AYN 426 INTERNATIONAL CAPITAL MARKET LAW AND REGULATION

· Intensive One Content

The Economics of Capital Market Regulation

A Little Philosophy of Capital Markets

The Role of Government, the Courts and Public Policy in Capital Market Regulation

· Key Learnings

· This topic will provide:

· Knowledge of the basics of the economics required to understand Capital Markets Law.

· Provide philosophical and political analysis of market regulation.

· Briefly explain the function of government in the regulation of markets.

· Economic Regulation

· Economics is used to assist governments with regulating markets, especially capital markets because the role of regulation is in part to manage risk and stimulate economic activity.

· Economic justification is often the primary basis for much public policy.

· For example, the sale of electricity generating assets in Australia was justified solely on the basis of economic rationality, i.e. competition would lower consumer prices.

· It didn’t. Possibly because of the imperfect market that now exists.

· Many tools are available to the economist and many ways of looking at the same data.

· Analysis Framework

· Economic Efficiencies

· Distributional and Non-economic Considerations

· “Collective Goods” – Public Policy/Political Expediency

· Common Law Solutions

· Regulation Justifications

· Market imperfections

· Externalities

· Curbing Free-Riding

· Costs Externalisation

· Economic Assumptions

· Cost-Benefit Analysis

· Cost-Benefit Analyses [CBA] (like many such analyses) are slippery beasts because usually the number of variables to be considered is HUGE and many are important.

· CBA’s for Government are often circumscribed by policy considerations driven out of political party ideologies and economic realities (political donations and electoral support).

· CBA Terms of Reference are often moderated by lobbyists through Cabinet;

· CBA Reports are often informed by many forms of politically-motivated and economically-driven activism.

· Note that often, the analysis seeks only to support a policy position already decided upon and is therefore worthless in any empirical sense.

· Economic Efficiencies

Using Positivist economics, regulation can be used to guide market activity in a very empirical manner, such as:

· Management of Scarce Resource Allocation

· Governments need to understand the demand for a particular resource and to determine the best result from use of that resource, i.e. the greatest bang for the buck.

· As with all economic modelling, the first assumption is that markets of individuals/firms are (and act) rational (they don’t). So regulators use incentives and disincentives to manipulate resource allocation and usage.

· Note: excessive regulation can have a deleterious effect on markets. See the “Indian Permit Raj”: http://www.youtube.com/watch?v=omtRNy_OOO0

· Economic Efficiencies

Using a Normative approach, market regulators seek to achieve economic outcomes that have a desirable social consequence.

· Redistribution of Wealth

· Broadens the “economic base” of society so as to increase general demand;

· Lessens economic hardship on society’s most vulnerable, e.g. elderly, children and impaired persons.

· Interference with free market forces of supply and demand often seeks to “level the playing field” of economic activity and spread opportunity and wealth.

· The Coase Theorum

· Prof. Ronald Coase, Nobel Laureate in Economics for his work on transaction costs, specifically in “The Nature of the Firm”, developed the Coase Theorum as a means of quantifying the economic effect of tort law.

· It’s relevance to the regulation of International Capital Markets stems from the idea that good law is the law the provides the most efficient outcome.

· Coase posits that “an efficient rule is one that minimizes the sum of accident costs and prevention costs, because such a rule will, given other assumptions, subtract the least from social wealth.”

http://nobelprize.org/nobel_prizes/economics/laureates/1991/coase-autobio.html

http://law.gsu.edu/wedmundson/Syllabi/Coase.htm

· The Coase Theorum

· A perfect example of the Coase Theorum at work can be found in the introduction of the Civil Liabilities Act 2003 (Qld).

http://www.legislation.qld.gov.au/LEGISLTN/CURRENT/C/CivilLiabA03.pdf

· The CLA essentially legislates much of the common law of negligence.

· Under this legislative instrument the range of tortious matters that Courts can consider is limited and the amounts that can be awarded in damages has been seriously curtailed.

· The CLA also provides for the effect on liability for persons who take unnecessary risks, consume alcohol, and engage in inherently dangerous activities with a general section defining “obvious risk”.

· Market Imperfections

· Characteristics of a “perfect market”:

· Frictionless

· Tax-free

· Zero Transactions Costs

· All participants omniscient at zero cost

· All participants are price-takers – no individual or company is influential enough to affect the price of an item. (www.investorwords.com/6890/price_taker.html)

· Clearly no such market exists or could exist – used for economic modelling purposes only.

· Take a perfect world, then slowly corrupt it until you get to reality.

· Market Imperfections

· Governments seeking to normalise markets through regulation need to deal with such things as:

· Firms’ Market Power – monopoly, duopoly, oligopoly;

· Information Asymmetries that create search costs;

· Taxes – duplicated (Fed/State), excessive, inequitable, improperly or unevenly applied;

· Costly bureaucratic intervention (“red tape”);

· Transaction Costs, e.g. bank fees, insurance and security fees.

· Externalities

· Externalities are the third party (or spill-over) effects arising from the production and/or consumption of goods and services for which no appropriate compensation is paid. 

· This ‘spill-over’ is characterised as having an ‘external effect’, i.e. an effect external to the producer of the G&S.

· This effect will always have a cost but that cost is not reflected in the market price of the thing produced.

· Externalities can cause market failure if the price mechanism does not take into account the full social costs and social benefits of production and consumption.

http://tutor2u.net/economics/content/topics/externalities/what_are_externalities.htm

· Externalising Costs

· Regulatory Fronts

Governments are usually called upon to legislate/regulate markets to deal with one of the following:

· Property Rights

· Contract Rights (often consumer protection)

In addition to the above-mentioned:

· Market Imperfections

· Externalities

· Curbing Free-riding

· ‘Public Good’ Effects

· Justifying Regulation

· To justify regulation/legislation, Governments conduct a range of administrative exercises to determine the scope of issues affecting societal well-being.

· These include Royal Commissions, parliamentary inquiries, surveys, audits, polls, reports, and investigations.

· One common type of justification tool is the “cost-benefit analyses”, i.e. to find whether the Benefits ≥ Costs of a program/policy.

· Note that “benefit” is a relative term!

· Intensive Two Content

History of Capital Markets, Financial Crises and Regulatory Responses

Understanding Financial Crises

Responding to Financial Crises

· Key Learnings

This topic will provide:

· The history of US Capital Market Development and its effects.

· An understanding of how financial crises develop, and a quick review of some of the worst to have occurred.

· A brief discussion of the issue of executive remuneration and risk.

· How Governments respond to financial crises with regulatory measures in context with a preliminary look at the Australian policy position and the regulatory response.

· United States Capital Market History

· Explaining the U.S. approach

· Since the late 1930s, large US corporations have been far more diffusely owned than in other countries.

· Before that, controlling shareholders were a big concern. By the late 19th century, “robber baron” tycoons (e.g. John D Rockefeller Sr) ran huge corporate empires through Trusts, often set up by the Morgan Bank.

· The tycoons used these Trusts to finance/launch huge takeovers, paying for targets’ shares with finance raised through Unit Trusts.

· Background to Unit Trusts

· Unit Trusts have unique characteristics that in some ways operate in a manner similar to a company and have become hugely popular.

· They are a type of Private Trust that:

· Hold investments on behalf of Beneficiaries or ‘Unitholders’

· Unitholders can each hold different quantities of units.

· The total value of the investments is divided equally into ‘units’.

· ‘Units’ are of equal value and a Unitholder’s share of the Trust’s revenue is determined by the number of units held.

· As the Trustee has no discretion as to the distribution of income, the Trust operates similarly to a Fixed Trust in this regard only.

· Units are transferable between Unitholders

· Like company shares, units can be bought and sold and the Trust’s Unitholder register is updated accordingly.

· As a business vehicle, Unit Trusts have become popular because:

· Negotiability of units.

· This flexibility is an attractive feature not found in other Trust vehicles.

· Fixed annual entitlements to income.

· The Trustee’s lack of discretion provides a measure of surety regarding a return on the investment.

· Fixed entitlement to the Trust ‘capital’.

· The value of each unit represents a share in the total value of the underlying capital assets.

· The court held in Charles v FC of T that each unitholder has a proprietary interest in each asset of the Trust and can lodge a caveat over any individual asset of the Trust.

· The biggest disadvantage of the Unit Trust model is that unitholders may be held jointly and severally liable for any debt incurred by the Trust in its operations where there is a shortfall when the Trust is wound up and the Trust’s assets are liquidated.

· To avoid this a carefully worded ‘Limitation of Indemnity’ clause may be inserted into the Trust Deed.

· See: JW Broomhead (Vic) Pty Ltd (in liq) v JW Broomhead Pty Ltd [1985] VR 891

· In The Beginning…

· By the 1890s, the Rockefeller family’s Standard Oil Trust so dominated oil production, refining, and distribution that it was considered a monopoly.

