ⓘ Financial law


ⓘ Financial law

Financial law is the law and regulation of the insurance, derivatives, commercial banking, capital markets and investment management sectors. Understanding Financial law is crucial to appreciating the creation and formation of banking and financial regulation, as well as the legal framework for finance generally. Financial law forms a substantial portion of commercial law, and notably a substantial proportion of the global economy, and legal billables are dependent on sound and clear legal policy pertaining to financial transactions. Therefore financial law as the law for financial industries involves public and private law matters. Understanding the legal implications of transactions and structures such as an indemnity, or overdraft is crucial to appreciating their effect in financial transactions. This is the core of Financial law. Thus, Financial law draws a narrower distinction than commercial or corporate law by focusing primarily on financial transactions, the financial market, and its participants; for example, the sale of goods may be part of commercial law but is not financial law. Financial law may be understood as being formed of three overarching methods, or pillars of law formation and categorised into five transaction silos which form the various financial positions prevalent in finance.

For the regulation of the financial markets, see Financial regulation which is distinguished from financial law in that regulation sets out the guidelines, framework and participatory rules of the financial markets, their stability and protection of consumers; whereas financial law describes the law pertaining to all aspects of finance, including the law which controls party behaviour in which financial regulation forms an aspect of that law.

Financial law is understood as consisting of three pillars of law formation, these serve as the operating mechanisms on which the law interacts with the financial system and financial transactions generally. These three components, being market practices, case law, and regulation; work collectively to set a framework upon which financial markets operate. Whilst regulation experienced a resurgence following the financial crisis of 2007–2008, the role of case law and market practices cannot be understated. Further, whilst regulation is often formulated through legislative practices; market norms and case law serve as primary architects to the current financial system and provide the pillars upon which the markets depend. It is crucial for strong markets to be capable of utilising both self-regulation and conventions as well as commercially mined case law. This must be in addition to regulation. An improper balance of the three pillars is likely to result in instability and rigidity within the market contributing to illiquidity. For example, the soft law of the Potts QC Opinion in 1997 reshaped the derivatives market and helped expand the prevalence of derivatives. These three pillars are underpinned by several legal concepts upon which financial law depends, notably, legal personality, set-off, and payment which allows legal scholars to categorise financial instruments and financial market structures into five legal silos; those being 1 simple positions, 2 funded positions, 3 asset-backed positions, 4 net positions, and 5 combined positions. These are used by academic Joanna Benjamin to highlight the distinctions between various groupings of transaction structures based on common underpinnings of treatment under the law. The five position types are used as a framework to understand the legal treatment and corresponding constraints of instruments used in finance


1. Three Pillars of Financial Law Formation

Three different and indeed inconsistent regulatory projects exist which form the law within financial law. These are based on three different views of the proper nature of financial market relationships.


1.1. Three Pillars of Financial Law Formation Market Practices

The market practices of participants constitutes a core aspect of the source of law of the financial markets, primarily within England & Wales. The actions and norms of parties in creating standard practices creates a fundamental aspect of how those parties self-regulate. These market practices create internal norms which parties abide by, correspondingly influencing legal rules which result when the market norms are either broken or are disputed through formal, court, judgments.

The principle role is to form soft-law ; as a source of rules of conduct which in principle have no legally binding force but have practical effects. This has created standard form of contracts for various financial trade associations such as Loan Market Association, which seeks to set guidance, codes of practice, and legal opinions. It is these norms, particularly those provided by Financial Market Law Committees, and City of London Law Societies which the financial market operates and therefore the courts are often quick to uphold their validity. Oftentimes "soft law" defines the nature and incidents of the relationships that participants of particular types of transactions expect.

The implementation and value of soft law within the system, is particularly notable in its relationship with globalisation, consumer rights, and regulation. The FCA plays a central role in regulating the financial markets but soft law, voluntary or practice created legal schemes play a vital role. Soft law can fill market uncertainties what are produced by common law schemes. Obvious risk that participants become lulled into believing statements of soft law is the law. However, the perception that an opinion constitutes ipso facto a clear and widely held opinion is wrong For example, the consumer relationship in the case of Office of Fair Trading v Abbey National EWHCExtended liens case where Briggs J struggled to determine the legislative intent of the Financial Collateral Directive.


