Insolvency Arrangements and Contract Enforceability - Contact group on the legal and institutional underpinnings of the international financial system

December 2002

Report of the Contact group on the legal and institutional underpinnings of the international financial system

Financial markets deal with the future. As Andrew Crockett, General Manager of the BIS, once remarked, the function of financial claims is to telescope into the present intrinsically uncertain cash flow streams. This "telescoping" is socially beneficial, as it permits risks to be priced, allocated and diversified across the economy. But performing this function smoothly and efficiently entails negotiating, concluding and settling financial contracts, sometimes of great complexity. To this end, there must be mechanisms for ensuring that the rights and obligations specified in the contract are observed, and for dealing with disputes predictably and fairly where they are not.

This is why financial transactions in every country are governed by a corpus of law that specifies the nature of the contract and provides mechanisms for seeking redress in the event of a failure to perform. Each national legislation tries to strike a balance between a plurality of needs which at times may conflict with each other: making the future more predictable; minimising transaction costs; ensuring equity of treatment of the parties involved in the contract. Needless to say, where the balance is struck will depend on many things, from the structure of the economy to legal traditions and political preferences. There is no guarantee that the choices made in each country will form a coherent whole across jurisdictions.

The combination of highly integrated capital markets worldwide and country-based jurisdictions is probably the most notable feature of today's international financial environment. This combination raises three concerns. First, policy-relevant frictions might arise from the diversity (and in some case incompatibility) of national legal systems. Second, there might be a concrete risk of legal arbitrage among jurisdictions, with a loss of predictability in the application of norms and thereby in the actual balance between the different goals that each legal framework tries to reconcile. Third, as a result of financial integration negative externalities (in the form of spillover and contagion effects) might be the consequence of deficiencies or gaps in the legal systems of certain jurisdictions (emerging market countries and offshore centres being obvious examples).

Market practitioners have over the years tried to fill some of the gaps by developing a set of practices, conventions, and customs to reduce the risks associated with international financial transactions. Such a "soft law", however, is unlikely to be an effective response to the needs of a global financial marketplace. In fact, informal conventions or understandings developed in the market, while perhaps efficient for a specific purpose, might have the unintended effect of making the overall legal apparatus presiding over international transactions more opaque, and therefore also less predictable in its application.

Over the past few years, several international financial institutions and other international organisations have launched initiatives in the legal field. In principle, such initiatives can be grouped into two different categories. The first category comprises initiatives that follow a "house-in-order" approach, namely which try to identify the basic building blocks of a satisfactory legal system, leaving to individual countries the responsibility for choosing how to fill the general canvas with the operational details that best fit their domestic context. The second category, by contrast, includes attempts to isolate areas where a kind of "minimal harmonisation" of national practices may be beneficial for the smooth working of the global marketplace. Typical of the latter approach is the drafting of a set of principles and best practices to be offered to emerging-market countries as a contribution towards strengthening their domestic institutional setup. The two approaches are not incompatible, though they are clearly different in scope and ambition. The "house-in-order" approach has attracted greater attention so far, both because removing institutional deficiencies in recipient countries seemed to warrant top priority, and because it was perceived as raising fewer political problems. It is important to recognise, however, that such an approach, while necessary, may not be sufficient to adequately contain the costs and risks associated with the functioning of increasingly integrated financial markets. Moreover, the lack of agreement on what constitutes a satisfactory "minimal harmonisation" may make the "house-in-order" approach more difficult to implement. Given the lack of international enforcement tools, in fact, the adoption of a given set of principles and standards must rest on the perception that, though there is no "one-size-fits-all" legal system, some practices and institutions are clearly better than others.

The time therefore seems ripe for initiatives aimed at:

a) surveying the work undertaken so far by the various IFIs, with the objective of identifying major themes as well as possible gaps and areas of overlap;

b) taking stock of and diffusing the lessons of the recent crisis episodes for the benefit of the reform process now under way in many emerging market countries;

c) deepening the international authorities' knowledge of the "soft law", with a view to assessing its features, potentialities and possible drawbacks;

d) identifying a possible role for international groups, such as the G10 or the G20, in promoting more robust, transparent and mutually consistent legal institutions and practices relating to financial transactions.

In this spirit, in the summer of 2000, on the initiative of the Bank of Italy, the G10 Deputies launched a reflection on the issues raised by the increasing integration of international financial markets, and especially by the emergence of large players whose financial activities span many countries and jurisdictions, for the operation of one important component of the legal system, namely insolvency law. The task was taken up by a Contact Group composed of interested countries and institutions. Participants have included representatives from Italy, Japan, the Netherlands, the United Kingdom and the United States, as well the BIS, ECB, IMF, OECD and World Bank.

This report is the outcome of that effort. Given its exploratory nature, the report contains no recommendations. It was not submitted to Ministers and Governors for their approval and the analysis and conclusion do not purport to reflect the views of the G10. Its aim is to stimulate interest and further reflection on a policy issue of ever greater significance, rather than to offer firm conclusions regarding the actual magnitude of specific problems or to formulate policy options. The document pursues this aim by identifying current trends in the area of insolvency laws, by discussing some problems created by the growing integration of financial markets, and by pointing to some areas where gaps or frictions seem likely to emerge (or have already emerged). The findings are largely based on two questionnaires: one on national insolvency arrangements and one on the treatment of financial contracts under these insolvency arrangements. The contracts reviewed through the latter questionnaire include closeout netting and setoff provisions, finality rules in payment systems and collateral agreements.

The text has benefited from observations and suggestions by a selected number of interested parties, to which a previous draft had been submitted for comment. The process of consultation has included other authorities in the countries represented in the Contact Group, the central banks and finance ministries in other industrial countries, and various groupings with an interest in the issue.

The report is preceded by a brief executive summary that summarises its main findings and identifies possible avenues for further investigation. Selected contributions by individual members of the Contact Group are also included as annexes.

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