· Other major companies of the era – Edison General Electric, US Steel, and Morgan’s railroad empire – were also built with takeovers.

· Like modern preference shareholders, Trust unit holders had no votes. They bore downside risk and reaped upside benefits, but the Trusts’ directors – the robber barons, their relatives, and “Morgan’s Men” – exercised absolute control. Such was the nature of U.S. Trust law at that time.

· The Powers That Were

· J.P. Morgan’s defence of Trusts was that, during the late 19th century, public investors were protected by the expertise of his men, who exercised a monitoring and control role of the Trust’s assets.

· Firms with a Morgan man on the Board had higher valuations.

· The robber barons saw themselves as “captains of industry” or “industrial statesmen” and the primary generators of economic activity and their names are esteemed in many circles: Astor, Carnegie, Rockefeller, Morgan, Harriman, Vanderbilt, Mellon, Duke.

· Many commentators note that these giant men (in pursuit of giant profits) brought much order to otherwise chaotic industries and drove improvements in production, standardisation, and labour productivity increases that vastly increased investor and national wealth.

· Using Trusts

· The “robber barons” (tycoons) used Unit Trusts to finance their takeover strategies to gain monopoly power in key markets.

· By the late 19th century, the robber barons’ vast wealth and political and economic power fuelled popular support for the 1890 Sherman Antitrust Act that empowered courts to disintegrate Trusts by order, hence the term “trust-busting” and “anti-trust” in US law.

· This Act outlawed price fixing, but some Trusts with market shares of 65% (U.S. Steel Trust) to 90% (American Tobacco Trust) remained untouched until 1904.

· In 1904, the US Supreme Court reinterpreted the Act to outlaw monopolies built with takeovers.

· US Congress later affirmed this by enacting in the 1914 Clayton Antitrust Act. Building large corporate empires via Trusts now risked attracting an antitrust investigation – monopoly or not.

· US President Woodrow Wilson admonished –

“...no country can afford to have its prosperity originated by a small controlling class. The Treasury of America does not lie in the brains of the small body of men now in control of the great enterprises … It depends upon the inventions of unknown men, upon the originations of unknown men, upon the ambitions of unknown men. Every country is renewed out of the ranks of the unknown, not out of the ranks of the already famous and powerful in control.”

· In the 1920’s (The ‘Great Gatsby’ era) robber barons were back in business: US tycoons replaced trust structures with pyramidal corporate groups.

· A takeover wave built huge pyramidal corporate groups, some containing 100’s of companies organized into a dozen or more tiers.

· Berle and Means (1932, p. 69) wrote:

‘Pyramiding’ involved “...the owning of a majority of the stock of one corporation, which in turn holds a majority of the stock of another – a process which can be repeated a number of times. An interest equal to slightly more than a quarter or an eighth or a sixteenth or an even smaller proportion of the ultimate property to be controlled is by this method legally entrenched. By issuing bonds or nonvoting preferred stock of the intermediate companies the process can be accelerated. … The owner of a majority of the stock of the company at the apex of the pyramid can have almost as complete control of the entire property as a sole owner even though his ownership interest is less than one percent of the whole.”

· In late 1929, a 90% stock market fall wiped out middle class savings, plus a 25% unemployment rate.

· The Great Depression was already underway when the crash came and the resulting collapse in equity markets entrenched an already deep recession into a global economic slowdown.

· Critics attacked corporate pyramidal groups on 3 main grounds:

· Shareholder democracy advocates attacked pyramidal groups for inducing an extreme separation of ownership from control – shareholders had almost no rights over the companies they owned.

· Antitrust advocates saw pyramidal groups as organizing collusion between seemingly distinct companies, through one common controlling shareholder.

Addressing the American Economic Association, President Roosevelt (1942) said“...close financial control, through interlocking spheres of influence over channels of investment, and through the use of financial devices like holding companies and strategic minority interests, creates close control of the business policies of enterprises which masquerade as independent units. … Private enterprise is ceasing to be free enterprise and is becoming a cluster of private collectivisms; masking itself as a system of free enterprise after the American model, it is in fact becoming a concealed cartel system after the European model.”

· The IRS in the US saw pyramidal corporate groups as tax cheats.

In a 1935 Senate Finance Committee hearing, Robert Jackson, the Assistant General Counsel to the Treasury (later US prosecutor at Nuremberg trials), described how one pyramidal group with “approximately 270” companies, holding companies, sub‐holding companies, etc. all reported “no tax due in any of the years 1929 through 1933” despite the large profits disclosed in their annual reports each year.

Jackson describes the adventures of the sixteen full time IRS auditors and 108 field agents chasing taxable income from company to company, always several steps behind. The testimony suggests group firms did business with each other at artificial transfer prices to shift income away from audited firms.

· The New Deal Government led by FDR sought explicitly to break up large US business groups in 3 main ways:

(1) The Govt attacked pyramiding via a series of mid-1930s income tax reforms.

· These subjected inter-corporate dividends to double taxation – in both the payers’ and recipients’ income taxes.

· Although the rate was ultimately only 15% of the regular rate, this sufficed to disadvantage large multi‐tiered pyramids relative to freestanding firms. Consolidated group filing was abolished, and capital gains holidays encouraged the absorption or divestment of controlled listed subsidiaries.

· By legislating to regulate the utilities industries.

· The Public Utilities Holding Companies Act explicitly banned large pyramidal groups from controlling public utilities companies on the grounds that utility firms’ cost‐plus pricing and regulated returns made them cash cows to unfairly subsidize group firms in more competitive industries.

· By legislating to regulate corporate structures.

· The Investment Company Act 1940 subjected listed companies whose assets were primarily shares in other companies to additional regulations.

· Additional regulatory activity included:

· The Securities and Exchange Commission (SEC) was established about this time;

· Coys were made more transparent to public investors;

· SEC and legislation tried to reduce insider trading and conflicts of interest, and established most of the shareholder rights that exist today.

· Roosevelt’s attack generally succeeded: extremely large business groups all but vanished.

· Late 1930s press accounts describe dozens of groups reorganizing themselves into unitary corporations.

· Late‐1930s data reveal widely diffused shareholdings, which persists today.

· Far from destroying the American free enterprise system, the New Deal restructuring of the 1930’s and 1940’s set up the U.S economy for the largest, fastest economic boom in the history of humankind.

· Regulatory Amendment Drivers

· The Napier Review (1935)

· Royal Commission on Monetary and Banking Systems, chaired by Napier in 1935, established to address stability in the capital market, and in response to criticism of the industry following the depression. Inquiry concluded that new regulations were required to avoid instability in the market.

· The Campbell Inquiry (1981)

· Recommended floating the dollar, letting in foreign banks and abolishing exchange controls.

· review was the emergence of privately owned institutions established outside of the reach of the existing regulations.

· Regulatory Amendment Drivers

· The Wallis Inquiry (1997)

· Recommended ‘light-touch’ approach, allow banks to expand in insurance and superannuation services and offshore investment.

· Regulation of the Australian financial system should be revised and reconfigured so as to promote competition and contestability without compromising system safety and stability.

· Urged removal of the policy banning mergers between the major banks and insurers, ultimately leading to ‘Four Pillars Policy’ announced by the Rudd Government.

· Australian Regulatory Response (some of it, anyway…)

· Legislation and Statutory Rules (among many!)

· Corporations Act 2001 (Cth) (amendments)

· Financial Services Reform Act 2001 (Cth) (amendments)

· Anti-Money Laundering and Counter Terrorism Financing Act 2006 (Cth)

· Australian Competition and Consumer Act 2010 (Cth)

· The Privacy Act 1988 (Cth) (amendments)

· Financial Advisers Act 2008

· Financial Service Providers (Registration and Dispute Resolution) Act 2008

Intensive Three Content

Overview of International Market Law and Regulation

Models of Regulation

Key Learnings

· This topic will provide:

· Some definitional scope for the discussion.

· The Philosophy, Regulation and Enforcement of International Capital Markets Law.

· Some theoretical models that are used to form regulatory systems across the capital market system.

· Some points for consideration about the difficulty and complexity of regulation generally, and regulating capital markets specifically.

Financial System

The OECD views the international financial system as having four layers:

· The Banking Sector;

· National Financial Markets;

· International Financial Markets;

· “World Economy” with market participants connected by trading and regulatory arrangements.

Currie, Carolyn "A new theory of financial regulation: Predicting, measuring and preventing financial crises". The Journal of Socio-economics , 35 (1), p. 48.

