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

Part V Legal and Conduct Risk in Interconnected Financial Markets, 17 Legal and Conduct Risk in a Globalizing Financial Market

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, 2015. All Rights Reserved. Subscriber: null; date: 07 July 2020

Credit risk

(p. 313) 17  Legal and Conduct Risk in a Globalizing Financial Market

Contemporary globalization is merely a stage upon a long journey that is, in all probability, not yet close to its end.1

A.  Banks in a Global Market

17.01  In his speech to the European Parliament on 24 March 2009, the UK Prime Minister called for the building of a ‘truly global society which is sustainable for all, secure for all and fair to all’. He wanted ‘to see a globalization that is open, free trading and flexible, but which is also reforming, inclusive and sustainable’. The speech was made shortly before the London G20 Summit and looked ahead to the issues to be discussed there. One of the most important items on the agenda was (and, at the time of writing, still is) the need to respond to the Financial Crisis in a way that does not result in a ‘race to the bottom’ with jurisdictions competing with each other to offer the easiest regulatory ride for financial activity. To this end, the Prime Minister called for agreement on ‘global standards’ amongst all the major countries. The search for global standards, and consensus around them, continues. In the UK, the promotion of standards in the financial markets is now a key objective of both the Banking Standards Board and the FICC Market Standards Board. ‘Globalization’ does not always get a good press—especially when linked with free market ‘ideology’ and the (p. 314) ‘Washington Consensus’2—but, following the Crises, there is a case for saying that we need more of it, not less (albeit ‘reforming, inclusive and sustainable’).3

17.02  Banking activity is both national and international. It is often asserted that the financial markets are ‘global’ but in fact a great deal of banking activity is comparatively parochial. One finds few ‘foreign’ bank branches in the countries of the EU. Euro cheques cannot be cashed across EU borders, and takeovers of banks by ‘foreign’ banks remain the exception rather than the rule (with some countries exhibiting notably more protectionist instincts than others). And of course even global banks revert to being ‘national’ when they get into difficulties (to paraphrase Mervyn King’s famous aphorism).

17.03  However, the banking industry is clearly one of the most internationally based. Individuals now expect to be able to use automatic telling machines to access cash all over the world and to use their credit cards for purchases in most countries. Banks in the major financial centres lend to national governments and government agencies around the world and have been doing so for centuries. In 1803, for example, Baring Brothers helped finance the Louisiana Purchase by arranging for the issue of US government bonds in London—the first international issue of securities by the US government. (The same bank’s appetite for overseas risk ultimately led to its requiring rescue by the Bank of England towards the end of the 19th century. It ultimately lost its independence as a result of the activities of a ‘rogue trader’4 about a hundred years later.) In the first half of 2010, fears of a sovereign default by Greece triggered concerns about the many private sector banks, in various countries, that were its creditors. Banks have been engaging in ‘cross-border’ transactions with a full range of counter-parties (including other banks) and sectors for so long that it seems slightly surprising when this is referred to as though it was in some way unusual. They finance complex capital projects in countries that have little or no relation to their home jurisdiction. (Sometimes such projects may involve several countries, as is the case with the more ambitious pipeline projects). And, of course, banks have been financing international trade for as long as there have been banks—since before the time of the Medici. There is nothing new about the international activities of banks, except, perhaps, the scale of the market and the arrival of the epithet, ‘global’.

17.04  What is relatively new is the influence of international financial institutions (IFIs), such as EBRD, IFC, and the World Bank on the laws and economic and environmental policies of the countries where they do business. The example of EBRD is considered in more detail in Chapter 18, Section C. It is clear that (p. 315) its ‘mission’ involves a degree of ‘standard setting’ on questions of both law and policy and this, in turn, leads to the creation of a ‘globalizing effect’ insofar as countries tend to conform, to a greater or lesser degree, to the ideas that it promotes. The involvement of private sector lenders in ‘co-financings’ can also lead to its influence on various issues spreading to other market participants.

17.05  The documentation used in international financial transactions tends to be governed by English law or New York law whenever possible. Even when another governing law is chosen, the drafting tends to conform to an ‘international’ standard, reflecting City of London or New York usage. Risk allocation issues that require resolution in negotiations tend to be settled in accordance with perceptions of the accepted market practice and precedent—viewed internationally—at any given time. Procedures followed by banks in relation to, for example, due diligence or environmental risk assessment tend to conform to international norms. Documentation for complex transactions such as project financings looks very similar wherever the project is situated. It might even be said that ‘the markets have created a kind of global law by contract’.5 In this way, banks and their advisers have been at the forefront of the phenomenon that we know as globalization and have become identified with it. They have—until the Financial Crisis—coped well with the risks involved, adopting various practices and customs that enable them to manage the risks that follow when so many legal systems can have a bearing on their activity (the selection of a governing law for documentation being of only limited value in keeping the number of such systems that may be relevant to a transaction within manageable bounds). However, the legal risks involved in international banking can be acute. As was shown by the case involving UBS and the US courts6—concerning the disclosure of details of banks’ customers allegedly involved in US tax evasion—the inconsistency in laws and regulations in different countries is by no means always an opportunity for ‘regulatory arbitrage’:7 it can place a bank in an impossible position, in effect requiring it to choose which country’s laws to break. Further, as discussed in Chapter 18, Section C, in the context of EBRD, legal risks that affect inward investment in transition economies add to the cost of attracting (p. 316) that investment. If such risks can be removed or ameliorated by law reform, this can deliver real economic benefits. The drive to achieve global standards on matters such as sustainability and respect for the environment,8 to reduce regulatory arbitrage and to lower the cost of raising investment for developing countries all point towards some form of globalization. Following the Crises, a new driver will be the need to achieve a better, and common, understanding of the ethical dimension in bank governance.9

17.06  The involvement of banks in both globalization and the Financial Crisis has political and legal risk consequences. It tends to increase the risk of banks being a target for criticism for the social ills and misfortunes that are associated with either of these phenomena. And that criticism will not necessarily stop at the printed page. It will often lead to lawsuits, political action or adverse regulatory measures; and sometimes a combination of these things.

