Articles
Lehman's Spill-over Effects:Cooperation v.Regulatory Arbitrage？
Rainer Kulms
Abstract：
When governments began to save financial institutions on a daily basis, international cooperation became imperative.Lehman had been a multinational conglomerate, relying on regulatory arbitrage, insouciant about negative externalities in the event of a bankruptcy.European and non-European jurisdictions had to come to terms with the implications of regulatory arbitrage for Lehman's retail structured products.Financial conglomerates questioned the belief that the negative externalities could be contained by comity and cooperative behaviour in the context of crossborder insolvency proceedings.Alternatively, cooperative solutions may be achieved through private party insolvency protocols or cross-border government intervention.As the credit market disruption crept in, the European Union stepped up its crisis management proposing regulatory intervention.On an international level, cooperation produced efforts to anticipate systemic risk by devising early warning mechanisms.This does not yet amount to a substantive public international law rule on cross-border coordination.
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Ⅰ.LEHMAN'S LEGACY
Lehman Brothers was a financial conglomerate of 2,985 entities globally, offering cross-border investment bank services and financial products（including structured products）in many jurisdictions, some regulated and others unregulated. In January 2008, Lehman Brothers Holdings, Inc.（LBHI）reported record revenues of nearly US$60 billion and earnings of more than US$4 billion for its fiscal year ending November 2007. Lehman's stock peaked at US$65.73 per share. Less than a year later, on 12 September 2008 Lehman's stock had lost 95% of its January value, closing under US$4 per share. On 15 September 2008, LBHI filed for protection under chapter 11 of the US Bankruptcy Code, triggering the largest bankruptcy in US history. A global banking crisis unfolded, prompting Governments to save banks of systemic importance. Various non-US LBHI subsidiaries went into bankruptcy or were subject to regulatory proceedings under the banking laws of their host states. On 12 May 2009, negotiations on a“crossborder insolvency protocol for the Lehman Brothers Group of Compa nies”were finalised in an attempt to coordinate insolvency proceedings in various jurisdictions. In July 2010, the US Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law. Sec.217 of this Act provides for a study on international cooperation relating to the resolution of systemic financial companies under the US Bankruptcy Code and applicable foreign law.
A.The Business Model
LBHI pursued a business model which was not unique.At the time of Lehman's bankruptcy, major investment banks would follow a variation of the high-risk, high-leverage model, relying on the confidence of the counterparties to sustain. Lehman's assets were predominantly long-term whereas its liabilities were largely short-term; hence the need to borrow from counterparties to stay in business. Thus, the LBHI group critically depended on market confidence.Due to Lehman's complex conglomerate structure a breakdown of investor confidence in one market segment would rapidly translate into financial problems of the whole group.The Lehman group was a multinational bank with many non-US subsidiaries integrated into a centralised cash-management system. Once the cash-pooling mechanism broke down, the subsidiaries would rapidly experience severe liquidity problems.
1.Prime Brokerage Services
As an investment bank Lehman did not take deposits.The Lehman group was active in offering prime brokerage services to hedge funds. Hedge funds lack back office functions, requiring a third party to deal with the trades and provide custodial services. Thus, hedge funds would employ Lehman as an intermediary to access credit lines and major central securities depository systems. In turn, Lehman required hedge funds to place collateral with them.LBHI's international conglomerate structure was determined by regulatory arbitrage.US hedge funds had exploited more lenient margin rules in the UK, when they channelled their business through Lehman's London subsidiary as their prime broker. Once the Lehman conglomerate had broken down, hedge funds came to realise that they were relegated to the role of unse cured creditors trying to get their collateral released from the London bankruptcy proceedings of the UK subsidiary.
Although the UK Lehman subsidiary had handled transactions with a volume of billions of US dollars, the freezing of hedge fund assets does not appear to have triggered off bankruptcies. Larger hedge funds had already diversified risk prior to the Lehman bankruptcy by abolishing single primer brokerage practices. The London experience of US hedge funds did, however, give rise to concurrent bankruptcy proceedings begging the question to what extent US and English judges were prepared to apply notions of comity in private international law.
2.Credit Default Swaps
Credit Default Swaps operate as highly sophisticated insurance mechanisms.Under a bilateral contract, the protection buyer undertakes to pay a premium（and/or an upfront payment）in exchange for a payment by the protection seller in the event of a credit default of a reference entity or a basket of reference entities. Lehman's business with credit default swaps was considerable, both as counterparty and otherwise. Nonetheless, the credit default swap branch did not generate much litigation. Lehman's transactions were based on the 1992 Master Agreement prepared by the International Swaps and Derivatives As sociation（ISDA）. The Master Agreement stipulates that the bankruptcy of one party to the contract will constitute a default entitling the other party to declare termination of the derivative transaction.In attempt to hedge risks, most counterparties exercised this option when Lehman filed for protection under chapter 11 of the US Bankruptcy Code. On the other hand, parties to credit default swap contracts with Lehman as counterparty settled their debts in a settlement engineered by the ISDA at a total between US$6bn to US$8bn.
3.Securitisation Programme
Lehman Brothers had significant mortgage businesses in the US and the UK. In order to maintain an adequate level of liquidity, business strategies were dictated by the economics of securitisation. Special purpose vehicles were established which purchased the receivables or other illiquid assets from the original lender（the“originator”, i.e.Lehman）. As separate legal entities these special purpose vehicle issued their own securities which were“asset-backed”since they built on the cash flows generated by the originator's former receivables. Lehman's special purpose vehicles issued certificates and warrants for which the underlying risks had been repackaged. As such, they were linked to an index or an asset class for a fixed period of time, using derivatives to provide a return based on the performance of the asset（structured products）.LBHI did only have to honour its repayment guarantee if the index had exceeded a pre-determined threshold.Under some schemes, however, LBHI guaranteed the return of the capital at maturity.
Historically, banks, financial institutions such as funds, and wealthy investors had been the main purchasers of structured financial products. But asset securitisation and repackaging of financial products ushered in the advent of retail investors.Regulatory arbitrage provided a powerful incentive for LBHI to devise a multinational retail network, exploiting differences in taxation, investor protection and bankruptcy rules, and deposit insurance duties under laws less demanding than US securities regulation.Dutch, Luxembourg and Netherlands Antilles subsidiaries operated as issuers of financial products guaranteed by LBHI New York.Lehman Brothers Treasury Co.B.V.（Amsterdam）offered unsecured notes guaranteed by LBHI New York. Lehman Brothers Securities N.V.（Netherlands Antilles）and Lehman Brothers（Luxembourg）Equity Finance S.A. acted as special purpose vehi cles for LBHI（New York）, offering a Warrant and Certificate Programme targeted at retail investors.
