13th Biennial Meeting - Penn State Law

TEXAS Volume 42 

INTERNATIONAL Number 3 

LAW Summer 2007 

JOURNAL 

CONTENTS 

INTERNATIONAL ACADEMY OF COMMERCIAL AND CONSUMER LAW 

CHANGING LAW FOR CHANGING TIMES, 13T BIENNIAL MEETING 

IN T R O D U CTIO N ....................................................................................................................... 369 

Jay Lawrence Westbrook 

PROPORTIONALITY: WTO LAW. IN COMPARATIVE PERSPECTIVE .................................. 371 

Mads Andenas and Stefan Zleptnig 

(Comparative Law, International Business, and Competition Law) 

THE MODERNIZATION OF EUROPEAN COMPETITION LAW: A STORY OF 

U NFIN ISH ED C O NCEPTS ........................................................................................................ 429 

Jirgen Basedow 

(International Business, Competition Law, and European Union) 

CORPORATE GATEKEEPER LIABILITY IN CANADA .......................................................... 441 

Stephanie Ben-Ishai 

(Comparative Law and Corporate) 

HARMONIZATION AND MODERNIZATION IN UNCITRAL's LEGISLATIVE 

G UIDE ON INSOLVENCY LAW ............................................................................................... 475 

Susan Block-Lieb and Terence Halliday 

(International Business and Insolvency) 

PROPERTY RIGHTS, COLLATERAL, CREDITOR RIGHTS, AND INSOLVENCY 

IN E A ST A SIA ........................................................................................................................... 5 15 

Douglas W. Arner, Charles D. Booth, Paul Lejot, Berry EC. Hsu 

(Comparative Law, Legal Institutions, and Secured 

Lending/Securitization) 

NEGOTIATION IN LETTER OF CREDIT PRACTICE AND LAW: THE 

EVOLUTION OF THE D OCTRINE ........................................................................................... 561 

James E. Byrne 

(Payment Systems) 

THEORIZING TRANSNATIONAL COMMERCIAL LAW ......................................................... 597 

Ross Cranston 

(International Business and Legal Theory) 

DEVELOPING A NEW COMMERCIAL COURT IN GHANA .................................................. 619 

Kofi Date-Bah 

(Legal Institutions) 

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DEVELOPING GLOBAL TRANSNATIONAL HARMONIZATION PROCEDURES 

FOR THE TWENTY-FIRST CENTURY:THE ACCELERATING PACE OF 

COMMON AND CIVIL LAW CONVERGENCE ........................................................................ 625 

Louis F Del Duca 

(Comparative Law and Legal Theory) 

CANADIAN PREFERENCE LAW REFORM ............................................................................ 661 

Anthony Duggan and Thomas G. W Telfer 

(Insolvency) 

RECENT INTERNATIONAL DEVELOPMENTS IN THE LAW OF NEGOTIABLE 

INSTRUMENTS AND PAYMENT AND SETTLEMENT SYSTEMS ............................................. 685 

Benjamin Geva 

(Comparative Law, International Business, Payment Systems, and 

European Union) 

SECURED LENDING AND ITS POVERTY REDUCTION EFFECT ......................................... 727 

Boris Kozolchyk 

(Comparative Law and Secured Lending/Securitization) 

SECU RITIZATIO N IN ISRA EL .................................................................................................. 751 

Shalom Lerner 

(Secured Lending/Securitization) 

JAPAN'S PERSONAL INSOLVENCY LAW ................................................................................ 765 

Junichi Matsushita 

(Insolvency and Consumer Law) 

THE LANDMARK 2005 HAGUE CONVENTION ON CHOICE OF COURT 

A G R E E M E N T S .......................................................................................................................... 773 

Ved P Nanda 

(International Business) 

BANKING LAW REFORM AND USERS-CONSUMERS IN DEVELOPING 

ECONOMIES: CREATING AN ACCESSIBLE AND EQUITABLE CONSUMER 

BASE FROM THE "E XCLUDED" ............................................................................................ 789 

Joseph J. Norton 

(Comparative Law and Consumer Law) 

GROUP INSOLVENCIES - SOME THOUGHTS ABOUT NEW APPROACHES ....................... 819 

Christoph G. Paulus 


LEGAL MERCANTILE EVOLUTION FROM THE TWENTIETH CENTURY TO 

THE DAWNING OFTHE TWENTY-FIRST CENTURY ............................................................. 831 

Arcelia Quintana-Adriano 

(Comparative Law) 

THE AGRICULTURAL EXEMPTION IN ANTITRUST LAW: A COMPARATIVE 

LOOK AT THE POLITICAL ECONOMY OF MARKET REGULATION ................................... 843 

Arie Reich 

(Comparative Law and Competition Law) 

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DISCLOSURE AS A PUBLIC POLICY INSTRUMENT IN GLOBAL CAPITAL 

M A R K E T S ................................................................................................................................. 87 5 

Janis Sarra 

(International Business) 

AVOIDANCE OF PRE-BANKRUPTCY TRANSACTIONS IN MULTINATIONAL 

B A N K RU PTCY C A SES .............................................................................................................. 899 

Jay Lawrence Westbrook 


THE DISAPPEARING DIVIDE BETWEEN PROPERTY AND OBLIGATION: THE 

IMPACT OFALIGNING LEGAL ANALYSIS AND COMMERCIAL EXPECTATION ................ 917 

Sarah Worthington 

(Legal Theory) 

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Introduction 

JAY LAWRENCE WESTBROOK* 

This issue of the Journal publishes papers presented at the 2006 Biennial 

Meeting of the International Academy of Commercial and Consumer Law. The 

Academy consists of one hundred scholars and teachers from around the world. 

Founded in the 1980s, its members come from thirty-three countries. They teach 

and write across the entire range of law affecting commerce, including contracts, the 

regulation of consumer transactions, banking and finance, market regulation, and 

bankruptcy/insolvency. Presiding over the 2006 meeting of the Academy was its 

President, Ross Cranston of the London School of Economics (and former Solicitor 

General of England). The President Elect was Juirgen Basedow, Director of the Max 

Planck Institute for Private International Law. The Treasurer was Ron Cuming of 

the University of Saskatchewan. 

The IACCL meets every other year to discuss papers presented by the 

members. These papers report developments in commercial law and law reform 

proposals in various countries and international institutions, public and private. The 

IACCL has met all over the world, including Oxford University in England, St. 

Louis University in the United States, Bar Ilan University in Israel, the Max Planck 

Institute in Germany, and the University of Riga in Latvia. 

The Journal is publishing twenty-two papers reflecting the eclectic interests of 

our group. It would be quite impossible in a short space to describe each of them, so 

I will limit myself to describing them by subject, with some mentioned twice in 

overlapping categories. The editors have helpfully marked them by the subject areas 

below. 

Comparative Law: Andenas; Ben-Ishai; Booth; Del Duca; Geva; Kozolchyk; 

Norton; Quintana-Adriano; Reich. 

International Business: Andenas; Basedow; Block-Lieb; Cranston; Geva; 

Nanda; Paulus; Sarra; Westbrook. 

Legal Theory: Cranston; Del Duca; Worthington. 

Legal Institutions: Date-Bah; Booth. 

Insolvency: Block-Lieb; Booth; Duggan; Matsushita; Paulus; Westbrook. 

Secured Lending/Securitization: Booth; Kozolchyk; Lerner. 

Consumer Law: Matsushita; Norton. 

Competition Law: Andenas; Basedow; Reich. 

Payment Systems: Byrne; Geva. 

Corporate: Ben-Ishai. 

Benno C. Schmidt Chair of Business Law, The University of Texas School of Law. 

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TEXAS INTERNATIONAL LAW JOURNAL 

VOL. 42:369 

European Union: Basedow; Geva. 

One of the joys of the Academy's meetings is the presentation of topics in areas 

of interest to each of us but just enough outside our specialties that we are 

introduced to concepts and developments we might not otherwise have considered. 

Nonetheless, one theme dominates throughout these papers: global law reform. 

Even developments in national and comparative reports frequently illustrate the 

spread of legal tools and concepts, not merely borrowed but re-engineered and 

internationalized. In describing this process, some papers are focused on 

harmonization or convergence, while others consider conventions and model laws 

that are designed to establish international or multinational rules. Nowhere is 

reform more active than in attempts to modernize and harmonize the law governing 

security interests. No less than five papers reflect a strong commitment to the idea 

that sound secured credit laws are important to economic growth and even the 

reduction of poverty, with the locus of reform proposals ranging from the 

traditionally commercial societies of the European Union to the emerging 

commercial giant, China. Insolvency and bankruptcy attracted a number of authors 

discussing, inter alia, UNCITRAL's work in insolvency law and the continuing 

spread of consumer bankruptcy laws. If one considers, as I do, that security and 

bankruptcy are essentially a single topic, nine papers make this one the most 

discussed subject. 

Competition law also receives considerable attention, including a critique of 

EU reform and a look at the special place of agricultural competition, while another 

paper considers the concept of proportionality in world trade law. Two papers 

discuss international payment systems, the conduit of through which all this global 

commerce must flow, and another paper addresses the related topic of disclosure in 

international capital markets. Three others address institutional questions, including 

the construction of a specialized court, the regularization of choice of forum, and the 

evolving concept of the gatekeeper. Three of the papers step back from the 

immediate proposals for reform to consider from a wider perspective the rule of law 

in the globalization process, harmonization across the civil law/common law 

boundary, and the evolving relationship between property and obligation. 

Although a number of the papers discuss issues important to consumers, there 

are two papers focused specifically on consumer reform in banking and insolvency 

law. 

These brief descriptions necessarily do no more than hint at the rich potpourri 

that we enjoyed during the Academy's meeting in Austin and that awaits the reader 

in this issue. Enjoy. 


Proportionality: 

WTO Law: in Comparative Perspective 

MADS ANDENAS" AND STEFAN ZLEPTNIG*" 

SUMMARY 

1. IN T R O D U CTIO N ................................................................................................... 372 

II. THE PRINCIPLE OF PROPORTIONALITY ............................................................ 375 

A . L egal P rincip les ........................................................................................... 375 

1. N ature of Principles .............................................................................. 376 

2. Public International Law and WTO Law .......................................... 379 

3 . C o nclusio ns ........................................................................................... 381 

B . Introducing Proportionality ....................................................................... 382 

C. Test in D ifferent C ontexts ........................................................................... 383 

D . Typology of Functions ................................................................................ 384 

1. Control and Limitation of Discretion ................................................ 384 

2. Balancing of Conflicting Rights and Interests .................................. 385 

3. Standard for Judicial Review .............................................................. 385 

4. Scope of Legal N orm s .......................................................................... 386 

5. Limit and Rationalize the Power of Judges ....................................... 386 

6. Political Theories and Proportionality ............................................... 387 

E. Different Elements of the Proportionality Test ........................................ 388 

1. S u itab ility ............................................................................................... 388 

2 . N ecessity ................................................................................................ 389 

3. Proportionality Stricto Sensu .............................................................. 390 

III. INTENSITY O F R EVIEW ....................................................................................... 392 

A. Intensity of Review in EC Law .................................................................. 393 

B. Standard of Review in WTO Law ............................................................ 395 

IV. PROPORTIONALITY IN PUBLIC INTERNATIONAL LAW .................................... 398 

A . C ounterm easures ......................................................................................... 398 

B. Use of Force and Armed Conflicts ............................................................ 400 

* Professor of Law, University of Leicester; Senior Fellow, Institute of European and Comparative 

Law, University of Oxford. Email: ma199@le.ac.uk. 

** Assistant, Institute of Constitutional and Administrative Law, University of Vienna. Email: 

stefan.zleptnig@univie.ac.at. 



VOL. 42:371i 

C. M aritim e D elim itation ................................................................................. 404 

D . C o n clusio n ................................................................................................... 404 

V. BALANCING IN US CONSTITUTIONAL LAW: THE INTERSTATE 

C O M M ERCE C LA U SE ........................................................................................... 404 

V I. BALANCING IN THE W TO .................................................................................. 408 

A. Objective Justifications: Public Policy Exceptions in the GA TT ............ 408 

1. Introduction .......................................................................................... 408 

2. G eneral D esign ..................................................................................... 409 

i. N ecessary to ................................................ 

410 

ii. R elatin g to ...................................................................................... 4 12 

3. Application of the Measure: The Chapeau ....................................... 413 

3. Conclusion: How the Tests in Article XX GATT Operate ............. 415 

B. Positive Obligations for Domestic Regulation .......................................... 416 

1. SPS A greem ent ..................................................................................... 416 

2. T B T A greem ent ................................................................................... 421 

3. Conclusion: How the Tests in the SPS and TBT Agreements 

O p erate ....................................................... 

423 

V II. C O N CLU SIO N ....................................................................................................... 424 

I. INTRODUCTION 

Proportionality, necessity and balancing are discussed in the context of the 

World Trade Organization (WTO). We find these tests at prominent places in the 

GATS and the GATT, as well as in the Agreement on the Application of Sanitary 

and Phytosanitary Measures (SPS Agreement) and the Agreement on Technical 

Barriers to Trade (TBT Agreement). The meaning of these tests and their 

interrelationship is not always clear. There is considerable controversy among 

participants at the diplomatic, policy, treaty-making, or the dispute settlement level, 

who put different meanings into the different tests and concepts. The discussion 

among scholars is often influenced by a projection of national meanings and 

discourses in the WTO and GATS context. 

The liberalisation of trade in goods and services requires that the meaning of 

and the relationship between these tests are clarified. In this article we set out a 

comparative approach for doing so at a general WTO level, but this approach is 

particularly relevant in the context of the GATS and the liberalisation of trade in 

services. 

In the WTO, as in any other legal and political system, value choices are 

reflected in the legal order. The fundamental question in this respect is which 

institution should be competent to make those choices and how this should be done.' 

It may be that this is a task for the legislator, the courts, or for both. 

1. See generally Joel Trachtman, Trade and... Problems, Cost-Benefit Analysis and Subsidiarity, 9 

EUR. J. INT'L L. 32 (1998). 


2007 

PROPORTIONALITY: WTO LAW IN COMPARATIVE PERSPECTIVE 

In those cases where courts and tribunals review the actions of other bodies, 

they usually face value choices in many different ways. That applies to the review of 

legislation and administrative action in domestic law. It also applies to the review of 

the compliance of states with international law obligations. The legal solutions and 

techniques for dealing with these issues will often be similar, but there is also 

considerable variation. 

Our focus is on the role of proportionality and balancing in the dispute 

settlement system of the WTO. Proportionality is a prominent legal principle in 

many legal orders, and all legal systems have to undertake different forms of 

balancing, both in determining the content of rules and in their application 

Proportionality has a major impact at the national level, in federal-type legal 

systems, and in international law. It also serves to control the discretion exercised by 

domestic authorities and to limit the interference with, or the restriction of, 

individual rights of citizens. It is a key legal concept to assist with the trading-off of 

competing values. These issues also arise in the context of WTO law, particularly in 

the context of the reconciliation of trade and non-trade issues. 

WTO lawyers have discussed the role of the principle of proportionality in the 

WTO legal order for several years. In 2001, Axel Desmedt published a rather full 

analysis in an article on proportionality in WTO law, and there have been a 

considerable number of other publications dealing with the same or related issues.' 

Desmedt's overall conclusion is that there is "not one single overarching (unwritten) 

proportionality principle in WTO law."' Other authors have similarly concluded that 

there is neither a general proportionality requirement in WTO law, nor has such a 

general test been applied by the WTO tribunals. The main argument advanced 

against proportionality is that the WTO is institutionally not ready for such a 

fundamental balancing of values and interests (mainly economic versus noneconomic), 

and that such balancing is at the core of the proportionality analysis. 

Marceau and Trachtman point to some additional reasons for skepticism against 

balancing and proportionality in the WTO: 

To many commentators, the idea of balancing tests in contexts where 

domestic regulation is subject to international scrutiny has been anathema 

to judicial restraint and national sovereignty .... There are two likely 

reasons. First, balancing tests seem to some to accord too much power to 

courts. However, it is not unusual for courts to be assigned the task of 

balancing, explicitly or implicitly, under specified circumstances ... 

Second, balancing tests seem to intervene too greatly in national 

regulatory autonomy. 6 

2. See discussion infra Part II. 

3. Axel Desmedt, Proportionality in WTO Law, 4 J. INT'L ECON. L. 441, 441-480 (2001); Id. at 478 

(arguing that "it seems that there is no basis yet for the recognition in WTO law of an unwritten and 

overarching proportionality principle as known in EC law."). 

4. Id. 

5. Jan Neumann & Elisabeth TUrk, Necessity Revisited: Proportionality in World Trade Organization 

Law after Korea-Beef EC-Asbestos and EC- Sardines, 37 J. WORLD TRADE 199, 231-33 (2003). 

6. Gabrielle Marceau & Joel Trachtman. The Technical Barriers to Trade Agreement, the Sanitary and 

Phytosanitary Measures Agreement, and the General Agreement on Tariffs and Trade: A Map of the World 

Trade Organization Law of Domestic Regulation of Goods, 36 J. WORLD TRADE 811, 850-51 (2002). 



VOL. 42:371 

In contrast, Meinhard Hilf has argued in his writing that "the principle of 

proportionality is one of the more basic principles underlying the multilateral trading 

system.", 7 The author emphasizes that a "sensitive balancing process, guided by the 

principle of proportionality . ..is needed in which no rule or principle involved 

should be left to redundancy or inutility. The principle of proportionality should 

govern any process of interpretation and application of WTO law with a view to 

obtaining a due relation between the different interests at stake." 8 

This disagreement in academic writing is the background against which this 

article is situated. We attempt to explore whether the disagreement is a matter of 

semantics or whether it impacts more fundamental issues of the WTO legal order. It 

could be argued that it does not really matter whether one refers to a particular legal 

phenomenon as "proportionality" if different terms ultimately bear the same 

meaning. This is a challenge regularly faced by comparative law scholars, namely 

that "[a]pparently identical words may have a different meaning and apparently 

different words may have the same meaning. ' 

The fundamental question which we address in this article is how comparative 

legal thinking about the principle of proportionality and other balancing tests can 

help explore some of the most challenging questions of WTO law. One core 

challenge is the balancing of competing values and interests in the WTO. Another 

challenge is the degree of international constraint imposed on domestic regulation. 

This leads to the questions of how much deference international organizations and 

their judicial bodies do show towards sovereign WTO Members, and how much they 

should show. 

Our analysis is informed by insights from domestic constitutional law, legal 

theory, the law of human rights, European law, public international law, and WTO 

law. We attempt to provide a conceptual framework to analyze how balancing and 

proportionality are made to work in the law of the WTO and the dispute settlement 

process. 

Our main conclusion is that there is no crude balancing of trade and non-trade 

values and interests in the WTO. The tests written into the WTO Agreements 

provide for a more sophisticated way of balancing, taking account of the individual 

circumstances at stake, and the competing rights and interests involved. We argue 

that comparative legal thinking based on insights gained from the principle of 

proportionality, and the role of principles generally, may help structure and 

rationalize this process. 

In this article, we proceed as follows. In Chapter II, we first discuss the nature 

of legal principles from a theoretical perspective and how this may influence the 

thinking about balancing in WTO law. We then discuss the role of principles in 

public international law and WTO law, providing a background for the subsequent 

discussion of the principle of proportionality. The latter parts of Chapter II deal 

with the principle of proportionality in a comparative context. We identify its core 

functions and elements to carve out its essential characteristics. In Chapter III, we 

discuss the interaction between the principle of proportionality and the concept of 

7. Meinhard Hilf, Power, Rules and Principles- Which Orientation for WTO/GA TT Law?, 4 J. INT'L 

ECON. L. 111, 120 (2001). 

8. Id. at 130. 

9. Mark Van Hoecke, Deep Level Comparative Law 10-11, (Eur. Univ. Inst. Working Paper LAW 

No. 2002/13), available at http:l/cadmus.iue.it/dspacelbitstreamll814/191/lllawO2-13.pdf. 


2007 


standard (or intensity) of review. We argue that these concepts, which are often 

treated separately, need to be assessed jointly to gain a fuller understanding of (a) 

judicial review generally and (b) the principle of proportionality as applied as a test 

of review. Proportionality is also a core principle in public international law. For 

this reason, we explore its main characteristics in Chapter IV to assess its possible 

impact on WTO law. In Chapter V, we explore the necessity and balancing tests of 

U.S. constitutional law. We then assess the different balancing tests in WTO law in 

Chapter VI. We focus on the tests under Article XX GATT and in the SPS and TBT 

Agreements. Our analysis of those tests is informed by the preceding discussion of 

the main features of the principle of proportionality in different contexts. Finally, 

we draw some conclusions and offer some suggestions for a better understanding of 

the balancing undertaken by the judicial bodies of the WTO. 

II. 

THE PRINCIPLE OF PROPORTIONALITY 

In this chapter, we discuss the function and scope of the principle of 

proportionality and similar balancing tests. We thereby understand proportionality 

not only as a judicial doctrine but also as legislative doctrine for the political 

institutions to follow. Proportionality is a trade-off-device which helps resolve 

conflicts between different norms, principles, and values. It is also a determining 

factor for the role of courts in reviewing administrative or legislative measures." 

Proportionality thus provides a legal standard against which individual or state 

measures can be reviewed." From a more procedural perspective, proportionality is 

closely related to the issues of intensity of review-the level of scrutiny exercised by 

judges-and whether there should be a full review on the merits or a more 

deferential standard of judicial review. 2 

A. Legal Principles 

We begin our discussion by providing some conceptual reflections about the 

nature of legal principles. This shall provide a basic framework for the subsequent 

analysis of the principle of proportionality in different legal fora. In this chapter, we 

primarily focus on the characteristics of, and the relationship between, legal rules 

and principles. This distinction features prominently in the writings of Ronald 

Dworkin and has subsequently been refined, most clearly by German constitutional 

scholars. 

There is no single authoritative definition of the concept of "legal principles," 

either in domestic or in international law.' 3 The approach taken depends on a 

variety of factors, including the legal system at issue and the underlying legal 

10. Grinne de Bdrca, The Principle of Proportionality and its Application in EC Law, 13 Y.B. EUR. 

L. 105. 105 (1993). 

11. Malcolm Ross. Behind Proportionality: The Cultural and Constitutional Context, in ENGLISH 

PUBLIC LAW AND THE COMMON LAW OF EUROPE 83, 91 (Mads Andenas ed., 1998). 

12. NICHOLAS EMILIOU, THE PRINCIPLE OF PROPORTIONALITY IN EUROPEAN LAW: A 

COMPARATIVE STUDY 171-74 (1996). 

13. See Meinhard Hilf & Goetz Goettsche, The Relation of Economic and Non-Economic Principles 

in International Law, in INTERNATIONAL ECONOMIC GOVERNANCE AND NON-ECONOMIC CONCERNS 5, 

9-10 (Stefan Griller ed., 2003) (defining "principles"). 



VOL. 42:371 

philosophy which informs the scholar's perspective on topics such as norms, rules, 

principles and values. Sometimes it also seems that continental lawyers are more 

interested in the search for underlying principles, taking the "top down" approach, 

as opposed to the common law "bottom up" approach.' 

The debate about, for instance, trade and environment or trade and human 

rights often reflects the crucial role that general principles may play in the WTO law. 

Economic and non-economic principles, from both within and outside the WTO 

legal order, often need to be reconciled with-and balanced against-each other. It 

has been argued that proportionality has to play a crucial role in guiding this 

'5 

process.. 

Finally, it is evident that principles, as understood in legal theory, are not 

necessarily the same as principles (or general principles) of EC law, public 

international law, or WTO law. These general principles may also be rules in a 

theoretical sense (see the discussion below), depending on their normative content. 

Werner Schroeder has argued that basic principles of EC law sometimes have a very 

narrow focus and lay down clear normative consequences; as a result, their legal 

character is one of rules rather than of principles. 6 

1. Nature of Principles 

One recent suggestion to define principles is that they are "legal norms laying 

down essential elements of a legal order."' 7 Another formula is that principles 

"formulate general and flexible imperatives," which are "fundamental legal concepts 

and essential values of any legal system."' 8 Yet another suggestion is that a principle 

of law may be conceived as aiming at particularly valuable objectives and thereby 

"explains and justifies all or any of the more specific rules in question."' 9 While each 

of these definitions emphasizes a different aspect, taken together they provide a 

fuller picture of the basic nature of legal principles. 

Traditionally, legal norms have been divided into rules and principles. One 

may alternatively distinguish between rules and standards, 0 but our approach is to 

focus on the rules - principles dichotomy. 2 ' 

14. Hilf, supra note 7, at 129. But see generally ALBERT DICEY, INTRODUCTION TO THE STUDY OF 

THE LAW OF THE CONSTITUTION (10th ed. Macmillan 1960)(1885) (discussing the "guiding" or "leading" 

principles of the law of the constitution of England). 

15. Hilf & Goettsche, supra note 13, at 38. 

16. WERNER SCHROEDER, DAS GEMEINSCHAFTSRECHTSSYSTEM. EINE UNTERSUCHUNG ZU DEN 

RECHTSDOGMATISCHEN, RECHTSTHEORETISCHEN UND VERFASSUNGSRECHTLICHEN GRUNDLAGEN DES 

SYSTEMDENKENS IM EUROPAISCHEN GEMEINSCHAFTSRECHT [THE COMMUNITY LAW SYSTEM. A STUDY 

OF DOGMATIC, THEORETICAL, AND CONSTITUTIONAL LAW BASICS OF THE SYSTEMIC THINKING IN 

EUROPEAN COMMUNITY LAW] 266 (2002). 

17. Armin von Bogdandy, Doctrine of Principles 10 (N.Y.U. School of Law Jean Monnet Center, 

Working Paper 9/03, 2003), available at http://www.jeanmonnetprogram.org/papers/03/030901-01.pdf. 

18. Hilf & Goettsche, supra note 13, at 9-10. 

19. NEIL MACCORMICK, LEGAL REASONING AND LEGAL THEORY 152 (1978). 

20. There is also considerable discussion on this issue in the US legal literature which distinguishes 

between rules and standards. See Trachtman, supra note 1, at 45-46; Kathleen Sullivan, The Supreme 

Court, 1991 Term - Foreword: The Justices of Rules and Standards, 106 HARV. L. REV. 22, 58 (1992) 

(emphasizing that in Ronald Dworkin's theory of rules and principles, standards would be called 

principles). 

21. Ronald Dworkin famously distinguished between rules and principles, and many other legal 


2007 


The main feature of rules is that they apply in an "all-or-nothing fashion." 22 

They may be either valid or invalid. 23 More technically speaking, the character of 

rules implies that they lay down a "binary validity claim." 24 Whenever there is a 

conflict of rules, this conflict can only be solved in two different ways: either by 

declaring one rule invalid or by "introducing an exception clause into one of the two 

rules., 2 1 In the second case, one of the rules is the exception to the other. 

Principles operate differently. They "express the idea of optimization." 26 

Principles are "norms commanding that something be realized to the highest degree 

that is actually and legally possible." 2 Accordingly, principles can be realized to 

different degrees, as opposed to the all-or-nothing approach underlying rules. 

Principles, similar to values, express the preference of some good over others. 

Whenever two countervailing principles collide, both will lay down competing 

optimization commands, and their relationship will not be absolute but relative. 6 

Principles are not invalidated (as this would be the case with rules); instead, they are 

outweighed, depending on each other's relative weight. It would not make sense to 

introduce an exception since one principle may not be the exception to another. 29 

Conflicts of principles can only be solved through a balancing act which takes 

into account each principle's weight. The "dimension of weight" is one of the main 

characteristics of principles." The weighing and balancing of countervailing 

principles will lead to a "conditional priority of one of the colliding principles over 

the other with respect to the circumstances of the case." 3 The assessment turns on 

the question of which principle carries relatively more weight. Note that the 

precedence of one principle over the other only relates to the specific facts of the 

case, and this relationship may change under different circumstances. 

In the context of international trade, this leads us to the preliminary conclusion 

that neither trade-related nor non-trade-related principles can be considered, from a 

legal point of view, as unconditionally preeminent. In many cases, their relationship 

can only be determined on the basis of the facts of an individual case. 

Principles play different functions in the legal order. One important aspect is 

that they fulfill an ordering function in a fragmented body of law and thus promote 

the coherence of the legal system. 2 Related is the function that principles help 

resolve ambiguities and fill gaps in the legal texts. Judicial reasoning and lawtheorists 

adopted this distinction as well. Despite some criticism raised against the rules - principles 

distinction, we believe it remains a useful and valuable conceptual tool to analyse legal norms and, in 

particular, to discuss the principle of proportionality and balancing. See RONALD DWORKIN, TAKING 

RIGHTS SERIOUSLY 24-26 (1978). 

22. Id. at 24. 

23. Id. (stating that "Jilf the facts a rule stipulates are given, then either the rule is valid, in which case 

the answer it supplies must be accepted, or it is not, in which case it contributes nothing to the decision."). 

24. JORGEN HABERMAS, BETWEEN FACTS AND NORMS: CONTRIBUTIONS TO A DISCOURSE THEORY 

OF LAW AND DEMOCRACY 255 (1996). 

25. Robert Alexy, On the Structure of Legal Principles, 13 RATIO JURIS 294, 295 (2000). 

26. Id. at 294. 

27. Id. at 295. 

28. Id. at 297. 

29. Id. at 296. 

30. DWORKIN, supra note 21, at 26. 

31. Alexy, supra note 25, at 296. 

32. von Bogdandy, supra note 17, at 7. 



VOL. 42:371 

making is supported by reference to general principles. Another crucial function of 

principles is that they can act as "'gateways' through which the legal order is 

attached to the broader public discourse."" All those aspects are relevant for WTO 

law as well, especially since it is in the process of evolving into a more mature legal 

system and generating some constitutional law-type norms, principles, and 

structures . 

Based on the preceding observations, one notes the crucial role that provisions 

such as Article XX GATT-and the legal rules and principles contained thereinplay 

in resolving conflicts between trade and non-trade interests." Framing those 

interests in terms of legally protected principles, trade-offs between principles are 

necessarily seen as relative, depending on the weighing and balancing of 

countervailing rights and interests in concrete circumstances. This weighing and 

balancing, undertaken by the judiciary, follows from the character of principles. An 

alternative approach could be to reduce the role of principles in the legal system by 

increasingly transforming them into specific legislative rules. This would reduce the 

discretion exercised by the judicial bodies and provide greater predictability. 36 

Conflicts between economic and non-economic values and interests can thus be 

resolved in different ways. First, it may be done through judicial balancing, based on 

legal provisions such as Article XX GATT or the relevant provisions in the SPS and 

TBT Agreements. Second, more specific legislation or treaty provisions may also 

address those concerns and reduce the discretion for the judicial bodies. 37 Given the 

frequent absence of specific rules on many sensitive issues and the prominent role of 

the dispute settlement process in shaping WTO law, the role and importance of 

principles has increased in the past and will continue to do so. 

Proportionality is commonly referred to as a legal principle. It can also be 

described as a test or standard, but its legal character is one of a principle. Robert 

Alexy wrote: "[t]he nature of principles implies the principle of proportionality and 

vice versa." 3 " The basic idea is that the principle of proportionality follows from the 

main characteristic of principles: the process of optimization. 

If one considers fundamental human rights as principles, one realizes how 

proportionality and its three-step analysis (suitability, necessity and proportionality 

stricto sensu) follows from the nature of competing principles: in the first step, the 

test of suitability is to avoid that measures, which are not capable at all of achieving 

the pursued objective, are adopted. Such measures do not bring any benefit to the 

objective pursued; and, instead, they only entail negative effects for other 

countervailing interests or principles. 3 9 The necessity element requires that the 

means employed to achieve the objective pursued by principle P 1 be the least 

intrusive with regard to countervailing principle P 2 . 40 Whenever there is a choice 

33. Id. at 8. 

34. See Deborah Cass, The "Constitutionalization" of International Trade Law: Judicial Norm- 

Generation as the Engine of Constitutional Development in International Trade, 12 EURO. J. INT'L L. 39, 42 

(2001). 

35. Joel Trachtman, The Domain of Dispute Resolution, 40 HARV. INT'L L. J. 333, 356 (1999). 

36. Id. at 350-54 (discussing rules and standards, the costs and benefits associated with them and their 

institutional and strategic dimensions). 

37. Id. at 376. 

38. ROBERT ALEXY, A THEORY OF CONSTITUTIONAL RIGHTS 66 (Julian Rivers trans., Oxford Univ. 

Press 2002) (1986). 

39. See id. at 68-69. 

40. "As a principle, P 2 requires optimizing relative to what is both legally and factually possible." Id. 


2007 


between different suitable measures, the least intrusive must be employed. 

Necessity therefore allows for a distinction and choice among different measures 

adopted on the basis of principle P,. But the broadest question of whether any 

measure should be chosen at all to pursue a certain objective is not part of the 

necessity analysis; this involves a true balancing of the competing principles P, and 

P. This final stage of the analysis, the process of weighing and balancing, is called 

proportionality in its narrow sense (proportionality stricto sensu). 4 1 

It is only in cases that have passed the necessity test that a balancing and 

weighing of competing principles will come into play. This final step, proportionality 

stricto sensu, is not guided by other substantive criteria, except for the criterion that 

the measures must not be excessive or disproportionate with regard to the pursued 

objective. One important requirement, however, is that the relative weight of each 

principle be taken into account." 

The remaining question is how the weighing in this process should be 

undertaken and whether there are any substantive criteria guiding the weighing. As 

stated, weighing is relative and depends on the circumstances of each individual case. 

It establishes a conditional, as opposed to an absolute, priority of colliding 

principles. 3 Weighing in that sense requires that the priority be established on the 

basis of reasons advanced in a discursive process.' 

This is the crucial link between the theory of principles and proportionality. 

The third step of the proportionality analysis may be regarded as a specific 

procedural obligation. It requires public authorities and the judiciary to justify their 

decisions on the basis of rational legal arguments and in a structured manner. 4 ' The 

factors that need to be considered and justified through legal reasoning are the 

weight attributed to each principle, the degree of interference with those principles, 

and the way in which those countervailing principles are balanced against each other. 

The importance of principles and proportionality increases in the absence of clear 

hierarchies of norms and whenever the outcome of a dispute cannot be determined 

simply on the basis of clear legislative provisions. A more principles-oriented 

approach (in conjunction with better rules) may help structure and rationalize the 

WTO legal system, clarify imprecise and open-ended provisions, and contribute to 

WTO law's growing maturity and sophistication in the years to come. 

2. Public International Law and WTO Law 

In the previous section, we outlined some general features of legal principles. 

We now explore the role and legal status of general principles in public international 

law and in WTO law. General principles of international law have a very specific 

at 68. 

41. Id. at 67-68. 

42. See Alexy, supra note 26, at 298. 

43. MANFRED STELZER, DAS WESENSGEHALTSARGUMENT UND DER GRUNDSATZ DER 

VERHALTNISMA IGKEIT [ESSENTIAL CONTENT ARGUMENT AND THE PRINCIPLE OF PROPORTIONALITY] 

217-26 (1991). 

44. Id. at 223. 

45. Martin Borowski, Prinzipien als Grundrechtsnormen [Principles as Norms of Basic Rights], 53 

ZEITSCHRIFT FOR OFFENTLICHES RECHT [AUSTRIAN JOURNAL OF PUBLIC AND INTERNATIONAL LAW] 

307, 313-14 (1998). 



VOL. 42:371 

connotation, whereas our previous discussion of principles was more generic. In 

light of the overall topic of this paper, both aspects should be covered and brought 

together in an attempt to define the role and status of the principle of 

proportionality in the WTO legal order. 

General principles are a well-known and yet somewhat vague concept in public 

international law. 46 Article 38(1)(c) of the Statute of the International Court of 

Justice (ICJ) lists "general principles of law" as one of the sources of international 

law. In international law, principles play an important role in filling the gaps left by 

the international legal order and to avoid a non liquet in rulings by international 

judges. 4 ' Furthermore, they are crucial for international tribunals which may refer to 

general principles to justify their own decisions, because they provide a conceptual 

background for the interpretation of the law and state practice. 49 The openness of 

principles to public and legal discourse is reflected in the fact that they help the 

judiciary construe the law "in a dynamic fashion responsive to today's problems." 5 

In cases of conflict between general principles and other specific norms of 

international law (treaties or customs), the norms will generally prevail." In the 

context of WTO law, "a principle could not be used with the effect of overriding a 

specific rule contained in the WTO agreements. 5 2 General principles only have a 

subsidiary function in the international legal order. 

General principles may originate from different sources. Some principles may 

be derived from domestic law, from which they are borrowed and distilled on a 

comparative basis. 3 On the other hand, general principles of international law are 

unique to international law, even though they mostly overlap with the general 

principles of law recognized by Article 38 of the Statute of the ICJ. One standard 

textbook definition of general principles of international law is that they are 

"primarily abstractions from a mass of rules and have been so long and so generally 

accepted as to be no longer directly connected with state practice."" 

Examples of general principles, which may be either procedural or substantive 

in nature, are the following: pacta sunt servanda, principles governing the judicial 

process, res judicata, and the principles of equity, good faith, equality of states, 

interpretation, right to self-defense, and right to independence. 5 It has been argued 

that proportionality is also characterized as a general principle of international law, 

with its own foundations in the international legal order. 56 

46. In EC law, general principles provide guidance for the interpretation of primary and secondary 

Community law and the exercise of powers by the institutions, and determine the legality of acts of the 

Community institutions and the member states, and, finally, fill gaps where lacunae exist in Community 

law. With regard to the principle of proportionality, see EMILIOU, supra note 12, at 121. 

47. Statute of the International Court of Justice art. 38(1)(c). 

48. JOOST PAUWELYN, CONFLICT OF NORMS IN PUBLIC INTERNATIONAL LAW: How WTO LAW 

RELATES TO OTHER RULES OF INTERNATIONAL LAW 129 (2003). 

49. PIERRE-MARIE Dupuy, DROIT INTERNATIONAL PUBLIC 303 (4th ed. 1998). 

50. PAUWELYN, supra note 48, at 130. 

51. Principles that are jus cogens are an exception.. See Hilf, supra note 11, at 128. 

52. Id. 

53. IAN BROWNLIE, PRINCIPLES OF PUBLIC INTERNATIONAL LAW 16-18 (6th ed. 2003). 

54. Id. at 18-19 (emphasis omitted). 

55. PAUWELYN, supra note 48, at 125-126. 

56. Riccardo Mazzeschi, Book Review, 13 EURO. J. INT'L L. 1031, 1035 (2002) (reviewing ENZO 

CANNIZZARO, IL PRINCIPIO DELLA PROPORZIONALITA NELL'ORDINAMENTO INTERNAZIONALE [THE 

PRINCIPLE OF PROPORTIONALITY IN INTERNATIONAL LAW] (2000)). 


2007 


WTO law is a branch of international law, and the WTO agreements need to be 

interpreted against the background of general principles of public international law. 57 

The preamble to the Agreement Establishing the World Trade Organization (WTO 

Agreement) states that the parties to the WTO Agreement are "determined to 

preserve the basic principles and to further the objectives underlying this multilateral 

trading system. ''8 As Meinhard Hilf pointed out, there is no list of principles which 

one could refer to, and it is unclear whether those principles only encompass the 

economic justifications and objectives of the WTO system.S 9 The long list of basic 

principles suggested by Hilf and Goettsche includes trade liberalization, sovereignty 

and national deference, sustainable development, non-discrimination, transparency, 

rule of law, due process, good faith, natural justice, and proportionality.' Cameron 

and Gray point to similar principles, such as the principles of effectiveness in treaty 

interpretation, in dubio mitius, legitimate expectations, non-retroactivity of treaties, 

state responsibility, estoppel, abuse of rights, and exhaustion of local remedies. 6 

Proportionality has not explicitly been recognized as a general principle of WTO 

law, even though it has been referred to by the appellate body to interpret individual 

provisions of the WTO Agreements. 6 The point of reference has been the principle 

of proportionality as applied in the law on international countermeasures. In Cotton 

Yarn, the appellate body concluded: 

It would be absurd if the breach of an international obligation were 

sanctioned by proportionate countermeasures, while, in the absence of 

such breach, a WTO Member would be subject to a disproportionate and, 

hence, "punitive", attribution of serious damage not wholly caused by its 

exports. In our view, such an exorbitant derogation from the principle of 

proportionality . .. could be justified only if the drafters of the ATC 

[Agreement on Textiles and Clothing] had expressly provided for it, which 

is not the case. 63 

3. Conclusions 

Many conflicts between legal provisions are not only conflicts of rules but also 

conflicts of principles. From a theoretical perspective, those conflicts may thus 

consist of conflicts between rules, principles, as well as rules and principles. 

57. JOHN JACKSON, THE WORLD TRADING SYSTEM 120 (2d ed. 1997): see generally PAUWELYN, 

supra note 48, ch. 2. 

58. Preamble to the Agreement Establishing the World Trade Organization (WTO Agreement) 

Marrakesh Agreement Establishing the World Trade Organization, Legal Instruments-Results of the 

Uruguay Round, 33 I.L.M. 1125 (1994). 

59. Hilf, supra note 7, at 112. 

60. Hilf & Goettsche, supra note 13, at 16-17. 

61. See generally James Cameron & Kevin Gray, Principles of International Law in the WTO Dispute 

Settlement Body, 50 INT'L & COMP. L. Q. 248. 256. 258, 260, 270, 292-95 (2001). 

62. Appellate Body Report, United States - Definitive Safeguard Measures on Imports of Circular 

Welded Carbon Quality Line Pipe from Korea, paras. 256-260, WT/DS202/AB/R (Feb. 15, 2002) 

[hereinafter US - Line Pipe], available at http://www.wto.org/english/tratop-e/dispu-e/202abr-e.pdf. 

63. Appellate Body Report, United States - Transitional Safeguard Measure on Combed Cotton Yarn 

from Pakistan, para. 120, WT/DS192/AB/R (Oct. 8, 2001) [hereinafter US - Cotton Yarn], available at 

http://www.wto.org/english/tratop-e/dispu-e/192abr-e.pdf. 



VOL. 42:371 

We shall make one caveat. "Global" principles of administrative law need to be 

reflected carefully, especially when transplanting national or European 

constitutional concepts to the WTO level." Analogies and transfers must, in each 

case, reflect the specific legal and political system in which they operate, in particular 

since legal principles from a variety of national legal orders seem to resemble each 

other. Lawyers from different backgrounds may approach the same principles with 

different concepts in mind and may speak about the same legal phenomenon using 

different terminology: "[a]pparently identical words may have a different meaning 

and apparently different words may have the same meaning." 65 ' In any case, one 

must not disregard the different forms of national constitutional and international 

law traditions which shape the thinking about principles-what they are as well as 

what they are based upon. In the European context, Jtirgen Habermas rightly 

warned that: 

the same legal principles would also have to be interpreted from the 

perspectives of different national traditions and histories. One's own 

tradition must in each case be appropriated from a vantage point 

relativized by the perspectives of other traditions, and appropriated in 

such a manner that it can be brought into a transnational, Western 

European constitutional culture.' 

The concepts of proportionality, necessity, balancing, and reasonableness are 

widely used in many different jurisdictions. As we attempt to show throughout this 

article, their use and connotation varies from author to author, and from jurisdiction 

to jurisdiction. It is often difficult to reflect on one particular concept since it may be 

understood in many different ways. Proportionality, for instance, may generally be 

understood as a very strict test of review or a more relaxed and deferential test of 

review. Our own approach is influenced by the classical three-step proportionality 

test, developed in continental European legal thinking. 

B. Introducing Proportionality 

The principle of proportionality has many different facets. It is regularly 

invoked but its function, constituent elements, and scope of application often remain 

elusive. Proportionality is not a standardized legal concept and to a large extent 

depends on the legal regime within which it is used. The simplest formula to explain 

proportionality is the prohibition on using a "steam hammer to crack a nut, if a 

nutcracker would do., 67 This formula is quite illustrative but not very helpful in 

addressing complex legal question that arise in connection with the proportionality 

test. 

Characterizing proportionality at a very general level, one of its key functions is 

to define the relationship between the state and its citizens, resolving conflicts of 

64. Giacinto Della Cananea, Beyond the State: the Europeanization and Globalization of Procedural 

Administrative Law, 9 EURO. PUB. L. 563, 563 (2003); John M. Jackson, Fragmentation or Unification 

Among International Institutions: The World Trade Organization, 31 N.Y.U. J. INT'L L. & POL. 823, 829 

(1999). 

65. Van Hoecke, supra note 9, at 10-11. 

66. HABERMAS, supra note 24, at 500. 

67. R v. Goldstein (1983) 1 W.L.R. 151,155 (UKHL)(Eng.). 


2007 


interest between these two spheres. More specifically, proportionality in its 

traditional form has provided a tool to define and restrain the regulatory freedom of 

governments. Proportionality "sets material limits to the interference of public 

authorities into the private sphere of the citizen . . . 

Proportionality as a legal concept mainly developed in the context of German 

Police Law (Polizeirecht) about a century ago.' The principle related to the 

interference by administrative authorities with civil liberties. 70 The German courts 

used proportionality to assess whether the measures taken by the police were more 

intrusive than necessary to achieve a certain objective. 7 ' In German administrative 

law, proportionality developed as a device to control the discretion exercised by the 

administration. 72 Some decades later, the principle of proportionality was also 

introduced to impose limitations upon the discretion of the legislator to enact 

legislation. This can be considered as the constitutional law aspect of proportionality 

as it is well-known it in many (federal) legal systems. 

The previous paragraph identified the two different ways in which the principle 

of proportionality can be applied. First, as a legislative and administrative doctrine 

which guides the actions of the legislator and the administration by establishing a 

standard against which those actions are measured. Second, as a judicial doctrine 

which lays down a specific standard of review applied by the judiciary in reviewing 

legislative and administrative measures. The proportionality test requires an active 

role to be performed by the judiciary." 

C. Test in Different Contexts 

Proportionality has developed as a test of review. It is used in different 

contexts. First, it is recognized in some systems as the test for the exercise of 

competences. Secondly, it is used to review justifications for interference with or 

restrictions on rights. Thirdly, it is also used to determine the extension of rights. 

Other limiting mechanisms, such as leaving national authorities a "margin of 

appreciation" in European Convention on Human Rights (ECHR) law, or having a 

rule of reason in U.S. federal anti trust law, may in fact incorporate similar balancing 

exercises. 

In ECHR law, for instance, proportionality is applied in at least three different 

contexts: first, as a benchmark to establish the legality of derogations; second, with 

the aim to establish the legality of interferences by states with Convention rights; 

and, third, to determine scope of application of some of the rights established by the 

Convention. 

On a more general level, a first use of proportionality is as a general test for the 

exercise of competences. This aspect features in domestic legal systems (e.g. control 

68. Jiurgen Schwarze, The Principle of Proportionality and the Principle of Impartiality in European 

Administrative Law, 1 RIVISTA TRIMESTRALE DI DIRITTO PUBBLICO [QUARTERLY JOURNAL OF PUBLIC 

LAW] 53, 53 (2003). 

69. Id. at 55. 

70. Id. 

71. Id. 

72. EKKEHART STEIN & GOTZ FRANK. STAATSRECHT 240 (19th ed. 2004). 

73. de Btirca, supra note 10, at 105. 



VOL. 42:371 

of discretion in German administrative law), 74 as well as EU law. In the latter case, 

the Community courts control the exercise of discretion conferred on the 

Community institutions and, in particular, the European Commission. There are 

differences in the intensity of review depending on the area and subject matter of the 

decision. A second use relates to justifications for interference with, or restrictions 

on, rights. This is typically the case in areas such as EC free movement law, national 

constitutional law, the law of the ECHR and human rights in English law. In 

addition to the differences in the intensity of review depending on the area and 

subject matter of the decision, the kinds of rights involved provide another variable. 

D. Typology of Functions 

In this section, we distill the main functions of the principle of proportionality, 

many of which are also reflected in the debate on judicial review in the WTO and the 

balancing of trade and non-trade interests. Each of the functions mentioned below 

emphasizes one particular aspect of the principle of proportionality, so they should 

be regarded as complementary to each other. 

1. Control and Limitation of Discretion 

The basic idea underlying proportionality is that citizens of liberal states should 

only have their freedom of action limited insofar as is necessary for the public 

interest. Public authorities should, in the choice of their measures, choose the least 

onerous one. The principle of proportionality guides this process and thereby 

imposes restrictions on the regulatory freedom of governments. 

The proportionality test, as a key legal instrument to control and check the 

discretion exercised by the administration, involves a means-ends relationship. 75 It 

establishes both a guideline as to the use of discretion by national authorities and a 

standard against which decisions are measured. The means employed by public 

authorities to attain a legitimate objective have to be the least onerous choice, and 

the impact on individual rights must not be out of proportion to the aim pursued. 

Democratic control over state actions is guaranteed through the close relationship 

between the rule of law and the principle of proportionality, whereby 

proportionality links the behaviour of public authorities to the rule of law. Modern 

thinking about the role of proportionality in public administration emphasizes that 

proportionality requires the administration to balance all relevant interests at issue 

and then to use its discretionary powers in light of this balancing exercise. 76 

74. Different conceptual approaches towards administrative law exist in the European legal systems. 

Traditionally, the French system emphasized the discretion or freedom of the administration to take 

decisions, whereas the German system focused on the protection of individual rights of citizens. Changes 

and convergences have occurred in the recent past. Jiirgen Schwarze, Konvergenz im Verwaltungsrecht der 

EU-Mitgliedstaaten [Convergence of Administrative Law of the EU Member-States], DEUTSCHES 

VERWALTUNGSBLAT-r [GERMAN ADMINISTRATION JOURNAL] 881-89 (1996). 

75. EMILIOU, supra note 12, at 23-24. 

76. Theo Ohlinger, Die Verwaltung zwischen Gesetz, Billigkeit und Biirgerniihe [Administration 

between Law, Fairness and Closeness to the People], ZEITSCHRIFT FOR VERWALTUNG [AUSTRIAN 

ADMINISTRATION JOURNAL] 678 (1999). 


2007 


2. Balancing of Conflicting Rights and Interests 

Whenever there is a conflict of rights, values and interests, this conflict will 

often need to be resolved through a judicial balancing act. If this process is guided 

by the principle of proportionality, the conflicting objectives will be reconciled 

through the application of the three-step proportionality test. 

Proportionality is applied, amongst others, to review domestic measures 

restricting the free movement within the EC Internal Market. In this context, 

proportionality guides the balancing process between free trade objectives and other 

legitimate public policy objectives. This reasoning also generally applies to WTO 

law, even though proportionality and balancing are not used as openly as in EC 

law. 77 The balancing aspect is also part of the proportionality and necessity tests in 

public international law. 

Frequently, competing interests and values are framed in terms of clear and 

precise rules elaborated by the law and policymaking process. If that is not the case, 

balancing of competing interests and values needs to be undertaken in the judicial 

arena and judges are required to make the necessary trade-offs according to the 

weight attributed to the different rights, interest, and values. It can be argued that 

the growing demand for necessity testing and balancing in WTO dispute settlement 

reflects the inability of the WTO's bodies to "legislate" on many of the complex 

issues." The danger is that judges then act as substitute legislators. 

The purpose of proportionality in such circumstances is to provide a test against 

which the balancing of conflicting interests may take place in a structured and 

deliberate manner. Legally, proportionality governs the ad hoc and variable 

substantive relationship between rules and principles and provides a rational legal 

tool to make the necessary trade-offs. 

3. Standard for Judicial Review 

Proportionality as a general principle of law underlies legislative and 

administrative actions. At the same time it is also used as a standard for judicial 

review. 

The proportionality test is usually associated with a full review on the merits, 

going beyond the more traditional and narrower concept of a reasonableness review 

of the initial decision.9 Judges applying the principle of proportionality also define a 

particularly active role for the judiciary within the legal system: the review of 

administrative or legislative measures on the merits. The fact that courts apply the 

proportionality test as an independent ground of review has always raised concerns 

77. Desmedt. supra note 4, at 445. 

78. Trachtman, supra note 1, at 85. 

79. Under the traditional Wednesbury test in English law a decision can be challenged "if it is so 

unreasonable that no reasonable public body could have made it." PAUL P. CRAIG. ADMINISTRATIVE 

LAW 537 (4th ed., 1999); see also R (Daly) v. Secretary of State for the Home Department [2001] UKHL 26, 

[2001] 2 A.C. 532, and Huang v Secretary of State for the Home Department, [2007] UKHL 11. 



VOL. 42:371 

about undue judicial interference with administrative and legislative decisionmaking, 

the separation of powers, and balancing undertaken by the judiciary." 

We can illustrate this point by reference to English law. Traditionally, the 

discretion exercised by public authorities was reviewed by the courts, which applied 

a deferential reasonableness test, the so-called Wednesbury test." Justification for 

this test was based on the constitutional position of the courts. The intensity with 

which courts apply the reasonableness test also depends on the subject matter at 

issue, ranging from fundamental rights to economic policy choices. Paul Craig has 

argued that in the context of English law, a proportionality test would provide a 

more structured formula than the Wednesbury test, because it would require both 

the administration and the courts to justify their decisions." Another argument in 

favor of the adoption of the proportionality test is that it demands a more reasoned 

analysis from the decision-maker than the imprecise reasonableness test. 83 Possible 

arguments against the adoption of the proportionality test as an independent ground 

of review relate to the separation of powers, the lack of expertise of the courts in the 

relevant area, and the fact that certain issues may be unsuited to a proportionality 

analysis." Recently, due to the adoption of the Human Rights Act 1998, the 

proportionality test, rather than the more deferential Wednesbury test, has become a 

key feature of judicial review in English law. 

4. Scope of Legal Norms 

Proportionality is also a tool to determine the scope and limitations of legal 

norms. Examples include the inherent limitations of the free movement provisions, 

such as the rule of reason in the context of Article 28 of the EC Treaty (the judicially 

created "mandatory requirements" doctrine). 8 5 Other examples include the 

provisions on unlawful discrimination in ECHR and EC law. Despite the usually 

general wording of equality provisions, differences in treatment are allowed under 

certain circumstances. Proportionality serves the purpose to determine whether 

discrimination can be objectively and reasonably justified and thus does not fall afoul 

of the equality principle. The non-discrimination provisions include a kind of rule of 

reason. 

5. Limit and Rationalize the Power of Judges 

The proportionality test and its three-step structure also provides an important 

tool to confine the legal authority conferred on judges. As stated above, one 

important aspect of the principle of proportionality is that it is a key tool for the 

80. See Paul Craig, Theory and Values in Public Law: A Response, in LAW AND ADMINISTRATION IN 

EUROPE: ESSAYS IN HONOUR OF CAROL HARLOW 38 (Paul Craig & Richard Rawlings eds., 2003). 

81. Associated Provincial Picture Houses v. Wednesbury Corp., (1948) 1 K.B. 223, 230 (Eng.). 

82. Paul Craig, Unreasonableness and Proportionality in UK Law, in THE PRINCIPLE OF 

PROPORTIONALITY IN THE LAWS OF EUROPE 99 (Evelyn Ellis, ed., 1999). 

83. Id. at 100. 

84. Id. at 102-03. 

85. See Treaty Establishing the European Community, Dec. 24, 2002, 2002 O.J. (C 325/33) art. 28 

[hereinafter EC Treaty]; see also Case 120/78 Rewe-Zentral AG v. Bundesmonopolverwaltung far 

Branntwein (Cassis de Dijon) [1979] ECR 649. The rule of reason has also been applied in the EU 

competition law field in interpreting arts. 81 and 82. 


2007 


judiciary to give substance to relatively open-ended norms by connecting them to 

their objectives. Counterbalancing such far-reaching powers wielded by the 

judiciary, proportionality introduces rational legal arguments in the decision-making 

process. Those arguments need to be presented and justified by the parties to a 

dispute and the judiciary in a public, deliberative process. The requirement ensures 

that through the three-step analysis, the interests at stake, the weight attributed to 

conflicting norms, and the other reasoning applied are made transparent.' 

6. Political Theory and Proportionality 

Finally, proportionality can be approached from the angle of different political 

theory. Pluralists may look at proportionality as a tool to enhance participation 

rights by requiring authorities to consider carefully the views of interested parties. 8 

Liberals may be particularly interested in the three-step structure of the 

proportionality analysis which requires the administration to justify its decisions 

along the lines of the different steps." 0 Proportionality thus becomes a tool to 

enhance accountability and justification for governmental action. 89 Additionally, 

judges may also become more accountable since they also have to justify their 

decisions in a detailed fashion. Finally, republicans may consider proportionality as 

"a defence against naked political bargain" because it prevents some influential 

groups from getting exclusive access to the decision-making process.9 

86. See Craig, supra note 82, at 99-100. In the case of R (Daly) v. Secretary of State for the Home 

Department, he pointed out that neither the traditional approach to judicial review in English law as 

formulated in Associated Provincial Picture Houses Ltd v. Wednesbury Corporation nor the heightened 

scrutiny approach adopted in R v. Ministry of Defence, Ex. P. Smith had provided adequate protection of 

European Convention rights as required under the Human Rights Act 1998, as held by the European 

Court of Human Rights (the 'Strasbourg court') in Smith and Grady v. United Kingdom. R (Daly) v. 

Secretary of State for the Home Department [2001] UKHL 26, [2001] 2 A.C. 532, paras 26-28. Having 

referred to a material difference between the Wednesbury and Smith approach on the one hand and the 

proportionality approach applicable where European Convention rights are at stake on the other, he said: 

"This does not mean that there has been a shift to merits review." Id. para. 28. In the case of Huang v. 

Secretary of State for the Home Department, the House of Lords revisited Daly and Lord Steyn's statement: 

This statement has, it seems, given rise to some misunderstanding. . . The point which, as we 

understand, Lord Steyn wished to make was that, although the Convention calls for a more exacting 

standard of review, it remains the case that the judge is not the primary decision-maker. It is not for 

him to decide what the recruitment policy for the armed forces should be. In proceedings under the 

Human Rights Act, of course, the court would have to scrutinise the policy and any justification 

advanced for it to see whether there was sufficient justification for the discriminatory treatment. 

Huang v Secretary of State for the Home Department, [2007] UKHL 11 para. 13. The transparency and 

predictability achieved in tying the review to a three-step approach has not been accorded judicial 

attention in this way by English courts: the proportionality test has been regarded as determined by 

European Human Rights law or European Union Law. 

87. Craig, supra note 80, at 38-39. Note that Craig's arguments are situated within the context of 

judicial review of agency decisions in the UK. 

88. Id. at 38. 

89. Id. 

90. Id. at 39. 



VOL. 42:371 

E. Different Elements of the Proportionality Test 

The principle of proportionality, in its most elaborate form, consists of three 

different elements: suitability, necessity, and proportionality stricto sensu 

(proportionality in the narrow sense). 9 ' These elements need to be assessed 

cumulatively, but they are in ascending order in terms of intensity with which the 

measure is reviewed. 9 

There is no single coherent principle of proportionality. Its constituent 

elements vary, as well as the degree and intensity of review imposed. It can also be 

the case that similar tests are given different names, such as necessity, 

reasonableness, 9 cost-benefit-analysis, 94 or rationality review, and yet their 

normative requirements may be very similar to the proportionality test. 

1. Suitability 

Suitability is the first step of assessment. It requires that the adopted measure 

is suitable or appropriate to achieve the objective it pursues. 95 In other words, 

suitability requires "a causal relationship between the the measure and its object. 9 6 

It can easily be argued that measures which are not suitable at all to pursue the 

stated objective should not be imposed on that basis. 97 Another function of this stage 

of assessment is to single out measures that claim to protect the general interest 

while, in reality, they have a protectionist purpose. 

Courts have to determine the moment at which the suitability of a measure, as 

an objective standard should be assessed. In a given case, it may make a difference 

whether the measure is evaluated from an ex ante perspective (the moment when the 

91. Jan H. Jans, Proportionality Revisited, 27 LEGAL ISSUES OF ECON. INTEGRATION 239, 240-41 

(2000). 

92. Id. The order of the steps and their emphasis may differ. For instance, in de Freitas v Permanent 

Secretary of Ministry of Agriculture, Fisheries, Lands and Housing [1999] 1 A.C. 69, at 80, the Privy 

Council, drawing on South African, Canadian and Zimbabwean authority, defined the questions generally 

to be asked in deciding whether a measure is proportionate: "whether: (i) the legislative objective is 

sufficiently important to justify limiting a fundamental right; (ii) the measures designed to meet the 

legislative objective are rationally connected to it; and (iii) the means used to impair the right or freedom 

are no more than is necessary to accomplish the objective." See also Aharon Barak, The Proportional 

Effect: The Israeli Experience, 57 U. Toronto L.J. 369 (2007) and Dieter Grimm, Proportionality in 

Canadian and German Constitutional Jurisprudence, 57 U. Toronto L.J. 383 (2007) (providing further 

comparative analysis, on the steps of the proportionality analysis and the relative role of the different steps 

by two senior judges and academic scholars). 

93. For the use of the concept of reasonableness in the sense of proportionality, see Federico Ortino, 

From "Non-discrimination" to "Reasonableness": A Paradigm Shift for International Economic Law? 33-37 

(N.Y.U. School of Law Jean Monnet Center, Working Paper 01105, 2005), available at 

http://www.jeanmonnetprogram.org/papers/05/050101.pdf (distinguishing between substantive and 

procedural reasonableness). 

94. See Trachtman, supra note 1, at 80-82 (pointing out the similarities and differences between 

proportionality, balancing and cost-benefit-analysis). 

95. JUKK.k SNELL, GOODS AND SERVICES IN EC LAW: A STUDY OF THE RELATIONSHIP BETWEEN 

THE FREEDOMS 196 (2002). 

96. Jans, supra note 91, at 240.. 

97. See Joined Cases 62 & 63/81 Seco v. ttablissement d'Assurance, 1982 E.C.R. 223, 236-37; Case C- 

240/95, Criminal proceedings against R~my Schmit, 1996 E.C.R. 1-3179, 1-3200. In German law, see 

BVerwGE 27, 181,187-88 (parking prohibition). 


2007 


measure was enacted) or an ex post perspective (the moment when the measure is 

analyzed by the court). In domestic law, the legislator is often granted a certain 

"right to err" in making his appraisals about future developments, operation, and 

effectiveness of the measure adopted. Thus, the scope of discretion granted to the 

initial decision maker will also affect the intensity of review-ranging from mere 

review of evidence to intense substantive review of the decision. 

2. Necessity 

The necessity test requires that the objective, upon which a measure is based, 

cannot be achieved by alternative means that are less restrictive than the measure 

adopted. If there is a choice between several appropriate measures, the least 

onerous and equally effective measure needs to be selected. 9 " This is often called the 

"least restrictive alternative." 99 The test combines two questions. The first question 

is whether there are less restrictive, or milder, measures. Secondly, one needs to ask 

whether the alternative measures are equally effective in achieving the pursued 

objective." ° 

The underlying objective of this test is that the measure adopted by the state 

should do minimal harm to citizens or the public interest. In the trade context, the 

necessity requires the states to impose the least trade-restrictive measure in pursuing 

non-trade-related domestic policy objectives. 

Referring to an example from the case law of the ECJ, the Court in de Peijper 

ruled out the necessity of domestic legislation which the Dutch authorities tried to 

justify on public health grounds. The ECJ held that the measure was not necessary 

since the domestic authorities could have pursued the same objective as effectively 

by adopting other means which were less-restrictive to intra-Community trade.' 

' 

In 

Familiapress, another free movement case, the ECJ ruled that it was for the national 

court to assess whether the national prohibition was "proportionate to the aim of 

maintaining press diversity and whether that objective might not be attained by 

measures less restrictive of both intra-Community trade and freedom of 

expression. ' ' 

In some English cases, such as the Shayler judgment, necessity is obviously 

interpreted differently than the classical three-step test outlined in this chapter.' 3 

98. SNELL, supra note 95, at 198. 

99. Jans, supra note 91, at 240. 

100. FEDERICO ORTINO, BASIC LEGAL INSTRUMENTS FOR THE LIBERALISATION OF TRADE: A 

COMPARATIVE ANALYSIS OF EC AND WTO LAW 471 (2004). 