B.  The Globalization Debate and Context

17.07  The globalization debate frequently features references to ‘justice’ and, not surprisingly, calls for change by the participants in the debate usually involve, expressly or impliedly, proposals for law reform at various levels. At the more aspirational, political level we see demands for change in the name of eradicating (or reducing) poverty or inequality. At the more commercial level—the level of the global markets—we see demands for the law to ‘keep up’ with the markets and find a way of functioning across jurisdictional borders. The debate, however, is not unified. Politicians and economists do not address the same globalization questions as market participants and lawyers. And yet the debate as a whole would surely be better informed if light could be thrown on the various issues that affect the arguments at both levels. This would, amongst other things, enable all the protagonists to have a better appreciation of the risk impact on markets of political and economic proposals and the political impact of market-driven demands for legal change.

17.08  Law and justice are not of course the same thing. Laws may be good or bad, right or wrong whereas justice, by definition, is ‘right’. Justice is, in essence, an accessible, easily understood concept—even though we may disagree as to when it has been achieved and, on occasions, with the addition of epithets such as ‘social’ or ‘global’, it is given a somewhat extended meaning. The most fundamental laws—for example, those that prohibit obvious moral wrongs—are accessible also. But there are many laws that are not. Law, at one level, is an obvious reflection of public moral values but, at other levels, it is the policy implementation tool kit, (p. 317) consisting of a mass of detail, some of which can be infuriatingly difficult to understand.

17.09  As we have seen, legal risk tends to arise in the financial markets when there is a misunderstanding as to the law’s effect on a transaction or on an entity’s financial or commercial position—or when someone’s behaviour gives rise to a possibility of legal redress or criminal charges (the latter, of course, being more closely aligned with conduct risk). Banks usually try to avoid taking unnecessary legal risks because the consequences can be catastrophic. Other risks, such as credit risk or political risk, tend to be easier to assess. But it is not always apparent that a particular proposal might involve a legal risk. This can be the case at both the level of an individual enterprise, for example, embarking on a new venture, and also at the higher, public level of proposals for political, economic or social reform. Globalization is bringing with it many proposals of the latter kind—some with the objective of achieving some form of ‘social justice’ and some with what at first sight may seem rather more prosaic objectives, for example, facilitating more consistent regulation of markets or harmonization (across jurisdictions) of a particular field of law. Well before the Financial Crisis struck, senior representatives of the Federal Reserve, the FSA and the SEC issued a joint statement to the effect that the regulation of the global derivatives market now required regulators to ‘pursue borderless solutions’. And Sir Howard Davies commented in Davos10 in February 2007 that the ‘international regulatory architecture is still organized as if the world had not changed. As a result, we have a regulatory architecture designed for a bygone age.’ The responses to the Crises considered in Chapters 8 and 9 underline the need for a global response to a global problem. Because law is so often the principal tool for implementation, proposals for global, borderless solutions, ‘global regulatory architecture’ and suchlike will always have an element of law reform. But they also tend to have legal risk implications, and it is important that these are thoroughly assessed by, amongst others, the ‘global architects’. It is not clear that they always are.

17.10  The approach of this book to the definition of legal risk (including conduct risk) reflects market usage rather than philological or philosophical analysis. It should be acknowledged, however, that there are some important, unresolved definitional issues, especially in the area of adverse claims and court actions, where the overlap with political risk and the categorization of rogue trader, or rogue chief executive-risk, is problematic—and not necessarily an academic question insofar as it impacts on responsibility for risk management as well as the management tools that may be available. It is not so easy to buy and sell protection against legal risk as it is for risks like credit risk, currency risk, and interest rate (p. 318) risk because legal risk is not only very unpredictable, it also tends, in many cases, to be self-induced.11

17.11  Globalization and the Crises, both powerful contemporary phenomena which have become linked in many people’s minds, raise a number of important questions for society. As regards the issues considered in this book, one of those questions is whether in the future we are likely to see an increase in legal risk. A related question is how legal risk in the financial markets may be affected not only by the ongoing globalization of those, and other, markets but also by reactions to globalization as that is in turn affected by the Crises. No attempt is made to define ‘globalization’ in this book but it should be noted, at the risk of stating the obvious, that its meaning varies according to the context. Thus, when an economist says, for example, that ‘globalization is not working’ he has something very different in mind (eg, widening gaps in ‘equality’) to the finance lawyer who complains that law is not keeping up with the globalization of markets. The difference relates not only to what is meant by globalization but what can reasonably be expected of it if it is to ‘work’.

