Throughout the centuries but in particular since the 1970s financial market players have become increasingly creative in mitigating their risk while at the same time striving to increase their returns. However, risk and return relate to each other in an inverse proportional way. The core issue is that risk does not disappear until the obligation that created the risk is settled – an old truth that had been forgotten in the meantime until piles of hidden risks materialised in the financial crisis. Parties may move the risk away to other parties, for example, to an insurer that covers the risk, but this naturally comes at a cost, as the insurer will ask a fee for taking over the risk. Hence, parties aim at using the law to shift risk to other parties without wiping out their returns. There are two main channels to achieve this:
There are two main channels to achieve this:
The first channel is to use the existing law in a creative way. This process could be regarded as akin to creative tax planning where the intended boundaries of the tax law are pushed to an extreme, while still trying to steer clear of illegality. In the context of finance, a similar phenomenon occurs. Parties shape their contracts in the way they regard most favourable, trying to mitigate the risk while at the same time keeping high levels of return. The classical example under English law is the creation of a fix charge over assets of a borrower while at the same time allowing the borrower to continue dealing in the assets, so that it can continue its business and make money. However, fix charges do not permit this in principle. It is rather the device of a floating charge that offers this flexibility. However, the latter offers a weaker position to the security taker. As parties try to get the advantages of both but not the disadvantages, the disadvantages are shifted to third parties, in this case, the other creditors of the debtor. It is only natural that this and similar cases regularly end up in courtrooms because the other creditors demand protection against the creative use of security interests. This continuous cat-and-mouse game comes at the cost of considerable legal uncertainty because the more efficient or creative the contractual arrangements are, the more uncertain is the outcome of future court decisions initiated by those frustrated that the risk has been shifted to them.
The second channel is to make the law itself more ‘efficient’, i.e. change the insolvency rules or the property law. This occurs in particular where governments perceive economic advantages in allowing risk shifts from one group of economic actors to another group of economic actors. To take the most basic example: we are used to the existence of security interests, but why does the insolvency law accept them? The answer is that the possibility of taking security over assets of a borrower encourages lending which, in turn, bolsters investment. In other words, insolvency privileges are afforded to lenders because states consider lending a crucial prerequisite for economic growth. Or, in certain jurisdictions, employee wages are privileged and paid first in the insolvency of an employer – here to maintain social peace and to keep the cost for the social security systems under control. In the context of this course, we will see that legislators sometimes introduce similar privileges for the benefit of the financial industry, for reasons of protecting the economy against systemic risk and economic crises. However, it is sometimes unclear whether these measures truly serve the common good or are geared more towards increasing the returns of the financial industry – a crucial question that merits a separate blog post.
Hence, the basic logic can be summarised as follows: risk and return are inversely proportional. Risk cannot disappear, it can only be mitigated by distributing it. Parties, in their contractual arrangement, attempt to be creative, so that they can optimise the risk/return relation. These very efficient contractual designs, however, bear a certain degree of uncertainty, because they typically go at the expense of third parties (other creditors) which may challenge the legality of such creative contractual arrangement in court. The law accepts risk mitigation, such as security interests, only to a certain degree, as legislators balance the interests of the privileged creditors with those of the general creditors. As a consequence, risk mitigation devices, such as security, collateral, netting and finality, will be enforceable in the event of the insolvency of the borrower only to the extent of what the law accepts.