Finance law reform is a high priority
5.1 Finance law is a high priority for cross border legal initiatives. Banks and the financial markets underpin much of Australia’s international trade and investment. They create and support practical techniques for dealing with credit and settlement risks and many of the other financial risks in international commerce. Finance law helps banks and others in the financial markets to do so, principally by confirming the allocation of financial risks and by requiring prudential safeguards. This means that the particular remedy issues faced by financiers have implications for other participants in international commerce. This chapter outlines and discusses those implications and recommends further work on certain areas of finance law.
5.2 This chapter also discusses electronic commerce. This is an emerging priority for cross border legal initiatives. It illustrates the need for legal support for business opportunities. This is being addressed by the Attorney-General’s Department’s work on electronic commerce law reform which the Commission recommends should be given a high priority. The Commission also recommends a supplementary project – the safe haven’ model – to provide a quicker, more flexible response to electronic commerce issues than the traditional forms of international legal initiative allow.
Banks and international commerce
The central role of banks
5.3 Banks play a central role in virtually all international commercial transactions. The inter-bank payments systems provide a mechanism by which value can be transferred from one person in one country to a different person in a separate country. This is primarily a mechanical function but it is fundamental to effective international commerce. Banks also contribute to the management by their customers of credit, settlement and other financial risks. They do this primarily through international trade finance and through the loans and other financial services they provide for international investments. Banks play this central role partly because of the competitive advantages they have built up as institutions but partly also because of laws which, for prudential reasons, give them a virtual monopoly over the payments systems and preserve their advantages in other banking activities.
5.4 This central role suggests that there should be a special focus on banks, and the laws that support them, in cross border legal initiatives. Many businesses do not have the resources to pursue cross border legal remedies, even if they are made cheaper, simpler and quicker. They rely upon someone in a select first tier’ group to undertake the cross border risk on their behalf. Banks are one of the major groups of institutions that perform this role. It is therefore appropriate to put a high priority on ensuring that cross border legal remedies support the international commerce of banks as this will in turn indirectly benefit others who rely upon them. The aim is not to focus exclusively on first tier’ groups but rather to recognise and pay due attention to the practical remedies they provide for small to medium size businesses and others outside the first tier’.
5.5 This section discusses the cross border legal implications of three areas of bank activity: international funds transfer, international trade finance and the financing of international investment. International funds transfer is discussed in some detail because it illustrates the complexities that can arise in cross border trade and investment and the importance of legal support for business systems. A further role of banks is as a mechanism of international regulation. This is also discussed below.
International funds transfers
5.6 The transfer of funds across international borders relies upon inter-bank payments and clearing systems. These systems have arisen in response to the volume, complexity and costs of making payments in international commercial transactions. The systems in turn require legal support and this is provided through a patchwork of local laws and international arrangements.
5.7 Local laws are relevant because almost all international funds transfers ultimately depends on domestic clearing systems. A payment anywhere in the world in a given currency is almost always ultimately settled through the home clearing system of that country, except to the extent that the payor and payee share the same bank or their banks share the same correspondent for that currency. Thus nearly all US dollar payments are settled by clearance in New York and nearly all Australian dollar payments are settled by clearance in Sydney.[ccxxiv]
5.8 The volume, complexity and costs involved in international payments illustrate the size and force of the commercial factors that lie behind legal initiatives aimed at supporting cross border trade and investment. Legal initiatives cannot create the commerce that delivers the benefits but in many cases they are a pre-requisite. The following figures give a broad indication of the significance of payments systems.
Turnover is a rough guide to volume. The average daily turnover in Australian foreign exchange markets that is attributable to customer based business is estimated at $US9 billion. Australia in turn represents about 2.5% of world turnover.
The benefit of payments systems is that they reduce costs. They bypass the transport and physical delivery of coins or bank notes from the payor to the payee. This eliminates or reduces the cost of storage and transportation as well as the ensuing risk of loss or theft.
The complexity arises from the multiple links in each payment transaction. Each payment in the international payments systems is initiated by the issue of a payment order by the payor to the payor’s bank. That order initiates a series of further instructions from the payor’s bank ultimately to the payee’s bank through one or more intermediary banks. Each inter-bank payment order must be paid by the sender to the receiving bank. The receiving bank must have settlement facilities which may be bi-lateral (ie a correspondent account) or multi-lateral (ie accounts held at a central counterparty). There are various arrangements for allocating legal liability between the sending and receiving banks and each of the intermediary banks. The volume of transactions, and the attachment of liabilities at each link in the transaction, creates the potential for very complex cross border legal issues.
5.9 The primary legal support for payments systems is the law of contract. The rights and liabilities of the payor, payee and each of the banks in the chain of transactions are primarily defined by the contracts between each of them and by agency principles. These principles are then supplemented by specific arrangements for communication of payment instructions between banks by, for example, cable or telex ( wire transfers’) or through telecommunications networks such as SWIFT (see Box 5A). They are also supplemented by clearing house arrangements. These arrangements facilitate the exchange of obligations and their payment, as against simply transferring instructions like SWIFT.
5.10 Clearing houses tend to be national systems rather than international systems like SWIFT. Thus the USA uses Fedwire and CHIPS (see Box 5B). Switzerland has the SIC ( Swiss Interbank Clearing’), the UK uses CHAPS, Japan uses BOJ-NET, and Gaitame-Yen, and Germany uses the EIL-ZV and EAF. Some of these systems are owned and operated by a central bank. Others are owned and operated by private associations.[ccxxvii] There is a variety of legal arrangements underpinning these systems.
The Society for Worldwide Interbank Financial Telecommunication ( SWIFT’) is a non-profit co-operative society organised under Belgian law, and owned by numerous banks throughout the world. The SWIFT system operated by it is a computerised telecommunications network that operates a global data-processing system for transmitting financial messages over dedicated lines among its members and other connected users.