C.  The Social and Political Background

17.12  Legal risk is affected by, and has sources in, many of our current and enduring political and social objectives. These include fighting serious crime (however that may be defined) and combating terrorism, whilst at the same time trying to make the world a better place for everyone by reducing, or even eliminating, poverty and—at a more mundane level—removing as much risk as possible from consumers of financial services. The measures we take in the name of these objectives often have the effect of placing banks and financial institutions at the centre of a legal framework, or aspirations for a legal framework, that is meant to influence the behaviour of banks and their customers by laws that typically:

  1. (a)  override traditional obligations of confidentiality, so that banks are required to report financial transactions and provide other information in suspicious circumstances (whether or not the suspicion is reasonable); the duty of confidentiality is often pejoratively referred to as ‘bank secrecy’;

  2. (b)  in determining whether or not a duty to report has arisen, require banks to adopt a standard of care by reference to an objective test of what they should reasonably know rather than the subjective test of what they actually know; this approach inevitably increases the risk of inadvertent infringement of the law and causes banks to manage the risk by behaving very conservatively;

  3. (p. 319) (c)  expect banks to comply with what is essentially a moral assessment as to the behaviour of their customers and (depending on the situation) decline to fund or (as the case may be) continue to fund against their commercial judgement;

  4. (d)  following the Financial Crisis, seek to pressurize banks (again, second-guessing their business judgement) to lend to commercial enterprises in order to help speed up economic recovery from a recession; and

  5. (e)  require banks and other providers of financial services to contract with consumers on a legal footing that has virtually suspended the concept of caveat emptor and which must operate in an environment where the regulator’s judgement as to what constitutes ‘fair treatment’ or is defensible as ‘a good customer outcome’ is of great importance.12

17.13  Banks are naturally cautious when faced with laws of this kind and are not likely to manage the legal risk entailed in not triggering, say, procedures in anti-money laundering laws in anything but a very conservative manner if there is the slightest ground for suspicion.

17.14  Such caution is reinforced by the fact that—at the regulatory level—we emphasize the need for banks to understand and manage all the risks associated with their business and, in the aftermath of the Financial Crisis, have placed a new emphasis on the need to manage risk. This is against the background of greatly increased concern about certain aspects of the derivatives and securitization markets and the legal complexities associated with them, as well as the expansion of banking activity away from traditional—and reasonably easily understandable—commercial corporate lending in a well understood and regulated domestic market. The context also includes an increased focus on corporate governance procedures and on the need for corporates generally (but banks especially) to manage risk in a systematic manner and set up internal mechanisms that demonstrate such management.13

17.15  Modern society is preoccupied with risk. At the level of ordinary consumer products, labels such as ‘this product may contain nuts’—especially when placed on a package which is self-evidently a packet of nuts—and ‘warning; coffee is hot’ are enduring symbols of our apparent need to be alerted to all risks associated with everyday life. What is often overlooked is that such labels evidence concern about (p. 320) two different kinds of risk. The first is the risk of possible damage to health or injury that is clearly implicit in the label. The second is the risk of litigation or some form of claim being made by a consumer against the seller of the product or its manufacturer, or possibly both. This of course is a legal risk.

17.16  Commentary abounds as to why we worry so much about risk. It seems that the more affluent we have become, at least in Western society, the more fearful we are of being denied the opportunity to enjoy life’s rich prizes as a result of some quirk of fate beyond our control. Even after the Financial Crisis, life’s prizes do indeed seem to be richer than ever—at least at a material level. In Western society, we can see that it is possible to live longer and have a happier and more fulfilling life than would have been dreamed possible by earlier generations. Recently, however, we have become at least dimly aware that the enjoyment of the good life comes at a cost that goes far beyond the immediate purchase price and may turn out to be greater than our own generation or succeeding generations can really afford. Plagued by increasing doubts and concerns over green issues, inequality and the like, we turn to altruistic objectives and, recognizing ‘inconvenient truths’, now worry about our carbon footprints, decide that we want to make poverty history and either join the ever louder rant against ‘globalization’ or at the very least insist that, as Joseph Stiglitz puts it, we want to ‘make globalization work’.14 It is, however, at least arguable that the desire to make the world a ‘fairer’ place is itself a product of globalization. It is not so easy to forget about poorer nations and those who suffer from earthquakes and other natural disasters when virtually every country can be reached by air in a day or so and the evening news bulletins (as well as 24-hour news channels) regularly bring the details of events around the world in graphic detail.

D.  Media Influence

17.17  The perception of risk and the accompanying insecurity only seem to get worse. We seem to be addicted to a culture of fear. We are constantly reminded of risk: volcanic ash in the atmosphere, ‘dirty bombs’, the ‘lone wolf’ terrorist, swine flu, bird flu, ‘mad cow’ disease; the list is endless. We know that there are terrorists, international drug dealers, people traffickers and all manner of serious criminals who potentially mean us harm and that, any time soon, we might all be overwhelmed by some pandemic (not a mere epidemic) of an incurable disease. How could we not know, given the combination of radio, television, an abundant supply of newspapers and, of course, the internet? In the 1960s few people would have had any idea that nuts could result in an allergic reaction. It (p. 321) now seems almost inconceivable that there could be anybody who is ignorant of this. Most adults in the 1960s would have known, however, that the value of investments could go down as well as up—and certainly those who, following the privatization policies of the 1980s, invested in companies such as British Telecom and British Gas. It seems, however, that, in the modern world, the fact that a risk is commonly known and understood is not a reason for dispensing with relentless warnings about it. This suggests that the paramount objective is to ward off legal risk rather than to inform.