101. Case 104/75, Adriaan de Peijper, 1976 E.C.R. 613, 636. 

102. Case C-368/95, Familiapress v. Bauer Verlag, 1997 E.C.R. 1-3689, 1-3717. See also Case C-275/92, 

Her Majesty's Customs & Excise v. Schindler, 1994 E.C.R. 1-1039 (granting the domestic authorities a wide 

margin of discretion to restrict or prohibit certain types of lotteries on public policy grounds). 

103. R. v. Shayler, (2003) 1 A.C. 247 (UKHL)(Eng.)(relating to the compatibility of Official Secrets 

Act 1989 with the Human Rights Act 1998). See R (Daly) v. Secretary of State for the Home Department 

[2001] UKHL 26, [2001] 2 A.C. 532; Huang v. Secretary of State for the Home Department, [2007] UKHL 

11; but see de Freitas v. Permanent Secretary of Ministry of Agriculture, Fisheries, Lands and Housing 

[1999] 1 A.C. 69 (laying down another version of the three step test which has been followed in the 

subsequent case law). 



VOL. 42:371 

The English courts in these cases have tended to align "necessity" with the principle 

of proportionality stricto sensu. The relevant part of Shayler reads as follows: 

It is plain from the language of article 10(2), and the European Court [of 

Human Rights] has repeatedly held, that any national restriction on 

freedom of expression can be consistent with article 10(2) only if it is 

prescribed by law, is directed to one or more of the objectives specified in 

the article and is shown by the state concerned to be necessary in a 

democratic society. "Necessary" has been strongly interpreted: it is not 

synonymous with "indispensable", neither has it the flexibility of such 

expressions as "admissible", "ordinary", "useful", "reasonable" or 

"desirable".. . . One must consider whether the interference complained 

of corresponded to a pressing social need, whether it was proportionate to 

the legitimate aim pursued and whether the reasons given by the national 

authority to justify it are relevant and sufficient under article 10(2) .... ." 

This quote illustrates quite well that necessity concepts may differ and yet 

reflect the same underlying concerns. 

3. Proportionality Stricto Sensu 

The third step is to analyze whether the effects of a measure are 

disproportionate or excessive in relation to the interests affected. This final stage of 

assessment comes into play once a measure has been found suitable and necessary to 

achieve a particular objective. It is at this stage that a true weighing and balancing of 

competing objectives takes place. The more intense the restriction of a particular 

interest, the more important the justification for the countervailing objective needs 

to be.' 5 

This third step will often not be reached. In EC law, the necessity analysis 

dominates most cases where the ECJ has applied the proportionality test. In some 

other cases, the ECJ tended to disguise proportionality stricto sensu as a normal 

necessity analysis, and it did not explicitly address the third step of analysis.' °6 

Within the necessity test, the Court has conducted a marginal review of 

proportionality, as some cases on consumer protection and product labeling 

illustrate.' 7 The Court has hereby implicitly questioned the level of protection 

adopted by the Member States, in addition to a traditional review of suitability and 

necessity of the domestic measures. 

In those rather rare cases where the ECJ has applied proportionality stricto 

sensu, it has usually reviewed the objectives submitted by the Member States to 

justify their domestic measures. In Stoke-on-Trent, the Court outlined 

proportionality stricto sensu in the most unambiguous way: 

104. Id. at 268-69. 

105. STEIN & FRANK, supra note 72, at 243. 

106. ORTINO, supra note 100, at 471. 

107. See Case 120/78, Rewe-Zentral v. Bundesmonopolverwaltung fur Branntwein, 1979 E.C.R. 649 

(holding that the fixing of a minimum alcohol content for alcoholic beverages is prohibited by Article 30 of 

the EEC Treaty) [hereinafter Cassis de Dijon]; see also Case 178/84, Comm'n v. Germany, 1987 E.C.R. 

1227 [hereinafter German Beer]. 


2007 


Appraising the proportionality of national rules which pursue a legitimate 

aim under Community law involves weighing the national interest in 

attaining that aim against the Community interest in ensuring the free 

movement of goods.'a' 

It should be noted that this was a rather exceptional statement in the 

jurisprudence of the ECJ.'" Nevertheless, this statement highlights that balancing in 

the trade context usually involves the comparison of the value and the importance of 

the national objective upon which the measure is based with the overall interest in 

ensuring free trade. The relative costs and benefits of the domestic measure and the 

restrictions imposed on free trade will be assessed. 

Danish Bottles is a classic case in which the ECJ applied the full proportionality 

test in the area of domestic environmental protection. It found that: 

[T]he system for returning non-approved containers is capable of 

protecting the environment and . . . affects only limited quantities of 

beverages compared with the quantity of beverages consumed in 

Denmark. . . . In those circumstances, a restriction of the quantity of 

products which may be marketed by importers is disproportionate to the 

objective pursued. "0 

In another case concerning the review of a Community legal act, the ECJ 

explained the full proportionality test as follows: 

[T]he principle of proportionality . . . requires that measures adopted by 

Community institutions should not exceed the limits of what is appropriate 

and necessary in order to attain the legitimate objectives pursued by the 

legislation in question, and where there is a choice between several 

appropriate measures, recourse must be had to the least onerous, and the 

disadvantages caused must not be disproportionate to the aims pursued 

111 

The application of the principle of proportionality in the area of fundamental 

rights is also illustrative. Whenever fundamental rights are restricted or interfered 

with by public authorities, the legislative or administrative measures will be assessed 

against the background of the principle of proportionality. This assessment is 

particularly relevant in areas covered by the ECHR and domestic constitutional law. 

Usually, the first stage of assessment is to identify the protected right or interest. 

One then moves on to identify the extent to which the right is interfered with or 

restricted. The next stage is to identify the reasons for that restriction. Finally, the 

last stage is to assess whether the interference was excessive or not. Restrictions 

have to be suitable, necessary, and proportionate. In this context, proportionality 

108. Case C-169/91, Stoke-on-Trent v. B&Q, 1992 E.C.R. 1-6625, 1-6658. 

109. Jans, supra note 91, at 248. 

110. Case 302/86, Comm'n v Denmark, 1988 E.C.R. 4607, 4632 (emphasis added) [hereinafter Danish 

Bottles]: see Case 44/79, Hauer v. Land Rheinland-Pfalz, 1979 E.C.R. 3727, 3749. 

111. Case T-13/99, Pfizer [2002] ECR 11-3305, paras 411-13; Case C-67/98, Questore di Verona v. 

Zenatti, 1999 E.C.R. 1-7289, 1-7316 (delegating the decision of whether domestic measure is 

disproportionate to the national courts). 



VOL. 42:371 

stricto sensu involves a "fair balance" between the disadvantages for the person 

whose rights are restricted and the weight of the legitimate aims pursued by the 

state. Interferences with fundamental rights need to be "proportionate to the policy 

aims that underlie them."" ' 

The justification for balancing and proportionality stricto sensu was outlined 

above. In the area of fundamental rights, for instance, state measures that are 

necessary may still be disproportionate because the disadvantages caused to an 

individual are excessive, compared to the aims pursued by the state. A necessary 

measure may be proportionate when it just marginally impacts on fundamental 

rights. On the other hand, even a severe impact on fundamental rights, such as the 

shooting of a criminal, may, in individual circumstances, be the only possible way to 

achieve a specific objective. It is only after a finding of necessity that a careful 

balancing and weighing will come into play.' 3 

III. INTENSITY OF REVIEW 

In the above sections we have discussed substantive aspects of the principle of 

proportionality. This section focuses on the procedural sibling: the issue of intensity 

of review. The reason for including this topic here is the following. When courts 

apply a particular test to assess the legality of the reviewed measure, they will also 

have to determine the level and rigour of scrutiny with which they apply those tests. 

Intensity or standard of review determines how strictly courts assess the compliance 

of a domestic measure with the substantive requirements." ' The question is whether 

courts defer to the justifications provided by the national authorities or rather 

undertake an entirely independent review of the measure at issue. 

In ECHR law, this question has been conceptualized as "margin of 

appreciation." " ' 5 The intensity of review of national measures will depend on, among 

other things, the fundamental right concerned, the wording of particular provisions 

of the ECHR, the type of legitimate aim pursued by the member state, and whether 

common European standards exist." 1 6 The concept of margin of appreciation, which 

is closely linked to the principle of proportionality, concerns the degree of deference 

that the European Court of Human Rights shows towards national authorities in 

interpreting and applying the ECHR. 

Intensity of review is often treated as a free-standing concept, as the concept of 

standard of review in WTO law demonstrates. In contrast, in the analysis of the 

principle of proportionality in EC law the assessment of the nature of the 

proportionality test is often combined with an assessment of the intensity of review 

adopted by the courts in applying this test. Courts can, for instance, impose a very 

strict proportionality standard while largely deferring to the findings of the national 

112. Philip Sales & Ben Hooper, Proportionality and the Form of Law, 119 L. Q. REV. 426, 426 (2003). 

113. MICHAEL KRUGMANN, DER GRUNDSATZ DER VERHALTNISMABIGKEIT IM VOLKERRECHT 

[THE PRINCIPLE OF PROPORTIONALITY IN INTERNATIONAL LAW] 55 (2004). 

114. SNELL, supra note 95, at 212. 

115. Eva Brems, The Margin of Appreciation Doctrine in the Case-Law of the European Court of 

Human Rights, 56 ZEITSCHRIFr FOR AUSLANDISCHES OFFENTLICHES RECHT UND VOLKERRECHT 

[HEIDELBERG J. INT'L L.] 240, 242 (1996). 

116. See generally Brems, supra note 115; see also HOWARD YOUROW, THE MARGIN OF 

APPRECIATION DOCTRINE IN THE DYNAMICS OF THE EUROPEAN COURT OF HUMAN RIGHTS 

JURISPRUDENCE 185-86 (1996). 


2007 


authorities. This deferential review will make the proportionality assessment less 

rigorous than it seems at first glance. Proportionality taken together with varying 

degrees of intensity of review may be a very sharp or rather blunt weapon in the 

hands of the judiciary. 

A. Intensity of Review in EC Law 

The close connection between the substantive requirements of proportionality 

and intensity of review is illustrated in the famous Fedesa judgment where the ECJ 

ruled that: 

[T]he principle of proportionality is one of the general principles of 

Community law. By virtue of that principle, the lawfulness of the 

prohibition of an economic activity is subject to the condition that the 

prohibitory measures are appropriate and necessary . . . when there is a 

choice between several appropriate measures recourse must be had to the 

least onerous, and the disadvantages caused must not be disproportionate 

to the aims pursued. 

However, with regard to judicial review of compliance with those conditions 

it must be stated that in matters concerning the common agricultural policy 

the Community legislature has a discretionary power .... Consequently, 

the legality of a measure adopted in that sphere can be affected only if the 

measure is manifestly inappropriate having regard to the objective which 

the competent institution is seeking to pursue .... "' 

The intensity of review may range from rigorous to very deferential. The 

overall degree of deference shown towards a reviewed measure will be determined 

by a variety of aspects, including the strictness of the examination of the underlying 

facts (and the necessity of the measure), the degree of justification required from 

national authorities, and the extent to which the court generally defers to the 

discretion of the authorities that took the initial decision. With regard to institutional 

considerations, courts do not show the same degree of deference to all institutions or 

actors involved. The case law of the ECJ serves as an illustrative example. The 

Court has regularly reviewed the activities of both member states and Community 

institutions. In many areas, the Court has adopted a more lenient standard of review 

towards the acts of Community institutions than of member states. 1 1 8 To give a 

concrete example, one may refer to Natalie McNelis' comparative study on the EC 

BSE case and the WTO EC - Hormones case." 9 McNelis concludes that the ECJ 

adopted a deferential approach in the BSE case because it trusted that the 

117. Case 331/88, The Queen v. Minister for Agriculture, Fisheries and Food ex parte Fedesa, 1990 

E.C.R. 1-4023, 1-4063 (emphasis added) [hereinafter Fedesa]. 

118. Takis Tridimas, Proportionality in Community Law: Searching for the Appropriate Standard of 

Scrutiny, in THE PRINCIPLE OF PROPORTIONALITY IN THE LAWS OF EUROPE 66 (Evelyn Ellis ed., 1999). 

119. Case C-180/96, United Kingdom v Commission, 1998 E.C.R. 2265: Appellate Body Report, 

European Communities - Measures Concerning Meat and Meat Products, para. 117, WT/DS48/AB/R (Jan. 

16, 1998) [hereinafter EC - Hormones ABR], available at 

http://www.wto.org/english/tratop-e/dispu-e/hormab.pdf. 



VOL. 42:371 

Commission had acted in the Community interest.' 20 In areas such as the Common 

Agricultural Policy and economic policy, the Commission, as a specialist bureaucracy 

with considerable expertise, and as guardian of the EC Treaty, enjoys a wide margin 

of discretion, particularly as to the nature and extent of the measures which it 

adopts. 121 Similarly, the Court of First Instance, reviewing harmonizing Community 

legislation, held that "[tihe Community judicature is not entitled to substitute its 

assessment of the facts for that of the Community institutions, on which the Treaty 

confers sole responsibility for that duty.' ' 2 In this context, the review by the courts 

of the necessity of the measure (the second element of the proportionality test) will 

be limited. While the Court is deferential towards the policy choices of the 

Community institutions, it puts more emphasis on the procedural aspects leading to 

the adoption of the measure. 23 Those processes and guarantees (e.g. due process 

and transparency requirements) will be reviewed more strictly. 

The Court's review is stricter when member states' measures constitute 

potential obstacles to the free movement guarantees of the EC Internal Market. 12 

This is the proper area to draw parallels to the WTO judiciary judging WTO 

Members' actions. 

The grounds of justifications and issues involved equally affect the intensity of 

review in EC law. Political issues, such as national security or economic policy, 

generally entail a wide discretion and choice of measures for public authorities. 

Courts will be ill-suited to evaluate these policy choices concerning the collective or 

public interest. Furthermore, Member States may have particular competence and 

expertise in certain areas which will lead courts to undertake a lighter review of the 

justifications provided by these states.' 25 Conversely, domestic measures aimed, for 

instance, at consumer protection have been scrutinized closely by the ECJ.1 26 

Consumer protection is an area closely linked to the EC's Internal Market where the 

Court has gained considerable experience. Equally, courts tend to adopt a stricter 

approach when individual rights and interests are at stake, such as the restriction of 

fundamental rights and market freedoms. 

Additionally, measures diverging from the majoritarian view or practice of the 

member states may be assessed more strictly than measures in areas where a 

consensus among the member states does not (yet) exist. 

120. See Natalie McNelis, The Role of Judge in the EU and WTO. Lessons from the BSE and 

Hormones Cases, 4 J. INT'L ECON. L. 189, 200-01 (2001). 

121. Case 55/75, Balkan-Import-Export v. Hauptzollamt Berlin-Packhof, 1976 E.C.R. 19, 30. The 

expertise argument is often invoked in the WTrO context (greater expertise of domestic agencies and 

decision-making processes). For an overview, see MATTHIAS OESCH, STANDARDS OF REVIEW IN WTO 

DISPUTE RESOLUTION 55-57 (2004). 

122. Case T-13/99, Pfizer, 2002 E.C.R. 11-3305, para. 169. See also Case C-84/94, United Kingdom v. 

Council, 1996 E.C.R. 1-5755 paras. 57-67 [hereinafter Working Time Directive]. 

123. Joanne Scott, International Trade and Environmental Governance: Relating Rules (and 

Standards) in the EU and WTO, 15 EURO. J. INT'L L. 307, 319 (2004). 

124. Compare Case C-369/89, Piageme v. BVBA Peeters, 1991 E.C.R. 1-2971 (stating that Article 30 

of the EEC Treaty precludes labeling requirement imposed by member state) with Case C-51/93, Meyhui v. 

Schott Zweisel Glaswerke, 1994 E.C.R. 1-3879 (labeling requirement imposed by a Directive). 

125. Sean Pager, Strictness vs. Discretion: The European Court of Justice's Variable Vision of Gender 

Equality, 51 AM. J. COMP. L. 553, 556 (2003). 

126. See German Beer, supra note 107; see also Case 261/81 Rau [1982] ECR 3961. 


2007 


B. Standard of Review in WTO Law 

In the WTO legal order, the concept of standard of review determines the 

nature and intensity of review exercised by the WTO judiciary. Similar to intensity 

of review in EC law, it is about the depth with which the challenged national 

measures are scrutinized.' 27 The underlying concern for WTO law is to what extent 

judges (need to) defer to national findings of facts and law and whether the judges 

may adopt different factual and legal conclusions than the domestic authorities 

under review (i.e., second guess the national determinations). 2 ' 

Through its central role in dispute settlement, standard of review influences the 

vertical relationship between supranational adjudicators and makers of sovereign 

member states. 2 9 It allocates the power to decide, in the last instance, on sensitive 

issues of law and fact. 3 " It is for this reason that standard of review has been 

recognized as an important concept of the WTO legal order and features 

prominently in the Panel and AB reports, as well as in the academic literature.' 

Usually, it is treated as a free-standing concept with a bearing on the conduct of the 

panel review of domestic measures. We attempt to situate it in the context of the 

overall subject of this article. 

The historical developments leading to the current standards of review have 

been explored elsewhere and need not be repeated here.' 32 It suffices to say that 

there is no explicit provision on standard of review in the GATT or the WTO 

Agreements, except for Article 17.6 of the Agreement on Implementation of Article 

VI of the General Agreement on Tariffs and Trade.' 33 

In the EC- Hormones case, the appellate body seized the opportunity to define 

a general standard of review for all WTO Agreements (except for those which 

prescribe a different standard).' The appellate body carefully ruled that the 

standard of review "must reflect the balance established . . . between the 

jurisdictional competences conceded by the Members to the WTO and the 

jurisdictional competences retained by the Members for themselves.', 135 Referring to 

DSU Article 11 as the textual basis, the AB declared the proper standard of review 

to be an "objective assessment of the matter" by the panel. 3 6 The relevant part of 

DSU Article 11 reads as follows: 

127. Matthias Oesch, Standards of Review in Dispute Resolution, 6 J. INT'L ECON. L. 635, 637 (2003). 

128. Id. at 637-38. 

129. See Stefan Zleptnig, The Standard of Review in WTO Law: An Analysis of Law, Legitimacy and 

the Distribution of Legal and Political Authority, 13 EURO. Bus. L. REV. 427, 456 (2002). 

130. See id. at 456-57. 

131. There is now considerable literature on this issue. See Stephen P. Croley & John H. Jackson, 

WTO Dispute Procedures, Standard of Review, and Deference to National Governments, 90 AM. J. INT'L L. 

193 (1996); see also OESCH, supra note 121 (discussing different approaches to standards of review). 

132. See OESCH, supra note 121, at ch. 4 (discussing GATT 1947 and its development of the notion of 

standard of review). 

133. See generally James Durling, Deference, But Only When Due: WTO Review of Anti-Dumping 

Measures, 6 J. INT'L ECON. L. 125 (2003) (discussing Article 17.6 of the Agreement on the Implementation 

of Art. VI of the General Agreement on Tariffs and Trade [hereinafter "Anti-Dumping Agreement"]). 

134. EC- Hormones ABR, supra note 119, para. 117. 

135. Id. para. 115. 

136. Id. para. 116. 



VOL. 42:371 

[A] panel should make an objective assessment of the matter before it, 

including an objective assessment of the facts of the case and the 

applicability of and conformity with the relevant covered agreements. 137 

In Hormones the AB ruled out two other possible standards of review. Both 

the de novo review (in which the panel substitutes its findings for that of the national 

authorities) and the total deference standard were rejected as inappropriate for the 

WTO dispute settlement system. 3 

The "objective assessment" standard itself is rather vague. It does not 

necessarily provide for precise substantive guidance regarding the nature and 

intensity of review exercised by the panels. Different authors have recently pointed 

out that, as a consequence, the appropriate standard of review is to be defined 

independently under each WTO agreement. For instance, panels will review 

national measures covered by the trade remedy agreements (e.g., anti-dumping, 

safeguards, and countervailing duties) differently from measures covered by the SPS 

and TBT Agreements or the GATT. 3 9 

The intensity of review set forth in DSU Article 11 relates to two different but 

interrelated aspects, the review of facts and law.' 0 The review of facts involves two 

steps. First, it relates to the process of fact-finding (the raw evidence) by domestic 

authorities.' The panel will review whether factual evidence was properly and 

sufficiently established.' 42 Second, it relates to the conclusions that national 

authorities draw from that factual evidence. 4 3 In their evaluation of raw evidence, 

WTO Members are usually granted a certain margin of discretion, subject to the 

condition that they adequately explain and justify how they reached their 

4 

conclusion.' 

Under the WTO trade remedy agreements, the panels' role is to review 

investigations and findings made by national authorities. Panels do not have the 

power to redo the original investigation and substitute their findings for that of 

national authorities (de novo review). They may, however, scrutinize whether the 

authorities respected the procedural requirements imposed on the domestic 

decision-making process and provided a "reasoned and adequate explanation" for 

their determinations. 14 

137. Understanding on Rules and Procedures Governing the Settlement of Disputes, Apr. 15, 1994, 

Marrakesh Agreement Establishing the World Trade Organization, Annex 2, Legal Instruments- Results 

of the Uruguay Round, 33 I.L.M. 1125 (1994) [hereinafter DSU], available at 

http://www.wto.org/English/docs-e/legal-e/28-dsu.pdf. 


139. See generally Holger Spamann, Standard of Review for World Trade Organization Panels in 

Trade Remedy Cases: a Critical Analysis, 38 J. WORLD TRADE 509 (2004) (arguing that national authorities 

would not necessarily fare worse under a de novo standard of review of trade measures); see also Claus- 

Dieter Ehlermann & Nicolas Lockhart, Standard of Review in WTO Law, 7 J. INT'L ECON. L. 491 (2004) 

(examining the review of trade remedy measures, SPS and TBT measures, and measures covered by the 

GATr 1994). 

140. Oesch, supra note 127, at 639. 

141. Id. 

142. Id. 

143. Id. 

144. Id. at 640-41. 

145. Appellate Body Report, United States - Safeguard Measures on Imports of Fresh, Chilled or 

Frozen Lamb Meat from New Zealand and Australia, para. 103, WT/DS177/AB/R (May 16, 2001) 


2007 


The following quote from US - Cotton Yarn summarizes the key elements of 

the standard of review as applied in this trade remedy case: 

[P]anels must examine whether the competent authority has evaluated all 

relevant factors; they must assess whether the competent authority has 

examined all the pertinent facts and assessed whether an adequate 

explanation has been provided as to how those facts support the 

determination; and they must also consider whether the competent 

authority's explanation addresses fully the nature and complexities of the 

data and responds to other plausible interpretations of the data. However, 

panels must not conduct a de novo review of the evidence nor substitute 

their judgement for that of the competent authority. 46 

The structure of review under the SPS and TBT Agreements will be different. 

Panels do not necessarily need to defer to formal investigations conducted at the 

national level. They will often be the first body to formally assess evidence, such as 

scientific justifications submitted in support of a particular domestic measure. Panels 

will then be less constrained in reviewing domestic fact-finding than under the trade 

remedy agreements. Under the GAT-F, panels may be in a similar position since 

they are often assessing facts which have neither been previously examined nor 

determined in formal procedures. Again, there may be no need to defer to the 

formal findings of domestic authorities. Regarding standard of review under the SPS 

Agreement, the AB once held: 

[W]ithin the bounds of their obligation under Article 11 to make an 

objective assessment of the facts of the case, panels enjoy a "margin of 

discretion" as triers of fact. Panels are thus "not required to accord to 

factual evidence of the parties the same meaning and weight as do the 

parties" and may properly "determine that certain elements of evidence 

should be accorded more weight than other elements."1 ' 7 

The review of law determines the consistency of a national measure (on the 

basis of established evidence) with the WTO Agreements and the extent to which 

panels can review the interpretation of WTO law submitted by the Members. In this 

area, it seems undisputed that the correct interpretation of the WTO Agreements is 

a matter for the panels and the AB, and there is no need to show deference towards 

national authorities. 14 

Standard of review in WTO law is a complex concept. It is hybrid in nature, 

due to "the interplay of substantive and procedural rules which, together, specify the 

role of Panels when reviewing national authorities' determinations." 149 ' The nature 

and intensity of review under the WTO Agreements depends on various factors. It 

(emphasis omitted) [hereinafter US - Lamb Meat], available at 

http://www.wto.org/english/tratop-e/dispu-e/cases-e/ds l77-e.pdf. 

146. US - Cotton Yarn, supra note 63, para. 74. 

147. Appellate Body Report, Japan - Affecting the Importation of Apples, para. 22t, 

WT/DS245/AB/R (November 26, 2003) (citations omitted) [hereinafter Japan - Apples], available at 

http://www.wto.org/english/tratop-e/dispu-e/245-abr-e.pdf. 

148. OESCH, supra note 121, at 30-33. 

149. Spamann, supra note 139, at 514. 



VOL. 42:371 

is relevant whether domestic authorities already conducted formal investigations 

which may include procedural guarantees for those affected by the decision-making 

process. Another issue is the expertise of the domestic decision-makers. On the 

other hand, panels may be the first to review evidence submitted to justify a 

particular measure. 

The way in which the review is conducted and the depth of scrutiny adopted by 

the panels will have a crucial impact on the substantive findings of the panels. To 

illustrate this point, we can refer to the necessity (or least trade-restrictiveness) 

requirement. 5 The panel will make a finding on the necessity of a domestic measure 

by taking into account and balancing a range of substantive, procedural, and factual 

criteria. Legal principles and substantive tests are hereby closely intertwined with 

the concept of standard of review, and the relationship between these different 

concepts will be one of mutual influence and dependence. The intensity of review 

strongly impacts on the court's assessment of the compliance of the reviewed 

measure with the substantive treaty requirements. It is this matrix-type relationship 

between substantive and procedural standards which governs the application of the 

principle of proportionality and similar tests in the judicial process. 

IV. 

PROPORTIONALITY IN PUBLIC INTERNATIONAL LAW 

The principle of proportionality has been extensively discussed in the context of 

domestic and EC law. In those areas, it is usually applied to the relationship 

between states and citizens and the exercise of legislative or regulatory competence. 

In addition, proportionality in public international law governs the relationship 

between equal and sovereign states. There are many areas of public international 

law where the principle of proportionality plays an important role. At the same 

time, it is difficult to identify a coherent substantive content of proportionality across 

the whole range of public international law. We focus on some core areas where 

proportionality plays a crucial role in determining the scope of international norms 

and the powers that states may exercise vis-A-vis other states and their populations. 

A. Countermeasures 

The principle of proportionality plays a prominent role in the law of 

international countermeasures. We will discuss proportionality and countermeasures 

generally and then turn to relevant case law and the important International Law 

Commission Articles on Responsibility of States for Internationally Wrongful Acts. 

Generally, proportionality in the law of countermeasures determines the extent 

to which countermeasures in response to wrongful acts are permissible, thus 

regulating both the nature and intensity of the response. 5 ' Proportionality imposes 

limitations on the unilateral power to take countermeasures. The precise normative 

content of proportionality in the area of countermeasures, however, is more difficult 

to determine. It includes at least two interconnected aspects: "[p]roportionality 

requires not only employing the means appropriate to the aim chosen, but implies, 

150. Alexy, supra note 38, at 66. 

151. Enzo Cannizzaro, The Role of Proportionality in the Law of International Countermeasures, 12 

EURO. J. INT'L L. 889, 915-16 (2001). 


2007 


above all, an assessment of the appropriateness of the aim itself."' 52 The latter aspect 

relates to the aim pursued by a state in response to wrongful conduct by another 

state. The aim itself needs to be appropriate and reasonable in the context of the 

situation and the breached rule.' 3 Once the appropriateness of the aim pursued has 

been established, countermeasures are required to be proportionate to the original 

breach. 

Proportionality featured prominently in the Gabcikovo-Nagymaros (Hungary 

v. Slovakia) case before the ICJ. The Court's succinct formula relating to 

proportionality was that "the effects of a countermeasure must be commensurate 

with the injury suffered, taking account of the rights in question."' 54 The 

countermeasure at issue- Czechoslovakia had diverted the river Danube-was 

found disproportionate and unlawful by the Court: 

Czechoslovakia, by unilaterally assuming control of a shared resource, and 

thereby depriving Hungary of its right to an equitable and reasonable 

share of the natural resources of the Danube-with the continuing effects 

of the diversion of these waters on the ecology of the riparian area of the 

Szigetk6z-failed to respect the proportionality which is required by 

international law.' 5 

The ICJ did not only evaluate the countermeasure in purely quantitative terms 

(the injury suffered), but took account of other qualitative factors as well (in 

particular, the parties' rights involved). Hungary, for instance, which had committed 

the original wrongful act, still had the right to an "equitable and reasonable share of 

the natural resources of the Danube." ' 6 It was by taking the countermeasures at 

issue that Czechoslovakia had deprived Hungary of this right and thus violated the 

principle of proportionality. 

Article 51 of the recent ILC Articles on Responsibility of States for 

Internationally Wrongful Acts is entitled "Proportionality." 15' This provision 

reaffirms the ICJ's approach in Gabcikovo-Nagymaros and reads as follows: 

"Countermeasures must be commensurate with the injury suffered, taking into 

' 

account the gravity of the internationally wrongful act and the rights in question. 

The Commentaries to the Draft Articles explain the reasoning behind Article 

51 and outline the two components of the proportionality requirement. The first 

component is quantitative and assesses the injury suffered by the injured state. The 

152. Id. at 897 (emphasis added). 

153. Id. at 899. 

154. Gabcikovo-Nagymaros Project (Hung. v. Slovk.), 1997 I.C.J. 7, 56 (Sept. 25). 

155. Id. 

156. Id. para. 85. 

157. See also U.N. International Law Commission, Responsibility of States for Internationally 

Wrongful Acts, (adopted at the Commission's fifty-third session in 2001 and submitted in the UN General 

Assembly as a part of the Commission's work) and Commentaries to the Draft Articles on Responsibility of 

States for Internationally Wrongful Acts, U.N. GAOR 56th Sess., Supp. No. 10, art. 51, para. 4, U.N. Doc 

A/56/10 (2001) [hereinafter International Law Commission's Articles], available at 

http://untreaty.un.org/ilc/reports/2001/2001report.htm (search by chapter "State Responsibility"). See also 

James Crawford et al. The ILC's Articles on Responsibility of States for Internationally Wrongful Acts: 

Completion of the Second Reading 12 EUR. J. INT'L. L. 963-991 (2007). 

158. Id. art. 51. 



VOL. 42:371 

second component is qualitative and requires that additional factors be taken into 

account, such as the "importance of the interest protected by the rule infringed and 

the seriousness of the breach. '" ' Proportionality of countermeasures will therefore 

be assessed in relation to the injury suffered, while the gravity of the wrongful act, 

the importance of the protected interests, and the impact on rights of both the 

injured and the responsible states are also taken into account and balanced against 

one another. 

Proportionality as a legal principle governing the relationship between the 

wrongful act and the countermeasure refines the basic requirement in Article 49 of 

the Draft Articles. This provision, which states the objects and limits of 

countermeasures, requires that they be taken only to induce the state responsible for 

the wrongful act to comply with its obligations.' 6 0 In this respect, proportionality 

goes beyond a mere necessity test since it is not only relevant whether the 

countermeasure was necessary to achieve compliance. It is possible that 

countermeasures are considered disproportionate in circumstances where they go 

beyond what is necessary to achieve compliance and instead pursue a punitive 

objective . 

B. Use of Force and Armed Conflicts' 62 

The principle of proportionality is an equally important concept for the law on 

the use of force (jus ad bellum) and the law of armed conflicts (/us in bello)' 6 In the 

first case, it relates to the response to a particular attack and, in the second case, it 

relates to the conduct of that response and the balance that needs to be struck 

between military objectives and the damages inflicted on the enemy. '6 1 

Proportionality is particularly interesting and controversial in these fields, given the 

significant and unalterable consequences which the interpretation and application of 

this principle may have. Moreover, the application of proportionality in these 

circumstances is useful to highlight its problems and limitations. In her 1993 article 

on proportionality and force in international law, Judith Gail Gardam critically notes 

that: 

Despite the potential of proportionality to undermine pleas of selfdefence, 

at no time has much attention been paid to its requirements. This 

omission is somewhat surprising, given the status of proportionality as one 

of the determinants of the legality of a state's use of force. Moreover, it 

remains relevant throughout the conflict 65 

In the law relating to the right to use force, proportionality refers to a 

belligerent's response to a grievance. The resort to force under the UN Charter is 

159. Id. art. 51, para. 6. 

160. Id. art. 49. 

161. Id. art. 49, para. 7. 

162. The authors gratefully acknowledge the research of Daniel Geron, which has been of assistance 

to this section. 

163. Judith Gardam, Proportionality and Force in International Law, 87 AM. J. INT'L L. 391, 391 

(1993); JUDITH GARDAM, NECESSITY, PROPORTIONALITY AND THE USE OF FORCE BY STATES 32-53 

(2004). 

164. Id., at 391. 

165. Id. at 404 (citation omitted). 


2007 


limited by the customary law requirement that it be proportionate to the unlawful 

aggression which caused it. Article 51 of the UN Charter prohibits the use of force 

other than in self-defense, but it does not mention the principle of proportionality 

expressly. The International Court of Justice (ICJ) in Military and Paramilitary 

Activities in and against Nicaragua referred to the well-established rule of customary 

international law that "self-defence would warrant only measures which are 

proportional to the armed attack and necessary to respond to it . . . ."'66 In its 

Advisory Opinion on the Threat or Use of Nuclear Weapons, the ICJ referred back to 

its Nicaragua decision and held: 

The submission of the exercise of the right of self-defence to the 

conditions of necessity and proportionality is a rule of customary 

international law .... This dual condition applies equally to Article 51 of 

the Charter, whatever the means of force employed. The proportionality 

principle may thus not in itself exclude the use of nuclear weapons in selfdefence 

in all circumstances. But at the same time, a use of force that is 

proportionate under the law of self-defence, must, in order to be lawful, 

also meet the requirements of the law applicable in armed conflict which 

comprise in particular the principles and rules of humanitarian law. 6 1 

The Court's jurisprudence highlights the requirement that actions of selfdefense 

shall observe both the criteria of necessity and proportionality. The role of 

proportionality in this context is to impose limitations on lawful self-defense and to 

determine the harm that may be done to others. The means employed shall be 

necessary to respond to, and fend off, a particular attack and be proportionate in 

relation to the severity of the attack. To give a concrete example, it would be 

disproportionate to respond to a minor raid across the border with the use of nuclear 

weapons. 

Taking a close look at the proportionality requirement, Judge Higgins has 

raised the fundamental question: "proportionate in respect of what?' 6 She then 

argued that proportionality usually relates to the injury received by a single 

incident.' 69 In cases of continuing aggression or invasion, proportionality might not 

relate to specific injuries as such, but to the overall objective of ending or reversing 

the aggression. 7 ' With regard to the possible use of nuclear weapons in self-defense, 

the ICJ's Advisory Opinion on the Threat or Use of Nuclear Weapons recognized still 

further factors involved in the assessment of proportionality, for instance the risks of 

escalating the conflict. 71 

In the Oil Platforms case, the ICJ considered two actions by the U.S. against 

Iranian targets to determine whether the self-defense responses were necessary and 

166. Military and Paramilitary Activities (Nicar. v. U.S.), 1986 I.C.J. 14, paras. 176, 194 (June 27), 

available at http://www.icj-cij.org/icjwww/icases/inus/inus-ijudgment/inus-ijudgment-19860627.pdf. 

167. Legality of the Threat or Use of Nuclear Weapons, Advisory Opinion, 1996 I.C.J. 226 (July 8) 

paras. 41-42 (emphasis added) [hereinafter Nuclear Weapons], available at http://www.icjcij.org/icjwww/icases/iunan/iunanframe.htm. 

168. ROSALYN HIGGINS, PROBLEMS AND PROCESS. INTERNATIONAL LAW AND How WE USE IT 

231(1994) (quotes omitted). 

169. Id. 

170. Id. at 231-232. 

171. Nuclear Weapons, supra note 167, para. 43. 



VOL. 42:371 

proportionate to the Iranian attack. 72 The United States failed to convince the ICJ 

that its attacks on the platforms qualified as "necessary" acts of self-defense against 

the Iranian attacks. 7 3 There is an interesting statement on the relationship between 

necessity and proportionality in the Court's decision. Referring to the U.S. attack of 

October 19, 1987, the ICJ stated that, had it found this attack to be a necessary 

response to the Iranian attack, it might have been proportionate. 74 With regard to 

other U.S. attacks of 1988, which were part of a broader operation entitled 

"Operation Praying Mantis," the Court held that neither the operation as a whole 

nor the more specific attacks could be regarded as "proportionate use of force in 

self-defence. "17 

The relevant parameters of the proportionality principle are even more 

complicated in the debate over the legality of the doctrine of anticipatory selfdefense. 

The main question is whether the force used in anticipation of an attack is 

proportionate to the threat. Brownlie, for instance, has put forward some objection 

to anticipatory self-defense on the basis that it may be contrary to the principle of 

proportionality. 176 More fully, his argument goes as follows: 

It is possible that in a very limited number of situations force might be a 

reaction proportionate to the danger where there is unequivocal evidence 

of an intention to launch a devastating attack almost immediately. 

However, in the great majority of cases to commit a state to an actual 

conflict when there is only circumstantial evidence of impending attack 

would be to act in a manner which disregarded the requirement of 

proportionality.' 77 

The substantive law of armed conflicts is also based on the requirements of 

proportionality. In the context of jus in bello proportionality refers to the balance to 

be struck between the achievement of a military goal and the cost in terms of lives of 

combatants and the civilian population. Proportionality is considered to be a 

fundamental principle of the law of armed conflict. 178 It is not always expressed as 

"proportionality" in the particular rules of the law of war, but its presence can be 

clearly seen to underpin and inspire many of the rules in this area.1 7 1 

Proportionality is a determining factor in a variety of situations, including the 

selection of targets, the means and methods of attack, and the conduct of the attack 

itself.' The underlying concern is to limit casualties and damages done to others "to 

what is proportionate to the achievement of the military goal.''. The choice of the 

means of warfare and the damages that may result is clearly restricted by the 

172. Oil Platforms (Iran v. U. S.), 2003 I.C.J. 161 (Nov. 6). 

173. Id. para. 76. 

174. Id. para. 77. 

175. Id. 

176. IAN BROWNLIE, INTERNATIONAL LAW AND THE USE OF FORCE BY STATES 261-262 (1963). 

177. Id. at 259. 

178. Gardam, supra note 163, at 391. 

179. See generally Convention Respecting the Laws and Customs of War on Land, Annex to the 

Hague Convention, U.S. - Neth., Oct. 18, 1907, 36 Stat. 2277 [hereinafter Hague IV]; Protocol Additional 

to the Geneva Convention of 12 August 1949 and Relating to the Protection of Victims of International 

Armed Conflicts, June 8, 1977, 1125 U.N.T.S. 3 [hereinafter Protocol I]. 

180. Gardam, supra note 163, at 407. 

181. Id. at 406. 


2007 


principle of proportionality. In this context, decision-makers and the military have 

to undertake a cost-benefit analysis to assess the damages that an action may cause, 

for instance, to non-combatants. It is hardly surprising that this involves a complex 

balancing of competing goals that needs to be reconciled by the military before and 

during their actions, and an assessment of those actions will take place by judges of 

those actions ex post. 

The difficulties in applying the principle of proportionality in this area were 

presented in a Report to the Prosecutor at the International Criminal Tribunal for 

the Former Yugoslavia (ICTY): 

The main problem with the principle of proportionality is not whether or 

not it exists but what it means and how it is to be applied. It is relatively 

simple to state that there must be an acceptable relation between the 

legitimate destructive effect and undesirable collateral effects. . . . It is 

much easier to formulate the principle of proportionality in general terms 

than it is to apply it to a particular set of circumstances because the 

comparison is often between unlike quantities and values. One cannot 

easily assess the value of innocent human lives as opposed to capturing a 

particular military objective. 

The questions which remain unresolved once one decides to apply 

the principle of proportionality include the following: 

(a) What are the relative values to be assigned to the military 

advantage gained and to the injury to non-combatants and/or the damage 

to civilian objects? ... 

(c) What is the standard of measurement in time or space? and 

(d) To what extent is a military commander obligated to expose his 

own forces to danger in order to limit civilian casualties or damage to 

civilian objects? 

The answers to these questions are not simple. It may be necessary to 

resolve them on a case by case basis, and the answers may differ 

depending on the background and values of the decision maker. It is 

unlikely that a human rights lawyer and an experienced combat 

commander would assign the same relative values to military advantage 

and to injury to non-combatants.' 

182. Id. at 406.; Final Report to the Prosecutor by the Committee Established to Review the NATO 

Bombing Campaign Against the Federal Republic of Yugoslavia. ICTR PR/P.I.S./510-E, paras. 48-50 (June 

8. 2000), reprinted in 39 I.L.M. 1257. 



VOL. 42:371 

C. Maritime Delimitation 

Finally, we may refer to the area of maritime delimitation, where 

proportionality appears as an element of equity intended to guide the decisionmaking 

process." 3 Recourse to the concept of proportionality is made to evaluate 

the award of continental shelf land to states. 

D. Conclusion 

We have shown that the principle of proportionality is an essential concept in 

international law. Yet its content remains diffuse, and the different nuances and 

functions vary from area to area. Generally, proportionality in international law is 

about the limits of unilateral state action necessary to pursue a legitimate objective. 

In some instances, proportionality goes further than that. In addition to the 

necessity of a state action, proportionality requires a complex balancing of 

quantitative and qualitative factors, including competing rights, values and interests. 

This is particularly pertinent in the areas of countermeasures and the use of force. 

The international legal system traditionally lacks the element of subordination 

that can be found in the domestic context. Within this legal order, the principle of 

proportionality plays an important role as a standard to determine how far sovereign 

states can go in their relationships with other states. One core function of 

proportionality in international law is to impose functional limitations on the 

exercise of state powers. In this context, proportionality appears in two different 

ways. First, it serves as an overarching principle guiding the relationship between, 

and the scope of, other rules and principles. One function of principles in 

international law is to fill gaps and to avoid a non liquet, and this is where 

proportionality may come into play. Second, proportionality may be part of the 

substantive law on countermeasures, self-defense, or armed conflicts, and thereby 

establishes positive obligations for state actions in those areas. 

V. BALANCING IN US CONSTITUTIONAL LAW: THE INTERSTATE 

COMMERCE CLAUSE 

The Interstate Commerce Clause (ICC) is an important and complex feature of 

U.S. constitutional law.' 8 ' Broadly speaking, the ICC covers two different aspects. 

First, it grants Congress the power to legislate on interstate commerce matters. 

186 

Second, it imposes limitations on states when interfering with interstate commerce. 

The ICC can be said to fulfill a similar function to the free movement provisions in 

183. HIGGINS, supra note 168, ch. 13. 

184. U.S. CONST. art. I, § 8, cl. 3 (providing that Congress shall have power to "regulate Commerce 

with foreign Nations, and among the several States, and with the Indian Tribes"). There is considerable 

literature on the development and current interpretation of the Commerce Clause. See generally 

LAURENCE TRIBE, AMERICAN CONSTITUTIONAL LAW § 6 (3d ed. 2000); Michael Lawrence, Toward a 

More Coherent Dormant Commerce Clause: A Proposed Unitary Framework, 21 HARV. J. L. & PUB. POL'Y 

395 (1998). 

185. Lawrence, supra note 184, at 407. 

186. Id. 


2007 


EC law. 8 7 1 Furthermore, the ICC has sometimes been compared to the GATT, with 

scholars attempting to gain some useful insights from the ICC doctrine for GAIT 

law. 88 The ICC has many different facets which will not be discussed in detail here. 

However, particularly relevant for the scope of this paper is the difference under the 

ICC between (a) the strict necessity test applied to discriminatory regulation and (b) 

the balancing approach applied to non-discriminatory 

9 

regulation. Whenever state 

regulation affects interstate commerce, even by doing so incidentally, it needs to 

satisfy those tests; otherwise it will be struck down as unconstitutional.' 90 The 

balancing approach seems to resemble the proportionality analysis in EC law. 

According to both of these concepts, the judges will ultimately assess whether 

legitimate interests sought by public authorities outweigh the burden imposed on 

free trade or other protected rights and interests. 

The applicable tests of review depend on whether state regulation discriminates 

against out-of-state or interstate commerce. If there is discrimination, state 

regulation will be measured against a strict standard, as opposed to the more 

deferential balancing test applied to non-discriminatory measures."" 

If state regulation is discriminatory against interstate commerce, it is subject to 

strict judicial scrutiny and may only be upheld if two conditions are fulfilled. First, 

the measure must pursue a legitimate local purpose.' 92 State interests may, for 

instance, involve public health or safety, environmental protection or the prevention 

of consumer fraud. 9 Second, even if state regulation pursues a legitimate purpose, it 

will be considered unlawful if there are less discriminatory means by which the state 

could achieve the same purpose.' 94 The burden is on the state to prove the necessity 

of its measure. 9 This approach has been called the heightened scrutiny test.'1 6 The 

courts may adopt different degrees of scrutiny under such a less restrictive means 

test. In C & A Carbone v. Town of Clarkstown, for instance, the Supreme Court 

formulated a particularly strict standard of scrutiny: 

Discrimination against interstate commerce in favor of local business or 

investment is per se invalid, save in a narrow class of cases in which the 

187. GEORGE BERMANN ET AL., CASES AND MATERIALS ON EUROPEAN UNION LAW 452 (2d ed. 

2002). 

188. Robert Howse, Managing the Interface between International Trade and the Regulatory State: 

What Lessons Should (and Should Not) Be Drawn from the Jurisprudence of the United States Dormant 

Commerce Clause, in REGULATORY BARRIERS AND THE PRINCIPLE OF NON-DISCRIMINATION IN WORLD 

TRADE LAW, 2 WORLD TRADE FORUM 139-66 (Thomas Cottier & Petros Mavroidis eds. 2000). 

189. TRIBE, supra note 184, at 1049-51. 

190. Id. 

191. One of the justifications provided for a strict standard for discriminatory measures is the political 

representation argument. It says that lawmakers may be exposed to pressures from the domestic 

constituency, which leads lawmakers to take decisions harmful to others who are not represented in the 

domestic political process (for instance, out-of-state companies). Courts should therefore only show 

deference towards democratic decisions if all interests affected have adequately been represented in the 

political process. See TRIBE, supra note 184. at 1051-55. 


193. JEROME BARRON & THOMAS DIENES. CONSTITUTIONAL LAW IN A NUTSHELL 116 (1999). 


195. Daniel Farber & Robert Hudec, Free Trade and the Regulatory State: A GA TT's-Eye View of the 

Dormant Commerce Clause, 47 VAND. L. REV. 1401, 1412-13 (1994). 

196. BARRON & DIENES, supra note 193, at 114. 



VOL. 42:371 

municipality can demonstrate, under vigorous scrutiny, that it has no other 

means to advance a legitimate local interest. . . . [A]rguments [that the 

municipality has no other means to advance a legitimate local interest] 

must be rejected absent the clearest showing that the unobstructed flow of 

interstate commerce itself is unable to solve the local problem ...."' 

Conversely, non-discriminatory measures with only incidental effects on 

interstate commerce are subject to a lighter balancing test. '9 The reason for this test 

is that state regulation, even in the absence of discrimination, may still place an 

undue or excessive burden on interstate commerce. 9 Courts, adopting the 

balancing test, will inquire whether legitimate regulatory interests of the state 

outweigh the impediment to free movement of interstate commerce." There is also 

an additional least-restrictive-means requirement which is less strict than the one 

applied to discriminatory measures.21 This ad hoc balancing test was elaborated by 

the Supreme Court in Pike v. Bruce Church: 

Where the state regulates even-handedly to effectuate a legitimate local 

public interest, and its effects on interstate commerce are only incidental, 

it will be upheld unless the burden imposed on such commerce is clearly 

excessive in relation to the putative local benefits. If a legitimate local 

purpose is found, then the question becomes one of degree. And the 

extent of the burden that will be tolerated will of course depend on the 

nature of the local interest involved, and on whether it could be promoted 

as well with a lesser impact on interstate activities. 0 2 

The main idea is that state regulation pursuing a legitimate interest is justified 

but should not be excessively burdensome on interstate commerce. This balancing 

test, in fact, leaves broad discretion to the courts to decide whether the burden on 

interstate commerce is excessive in relation to the benefits for the regulating state." 0 3 

Applying this judicial balancing test, the Supreme Court has "most often upheld the 

statute as one whose benefits outweigh its burdens." 2 °4 This reflects the fact that the 

ICC balancing test is less intrusive and more deferential towards regulatory decisionmaking 

than the ICC test as applied to discriminatory regulation. 

The application of this test goes beyond the ICC. Regulatory takings cases 

have developed over time using a variety of similar tests. The Rehnquist Court 

advanced a reasonable relationship test, which bore a striking similarity to the 

rational basis test utilized in economic analysis for Due Process and Equal 

Protection Clause cases. 05 The court also referred to this relationship as an essential 

nexus. 2°6 In Dolan v. City of Tigard, Chief Justice Rehnquist stated that despite any 

semantic differences, jurisdictions applied the proper reasonable relationship test, 

197. C & A Carbone v. Town of Clarkstown, 511 U.S. 383,392-93 (1994) (emphasis added). 

198. BARRON & DIENES, supra note 193, at 110-13. 

199. Id. 

200. Id. at 115. 

201. Id. at 114. 

202. Pike v. Bruce Church, Inc., 397 U.S. 137, 142 (1970) (citation omitted). 

203. ERWIN CHEMERINSKY, CONSTITUTIONAL LAW: PRINCIPLES AND POLICIES § 5.3.5 (2d ed. 2002). 

204. TRIBE, supra note 184, at 1062. 

205. Daniel A. Crane, A Poor Relation? Regulatory Takings after Dolan v. City of Tigard, 63 U. CHI. 

L. REV. 199,215 (1996). 

206. Nollan v. California Coastal Comm'n, 483 U.S. 825,837 (1987). 


2007 


balancing the state interest against the exaction of private property. Each is 

arguably a form of proportionality, the same which is applied in Eighth Amendment 

capital punishment cases, in the ICC and in every clash of congressional legislation 

with the interests 

8 

of the states . 

The Court's approach towards the Commerce Clause, and in particular the 

balancing test, has been subject to considerable criticism by judges and academics 

alike. 2 ' On the one hand, some are concerned that it is inappropriate for judges to 

engage in a balancing process of competing (and often non-comparable) values or 

interests, in particular with respect to non-discriminatory measures. It is argued that 

this should be left to the legislative process rather than to judicial activism. As a 

consequence, courts are considered to be ill-suited to undertake that kind of 

balancing. They should adopt a deferential approach instead of second-guessing 

regulatory measures." ° Another argument is that the balancing test has proven too 

uncertain and imprecise, which is why it has failed to become a guiding principle of 

constitutional law. This far-reaching debate on the merits of the Court's 

jurisprudence is beyond the scope of this article. 

A few conclusions can be drawn from the preceding discussion. First, both the 

least-restrictive means test and the balancing test provide standards against which 

regulatory measures can be assessed. This is a useful attempt to rationalize judicial 

review. Doubts remain as to whether the standards are sufficiently precise, 

intellectually coherent, and clear enough to provide guidance to the regulators, as 

well as to make judicial review more predictable. " ' The discussion about the 

Commerce Clause reflects similar issues arising in WTO law. It relates to the 

appropriate role for judges and judicial review in a federal and international legal 

system. It is also about the allocation of powers and the question of whose view 

should ultimately prevail in case of disputes: the judges' or the regulators' view. 

Both in the context of the Commerce Clause and WTO law, political 

representation arguments have been raised. One justification for judicial review is to 

ensure the appropriate protection of minorities (or foreigners) not represented in 

the domestic political process. These arguments can be turned into an important 

proceduralist aspect of substantive tests, such as balancing under the Commerce 

Clause or proportionality. The greater the representation of all interests affected in 

the domestic process, the more deference tribunals may show towards the political 

212 

process. 

207. Crane, supra note 205, at 223. 

208. Regarding the Eighth Amendment, see Ewing v. California, 538 U.S. 11 (2003). Regarding issues 

of federalism, see Tennessee v. Lane, 541 U.S. 509 (2004); F.E.R.C. v. Mississippi, 456 U.S. 742 (1982): U.S. 

v. Lopez, 514 U.S. 549 (1995). 

209. See, e.g., TRIBE, supra note 184. 

210. The Commerce Clause jurisprudence is a highly complex and difficult area of constitutional law. 

One commentator noted that "[glenerations of law students, judges, practicing lawyers, and legal 

commentators have struggled to understand exactly what the Supreme Court does when it decides cases 

involving the Dormant Commerce Clause." Lawrence, supra note 184, at 464. 

211. Lawrence, supra note 184, at 397. 

212. See Zleptnig, supra note 129, at 450-54: Robert Howse, Adjudicative Legitimacy and Treaty 

Interpretation in International Trade Law: The Early Years of WTO Jurisprudence, in THE EU, THE WTO 

AND THE NAFTA. TOWARDS A COMMON LAW OF INTERNATIONAL TRADE 35-69 (JHH Weiler, ed., 

2000). 



VOL. 42:371 

VI. BALANCING IN THE WTO 

One aim of this paper is to outline some important areas of WTO law where 

proportionality or similar balancing tests do occur. The preceding discussion has 

shown that the concept of proportionality, while its core remains the same, has 

different constitutive elements and objectives which very much depends on the area 

of application of this principle. Another factor is that the different elements of the 

proportionality test may be applied with an ascending degree of scrutiny. 

Within WTO law, we can conceptually distinguish between two different areas 

of application: public policy exceptions, which limit the scope of legal rules and 

provide for derogations from main treaty obligations (e.g., GATT Article XX), and 

positive obligations imposed on Members by the SPS and TBT Agreements. These 

positive obligations lay down substantive criteria for domestic regulation to ensure 

that domestic regulation does not impose too burdensome constraints on 

international trade. 2 3 

Within either of these categories, one may further distinguish between the 

substantive and procedural aspects of the different tests. The substantive aspects lay 

down normative requirements to assess the compliance of domestic measures with 

WTO law. Related to substantive obligations are procedural obligations incumbent 

on the Members, which we will refer to as the procedural aspect. Procedural 

obligations need to be taken into account at the national level (in administrative 

proceedings or the legislative process) and will subsequently be reviewed by the 

judicial bodies of the WTO. Insofar as these procedural requirements relate to the 

quality of the domestic processes, they impose "procedural checks" on domestic 

decisionmaking 14 

A few authors have argued that the principle of proportionality is not explicitly 

(or even implicitly) recognized in the law of the WTO. 21 Our own approach in this 

chapter is to move the existing debate further and to outline some structural features 

inherent in the different tests laid down in the WTO Agreements. Whenever 

appropriate, we will draw parallels to the proportionality and balancing tests in other 

legal orders. 

A. Objective Justifications: Public Policy Exceptions in the GA TT 

1. Introduction 

GATT Article XX provides for a list of general exceptions from the GATT 

obligations. The scope and application of this provision is crucial for WTO Members 

that want to justify their domestic policies as GATT-consistent and invoke one of 

the public policy exceptions in Article XX. To date, this provision has already 

touched upon some of the most sensitive issues of WTO law and is likely in the 

future "to raise some of the most difficult questions that the WTO will face. 21 6 

213. Howse, supra note 188, at 154. 

214. Scott, supra note 123, at 337. 

215. See Desmedt supra note 3. 

216. Donald McRae, GATT Article XX and the WTO Appellate Body, in NEW DIRECTION IN 

INTERNATIONAL ECONOMIC LAW: ESSAYS IN HONOUR OF JOHN H. JACKSON 219, 233 (Marco Bronckers 

& Reinhard Quick eds., 2000). 


2007 


Any domestic measure, in order to qualify as a lawful exception under Art XX 

GATT, needs to comply with the conditions laid down in this provision. 2 7 The AB 

in US - Gasoline set out the appropriate method and sequence of steps for applying 

Article XX. 2 " This consists of two different steps, which, taken together, make the 

full assessment of a measure under Article XX. The first step is to assess whether 

the general design of a measure falls within the scope of one of the exceptions in 

Article XX (a) - (j). Subsequently, the application of a measure is assessed against 

the criteria in the introductory clauses (Chapeau) of Article XX. 

2. General Design 

The first step is to determine whether the domestic measure can be justified in 

accordance with one of the public policy exceptions. So far, the main focus of the 

case law has been on health measures (paragraph b), enforcement measures 

(paragraph d) and conservation measures (paragraph g). 2 9 The right of WTO 

Members to adopt a specific public policy objective and to choose the desired level 

of protection or enforcement has not been questioned by the panels or the AB. 22 ° In 

Asbestos, for instance, the AB held that "it is undisputed that WTO Members have 

the right to determine the level of protection of health that they consider 

appropriate in a given situation." 2 ' In US - Gasoline, the AB previously stated that 

"WTO Members were free to set their own environmental objectives, but they were 

bound to implement these objectives through measures consistent with ... [GATT] 

provisions.... ,,2 As far as the assessment of the appropriateness of the aim pursued 

is concerned, Members will have a wide margin of discretion. This discretion is 

subject to the condition that the chosen objective falls within the scope of the 

exceptions mentioned in Article XX GATT. 

The next step will be to determine the relationship, or connection, between the 

aim pursued and the measure adopted. This is a sensitive issue, for it has an impact 

on the intensity with which judges review (second-guess) domestic policy choices. 

The relationship between the aim and measure is typically at the core of any 

217. In this paper we will not specifically deal with Article XIV of the CATS, as it is equivalent to 

Art. XX GAIT; the recent U.S. - Gambling dispute confirmed that jurisprudence developed under Article 

XX of the GATT is also relevant for the interpretation of Article XIV of the GATS. For a discussion of 

the relevant GATS issues, see THE WORLD TRADE ORGANISATION AND TRADE IN SERVICES (Mads 

Andenas and Kern Alexander eds., 2007) and Panagiotis Delimatsis, Determining the Necessity of Domestic 

Regulations in Services. The Best is Yet to Come. 18 EUR. J. INT'L L (forthcoming, 2007) (arguing for a 

horizontal approach for all services sectors built on a necessity test to be adopted in the negotiations within 

the Working Part on Domestic Regulation based on the mandate in Art. VI:4 GATS). 

218. Panel Report, United States - Standards for Reformulated and Conventional Gasoline, para. 6.20, 

WT/DS2/R (Jan. 29, 1996) [hereinafter U.S. - Gasoline PR], available at 

http://docsonline.wto.org/gen-search.asp?searchmode=simple (search by "document symbol"). 

219. Committee on Trade and Environment, Note by the Secretariat: GATT/WTO Dispute Settlement 

Practice Relating to GA TT Article XX, Paragraphs (b), (d) and (g), WT/CTE/W/203 (March 8, 2002) at 

paras. 1-5 [hereinafter GA TT Secretariat]. 

220. Id. para. 16. 

221. Appellate Body Report, Measures Affecting Asbestos and Asbestos-Containing Products, para. 

168. WT/DSI35/AB/R (Mar. 12, 2001) [hereinafter EC - Asbestos], available at 

http://www.wto.org/english/tratop-e/dispu-e/135abr-e.pdf. 

222. US - Gasoline, supra note 218, para. 7.1. 



VOL. 42:371 

proportionality inquiry (both in the domestic and international context) but also of 

other tests such as the Interstate Commerce Clause. 

In Article XX there is a textual difference in the individual paragraphs between 

the requirement that a measure be "necessary" to protect a specific public policy 

objective (e.g. public morals; human, animal or plant life or health) or, alternatively, 

that it be "related" to such an objective (conservation of exhaustible natural 

resources; products of prison labor). We now explore the scope and application of 

these two tests. 

i. Necessary to ... 

The necessity test in Articles XX (b) and (d) has been subject to considerable 

academic interest and also featured prominently in the WTO jurisprudence. In the 

Thai - Cigarettes case, the panel elaborated on the necessity criterion and stated that 

trade restrictions were necessary "only if there were no alternative measures 

consistent with the [GATT], or less inconsistent with it, which Thailand could 

reasonably be expected to employ to achieve its health policy objectives." 223 ' In US - 

Gasoline, the panel's standard was whether "there were measures consistent or less 

inconsistent with the General Agreement that were reasonably available ... ,224 

The focus on the least trade-restrictive and least GATT-inconsistent measure has led 

to considerable criticism in the academic literature, particularly for imposing too 

many constraints on legitimate domestic policy choices. 

Subsequent reports by the AB refined the necessity test. Korea - Beef is 

particularly relevant in this respect. According to the AB, in order to evaluate the 

necessity of a measure one needs to take into account, first, "the extent to which the 

measure contributes to the realization of the end pursued," and second, "the extent 

to which the compliance measure produces restrictive effects on international 

commerce." 225 ' As a consequence, measures with a lesser impact on international 

commerce "might more easily be considered as 'necessary' than a measure with 

intense or broader restrictive effects. 226 Summarizing its approach, the AB held that 

determination of whether a measure, which is not "indispensable", may 

nevertheless be "necessary" within the contemplation of Article XX(d), 

involves in every case a process of weighing and balancing a series of 

factors which prominently include the contribution made by the 

compliance measure to the enforcement of the law or regulation at issue, 

the importance of the common interests or values protected by that law 

or regulation, and the accompanying impact of the law or regulation on 

221 

imports or exports. 

The AB stressed that a "weighing and balancing" approach contributes to 

determining whether a Member could "reasonably be expected to employ" an 

223. Panel Report, Thailand - Restrictions on Importation of and Internal Taxes on Cigarettes, para. 

75, DSIO/R - 37S/200 (November 7, 1990) [hereinafter Thai - Cigarettes]. 

224. US - Gasoline PR, supra note 218, para. 6.25. 

225. Appellate Body Report, Korea - Measures Affecting Imports of Fresh, Chilled and Frozen Beef, 

para. 163, VT/DS161/AB/R (Dec. 11, 2000) [hereinafter Korea - Beef], available at 

http://www.wto.org/english/tratop-e/dispu-e/161-169abr-e.pdf. 

226. Id. 

227. Id. para. 164. 


2007 


alternative measure or "whether a less WTO-inconsistent measure is reasonably 

available. 

' 228 

One interpretation of this judicial development is that the necessity test evolved 

from a "least-trade restrictive approach to a less-trade restrictive one, supplemented 

with a proportionality test ('a process of weighing and balancing of a series of 

factors'). '2 9 Within this balancing test, the AB will assess the relative importance of 

domestic interests or values pursued. This approach implies a significant shift 

towards a greater role of the panels and the AB in evaluating the legitimacy and 

necessity of domestic measures. On the other hand, some have argued that the 

approach in Korea - Beef introduces a more relaxed necessity test-a kind of de 

minimis rule-which leaves more discretion and an additional margin of 

appreciation to the Members. 3 

The AB further elaborated on the necessity requirement of Article XX in the 

Asbestos case. The report concludes that "in determining whether a suggested 

alternative measure is 'reasonably available,' several factors must be taken into 

account, besides the difficulty of implementation., 23 ' That determination will be 

influenced by the "the weighing and balancing" of various factors, as outlined in 

Korea - Beef. 32 The main factors that need to be taken into account in this 

assessment are (a) the extent to which the alternative measure contributes to the 

realization of the end pursued and (b) the importance of the interests and values 

pursued by the Member. 3 It is then necessary to assess whether there "is an 

alternative measure that would achieve the same end and that is less restrictive of 

trade than a prohibition." 234 ' This approach does not put into question the objective 

pursued by the Member, but is intended to provide a standard for evaluating the 

necessity of a domestic measure. 

In recent disputes the AB has confirmed and applied the concept of necessity as 

previously developed in Korea - Beef and EC - Asbestos. The AB report in US - 

Gambling elaborated on the necessity standard under Art XIV(a) GATS, and the 

AB report in Dominican Republic- Cigarettes dealt with the necessity standard 

under Art XX(d) GATT . 