· To be lawful, beneficial and effective, regulation must be/have:

· Explicitly stated objectives as part of a public policy document;

· Quantifiable and capable of empirical measurement;

· Intended to reduce transaction costs, i.e. “red tape”;

· Inclusive of disclosure obligations;

· Structured to avoid or prohibit conflicts of interest, e.g. directors’ duties, insider trading, related party transactions etc.;

· To be lawful, beneficial and effective, regulation must be/have:

· Designed to redress or prohibit imbalances in bargaining power, e.g. minority shareholder rights, employee entitlements legislation, collective bargaining rights, etc.;

· Operationally achievable in practice – no use if purely hypothetical/aspirational;

· Utilitarian (greatest good for greatest number);

· Minimal side effects and unintended consequences;

· Constitutional and democratic and reflective of common will;

· Capable of redesign, modification, amendment and repeal.

· The objectives of regulation therefore must be to:

· Act as a reflection of aggregate stakeholder needs;

· Cause minimal economic disruption or distress;

· Benefit as many people as possible;

· Harm as few people as possible (preferably none);

· Provide a fair, equitable and just system of governance.

For example, under s.1(2) of the Australian Securities and Investment Commission Act 2001, ASIC’s objectives are stated as follows:

· to maintain, facilitate and improve the performance of the financial system and the entities within that system in the interests of commercial certainty, in order to reduce business costs and in order to ensure efficiency and development of the economy;

· to promote the confident and informed participation of investors and consumers in the financial system;

· to achieve uniformity throughout Australia in how the ASIC performs its functions and exercises its powers;

· to administer the laws that confer functions and powers on the ASIC effectively and with a minimum of procedural requirements;

http://www.comlaw.gov.au/Details/C2011C00004

Administration and Execution

Enforcement

Enforcement Mechanisms

· Types of enforcement mechanisms include:

· ‘Please Explain’ Letters (ASX)

· Trading Halts (ASX)

· Suspension and Delisting (ASX)

· Infringement Notices

· Civil Penalties

· Compensation Orders

· Injunctions and Declarations

· Enforceable Undertakings

· Disqualification from being a Director/Officer

· Criminal Charges and Monetary Penalties

· Imprisonment

· Virtually any combination of the above

Enforcement Issues

· The enforcement of regulatory regimes is difficult due inter alia to:

· Robust evasion tactics by market players;

· Sophisticated accounting and legal strategies;

· Interjurisdictional contradictions and enabling laws;

· Lack of political will;

· Rapid shifts in market strategies, products and technologies;

· Inadequate statutory purview;

· Misunderstanding by regulatory authorities as to the nature of market inefficiencies;

· Regulatory capture;

· Inadequate resourcing of enforcement agencies.

Enforcement Issues

· The enforcement of regulations always involves the adducement of evidence to the regulatory authority.

· The collection of evidence and its legality is in itself a body of law that must be followed carefully and is often the cause of trial decisions being overturned.

· To ensure evidence is lawful, a plethora of law exists in all jurisdictions to support other regulation. In Australia:

· Evidence Act 1977 (QLD) and all other jurisdictions;

· Whistleblower Protection, e.g. Pt 9.4AAA Corporations Act, SOX (40% of frauds caught this way);

· Privilege against self-incrimination not available for companies, e.g. s.1316A Corporations Act;

· Standard of Proof, e.g. s.1332 Corporations Act.

Models of Regulation

· Public vs Private/Self-Regulation

· ‘Public Regulation’ refers to regulation of the market by independent government agency or agencies;

· ‘Private’ or ‘Self-Regulation’ refers to the regulation of industry by industry, by means of Corporate Governance Guidelines, Listing Rules, Codes of Conduct, Standard Operating Procedures, and Market Conduct Rules

· Public vs Private/Self-Regulation

· Issues include:

· Judge, jury and executioner mentality

· See the Therapeutic Goods Administration v Pan Pharmaceuticals $117m compensation debacle

http://www.dailytelegraph.com.au/news/national/million-a-pan-pharmaceuticals-painkiller/story-e6freuzr-1226028360765

· Rise of ‘insiders’ who ‘protect’ their industry (bureaucrats)

· Potential for conflicts of interest and corrupt practices

· Susceptible to Stigler’s “capture theory” or Posner’s “private interest theory”

Models of Regulation

· Interventionist View vs Liberalist View

· There is a continuum of intervention, from ultra-left socialist interventionism to extreme right disengagement principles in all but commonwealth matters.

· Social(ist) Policy vs Laissez Faire Capitalism

· Heavy-Handed vs Light-Touch Regulation

Agencies of Regulation

· Single Agency vs Multiple Agency

· ‘Single Agency’ model with ‘supreme’ authority, e.g. FDA in US as supremo Government Regulator for food and drug manufacture and distribution.

· Huge issue with regulatory capture and ‘silo’ effect.

· ‘Twin Peaks’ model in Australia, e.g. ASIC and APRA as Government financial market regulators, in conjunction with the RBA, ACCC and ASX.

http://www.asic.gov.au/asic/pdflib.nsf/lookupbyfilename/integration-financial-regulatory-authorities.pdf/$file/integration-financial-regulatory-authorities.pdf

· ‘Multi-Agency’ model in the USA – SEC, FTC, IRA, and host of others, including the NYSE, NASDAQ, and other self-regulating agencies.

Carrot-and-Stick Regulation

· Prescriptive vs Enabling Regulation

· Prescriptive Regulation is a highly interventionist, heavy-handed form of regulation that provides that businesses shall conduct certain transactions or face penalties for not doing so (cf. proscriptive which provides that businesses “shall not do”)

· Enabling Regulation is a very light-touch form of regulation that allows/enables business to undertake certain ventures should it be viable for them to do so but the decision is left to the investor’s discretion.

· In Australia, Government uses a bit of both to achieve policy objectives: carrot-and-stick approach.

Policy Drivers of Regulation

· Restrictive vs Expansive Objectives

· ‘Restrictive’ Policy Objectives, e.g. to restrict fraudulent or other criminal activity in a market or to address a serious imbalance or inequity in a market;

· Expansive Policy Objectives, e.g. to promote/develop a stock exchange (micro-economic) and/or to stimulate broad economic growth (macro-economic)

Models of Regulation

· Principle-based Regulation vs Rule-based Regulation

· The Theory

· Principle-based regulation provides room to move, i.e. the Court and other regulatory agencies have plenty of interpretative power to assist the market find efficiencies.

· Rule-based regulation provides only for strict adherence to “commandments”, i.e. black-letter, codified law that is interpreted very literally by government officials.

· The Practice

· Rule-based regulation is fodder for clever lawyers to find “wiggle room” where none was intended, general rule avoidance and obligation evasion by seemingly endless questioning of regulatory definitions and interpretations.

Common Law Solutions

· The common law has provided a plethora of social controls through the principle of stare decisis.

· Courts can only act to create a precedent where a dispute is brought before it and properly argued.

· Government departments generally do not act to regulate precedent law, except pursuant to court order.

· In the absence of a precedent, regulation through legislation may be required.

Intensive Four Content

International Capital

Market Regulation

Key Players

(Who, What … and How!)

IOSCO – Regulator

· IOSCO’s Core Principles:

· To develop markets that protect investors;

· To ensure that markets are fair, efficient and transparent; and

· To work towards the reduction of systemic risk.

http://www.iosco.org/about/index.cfm?section=background

IOSCO – Regulator

· To ensure the safety of the financial system as a whole and allow other objectives (e.g. consumer and investor protection, market conduct) to be attained efficiently and effectively;

· The role of IOSCO may increase over time if it has a sufficiently powerful set of sponsors and gets organised for the task, much as the ICCC has taken regulatory management of the documentary credit market;

· “Today [the International Organisation of Securities Commissions] IOSCO is recognized as the international standard setter for securities markets. Its membership regulates more than 95% of the world's securities markets and it is the primary international cooperative forum for securities market regulatory agencies. IOSCO members are drawn from, and regulate, over 100 jurisdictions and its membership continues to grow.”

http://www.iosco.org/about/index.cfm?section=background

Australian Legal Framework

· Legislation and Statutory Rules

· Acts of Parliament and Regulations that contain the overarching regulatory framework

· Common Law

· Cases that examine and further refine our understanding of the legislation, and cases that apply legal principles and definitions developed by Courts over time.

· Legislation and Statutory Rules (among many!): Acts of Parliament and Regulations that contain the overarching regulatory framework.

· Corporations Act 2001 (Cth)

· Financial Services Reform Act 2001 (Cth)

· Anti-Money Laundering and Counter Terrorism Financing Act 2006 (Cth)

· Australian Competition and Consumer Act 2010 (Cth)

· The Privacy Act 1988 (Cth)

· Financial Advisers Act 2008 (Cth)

· Financial Service Providers (Registration and Dispute Resolution) Act 2008 (Cth)

Key Issues

· Intensive Five Content

· Applied Market Regulatory Practices – Capital Market Financial Instruments

· Applied Market Regulatory Practices – Documentary Credit Law and Use

· Applied Market Regulatory Practices – Bank Payment Obligations

· Applied Market Regulatory Practices History, Instrument Types, and Multi-jurisdictional Regulation

· Financial Instruments Types

· Negotiable Instruments

· Promissory Note

· Bill of Exchange

· Documentary Credit / Letter of Credit

· Bank Payment Obligation

· Negotiable Instruments

· Promissory Notes and Bills of Exchange are two primary types of N/I but Bonds and Bills of Lading can also be negotiable.