17.18  Dominic Lawson commented on the culture of fear phenomenon in the Sunday Times (25 April 2010).15 Lawson was particularly concerned about ‘scaremongering’ by certain ‘scientists’ and the unwillingness of politicians to challenge them. A government minister had confided to him: ‘… the scientists who get the most traction in the media are those offering the most horrifying predictions of imminent doom and disaster’. If that was the case, Lawson suggested, ‘those largely to blame for the culture of fear are tabloid newspapers—the means by which scientists who aspire to high public profile can achieve this ambition (just so long as they are prepared to indulge in some unprofessional ambition)’. The culture of fear was linked to modern perceptions of the place of risk in society: it should not exist. We have started to believe that ‘there is no such thing as an accident’. If anything ever goes wrong, there must be someone to blame. Hence the weak-kneed attitude of politicians to (apparently) risk-bearing phenomena. Lawson observes: ‘On the basis of the so-called precautionary principle (which, if it had existed in prehistoric times, would have been bad news for the caveman who discovered fire) governments are expected to remove all possibility of risk from the field of human conduct.’ Against this background, it is vitally important that risk management—of any kind—is clearly understood to be an exercise in the art of the possible and the practical. In other words, risk management means just that and only that: it is not a question of risk elimination and there is no guarantee that bad things will not happen under any circumstances.

17.19  The media’s relevance to the culture of fear and ‘zero risk tolerance’ is not limited, however, to the mere provision of information. They invariably place their own ‘spin’ on any story of any significance and frequently generate their own ‘news’, sometimes mounting ‘sting’ operations with the use of secret tape recording of private conversations. The combination of intense media interest with the financial market’s tendency to follow herd instinct can have troubling effects in markets when confidence is low. A media story about short selling (triggered, eg, by regulatory action against a bank) can serve to generate much more short selling (against that bank and possibly other banks perceived to have comparable difficulties). The media story can become a self-fulfilling prophecy. Where the ‘target’ (p. 322) is a deposit-taking bank, panic and a bank run may well follow quickly if no action is taken. During the Crisis, and to some extent following it, the authorities in various jurisdictions reacted to such phenomena with temporary short selling restrictions. Similarly, if there is wide coverage of an internet-based protest against, say, bank charges, the news will eventually generate its own story, and banks will become swamped with even more letters protesting against bank charges.

17.20  The media tend to display a particular attitude to risk, causation and blame that has started to colour the behaviour of individuals who have responsibility for dealing with risk. Let us take three examples:

  1. (a)  The media are invariably ‘wise after the event’ and, using the benefit of hindsight, are never slow to ask, after the occurrence of some disaster or another, ‘Why wasn’t this disaster prevented? Is there anybody in any position of authority who could or should have foreseen that there was a risk of the disaster and could they not have done something to stop it happening?’

  2. (b)  The media habitually ask individuals in positions of authority for guarantees that ‘bad things’ will not happen in terms that no sensible person could ever give.

  3. (c)  The media also, performing (as they see it) the role of ‘holding to account’, tend to attribute blame—and require retribution (perhaps in the form of someone’s resignation or, at the very least, ‘saying sorry’) at an individual level for just about any accident. Their reaction perhaps expresses the collective outrage that we do not live in a risk-free society after all, and someone must carry the can for this.

17.21  It may be felt that this behaviour is not in itself objectionable and one should be pleased that the media perform what some would regard as a vital service ‘in a democracy’. The media certainly take pride in what they regard as a tradition of investigative journalism. However, for any individual in public life, whether a politician, a leading industrialist or a public servant (including a central banker or a regulator)—the behaviour appears to encourage a risk-averse mentality which in many cases impacts adversely on the enjoyment of ordinary life and (depending on the context) may lead to a ‘chilling effect’ on commercial activity. School trips do not take place, contact sports are discouraged, intelligent and able people are discouraged from taking on roles in public life and the erstwhile gatekeepers of ordinary everyday living walk in fear of infringing health and safety or human rights legislation, contravening one or more of an impenetrable mass of regulations or falling into some other trap.

17.22  If individuals in public life are first in the line of fire for the ‘blame game’, banks and bankers are not far behind. There are a number of specific parallels in financial market contexts. If the ‘accident’ in question is the financial collapse of a company, it often seems to be the case that its bankers are put in the dock for (p. 323) either calling in a loan or, possibly, for not calling in a loan at an earlier time and thus creating a misleading impression as to the company’s financial health. In the post-Enron era, questions were always likely to be asked about whether the banks were complicit in any fraud or misbehaviour that may be associated with the collapse. The Crises have accentuated this trend. Any financing involving, for example, a special purpose vehicle (SPV) will be singled out for very close scrutiny as though the SPV was itself a badge of fraud. If the problem is not a corporate collapse but, say, the economic meltdown of a country’s economy, its bank lenders can again expect to face charges of ‘irresponsible’ lending (and, possibly, helping to prop up a corrupt regime) as well as unethical insistence on their rights to repayment. And then, of course, if a bank itself goes bust, it must be the regulator’s fault—as the Bank of England found after the BCCI scandal, and the FSA found after Northern Rock. As the very nature of the regulatory regime in the UK (and possibly elsewhere) becomes a party political issue, the prospect of getting a clear and objective analysis of the causes of, and solutions to, financial crises starts to recede.

17.23  The ‘blame game’ mentality is not merely a reflection of media commentary; it is reflected in all-too-real lawsuits—usually against banks (a favourite deep-pocket target) that accompany most financial accidents. One of the post-Enron lawsuits16 involved the theory of ‘scheme liability’ being put to the US Supreme Court—under which it was argued that law firms, accountants, and investment banks who had provided advice to Enron had been conspiring to deceive Enron’s shareholders and should be liable to them in damages. The argument was rejected but judicial opinion was evidently divided. More than US$7.3 billion were recovered from Enron’s directors and banks. Litigation against banks was also triggered by the Financial Crisis, as described in Chapter 16, Section B. It is true that the banks have largely brought this on themselves. But there is cause for concern when politicians, so readily and so frequently, add their voices to those baying for the bankers’ blood. The media ‘feeding frenzy’ that so often ensues generates ‘second phase’ risks that can be extremely difficult to manage, even for banks that had no direct involvement in the events that first triggered the controversy.