In its current SWIFT II configuration, SWIFT is a central switch system linking numerous and diverse bank terminals all over the world. The central switch currently consists of two slice processors, one situated in the Netherlands and the other in the USA, each functioning as an independent and ad hoc network, linking SWIFT access points. Each country is assigned to a SWIFT access point. Interbank communication is via the SWIFT access points mediated by a slice processor. A system control processor monitors and controls functions of the system but is not involved in routing messages.
More specifically, each SWIFT message travels first on a domestic circuit from the sending bank’s terminal to the SWIFT access point for that country. From there, it continues on an international circuit to the slice processor and onward to the SWIFT access point for the receiving bank’s country. At that point it is routed on the domestic circuit of that country to the ultimate destination of the receiving bank’s terminal. Each message is validated and processed under heavy security.[ccxxviii]
CHIPS ( Clearing House Interbank Payments Systems’) is a New York based automated private sector clearing facility for large value transfers. It is owned and operated by the New York Clearing House Association. It is a central switch communication and net net settlement system where participating banks exchange same-day irrevocable payment orders over dedicated communication lines linking each onto the CHIPS central computer. Credit risks are controlled by bilateral credit limits, net debit caps, collateral, and a loss-sharing arrangement among all participants, effectively providing for settlement finality.
CHIPS settlement takes place at the end of each day banking activity. A relatively small number of settling participants settle both for themselves and for their respective correspondent non-settling participants for which they agree to settle. Multilateral balances of settling participants, incorporating also those of represented non-settlement participants, are settled between net net debtor banks and net net creditor banks over Fedwire at the Federal Reserve Bank of New York. Failure to complete the overall daily settlement, notwithstanding the collateralised loss sharing obligations of all banks, may result in unwinding the settlement. This, however, is quite a remote possibility.[ccxxix]
5.11 In Australia there are several relevant clearing systems, including paper, direct entry, consumer electronic and high value electronic systems (including BITS, RITS and Austraclear). The current systems are subject to rules issued or being developed by Australian Payments Clearing Association Limited (APCA). APCA is a non-listed public company established in February 1992 with a charter to coordinate, manage and insure the implementation and operation of effective payments systems. Its shareholders include the Reserve Bank, each of the four major banks and State and regional banks.
5.12 The volume and speed of international funds transfers requires very precise and certain allocation of legal risks and liabilities, and well developed systems to manage those risks. Any default is likely to lead to a very complex range of legal issues, involving international, national and private arrangements partly based on contract and partly on statute or a multilateral arrangement. The risks fall into essentially three categories.
Herstatt risk arises where a transaction requires the concurrent delivery of payments. For example, a foreign exchange transaction requires a concurrent delivery of two currencies between two counterparties. Unless there is a delivery against payment mechanism, each transfer is carried out separately on the payment date. The bank that has transferred funds and discharged its own obligation incurs a risk that its counterparty might fail to transfer the consideration.[ccxxxi] The timing of international funds transfers is such that some degree of Herstatt risk may be inevitable.
There is also the risk that a bank may fail to make payment or delay in making payment, simply due to administrative error or unclear or misunderstood instructions.
A third risk is that third party fraud may interfere with the funds transfer and any loss resulting from that fraud will need to be allocated between the payor, payee and banks involved in the transaction.
5.13 Preliminary comments from the finance industry indicate that these are significant and continuing issues which will need further attention from a cross border perspective as new technologies and commercial arrangements open up new ways of making payment. The complexity of the cross border legal issues raised by the Swiss Bank case (see Box 5C) and the issues in the ECHO case study (see Box 5D) illustrate the kinds of questions law reform and international arrangements will need to address. The Australian Treasury Operators Association (ATOA) has been active in developing best practice principles for the industry in Australia and has received some international interest in extending those principles to cross border transactions.
Swiss Bank case – overview[ccxxxii]
The Swiss Bank case illustrates the complex issues that can arise when a fraud is effected through electronic payments and clearing systems. Many different jurisdictions can be relevant and the law governing the particular payments or clearing system can be a critical factor.
From the judgment of the trial judge, the material facts are as follows.
In 1989 the Essington group of companies (Essington) engaged an agent to raise $500 million to refinance group debt. During the course of that fundraising the agent together with an employee of the Swiss Bank Corporation (SBC) effected the transfer from that bank to the State Bank of NSW (State Bank) of $20 million as a purported advance to Essington under the refinancing arrangements.
The SBC employee in the Zurich office of SBC (SBC Zurich) prepared documentation falsely showing a $20 million overnight deposit by State Bank with the New York office of SBC (SBCNY) repayable the following day. A SWIFT message was transmitted by SBC Zurich to SBCNY. The SWIFT message generated an electronic CHIPS message from SBCNY to the New York office of the State Bank (State Bank NY) for the transfer of $20 million to the account of State Bank NY in purported repayment of the previous day’s fictitious deposit. State Bank NY then transferred the funds to Essington’s account at State Bank in Sydney. Essington then disbursed the $20 million, in large part by payment of a large commission to its agent but also in discharge of the liabilities of the group, including to State Bank itself.
SBC discovered the fraud and unsuccessfully sought its repayment from State Bank. Litigation over the matter commenced in the Supreme Court of New South Wales in 1989 finalising in 1995 with judgment against State Bank for $12.7 million plus $4 million in interest, credit being given for other recoveries by State Bank.
SBC sought restitution from State Bank and Essington for moneys paid under mistake of fact (among other claims). State Bank countered this by claiming that it had changed its position, in good faith, by disbursing the moneys which were no longer recoverable. At the trial the court held that the CHIPS message did not entitle State Bank NY to treat the funds as available for Essington as it did no more than effect a payment to State Bank (the CHIPS message did not mention Essington).
On appeal State Bank argued that the fraud provisions of the CHIPS rules bound both banks and required SBC to bear any loss. However, the Court of Appeal decided that the CHIPS rules did not bar SBC from succeeding in a claim in restitution against State Bank.
The proceedings were lengthy and complex. Although consideration of New York law in relation to the application of CHIPS rules was ultimately regarded as unnecessary, comments were made by the court about the need for cross border judicial collaboration in the ascertainment of questions of foreign law.