· A Negotiable Instrument is not a contract and the right to the performance of a Negotiable Instrument is linked to the possession of the Instrument itself (with certain exceptions such as loss or theft).

· Transfer of the Negotiable Intrument enables the transferee to become entitled to the embodied right and to enforce it in his own name.

· Transferring Title (ownership)

· Transfer of title can be effected by:

· endorsement and delivery (order instruments such as Promissory Notes), or

· by delivery alone (bearer instruments such as cheques and Bearer Bonds).

· nemo dat quod non habet: No one can give a better title than he has, i.e. one cannot transfer title in something unless that title is held by the transferor.

· While the law generally applies the Rule of Derivative Title, which does not allow a property owner to transfer rights in a piece of property greater than his own, this is suspended with negotiable instruments. This means that a good faith purchaser of a N/I, the “holder in due course”, who does not have any knowledge of a defect in the title or claims against it, takes title to the instrument free of any defects or claims (“free of equities”).

· Promissory Notes

· A negotiable Promissory Note is an unconditional promise in writing made by and signed by the maker/promisor, to pay on demand, or at fixed or determinable future time, a certain sum in money to order or to bearer (i.e. to a specific, named person or to the person in possession of/who presents the Note).

· A Promissory Note, briefly stated, is a promise to pay a sum of money.

· The maker personally promises to pay rather than directing a third party (a bank or other person) to pay.

· A Bill of Exchange is a document drawn on a banker and payable on demand, i.e. on presentation.

· Bills of Exchange are used primarily in international trade, and are written orders by one person to his bank to pay the bearer a specific sum on a specific date.

· Prior to the advent of paper currency, Bills of Exchange were a common means of exchange.

· Other than cheques, Bills of Exchange are not used as often in today’s commercial world.

· Bills of Exchange Types

· Time Bill

· Drawee must pay at a definite future time.

· Sight/Demand Bill

· Drawee must pay on presentation or at a specified time after presentation.

· Trade Acceptances (a bit like a cheque)

· Drawee is a credit/buyer.

· Payee is a debtor/seller

· Either Time Bill or Sight Bill.

· Bills of Exchange Elements

· An unconditional order …

· From Drawer

· Directing the Drawee

· To pay money to the stated Payee

· for a definite sum of money …

· with payment to be made …

· on demand, or

· at a specified future time.

· It is essentially an order made out by one person and given to another person instructing them to pay money to a third person.

· Bills of Exchange Applicable Law

· Australia

· Bills of Exchange Act 1909 (ABEA)

http://www.comlaw.gov.au/ComLaw/Legislation/ActCompilation1.nsf/0/A59C9D433F197AB7CA256F71004ED0D2/$file/BillsExchange09.pdf

· Anglo-American

· UK & Commonwealth: Bills of Exchange Act 1882 (BEA)

· USA: Uniform Commercial Code (UCC) §3-104

See: http://www.law.cornell.edu/ucc/

· Model Laws – Other Jurisdictions

· Uniform Law of Bills of Exchange and Promissory Notes of 1930 (ULB)

· Uniform Law for Checks adopted 1931

· United Nations’ Convention

· Convention on International Bills of Exchange and International Promissory Notes of 1988

· Not yet in force (and unlikely to be in near future).

· Cheques/Checks

· Cheques/Checks (US)

· Cheques are bearer drafts drawn on a cash held in a bank account that instructs the bank to pay the bearer the amount indicated.

· Cheques Act 1986 (Cth)

· SS52-55 provide for ‘crossing’ a cheque, i.e. marking it “not negotiable” within two parallel lines traversing the face. This instructs the bank to only pay the funds to another financial institution, i.e. it effectively stops the cheque from being cashed.

· Cheques/Checks

· Cheques/Checks (US)

· Design and payment managed by Australian Payments Clearing Association http://www.apca.com.au/payment-systems/cheques through their Australian Paper Clearing System. The Association is a “self-regulatory body for Australia’s payments industry” whose membership comprises the major players in the financial services sector.

· Almost defunct in Australia as a means of payment – predicted to be virtually non-existent wthin 5 years, although recent UK attempt to ban them failed.

· Types include:

· Personal/Business cheques

· Bank cheques

· Travellers cheques (quite a different model)

· Documentary Credits Uses

· Have existed in different forms since the dawn of trading civiliation, inc. ancient Rome, China and Egypt.

· Used in over 175 countries: flexible in different jurisdictions and relatively inexpensive risk mitigation.

· Relies on integrity of banking system.

· Difficult to measure either total value or total volume without a central reporting authority.

· The 2012 SWIFT traffic indicateed that 44% of all import and export trade instruments were Commercial LoC’s.

· Another 10% was taken up by Standbys.

· Uses include as a:

· Payment Guarantee (especially in North-South transactions)

· Financial Guarantee (Financial Standby D/C’s in particular)

· Credit Instrument (replacing other credit instruments)

· Documentary Credits (D/C or L/C)

· The terms “Letter of Credit” (L/C) and “Documentary Credit” (D/C) are largely interchangeable, however the latter is more technically correct.

· The Documentary Credit is perhaps a creature of Lex Mercatoria, the “autonomous body of transnational commercial rules” which arose out of the need for consistent rules to govern trade during the middle ages and since.

· Lex Mercatoria has been described as “a process in which regulatory norms travel from the bottom (the practices of corporations) to [the] top (recognition by the state)”.

· Wooler, P.8

· Documentary Credits Definition

· A commercial D/C is a contractual agreement between a bank, known as the Issuing Bank, on behalf of one of its customers, authorizing another bank, known as the Advising Bank or Confirming Bank, to make payment to the Beneficiary of the D/C on its behalf.

· The Issuing Bank makes a commitment to honour drawings made under the D/C notwithstanding any underlying contract issues. Essentially, the Issuing Bank replaces that Bank's customer as the payer.

· The Issuing Bank produces a Bill of Exchange that must conform exactly with the terms of the D/C with the specified value of the BoE not exceeding the amount of the D/C.

· In effect, a D/C substitutes the creditworthiness of a bank for the creditworthiness of the buyer.

· Documentary Credits Trade Volumes

· Difficult to measure either total value or total volume of D/Cs on issue in the absence of a central global reporting authority.

· An estimated 90% of all D/C transactions are carried via SWIFT (Society for Worldwide Interbank Financial Telecommunication)

· Break Time! See you in 15 minutes!

· Documentary Credits Exceptions to Autonomy

· The Autonomy Principle provides that the irrevocable undertaking provided for in LC’s is independent or autonomous from the underlying contract into which the parties entered and under which the requirement to provide a LC arises.

· This means that in the case where a contractual dispute arises between the parties, the obligation undertaken by the Issuing Bank to make payment upon a receipt of a ‘complying presentation’ remains irrespective of the merits of the dispute.

· Documentary Credits The Fraud Exception

Fraus Omnia Vitiat : Fraud Vitiates Everything

· The mere suspicion of fraud by the Beneficiary is not sufficient for the Issuing Bank to withhold payment.

Society of Lloyd’s v Canadian Imperial Bank of Commerce [1993] 2 Lloyd’s Rep 579 per Justice Saville

· However, in the event of a prepayment (accelerated payment) or discount by the Paying Bank, the Issuing Bank must reimburse where the documents are compliant on their face.

· UCP 600 (Articles 7(c), 8(c), and 12(b)) expressly provide that the Issuing Bank or Confirming Bank’s obligation to reimburse the Nominated Bank that has paid upon the presentation of the documents, is independent from such banks’ obligations with respect to the Beneficiary.

· This obligation remains even where fraud is subsequently found in either the underlying contract or in the documentation on which payment was based.

· Documentary Credits Other Exceptions

· Unconscionable Conduct

· Only exists with certainty in Singaporean jurisdiction.

· Majority of cases (if not all) arose out of construction cases, which is not surprising given that Standby credits are widely used in that high-risk, highly litigated industry.

· The exception is fraught with legalistic controversy as to the basis for the law and is often confused with the law relating to injunctions, e.g. ‘balance of convenience’ rules.

· Illegality

· A rare exception used when LCs are used to attempt some contravention of the law: United City Merchants v Royal Bank of Canada

· Moens and Gillies differentiate between Commercial Credits and Standby Credits on the basis of the documents required under each.

· In the latter case, they state “the required documents may be of any description.”

· Documentary Credits Types

· Commercial Documentary Credit – governed by UCP600 & UCC §5

· Expected to be drawn upon at some point.