17.24  It would of course be wrong to conclude that the media alone are to blame for all these risk-related phenomena. But we do live in the media age, the media operate on a global, 24-hour basis, and their behaviour, especially when the power of the internet is taken into account, clearly does have an impact on the risks that have to be managed by banks.

(p. 324) E.  Limits of Global Law

17.25  Although our awareness of risk may have increased, this has not curbed our ambitions. If anything, it has contributed to them. We seem to believe that a perfect society is within reach and we will have no truck with anything that gets in its way. We want to make poverty history, make globalization work, and we declare ‘war’ on terror and ‘war’ on drugs—and, of course, ‘war on want’. It is interesting to reflect on who the ‘we’ is in this context. Whenever it seems that some kind of consensus has developed as to common values—whether expressed as human rights, natural justice, the rule of law, the Washington consensus, fair trading or whatever else may be the current dominant theme—something or somebody seems to disrupt that consensus and we find that the views we thought we shared with all right-thinking people are perhaps not so widely shared after all. ‘Preaching’ a consensus, especially after the Crises, can seem patronizing to those who do not derive any benefit from it but, on the contrary, feel that it is working against them.17 Nevertheless, the striving for a common understanding on fundamental issues that reaches across national boundaries and cultures will not go away. And in any case we are only too aware that global markets in a wide range of products and services have now developed, that many businesses and consumers feel that such markets are to their benefit, but that we lack not only the laws, but even the ability to make the laws that would have a global effect. Law remains trapped inside individual jurisdictions; and states will not lightly give up any element of sovereignty that could cause this to be otherwise unless the advantages are sufficiently certain, tangible and immediate to be sold to sceptical electorates. We can enter into treaties and develop a wide range of soft laws (such as Basel III and the Equator Principles)18 that have an international effect, but they are rarely able to deal with the nitty-gritty of, say, differing approaches to corporate insolvency, contract validity, the effectiveness of security interests or rights in real property. At the relatively parochial level of the EU—taking its Financial Services Action Plan as an example—we can see how grand designs need to come to terms with the painstaking detail of black letter law as the main item in the tool kit of implementation, and how easy it is to trip up on the detail and generate unhelpful (p. 325) and unintended legal risk as a result. Implementing the de Larosière proposals has given rise to comparable issues.19

17.26  The market, however, can still function with some confidence at a global level because of what Keith Clark20 (in a paper21 given in June 2006 at a seminar in Lincoln’s Inn to commemorate the founding of Jamestown) identifies as ‘the virtual financial world created by common law traditions’ which ‘operates globally, irrespective of country, jurisdiction, nationality, surrounding politics or legal system’. This virtual world, he tellingly observes, has been created by ‘private lawyers, many of them working in the large US and UK origin law firms that service the financial markets. They share a common language. They share a common method of drafting. They share the same conceptual legal world.’ Such efforts are of course bolstered by trade associations producing standardized documentation that not only gives market activity a higher degree of legal predictability but also, some argue, creates a quasi-regulatory effect. It is perhaps on the foundation of the confidence generated by this virtual world—and the relative contractual certainty that accompanies it—that the financial markets, ever-eager for innovation, have largely refused to be held back by cross-border legal differences and continue to venture boldly into transaction structures and practices that frequently assume that the law of all relevant countries will somehow fall into line. The same entrepreneurial attitude underpins banks’ willingness to provide funding in jurisdictions where the general legal infrastructure is known to be somewhat underdeveloped. Such boldness may be admirable but it brings legal risk with it. It remains to be seen to what extent (if any) the Crises will have any lasting effect on this.

F.  Reactions to Globalization

17.27  Prior to the Financial Crisis at least, globalization worked reasonably well for the financial markets. Even after the Financial Crisis, those markets remain as global as ever (notwithstanding the reduction in size of many banks and government acquisition of their shares). But it is not surprising that socially conscious writers (such as Joseph Stiglitz) find it frustrating that globalization does not always appear to work in the manner that they would like. What is interesting is the extent to which proposed solutions to the perceived problems attributable to globalization (not merely to problems caused by the Financial Crisis) involve (p. 326) banks and sweeping new laws at various levels that would affect bank activity and inevitably increase legal risk for banks. Thus, for example:

  1. (1)  Despite the collapse of communism, and a gradual spread of prosperity (albeit not accompanied by an obvious reduction in inequality)—there remain a large number of countries that are run by ‘bad guys’ or, even if run by ‘good guys,’ seem to be trapped by poverty, civil war, famine and other appalling misfortunes. Many of them have raised finance from international banks. Why not do something about what Stiglitz characterizes as ‘boom and bust lending’ so that bankers are discouraged from wanting their money back ‘just when the country needs it most’ when, for example, they run into difficulties meeting their debt obligations? Stiglitz calls for a ‘form of international bankruptcy’. We need, he says, ‘better mechanisms for sharing risk and for resolving debt problems’. There is a lack of specifics as to what this new international bankruptcy law would say, but there seems to be support for the idea that, say, a given percentage of a country’s creditors could reach an agreement on debt restructuring which would bind all of the creditors and, more radically, that we should have a ‘systematic way of engaging in debt forgiveness/restructuring’ guided by principles such as enough debt being forgiven ‘so that the country will not face a high probability of default in, say, five years’. Stiglitz also says that ‘the primacy of a government’s obligations to its citizens is inviolable’—so, for example, debts owed to unpaid nurses, teachers and other public sector employees get priority. (One wonders where money owed by a government for the supply of ‘public services’ pursuant to a public/private partnership scheme would rank.) No upper limit is proposed, so such a measure would be akin to introducing a layer of preferred creditors in a form of sovereign insolvency that, depending on the nature of the sovereign borrower’s economy at the relevant time, could permanently swamp out any claim for repayment of bank loans. It is not clear what would trigger the application of this sovereign rescue regime. To make the trigger a simple default would surely make it too tempting—but what would be the appropriate level of financial difficulty? To administer such a regime, an ‘international mediation service’ is suggested—which should evolve into an ‘international bankruptcy organisation’ to oversee what is described as ‘fair repayment’.