B.Regulatory Policy Challenges
1.The Collapse and the Crisis
When the chairman of the United Kingdom（UK）Financial Services Authority（FSA）reviewed the global banking crisis after the failure of Lehman Brothers, he emphasised“...that decisions about fiscal and central bank support for the rescue of a major bank are ultimately made by home country national authorities focusing on national rather than global considerations ....The decisions of the US authorities to allow Lehman to fail...clearly had huge global, rather than solely US, financial and subsequently economic implications”. The analysis of the FSA is couched in the subtle language of a regulator, but it contains an important message with respect to the legal dimension of the Lehman bankruptcy.National regulators face a conflict of interest when they approach financial problems of an international conglomerate of systemic importance. A cynic might be tempted to suggest that, by letting go LBHI asunder, the financial risks of the group were internationalised, thus economising on US government funds for the rescue of the financial industry as a whole.Closer inspection suggests that a multi-dimensional approach is more appropriate.Admittedly, European banks suffered more intensely from increasing spreads in counterparty transactions with the Lehman group than US financial institutions. But this does not constitute conclusive evidence that Lehman's petition under chapter 11 was instrumental in unleashing the collapse in credit. Lehman did，however, dramatically alert the investment community to the international risks of the subprime crisis, counterparty transactions and asset securitisation .Global bank equity prices began to fall as uncertainty about bank exposure to Lehman risks and eventual recovery rates on these exposures began to creep in.
The globalisation of banking and financing is common ground. There is nothing wrong in combining decentralised investment services with cash-pooling mechanisms on a transnational scale. In devising its conglomerate structure, Lehman engaged in regulatory arbitrage, skilfully exploiting differences between national laws on bankruptcy and minimum deposit requirements. Later, under emergency conditions, the Lehman conglomerate failed to coordinate its bankruptcy filings in the various jurisdictions. Lehman bankruptcy proceedings are highly complex with judges facing considerable difficulties to determine the full impact on the creditors of the conglomerate. Cross-border bankruptcy litigation is lawyer's delight.In the case of Lehman it demonstrated to what extent the conglomerate had externalised the costs of regulatory arbitrage.Moreover, litigation over retail structured products placed the burden of repackaged structured products with financial intermediaries and creditors, begging the question whether international cooperation might stave off some of the risks.
Post-Lehman anti-crisis management was not confined to scrutinizing the bankruptcy scenario. Instead, national regulators focused on emergency measures, supplying ailing financial institutions with liquidity or guarantees. It is one of the main characteristics of the post-Lehman-era that regulators are moving from ex post to comprehensive ex ante strategies to contain systemic risk. New rules on bank governance, prudential supervision and transparency are urged. International institutions such as the International Monetary Fund（IMF）, the Bank for International Settlements（BIS）and the Financial Stability Forum（FSF）are advocating closer cooperation between countries in order to establish early warning mechanisms. It is less clear, however, to what extent current policy measures establish a duty to pursue cooperative strategies, thereby averting beggar-thy-neighbour policies.
2.Outline of the Paper
This paper will first address the externalities of Lehman's regulatory arbitrage.The focus is on litigation over structured products in European countries and non-European jurisdictions（USA, the Hong Kong area of China and Singapore）. The analysis will then assess the potential for cooperative solutions for financial conglomerates in crisis.It will be asked whether the negative externalities of regulatory arbitrage can be overcome by comity and cooperative behaviour in the context of international insolvency proceedings. The paper continues with a scrutiny of the status quo of cooperative behaviour through private party insolvency protocols and cross-border government intervention.This ushers in a final section on the perspectives of international cooperation in the face of systemic risk.
Ⅱ.Regulatory Arbitrage I: Lehman's Structured Products in European Jurisdictions
A.France
In 2007, French per-capita sales of structured products were less than 10% of the Swiss trading volume in structured products, and slightly more than one third of comparable German transactions. Although French banks have attempted to make major inroads into private retail investing, the traditional patterns for retail investment persist: Fi nancial institution and wealthy investors are the main purchasers of structured products.Industry representatives describe the French market in retail structured products as very mature. Unlike some other European countries, France opted for a sector-wise approach of oversight, leaving the French Autoritéde Marchés Financiers（AMF）with no overall supervision of banking products and services and life insurance contracts. Prior to the collapse of Lehman, it was standard French regulatory practice to rely on internal controls by institutional investors and wealthy individuals who were thought to be knowledgeable enough to negotiate for adequate protection when investing in innovative financial products.As the financial crisis accelerated , the AMF stepped up its regulatory controls, imposing fines on banking agencies for distributing securities without sufficient information and on a fund management company with unconvincing governance structures. The AMF exercised its statutory powers to strengthen the financial structure of some investment funds.
Although France implemented the EU's capital market and financial services directives, its current regulatory regime of ex ante-controls and oversight has been found to be deficient.A report commissioned by the Ministry of Finance proposes more stringent controls of banks and financial intermediaries with respect to their discharge of professional duties towards investors. In its policy recommendations on structured investment, the AMF acknowledges the competitive impact of retail investment products. This should, however, not affect the transparency of the credit market.The AMF warns of a potential conflict of interests between the originator of the financial product and the intermediaries and between intermediaries and the ultimate investor-client. Similar to transparency on secondary markets for listed products, posttrading efficiency would be greatly enhanced by regulatory clarification of the duty to be transparent. In June 2009, the AMF published a strategic plan, redefining its oversight priorities.The AMF's policy statement explicitly acknowledges that retail investors pursue portfolio strategies typical of depositors with a savings account.
B.United Kingdom
1.The Financial Services Authority（FSA）and Lehman's Retail Business
At the time of the collapse of the Lehman group over 5,000 retail investors had invested a total of UK£ 107 m in structured investment products backed by a Lehman guarantee. The FSA initiated an investigation in order to assess the quality of advice afforded by financial intermediaries to retail investors. The FSA analysed key documentation data of a sample of 11 firms, conducted interviews with relevant firm personnel and assessed the files of 157 customers who had bought Lehman-backed structured investment products between November 2007 and August 2008. Advice given by the financial intermediary was unsuitable if the customer had been recommended a product ill-matched with their financial circumstances or the investment time scale. A finding of unsuitability is warranted if there was disregard for customers'risk preferences, an inadequate level of diversification in the individual investment portfolios or neglect of specific tax needs. The FSA investigation extended to the suitability of disclosure to adequately alert the customer to the risks of structured investment products（including the disclosure of the counterparty risk）.