· Standby Documentary Credit – governed by UCP600 or ISP98 & UCC §5

· Financial Standby Credit

“an irrevocable undertaking by a banking organization to guarantee payment of a financial obligation … [that is] … considered a direct credit substitute…”

· Performance Standby Credit

“to make payment in the event the customer fails to perform a non-financial contractual obligation.”

Board of Governors of the Federal Reserve System, Division of Banking Supervision and Regulation, ‘Financial Standby Letters of Credit and Performance Standby Letters of Credit’, Memorandum #SR 95-20 (SUP), dated March 30, 1995.

· Commercial Letters of Credit Elements

· A payment undertaking …

· given by a bank (Issuing Bank) …

· on behalf of a Buyer (D/C Applicant) …

· to another bank (Confirming Bank) …

· to pay a Seller (D/C Beneficiary) …

· a prescribed amount of money.

· Payment is made on presentation of specified documents …

· (generally always includes a commercial Invoice, a transport document such as a Bill of Lading or Air Waybill, and Country of Origin and Insurance documents)

· representing the supply of goods …

· within specified time limits.

… also…

· Documents must conform strictly to terms and conditions set out in the Credit.

· Documents to be presented at a specified place.

· Documentary Credits Applicable Law

· Commercial D/C’s are used in international transactions and are governed by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits (UCP 600).

· The U.S. is the world’s largest user of D/C’s and the only major country to statutorily control D/C usage:

· Uniform Commercial Code (UCC) §5-000 provides clear guidance on D/C issuance and use.

· United Nations Convention on Independent Guarantees and Stand By Letters Of Credit

· Only 8 countries have ratified this and is therefore inoperative.

· Courts in nearly all jurisdictions have recognised the UCP600 or its predecessors.

· Documentary Credits Formal Requirements

· For Documentary Credits to be valid, they must:

· Be in writing (obviously);

· Be properly executed;

· Be complete;

· Concisely dictate the documentary requirements for presentation;

· Be appropriately marked if revocable …

· For Documentary Credits to be valid, they must:

· Indicate when and how D/C will be honoured:

· By sight

· Deferred

· By Acceptance

· By Negotiation

· Name the bank/s authorised to:

· Pay credit

· Accept Bill of Exchange drawn in accordance with the letter

· Negotiate the Documentary Credit

· Documentary Credits Responsibilities and Rights

· The Confirming Bank must:

· Examine documents with reasonable care (Article 8 UCP 600), but

· is not required to indemnify any party for errata (Article 34 UCP 600).

· within 5 working days (Article 14(b) UCP 600).

· Paying, Accepting or Negotiating Banks must forward irregular documents to the Issuing Bank.

· Honour (or refusal to honour) D/C’s is carried out on the basis of the documents alone.

· Beneficiaries must -

· Comply with the terms and conditions of the credit;

· Present the documents designated in the credit, commonly:

· Certificate of Origin • Export Licence

· Certificate of Inspection • Commercial Invoice

· Marine Insurance Policy • Bill of Lading / Air Waybill

· Applied Market Regulatory Practices New Events: ‘Bank Payment Obligations’

· Bank Payment Obligations

· Seen as an ‘electronic letter of credit’ between banks.

· Fully automated, electronic capital transfers between banks and other major financial institutions conducted throught the SWIFT systems.

· “The BPO is an irrevocable undertaking given by a bank to another bank that payment will be made on a specified date after successful electronic matching of data according to an industry-wide set of ICC rules.” www.swift.com/resources/documents/Bank_payment_obligation.pdfý

· ICC’s ‘Uniform Rules for Bank Payment Obligations’ (URBPO) adopted in Dubai on June 24, 2013.

http://www.iccwbo.org/About-ICC/Policy-Commissions/Banking/Task-forces/Bank-Payment-Obligation-%28BPO%29/

Intensive Six Content

· Applied Market Regulatory Practices – Factoring and Forfeiting

· Applied Market Regulatory Practices – Fractional Reserve Banking

· Applied Market Regulatory Practices – Margin Lending

What is Factoring?

· Factoring is one of the oldest forms of business finance still utilised by merchants as a method of raising capital for international trade.

· Factoring is a form of commercial finance.

· Definition: “A financing method in which a business owner sells accounts receivable at a discount to a third-party funding source to raise capital.” http://www.entrepreneur.com/encyclopedia/factoring

How Does Factoring Work?

Parties: There are typically three parties involved when an invoice is held by a local debtor:

· Seller

· Buyer/Debtor

· The Factor (the factoring company)

Typically one party, the Seller/Producer, sells its accounts receivable at a discount to another party, the Factor.

Pop Quiz: What are ‘accounts receivable’?

Accounts Receivable

· Accounts receivable – typically where an invoice is delivered by a business to a customer requiring payment within an established timeframe called “credit terms” or “payment terms”.

· For example, “payment net 30 days” requires payment of the invoice amount within 30 days.

· This impacts the company's balance sheet. The balance sheet shows the accounts receivable is the amount that customers owe a business. They are classified as current assets.

· When the customer pays, the firm debits cash and credit the receivable in the journal entry, i.e. both transactions occur on the asset side of the ledger. The statements should balance accordingly.

Factoring Example

Step 1: Small Supplier, S, sells $1 million in tomatoes to its customer Big Buyer, B, a large multinational exporter. S in a competitive gesture offers B 30-days trade credit. S records the sale as $1 million in accounts receivable and B records the purchase as $1 million in accounts payable.

Step 2: S needs working capital to produce more inventory. A Factor, F, purchases S’s accounts receivable (S “assigns” its accounts receivable from B to F). S receives today 70% of the face value of the accounts receivable ($700,000). B is notified that S ’s receivables have been factored.

Step 3: In 30 days, F receives the full payment directly from B , and S receives the remaining 30% less interest (on the $700,000) and service fees.

Why use it?

· Factoring facilitates international trade by providing the exporter with increase cash flow, thereby enabling the exporter to concentrate on the business of trade.

· The exporter utilises a finance house, called the ‘Factor’ to remove or reduce the financial burden.

· The export is undertaken by the exporter whilst the financial management is shifted to the Factor.

Benefit to Seller

· Factoring shifts the firm’s dependency on the conversion of accounts receivable to cash.

· The firm benefits by increased cash flow.

· Ideally the amount paid equals the face value of the sold accounts receivable, less the Factor's fee and a market discount.

· Gouging would be quite possible in tight markets.

Effect on Seller’s Balance Sheet

· Factoring is considered ‘Off-Balance Sheet’ financing in that it is not a form of debt or a form of equity and therefore doesn’t appear on either side of the ledger.

· This makes Factoring more readily accessible than traditional bank and equity financing.

The Factor’s Business Model?

· An important feature of the factoring relationship is that a Factor will typically advance less than 100% of the face value of the receivable even though it takes ownership of the entire receivable.

· The difference between this advance amount and the invoice amount (adjusted for the effect of such things as sales rebates etc) creates a reserve held by the Factor.

· The Factor’s reserve will be used to cover any deficiencies in the payment of the related invoice.

· If and when the invoice is paid in full, the reserve amount is remitted by the Factor to its client.

· A typical advance rate might be 70%, which establishes a 30% reserve.

· Factors enjoy a number of important advantages in offering credit and collection services along with its funding services.

· It may enjoy significant economies of scale in both of these activities relative to its clients. Few small firms are likely to have much expertise in either area.

· Most entrepreneurs have backgrounds in the product side of their businesses.

· Factors generate their own proprietary databases on account payment performance. The largest Factors essentially become the equivalent of large credit information exchanges essentially offering an alternative source of information to private commercial credit bureaus and public credit registries.

Factoring Reserve System

Types of Factoring

Risk-related Considerations

or

“It’s always about the risk!”

· The type of factoring employed is often a corollary of the type of risk inherent in the deal.

Recourse Factoring

· Now the most common type of factoring transaction.

· Allows the Factor to go back to the seller if payment is not received (normally after a 90 day period).

· The credit risk does not transfer to the Factor during the recourse factoring process.

· Normally, in the event of non-payment by the customer, the seller must buy back the invoice with another invoice (given credit-worthiness).

· Recourse factoring is typically the lowest cost for the seller because the risk for the Factor on the funding transaction is lower, i.e. the only risk the Factor carries is that the seller cannot pay.

Pop Quiz: What does the Risk-Return Ratio Theory state?

Non-recourse Factoring

· Non-recourse factoring is the traditional method of factoring and puts the risk of non-payment, in the event the debtor becomes insolvent, fully on the Factor.

· If the debtor cannot pay the invoice due to insolvency, it is the Factor's problem to deal with and the factor cannot seek payment from the seller.

· The Factor will only purchase solid credit-worthy invoices and often turns away average credit quality customers.

· The cost is typically higher with this factoring process as the Factor assumes a greater risk.

Disclosed Factoring

· Disclosed Factoring

· Debtors are aware of the finance facility.

· A Notice of Assignment included on each invoice.