We are of course a long away from any kind of international bankruptcy law that would have such an effect, but the example shows how commentators who are concerned to make a better world often see banks as the natural fall-guys for carrying the downside risks that come with the reforms. There is a strong implication in much of the commentary that those wicked bankers (and of course they seem more wicked than ever after the Crises) should never have lent the money in the first place but that it is even more wicked of them to want it back. The beguiling phrase ‘firms and individuals faced with overwhelming debt need a fresh (p. 327) start’ tells us where Stiglitz is coming from. But what about those whose attitude to debt obligations, or disclosure of their financial position, borders on the dishonest and who are almost certain to repeat the behaviour?

  1. (2)  Somewhat more alarming is Stiglitz’s suggestion that so-called ‘odious debts’ should not be recoverable at all. Stiglitz is not entirely clear on what would constitute an odious debt, but it would seem to include any lending to a government that is ‘not democratically chosen’ and (although the requirement does not appear to be cumulative) any ‘brutal regime’. Iraq, Ethiopia, Nigeria, Chile and Argentina—at various points in their history—are cited as possible examples. It is suggested that in the future the UN could keep a list of countries for which contractors and creditors would be put on notice that their contracts and debts will be re-examined once the regime is gone. Stiglitz also tells us that, ‘To many, the issue is not just whether the debts should be repaid or the contracts honoured but whether Western institutions should be liable for some of the damages that resulted from the continuation of regimes they helped to perpetuate.’ So, not only would banks not get their money back, they might be on the wrong end of a claim for billions of dollars. A sizeable legal risk!

In his argument, Stiglitz uses a concept that is found in a number of new laws, already mentioned, that place responsibility on banks for stopping bad things happening: constructive knowledge. He is concerned, for example, that lenders to the Congo, ‘knew, or should have known’, that the money that was being lent by them was not being used for its intended purposes. In the same way, banks and financial institutions now have to be on their guard under current legislation with regard to transactions which they know or should reasonably know give rise to suspicion as to insider dealing, money laundering or other suspicious activities.22 The increased legal risk for banks and financial institutions caused by this legislation is undeniable. It seems to be a trend that is set to continue.

  1. (3)  Stiglitz’s suggestions, however, do not stop at banks. He supports the use of litigation as a means of containing bad corporate behaviour, informing us that ‘when consumers within the United States and certain other countries are hurt by price fixing, they can band together, file what is called a “class action” suit and if they succeed, they receive an amount that is triple the damages they incurred. This provides a strong incentive for firms not to engage in price fixing.’ He goes on to suggest that ‘consumers around the world need to band together and perhaps sue, in, say, American courts’. Obviously we would need to create another series of laws and legal frameworks to enable this to happen—Stiglitz suggests that ‘we need to make it easier to pursue global class action suits either in newly established global courts or in (p. 328) national courts’. Again, we are a long way from developing global courts of this kind, not least because there is no prospect of being able to develop laws with an international application that would cover the issues that such courts would have to decide. However, the sentiment is pretty clear.

  2. (4)  Stiglitz is also very encouraged by ‘the corporate social responsibility movement’ and is concerned about the fact that ‘with globalisation abuses of limited liability have become global in scale’. (One might pause in passing to reflect on the facts of the leading case of Salomon v Salomon23 as providing perhaps the most famous example of a perceived abuse of limited liability; this debate has been going on for over a century and it is not clear that globalization has changed the issues in any material way.) The trade union movement in the UK has been lobbying for some time to make corporate manslaughter laws tougher and there are many in the green lobby who would like to see company directors made more responsible personally for corporate wrongdoing, especially to so-called ‘stakeholders’. So it seems that the protection of limited liability is under pressure as well and it may not be long before we see directors of banks in the dock to answer for the ‘odious’ behaviour of borrower customers which they are alleged, in some way, to have supported.

17.28  The general drift of these ideas—which are shared by a fair number of commentators—is that:

  1. (1)  There is a considerable number of situations in which banks should not be allowed to rely on contractual claims to repayment of debts. They may take the risk of insolvency—that comes with the territory with banking—but the risk should be increased in that they should accept that there will be situations in which they have no claim to repayment at all. The debate appears to centre on heavily indebted countries but there is no logical reason why it should stop there.

  2. (2)  Whatever we may feel about the compensation culture, it should be viewed as a good thing when it is deployed in curbing the excesses of international capitalism, and especially where the defendant is a bank. Penal damages should be enforced by global courts.

  3. (3)  Far too many corporate executives have been getting away with sheltering behind limited liability for far too long. There are certain risks, defined by reference either to scale or type (or both?), for which limited liability should not be available.