228. Id. para. 166. 

229. GA TT Secretariat, supra note 219, para. 42. 

230. Neumann & Ttrk, supra note 5, at 211: Robert Howse & Elisabeth Turk, The WTO Impact on 

Internal Regulations-A Case Study of the Canada - EC Asbestos Dispute, in THE EU AND THE WTO. 

LEGAL AND CONSTITUTIONAL ISSUES 283, 324-25 (Griinne de B(Irca & Joanne Scott eds., 2001). See also 

Panagiotis Delimatsis Determining the Necessity of Domestic Regulations in Services. The Best is Yet to 

Come 18 EUR. J. INT'L L (forthcoming, 2007)(going further in finding a shift that allows for a less intrusive 

necessity test with greater regulatory diversity, and supporting this on his analysis of Dominican Republic - 

Cigarettes, infra note 244). 

231. EC- Asbestos, supra note 221, para. 170. 

232. Korea - Beef, supra note 225, para. 164. 

233. For instance, the more important the interest or value pursued, the easier it will be to justify the 

domestic measure enacted to achieve that objective as "necessary." See Korea - Beef, supra note 225 

paras. 163-164. 

234. EC- Asbestos, supra note 221, para. 172. 

235. Appellate Body Report, United States - Measures Affecting the Cross-Border Supply of 

Gambling and Betting Services, paras. 304-327, WT/DS285/AB/R (Apr. 7. 2005) [hereinafter US - 

Gambling], available at http:/www.wto.org/englishltratop-e/dispu-e/285arb13-e.pdf: Appellate Body 

Report, Dominican Republic - Measures Affecting the Importation and Internal Sale of Cigarettes paras. 

57-74, WT/DS302/AB/R (Apr. 25, 2005) [hereinafter Dominican Republic - Cigarettes], available at 

http://www.wto.orglEnglish/tratop-e/dispu-e/302abr-e.pdf. 



VOL. 42:371 

In sum, the necessity test seems to imply the following: a measure is necessary if 

it is indispensable or alternative measures are not reasonably available to achieve 

the same legitimate public policy objective. 236 This determination will be made upon 

a weighing and balancing of different factors, including the trade-restrictive effects 

of the measure, the importance of the aim pursued, and the contribution made by 

possible alternative measures to achieve that aim pursued. This test certainly 

introduces a flexible balancing approach into Article XX GATT and a certain 

degree of subjectivity on the part of the judiciary. At the same time, it requires both 

the judiciary and the parties to the dispute to structure and justify their arguments 

along the lines defined by the AB in its jurisprudence and to present the arguments 

in such a way that they fit with the requirements imposed by the necessity analysis. 

ii. 

Relating to... 

Other exceptions in Article XX are subject to the condition that the measure is 

"related to" a legitimate public policy objective (e.g. conservation of exhaustible 

natural resources in Article XX(g)). The term "related to" indicates that this 

standard requires a looser degree of connection between the measure and the aim 

than the stricter necessity test. The AB in Korea - Beef stressed that the term 

"relating to" is "more flexible textually than the 'necessity requirement' found in 

Article XX(d)." 237 ' Initially, the GATT panel in the Canada - Salmon and Herring 

case argued that "relating to" included not only measures that are necessary or 

essential to achieve the conservation of exhaustible natural resources but are 

"primarily aimed at" the chosen objective."" Subsequently, the AB in US - Gasoline 

clarified that the term "relating to" requires at least a "substantial relationship" 

between the means and end which "cannot be regarded as merely incidentally or 

inadvertently aimed at the conservation of clean air .... 

In US - Shrimp, the AB assessed whether the domestic measure was 

"reasonably related" to the ends, arguing that "[t]he means and ends relationship 

[between the measure and the policy pursued in that case] ... is observably a close 

and real one . ,240 This was also the AB's interpretation of the test as applied in 

the previous Gasoline case. The AB reaffirmed that the requirement of "relating to" 

is about a "close and genuine relationship of end and means. 24 ' The AB further 

held that the design of the domestic measure was "not disproportionately wide in its 

236. In Korea - Beef, the AB referred to "a range of degrees of necessity," and determined that 

indispensable, absolutely necessary and inevitable measures "certainly fulfill the requirements of Article 

XX (d)." Korea - Beef, supra note 225, para. 161. 

237. Id. para. 161, n. 104. 

238. Panel Report, Canada - Measures Affecting Exports of Unprocessed Herring and Salmon, para. 

4.6, L/6286 - 35S/98 (Nov. 20, 1987) [hereinafter Canada - Herring], available at 

http://www.wto.org/gatt-docs/English/SULPDF/91330016.pdf. 

239. Appellate Body Report, United States - Standards for Reformulated and Conventional Gasoline, 

19, WT/DS2/AB/R (Apr. 29, 1996) [hereinafter U.S. - Gasoline ABR], available at 

http://docsonline.wto.org/gen search.asp?searchmode=simple (search by "document symbol"). 

240. Appellate Body Report, United States - Import Prohibition of Certain Shrimp and Shrimp 

Products, para. 141, WT/DS58/AB/R (Oct. 12, 1998) [hereinafter US - Shrimp], available at 

http://www.wto.org/English/tratop-e/dispu-e/58abr.pdf. 

241. Id. para. 136. 


2007 


scope and reach in relation to the policy objective of protection and conservation of 

sea turtle species." 2 '2 

While the scope of the "relating to" test is still somewhat unclear, the AB has at 

least outlined some general criteria for that test." 3 The main requirements are a 

"close and genuine relationship" between the measure and the aim pursued, which, 

in other words, need to be reasonably related. " The test is less strict than the 

necessity test. This may lead to the result that-insofar as the specific tests are 

concerned-a measure relating to environmental objectives can be justified more 

easily under Art XX(g) GAT (conservation of exhaustible natural resources) than 

under Article XX(b) GATT (protection of human, animal or plant life or health). In 

both cases, WTO Members can define and choose without judicial interference the 

level of protection they consider appropriate. The assessment of the measures 

adopted pursuant to that policy choice, however, will be more intrusive. First, the 

necessity test requires an assessment of whether a WTO Member could reasonably 

have been expected to employ a less trade-restrictive alternative. This 

determination will be governed by a balancing and weighing of different factors. 

Conversely, the "related to" test seems to be a more deferential reasonableness 

standard which also includes some elements of a proportionality inquiry. 24 

3. Application of the Measure: The Chapeau 

In the preceding analyses we focused on the tests set out in individual 

paragraphs of Article XX GATT. If a national measure is found to comply with 

these requirements, it will be "provisionally justified. 2 1 6 The next step is to turn to 

the introductory clause of Article XX GATT, also known as Chapeau, to determine 

whether a measure, in its concrete application, is lawful under Article XX as a whole. 

The chapeau reads as follows: 

Subject to the requirement that such measures are not applied in a manner 

which would constitute a means of arbitrary or unjustifiable discrimination 

between countries where the same conditions prevail, or a disguised 

restriction on international trade, nothing in this Agreement shall be 

construed to prevent the adoption or enforcement by any contracting 

party of measures .... 247 

In US - Gasoline the AB had begun to develop a coherent theory regarding 

both the function of the chapeau and its relationship with the general exceptions. 

The AB stressed that the "purpose and object of the introductory clauses of Article 

XX is generally the prevention of [abuse of the exceptions in Article XX]." 2 8 While 

those exceptions "may be invoked as a matter of legal right, they should not be 

242. Id. para. 141. 

243. McRae, supra note 216, at 226. 

244. Id. 

245. Desmedt, supra note 4, at 470-76. 

246. US - Shrimp, supra note 240, para. 147. 

247. General Agreement on Tariffs and Trade, art. XX chapeau, Oct 30, 1994, 1867 U.N.T.S. 187 

(emphasis added) [hereinafter GATT]. 

248. U.S. - Gasoline ABR, supra note 239, at 22. 



VOL. 42:371 

applied so as to frustrate or defeat the legal obligations of the holder of the right 

under the substantive rules of the [GATT]. '24 9 

The main idea that the chapeau shall prevent an abuse of the right to invoke an 

exception by a Member was refined in US - Shrimp. Here the AB stated that the 

Chapeau "embodies the recognition on the part of the WTO Members of the need 

to maintain a balance of rights and obligations between the right of a Member to 

invoke one or another of the exceptions of Article XX ... on the one hand, and the 

substantive rights of the other Members under the GAT" 1994, on the other 

hand." 25 The AB further noted: "[t]he same concept may be expressed from a 

slightly different angle of vision. Thus, a balance must be struck between the right of 

a Member to invoke an exception under Article XX and the duty of that same 

Member to respect the treaty rights of other Members." ' 

Interestingly, the AB focuses on the balancing of competing rights, interests 

and obligations as the predominant feature within the chapeau analysis. This 

expresses the concern of the AB to prevent abuse of the general exceptions which 

are only available upon a careful balancing of different factors. 

The wording of the chapeau provides for three different standards for domestic 

measures.2 52 These must neither constitute "arbitrary discrimination" or 

"unjustifiable discrimination" between countries where the same conditions prevail, 

nor must they constitute "a disguised restriction on international trade. 2 53 US - 

Shrimp demonstrates that the interpretation and application of these three 

requirements will be influenced and governed by the overarching balancing 

approach . 4 

With regard to the test of "arbitrary discrimination," the AB held that the 

certification proceedings adopted in the United States: 

appear to be singularly informal and casual, and to be conducted in a 

manner such that these processes could result in the negation of rights of 

Members. . . . It appears to us that, effectively, exporting Members 

applying for certificates whose applications are rejected are denied basic 

fairness and due process, and are discriminated against, vis-A-vis those 

Members which are granted certification. 255 

The requirements in the chapeau indicate that Members wanting to invoke an 

exception to Article XX need to apply their measures in a reasonable manner, 

taking into account not only their own treaty rights but also those of other GATT 

Members. It is this balancing process which will ultimately determine whether a 

discriminatory measure is arbitrary or unjustifiable, or constitutes a disguised 

restriction on international trade. 

Balancing does not necessarily involve such broad and general objectives as 

free trade and environmental protection. The way in which balancing has been 

developed in the jurisprudence of the AB implies a weighing of more concrete rights 

249. Id. 

250. US- Shrimp, supra note 240, para. 156. 

251. Id. 

252. Id. para. 150. 

253. Id. 

254. See McRae, supra note 216, at 229-33. 

255. US - Shrimp, supra note 240, para. 181. 


2007 


and interests at stake. This process resembles a proportionality analysis. 

Historically and conceptually, proportionality is very much about the balancing of 

one or more public policy objectives against concrete individual or collective rights 

and interests. One could argue that this is also one of the AB's interpretations of the 

chapeau. Such an approach does not question the general policy objective pursued 

by the Members, but it introduces a test to assess whether a concrete measure, as 

applied, is disproportionate or unreasonable. 

In US - Shrimp, the AB found that a measure constituted unjustifiable and 

arbitrary discrimination since that discrimination could reasonably have been 

avoided. That aspect of the analysis, in particular the assessment whether 

discrimination is unjustifiable or arbitrary, requires a typical balancing of competing 

rights and interests protected by the GATT. Part of the assessment in US - Shrimp 

turned on factors inherent in the regulatory process, such as transparency, due 

process or elements of basic fairness in domestic administrative proceedings. 2 6 This 

can be seen as the procedural side of the balancing test or proportionality inquiry, 

recognizing that rights and interests can only be realized through fair and equitable 

domestic procedures. Such a proceduralist approach in the assessment of trade 

restrictions might lead to greater deference toward domestic regulatory choices 

although it includes, at the same time, a close scrutiny of the regulatory processes 

underlying the decision-making process."' 

3. Conclusion: How the Tests in Article XX GATT Operate 

One function of Article XX is to define the scope of the legal obligations under 

this provision."' This is done through a two-step analysis which includes different 

standards and tests necessity or reasonableness. It also involves the due balancing of 

the right of a WTO Member to invoke the exception and the substantive rights of 

other WTO Members. 

It has been argued that "in no case will the proportionality requirements 

contained in Article XX of GATT' allow for a 'balancing test' of advantages resulting 

from overall trade objectives underlying the WTO agreements with the advantages 

resulting from national policy objectives as mentioned in the individual clauses of 

Article XX." ' 9 Our approach is slightly different. One aspect of proportionality is 

to govern the scope and application of exceptions such as Article XX and, as a 

consequence, to evaluate and balance the different interests at stake. As outlined 

above, balancing within Article XX needs to be undertaken several times in order to 

determine the necessity, reasonableness or proportionality of a particular measure. 

The question in those cases is to determine which rights or interests need to be 

balanced against each other, and it would be misleading to reduce this balancing act 

solely to general trade versus non-trade concerns. 

Within the scope of Article XX, proportionality can be seen as a governing 

principle and flexible tool to guide the judicial inquiry into the lawfulness of 

domestic measures. In the chapter on proportionality in public international law, we 

256. ld. paras. 181-182: Scott, supra note 123, at 350-351. 

257. Scott, supra note 123, at 350-351. 

258. See McRae, supra note 216, at 232. 

259. Desmedt, supra note 4, at 476. 



VOL. 42:371 

concluded that proportionality is a standard to determine how far states can go in 

their relationship with other states. Very often such a proportionality inquiry will 

not only include quantitative elements but also a balancing of protected rights, 

interests and values. We are well aware that proportionality, for instance, in the law 

of international countermeasures has a different normative role to play. Yet it is 

interesting to note that the necessity and balancing approach developed by the AB 

in the application of Article XX GATT structurally resembles the proportionality 

analysis in other areas of international law. 

Finally, the balancing in Article XX should not be reduced to crude balancing 

of free trade against other legitimate public policy objectives, to the detriment of 

either of those categories. The test is more sophisticated than that, compared to the 

application of the principle of proportionality in EC law. Balancing in Article XX 

relates to (and influences) very specific legal requirements such as "necessary to," 

"arbitrary," "unjustifiable" or "disguised." Those provisions are interpreted through 

a subtle balancing of the different interests at stake. Taken together, these different 

tests define the treatment of domestic measures under Article XX. This approach is 

more refined and structured than the proportionality analysis in Article 30 EC. It is 

also more structured than the US Interstate Commerce Clause or the general 

application of the principle of proportionality in public international law. 

B. Positive Obligations for Domestic Regulation 

The SPS Agreement and the TBTAgreement set out detailed positive 

obligations for domestic regulation. The most prominent standards are necessity, 

reasonableness, and proportionality. They apply as independent, positive 

requirements for domestic regulation and not just as justification provisions for a 

prima facie violation of other provisions. The positive obligations set out in the SPS 

and TBT Agreements are intended to mitigate the trade-restrictive effects of 

domestic regulation, while leaving sufficient discretion to Members to pursue their 

domestic public policy objectives. 

1. SPS Agreement 

The SPS Agreement applies to "all sanitary or phytosanitary measures which 

may, directly or indirectly, affect international trade. '' 26 0 One aim of the agreement is 

to provide national authorities with appropriate and clear normative standards to 

find a balance between trade liberalization and national regulatory competences. 2 6 ' 

The Preamble to the SPS Agreement mentions, among others, two major concerns: 

1) that domestic sanitary and phytosanitary measures shall constitute neither 

arbitrary or unjustifiable discrimination between WTO Members nor a disguised 

restriction on international trade and 2) that the multilateral framework governing 

sanitary and phytosanitary measures contributes to minimizing their negative effects 

on international trade . 

260. Agreement on the Application of Sanitary and Phytosanitary Measures, Art. 1, Apr. 15, 1994, 

Multilateral Agreement on Trade in Goods, Annex 1 [hereinafter SPS], available at 

http://www.wto.org/english/docs-e/legal-e/15-sps.pdf. 


262. SPS, supra note 260, Preamble. 


2007 


SPS measures are a very sensitive area of WTO law and policy. They often 

significantly impact core areas of public policy, such as national health and safety. 

According to the SPS Agreement, each WTO Member is free to determine its own 

appropriate level of sanitary or phytosanitary protection. 26 The determination of the 

appropriate level of protection is considered by the AB to be "a prerogative of the 

Member concerned and not of the panel or of the Appellate Body. '2 M The chosen 

level of protection is generally not questioned by the panels, and WTO Members 

could well pursue a zero-risk approach (if it complies with the other conditions of the 

SPS Agreement). However, the instrument chosen to attain that level of protection 

will be assessed as to whether it is adequate and complies with the necessity 

requirements laid down in the SPS Agreement. Within the scope of the SPS 

Agreement it is important to outline this distinction between the objective pursued 

by the state and the instrument chosen to attain that objective. 65 

Article 5.4 of the SPS Agreement requires Members, in determining their level 

of protection, to "take into account the objective of minimizing negative trade 

effects. 2 6 1 This provision could been seen as allowing for a full balancing of 

competing objectives, along the lines of proportionality stricto sensu (i.e., no 

excessive impact on trade). Yet the more limited nature and legal effect of this 

provision was clearly outlined by the panel in the Hormones case: 

Guided by the wording of Article 5.4, in particular the words "should" 

(not "shall") and "objective", we consider that this provision of the SPS 

Agreement does not impose an obligation. However, this objective of 

minimizing negative trade effects has nonetheless to be taken into account 

' 

in the interpretation of other provisions of the SPS Agreement. 

One possible reading of Article 5.4 of the SPS Agreement is that Members 

should avoid measures with excessive trade-restrictive effects. This means that the 

determination of the appropriate level of protection by a Member is subject to the 

condition that it "should" take into account the effects on trade.1 6 Due to this 

wording, Article 5.4 does not seem to allow for a true balancing and trade-off of 

possible negative effects on trade against the desired level of protection. It does not 

require any cost-benefit analysis of the intended level of protection either. These 

restrictions would run counter to the AB's repeated findings that it is the Member's 

prerogative to determine the appropriate level of protection. 

Panels may face the difficulty that Members do not determine their appropriate 

level of protection explicitly or with sufficient precision. The AB stated that, in such 

circumstances, panels may establish the Member's level of protection on the basis of 

the actual SPS measure applied. 269 Such an initial determination is necessary to 

263. Id. art. 2. 

264. Appellate Body Report, Australia - Measures Affecting Importation of Salmon, para. 199, 

WT/DS18/AB/R (November 6,1998) [hereinafter Australia - Salmon] (emphasis omitted), available at 

http://www.wto.org/English/tratop-e/dispu-e/dsl 8abr.pdf. 

265. Id. para. 200. 

266. SPS, supra note 260, art. 5.4. 

267. Panel Report, European Communities - Measures Affecting Meat and Meat Products, para. 8.166., 

WT/DS26/R (August 18, 1997) [hereinafter EC- Hormones PR]. 


269. Japan - Apples, supra note 147, para. 207. 



VOL. 42:371 

assess whether the measure adopted complies with the relevant provisions of the 

SPS Agreement. 

Subsequently, WTO Members need to undertake a risk assessment, upon which 

the national measures shall be based. 270 The AB has clarified that the criterion that 

the measure be "based on" risk assessment requires "a rational relationship between 

the measure and the risk assessment. '7 ' In other words, Members can only lawfully 

enact a SPS measure in those cases where the risk assessment "reasonably 

support[s]" the measure at stake. Note that the rational relationship requirement 

is a separate obligation from the traditional necessity or proportionality analysis in 

other provisions of the SPS Agreement. 

According to Article 2.2 of the SPS Agreement, domestic measures cannot not 

be maintained without "sufficient scientific evidence., 273 Clarifying this provision, 

the AB in Japan - Apples followed the panel's conclusions and held that the 

sufficient scientific evidence criterion requires a "'rational and objective relationship' 

between the measure and the relevant scientific evidence., 274 The panel in this case, 

noting the lack of sufficient scientific evidence to support the Japanese measure, had 

found that the measure at issue was "clearly disproportionate to the risk identified on 

the basis of the scientific evidence available. 279 

The next step of analysis is to turn to the necessity of the measure. This relates 

to the relationship between the aim pursued and the measure at issue. Article 2.2 of 

the SPS Agreement requires that any SPS measure is "applied only to the extent 

necessary to protect human, animal or plant life or health ... ,,276 Article 5.6 of the 

SPS Agreement refines this obligation, requiring WTO Members to ensure that SPS 

measures are not "more trade-restrictive than required to achieve their appropriate 

level of . . . protection, taking into account technical and economic feasibility., 277 

Footnote 3, which is attached to Article 5.6 of the SPS Agreement, further delineates 

the concept of necessity: 

[A] measure is not more trade-restrictive than required unless there is 

another measure, reasonably available taking into account technical and 

economic feasibility, that achieves the appropriate level of sanitary or 

phytosanitary protection and is significantly less restrictive to trade. 278 

The AB in Australia - Salmon elaborated on the necessity test and mainly 

referred to the requirements grounded in Footnote 3 of the SPS Agreement. It held 

that the three elements are cumulative, in the sense that all three elements have to 

be met for a finding of inconsistency with Article 5.6 of the SPS Agreement. 279 A 

measure will therefore be consistent with Article 5.6 of the SPS Agreement if there 

270. See SPS, supra note 260, arts. 2.2, 5.1. 

271. EC- Hormones ABR. supra note 119, para. 193 (emphasis added). 

272. Id. 

273. SPS, supra note 260, art. 2.2 (emphasis added). 

274. Japan - Apples, supra note 147, para. 147. 

275. Id. para. 163 (emphasis added). 

276. SPS, supra note 260, art. 2.2 (emphasis added). 

277. Id. art. 5.6. 

278. Id. at n.3. 

279. Australia - Salmon, supra note 264, para. 194. 


2007 


is no alternative measure available, if the alternative measure does not achieve the 

appropriate level of protection, or if it is not significantly less trade-restrictive."" 

Some have argued that the components of the necessity test as outlined above 

(in particular, the criteria of being reasonably available and significantly less 

restrictive to trade) indicate a relaxed necessity test under the SPS Agreement. 

Member states may choose among several alternatives without being obliged to opt 

for the least trade-restrictive measure. This approach resembles the necessity 

requirement under Article XX GATT for which the AB introduced a flexible 

balancing approach. The conceptual similarity between Article XX GATT and 

Article 5.6 of the SPS Agreement remains to open to future clarification. With 

regard to the burden of proof, the complainant must establish a prima facie case that 

there exists an alternative measure which meets all three requirements, i.e. establish 

the prima facie inconsistency of the national measure with the SPS Agreement. 

Member states are further required to comply with an additional discipline laid 

down in Article 5.5 of the SPS Agreement. The relevant part of this provision reads 

as follows: 

With the objective of achieving consistency in the application of the 

concept of appropriate level of sanitary or phytosanitary protection 

against risks to human life or health, or to animal and plant life or health, 

each Member shall avoid arbitrary or unjustifiable distinctions in the levels 

it considers to be appropriate in different situations, if such distinctions 

result in discrimination or a disguised restriction on international trade. 28 ' 

The objective of this provision, which needs to be read in the context of Article 

2.3 of the SPS Agreement, is to achieve "consistency in the application of the 

concept of appropriate level of ... protection" within the state. 283 The underlying 

rationale is to prevent products that are similarly dangerous from being given 

different treatment: for instance, through a very high level of protection in one case 

and a very lenient treatment in another.' The AB in EC - Hormones and Australia 

- Salmon specified the three elements which are part of the test under Article 5.5 

SPS. First, the WTO Member adopts different appropriate levels of protection in 

different situations. Second, the different levels of protection are arbitrary or 

unjustifiable. Finally, the arbitrary or unjustifiable distinctions in the level of 

protection result in either discrimination or a disguised restriction of international 

trade.2" 

280. Id. 


282. Article 2.3 SPS reads as follows: "Members shall ensure that their sanitary and phytosanitary 

measures do not arbitrarily or unjustifiably discriminate between Members where identical or similar 

conditions prevail, including between their own territory and that of other Members. Sanitary and 

phytosanitary measures shall not be applied in a manner which would constitute a disguised restriction on 

international trade." SPS, supra note 260, art. 2.3. 

283. Id. 

284. Joost Pauwelyn, The WTO Agreement on Sanitary and Phytosanitary (SPS) Measures as Applied 

in the First Three SPS Disputes: EC - Hormones, Australia - Salmon, Japan - Varietals, 2 J. INT'L ECON. L. 

641,653 (1999). 




VOL. 42:371 

The third element ("discrimination" or "disguised restriction") seems 

conceptually the most controversial.8 The AB in EC - Hormones ruled that 

arbitrary or unjustifiable differences in the levels of protection may act as a "warning 

signal" that the measure in its application leads to discrimination between Members 

or to a disguised restriction on international trade. 287 What therefore needs to be 

proven to find a violation of the third element of Article 5.5 SPS is that the Member 

in fact applies the SPS measure in a way which either discriminates between WTO 

Members or constitutes a disguised restriction, i.e., it provides protection for the 

domestic producers. In the subsequent Australia - Salmon case, the AB made an 

interesting finding concerning what constitutes a disguised restriction on 

international trade. It held that a measure that is not based on risk assessment 

strongly indicates a "trade-restrictive measure taken in the guise of an SPS measure, 

i.e., a 'disguised restriction on international trade'.""" 

The wording of Article 5.5 is clearly modeled upon the chapeau of Article XX 

of the GATT. Despite this similarity, the AB ruled out that the interpretation and 

reasoning of the chapeau may be imported into the analysis of Article 5.5 of the SPS 

Agreement. The justification provided by the AB is that there are "structural 

differences" between those two provisions and the standards they impose. 8 9 The 

chapeau of Article XX GATT is generally more concerned with preventing the 

abuse of rights in the application of a measure, whereas Article 5.5 SPS primarily 

aims for consistency in the levels of protection with the aim to reduce unnecessary 

regulation. 290 

As was shown above, Article 5.5 does not require "absolute and perfect 

consistency" in the appropriate levels of protection in different situations. The AB 

recognizes that the different levels of protection are set on an "ad hoc basis and over 

time," whereby the perception of risks is not the same at all times. Arbitrary and 

unjustifiable inconsistencies, however, are prohibited under the SPS Agreement. 

The SPS Agreement attempts to bridge the gap between national regulatory 

autonomy and protectionist trade restrictions enacted as sanitary and phytosanitary 

measures. The individual provisions of the SPS Agreement guide the task of the 

panels and the AB to strike the delicate balance between necessary, legitimate, and 

protectionist measures. On the one hand, the agreement does not authorise a broad 

balancing of the costs and benefits of a regulatory measure in the sense of 

proportionality stricto sensu. Most importantly, Members are free to determine their 

level of protection without judicial interference, except for the requirement that 

differences in levels of protection shall be consistent. The Agreement's detailed 

provisions, however, provide strict normative standards for the instruments chosen 

and applied by a WTO Member to achieve its level of protection. The necessity 

requirement aims to ensure that the chosen measure is no more trade restrictive than 

necessary. Proportionality elements also govern the determination whether 

different levels of protection are reasonably consistent and do not result in 

discrimination or a disguised restriction on trade. As outlined above, this 

286. Pauwelyn, supra note 284, at 654. 


288. Australia - Salmon, supra note 264, para. 166. 


290. JAN NEUMANN, DIE KOORDINATION DES WTO-RECHTS MIT ANDEREN VOLKERRECHTLICHEN 

ORDNUNGEN. KONFLIKTE DES MATERIELLEN RECHTS UND KONKURRENZEN DER STREITBEILEGUNG 

479 (2002). 


2007 


consistency requirement is subject to different conditions whose normative content 

remains somewhat elusive. For instance, there is some leeway in determining which 

distinctions in the levels of protection will be considered arbitrary or unjustifiable 

and those that will be acceptable. A further question is how far the consistency 

requirement imposes constraints on WTO Members to autonomously determine 

their level of protection and whether this does not lead to a true balancing of 

competing factors (chosen level of protection vs. discrimination; trade restriction vs. 

arbitrariness and justifiability) by means of judicial review. 

2. TBT Agreement 

The Agreement on Technical Barriers to Trade (TBT Agreement) aims to 

ensure, among other things, that national regulations, standards, testing, and 

certification procedures do not create unnecessary obstacles to international trade. 

Our analysis of the TBT Agreement primarily focuses on Article 2.2 as this provision 

seems most relevant for the purposes of this paper. 

Within the scope of the TBT Agreement, both the policy objectives pursued by 

the Member and the level at which it decides to pursue those obligations are 

prerogatives of the states. 29 ' The preamble of the TBT Agreement recognizes that 

no Member shall be prevented from determining its appropriate level of 

protection. 92 This is similar to the WTO Members' discretion identified under the 

SPS Agreement. 

The substantive obligation in Article 2.2 TBT requires that 

Members shall ensure that technical regulations are not prepared, adopted 

or applied with a view to or with the effect of creating unnecessary 

obstacles to international trade. For this purpose, technical regulations 

shall not be more trade-restrictive than necessary to fulfil a legitimate 

objective, taking account of the risks non-fulfilment would create. 293 

The last sentence refers to "legitimate objectives" that domestic measures (i.e., 

"technical regulations") aim to achieve. Article 2.2 TBT defines those objectives in 

a non-exhaustive list. The objectives include, among others, national security 

requirements, the prevention of deceptive practices, and protection of the 

environment. Both the panel and the AB in EC - Sardines stated that this list is only 

illustrative; other objectives may also be considered "legitimate." It is for the 

Member to determine those objectives. 

While the chosen level of protection may not be called into question, the 

subsequent assessment of a domestic measure under Article 2.2 TBT takes place in 

different steps. Technical regulations must first be capable of contributing to a 

"legitimate objective." In contrast to the SPS Agreement, this term indicates that the 

291. Panel Report, European Communities - Trade Description of Sardines, para. 7.120, WT/DS231/R 

(May 29, 2002) [hereinafter EC - Sardines PR], available at 

http://www.wto.org/english/tratop-e/dispu-e/231r-e.pdf. 

292. Agreement on Technical Barriers to Trade, Preamble, April 15, 1994, Multilateral Agreement on 

Trade in Goods, Annex 1 [hereinafter TBT]. 

293. Id. art. 2.2 (emphasis added). 



VOL. 42:371 

object and purpose of a measure may be questioned by the panels with regard to 

their legitimacy. The AB in EC -Sardines clearly stated that it was prepared to 

examine and determine the legitimacy of a TBT measure's objective, and the panel 

equally ruled that it was required to do so. 294 Interestingly, the panel in EC - 

Sardines referred to a finding of the panel in Canada - Pharmaceuticals Patents, 

which defined the notion of "legitimate interests" in the context of Article 30 of the 

TRIPS Agreement. 2 95 The panel in Canada - Pharmaceutical Patents stated that a 

legitimate interest is "a normative claim calling for protection of interests that are 

'justifiable' in the sense that they are supported by relevant public policies or other 

social norms. 2 96 

Some authors are skeptical about the possibility that panels and the AB 

question the legitimacy of objectives pursued by WTO Members. Neumann and 

Tuirk, for instance, argued that Article 2.2 TBT should not equip WTO tribunals with 

the ability to a priori rule out the legitimacy of measures, since this could interfere 

with domestic policy choices. In addition to such political considerations, recital 6 of 

the TBT-Preamble clearly establishes that WTO Members remain free to adopt their 

level of protection. If the level of protection remains a national domaine r~serv , it is 

not evident that the decision which value is legitimate should be centralized at the 

WTO level. 297 We believe that there are also some valid arguments against this 

interpretation. Textually, Article 2.2 incorporates the notion of legitimate objectives, 

which implies that there are illegitimate objectives as well. The question then is 

"Who shall ultimately determine whether a measure is legitimate or illegitimate with 

regard to Article 2.2 TBT?" It would be unduly deferential towards WTO Members 

to let them decide on the legitimacy of the objectives pursued, without subjecting 

them to any subsequent oversight by the WTO judicial bodies. Finally, the issue of 

legitimate objectives should not necessarily be discussed together with the 

appropriate level of protection. As was stated by the Sardines panel, "it is up to the 

Members to decide which policy objectives they wish to pursue and the levels at 

which they wish to pursue them." '2 98 These two issues closely interrelate, but they 

should be assessed independently of each other. 

If a measure has a legitimate objective, it shall be no "more trade-restrictive 

than necessary." 2 99 It is one of the key objectives of the TBT Agreement that 

Members avoid unnecessary obstacles to international trade. This requirement 

imposes constraints on the WTO Members which are similar to the least traderestrictiveness 

requirement under the SPS Agreement. Referring to the preamble, 

294. Appellate Body Report, European Communities - Trade Description of Sardines, para. 286., 

WT/DS231/AB/R (September 26, 2002) [hereinafter EC - Sardines ABR], available at 

www.wto.org/english/tratop-e/dispu-e/231abre.pdf. 

295. Article 30 provides for an exception to exclusive rights conferred by a patent. The provision 

reads as follows: "Members may provide limited exceptions to the exclusive rights conferred by a patent, 

provided that such exceptions do not unreasonably conflict with a normal exploitation of the patent and do 

not unreasonably prejudice the legitimate interests of the patent owner, taking account of the legitimate 

interests of third parties." Agreement on Trade-Related Aspects of Intellectual Property Rights, art. 30. 

Apr. 15, 1994, Marrakesh Agreement Establishing the World Trade Organization, Annex IC, 33 I.L.M. 

1125 (1994) [hereinafter TRIPS], available at www.wto.orgfEnglish/docs-e/legal-e/27-trips.pdf. 

296. Panel Report, Canada - Patent Protection of Pharmaceutical Products, para. 7.69, WT/DS 1l4/R 

(Mar. 17, 2000) [hereinafter Canada - Pharmaceutical Patents], available at 

http://www.wto.org/english/tratop e/dispu-e17428d.pdf. 

297. See Neumann & TOrk, supra note 5, at 226-27. 

298. EC- Sardines PR, supra note 291, para. 7.120. 

299. Id. para. 4.7. 


2007 


the panel in EC - Sardines ruled that "Members cannot create obstacles to trade 

which are unnecessary or which, in their application, amount to arbitrary or 

unjustifiable discrimination or a disguised restriction on international trade." 3 

The question arises whether the necessity analysis in Article 2.2 TBT should be 

the same as the three-step test under the SPS Agreement. According to this test, 

national measures will be consistent with Article 5.6 SPS if there is no alternative 

measure available, or if the alternative measure does not achieve the appropriate 

level of protection, or if it is not significantly less trade-restrictive. Due to the similar 

wording of the relevant provisions in the SPS and TBT Agreements, one may argue 

that the core necessity standards should be the same. 

Finally, technical regulations shall not be more trade-restrictive than necessary 

to fulfil a legitimate objective, "taking account of the risks non-fulfilment would 

create.""" There is some uncertainty about the meaning of this requirement. On the 

one hand, it seems like a balancing or cost-benefit-analysis test, similar to the tests 

adopted in Korea - Beef and EC - Asbestos (balancing of the importance of the 

values and policies and the extent to which the measure contributes to the aim 

pursued). Assessing the risks of non-fulfillment of a particular objective will be part 

of the necessity analysis. It may actually make the necessity requirement more 

relaxed and less rigid." 2 On the other hand, the term could also point towards a full 

proportionality test. That would allow the panel to determine whether the costs of a 

measure (i.e., the negative effects on international trade) are excessive or 

disproportionate to the risks of not fulfilling the pursued objective. A measure could 

therefore be disproportionate even though it is the least trade-restrictive measure. 

This question has not been fully clarified yet. 

3. Conclusion: How the Tests in the SPS and TBT Agreements Operate 

The TBT Agreement is deferential towards the policy objectives that WTO 

Members want to achieve, but it shows less deference to the means employed to 

achieve those objectives. This is not unusual and reflects similar normative 

standards in the GATT and the SPS Agreement. It can be argued that there is a 

broader scope for a balancing test in the TBT Agreement. Additional criteria, which 

are not included as such in the SPS Agreement, relate to the legitimacy of the 

objectives pursued and the risk of non-fulfillment of those objectives. This entails 

more subjectivity, or discretionary elements, permitted in a panel decision? °3 

It remains to be seen whether the jurisprudence interpreting the TBT 

Agreement will move more towards a necessity and balancing test that structurally 

resembles the traditional proportionality test (for instance, as applied in public 

international law). Weighing and balancing of protected rights and interests may 

take place with regard to both the legitimacy of the objectives pursued and the 

weight attributed to the risk of non-fulfilment of that objective. 

Generally, the SPS and TBT Agreements lay down positive normative 

standards for trade restrictive measures that go beyond the principle of non- 

300. Id. para. 7.120. 

301. Id. para. 5.15. 


303. Desmedt, supra note 4, at 459-60. 



VOL. 42:371 

discrimination and also apply to non-discriminatory domestic regulation. These 

standards provide for detailed obligations that are more sophisticated and structured 

than the tests applied in the GATT, in EC free movement law or in the Interstate 

Commerce Clause. One difference is that the tests applied in the context of EC law 

and the Interstate Commerce Clause have been developed and elaborated through 

the jurisprudence, while the tests in the SPS and TBT Agreements were explicitly 

written into these more modern trade agreements. The main standards in the SPS 

and TBT Agreements are that the domestic measures pursue an accepted public 

policy objective and that they are no more trade-restrictive than necessary. This 

determination is governed and influenced by a balancing and weighing process 

aiming to ensure that the obstacles to international trade are not disproportionate or 

excessive to the objectives pursued by the Members. 

VII. CONCLUSION 

The WTO is a developing legal system. More than ten years after its creation, 

many of its provisions and underlying concepts are constantly being refined by 

jurisprudence and scholarly writing. This process is frequently accompanied and 

influenced by comparative legal thinking. A comparative view, which is also the 

basis of this article, may contribute to clarifying uncertainties and providing some 

input into the thinking about WTO law. Conversely, an overly simplistic 

transplantation of legal concepts from one legal order to another is not what this 

process should be about. This would lead to misunderstandings and confusion, and 

it would be perceived as illegitimate. A more fruitful approach is to reflect on 

concepts that have developed over decades in other legal systems and to benefit 

from the core elements of those concepts when analysing WTO law. 

One of the most important challenges for WTO law is the balancing of 

competing rights, principles, values, or interests. The perceived juxtaposition of free 

trade and non-trade interests is one fundamental expression of this concern. 

Another concern is whether the WTO judicial bodies should do balancing at all or 

better leave that to national institutions. Legally, balancing in the WTO requires 

constant (re-)interpretation of specific provisions of the WTO Agreements which lay 

down the criteria to shall be taken into account by the WTO Members. 

The increasing demand for authoritative and sensitive balancing is a major 

challenge for judicial bodies that have to cope with concrete disputes. Difficult 

practical questions relate to the scope of WTO law, the interaction with other legal 

regimes, the precise meaning of open-ended provisions, or the importance of noneconomic 

values and interests in WTO law. Such a process requires appropriate and 

legitimate legal instruments for the judiciary to work with. 

Some dispute that there is, or that there should be, adjudication of competing 

values in the WTO. Others may want to cloud the issue for a variety of reasons. 

Judges, for instance, may favor tests, so as to avoid "the impression that there is any 

need to adjudicate competing values at all." 3 ' 4 In analyzing the jurisprudence and 

disputes, which appear rather technical at first glance, one finds many instances 

where such a balancing of rights, principles, values, and interests is actually taking 

place and can hardly be avoided. 

304. Howse, supra note 188, at 140. 


2007 


The main concern is how to undertake balancing within the WTO legal system. 

This includes the definition of the standards and tests against which this balancing 

may take place. Most prominent are the concepts of necessity, reasonableness, and 

proportionality. 

In our chapter on legal principles, we have concluded that one of the main 

characteristics of principles is the idea of optimization. Principles command that 

they be realized to the highest extent possible, and they do not apply in an all-ornothing 

fashion. In case of a conflict, two principles do not strike each other out, as 

is the case with rules. Both principles generally remain valid and need to be 

balanced against each other. One insight from this theoretical approach is to 

recognize that in legal orders, which lack a clear hierarchy of norms and which 

contain many open-ended provisions, conflicts will often be resolved through a 

balancing of conflicting principles. In fact, the very nature of the existence of legal 

principles and open-ended provisions makes balancing unavoidable. The 

relationship between the different values and principles laid down in the WTO 

Agreements is thus relative, depending on the facts of the case and the different 

interests at stake. Substantive tests may help structure and rationalize this process, 

aiming to find an equilibrium between different competing objectives. 

The increasing maturity of the WTO legal system has been analyzed against the 

background of its "constitutionalization." One particular aspect of this process is the 

so-called "judicial norm-generation," whereby constitutional-type principles and 

techniques are generated through the WTO jurisprudence."' Deborah Cass 

explicitly mentions the principle of proportionality, rational relationship testing, and 

less restrictive means. It is necessary to have an open debate about the normative 

content and implications of these principles in WTO law. 

Balancing within the WTO legal system can take place at two different levels. 

First, at the national level, domestic authorities are in many instances required by 

WTO law to take into account and weigh competing interests as part of their 

domestic decision-making process. Additionally, the domestic decision-making 

process must be transparent, open, and unbiased. This can be considered as the 

procedural aspect of substantive tests imposed by WTO law. Second, balancing also 

takes place at the WTO level, in particular in the dispute settlement proceedings. 

Whenever a dispute arises, the judicial bodies, applying the specific provisions of the 

WTO Agreements, will have to balance competing factors. This balancing process is 

structured and mediated by the the standards and tests discussed in this paper. 

Balancing is incorporated in many specific WTO provisions. Article XX 

GATT, for instance, consists of different steps of analysis, relating both to the design 

and application of domestic measures. While there is no overall balancing of 

competing values, the different steps of analysis within Article XX GATT each 

require a concrete evaluation and balancing of specific rights and interests at issue. 

One important function of the tests in Article XX GATT is to structure and 

rationalize the assessment of domestic measures. The same holds true for the SPS 

and TBT Agreements. 

The principle of proportionality plays an important role in many national and 

international jurisdictions. It is both a doctrine for the legislature and for the 

administration to follow and a standard applied by the judiciary when reviewing the 

305. See generally Cass, supra note 34. 



VOL. 42:371 

acts of public authorities. Its normative content, including the intensity of review, 

may vary, but the core of any proportionality analysis remains the same. The basic 

idea is to limit discretion exercised by public authorities in a democratic society and 

to balance competing interests. Proportionality is a key principle in determining the 

relationship between different actors, including states vs. individuals (in domestic 

law), federal level vs. state level (in federal systems), and States vs. States (in 

international law). More specifically, the principle of proportionality is recognized in 

some systems as a general test for the exercise of free discretion. It is also used to 

review justifications for interference with, or restrictions on, rights. Other tests, such 

as necessity or reasonableness, may equally includes elements of proportionality 

without disclosing this factor. 

Proportionality analysis is closely linked to the concepts of intensity or standard 

of review. The experience in other legal systems has shown that intensity of review 

is one specific aspect of the principle of proportionality and relates to its procedural 

dimension (as opposed to the normative content-the substantive dimension). We 

therefore advocate a comprehensive assessment of the review power exercised by 

judges, taking into account the interwoven aspects of proportionality and intensity 

(or standard) of review. One can attempt to clarify these concepts by separating the 

procedural from the substantive aspects of judicial review and, at the same time, by 

outlining their interrelationship. 

In the WTO, proportionality is not mentioned as such in the individual 

Agreements and has not been explicitly recognized as a general principle. Our basic 

argument is that proportionality, though not recognized as such, underpins and 

inspires many of the specific rules laid down in the WTO Agreements. 

We can identify at least two possible ways how the principle of proportionality 

could apply in WTO law. First, proportionality as a principle of general 

international law may inform the interpretation of specific provisions of the WTO 

Agreements. Second, proportionality may be a specific obligation within the WTO 

Agreements, having been laid down in provisions such as Article XX GATT and 

similar provisions in the SPS and TBT Agreements. Those provisions often require 

balancing and the reliance on some sort of proportionality theory to define the 

specific obligations incumbent on the WTO Members. 

Tests like necessity, reasonableness, and proportionality are not standardized 

and may well lead to confusion, given that they are applied in many different legal 

regimes. For instance, the concept of necessity is often mentioned in the WTO 

Agreements as well as in other legal systems. In the traditional reading of the 

principle of proportionality, necessity is the second step of analysis. It does not 

(explicitly) include a weighing and balancing of the advantages and negative impacts 

of a measure. Alternatively, the use of the concept of necessity in the context of UK 

human rights law stands for-and includes-a fuller proportionality analysis. Public 

international law also includes some balancing of rights and interests to refine the 

concept of necessity. Within the scope of Article XX GAT, necessity is equally not 

restricted to a simple assessment of the least trade-restrictiveness of a domestic 

measure. The determination whether a trade-restrictive measure is necessary to 

pursue a legitimate public policy objective will be made upon a balancing of different 

factors as elaborated in the jurisprudence. 

What can be the possible consequences of a more coherent proportionality 

theory applied by the WTO judiciary? First, it imposes an obligation on Members to 

justify their measures according to a relatively structured legal criterion. It further 


2007 


makes the judicial process more rational, coherent, and predictable. One effect is to 

limit the discretion of judges by requiring them to follow a sequence of steps in 

analyzing domestic measures. Through the three-step analysis, a structured 

deliberative process may take place, within which judges play a predominant role. 

The procedural aspect of proportionality, both in its application by domestic 

authorities and by the WTO judiciary, involves a "structured weighing of 

interests. 3 6 1 This includes the fact that all interested parties may articulate their 

views, which subsequently need to be taken into account in the balancing process. In 

that sense, the principle of proportionality may pose less of a danger to WTO 

Members pursuing legitimate policy choices than some other, vaguely defined tests. 

One counterargument against proportionality (and balancing) in the WTO 

context is that it often provides judges with too great a power to examine legitimate 

domestic measure and to interfere with sovereign policy choices. Balancing by the 

judiciary may promote vagueness and leave the courts a "permanent loophole," 

maximizing their freedom of action. 7 Our argument is different. The more 

structured and rational a test, the more the courts will have to engage in a 

transparent judicial discourse with regard to trade-offs they are constantly required 

to make. Such discourse needs to take the arguments advanced by the parties more 

seriously. As the experience in other legal systems shows, this is no guarantee for 

elaborate and sophisticated judgments. Yet, it may contribute to reducing the 

vagueness and unpredictability of judicial reasoning in the WTO. 

306. de Btlrca, supra note 10, at 146. 

307. Donald Regan, The Supreme Court and State Protectionism: Making Sense of the Dormant 

Commerce Clause, 84 MICH. L. REV. 1091, 1286-87 (1986). 



The Modernization of European Competition 

Law: A Story of Unfinished Concepts 

JORGEN BASEDOW* 

SUMMARY 

I. D ECENTRA LIZATIO N .......................................................................................... 430 

II. A MORE ECONOMIC APPROACH IN MERGER CONTROL ............................... 433 

III. PRIVATE E NFORCEM ENT ................................................................................... 436 

In the late 1990s the European Commission started to conceive a complete 

overhaul of its competition policy. In view of the imminent enlargement of the 

Community to central and eastern Europe and the accession of a great number of 

new Member States, the Commission feared that it would be less and less able to 

ensure a satisfactory degree of enforcement of European competition law. In the 

spring of 1999 it therefore published a White Paper that suggested an entirely new 

structure for the enforcement of Articles 81 and 82 EC.' Its most important effect 

was that it replaced the previous monopoly of the European Commission to grant 

exemptions under Article 81(3) with a network of national competition authorities, 

which would be entitled to the direct application of Article 81(3) EC. This 

decentralisation, which will be outlined in the first part of this paper, is accompanied 

by a certain change in the application of the substantive provisions. It is probably 

due to an increased American and Anglo-Saxon influence on European competition 

law that a shift towards a more economic approach can be observed. Various 

Commission instruments give evidence of this trend. It comes to the surface most 

clearly in the new Merger Control Regulation 139/2004, which will be discussed in 

the second part. A third spectacular change of direction became visible in late 2005 

and relates to private enforcement of Articles 81 and 82. The Commission had 

already hinted at the need for an increased use of private litigation in its early 

proposals for Regulation 1/2003.2 A Green Paper on this subject was published in 

December 2005.' 

Prof. Dr. h.c. Jiirgen Basedow, LL.M. (Harvard Univ.), Director of the Max Planck Institute for 

Comparative and International Private Law, Professor at the University Hamburg, Chairman of the 

German Monopoly Commission. 

1. Commission White Paper on Modernisation of the Rules Implementing Articles 85 and 86 of the EC 

Treaty, COM (99) 101 final, 1999 O.J. (C 132) 1. 

2. See id. paras. 99-100. 

3. Commission Green Paper on Damages Actions for Breach of the EC Antitrust Rules, COM (2005) 



VOL. 42:429 

I. DECENTRALIZATION 

Ever since the promulgation of Regulation 17 in 1962' European competition 

law has been characterized by the Commission's monopoly to grant exemptions 

under Article 81(3) EC. While national competition authorities and courts were 

allowed or even under an obligation to apply the prohibition of restrictive 

agreements laid down in Article 81(1) EC, they were not in a position to decide 

whether the case under scrutiny was exempted or not. Since the defendant 

undertakings usually invoke some justification for their anticompetitive behaviour, 

complaints lodged with a national competition authority or litigation started in a 

national court for violation of Article 81 were rather useless. Those who suffered 

from anticompetitive behaviour preferred to directly address the European 

Commission. The number of such complaints grew constantly with the accession of 

new Member States, and the Commission was less and less able to efficiently enforce 

European competition law. 

The Commission used two instruments to cope with the problem. With regard 

to standard situations it issued block exemption regulations which declared Article 

81(1) inapplicable to certain categories of agreements and concerted practices. 

Moreover, individual applications for exemptions were more and more often 

answered by so-called comfort letters. Without providing for definite clearance of 

the respective behaviour, they would state that the Commission, while reserving the 

right of later investigation, did not see any reason to intervene for the time being. 

The resulting uncertainty was most clearly felt when contracts containing 

anticompetitive clauses gave rise to private litigation: Would a national judge be 

allowed to consider a clause covered by a comfort letter as null and void under 

Article 81(2) EC, or would that clause have to be respected as valid until further 

action would be taken by the Commission? 5 

In view of the imminent enlargement of the Community towards central and 

eastern Europe and the accession of 10 new Member States, the Commission feared 

a flood of new cases would cause the situation to become untenable. It therefore 

gave up its monopoly on granting exemptions. Under Article 1(2) of Regulation 

1/2003 "agreements, decisions and concerted practices caught by Article 81(1) of the 

Treaty which satisfy the conditions of Article 81(3) of the Treaty shall not be 

prohibited, no prior decision to that effect being required., 6 At the same time the 

competition authorities of the Member States are deprived of their discretion to 

apply either national competition law or Articles 81 and 82 when investigating 

anticompetitive behaviour. While the investigation as such remains discretionary, 

they have to apply Article 81 and 82 to behaviour that may affect trade between 

Member States if they decide to initiate proceedings. 7 In respect of anticompetitive 

agreements, Article 3(2) explicitly establishes that Article 81 takes priority over a 

parallel application of national competition law. This rule and the direct 

672 final (Dec. 19, 2005). 

4. Council Regulation 17, 1962 J.O. (13) 204 (EEC); amended by Council Regulation 1216/1999, 1999 

O.J. (L 148) 5 (EC). 

5. See Schrdter, in VERTRAG OBER DIE EUROPAISCHE UNION UND VERTRAG ZUR GRONDUNG DER 

EUROPAISCHEN GEMEINSCHAFT - KOMMENTAR (Groeben & Schwarze eds., 6th ed. 2003), Art. 81 EC, 

para. 229 with further references. 

6. Council Regulation 1/2003, art. 1, 2003 O.J. (L 1) 7 (EC). 

7. See id. art. 3(1). 


2007 

THE MODERNIZATION OF EUROPEAN COMPETITION LAW 

applicability of Article 81(3) EC are supposed to prevent the distortion of the 

uniform substantive principles of Article 81 by the simultaneous application of 

national competition law. 

But is that presumption justified? Is the obligation to apply uniform 

substantive standards sufficient to ensure uniform practice? We would be prepared 

to accept that assumption in the context of uniform private law in, for instance, the 

law of the international sale of goods or in respect of international transport 

conventions. But in competition law national interest and political involvement are 

much stronger than in traditional private law. In this respect the traditions differ 

widely among the 25 Member States. Economic policy in some of the old Member 

States, such as France, has always focused on the support of large national 

corporations whereas the economic policy of other countries, in particular Great 

Britain and Germany, has traditionally stressed the need for a competitive 

environment for the sake of consumer welfare and economic freedom. In most of 

the new Member States, competition law and policy are new achievements. 

Economic and political leaders of the older generation may have difficulty with 

competition policy, and the new generation sometimes appears to reject state 

intervention altogether even if it is meant to protect competition. The divergences 

are far-reaching and raise serious doubts about the possibility of a uniform 

competition regime under which administration is largely left to national authorities. 

The Commission has been aware of the risks inherent in decentralization. The 

concept underlying Regulation 1/2003 provides for replacement of the Commission's 

monopoly-not by the decisions taken by single national authorities, but by a 

network composed of the Commission and the competition authorities of the 

Member States which are put under an obligation of close cooperation. The 

mechanisms of information and consultation are set forth in various provisions of 

Regulation 1/2003 and in further Community instruments (in particular a common 

declaration' and a so-called network communication). In this context only some 

basic structures can be explained. 

A basic issue relates to the allocation of cases to a national competition 

authority. Given the effects doctrine which has been espoused by many national 

competition laws of Member States, anticompetitive behaviour affecting trade 

between Member States will often give rise to investigations conducted by two or 

more competition authorities of different countries. Their respective competence 

cannot be doubted, but it goes without saying that parallel proceedings conducted in 

several Member States may generate excessive costs and lead to contradictory 

results. Article 13 of Regulation 1/2003 therefore allows Member States to suspend 

or terminate proceedings in view of proceedings initiated by the authority of another 

Member State. Contrary to the objection of lis alibi pendens in civil procedure, it is 

not necessarily the court first approached that will conduct the proceedings. Rather, 

the allocation of a case will be decided by a consultation between the Member States 

involved and the Commission. 

8. Joint Statement of the Council and the Commission on the Functioning of the Network of 

Competition Authorities (EU) No. 15435/02 of 10 Dec. 2002. 

9. Commission Notice on Cooperation Within the Network of Competition Authorities (EU) of 27 

Apr. 2004,2004 O.J. (C 101) 43. 



VOL. 42:429 

According to the network communication, the case should be allocated to the 

authority best suited for that purpose.'" While some relevant considerations are set 

forth in the communication, their mutual relation is unclear. For example, the case 

may be allocated to the authority of a Member State where most of the relevant 

proof is located, but it would also be possible for the case to be left to the authority 

of another Member State which has the resources for investigation at the relevant 

time. After two years of operation, officials of the Commission and of national 

competition authorities appear to be highly satisfied with the results. 

We know much less, however, about the evaluation by industry. The 

discretionary character of case allocation may generate unforeseeable risks and high 

costs for businesses. Take the example of criminal sanctions for the responsible 

managers, which exist only in some Member States, such as Great Britain or 

Slovakia. Suppose that a case, which has its centre of gravity in a country such as 

Germany, where criminal sanctions are unknown, is allocated by the discretion of 

the network to the Slovak or the British competition authorities. Could we really 

assume that such discretionary case allocation would be in line with basic rights such 

as those enshrined in Article 6 of the European Human Rights Convention" and in 

Article 47 of the Charter of Basic Rights?' 2 

Regulation 1/2003 provides for many obligations in the field of information and 

consultation. 3 It also allows the competition authorities of Member States to carry 

out investigations on behalf of the competition authority of another Member State in 

order to establish whether there has been an infringement of Article 81 or 82.14 It 

must, however, be stressed that this type of cooperation is voluntary. How can we 

expect a thorough investigation into a cross-border cartel if Member States' 

authorities are not obligated to carry out investigation requests from the national 

authorities of other Member States? The underlying assumption is that the national 

competition authority designated by the network is to carry out such a 

comprehensive inquiry into all effects of anticompetitive behaviour wherever they 

are felt within the Community. This assumption may be optimistic, however. 

Regulation 1/2003 does not put the designated competition authority under an 

obligation to extend its investigation beyond the national boundaries of its own state. 

Given the difficulties of taking evidence abroad and the delay caused by 

transnational cooperation, national competition authorities are likely to limit their 

investigations to their respective national territories. If that is true, the case 

allocation mechanism has to be questioned. If an anticompetitive behaviour affects 

several Member States and the national authority designated by the network only 

investigates the effects felt in its own territory, case allocation may lead to 

underpunishment since the effects in other Member States will not be taken into 

account by the investigating authority when fixing the amount of the fine. 

To sum up, decentralization may intensify the public enforcement of Articles 81 

and 82. On the other hand the structure of the European competition network as 

10. Id. at 43, para. 7. 

11. Convention for the Protection of Human Rights and Fundamental Freedoms, Apr. 11, 1950, 213 

U.N.T.S. 221. 

12. Charter of Fundamental Rights of the European Union, Dec. 18, 2000, 2000 O.J. (C 364) 1. 20 

(discussing the right to an effective remedy and to a fair trial). 

13. See, e.g., Council Regulation 1/2003, supra note 6, arts. 11, 12 and 15; see also Commission Notice 

on Cooperation, supra note 9, art. 2.2 (discussing concrete mechanisms of cooperation). 

14. See id. art. 22. 


2007 


enshrined in Regulation 1/2003 is conceptually incomplete and inconsistent; it will 

most probably lead to underpunishment. This is underpinned by the final 

observation that there is no mutual recognition and enforcement of decisions within 

this network of competition authorities. Regulation 1/2003 is no more than a first 

step towards a true network of competition authorities. 

II. 

A MORE ECONOMIC APPROACH IN MERGER CONTROL 

A second distinctive feature of the modernization of EC competition law is the 

increased significance of economics. Clear evidence for this shift in methodology 

can be found in the guidelines on horizontal cooperation 6 and in the block 

exemption Regulation for vertical restraints. 7 But the most significant legal 

instrument that reflects this evolution is the substantive test of merger control 

adopted by the new Merger Control Regulation no. 139/2004." 

The control of concentrations has been introduced into Community law by 

Regulation 4064/89.9 Under its Article 2(3), a concentration "which creates or 

strengthens a dominant position as a result of which effective competition would be 

significantly impeded" had to be declared incompatible with the common market. 

The second element of this two-tiered test turned out to be rather insignificant in its 

practical application. Whenever the Commission assessed the creation or 

strengthening of an individual or collective dominant position, a significant 

impediment of effective competition was presumed to result therefrom. 2 ' The 

dominance test was inherently linked to Article 82: if the abuse of a dominant 

position is forbidden under that provision, the law should be reluctant to accept the 

emergence of dominant positions except for the case of internal growth. As a 

consequence of Regulation 4064/89, the same concept of dominance of the relevant 

market could be used for both merger control and the control of abusive practices. 

In particular, the judicial presumption of dominance flowing from a market share of 

more than fifty percent 2 ' and the test of collective dominance espoused by the Court 

of Justice 22 could be used in both contexts 3 

15. See, e.g.. Doris Hildebrand, Der "more economic approach," in DER WETTBEWERBSPOLITIK - 

DYNAMIK UND AUSBLICK 513 (2005); ARNDT CHRISTIANSEN, DIE "OKONOMISIERUNG" DER EU- 

FUSIONSKONTROLLE: MEHR KOSTEN ALS NUTZEN? 285 (2005); ULF BOGE, DER "MORE ECONOMIC 

APPROACH" UND DIE DEUTSCHE WETTBEWERBSPOLITIK 727 (2004). 

16. Commission Notice: Guidelines on the Applicability of Article 81 of the EC Treaty to Horizontal 

Cooperation Agreements, 2001 O.J. (C 3) 2 (EC) [hereinafter Commission Notice: Guidelines]. 

17. Commission Regulation 2790/1999, 1999 O.J. (L 336) 21 (EC). 

18. Council Regulation 139/2004, 2004 O.J. (L 24) 1 (EC). 

19. Council Regulation 4064/89, 1989 O.J. (L 395), 1 (EEC). 

20. For the discussion on the relevance of this element, see Immenga, in Immenga/Mestmacker, EG- 

Wettbewerbsrecht, Vol. 1 (1997), Art. 2 FKVO, para. 18 seqq.; R6sler, in Frankfurter Kommentar zum 

Kartellrecht, Vol. 6, Art. 2 FKVO, para. 216 seq. 

21. See, e.g., Case C-85/76, Hoffmann-La Roche v. Comm'n, 1979 E.C.R. 1-461; Case C-62/86, AKZO 

Chemie v. Comm'n, 1991 E.C.R. 1-03359 (both concerning abuse of dominance law). 

22. See, e.g., Joined Cases T-68/89, T-77/89 & T-78/89 Societa Italiana Vetro SpA v. Comm'n, 1992 

E.C.R. 11-1403; Case C-393/92, Almelo v. NV Energiebedrijf Ijsselmij, 1994 E.C.R. 1-1477; Joined Cases C- 

140/94, C-141/94 & C-142/94, DIP SpA v. Comune di Bassano del Grappa, 1995 E.C.R. 1-3257; Joined 

Cases T-24/93, T-25/93, T-26/93 & T-28/93, Compagnie Maritime Beige Transports SA v. Comm'n, 1996 

E.C.R. 1-1201; Joined Cases C-68/94 & C-30/95, French Republic v. Comm'n, 1998 E.C.R. 1-1375; Case T- 

102/96, Gencor Ltd. v. Comm'n, 1999 E.C.R. 11-753; Case T-342/99, Airtours plc v. Comm'n, 2002 E.C.R. 



VOL. 42:429 

Article 2(3) of Regulation 139/2004 has changed the order of the two elements 

of the substantive test of merger control. At present, a concentration "which would 

significantly impede effective competition ... in particular as a result of the creation 

or strengthening of a dominant position, shall be declared incompatible with the 

common market., 24 Under the new rule the dominance test is only an example for a 

significant impediment of effective competition. The latter now provides the main 

criterion. As a consequence, even a merger that does not satisfy the dominance test 

can be prohibited under the new SIEC test. 

This amendment may appear marginal at first sight. But it has the effect of 

depriving the previous case law of much of its significance. Given the impediment to 

economic competition exemplified by the dominance test, it is unlikely that a merger 

that satisfies the latter will be declared compatible with the common market. On the 

other hand, the application of the dominance test is not exhaustive. There may be 

mergers that are not caught by the dominance test that still constitute a significant 

impediment to economic competition. 

In order to explain the need for this additional possibility of control, recital 25 

of Regulation 139/2004 refers to the non-coordinated or unilateral effects that a 

merger may have in oligopolistic markets. A good illustration of these 

uncoordinated effects is the Airtours case, decided by the Court of First Instance. 25 

It relates to the British market of all-inclusive tours to the European continent and 

its surroundings. Among the four leading tour operators, numbers three and four, 

with market shares of 15 and 19.4% respectively, had merged. 26 As a consequence, 

the merged entity was now number one, with a 34.4% market share; this placed it in 

front of the previous leader, which had a 30.7% market share, and the fourth 

company, which had a 20.4% market share. 27 The Commission had prohibited the 

merger, stating that it would strengthen a collective dominant position of the four 

leading undertakings." On review, the Commission decision was declared void by 

the Court of First Instance. The Court pointed out that, for the assumption of 

collective dominance, considerable transparency of the market would be required so 

that every member of the leading oligopoly could monitor with sufficient precision 

and speed the behaviour of other market actors. 2 9 Moreover, collective dominance 

would require the ability of the members of the oligopoly to impose severe sanctions 

on deviating members, therefore discouraging them from any attempt to push 

forward in competition." The Court held that the Commission had not sufficiently 

proven the presence of these elements of collective dominance in the case at hand. 3 

It is not unlikely that the collective dominance test has reached its limits in this 

case. Apparently, one of the basic requirements of collective dominance, i.e., the 

11-2585 [hereinafter Airtours]. 

23. In assessing market shares, one has to be aware, however, that due to the prospective character 

and the more dynamic approach of merger control, the ECJ decisions on Article 82 concerning the field of 

abuse of dominance can only cautiously be transferred to the situation of merger control; see Immenga, 

supra note 20, art. 2 FKVO, para. 102. 