5.14 There have been a significant number of international initiatives to date on various aspects of international funds transfers, including place and time of payment, foreign money liabilities, general payments issues, clearing and payments systems and netting, electronic data interchange, collections, bankruptcy and private international law.[ccxxxiii] The international initiative that has received most attention is UNCITRAL’s Model Law on International Credit Transfers, which was published in May 1992. This model law has not yet been adopted anywhere in the world. The reasons for its apparent lack of success are unclear but may be due to lack of US support as the model law has not been adopted by the USA. It is inconsistent in some respects with US domestic laws and clearing systems rules.[ccxxxiv]
International trade finance
5.15 International trade finance is directly concerned with reducing or removing cross border risk for customers of the bank. There are complications and risks in international trade transactions which are not usually present in domestic transactions. These include direct legal risks, such as the differing legal systems, and other risks which have indirect legal implications, such as geographic separation, difficulties in returning and recovering goods, foreign currencies, international remittance of payments and broader country political or economic risks. In most international trade transactions both the buyer and the seller will wish to control those risks by relying on the safeguards in commercial letters of credit or documentary collections.[ccxxxv]
5.16 Trade finance forms a significant part of Australian bank business and a significant service to Australian exporters and importers in managing cross border legal risk. The law supporting international trade finance has developed over a long period. The primary instruments – bills of lading, bills of exchange and documentary letters of credit – each now have a body of case law and statutory provisions governing their creation, use and enforcement. Their international use has been greatly assisted by the publication by the International Chamber of Commerce of standard terms and conditions, called the Uniform Customs and Practice for Documentary Credits (UCP). The standard terms and conditions are commonly incorporated in the terms of the credit and thereby become enforceable.[ccxxxvi]
ECHO and settlement risk[ccxxxvii]
Settlement of foreign exchange (FX) trade requires the payment of one currency and the receipt of another, often in different jurisdictions and different time zones. Without an adequate settlement systemthere is the risk that one party to an FX transaction could pay out the currency it sold but not receive the currency it bought. Drexel, BCCI and Barings illustrate the potential problems.
In 1990 the Drexel Burnham Lambert group (DBL) collapsed leading to settlement problems between its UK subsidiary (which traded as principal in the FX and gold markets) and various counterparties in these markets.
In 1991 the Bank of Credit and Commerce International (BCCI) collapsed causing principal loss to UK and Japanese foreign exchange counterparties of the failed institution. Because settlement of counterparty trades was occurring in different time zones and involved transaction queuing on the relevant automated clearing systems (CHIPS and the Foreign Exchange Yen Clearing House) the BCCI liquidator was able to freeze assets and cancel settlement payments to the detriment of the counterparties.
The unforeseen collapse of Barings Bank in 1995 caused a problem in the ECU clearing system requiring a counterparty bank to borrow to cover an FX trade Barings Bank could not complete. Without this action by the counterparty bank the settlement of more than ECU 50 billion in payments between the 45 banks participating in the clearing on that day would have been frustrated.
Central banks have paid close attention to settlement risk and have set out various requirements for bilateral and multilateral netting and settlement arrangements to ensure it is minimised.
The Exchange Clearing House Limited (ECHO) provides multilateral level netting and settlement services. ECHO is a privately owned company controlled by a group of major banks which sets certain financial and other criteria for membership. To address the central bank requirements it provides details of maximum and minimum FX settlement risk twice daily to its users, it enables banks to mark limit usage so that the bank can trade its FX exposure down below its own limit, it is operational 24 hours a day, reconciles receipts in real time on the due date and does not release funds until all receipts from the previous day have been confirmed as received.
The multilateral nature of ECHO’s clearing house system inevitably creates the potential for legal issues to arise. Where an Australian payment or participant is involved those issues may or may not be determined under Australian law, taking into account (among other things) the law governing ECHO’s rules. Some examples of the potential for issues to arise include
as ECHO is a multilateral netting arrangement, failure of one institutional participant may result in calls on other members and could expose other participants to significant financial exposure or collapse
if a member of ECHO is unable to meet calls on funds this could cause systemic problems with significant legal dispute over such issues as jurisdiction and liability
a technical payment failure within the ECHO system could lead to failure outside the ECHO system raising questions about the liability of ECHO itself as well as reflecting adversely on the reputation of ECHO s individual members
as ECHO has access to bank accounts as part of its settlement arrangements with members this may raise the possibility of exposure to fraud.
5.17 The UCP is an example of a successful international legal initiative. It is a significant legal support for international commerce, enhancing the speed, volume, and ease of international trade transactions. Several factors are relevant to its success and should be taken into account in the way in which international legal initiatives are developed and in any expectations of what they may deliver.
The UCP derived from a long period of industry practice. The first UCP were published in 1933 and they arguably reflected industry practice developed over more than 100 years.
The UCP are regularly revised to meet changing patterns of international trade. Revised versions were issued in 1951, 1962, 1974, 1983 and 1993.
The UCP are confined to a narrow issue, in essence the documentary evidence required to confirm a payment instruction. They separate the issue of payment from the underlying features of the transaction. A number of the preliminary comments received by the Commission indicated that an international legal initiative is more likely to be successful if it is focused very narrowly since this allows more precise rules to be formulated.
The preliminary comments received by the Commission suggest that there are no significant Australian law issues on commercial letters of credit or documentary collections that warrant high priority.
5.18 A closely related issue, electronic data interchange (EDI), does warrant attention. Substantial attention has already been devoted in Australia to the issue of electronic bills of lading relevant to trade finance but there are other continuing international legal initiatives on EDI in which Australia should participate.[ccxxxix] The International Chamber of Commerce has published uniform rules of conduct for the interchange of trade data by teletransmission (UNCID) which set out high level indicators of the approach to be taken to different EDI related issues. The UN working group on EDI published draft uniform rules in 1993 but these have not yet been widely adopted. There is also a European program developing a standard form EDI agreement (the TEDIS program), a standard EDI agreement published by the UK EDI Association and various industry specific EDI arrangements.
