. In fact, this had not been admitted by the administrators and was said to be ‘likely to be the subject of a major dispute’.

108  LBIE was of course engaged in ‘MiFID business’, for the most part. (It was accepted that some of its business with affiliates was not exclusively MiFID business.)

109  This could include a bank holiday or weekend; it was not necessarily only 24 hours.

110  Re Global Trader Europe Ltd (In liquidation) (No. 1) [2009] EWHC 602 Ch and (No. 2) [2009] EWHC 699 Ch.

111  [2011] EWCA Civ 1544.

112  See, for example, the Braithwaite paper commenting on a seminar discussion of academics and others at the London School of Economics: ‘… the case … marked the parties’ treatment of proprietary rights being held up by the court as determinative … It was regarded as a cause for concern that this case law seems to prioritize what the parties seek to achieve over what they have done. The concern was expressed that [cases like Rascals] in the long term threaten to undermine the certain operation of property rights, particularly on an insolvency, which is when they matter most.’

113  [2012] EWCA Civ 419.

114  See also Lehman Brothers Special Financing v Carlton Communications Ltd [2011] EWHC 718 (Ch).

115  See para 8.66.

116  In the Matter of Lehman Brothers International (Europe) and The Insolvency Act 1986 [2012] EWHC 2997.

117  See Yeowart and Parsons, The Law of Financial Collateral (Elgar, 2016) at Chapter 8.

118  [2010] EWHC 1772 (Ch).

119  The charge was thus void as against a liquidator.

120  The account was ‘far from being a blocked account’: see Yeowart and Parsons n 117 at 8.28.

121  See Yeowart and Parsons n 117 at 8.54–8.62.

122  A repo transaction is an agreement for the sale and repurchase of securities (or, to be more precise, the repurchase of equivalent securities). It is essentially a financing arrangement—usually of a short term nature. See para 22.08.

123  The Valukas Report quotes figures of $US38.6 billion, $US49.1 billion and $US50.38 billion for the fourth quarter 2007 and the first two quarters of 2008 respectively.

124  See generally Ch 22.

125  The FSA’s Chief Executive, Hector Sants, was quoted in the Financial Times of 17 March 2010 as saying: ‘The balance sheet effect referred to in the Lehman report only occurred in the consolidated accounts which were prepared under US GAAP. This is a matter for US financial reporting standards, not … for UK supervision.’

126  As at the time of writing, the political and legal ‘fall out’ from the Iceland debacle continues in the UK, the EU and Iceland itself. Apparently, a senior civil servant in the UK expressed ‘deep concerns’ at the time about the UK bailing out Icesave depositors, the Icelanders themselves have, in a referendum, overturned a proposed law authorizing payments to be made to the UK (which may prejudice Iceland’s ability to access assistance from the IMF) and various warrants for the arrest of Icelandic bankers suspected of fraud have been issued by the Icelandic authorities. The UK Serious Fraud Office has also launched an investigation.

127  ‘The Landsbanki freezing order 2008: a legal assessment of the impact on financial markets.’

128  The Treasury Select Committee Report into the Iceland banks affair (‘Banking Crisis: the impact of the failure of the Icelandic banks’, 31 March 2009) notes (at para 51) that the use of that legislation ‘inevitably stigmatises’ those against whom it is used and, in effect, suggests that replacement legislation be considered. The Report also noted that the ‘passporting’ law required further consideration in view of the experience with the Icelandic banks (para 112).

129  It should be mentioned, however, that a basic problem was caused by the fact that the Order came into force before the market could possibly have known of its existence, let alone its detailed terms.

130  P 55.

131  P 57.

132  Consultation Paper 08/22, ‘Strengthening liquidity standards’.

133  P 72.

134  See Ch 6, Section D.

135  This is reflected, eg, in the Report of the Treasury Select Committee entitled ‘Banking Crisis: reforming corporate governance and pay in the City’ (12 May 2009) which states that: ‘bonus-driven remuneration structures encouraged reckless and excessive risk-taking and … the design of bonus schemes was not aligned with the interests of shareholders and the long term sustainability of the banks’. (See Summary section.) This report in fact expresses concern that the Turner Review downplayed the role of remuneration structures in the Crisis.

136  P 88. See also Consultation Paper CP 10/3 of January 2010.

137  See Section F of this chapter.

138  P 106.

139  See, generally, Part III of this book.

140  Roger McCormick.

141  From the FSA paper, ‘Treating customers fairly—guide to management information’ July 2007 (p 6).

142  26 March 2008.

143  See Evening Standard, 27 March 2008 at p 30.

144  And, even now, some fear that the regulators and politicians have not quite got the message. George Soros, writing in the Financial Times on 2 April 2008 complained (in relation to suggested reforms in the US) that: ‘We need new thinking, not a reshuffling of regulatory agencies … For the past 25 years or so the financial authorities and institutions they regulate have been guided by market fundamentalism: the belief that markets tend towards equilibrium and that deviations from it occur in a random manner. All the innovations—risk management, trading techniques, the alphabet soup of derivatives and synthetic financial instruments—were based on that belief. The innovations remained uncorrected because the authorities believe markets are self-correcting. Regulators ought to have known better because it was their intervention that prevented the financial system from unravelling on several occasions. Their success has reinforced the misconception that markets are self-correcting.’

145  A quote attributed to the Chief Executive of Deutsche Bank in March 2008.

146  Unless otherwise stated, all the recommendations relate to banks. Walker in fact tends to refer to ‘BOFIs’—‘banks and other financial institutions’.

147  ‘Effective corporate governance’ (CP 10/3). See also Fitzsimons ‘Effective Corporate Governance?’ LFMR Vol. 4 No. 3 at p 276.

148  The Annual Lubbock Lecture in Management Studies.

149  See, eg, the article by Ken Costa (chairman of Lazard International) in the Financial Times of 3 November 2009, ‘Tame the markets to make capitalism ethical’, in which he says: ‘The task we face is to rediscover … the moral spirit of capitalism so that it best serves all people. Regulation, though necessary, is not enough. A box ticked is not a duty done. It does not address the complexity of human beings. We have spiritual desires (longing for happiness) and a moral spirit (an instinct that doing things well comes from doing right), as well as financial imperatives.’