17.29  Two books published (by Oxford University Press) in 2007 and 2006 respectively, contain very similar ideas and give examples of a line of thinking that seems to be gathering some momentum in the early 21st century. In Making (p. 329) Foreign Investments Safe, Wells and Ahmed express ‘concern’ about ‘property rights, including enforcement of contract’ and they assert that efforts to protect such rights—in the hands of investors in developing countries—have ‘gone astray’ resulting in rigidity and inflexibility. Property rights, they say, ‘need to be interpreted in the context of broader national interests’. Amongst their proposals is the idea that contracts with governments for infrastructure projects should be subject to arbitration, with the arbitrator having the right to ‘impose new contract terms on the parties’—especially if there have been ‘sharply changed circumstances’ ‘corruption’ ‘unreasonable terms’ ‘incompetence’ or ‘compulsion’. These contracts are typically a vital component in banks’ security for PPP/BOT infrastructure and energy project finance lending as well as the main documentary home of the project sponsors’ rights. According to the Financial Times of 13 October 2006, infrastructure financing hit a new record of US$145 billion worldwide. Overriding the terms of a contract in this way, it is argued, enables conclusions to be reached which are ‘fair and just’.24

17.30  In Global Governance of Financial Systems, Alexander, Dhumale, and Eatwell argue that ‘the internationalisation of financial markets necessitates the establishment of universal standards for corporate governance for financial institutions’, and are concerned about limited liability. One of their proposals is that ‘management should … have personal liability for overseeing the firm’s compliance with regulations regarding margin trading and the detection of conflicts of interest or manipulative practices’. An article by Edward Fennel in The Times of 23 January 2007 had a similar theme as regards personal liability, but in a different context. Commenting on perceived defects in BP’s ‘safety culture’ in the aftermath of a serious accident at its Texas refinery, the article reported that many lawyers involved in such cases see the fact that we ‘shy away from making individuals accountable for corporate failure’ as being ‘at the heart of the problem’. The problem will not be solved, it is suggested, ‘until there are serious penalties for individual directors—including naming and shaming, disqualification and prison’. Similar sentiments—at least as regards individual accountability—were expressed in The Times’ Business Editorial on 17 January 2007—but there is a huge difference between ‘accountability’ (eg, you might be fired) and personal liability (you might be made bankrupt and/or imprisoned).

(p. 330) 17.31  David Held has rightly pointed out that ‘… the story of globalisation is not just economic: it is also one of growing aspirations for international law and justice’ and that there is ‘ a narrative which seeks to reframe human activity and entrench it in law, rights and responsibilities’.25 However, much of the writing in this area appears to see law more as an instrument of coercion and punishment than as a safeguard of rights. Penal damages, as favoured by Stiglitz, are sometimes known as punitive damages—they are designed to punish, not merely redress a wrong. Stiglitz, like everyone else, wants to fight corruption and, having praised the US Foreign Corrupt Practices Act says, ‘Every government needs to adopt a foreign corrupt practices act, and penalties should be imposed on governments that do not enact or impose such laws.’ He has in mind something similar for ‘rules against bank secrecy’ which should be extended ‘beyond terrorism’ to deal with corruption, arms sales, drugs and tax evasion’. The G8, he says, should act ‘by simply forbidding any of their banks to have dealings with the banks of any jurisdiction that did not comply’. He leaves open the question of what would be a law that did ‘comply’—and what would not—unless it is assumed that the language of US legislation can simply be imported wholesale into every jurisdiction in the world. One may sympathize with his objectives but a narrow, over-zealous approach can lead not only to ineffective or inefficient implementation at the law reform level but also to political disaffection in the very countries whose cooperation is needed.26

G.  The Need for Legal Certainty

17.32  Leading economists’ criticisms of the effects of unfettered laissez-faire market capitalism and the Washington consensus must obviously be taken seriously. Following the Financial Crisis, it would even seem that their views have gained the high ground. However, some of their ideas on the laws that they think would help achieve their objectives need careful consideration. To tell the rest of the world to adopt US laws in controversial areas (including the concept of triple damages and class actions) may not be the best way to win over the unconverted—even though we are now seeing US class action specialists opening (p. 331) law offices in London. The value of legal certainty is evidently heavily discounted, but can this be wise? One might identify banks with the evils of extreme (‘casino’) capitalism, and a banker waving a contract in your face (or the face of an impoverished nation) may not be a pretty sight. Nor, of course, is the politician who has squandered his country’s resources on his personal comfort and lifestyle. But once we start to chip away at certainty of contract, ignoring property and contractual rights in the name of some higher ideal of justice, we are heading down a road that is fraught with legal risk. As Keith Clark, in the paper referred to above, observed, ‘… stable contract rights and stable property rights are fundamental in the world in which I work: the financial markets’. And are we, in any event, really doing the poor a favour if we make it impossible for their governments to enter into contracts in connection with raising finance on which anyone can rely?

17.33  There is a danger that the increased level of legal risk causes a number of relatively routine transactions to become unbankable. There must be a way of achieving ideals of fairness and justice without throwing away contractual certainty and recognition of basic rights en route. Sacrificing or suspending rights in the pursuit of some loftier purpose was, after all, the justification used for Guantanamo Bay. We would surely do better to look at how we can lower legal risk for financing in developing countries—for example, by making the provision of collateral over movable assets less risky—than propose policies that seem certain to increase it. This would not grab the headlines or have mass, populist appeal but it might be of more practical benefit, making it easier for small and medium-sized enterprises to raise finance on better terms.