The FSA's findings on internal governance mechanisms are sobering.Although most firms had performed an acceptable analysis of customers'needs and circumstances, customers were exposed to an inappropriate level of risk in a substantial number of cases（43% of all files reviewed）. Disclosure by advisors was generally found to be deficient with respect to specificities of the product recommended and the counterparty risk. The results on internal governance mechanisms and quality controls were mixed.Even after the collapse of Lehman Brothers most investment firms failed to substantially mitigate the risk of providing unprofessional advice. The results of its review prompted the FSA to clarify the standards for a professional quality assessment of structured investment products. A note to the FSA's regulatory guide on responsibilities of providers and distributors for the fair treatment of customers was published, urging the industry to improve due diligence procedures with respect to credit providers and distributions channels and to assume post-sale responsibility towards their customers. The FSA has made it clear that it will insist on improving standards for structured investment products.In February 2010, the FSA imposed a fine of £ 700,000 on a financial intermediary who had failed to adequately advise on investment, credit and liquidity risks associated with Lehmanbacked structured products.
2.Alternative Dispute Resolution
Litigation in the UK is costly, and retail investors appear to shy away from suing financial intermediaries as long as the law on retail investor claims is unclear. Instead, purchasers of Lehman's structured products have turned to the Financial Ombudsman Service to settle their claims against financial institutions. The Financial Ombudsman Service is a statutory dispute resolution scheme established under the Finan cial Services and Markets Act 2000 and the Consumer Credit Act 2006. There are no empirical data available on how and whether claims related to Lehman-backed structured products were settled.However, both the Financial Ombudsman Service and the FSA recognise the regulatory challenge emanating from Lehman's collapse for the UK structured investment product market.
The current UK regulatory approach towards Lehman-backed structured investment products creates two classes of investors.Retail investors who bought Lehman-backed securities from financial intermediaries which are still operative will have to rely on the Financial Ombudsman Service to negotiate a settlement of their claims through alternative dispute settlement mechanisms.However, if a financial intermediary has gone into administration under insolvency law, the investor is entitled to compensation under the Financial Services Compensation Scheme（FSCS）. FSCS was established by the Financial Services and Markets Act 2000 .FSCS is funded by levies on authorised investment firms, and the maximum compensation for lost investments is £ 50,000 per person per firm.
C.Switzerland
1.Conciliatory Banks and a Banking Ombudsman
When the Lehman group collapsed, it had 83 different financial products on the Swiss market. Banks which had marketed Lehman's products were quick to deny any liability to their clients as they had acted as mere intermediaries. In the end, reputation mechanisms proved to be too powerful: Swiss banks paid compensation to private investors, yielding to a combination of administrative suasion , public criticism and alternative dispute resolution. In 2008, the docket of the Swiss Banking Ombudsman reached an all-time-high of 4,144 new cases, 50% of which were generated by Lehman-backed securities, products of the Icelandic Kaupthing Bank and absolute return products. With respect to Lehman-related disputes the Swiss Banking Ombudsman makes a clear distinction between experienced investors and risk-averse consumers.Investors familiar with the risk of asset-backed securities and derivatives do not require extensive professional advice by the bank even if the financial product contains highly speculative ele ments. Conversely, less experienced investors are entitled to detailed documentation on the issuer and may expect to be warned if it occurs to the bank that the customer's risk assumptions are erroneous. However, the bank may exonerate itself if its client disregarded the bank's investment recommendations for structured products, opting for riskier multi-barrier reverse convertibles instead. The Ombudsman imposes on banks an ex post-duty to warn if subsequent to the investment transaction negative information on the issuer of a structured product becomes available.
2.（Mature）Investors under the Swiss Law on Collective Invest-ments
The 2007 Federal Act on Collective Investment Schemes（CISA/Bundesgesetz über die kollektiven Kapitalanlagen）conditions the marketing and distribution of non-domestic securities on the approval of FINMA（the Swiss Financial Market Supervisory Authority）. But there is no statutory scheme on continuous oversight.Instead, the legislator accepted that financial intermediaries would subscribe to industry standards laid down by self-regulatory bodies. It is not the express intention of this statute to advance consumer protection. According to Art.1 CISA, Swiss capital market law pledges to protect investors and to establish a transparent and well-functioning capital market.In assessing the ombudsman's report in the light of mandatory law, FINMA notes that Swiss private law is guided by the notion of a mature investor capable of assessing capital market information at his disposal. Nonetheless, a new type of investor emerges from the Ombudsman's findings: Mass retail investors with little experience have entered the business of structured products who quintessentially behave as depositors with a savings account. As FINMA explains, this is a category of investors not envisaged by the drafters of the statute.Excessive reliance on a prospectus is misplaced and does not afford sufficient investor protection. More attention should be devoted to improving internal governance mechanisms of financial intermediaries. In reaction to FINMA's criticism, the Swiss finance industry introduced new risk classification standards to assure the transparency of Swiss-made structured financial products.
D.Germany—Litigation
The German regime on Lehman-backed structured products is based on a complex interface between statutory duties under securities and banking laws and the stipulations of a contract on retail investment products. The court cases on retail investment transactions for credit swaps, derivatives and structured products are marked by a great factual similarity.They differ, however, considerably in the judicial assessment of the respective risk structures and the corresponding duties to warn the investor and to protect his financial interests.Investors had an ongoing contractual relationship with their（local）financial institution, including some transactions in retail investment products more risk-prone than a mere savings account.Frequently, investors sought to improve the returns of their previous investment.Sometimes they approached their investment advisor at the bank.Sometimes the bank advisor called them, offering Lehman-backed structured products and other retail investment products.Under these circumstances, the German courts invariably imply a contract on investment advice to be supplied by the bank even if there is no evidence of an express conclusion.