Financing international investment
5.19 Banks play a significant role in financing international investment although the services that they provide are not as dominant as their funds transfer or trade finance services. There are other sources of finance and financial services for international investment, including investment funds and bond markets. The pattern and growth of Australia’s international investment is set out in chapter 2. Australian banks are involved both as lenders on projects outside Australia and as lenders within Australia to businesses whose revenues or assets are located outside Australia.
5.20 By contrast with international trade finance, cross border lending has largely developed without any international legal initiatives. Indeed, the Eurobond market developed by avoiding both national and international regulation. Lenders in international projects rely primarily on the structuring of the transaction to limit their credit risk and on the law of contract. This leaves significant gaps in the management of legal risk. Notably they are exposed to all of the difficulties associated with the enforcement of money judgments that are outlined in chapter 4 and Part II of this report. They, and their customers, are also subject to any inadequacies in the property laws of the countries in which the relevant project or asset are located. This is a particular problem in relation to intellectual property and the taking of security.[ccxl]
5.21 Any legal initiatives in this area should focus on the legal support required for the investment rather than the lending activity. Funds transfer and trade finance rely heavily on the banks’ capacity to provide those services and this depends in part on their legal support. By contrast the financing of international investment depends primarily on the credit capacity of the business or project in which the investment is being made. The role of taxation is also central to the financing of international investment, in particular withholding tax and the availability of relief from double taxation. This means that legal initiatives should focus primarily on the business or project. This focus will tend to relate more to local laws than international initiatives.
5.22 Nonetheless the two property issues noted above – intellectual property and the taking of security – warrant some international attention. Intellectual property already has a high international profile and is part of the WTO agenda. The law on personal property securities has received less international attention. Unidroit is currently working on a draft convention for the taking of securities over major mobile equipment regularly involved in cross border trade, such as airframes and aircraft engines. UNCITRAL has published a preliminary draft of uniform rules on assignment in receivables financing. There has also been some attention given in local law reform initiatives to the system of registration of personal property securities set out in Article 9 of the US Uniform Commercial Code.[ccxli]
Banks as a mechanism of international regulation
5.23 As a result of their central role in international commerce banks have been used by national governments to assist in international regulation. A stable banking industry is generally considered essential to any economy. Banks are therefore subject to licensing requirements and prudential safeguards in most countries. Some of these prudential safeguards are now applied on an international basis (for example, capital adequacy rules). In many countries banks are also used to assist in the detection and prevention of money laundering.[ccxlii] Banks are usually required by statute to provide this assistance. The use of banks in this way affects the general pattern of the laws applying to banks in cross border transactions, particularly regulatory arrangements. Regulatory arrangements will be examined in the Financial System Inquiry announced by the federal Treasurer on 30 May 1996.
5.24 The central role of the banks should not obscure the emerging importance of other players and markets. Funds managers, superannuation or pension funds, insurance companies and other non-bank financial institutions are all taking an increasing role in international finance. The past two decades have also seen the emergence of new and significant international financial markets, particularly in exchange-traded and over-the-counter derivatives. These new players and markets have an important and developing role in cross border risk management and therefore form part of the context for any analysis of cross border legal risk.
5.25 The central legal issue for these players and markets is the impact of local regulatory regimes. The collapse of Barings Bank in 1995 due to losses incurred in trading on the Singapore futures market illustrates how the prudential safeguards required for a futures exchange can limit the consequences of fraud. In the Barings case, transactions which were essentially cross border in commercial significance were made domestic’ by exchange trading rules and then supplemented by the insurance’ of margin and deposit requirements. This effectively limited the persons who suffered damage from the fraud to Barings’ shareholders and staff. The potential need for cross border legal remedies was effectively reduced by the structure of the Singapore futures market.
5.26 There are some further areas where regulatory or legal support is required. Netting stands out as the highest priority. It is discussed later in this chapter. In some cases the work required may be to remove uncertainties or complexities that have arisen out of the application of existing legal principles to new markets. It was submitted to the Commission that financial markets can be distorted or inhibited by local regulations which have not adjusted to developments in these markets.
5.27 An example of this kind of problem that was given to the Commission is the difficulties faced by funds managers wishing to offer foreign investment products in Australia. It was submitted that the combined effect of the foreign investment fund tax legislation and the prescribed interest provisions of the Corporations Law is to make such offerings commercially impractical notwithstanding that the Australian Securities Commission has issued a policy statement setting out the circumstances in which such offerings would be permissible.[ccxliii] The best support for financial markets may therefore come from legal initiatives that have a dual focus: ensuring that prudential safeguards are structured around the development of markets rather than institutions and ensuring that there is ongoing attention to identifying and promptly removing legal uncertainties and unnecessary complexities.
Cross border banking issues
A high level of exposure
5.28 The nature of its business gives the banking industry particular exposure to cross border legal risk. Banks have for many years dealt with customers, payees and correspondent banks in other countries and have had branches in other countries. They have therefore had much experience with the problems of jurisdiction, evidence, asset recovery and so forth outlined in chapter 4 and in Part II of this report. In addition some aspects of banking practice make those problems more acute. Two longstanding issues are the doctrine of tracing and banker/customer confidentiality. An emerging issue is the impact of electronic banking.
Banks, tracing and constructive trusts
5.29 Banks may become exposed through the doctrine of tracing where assets have been fraudulently misappropriated and the proceeds have been deposited in a bank account or, more commonly, transferred through a chain of bank accounts and through several different countries. If the proceeds have been lost or become irrecoverably intermixed with other funds the victim of the fraud may seek to recover from other participants in the chain of transactions either on the basis of negligence, restitution or constructive trust. Banks are likely to receive such claims because they are invariably involved in the chain of transactions and, unlike the fraudster, have a reputation to consider and a presence and assets in the jurisdiction. The Swiss Bank case (Box 5C) illustrates how this exposure can arise.