24. Council Regulation 139/2004, supra note 18, art. 2(3). 

25. Airtours, supra note 22. 

26. Id. para. 66. 

27. Id. 

28. Commission Decision 2000/276, 2000 O.J. (L 93) 1, 9 (EC). 

29. Airtours, supra note 22, para. 60. 

30. Id. para. 62. 

31. Id. para. 277. 


2007 


homogeneous character of the goods in the market, is absent here. Nevertheless, 

economists maintain that a merger in a narrow oligopoly may provide additional 

room to manoeuvre for the remaining undertakings in the market. In particular, a 

competitive initiative taken by a tour operator with a very large market share would 

be unlikely to be matched by its competitors who would be unable to book a 

sufficient number of hotel rooms and air transport capacity to strike back. 

Unilateral effects of this kind are said to be unsusceptible of being accounted for by 

the dominance test. Economists suggest that the SIEC test is more flexible and 

would allow for a prohibition needed in these cases. 32 While this may be true, the 

economic reasoning underlying the analysis of the Airtours case appears 

questionable. It is based on a very limited time frame of one year and does not take 

into account the reaction of competitors in subsequent years. It is possible that 

competitors who have been surprised by the market leader pushing forward in one 

year will strike back in the following year. If that is true, the need for merger review 

beyond the dominance test would not appear to be well founded. 

Another element of economic analysis that has received increased significance 

in the framework of the SIEC test is the efficiency defence. 33 The previous 

Regulation 4064/89 had pointed out, in recitals 4 and 13, that concentrations are apt 

to increase the competitiveness of European industry, to improve the conditions of 

growth, to raise the standard of living, and to strengthen the Community's economic 

and social cohesion. But these goals were related to the fundamental objectives of 

the Community as laid down in Articles 2 and 130(a) (now 158) EC, while the 

efficiency gains to be derived from a merger were not explicitly addressed. Those 

gains could give support to a merger insofar as they contributed to "the development 

of technical and economic progress. ' But their role was ambivalent since they 

might also be suited to give additional strength to the merged entity in relation to its 

competitors. 

To the contrary, the Green Paper on the overhaul of the merger control 

Regulation 35 makes reference to efficiency gains only in defence of concentration, as 

does Regulation 139/2004. While the wording of Article 2(1) has remained 

unchanged in this respect, recital 29 makes explicit reference to the possibility "that 

the efficiencies brought about by the concentration counteract the effects on 

competition, and in particular the potential harm to consumers ... and that, as a 

consequence, the concentration would not significantly impede effective competition 

.... ,,36 Thus, efficiency is considered as an element of the restriction of competition, 

and the guidelines on horizontal mergers published by the Commission 3 point 

equally to the possibility that efficiency gains will offset anticompetitive effects. 

32. See Bundeskartellamt, Arbeitskreis Kartellrecht, Das Untersagungskriterium in der 

Fusionskontrolle - Marktbeherrschende Stellung versus Substantial Lessening of Competition?, Konzepte 

fuir die Prufung von Unternehmenszusammenschltissen 16 (2001). 

33. See MESTMACKER & SCHWEITZER, EUROPAISCHES WETTBEWERBSRECHT § 25, para. 142 (2d 

ed. 2004); Zeise, in HANDBUCH DER FUSIONSKONTROLLE 358. para. 1282 (Schulte ed., 2005). 

34. Council Regulation 4064/89, supra note 19. art. 2(1)(b) (EC). 

35. Commission Green Paper on the Review of Council Regulation. No. 4064/89, COM (2001) 745/6 

final (Nov. 12, 2001). 

36. Council Regulation 139/2004, supra note 18, recital 29. 

37. Commission Notice: Guidelines, supra note 16. 



VOL. 42:429 

There are two major objections to the new approach. In the first place, the very 

measurement of efficiency gains by a state authority appears to contradict the model 

of the market economy. This model departs from the basic assumption that market 

actors-whether individuals or undertakings-determine their own economic 

preferences individually and in a subjective way. There is no rational way of 

convincing an individual that the purchase of a Rolls Royce has to be preferred to 

that of a Skoda. It is not possible to find objective criteria that cause people to 

spend their money on large apartments instead of luxury cars. These individual 

preferences may be explained by psychological and cultural factors, or by specific 

needs and inclinations of the single market actors. But the market process has to 

accept these preferences as a point of departure, i.e., for the exchange of goods and 

services and the formation of prices. As a consequence, efficiency gains can only be 

determined on the basis of individual decisions to pay a certain price for goods or 

services. Efficiency is the aggregate of the increase of satisfaction felt by market 

actors as a result of the market process. In this respect, it is not sufficient to take 

into account the satisfaction of the undertakings involved in a merger; the 

satisfaction of third parties and consumers has to be considered as well. How can a 

state authority assess all these individual appreciations of a merger? Since the 

individual appreciation would usually depend on the prediction of the effect of a 

merger in the future, prognostic capacities of which nobody can boast would be 

required. 

A second objection relates to the alleged offsetting of the anticompetitive and 

efficiency effects of a merger. This would require a kind of quantification of both 

effects which is, in fact, insinuated in the Commission's guidelines on horizontal 

mergers. But such quantification would unnecessarily limit the analysis. It would 

focus on the merger's effect on prices, predicting efficiency gains if prices decrease, 

and prevailing anticompetitive effects if prices increase. It risks excluding the 

structural effects of the merger that would usually last for a much longer period than 

the immediate effect on prices. It should not be forgotten, however, that the review 

of mergers was introduced precisely for those structural effects which are reflected 

by the dominance test. 

To sum up, the more economic approach as applied by Regulation 139/2004 to 

the review of mergers raises many questions. It appears doubtful whether the 

amendment helps to protect competition, and its impact on the legal certainty 

required for merger operations is equally doubtful. 38 It is safe to assume, however, 

that the bar specializing in competition law will acquire additional business. 

III. PRIVATE ENFORCEMENT 

A further element of the modernization of EC competition law may be a shift 

towards private enforcement. Private enforcement has always been contemplated as 

a shield against private claims as far as the function of Article 81 is concerned. 9 In 

fact, claims arising from anticompetitive agreements have always been countered by 

defendants invoking the nullity of the contract under Article 81(2) EC. The recent 

debate focuses on the offensive use of Articles 81 and 82 as a "sword" in the hands 

of the victims of anticompetitive behaviour. It is well-known that private claims for 

38. See also Christiansen, supra note 15. 

39. See, e.g., K. Schmidt, supra note 20, art. 85, para. 38. 


2007 


compensation of the losses suffered from cartels and monopolistic abuses play a 

significant role in the enforcement of U.S. antitrust law, where the plaintiff is entitled 

to three times the amount of his loss. 4 ° In Europe, such claims have not been 

recognized until recently in Community law. While Member States would usually 

provide for a cause of action for damages resulting from the violation of Articles 81 

and 82 EC in their municipal laws, no Member State is as generous to the plaintiff as 

U.S. law. 

As early as 1999, when presenting the proposal for the later Regulation 1/2003, 

the Commission pointed out that the "proposal aims at promoting private 

enforcement through national courts."' 

' , In fact, the direct applicability of Article 

81(3) allows national courts to give judgement on actions for compensation based 

upon the violation of Article 81 EC without staying proceedings, until the 

Commission decides upon a possible exemption under Article 81(3) EC. But at that 

stage there was no cause of action under Community law for such claims. This 

changed in September 2001, when the European Court of Justice handed down its 

opinion in Courage v. Crehan. 

42 The Court pointed out that the practical effect of 

the prohibition of restrictive agreements in Article 81(1) "would be put at risk if it 

were not open to any individual to claim damages for loss caused to him by a 

contract or by conduct liable to restrict or distort competition." 43 In the Court's 

view, "actions for damages before the national courts can make a significant 

contribution to the maintenance of effective competition in the Community." 4 4 

However, "in the absence of Community rules governing the matter" the Court 

referred such claims to the domestic legal systems of the single Member States. 

The explicit reference to the lack of Community rules was immediately 

understood by the Commission. It placed an order for a comprehensive comparative 

survey with the international law firm Ashurst; the report was published on the 

website of the Directorate General Competition in 2004.46 Thereafter, it convened 

an expert group consisting of five judges and scholars to give advice on the various 

issues raised by private enforcement. 47 The resulting Green Paper on the matter was 

published in December 2005. ' 

40. Clayton Act, ch. 323, § 4, 38 Stat. 730 (1914) (current version at 15 U.S.C. § 15(a) (2006)). 

41. Commission Proposal for a Council Regulation on the Implementation of the Rules on Competition 

Laid Down in Articles 81 and 82 of the Treaty ("Regulation implementing Articles 81 and 82 of the Treaty"), 

at 6, COM (2000) 582 final (Sept. 27, 2000). 

42. Case C-453/99, Courage Ltd. v. Crehan, 2001 E.C.R. 1-6297. 

43. Id. para. 26. 

44. Id. para. 27. 

45. Id. para. 29. 

46. Denis Waelbroeck, Donald Slater, & Gil Even-Shoshan, Study on the Conditions of Claims for 

Damages in Case of Infringement of EC Competition Rules, available at 

http://ec.europa.eu/comm/competition/cartels/studies/comparative-report-clean-en.pdf. 

47. The members of the group were Professor Walter van Gerven (Belgium), a former Advocate 

General of the Court of Justice as chairman, and JiIrgen Basedow, the author of the present article, Sir 

Christopher Bellamy (United Kingdom), President of the British Competition Appeals Tribunal, Carole 

Champalaune (France), judge at the French Supreme Court, and Professor Robert Mok (Netherlands). 

48. Commission Green Paper on Damages Actions for Breach of the EC Antitrust Rules, supra note 3. 

For an appraisal of the Green Paper see PRIVATE ENFORCEMENT OF EC COMPETITION LAW (Basedow 

ed. 2007). 



VOL. 42:429 

It follows that the law in this field has not developed as far as it has regarding 

decentralization and the more economic approach. It is therefore too early to go 

into details. But it is worth raising some questions that might help foster 

understanding for the considerable difficulties of private enforcement. Given the 

coexistence of Articles 81 and 82 on the one side and national competition law on 

the other, the Commission must clarify the relation between Community and 

national law. Accordingly, it will have to decide whether the approximation of 

national laws or the creation of a uniform liability regime is appropriate. Since 

Community law will be somehow embedded in national private law, it will be 

important to know which national law should supplement a Community instrument. 

This issue of private international law will have to be answered in view of the 

proposal for a Rome II Regulation 49 on the law applicable to non-contractual 

obligations, which will be adopted and promulgated shortly. 

A further basic issue relates to the type of claim that is to be granted to the 

victims of a cartel: Should the undertakings involved in anticompetitive behaviour be 

put under an obligation to make restitution of the rent earned from the cartel, as a 

kind of unjust enrichment? Or should the victims be entitled to claim damages for 

compensation of their losses? The most important question that arises in this 

context deals with the so called passing-on defence of the cartel members." If the 

victims have not suffered any loss because they were able to pass the higher input 

prices on to their customers, should this exclude their claims? In that case it would 

be up to the clients on the downstream market, and perhaps eventually the 

consumers, to claim compensation from the undertakings involved in 

anticompetitive practices. Since the losses dissipate as the goods are traded 

downstream, they get smaller and smaller and experience shows that the final 

consumers do not have sufficient incentive to file an action for compensation. If the 

plea of the European Court of Justice for full effectiveness of Article 81 is to be 

taken seriously, the law must therefore allow for some kind of aggregation of small 

claims in a class action or other type of group action. Other issues would relate to 

the alleviation of proof, to the interest owed by the cartel members on the 

compensation, and to additional incentives which potential plaintiffs would need in 

order to bring action, i.e., eventually to the recognition of double or treble damages. 

It is my impression that the European Commission is pushing forward 

impatiently in this field, as it has done in the other fields mentioned before. The 

Green Paper is based on thorough research into the antecedents of comparative and 

Community law. But it is uncertain whether all the concepts and options are well 

thought-out. Here, as in the other fields, a certain trend of Community policy 

49. Commission Proposal for a Regulation of the European Parliament and the Council on the Law 

Applicable to Non-Contractual Obligations (Rome 11), COM (2003) 427 final (Jul. 22, 2003); Commission 

Amended Proposal for a European Parliament and Council Regulation on the Law Applicable to Non- 

Contractual Obligations ("Rome II"), COM (2006) 83 final (Feb. 21, 2006). For an appraisal of the 2003 

proposal in general, see, von Hein, Die Kodifikation des europdiischen Internationalen Deliktsrechts - Zur 

geplanten EU-Verordnung iiber das auf auf3ervertragliche Schuldverhdltnisse anzuwendende Recht, 102 

ZVGLRWIsS 528 (2003); for background specifically on private enforcement of EC competition law, see 

Hamburg Group for Private International Law, Comments on the European Commission's Draft Proposal 

for a Council Regulation on the Law Applicable to Non-Contractual Obligations, 67 RABELS ZEITSCHRIFF 

FUR AUSLANDISCHES UND INTERNATIONALES PRIVATRECHT 1 (2003): see also Bulst, Internationale 

ZustAndigkeit, anwendbares Recht und Schadensberechnung im Kartelldeliktsrecht, EWS 2004 403 (408). 

At the time of reading the proofs of this article a compromise on Rome I has been reached and the 

promulgation of the instrument is imminent. 

50. See, e.g., Roth, in 3 FRANKFURTER KOMMENTAR ZUM KARTELLRECHT § 33, para. 143. 


2007 THE MODERNIZATION OF EUROPEAN COMPETITION LAW 439 

becomes visible: one that gives greater weight to setting a new policy afloat than to a 

thorough investigation into its consequences. The Community should avoid the 

premature implementation of another unfinished concept. It is now up to the 

European public to subject the Green Paper to close scrutiny. 



Corporate Gatekeeper Liability in Canada 

STEPHANIE BEN-ISHAI" 

SUMMARY 

I. INTRO D U CTIO N ................................................................................................... 442 

II. CORPORATE GATEKEEPER LIABILITY THEORY ............................................. 443 

III. THE CANAD IAN SYSTEM .................................................................................... 445 

A . C om m on L aw .............................................................................................. 446 

B . Statutory L iability ........................................................................................ 448 

i. C orporate Statutes ............................................................................... 448 

ii. Securities Statutes ................................................................................. 450 

iii. Secondary M arket Liability ................................................................. 453 

C. O ther R egulatory Regim es .......................................................................... 454 

i. Provincial Securities Commissions ..................................................... 454 

ii. Market Regulation Services Inc ......................................................... 456 

iii. Professional Regulatory Bodies .......................................................... 457 

a. Provincial Law Societies ............................................................... 457 

b. Investment Dealers Association of Canada ............................... 458 

c. Provincial Institutes of Chartered Accountants ........................ 460 

d. International Organization of Securities Commission .............. 461 

D. Criminal and Quasi-Criminal Liability ..................................................... 462 

IV. LOCATING THE CANADIAN SYSTEM IN AN INTERNATIONAL CONTEXT ....... 465 

A . D irecto rs ....................................................................................................... 465 

B . L a w y ers ............................................................ 

466 

C . A u d ito rs ........................................................................................................ 467 

D . C redit R ating A gencies ................................................................................ 469 

LL.B., LL.M. (Harvard), Associate Professor, Osgoode Hall Law School of York University, 

Toronto, Canada. Parts of this article are drawn from research undertaken by the author for the Task 

Force to Modernize Securities Legislation in Canada. The research assistance provided by Zohar Levy and 

Val Culp is gratefully acknowledged. Colleagues at the 13 h Biennial Conference for the International 

Academy for Commercial and Consumer Law, August 9-12, University of Texas School of Law, and the 

2006 Meetings of the Canadian Law and Economics Association, University of Toronto, Faculty of Law, 

September 29-30, 2006 provided most helpful comments on earlier drafts of this paper. The author is 

particularly grateful to Jacob Zeigel and Poonam Puri for comments. All errors are my own. 



VOL. 42:441 

E . Financial A nalysts ....................................................................................... 469 

F. R etail Investm ent A dvisors ......................................................................... 471 

G . U n derw riters ................................................................................................ 472 

V . C O N C LU SIO N ....................................................................................................... 472 


A series of significant reforms with respect to the legal treatment of corporate 

gatekeepers have taken place over the last five years in a number of countries 

around the world. This article serves as a taking-stock exercise of the current 

gatekeeper liability regime in Canada, supplemented by an examination of the 

options for dealing with corporate gatekeepers presented in other jurisdictions, most 

notably the United States and the United Kingdom. The two primary forms of 

liability in the Canadian system are civil liability, through both common law and 

statutes, and administrative liability, found in various regulatory regimes for the 

different types of gatekeepers. There is also the possibility of criminal or quasicriminal 

liability for many gatekeepers. This article suggests that the polycentric 

system in which there are multiple sources of liability for gatekeepers is effective in a 

Canadian context. While there is an international trend towards increased 

streamlined government regulation of gatekeepers, as demonstrated in the U.S. and 

U.K., it is not a system that should be adopted by Canada. Ultimately, though the 

Canadian system is imperfect, this article concludes that the current Canadian 

regime is best suited to provide gatekeepers with guidance and incentives to perform 

their gatekeeping function while facilitating the competitiveness of Canadian capital 

markets. The key challenges with the current model center on the legitimacy and 

independence of the sources of liability. 

For the purpose of this article, corporate gatekeepers are defined as third 

parties who can disrupt misconduct by withholding support. The categories of 

corporate gatekeeper considered in this article are directors, lawyers, auditors, 

underwriters, credit rating agencies (CRAs), financial analysts, and retail investment 

advisors (RIAs). In this article, gatekeeper liability includes civil, administrative, 

and criminal sanctions that can be imposed on gatekeepers who fail to withhold 

support. This includes rules that can be enforced by public regulators and also rules 

that can be enforced by private parties like investors. The sources of law reviewed 

are statute (corporate and securities), common law, self-regulatory organizations' 

(SROs) rules, and rules of professional conduct set by industry bodies. The focus of 

this article is on gatekeepers of public companies. 

Part II provides a theoretical framework of corporate gatekeeper liability, 

through a survey of previous academic writing on the subject. For example, the 

works of Reinier Kraakman and John C. Coffee Jr. are considered in this section. 

Part III examines the sources of corporate gatekeeper liability at common law in 

Canada, including civil liability, statutory liability, and other regulatory regimes such 

as those put into place by provincial law societies. In Part IV, the author deals with 

each category of gatekeeper separately and suggests reforms to improve the 

Canadian system. A comparison with the United States and United Kingdom 

informs this analysis. Part V concludes. 


2007 

CORPORATE GATEKEEPER LIABILITY IN CANADA 

II. 

CORPORATE GATEKEEPER LIABILITY THEORY 

In the 1980s, Reinier Kraakman published two articles that expanded on the 

concept of "gatekeeper liability," which he defined as liability imposed on private 

parties who are able to disrupt misconduct by withholding their support from 

wrongdoers.' This support-which might include a specialized good, service, or form 

of certification that is essential for a wrongdoer to succeed-"is the 'gate' that the 

gatekeeper keeps." 2 True gatekeeper liability is designed to enlist the support of 

outside participants in the firm when controlling managers commit offences; the first 

requisite for gatekeeper liability is an outsider who can influence controlling 

managers to forgo offences.' As outsiders to the firm, these professionals are less 

likely to risk their reputations over fraudulent or suspicious transactions. Kraakman 

identified outside directors, accountants, lawyers, and underwriters as potential 

targets for gatekeeper liability strategies: they each have access to information about 

firm misconduct, they already perform a private monitoring service on behalf of the 

capital markets, and they face incentives that differ from those of managers (that is, 

they are likely to have less to gain and more to lose from firm misconduct than inside 

managers).' Like other liability regimes, gatekeeping imposes costs; Kraakman 

examines whether legal rules can induce gatekeepers to prevent misconduct at an 

"acceptable price." ' After outlining possible costs of a gatekeeping model, 

Kraakman suggests ways to adjust these costs, such as limiting penalties that 

gatekeepers face for breach of duty or selecting prescribed duties for gatekeepers to 

undertake. 6 Finally, Kraakman canvasses other enforcement strategies and 

concludes that gatekeepers' response to misconduct, by withholding support, has 

significant advantages over other third-party enforcement duties. 7 

For Kraakman, legal duties should be imposed on intermediaries to act as 

gatekeepers in certain markets, due to defects in the ability of parties to contract or 

ascertain the reputation of different intermediaries! Stephen Choi, however, argues 

that Kraakman's argument "fails to take into account the impact of different 

screening accuracies in the market, the incentives of intermediaries to invest in 

accuracy, the ex ante response of producers to the possibility of certification, and 

potential market defects." 9 Choi argues that "gatekeeper liability is too heavyhanded 

a response"' and instead advocates for less intervention through a system of 

self-tailored liability, a regime where "lawmakers may allow intermediaries to 

choose for themselves the specific duties that they will be held accountable ...."" 

1. Reinier H. Kraakman. Gatekeepers: The Anatomy of a Third-Party Enforcement Strategy 2 J. L. 

ECON. & ORG. 53, 54 (1986) [hereinafter Kraakman, Gatekeepers]: see also Reinier H. Kraakman, 

Corporate Liability and the Costs of Legal Controls 93 YALE L.J. 857 (1984) [hereinafter Kraakman, 

Corporate Liability]. 

2. Kraakman, Gatekeepers, supra note 1, at 54. 

3. Kraakman, Corporate Liability, supra note 1, at 890. 

4. Id. at 891. 

5. Kraakman, Gatekeepers, supra note 1, at 75. 

6. Id. at 79-81. 

7. Id. at 85. 

8. Id. at 93-100. 

9. Stephen Choi. Market Lessons for Gatekeepers. 92 Nw.U. L. REV. 916, 918 (1998). 

10. Id. 

11. Id. at 951. 



VOL. 42:441 

More recently, John C. Coffee, Jr. has popularized Kraakman's concept in the 

aftermath of Enron and other corporate scandals. Coffee has blamed such scandals 

on the failure of gatekeepers, who, he asserts, allowed management to engage in 

fraud. 12 Coffee has defined gatekeepers as independent professionals who act as 

reputational intermediaries, providing verification or certification services to 

investors. 3 Gatekeepers have less incentive to deceive; therefore, the market views 

gatekeepers' assurances as more credible. Their credibility also stems from the fact 

that gatekeepers pledge their reputational capital. 1 4 Theoretically, a gatekeeper 

would not sacrifice the reputational capital built up over many years of performing 

services for a single client or a modest fee. However, there are instances where 

reliance on gatekeepers may be misplaced, such as: where there is a sudden decline 

in the deterrent threat facing gatekeepers and they are thus more willing to take 

risks; where greater inducements are offered to gatekeepers to breach their duties; 

or where certain market scenarios lessen injury to a gatekeeper's reputation. 5 

Included amongst Coffee's list of gatekeepers are auditors, credit rating agencies, 

securities analysts, investment bankers, and securities lawyers. 6 Coffee concludes 

that the creation of excessive liability might cause the market for gatekeeping 

services to fail; instead, he advocates a shift towards stricter liability standards with a 

ceiling on gatekeeper liability adequate to deter misconduct. 7 

Whereas Coffee's proposed system is essentially regulatory, Frank Partnoy 

advocates a contractual system based on a percentage of the issuer's liability. 

Under Partnoy's proposed regime, gatekeepers would be strictly liable for any of the 

issuer's securities fraud damages pursuant to a settlement or judgment. 9 Although 

gatekeepers would not have available to them due diligence defenses, they could 

limit their liability by agreeing to and disclosing a percentage limitation on the scope 

of their liability. Authors such as Larry Ribstein oppose mandatory personal 

liability for professionals as a relatively ineffective way to encourage professional 

firms to perform their duties to clients and others. 2 ' Ribstein argues that this liability 

is based on "an attenuated notion of responsibility and unrealistic assumptions about 

12. John C. Coffee, Jr., Understanding Enron: "It's About the Gatekeepers, Stupid", 57 BUS. LAW. 

1403 (2001-2002); JOHN C. COFFEE, JR., GATEKEEPERS: THE ROLE OF THE PROFESSIONS IN CORPORATE 

GOVERNANCE (CLARENDON LECTURES IN MANAGEMENT STUDIES) (Oxford University Press 2006) 

(attributing the corporate failures of the 1990s to a decline in exposure to gatekeeper liability and the 

increase of acquiescence in clients' demands); John C. Coffee, Jr., Gatekeeper Failure and Reform: The 

Challenge of Fashioning Relevant Reforms (Columbia Law Sch. Ctr. for Law and Econ., Working Paper 

No. 237, 2003) [hereinafter Coffee, Gatekeeper Failure and Reform]. 

13. Coffee, Gatekeeper Failure and Reform, supra note 12, at 12. 

14. Id. at 13. 

15. See generally Coffee, Gatekeeper Failure and Reform, supra note 12 (discussing in detail reasons 

for gatekeeper failure). See also John C. Coffee Jr., The Acquiescent Gatekeeper: Reputational 

Intermediaries, Auditor Independence and the Governance of Accounting (Columbia Law Sch. Ctr. for Law 

and Econ., Working Paper No. 191, 2001) (expanding on why gatekeepers might be undermotivated to 

protect their reputations) [hereinafter Coffee, The Acquiescent Gatekeeper]. 

16. Coffee Gatekeeper Failure and Reform, supra note 12. 

17. Id. at 67-68. 

18. Frank Partnoy, Strict Liability for Gatekeepers: A Reply to Professor Coffee (Univ. of S.D. Sch. of 

Law, Law and Econ. Research Paper Series, Paper 5, 2004). 

19. Frank Partnoy, Barbarians at the Gatekeepers?: A Proposal for a Modified Strict Liability Regime 

79 WASH. U. L. Q. 491 (2001). 

20. Id. 

21. Larry Ribstein, Limited Liability of Professional Firms after Enron, 29 J. CORP. LAW 427, 429 

(2004). 


2007 


firm members' ability to monitor., 2 Furthermore, he suggests, imposing personal 

liability on professionals may increase agency costs between professionals and their 

clients; affect professional firm size, structure and scope; and reduce desirable 

liability of the firm. 23 In relation to auditors, Lawrence Cunningham prescribes a 

framework that uses financial statement insurance as an alternative to financial 

statement auditing backed by auditor liability." In his proposed framework, 

companies could opt for either model, subject to investor approval. 2 Financial 

statement insurance policies would cover damages arising from audit failuredamages 

due to financial misstatements that auditors did not discover-replacing 

auditor and issuer liability. 26 

In the broader context of the regulation of gatekeepers, Richard Painter 

stresses the balancing act that this type of regulation entails. 27 Gatekeeper 

regulation, he argues, is pointless if it impairs information flow to gatekeepers: "Any 

improvement in gatekeeper response to risk that comes from these rules has to be 

weighed against potential reduction in gatekeeper information and consequent 

impairment of gatekeeper evaluation of risk." 2 In order to optimize the regulation 

of gatekeepers, he suggests that experimentation with divergent rules-for example, 

American and European rules for auditor and lawyer intervention, rather than 

convergence of legal rules, will facilitate the learning process." 

III. THE CANADIAN SYSTEM 

The Canadian model for gatekeeper liability reflects Painter's suggestion for 

resisting a convergence of legal rules, as there remains a high degree of divergence in 

the nature of the liability for each corporate gatekeeper. In addition, Choi and 

others' concerns with an excessively heavy-handed or interventionist liability scheme 

have been largely limited in the Canadian context. Rather, relying heavily on selfregulation, 

but resisting the contractual and insurance models proposed by Choi and 

Cunningham, the Canadian system has attempted to achieve the balance called for 

by Coffee. 

Under the current Canadian regime, corporate gatekeepers are open to civil 

liability, but in practice, investors' ability to impose civil liability on corporate 

gatekeepers is quite limited. Both substantive and procedural obstacles limit 

common law civil liability. The application of the business judgment rule and a 

range of statutory defences, in addition to procedural obstacles, limit statutory 

(corporate and securities) civil liability, including the new secondary market civil 

liability regime found in Ontario's securities legislation. The rules of professional 

conduct provided by gatekeepers' Self-Regulatory Organizations (SROs) or industry 

22. Id. 

23. Id. 

24. Lawrence A. Cunningham, Choosing Gatekeepers: The Financial Statement Insurance Alternative 

to Auditor Liability, 52 UCLA L. REv. 413 (2004). 

25. Id. 

26. Id. at 415. 

27. Richard W. Painter, Convergence and Competition in Rules Governing Lawyers and Auditors, 29 

J. CORP. L. 397, 400 (2004). 

28. Id. at 407. 

29. Id. at 425. 



VOL. 42:441 

bodies either do not provide for or are unlikely to result in liability to third parties. 

Taken together, the Canadian approach to civil liability for corporate gatekeepers is 

consistent with the U.S. and U.K. models, to the extent that it has been informed by 

concerns relating to the promotion of investor confidence in the fairness of the 

market. The harm perpetrated against individual investors has been seen as a matter 

of secondary importance. 

A. Common Law 

A traditional source of civil liability for many gatekeepers, including directors 

and auditors, is common law. Under common law, investors are able to bring an 

action against directors for a breach of fiduciary duty and duty of care, as well as 

seek remedies in contract and tort. However, these causes of action have generally 

been supplanted by securities and corporate legislation as the common law remedies 

have more onerous substantive and procedural requirements to be met. 

In order to bring a common law action forward against a lawyer, investors must 

meet the standard set forth in Filipovic v. Upshall, which established that "the 

[lawyers] stood in a sufficient relationship of proximity with the plaintiffs to 

engender a duty of care on their part . . . . It required the defendants to carry out 

their duties as corporate lawyers in a reasonably professional and competent manner 

and with the utmost good faith." 3 " In CC&L Dedicated Enterprise Fund v. 

Fisherman, the court held that a prima facie duty of care exists when a lawyer makes 

representations to the investing public for the purpose of furthering the investments 

in their client. " This duty will only be negated through policy considerations if the 

factual situation shows no reasonable alternative action by the lawyer that would not 

bias the client. The motion also holds that this duty may be breached through a 

failure to prevent misrepresentations by the client or failure to withdraw services in 

the face of fraudulent activities. However, while CCL and Filipovic do allow the 

possibility that a lawyer may be found to owe a fiduciary duty of care to investors, it 

is difficult for investors to establish that duty, and once established, the courts are 

relatively unlikely to find negligence or breach of duty of care giving rise to 

damages. 32 

Against auditors, there is the possibility of relief for shareholders in tort, as the 

Supreme Court of Canada held in Hercules that it is reasonable for a corporation's 

shareholders to make investment decisions relying on the correctness of the 

corporation's audited financial statements. 33 However, that decision largely curtailed 

the potential scope of liability under the second stage of the Anns/Kamloops test, 

which addresses policy considerations. 34 The primary concern is that the defendant 

might be exposed to indeterminate liability from an indeterminate class, and in 

Hercules the Court held that a duty of care for negligence only arises when the 

claimants are known to the defendant as a clearly defined class, and that their usage 

of the representation is for the primary purpose for which the representation was 

30. Filipovic v. Upshall, No. 2256, 1998 O.J. 

31. C.C.&L. Dedicated Enterprise Fund v. Fisherman, 18 B.L.R. (3d) 240 (Ont. Sup. Ct. J. 2001). 

32. Dupuis v. Pan American Mines, 7 B.L.R. 288 (Que. S.C. 1979). 

33. Hercules Management Ltd. v. Ernst & Young, 2 S.C.R. 165 (1997) (Can.). 

34. Id. at paras. 44-46. 


2007 


created. 35 In that case, it was held that the corporations' auditors did not have a duty 

of care to the shareholders and investors. 6 Beyond tort, shareholders cannot sue 

auditors under contracts, because the courts have consistently held that auditors 

enter into a contract with a corporation and not its shareholders . 

In contrast, a common law action for negligent misrepresentation by the 

investment advisor may be possible, as an investment advisor will likely be found to 

owe a duty of care to the investor through application of the Anns/Kamloops test. 

The investment advisor's relationship with the client generally indicates a provision 

of professional services in accordance with industry practice and standards. 8 There 

may also be a contractual relationship between the client and the investment advisor, 

with any claim of liability dependent on the written and unwritten terms of such a 

contract. As well, since the investment advisor's relationship with his or her client is 

one of agency, the investment advisor owes a fiduciary duty to the client. 

Accordingly, to the extent that investment advisors are required by their fiduciary 

relationship, their contracts, and industry practise and standards to suggest and sell 

suitable products to their clients, those advisors may also be performing a 

gatekeeping function. However, the case law does not suggest that this is the focus 

of litigation in this area." 

The other three categories of gatekeepers-underwriters, credit reporting 

agencies, and financial analysts-are even less likely to be held liable under common 

law. For underwriters, common law is largely irrelevant; their primary source of civil 

liability is statutory. Like auditors, credit reporting agencies also use the second 

stage of the Anns/Kamloops test to avoid liability to shareholders in tort actions. 

Finally, financial analysts can sometimes be liable for negligent misrepresentation, 

40 

but that type of action is only likely to be pursued in very extreme cases. 

35. Id. at para. 46; see also Bow Valley Huskey (Bermuda) Ltd. v. Saint John Shipbuilding Ltd., 3 

S.C.R. 1210, para. 62 (1997). 

36. Although Hercules limits the common law right against auditors for negligent misrepresentation, 

this limit only reaches so far. In Kripps v. Touche Ross, 6 W.W.R. 421 (1997), 33 B.C.L.R. (3d) 254 (C.A.) 

(leave to appeal refused 225 N.R. 236n (S.C.C. 1997)) (note: although Kripps was decided before the 

Hercules case, leave to appeal was denied after Hercules), investors who purchased debentures issued by a 

mortgage company that went bankrupt sued the auditors. The investors claimed the auditor's report was a 

negligent misrepresentation since the financial statements had not accurately reflected the company's 

financial position. The plaintiff investors argued that they had relied on the auditor's report and the 

auditors should have been aware that the investors would rely on the auditor's certification that the 

mortgage company's financial statements were accurate. Unlike in Hercules, the British Columbia Court of 

Appeal held that the auditor was liable. Although the auditors complied with applicable accounting and 

auditing rules, they allowed the company to understate its losses in a fashion that could mislead investors. 

At the time of the events in Kripps, there was no statutory civil liability for auditors under the Britsh 

Columbia Securities Act. In contrast, in Hercules, since financial statements were only part of the 

company's annual financial disclosure then, for policy reasons, the auditors were not held liable for 

negligent misrepresentation. 

37. See Hercules, supra note 33. Roman Corp. Ltd. v. Peat Marwick Thorne., 11 O.R. 3d 248 [1992]. 

38. Gowlings Lafleur Henderson LLP, INVESTMENT ADVISORS' LIABILITY (2001), 

http://www.gowlings.com/resources/publicationpdfs/InvestmentAdvisorsLiability.pdf (last visited Feb. 20, 

2007). 

39. Id. The Gowlings memorandum provides an excellent overview of the case law in this area. 

40. Securities Industry Committee on Analyst Standards, Setting Analyst Standards: 

Recommendations for the Supervision and Practice of Canadian Securities Industry Analysts (2001), 38 

(SICAS Report). 



VOL. 42:441 

B. Statutory Liability 

i. Corporate Statutes 

The gatekeepers most heavily regulated by statute are directors. They owe a 

fiduciary duty to the corporation under section 122(1)(a) of the Canada Business 

Corporations Act (CBCA) (and the equivalent sections of the provincial acts) to 

"act honestly and in good faith with a view to the best interests of the corporation." 1 

If they breach that fiduciary duty to the detriment of the company, stakeholders can 

bring forward a suit using section 239 of the CBCA, which allows derivative actions 

by complainants on behalf of the corporation." Section 238 of the CBCA defines 

complainants and includes "any other person who, in the discretion of a court, is a 

proper person to make an application under this Part." 43 However, in the recent case 

of Peoples Department Stores Inc. v. Wise, the Supreme Court of Canada held that 

the fiduciary duty of directors does not extend beyond the corporation directly to its 

creditors." The Court stated that "in determining whether [directors] are acting with 

a view to the best interests of the corporation it may be legitimate, given all the 

circumstances of a given case, for the board of directors to consider, among other 

things, the interests of shareholders, employees, suppliers, creditors, consumers, 

governments and the environment."" 

Thus, one argument available to directors is that they were balancing multiple 

interests, or acting in "the best interests of the corporation" in the discharge of their 

fiduciary duty. 46 Directors can also use other principles including the "business 

judgment rule" to help defend against allegations of breach of duty." The business 

judgment rule holds that directors are not obliged to give continuous attention to the 

company's affairs but their duties are awakened when information and events that 

require further investigation become known to them. 48 This rule is utilized by the 

judiciary to "protect[] Boards and directors from those that might second-guess their 

41. Business Corporations Act, R.S.C, ch. C-44 (1985) [hereinafter CBCA]; see also Business 

Corporations Act, R.S.O., ch. B.16, § 134 (1990) [hereinafter OBCA]; Business Corporations Act, 

R.S.B.C., ch. 57, § 142 (2002) [hereinafter BCBCA]; Business Corporations Act, R.S.A., ch. B-9, § 122 

(2000) [hereinafter ABCA]; Corporations Act, C.C.S.M. ch. C-225, § 117 [hereinafter MCA]; Business 

Corporations Act, R.S.S., ch. B-10, § 117 (1978) [hereinafter SBCAJ; Business Corporations Act, S.N.B., 

ch. B-9.1, § 79 (1981) [hereinafter NBBCA]; Corporations Act, R.S.N.L., ch. C-36, § 203 (1990) [hereinafter 

NFCA]; Business Corporations Act, R.S.Y., ch. 20, § 124 (2002) [hereinafter YBCA]; Business 

Corporations Act, S.N.W.T., ch. 19, § 123 (1996) [hereinafter NW'TBCA]. 

42. CBCA, supra note 41; see also OBCA, supra note 41, § 246; BCBCA, supra note 41, § 232; ABCA, 

supra note 41, § 240; MCA, supra note 41, § 232; SBCA, supra note 41, § 232; NBBCA, supra note 41, § 

164; NFCA, supra note 41, § 369; YBCA, supra note 41, § 241; NWTBCA, supra note 41, § 241; and 

Companies Act, R.S.N.S., ch. 81 Third Schedule, § 4 (1989) [hereinafter NSCA]. 

43. CBCA, supra note 41; see also OBCA, supra note 41, § 245; BCBCA, supra note 41, § 232; ABCA, 

supra note 41, § 239; MCA, supra note 41, § 231; SBCA, supra note 41, § 231; NBBCA, supra note 41, § 

163; NFCA, supra note 41, § 368; YBCA, supra note 41, § 240; NWTBCA, supra note 41, § 240; NSCA, 

supra note 41, Third Schedule, § 1. 

44. Peoples Dep't Stores, Inc. v. Wise, [2004] 3 S.C.R. 461, para. 43. 

45. Id. para. 42. 

46. UPM-Kymmene Corp. v. UPM-Kymmene Miramichi, Inc. No. 2412, [2002] 214 B.L.R. 496, 528, 

para. 117. 

47. Id. paras. 152-56. 

48. Id. para. 126. 


2007 


• . . business decisions." 9 To apply the rule, the courts must find that the directors 

were "scrupulous in their deliberations and demonstrate diligence in arriving at 

decisions." 5 

The other major defence available to directors is that of due diligence or good 

faith reliance. Directors can be relieved of any liability if they relied in good faith on 

financial statements produced by an officer or auditor of the corporation or a report 

of a professional. A number of provinces offer directors both a good faith reliance 

and due diligence defence similar to section 123(4) of the CBCA. 5 These defences 

have meant that, in practice, the application of the statutory duty of care has been 

extremely limited. 

Individual investors can move beyond the statutes mentioned above, and seek 

to use the oppression remedy against directors who have failed in their gatekeeping 

role. 2 Using that statutory remedy contained in the CBCA and most provincial 

statutes, a "complainant" may apply to the court for relief if the business of the 

corporation or the powers of the directors have been exercised in a manner that is 

"oppressive or unfairly prejudicial to or that unfairly disregards the interests" of any 

security holder, creditor, director or officer. 53 In Peoples, the Court's reasoning 

suggests that in future cases the oppression remedy analysis will not require a 

determination of whether directors have breached their fiduciary duties and that it 

may be possible to use the oppression remedy to hold directors accountable to 

individual stakeholders. " However, neither position is new and the above statement 

can be taken as obiter as the case itself did not concern an oppression action. 5 This 

highlights one of the difficulties in assessing the oppression remedy, as there are 

relatively few oppression actions in the courts each year. As a result, the judicial 

treatment of the oppression remedy has frequently drawn from the case law on 

breach of statutory duties, importing concepts such as the "best interests of the 

corporation" and the "business judgment rule." 56 The notion that a director's 

49. Id. para. 152. 

50. Id. para. 153. 

51. ABCA, supra note 41, § 123(3); see also YBCA, supra note 41, s. 125(3); NWTBCA, supra note 

41, § 124(3). 

52. See Peoples, 3 S.C.R. 461, para 48. 

53. CBCA, supra note 41, § 241(1) and (2); OBCA, supra note 41, § 248; ABCA, supra note 41, § 242; 

SBCA, supra note 41, § 234; MCA, supra note 41, § 207; NBIBCA, supra note 41, § 166; NSCA, supra note 

42, Third Schedule, § 5; NFCA, supra note 41, § 371; YBCA, supra note 41, § 243; and NWTBCA, supra 

note 41, § 243. Under the CBCA, supra note 41, § 238, a complainant is defined as a registered holder or 

beneficial holder of a security (or a former registered holder or beneficial holder) of a corporation or any 

of its affiliates, a director or an officer of a corporation or any of its affiliates (or a former director/officer), 

the Director (appointed under § 260 of the act), or any other person deemed a "proper person" by the 

court. 

54. Peoples, 3 S.C.R. 461, para. 53. 

55. Rather, the case was based on the issue of whether directors owe a duty to creditors. The trustee, 

representing the interests of the creditors, sued the directors for an alleged breach of the duties imposed by 

§ 122(1) of the CBCA. In its analysis, the Court recognized that, according to article 300 of the Q.C.C. and 

§ 8.1 of the Interpretation Act, R.S.C., ch. 1-21 (1985), the civil law serves as a supplementary source of law 

to federal legislation. The CBCA does not entitle creditors to sue directors directly for breach of their 

duties, and so the Court deemed it appropriate to have recourse to the Q.C.C. to establish how rights 

grounded in a federal statute should be considered in Quebec. The Court also looked to the Q.C.C. to 

determine how § 122(1) of the CBCA can be harmonized with the principles of civil liability. See Peoples, 

3 S.C.R. 461, paras. 29-30. 

56. Peoples, 3 S.C.R. 461, para. 64. 



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fiduciary duty includes an obligation to balance a number of interests has also been 

considered by courts applying the oppression remedy, as in Re Ferguson and Imax 

Systems Corp., 7 wherein the Court of Appeal for Ontario held that it was imperative 

that the oppression remedy be applied in a manner that balances the protection of 

stakeholders and the ability of management to conduct business in an efficient 

manner. 

ii. 

Securities Statutes 

While directors are the primary gatekeepers regulated under the CBCA, all 

corporate gatekeepers are, to some degree, subject to securities statutes. The 

statutes differ from province to province, but here, the discussion will focus on the 

Ontario Securities Act (OSA). While many of its provisions are similar to those of 

other provinces, Ontario is noteworthy as it is the only province to impose secondary 

market liability on some corporate gatekeepers." 

Under securities legislation, directors may be liable to persons who acquire 

securities in a corporation during the period of distribution while there are 

uncorrected misrepresentations in a prospectus." The purchaser need not show 

reliance on the misrepresentation for liability to attach. 6 The onus shifts to the 

defendant to show that any depreciation in the value of the securities was not the 

result of the misrepresentation. 61 The plaintiff has no claim if he or she knew of the 

57. 43 O.R. 2d 128, 137 (C.A. 1983). This was an appeal after the application for relief was dismissed 

under s. 234 of the Canada Business Corporations Act. S.C., c. 33 (1974-5). The appellant claimed that the 

corporation and the directors had, by organizing a special meeting to vote on a resolution to amend its 

articles to reorganize its capital, acted in a manner that was oppressive, unfairly prejudicial, or unfairly 

disregarded her interests as a security holder. On appeal, Brooke J.A. found for the appellant and granted 

her relief for oppression. 

58. British Columbia has proposed legislation (Bill 38) implementing a similar regime, but the 

implementation of this legislation has been put on hold. See BC Securities Commission, 

http://www.bcsc.bc.ca/instruments.asp?id=1894#moving and http://www.bcsc.bc.ca/release.asp?id=2944 for 

details. 

59. Securities Act, R.S.O., ch. S-5, § 58 (1990) [hereinafter OSA]; Securities Act, R.S.B.C., ch. 418, § 

68 (1996) [hereinafter BCSAJ: Securities Act, R.S.A., ch. S-4, § 116 (2000) [hereinafter ASA]; Securities 

Act, C.C.S.M. ch. S-50, § 52(1) [hereinafter MSA] (requires certification by the directors that a prospectus 

contains "full true and plain disclosure"); Securities Act, R.S.Y., ch. 201, § 22 (2002) [hereinafter YSA] 

(requires only the signing of the prospectus by the directors with no specific certification); see also 

Securities Act, R.S.Q., ch. V-I.1, § 220 [hereinafter QSA]; Securities Act, 1988, S.S., ch. S-42.2, § 66 (1988- 

89) [hereinafter SSA]; Securities Act, S.N.B., ch. S-5.5, §74(3) (2004) [hereinafter NBSA]: Securities Act, 

R.S.N.S., ch. 418, § 63 (1989) [hereinafter NSSAI; Securities Act, R.S.P.E.I., ch. S-3, § 8.5 (1988) 

[hereinafter PEISA]; Securities Act, R.S.N.L., ch. S-13, § 59 (1990) [hereinafter NLSA]; but see Securities 

Act, R.S.N.W.T., ch. S-5 (1988) [hereinafter NWTSA], which does not mention certification by directors. 

60. OSA, supra note 59, § 130(1); BCSA, supra note 59, § 131(1)(a); ASA, supra note 59, § 203(1); 

SSA, supra note 59, § 137(1); NBSA, supra note 59, § 149(1); NSSA, supra note 59, § 137(1); PEISA, supra 

note 59, § 16(1); NLSA, supra note 59, § 130(1); but see QSA, supra note 59, §§ 217-219 (where there is no 

specific reference to deemed reliance, although non-reliance is not a listed defence under § 217 or § 220); 

MSA, supra note 59. This act makes no specific reference to deemed reliance, although non-reliance is not 

a listed defence under § 65. The right to rescission under § 65 applies only to the issuer. See also NWTSA 

and YSA, supra note 59 (Under these acts, like the MSA, the right to rescission applies only against the 

issuer and there is no specific mention of deemed reliance). 

61. ASA, supra note 59, § 203(9); BCSA, supra note 59, § 131(10); OSA, supra note 59, § 130(7); SSA, 

supra note 59, § 137(8); NBSA, supra note 59, § 149(8); NSSA, supra note 59, § 137(7); PEISA, supra note 

59. § 16(7); NLSA, supra note 59, § 130(7). 


2007 


representation. 62 Directors, along with the issuer, underwriter, an expert who has 

filed a consent, and anyone else who has signed the prospectus, are jointly and 

severally liable. 

Liability for a prospectus misrepresentation is generally only alleviated if the 

prospectus was filed without the director's consent, the director withdrew consent 

within a reasonable period of time upon discovery of a misrepresentation, or the 

director exercised due diligence but failed to ascertain the existence of the 

misrepresentation (other defences are not relevant to the gatekeeping function). 6 

Most recently, in Kerr v. Danier Leather Inc.,6' the first class action to be litigated to 

the final stages by shareholders for a prospectus misrepresentation under section 130 

of the OSA, the Court of Appeal for Ontario used the business judgment rule to 

protect directors from personal liability. The decision suggests that the business 

judgment rule will serve as an important shield for directors in future litigation using 

the statutory liability provisions for misrepresentation found in the provincial 

securities acts, including the new secondary market civil liability regime in Ontario 

discussed below. The liability for initial disclosure documents in general does not 

appear to be consistent across Canada, though generally, the scope of damages for a 

misrepresentation in the primary markets is limited to the price at which the 

securities were offered to the public. 65 Quebec, which does not appear to have a 

specific clause limiting damages, is the exception.' 

The Ontario Securities Commission (OSC) is also limited in its authority to deal 

with lawyers. While it can exercise some control over lawyers practicing within its 

area of jurisdiction, according to the Court of Appeal for Ontario, solicitor-client 

privilege must be maintained. 67 It must be noted that the power of the securities 

commissions to sanction and reprimand lawyers does not necessarily extend to the 

ability to place remedial sanctions limiting lawyers' ability to practice in the 

securities area in the future; this would bring the commission into the role of 

regulating the practice of law, an area reserved for the law societies. 6 " Still, section 

130(1) of the OSA applies to lawyers, including their statements in a category of 

"expert" opinions to which liability may be attributed for misrepresentations. 69 A 

misrepresentation that triggers this section will create joint and several liability with 

any other party listed in section 130(1)." 0 The defenses for experts like lawyers, 

auditors, and other gatekeepers discussed below include: filing of the prospectus 

without consent, withdrawal of consent upon discovery of a misrepresentation, 

62. ASA, supra note 59, § 203(4): BCSA, supra note 59, § 131(4); OSA, supra note 59, § 130(2); SSA, 

supra note 59, § 137(3); NBSA, supra note 59, § 149(3); NSSA, supra note 59, § 137(2); PEISA, supra note 

59, § 16(2); NLSA, supra note 59, § 130(2). 

63. See MSA, supra note 59, § 97. 

64. Kerr v. Danier Leather Inc., [2005] O.J. No. 5388; [2005] LEXIS 6560.[Ruth, the only version we 

are able to get is the LEXIS version because Tarlton stopped getting the printed cases, Andy]. 

65. OSA, supra note 59, § 130(9); BCSA, supra note 59, § 131(13); ASA, supra note 59, § 203(13); 

SSA, supra note 59, § 138(11); NBSA, supra note 59, § 149(11); NSSA, supra note 59, § 137(9); PEISA, 

supra note 59, § 16(9); NFSA, supra note 59, § 130(9). NWT, Yukon, and Manitoba appear to only provide 

a right of rescission, which would preclude a need to limit damages to the price at offering. 

66. RSQ, supra note 60 § 214 (discussing damages, but not indicating any limitations). 

67. Wilder v. Ontario Sec. Comm'n, [20011 53 O.R. (3d) 519 (C.A.). 

68. See Henderson v. Alberta Sec. Comm'n, [2002] ABCA 264 (Alta. C.A.) and Ainsley Fin. Corp. v. 

Ontario Sec. Comm'n, [1994] 21 O.R. (3d) 104 (Ont. C.A.). 

69. OSA, supra note 60, §130(1). 

70. Id. 



VOL. 42:441 

notification of the securities commission and the public of the misrepresentation, and 

due diligence. 71 

Auditors are also covered under section 130(1) of the OSA as experts, and thus 

securities statutes are a source of liability for them.' However, because the Supreme 

Court of Canada in Hercules-found that auditors owe a duty of care to corporations 

and not shareholders, for shareholders to bring an action using a corporate statute 

against an auditor, they would need to use the derivative action discussed above in 

the context of directors. 7 Another similarity between auditors and directors is that 

the oppression remedy may possibly be used against auditors though it is far more 

limited in that context, as an attempt to use oppression action in Ontario was 

rejected because it is the "corporation or any of its affiliates" that must have acted 

oppressively and auditors were found to fall outside of this realm. 

Securities statutes provide a source of liability for underwriters as well as 

lawyers and directors. The OSA requires underwriters to provide a signed 

certificate for inclusion with the prospectus with respect to the securities offered by 

the prospectus that: 

[T]o the best of their knowledge, information and belief, the foregoing 

constitutes full, true and plain disclosure of all material facts relating to the 

securities offered by this prospectus as required by Part XV of the 

Securities Act and the regulations there under. 75 

Underwriters who certify the prospectus are exposed to statutory civil liability 

to any purchaser for damages or rescission where such purchaser buys a security 

offered pursuant to a prospectus during the distribution period." However, where 

an underwriter is a defendant, the underwriter's maximum liability is generally the 

portion of the distribution underwritten by the underwriter (this limitation of 

liability does not exist in Quebec).7 

Credit rating agencies, financial analysts and retail investment advisors are all 

subject to section 130(1) of the OSA. However, as section 130 applies to civil 

liability for misrepresentation, these groups would only be included as possible 

defendants under paragraph (d) if their consent had been filed pursuant to a 

requirement of the regulation with respect to reports, opinions, or statements that 

had been made by them, or, under paragraph (e), if the CRA actually signed the 

prospectus or amendment to the prospectus. 78 The scope of civil liability stemming 

from securities statutes is smaller for these gatekeepers than the liability of those 

discussed above. 

71. OSA, supra note 59, §§ 138.5(3), 138.4(11), 138.4(14), 138.4(6), 138.4(9). 

72. Id. § 130(1). 

73. Hercules, supra note 33, at 171-72. 

74. Budd v. Gentra, B102/95, [1996] O.J. 3515 QUICKLAW (Gen. Div.), [19961 12 O.T.C. 117, aff'd 

[1998] 43 B..R. (3d) 27 (Ont. C.A.). In the appeal decision, the oppression claim against the officers and 

directors was also struck because it contained no allegation of specific acts they had done. 

75. OSA, supra note 59, § 59(1); see also BCSA, supra note 47, § 69; ASA, supra note 59, § 117; MSA 

supra note 59, § 53; SSA, supra note 59, § 67; QSA, supra note 59, § 33.2; NBSA, supra note 59, § 74(3); 

NSSA, supra note 59, § 64; PEISA, supra note 59, § 8.6; NLSA, supra note 59, § 60. 

76. OSA, supra note 60, §§ 59 and 130(1)(b); see also QSA, supra note 59. 

77. Id. 

78. Id. § 130(1). 


2007 


iii. 

Secondary Market Liability 

Pearson v. Boliden Ltd. 9 confirms that to take advantage of the above statutory 

provisions creating civil liability for primary market misrepresentations, the 

purchaser must have purchased the securities directly from the issuer rather than in 

the secondary market. However, in Ontario, the recent proclamation of the 

"Keeping the Promise for a Strong Economy Act" which went into effect on 

December 31, 2005, has introduced a statutory regime of civil liability for secondary 

market disclosures through the introduction of part XXIII.1 to the OSA., The 

amendments extend the civil liability regime beyond primary market disclosures, and 

they apply to all Ontario reporting issuers and to any company with publicly traded 

securities that has a real and substantial connection to Ontario. The amendments 

also open the door for class action lawsuits that allege misrepresentations by creating 

a statutory right of action without regard to whether the purchaser or seller of 

securities relied on the alleged misrepresentation or delay in disclosure. Improper 

continuous disclosure can include a misrepresentation in a document or other 

communication, which would reasonably be expected to affect the share price, or a 

failure to make timely disclosure of material changes." 

It is important to note that in order to proceed with an action for damages 

under the new secondary market liability scheme, an investor must obtain leave of 

the court." Each defendant must receive notice of the motion for leave to proceed. 83 

The court will grant leave only if it is satisfied that the investor is bringing the action 

in good faith, and there is a reasonable possibility that the action will be resolved at 

trial in favour of the investor." The plaintiff must have bought the securities while 

the misrepresentation was uncorrected and without knowledge of the 

misrepresentation, but need not show reliance on the misrepresentation. 85 

Directors can defend themselves with any of the following arguments: (1) the 

change in the value of the securities is not related to the misrepresentation (onus on 

defendant to show);6 (2) the defendant relied on an expert report; 8 7 (3) the 

defendant relied on another publicly filed report;m (4) the defendant conducted a 

reasonable investigation, or, for a failure to make timely disclosure, if the defendant 

can prove he did not know of the change; 9 and (5) an exemption on 

misrepresentation of "forward-looking" information, provided that the document or 

public oral statement contains cautionary language relating to the forward-looking 

79. Pearson v. Boliden Ltd. [2002] BCCA 624, 7 B.C.L.R. (4th) 245 (B.C.C.A.), 2002 BCCA 624. 

80. Keeping the Promise for a Strong Economy Act (Budget Measures), 2002, S.O. 2002, cls. 182-83. 

81. OSA, supra note 59, § 138.3. The distinction between "material fact" and "material change," also 

found in § 130 of the OSA (and defined in § 1 of the OSA), was critical to the appellate ruling in Kerr v. 

Danier, supra note 64, where the court confirmed that "material fact" is intended to be defined more 

broadly than "material change" in the Act. The Court of Appeal agreed with the trial court that the impact 

of unseasonably warm weather did not constitute a "material change" in Danier's business or operations. 

82. OSA, supra note 60, § 138.8(1). 

83. Id. § 138.8(1)(a)-(b). 

84. Id. § 138.8(1). 

85. Id. §138.4(7)(f). 

86. Id. § 138.5(3). 

87. Id. § 138.4(11). 

88. OSA, supra note 60, § 138.4(14). 

89. Id. § 138.4(6). 



VOL. 42:441 

information, identifies material factors that could cause actual results to differ 

materially, and states the material factors or assumptions that were applied in 

making a forecast or projection in the forward-looking information.' There is also a 

whistleblowing defence available if the following criteria are satisfied: the 

contravention was made without that defendant's knowledge or consent; upon 

becoming aware of the misrepresentation the defendant promptly notified the board 

of directors of the issuer of the matter, and. if no correction or subsequent disclosure 

was made, the defendant promptly provided the Ontario Securities Commission 

(OSC) with written notification of the misrepresentation. 9 ' 

Secondary market liability also applies to lawyers, auditors and financial 

analysts as experts under section 138.1 of the OSA if their report, contains 

misrepresentations used in a public statement (written or oral).' An investor can 

sue an "expert" if the misrepresentation is also contained in a report, statement or 

opinion made by the expert (Expert Report); if the document or statement includes, 

summarizes or quotes from the Expert Report; and the expert consented in writing 

to the use of the Expert Report in a document released or statement made by 

someone other than the expert. 93 Experts are able to use the same defences as 

directors, listed above, and their liability is limited to the greater of $1 million or the 

amount of revenue raised from the responsible issuer within the last 12 months. 9 

Unlike the other groups of gatekeepers, underwriters are not included in section 

138.3(1), and credit rating agencies are explicitly excluded from secondary market 

liability in section 138.1(1) of the OSA. It is not immediately clear from the 

legislation if retail investment advisors are included under this section. 

Because secondary market liability is quite new to Ontario, there has been little 

jurisprudence, so it is unclear how much protection these defences will afford 

directors and other gatekeepers, and how much success shareholders will have in 

holding failed gatekeepers liable. 

C. Other Regulatory Regimes 

i. Provincial Securities Commissions 

Provincial securities commissions have broad powers to enforce securities laws 

through the imposition of administrative orders in the public interest. Included 

among the long list of possible administrative sanctions is the ability of commissions 

to impose a penalty, if it is determined at the hearing that a person or company has 

contravened-or failed to comply with-any provision of the securities legislation. 95 

90. Id. § 138.4(9). 

91. Id. § 138.4(15). 

92. Id. § 138.3. 

93. Id. § 138.4(12). 

94. OSA, supra note 60,. § 138.1. 

95. Id. § 127(1)10 (imposing a penalty of up to $1 million); BCSA, supra note 59, § 162 (up to $250,000 

for individuals and $500,000 for persons who are not individuals); ASA, supra note 59, § 199 (up to $1 

million); MSA, supra note 59, § 148 (up to $100,000 for an individual and $500,000 for persons who are not 

individuals); SSA, supra note 59, § 135 (up to $100,000); QSA, supra note 59, §273 (up to $1 million); 

NBSA, supra note 59, § 186 (up to $750,000); NSSA, supra note 59, § 135 (up to $100,000). 


2007 


In addition, the securities commissions can apply to the court for a declaration 

that a person or company has not complied with a provision of the securities act. 6 

On application by a commission, the court may make an order imposing a penalty or 

requiring current directors or officers to be removed and replaced, requiring a 

person or company to compensate or make restitution to an aggrieved person or 

company, requiring a person or company to pay general or punitive damages, or 

requiring a person or company to pay the Provincial Treasurer any amounts 

obtained as a result of non-compliance with any provision of the securities act. 97 

These judicial and administrative sanctions apply to all of the corporate gatekeepers 

under consideration. 

For directors specifically, the OSC can seek administrative sanctions if the 

financial information contained in the company's press release was materially 

misleading and that the directors therefore acted contrary to the public interest by 

not making sufficient inquiries before releasing the interim financial results, as in 

Standard Trustco Ltd. 98 In that case, the OSC criticized the directors for 

inappropriately approving financial statements and disseminating the information 

publicly. It also noted that directors who are members of the audit committee 

should bear more responsibility than other directors for a compliance deficiency in 

the corporation's financial statements. 99 

The securities commissions do not appear to have successfully extended liability 

to lawyers acting merely in their role as gatekeeper: something more is required for 

liability to attach. For example, in Re Orsini, a lawyer prepared a financing scheme 

that breached various provisions of the OSA; the lawyer was involved directly in 

developing the scheme, and benefited materially from the sale of shares."' In 

contrast, Henderson v. Alberta (Securities Commission) involved a situation where a 

lawyer had met with potential investors and did not deliver them the required 

documentation; despite the initial finding of the trial court against the lawyer, the 

Alberta Court of Appeal held that he had made his dealings in good faith, and 

reversed the trial judgment. 01 These two cases suggest that innocent-though 

nonetheless negligent-failure to prevent a client from committing a violation of 

securities law does not create a violation giving rise to administrative sanctions 

against lawyers. Sanctions will not be imposed unless the lawyer personally 

performed an action which triggers an offence. 

Underwriters are treated somewhat uniquely by provincial securities 

commissions, as their role is to be not only a gatekeeper but also a devil's advocate, 

as per the OSC's regulatory proceeding, YBM Magnex International Inc. (Re). l "' In 

96. OSA, supra note 59, § 128; BCSA, supra note 59, § 157; ASA, supra note 59, § 197; MSA, supra 

note 59, § 152; SSA, supra note 59, § 133; NBSA, supra note 59, § 187; NSSA, supra note 59, § 133; NFSA, 

supra note 59, § 128.1. 

97. OSA, supra note 59; BCSA, supra note 59; ASA, supra note 59; MSA, supra note 59; SSA, supra 

note 59; NBSA, supra note 59; NSSA, supra note 59; NFSA, supra note 59; see also QSA, supra note 59 § 

269.2 (the QSA specifies only damages as possible remedies); PEISA, supra note 59, § 19; YSA, supra note 

59, § 19; NWTSA, supra note 59, § 22. 

98. Re Standard Trustco Ltd., [1992] 6 B.L.R. (2d) 241,244; 15 O.S.C. Bull. 4322 (Ont. Can.). 

99. Id. at 245. 

100. Re Orsini, [1991] 2 B.L.R. (2d) 271, 14 O.S.C.B. 4820 (Ont. Can.). 

101. Henderson v. Alberta, [20021 ABCA 264 (Alta. C.A.). 

102. Re YBM Magnex Int'l, [2003] 26 O.S.C. Bull. 5285, paras. 187-99 (Ont. Can.). 



VOL. 42:441 

Re A.E. Ames & Co. Ltd, the OSC held that as gatekeeper, there is a duty upon the 

underwriter to uncover all the facts.' 7 While in Feit v. Leasco Data Processing 

Equipment Corp. the OSC recognized limits of the underwriter's role because of 

more limited access to information, as devil's advocates, underwriters must challenge 

the issuer's disclosure with respect to any misconduct, otherwise they may be subject 

to administrative sanctions in addition to civil liability as discussed above" 

Underwriters, financial analysts, and retail investment advisors must all register 

under provincial securities legislation, as firms that engage in securities underwriting, 

investment firms, and all securities firms and their employees who provide trading 

and advising services, respectively' 5 As a result of the mandatory registration 

requirement, the provincial securities commissions have the power to suspend or 

revoke the registration of a wayward registrant,'06 which may include situations 

where the firm fails to properly supervise the analysts (employees) at the firm. 

ii. 

Market Regulation Services Inc. 