The cases tread a very fine between the client's inclination to engage in speculative transaction and a bank's duty to adequately warn about the risk assumed. In fact, this risk assessment is a decisive threshold for deciding whether an investor has met the private law requirement for establishing advisor liability. If the information supplied is adequate the investor will have to bear the risk associated with indexed financial products, including the risk of the issuer's insolvency. Courts have declined to impose a specific duty to warn prior to the Lehman collapse as long as the Lehman group was a financial institution awarded high rankings by the rating agencies. Banks are under a duty to alert their clients to the fact that these products are not covered by a depositor-insurance scheme. The cases send an important message to German financial institutions emphasising the need to improve internal information processes so that the individual investment advisor will understand the structured product recommended to a client.
Ⅲ.Regulatory Arbitrage II: Lehman's Structured Products in Non-European Jurisdictions
A.USA
Prior to the financial crisis, LBHI was one of the major Wall Street players, well interconnected and constantly communicating back and forth. Structured finance transactions were organised over-the-counter（OTC）with little public oversight.In testifying to the US Senate Committee on Banking, Housing and Urban Affairs, Professor John Coffee described asset-backed securitisations as a“financial technology that failed”. This failure was to be attributed to severe moral hazard problems experienced by loan originators and underwriters: In the face of high profit expectations on a global market for structured products loan originators and underwriters relaxed lending standards and packaged non-creditworthy loans into new portfolios. Recently, the examiner appointed by the US Bankruptcy Court for the Southern District of New York determined that LBHI had pursued an accounting strategy to shield its liquidity problems from public scrutiny. The US Securities and Exchange Commission（SEC）is critical of the“Balkanized structure”of US financial regulation which prohibited the Commission from overseeing much of the OTC derivatives market. Until 2008 the SEC had operated a“Consolidated Supervised Entity Program”which enabled participants（including LBHI）to apply a more relaxed“alternative net capital rule”without any meaningful cap on the debt-equity-ratio. However, even after the SEC had determined in June 2008 that LBHI was overstating its liquid assets, no enforcement action was taken by the agency.
The publication of the examiner's report on the LBHI bankruptcy shed new light on LBHI's internal governance mechanisms, supplying investors with fresh information for commencing litigation on structured products. As early as 2003, the National Association of Securities Dealers（NASD）published notices on structured products recommending best practices and internal assessment mechanisms. Two years later NASD insisted that transactions should be based on a customer suitability analysis, including customers'financial status, their investment objectives and their capability to evaluate the risk of the recommended transactions.
Investor-related litigation focuses on the practices of financial intermediaries selling Lehman structured products.The publicised cases appear to confirm Professor Coffee's findings that financial intermediaries had succumbed to moral hazard.In April 2010, a Swiss Bank lost a US$432,000 case in arbitration proceedings before the Financial Industry Regulatory Authority（FINRA）. The bank was found to have misrepresented the risks associated with Lehman products. Moreover, the bank had failed to disclose certain material facts about its relationship with the LBHI group. In stepping up law enforcement the SEC has decided to police more vigorously breaches of statutory disclosure obligations.In April 2010 Goldman, Sachs &Co.was charged for defrauding investors by misstating and omitting key facts about a synthetic collateralised debt obligation（CDO）pegged to the performance of subprime mortgage-backed securities in a faltering market. Goldman, Sachs &Co.was accused of not disclosing that one of the business partners in the transaction had an economic interest materially adverse to CDO investors.On 15 July 2010, Goldman, Sachs&Co.entered into a consent decree, paying disgorgement and a civil amount at the amount of US$550,000,000. Recently, the SEC has decided to rely on Sec. 304 of the Sarbanes-Oxley Act in order to police breaches of accounting and disclosure laws.In July 2009, the Commission filed a complaint to make a chief executive officer reimburse his bonuses and other incentive-compensation for having allegedly misstated the company's accounts. Recently, the US District Court for Arizona rejected the defendant's motion to dismiss for failure to state a claim. If the SEC's position survives closer scrutiny, chief executives of investment banks and financial intermediaries specialising in structured products may well have to reconsider their personal risk strategies.
B.The Hong Kong area of China
According to an IMF Working Paper, the exposure of China's financial system to US structured products in 2008 was about US$10 billion. Hong Kong banks'exposure to US subprime securities and structured assets was less than 50 percent of the assets within the local banking system. Nonetheless, the repercussions of the LBHI bankruptcy caused a major uproar among Hong Kong retail investors. In July 2010, the Hong Kong Monetary Authority（HKMA）reported that it had received a total of 21,674 LBHI-related complaints of which 99 percent had been investigated. Hong Kong retail banks had sold several categories of Lehman-structured products; investment accounts holding such products exceeded 48,000. Some LBHI-related products had been authorised for sale by the Hong Kong Securities and Futures Commission（SFC）.A majority, however, was channelled into the market by private placement for which no SFC authorisation had been given. In Hong Kong, a Cayman Islands-incorporated special purpose vehicle issued unlisted credit-linked notes（called minibonds）to retail investors. These minibonds were structured financial products consisting of high-risk derivatives（including credit default swap agreements）guaranteed by Lehman as counterparty. Under the stipulations of the swap arrangements the failure of LBHI constituted an event triggering early termination.Hence these investment products crucially depended on LBHI's continuation of business.
In an effort to contain minibond unrest and to preserve the status quo of the Hong Kong financial market, the local authorities decided for a combination of alternative dispute settlement and administrative suasion.In mid-2006, the SFC and the HKMA had finalised an agreement with 16 distributing banks, providing for the repurchase of Lehman minibonds from eligible customers.In fact, this agreement requires financial intermediaries to rescind previous contracts and make compensation payments in exchange for dropping an investigation alleging misconduct during the sale and the distribution of Lehman's structured products.The stipulations of the agreement acknowledge that retail investors had considered minibonds as a device to increase pensioner income:Customers beyond the age of 65 will receive 70 percent of the nominal value of their original investment; younger ones are to be satisfied with 60 percent. In the event of collection of collateral additional payments are envisaged.
The settlement agreement reached under Sec.201（3）of the Hong Kong Securities and Futures Ordinance was challenged in court, but the court refused to judicially review the decisions made by the SFC and the HKMA. In commenting on alternative dispute settlement in the context of the Lehman's minibonds crisis, the Hong Kong Law Reform Commission recommended the introduction of class action procedures for multi-party litigation. The Law Reform Commission noted that the absence of class actions might in fact increase public pressure on the SFC to seek compensation from those financial institutions it is mandated to regulate. Thus, class action mechanisms would seem to shield the financial industry from accepting compensation settlements where liability remains doubtful.