17.34  There seems to be a growing body of opinion that it does not matter if, in order to achieve the ambition of making the world a better, more equal place, life is made increasingly difficult and risky for banks and other financial institutions. It may be argued that if this helps us catch international criminals and alleviate poverty, then so be it. However, risk will follow. If you wish to confer better rights on the poor people of the world, it is very difficult to do so without taking away rights or imposing burdens on somebody else. A currently popular analysis of the situation points to the conclusion that the ‘somebody else’ should be, for the most part, banks. They are a temptingly unpopular, big, easy, and rich target. They have been habitually over-rewarding their employees to an exorbitant extent and they have cost the taxpayer huge amounts of money in bail-outs. Nobody likes them. But let us not forget that—directly or indirectly—they also have our money on deposit. We are all stakeholders in the international financial system and the banks that participate in it. Despite the resentment, even disgust, that the Crises have provoked, it is in our interest that they remain financially sound and able to conduct business for profit, rather than become overburdened with their role as unpaid agents in the fight against crime or the reduction of poverty. And (p. 332) there is, of course, a cost to these extra risks placed on banks which, ultimately, we all share. Perhaps the risks and costs associated with fighting crime should be allocated in this way—the banks, after all, have a good deal of the information that we need to catch the criminals and limit their operations. But it might be more honest if the risks and costs of what is essentially overseas aid were allocated through the aid budgets of donor governments rather than by making sweeping changes to the law relating to financial transactions.


1  Wolf, Why Globalization Works (Yale Nota Bene, 2005) at 97.

2  This is usually characterized as a preference for markets, privatization and deregulation. Following the London G20 Summit, Gordon Brown declared that the ‘old Washington consensus is over’ (and that a new consensus had now been reached).

3  With regard to politicians’ fondness for the word ‘sustainable’, see para 11.01.

4  See Ch 23, Section D.

5  See Golden, ‘The Future of Financial Regulation: The Role of the Courts’ in MacNeil and O’Brien (eds), The Future of Financial Regulation (Oxford, Hart Publishing, 2010) at p 86.

6  See para 16.07.

7  There is no generally accepted definition of ‘regulatory arbitrage’. Fleischer described the term as the process by which financial institutions ‘… take advantage of a gap between the economics of a deal and its regulatory treatment, restructuring the deal to reduce or avoid regulatory costs without unduly altering the underlying economics of the deal.’ (Victor Fleischer, ‘Regulatory Arbitrage’ (2010) Texas Law Review 89(2) at 227–89). In this context, the term should be distinguished from financial arbitrage, which occurs when there are multiple prices on economically identical assets. A more colloquial definition can be found in the Financial Times’ Lexicon, which describes this as being ‘where firms take advantage of loopholes in regulatory systems to avoid certain types of regulation. This can be achieved by conducting business, creating products and services in certain locations that are outside the purview of regulators’.

8  See Ch 11.

9  See Ch 11.

10  The ‘World Economic Forum’.

11  Which may give rise to conceptual challenges over whether there is an insurable interest.

12  Pursuant, not least, to the FCA’s consumer protection objective (s 1C Financial Services and Markets Act 2000). Although, it is noted that the above premise (and indeed the s 1C objective) is attenuated—albeit to a questionable practical extent—by s 3B FSMA, which requires the regulator to have regard to the ‘general principle that consumers should take responsibility for their decisions’.

13  The Law Society’s Gazette of 17 May 2007 (at p 6) reported that a survey of general counsel at some 84 multinationals, recently carried out, showed that budgets for legal risk and compliance were continuing to increase and that ‘in-house lawyers at multi-national companies believe they have made significant progress in raising the profile of legal risk management.’

14  See Stiglitz, Making Globalization Work (subtitled ‘The next steps to global justice’) (Allen Lane, 2006). All subsequent quotations below from this author are from this book.

15  ‘Tolerance set to zero, craziness to sky-high’.

16  See US Supreme Court decision (No. 06-43) (2008): Stoneridge Investment Partners LLC v Scientific Atlanta et al.

17  The resentment is shown to some extent by the ‘Least Developed Countries Report’ of the UN Conference on Trade and Development (UNCTAD) for 2009 which asserts (in the first sentence of the Introduction) that the Crisis ‘is the result of weakness in the neoliberal thinking that has shaped global economic policies in the last three decades’. It also observes that although the Crisis originated in the USA and Western Europe its effects will be felt most severely in least developed countries (because of the reduction in foreign direct investment). ‘… there is a moral issue raised by rich countries forcing the poorest to go further into debt in order to deal with a problem created by the rich’ (p 11).

18  See Ch 12, Section B.

19  See Ch 9, Section A.

20  Formerly the senior partner of Clifford Chance and International General Counsel of Morgan Stanley.

21  ‘Economic Stability and the Creation of Stable Contract and Property Rights’ (7 June 2006). COMBAR, The Jamestown Lectures 2006–2007: The Rule of Law (Hart Publishing, 2008) 15 (at 23).

22  See Ch 21, Section B.

23  [1897] AC 22 HL.

24  These authors are not the only critics of the strict application of the law being used to hold the governments of investee countries to account, under arrangements such as concession contracts and Bilateral Investment Treaties. An article by Alan Beattie under the title, ‘How lawsuits are coming to dictate terms of trade’ in the Financial Times of 19 March this year seemed to express surprise that a submission by a government to a binding arbitration procedure could indeed be just that—binding.

25  ‘Violence, Law and Justice in a Global Age’ (SSRC essay, 5 November 2001).

26  In a revealing interview on BBC’s ‘Today’ programme on 28 May 2007 Professor Robert Wade (Professor of Political Economy, London School of Economics)—commenting on circumstances leading up to Paul Wolfowitz’s resignation as Head of the World Bank—expressed the view that the latter’s ‘zeal’ (and that of his ‘lieutenants’) for his ‘crusade’ against corruption was ‘narrow and punitive’ in that it required disengagement from any country that had corrupt elements in its government (so that, eg, there would be no new World Bank loans to that country) and failed to recognize the reality that corruption was ‘a definitional characteristic of an underdeveloped country’ which may need help in dealing with ‘wider circumstances’ such as the need for civil service reform.