Market Regulation Services Inc. (RS) is a SRO recognized by the securities 

commissions in Alberta, British Columbia, Manitoba, Ontario and Quebec as a 

market regulation provider for the trade exchanges and trading systems in Canada.' 7 

RS administers the Universal Market Integrity Rules (UMIR), which apply to 

directors and lawyers as corporate gatekeepers. 10.16 of UMIR provides a set of 

reporting obligations for directors as gatekeepers of market participants.' Directors 

of market participants are obligated to report trading violations to the compliance 

department of the participant. Section 10.3 of UMIR allows for a finding of liability 

for a market participant through the actions of their directors, officers, partners, or 

employees." 9 Similarly, a director or partner may be found liable for the actions of 

the firm and face personal sanctions, while a lawyer hired by a market participant 

can be liable under this section as the employee of a market participant. 

Section 10.5 of UMIR provides a broad power to the market regulator to 

impose sanctions for violations of UMIR."" Sanctions include a reprimand, a fine of 

up to one million dollars or the amount equal to triple the financial benefit which 

accrued to the person as a result of committing the violation, or any other remedy 

deemed appropriate under the circumstances. "' 

103. Re A.E. Ames & Co. Ltd., [1972] 3 OR. 405 (Ont. C.A.). 

104. Feit v. Leasco Data Processing Equip. Corp., 322 F. Supp. 544, 582 (E.D.N.Y. 1971). 

105. OSA, supra note 59, § 25(1); BCSA, supra note 59, § 34; ASA, supra note 59, § 75; MSA, supra 

note 59, § 6; SSA, supra note 59, § 27; QSA, supra note 59, § 148; NBSA, supra note 59, § 45; NSSA, supra 

note 59, § 31; PEISA, supra note 59, § 2; NLSA, supra note 59, § 26; YSA, supra note 59, § 3; NWTSA, 

supra note 59, § 4. 

106. OSA, supra note 59, § 25(1); BCSA, supra note 59, § 34; ASA, supra note 59, § 75; MSA, supra 

note 59, § 6; SSA, supra note 59, § 27; QSA, supra note 59, § 148; NBSA, supra note 59, § 45; NSSA, supra 

note 59, § 31; PEISA, supra note 59, § 2; NLSA, supra note 59, § 26; YSA, supra note 59, § 3; NWTSA, 

supra note 59, § 4. 

107. See Market Regulator, Universal Market Integrity Rules [hereinafter UMIR] 

http://www.rs.ca/en/pdfIUMIR.pdf. 

108. UMIR §10.16. 

109. Id. §10.3. 

110. Id. §10.5. 

111. Id. §10.5(1). 


2007 


iii. 

Professional Regulatory Bodies 

Beyond the common sources of liability discussed above, many corporate 

gatekeepers are also regulated by their own professional groups. Lawyers are 

accountable to their provincial law societies; underwriters, financial analysts, and 

retail investment advisors to the Investment Dealers Association of Canada (IDA); 

auditors are accountable to provincial institutes of chartered accountants; and credit 

rating agencies are accountable to the International Organization of Securities 

Commission. 

a. Provincial Law Societies 

In Ontario, lawyers are regulated by the Law Society of Upper Canada. The 

Society's Rules of Professional Conduct Rule 2.02(5) holds that lawyers cannot 

knowingly assist in or encourage any dishonesty or crime, or tell their client how to 

violate the law and avoid punishment. 1 2 The comments to this rule indicate that a 

lawyer has an obligation to investigate any suspicions both prior to and during a 

retainer.' 13 Other provinces have similar rules, although Ontario is the only province 

to require "up the ladder" reporting; that is, lawyers must inform representatives of 

the organization up through the board of directors if it is known that the client is, has 

previously, or will engage in dishonest, fraudulent, or illegal conduct."' In Ontario, 

lawyers must also withdraw from acting in the matter should corrective action not be 

taken."' 

Even with this obligation for lawyers, every province recognizes the 

confidential nature of the solicitor-client relationship. Ontario Rules of Professional 

Conduct Rule 2.03 governs confidentiality." 6 Generally confidentiality is protected 

across the board, meaning there is little room for whistleblowing. Rule 2.03(2) and 

(3) outline the areas of justified disclosure in Ontario. The commentary confirms 

that when a lawyer becomes aware that a client that may commit a fraudulent, 

criminal, dishonest, or illegal act, he or she is prevented from passing any 

confidential information to the correct authorities, though he or she must follow the 

procedures outlined above in Rule 2.02." 7 The confidential information provisions in 

all other provinces except Alberta and Saskatchewan also prevent lawyers from 

whistleblowing on corporate wrongdoing." ' As whistleblowing is not often an option 

for lawyers, most jurisdictions either allow or oblige lawyers to withdraw from a case 

where the client persists in instructing the lawyer to breach ethics. For corporate 

counsel, withdrawal means refusing to implement the client's instructions in that 

matter, while continuing to advise the corporation or government in other respectsincluding, 

in certain cases, resigning." 9 

112. LAW SOCIETY OF UPPER CANADA, RULES OF PROF'L CONDUCT R. 2.02(5) cmt. (2005), R. 

2.02(5.1), R. 2.02(5.2) cmt. (2004). 

113. Id. R. 2.02(5) cmt. 

114. Id. R. 2.02(5.1). 

115. Id., R. 2.02(5.1), R. 2.02(5.2), and R. 2.02(5.2) cmt. (2004). 

116. Id. R. 2.03. 

117. Id. R. 2.02. 

118. LAW SOCIETY OF ALBERTA, CODE OF PROF'L CONDUCT HANDBOOK, ch. 5. 

119. LAW SOCIETY OF ALBERTA. CODE OF PROF'L CONDUCT, ch. 12, R. 4 cmt. 4 (2006). 



VOL. 42:441 

If a lawyer does not fulfill his or her gatekeeper function, he or she could be 

disbarred, reprimanded, suspended, or face other conditions on practicing. Some 

law societies can issue any order they deem appropriate for breaches of professional 

conduct, which opens up the possibility for fines and/or payments to third parties. 1 20 

Fines are rarely imposed as penalties,' 2 ' and the author has found no evidence of 

payments to third parties being ordered. Some provinces do not give law societies 

the ability to impose sanctions beyond disbarment, reprimand, suspensions, or 

conditions. 1 22 

b. Investment Dealers Association of Canada 

Underwriters, financial analysts, and retail investment advisors all fall under the 

scope of the Investment Dealers Association of Canada (IDA). The IDA's mission 

is to protect investors and enhance the efficiency and competitiveness of Canadian 

capital markets.' 23 The IDA enforces rules and regulations regarding the sales, 

business, and financial practices of its Member firms and its Approved Persons, 

investigates complaints, and disciplines Members and Approved Persons. 

One IDA By-Law, No. 29, deals with ethics and business conduct, charging its 

members to "observe high standards of ethics" and to "not engage in any business 

124 

conduct or practice which is unbecoming or detrimental to the public interest.' 

Policy No. 5 provides an elaboration on the By-Law, and provides in section 4.1 that 

its members have a duty to deal fairly and "act fairly, honestly and in good faith"; 12 1 

section 4.2 provides that the public interest is held in high regard; 26 and section 4.5 

states that members shall ensure that their trading does not contravene any criminal 

and regulatory laws. 27 Most importantly, with regard to withholding support and 

services from clients engaging in misconduct, if underwriters fail to act properly, they 

may be held liable under section 4.6 with regard to misrepresentation and false 

remarks. The sanctions if the standard of business conduct falls below the standard 

set by the policy and by-laws are contained in section 5 of IDA Policy No. 5, 

including fines of up to $1 million per offence or (in the case of a Member) triple the 

amount of the benefit from the breach, reprimands, suspension or termination of 

approval, or expulsion. 2 1 

120. See e.g. Law Society Act, R.S.O., ch. L 8, § 35 (1990); Legal Profession Act, S.S., ch. L 10.1. § 

55(2) (1990-91); Legal Profession Act, C.C.S.M. ch. L 107, § 72(1) (2002); Legal Profession Act, S.N.S., ch. 

28, § 45(4) (2004); Law Society Act, 1999, S.N.L., ch. L 9.1, § 48(3) (1999); and Law Society Act, S.N.B., ch. 

89. § 51(1) (1995). 

121. GAVIN MCKENZIE, LAWYERS AND ETHICS: PROFESSIONAL RESPONSIBILITY AND DISCIPLINE 

(Thompson Canada 1993). 

122. See, e.g., Legal Profession Act, R.S.A., c. L-8. § 72 (2000). Some jurisdictions allow fines, but give 

the society no residual discretion. British Columbia allows fines up to a maximum of $20,000: Legal 

Professions Act, S.B.C., ch. 8, § 38 (1990). Prince Edward Island allows fines up to a maximum of $10,000: 

Legal Profession Act, R.S.P.E.I., ch. L 6.1, § 38(1) (1988). Quebec allows a maximum fine of $6000: 

Professional Code, R.S.Q. c. C-26, § 156. 

123. IDA, About the IDA: Roles and Responsibilities, http://www.ida.ca/About/Roles-en.asp. 

124. IDA By-Law No. 29, Business Conduct at 29.1. 

125. IDA Policy No. 5, Code of Conduct for IDA Member Firms Trading in Domestic Debt Markets, 

§ 4.1. 

126. Id. at § 4.2. 

127. Id. at § 4.5. 

128. Id. at §5.3. 


2007 


Retail investment advisors are generally employed by investment firms which, 

like underwriters, are regulated by the IDA and must adhere to its by-laws, rules, 

and regulations. In addition, investment advisors themselves must personally 

register as a Registered Representative (RR) or Investment Representative (IR). 20 

An RR has full authority to deal with the public and can advise on trades. 3 An IR 

cannot advise on trades although he or she can take unsolicited client orders. 3 ' For 

both types of registration an individual must successfully complete the Canadian 

Securities Course, the Conduct and Practices Handbook Exam, and a training 

program offered by his or her firm. For IRs, the length of the training course is 30 

days, and for RRs, the length of the training course is 90 days. After registration, six 

months of extra internal supervision is required. RRs must then go on to complete 

an additional course (the Professional Financial Planning Course or Investment 

Management Techniques Course) within 30 months of registration. Along with the 

registration, the IDA imposes an obligation on RRs to take "reasonable precautions 

to ensure that any transaction in which he or she 

32 

is involved is transacted to the 

benefit of and best interests of his or her client.' 

The IDA regulates investment firms that employ financial analysts, and IDA 

members have a supervisory responsibility over their employees. 33 While they are 

subject to the same rules as other firm employees, financial analysts are not required 

to be registered. However, senior analysts are usually officers and/or directors of 

Member firms, and therefore subject to additional liability. The IDA provisions that 

govern objectivity and accuracy do not specifically relate to analysts, but rules like 

2(b), which ensures a level of objectivity and accuracy of information, can be 

applied. 34 There is also an explicit duty for analysts to prevent any potential 

conflicts of interests in rule 11, and rule 17 obliges them to uphold the Chartered 

Financial Analyst (CFA) Institute's Code of Ethics and Standards of Professional 

Conduct.' 35 Breach of IDA Rules will lead to investigation for all gatekeepers 

subject to them, and if the investigation leads to a need for further action, a 

disciplinary hearing will be held. The IDA can impose penalties on both registered 

employees and Member firms, including: a reprimand, fines, suspension, 

prohibitions, termination, and expulsion of membership.' 36 

Even without the IDA obligation, many financial analysts are subject to the 

Code of Ethics and Standards of Professional Conduct. 37 The CFA does not cover 

all securities analysts, since membership in the organization is not a requirement 

according to provincial securities legislation. However, those that are must adhere 

129. Investment Dealers Association of Canada, IDA Bulletin # 2663, Policy No. 6 - Part III the 

Continuing Education Program and Parameters and Guidelines for the Securities Industry Continuing 

Education Program (November 1999), http://www.ida.ca/Files/BulletinsNotices/Bulletins/B2663-en.pdf. 

130. Id. 

131. Id. 

132. Investment Dealers Association of Canada, IDA Bulletin # 3332, Discipline Penalties Imposed on 

Alan Bruce Alexander Thomson - Violations of By-law 29.1 (Sept. 2004), 

http://www.ida.ca/Files/BulletinsNotices/Bulletins/B3332-en.pdf. 

133. Securities Industry Committee, supra note 40, at 37. 

134. IDA Policy No. 11, Research Restrictions and Disclosure Requirements, R. 2(b). 

135. Id. R. 11 and R. 17. 

136. IDA, Enforcement: Disciplinary Actions (Jan. 2005), 

http://www.ida.ca/Enforcement/FactsAndStats/DisciplinaryActions-en.asp. 

137. CFA Institute, Code of Ethics and Standards of Professional Conduct (2005). 



VOL. 42:441 

to the Code of Ethics, which obliges its members to act with integrity and in an 

ethical manner. 38 The Standards of Professional Conduct sets out a guideline that 

,'members and Candidates must not knowingly make any misrepresentations relating 

to investment analysis, recommendations, actions, or other professional activities.,1 39 

The guideline on misconduct states that "members and Candidates must not engage 

in any professional misconduct involving dishonesty, fraud, or deceit or commit any 

act that reflects adversely on their professional reputation, integrity, or 

competence. '40 Violation of the Code results in loss of membership, but as it is not a 

requirement for industry participation, this sanction has limited force. 

c. Provincial Institutes of Chartered Accountants 

The Provincial Institutes of Chartered Accountants Rules of Professional 

Conduct (Rules) forms the professional obligations of CAs that perform audits.'' 

With the exception of the Quebec Code of Ethics, the Rules are substantively 

equivalent across all provinces. 142 Most importantly, Rule 213 of the Rules of 

Professional Conduct, explicitly states "a member, student or firm shall not 

knowingly associate with any unlawful activity."' 43 As such, upon detection of client 

misconduct, an auditor may be explicitly obligated to withhold support and services. 

However, often client misconduct falls into a grey area, and may not be 

considered outright unlawful. As such, other rules which pertain to the auditor's 

liability as gatekeeper include the following: Rule 201.1 provides, "a member, 

student or firm shall act at all times in a manner which will maintain the good 

reputation of the profession and its ability to serve the public interest"; Rule 202 

provides, "a member, student or firm shall perform professional services with 

integrity and due care"; and Rule 205 provides, "a member, student, or firm shall not 

sign or make false or misleading documents and oral representations."'" In 

particular Rule 204.1, which pertains to maintaining independence in any accounting 

engagement, provides that any member of a firm who participates in an engagement 

shall be and remain free of any influence impairing the professional judgment or 

objectivity of the member, or which a reasonable observer thinks might impair the 

member.' 45 Rule 206 deals with professional standards, and carries an ethical 

138. Id. 

139. Id. R. I(c). 

140. Id. R. I(d). 

141. Institute of Chartered Accountants of Ontario, Rules of Professional Conduct; Institute of 

Chartered Accountants of British Columbia, Rules of Professional Conduct; Institute of Chartered 

Accountants of Alberta, Rules of Professional Conduct; Institute of Chartered Accountants of Manitoba, 

Rules of Professional Conduct; New Brunswick Institute of Chartered Accountants, Rules of Professional 

Conduct; Institute of Chartered Accountants of Newfoundland, Rules of Professional Conduct; Institute of 

Chartered Accountants of Nova Scotia, Rules of Professional Conduct; Institute of Chartered Accountants 

of Prince Edward Island, Rules of Professional Conduct; Ordre des comptables agrd6s du Quebec, Code of 

Ethics of Chartered Accountants; Institute of Chartered Accountants of Saskatchewan, Rules of 

Professional Conduct; Institute of Chartered Accountants of Northwest Territories, Rules of Professional 

Conduct. 

142. Id. 

143. Id. 

144. Id.; see also Qu6bec, id. R. 5, 23, and 34. 

145. Id.; see also Quebec, id., R. 36.4. 


2007 


standard of conduct not found in provincial securities legislation or the corporate 

statutes. 146 

The Professional Conduct Committee investigates all written complaints 

received about Institute members, students, and firms for violations of the Institute's 

rules of professional conduct, regulations, or bylaws. When the Professional 

Conduct Committee lays a charge or charges of professional misconduct against a 

member, student or firm, a formal hearing is held in front of the Institute's 

disciplinary committee; if a finding of guilt is made, the disciplinary committee has 

the power to order that the member, student or firm be: reprimanded; fined; charged 

the costs of the investigation and hearing; suspended from the Institute; struck off 

the register of students; or expelled from membership in the Institute.' The CGA 

and the CMA regulatory bodies also have their own sets of rules of professional 

conduct that are similar to the Rules outlined above. A detailed examination of 

these rules is not necessary as the Canadian Public Accountability Board and 

accompanying legislation in most instances require members to follow the Rules. 

Auditors are also regulated under the Canadian Public Accounting Board 

(CPAB). 4 National Instrument 52-108 requires auditors of reporting issuers to be 

members in good standing with the CPAB, a new independent public oversight 

system that includes regular and rigorous inspections of auditors of Canada's public 

companies. 149 Section 300 of the CPAB Rules sets out the professional standards 

that audit firms must adhere to, which generally echoes the ethical standards 

imposed by the professional regulatory bodies that have jurisdiction over them. 50 If 

a violation occurs, sanctions are prescribed on the audit firm under CPAB Rules 

section 601 including: additional professional education for some or all of the 

designated professionals of a participating audit firm; the design, adoption or 

implementation of policies by a participating audit firm to ensure its compliance with 

the CPAB Rules; and appointment of an independent monitor, subject to the 

approval of the Board, to observe and report to the Board on a participating audit 

firm's compliance with the CPAB Rules. ' 

d. International Organization of Securities Commission 

Unlike CPAB and other regulatory bodies, the International Organization of 

Securities Commission's (IOSCO) Code of Conduct Fundamentals (IOSCO Code)' 52 

does not act as a code of conduct to which CRAs are expected to adhere. Instead it 

contains a set of provisions that the IOSCO expects all CRAs will incorporate and 

give full effect to in their codes of conduct. The IOSCO Code addresses issues 

including how CRAs should avoid or mitigate potential conflicts of interest, improve 

146. Id.; see also Qudbec, id. R. 19. 

147. See generally Institute of Chartered Accountants, supra note 141 and accompanying text. 

148. National Instrument 52-108 Auditor Oversight, 27 O.S.C.B. 874 (2004) 

149. 27 OSCB 3227 (2004). For greater detail see P. Puri and A. Pritchard, The Regulation of Public 

Auditing in Canada and the United States: Self-Regulation or Government Regulation (Fraser Institute 

2006). 

150. CPAB Rules, § 303(a) and (b). 

151. Id.§ 601. 

152. International Organization of Securities Commissions, Code of Conduct Fundamentals (Dec. 

2004) [hereinafter IOSCO Code].. 



VOL. 42:441 

the transparency of the ratings process, and protect their integrity and independence 

while dealing fairly with issuers, investors, and other market participants.'" The 

liabilities of CRAs for failing to withhold their support and services upon detection 

of misconduct are primarily implicit. Rule 1.6 of the IOSCO Code deals with the 

quality of the rating process, and states that "the CRA and its analysts should take 

steps to avoid issuing any credit analyses or reports that contain misrepresentations 

or are otherwise misleading as to the general creditworthiness of an issuer or 

obligation."' 54 While the IOSCO Code provides indications on how CRAs should 

conduct their business, it should be noted that currently there is no mandatory 

disclosure of CRAs' codes of conduct under any provincial securities legislation, and 

no explicit sanctions for non-compliance. 

D. Criminal and Quasi-Criminal Liability 

The potential for criminal and quasi-criminal liability can be demonstrated 

through an examination of provisions that can apply to many gatekeepers. For 

example, under provincial securities law, anyone who authorizes, permits, or 

acquiesces in a contravention of the provincial securities acts may be liable for a fine 

of not more than $5 million and/or imprisonment for a period of up to five years less 

one day in Ontario, British Columbia, and Alberta.1 5 The penalties vary by 

province, but the underlying behaviour triggering the offence is the same. Also, it is 

important to note that this behaviour is only quasi-criminal, since the legislation is 

provincial, thus the mens rea requirement for this offence is one of strict liability.' 5 6 

Only a due diligence defence will be afforded a director who has authorized, 

permitted, or acquiesced to the company's violation of securities law. 

There is also federal legislation with quasi-criminal effects. Under the CBCA 

and parallel provincial corporate law statutes, § 250(1) states: 

a person who makes or assists in making a report, return, notice, or other 

document required by this Act or the regulations to be sent to ...any 

person that 

(a) contains an untrue statement of a material fact, or 

(b) omits to state a material fact required therein or necessary to make a 

statement contained therein not misleading in the light of the 

circumstances in which it was made... 

153. International Organization of Securities Commissions, Press Release, Task Force of Securities 

Regulators from Major Markets Agrees on Code of Conduct Fundamentals for Credit Rating Agencies 

(December 2004). 

154. IOSCO Code, supra note 152, r.1.6. 

155. OSA, supra note 59, § 122(3); ASA, supra note 59, § 194(3); BCSC, supra note 59, § 155(3). In 

Ontario, for example, § 122 of the OSA makes it an offence to make a materially misleading or untrue 

statement or material omission in any document required to be filed or furnished under Ontario securities 

legislation. 

156. R. v. City of Sault Ste. Marie, 2 S.C.R. 1299 (1978) (Can.). 


2007 


is guilty of an offence and liable on summary conviction to a fine not 

exceeding $5000 or to imprisonment for a term not exceeding six months 

or to both.'" 

In addition, if the corporation itself does any of the above, any director or officer of 

the corporation who knowingly authorized, permitted or acquiesced in the 

commission of the offence is a party to and guilty of the offence and is liable on 

summary conviction to the same penalties as listed above. 5 A due diligence defence 

is provided under the corporate statutes such that no person is guilty of a quasicriminal 

offence "if the person did not know, and in the exercise of reasonable 

diligence could not have known, of the untrue statement or omission. ' 5 0 1 

Along with quasi-criminal liability, directors can be held criminally liable 

through various sections of the Criminal Code of Canada (CC), including section 

400, under which it is an offence to make, circulate, or publish a prospectus that is 

known to be false in a material particular 

with intent 

(a) to induce persons to become shareholders or partners in a company, 

(b) to deceive or defraud the members, shareholders or creditors ... of a 

company, or 

(c) 

to induce any person to 

(i) 

entrust or advance anything to a company, or 

(ii) enter into any security for the benefit of a company .... '60 

Other applicable sections include section 382, which creates an indictable offence 

liable to imprisonment for a term not exceeding 10 years for entering transactions 

that create false or misleading appearances of market activity or a misleading 

appearance as to the market price of a security, 16" ' and 380(2) which extends the 

prohibition against fraud to any deceit, falsehood or fraudulent practice that affects 

the public market price of stocks or shares and creates an indictable offence liable to 

157. CBCA, supra note 41, § 250; ABCA, supra note 41, § 251; SBCA, supra note 35, § 300; NBBCA, 

supra note 41, § 175; NFCA, supra note 4135, s.§ 504; YBCA, supra note 41, at § 251; NWTBCA, supra 

note 41, § 252. See also OBCA, supra note 41, § 256 (liability in Ontario is $2,000 or imprisonment for 1 

year, or $25,000 for a corporate body); BCBCA, supra note 41, §§ 427-428 (liability in B.C. is $10,000 for an 

individual, or $25,000 if not an individual). Note that Companies Act, R.S.Q. c. C-38, §§ 108 and 201, 

creates liability for untrue entries in the corporate books $100 per entry and liability for damages and 

Companies Act, R.S.P.E.I., c. C-14, § 54 (1988) creates liability for damages stemming from 

misrepresentations in the corporate books. There does not appear to be quasi-criminal liability under the 

NSCA, supra note 42. 

158. NSCA, supra note 42. 

159. Id. 

160. Criminal Code, R.S.C., ch. C-46, § 400 (1985). 

161. Id. § 382 



VOL. 42:441 

imprisonment for a term not exceeding 14 years.' 62 Even when the directors are not 

the party for actually committing the offence, they may also be liable for aiding and 

abetting, 163 as exemplified in the case of R. v. Fell. 64 

Section 380.1 was introduced in March 2004, establishing four aggravating 

circumstances that a court can consider when imposing a sentence for market fraud 

offences. 65 A court can impose tougher penalties if: 

(a) the value of the fraud committed exceeded one million dollars; 

(b) the offence adversely affected, or had the potential to adversely affect, the 

stability of the Canadian economy or financial system or any financial 

market in Canada or investor confidence in such a financial market; 

(c) the offence involved a large number of victims; and 

(d) in committing the offence, the offender took advantage the high regard in 

which the offender was held in the community. '6 4 

These provisions apply equally to other corporate gatekeepers, including 

lawyers. Lawyers face quasi-criminal liability through the Ontario Provincial 

Offences Act under sections 77 and 78, which make a lawyer party to an offence 

under provincial securities or corporate legislation if he or she did or omitted to do 

anything to aid or abet a client in committing an offence, or if he or she counseled 

another person to commit an offence.' 67 Some other provinces have similar 

legislation. 

There are a number of examples where lawyers have become liable for a 

criminal action under the CC through their actions on behalf of a corporation, which 

may be characterized as a failure in performing their gatekeeping function. In one 

example, R. v. Sahaidak, a lawyer was held criminally liable for a fraudulent stock 

scheme, despite being neither the "creator" nor the "driving force" behind the 

scheme. 6 However, the judge noted that "there are offences... that need lawyers 

in order to be committed" and found the lawyer to have been "an active participant 

in each of the frauds and an important participant."' 69 In another example, R. v. 

Shead, a lawyer was held liable for several counts of fraud for making negligent 

disclosures to investors.' 0 This case suggests a requirement of subjective knowledge 

of the facts to draw a legal conclusion of fraud (i.e., objectively dishonest conduct 

and deprivation caused by the dishonest act) and an action to aid in the commission 

of the crime, which is a high mens rea threshold to be met. A lawyer is generally 

unable to control a corporate client from engaging in the dishonest act unless the 

dishonest act is reliant upon an action by the lawyer. Thus, in general, the 

withholding of consent should be sufficient to prevent a fraudulent act; intentionally 

aiding a client when there is knowledge of a criminal action will constitute aiding and 

abetting under the CC. 

162. Id. § 380(2). 

163. Id. § 21(1). 

164. 34 O.R. (2d) 665 (C.A. 1981). 

165. Criminal Code, supra note 160, § 380.1. 

166. Id. 

167. Provincial Offences Act, R.S.O., ch. P-33 (1990). 

168. R. v. Sahaidak, No. 2792, 10 W.C.B. (2d) 245 (Ont. H.C. Jan. 20, 1990), available at 1990 W.C.B.J. 

LEXIS 8591, 11. 

169. Id. 

170. R. v. Shead, [1996] 114 Man. R.2d 42 (Can.). 


2007 


All categories of corporate gatekeepers can be exposed to criminal liability 

under the CC, depending on the degree of misconduct. Auditors, credit rating 

agencies, financial analysts, and retail investment advisors are all also liable to quasicriminal 

charges under securities and corporate legislation. Underwriters and 

CRAs, through the adoption of Bill C-45, can be held liable as an "organization, 

which includes a law firm, based on criminal activity of senior officers of the 

organization. 7 ' 

IV. 

LOCATING THE CANADIAN SYSTEM IN AN INTERNATIONAL 

CONTEXT 

A. Directors 

In the United States, the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) 

imposes increased responsibilities on directors, without direct legal penalties for 

directors who breach those responsibilities. 2 In the United Kingdom, there have 

been recent amendments to company law which have relaxed the provisions 

protecting directors and other company officers from liability.' 73 Amongst these 

changes is the introduction of director liability to third parties, under sections 19 and 

20 of the Companies (Audit, Investigations and Community Enterprise) Act 2004 

(C(AICE)). 7 ' The current Canadian gatekeeper liability regime for directors is in 

line with the U.S. model, but has not gone the U.K. route of attaching additional 

liability to the additional responsibilities now placed upon directors, and particularly 

independent directors, as gatekeepers. 

The academic literature suggests that the exact nature of the gatekeeping role 

that directors should play remains unclear. For example, James Kirkbride and Steve 

Letza suggest that non-executive directors might serve as internal monitors of CEO 

behaviour because they have access to privileged information about firm operations, 

which is inaccessible to public enforcement officials. 7 ' However, they outline some 

of the problems associated with imposing gatekeeper liability, including the cost 

element; if gatekeepers cannot shift their liability risks, they will charge higher 

premiums.' 76 This suggests that imposing increased liability on directors as 

gatekeepers does not necessarily contribute to a more effective gatekeeper liability 

regime. 

Indeed, public opinion does not support an increase in sources of director 

liability."' Instead, increasing transparency and disclosure about directors' salaries 

171. For a more detailed discussion see Darcy L. MacPherson, Extending Corporate Criminal 

Liability?: Some Thoughts on Bill C-45, 30 MAN. L.J. 253 (2004). 

172. Public Company Accounting Reform and Investor Protection Act (Sarbanes-Oxley) 18 U.S.C. § 

7261 (2002) [hereinafter Sarbanes-Oxley]. 

173. See Companies (Audit, Investigations, and Community Enterprise) Act, 2004, ch. 27, § 19-20 

(U.K), available at http://www.opsi.gov.uk/acts/acts2004/ukpga-20040027-en.pdf [hereinafter C(AICE)]. 

174. Id. 

175. See James Kirkbride & Steve Letza, Can the Non-Executive Director Be an Effective Gatekeeper? 

The Possible Development of a Legal Framework of Accountability, 13 CORP. GOv. 542, 544 (2005). 

176. Id. 

177. The Ditchley Foundation Conference, Confidence, Control and Compensation: Questions for 

the Modern Corporation (Sept. 5-7, 2003), at http://www.ditchley.co.uk/page/175/modern-corporation.htm. 



VOL. 42:441 

may help allay general concerns. The sharp rise in directors' salaries relative to the 

salaries of the average employee was cited as a major problem by many Ditchley 

Foundation conference participants, including business people, regulators, and 

politicians.' Further demonstrating the problem with directors' salaries, the 

Ontario Teachers' Pension Plan released a report in June of 2006 showing little 

correlation between CEO pay and total stock return.' 79 To combat the public 

perception problems with directors' compensation, the Canadian Coalition for Good 

Governance has suggested transparency guidelines and assists in their 

implementation.'9 

Additionally, the recent introduction of the secondary market civil liability 

scheme in Ontario presents an opportunity to evaluate the impact of increased 

gatekeeper liability for directors and at the same time examine the judiciary's role in 

applying such a regime. Further amendments are not recommended until this 

experience has been fully evaluated in the Canadian context. Following an 

evaluation of the current regime, further consideration should be given to attaching 

increased liability to the added responsibilities placed on directors, and in particular, 

independent directors. 

B. Lawyers 

In Canada, the United States, and the United Kingdom, lawyers are regulated 

both by law societies and securities statutes. Under section 307 of Sarbanes-Oxley, 

the SEC has developed rules of professional conduct for lawyers, and those who 

violate the rules are subject to all remedies and sanctions available to the SEC for 

the violation of federal securities laws. 8 ' Lawyers are also regulated by their state 

bar association, many of which have adopted the American Bar Association's Model 

Rules of Professional Conduct (Model Rules), though it is up to each state bar 

association to develop its own rules and standards. In the U.K., the Law Society sets 

out The Guide to the Professional Conduct of Solicitors.' Lawyers in the U.K. are 

also regulated under the Financial Services and Markets Act 2000 (FSMA 2000). 8 1 

Unlike the U.S. model and more akin to the U.K. model, the Canadian model 

for gatekeeper liability for lawyers clearly assigns the key regulatory function to the 

provincial law societies. The benefit of this model is that the problem of conflicting 

standards that exists in the U.S. between the Rules of Professional Conduct, set by 

each state Bar Association and the SEC rules does not arise. It is also the case that 

the law societies are keenly aware of the competing tensions between lawyers' 

gatekeeping function and the confidentiality requirements that are required 

178. Id. 

179. See INSTITUTIONAL SHAREHOLDER SERVICES, SPOTLIGHT ON EXECUTIVE PAY AND BOARD 

ACCOUNTABILITY 38 (2006), http://www.issproxy.com/pdf/2006PostSeasonReportFINAL.pdf (last visited 

Apr. 16, 2007). 

180. See Good Governance Guidelines for Principled Executive Compensation, (Canadian Coalition 

for Good Governance, Working Paper, 2006), http://www.ccgg.ca/guidelines/executive-compensation/ 

(follow "Guidelines for Principled Executive Compensation" hyperlink) (last visited Apr. 16, 2007). 

181. Sarbanes-Oxley, 18 U.S.C. § 307 (2005). 

182. See generally THE GUIDE TO THE PROFESSIONAL CONDUCT OF SOLICITORS, (Nicola Taylor ed., 

8th ed. 1999). 

183. See generally Financial Services and Markets Act 2000, c.8 (U.K.), available at 

http://www.opsi.gov.uk/acts/acts2000/20000008.htm. 


2007 


generally of all lawyers. However, there is variation among the law societies to the 

extent they have created specific rules to address lawyers' gatekeeping function. 

Ontario appears to have created the model most similar to the U.S. model, striking a 

balance between lawyers' roles as gatekeepers and advocates. 

To improve the competitiveness of Canadian capital markets, it is 

recommended that each law society give consideration to adopting a similar set of 

rules-with the input of each provincial securities commission. A more uniform and 

comprehensive set of rules of professional conduct will simplify the existing system 

and at the same time ease investors' concerns about the role that lawyers are playing 

in Canadian capital markets. Following a provincial consultation process, it may be 

helpful to form a national working group to develop a uniform set of rules of 

professional conduct. 

C. Auditors 

After the financial collapse of Enron, there was very little public confidence in 

auditors and accountants. While it was an American corporation, seventy-three 

percent of Canadians doubted their public protections, and believed an Enron-like 

scandal would take place there as well.' 8 Further, inconsistencies between the 

Canadian and American systems have since been highlighted by Al Rosen, founder 

of the forensic accounting firm Rosen & Associates Ltd.' 85 He contends that in 2003, 

two-thirds of Canadian companies would have lower reported profits if American 

accounting rules were used in place of their Canadian counterparts. 186 Recent 

Canadian reforms, detailed below, have helped to address these concerns, and this 

article offers additional suggestions to increase public confidence in auditors further. 

In the U.S., Sarbanes-Oxley imposed extensive federal regulation on the 

accounting profession.' 87 The act created the Public Company Accounting Oversight 

Board (PCAOB) to oversee the audit of public companies. 18 ' Accounting firms must 

register with the PCAOB which has broad powers to promulgate binding rules and 

standards, conduct investigations, and impose discipline; by shifting control of the 

accounting profession to a new body, the PCAOB aims to address the problem of 

accounting irregularities by establishing auditing standards and imposing 

professional discipline.' 89 

The U.K.'s counterpart to the PCOAB is the Financial Reporting Council 

(FRC), an independent regulator for corporate reporting and governance, created in 

April 2004 under the authority of the C(AICE) Act.' 9 The functions of the FRC 

include: establishing, monitoring, and enforcing accounting and auditing standards; 

184. Pollara, Canadians Expect Enron-Like Scandal Here, (May 2002), available at 

http://www.pollara.ca/LibraryNews/enron.html. 

185. Elizabeth Raymer, Accountants, Auditors Adopt New Rules, GLOBE AND MAIL (Canada), April 

1. 2003, at E6, available at 

http://www.globeinvestor.com/servlet/ArticleNews/story/GAM/20030401/CGACCT. 

186. Id. 



189. See Coffee Gatekeeper Failure and Reform, supra note 12, at 50. 

190. See C(AICE) Act, 2004, c. 27, § 14 (U.K.). 



VOL. 42:441 

regulating auditors; operating an independent investigation and disciplinary scheme 

for public interest cases; overseeing the regulatory activities of professional 

accountancy bodies; and promoting high standards of corporate governance. ' 

Drawing on the U.S. and the U.K. models, the author believes that 

consideration should be given to conferring SRO status on the Canadian CPAB, 

subject to oversight by each of the securities regulators; the development of the 

CPAB provides an opportunity to improve the current gatekeeper liability regime 

for auditors. The current model, in which the CPAB relies on the ethical standards 

imposed by the industry bodies that have jurisdiction over auditors is consistent with 

the current Canadian self-regulatory approach. However, the status of the CPAB, 

as a creature of contract, is distinct from other similar organizations, creating issues 

concerning legitimacy, fairness and effectiveness. Currently, three SROs are 

recognized by the OSC and most other provincial securities regulators. The SROs 

currently recognized by the OSC are the Investment Dealers Association of Canada 

(IDA), the Mutual Fund Dealers Association of Canada (MFDA), and Market 

Regulation Services Inc. (RS). An SRO is an entity that represents registrants and is 

organized for the purpose of regulating the operations, standards of practice, and 

business conduct of its members and their representatives, with a view toward 

promoting the protection of investors and the public interest. It is recommended 

that the CPAB be accorded SRO status. This will improve investor confidence in 

both the CPAB, as regulator, and auditors, as gatekeepers, because their chief 

regulator-the provincial securities commission-will be perceived to be more 

legitimate and fair. At the same time this change will bring the Canadian position 

more in line with the U.S. and U.K. positions. In its capacity as an SRO, the CPAB 

will be in a better position to work with the industry bodies that regulate the 

accounting profession, thereby ensuring that the ideal level and form of gatekeeper 

liability for auditors is in place. 

The recent reforms and the changes proposed still leave the "two master 

problem" unresolved: auditors are still asked to treat the public as master, but 

continue to be paid by the corporation. 9 While this is recognized as an issue for 

gatekeepers, there is insufficient evidence to suggest that the current Canadian 

system needs to be completely overhauled at this time. Much has happened in 

Canada, the U.S., and the U.K. in the context of oversight of auditors over the last 

five years, and at this point, it is justifiable to resist making further changes and to 

allow the current system to develop while continuing to monitor it. In particular, the 

recent expansion of the number of accountants who may perform public audits 

should be observed. 93 The role that increased competition may play will be a factor 

in future regulatory decisions. 

191. Financial Reporting Council, Regulatory Strategy 2 (2006), http://www.frc.org.uk/about (follow 

the "Regulatory Strategy (Version 2.1)" hyperlink) (last visited Jan. 19, 2007). 

192. See Amy Shapiro, Who Pays the Auditor Calls the Tune?: Auditing Regulation and Clients' 

Incentives, 35 SETON HALL L. REV. 1029 (2005). 

193. Though most public accountants in Canada are certified accountants, as of 2005, certified general 

accountants were given the authority by provincial legislation to practise public accounting and auditing 

throughout Canada except Quebec. See Certified General Accountants Association of Canada, Public 

Accounting Rights for Certified General Accountants in Canada, May 2005, http://www.cga- 

online.org/servlet/portal/serve/library/news+and+media/_Product/carep_2005- 

05_pa-issue-brief?SESSION=najlvf7mjzYNnNo2ll38 (last visited Apr. 16, 2007). 


2007 


D. Credit Rating Agencies 

Commentators such as Frank Partnoy see CRAs as possessing little 

informational value.' 94 That is, while initial credit ratings provide guidance on 

purchases, it is unclear whether they provide any information beyond that already 

reflected in the "price talk" before a fixed instrument is issued. 9 Building on this 

critique, the best reforms should create incentives for CRAs to generate greater 

informational value while reducing the impact of ratings on markets. 96 In the 

current American context, Partnoy argues that CRAs are important not because 

they offer valuable information, but because they grant issuers "regulatory 

licenses"-that is, a good rating entitles the issuer to certain advantages related to 

regulation.97 

The effectiveness of CRA's gatekeeping role remains an open question. 

However, both the public perception and academic writing suggest that the existing 

liability regime does not instill confidence in capital markets and that there is room 

for modernizing Canadian securities legislation to improve the current situation. 

Accordingly, reforms to the current regime should focus on creating incentives for 

CRAs to generate informational value while reducing the market impact of ratings 

from a small group of CRAs. 

Given the uncertainty around CRAs' role and that there is no Canadian SRO 

or industry body charged with regulating CRAs, the securities commissions could 

play a critical role. Securities legislation should be amended to create a mandatory 

registration requirement for all CRAs and the provincial securities commissions 

should have the power to revoke or suspend registration of a wayward registrant. 

The disclosure obligations formulated by the IOSCO should be a condition to 

registration with the provincial securities commissions. The registration requirement 

would bring the treatment of CRAs more in line with the spirit of Canadian 

securities legislation as it relates to oversight of corporate gatekeepers. Registration 

would also create a threat of liability for rating malfeasance. Given concerns with 

imposing civil liability on CRAs, the ideal gatekeeper liability scheme should focus 

on administrative liability.' 9 The IOSCO Code, which CRAs have already generally 

adopted, presents a good model for imposing liability on CRAs. 

E. Financial Analysts 

Because of their unique intermediary role in capital markets, conflicts often 

arise between an analyst's duty to provide independent, objective advice to investor 

clients and pressures to support investment banking revenues.' 99 In the current 

194. Frank Partnoy, How and Why Credit-Rating Agencies Are Not Like Other Gatekeepers 

(unpublished manuscript, http://www.tcf.or.jp/data/20050928_FrankPartnoy.pdf). 

195. Id. n.13. 

196. Id. 

197. Id. at 28. 

198. See Stephane Rousseau, Enhancing the Accountability of Credit Rating Agencies: The Case for a 

Disclosure-Based Approach, CAPITAL MARKETS INsT. (Aug. 2005), available at 

http://www.rotman.utoronto.ca/cmi/papers/CRA-Study-Rousseau.pdf; see also Partnoy, supra note 196. 

199. SICAS Report, supra note 40, at 30. 



VOL. 42:441 

context, buy-side pressures on financial analysts are increasing in significance. For 

example, there is incentive for a mutual fund with large holdings in a stock to 

persuade an analyst not to put a "sell" recommendation on the stock that might 

contribute to a decline in its price. Following the SICAS Report, the IDA has taken 

significant measures to address the gatekeeping role played by analysts. However, 

given the recent reforms in the U.S. and the U.K. to bolster confidence in analysts 

function as gatekeepers, analysts should require more detailed disclosure by 

analysts, with accompanying liability for failure to disclose. 

U.S. reforms include SEC Regulation AC (Analyst Certification), 0 effective 

April 2003, which requires that when a broker, dealer, or covered person furnishes 

research prepared by a research analyst, the research must include a statement by 

the research analyst that the research truly reflects the analyst's opinion, and disclose 

whether or not an analyst received compensation in connection with his or her 

specific recommendations or views. ' Penalties under the Securities Act (or rules or 

regulations promulgated under the act, such as Regulation AC) may amount to fines 

of up to $10,000, or imprisonment of up to five years. 2 

The U.K.'s attempt to raise confidence in analysts' function is found in the 

Financial Services Authority's (FSA) Conduct of Business Sourcebook, section 7.17, 

which imposes "fair presentation" and disclosure requirements on analysts. 0 3 Since 

July 2004, firms that publish impartial research must have implemented a policy on 

identifying and managing conflicts to ensure analysts' impartiality. The FSA's rules 

set out minimum standards for conflict management processes and procedures. 2°' 

In Canada, IDA Policy No. 1125 should be amended to require: 1) a statement 

by the analyst that the research truly reflects the analyst's opinion; and 2) a 

prohibition on the investment banking department supervising or controlling 

analysts. Currently, Rule 2(b) requires that members disclose their system for 

ratings. More specific disclosure requirements, including identification of the analyst 

responsible for the production, dissemination of the research, and a statement by the 

analyst that the research truly reflects the analyst's opinion would bolster investors' 

confidence in the information that is provided. This reform will address both sellside 

and buy-side pressures facing financial analysts. In addition, members should 

not only set policies and procedures under IDA Rule 11 to avoid conflicts of interest, 

but also put in place controls and maintain records of supervision of analysts, and 

explicitly prohibit supervision and control of analysts by the investment banking 

200. 17 CFR § 242.100 (2005). 

201. See David J. Labhart, Securities Analysts: Why These Gatekeepers Have Abandoned Their Post, 

79 IND. L.J. 1037, 1054 (2004); see also Sec. and Exchange Commission, Regulation Analyst Certification 

(Apr. 2003), at http://www.sec.gov/rules/final/33-8193.htm. 

202. Securities Act, § 24, 15 U.S.C. § 77x. 

203. EMILIOs E. AVGOULEAS, MECHANICS AND REGULATION OF MARKET ABUSE: A LEGAL AND 

ECONOMIC ANALYSIS 366 (2005). Note that COB 7.17 was adopted in compliance with Article 6(5) of the 

MAD. 

204. FIN. SERVICES AUTHORITY, EX-POST ANALYSIS OF FSA's CONDUCT OF BUSINESS RULES ON 

CONFLICTS OF INTEREST IN INVESTMENT RESEARCH, (Sept. 2005), available at 

http://www.fsa.gov.uk/pubs/other/post-analysis.pdf; see also CONFLICTS OF INTEREST IN INVESTMENT 

RESEARCH - FEEDBACK ON CP205 AND MADE HANDBOOK TEXT (March 2004), available at 

http://www.fsa.gov.uk/pubs/policy/ps04_06.pdf. 

205. IDA Rule Book, Policy No. 11: Research Restrictions and Disclosure Requirements available at 

http://ida.knotia.ca/Knowledge/View/Documentcfn?Ktype=445&linkType=toc&dbID=200703341&toclD= 

796. 


2007 


department. While such measures may appear to be outdated to the American 

reader given that similar measures were introduced in the U.S. in 2003 following 

Eliot Spitzer's investigation of conflicts of interest at Wall Street investment firms, 

they are not outdated in the Canadian context. 2 " These measures will bring the 

Canadian approach to gatekeeper liability for analysts more in line with the U.S. and 

the U.K. approaches, while maintaining the Canadian self-regulatory model. 

F 

Retail Investment Advisors 

Recent reform efforts regarding the liability of investment advisors in Canada 

have not focused on their role as corporate gatekeepers. Rather, the focus has been 

on establishing consumer protection mechanisms to address power imbalances in 

investment advisors' relationships with customers. The evidence suggests that 

consumer protection issues are the most pressing concern in the Canadian context. 

In certain instances, there is an overlap between liability introduced for more 

general consumer protection purposes and liability for failure to perform a corporate 

gatekeeping function. However, recent U.S. and U.K. reform efforts demonstrate 

that similar issues arise with respect to the role of analysts and investment advisors 

as corporate gatekeepers and accordingly, similar gatekeeper liability regimes 

(specific to the role of each gatekeeper) are justified and should be put into place. In 

the U.S., a full service investment advisor is obligated to recommend to a customer 

only those securities that match the customer's financial needs and goals (the 

"suitability obligation"), which is imposed on NASD members through Rules of Fair 

Practice (Conduct Rule 2310).207 Similar consumer protection issues arise in the 

American context, as breach of the suitability obligation has grown into the most 

commonly alleged basis of investor recovery against investment advisors. °0 

To a certain extent, the corporate gatekeeping role of investment advisors in 

Canada has been underestimated. The IDA, as a national SRO, is ideally suited to 

develop and implement a parallel policy to Policy No. 11, which is specific to the role 

of investment advisors. In particular, like Policy No. 11, the policy for investment 

advisors should build on the existing requirements in securities legislation for 

disclosure of possible conflicts resulting from the firm's relationships to issuers and 

clients. The new policy should respond to issues created by relationships in the firm, 

in the same way as Policy No. 11 seeks to respond to relationships between analysts 

and investment bankers. 

206. See generally Press Release, Eliot Spitzer, Office of New York State Attorney General, Conflict 

Probes Resolved at Citigroup and Morgan-Stanley (Apr. 28. 2003), available at 

http://www.oag.state.ny.us/press/2003/apr/apr28aO3.html. 

207. NASD Rules of Fair Practice: Conduct Rule 2310, at 

http://nasd.complinet.com/nasd/display/display.html?rbid= 189&element-id-Id= 9000500 (last visited Apr. 

17, 2007). 

208. Frederick Mark Gedicks, Suitability Claims and Purchases of Unrecommended Securities: An 

Agency Theory of Broker-Dealer Liability, 37 ARIZ. ST. L.J. 535, 543. 



VOL. 42:441 

G. Underwriters 

Recent reforms in the U.S. have not focused on imposing or modifying the 

liability to which underwriters are subject as gatekeepers. For example, Choi writes 

that underwriters face strong incentives to act as certifiers; if they can provide 

credible assurances that an issuer's disclosures are truthful, investors will be willing 

to pay more for the issuer's securities. 2 ° The issuer will then pay more for the 

underwriter's certification service. There is less need for underwriter liability if they 

are incentivized to become more independent, and arguably better gatekeepers, by 

the market for independent certifiers. This argument applies to the Canadian 

context, suggesting that, like in the U.S., underwriters do not need to be subjected to 

additional liability. 

The reforms introduced by National Instrument 33-1052' 

help promote this 

model in Canada, and are consistent with the recent and proposed reforms in the 

U.S. and the U.K. to improve the effectiveness of underwriters' role as gatekeepers. 

The current regime does subject underwriters to civil, administrative and criminal 

liability for failure to perform their gatekeeping role. However, the focus is on 

disclosure of conflicts rather than on enlarging the instances and possibility for 

gatekeeper liability. In this way, the current regime is consistent with the model that 

Choi advocates. There is insufficient evidence to suggest that increasing or 

modifying the gatekeeper liability regime to which underwriters are currently subject 

will contribute to more competitive Canadian capital markets. At the same time, 

time constraint issues related to fast track offerings and the implications for the 

ability of underwriters to conduct adequate due diligence should continue to be 

monitored. 

V. CONCLUSION 

The analysis of the academic literature and the comparative context suggest 

that developing a streamlined approach to amending the gatekeeper liability scheme 

in Canada, which comes closer to the U.S. and the U.K. models, is not desirable. 

Overall, the polycentric legal environment for gatekeeper liability in Canada appears 

to be developing in a manner that gives gatekeepers guidelines on how to perform 

their functions, as well as adequate reason to do so. This can be demonstrated by 

indexes such as the Rotman School of Management's Board Shareholder 

Confidence Index, which found that governance scores, designed to reflect the 

degree to which elements of good governance are implemented by a company, have 

improved every year since 2003.21 

In examining the existing Canadian model where the boundaries between law 

and professional practice are somewhat blurred and subsystems of liability that apply 

to various gatekeepers differ both from gatekeeper to gatekeeper and also 

geographically, it became apparent that participants in the market and other 

209. Choi, supra note 9, at 962. 

210. BCSA, supra note 59, § 33-10. 

211. Michael Wilson, Corporate Governance Practices: Impact on Valuation, Canadian Coalition for 

Good Governance, in a speech given to the CFA Conference: Equity and Research Valuation Techniques 

(Dec. 2005), 

http:lwww.ccgg.calmedia/files/speeches/Speech%5Fto%5FCFA%5FDecember%5F1%5F2005.pdf, at 6. 


2007 CORPORATE GATEKEEPER LIABILITY IN CANADA 473 

members of the public may not be aware of the extent of the existing corporate 

gatekeeper liability regime in Canada. Awareness of the liability scheme plays a key 

role in developing confidence in Canadian capital markets. Accordingly, a final 

recommendation is made with regards to the widespread dissemination and 

availability of papers that seek to map out the existing gatekeeper liability regime in 

Canada and situate it in the context of recent academic literature and reforms in 

comparable jurisdictions. 



Harmonization and Modernization in 

UNCITRAL's Legislative Guide on 

Insolvency Law 

SUSAN BLOCK-LIEB* AND TERENCE HALLIDAY** 

SUMMARY 

I. UNIFICATION, HARMONIZATION, AND MODERNIZATION ............................. 481 

A. The Shift Toward M odernization .............................................................. 488 

B. Redefining Harmonization to Meet the Challenges of Modernization .. 493 

II. UNCITRAL's LEGISLATIVE GUIDE ON INSOLVENCY LAW .......................... 498 

A. The Design of the Legislative Guide on Insolvency Law ........................ 498 

B . A rrays of R ule-Typ es .................................................................................. 502 

C. Rule- Types and Prospects for Consensual Decisionmaking ................... 506 

11. RULE-TYPES, MODERNIZATION AND HARMONIZATION ............................... 507 

A . M odernization ............................................................................................. 507 

B . H arm onization ............................................................................................ 509 

IV. MODERNIZATION AND GLOBAL LAW REFORM .............................................. 511 

Susan Block-Lieb, Professor of Law, Fordham University School of Law, 

sblocklieb@law.fordham.edu. 

Terence Halliday, Co-Director, Center on Law and Globalization, American Bar Foundation and 

University of Illinois College of Law; Senior Research Fellow, American Bar Foundation; Adjunct 

Professor of Sociology, Northwestern University, halliday@abfn.org. Professor Halliday's empirical 

research was funded through grants from the American Bar Foundation and National Science Foundation 

project SES-0214301. 

Both of us have been involved in UNCITRAL proceedings since 1999: Block-Lieb as a delegate 

from the American Bar Association and Halliday as a social scientific observer. Our findings are based on 

a combination of research methods, including participation in all formal Working Group and Commission 

sessions and informal expert meetings, statistical analysis of speech turns by all delegates, content analysis 

of all recommendations, and interviews of key delegates and UNCITRAL staffers during all phases of the 

proceedings. 

We thank Eric Bergsten, Ross Cranston, Bruce Carruthers, Whit Gray, Ted Janger, Ronald Mann, 

Junichi Matsushita, Christoph Paulus, John Pottow, Bob Rasmussen, Nick Segal, Joe Sweeney, Jay 

Westbrook, Jacob Ziegel, and others for comments and suggestions. An early version of this paper was 

presented at the bi-annual meeting of the International Academy of Commercial and Consumer Law at the 

University of Texas Law School; another version was presented at a conference we attended at Brooklyn 

Law School. We also greatly appreciate the research assistance provided by Jamie Hanlon (Fordham '08) 

and Jeanine Floyd (Fordham '08). 



VOL. 42:475 

If (international) commercial law is to keep pace with (international) 

commercial practices, then there has been much to do in the way of (international) 

law reform over the past forty years. During this period, commercial practices have 

changed substantially due to numerous factors: advances in telecommunications; the 

fall of the Soviet Union and attendant re-unification of Europe; systemic financial 

crises in South East Asia and South America; globalization; and developments, 

indeed, the revolution, in information and payment technology-the Internet and 

electronic funds transfers, to name just a few. To meet this challenge, UNCITRAL 

(the United Nations Commission on International Trade Law) has done more than 

simply reform trade law; it has also reconceived its very mission and the means by 

which it carried out its central purposes. 

Although the UN resolution creating UNCITRAL initially spoke in terms of 

the "progressive harmonization and unification" of the law of international trade, 1 

UNCITRAL now defines its mission as the "modernization and harmonization" of 

trade law. 2 Arguably, the task of modernizing the law of international trade was 

implicit in UNCITRAL's core mission. The resolution creating UNCITRAL 

referred to the "progressive" harmonization and unification of trade law, not simply 

its harmonization and unification.' This resolution emphasized that the progressive 

harmonization and unification of trade law followed from the United Nation's 

broader agenda of economic development and the promotion of friendly relations 

among nations 

Nonetheless, there may be an enormous difference between the task of 

harmonizing and unifying existing bodies of national law on the one hand, and the 

modernization of national laws on the other hand. Depending upon how one defines 

the task, 5 harmonization may present only minimal intrusions upon national 

1. G.A. Res. 2205 (XXI), U.N. GAOR, 21st Sess., Supp. No. 16, U.N. Doc. A/6594 (Dec. 17, 1966), 

available at http://www.un.org/documents/ga/res/21/ares21.htm (follow "2205 (XXI)" hyperlink). 

2. See Welcome to the UNCITRAL Web Site, http://www.uncitral.org/uncitral/welcome.html (last 

visited on May 24, 2007) (describing its mission as: "The core legal body of the United Nations system in 

the field of international trade law. A legal body with universal membership specializing in commercial law 

reform worldwide for over 40 years. UNCITRAL's business is the modernization and harmonization of 

rules on international business."). 

3. G.A. Res. 2205 (XXI), supra note 1, pt. I (stating that the General Assembly "[d]ecides to establish 

a United Nations Commission on International Trade Law . . . , which shall have for its object the 

promotion of the progressive harmonization and unification of the law of international trade. 

4. In establishing UNCITRAL, the General Assembly stated: 

Considering that international trade co-operation among States is an important factor in the 

promotion of friendly relations and, consequently, in the maintenance of peace and security, 

Recalling its belief that the interests of all peoples, and particularly those of developing 

countries, demand the betterment of conditions favouring the extensive development of 

international trade, 

Reaffirming its conviction that divergencies arising from the laws of different States in matters 

relating to international trade constitute one of the obstacles to the development of world 

trade. 

G.A. Res. 2205 (XXI), supra note 1. 

5. In its website, UNCITRAL defines the terms harmonization and unification in this way: 


2007 

HARMONIZATION AND MODERNIZATION 

legislation, involving the identification of common approaches among existing 

domestic laws. Reports to the General Assembly and the Commission in the late 

1960s suggest that international actors understood the "progressive harmonization 

and unification" of trade law as involving the reconciliation of divergent practices 

and an articulation of emerging international norms. Current statements of 

UNCITRAL's efforts in achieving the "modernization and harmonization" of trade 

law depict UNCITRAL as a more pro-active participant in the reform of global 

commercial law. This version of international law reform-which looks to 

modernize, rather than simply harmonize, national laws-can come with one of two 

purposes. Where technical or market developments have outstripped existing law 

and the lack of suitable regulation is viewed by the international community to stall 

commercial development, modernization would require an (international) 

organization to create new law. With this relatively new method of modernization, 

the global actor purports to speak authoritatively to national legislatures about both 

the need for and content of law. Modernization may threaten national legislatures' 

sovereignty more acutely than an "in with the new" reform agenda where national 

law exists on a topic, but is viewed by the international community as out-of-date. 

This "out with the old" method of modernization requires the international 

organization both to reject existing legislation and create new law, whereas "in with 

the new" modernization requires simply the filling of a gap in the old law with new 

law. In either case, modernization might work against harmonization or unification 

since "modernization" presumably relates to a revision of the law to meet new 

exigencies, revisions that might not be consistent with existing national laws or 

global norms.' 

Both "in with the new" and "out with the old" modernization challenge 

traditional concepts of international law and law reform, and with this challenge 

"Harmonization" and "unification" of the law of international trade refers to the process 

through which the law facilitating international commerce is created and adopted. 

International commerce may be hindered by factors such as the lack of a predictable governing 

law or out-of-date laws unsuited to commercial practice. The United Nations Commission on 

International Trade Law identifies such problems and then carefully crafts solutions which are 

acceptable to States having different legal systems and levels of economic and social 

development. 

"Harmonization" may conceptually be thought of as the process through which domestic laws 

may be modified to enhance predictability in cross-border commercial transactions. 

"Unification" may be seen as the adoption by States of a common legal standard governing 

particular aspects of international business transactions. A model law or a legislative guide is 

an example of a text which is drafted to harmonize domestic law, while a convention is an 

international instrument which is adopted by States for the unification of the law at an 

international level. Texts resulting from the work of UNCITRAL include conventions, model 

laws, legal guides, legislative guides, rules, and practice notes. In practice, the two concepts are 

closely related. 

FAQ - Origin, Mandate and Composition of UNCITRAL, 

http://www.uncitral.org/uncitral/en/about/originjfaq.html (last visited May 24, 2007). 

6. Frequently, of course, "modernization" is a euphemism for adaptation of a weaker country's laws 

in the direction of a powerful sovereign state or international organization that has the cultural authority to 

define the meaning of "modern." This implies that modernization might either take the form of a 

functional adaptation of law to new circumstances, or the form of cultural conformity with a powerful 

symbolic standard promulgated by a "modernizing" global institution, or both. 



VOL. 42:475 

comes an impetus for new tools. Because uniformity may not be necessary to (and 

may, in some cases, undermine) the goal of modernization, there is room to question 

whether law reform projects intending to modernize the law of international trade 

should rely on international instruments meant to produce a single, uniform legal 

standard. 

UNCITRAL has predominantly relied on conventions and model laws to reach 

agreement on international instruments promoting international trade. A 

convention takes the form of a multilateral treaty. Countries accede to a single 

standard. As a result, the demands for accession are high since countries may not 

alter any part of the convention to suit domestic political or legal differences. 

Likewise, conditions of formulation require zero-sum bargaining in order to reach 

agreement. Both conditions mean that conventions are more likely to succeed 

where agreement across radically different legal families and levels of economic 

development is possible. 7 Those conditions further imply that the politics of 

formulation and implementation will be time-consuming and the prospects of 

subsequent adaptation prohibitive. 

A model law relaxes some of the strictures of conventions. 8 It takes the form of 

a legislative text that UNCITRAL recommends for enactment. However, in order 

to be responsive to the particular needs of a given state, a model law may implicitly 

permit states to exclude or modify some provisions. 9 While a model law sets a global 

standard, neither its conditions of formulation are as demanding nor its conditions of 

implementation as severe as a convention. ° As a result-although it appears as a 

less harmonizing instrument than a convention-it may permit a higher threshold in 

the standard itself and encourage a greater number of countries to adopt a form of 

it." As an enhancement on a model law, UNCITRAL has coupled a model law with 

a guide to enactment that sets out background information, explanations of decisions, 

and information on various policy options that might enable legislators to make 

informed decisions. 2 

7. One senior official of UNCITRAL stated: "ITIhe realities of many subjects are that you couldn't 

do a convention on them." Interview by Terence Halliday with 4003 (Aug. 9, 2002) (unpublished 

interview, on file with authors) [hereinafter Interview 4003]. 

8. See UNCITRAL, Working Group on Insolvency Law, Working Paper: Possible Future Work on 

Insolvency Law, paras. 162-68, U.N. Doc. A/CN.9/WG.V/WP.50 (Sept. 20, 1999) [hereinafter 

UNCITRAL, Possible Future Work on Insolvency Law]. 

9. It permits it by default because international model laws can only recommend; they cannot 

prescribe. By contrast, it is impossible to sign on to only portions of a convention. 

10. There are also variations in the form of model laws. Contrast the Model Law on International 

Commercial Arbitration, which is a procedural instrument with tightly linked inter-dependent articles, and 

the Model Law on Electronic Commerce, which offers sets of principles with potential variations for 

satisfying them. UNCITRAL, Possible Future Work on Insolvency Law, supra note 8, paras. 165-66. A 

former Secretary of UNCITRAL observes that the Model Law on Arbitration now covers approximately 

one third of the world, something that would have been impossible with a convention. Interview 4003, 

supra note 7. 

11. In practice, UNCITRAL observes that "[d]eviations from the Model Law text have, as a rule, very 

rarely been made by countries adopting enacting legislation, suggesting that it has been widely accepted as 

a coherent model text." UNCITRAL, Possible Future Work on Insolvency Law, supra note 8, para. 165. 

This is something of an overstatement-scholars and practitioners agree that various countries' legislation 

to implement the Model Law on Cross Border Insolvencies have varied in how true the provisions of the 

implementing legislation have been to the terms of the Model Law. 

12. Id. para. 164. 


2007 


Whatever the merits of conventions and model laws for the inducement of 

unification or harmonization, UNCITRAL has also historically understood the need 

for flexibility, diplomacy and patience in its law reform projects and the potential 

inflexibility of uniformity as a goal of global law reform. Because conventions can 

limit drafters' room to maneuver, lead to the exclusion of issues on which delegates 

cannot reach consensus or, worse still, be conducive to reliance on compromise 

language that leaves an issue either unresolved or muddier than before, international 

conventions may not provide the best route toward modernization. While model 

laws are generally viewed as softer tools in the hands of international reformers than 

conventions, they too may possess an appearance of completeness and intractability. 