· Factoring company normally does the credit control, i.e. collects the outstanding debts.

· Provisions of the Property Law Act 1974 s199 apply (dealing with the assignment of debt and things in action), e.g. assignment must be in writing, formally executed, absolute (not partial assignment) and express notice provided to Debtor.

Undisclosed Factoring

· Undisclosed or Confidential Factoring (aka Invoice Discounting)

· With Undisclosed Factoring, the Seller is under no obligation to apprise the Buyer that s/he is factoring her accounts receivable.

· Legally constitutes equitable assignment of Seller’s claim against the debtor.

· Debtor continues to pay Seller, who is obliged to place the funds in trust in a designated account or face action for the tort of conversion.

· In sui generis Private Law, factoring is governed by disparate groups of factors’ regulatory rules, e.g. the General Rules for International Factoring: Factors Chain International http://www.factors-chain.com/

Other Types of Factoring

· Export Factoring: the sale of foreign receivables in manner that can facilitate and reduce the risk of international sales by collecting foreign receivables.

· Reverse Factoring: The lender purchases accounts receivables only from high-quality buyers (for example any receivable owed by a reliable buyer from any suppliers). The lender only needs to collect credit information and calculate the credit risk for the buyer (for example a large, very transparent, internationally accredited firm). In Reverse Factoring, the credit risk is equal to the default risk of the high-quality customer, and not the risky firms. This arrangement allows creditors in developing countries to factor “without recourse” and provide low-risk loans to high-risk firms.

Downsides

· Factoring can be a very expensive source of financing and is only recommended to companies that are growing faster than their current financing permits.

· Because factoring can be expensive, many companies use it only as a financing means of last resort.

· Factoring allows a company that is growing rapidly or is in financial difficulty to focus attention on the operations of its business.

International Conventions

· No international convention on factoring has been ratified but the following provide clear guidance on the underlying legal principles of factoring:

· The Unidroit Convention of International Factoring (1988) (http://www.unidroit.org/english/conventions/1988factoring/1988factoring-e.htm)

· The UNCITRAL Convention on the Assignment of Receivables in International Trade (http://www.uncitral.org/pdf/english/texts/payments/receivables/ctc-assignment-convention-e.pdf)

Break Time! See you in 15 minutes!

What is Forfaiting?

· A form of fixed-rate trade finance originally developed in Europe but ultimately lost to London.

· Forfaiting involves the purchase by a financial institution - the Forfaiter - of financial instruments received by exporters from their international customers as guarantee of payment.

· These instruments are usually in the form of Letters of Credit or Bills of Exchange or Promissory Notes.

· Forfaiting is a highly flexible rubric that allows an Exporter to grant attractive credit terms to cross-border Buyers, without loading cash flow or assuming the risks of late payment or debtor default.

· Simultaneously, the Exporter is fully protected against unfavourable interest/currency rates during the credit period.

What is Forfaiting?

Potential Parties to Forfaiting Transactions

Forfaiting Transaction Model

Exporter Benefits from Forfaiting

Importer Benefits from Forfaiting

· The Importer can:

· access relatively inexpensive medium-to-long-term financing which may be unavailable locally;

· schedule repayments in line with projected revenues, regulatory/legal restraints and contractual grace periods;

· obtain 100% financing and avoids overloading cash stream over the short term;

· possibly take advantage of export subsidies and other incentives available from Exporter's government;

· pay interest at a fixed rate, generally for the duration of the credit which is conducive to simpler and consistent budgeting.

Drawbacks to Forfaiting

· Virtual non-availability for short period access to credit;

· Difficulty in procuring international bank guarantees;

· Dominance of western currencies in trade transactions and shortage of hard currencies in developing economies;

· Virtual non-availability for financially weak countries.

Jurisprudential View

· Forfaiting falls broadly under the law of contract, the parties being the Seller and the Forfaiter.

· Contracts will usually contain jurisdictional and choice-of-law provisions.

· No international conventions govern forfaiting.

Factoring versus Forfaiting

· Suitable for ongoing open account sales; not backed by LC or accepted Bills of Exchange.

· Usually provides financing for short-term credit period of up to 180 days.

· Requires a continuous arrangements between factor and client, whereby all sales are routed through the factor.

· Factor assumes responsibility for collection, helps client to reduce his own overheads.

· Oriented towards single transactions backed by LC or bank guarantee.

· Usually for medium-to-long-term credit periods up to seven years though shorter terms are available for large transactions.

· Seller not committed to Forfaiter; can be single transaction.

· Forfaiter’s responsibility extends to collection of unpaid debt only. Other lines of credit remain unaffected.

Factoring versus Forfaiting

· Separate charges are applied for:

· financing

· collection & administration

· credit protection and

· provision of information.

· Both domestic and export receivables may be factored.

· Factoring liability can be ‘with’ or ‘without’ recourse.

· Single discount charges applied depending on:

· guaranteeing bank;

· country risk;

· credit period involved;

· currency of debt.

· Usually available for export receivables only (i.e. not domestic) denominated in any freely convertible currency.

· Forfaiting is always ‘without’ recourse and is in essence just a financing product.

Margin Borrowing

Margin Borrowing

Loan to Value Ratios

Loan to Value Ratios

Advantages to Margin Finance

Disadvantages to Margin Finance

· Welcome to Intensive Seven!

The Global Financial Crisis Causes and Effects Internationally

GFC-Driven Collapses

Global Regulatory Responses to the GFC

· Key Learnings

· This topic will provide:

· An understanding of the broad causes of the Global Financial Crisis.

· A brief history of some of the major corporate collapses caused by the GFC.

· A narrow understanding of the regulatory and statutory responses to the GFC including the objectives and outcomes from the Australian Government’s Inquiry in the financial services sector.

· Why Learn This?

· The Global Financial Crisis provides us with an especially clear picture of what types of elements and behaviours need to be present in markets for them to go rogue.

· The Global Financial Crisis could have been much, much worse and the ongoing effects of it are still being seen. Much is still being written in the story – the problems of PIGS are not solved.

· This will affect each and every one of us over the next few years – economically, politically, personally.

· A Perfect Storm

· The ongoing(?) Global Financial Crisis, has provided academics a textbook case study of a perfect economic storm. It has virtually all the elements of an economic meltdown, writ large:

· An extremely inept and incompetent and evidently corrupt administration in the White House (Bush/Cheney);

· An unsustainably over-leveraged, under-regulated, evermore technically-retarded European economy (relative to Asia);

· An enormous speculative bubble in U.S. domestic real estate with little corresponding growth in the means of production;

· Several major wars breaking out simultaneously involving the world’s largest, most indebted consumer-driven economy;

· A global banking and finance system with virtually no risk aversion or fiduciary obligations;

· A market-driven executive rewards systems that is so generous as to make any potential downside seem worthwhile.

· What Triggered The GFC?

The collapse of the US sub-prime mortgage securities market was the pin that pricked the speculative “bubble”.

· Highly leveraged private investment pools (flawed financing models)

· Undercapitalized securitized loans (flawed financing models)

· Speculation in complex credit derivatives (eg. credit default swaps, instalment warrants, MBSs, Collateralised Debt Obligations [CDO’s])

· Unchecked real estate bubble (median US housing prices rose 124% 1997-2006)

· Fiscal & Legal Context

Broad causes of the GFC:

· Dubious Corporate Ethics

· Flawed Corp Governance

· Sophisticated but “flawed” Financing Models

· Flawed Regulatory Models

· Exploitation of Legal Loopholes

· Corrupt, incompetent government

1. Flawed Corporate Ethics

Galbraith states that beneficiaries of the system don’t want to assign responsibility to the corporation. Better to use a benign reference to the ‘market’.

· “Policy legitimacy is dependent not only on economic rationality, but on assumptions about the limits of what is acceptable corp. behaviour .”

· “21st century has a corporate system based on unrestrained power of self-enrichment”

· “analogous to a harlot who dresses very nicely”

· “lack of a ‘moral compass’”

2) Flawed Corporate Governance

· Disclosure (and exemptions) … or lack thereof;

· Conflicts of interest;

· Remuneration;

· Incentives for highly risky investments;

· Hedging executive pay;

· ‘Sophisticated’ vs ‘unsophisticated’ investor bifurcation.

2. Flawed Corporate Governance

· Financial Reporting – new standards have been incorporated into the Corporations Act.

· These new standards however remain wedded to certification and verification (based on albeit weakened presumptions of management good faith).

· Many companies had Codes of Ethics or Practice which met or exceeded industry ‘best practice’ standards. This however gives rise to two issues:

· Whether industry ‘standards’ are high enough; and

· A “tick the box” mentality will result, without empirical analysis.

· Banks were complicit in the GFC by:

· Lending too liberally to companies and individuals euphemistically known as:

· NINJA Loans – No Income, No Job Applicant

· Marketing off-balance sheet financing products to companies;

· Using off-balance sheet financing themselves to circumvent Basel Accord (prudential regulation requirements).