The minibonds crisis ushered in a review of Hong Kong regulatory policies on financial markets.In its 2008 report, the HKMA expressed a preference for continued disclosure and improved professional standards for financial intermediaries. In May 2010, the SFC published its conclusions on the consultation on proposals enhancing investor protection. The SFC pledges to introduce a unitary handbook setting out in greater detail the transparency standards and disclosure requirements for unit trusts and mutual funds, investment-linked assurance schemes an unlisted structured investment products. Moreover, a plain language requirement is envisaged. Product arrangers（i.e.special purpose vehicles）will have to be licensed and eligibility criteria for collateral will be introduced.The SFC accepts proposals to classify investors according to their knowledge on derivatives. A cooling-off period will be incorporated in investment products so that a client may revoke the contract, subject to a reasonable administrative charge.
C.Singapore
When the repercussions of the Lehman collapse reached Singapore, the Monetary Authority of Singapore（MAS）made it clear that, although it might take appropriate regulatory action against distributors of minibonds, investors should not rely on government authorities to realise claims for compensation. Nonetheless, MAS explained that financial institutions should take responsibility where Lehman-related products had been mis-sold or advice had been given irrespective of the investor's profile.MAS then advised investors to lodge their complaint directly with their financial institution. After discussions with the financial institutions the MAS identified three individuals to oversee whether com plaints were handled speedily and resolution processes were adequate. A MAS policy statement indicated a clear preference for favouring alternative dispute settlement mechanisms over protracted litigation. In the end, investors recovered between 21.5 and 70.8 percent of their original investment, depending on the series of the minibonds and their respective annuity : A first settlement was reached in October 2009 with a Lehman subsidiary which had acted as counterparty in minibond notes transactions. In February 2010, MAS announced the distribution of the recovery values of the minibonds. As of 22 November 2009,1,263 minibond-related complaints against financial intermediaries had been lodged with the Singapore Financial Industry Dispute Resolution Centre. The centre's total settlement rate in structured products cases was at 72 percent. There are no data available to what extent retail investors prevailed over financial intermediaries.
Under the revised Singapore Consumer Protection（Fair Trading）Act consumer protection is also available with respect to various finan cial products and services. In reaction to the minibond crisis the MAS launched a policy consultation on the review of the regulatory regime on the sale and marketing of unlisted investment products. The MAS now pledges to improve disclosure requirements（including ongoing disclosure requirements）and to expand issuer duties to make publicly available bid or redemption prices. Marketing and advertising materials are to supply a fair and balanced view of the product easily understandable for audience addressed.Distributors will be urged to implement formal policies and procedures to assess the quality of a new investment for targeted customer segments.This will also include enhanced documentation duties.Sales without advice will only be acceptable if the prospective buyer has expressly waived his right to receive advice.
Ⅳ.Cooperative Solutions for Financial Conglomerates
A.A Universal Approach under Bankruptcy Law and Comity between Law Courts
From an ex post perspective the externalities of regulatory arbitrage can be best overcome by universal bankruptcy proceedings, comity, or by piercing the corporate veil of an international financial conglomer ate. Early in 2010, there were at least ten concurrent insolvency proceedings of Lehman companies world-wide. Lehman's specific conglomerate structure was not matched by international norms on crossborder insolvencies.Legal analysis is therefore relegated to private international law principles on multi-jurisdictional insolvency proceedings. From a creditor's point of view, national laws should treat insolvent banks as a“single entities”, forsaking the privileges of territoriality under bankruptcy law for the benefit of equal treatment of domestic and foreign claims. But even bankruptcy jurisdictions which implement universality and comity struggle with conflicting concepts of national substantive laws. The concurrent English and US cases on the enforceability of Lehman's ipso facto clauses in credit swap contracts highlight the practical obstacles to coordinating bankruptcy proceedings. English common law rules recognise contractual stipulations which provide for a switch from swap counterparty priority to noteholder priority, applicable once LBHI had filed for insolvency.US bankruptcy law does not.
English common law traditionally favours the universal application of bankruptcy proceedings in order to guarantee fairness between creditors. The UK has enacted the UNCITRAL Model Law on Cross-Border Insolvency , authorising foreign creditors to participate in a proceeding under British insolvency law and requiring an English court to recognise foreign proceedings .English law will, however, disregard universality of bankruptcy and comity if recognition of a foreign proceeding would be manifestly unfair or in breach of public policy. Chapter 15 of the US Bankruptcy Code codifies similar rules. US courts disregard foreign proceedings if an orderly, efficient and equitable distribution of the debtor's assets is unlikely. 11 § 1525 U.S.C. empowers a US court to communicate directly with a foreign court. Both US and English laws recognise that the interest of domestic credi tors shall not be prejudiced by cross-border cooperation. After recognition of a foreign main proceeding, concurrent proceedings may only be brought if the debtor has domestic assets. Otherwise, the rule of res judicata would prevail. In the concurrent English and US proceedings on Lehman credit swap contract proceedings the parties have kept the courts fully informed of the progress of the respective foreign litigations.Moreover, either court has made effort not to thwart the other's proceeding.An exchange of letters between the courts took place. In fleshing out the principle of comity, the courts suggested that even in case of discrepancies between material English and US law concepts only declaratory relief should be granted. The degree of cooperation between Anglo-Saxon judges in the Lehman context amply demonstrates that the bankruptcy universality has a great potential of engendering cooperative behaviour between courts in cross-border insolvencies. However, procedural coordination will not overcome differing policy choices by national regulators. This would also apply to bank resolution laws which speed up crisis management in a nation-state context, but fail to address the cross-border repercussions in a world of global financial institutions.
B.Liaising Through Private Party Negotiations—Insolvency Proto-cols
As a matter of sheer practicality, the collapse of the LBHI group made a coordination of the various bankruptcy proceedings imperative. LBHI had relied on a centralised cash management system generating claims and counter-claims between subsidiaries and affiliates and the holding company.Information was distributed throughout the conglomerate, satisfying internal monitoring and forecasting needs and regulatory requirements of various jurisdictions. After seven months of negotiating the administrators of 18 Lehman subsidiaries agreed on cross-border insolvency protocol to arrange, inter alia, for coordination, asset preservation, claims reconciliation and maximisation of recoveries. Lehman UK, however, declined to participate, filing instead a claim of US$100bn against LHBI. The Lehman collapse demonstrates both the potential of private-party negotiations in bankruptcy proceedings and the shortcomings of the current state of law on cross-border protocols.