Cognizant of these trade-offs, as UNCITRAL has shifted its focus toward 

modernization it has invented new legal technologies-guides to enactment, 

recommendations, model legal provisions, and legislative guides-that offer greater 

flexibility to reform a broader range of laws, especially with the benefit of time and 

incremental progress. 3 Indeed, the implementation of this more expansive mission 

could only have proceeded on the basis of a broader repertoire of legal 

technologies.' 4 

This shift in goals through the invention of technologies is well illustrated by 

UNCITRAL's work on the Legislative Guide on Insolvency Law." 3 Although many 

experts were pessimistic about the prospect of a legislative guide on insolvency, the 

UN General Assembly confounded their expectations and ratified a Legislative 

Guide on Insolvency Law in December 2004.16 How did UNCITRAL succeed in 

promulgating the Legislative Guide on Insolvency Law? 7 How did its reliance on a 

legislative guide, rather than a convention or model law, enable the UNCITRAL's 

Working Group on Insolvency to produce global rules on insolvency law? In this 

article," we argue that by inventing a new legal technology UNCITRAL was able to 

join specific recommendations with lengthy and nuanced commentary intended to 

13. Other scholars have argued the UNCITRAL acts "incrementally" and count this incrementalism 

as among its strengths. The term was first employed by John Pottow. See John A.E. Pottow, Procedural 

Incrementalism: A Model for International Bankruptcy, 45 VA. J. INT'L L. 935 (2005) (describing 

UNCITRAL Model Law on Cross Border Insolvency as fundamentally procedural in focus and describing 

merits of process of incremental proceduralism). 

14. By "social technologies," social scientists refer to systematic social means of achieving a particular 

outcome. A legal technology is simply a social technology adapted to and employed in the legal arena. See 

Terence C. Halliday, Legitimacy, Technology, and Leverage: The Building Blocks of Insolvency 

Architecture in the Decade Past and the Decade Ahead, 33 BROOK. J. INT'L L. (forthcoming 2007). 

15. UNCITRAL, LEGISLATIVE GUIDE ON INSOLVENCY LAW, U.N. Sales No. E.05V.10 (2005) 

[hereinafter Insolvency Guide], available at http://www.uncitral.org/pdf/english/texts/insolven/05- 

80722_Ebook.pdf. 

16. Id. at iii. 

17. Not all share our opinion that UNCITRAL has succeeded in this arena. See, e.g., Clayton P. 

Gillette & Robert E. Scott, The Political Economy of International Sales Law, 25 INT'L REV. L. & ECON. 

446 (2005) (expressing skepticism about the necessity and desirability of efforts to unify and harmonize 

laws governing international commerce); Paul B. Stephan, The Futility of Unification and Harmonization in 

International Commercial Law, 39 VA. J. INT'L L. 743 (1999) (decrying wisdom of UNCITRAL's quest for 

global harmonization in commercial law as wrong-headed). 

18. This Article builds on a companion work in which we argue that UNCITRAL's success as an 

agent of global law reform follows from its unique claim to legitimacy among international actors given its 

representativeness and consensual decisionmaking. See Susan Block-Lieb & Terence C. Halliday, 

Legitimation and Global Lawmaking (Fordham Law Legal Studies Research Paper No. 952492, 2006), 

available at http://papers.ssrn.com/sol3/papers.cfmabstract-id=952492. 



VOL. 42:475 

educate domestic legislatures. In addition, by inventing an array of rule-types within 

the recommendations made in the legislative guide, UNCITRAL enabled the 

Working Group to speak authoritatively and in great detail on a range of topics, but 

on other issues to say little in deference to social and political concerns. In short, 

UNCITRAL succeeded in this arena by embracing its diplomacy as a strength and 

not a weakness. 

Our examination of UNCITRAL's Legislative Guide on Insolvency Law 

demonstrates that modernization may come at a price. A legislative guide is on its 

face less harmonizing than a model law, just as a model law is on its face less 

harmonizing than a convention. Nonetheless, we argue that less is more, at least in 

this instance. Many in the Insolvency Working Group believed that it would have 

been impossible to achieve a convention or a model law on insolvency law. 

UNCITRAL consciously decided to rely on a legislative guide to structure its work 

principally because the flexibility of this technology took away the need to reach 

consensus on myriad details, and more importantly, the contentious policy issues 

inherent in such an endeavor. UNCITRAL created a legal technology purporting to 

require less harmonization because it viewed the flexibility of a legislative guide as 

increasing the likelihood that it would succeed in promulgating an international 

instrument on domestic insolvency law. 

This is not to deny that the Legislative Guide on Insolvency Law might have a 

harmonizing effect. Nor should we view UNCITRAL's reliance on technologies 

other than conventions and model laws as an abandonment of the desirability of 

promoting the "progressive harmonization and unification" of trade law. 

Harmonization takes time, and global law reform involves the efforts of both 

international and domestic actors. Because national actors may not feel 

international pressure to adopt the recommendations in a legislative guide 

wholesale, they can feel free to adopt what they can. With a convention or model 

law, accession or implementing legislation may fail precisely because the choices are 

binary-either accept it in its entirety or reject it outright. A legislative guide offers 

national actors choices, albeit within limits. The decision to promulgate a legislative 

guide might in practice result in greater harmonization "on the ground" than a 

model law or convention. 9 

The remainder of this Article is organized as follows. Part I briefly traces the 

organizational development of UNCITRAL and demonstrates that UNCITRAL 

broadened its mission over time to include not just the harmonization of 

international commercial law but also its modernization. This Part finds that, in the 

course of more broadly defining its core mission, UNCITRAL also broadened the 

range of international instruments it relied upon to accomplish law reform, and that 

the breadth of mission and technologies are inter-related. Part II focuses on 

UNCITRAL's most recent project-the Legislative Guide on Insolvency Law-and 

compares and contrasts it with UNCITRAL's earlier work. This Part describes this 

new legal technology-a legislative guide-as combining legislative 

recommendations with commentary. The commentary justifies the 

recommendations made in the Guide in terms of the policy purposes of the 

provisions; where recommendations are more open-ended, the commentary assists 

legislatures with the Herculean task of assessing the choices that remain. We 

19. In part, this may occur because a guide has greater legitimacy-both formulated by a global quasilegislature 

and adopted by a national legislature. See id. 


2007 


conclude that the array of linguistic forms in which the recommendations were 

expressed in the Guide gave UNCITRAL the flexibility to adjust its level of 

prescription to the level of consensus it could achieve and, as a result, the flexibility 

to modernize insolvency law. Part III turns back to the apparent tension between 

modernization (at least the "out with the old" variety) and UNCITRAL's original 

mission: the "progressive harmonization and unification" of trade law. We argue 

that UNCITRAL's pursuit of the modernization of the law of international trade 

should not be viewed as inconsistent with the goals of "harmonization and 

unification;" instead, UNCITRAL has adapted its implementation of the goals of 

harmonization and unification in recognition of pragmatic limitations that inhere in 

(second order) international lawmaking. In Part IV, we conclude that UNCITRAL's 

adoption of modernization as a goal both expands its organizational reach and 

demands technologies that will underwrite its expansive aspirations. 

I. UNIFICATION, HARMONIZATION, AND MODERNIZATION 

The United Nation's General Assembly adopted a resolution to establish its 

Commission on International Trade Law in 1966. In justifying the creation of 

UNCITRAL, the General Assembly "[r]eafflrm[ed] its conviction that divergencies 

arising from the laws of different States in matters relating to international trade 

constitute one of the obstacles to the development of world trade." 2 " Thus, the 

decision to establish a Commission, "which shall have for its object the promotion of 

the progressive harmonization and unification of the law of international trade," was 

based on a belief that "the extensive development of international trade" could best 

be furthered by removing "divergencies arising from the laws of different States"- 

by harmonizing and unifying the law of international trade through "promoting the 

adoption of international conventions, uniform laws, standard contract provisions, 

general conditions of sale, standard trade terms and other measures."'" The 

harmonization and unification of the law of trade was sought on the presumption 

that it enabled international trade and not simply for the sake of harmonizing and 

unifying laws. International trade was said to favor "the interests of all peoples" and 

"particularly those of developing countries" because "international trade cooperation 

among States is an important factor in the promotion 

2 

of friendly relations 

and, consequently, in the maintenance of peace and security. 

Over time, UNCITRAL has pursued its mission of the "progressive 

harmonization and unification" of trade law with a pragmatic vision of its primary 

purpose-the promotion of international trade. UNCITRAL is probably best 

known for its drafting of the Convention on Contracts for the International Sales of 

Goods, 23 which has been adopted in nearly seventy countries including the United 

States." Over the past forty years, UNCITRAL has produced conventions, model 

20. G.A. Res. 2205 (XXI), supra note 1. 

21. Id. 

22. Id. 

23. United Nations Convention on Contracts for the International Sale of Goods, Apr. 11, 1980, S. 

Treaty Doc. No. 98-9. 1489 U.N.T.S. 59, available at 

http://www.uncitral.org/pdf/english/texts/sales/cisg/CISG.pdf. 

24. For a list of the roughly seventy nations that have adopted the United Nations Convention on 

Contracts for the International Sale of Goods (CISG) in one form or another, see Status, 1980 - United 



VOL. 42:475 

laws, legislative guides and other international instruments on many areas of 

procedural and substantive law, including international arbitration, 2 5 e-commerce, 2 6 

international payments, 27 procurement, and infrastructure development, 8 

international transport of goods, 29 and insolvency. 0 There currently are six active 

Nations Convention on Contracts for the International Sale of Goods, 

http://www.uncitral.org/uncitral/en/uncitral-texts/sale-goods/1980CISG-status.html (last visited May 26, 

2007). Neither Japan nor the United Kingdom has adopted the CISG. 

25. See, e.g., UNCITRAL Arbitration Rules, 15 I.L.M. 701 (1976), available at 

http://www.uncitral.org/pdf/english/texts/arbitration/arb-rules/arb-rules.pdf; UNCITRAL Conciliation 

Rules, G.A. Res. 35/52, U.N. GAOR, 35th Sess., Supp. No. 48, U.N. Doc. A/35/52 (July 23, 1980), available 

at http://www.uncitral.org/pdf/english/texts/arbitration/conc-rules/conc-rules-e.pdf; Recommendations to 

Assist Arbitral Institutions and Other Interested Bodies with Regard to Arbitrations Under the UNCITRAL 

Arbitration Rules, 1982 Y.B. Int'l Trade L. Comm'n 420, U.N. Sales No. E.84.V.5, available at 

http://www.uncitral.org/pdf/english/texts/arbitration/arb-recommendation/arb-recommendation-e.pdf; 

UNCITRAL: Model Law on International Commercial Arbitration, 24 I.L.M. 1302 (1985), available at 

http://www.uncitral.org/pdflenglish/texts/arbitration/m-arb/06-54671-Ebook.pdf; UNCITRAL Notes on 

Organizing Arbitral Proceedings, U.N. GAOR, 29th Sess., Supp. No. 17, U.N. Doc. A/51/17 (1996), 

available at http://www.uncitral.org/pdf/english/texts/arbitration/arb-notes/arb-notes-e.pdf; UNCITRAL 

MODEL LAW ON INTERNATIONAL COMMERCIAL CONCILIATION WITH GUIDE TO ENACTMENT AND USE, 

U.N. Sales No. E.05.V.4 (2002), available at http://www.uncitral.org/pdf/english/texts/arbitration/mlconc/ml-conc-e.pdf. 

26. UNCITRAL Recommendation on the Legal Value of Computer Records (1985), available at, 

http://www.uncitral.org/pdflenglish/texts/electcom/computerrecords-e.pdf; UNCITRAL MODEL LAW ON 

ELECTRONIC COMMERCE WITH GUIDE TO ENACTMENT, U.N. Sales No. E.99.V.4 (1996), available at 

http://www.uncitral.org/pdf/english/texts/electcom/05-89450_Ebook.pdf; UNCITRAL MODEL LAW ON 

ELECTRONIC SIGNATURES WITH GUIDE TO ENACTMENT, U.N. Sales No. E.02.V.8 (2001), available at 

http://www.uncitral.org/pdflenglish/texts/electcom/ml-elecsig-e.pdf; United Nations Convention on the Use 

of Electronic Communications in International Contracts, G.A. Res. 60/21, U.N. GAOR, 60th Sess., Supp. 

No. 49, U.N. Doc. A/RES/60/21 (Dec. 6, 2005), available at 

http://www.uncitral.org/pdf/english/texts/electcom/06-57452_Ebook.pdf. 

27. United Nations Convention on International Bills of Exchange and International Promissory 

Notes, Dec. 9, 1988, 28 I.L.M. 177 (1989), available at 

http://www.uncitral.org/pdf/english/texts/payments/billsnotes/X_12_e.pdf; UNCITRAL Model Law on 

International Credit Transfers, 32 I.L.M. 587 (1992), available at 

http://www.uncitral.org/pdf/english/texts/payments/transfers/mi-credittrans.pdf; United Nations 

Convention on Independent Guarantees and Stand-by Letters of Credit, Dec. 11, 1995, 2169 U.N.T.S. 190, 

35 I.L.M. 735, available at http://www.uncitral.org/pdf/english/texts/payments/guarantees/guarantees.pdf; 

United Nations Convention on the Assignment of Receivables in International Trade, Dec. 12, 2001, G.A. 

Res. 56/81, U.N. GAOR, 56th Sess., U.N. Doc. A[RES/56/81 (2002), available at 

http://www.uncitral.org/pdf/english/texts/payments/receivables/ctc-assignment-convention-e.pdf. 

28. UNCITRAL LEGAL GUIDE ON DRAWING UP INTERNATIONAL CONTRACTS FOR THE 

CONSTRUCTION OF INDUSTRIAL WORKS, U.N. Doc. A/CN.9/SER.B/2, U.N. Sales No. E.87.V.10 (1987), 

available at http://www.uncitral.org/pdf/english/texts/procurem/construction/Igconstr-e.pdf; UNCITRAL 

Model Law on Procurement of Goods and Construction with Guide to Enactment (1993), available at 

http://www.uncitral.org/pdf/english/texts/procurem/proc93/proc93.pdf; UNCITRAL Model Law on 

Procurement of Goods, Construction and Services, with Guide to Enactment, U.N. Doc. AICN.9/403 (1994), 

available at http://www.uncitral.org/pdf/english/texts/procurem/ml-procurement/m-procure.pdf; 

UNCITRAL LEGISLATIVE GUIDE ON PRIVATELY FINANCED INFRASTRUCTURE PROJECTS, U.N. Doc. 

A/CN.9/SER.B/4, U.N. Sales No. E.01.V.4 (2000), available at 

http://www.uncitral.org/pdf/english/texts/procurem/pfip/guide/pfip-e.pdf; MODEL LEGISLATIVE 

PROVISIONS ON PRIVATELY FINANCED INFRASTRUCTURE PROJECTS, U.N. Sales No. E.04.V.11 (2003), 

available at http://www.uncitral.org/pdf/english/texts/procurem/pfip/model/annexl-e.pdf. 

29. United Nations Convention on the Carriage of Goods by Sea, Mar. 31, 1978, 1695 U.N.T.S. 3, 17 

I.L.M. 608, available at http://www.uncitral.org/pdf/english/texts/transport/hamburg/Xl-d-3-e.pdf (referred 

to as the Hamburg Rules); Unit of Account Provision and Provisions for the Adjustment of the Limit of 

Liability in International Transport and Liability Conventions (1982); United Nations Convention on the 

Liability of Operators of Transport Terminals in International Trade, Apr. 19, 1991, 30 I.L.M. 1503, 

available at http://www.uncitral.org/pdf/english/texts/transport/ott/X_13-e.pdf. 


2007 


UNCITRAL working groups, whose topics range from insolvency 3 and secured 

transactions 32 to electronic commerce, procurement, transport law, and international 

arbitration and conciliation 3 Consistent with its mandate to coordinate legal 

activities among international organizations working in the field of international 

trade law,- UNCITRAL also partners loosely from time to time with entities such as 

the Hague Convention, the World Bank and the International Monetary Fund 

(IMF) for the drafting and implementation of core areas of commercial law in 

transitional and developing countries. 3 

Table 1 lists UNCITRAL's work product over time. It also lists the legal 

technologies UNCITRAL employed for these projects. Table 1 demonstrates that 

UNCITRAL has historically relied on model laws and conventions to communicate 

to domestic legislatures. Over time, it has adopted two sets of rules, seven 

conventions, two recommendations, two sets of model legal provisions, eight model 

laws (four of which it combined with guides to enactment), one legal guide and one 

set of notes. Of the twenty-five international instruments produced by UNCITRAL 

since its inception, fifteen constitute model laws or conventions. When we focus 

exclusively on legal technologies directed to domestic legislatures and other public 

audiences, however, these technologies nearly uniformly have taken the form of 

conventions, model laws or model legal provisions (with three exceptions). On this 

ground, we exclude UNCITRAL's product on arbitration and conciliation from the 

count, since these media are directed to private parties, including international 

arbitrators, rather than domestic legislatures. Similarly, we exclude UNCITRAL's 

Legal Guide on Drawing Up International Contracts for the Construction of 

Industrial Works for nearly the same reason: it is directed to contracting parties, 

although in this case the intended audience includes both private parties and 

government agencies drafting construction contracts with an international focus. 

When it has spoken to domestic legislatures, UNCITRAL has overwhelmingly 

chosen to speak through conventions (of which it has produced seven), model laws 

(of which there are eight) and model legal provisions (of which there exist two sets). 

The only exceptions to this general observation include one recommendation (on the 

30. UNCITRAL, UNCITRAL MODEL LAW ON CROSs-BORDER INSOLVENCY WITH GUIDE TO 

ENACTMENT, U.N. Sales No. E.99.V.3 (1997), available at 

http://www.uncitral.org/pdf/english/texts/insolven/insolvency-e.pdf; see also INSOLVENCY GUIDE, supra 

note 15. 

31. For a list and description of the ongoing work of the Insolvency Working Group, see Working 

Group V, http://www.uncitral.org/uncitral/en/commission/working__groups/51nsolvency.html (last visited 

June 4, 2007). 

32. The Working Group on Secured Transactions Law began its work on the Secured Transactions 

Guide in 2000 and projects the guide's completion in late 2007. For a list and description of the ongoing 

work of the Secured Transactions Working Group, see Working Group VI, 

http://www.uncitral.org/uncitral/en/commission/working-groups/6Security-Interests.html (last visited June 

4, 2007). 

33. For a description of Working Groups I, II, III, and IV and their ongoing projects and draft work 

product, see Working Groups, http://www.uncitral.org/uncitral/en/commission/working-groups.html (last 

visited June 4, 2007). 


35. For a description of UNCITRAL's coordination with other international organizations, see 

Coordination of Work on International Trade Law, 

http://www.uncitral.org/uncitral/en/tac/coordination.html (last visited June 4, 2007). 


TEXAS INTERNATIONAL LAW JOURNAL VOL. 42:475 

Legal Value of Computer Records) and two legislative guides (one on Privately 

Financed Infrastructure Projects and another on Insolvency Law). 

UNCITRAL's reliance on conventions, model laws and model legal provisions 

seem well matched with its core mission to produce "the progressive harmonization 

and unification of the law of international trade." 36 Conventions necessarily unify 

the law that a convention covers, at least for those nations who accede to it; where 

numerous countries agree to be bound by the terms of the convention, the 

unification of law follows a broad path. Model laws can have similarly unifying 

effects, although only where national legislatures implement the model law 

provisions by adopting domestic legislation that closely tracks the model law. 7 

Because model laws are not self-executing in that they depend upon national 

legislatures to adopt implementing legislation for their effectiveness, they intrude 

less on national sovereignty. 38 In permitting national legislatures greater freedom to 

adjust the model law provisions to local social and political demands, model laws risk 

non-uniformity. 39 Where implementing legislation differs only in small ways from 

the model law, however, the distinction between a convention and a model law 

pertains not so much to the uniformity of the resulting legal rules but to the number 

of countries who agree to be bound.' The assumption is that fewer nations will sign 

and ratify a convention, given the lack of flexibility on its terms, than will support 

UNCITRAL's promulgation of a model law and adopt their own implementing 

legislation. 

36. G.A. Res. 2205 (XXI), supra note 1, pt. I. 

8. The Commission shall further the progressive harmonization and unification of the law of 

international trade by: 

(c) Preparing or promoting the adoption of new international conventions, model laws and 

uniform laws and promoting the codification and wider acceptance of international trade terms, 

provisions, customs and practices, in collaboration, where appropriate, with the organizations 

operating in this field.... 

G.A. Res. 2205 (XXI), supra note 1, para. 8. 

37. For a similar statement of the relationship between unification and conventions, harmonization, 

and model laws, see FAQ - Origin, Mandate and Composition of UNCITRAL, supra note 5 ("A model 

law or a legislative guide is an example of a text which is drafted to harmonize domestic law, while a 

convention is an international instrument which is adopted by States for the unification of the law at an 

international level."). 

38. UNCITRAL's secretariat describes a model law in the following terms: 

A model law is a legislative text that is recommended to States for adoption as part of their 

national law. In incorporating the text of the model law in its system, a State may tailor the text 

of the law to its needs and, if appropriate, modify or leave out some of its provisions. 

UNCITRAL, Possible Future Work on Insolvency Law, supra note 8, para. 162. 

39. See id. para. 162-63 ("A model law is an appropriate vehicle for modernization and unification of 

national laws when it is expected that States will wish or need to make adjustments to the uniform text to 

accommodate local requirements that vary from system to system, or where strict uniformity is not 

necessary."). 

40. In some instances, UNCITRAL understood from the promulgation of a model law that States 

would deviate from the text of the model. See UNCITRAL, Possible Future Work on Insolvency Law, 

supra note 8, paras. 165-66. 


2007 


TABLE 1. UNCITRAL WORK PRODUCTS AND LEGAL TECHNOLOGIES, 

1976-2005 

Year UNCITRAL Work Product Legal Technology 

1974 Convention on the Limitations Convention 

Period in the International Sales of 

Goods 

1976 Arbitration Rules Rules 

1978 Convention on the Carriage of Convention 

Goods by Sea (the "Hamburg 

Rules") 

1980 Conciliation Rules Rules 

1980 Convention on Contracts for the Convention 

International Sale of Goods 

1982 Recommendations to assist arbitral Recommendations 

institutions and other interested 

bodies with regard to arbitrations 

under the UNCITRAL Arbitration 

Rules 

1982 Unit of Account Provision and Model legislative provisions 

Provisions for the Adjustment of the 

Limit of Liability in International 

Transport and Liability Conventions 

1983 Uniform Rules on Contract Clauses Rules 

for an Agreed Sum Due to Failure of 

Performance 

1985 Model Law on International Model law 

Commercial Arbitration 

1985 Recommendation on the Legal Recommendation 

Value of Computer Records 

1987 Legal Guide on Drawing Up Legal guide 

International Contracts for the 

Construction of Industrial Works 

1988 Convention on International Bills of Convention 

Exchange and International 

Promissory Notes 

1991 Convention on the Liability of Convention 

Operators of Transport Terminals in 

International Trade 

1992 Model Law on International Credit Model law 

Transfers 

1992 Legal Guide on International Legal guide 



VOL. 42:475 

Counter-Trade Transactions 

1993 Model Law on Procurement of Model law + guide to 

Goods and Construction with Guide 

enactment 

to Enactment 

1994 Model Law on Procurement of Model law + guide to 

Goods, Construction and Services, 

enactment 

with Guide to Enactment 

1995 Convention on Independent Convention 

Guarantees and Stand-by Letters of 

Credit 

1996 Notes on Organizing Arbitral Notes 

Proceedings 

1996 Model Law on Electronic Commerce Model law + guide to 


enactment 

1997 Model Law on Cross-Border Model law + guide to 

Insolvency with Guide to Enactment 

enactment 

2000 Legislative Guide on Privately Legislative guide 

Financed Infrastructure Projects 

2001 Model Law on Electronic Signatures Model law + guide to 


enactment 

2001 Convention on the Assignment of Convention 

Receivables in International Trade 

2002 Model Law on International Model law + guide to 

Commercial Conciliation with Guide enactment and use 

to Enactment and Use 

2003 Model Legislative Provisions on Model legislative provisions 

Privately Financed Infrastructure 

Projects 

2005 Convention on the Use of Electronic Convention 

Communications in International 

Contracts 

2005 Legislative Guide on Insolvency Law Legislative guide 

Table 1 also demonstrates that conventions and model laws retain importance 

even today, evidencing UNCITRAL's continued commitment to the goals of 

unification and harmonization. UNCITRAL promulgated six conventions between 

1978 and 2005. 41 Its reliance on model laws is also evenly spread over time; between 

1982 and 2003, UNCITRAL adopted ten model laws or model legislative 

provisions." Table 1 does not, however, demonstrate any obvious correlation 

between whether UNCITRAL chose to rely on a convention or model law and the 

subject matter of the instrument. Every Working Group has produced at least one 

model law. UNCITRAL was most likely to rely on conventions when international 

41. See supra Table 1 (listing conventions promulgated by UNCITRAL during that time period). 

42. Id. (listing model laws developed by UNCITRAL during that time period). 


2007 


transport of goods 3 and international payments" were the topic, but there are also 

conventions regarding electronic commerce 5 and the international sales of goods. 46 

Indeed, since 2000, UNCITRAL's work has been fairly evenly divided between 

conventions (2), model laws (3) and legislative guides (2). 

When we look at UNCITRAL's ongoing work, we see a similar pattern. There 

are six Working Groups, five of which met during 2006 and 2007. Working Groups 

I, 1I, and III are engaged in revisions to an earlier UNCITRAL model law or 

convention. Working Group I (procurement and project finance) continues to meet 

to discuss possible revisions to the UNCITRAL Model Law on Procurement of 

Goods, Construction and Services. 8 Working Group II (international arbitration 

and conciliation) actively is considering revisions to the UNCITRAL Arbitration 

Rules. 49 Moreover, in its meeting in June and July of 2006, the Commission adopted 

amendments to the Model Law on International Commercial Arbitration that 

Working Group II had approved in its earlier meetings: ° Working Group III 

(transport law) is engaged in a review of a draft convention on the carriage of goods 

by sea." Only Working Groups V (insolvency) and VI (secured transactions) are not 

working on revisions to a model law or convention. The Secured Transaction 

Working Group has been working steadily since 2000 on its Legislative Guide on 

Secured Transactions Law, with its work projected to be complete by some time in 

2007 or 2008.2 Following ratification of its Legislative Guide on Insolvency Law by 

the Commission and the UN's General Assembly, UNCITRAL directed the 

Insolvency Working Group to consider three additional topics: the treatment of 

corporate groups, particularly in cross-border insolvency proceedings; financing of 

cross-border insolvency proceedings; and court-to-court communication and the use 

of protocols in cross-border insolvency proceedings. 3 

43. See supra note 29 (listing UNCITRAL conventions dealing with the international transport of 

goods). 

44. See supra note 27 (indicating that there are three conventions and one model law on the topic of 

international payments). 

45. See supra note 26 (indicating that UNCITRAL has promulgated one convention concerning 

electronic commerce). 

46. See United Nations Convention on Contracts for the International Sale of Goods, supra note 23. 

47. See supra Table 1 (listing conventions, model laws, and legislative guides created by 

UNCITRAL). This does not count work in progress, and so does not include ongoing work on the 

Legislative Guide on Secured Transactions Law, for example. 

48. For a description of UNCITRAL's ongoing work on procurement, see Working Group I, 

http://www.uncitral.org/uncitrallen/commissionlworking-groups/lProcurement.html (last visited June 4, 

2007). 

49. For a description of UNCITRAL's ongoing work on arbitration, see Working Group II, 

http://www.uncitral.org/uncitral/en/commission/working-groups/2Arbitration.html (last visited June 4, 

2007). 

50. Id. 

51. For a description of the UNCITRAL's ongoing work on transport law, see Working Group III, 

http://www.uncitral.org/uncitrallen/commissionlworking__groups/3Transport.html (last visited June 4, 2007). 

52. See G.A. Res. 2205 (XXI), supra note 1. 

53. For a description of the ongoing work of the Insolvency Working Group, see Working Group V, 

supra note 31. Despite having met twice, it remains unclear whether the Group conceives of its mandate as 

one to draft a legislative guide or other document. 



VOL. 42:475 

A. The Shift Toward Modernization 

What can be said about UNCITRAL's work that did not take the form of a 

convention or a model law but still was addressed to legislatures and national actors 

(rather than private parties)? For instance, what of the Recommendation on the 

Legal Value of Computer Records, promulgated by UNCITRAL in 1985? We view 

this Recommendation as UNCITRAL's first effort at modernizing the law of trade, 

and note that with this international instrument UNCITRAL walked very gingerly 

into the topic of automatic data processing, computer records and electronic 

communications. Comprising no more than two pages in length, it amounts to little 

more than a "Recommendation" to "Governments" that they review their "legal 

rules affecting the use of computer records as evidence in litigation in order to 

eliminate unnecessary obstacles to their admission," as well as any "legal 

requirements" that "trade related documents" or "documents for submission to 

governments" be "in writing" or signed." The preamble paragraphs of the 

Recommendation make clear that, although the commercial practices associated 

with electronic communications were rapidly changing, domestic commercial laws 

had not. 55 Because there were no existing domestic laws on the books, there was 

nothing particular to harmonize; instead, there was a sense that the technology was 

poised to mushroom in importance and a fear that international trade would be held 

back if commercial law was not brought up to speed with these commercial practices. 

The case for "in with the new" modernization was, thus, first made with this 

Recommendation. 

The concepts of electronic commerce and, indeed, of UNCITRAL as an agent 

of modernization, were so new that eleven years passed before UNCITRAL next 

spoke on the topic of the computerization of commercial practices, 6 but since then, 

UNCITRAL has promulgated two model laws and one convention on the topic 57 and 

54. UNCITRAL Recommendation on the Legal Value of Computer Records, supra note 26. 

55. Id. It reads: 

Noting that the use of automatic data processing (ADP) is about to become firmly established 

throughout the world in many phases of domestic and international trade as well as in 

administrative services, [and] 

Noting also that legal rules based upon pre-ADP paper-based means of documenting 

international trade may create an obstacle to such use of ADP in that they lead to legal 

insecurity or impede the efficient use of ADP where its use is otherwise justified .... 

Id. 

56. It may be unfair to say that UNCITRAL waited eleven years to speak on the topic of electronic 

communications. The Model Law on International Commercial Arbitration, promulgated in 1985, broadly 

defines a "writing" to include communications in an electronic format. UNCITRAL Model Law on 

International Commercial Arbitration, supra note 25. Similarly, UNCITRAL's Legal Guide on Electronic 

Funds Transfers (1987) and Model Law on International Credit Transfers (1992) focused on the needs of 

electronic commerce. UNCITRAL LEGAL GUIDE ON ELECTRONIC FUNDS TRANSFERS, Sales No. 

E.87.V.9 (1987); UNCITRAL Model Law on International Credit Transfers, supra note 27; see 

UNCITRAL MODEL LAW ON ELECTRONIC SIGNATURES WITH GUIDE TO ENACTMENT, supra note 26, at 

9 (discussing the background to the UNCITRAL Model Law on Electronic Signatures with Guide to 

Enactment). 

57. In 1996, UNCITRAL adopted a Model Law on Electronic Commerce with Guide to Enactment; 

in 2001, it promulgated the Model Law on Electronic Signatures with Guide to Enactment. UNCITRAL 

MODEL LAW ON ELECTRONIC COMMERCE WITH GUIDE TO ENACTMENT, supra note 26; UNCITRAL 

MODEL LAW ON ELECTRONIC SIGNATURES WITH GUIDE TO ENACTMENT, supra note 26. Most recently, 


2007 


the term "modernization" is regularly employed with reference to these instruments 

and the topic of electronic communication and electronic commerce. For example, 

the UNCITRAL Model Law on Electronic Commerce explains its history and 

background as "prepared in response to a major change in the means by which 

communications are made between parties using computerized or other modern 

techniques in doing business" 58 and, thus, "to enhance the needed modernization of 

legislation." 59 The Guide to Enactment of the Model Law on Electronic Commerce 

also employs the rhetoric of modernization, explaining the need both for the Model 

Law ° and for the accompanying Guide to Enactment 6 ' in terms of a need to 

modernize. Similarly, the UNCITRAL Model Law on Electronic Signatures notes, 

in its Guide to Enactment, that it "is designed to assist States in establishing a 

modern, harmonized and fair legislative framework to address more effectively the 

issues of electronic signatures., 62 The United Nations Convention on the Use of 

Electronic Communications in International Contracts also justifies its need on the 

grounds that it "may help States gain access to modern trade routes."" 

An interest in the modernization of trade law, including revisions to existing 

UNCITRAL product, currently dominates the Working Groups' work in progress 

and, frequently, the focus is on "in with the new" modernization intended to enable 

reliance on recent applications of electronic media to new industries. For example, 

among the reasons Working Group I (procurement and project finance) provides for 

its consideration of revisions to the Model Law on Procurement of Goods, 

Construction and Services is the need to add provisions in the Model Law addressing 

procurement by electronic means (for example, by email or over the Internet). 

Similarly, Working Group II (international arbitration and conciliation) proposed 

in 2005, the UN adopted its Convention on the Use of Electronic Communications in International 

Contracts. United Nations Convention on the Use of Electronic Communications in International 

Contracts, supra note 26; see supra Table I (listing the above provisions with dates of enactment). 

58. UNCITRAL MODEL LAW ON ELECTRONIC COMMERCE WITH GUIDE TO ENACTMENT, supra 

note 26, at 64. 

59. Id. at 67. 

60. Id. at 16 (describing the objectives of the Model Law as premised on the emergence of this 

"modern" technology: "The use of modern means of communication such as electronic mail and electronic 

data interchange (EDI) for the conduct of international trade transactions has been increasing rapidly and 

is expected to develop further as technical supports such as information highways and the INTERNET 

become more widely accessible."); id. at 64 (explaining the history and background of the Model Law as 

follows: "The Model Law is intended to serve as a model to countries for the evaluation and modernization 

of certain aspects of their laws and practices in the field of commercial relationships involving the use of 

computerized or other modern communication techniques, and for the establishment of relevant legislation 

where none presently exist."). 

61. Id. at 15 (explaining the need for a Guide to Enactment on the grounds that "the Model Law 

would be a more effective tool for States modernizing their legislation if background and explanatory 

information would be provided to executive branches of Governments and legislators to assist them in 

using the Model Law"). This Guide to Enactment also as much as admits harmonization had no role in its 

provisions. Id. at 16 ("While a few countries have adopted specific provisions to deal with certain aspects 

of electronic commerce, there exists no legislation dealing with electronic commerce as a whole."). 

62. UNCITRAL MODEL LAW ON ELECTRONIC SIGNATURES WITH GUIDE TO ENACTMENT, supra 

note 26, at 8. 

63. United Nations Convention on the Use of Electronic Communications in International Contracts, 

supra note 26, at 1, 25 ("Convinced that the adoption of uniform rules to remove obstacles to the use of 

electronic communications in international contracts, including obstacles that might result from the 

operation of existing international trade law instruments, would enhance legal certainty and commercial 

predictability for international contracts and help States gain access to modern trade routes ... "). 



VOL. 42:475 

amendments to the Model Law on International Commercial Arbitration and is 

considering revisions to UNCITRAL's Arbitration Rules partly to address issues 

raised by online dispute resolution. In addition, the work of Working Group III 

(international transport) on a draft convention on the carriage of goods by sea 

addresses, among other issues, questions regarding the validity and enforceability of 

electronic transportation documents. 

References to the need for modernization are not limited to "in with the new" 

modernization. In its 1999 report on Possible Future Work on Insolvency Law, the 

UNCITRAL Secretariat noted that an important justification for authorizing the 

Working Group on Insolvency Law to begin its work on the Legislative Guide on 

Insolvency Law "was to modernize insolvency practices and laws. '' M With this 

reference, the term "modernization" took on a new meaning. Unlike UNCITRAL 

work to modernize commercial laws so that they reflect modern commercial 

practices involving electronic means of communication and commerce, the 

Legislative Guide on Insolvency Laws sought to "modernize insolvency practices 

and laws" by recommending to national actors that they replace their existing 

domestic insolvency laws with more modern ones. "Out with the old" 

modernization is not limited to insolvency reform. Similarly, a 2000 report on the 

then-current activities and possible future work of the Working Group on Secured 

Transactions justified authorizing it to begin work on the Legislative Guide on 

Secured Transactions Law on the grounds that "modernization and optimization of 

secured credit law can lead to expanded economic development and, therefore, 

promote the general welfare., 6 1 In every year since 2000, the Commission's yearly 

report to the UN General Assembly reaffirms "its belief that the progressive 

modernization and harmonization of international trade law" both "reduce[es] or 

remov[es] legal obstacles to the flow of international trade" and "contribute[s] 

significantly to universal economic cooperation among all States on a basis of 

equality, equity and common interest .... 

By now, UNCITRAL has incorporated the modernization of the law of 

international trade within its core mission. Although the term "modernization" 

nowhere appears in the UN Resolution establishing UNCITRAL, 67 UNCITRAL's 

mandate to "modernize" the law of international trade has become deeply ingrained 

in the ethos of the Commission - so much so that UNCITRAL describes its 

64. UNCITRAL, Possible Future Work on Insolvency Law, supra note 8, para. 2. 

65. UNCITRAL, Working Group on Secured Transactions Law, Security Interests: Current Activities 

and Possible Future Work, para. 45, U.N. Doc. A/CN.9/475 (April 27, 2000) [hereinafter UNCITRAL, 

Security Interests], available at http http://www.uncitral.org/uncitral/en/commission/sessions/33rd.html 

(follow "A/CN.9/475 - Security Interests - Current activities and possible future work" hyperlink). 

66. G.A. Res. 58/75, U.N. GAOR, 58th Sess., Supp. No. 17, U.N. Doc. A/RES/58/75 (Dec. 9, 2003), 

available at http://www.uncitral.org/uncitral/en/GA/resolutions.html (follow "A/RES/58/75" hyperlink). 

Similar language appears in the General Assembly resolutions to adopt the Commission's reports on 

sessions between 2000 and 2005. The reference to "modernization" does not appear in reports pre-dating 

2000. The report reaffirms "its convictions that the progressive harmonization and unification of the law of 

international trade" would both "reduce[e] or remov[e] legal obstacles to the flow of international trade" 

and "contribute significantly to universal economic cooperation among all States on a basis of equality... 

Id. For a complete list of these reports of the General Assembly, see General Assembly Resolutions, 

http://www.uncitral.org/uncitral/en/GA/resolutions.html (last visited June 4, 2007). 

67. See G.A. Res. 2205 (XXI), supra note 1, pt. I (establishing a UN Commission "which shall have 

for its object the promotion of the progressive harmonization and unification of the law of international 

trade .... ). Perhaps the term "modernization" derives from emphasis on the need for "progressive" 

harmonization and unification of trade law. 


2007 


"business" as "the modernization and harmonization of rules on international 

business." ' 

This focus on the modernization of the law of trade infuses more than 

UNCITRAL's substantive choices about what projects to adopt. It also affects the 

legal technologies through which UNCITRAL articulates its recommendations to 

domestic legislatures. The development of more flexible international technologies 

derives in part from the expanded list of topics on which UNCITRAL has focused. 

In a 1981 Report to the Commission, UNCITRAL's Secretariat reports success on 

its initial "four fields of interest: the law of international sales of goods, carriage of 

goods by sea, international negotiable instruments and international commercial 

arbitration." 69 In each of these fields, the Secretariat reported the adoption of 

"comprehensive texts," but went on to opine that "[t]he subject matter of the 

Commission's new programme of work does not always require a comprehensive 

solution. The difference in magnitude of the problems considered may have an 

impact of the final form which the Commission's work might take." 70 Specifically, 

the Secretariat suggested that, if it was not feasible for the Commission to propose 

"a text ready for adoption," then it might instead adopt a "guidelines approach" on 

the grounds that "the development of guidelines or recommendations may be an 

appropriate first objective, leaving until later a decision as to whether further actions 

are desirable." 7 By 1985, UNCITRAL promulgated its Recommendation on the 

Legal Value of Computer Records. 72 

Neither a convention nor a model law would seem appropriate tools when law 

reform looks to reject out-moded law in favor of new, more modern text. These 

sorts of international instruments are ill-suited to suggesting that national actors to 

reform existing bodies of law because, to some degree, they demand adherence to 

the terms of the international instrument. For example, national actors face a binary 

choice with regard to a convention: accede to the terms of the convention in full or 

fail to follow it at all. Model laws permit slightly greater freedom, in that domestic 

legislatures may adopt implementing legislation that fails to adopt all of the 

provisions of the model law, but it stretches the concept of a "model" law to invite 

68. Welcome to the UNCITRAL Web Site, supra note 2. A similar statement appears at the index to 

UNCITRAL's website. Welcome to the UNCITRAL Web Site: Highlights, 

http://www.uncitral.org/uncitral/index.html. The "frequently asked questions" section of the website 

defines both "harmonization" and "unification" and provides examples of each. FAQ - Origin, Mandate 

and Composition of UNCITRAL, supra note 5. However, nowhere does the website define 

"modernization." 

69. The Secretary-General, Report of the Secretary-General on the Question of Co-ordination: 

Direction of the Work of the Commission, at 251, U.N. Doc. A/CN.9/203 (1981), available at 

http://daccessdds.un.org/doc/UNDOC/GEN/NL8/102/43/PDF/NL810243.pdf?OpenEement. 

70. Id.. 

71. Id.; see also id. at 252 (further discussing advantages and disadvantages of conventions, model 

laws, and recommendations). 

72. We do not claim that UNCITRAL has not relied on conventions or model laws when it seeks to 

"modernize" global commercial laws to accord with modern commercial practices: it has. For examples of 

"in with the new" modernization accomplished by means of conventions and model laws, see supra note 26 

(referring to Model Law on Electronic Commerce with Guide to Enactment (1996); Model Law on 

Electronic Signatures with Guide to Enactment (2001); and United Nations Convention on the Use of 

Electronic Communications in International Contracts (2005)). Our claim is that recommendations, 

legislative guides, and other more flexible international instruments have been instrumental in 

UNCITRAL's shift from the harmonization and unification to the modernization and harmonization of 

trade law, not that they are a necessary requisite for modernization. 



VOL. 42:475 

national actors to pick and choose among the provisions of a model law. Not 

surprisingly, then, we find that both the Insolvency and Secured Transactions 

Working Groups consciously chose to work on legislative guides rather than a model 

law or convention. 7 In its Reports to the Working Groups on Possible Future Work 

on Insolvency and Secured Transactions Laws, intended to convince the Commission 

to take on the task of drafting these legislative guides, UNCITRAL's Secretariat 

talks openly about the need for flexibility in modernizing these areas of the law, 

particularly in light of the global dissensus the drafters faced. Both reports 

emphasize the need for a legislative guide rather than a convention or model law. 

When reporting to the Working Group on Insolvency Law, the Secretariat put 

the issue this way: 

It is not always possible to draft specific uniform provisions in a suitable 

form, such as a convention or a model law, for incorporation into national 

legal systems. One reason may be, for example, that national legal systems 

use widely disparate legislative techniques and approaches for solving a 

given issue, or that States are not yet ready to agree on a common 

approach or a common rule. A further reason may be that not all States 

perceive a sufficiently urgent need to find a uniform solution to a 

particular issue. 74 

In this event, "it may be appropriate not to attempt to elaborate a text in the form of 

a model statute, but to limit the action to a set of principles or legislative 

recommendations." 7 In other words, given the Working Group's need for flexibility, 

it may be best to produce a legislative guide rather than a model law. 

A similar debate on the form of reform occurred within the Secured 

Transactions Working Group. Before beginning to draft the Legislative Guide on 

Secured Transactions Law, Working Group VI debated the merits of a "convention 

unifying substantive rules governing security interests," a "convention establishing 

uniform conflict rules," a "convention or model law creating an international 

security interest," a "statement of principles accompanied by a model law," and 

"more limited solutions," such as a "statement of principles accompanied by a legal 

guide. 7 6 The Secured Transactions Working Group favored the latter both because 

"at present the national legal systems are still too divergent" and because a 

convention or model law would not be "flexible enough to take into account the 

varying circumstances of the countries of the world.... " 7 7 

73. However, legislative guides are the invention of neither the Working Group on Insolvency nor on 

Secured Transactions Law. UNCITRAL promulgated earlier legislative guides with its 1987 Legal Guide 

on Drawing up International Contracts for the Construction of Industrial Works and, later, in 2000, its 

Legislative Guide on Privately Financed Infrastructure Projects. In this arena, the Legislative Guide on 

Privately Financed Infrastructure Projects served as a stepping stone toward the adoption of Model 

Legislative Provisions on Privately Financed Infrastructure Projects. The preface to the Model Legislative 

Provisions explains the relationship between the Legislative Guide and the provisions as clear cut. 

UNCITRAL MODEL LEGISLATIVE PROVISIONS ON PRIVATELY FINANCED INFRASTRUCTURE PROJECTS, 

supra note 28, at iii. Work on the Model Legislative Provisions followed nearly on the heels of the Guide, 

although it was agreed to carve out several subjects from the scope of topics previously covered in the 

Guide for fear that consensus would not be reached on these topics in the Model Legislative Provisions. 

74. UNCITRAL, Possible Future Work on Insolvency Law, supra note 8, para. 167. 

75. Id. para. 168. 

76. UNCITRAL, Security Interests, supra note 65, paras. 46-62. 

77. Id., para. 46. 


2007 


B. Redefining Harmonization to Meet the Challenges of Modernization 

UNCITRAL reconciled its goal to promote "in with the new" and "out with the 

old" modernization with its core mission - the "progressive harmonization and 

unification" of the law of trade-by expanding the definition of harmonization to 

subsume modernizing law reform. Currently, UNCITRAL defines harmonization 

"as the process through which domestic laws may be modified to enhance 

predictability in cross-border commercial transactions," 78 but it did not always 

conceive of harmonization so expansively. 

UN documents pre-dating the creation of UNCITRAL define "harmonization" 

in a way that approximates or, at least, approaches "unification." In the year before 

UNCITRAL was created, the UN General Assembly requested the Secretary- 

General to submit to it a comprehensive report on the need for UNCITRAL. 9 This 

Resolution 2102 (XX) explained the UN's preliminary interest in establishing a UNconnected 

international organization on trade law as based on a recognition "that 

conflicts and divergencies arising from the laws of different States in matters relating 

to international trade constitute an obstacle to the development of world trade... 

.,," It described the mission of such an organization as focused on the "progressive 

unification and harmonization""' of trade law "by promoting the adoption of 

international conventions, uniform laws, standard contract provisions, general 

conditions of sale, standard trade terms and other measures .... ,"2 

In response to Resolution 2102 (XX), the Secretary-General commissioned a 

report from Prof. Clive M. Schmitthoff of the City of London College, a prominent 

scholar on the law of international trade and conflicts of law, and, in September 

1966, Prof. Schmitthoff submitted a lengthy report to the Secretary-General. 83 Like 

Resolution 2102 (XX), the Schmitthoff Report referred to "the progressive 

harmonization and unification of the law of international trade . . . ."" It referred to 

"harmonization" as a technique for "reduc[ing] conflicts and divergencies arising [in] 

international trade [law]," 89 and described unification as "[tihe most effective 

78. FAQ - Origin, Mandate and Composition of UNCITRAL, supra note 5. This definition seems 

intended to disassociate "harmonization" from "unification." In the same "frequently asked questions" 

section of the UNCITRAL's website, we are told that "'[ulnification' may be seen as the adoption by 

States of a common legal standard governing particular aspects of international business transactions." Id. 

These definitions go on to distinguish harmonization from unification in terms of the international 

instruments most likely to be employed to pursue each interest: "A model law or a legislative guide is an 

example of a text which is drafted to harmonize domestic law, while a convention is an international 

instrument which is adopted by States for the unification of the law at an international level." Id. 

79. G.A. Res. 2102 (XX), U.N. GAOR, 20th Sess., Supp. No. 14, U.N. Doc. AJ6014 (Dec. 20, 1965), 

available at http://www.un.org/documents/ga/res/20/ares20.htm (follow "2102 (XX)" hyperlink). 

80. Id. 

81. Id. Note the inversion of these terms by the time Resolution 2205 (XXI) establishes UNCITRAL; 

this phrase shifts from "progressive unification and harmonization" to "progressive harmonization and 

unification." Compare G.A. Res. 2205 (XXI), supra note 1, with G.A. Res. 2102 (XX), supra note 79. 


83. See The Secretary-General, Report of the Secretary-General, para. 2, delivered to the General 

Assembly, U.N. Doc. A16396 & Add.1, Add.2 (Sept. 23, 1966), available at 

http://www.uncitral.org/pdf/english/yearbooks/archives-e/A-6396-E.pdf. 

84. Id. para. 8. 

85. Id. paras. 15-17 (surveying existing work in the field of harmonization and unification of the law of 

international trade and reviewing legal techniques employed in "reduc[ing] conflicts and divergencies 



VOL. 42:475 

method of conflict avoidance . . . "6 Implicit in the Schmitthoff Report is a view of 

harmonization as the convergence of legal rules toward a unified code of conduct; in 

this view, harmonization would, over the long run, approach a unification of legal 

rules. 

This substance-focused definition of harmonization also permeates UN 

Resolution 2205 (XXI), which subsequently established UNCITRAL. When it 

created UNCITRAL, the General Assembly "[r]eaffirm[ed] its conviction that 

divergencies arising from the laws of different States in matters relating to 

international trade constitute one of the obstacles to the development of world 

trade. ' ' w The decision to establish a Commission was based on a belief that "the 

extensive development of international trade" was best advanced by removing 

"divergencies arising from the laws of different States," differences which would 

dissipate "by promoting the adoption of international conventions, uniform laws, 

standard contract provisions, general conditions of sale, standard trade terms and 

other measures.... "8 This is a "hard" definition of harmonization that views 

harmonization in terms of the convergence of non-uniform national laws around an 

agreed upon international standard. It is at the same time, however, a definition of 

harmonization couched in terms of the pragmatic and progressive ends it envisions: 

harmonization is sought in order to enable international trade and not for its own 

sake; international trade is viewed as favoring "the interests of all peoples" and 

"particularly those of developing countries" because "international trade cooperation 

among States is an important factor in the promotion of friendly relations 

and, consequently, in the maintenance of peace and security.....90 

Even this "hard" definition of harmonization leaves room for ambiguity. Did 

UNCITRAL view harmonization as intended to remove all dissensus among 

national laws, or simply to reduce the number of divergencies and their impact on 

international trade? Some support for a "unification over time" definition of 

harmonization can be found in the form of legal technologies employed by 

UNCITRAL: Conventions look for a single set of principles or legal rules that can 

garner international agreement; a model law differs from a convention more in terms 

of its means of implementation than in the number of options and alternatives it 

arising [in] international trade [law]" and finding two basic techniques: "choice of law rules" and the 

"harmonization and unification of substantive rules"). 

86. Id. para. 18. The Schmitthoff Report refers to "harmonization and unification" as the 

",preventive' method" of private international law because it "has the purpose of avoiding law conflicts" 

thus preventing the need to rely on choice of law rules. Id. para. 17. It describes both harmonization and 

unification as achievable because "[t]he similarity of the law of international trade transcends the division 

of the world between countries of free enterprise and countries of centrally planned economy, and between 

the legal families of the civil law of Roman inspiration and the common law of English tradition." Id. para. 

22. The report identifies the primary obstacles to harmonization and unification, not as dissensus in the 

law of trade, but rather the existence of a plethora of international law reforming institutions whose work 

overlapped and whose membership represented developed nations, predominantly in Europe and North 

America, and not developing nations. Id. para. 210. The Schmitthoff Report recommended the formation 

of a UN-related international law reform entity on the grounds that it would provide more inclusive 

representation of the nation's legal and economic systems and, thus, better coordinate among other 

international actors. Id. para. 225. His conception of UNCITRAL, thus, was primarily as a coordinating 

entity that derived the representative benefits of the UN. 

87. G.A. Res. 2205 (XXI), supra note 1, pt. I. 

88. Id. 

89. Id. 

90. Id. 


2007 


leaves open for national deliberation." UNCITRAL has relied predominantly on 

conventions and model laws when addressing national actors. We also find support 

for a "reduction of differences over time" perspective on harmonization, although 

evidence of this "softer" definition of harmonization emerges only slowly over time. 

UNCITRAL's first international instruments directed to national actors are 

conventions-namely, the Convention on the Limitations Period in the International 

Sales of Goods, the Convention on Carriage of Goods by Sea, and the Convention 

on Contracts for the International Sale of Goods, adopted in 1974, 1978, and 1980, 

respectively-but two years later, in 1982, UNCITRAL promulgated the Unit of 

Account Provision and Provisions for the Adjustment of the Limit of Liability in 

International Transport and Liability Conventions, model legal provisions but not a 

model law. Model legal provisions do not attempt to cover an area of commercial 

law in its entirety. Because they intentionally leave some portion of the topic for 

non-uniform national laws, they are best described as intended to reduce rather than 

eradicate divergencies among national laws; they look for harmony on only a limited 

set of issues. Nonetheless, model legal provisions do offer national actors a single set 

of options around which to converge. 

The next UNCITRAL product directed to a public audience, the 

Recommendation on the Legal Value of Computer Records, dated 1985, cannot be 

described as seeking either uniformity or harmonization on the topic of 

computerization in commercial transactions. As noted earlier, 92 the 

Recommendation speaks only in broad generalities and merely recommends that 

national actors review and update existing laws to account for technological 

developments. This Recommendation should not be viewed as a rejection by 

UNCITRAL of an interest in reaching international consensus on a single unified set 

of principles on the topics of computerization and electronic commerce, for the 

Recommendation was followed, nearly immediately, with a long string of 

conventions 93 and model laws. 4 We note, however, that the model law projects 

changed during this period. Beginning with the Model Law on Procurement of 

Goods and Construction, all subsequent model law projects are joined with an 

accompanying guide to enactment. 

91. But even this unifying ideal suffers from practical limitations. Neither conventions nor model laws 

are self-enforcing. Conventions require national actors to sign, ratify, and accede to the terms of the 

convention. Model laws leave even more discretion to national actors' decisions to abide by its terms; 

model laws are not binding on States unless domestic legislatures adopt implementing legislation. With 

either technology, uniformity is achieved one nation at a time, and, thus, "universally" only over time. 

Moreover, UNCITRAL's practice of consensual decisionmaking limits the extent of the uniformity that 

either form of international instrument can achieve. To reach consensus on the terms of a convention or 

model law, UNCITRAL may agree not to cover some more controversial topic; these gaps in the 

convention or model law permit divergent national practices to persist, contrary to the need for "one 

unified" rule on the topic. 

92. See supra notes 54-55 and accompanying text. 

93. These are the Convention on International Bills of Exchange and International Promissory Notes 

(1988), Convention on the Liability of Operators of Transport Terminals in International Trade (1991), 

and Convention on Independent Guarantees and Stand-by Letters of Credit (1995). See supra Table 1. 

94. These are the Model Law on International Credit Transfers (1992), Model Law on Procurement 

of Goods and Construction with Guide to Enactment (1993). Model Law on Procurement of Goods, 

Construction and Services, with Guide to Enactment (1994), Model Law on Electronic Commerce with 

Guide to Enactment (1996), and Model Law on Cross-Border Insolvency with Guide to Enactment (1997). 

See supra Table 1. 



VOL. 42:475 

We see UNCITRAL's reliance on guides to enactment as connected to its 

recognition of the pragmatic difficulties of promoting "the progressive 

harmonization and unification" of the law of trade by means of a model law. While 

on their face harmonizing, model laws reduce the divergencies among national laws 

only if national actors enact implementing legislation that replicates the terms of the 

model law. Guides to enactment are intended to explain the model law to a 

domestic legislature; they advocate enactment of implementing legislation. 

UNCITRAL recognized that national delegates' willingness to adopt the text of a 

convention or model law as an UNCITRAL product did not guarantee that their 

nations would accede to the terms of the convention or adopt legislation modeled on 

the UNCITRAL model law. 

If guides to enactment are used to bolster the "one rule" espoused in the model 

law, they would be consistent with a "unification over time" concept of 

harmonization, but UNCITRAL used its guides to enactment for other purposes, as 

well. Over time, UNCITRAL recognized that domestic legislatures could do more 

than enact legislation to implement a model law or reject its terms in toto. Where a 

Working Group could not reach consensus on some provisions in a model law, it 

needn't abandon the model law project in favor of a more limited set of model legal 

provisions that did not cover the field. For example, it could include alternative 

provisions in the model law (option A; option B), and leave it to domestic 

legislatures to choose between the two; 95 alternatively, a model law might on its face 

allow for domestic legislatures to adopt exclusions from its terms to reflect social or 

cultural norms contrary to the international norms expressed in the model law. 96 In 

this event, guides to enactment developed a secondary purpose: With a model law 

that offered an array of choices to national audiences, the accompanying guide to 

enactment explained how alternatives might work in practice and the competing 

policies and principles embedded in the choices offered. 

Alternative model law provisions and open-ended exclusions permitted by the 

terms of the model law promote a "softer," "reduction of differences over time" 

concept of harmonization. By 1999, UNCITRAL's Secretariat put the issue in this 

way: 

165. Within the category of model laws prepared by UNCITRAL, two 

texts, the Model Law on International Commercial Arbitration and the 

Model Law on Electronic Commerce, illustrate the flexibility of the form. 

The Model Law on International Commercial Arbitration, which could be 

described as a procedural instrument, provides a discrete set of interdependent 

articles. It is recommended that, in adopting the Model Law, 

very few amendments or changes are required. Deviations from the 

Model Law text have, as a rule, very rarely been made by countries 

adopting enacting legislation, suggesting that it has been widely accepted 

as a coherent model text. 

166. The Model Law on Electronic Commerce, on the other hand, is a 

more conceptual text. Legislation adopting or proposing to "enact" the 

95. See Working Group VI, supra note 32. 

96. See UNCITRAL MODEL LAW ON ELECrRONIC COMMERCE WITH GUIDE TO ENACTMENT, supra 

note 26, arts. 6-8, 11-12, 15, 17. 


2007 


Model Law largely reflects the principles of the text, but may depart from 

it in terms not only of drafting, but also in the combination of provisions 

adopted or proposed for adoption. As such, and so far as it is appropriate 

to distinguish between a model law and model provisions, the Model Law 

on Electronic Commerce perhaps can be regarded as establishing a set of 

model principles, which are drafted in the form of legislative provisions to 

facilitate consideration by legislators and assist in the development of 

laws. 97 

This is a pragmatic acceptance of the limitations of second-order 

decisionmaking in that these "more conceptual" model laws, such as the Model Law 

on Electronic Commerce, only indirectly and over the long haul accomplish the 

"harmonization" needed to promote international trade. This "conceptual" form of 

model law does not offer unification, even in the long run." But rather than despair 

of the inherent constraints of international lawmaking, UNCITRAL accepts these 

limits as part of the challenge. 

Once UNCITRAL shifts its gaze from the accepted wisdom that a convention 

unifies and a model law harmonizes to the notion that unification and harmonization 

are to be judged by looking, not at international instruments, but at domestic 

practices, it is only a small step to the conclusion that a legal technology, such as a 

legislative guide, might also harmonize domestic practices even though a legislative 

guide provides national actors with more than one or two options. A recognition 

that what matters is, not so much harmonization "on the books," but rather 

harmonization "in practice," might also constitute an acceptance that the form of 

"the book"-that is, the form of the legal technology or international instrument 

employed by the decisionmaking institution - is less important than its practical 

consequences. 

A changing context and a challenging diversity in the world's legal systems 

stimulated UNCITRAL to shift its mission and invent new forms of modernizing 

instruments that vindicate that mission. What, then, are the formal properties of a 

legislative guide that allow it to function in ways that other UNCITRAL 

technologies do not? What is it about a legislative guide that might stimulate 

modernization concomitantly with enhancing global trade across an enormous 

diversity of the world's legal systems? We turn to these questions in the next 

section. 

97. UNCITRAL, Possible Future Work on Insolvency Law, supra note 8, paras. 165-66. 

98. See UNCITRAL MODEL LAW ON ELECrRONIC COMMERCE WITH GUIDE TO ENACTMENT, supra 

note 26, at 18: 

9. The objectives of the Model Law are best served by the widest possible application of the 

Model Law. Thus, although there is provision made in the Model Law for exclusion of certain 

situations from the scope of articles 6, 7, 8, 11, 12, 15 and 17, an enacting State may well decide 

not to enact in its legislation substantial restrictions on the scope of application of the Model 

Law. 



VOL. 42:475 

II. 

UNCITRAL's LEGISLATIVE GUIDE ON INSOLVENCY LAW 

Based on a multi-faceted empirical study of UNCITRAL's Working Group on 

Insolvency, 9 the interplay of two broad formal strategies enabled UNCITRAL to 

craft a technology capable of modernizing exceedingly diverse national laws.' First, 

it created a combination of design elements within the structure of the Guide itself. 

Second, it invented a sophisticated array of rule-types that could be deployed, 

combined and recombined, as the consensus-building challenge demanded. 

A. The Design of the Legislative Guide on Insolvency Law 

The content and structure of the Legislative Guide on Insolvency Law 

exemplify the formal capacities of a technology to facilitate agreement among a 

broad diversity of actors and interests in a contentious policy domain. Following an 

introduction and glossary, the Guide is divided into two parts. Part One of the 

Insolvency Guide articulates broad policies and purposes common to all insolvency 

laws. Drawing on earlier works promulgated by the International Monetary Fund, 

the Asian Development Bank and the World Bank, Part One identifies nine "key 

objectives," providing high order principles that orient the remainder of the Guide. 

They are accompanied by a word of caution regarding the tensions among these 

fundamental purposes. Part Two of the Guide details the core provisions for an 

effective and efficient insolvency law. It comprises the lion's share of the Guide, and 

provides a detailed discussion of the core provisions of a modern insolvency law. 

Divided into eight sections (and twenty subparts), it covers topics ranging from 

commencement to the closing of a liquidation or reorganization proceeding. 

Cognizant of the difficulty of absorbing this amount of detail, the Guide takes great 

pains to organize this commentary with indices and headings and to sum up each 

section with Recommendations that derive from the lengthier commentary that 

precedes them. The Guide provides 198 numbered recommendations divided 

among the twenty topics it covers. Occasionally, the Guide provides commentary on 

a topic (institutional framework; corporate groups), but no recommendations. 

Three formal elements of the Guide demonstrate how the Secretariat crafted a 

product that could embrace existing extremes of substantive and institutional 

variation. 

1. Glossary. The Guide begins with a Glossary. What first appears as a 

technical aid to an understanding of the text, in fact functions as a formal mechanism 

for defusing national contests over legal concepts and terminology. UNCITRAL 

both adopts and creates a universal vocabulary to standardize usage within the 

Guide. By relying on no particular country's terminology, and instead creating its 

own internal language, the Guide adeptly promotes "out with the old" 

99. The empirical sources for this study include the classic social science methods of (a) participant 

observation (attendance at all meetings of the Working Group, the Commission, and expert groups held 

between formal meetings), (b) interviews of participants-staff, delegates, observers-at all stages of 

deliberations from the Commission's initial exploratory meeting to its final vote, and (c) statistical analysis 

of all speech turns by delegates at all formal meetings. The sources also include a legal analysis of the 

Working Group's texts, most importantly its final authorized version, and those of UNCITRAL from its 

founding. 

100. For a discussion of the degree of dissensus that separates national laws on insolvency practices, 

see Block-Lieb & Halliday, supra note 18. 


2007 


modernization of insolvency laws without the need for explicit rejection of terms or 

concepts. In addition to the obvious political advantage of avoiding identification of 

UNCITRAL's products with any particular legal system, this also has the juridical 

effect of detaching national actors, such a legislatures and judges, from standard 

interpretations of terms in their own legal traditions. ' 

The Glossary accomplishes this feat of transcending the particularity of the 

national with several techniques. It does adopt terms that are terminological 

universals, such as "debtor" and "creditor." These terms are common to all legal 

families. In other instances, UNCITRAL embraces terms that are associated with a 

politically important actor. For example, in both the Guide and the Model Law on 

Cross-Border Insolvency, UNCITRAL solved a problem of jurisdiction over crossborder 

insolvencies by incorporating the term "centre of main interests," which was 

first employed in the European Union's draft Convention on Cross-Border 

Insolvency.' °2 Although its Regulation on Cross-Border Insolvency was not adopted 

by the EU and its member states until after promulgation of UNCITRAL's work 

product on the same topic, UNCITRAL successfully co-opted a term first coined by 

a "competing" international lawmaking body. 