5.30 Tracing misappropriated funds can be a very complex process.[ccxliv] Much evidence is needed to establish each link in the chain of transactions and the bank’s culpability, if any. There can be conflict of law issues with important practical consequences.[ccxlv] There is also uncertainty regarding bank liability for knowing assistance or knowing receipt in misappropriation cases. While English courts have recently held that banks will only be liable if they have actual knowledge of the fraud Australian courts continue to apply a lower threshold test for bank culpability whereby constructive knowledge will be attributed to the bank if its knowledge of the circumstances would indicate the real facts to an honest and reasonable person.[ccxlvi] A further complication arises in the case of multi-jurisdictional transactions involving civil law countries which may not recognise the doctrine of tracing. As the doctrine is one of the principal elements in many restitutionary claims, its complexity, uncertainty and lack of international consistency need attention.[ccxlvii]
5.31 Australian law, like the law of many jurisdictions, provides that a bank has a duty of confidentiality to its customer. Some jurisdictions supplement this duty by statute so that breach of the duty will give rise to criminal as well as civil proceedings. There are also differences between jurisdictions in the amount of information a bank is required to collect about the identity of its customers.[ccxlviii] The duty of confidentiality can be a significant impediment to collecting evidence and tracing assets, particularly when it is compounded by only holding limited information about the customer’s identity. Given the central role of banks in many international commercial transactions, this can often be an issue in cross border litigation in which the bank is not involved except as a potential source of information.
5.32 Privacy is an additional consideration. Banking raises privacy concerns precisely because it is data intensive. The law has recognised that a balancing of the public interests in privacy and in law enforcement is necessary. Certain laws already override both statutory and common law privacy and confidentiality requirements. For example, the Financial Transactions Reports Act 1988 (Cth) requires banks to report certain transactions to AUSTRAC. More generally, Information Privacy Principle 11 of the Privacy Act, which includes exceptions to the general rule of non-disclosure, allows for disclosure for law enforcement purposes.
5.33 The European Union’s Data Protection Directive has become highly influential in the development of privacy legislation throughout the world.[ccxlix] In developing it the EU was concerned not to impede the efficiency of retail cross border payment systems or to raise unnecessary obstacles to the development of more efficient cross border payment systems. Nonetheless there remain doubts that privacy laws can keep up to date with banking developments. One commentator on the EU Directive and its impact on payment systems has concluded that:
The proposed Directive in its current form can function only if there is a large number of derogations at national level. The control over the banking sector is therefore passing imperceptibly from bank regulators to data protection authorities, and at the same time the data protection authorities are slipping imperceptibly into the shoes of the enterprises.[ccl]
5.34 The impact of electronic banking through payment systems and EDI has been briefly canvassed earlier in this chapter. It raises many other issues including problems of evidence, methods of dealing with electronic fraud, questions of liability for systems failures and other issues which do not arise from traditional paper based methods of banking. Data security and electronic money illustrate the types of considerations that are emerging.
5.35 Banks need to keep data secure for several reasons: to satisfy customer requirements of confidentiality and privacy; to maintain their own rights over the use of the data; and to ensure the integrity and availability of the data so that it can be efficiently used. In the context of cross border remedies one of the particular issues in that third category is when electronic data will be adequate for statutory purposes and for the purposes of evidence. It is necessary to give express recognition in national legislation and by regulatory authorities to the efficacy of electronic records.[ccli] Australian law is well advanced on this with the recent enactment of the federal Evidence Act 1995 which arguably provides for the admissibility of electronically generated business records (for example, SWIFT transaction print outs).[cclii]
5.36 Currently there are a number of electronic money projects in various stages of development. The Mondex electronic cash system, developed by the National Westminster Bank, provides electronic money in the form of smart cards. The four major Australian banks have purchased an equity stake in Mondex International which gives them rights to the product in Australia.[ccliii] In the Netherlands Digicash is experimenting with payment services using ecash’, electronic money on the Internet.[ccliv] Electronic money essentially involves the electronic processing of debit and credit data. To be effective it is necessary to be able to verify the authenticity of the data and to prevent its multiple use.
5.37 The technological features of electronic money have implications for the legal frameworks for national currency systems.[cclv] The legal concept of money is generally discussed in the context of national jurisdictions since the use of a country’s currency is generally limited to within the country where the central bank is a sole issuer of the currency.[cclvi] By contrast electronic money lends itself to international circulation and its use is less readily supervised by national regulators: it is not immediately identifiable from the data transmission whether the data represents electronic money or some other form of information; ownership of the money may be anonymous; the money can be accessed from anywhere on the network and transferred to anywhere in the network regardless of geographical boundaries.
If money is transformed into electronic data and banks need no physical offices, it is likely that there will emerge virtual banks in a regulatory haven (but not a tax haven) where banks have no regulatory burden.[cclvii]
Finance law reform
The need for systematic reform
5.38 The comments above indicate that there is a range of interrelated finance law issues that need attention both to assist Australia’s banking industry and more broadly to assist Australia’s international trade and investment. The issues are partly systemic, such as those relating to payments systems, and partly directed at the impact of laws on particular transactions, such as the issues relating to bank confidentiality and tracing. The priority areas are: netting and set off, payments systems, bank confidentiality and privacy, tracing and restitution, and the taking of securities.
5.39 The terms of reference require the Commission to report on the scope for the Commission to review and report further on the matters addressed in this report. The Commission is an appropriate body to review this kind of finance law reform and would be pleased to assist. The terms of reference should be limited to the nominated priority areas of reform listed above, each of which is discussed in more detail in following paragraphs. In addition the further work in this area will involve not only legal analysis but also input from the Reserve Bank, APCA, trading banks and others in the financial community, as well as Australian firms which use financial services in their international trade and investment. The Privacy Commissioner should be consulted on the privacy issues outlined above.
Recommendation 30 – finance law reform
The Attorney-General should refer to the Australian Law Reform Commission Australia’s laws and regulatory practices relating to cross border financial transactions with a view to reporting within two years on the priority areas for reform recommended in this chapter.