Cooperation in cross-border settings is predicated on accepting（degrees of）universalism as a guiding principle for insolvency law. Both 11 § 1527（4）U.S.C.and Art.27（d）provide for court approval of agreements concerning the coordination of（multi-state）proceedings.To date, cross-border protocols have been used to coordinate proceedings for conglomerates , to achieve agreement on professional fees and to determine the law applicable to asset sales. The English case In re T &N Ltd.deals with a transatlantic cross-border protocol purporting to settle asbestos-related liabilities of an Anglo-US debtor conglomerate.The judge was prepared to cooperate fully with US courts, but noted that it would be difficult to accept a cross-border protocol under which domestic creditors would receive less than under winding-up procedures for English companies. Later, US debtors agreed to enter into a UK Global Settlement, funding company voluntary arrangements for the benefit of English creditors. In Sendo International Ltd., the concept of cross-border protocols is applied to an English main insolvency proceeding with a French secondary insolvency under the European Insolvency Regulation. To add a dose of realism, cross-border protocols will only be able to accommodate problems of coordination if national legal orders allow for freedom of contract in an insolvency setting, implementing contract-based and market-based strategies.
C.Liaising in a Transnational Context—Governments
1.Bank of Commerce and Credit International（BCCI）
In the history of bankruptcies of complex global financial institutions LBHI had an infamous predecessor.On 5 July 1991, BCCI collapsed exposing over 1,000,000 depositors and creditors to potential loss of their financial security. BCCI was not a financial conglomerate.A non-bank holding company in Luxembourg（BCCI Holdings SA）owned two subsidiaries, BCCI SA in Luxembourg and BCCI Overseas in Cayman Islands.In organising its banking activities BCCI engaged in regulatory arbitrage.BCCI SA had been granted a Luxembourg banking license, but its financial operations were not masterminded from the Grand Duchy.Instead, most management decisions were taken in London where the banks'founder resided.BCCI SA and BCCI Overseas relied on branches to conduct their banking businesses in various foreign countries. BCCI never had to submit a consolidated statement to a bank regulator, using separate auditors. Prior to its 1991 collapse, BCCI had acquired a reputation of false or deceitful accounting. In an effort to inject fresh liquidity into BCCI, the government of Abu Dhabi was permitted to increase its investment in the bank. When BCCI failed, it did not create major repercussions in the financial markets , but it exposed serious shortcomings in administrative oversight. It requires little imagination to doubt whether Luxembourg regulators would have had the manpower to supervise BCCI's world-wide activities even if they had been willing to do so. Since 1987 a college of na tional supervisors had been operative to share information on BCCI, but the college failed to control BCCI's activities or to contain negative externalities of regulatory arbitrage. When BCCI finally collapsed in July 1991, regulators in eight nations made a coordinated effort at damage control and closed down the bank's branch offices. The BCCI experience highlighted that multinational Colleges of Supervisors could only live up to the promise of multi-national oversight if their members had sufficient statutory powers to oversee and to exchange information with non-domestic supervisors. On the other hand, the joint effort to close down BCCI operations in July demonstrated the potential of cooperative behaviour in international banking supervision.
2.Fortis Bank SA/NV
Until September 2008, Fortis Holdings was one of Europe's twenty largest cross-border financial groups with business activities in Belgium, the Netherlands and Luxembourg. In 2007, Fortis had participated in a consortium of European banks taking over ABN AMRO banks. As the financial crisis accelerated Fortis found it increasingly difficult to raise funds on interbank markets, both to finance the takeover and to maintain a level of liquidity necessary to operate its wholesale and retail operations. Fortis share prices plummeted and the group was obliged to approach the Dutch and Belgian governments for help.Late in September 2008 an agreement was secured under which the Belgian government had committed to acquire a stake of 49.9 percent in the Belgian Fortis banking subsidiary by means of a capital increase.The Dutch government issued a comparable pledge with respect to Fortis Nether lands. This proposed deal, however, did not succeed in allaying market fears about Fortis and depositors began to move out.The Dutch government abandoned its initial plan and moved instead for the acquisition of the shares of Fortis Netherlands. Belgium accused the Dutch government of having reneged on its former commitments. The Belgians bought the Belgian Fortis banking subsidiary and immediately sold 75 percent of the activities to the French bank BNP Paris Bas.
In a European context, the Fortis Bank cross-border rescue measures raised important legal issues.Although there is little doubt that the Fortis group was of systemic importance for Belgium, the Netherlands and Luxembourg, it is unclear to what extent European Union law imposes a duty of cooperative behaviour on the respective Member State governments.Belgium had combined its acquisition transaction with a state guarantee for the Belgian part of the Fortis group in order to address liquidity problems and to shield the bank from potential liability claims raised by third parties.In declaring the Belgium guarantee compatible with European state aid rules, the EU Commission noted the temporary nature of any government intervention. Moreover, the Belgian government had to observe the EU Commission's rules on restructuring financial institution with a view to facilitate a return to free market rules. The EU Commission classified the acquisition of Fortis Netherlands by the Dutch government as a state aid and found it to be compatible with EU competition rules.
The transactions engineered by the Dutch and Belgian governments were not greeted with shareholder enthusiasm.Shareholders of the Fortis holding company convinced a Brussels court that a shareholder vote was necessary to ratify the sale of the Belgian and Dutch Fortis banking subsidiaries.At an extraordinary general meeting of shareholders, the Dutch and Belgian government sales were rejected.Later, the Belgian Cour de Cassation insisted on a more nuanced balancing test between shareholder rights and the legitimate interest of a bank with systemic importance, remanding for reconsideration. The Dutch government maintains that its（emergency）acquisition of Fortis'Netherlands banking activities is not conditioned on shareholder approval. It is obvious that crisis management affects citizens'rights and, constitutional lawyers will have to examine under what circumstances the reduction of systemic risk prevails over shareholder rights.
