CLS Bank International

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1 Version for Publication David V. Skoblow Executive Vice President and General Counsel CLS Bank International 39 Broadway 29 th floor New York, NY Tel: +1 (212) Fax: +1 (212) June 26, 2006 Mr. Mario Nava Head of Financial Market Infrastructure European Commission Directorate-General Internal Market and Services B Bruxelles/Brussel Belgium mario.nava@cec.eu.int Re: CLS BANK INTERNATIONAL Settlement Finality Directive 98/26/EC Dear Mr. Nava, Further to the European Commission's Evaluation Report (the Report) dated 27 March 2006 on the Settlement Finality Directive (the SFD), CLS Bank International (CLS Bank) sets out below some observations on the SFD as it has been implemented in the various EU jurisdictions in which CLS Bank has Members, and in light of CLS Bank's experience in relation to settlement finality issues in jurisdictions outside the EU. For example, CLS Bank has been involved in the preparation and application of recent settlement finality legislation in Hong Kong, Singapore, New Zealand, South Korea, South Africa and Switzerland. 1 CLS Bank is a special purpose bank that provides a continuous linked settlement service that simultaneously settles both payments under a foreign exchange transaction. The service is a private sector initiative designed to eliminate the risk which can occur when each leg of a foreign exchange transaction is settled separately, i.e., one payment could be made and the corresponding payment not received. CLS Bank is based in New York and is an Edge Corporation bank supervised by the Federal Reserve Bank of New York. It is a multi-currency bank, holding an account for each of its Settlement Members (an Account) and an account at each eligible currency s Central Bank, through which funds are received and paid. It settles 15 currencies, including the euro, pounds sterling, Danish Krone and Swedish Krona. 1 In Switzerland, special protections apply to payment systems, although there is no designation process.

2 CLS Bank is designated by the Bank of England for the purposes of the UK legislation which implements the SFD and has been notified to the Commission under Article 10,1 of the SFD. CLS Bank's Rules are governed by English law and each of CLS Bank's Members is an "institution", as that term is defined in the SFD. CLS Bank has Settlement Members in Belgium, Denmark, France, Germany, Italy, Luxembourg, the Netherlands, Spain, Sweden and the United Kingdom, and has obtained fully reasoned legal opinions (the Finality Opinions) in relation to, inter alia, settlement finality issues from leading law firms in each of those jurisdictions. Currently CLS Bank settles instructions relating to foreign exchange transactions, but aims in the future also to settle instructions relating to non-deliverable forwards and FX option premiums and the settlement of instructions relating to other transactions is under review. CLS Bank has 56 Members throughout the world, has settled over 500,000 instructions in one day and, at peak times, has settled instructions with a value of over US$ 5 trillion in one day. Over 700 third parties use the Members of CLS Bank to settle their transactions (including many third parties incorporated in other EU Members States), so CLS Bank's systemic importance extends beyond its immediate membership. In preparing these comments we have limited ourselves to identifying points which have seemed to us of particular importance, rather than commenting on the suggestions and issues already raised in the Report. We support the process which the Commission is undertaking to review and, where appropriate, improve the operation of the SFD. 1. Law of the system 1.1 Article 8 of the SFD states: "In the event of insolvency proceedings being opened against a participant in a system, the rights and obligations arising from, or in connection with, the participation of that participant shall be determined by the law governing that system." In addition, Recital (17) of the SFD states: "Whereas, in the event of insolvency proceedings against a participant in a system, this Directive furthermore aims at determining which insolvency law is applicable to the rights and obligations of that participant in connection with its participation in a system." Whilst it would usually be clear what jurisdiction's law is "the law governing that system" (thus, there is no doubt that English law is the law of the CLS Bank system for SFD purposes), there is less agreement on what aspects of the governing law are to be taken into account in other EU jurisdictions. 1.2 Taking CLS Bank as an example, it is arguable that the applicable English law would be the general law as it applies prior to the commencement of English insolvency proceedings (the general law). It is also arguable that it is English insolvency law that would apply (the insolvency law). Or one could argue that both the general law and the insolvency law would apply (the combined laws). 1.3 The Finality Opinions take slightly differing views on this issue. Most just confirm that "English law" will govern the rights and obligations arising from the system. Other Finality Opinions, however, expressly refer to the combined laws approach. 2