Netting and set off
5.40 Close out netting has been recognised for some years as a major legal issue for the financial markets.
The bi-lateral or multi-lateral netting of contractual payments due on settlement dates, and of unrealised losses against unrealised gains in the event of a counterparty’s default, is the most important means of mitigating credit risk. By reducing settlement risk as well as credit exposures netting contributes to the reduction of systemic risk.[cclviii]
5.41 The law in Australia is generally supportive of close out netting although for some years it has been recognised that there are some residual uncertainties.
A master netting agreement’ containing certain provisions can result in a party being entitled to net its obligations under derivatives with a counterparty. However, legislation dealing expressly with the ability of a party to net its obligations under derivatives would help. Having such legislation (similar to that enacted in the USA) would mean that both the Reserve Bank of Australia and participants in the market would have an express legislative framework in which to authorise and create netting arrangements.[cclix]
5.42 The Companies and Securities Advisory Committee (CASAC) is currently reviewing Australian law and practice relating to exchange traded and off market derivatives. It has been working with the financial community on the issue of close out netting and has recently released a draft discussion paper on the regulation of OTC derivatives markets[cclx] as well as a draft report on the regulation of on-exchange derivatives markets.[cclxi] It is expected to release a final report by the end of 1996. The issue of close out netting is thus being addressed. The Commission’s consultations indicate that prompt consideration and response to CASAC’s report will be a significant step in finance law reform.
5.43 The work on finance law reform should also consider the law of netting and set off beyond close out netting for the derivatives markets. It is a broader issue that can have benefits not only for cross border banking generally but also more directly for the trading relationships of Australian firms. In many respects set off is one of the fundamental remedies in cross border banking.
Remedies in cross border banking fall, in important respects, into the category of self-help. The default clause in a loan agreement, and the right of set-off are well known examples. Self-help looms large because of practical advantages such as speed and the legal, and other, uncertainties surrounding the alternative of invoking the judicial machinery. Yet these self-help remedies are not legally clear cut; in cross border banking this is compounded by the conflict of laws problems to which they give rise.[cclxii]
5.44 The direct benefit of set off to an Australian firm was well illustrated in one of the submissions to the inquiry.
Hence, to take a simple example, in a transaction governed by the law of an Australian State where A is an Australian business person dealing with an Indonesian company, C and A owes C $10 000 but is himself owed $8 000 the result of an exercise of set off is that A’s only enforceable obligation to C will be to pay the balance, namely, $2 000.
The effect of the exercise of the set off is thus as if A had sued C for the $8,000 in an Australian court and had recovered his debt in full. The procedure is, however, both less costly – since there are no proceedings (unless the exercise is contested) – and less problematic since it avoids the need to enforce a judgment where C fails to pay the judgment debt. An exercise of set off is particularly advantageous where an action of recovery for the debt would otherwise have to be brought in Indonesia with all the additional expense and uncertainty that suing in any foreign jurisdiction (and particularly one that offers only limited recognition to foreign judgements) inevitably entails.[cclxiii]
5.45 The law of set off in Australia is complex and there can be problems in the exercise of contractual set off.[cclxiv] While many foreign jurisdictions recognises some form of set off there are significant differences in doctrines and application.[cclxv] It has been submitted to the Commission that Australian law on set off should be reviewed with a view to establishing a new limited statutory right to set off pre-insolvency. This would make the law on set off simpler and more certain and would extend the benefits of set off to firms which had not considered including it in their contracts.[cclxvi] The Commission agrees with this submission. The Commission also considers that the review of the law of set off should extend to a review of the prospects for greater international consistency or cooperation on set off. As one of the most serious limitations on the effectiveness of set off arrangements lies in the insolvency of either party any such international initiatives by Australia in the set off area should be coordinated with Australia’s participation in the UNCITRAL Working Group on Insolvency.[cclxvii]
Recommendation 31 – netting and set off
The priority areas of finance law reform should include Australian law on netting and set off. Netting should only be considered in relation to cross border transactions not covered by CASAC s recommendations on netting.
5.46 The significance of payments systems for Australia’s international trade and investment is outlined earlier in the chapter. They are a priority for international legal attention because of the significant jurisdictional issues they raise and emerging concerns that Australian participants might suffer losses or incur liabilities with only limited input into the legal framework governing those systems, either by way of individual contract or national regulation. The Swiss Bank case (Box 5C) illustrates the jurisdictional difficulties. The ECHO case study (Box 5D) illustrates the concerns about the potential losses and liabilities.
5.47 These issues need to be explored more fully. They have implications not only for bank regulators but also for participating institutions, the back offices of trading institutions, and traders. An illustration of the types of issues that need to be considered from a legal perspective can be found in the European Union’s November 1993 report entitled Minimum common features for domestic payment systems’. That report suggested 10 principles to serve as guidelines for payment systems within the European Union:
access to interbank funds transfers systems should be limited to credit institutions and properly supervised bodies
no discrimination in access
transparency of access criteria
introduction of real time gross settlement systems
enhancement of large value net settlement systems
flexible approach with regard to other interbank transfers systems
sound and enforceable legal basis
technical compatibility and efficiency
pricing policies of European Union central banks
overlap between operating hours.
It is apparent that those principles raise legal policy issues that go beyond the traditional and settled areas of law on liability for default or fraud.
Recommendation 32 – payments systems
The priority areas for finance law reform should include Australia’s legal framework for payments systems and the potential for international cooperation on legal issues relating to payments systems.
Bank confidentiality and privacy
5.48 The issues concerning bank confidentiality and privacy have been outlined earlier in this chapter. Recent reports have recommended that privacy legislation in Australia should be extended.[cclxviii] The issue of transborder data flow has been addressed by the OECD in its privacy guidelines.[cclxix] Flowing from those guidelines has been the EC Directive prohibiting transfers of data to third countries unless the data will be guaranteed an adequate level of protection in that third country.[cclxx] This would have significant implications for Australia’s banking industry and its international transactions. Any privacy legislation would need to be carefully framed to fit with bank confidentiality, rules of evidence and data security law. It would also need to take into account the laws on those topics and other jurisdictions, such as the European Union Data Protection Directive. This is an area which requires substantial legal and policy analysis and substantial input from the finance industry and others in the community.