The Guide also excludes terms that are associated with one particular 

insolvency system: even though concepts of U.S. bankruptcy law informed many of 

the debates over the Guide, the Guide does not uniformly adopt terms of art from 

the U.S. Bankruptcy Code or practice. For example, the Guide addresses the 

treatment of contracts, but refers to the continuation of such contracts rather than to 

their assumption as is true under U.S. law. As another example, the Guide 

recommends that stay or moratorium of creditor collection activity ensue upon the 

commencement of an insolvency proceeding, but nowhere refers to it as an 

"automatic stay. ' ' 

In addition, the Guide invents terms to avoid aligning itself with one country 

and to provide universal umbrella concepts that transcend the practices associated 

with particular insolvency regimes. UNCITRAL's term "insolvency representative" 

corresponds with no such usage in any legal system, yet it encompasses every 

configuration of insolvency actor in the world's insolvency systems, including not 

only roles (e.g., trustees, liquidators, administrators, insolvency practitioners) but 

also professionals (e.g., lawyers, accountants, bureaucrats). UNCITRAL's term 

"court" is also a universal defined to include any kind of supervising agency, 

including both administrative agencies and judicial decisionmakers. 

At times, this invented language launders terms that might appear too 

derivative of one country's system. Rather than adopt the U.S. term of "adequate 

101. Interview by Terence Halliday with 2065A (Dec. 7, 2000) (unpublished interview, on file with 

authors). The interviewee stated: 

If you use a particular word in this actual text, the judge in one legal system will give it its own 

meaning, and we don't want the judge to give it that historical meaning. We want to give the 

international meaning, which is then spelled out. So we want not to confuse the user of the text 

by using a text which he learned in law school. 

Id. 

102. European Union Convention on Insolvency Proceedings, Nov. 23, 1995, 35 I.L.M. 1223. 

103. Later versions removed one or two terms too closely associated with one country, such as the 

U.S. concept of "super-priority," or the English and European concept of "retention of title." 



VOL. 42:475 

protection," the Glossary adopts the concept but with another term-"protection of 

value." ' ° And in the text of the Guide, rather than referring to the U.S. concept of 

"pre-packaged" reorganization plans to describe a practice of reorganization, 

UNCITRAL adopts the phrase "expedited procedures," even though the underlying 

meaning is virtually identical. Similarly, retention of title transactions, which has 

created a major sticking point for UNCITRAL's Working Group on Secured 

Transactions Law, are referred to only obliquely. Rather than refer to the 

transaction, the Guide refers only to the subject of the transaction, and then talks in 

terms of "third party-owned assets," which are in turn defined to include, among 

other assets, those that are the subject of a retention-of-title transaction. 

UNCITRAL's manipulation of form to solve problems that are inherently 

political extends to terms and concepts. In the former case, it embraces a diversity of 

substance or practice with the substitution or invention of a term. This may be as 

little as substituting a label or as much as inventing a higher order term. In the latter 

case, it invents a new concept to solve a distinctively transnational problem, such as 

deciding on jurisdiction in cross-border insolvency cases. 

2. Commentary. The Working Group on Insolvency pitched the text of its 

Legislative Guide on Insolvency Law between a minimalist threshold, which would 

go no farther than producing a comparative report, and a maximal threshold, which 

would include only statutory language. Most of the twenty substantive sections in 

the Guide present commentary followed by recommendations. 

The commentary combines several elements. First, it usually identifies an issue 

and indicates why it is important. Second, it may offer a principle in relation to the 

issue and justify the principle (e.g., "it is desirable that the commencement standard 

be transparent and certain .... ",;105 'an insolvency law will need to clearly identify 

the assets" because this will produce "transparency and predictability . ,).106 

Third, where there is considerable cross-national variation on an issue, the 

commentary presents a comparative analysis, without ever identifying countries. For 

example, on standards for commencing an insolvency proceeding, the Guide 

distinguishes between a cash flow and a balance sheet test of insolvency. 7 Fourth, it 

discusses the benefits and deficiencies of the alternatives, focusing both on juridical 

and practical advantages and disadvantages. 08 Finally, it often expresses a 

preference (e.g., it is increasingly recognized that a certain course of action will have 

more advantages to the economy)." 9 Or, if two possibilities are acceptable, the 

Guide may explicate how the two versions might be related to each other. For 

example, on the test for insolvency, it explains why a cash flow test might be 

acceptable, and goes on to note that a balance sheet test should not be used alone 

° 

but only in combination with a cash flow test. 

The commentary thereby serves both internal and external functions. For 

purposes of reaching agreement among the Working Group, the commentary 

104. INSOLVENCY GUIDE, supra note 15, at 6. In this case, the definition of "protection of value" 

does include in parentheses the statement that "(in some jurisdictions referred to as 'adequate 

protection.')". Id. 

105. Id. pt. 2, I(B)(1), para. 21. 

106. Id. pt. 2, II(A)(1), para. 3. 

107. Id. pt. 2, I(B)(2)(a), (b), paras. 23-26. 

108. INSOLVENCY GUIDE, supra note 15, pt. 2, I(B)(2)(a), (b), paras. 23-26. 

109. Id. 

110. Id. 


2007 


provides a space where disagreements can be defused by signaling that dissent has 

been heard and that points of view have been fairly aired for debate. By including 

contending views in the commentary, even if one of those views will be preferred 

over others, groups may be pacified and country delegates can signal to their 

ministries that their opinions were expressed and recorded. As a result, "out with 

the old" modernization can implicitly reject out-moded approaches by failing to 

include them within the recommendations offered by the Guide, but cushion this 

rejection in the recommendations with explanatory text in the commentary that may 

describe in great detail the pros and cons of the rejected approach. For purposes of 

implementation, the commentary has a significant didactic role for it expresses a 

global consensus on what issues must be addressed in legislation, it explains to 

national law-makers the costs and benefits of alternatives, and it offers a guide to 

judges, providing reasoning to support recommendations. 

Within the commentary, UNCITRAL engages in a rhetoric of self-validation. 

UNCITRAL must rely on persuasion and the intrinsic merits of a product in order to 

facilitate adoption by national law-makers. The Guide makes claims about the value 

of adopting it for investment, economic development, and integration into the world 

economy. On specific provisions, the Guide uses three additional techniques of 

persuasion of the rightness of a particular preference in the Guide and of extrinsic 

reasons for its adoption. 

First, the Guide endeavors where possible to signal that a recommendation 

reflects universal consensus or at least a heavy preponderance of practice. It is said, 

for instance, that exceptions for banking and insurance companies from coverage by 

insolvency laws are "widely reflected in insolvency laws" ' ' or that insolvency laws 

"generally permit" an application for liquidation to be made by debtors, creditors, 

and government agencies."' 

Second, if universality cannot be claimed, the Guide relies on a quantitative 

criterion. The commentary states that "many insolvency laws identify the minimum 

threshold of support required from creditors,"'. 3 or that a standard is "used 

extensively,"" 4 or that the "most common approach" to application of the stay is that 

it begins at commencement of proceedings."' 

Third, the Guide occasionally invokes the notion of a trend. On the highly 

contentious issue of whether secured property should be included in a bankruptcy 

estate, the world divides probably with a preponderance of countries in favor of its 

exclusion. Yet the move towards reorganization requires that secured property be 

brought the bankruptcy estate, even if a minority of countries follows that principle. 

Although the Guide takes the minority view, it concludes that this view is 

"increasingly recognized" and that inclusion has economic advantages over 

exclusion. 

The juxtaposition of the discursive commentary with the statutory-like language 

of the recommendations gives the Guide added flexibility. Depending on the 

111. INSOLVENCY GUIDE, supra note 15, pt. 2, I(A)(1)(c), para. 11, at 41. 

112. Id. pt. 2, I(B)(3)(a), para. 32, at 49. 

113. Id. pt. 2, IV(A)(5)(g), para. 47. 

114. Id. pt. 2, l(B)(2)(a), para. 23, at 45 (referring to the liquidity or cash flow test as "used 

extensively"). 

115. Id. pt. 2, II(B)(5)(c), para. 46, at 90. 



VOL. 42:475 

shifting sense of the Working Group, materials on which consensus could not be 

reached might be shifted from the recommendations back to the commentary; 

conversely, materials thought to be critical by influential delegations could be made 

more imperative by moving them from the commentary into the form of a 

recommendation. The content moves to the formal locus where the micro-politics of 

Working Group negotiation permit. 

3. Recommendations. At the end of each substantive section of commentary, 

the Guide includes recommendations. Recommendations are always prefaced by a 

set of purposes, which themselves have been negotiated by delegates. 1 1 6 These 

statements of purposes range from a single sentence to four to six specific goals, 

providing both an introduction to the recommendations they precede and a 

statement of their intended reach. 

The commentary, purposes and recommendations work together to guide 

domestic legislatures to adopt modern insolvency laws. The commentary provides a 

detailed examination of each of the topics on which the Guide expresses 

recommendations. The key objectives and purpose provisions offer national lawmakers 

a checklist of issues and goals to guide law-making. 

We now turn to examine in detail the recommendations. The variety of forms 

in the recommendations provides the Guide with a repertoire of rule-types that 

alone or in combination enable the Guide to adjust for the degree of diversity and 

dissent on issues. 

B. Arrays of Rule-Types 

In the Legislative Guide on Insolvency Law, the UNCITRAL Secretariat 

created a variety of rule-types that can be arrayed along a spectrum of specificity 

that ranges from broad statements of commercial norms to explicitly detailed 

language ready for enactment: 

1. Imperative recommendations propose that national legislatures take specific 

types of action whose content is expressly stated. These subsume several subcategories 

of norms. 

a. Substantive recommendations take the general form: "There should be a rule 

[about the substantive entitlements of participants in an insolvency proceeding] that 

[contains particular substantive provisions]." For instance, on the all-important 

scope of an insolvency law, a key substantive recommendation reads: "The 

insolvency law should govern insolvency proceedings against all debtors that engage 

in economic activities, whether natural or legal persons, including state-owned 

enterprises, and whether or not those economic activities are conducted for profit... 7 

b. Procedural recommendations take a similar form: "There should be a rule 

[about how an insolvency proceeding should be conducted] that [contains particular 

procedural elements]." For example, on commencement of an insolvency 

proceeding, a procedural recommendation provides that: "The law generally should 

116. Id. at 233 (stating that the "purpose of provisions relating to the reorganization plan" is "(a) To 

facilitate the rescue of businesses subject to the insolvency law, thereby preserving employment and, in 

appropriate cases, protecting investment .... "). 

117. INSOLVENCY GUIDE, supra note 15, Recommendation 8, at 44. 


2007 


specify that, where a creditor makes the application for commencement: (a) Notice 

of the application promptly is given to the debtor .... "' 

c. Conditional recommendations. Some imperative recommendations are 

conditional and provide roughly as follows: "If a rule [about some substantive or 

procedural topic of insolvency law] is enacted, then it should [have the following 

content]." For example, in the provisions on the confirmation of a reorganization 

plan, the Guide recognized that not all laws require that all classes must approve a 

plan. Even so, it directed that in this subset of nations: 

Where the insolvency law does not require a plan to be approved by all 

classes, the insolvency law should address the treatment of those classes 

which do not vote to approve a plan that is otherwise approved by the 

requisite classes. That treatment should be consistent with the grounds set 

forth in recommendation 152.19 

A conditional recommendation can be distinguished from a substantive or 

procedural recommendation in that, while conditional recommendations identify the 

content of language that might be adopted by a domestic legislature, they leave the 

question of whether such a rule should be enacted to local discretion. This has the 

tactical effect that a conditional recommendation can be combined with any number 

of other rules. Substantive and procedural rules might both be qualified by the 

condition, "if you have a substantive/procedural rule, then it should include this 

content." Conditional recommendations give UNCITRAL the capacity to 

acknowledge local contingencies and variations in an orderly way. 

Imperative recommendations have in common that they all provide domestic 

legislatures with proposed statutory language. If a legislative guide were comprised 

of only imperative recommendations, it would closely resemble a model law. 

2. Constraining recommendations are not explicitly directive of particular 

legislative language, although they are conducive to convergence. Often they point 

in a direction and then give choices. We discern at least three variants of these. 

a. Baseline recommendations take the form - "there should be a rule on a topic, 

and it should include at least the following elements (with the implication that other 

elements might also be included)." For instance, in the section on expedited 

proceedings, baseline recommendations set a floor or minimal standard for 

commencement of such a proceeding: 

The insolvency law should specify that the following additional materials 

should accompany an application for commencement of expedited 

reorganization proceedings: 

(a) The reorganization plan and disclosure statement; 

(b) A description of the voluntary restructuring negotiations that preceded 

the making of the application for commencement, including the 

118. Id. Recommendation 19, at 65. 




VOL. 42:475 

information provided to affected creditors to enable them to make an 

informed decision about the plan; 

(c) Certification that unaffected creditors are being paid in the ordinary 

course of business and that the plan does not modify or affect the rights or 

claims of unaffected creditors without their agreement; 

(d) A report of the votes of affected classes of creditors demonstrating 

that those classes have accepted the plan by the majorities specified in the 

insolvency law; 

(e) A financial analysis or other evidence that demonstrates that the plan 

satisfies all applicable requirements for reorganization; and 

(f) A list of the members of any creditor committee formed during the 

course of the voluntary restructuring negotiations."" 

This non-exclusive list-like many found in the Guide-merely sets minimum 

standards to be found in enacting legislation. 

b. Permissive recommendations take the form - "a country may adopt a rule 

that includes [X], [Y] and [Z]." Permissive recommendations are often supported by 

explanatory footnoted materials and commentary. They enable UNCITRAL to 

acknowledge the acceptability of a strongly-held preference by a nation-state, 

permitting it to give some guidance without endorsing the position for all nations. 

For example, on the protection of debtors and creditors when a stay is placed on 

creditors' efforts to collect on claims, the Guide grants courts power in those 

countries that so choose and indicates what those powers might be: 

The insolvency law may provide the court with the power to: 

(a) Require the applicant for provisional measures to provide 

indemnification and, where appropriate, to pay costs or fees; or 

(b) Impose sanctions in connection with an application for provisional 

121 

measures. 

The Guide often combines permissive recommendations with others, such as a 

substantive rule that has an imperative element plus a permissive element. 

c. Norms of minimalism instead take the form-"if there is to be a rule on a 

topic, or an exception to the rule on a topic, it should be kept to a minimum." There 

are many examples in the Guide of the norm of minimalism. When discussing the 




2007 


choice of law rules that should govern an insolvency proceeding, Recommendation 

31 establishes the general rule, when it provides that: 

The insolvency law of the State in which insolvency proceedings are 

commenced (lex fori concursus) should apply to all aspects of the 

commencement, conduct, administration and conclusion of those 

insolvency proceedings and their effects. 2 

Recommendations 32 and 33 provide two exceptions to the general rule: one 

pertaining to the rights and obligations of the participants in a payment or settlement 

system or in a regulated financial market (imperative recommendation) and another 

pertaining to the rejection, continuation and modification of labor contracts 

(permissive recommendation). On the topic of additional exceptions to the general 

rule in Recommendation 31, the Guide also turns to the norm of minimalism: "Any 

exceptions additional to recommendation 32 and 33 should be limited in number and 

be clearly set forth or noted in the insolvency law." 

The same norm of minimalism dictates the contours of Recommendation 188, 

on the topic of secured claims: 

The insolvency law should specify that a secured claim should be satisfied 

from the encumbered asset in liquidation or pursuant to a reorganization 

plan, subject to claims that are superior in priority to the secured claim, if 

any. Claims superior in priority to secured claims should be minimized 

and clearly set forth in the insolvency law. 23 

Recommendations applying the norm of minimalism frequently also rely on the 

norm of disclosure or some other specifying recommendation, as noted below. 

3. Focusing recommendations look only to sharpen the focus of any law 

adopted by a domestic legislature. We identify two of these. 

a. Architectural recommendations state that-"there should be rule on [some 

specific topic of insolvency law]," but do not specify what the rule should be. On the 

topic of plans of reorganization, Recommendation 185 speaks of the need to create 

classes of creditors and to make clear what priority they should be accorded, but it 

does not indicate how it should be done: "The insolvency law should specify the 

classes of creditors that will be affected by the commencement of insolvency 

proceedings and the treatment of those classes in terms of priority and 

distribution. 1 24 

The Working Group viewed it as important for an insolvency law to provide for 

the appointment of a committee, but did not feel the need to provide detailed 

directions on how that appointment should be accomplished in an insolvency law. If 

the architectural recommendation is very detailed about the subject of the rule on 

which it views the need for legislation, then it may differ only subtly from an 

imperative recommendation. If, on the other hand the architectural 






VOL. 42:475 

recommendation speaks in broad generalities, it more closely resembles a norm of 

disclosure. 

b. Norms of disclosure indicate only that some rule "should be clearly and 

expressly set forth in the insolvency law." For example, in Recommendation 186 on 

priority claims in distributions, a norm of minimalism is immediately followed by a 

norm of disclosure in Recommendation 187. Together they read as follows: 

The insolvency law should establish the order in which claims are to be 

satisfied from the estate. 25 

The insolvency law should minimize the priorities accorded to unsecured 

claims. The law should set out clearly the classes of claims, if any, that will 

be entitled to be satisfied in priority in insolvency proceedings.' 26 

The norm of disclosure often works hand in hand with the norm of minimalism. 

4. Policy recommendations identify and affirm broad normative statements of 

insolvency law. These are the highest order principles in the Guide. They are found 

primarily in a list of eight governing norms or key objectives. These include the need 

to provide certainty in the marketplace sufficient to permit economic stability and 

growth, the desirability of maximizing asset values and striking a balance between 

liquidation and reorganization, and the need to provide timely, efficient and 

impartial resolution of an insolvency proceeding and to establish a framework for 

resolution of cross-border insolvency proceedings. 

Although these norms might, at first glance, be dismissed as little more than 

blandishments of "motherhood and apple pie," in fact, they are much more than 

that. Each addresses potentially ubiquitous problems in the functioning of 

bankruptcy systems. 

C. Rule- Types and Prospects for Consensual Decisionmaking 

A simple tally of all rule-types used in the Insolvency Legislative Guide yields 

ninety-one substantive recommendations, twenty procedural recommendations, 

twenty-two conditional recommendations, forty baseline recommendations, thirtynine 

permissive recommendations, fifty-eight architectural recommendations, 

twenty-six norms of disclosure, seven norms of minimalism and seven policy 

norms. 12 7 By this count, the overwhelming majority of the recommendations made in 

the Insolvency Guide are, thus, imperative recommendations. We found this count 

surprising, given that the Working Group consciously chose to frame this as a 

Legislative Guide rather than a model law or convention. Except in how they are 

framed, there is little difference between model law provisions and imperative 



127. The arithmetically astute reader will have noted that this tally exceeds the 198 numbered 

recommendations specified in the Legislative Guide on Insolvency Law. We exceed 198 because some of 

the numbered recommendations contain more than one sentence; we count each sentence in the 

recommendations as constituting a separate recommendation. By this count, there are 310 distinct 

recommendations in the Guide. For a matrix identifying and characterizing each of the recommendations 

contained in the Guide, see [website created by Prof. Block-Lieb]. 


2007 


recommendations. From this perspective, the Insolvency Guide appears a largely 

harmonizing instrument. 

We do not minimize the commercial importance of constraining and focusing 

recommendations, however. Both are critical to the goal of modernization. They 

each step more lightly than imperative recommendations on national sovereignty, 

and should in this way serve UNCITRAL's interest in not being seen to infringe 

unnecessarily on controversial issues of insolvency law. Moreover, even broadly 

stated norms serve important commercial purposes in the Guide. Delegates at the 

Working Group were often heard to extol the commercial benefits of transparency 

and predictability in an insolvency law. Norms of disclosure directly accomplish this 

more limited goal when delegates could not, for one reason or another, agree on the 

substance that an insolvency law should be recommended to follow. Not 

surprisingly, we observe that norms of disclosure are most likely to be employed 

where the subject involves insolvency law issues that infringe on subjects of social, 

cultural or political significance. 

The array of linguistic forms in which recommendations can be expressed 

thereby gives UNCITRAL the flexibility in a legislative guide to adjust its level of 

prescription to the level of consensus among the most influential blocs of delegates. 

This flexibility provides UNCITRAL the room to raise and lower levels of 

prescriptive force between and within clusters of recommendations on substantive 

topics. Through the flexibility obtained by this range of technologies and rule-types, 

UNCITRAL avoids either extreme of enunciating norms that are effectively 

meaningless or are so precise as to engender a backlash through encroachment on 

sovereignty. It permits UNCITRAL to achieve as much harmonization as necessary 

to the task of modernizing the insolvency laws of national actors. The Legislative 

Guide on Insolvency Law, thus, wavers between a "unification over time" vision of 

harmonization and one that merely attempts a "reduction of differences over time." 

III. RULE-TYPES, MODERNIZATION AND HARMONIZATION 

The flexibility needed to modernize an area of the law-and to accomplish law 

reform (especially law reform on a global level) in the face of divergencies in the 

law-comes at a price: Flexibility may reduce the unifying influence of the law 

reform effort. In this section, we explain how a legislative guide containing both 

commentary and a range of recommendations afforded UNCITRAL the ability to 

both modernize and harmonize insolvency law. 

A. Modernization 

How did its use of a legislative guide permit UNCITRAL to "modernize" 

insolvency law, despite its need for consensual decisionmaking, despite enormous 

divergences among national laws on the topic of insolvency, and despite the 

propensity for insolvency laws to butt up against important social and political issues 

of national interest? In a companion piece, we argue that this range of rule types, 

nested in a wider formal script, provided UNCITRAL with needed flexibility to 

accomplish "out with the old" (and in some cases "in with the new") modernization 

in an area of commercial law on which there existed few global norms and great 



VOL. 42:475 

disagreements cross-nationally over the policy implications of bankruptcy law. 20 The 

Legislative Guide on Insolvency Law achieved this feat of diplomacy in two steps, 

with both moves highly dependent on the formal structure of the Guide. 

First, the Guide builds on an international consensus on the desirability of 

enabling the reorganization of a viable commercial entity. 129 The eight policy 

norms-those key objectives based on earlier work done by the IMF and World 

Bank and found in Part One of the Legislative Guide-were instrumental in 

identifying reorganization as a central component in any "modern" insolvency 

statute and in providing policy-oriented touchstones to which the Guide could 

return, time and again, to justify both the tenor and content of reorganizationfriendly 

recommendations. Where an issue might affect the success of a 

reorganization proceeding, we find that the Guide is more likely to deviate from 

global norms and more likely to do so using an imperative recommendation. Thus, 

recommendations were crafted with an eye on whether they were central to 

promoting the reorganization of viable commercial entities. Where necessary to 

advance reorganization, the Working Group was more likely to reach for imperative 

recommendations. For example, despite global dissensus on the topics, the Guide 

contains imperative recommendations on: the breadth of property in an insolvency 

estate (including property subject to a security interest);' 30 the scope of any stay upon 

commencement (including secured creditors' collection efforts);' the use of 

collateral during an insolvency proceeding; 3 2 the need for and contours of postcommencement 

finance of an insolvency estate; " ' the standards for confirmation of a 

plan of reorganization' 34 and for expedited reorganization proceedings.' 

In other places, the Guide steps back from adopting imperative 

recommendations in areas that might be viewed as important to a debtor-friendly 

reorganization proceeding. The Guide contains several permissive 

recommendations on topics central to U.S.-style reorganization. For example, it 

provides that an insolvency law "may" provide for a debtor-in-possession 

reorganization proceeding in which the debtor's management is not removed from 

its management of day-to-day operations and is entrusted with obligations ordinarily 

vested in an insolvency representative, such as the obligations to negotiate a plan of 

reorganization.36 The Guide similarly "permits" ' but does not require the creation 

of a creditors' committee, stating only that an insolvency law "should facilitate the 

active participation of creditors in insolvency proceedings such as through a creditor 

committee, a special representative 

' 

or other mechanism for representation. 

Second, the range of available rule-types permitted the Working Group to 

avoid issues on which consensus was unlikely and which were likely to stall or 

128. Block-Lieb & Halliday, supra note 18. 

129. See id. 

130. See INSOLVENCY GUIDE, supra note 15, Recommendation 35, at 82. 

131. Id. Recommendations 39(a), at 99-100, & 46(b)-(c), at 102. 


133. Id. Recommendations 63-68, at 118-19. 



136. Id. Recommendation 112(a), at 173. 




2007 


impede production of the Legislative Guide. 3 ' We find that the Working Group 

used softer, less constraining rule-types to minimize the likelihood that dissenting 

nations might abandon the central tendency of the Guide, particularly where cultural 

and social issues were at stake. In general, where issues of social, political or cultural 

significance overlapped with insolvency law, such as with questions of the priority to 

be accorded to workers' claims or the desirability of various exceptions to a stay or 

to the avoiding powers, the Guide spoke softly by employing norms of minimalism 

and norms of disclosure rather than imperative recommendations. 4 The Guide also 

avoided a hot-button that had divided the deliberations of the Working Group on 

Secured Transactions on its Legislative Guide-the characterization of retention-oftitle 

transactions in insolvency proceedings-by deferring to the secured transactions 

or other non-insolvency law of the enacting State rather than articulating an 

insolvency law solution to the issue. 4 The Guide declined to decide whether a 

debtor's management should be liable for trading while insolvent, or the proper 

treatment of corporate groups in insolvency proceedings, by discussing these issues 

in commentary but not reaching any recommendation on the topic.' In each case, 

the Guide employs an approach that is a more nuanced one than could have been 

accomplished in a model law, where sidestepping an issue involves avoiding any 

discussion of it in the legal technology. The flexible range of rule-type available in 

the Legislative Guide permitted UNCITRAL to emphasize the important 

insolvency-law issues on these hot-button topics (i.e., minimize statutory priorities 

for otherwise unsecured creditors; keep socially constructed exceptions to a stay or 

to the avoiding powers to a minimum and disclose them in the insolvency law itself; 

refer to non-insolvency law to differentiate between a transactions as a retention-oftitle 

transaction or a financing transaction), rather than remaining completely silent 

on the topic. 

The flexibility inherent in the Guide-in its commentary and its range of rule 

types-permitted UNCITRAL to promulgate a Legislative Guide on Insolvency 

Law that accomplished "out with the old" modernization of an area of law on which 

there was disagreement, not only on the technical details of the law, but also on its 

social underpinnings. However, this accomplishment might have been subversive if 

flexibility undermined the "unification over time" effect of the Guide. Did 

modernization subvert harmonization? 

B. Harmonization 

On the face of it, the Legislative Guide on Insolvency Law is only halfheartedly 

harmonizing. After all, only 133 of its 310 recommendations are drafted as 

imperative recommendations. Thus, even if we were to assume (unrealistically) that 

all domestic legislatures would agree to implement all of the imperative 

recommendations in the Insolvency Guide, the Guide would harmonize with only 

slightly more than half of the recommendations.' 43 If national actors similarly were 

139. See Block-Lieb & Halliday, supra note 18. 

140. Id. (listing these hot buttons). 

141. Id. 

142. Id. 

143. By their nature, imperative recommendations have the greatest potential for achieving 

harmonization: If, on a global basis, domestic legislatures were to adopt each of the these imperative 



VOL. 42:475 

assumed to follow the constraining"' and focusing 5 recommendations and policy 

norms in the Guide, 4 6 we would not expect to see much reduction in the 

"divergencies arising from the laws of different States,' 47 at least not for some time. 

But it would be a mistake not to view the Legislative Guide on Insolvency Law as a 

harmonizing technology. While a guide is not as homogenizing as a convention, or 

even as a model law, it nevertheless presses countries towards global statutory norms 

where they will find differing levels of global consensus. 

First, nearly half of the Guide's recommendations (133 of 310) are framed as 

imperative recommendations. And another forty baseline and thirty-nine permissive 

recommendations offer domestic legislatures concrete and detailed 

recommendations on the substance of an insolvency law. That a range in rule-types 

was employed does not, on its own, create tension with the goal of harmonization 

since many, if not most, of the recommendations in the Insolvency Guide provide 

detailed substantive rules for a domestic legislature to adopt. 

Moreover, where UNCITRAL viewed an issue as important, it employed 

imperative recommendations to express the tenor and nature of its support. This is 

especially true with recommendations touching on the desirability of reorganization 

recommendations as a part of their insolvency laws, the world's insolvency laws would harmonize on the 

legislative topics covered by the imperative recommendations. 

144. By definition, constraining recommendations identify a limited range of permissible variation 

among domestic insolvency laws; as a result, we would expect that convergence, a form of harmonization, 

would result if domestic legislatures were to follow the recommendation. But the strength of this 

conclusion varies depending on the nature of the constraining recommendation at issue. Baseline 

recommendations unequivocally lead to greater convergence, regardless of the level of dissensus among 

national law. Where the baseline recommendation excludes a standard approach in existence around the 

globe, the convergence effect is likely to be substantial. Norms of minimalism, which contain only broad 

statements that exceptions should be kept to a minimum, might also slowly lead to convergence. As 

legislatures "keep exceptions to a minimum," they may converge around a global consensus regarding the 

bare minimum, essential exceptions. But a norm of minimalism does not, on its face, require this result. 

Permissive recommendations are even less likely to result in harmonization. Permissive 

recommendations may not lead to greater convergence, because, unlike baseline recommendations that 

identify a limited range of acceptable possibilities, permissive recommendations open up rather than 

constrain substantive choices. This is especially true if the permissive recommendation indicates that an 

insolvency law "may" provide for a rule that is inconsistent with global norms. Where the 

recommendation "permits" results that fly in the face of global consensus, the Guide may have modernized 

insolvency law but has, at the same time, produced less uniformity in the law. In some instances, 

permissive recommendations state that an insolvency law "may" adopt a rule that the commentary 

identifies as out of step with the global consensus (and generally does so in order to promote the goal of 

promoting reorganization); in others, the permissive recommendation reflects the Working Groups' 

reluctance to "choose" among approaches. In the first case, the permissive recommendation is deharmonizing; 

in the second, the permissive recommendation simply permits a disharmonious status quo to 

persist. If a permissive recommendation identifies an otherwise controversial legislative position as one 

among several possible approaches that UNCITRAL approves, the Guide moves away from convergence 

around the status quo; it may, at the same time, however, serve as a hard push toward convergence at a 

new global equilibrium-stirring the pot may eventually push the global standard toward a newly 

convergent position over time, but only in the long run. 

145. The harmonizing influence of architectural recommendations in the Guide is unclear, since they 

provide no substantive direction to domestic legislatures. Similarly, norms of disclosure will have not 

converging influence, on their own, unless we also assume that simply by requiring a legislature to place its 

insolvency laws "on the books" it will discourage non-convergent rules from being adopted. 

146. Like focusing recommendations, the harmonizing influence of policy norms is unclear since they, 

too, offer little in the way of content. 



2007 


or viewed as essential to a reorganization-friendly insolvency regime."' In addition, 

there are more than several conditional and permissive recommendations important 

(but not central) to an insolvency law intended to facilitate reorganization 

proceedings, such as a recommendation providing that an insolvency law "may" 

provide for a debtor-in-possession regime and "may" institute a system in which a 

"committee of creditors" provides a check on the powers of a debtor in possession.' 49 

These permissive recommendations may not "require" a domestic legislature to 

adopt implementing statutory language, but where a legislature is so inclined the 

Guide provides detailed guidance on how to achieve such a result. 

The Legislative Guide, thus, simultaneously accomplishes different levels of 

harmonization. The 133 imperative recommendations provide "unification over 

time" with the specificity and range that closely resemble model legal provisions 

coupled with a guide to enactment. The remaining recommendations - those that 

constrain, focus and set policy norms - may not lead to a single international 

standard, even when considered in light of long stretches of time, because they sit 

comfortably within a range of national variation. Nonetheless, these more flexible 

recommendations nearly all "reduce differences over time," and so "harmonize" 

consistent with the goal of modernization. Even the recommendations that are 

devoid of content, such as the architectural recommendations, and the norms of 

minimalism and disclosure, "harmonize" in the broadest sense of the term "as the 

process through which domestic laws may be modified to enhance predictability in 

cross-border commercial transactions. '' "0 

The Guide makes a persuasive case for the modernization of insolvency law, 

but only time will tell which recommendations nations will implement and, thus, 

whether it will have a harmonizing effect. Regardless of whether the Guide should 

be viewed as an instrument of "unification over time" or "reduction of differences 

over time"-and it is both-the harmonizing effect of the Legislative Guide on 

Insolvency Law will only be felt "over time." To assess the harmonizing effect of the 

Guide, we will need to wait to judge the influence of the Guide "on the ground;" we 

will need to study the legislation it inspires and the implementation of that 

legislation by courts, insolvency representatives and insolvency professionals. 

IV. MODERNIZATION AND GLOBAL LAW REFORM 

We have argued that over the forty years since its inception, UNCITRAL both 

broadened and shifted its mission. While created to promote the "progressive 

harmonization and unification" of the law of trade, it now also views itself as an 

agent for the "modernization and harmonization" of trade law. The goals are not 

disconnected. Both follow from an interest in promoting an expansion of 

international trade, particularly trade with developing and under-developed nations. 

At its inception, UNCITRAL was conceived around the notion that "divergencies 

arising from the laws of different States in matters relating to international trade 

constitute one of the obstacles to the development of world trade."'.'. It now 


149. See supra note 121 and accompanying text. 

150. FAQ - Origin, Mandate and Composition of UNCITRAL, supra note 5. 




VOL. 42:475 

understands that these "divergencies" constitute only one "obstacle to the 

development of world trade," and perhaps a relatively unimportant obstacle at that. 

By embracing "modernization," UNCITRAL looks to tackle obstacles that go 

beyond divergencies among national laws. It has taken on the charge of law reform 

writ large. 

In order to execute its expanded shift in mission, UNCITRAL found it 

necessary to invent new legal technologies. Table 1 demonstrates that UNCITRAL 

has employed, not only conventions, model laws and model legal provisions, but also 

recommendations, guides to enactment, legal guides and legislative guides. We have 

shown that the Legislative Guide on Insolvency Law is a skillfully crafted set of 

norms that enabled UNCITRAL concomitantly to push towards an overarching 

global norm-the value of corporate reorganization as a complement to corporate 

liquidation-while allowing significant flexibility for national lawmakers to 

modernize their own laws in ways appropriately adapted to variations in legal 

families, economic circumstances, and policy preferences, among others. As a result, 

this explicitly modernizing Legislative Guide also aspires to some measure of 

harmonization, thus, enabling UNCITRAL to lean towards the current primacy it 

accords modernization without losing touch with its original mandate. 

Nevertheless, one or two puzzles remain that warrant further comment. For 

the most part, we have explained UNCITRAL's shift in mission as an adaptation to 

changes in the world of commerce. However, another story might be told that is 

consistent with the experience of many organizations. UNCITRAL is nested within 

at least three organizational contexts. It is a very small entity within the United 

Nations system. To justify its own existence, to expand its budget, and to enable the 

UN itself to demonstrate its responsiveness in a changing world, UNCITRAL may 

have been compelled to show its relevance to a world where transitions from 

command to market economies required new law, or where financial crises required 

legal institution-building, or where the legal infrastructure of markets goes far 

beyond the substantive domains of its founding. If this could not be managed within 

the constraints of its founding mandate, then its senior management was pressed to 

reinvent its mission and technologies. To the extent that UNCITRAL could show 

itself responsive to demands upon the United Nations that it be more proactive in 

the legal construction of markets, then UNCITRAL would ensure its viability and 

perhaps even expansion within the UN. 

UNCITRAL also exists in a field of organizations concerned with law reform. 

Since the Asian financial crises, a variety of international organizationsinternational 

financial institutions such as the World Bank and IMF, regional 

development banks such as the Asian Development Bank, clubs of nations such as 

the G-7, G-22 and OECD-together with expert professional associations (in the 

insolvency field these prominently include INSOL, IBA, and ABA) all moved into 

fields of law reform thought to be salient to developing countries and transitional 

economies. Insolvency and secured transactions featured prominently among these. 

In the insolvency field, for a short period it seemed as if UNCITRAL would be 

marginalized by initiatives of the World Bank, IMF and Asian Development Bank. 

But perception was short lived. UNCITRAL's flexible technology, coupled with its 

legitimate deliberative process, gave it an edge that no other organization could 

match. "Modernization" provided the substantive reach to treat national bankruptcy 

law. Reliance on a legislative guide format gave it the flexibility to be salient to the 

entire world, while also integrating constructively -perhaps even transcending-the 

previous efforts of potential rivals. The flexibility of a legislative guide enabled 


2007 


UNCITRAL to be competitive with other international organizations and ultimately 

to emerge with a global standard to which its potential rivals acceded. 

By the same logic, the matching of a flexible technology to an expansive goal 

permitted UNCITRAL's leadership to take onto its agenda issues at the heart of the 

ideological consensus about law and markets. Both the Washington Consensus and 

post-Washington Consensus champion the regulatory import of law for the 

liberalization of national markets as well as the integration of global markets. Once 

bankruptcy law became part of the agreed-upon bundle of a "modern" regulatory 

apparatus, then UNCITRAL's expanded mission gave it a legitimate claim to enter 

the field of global lawmakers with a technology that would balance convergence 

towards the ideological center with national variation at the global periphery. By 

this means, UNCITRAL's organizational adaptations justified its position at the 

table of global agents for market regulation. At the same time, it could hold itself 

out as responsive to sovereign interests that would likely not subscribe to all 

convergent provisions in a set of global norms. 

Nevertheless, it is not only the legal technology that displays UNCITRAL's 

adroitness in adapting to its various organizational contexts, but also the choice of 

"modernization" as a goal. A notion of the "modern" is a social construction. As a 

concept, it appears self-validating. Inherent in its meaning are the notions of 

progress and development, of advancement and maturity. Paradoxically, part of its 

power lies precisely in its vacuity; it is relatively empty of meaning and may, thereby, 

be infused with content as circumstances require. For instance, it could mean 

something temporal (i.e., it is "modern" simply because it is different from 

something older or pre-modern); it could mean something comparative (i.e., this 

country claims to be "modern" in comparison to that country which is not); or it 

could be functional (i.e., it achieves a "modern" function hitherto missing in a legal 

or economic system). We have seen that in practice UNCITRAL uses it in two 

ways-"modern" means filling a gap in the law with contemporaneous content ("in 

with the new") or replacing former law ("out with the old"). 

Something of this adeptness in mobilization of the term can be seen within the 

Legislative Guide on Insolvency itself. The Guide shows itself to be substantively 

modern by adopting an approach to bankruptcy in its policy norms that is consistent 

with the world's most powerful economy and perhaps most "modern" nation-the 

primacy of reorganization. That the IMF and World Bank-themselves close to the 

policy preferences of Washington-also adopt this norm merely reinforces 

UNCITRAL's modernizing credentials. Furthermore, we have seen that the Guide 

engages in rhetorical gestures that seem intended to underline its "modern" 

auspices. Frequently the commentary suggests choices based on modern 

developments and trends. Repeatedly the Guide encourages a path of action that 

would be consistent with a "modern economy," a "modern insolvency regime," a 

"modern commercial law framework," and a "modern, interconnected world." In all 

these ways, a very small international organization legitimates itself and its product 

through links to powerful nations that label themselves "advanced" and to the 

international organizations that urge other nations towards the modernity inherent 

in an advanced status. 

But it should also be clear that the label of "modernity" relates to power. It is 

powerful countries that can adopt the label for themselves and then project their 

definition of modernity onto countries they label as not modern. In this sense, 



VOL. 42:475 

UNCITRAL's adoption of the label may be viewed as the appropriation of claims 

made by powerful nations and institutions that they stand at the vanguard of 

development and, indeed, have the responsibility or even the right to make those 

claims pervasive throughout the "unmodern" world. This symbolic alignment of 

UNCITRAL with economic and political power thereby earns it an increased 

capacity to set global agendas and to earn the respect of global actors for the 

"modern" norms it produces. 

The very ambiguity in the term "modern" may also serve a useful pragmatic 

function. We have argued that UNCITRAL has long recognized the improbability 

of far-reaching unification of laws, particularly in contentious policy areas. If widely 

relied upon, the Legislative Guide on Insolvency is also likely to be harmonizing at 

least in its convergence on reorganization as a policy goal. Beyond this, the 

vagueness of "modernization" as a goal allows global convergences around a set of 

variations on the global theme such that "modern" insolvency systems might 

variously approximate those of the United States, Great Britain, Australia, 

Germany, or France, among others-all nations indisputably modern by their own 

claims and yet with perceptibly different choices on the options presented by the 

Legislative Guide. 

As a rhetorical strategy and form of organizational adaptation, therefore, 

UNCITRAL's shift away from the goal of unification towards that of modernization 

simultaneously solves a number of problems. Insofar as it is conducive to 

harmonization, then modernization keeps UNCITRAL faithful to the spirit of its 

original mission to facilitate global trade by reducing the divergence of national laws. 

Insofar as it seeks to remain a player in the world of global norm making institutions, 

modernization provides UNCITRAL the maneuverability to adjust to changing 

global agendas. Insofar as UNCITRAL seeks to demonstrate its own relevance, and 

that of its parent organization, then modernization gives it reach. And insofar as it 

tolerates national diversity around overarching policy objectives, UNCITRAL can 

balance its deference to the global center with responsiveness to the global 

periphery. All these moves are enabled by the technological inventiveness of the 

Legislative Guide on Insolvency. 


Property Rights, Collateral, Creditor Rights, 

and Insolvency in East Asia' 

DOUGLAS W. ARNER,* CHARLES D. BOOTH,** PAUL LEJOT***, & BERRY 

F. C. Hsu*** 

SUMMARY 

1. IN T R O D U CT IO N ................................................................................................... 516 

II. GOVERNANCE, ECONOMIC AND LEGAL SYSTEMS .......................................... 518 

III. THE SIGNIFICANCE OF PROPERTY RIGHTS ...................................................... 524 

IV. COLLATERAL AND SECURED TRANSACTIONS ................................................. 525 

A . R eal P rop erty ............................................................................................... 530 

B. International Standards for Movables ....................................................... 531 

C . C ollateral in E ast A sia ................................................................................ 532 

1. O verview ............................................................................................... 534 

2. R eal P roperty ........................................................................................ 535 

D . 

3. Movables and Unsecured Property .................................................... 538 

Securitizatio n ............................................................................................... 541 

V. CREDITOR RIGHTS AND INSOLVENCY .............................................................. 544 

A . Inso lven cy .................................................................................................... 544 

B. Interaction between Creditor Rights and Insolvency ............................... 546 

1. This is an expanded and updated version of a study that was published as Douglas W. Arner, 

Charles D. Booth, Berry F. C. Hsu, Paul Lejot, Qiao Liu & Frederik Pretorius, Property Rights, Collateral 

and Creditor Rights in East Asia, in EAST ASIAN FINANCE: SELECTED ISSUES (Ismail Dalla ed., World 

Bank 2006). The authors thank Dean Polizzotto of the Asian Institute of International Financial Law of 

the Faculty of Law of the University of Hong Kong for research assistance, and the Hong Kong Research 

Grants Council Competitive Earmarked Research Grant program and the University of Hong Kong 

Strategic Research Areas initiative for financial support. 

Associate Professor; Director, Asian Institute of International Financial Law (AIIFL); & Director, 

LLM (Corporate & Financial Law) Program, Faculty of Law, University of Hong Kong. 

.. Professor & Director, Institute of Asian-Pacific Business Law, William S. Richardson School of 

Law, University of Hawai'i at Manoa. 

..* Visiting Fellow, AIIFL, Faculty of Law, University of Hong Kong; & Visiting Research Fellow, 

ICMA Centre, University of Reading. 

.... Associate Professor, Faculty of Architecture, & Deputy Director, AIIFL, Faculty of Law, 

University of Hong Kong. 



VOL. 42:515 

C. Creditor Rights and Insolvency in East Asia ............................................ 547 

1. Insolvency: Pre-1997 O verview ........................................................... 548 

2. Insolvency: Post-Financial Crisis Legal Reforms ............................. 551 

3. Insolvency: Post-Financial Crisis Out-of-Court Reforms ................ 554 

4. Interaction between Creditor Rights and Insolvency ...................... 556 

5 . Su m m ary ................................................................................................ 558 

VI. CONTRACT ENFORCEMENT AND DISPUTE RESOLUTION ............................... 559 


A number of common preconditions must prevail if a market-orientated 

financial system or national economy is to develop and function effectively. 2 Those 

relating to financial sector development rest on three principles: the first, 

institutional and legal; the second, largely legal; and the third, related mainly to 

policy. 

First, a market economy and a market-based financial system cannot exist if 

certain institutional and legal supports are not in place, namely, a governance 

mechanism that establishes property rights and provides for the consistent 

enforcement of contracts and resolution of commercial disputes. It is also important 

that the setting provides for the development of human capital. 3 

With these institutional foundations in place, a number of legal underpinnings 

must then be available for a market-based financial system to function effectively. 

These include the availability of collateral to support secured transactions, a system 

of law for the establishment and dissolution of corporate bodies, and a transparent 

system of government funding, including taxation. To maintain such effectiveness, 

national and sub-national governance should also provide more widely for the rule 

of law, which is taken to be transparent and non-discriminatory, in addition to 

establishing specific property rights, enforcing contracts and supporting commercial 

dispute resolution. 

Third, a financial sector functions most effectively in the context of appropriate 

macroeconomic policies. These policies, while largely outside legal and institutional 

concerns, operate best in the context of an appropriately designed and transparent 

institutional framework. 

No sophisticated market economy or market-based financial system can exist 

without these prerequisites, regardless of indigenous or acquired national 

characteristics or the form manifested by that system. In this context, this article 

examines the relationships within East Asia between economic development, 

governance, property rights, provisions for the deployment of collateral and the 

creation of secured financial transactions, and creditor rights and their relationship 

with insolvency. 

2. The framework of analysis underlying this study is based upon DOUGLAS W. ARNER, FINANCIAL 

STABILITY, ECONOMIC GROWTH AND THE ROLE OF LAW (2007). 

3. Human capital development is not examined here. It became an acknowledged feature of growth 

studies with Lucas's 1985 Marshall lectures. See Robert E. Lucas, Jr., On the Mechanics of Economic 

Development, 22 J. MONETARY ECON. 1, 17 (1988). 


2007 PROPERTY RIGHTS, COLLATERAL, CREDITOR RIGHTS, AND INSOLVENCY 517 

The eleven subject jurisdictions appear in two groups, shown in Table 1. First is 

a core group of nine, which have undergone, or intend to enact, reforms in the 

subject areas. Second are two common law jurisdictions that are perceived as being 

among the most sophisticated in the region in terms of the issues examined, and 

which may represent benchmarks for reform elsewhere. It is not suggested that 

either jurisdiction represents an institutional or practical optimum.' 

TABLE 1: JURISDICTION CLASSIFICATIONS 

Study Core 

Regional Benchmarks 

Jurisdictions 

Cambodia South Korea Hong Kong 

China Taiwan Singapore 

Indonesia Thailand 

Malaysia Vietnam 

Philippines 

Neither law nor practice is advanced in relevant areas in most of the remaining 

jurisdictions within the region, but the issues addressed in this article have begun to 

receive attention from policymakers and commercial interests. The issues of policy 

and principle raised in this article have been regularly debated in official and legal 

circles since the economic and social shocks associated with the 1997-98 Asian 

financial crisis. In no national case can the legal, regulatory, or policy background be 

described as either complete or fully integrated, even in the two examples of 

benchmarks, or elsewhere in countries where specific reforms have been recently 

instigated or completed, for example, China or the Philippines. 

Later sections include tables that give appraisals of the legal framework for 

creditor rights, especially in relation to secured claims; the effectiveness of national 

insolvency systems; specific or general provisions for private securitized transactions; 

and the mutual compatibility of systems for enforcement. Thus in Tables 2, 5, 7 and 

8, a scale rising from 1 to 5 is used to indicate the quality or effectiveness of specific 

factors that are self-explanatory, with "NA" used to signify where the law makes no 

provision in a specified matter, based primarily upon qualitative analysis. Unless 

stated, these tables use terms such as "security" and "interest" in a generic sense 

without attachment to any legal system or jurisdiction. In each case, the appraisals 

acknowledge not only pure aspects of law and regulation (often clear where the law 

includes recent legislation), but also qualifications to reflect enforcement issues, 

integration with related law, and the stability of the regulatory setting. Commercial 

participants throughout the region have often found that while the law appears clear, 

it suffers from uncertain application. The results appear in complex private financial 

transactions that seek to mitigate such risks. 

It is now generally accepted that the form and practice of law influences 

economic behavior. In particular, institutional quality is an important determinant of 

4. Certain reforms in Japan's civil code and statutes have guided changes elsewhere among civil law 

jurisdictions in the study group. See infra note 80. 



VOL. 42:515 

credit creation and flows of capital, both among the main sectors of an economy and 

in cross-border savings and investment. Factors such as legal origin, the nature of 

the acquisition or founding of law, and details of its application and enforcement are 

seen in features of governance, economic systems and structure, commercial culture, 

corporate behavior, and financing patterns. These conditions also affect broader 

variables such as national output or personal income. The appraisals in this article 

and the research upon which they are based thus adopt the view of users, that is, 

principals and agents, that become subject to the law rather than those involved in its 

creation or administration. 

At the same time, the efficiency and consistency of the law's operation will 

always form part of its institutional costs, so that no assessment can ignore the 

organization and management of legal systems. This is especially valid in the context 

of creditor claims and corporate distress. In general, the main objective of the 

reform of laws governing security and creditor rights will be to influence behavior 

through changes in costs. The following two parts of this article discuss respectively, 

its theoretical background and the role of property rights in transaction formation 

and credit creation. Parts IV and V then examine collateral and secured 

transactions, and creditor rights and insolvency, respectively. Part VI concludes with 

an outline of provisions in Asia for contract enforcement and commercial dispute 

resolution. 

II. 

GOVERNANCE, ECONOMIC AND LEGAL SYSTEMS 

State governance and the appropriateness of political and economic structure 

have been of interest for over ten thousand years, prompted by specialized human 

activity encouraging the first agricultural settlements. This in turn allowed the 

development of writing systems appropriate and necessary to sustain the 

administrative structures of such settlements. Building the "perfect society" and 

creating governance systems to encourage its development has been a focus of many 

thinkers, including Confucius, Plato, Aquinas, Locke, and Marx. All political and 

economic systems function in close parallel, even though the interplay may not 

always be acknowledged by political theorists. Certainly, the relationship between 

politics (or governance) and economics has been a central interest of Smith, Marx, 

and more recently Keynes, Hayek, and Friedman. Although politics and economics 

became increasingly distinct disciplines in the twentieth century, the end of the 

millennium saw a reviving interaction between governance and economics, partly 

encouraged by the experience of market orientation undertaken by many centrally 

planned economies, and from the conspicuous failure of earlier economic 

development models in neglecting institutional issues of governance. 

The role and development of financial intermediaries have become a focus of 

attention only recently in law, financial policy, and economics, although each 

discipline is directly concerned with both the problem and its several explanations. 

Similarly, conditions influencing how financial structure develops have begun to 

interest scholars in the developed and developing world, and those helping to create 

supportive policy. Until the 1970s few economic or finance theorists gave attention 

to the nature of financial systems or how they may affect economic development. 

Similarly, the importance and influence of the characteristics of financial markets 

and intermediaries has been accepted only since the late-1980s, with the inception 

and success of the law and finance and institutional economics schools. Financial 



intermediation is now recognized as vital to many aspects of economic development, 

and what determines the nature of financial intermediaries and financial system 

infrastructure is susceptible to both quantitative analysis and the tools of legal and 

economic theory. 

By the beginning of the 1990s, two traditionally polar alternatives-central 

planning under state ownership and laissez-faire-had been subsumed into an 

apparent consensus as to the general superiority of a market economy, but one 

functioning under the framework of an appropriate and transparent regulatory 

system, with the state taking a benign but active role in addressing the interests of 

any society through the provision of largely agreed public goods, systems to limit or 

ameliorate market failure, and sanctions to penalize market abuse, whether arising 

from monopoly or the occurrence of asymmetric information available to privileged 

participants. Nonetheless, as Shleifer and others have recognized, many differences 

remain among today's economic and governance models.' The question then arises 

as to what may represent the best choices among available options, and to what 

extent those choices lead to the disadvantage of certain interests. 

For institutional economists such as North, and writers in the law and 

economics school, governance systems must provide for two fundamental features to 

support a market economy, regardless of its ideological identity and consequent 

form. First, the system must provide for clear and usable property rights. Second, it 

must facilitate practical and fair contract enforcement. Both literatures agree that 

these conditions are essential in the context of imperfect markets where there exist 

discernable transaction costs. While there appears to be agreement as to the need to 

satisfy these basic points, the governance structure that best supports a market 

economy is less apparent, and may change in relation to the relative development of 

the host economy. 

Many scholars have argued further that democratic models of governance are 

optimal in protecting property rights and enforcing contracts, albeit this was the 

result they sought most often to prove. However, Olson has presented a convincing 

argument that a variety of governance structures can provide each of these necessary 

features. 6 Specifically, he suggested that an autocrat with a long-term time horizon 

will have a strong incentive to support both property rights and contract 

enforcement in order chiefly to maximize revenue from taxation. 7 Conversely, Olson 

argues that any democracy, while potentially providing for property rights and the 

enforcement of contracts, may nevertheless become subject to inefficient outcomes 

due to its responsiveness to representative but factional interests. 8 Thus neither 

autocracy nor democracy is necessarily a superior political system in providing the 

most beneficial support for a market economy. Instead, what is necessary is a 

"market-augmenting government." 9 There is contemporary anecdotal evidence that 

5. See Simeon Djankov et al., The New Comparative Economics, 31 J. COMP. ECON. 595 (2003). 

6. MANCUR OLSON, POWER AND PROSPERITY: OUTGROWING COMMUNIST AND CAPITALIST 

DICTATORSHIPS (2000). 

7. Id. 

8. Id. 

9. Charles Cadwell, Foreword to MANCUR OLSON, OUTGROWING COMMUNIST AND CAPITALIST 

DICTATORSHIPS, at x (2000). 



VOL. 42:515 

certainly supports Olson's theory,' and recent empirical research has begun to test 

these ideas and appears to be supportive." 

North sums up the interaction between the political system and property rights 

thus: 

Broadly speaking, political rules in place lead to economic rules, though 

the causality runs both ways. That is, property rights and hence individual 

contracts are specified and enforced by political decision-making, but the 

structure of economic interests will also influence the political structure. 

In equilibrium, a given structure of property rights (and their 

enforcement) will be consistent with a particular set of political rules (and 

their enforcement). Changes in one will induce changes in the other. 2 

The result is that a national governance structure is important and must provide 

for property rights and the enforcement of contracts, as well as human capital 

development. However, while some governance structures are clearly not conducive 

to liberty (any state run by the myopic autocrat-bandit), there is at present no clearly 

preferable model. Both autocratic and democratic governance systems can support 

a market economy. Similarly, each can provide for institutional choices that fail to 

result in efficient, wealth-maximizing outcomes in a given economy. 

Two further underlying issues are present throughout this study: those relating 

to the mechanisms that transmit influences on economic growth, and those involving 

the means by which finance affects economic development, including the 

relationship between legal systems and financial structure. Neoclassical economic 

theory, post-1940s growth theories and traditional finance theory all ignore or 

assume away the nature of financial systems." While finance and corporate finance 

theory examine commercial organizations in terms of contract or cost, a similar 

approach has been applied only recently to financial intermediaries, and rarely to 

examine financial systems. Thus, early modern studies of the determinants of 

economic growth identified a strong correlation between the "rule of law" and per 

capita growth.'" These analyses were weak in terms of identifying with any practical 

precision the ways in which legal reform might be invoked to promote growth, given 

10. Cf. China, Singapore. 

11. See Djankov et al., supra note 5 (indicating that policies are more important than democratic 

institutions, and specifically, that human capital is a more basic source of growth than democratic 

institutions; that poorer states can alleviate poverty through sound policies, even when pursued by 

dictators; democratic institutions are developed after economic "take-off"). 

12. DOUGLASS C. NORTH, INSTITUTIONS, INSTITUTIONAL CHANGE, AND ECONOMIC PERFORMANCE 

48 (1990). 

13. This growth school pattern probably began with WALTER ROSTOW, THE PROCESS OF ECONOMIC 

GROWTH (1952); Lucas, supra note 3, perhaps the most willful financial agnostic, based indifference upon 

the thesis that at firm level, financial performance is unrelated to the composition of funding. Certain 

Marxian analysis asserts a causal relationship running from economic activity to financial structure to 

accord with the primacy of capitalist production. It is often unspecific in its treatment of both law and 

financial activity in this area, perhaps reflecting Marx's disdain for "merchant" or "commercial" capital an 

exception is J. J. McManus The Emergence and Non-emergence of Law, 5 BRIT. J. LAW & SOC'Y 185. 190 

(1978) (describing the origin of English consumer credit legislation). 

14. Notably, Robert J. Barro, Economic Growth in a Cross Section of Countries, 106 Q. J. ECON. 26-28 

(1971); ROBERT J. BARRO, DETERMINANTS OF ECONOMIC GROWTH: A CROSS-COUNTRY EMPIRICAL 

STUDY 26-28 (1997). 



that the measures used to specify rule of law explanatory variables were primitive 

and included subjective components such as commercial indexes of sovereign risk. 

The law and finance school asserts that there exist significant causal links 

between the origins of law or the means by which a national system of law is 

acquired, and the nature of financial system development. 15 Certain scholars further 

suggest a causal relationship that flows from financial development to economic 

performance, although most accept that such links are unlikely to be unicausal 6 

Questions investigated or prompted by the law and finance school include: first, the 

relationship of institutional development to general economic welfare; second, the 

relationship between legal origin and the effectiveness and even-handedness of legal 

systems; third, whether the effectiveness of a national legal system is significantly 

determined by its origin or the form of its acquisition; and finally, whether common 

law is inherently more effective than other systems in encouraging financial 

development, stimulating credit growth or protecting property rights. 7 

While the general premise of law and finance protagonists has become 

accepted, especially in suggesting more specific legal research agendas, the school 

has been criticized for two main methodological reasons. The first is its choice and 

specification of explanatory variables:" 8 which may either be incomplete or 

endogenously related to the objective questions that the analysis seeks to answer;" 

which may not signify close substitutes or take account of compensatory mechanisms 

in different legal systems; 0 or may reflect customary choice appropriate mainly to 

15. Djankov et al., supra note 5; Robert G. King & Ross Levine, Finance & Growth: Schumpeter 

Might Be Right, 108 Q. J. ECON. 717 (1993), Ross Levine, Finance & Growth: Theory & Evidence (Nat'l 

Bureau of Econ. Res. Working Paper No. 10766, 2004); Ross Levine, Financial Development and 

Economic Growth: Views and Agenda, 35 J. ECON. LIT. 688 (1997); Raghuram G. Rajan & Luigi Zingales, 

Financial Systems, Industrial Structure, and Growth, 17 OXFORD REV. ECON. POL. 467 (2001). 

16. Notably Thorsten Beck et al., Law and Finance: Why Does Legal Origin Matter? (World Bank 

Pol'y Res. Working Paper 2904, 2002); Thorsten Beck & Ross Levine, Legal Institutions and Financial 

Development (Nat'l Bureau of Econ. Res. Working Paper No. 10126, 2003); Rafael La Porta et al., Law 

and Finance, 106 J. POL. ECON. 1113 (1998); Legal Determinants of External Finance, 52 J. FIN. 1131 (1997); 

Paul G. Mahoney, The Common Law and Economic Analysis: Hayek Might be Right, 30 J. LEGAL STUD. 

503 (2001); Peter L. Rousseau & Richard Sylla, Financial Systems, Economic Growth and Globalization 

(Nat'l Bureau of Econ. Res. Working Paper No. 8323, 2001). 

17. Given that the quality of creditor and shareholder protection measures the effectiveness of a 

national legal system. This is not synonymous with financial development but is often so taken, with the 

protection of claims used as a proxy for financial sophistication. 

18. Philip Arestis & Panicos Demetriadis, Financial Development & Economic Growth: Assessing the 

Evidence, 107 ECON. J. 783 (1997): Daniel Berkowitz et al., The Transplant Effect, 51 AM. J. COMP. L. 163 

(2003); David Blum et al., The Financial-Real Sector Nexus: Theory & Empirical Evidence (Res. Inst. for 

European Affairs Working Paper No. 43, 2002); Charles Kenny & David Williams, What do we know about 

Economic Growth? Or, Why don't we know very much?, 29 WORLD DEV. 1 (2001); Michael Thiel, Finance 

& Economic Growth: A Review of Theory & the Available Evidence (Eur. Comm. Econ. Pap. No. 158, 

2001); Paul Wachtel, How much do we really know about Growth & Finance?, 88 FED. RES. BANK 

ATLANTA ECON. REV. 1 (2003). 

19. See Rajan, supra note 15. 

20. MARK J. ROE, STRONG MANAGERS, WEAK OWNERS: THE POLITICAL ROOTS OF AMERICAN 

CORPORATE FINANCE (1994); KATHARINA PISTOR & PHILIP WELLONS, THE ROLE OF LAW AND LEGAL 

INSTITUTIONS IN ASIAN ECONOMIC DEVELOPMENT 1960-1995 (1999); Katharina Pistor et al., Law and 

Finance in Transition Economies, (European Bank for Reconstruction & Dev. Working Paper No. 48, 

2000); Sofie Cools, The Real Difference in Corporate Law Between the United States and Continental 

Europe: Distribution or Powers, 30 DEL. J. CORP. L. 697 (2005); Mathias Siems, Legal Origins: Reconciling 

Law & Finance And Comparative Law, available at SSRN: http://ssrn.comnabstract=920690. 



VOL. 42:515 

developed, homogenous markets. 2 The second attack concerns the usefulness of the 

school's conclusions in indicating legal or regulatory reform, given that legal related 

explanatory variables have of necessity been general and unspecific. 22 

As examples, the scale of finance evident in an economy has often been used as 

an explanatory variable, but it may not measure financial sophistication, contrary to 

the intentions of La Porta, L6pez-de-Silanes, Shleifer & Vishny (LLSV) or Rousseau 

& Sylla; 23 no distinction is made between types of claims against a debtor or firm. 

Rather, all debt is generally taken as secured. The chain of causation identified by 

the law and finance school (especially LLSV) runs from legal origin to enforcement, 

to financial development and finally to growth. This is unreliable for policy 

development if legality impacts growth but legal origin does not impact legality. A 

more fully informed identification of explanatory variables will assist with these 

problems. It may also overcome problems caused by the static nature of the law and 

finance school's analysis, for example, ignoring the convergence of civil and common 

commercial law with political regionalization and financial harmonization, more 

extensive financial and trade treaty networks, and the activity of international selfregulatory 

bodies. 

Theoretical interest in the structure and operation of financial systems was 

largely absent from legal and financial studies before the 1970s, and in schools of 

24 

economics was confined to political economy. That such indifference has vanished 

results largely from the influence of two trains of scholars. First, Goldsmith sought 

ways to test whether financial structure could be related to levels of economic 

development." This work was to become a foundation of the law and finance school. 

Second, North and others synthesized hitherto separate concepts from law, finance 

and economics in what has become modern institutional economics, which stresses 

the nature and effect of core rights, duties and incentives. While the first is primarily 

concerned with whole markets or national economies and the latter is initially 

microeconomic in its emphasis, the two disciplines share certain interests, and meet 

in the analysis of the effects of legal systems and property rights, for example, on 

economic conditions and development. 

The approach of the traditional financial development school was to examine 

the role of banking and bank credit creation. More recent law and finance analysis 

has taken account of environmental and cultural factors, and indeed all measurable 

financial variables. None has yet examined in detail the quality of law enforcement 

in a commercial context, for example, in the willingness of national courts to enforce 

foreign judgments and accept non-exclusive jurisdiction transaction provisions. 