3 1.4 If it is correct to apply the insolvency law or combined laws approaches, the difficulty to be considered as part of the review of the SFD is what is meant by the application of insolvency law. For example, CLS Bank's Members are typically credit institutions and so, in relation to a credit institution with its head office in an EU jurisdiction, the Credit Institutions Winding up Directive 2001/24/EC basically states that it must only be wound up in the Member State where its head office is located. It follows that no English insolvency proceedings can be started in relation to a Member whose head office is in a Member State other than the UK. 1.5 Yet, if one applies the insolvency law or combined laws approach to the SFD, it is English insolvency law which must be applied. Must one therefore deem the Settlement Member to be insolvent under English law, even though it cannot in fact be insolvent under English law because of the Credit Institutions Winding up Directive? If so, that is not an entirely straightforward process. For example, as is the case with many other jurisdictions, there are different insolvency proceedings under English law whose use depends on the nature of the insolvent person's difficulties. For instance, a company which is capable of being rehabilitated is likely to be the subject of administration proceedings, rather than liquidation proceedings. To which English insolvency proceeding would one therefore deem an insolvent Member to be subject? When would these insolvency proceedings be deemed to have started? Does one just try to deem the insolvency proceedings which are closest in nature to those actually started in the home Member State? No doubt there could be many other facts which one would have to assume for this deemed insolvency approach to make sense. 1.6 If, as we believe is the case, there is no guidance to be found in the SFD or the literature surrounding it to indicate how one should deem a participant to be insolvent, does that suggest that the general law only should be applied? It is perhaps easier to imply this construction of the language into the SFD than to imply answers to the questions in paragraph 1.5, although it is arguably inconsistent with Recital (17), quoted above. However, to adopt the general law approach could lead to an unbalanced outcome. For example, English Members of CLS Bank would, if insolvent, be subject to English insolvency law which has certain consequences for finality purposes: e.g., Article 3,1, para 2 validates only certain transfer orders this rule applies in an English insolvency. An insolvent CLS Bank Member from another Member State would, if the general law approach prevailed, only be subject to English general law, which (as a general principle) would consider everything to be enforceable, even transfer orders settled after the cut-off in Article 3,1, para 2. We think it would be curious if the outcome for an insolvent English Member were noticeably different for an insolvent Member from another Member State. 1.7 In short, there is an uncertainty inherent in the text of the SFD which CLS Bank suggests should be clarified. 2. Article 3,1, para 2 and the meaning of "day" 2.1 Article 3,1, para 2 concerns transfer orders entered into the system after the opening of insolvency proceedings and has, in general terms, been implemented into the domestic legislation of the EU Member States in respect of which CLS Bank has obtained legal opinions. However, we are aware of discrepancies in the way the Article has been implemented in various jurisdictions. For example, in France a transfer order is irrevocable 3

4 until 12 midnight on the day insolvency proceedings are opened, irrespective of when it is entered into the system and the settlement agent's awareness. 2.2 Nevertheless, Article 3,1, para 2 has been implemented in most EU Member States. As a result, each of the Finality Opinions in respect of the relevant Member States concludes that transfer orders submitted to the CLS system after the moment of opening of the insolvency proceedings will be binding if "carried out" on the day of opening of the insolvency proceedings and if CLS Bank can prove that it is not aware of the insolvency proceedings until "after the time of settlement". 2.3 First, the expression "carried out" is unclear in this context. Does it mean (as CLS Bank proposes it should) when a transfer order is settled in accordance with the rules of the system? If so, can the language be clarified along these lines? This would also help to clarify what "settlement" might mean where used later in the paragraph in relation to the settlement agent's awareness. 2.4 Secondly, most jurisdictions view "day" in the context of their own laws. However, with an English law-governed system like CLS Bank, this construction introduces a potential one hour mismatch between GMT (or British Summer Time during the summer) and CET. For example, interpreting "day" according to CET, in practice reduces by one hour the time within which the transfer order can be carried out. One of the other Finality Opinions reasons that GMT/BST should be the appropriate basis for determining what is meant by "day", since the Finality Directive was intended to facilitate the operation of designated systems by providing for the application of the insolvency laws of a single jurisdiction. CLS Bank proposes that "day" be interpreted in line with the law of the system (i.e. English law in CLS Bank's case), not least because this would be consistent with the principle of having regard to the system's governing law in interpreting its effect generally. 2.5 Thirdly, Article 3,1, para 2 requires the settlement agent etc. to prove that, at the relevant time, it was not aware of the opening of insolvency proceedings. This raises the customary logical problem of how can one prove a negative. How could CLS Bank prove that it did not know something? All it can sensibly demonstrate is when it did know something. CLS Bank therefore proposes that the burden of proof be changed in this situation so that the person challenging the system's actions must prove that the settlement agent etc. did know of the opening of insolvency proceedings at the time in question. 3. Finality of pay-ins 3.1 You will have noted above that the amounts being settled through the CLS Bank system are considerable. As stated above, these amounts are settled through Accounts for each Settlement Member maintained by CLS Bank on its books and records. CLS Bank also has an account with each central bank for each currency for which it provides settlement services. The design of the service draws a clear distinction between the funding of payments and the settlement of Instructions. Funding occurs on a net basis between CLS Bank and its Settlement Members, while the settlement of Instructions occurs on a gross basis between Members through Accounts on the books of CLS Bank. Although funding and settlement are legally separate processes, the two processes are linked and operationally run in parallel. Even once the netting process has been completed, the absolute amount of pay-ins made by CLS Bank's Settlement Members is also significant. 4