Recommendation 33 – bank confidentiality and privacy
The priority areas for finance law reform should include Australian law on bank confidentiality and privacy, including recommendations on the application of privacy legislation to Australia’s finance industry and the prospects for international consistency on bank confidentiality, privacy and related data security law issues.
Tracing, restitution and constructive trusts
5.49 The complexity and other concerns with Australia’s law of tracing, restitution and constructive trusts are outlined earlier in this chapter. Australian law on tracing, restitution and constructive trust seems to be unduly complex. This is of particular concern with the increasing potential for undue enrichment claims to arise in cross border transactions. The complexity reflects the very broad scope of situations that are covered by Australian law on tracing and restitution.[cclxxi] It is not feasible or commercially appropriate to seek to simplify the law across that broad canvas. However there is a need to review the differences emerging between Australian and English law on such issues as knowing assistance and knowing receipt in relation to claims on banks and to assess whether Australian law can be simplified for the purposes of undue enrichment claims on banks.
Recommendation 34 – tracing and restitution
The priority areas for finance law reform should include
· the prospects for simplifying the doctrine of tracing in relation to claims made on banks and making the doctrine more internationally consistent, and
· improvements that can be made to Australia’s law on restitution in relation to claims of undue enrichment made on banks.
5.50 The need for adequate laws supporting the taking of security for financing transactions has been mentioned earlier in the chapter. Nonetheless in the Commission’s view it is premature to include this in the finance law reform program. Australia’s law on personal property securities is currently under review. The federal government is currently considering its response to the Commission’s 1993 report on Personal Property Securities.[cclxxii] International consistency is one of the issues that will need to be taken into account in that government response. Until the government has responded to that report it would be inappropriate for there to be any further review of Australian law on personal property securities or for Australia to promote any particular project seeking international consistency outside Australia.
5.51 In this report electronic commerce’ includes all business transactions on, or using facilities provided by, electronic networks and extends to non-transactional interchanges such as electronic mail and personal entertainment. There has been much discussion in the last couple of years about the opportunities that are expected to be generated from electronic commerce.[cclxxiii] Some of these opportunities are yet to be realised but others are already being actively pursued. The discussion earlier in this chapter illustrates that in the banking industry electronic commerce is already significant, particularly in the form of electronic banking. It is expected that electronic commerce will become increasingly important in many other service sectors. Its influence in entertainment and advertising is already apparent. There are also signs of its emerging importance in training and health care. These services in turn have an impact on business practices and markets in other parts of the economy. As a result electronic commerce is encouraging new content industries, the reaching of new markets and the re-engineering of business operations and service deliveries.[cclxxiv] The US Commerce Department has estimated that electronic purchasing turnover will grow to approximately US$3 000 billion by 2005.[cclxxv]
5.52 Electronic commerce reinforces the high priority of finance law reform.
The on-line economy cannot be achieved without Australia creating a world class electronic payment system for consumer transactions as well as business-to-business transactions.
The ability to charge customers interactively over trusted networks is an essential pre-requisite for a viable consumer on-line service industry. Without easy-to-use payment systems, the provision of content cannot develop into a viable industry. To date in Australia there has been only limited progress towards setting up such payment systems, in contrast to the United States and Europe. Australian banks and credit unions are, however, progressing in trialing of electronic purses’, in the form of smart cards.[cclxxvi]
5.53 There is a need for legal support for electronic commerce but not a legal straightjacket. The role of Australian law should be to facilitate national goals for electronic commerce such as enhancing business and trade, ensuring broad access, encouraging use and innovation, and ensuring respect for the rights and sensitivities of users, including interests such as privacy and freedom of communication. Some commentators are concerned that governments may overreact to fears about the new technologies or introduce measures with unintended consequences, for example through regulation of content, gambling, money flows or encryption or through taxes.[cclxxvii]
5.54 For Australian law the key issues are intellectual property, content regulation and liability issues.[cclxxviii] Intellectual property laws affect both the incentive to create and publish content on electronic networks and also access to and use of that content. They are central to the development of electronic commerce. It is generally recognised that the current intellectual property laws have difficulty responding to the new technologies and patterns of commerce involved in electronic networks, and require significant amendment or transformation.[cclxxix] The other major content issues include: privacy and data security; defamation and censorship; and the allocation between participants of liability for wrong or damaging content and for other failures in the electronic networks.
5.55 There are also other aspects of commercial law for on-line commerce in goods and services that need review and adjustment, including evidentiary issues, consumer protection and product liability, data security, fraud and crime.
Law reform initiatives
5.56 The cross border character and potential of electronic commerce means that legal issues of this kind are of common concern internationally. They are faced by all countries whose firms are involved in electronic commerce. They will be addressed partly through local law making and partly through international initiatives, such as UNCITRAL’s work on EDI and the European Union’s Data Protection Directive. To ensure that the Australian legal system develops in line with Australian goals, Australia must be fully involved in the relevant international initiatives and must take them into account in its domestic law making. At the same time it will be important to keep Australian law as consistent with international practices as possible.
5.57 At a domestic level Australian laws, both federal and State, need to be thoroughly reviewed to identify aspects which impede or restrict the adoption of efficient electronic practices. Impediments can arise in various ways including lack of recognition or validity of electronic transactions, requirements for written instruments or records, and a lack of uniformity in State and Territory laws that discourages efficient electronic practices.
5.58 The need for legislative change has been recognised. In September 1995, the then Attorney-General, Michael Lavarch, agreed in principle to legislation, if necessary, to resolve legal issues posed by implementation of electronic commerce and agreed to the establishment of an expert group to define the form and scope of that legislation. Work had commenced on this in the Attorney-General’s Department before the change of government. The Attorney-General, Daryl Williams, has recently agreed to the continuation of this initiative. It is understood that the expert group is soon to be established with the objective of reporting as soon as possible and preferably no later than October 1996.