3.Landsbanki of Iceland and its Foreign Depositors
As a member of the European Economic Area Iceland is subject to many rules of EU Union law , including the directive on mandatory deposit-guarantee schemes. When the financial crisis accelerated, Iceland three major banks（Kaupthing, Glitnir and Landsbanki）soon faced enormous solvency and liquidity problems.The balance sheet of Iceland's banking sector represented 900 percent of the annual GDP. The hold-to-maturity assets were insufficient to cover the obligations of the Icelandic banking sector.
Landsbanki was Iceland's oldest commercial bank which had been completely privatised by 2003.Landsbanki operated as a universal bank, with retail, corporate banking and investment banking business. To a substantial extent, the bank was financed by（foreign）deposits.Prior to the financial crisis it had branches in Amsterdam and London and a subsidiary banking company in Luxembourg.Landsbanki raised retail internet deposits under the Icesave brand. On 7 October 2008, the Icelandic Financial Supervisory Authority used its statutory emergency powers to take over Landsbanki. Two days later, the domestic depositors were transferred to the new bank, the“new Landsbanki”, established by the Icelandic government. This move ensured that domestic depositors would have continued access to their funds.At the same time, the Landsbanki UK branch suspended its Icesave operations, blocking（foreign）customer access to internet accounts. Comparable problems existed in the Netherlands.In invoking its statutory powers under the Anti-Terrorism, Crime and Security Act 2001, the UK government froze the assets of Landsbanki's London branch. The Luxembourg subsidiary of Landsbanki was placed in moratorium by Luxembourg's regulatory authorities and is now in liquidation. The liquidator is currently assessing the value of the claims.Apparently, Luxembourg authorities are unwilling to enter into negotiations with the Icelandic resolution committee of Landsbanki before creditors'claims a gainst the assets of the local subsidiary are satisfied.
Landsbanki Iceland had participated in a statutory deposit insurance scheme.However, soon after the initiation of winding-up the“old”Landsbanki institution, the Icelandic government intimated that there wouldn't be sufficient funds in the country's deposit insurance scheme to satisfy claims of non-domestic depositors.Although Landsbanki had participated in British and Dutch deposit-insurance schemes, full recovery would not have been assured under the terms of the schemes. Both, in the Netherlands and the UK, government officials had explained that former Icesave customers would be compensated under the respective deposit-insurance schemes.The UK government reimbursed depositors in full.Dutch authorities organised a pay-out of up to 100, 000 per individual customers. The Netherlands and the UK now seek compensation from the Icelandic authorities for having advanced payments to Icesave depositors.The legal question is whether Iceland may be required to afford payments to depositors in excess to the amount that could be claimed under the respective national schemes.In the context of the public international law obligations under the Treaty on the European Economic Area this is a matter of whether there is a duty to cooperative behaviour between Iceland on the one hand and Britain and the Netherlands on the other.The EFTA Surveillance Authority which is responsible for enforcing Iceland's treaty obligations has indicated that the country may have failed to comply with its obligations.Interestingly, the Surveillance Authority does not expressly rest its interpretation on a duty to cooperative behaviour.Rather, it maintains that Iceland is in breach because it applied its obligations in a discriminatory manner, treating Landsbanki's domestic and foreign depositors differently.
D.European Coordination Mechanisms in a（Traditional）Bankruptcy Setting
Under European Union law, the Directive on the reorganisation and winding-up of credit institutions and the Regulation on insolvency bind Member States on the single entity principle, a modified version of the universality principle and a mutual recognition of reorganisation and winding up procedures. Art.3,9 of the Directive on credit institutions decree that the administrative or judicial authorities of the home Member States shall alone be empowered to commence reorganisation measures or winding-up proceedings for a credit institution, including its branches in another Member State.Art.4 provides for consultation mechanisms between the Member States involved.Art.10 addresses conflict of law issues.The Insolvency Regulation has much more regulatory clout for cross-border business.Art.3（1）of the Regulation is informed by the principle of the centre of debtor's main interest for triggering insolvency proceedings.Secondary proceedings in another Member State may only be opened if the debtor possesses assets in that Member State（Art.3（2））.Judgments opening insolvency proceedings in accordance with Art.3（1）shall be recognised in all other Member States（Art.16（1））.The opening of secondary proceedings may be requested by the liquidator of the main proceedings（Art.29（a））. Art.31 imposes extensive communication duties on the liquidators of the main and secondary proceedings.
In honouring the spirit of cooperative behaviour European courts have been mindful of the implications of a universal approach towards insolvency proceedings. Under Art.32（3）the liquidator is entitled to participate in a main or secondary proceeding.This provision of the Insolvency Regulation has been used as a statutory basis for cross-border insolvency protocols although their status under European Union law is unclear. Art.35 proclaims that once the assets have been distributed to the creditors of a secondary proceeding the remainder shall accrue to the assets in the main proceedings, however unlikely this may be. The Insolvency Regulation recognises potential clashes between concurrent main and secondary proceedings.Art.33（1）allows for a stay of secondary proceedings up to three months in order to avoid potential conflict with the main liquidation. Moreover, the liquidator may move for a rescue plan or a comparable measure to close the secondary proceeding without liquidation.
In spite of their cooperative thrust neither the Directive on credit-institutions nor the European Insolvency Regulation envisaged the problems created by the Lehman insolvency.The Directive on credit institutions does not apply to banks which operate through a financial conglomerate of subsidiaries with legal personality.Art.1（2）of the Insolvency Regulation exempts credit institutions and investment undertakings.Moreover, the Regulation is unhelpful in fleshing out the implications of universality for cross-border financial conglomerates.The collapses of the LBHI conglomerate and of BCCI, Fortis and Landsbanki have come to underline the deficiencies of insolvency laws for conglomerates with substantial internal contracting.In fact, cross-border insolvencies of financial institutions beg the question whether some transactions should not be allowed to continue in order to avoid a spiralling effect of illiquidity, thus magnifying systemic risk.