1.2. Three Pillars of Financial Law Formation Financial Collateral Regulations

In addition to national and cross-national regulations on finance, additional rules are put into place in order to stabilise the financial markets by reinforcing the utility of collateral. In Europe, two regimes of collateral carve-outs exist; the Financial Collateral Directive, and the Financial Collateral Arrangement No 2 Regulations 2003. The EUs development of the Financial Collateral Directive is curious if we view it through the lens of only a regulatory matter. It is clear that the law here developed through market practice and private law statutory reform. The EU has played a substantial role in this field to induce and encourage the ease of transfer & realisation of assets and liquidity within markets. The provisions are well adapted to short term transactions such as repos or derivatives.

Further harmonisation rules pertaining to commercial conflict of laws matters were clarified. The additional Geneva Securities Convention set by UNIDROIT provides a basic framework for minimum harmonised provisions governing rights conferred by the credit of securities to an account with an intermediary. However, this international project has as of late been ineffective with only Bangladesh signing.


2. Legal concepts prevalent in Financial Law

Several legal concepts underpin the law of finance. Of these, perhaps the most central concept is that of legal personality, the idea that the law can create non-natural persons is one of the most important common myths and among the most ingenious inventions for financial practice because it facilitates the ability to limit risk by creating legal persons which are separate. Other legal concepts, such as set-off and payment are crucial to preventing systemic risk by lessening the level of gross exposure of credit risk a financial participant might be exposed to on any given transaction. This is often mitigated through the use of collateral. If financial law is centrally concerned with the law pertaining to financial instruments or transactions, then it can be said that the legal effect of those transactions is to allocate risk.


2.1. Legal concepts prevalent in Financial Law Limited liability and legal personality

A limited liability company is an artificial creation of legislature which operates to limit the level of credit risk and exposure a financial market participant will participate within. Lord Sumption summarised the position by stating

Subject to very limited exceptions, most of which are statutory, a company is a legal entity distinct from its shareholders. It has rights and liabilities of its own which are distinct from those of its shareholders. Its property is its own, and not that of its shareholders Bank LR 267, Hobhouse J held that acceptance of payment need not be communicated and his judgment provides a clear, two-stage test for determining whether payment has been made. If A;

  • the conduct of the creditor, viewed objectively, amounts to acceptance, then payment has passed.
  • places the money unconditionally at the disposal of his creditor; and

Thus, in Libyan Arab Bank v Bankers Trust Co the court held that when the collecting bank decided unconditionally to credit the creditors account, the payment is completed. Presentation and subsequent rejection of payment provides an absolute defence for to an action brought by the creditor, but without the action and opportunity to pay into the court and with exceptions, the debtors proffering of payment does not discharge the money obligation nor does it constitute as payment. In the case of The Laconia, the English House of Lords set out clear conditions on timing of payment in relation to the debtor proffering payment. The charterers had procured a vessel for 3 months, 15 days with a payment due on April 12, a Sunday. The charterers delivered payment on Monday. The vessel owners rejected the payment, which was sent back the following day. Primarily, The Laconia regards the requirement for a tender to be congruent with the conditions in order to amount to a tendering of payment. However, the case might also be used to highlight the necessity for the creditor to accept such tendering. Had the vessel owners merely taken receipt of the payment and not instructed their bank to return the money, then it seems likely that payment was accepted. The consensual nature of payment thus derives from the requirement that both debtor must offer, and creditor must accept, the medium of payment; and secondly from the fact that creditor rejection of procurement, even if his agent is in receipt of the payment, results in a failure to effect payment. Goode discusses two forms where receipt does not take effect as acceptance that fall into the second aforementioned stage of mutual consent;

  • Conditional acceptance. Where a cheque is accepted it is conditional on such a cheque being met. Here, letters of Credit come to mind in that their conditional nature is dependent on the bank effecting payment. In The Chikuma and The Brimnes the court examined whether payment was fulfilled on the side of the payer. From that perspective, it was necessary for the court to analyse whether the payer had fulfilled the conditions in order to effect discharge.
  • Receipt by creditors agent. The Laconia falls within this category. This is primarily because it is not always clear whether the agent lacked the authority to accept the payment.