· Flawed structures can exert onerous costs and legitimise conflicts of interest

· It has been argued that self-regulation (eg. by ASX and various industries) is definitionally a conflict of interest

· National CG regimes can be compromised by cross-border tactics of multi-national corporate groups (e.g. James Hardie moving to the Netherlands or News Corp moving to Delaware in the U.S.)

· Enforcement of regulatory instruments is as important as creating them – ACCC, various Ombudsmen and others seriously underfunded and hamstrung by policy and law.

· Risk of regulatory empire building vs. risk of State capture (political influence)

· The Law’s ‘Contribution’

Four primary ways the prevailing legal systems failed to protect investors from market excesses:

1) Investor protections were diminished when the explicit exemptions to fundraising disclosure requirements were expanded (e.g. “sophisticated investors”, private offerings).

2) Some types of investments (e.g. securitised investment pools, credit default swaps) were simply definitionally outside existing fundraising disclosure laws. The law lagged market innovation (partly through administrative complicity).

· U.S. Casualties (more detail on some of these in Intensive 8)

· U.S.-based companies that have hit the wall since the GFC include:

· Lehman Brothers

· Bear Stearns

· Citigroup? (Ben Bernanke – “too big to fail”)

· General Motors? (“ditto”)

· AIG? (“ditto”)

· Aussie GFC Casualties (more detail on some of these in Intensive 8)

Financial Services

· Opes Prime

· Storm Financial

· Babcock & Brown

· MFS

· Westpoint

· Bridgecorp

· Fincorp

· Aust Capital Reserve

· Allco Finance

Corporate

· ABC Learning

· Cubby Station

· Timbercorp

· Gunns

· Great Southern

· Kleenmaid

· The GFC “we had to have”?

“Those who cannot remember the past are condemned to repeat it.”

George Santayana

· Lots of historical evidence that demonstrated the dangers of excessive leverage and speculation.

· South Sea Bubble

· 1929 Crash

· 1980-90s “Recession we had to have” – PM Paul Keating

· Late 1990s ‘Dot.com’ boom and Asian financial crisis

· Early 2000’s – Enron, WorldCom, HIH, FAI etc etc

· Break Time! See you in 15 minutes!

· The Financial Services Inquiry Terms of Reference

· Inquiry into recent financial product and services provider collapses, such as Storm Financial, Opes Prime and other similar collapses.

· Particular focus on:

1. the role of financial advisers;

2. the general regulatory environment for these products and services;

3. the role played by commission arrangements relating to product sales and advice, including the potential for conflicts of interest, the need for appropriate disclosure, and remuneration models for financial advisers;

4. the role played by marketing and advertising campaigns;

5. the adequacy of licensing arrangements for those who sold the products and services;

· Inquiry into recent financial product and services provider collapses, such as Storm Financial, Opes Prime and other similar collapses.

· Particular focus on:

6. the appropriateness of information and advice provided to consumers considering investing in those products and services, and how the interests of consumers can best be served;

7. consumer education and understanding of these financial products and services;

8. the adequacy of professional indemnity insurance arrangements for those who sold the products and services, and the impact on consumers; and

9. the need for any legislative or regulatory change.

· Inquiry Report Chapter 5 Issues

· The Inquiry had a range of quite different matters to address:

· Defining the financial service ‘industry’.

· Scoping and defining the product of the industry.

· Determining what constitutes below-standard product.

· Regulatory control issues.

· Advisor compensation regimes and managing conflicts of interest.

· Determining competencies under the present licensing system.

· Lending and other financing practices.

· Investor compensation.

· Enforcement issues.

· Financial literacy of client base.

· Suggested Areas for Reform

· Standards of advice

· Fiduciary duty

· Dual standards of advice

· Risk-based audits

· Disclosure

· Remuneration

· Bans on commissions

· Consumer choice and asset-based fees

· Tax deductibility

· Licensing

· Separate licence categories

· Raising competency standards

· Capital adequacy requirements

· Licensing individual planners

· Professional Standards Board

· Accountants

· Lending practices

· Product limitation

· Investor compensation

· Financial literacy

1) Corporations Act be amended to explicitly include a fiduciary duty for financial advisers operating under an AFSL, requiring them to place their clients' interests ahead of their own.

2) ASIC is appropriately resourced to perform effective risk-based surveillance of the advice provided by licensees and their authorised representatives. ASIC should also conduct financial advice ‘shadow shopping’ exercises annually.

3) Corporations Act be amended to require advisers to disclose more prominently in marketing material restrictions on the advice they are able to give consumers and any potential conflicts of interest.

4) Cease payments from product manufacturers to financial advisers.

5) Consider making the cost of financial advice tax deductible.

6) Section 920A of the Corporations Act be amended to provide extended powers for ASIC to ban individuals from the financial services industry.

7) As part of their licence conditions, ASIC require agribusiness MIS licensees to demonstrate they have sufficient working capital to meet current obligations.

8) Sections 913B and 915C of the Corporations Act be amended to allow ASIC to deny an application, or suspend or cancel a licence, where there is a reasonable belief that the licensee 'may not comply' with their obligations under the licence.

9) Establish an independent, industry-based professional Standards Board to oversee nomenclature, and competency and conduct standards for financial advisers.

10) Investigate the costs and benefits of different models of a statutory ‘last resort’ compensation fund for investors.

11) ASIC develop and deliver more effective education for consumer groups seeking financial advice for the first time.

· O’Brien argues that neither SOX or CLERP9 can deal with motivation or the capacity of executives to rationalise their behaviours ex post.

“Fuelled by increases in personal wealth, misfeasance continues to be rationalised as part of the ‘acceptable’ rules of the game …”

· In fact, it could be argued that it is an exercise in executive hubris to see how far the restraints of law can be pushed, given the difficulties and complexities associated with compliance measurement and policing.

· To prohibit excessive leverage and speculation that create cycles of ‘irrational exuberance’ followed by financial panics, Taub recommends:

· Eliminating loopholes that allow securitised investment pools, without transparency or oversight.

· Tighten requirements for securitising debt (e.g. equitable assignments of large debt pools to a ‘Special Purpose Vehicle’ [SPV]). This must be more than just tightening regulation governing financial advisers.

· If financial engineers contributed to the GFC, it is only right that they should be more tightly regulated.

· Many ‘sophisticated’ investors (whoever they are!) cannot take care of themselves after all.

· Human nature (e.g. greed & hubris) can be successfully constrained by sufficiently powerful disincentives.

· Government regulation can be effective if designed appropriately to facilitate steady business growth.

· The cost of regulation is contingent on its design; regulation is not necessarily too expensive.

· Architects of regulation can second-guess the reactions of corporate directors and managers.

· Key Issues

The causes of the meltdown in global capital markets include:

· Conflicts of Interest

· Appropriate Levels of Information and Risk Disclosure

· Sophisticated Investors vs Naïve/Conflicted Advisors

· Contagion

· Externalisation

· Executive Remuneration

· Failure of Government Oversight

· Failed Corporate Governance

· Corporate failure and some fraud are inescapable in business life.

· Academics have a role to play in rejecting intellectual ghettoization and ‘barren legalism’ (i.e. focusing on technical questions of procedure, rather than seeking to embed ethics)

· Effective Corporate Governance necessitates a modification to cultural norms – greed is NOT good.

· For CG and regulatory oversight to be effective in an age of global markets, the overriding policy imperative is to institutionalize an ethical framework that is capable of transcending technical compliance, i.e. only by inculcating values into the corporate culture can the corporate system effectively regulate its own activities.

· Intensive Eight Content

Corporate Collapses From the GFC

Capital Market Regulation

Today and Tomorrow

Key Challenges

World Championship

Spectacular Fails

Australia versus the World

In

Corporate Misfeasance

· Overview

· Australia

· Storm Financial

· Opes Prime

· United States

· Bear Stearns

· Lehman Brothers

· United Kingdom

· Northern Rock

· Lloyds

· Anglo Irish Bank

· Storm Financial Group

The Report looks at the following aspects of the Storm matter:

· The effect of the collapse on investors;

· The Storm Financial business model;

· Events surrounding the collapse of Storm Financial;

· General issues of concern;

· The advice and contractual undertakings made;

· Levels of client understanding of product, risk and protection.

· In the aftermath of the Storm collapse, the Inquiry Committee looked at:

· The nature of the relationships between Storm and the lenders

· Increases in bank sales and lending targets

· Inaccurate figures on loan applications, leading to inappropriate lending: investors signing blank loan applications!

· Misuse of the Valuation Assessment System (VAS)

· The Report’s findings include:

· Poor management of margin calls by multiple parties;

· Limited oversight and regulatory gaps;

· Inadequate lender response to the Storm collapse;

· Brief examination of ASIC's response to the collapse.