5 3.2 Nevertheless, there remains some residual uncertainty whether pay-ins made by Settlement Members to CLS Bank to satisfy their netted obligations are transfer orders within the meaning of the SFD. The systemic value of such pay-ins being final and irrevocable is, to CLS Bank's mind, clear: the final receipt by CLS Bank of the funds is an essential part of the larger settlement and payment process which CLS Bank is offering. CLS Bank believes that clarification regarding the scope of protections offered by the SFD in connection with funding of payments would be helpful. 3.3 In this context, we draw your attention to the finality legislation introduced in Hong Kong, Singapore, South Africa and Switzerland since the implementation of the SFD, where the protected payments include those made in respect of pay-ins. To cite one example, section 7 of Singapore's Payment and Settlement Systems (Finality and Netting) Act 2002 states: "(1) This section shall apply where the rules of a designated system provide that (a) (b) the transfer of funds into and out of an account of a participant; the settlement of any payment obligation; or (c) the settlement and transfer of book-entry Government securities, is final and irrevocable. (2) Not withstanding anything to the contrary in any written law or rule of law, any transfer or settlement referred to in subsection (1) shall not be reversed, repaid or set aside and no order shall be made by any court for the rectification or stay of such transfer or settlement." 3.4 A provision of this kind allows the rules of a system to set out what elements of the settlement process will be treated as final and irrevocable, thereby removing any uncertainties. CLS Bank believes that a clarification in the SFD would be useful as a way of enhancing the finality protections provided by the national payment systems by ensuring that, in the insolvency of an EU participant, the payments made by that participant into a designated system, and made by that designated system to the participant, would be final if the rules of that system say so, even though they are not the direct result of a transfer order of that designated system. 5

6 4. Third party transactions 4.1 A related issue is the systemic risk presented by the transactions of the third parties who use CLS Bank's Settlement Members to settle their foreign exchange transactions (and other market transactions in the future). The arrangements between CLS Bank and its Members are protected by, inter alia, the CLS Rules and CLS Bank s designation for the purposes of the SFD. By contrast, the back-to-back arrangements between each Settlement Member and its third party customers are probably completely unprotected. If the authorities wish to reduce or remove this considerable element of systemic risk from the financial system, it seems to CLS Bank that the definition of "transfer order" should be extended so that it clearly refers to a broader category of payment instructions and arrangements of the type that might reasonably be expected to exist between participants of a system and their customers. Consequential amendments may be required to other definitions in the SFD, such as "netting" and "indirect participant". 4.2 Further, is there a reason why "indirect participant" is limited to credit institutions, and not extended to, for example, investment firms, as the definition of "institution" is? 5. Actio Pauliana The Netherlands and Italy have statutory provisions (often referred to as the Actio Pauliana) which may nullify actions performed without an obligation where the insolvent person and its counterparty knew that other creditors would be adversely affected by the action. In addition, the Netherlands have a comparable civil action in relation to fraudulent conveyances which can be invoked outside of insolvency proceedings. The SFD does not purport to address this kind of provision, since the focus of the SFD is on insolvency proceedings. Nevertheless, since the primary intentions underlying the SFD are to promote financial stability, to reduce systemic risk and to ensure finality of payments, the Actio Pauliana and similar legislation that renders systems potentially vulnerable to challenge should likewise be addressed. CLS Bank therefore recommends that the scope of the SFD be extended beyond insolvency proceedings to include such other legislation. 6. Attachment etc. Comparable to the risk of Actio Pauliana claims are the claims of third party creditors of a participant in a system who might seek attachment orders in respect of the participant s claims against the system or against other participants, including the attachment of a participant s accounts with the system or other account provider. Such orders are not currently covered by the SFD. Whilst it may be possible to exclude certain of these risks contractually, it is not always possible to exclude all such risks in all jurisdictions. Again, in the interests of systemic risk reduction, CLS Bank recommends that the scope of the SFD be extended to exclude the possibility of attachment and similar orders being made by a court in respect of claims arising in connection with a designated system. 6

7 7. IMF Treaty 7.1 Section 2(b) of the Articles of Agreement of the International Monetary Fund provides that "exchange contracts which involve the currency of any member and which are contrary to the exchange control regulations of that member maintained or imposed consistently with this Agreement shall be unenforceable in the territories of any member." All EU Member States are members of the IMF and should have implemented this agreement under their laws. 7.2 The issue is that a payment in connection with a designated system which is in the currency of an IMF member but which is in breach of that IMF member's exchange controls would arguably be unenforceable and theoretically could be unwound even if made through a designated system and treated as final by the SFD. CLS Bank believes that the finality position of all designated systems would be improved if the SFD made clear that no laws such as those implementing the IMF Articles of Agreement could lead to an unwinding of payments that are final under the rules of designated systems. Yours truly, David V. Skoblow Executive Vice President and General Counsel cc: KonstantinosTomaras, European Commission konstantinos.tomaras@ec.europa.eu Ian Annetts, Allen & Overy Ian.Annetts@AllenOvery.com 7