The fact that rejection of tender is sufficient to prevent payment derives from the fact that payment is the conferral of property to fulfil the obligation. Property and obligation aspects of the transaction cannot be separated without the transaction ceasing to be "payment".


3. Financial law transactional categories

As well as being fragmented, financial law is often muddled. Historical segregation of the industry into sectors has meant each has been regulated and conducted by different institutions. The approach to financial law is unique depending on the structure of the financial instrument. The historical development of various financial instruments explains the legal protections which differ between, say, guarantees and indemnities. Due to the limited cross-sectoral legal awareness, innovations in finance have been associated with varying levels of risk. Several different legal "wrappers" provide different structured products, each with differing levels of risk allocation, for example, funded positions consist of bank loans, capital market securities, and managed funds.

The primary purpose of financial law is to allocate risk from one person to another and change the nature of risk being run by the protection buyer into the credit risk of the risk taker. Five categories of market structures are divided according to how the contract deals with the credit risk of the risk taker.


3.1. Financial law transactional categories Simple financial positions

Guarantees, insurance, standby letters of credit and performance bonds. The terms Simple can often be misleading, as often the transactions which fall within this category are often complicated. They are termed simple not because of the lack of sophistication but because the transactions do not address the credit exposure of the protection buyer. Rather, as with a guarantee, the protection buyer simply takes the risk of protection seller. Derivatives often fall within this regulatory category because they transfer risk from one party to another.


3.2. Financial law transactional categories Derivatives law

The second portion of simple transactions are derivatives, specifically unfunded derivatives of which, four basic types exist. At law, the primary risk of a derivative is the risk of a transaction being re-characterised as another legal structure. Thus, the courts have been cautious to make clear definitions of what amounts to a derivative at law. Fundamentally, a derivative is a contract for difference, it utilises netting to set obligations between parties. Rarely does delivery of the asset occur. In English law, the judgment of Lomas v JFB Firth Rixon EWHC 1039 Comm, per Blair J

Therefore, a change will be material if it significantly affects the borrowers ability to repay the loan in question. Normally this is done by comparing borrowers accounts or other financial information then and now.


3.3. Financial law transactional categories Net Positions

A net position represents a financial position in which a debtor may "off-set" his obligation to the creditor with a mutual obligation which has arisen and is owed from the creditor to the debtor. In financial law, this may often take the form of a simple or funded position such as a securities lending transaction where mutual obligations set-off one another. Three crucial types of netting exists:

  • Transaction Netting
  • Novation Netting
  • Settlement Netting

Each party can use its own claim against the other to discharge. Each party bears credit risk which may be offset. For example, a guarantor who is a depositor with a banking institution can set-off obligations he may owe to the bank under the guarantee against the banks obligation to repay his deposited assets.


3.4. Financial law transactional categories Asset-backed positions

Propriety securities like mortgages, charges, liens, pledges and retention of title clauses are financial positions which are collateralised using proprietary assets to mitigate the risk exposure of the collateral-taker. The core purpose it to Manage credit risk by identifying certain assets and ear-marking claims to those assets.


3.5. Financial law transactional categories Combined positions

Combined positions use multiple facets of the other four positions, assembling them in various combinations to produce large, often complex, transactional structures. Examples of this category are primarily CDOs and other structured products. For example, a Synthetic collateralised debt obligations will draw upon derivatives, syndicated lending, and asset-backed positions to distinguish the risk of the reference asset from other risks. The law pertaining to CDOs is particularly noteworthy, primarily for its use of legal concepts such as legal personality, and risk transfer to develop new products. The prevalence and importance of combined positions within the financial markets, has meant that the legal underpinnings of the transactional structures are highly relevant to their enforcement and effectiveness.