In October 2009 the EU Commission launched a consultation on a framework for cross-border crisis management in the banking sector. The Commission's policy statement envisages a combination of early supervisory intervention, specific rules on intra-group asset transfers and an EU-wide regime on bank resolution, laying down thresholds. The Commission Staff Working Document analyses in depth the implications of cross-border resolution scheme for shareholders'rights and assesses an extension of liability to affiliated entities in a（reverse）piercing the corporate veil situation. In reviewing the submissions the Commission noted that the IMF's plea for a 28th regime for systemic cross-border banks, focusing on individual banks and branch-based cross-border operations, and for rules on banking groups had been rejected. There was broad consensus in favour of early intervention tools.Member States prefer flexible thresholds for triggering resolution procedures over regulatory rigidity.The European Central Bank（ECB）, while paying lip service to flexibility, emphasises the need for qualitatively defined conditions.Moreover, the ECB wishes to empower national authorities to delay a bank's counterparty's termination rights under contractual stipulations. In the interest of speedy administration of financial institutions of liquidity, derogations from shareholders'and creditors'should not be ruled out although human rights considerations dictate that this mechanism should be used sparingly. Apparently, the Commission has not yet committed on cooperative procedures in the context of cross-border resolution schemes.There are proposals to establish cross-border stability groups, reminiscent of the college of supervisors in the BCCI context. The Cross-Border Resolution Group of the Basel Committee on Banking Supervision supports convergence of national resolution measures and cooperation structures similar to those envisaged by the UNCITRAL rules for judicial bankruptcy proceedings.
E.Whither International Cooperation？
1.Europe after the Crisis: Intensifying Internal Coordination
With the benefit of hindsight a combination of ineffective regulation and supervision, deficient corporate governance standards and little oversight over the non-bank financial sector（including financial intermediaries）contributed to the outbreak of the financial crisis. The European Union pledged to introduce financial stability arrangements, based on cross-border crisis management and improved for tools for crisis prevention. The EU Commission's anti-crisis policy concentrates on pan-European supervisory bodies, financial institutions and intermediar ies. A European body is intended to combine micro-and macro-prudential supervision.Early crisis intervention measures are proposed; derivatives and hedge and private equity funds will be regulated. In February 2010, the Commission launched a public consultation on amendments to the Capital Requirements Directive which would address liquidity standards, the leverage ratio, counterparty credit risk, and systemically important financial institutions.
With respect to intermediation, the Commission proposes to strengthen financial oversight and to tighten the rules on structured investment products. Its communication on packaged retail products pledges to apply a horizontal approach to selling practices in order to thwart regulatory arbitrage. It does not seem that the Commission aims at a complete overhaul of European securities regulation.Rather, it plans to introduce rules on pre-contractual disclosures, standardising, inter alia, information on risk, cost and performance metrics. This would also include substantive legislation on the responsibilities for pre paring the prospectus and on selling practices.The Commission also seeks to refine the rules on conflicts of interest, inducements and the appropriateness and suitability of certain retail product in accordance with the needs of the potential investor.
The Commission's Banking Communication and its Communication on recapitalisation seek to strike a balance between the EU law on state aids and the problems of financial institutions in distress.National guarantee schemes will be accepted if they require payment of an adequate remuneration by the beneficiary, based on price mechanisms which reflect the varying degrees of risk. Financial institutions with endogenous problems will be treated with lesser leniency.A combination of massive state-aided recapitalisation and a high risk profile is conditioned on an exit-mechanism for the government. Otherwise, the beneficiary banks would receive a negative incentive dissuading them from a return to business under normal market conditions. Similar conditions apply to bad bank schemes which receive government support.
2.International Law Implications
Lehman's predicaments had positive side-effects.They demonstrated the potential for innovation in a world of global finance.But they did also shed light on the negative externalities of regulatory arbitrage. Bankruptcy proceedings have been found to be cumbersome mechanisms of settling claims in a cross-border context.In fact, current rules on anti-deprivation in an insolvency setting may even operate as to deepen a crisis by unravelling the complete structure of financial contracting.Moreover, current law fails to reflect the complexity of internal transactions in international financial conglomerates.It would be unfair to suggest that regulators are side-stepping problems by moving from an ex post perspective to ex ante measures of matching supervision and micro-economic oversight with macro-economic policy analysis.The emphasis on policy coordination ex ante betrays dissatisfaction with crisis management by bankruptcy.There is also an element of doubt about the inclination to play cooperative games once systemic risk materialises.
International insolvency law and the notion of comity as interpreted by the courts do not easily lend credence to the belief that a customary international law would require cooperation under cross-border circumstances. To that extent, Jack Goldsmith and Eric Posner rightly assume that states are just maximizing their interests. They acknowledge that a bilateral repeated prisoner's dilemma might bring forth some cooperative behaviour between the states. Against this backdrop, the BCCI and Fortis cases might be read as an attempt to overcome the shortcomings of a cross-border insolvency.Landsbanki demonstrates that the rules for cooperative games in the European context require improvement with respect to depositor insurance and liquidity requirements.Privately negotiated cross-border insolvency protocols in the Lehman drama mark an attempt to escape from a prisoner's dilemma through coordination.Closer inspection of international crisis management in the aftermath of Lehman's collapse and the disruptions of the credit markets suggests that new standards of cooperation emerge as the result of repeated prisoner's games under systemic risk are hard to predict.
A report prepared for the G-20 Study Group on Global Credit Market Disruptions almost emphatically supports international cooperation and coordination to handle episodes of financial stress. As early as 1975, cooperative attempts to supervise cross-border activities were launched under the auspices of the Committee on Banking Supervision by the Bank for International Settlements. The current“High-level principles for the cross-border implementation of the New Accord”places supervision of international banking groups with the home country authorities. More recently, the Basel Committee finalised a 2005 accord on capital（Basel II）. In the aftermath of the financial crisis there is consensus on the key principles of regulatory reform.Regulatory efforts should address all systemically important institutions, improve supervision and prudential rules, accommodate systemic risk and strengthen crisis resolution mechanisms（including cross-border bank resolution）.Although international institutions such as the IMF, the BIS and the FSF have important role in establishing a macro-economic policy framework, it is unclear who the standard setters should be.The IMF might lack expertise in addressing problems of the financial markets and is likely to be influenced by the political interests of its shareholders whereas both the BIS and FSF suffer from a lack of legitimacy. Nonetheless, cooperation and exchange of information is crucial in the face of international networks. Data exchange alone will not assure appropriate market discipline and intervention by regulators and supervisors. As ex ante macro-prudential and traditional micro-economic supervisions are intensified, international cooperation will have to bring about early warning mechanisms on the basis of so-called risk maps.
In the face of systemic risk countries have come to realise that patterns of comity will not be enough to solve their prisoner's dilemma.Cooperation is institutionalised in order to implement early warning mechanisms.It would appear, though, that this type of cooperation has not yet attained the quality of customary international law. We still have some way to go to agree on core coordination standards.