5.59 The Attorney-General’s Department is responsible for this project. The Commission understands from the Attorney-General’s Department that the project will be undertaken in two stages. At the first stage, the expert group will examine the legal issues arising in the implementation of electronic commerce. The expert group will then make recommendations. Members of that expert group are to be selected from a number of business, legal and other specialist organisations. Once this initial scoping task has been completed, the report of the expert group may be referred to a more broadly constituted group for development of any necessary legislation.
5.60 In the Commission’s view the review of the legal implications of electronic commerce should be given a high priority. The indications from this feasibility study are that to address electronic commerce issues effectively, particularly those arising in relation to Australia’s international trade and investment, the legal issues considered should include federal laws, uniformity of State and Territory laws, and relevant international legal and non-legal options. The Commission understands from the Attorney-General’s Department that it is expected that the expert group will adopt a broad approach of that kind. The Commission would be pleased to assist on any of the cross border legal implications of electronic commerce if the Attorney-General wishes to refer this aspect of the topic to the Commission.
Recommendation 35 – electronic commerce law reform
The Attorney-General should commission a comprehensive review of the legal implications of electronic commerce, including a review of the implications of electronic commerce for federal laws, uniformity of State and Territory laws and relevant international legal and non-legal options. The Commission notes that preparatory work on some parts of this review has already been commenced in the Attorney-General’s Department.
Safe haven project
5.61 The indications from this feasibility study are that an advantage could be created for Australian firms if Australian law could be adjusted quickly to meet issues arising in relation to electronic commerce. There is a need both for greater legal certainty on some points and for greater legal flexibility on others. Timing is a key factor. If regulatory difficulties or legal uncertainty affecting a commercial venture cannot be resolved promptly, the venture may lose its commercial viability.
5.62 Traditional methods of addressing business law issues are not quick enough for this purpose. They need to be supplemented by shorter term techniques that are consistent with the broader law reform process but provide more immediate and specific legal certainty and flexibility. For example, the uniform law reform on electronic commerce discussed above is essential and must be given a high priority. However, as a practical matter national uniformity is likely to be hard to achieve and may suffer from delays. This has been Australia’s experience with other uniform laws such as the Corporations Law, the Credit Code and most recently the Evidence Act. The problem is compounded if legal principles need to be agreed internationally to be effective. Developing agreed principles through the traditional international institutions is a slow process, often measured in decades.
5.63 Traditional methods of reform also have other shortcomings. Legal initiatives concerning electronic commerce will need to focus as much on deregulation – removing the constraints of inappropriate laws (for example, requirements for written instruments of transfer) – as they do on new laws. This is difficult to do on a broad generic basis when addressing a wide range of commercial activity, but much easier on an interim, case-specific basis.
5.64 In light of those factors the Commission suggests a short term experimental project to design and test a safe haven’ model for the development of on-line electronic trading and investment facilities. The aim would be to develop a new technique for providing legal certainty and support within the framework of existing laws but more quickly and more specifically than is possible through comprehensive legislative reform designed to set out broad principles of law. The safe haven model is intended to be supplementary to the electronic commerce law reform project discussed above and should be developed and administered consistently with that broader law reform.
5.65 The safe haven model could provide specific legal support in two ways.
It could provide that certain types of electronic trading and investment facilities would be exempt from certain types of regulatory control (for example aspects of the Corporations Law) if they satisfy certain conditions (for example financial capacity, prudential safeguards). The exemptions could be provided by defined categories or by a system of rulings (for example similar to ATO rulings).
Second, the model could set out supplementary rules to current Australian law on use and liability issues to give greater certainty and support to the particular electronic facilities covered by the model (for example clarifying the extent of rights to use data, or allocating liability for damage resulting from content distorted by systems failure). These rules might take the form of deemed or optional standard terms and conditions for particular categories of transaction.
5.66 The model would be designed primarily through adjustments to Australian law. However if it were necessary and achievable, the project could seek bilateral or selected multilateral adjustments to make the model work. For example, if the particular electronic facility was concerned mainly with commerce with the UK and the USA, and it was necessary to have regulatory cooperation on the interpretation of certain securities law issues, it might be possible to develop a protocol between the relevant national regulators for this purpose.
5.67 The model would be intended to supplement existing electronic commerce law reform initiatives and complement the current work of the Australian Securities Commission on electronic commerce.[cclxxx] It is intended, for example, that it would fit with the ASC’s current use of its discretionary powers but extend the scope for the use of those powers and also establish similar discretions in other relevant regulators. The ASC’s experience with its existing powers and with the development of safe haven’ models in other contexts, such as derivatives trading, would be directly relevant. The model would also be intended to complement government initiatives on operational aspects of electronic commerce, including the Commonwealth Electronic Commerce Service’ project of the Department of Administrative Services which concerns government procurement and tendering procedures.
5.68 Further work is required in designing the safe haven model in relation both to the scope of the exemptions and rules and to the mechanisms by which they are given legal effect. The model, once designed, also needs to be tested to ensure that it is a cost-effective method of supporting Australia’s electronic trading and investment ventures. This should be done by developing and testing the model against a specific commercial venture. Two potential ventures have been raised with the Commission during the inquiry, one concerning the development of software for an electronic payments system and the other concerning the international publication of investment research. Expressions of interest should be sought for other commercial ventures that might be used to develop and test the model.
5.69 It is likely that the development of the model will require legal analysis, commercial expertise relating to the specific commercial venture, and government participation in relation to securities markets and financial systems. It is therefore suggested that the project be undertaken by a working group with those skills, including in particular representation from the Australian Securities Commission and the Reserve Bank of Australia. Since it will relate to both of their portfolios, the working group should be established by the Treasurer and the Attorney-General, jointly.
Recommendation 36 – electronic commerce safe haven’
The Attorney-General and the Treasurer should jointly establish a working group to design and test a safe haven’ model for the development of on-line electronic trading and investment facilities in Australia. The model would be supplementary to existing law reform and regulatory initiatives on electronic commerce. The project should be completed within 18 months.