· The Report looks at the following aspects of the Opes matter:

· The effect on Opes Prime clients;

· The limitations of the committee's inquiry;

· The Opes Prime business model;

· Events surrounding the collapse of Opes Prime;

· The extent of client understanding of the Opes strategy and their contractual undertakings.

· The Role of the ANZ Bank

4.38 Many investors were using the Opes product reassured by the prominence of ANZ in their marketing materials, replete with ANZ logo describing them as 'banker and custodian bank' …

· The Position of the ANZ Bank

4.40 ANZ's own involvement with Opes Prime was limited solely to its capacity as a financier to Opes Prime. In respect of its dealings with Opes Prime, at no time did ANZ have any relationship with Opes Prime's customers.

Opes Prime Scheme of Arrangement (Settlement)

4.61 The terms of settlement included an agreement by the regulator not to pursue ANZ and Merrill Lynch for an alleged contravention of the managed investment provisions of the Corporations Act 2001. ASIC also agreed not to pursue directors of ANZ for civil penalty and compensation claims under section 181 of the Corporations Act. In accepting the scheme of arrangement, the Opes Prime liquidators and clients also renounced all claims and legal proceedings against Merrill Lynch and ANZ.

· Bear Stearns

· Bear Stearns

· Established in 1923 as a Wall Street equities trader – very long-surviving.

· One of a few companies to survive Great Depression without laying off any employees!

· Became a public company in 1985 in huge IPO.

· Became leading global investment bank, based in Manhattan, New York – into all types of lending, trading and investing activities.

· Pioneered securitisation and mortgage-backed securities markets.

· Bear Stearns

· Impact of the GFC

· U.S. sub-prime mortgage securities crisis largely driven by Bear Stearns’ marketing and practice.

· Company increased its exposure in MBSs to fatal levels in 2006-2007.

· As mortgage defaults skyrocketed and returns on securities dried up, BS’s share price fell from a high of $133.20 to a low of $10 per share.

· Teddy Bear Stearns

· Teddy Bear Stearns

· Lehman Brothers

· Background

· Global financial services firm based in New York

· Investment banking, private equity, investment management and fixed interest sales.

· Fourth-largest investment bank in the US in 2008.

· The GFC’s Biggest Victim

· Massive exposure to sub-prime MBS’s; kept huge amounts of toxic assets on its own books;

· Downgrading of credit rating by credit rating agencies;

· Drastic downgrade of stock value;

· Massive attrition to its ‘big-end’ investment client base.

· Lehman Brothers

· Lehman Brothers

· Lehman Brothers

· Lehman Brothers is the only truly large American corporation allowed to completely fail.

· Everyone else got a bailout, but no good reason has been given as to why LB was allowed to fail when equally-sized and indebted firms were saved.

· It is widely thought that Lehmans management either simply didn’t have enough time (they were in deep trouble before the body politic realised how bad things had become), or didn’t have enough political clout or were in such poor shape that it wasn’t worth the effort of saving them.

· Break Time! See you in 15 minutes!

· Spend, Stabilise, and Reform

· Following the emergency responses to the GFC, the ongoing global work is to stabilise and plan for the future.

· The GFC and its after-effects threw up many market anomolies (LIBOR fraud, product rating misinformation); exposed a range of weaknesses in the global capital market (RMBS, Real Estate bubbles); shut down national economies with critical levels of sovereign debt (Greece, Iceland); and undermined market confidence (liquidity shortages).

· The Eurozone, Japanese and US economies are still heavily reliant on a range of fiscal stimulus programs – “quantitative easing” programs in which national governments are selling bonds to print money; reforming taxation collection systems; engaging in huge cuts to government spending (social support and employment).

· Regulatory Reform

· Government regulators were caught off-guard by the sheer complexity of the Global Capital Market when the GFC struck.

· Financial institutions have broadened their product ranges to include products that are functionally impossible to understand in any meaningful way. Risk can only be calculated as multiples of multiples that ultimately mean nothing in real terms, i.e. it can only be measured once it’s realised … which is too late, of course.

· Governments globally, by and large, do not attract the best and brightest (except perhaps Germany) and rarely encourages an environment of “best practice, assiduously performed”.

· Making Government regulators ever more sophisticated and adept at the market requires very expensive expertise to be bought in from outside.

· Regulatory Reform – USA

· Government regulators continue attempts to beef up capital market agencies as they negotiate with reluctant lawmakers to implement and finance surveillance, investigative, prosecutorial and judicial agencies.

· In the USA, there is a push to reinstate the Glass-Steagall Act that effectively separates investment banking and commercial banking – one of the contributing factors that led to the excess of market liquidity that blew out the real estate market.

· There is also an argument for breaking big financial organisations into smaller parts so a collapse by one doesn’t cause excessive market contagion and economic distress: too big to fail; too big to manage; to big to regulate.

· Anything Else?

· Current Regulation of Financial Products and Services in Australia

Regulation of Capital Market includes:

· Financial Services Regulation

· Financial Advisor Licensing

· Regulating Conduct

· Regulating Disclosure Obligations

· Setting Competency and Training Requirements

· Professional Indemnity (PI) insurance

· Oversight of Margin Lending Practice

· Investigation and Enforcement

· Financial Services Regulation

· Aim is to ensure market efficiency, transparency and investor protection.

· Regulation of conduct and information disclosure requests.

· ASIC does not vet licensees' business models or prevent complex or high risk financial products being sold to investors but will investigate irregularities or complaints to ensure compliance.

· Licencing & Prudential Regime

· As a result of the Wallis Inquiry in 1996, a new licensing and prudential regime was incrementally implemented from July 1998:

· APRA – regulator of banking, super, insurance

· ASIC – enforces laws that govern the way financial services businesses deal with individuals

· RBA – monetary policy

· Treasury Dept. – fiscal policy

· ACCC – administers the Australian Competition and Consumer Act (ACCA) http://www.comlaw.gov.au/Details/C2011C00003/Download

· ATO – taxation law, self-managed super funds

· The Need for Licencing

· If a person wants to provide personal advice to someone else relating to a financial product (as defined in the Corporations Act), they must be licenced or be an authorised representative of an Australian Financial Services Licence holder.

· A person does not need to be licenced or an authorised representative to give general advice or incidental advice.

Refer Corporations Act sec 766(B) and ASIC RG 36 and RG 175

· The Need for Licencing

· Accountants and other persons working in the financial sector who do not have an Australian Financial Service Licence must be extremely careful as to the content of advice that they provide their clients.

· In some cases there will be a fiduciary duty but there is now a statutory obligation to ensure that any advice provided is of a general factual nature and can not be construed as financial product advice.

http://www.asic.gov.au/asic/ASIC.NSF/byHeadline/Do%20you%20need%20an%20AFS%20licence%3F

· The Need for Licencing

· A person may need an AFS licence if, as part of their business, they:

· provide financial product advice

· deal in a financial product

· create a market for a financial product

· operate a ‘registered scheme’

· provide a custodial or depository service

http://www.asic.gov.au/asic/ASIC.NSF/byHeadline/Do%20you%20need%20an%20AFS%20licence%3F

· Regulatory Regime Characteristics

· Relevant criteria for assessing the efficiency of a supervisory regime include:

· cost effectiveness,

· transparency, and

· accountability.

· However, de omnibus disputandum ! How does one accurately measure transparency and accountability?

· Who Wins?

· Utopia…where for art thou??

· Given the range of different nations, markets and jurisdictions in which the US sub-prime mortgage debacle affected, the question must be “what do those least affected have in common?”

· Australia and Germany and a few other advanced economies suffered slightly or moderately.

· High levels of financial market regulation and monitoring

· Non-negotiable prudential regulatory system

· Strong auditing, fiduciary and solvency reporting requirements

· Low exposure to GFC speculative products

· Insignificant levels of political corruption

· Many alternative models exist and can be made to work effectively under normal circumstances – the question is always about how they will behave in irrational markets.

· Capital Market Regulation Key Issues

· Capital Market Regulation Key Challenges

· Greed and excessively generous remuneration packages;

· Mismanagement/Incompetence;

· Inattentive Boards (Executive management acting with little/no oversight or accountability);

· Failure of internal and external gatekeepers to act on warning signs

· Lack of relevant/appropriate experience/expertise on part of regulators;

· Lack of regulatory funding and legislative authority;

· How much is society willing to pay to regulate the market?

· Complex transaction models that the marketplace cannot properly evaluate for risk.

· Capital Market Regulation Key Questions

· Can there ever be sufficient regulation and oversight or is the attempt sisyphean in nature?

· Is the most effective approach to prosecute an individual scapegoat?

· Does prosecution of companies or individuals act as a deterrence?

· Can real regulation ever be achieved where domestic regulatory authority is fragmented (eg. ASIC, APRA, ASX), and international regulation is victim to corruption and shifting political imperatives?