Instead, where quality of law and regulation is included in analysis, its tendency to 

date has been on subjective index measures of the "rule of law." In addition, while 

law and finance scholars have sought to quantify the effects on financial 

21. Naomi R. Lamoreaux & Jean-Lamoreaux Rosenthal, Legal Regime and Business Organizational 

Choice: A Comparison of France and the United States (Nat'l Bureau of Econ. Res. Working Paper No. 

10288, 2004). 

22. Frank B. Cross, Law and Economic Growth, 80 TEx. L. REV. 1736 (2002); Kevin E. Davis, What 

Can the Rule of Law Variable Tell Us About Rule of Law Reforms? (N.Y.U. L. & Econ. Res. Paper Series 

Working Paper No. 04-026, 2004); Kevin E. Davis & Michael J. Trebilcock, Legal Reforms and 

Development, 22 THIRD WORLD 0. 210 (2001); Roe, supra note 20. 

23. See supra note 16. 

24. Due largely to Marx, Schumpeter, and Weber and their later acolytes, but in no instance with the 

dedication to detail of the modern law and finance school. 

25. RAYMOND GOLDSMITH, FINANCIAL STRUCTURE AND DEVELOPMENT (1969). 



development of national legal systems or their origins, 26 no systematic attempt has 

yet appeared in this context that together considers legal origins, their form of 

acquisition and the distinct nature of jurisdictions, especially when their roots are 

mixed. 2 ' Nor has analysis yet recognized that the nature of commercial legal disputes 

may itself be endogenous to the legal system. 

Related work includes a considerable body of empirical studies in the style 

pioneered by Goldsmith and following the methods adopted by King & Levine and 

LLSV in seeking evidence of causal relationships between financial market or 

institutional sophistication or structure (including legal origins and conditions), and 

economic development, commonly measured by growth in national output. While 

not unanimous, these generally suggest that finance often has a positive effect on 

growth, although contrary to popular belief there is no theoretical school that asserts 

the contrary: that the primary causal flow is from economic growth to financial 

development. 28 

The remainder of this article contains summaries of appraisals of the 

effectiveness of current law and practice as to collateral and creditor rights in eleven 

prominent East Asian jurisdictions. In particular, it examines discrete aspects of the 

creation and treatment of secured creditor interests, processes for insolvency, 

securitization, and the functional relationship between these related aspects of law. 

The effects of globalization on both market practice and harmonization of financial 

regulation mean that the private law governing international financial transactions 

differs less by virtue of the location of parties or the place of transaction execution 

than by issues of judicial enforcement, including the willingness of courts to provide 

equitable and predictable judgments to domestic and foreign creditors." The quality 

of legal and practical provisions for insolvency is also central to the willingness of 

lenders and investors to provide funds for capital investment. By contrast, legal 

frameworks for the taking or enforcement of collateral may be influenced by 

informal or traditional national or local commercial custom, although remaining 

subject also to the prevailing form of law and the roots of national law. 

26. See La Porta et al., supra note 16 (classifying forty-nine national legal systems by their origins in 

English common law or French, German or "Scandinavian" civil law); Berkowitz et al., supra note 18 

(dividing the same sample among ten original systems); PHILIP WOOD, COMPARATIVE FINANCIAL LAW 

(1995) (perceiving seven categories, not including states that lack a clear legal system or for which it may 

be "emerging"). Earlier comparatists found different solutions, the most contemporary being David, who 

identifies eight "families" of law, see RENt DAVID & JOHN E. C. BRIERLEY, MAJOR LEGAL SYSTEMS IN 

THE WORLD TODAY: AN INTRODUCTION TO THE COMPARATIVE STUDY OF LAW (John E. C. Brierley 

trans., 2d ed. 1978), not all of which subsist in the form described. 

27. Philip Wood, Global Law Maps: Key Map of Jurisdictions (mimeo, 2001) identified up to 307 

distinct national and state jurisdictions. The number is certain to change. 

28. That a body of scholarship contends that financial development largely responds to economic 

growth was first suggested against the theme of his study by Richard C. Porter, The Promotion of the 

"Banking Habit" and Economic Development, 2 J. DEV. STUD. 346, 363 (1966) (asserting in a footnote that 

"the few economists who have proposed a clear direction of causation between real and financial growth 

usually suggest [that real growth precedes financial sector development]"). The remark is often repeated 

without substantiation. 

29. This appears in contemporary comparative analyses of commercial law. See WOOD, supra note 



VOL. 42:515 

III. THE SIGNIFICANCE OF PROPERTY RIGHTS 

Property rights were an important concern for Smith, Marx and Weber but 

received little attention from economists for generations until becoming subject to 

intensive research in the late 1970s. Until recently the nature of finance and thus the 

preconditions for its provision were ignored or assumed away by generations of 

economists and finance specialists; only "maverick" opinion appears to have 

considered otherwise. 

The importance of property rights began to receive significant contemporary 

attention when the disintegration of the Soviet bloc introduced the challenge of 

transforming command economies to market-based systems. Development specialist 

de Soto deserves considerable credit for increasing awareness of the importance of 

property rights in this respect, especially in relation to the potential impact of 

formally endowing individuals with such rights. 

Classically, property is seen as a "bundle of rights." More specifically, 

"property" includes some or all of a variety of different "rights," including the rights 

to hold, use, modify, transfer, or destroy a real or intangible asset. Questions of 

degree and time relate to all such varied rights, and the extent to which a property 

owner may exploit such rights may be constrained by the competing rights of others 

within a legal system or as part of public policy. In addition, property can be real or 

personal, tangible, or intangible. The more complex a system of property rights, the 

more effective is their potential use in the context of finance and capital-raising. 

According to North: 

Property rights are the rights individuals appropriate over their own labor 

and the goods and services they possess. Appropriation is a function of 

legal rules, organizational forms, enforcement, and norms of behaviorthat 

is, the institutional framework. 3 " 

De Soto argues that capital is the engine of a market economy, with property 

rights the mechanism that allows it to be effectively deployed. 31 Further, relatively 

poor countries often fail to produce capital sufficient for economic development due 

to five main failings in property systems. First, such societies may have substantial 

masses of capital, 32 yet it represents "dead" resources in that it is constituted by 

assets, interests or claims that cannot be used or mobilized as capital. Second, 

capital is intrinsically difficult to define or recognize. Third, many states have 

neglected the importance of the preceding two factors, an attitude that has begun 

only slowly to change. 33 Fourth, while de Soto's process of mobilizing property rights 

30. DOUGLASS NORTH, INSTITUTIONS, INSTITUTIONAL CHANGE AND ECONOMIC PERFORMANCE 33 

(1990). 

31. HERNANDO DE SOTO, THE MYSTERY OF CAPITAL: WHY CAPITALISM TRIUMPHS IN THE WEST 

AND FAILS EVERYWHERE ELSE (2000). 

32. Id. at 35. By his calculation, "the total value of the real estate held but not legally owned by the 

poor of the Third World and former communist nations is at least [US]$ 9.3 trillion." Id. 

33. De Soto states this best: 

The substantial increase of capital in the West over the past two centuries is the consequence of 

gradually improving property systems, which allowed economic agents to discover and realize 

the potential in their assets, and thus to be in a position to produce the non-inflationary money 

with which to finance and generate additional production. 



needed in emerging or transition economies had occurred earlier elsewhere, it was 

often poorly understood or documented, even in relatively sophisticated states. 

Finally, laws need to reflect national or local circumstances in order to allow the 

effective transformation of property rights into capital. 

For de Soto: 

A well-integrated legal property system in essence does two things: First, 

it tremendously reduces the costs of knowing the economic qualities of 

assets by representing them in a way that our senses can pick up quickly; 

and second, it facilitates the capacity to agree on how to use assets to 

create further production and increase the division of labor." 

De Soto concludes that formal property systems are required to produce six 

effects so as to allow individuals to generate usable capital. These are: first, making 

certain the economic potential of existing assets; second, integrating dispersed 

information into a single dependable system; third, making individuals accountable 

for their economic actions; fourth, increasing the fungibility of assets; fifth, 

marshalling individuals into valuable social networks; and sixth, protecting the 

integrity of legitimate transactions." 

Established and accepted property rights and their identification and 

protection, including rights over intellectual property are, therefore, essential in any 

market economy. 36 Unfortunately, de Soto notes that such rights have evolved in 

advanced economies over protracted periods, making it difficult even for the legal 

historian to discern how they function or become established. Without complete 

templates of this kind it may never be simple for emerging, transition or developing 

economies to introduce those experiences or systems, even when respecting the 

integrity of local or state culture. Furthermore, the recognition of property rights is 

not self-justifying; the need is for such rights to be available for use other than in 

instantly completed transactions. This is an underlying theme of the remainder of 

this article. 

IV. 

COLLATERAL AND SECURED TRANSACTIONS 

Collateral exists to meet commercial customs, national practices, and socioeconomic 

constraints that differ strongly between jurisdictions, even in an era when 

commercial practice and financial regulation are often well-integrated and the 

international harmonization of financial markets is well-advanced. Several World 

Bank studies have surveyed law, institutions, and secured transactions, 37 but the 

reasons for security differ everywhere by intention, nature, and degree. This affects 

whether the granting of collateral is an efficient choice for commercial or individual 

Id. at 65. 

34. Id. at 63. 

35. Id. at 49-62. 

36. Leora Kapper et al., Business Environment and Firm Entry: Evidence from International Data 27- 

28 (World Bank Policy Research, Working Paper No. 3232, 2004). 

37. See World Bank, 1989 World Bank Dev. Rep. (1989); 2002 World Bank Dev. Rep. (2002); Yoram 

Keinan, The Evolution of Secured Transaction's Background Study for World Development Report 2002 

(2001). 



VOL. 42:515 

borrowers, or for creditors at large. Recent analysis of European transition 

economies suggests that the provision of collateral is important in inducing earlystage 

development." 

Schumpeter's 1939 description of the working of capitalism 39 draws on his 

earlier theoretical approach to interest and credit creation that came to be disputed 

by contemporary traditional classicists (Cannan), radicals (Keynes and Joan 

Robinson), and for some remains controversial. It includes a generic description of 

the role of credit creation in banking not attempted by his contemporary critics. 

Schumpeter's approach includes a customary means by which a creditor bank may 

seek to overcome transaction obstacles and thus lessen the costs resulting from 

asymmetric information, which otherwise would often force the adoption of 

incomplete lending contracts. Modern structured finance techniques such as nonrecourse 

project finance or securitization are intended to limit to the greatest 

possible extent the incompleteness of financing contracts. In each case, contractual 

structuring results in the debtor having no surplus value, so as to become 

theoretically constrained from engaging in activity outside the financed enterprise. 

By contrast, lending conducted under typical incomplete contracts involves 

credit risks subject to unquantifiable Knightian uncertainty, since lenders can only be 

partially informed as to the scope of activities of companies to which they lend. 

Even though lenders may hope to mitigate the effects of incomplete contracts by 

incorporating covenants and assignments of actual or potential revenue into 

contracts, the result will inevitably be subject to general practice and comparative 

strengths in negotiation. Even if a lender has full knowledge of a debtor enterprise, 

the volition of the debtor may lead to default, which on occasion may be 

economically rational.' Other mechanisms to encourage contract compliance (given 

that few non-fraudulent debtors in advanced economies now face the threat of 

prison) include socioeconomic forces of the kind traditionally associated with distinct 

lending markets, for example, in the financing of the trade in diamonds or ship 

purchase. By this view, the taking of collateral is thus not related to information 

discontinuities but represents a sanction to encourage contract compliance by the 

debtor. In terms of institutional analysis it will typically constitute a distortion, 

38. Rainer Haselmann, Katharina Pistor & Vikrant Vig, How Law Affects Lending (Colum. L. Econ. 

Working Paper No. 285, 2005). By contrast, this may not have been the case in the British industrial 

revolution, when the existence of reliable non-possessory land mortgages failed to induce banks to lend in 

a major way to industrial capitalists, allowing historians to discount the importance of finance in 

development; see MAURICE DOBB, STUDIES IN THE DEVELOPMENT OF CAPITALISM (1947); MICHAEL 

FLINN, ORIGINS OF THE INDUSTRIAL REVOLUTION (1966) 52-53. A similar pattern of bank passivity is 

observed in the United States at the turn of the twentieth century; see Naomi R, Lamoreaux, Margaret 

Levenstein & Kenneth L. Sokoloff, Financing Invention during the Second Industrial Revolution: Cleveland 

Ohio 1870-1920, 27-30 (Nat'l Bureau of Econ. Res. Working Paper No. 10923, 2004). Yet only after 1850 

did a reliable form of non-possessory chattel mortgage emerge in Britain, and it was arguably not fully 

trusted by lenders until the early twentieth century. ROY GOODE, COMMERCIAL LAW 586 (3d ed. 2004). 

Neal observes that England's preceding seventeenth to eighteenth century "financial revolution" has long 

been underestimated in its effect on later commercial development, see Larry Neal, The Finance of 

Business during the Industrial Revolution, in 1 THE ECONOMIC HISTORY OF BRITAIN SINCE 1700, 151 

(Roderick Floud & Deirdre McCloskey eds.(1994). Hartwell similarly acknowledges a lack of attention to 

private finance in growth studies, describing the service sector as the "neglected variable"; see RONALD 

MAX HARTWELL, THE INDUSTRIAL REVOLUTION AND ECONOMIC GROWTH (1971). 

39. JOSEPH SCHUMPETER, BUSINESS CYCLES: A THEORETICAL, HISTORICAL, AND STATISTICAL 

ANALYSIS OF THE CAPITALIST PROCESS (1939). 

40. For example, in the case of home mortgage loans where the value of collateral falls below the 

amounts outstanding, given certain limits to creditor rights in bankruptcy. 



enabling credit substitution to become the means by which a bank lender avoids the 

moral hazard associated with asymmetric information. 

At the same time, contrary to the findings of certain studies of domestic U.S. 

practice-except in cases where recourse to the principal debtor is non-existent or 

limited-taking security is not generally a device to signal credit quality but the 

converse, 4 ' as with conventional non-recourse project finance. Rather, it serves three 

main purposes for the principals involved or prospectively engaged in financial 

bargaining, shown in Figure 1. 

FIGURE 1: PRINCIPAL FUNCTIONS OF COLLATERAL 

(A) 

financier. 

Transformative 

(B) 

Informative 

(C) 

(D) 

(E) 

Providing incentives 

(F) 

(G) 

(H) 

Mitigation or substitution in credit risk for a potential 

Change in capital asset use to make financing available. 

Signal credit risk strengths or borrower status. 

Signal risk or bargaining weaknesses. 

Facilitate credit substitution. 

Effect on costs and information for credit creation. 

Provide financiers with known credit risks. 

Encourage contractual compliance by collateral providers. 

Adequate institutional infrastructure enable banks to extend the duration of 

their loans and reduce regulatory capital costs by providing greater confidence as to 

the credit risk associated with likelihood of repayment. In this regard, two aspects of 

lending infrastructure are especially important for risk management: an effective 

system for taking security, and sufficient sources of information through accounting 

standards, audit practice, credit rating methodology and oversight, and acceptable 

credit information systems. In addition, banks need systems to manage risks 

appropriately, these typically being required by capital adequacy and other 

prudential regulatory requirements. 

41. This and other motivations for borrowers to grant security have been questioned notably by 

Schwartz, who (assuming with Modigliani and Miller that the value of an enterprise is unrelated to the 

composition of its capital) asks whether security represents an efficient practice, given its effect on other 

potential creditors and the interplay of priority of claims with U.S. precepts of bankruptcy. See Alan 

Schwartz, Security Interests and Bankruptcy Priorities: A Review of Current Theories, 10 J. LEGAL STUD. 1, 

1 (1981) [hereinafter Schwartz, Security Interests]; Alan Schwartz, The Continuing Puzzle of Secured Debt, 

37 VAND. L.R. 5, 1051 (1984) [hereinafter Schwartz, Puzzle of Secured Debt]; Franco Modigliani & Merton 

Miller, The Cost of Capital, Corporation Finance and the Theory of Investment, 48 AM. ECON. REV. 261 

(1958). A more recent study suggests that collateral provides incentives for lenders to monitor loan 

performance and is correlated with generally poor business conditions or the debtor's financial distress. 

See Raghuram Rajan & Andrew Winton, Covenants and Collateral as Incentives to Monitor, 50 J. FIN. 1113 

(1995). 



VOL. 42:515 

As an institution of risk management, an effective system to create security 

allows lenders to obtain collateral to reduce unwanted credit risk and have 

confidence that such collateral may be realized where necessary to permit the full or 

partial repayment of a loan. Effective security creation and registration thus 

provides two advantages for lenders. First, it allows the limiting of monitoring costs 

by means of partial or complete credit risk substitution, providing that no failure to 

monitor collateral results in the erosion of security protection. Second, it increases 

simplicity in lending decision-making, thereby increasing the probability that such 

decisions will be made. 42 

If property rights are to create capital, they must be applied to procure funding 

so that the taking of security is the lender's simplest form of risk mitigation. Loans 

are disbursed provided the lender is given a contingent claim to property of a 

proportionately equivalent or greater value. If the debt is not satisfied, the lender 

retains the property and need take little or no account of the credit risk of the 

borrower. In this simple case, the availability of collateral induces marginal lending. 

However, to prompt this simple transaction, the lender must be confident of 

retaining rights to the property given contractual non-payment by the debtor. Thus, 

the borrower must have valid initial title to the property, and the law must provide 

for certain and effective transfer of ownership in the event of the security being 

enforced. Finally, the lender will need a means to appraise supporting collateral. 

This has often been a problematic feature of all economies, whether developed, 

emerging, transition, or developing, and usually in the context of loans secured by 

real property. 

Complex collateral-based lending involves sophisticated distinctions between 

property rights and the certainty of contractual enforcement, derived from the 

prevailing legal and institutional framework. For example, in the simple transaction 

of the preceding paragraph, a borrower provided physical, recognizable collateral to 

secure its indebtedness, as in the common South Asian example of personal loans 

secured by quantities of gold or silver. This is collateral deployed in its most simple 

form. For reasons presented in the preceding paragraphs, the use of collateral in 

secured transactions can become more complex only to the extent that it is 

supported by an adequate legal and institutional framework. If a borrower must 

deliver physical collateral to a lender then poorly capitalized enterprises will lack 

access to most secured lending, and excessive transaction costs render the exercise 

sub-optimal. 

With institutional support for more advanced practices, a borrower may be 

allowed physical possession of collateral pre-dating the creation of a new loan, thus 

keeping day-to-day control of the use and enterprise value of existing assets, 

whether land, buildings, plant, or machinery. At a still more sophisticated legal 

level, a loan might be used to purchase real property or productive assets, secured by 

those newly-acquired assets, with the borrower retaining their full use in ways that 

may be expected to assist in the servicing of the loan. While the mechanics of such 

transactions are simple to describe, this type of purchase money security is not 

universally supported by security or bankruptcy law. Whether national law allows or 

42. The contrary argument is that over-reliance on collateral in lending to commercial enterprises 

represents an inefficient solution and raises a moral hazard, in each case by disassociating the creditor from 

a true interest in the borrower's commercial prospects. Even if this is not the case, in certain common law 

jurisdictions where banks may be encouraged to seek security interests in order to gain a degree of 

contractual influence over the debtor. 



limits such arrangements reflects an underlying view of the economic welfare 

associated with security and collateral. This is seen in the competing views of a 

commercial enterprise as being either revenue generating or a custodian of assets, 

and may result in the legal treatment of the purchase of money security as unfairly 

benefiting individual creditors at the expense of others. 3 

In each case, transaction complexity requires greater legal sophistication, and 

deploying moveable property as collateral typically requires a more complex legal 

framework than real property. Furthermore, while real or movable physical 

collateral is associated with the largest share of secured lending in most emerging 

and developed economies, intangible property may also represent potential 

collateral, including intellectual property or trade receivables. The rights of a 

secured creditor could thus extend to defined classes of assets such as inventory or 

receivables, to a company's entire asset base if it becomes subject to whole business 

securitization, or where debts are secured by floating charges as found in English law 

and certain other common law jurisdictions. They might also extend to the right to 

receive revenues rather than actual receipt of revenues, providing in each case that 

the institutional system is sufficiently supportive. 

Simple financial markets are greatly enhanced when the availability of 

collateral increases, even though there may be diminishing returns in the welfare 

created by collateral-based lending. As a minimum, functional markets require that 

real property used as security be left in the possession of the borrower, and that 

security over movable assets does not hinder their normal commercial use." 

Developed financial markets typically operate with a wide range of feasible 

collateral assets, and sophisticated financial markets similarly require commensurate 

techniques for taking security, for example, in using future receipts and providing for 

securitization. Nonetheless, questions and anomalies exist even in advanced 

financial markets. De Soto asserts that property must be allowed in use as collateral 

in order to encourage economic development, but then fails to distinguish between 

the legal and institutional issues concerning property, which he addresses in a 

"capitalization process," and in the use of property as collateral, except in relation to 

the recording or registration of property rights. In reality, capital is created or 

released only given both aspects of the framework supporting the use of property 

and property rights as collateral for secured transactions. To refine de Soto's 

analysis, property rights must exist and property must also be usable in support of 

funding for a financial system to develop comprehensively beyond a basic level." 

Despite the importance of collateral and secured transactions, this is an area of 

law involving highly varied legal systems, which in developed jurisdictions is also 

highly technical. Perhaps as a result, secured transactions tend to receive analytical 

attention at relatively advanced levels and involve those emerging economies that 

are already well-progressed in systems supporting basic secured transactions. Once 

43. An alternative approach distinguishes between the common law view of the firm as a nexus of 

contractual bargains, following Ronald H. Coase, The Nature of the Firm, 4 ECONOMICA 386 (1937), and 

the more civilian view of the firm as a commercial hub of rights and obligations. 

44. Which might be the case, for example, under the traditional English common law mortgage or civil 

law possessory pledge. 

45. Note that in certain jurisdictions in the study core group, sophisticated financial transactions and 

state funding mechanisms exist alongside relatively primitive consumer banking or low-scale credit 

creation. 



VOL. 42:515 

such transactions are supported by a legal and institutional system, there is 

considerable development potential in enhancing similar support for more advanced 

secured transactions. Furthermore, sophisticated transactions may provide an 

interim financing solution for states with incomplete or emerging legal systems. 

A. Real Property 

Recent research supports the view that systems of finance based upon property 

are highly relevant to financial and economic development. 46 Byamugisha's 1999 

World Bank study develops a theoretical framework to guide the empirical analysis 

of the effects of property finance on an entire economy, 47 arguing that the conceptual 

framework linking real estate finance to financial development and economic growth 

has five main features. First, land tenure security and investment incentives; second, 

land title, collateral, and credit; third, land liquidity, deposit mobilization, and 

investment; fourth, land markets, transactions, and efficiency; and last, labor 

mobility and efficiency. All must be effective to facilitate real estate-based finance, 

and each demands the existence of appropriate legal infrastructure. 

Given the significance of real estate finance for economic development, an 

ensuing question focuses on markets in which the secondary refinancing of mortgage 

lending is prominent. For example, a 1997 World Bank study analyzed factors 

hindering the development of home loan markets in the transition economies of 

Central and Eastern Europe and proposed a strategy to expedite their 

development. 48 The analysis shows that banks in transition economies may be 

reluctant to make mortgage loans for house purchase because of the scale of risks 

they perceive in such lending; that is, the extent of credit, interest rate basis, and 

liquidity risks. It suggests that a secondary mortgage market is likely to assist in 

solving these problems by allowing banks to manage their loan books to meet 

preferences over risk concentration and duration, assuming that the initial primary 

provision of loans meets certain institutional standards. 

A third World Bank study argues that successful land and real estate reforms 

must be "comprehensive in design, even if implementation is phased in over time., 49 

It contends that such reforms include three elements: first, institutional reforms that 

better define property rights, reduce information asymmetries and improve contract 

performance (termed Property Rights, Information, Contracting and Enforcement); 

46. In addition to de Soto's suggestion, supra note 31, that legal reform in developing economies can 

energize idle capital, North & Thomas, supra note 12, argue that efficient economic organization is the key 

to growth; Nathan Rosenberg & L. E. Birdzell, Jr., HOW THE WEST GREW RICH: THE ECONOMIC 

TRANSFORMATION OF THE WESTERN WORLD (1986), argue that Western economic development hinged 

on factors promoting experimentation; Goldsmith, supra note 25, provides empirical evidence that the 

growth of democratic freedoms and property rights in poor countries may lead to increased local 

prosperity; Johan Torstensson, Property Rights and Economic Growth: An Empirical Study, 47 KYKLOS 

231 (1994), applies empirical analyses of property rights and economic growth to substantiate the findings 

of both Rosenberg & Birdzell and North & Thomas. 

47. Frank Byamugisha, The Effects of Land Registration on Financial Development and Economic 

Growth: A Theoretical and Conceptual Framework (World Bank Pol'y Res. Working Paper No. 2240, 

1999). 

48. Dwight M. Jaffe & Bertrand Renaud, Strategies to Develop Mortgage Markets in Transition 

Economies (World Bank Pol'y Res. Working Paper No. 1697, 1996). 

49. Ahmed Galal & Omar Razzaz, Reforming Land and Real Estate Markets 31 (World Bank Policy 

Research Working Paper No. 2616, 2001). 



second, capital market reforms making mortgage finance available at reasonable 

costs, especially for the poor (Finance and Risk Management); and third, market 

reforms that reduce or eliminate distortions in the price of goods and services, the 

production of which is enabled by land and real estate assets (Market Regulation 

and Fiscal Policy). Their conclusions tie effective mortgage markets to the broader 

concept of using real estate finance to encourage all aspects of financial and 

economic development. 

Jaffee and Renaud suggest that secondary mortgage markets confer two main 

benefits: allowing lenders to shed risks associated with holding mortgages, and 

creating common standards for credit evaluation and collateral procedures that lead 

to greater efficiency in new mortgage lending. They suggest that governments adopt 

catalytic policies in developing secondary mortgage market systems and institutions. 

This follows the experience of the U.S. and certain other developed countries, and 

has been adopted by several of the jurisdictions considered in this article. 

B. International Standards for Movables 

Wide disparities exist in secured transactions law in developed economies, and 

are often central in distinctions between common and civil law traditions. '° As a 

result of those disparities, there exist no internationally agreed standards or 

principles governing secured transactions." Creating effective provisions for secured 

transactions demands a mastery of many aspects of an entire legal system, including 

laws of property, obligations, insolvency, and civil procedure, and of administrative 

practices and procedures such as registration and enforcement. Nonetheless, 

research shows that the sound development of legal infrastructure underlies 

functioning collateral-based credit provision and that inadequacies in such 

infrastructures hinder financial and economic development.2 

Recent guidance from the Bank for International Settlements (BIS) describes 

the features of a generic collateral and credit law, 53 which include two main elements. 

First are credit laws to govern creditor-debtor relationships in commercial 

transactions. These may be established by common law, contract law, civil codes or 

specific legislation, for example, in usury laws, banking statutes or creditor-debtor 

statutes. Second, are pledges and collateral laws helping to create and enforce rights 

in collateral security, preferably through legislation of specific or general application, 

rather than through contract or common law. Such laws establish priority rankings 

among secured and unsecured claims in situations of default or insolvency, requiring 

legislation of a specific or general application. 

50. For an excellent discussion, see Fr6d~rique Dahan, Secured Transactions Law in Western 

Advanced Economies: Exposing Myths, in EUROPEAN BANK FOR RECONSTRUCTION AND 

DEVELOPMENT, LAW IN TRANSITION 37 (2000), and sources cited therein. 

51. See Arjun Goswami & Hamid Sharif, Preface in Nuria de la Pena, Heywood Fleisig & Philip 

Wellons, Secured Transactions Law Reform in Asia: Unleashing the Potential of Collateral. in LAW AND 

POLICY REFORM AT THE ASIAN DEVELOPMENT BANK 2 (2000). 

52. See generally de la Pena et al., supra note 51. 

53. BANK FOR INT'L SETTLEMENTS COMMITFEE ON PAYMENT AND SETTLEMENT SYSTEMS, 

GENERAL GUIDANCE FOR NATIONAL PAYMENT SYSTEM DEVELOPMENT 65-5 (2006). 



VOL. 42:515 

Example of such laws and regulations include the U.S. Uniform Commercial 

Code (UCC) Article 9; the European Union Directive 20021471EC on financial 

collateral arrangements; the 1997 OHADA Uniform Law on Security Rights; the 

1994 European Bank for Reconstruction and Development (EBRD) Model Law on 

Secured Transactions; the UNCITRAL Legislative Guide on Secured Transactions; 

the Cape Town Convention on International Interests in Mobile Equipment; and the 

West African Economic and Monetary Union Regulation 15I2002ICM/UEMOA 

Regarding Payment Systems in the Member States. 

Among multilateral agencies, the EBRD's Model Law is one of the few 

international standards for secured transactions that has been applied successfully as 

part of an established process to collateral law reform, drawing also upon the Bank's 

core principles and glossary. 5 ' The Asian Development Bank (ADB) has assisted in 

creating specific new secured transaction frameworks and the World Bank has 

addressed some of these issues in relation to insolvency. More directly, the United 

Nations Commission on International Trade Law (UNCITRAL) is completing a 

Legislative Guide on Secured Transactions. 5 Other significant international efforts 

have been made by the International Institute for the Unification of Private Law 

(UNIDROIT), 6 while regional efforts are under way in North America, 57 Asia, " and 

Europe. In addition, important harmonization efforts were made in respect of U.S. 

UCC Article 9 and Canada's Personal Property Security Acts, with both frameworks 

often serving as models in East Asia and elsewhere. 

C. Collateral in East Asia 

A sound framework for secured lending can encourage the provision of credit 

and assist in the development of domestic financial markets. At the same time, any 

system that involves the widespread use of collateral assets to support corporate 

lending may risk fostering a monopolistic banking sector. The use of secured lending 

as a proxy for informed risk appraisal can become inefficient to the economy as a 

whole, both by encouraging wasteful credit risk substitution and acting as a force 

oppressive to non-financial trade creditors. In East Asia, an over-reliance by 

lenders on the use of private and corporate real estate as collateral for corporate 

credit may have contributed to the scale and rapidity of the 1997-98 financial crisis. 

Following the widespread collapse of asset values, this over-reliance provoked a 

severe subsequent credit squeeze affecting otherwise "healthy" borrowers, even in 

national markets that were the least affected by the general loss in confidence. 

Collateral must be available as security to release the flow of capital but not so 

unreasonably as to protect the oppressive and inefficient. 

54. See John Simpson & Joachim Menze, Ten Years of Secured Transactions Reform, in EUROPEAN 

BANK FOR RECONSTRUCTION AND DEVELOPMENT, LAW IN TRANSITION 20 (2000). 

55. See UNCITRAL, http://www.uncitral.org (last visited Nov. 24, 2006). 

56. See UNIDROIT, Convention on International Factoring, May 28, 1988, available at 

http://www.unidroit.orglenglish/conventions/1988factoring/main.htm (last visited Nov. 24, 2006); 

UNIDROIT Convention on International Interests in Mobile Equipment (2001), available at 

http://www.unidroit.org/english/conventions/mobile-equipment/main.htm (last visited Nov. 24, 2006). 

57. See American Law Institute, International Secured Transactions Project (1997), available at 

http://www.ali.org (last visited Nov. 24, 2006). 

58. See de la Pena, Fleisig & Wellons, supra note 51. 

59. See also supra notes 41 and 42. 



These concerns prompt a series of questions applicable to any jurisdiction. 

First, to what extent is commercial secured lending or title finance possible? Second, 

what legal provisions exist for home mortgages? Third, what provisions are made 

for the transfer of secured claims? Fourth, what are the principal effects of related 

legal reforms, for example, in civil jurisdictions that choose to enact wholesale 

securitization legislation? Fifth, what is the position of secured claims vis-A-vis 

statutory priority, for example, in government or employee creditor claims? Last, is 

there simplicity of execution, perfection, notification, registration, and enforcement? 

Table 2 synthesizes an analysis of these issues in the economies addressed by this 

study, using a rising 1-5 scale. Scores such as 2/3 represent an intermediate appraisal 

between two given levels. As with Tables 5, 7, and 8, these "split" scores are 

intended to reflect degrees of uncertainty as to commercial outcomes. 

TABLE 2: LEGAL FRAMEWORK FOR CREDITOR RIGHTS 

Enforcement Security Registration Enforcement 

of Unsecured Interest and Disclosure of Secured 

Rights Legislation of Secured Rights 

Rights 

Cambodia 1 160 16 1 

China 2 2 2 2 

Indonesia 1 2 1/2 1 

Malaysia 5 4 4 5 

Philippines 2 2/3 2/3 2 

South Korea 3 1/2 1/2 2/3 

Taiwan 3 4 3 3/4 

Thailand 2 1/2 2 2 

Vietnam 1 1 1 1 

Hong Kong 5 4 4 5 

Singapore 5 4 4 5 

Here, granting and making security effective is treated as a form of property 

right, regardless of the nature of the legal systems under review. Any appraisal will 

therefore question how the law links the granting of security to the rights of general 

creditors in both normal and distressed circumstances. Table 2 thus shows how the 

system now supports, undermines, or confuses all aspects of secured transactions. 

No account is taken of informal systems, even if commercially entrenched. 62 Ideally, 

the law will allow simple cost-effective creation of security without affecting rights of 

60. When enacted, a forthcoming secured transactions law is expected to allow a score of "4" in this 

category. 

61. When implemented, new provisions are expected to allow a score of "4" in this category. 

62. But account is taken of legal provisions peculiar to certain jurisdictions, such as Taiwan's right of 

dien which is recognized in the Civil Code Art. 911 as a form of leasehold interest in immovable property, 

or the contractual antichresis permitted under the Philippines Civil Code Art. 2132, but which is 

increasingly disused as a form of pledge. 



VOL. 42:515 

conventional day-to-day collateral usage. It will be public, transparent, function 

without discrimination, and be enforceable in ways compatible with declared public 

policy, especially in relation to insolvency, receivership, and rearrangements 

following corporate distress. 

The effectiveness of a national legal and administrative framework permitting 

the creation of collateral for secured transactions is revealed in several elements, not 

all of which are consistently present in the review countries. Among the matters to 

be considered are the ease and cost of creating reliable security interests, the systems 

for such interests to be disclosed, the costs and risks associated with the enforcement 

of charges, the relationship of security and collateral with insolvency and 

receivership practice, and the operation of creditor protection and stays to 

enforcement. These are contained in Table 2. 

Civil and common law traditionally have different approaches to security 

interests, and the introduction of reform always needs to be sensitive to the existing 

contractual and legal setting. While the EBRD Model Law on Secured Transactions 

was intended to be adopted by jurisdictions of all types, it is likely that the presence 

of relatively well-developed legal systems in the core review group make a single 

benchmark impractical. Such a device might have value, however, in other 

developing Asian jurisdictions. 63 Elsewhere, recent legislative reforms appear to be 

effective in supporting transaction creation, but have yet to be tested in cases 

involving economic stress, in particular a downward phase in the credit risk cycle or 

weakening. This applies to Indonesia, South Korea, and Thailand, for example, as 

well as to Cambodia's pending Secured Transactions Law and the registry that will 

support its implementation. In each case, a further concern for the integrity of new 

laws in relation to existing and succeeding legislation may arise, given that measures 

are often introduced in discrete steps despite leading to a complex commercial 

whole. In China, for example, legislation introduced since 2003 has necessitated the 

reconsideration of statutes that were created in recent but earlier days of reform. 

Likewise, implementation of China's 2007 Property Law is likely to have significant 

impact, though the exact scope is as yet unclear. 

In a related area of law, securitization legislation or decrees have been adopted 

in recent years and remain largely untested in Indonesia and the Philippines.' Those 

introduced in South Korea, Taiwan, and Thailand appear to be transactionally sound 

but have not yet been made subject to credit or valuation stress of the kind indicated 

in the preceding paragraph. 

1. Overview 

Asia's legal provisions for secured credit transactions regimes at the onset of 

the 1997-98 financial crisis were at least as outdated and inefficient as its insolvency 

laws. Yet less effort has since been made to reform those laws. Immediately after 

the crisis, most attention was directed to reforming corporate reorganization 

procedures and other features of insolvency law, even though such laws cannot work 

63. Vietnam, for example, introduced a general bankruptcy law in 1993 (and a new bankruptcy law in 

2004) and commercial and property laws in 1991. 

64. A recent unreported decision of the Indonesian Supreme Court may affect the use of a special 

purpose vehicle to facilitate foreign currency borrowing by Indonesian entities. See Kate Linebaugh, How 

Indonesia's Bond Market Stayed Hot Despite Court Ruling, WALL ST. J. ASIA (Nov. 10, 2006) at A22. 



efficiently when secured creditors find it difficult or impossible to enforce their rights 

in bankruptcy. Such delays were common in Asia prior to the financial crisis. 65 

Similarly, credit creation is adversely affected when either valid collateral must be 

held in possession by a secured creditor or limits exist to the permissible categories 

of assets that may be used as collateral. As will be seen in the country-specific 

discussion below, these problems were also endemic prior to the crisis, 66 but its 

impact finally drew attention to the need for coordinated legal reform as well as the 

creation of modern provisions for secured transactions. Thailand is an example of 

how this acceptance has been made, as legislation was under preparation 

immediately prior to the suspension of the legislature in September 2006. 

2. Real Property 

In each jurisdiction within this study, the legal system provides for real property 

to be offered and taken as collateral. However, there is considerable divergence as 

how best to resolve a variety of issues, including the following: the ease and 

efficiency with which mortgages, charges or liens may be created; the requirements 

for registration and its usefulness to third parties; whether a mortgagor retains title 

to collateral while the extension of credit that the charge purports to secure remains 

outstanding; and how secured creditors may enforce their collateral rights. 

Differences also exist in some cases in the treatment of collateral arising from 

varying statutory provisions for real property ownership by domestic and foreign 

interests. 

Table 3 does not address the distribution of property rights, which is a focus of 

de Soto's work that merits further attention in the context of the relationship 

between state governance and property rights, and economic outcomes. 

TABLE 3: TREATMENT OF REAL PROPERTY 

Cambodia 

China 67 

Real property may be mortgaged, but enforcement can be 

extremely problematic. Registration is efficient and effective. A 

foreign creditor may take a mortgage over land but not become 

the owner of land. 

Land may not be mortgaged, but mortgages over land-use rights 

are permitted. Registration is necessary to protect secured 

creditor rights. The enforcement of a mortgage can require 

litigation in cases in which the mortgagee and mortgagor cannot 

reach agreement as to how the mortgagee claim may be 

satisfied. Transactions involving mortgages to be held by 

foreign entities are subject to prior approval and registration 

with the State Administration of Foreign Exchange (SAFE). 

65. See ADB Office of the General Counsel, Insolvency Law Reforms in the Asian and Pacific Region, 

Report of the Office of the General Counsel on TA 5795-Reg: Insolvency Law Reforms, Law and Policy 

Reform at the ADB 10-11, 70-75 (2000) [hereinafter Report on Insolvency Law Reforms]. 

66. See Lampros Vassiliou, The Restructuring Revolution in the Asia-Pacific Region, in THE ASIA- 

PACIFIC RESTRUCTURING AND INSOLVENCY GUIDE 2006 18,21 (2006). 

67. After extensive discussions and the withdrawal of an earlier draft law in 2006, a new property 



VOL. 42:515 

Indonesia 

Philippines 

Security interests may be taken in land, but it often proves 

difficult for creditors to enforce a security interest. The process 

is inefficient; enforcement can take many years. Auction fees 

and taxes are high and, in practice, recourse to the courts is 

almost always necessary." Official registers are maintained 

manually, which causes difficulties for potential lenders wishing 

to search for title or prior claims. 69 Security rights may be 

impaired by the creation of a parent company guaranty in 

respect of like debt. 

Real property may be mortgaged (under provisions of the Civil 

Code). While both registration and notarization are necessary 

for creditor protection, the requirements are set out in a mix of 

statute and presidential decree. Ownership is retained by the 

mortgagor while a charge is outstanding. Delays in foreclosure 

can occur because the secured party must use the courts in the 

absence of any contractual agreement for extrajudicial 

foreclosure." Contractual antichresis was a common form of 

commercial pledge, but it is becoming increasingly less used. 

Unless stated by agreement, mortgages over land will embrace 

subsequent buildings or improvements to the land, and may 

gain inadvertent priority over other subsequent charges. 

Foreign creditors may become mortgagees of land but not 

buildings, and may subsequently not take possession of land. 

rights law was approved by the 10th National People's Congress in March 2007, to take effect on October 

1, 2007. See Property Rights Law of the People's Republic of China 2007. This covers both real property 

and movable assets, and for the first time establishes rights in respect of both state and non-state interests. 

The law makes most real property ownership rights contingent upon registration. See id. Art. 9-22. Art. 

170-240 establish conditions for the granting of security interests by a property owner, including the right to 

mortgage real property and specified movable assets, and the right to pledge other assets, including certain 

defined intangibles. The creation of registry facilities throughout China will be a considerable 

administrative burden. 

68. EMIR NURMANSYAH, THEODOOR BAKKER, CLIFFORD REES & DAVID ADAMS, INDONESIA: THE 

ASIA PACIFIC RESTRUCTURING AND INSOLVENCY GUIDE 80 (2006). 

69. Id. 

70. RICARDO ONGKIKO, CARINA LAFORTEZA, CARLOS FRANCISO & COSETrE CANILAO, 

PHILIPPINES: THE ASIA PACIFIC RESTRUCTURING AND INSOLVENCY GUIDE 135 (2006), noting that 

mortgage contracts now usually provide for extra-judicial foreclosure to address this problem. 



South Korea 

Taiwan 

Thailand 

Vietnam 

Most real estate rights must be registered. However, there are 

important exceptions from this rule (e.g., property acquired 

through inheritance or pursuant to a judgment auction). 

The Civil Code allows mortgages to be created over defined 

classes of real property, 7 and for possessory security or 

attachments. In addition, the right of "dien" is allowed as a 

form of possessory pledge similar to a leasehold interest, and 

may be created effectively over assets not specified in law. 

Registration in all cases is mandatory and efficient, without 

which the charge will be void. There is some uncertainty as to 

whether notice or consent is required of a secured creditor for 

the creation of a subsequent mortgage. Foreign creditors are 

restricted as to the types of real property over which they may 

hold security interests. 

Real property may be mortgaged and registration is necessary 

to protect the secured creditor's rights, but foreclosure cannot 

occur unless loan interest or charges have been outstanding for 

five years, contributing to an inefficient enforcement process 

that can extend over many years. Separate charges are 

necessary in respect of plant or equipment contained in a 

mortgaged property, and may be subject to official inspection. 

The 1992 constitution adopted the general recognition of 

private property rights but land ownership continues to be 

vested solely in the state. Nonetheless, rights of land use are 

clear and may be mortgaged under the Land Law of 1993. 

Hong Kong, All allow for a charge to be taken over land, which must be 

Malaysia, registered. 72 Hong Kong and Singapore also provide for 

Singapore mortgages to be taken over land, but in Hong Kong (since 1984) 

the mortgage may be created only by a legal charge. The 

Malaysian courts will generally recognize a charge that is 

executed but not yet registered. All three jurisdictions allow for 

the appointment of a receiver to protect the creditor's interest 

and in all three jurisdictions there is a high level of predictability 

and efficiency as to the creditor's ability to enforce its rights. 

Hong Kong land ownership is (with a single exception) held by 

the territory's government but this does not materially affect 

rights of use or the creation of security. 

71. It was until recently customary for lenders to require registration of a "comprehensive mortgage" 

over an undefined amount prior to approving a loan (compared to the widespread practice elsewhere 

making disbursal subject to security conditions) but the practice was held invalid by the courts as being 

contrary to the specificity required of charges by the Civil Code. Reform has not yet been completed. 

72. Laws governing land registration differ between Peninsular and East Malaysia, the latter 

excluding Labuan, which became a federal territory in 1990 upon being designated an offshore financial 

center. The taking of land and movable assets owned by Labuan companies as collateral is governed 

largely by the Offshore Companies Act 1990. 


538 TEXAS INTERNATIONAL LAW JOURNAL VOL. 42:515 

3. Movables and Unsecured Property 

The treatment of secured rights over movable property is still more varied 

throughout the study group. Although none of the jurisdictions within this study has 

adopted a U.S. Article 9-style regime, the English origin systems of Hong Kong, 

Malaysia and Singapore work relatively well. However, Table 4 shows that delays 

and inefficiencies in the enforcement of secured rights are common. Similarly, limits 

to the movable assets that may be used as collateral is problematic or constraining in 

most jurisdictions. These include bars to taking security interests in chattel paper or 

accounts receivable, and more broadly a lack of provisions for charges over future 

property or the use of security to collateralize future loans. 



TABLE 4: TREATMENT OF MOVABLES 

Cambodia 

A new Secured Transactions Law is expected to be enacted in 

the foreseeable future, providing a modern legal framework for 

security, including support through an electronic registration 

system. However, enforcement is likely to remain problematic, 

and the commercial effectiveness of the law may be colored by 

other current omissions in law. 

China 73 Mortgages may be taken over existing tangible movable 

property, but not over future property. Secured creditors must 

register their claims to protect all such non-possessory rights. 

They may also protect themselves through possession in the 

form of a pledge. As with real property, foreign entities seeking 

security over movable property must comply with SAFE 

approval and registration procedures. The treatment of security 

interests in intangible assets such as bank accounts or 

receivables is less straightforward. Regulations have been 

issued allowing mortgages over such assets, but the 

effectiveness of these new forms of collateral is largely untested. 

Enforcement of unsecured claims can sometimes run into 

resistance at a local level; there have been reported instances in 

which banks and their clients have colluded to hide assets from 

the court. 

Indonesia 

Philippines 

Under the Fiduciary Security Law, a debtor may transfer title in 

goods to a creditor and retain possession of the goods in the 

absence of any default. Pledges are also permitted. A fiduciary 

assignment may be taken for security purposes over intangible 

property and receivables. 4 As with real property, enforcement 

over movable property requires recourse to the courts, and both 

auction fees and taxes are punitive. 7 " In essence, secured 

creditors foreclosing on collateral are forced to resort to 

substantially the same court proceedings as unsecured 

creditors. 76 

Chattel mortgages and pledges are permitted over movable 

property. Chattel mortgages must be recorded. Philippine law 

does not recognize chattel mortgages over future property; but 

the courts have created exceptions for interests in inventories of 

raw materials, goods in process, and finished goods. Future 

obligations cannot be secured by chattel mortgages. 

73. The treatment of movables will be clarified by the introduction of the new Property Rights Law of 

the People's Republic of China 2007, to come into force in October 2007. See supra note 67, providing at 

Arts. 179-202 for the creation of mortgages over specified movable assets. Such mortgages will take effect 

only upon registration. 

74. NURMANSYAH ET AL., supra note 68, at 80. 

75. Id. 

76. Id. 



VOL. 42:515 

South Korea Rights in personal property may only be protected by 

possession. South Korean law does not recognize purchase 

money security interests or floating liens. 

Taiwan 

Thailand 

Vietnam 

Hong Kong 

Malaysia 

Singapore 

Non-possessory charges are possible under the Chattel Secured 

Transaction Act and by separate laws regarding ships and 

aircraft. Registration is mandatory in each case in order to 

protect priority. Enforcement is generally procedural and not 

subject to judicial uncertainty. 

Only certain forms of movable property may be mortgaged, 

including large ships, boats, floating houses, beasts of burden, 

and classes of machinery. Creditors holding rights of retention 

are also recognized as secured creditors. Other types of 

property may be pledged. Enforcement of secured rights 

requires either a court judgment or a public auction. 

Enforcement is slow and costly. Fixed and floating charges are 

not permitted at present, but would be allowed under draft 

secured transactions law. The enforcement of unsecured debts 

in Thailand can extend for many years. 

Private property rights are constitutionally recognized and 

charges over movables permitted by the civil code. 

Improvements were made to Vietnam's secured transaction 

framework in 2005 amendments to the civil code, which took 

effect in January 2006. Further decrees are expected to assist 

with the implementation of these changes. A National 

Registration Agency for Secured Transactions has been 

established with offices in Hanoi, Ho Chi Minh City, and 

Danang. However, enforcement of security interests remains 

difficult. Unless bankruptcy proceedings have been 

commenced, a court order is not necessary for the enforcement 

of a secured transaction. 

The laws in all three jurisdictions provide a variety of security 

over movable property (both tangible and intangible), including 

charges, liens, and pledges. Retention of title is also permitted. 

Security may be taken over future property. Fixed charges may 

be taken over tangible assets and floating charges may be taken 

over classes of variable assets such as inventory or book debts. 

The taking of fixed charges over book debts by secured 

creditors is much more difficult..7 These English-origin systems 

require the registration of many types of charges, including 

charges over book debts and floating charges over the general 

undertaking of a company, but statutory rules are less clear and 

comprehensive than U.S. UCC Article 9. Usual practice in 

77. In these three jurisdictions the decision by the U.K. House of Lords limiting the validity of fixed 

charges over book debts to cases in which the secured creditor exercises sufficient control over the 

collateral (e.g., through including a provision in the debenture requiring the deposit of proceeds of book 

debts into a blocked account and in fact operating the account as a blocked account) would be persuasive 

authority. See Re Spectrum Plus Ltd; National Westminster Bank plc v. Spectrum Plus Ltd. and others 

[2005] 2 BCLC 269. 



these three jurisdictions is for a debenture to provide a secured 

financial creditor with contractual remedies upon default, 

allowing appointment of a receiver or special manager. All 

have efficient debt collection procedures for unsecured 

creditors. 

D. Securitization 

Securitized transactions require a permissive framework of existing or 

dedicated law, acceptance of certain accounting principles, acceptable regulatory 

assent, and a non-discriminatory taxation background. 78 They also require accepted 

commercial precepts that are not matters of legal policy; for example, a lack of 

contractual restrictions to the transfer of financial claims. Such restrictions are 

common in all review markets, except in Hong Kong and Singapore. 

The details of typical transactions will vary among jurisdictions, but are 

assumed to entail the irrevocable transfer of assets to an insubstantive special 

purpose vehicle (SPV) to which the asset seller has no ties of ownership or control. 

Funding for the asset purchase is provided by the sale of public or private securities 

to third party investors. The transaction must withstand any legal claim in 

bankruptcy against the asset seller; its economics must withstand taxes and duties on 

transfer; in most cases, securities issued by the SPV must provide for the dependable 

subordination of claims. 

In general, the elements of law typically associated with securitized transactions 

in advanced markets are present in the three common law review jurisdictions, 

especially those affecting existing or future claims originated by financial 

intermediaries. However, certain future claims that cannot be specified in ways 

required by current law may be seen as hazardous source material by investors or 

third party monoline insurers, such as credit card receivables. 

A summary of the provisions for securitized transactions and their effectiveness 

is given in Table 5. Its assessments of the effectiveness of enabling legal provisions 

(column 2), the enforcement of foreclosure or repossession of source assets (column 

5), and ongoing threats to the integrity of transfer of assets to a SPV (column 6) are 

in each case based on transactional evidence and appraisals of governing laws. 

However, it must be noted that in most jurisdictions, transactional integrity has yet 

to be fully tested through a complete credit cycle. This would apply in relation to 

new rules such as the creation of real estate investment trusts in common law 

jurisdictions such as Hong Kong and Singapore. Nevertheless, in each case the 

probability is small that a completed transaction will be successfully challenged. 

While aspects of law may now be clear in some cases, it may be little used, such 

as law regarding private contracts in the Philippines or Thailand, and is thus yet 

untested. Further, no significant number of completed securitized transactions has 

yet to undergo periods of economic stress or be attacked by creditors of the 

originator. In contrast, since 1998, South Korean reforms seem to be demonstrably 

successful. 

78. See Douglas Arner, Emerging Market Economies and Government Promotion of Securitization, 12 

DUKE J. COMP. & INT'L L. 505 (2002). 



VOL. 42:515 

Malaysian common law supports securitization. Rules setting out general 

parameters for securitization were first published only in 2001, but sales of whole or 

partial interests in pools of home mortgages began in the mid-1980s. Shariahcompliant 

transactions have been few to date and involve intricate structuring at all 

stages, but are now considered to be generally feasible, at least as single deals. 

TABLE 5: PROVISIONS FOR SECURITIZATION 

Sale, assignment, or other conveyance of Creation, 

assets by originators to securitization maintenance, Other 

vehicles 

and operation of 

SPV 

-t CD o:. 

. CD -CD pc CD 

-.o.---R. ' O" 

=o C -0 C0CD 

= 

. C, t a. -. 

- 't- t 

-. 0- .-. 

Uq CD AC -t 

Cn Cn 0 

-- _-. < 

"a t .3 (D W CD o 

0 CD 

Cambodia NA NA NA NA NA NA NA 

China 1/2 1 1 1 1 1 1 

Indonesia 2 2 2 2 1 2 2 

Malaysia 5 4 4 3/4 4 4 5 

Philippines 2/3 2/3 1/2 2/3 2/3 1/2 2/3 

South 

Korea 

Taiwan 4/5 4 3/4 4 4 2/3 4 

Thailand 3/4 3 3/4 3/4 2/3 4/5 2/3 

Vietnam NA NA NA NA NA NA NA 

Hong 54 5 

Kong 

Singapore 5 5 5 4 5 5 5 

Since 1998, four of the eight civil law review jurisdictions have introduced, or 

are planning to introduce, enabling laws that permit the creation of securitized 

transactions recognizable by international standards. The most notable provisions 

are shown in Table 6. In particular, these allow for the creation of SPVs, which 

would not otherwise be permitted by the general provisions of national civil codes. 9 

79. A recent unreported decision of the Indonesian Supreme Court has created transaction 

uncertainty in the context of foreign borrowing by affirming the contiguous treatment of a company 



Indonesia permits certain transactions under authority granted to the principal 

securities regulator, Bapepam. Several Indonesian securitized transactions were 

completed before 1997 but post-crisis deals are virtually non-existent because 

counterparties may have been more willing to enter deals in a time of moderate 

confidence than thereafter. Since 2000, there has been some doubt that regulatory 

decrees, upon which any new transaction will depend, may subsist during its lifetime. 

Finally, certain jurisdictions are affected by related issues of law, tax, or market 

rules, rather than pure securitization provisions. This increases contractual 

uncertainty, and applies, for example, in the Philippines and for domestic 

transactions in Taiwan. 

TABLE 6: STATUS OF ENABLING LEGISLATION FOR SECURITIZATION ° 

Cambodia 

China 

Indonesia 

Philippines 

South Korea 

Taiwan 

Thailand 

Vietnam 

Years of Enactment or Proclamation 

None 

Major bank and possibly other sector securitization legislation 

forthcoming 2007-08 

Trial deals permitted by banking and securities regulators in 

2006-07 

Pre-1997 Securitization Decrees 

2002-03 Securities Regulator Guidelines 

2003 Special Purpose Vehicle Act 

2004 Securitization Act (largely untested) 

Implementing Rules and Regulations (2005) over credit rating 

requirements and the use of SPVs. 

1998 Asset-backed Securities Law 

1999 Mortgage-backed Securities Law 

2003 Korea Housing Finance Corporation law 

2002 Financial Asset Securitization Act 

2003 Real Estate Securitization Act 

1997 Securitization Decree 

2003 Asset-backed Securitization Act 

2004 Special Purpose Vehicle Act 

None 

guarantor and its subsidiary SPV and voiding a financing contract to which the two entities purported to be 

separate parties. This may increase the legal risks of securitized transactions. See also supra note 64. 

80. A model for other Asian civil law jurisdictions may have been legislation enabling securitization in 

Japan, including notably its 1998 Perfection Law, 1998/2000 Asset Liquidation Law, and 2004 Trust 

Business Law (Amendment). 



VOL. 42:515 

V. CREDITOR RIGHTS AND INSOLVENCY 

At the formative stage of economic development, the risk and incidence of 

defaults by debtors often prevent the efficient deployment of funds for investment. 

A proper framework of law that provides both for company incorporation and the 

orderly resolution of proceedings for recovery and insolvency is therefore a crucial 

foundation of development. 

A. Insolvency 

A functioning legal framework for insolvency management is essential in the 

operation of any modern market-based economy. No commercial sector can function 

effectively without mechanisms to recognize and govern the exit of insolvent 

participants. Furthermore, the financial sector will limit credit creation for many 

companies and individuals if lenders are uncertain that their status as secured 

creditors will prevail upon the liquidation of their debtors, or that a reliable means 

will be available for the enforcement of properly-constituted security. The general 

objectives of a system of corporate insolvency have been described as the reduction 

of uncertainty, promotion of efficiency, and fair and equitable treatment for all 

participants.' A functioning insolvency regime can thus help reduce and simplify the 

risks associated with lending and the potential cost of debt service; if this is the case, 

long-run credit availability and capital investment will increase." 

Functioning insolvency procedures are thus central to the legal and institutional 

environment for sound finance in any market-based economy, regardless of whether 

public policy requires the law to favor debtors or creditors. A well-administered 

insolvency system may be valuable in promoting market discipline. Effective 

insolvency laws provide the means for the identification of non-competitive 

participants and, in some cases, for their controlled exit. It thus provides an effective 

penalty for the least competitive as well as a potential solution to the ensuing 

reallocation of resources. While this view stresses the retroactive character of 

insolvency law, it also has a considerable preventive element by creating incentives 

for the uncompetitive to improve performance and to avoid the sanction of 

administration by a third party on its creditor's behalf. 

A number of international organizations and associations have assisted the 

development of standards for modern insolvency law and related systems. Many of 

these activities have focused in particular on norms and standards for cross-border 

insolvency cases, such as the UNCITRAL Model Law on Cross-Border Insolvency 

and the EU Insolvency Regulation of 2000.83 A working group chaired by the legal 

department of the IMF presented a document containing detailed principles for the 

development of workable, modern insolvency legislation. 8 While there is no 

81. See Report of the G-10, Report of the Contact Group on the Legal and Institutional 

Underpinnings of the International Financial System (Sep. 2002), available at 

http://www.bis.org/dcms/fd.jsp?p=l&uri=/publ/gten06.htm (last visited Nov. 24, 2006). 

82. IMF Legal Department, Orderly & Effective Insolvency Procedures: Key Issues (1999), available 

at http://www.imf.org/external/pubs/ft/fandd/2000/03/hagan.htm (last visited Nov. 24, 2006). Note that this 

argument is silent as to the quality of investments so financed. 

83. UNCITRAL MODEL LAW ON CROSS BORDER INSOLVENCY WITH GUIDE TO ENACTMENT 

(1997); Council Regulation 1346/2000 O.J. (L 160). 

84. IMF Legal Department, supra note 82. 



internationally agreed key standard in the area of insolvency, the World Bank is 

coordinating efforts to develop such a benchmark and is working with UNCITRAL 

to develop a suitable framework for its implementation. 

The World Bank first issued its Principles and Guidelines for Effective 

Insolvency and Creditor Rights Systems in April 2001" and a revised version under 

development will take into account feedback from insolvency assessments conducted 

under the IMF-World Bank Reports on Observance of Standards and Codes 

(ROSC) initiative. 6 The Bank is also preparing a technical report containing 

detailed implementation guidelines to support the principles. UNCITRAL released 

a Legislative Guide on Insolvency Law in 2005, a combination of model provisions, 

recommendations, and explanatory notes that builds upon the work of other 

international organizations, including the World Bank, IMF, and ADB. 7 

The World Bank identifies nine objectives for effective corporate insolvency:s 

1) Integrate with broader national legal and commercial systems. 

2) Maximize the value of a firm's assets by providing an option to 

reorganize. 

3) Strike a careful balance between liquidation and reorganization. 

4) Provide for equitable treatment of similarly situated creditors, including 

foreign and domestic creditors. 

5) Provide for timely, efficient, and impartial resolution of insolvencies. 

6) Prevent the premature dismemberment of a debtor's assets by 

individual creditors seeking quick judgments. 

7) Provide a transparent procedure that contains incentives for gathering 

and dispensing information. 

85. World Bank, Principles and Guidelines for Effective Insolvency & Creditor Rights Systems (Apr. 

2001), available at 

http://web.worldbank.org/WBSITE[EXTERNAL/TOPICS/LAWANDJUSTICE/GlLD/0,,CONTENTMD 

K:20086184-menuPK:146153 -pagePK:64065425-piPK:162156-thesitePK:215006,00.html. The Principles 

(ICRPs) were prepared in collaboration with the AfDB, ADB, EBRD, IADB, IFC, IMF, OECD, 

UNCITRAL, INSOL International, and International Bar Association. 

86. The latest draft dates from 2005. See http://www.worldbank.org/ifa/rose-icr.htm (last visited Nov. 

24. 2006). 

87. See Legislative Guide on Insolvency Law, UNCITRAL, available at 

http://www.uncitral.org/pdf/english/texts/insolven/05-80722-Ebook.pdf (last visited Nov. 24, 2006). 

88. World Bank ICRP 6, 24, (Apr. 2001) (stating that these elements were identified by the G-22). Id. 

at 24, n.10 (citing G-22 16, 44-45 (1998)). 



VOL. 42:515 

8) Recognize existing creditor rights and respect the priority of claims with 

a predictable and established process. 

9) Establish a framework for cross-border insolvencies, with recognition of 

foreign proceedings. 

In supporting these objectives, the thirty-five World Bank insolvency principles 

cover five main areas: first, a legal framework for creditor rights (principles 1-5); 89 

second, a legal framework for corporate insolvency (principles 6-16); third, corporate 

rehabilitation (principles 17-24); four, informal workouts and restructuring 

(principles 25-26); and five, institutional and regulatory frameworks for 

implementation of the insolvency system (principles 27-35). 

The most recent version of the UNCITRAL Guide has two parts. 90 The first 

deals with the design of the key objectives and structure of an insolvency law, while 

Part II includes core insolvency law provisions. Regretfully, until the revised World 

Bank principles and final UNCITRAL Guide are integrated, approved, and 

released, it is impossible to identify an international consensus in this area. 

B. Interaction between Creditor Rights and Insolvency 

Debtor-creditor laws include systems for collecting debts and insolvency 

systems for terminating the collection of unpaid debts. Collection systems include: 

secured transactions, using movable property as collateral; mortgages, using fixed 

property as collateral; and unsecured lending, a system that employs no property or 

other rights as collateral. 9 ' One view of the interaction between secured lending and 

insolvency law sees each as addressing distinct problems, with separate solutions. A 

secured lending system determines how lenders are repaid, whereas an insolvency 

system establishes the appropriate treatment for defaulting borrowers. 

At the same time, there are important points of intersection between secured 

transactions and insolvency, and the two systems must be integrated. Neither system 

can substitute for the other. Thus, reforms of debtor-creditor laws must embrace 

both secured lending and insolvency law, as well as other closely related areas of law. 

The need for such drafting integration may be more widely realized in East Asia 

now, as governments contemplate reform, than would have been the case prior to 

the 1997-98 financial crisis. 

Secured transactions have often been seen as important in improving general 

welfare by helping create and encourage certain benefits for society as a whole. 

Regardless of the nature of preferred insolvency laws, East Asian national 

economies are likely to advance by improving their respective laws on secured 

lending. This relies on the premise that general access to credit, and the specific 

terms on which it becomes available, will improve in the borrower's favor as the 

89. This Section, while at first glance appearing to address collateral and secured transactions, 

addresses these only in the context of insolvency. 

90. UNCITRAL, Draft Legislative Guide on Insolvency Law, AICN.9/WG.V/WP.70 (Parts I and II) 

(2003). 

91. Banking practice in civil law jurisdictions often treats guarantees as providing security, which is 

not usual in common law systems, regardless of the effect on credit risk. 



quality of collateral-taking improves. 92 Effective secured transactions systems that 

allow for movable property to be used as collateral may allow distressed firms to 

gain access to credit and so avoid the final resort of insolvency. In such conditions, 

creditors may anticipate repayment without necessarily initiating the insolvency 

process. 

All security interests must be properly publicized. An effective method of 

publication puts both existing and potential creditors on notice that a debtor 

company has fewer unencumbered assets available in which potential lenders might 

obtain meaningful interests. It also provides notice as to the order of priority for the 

distribution of assets if a company becomes insolvent. Filing or registration systems 

are comparatively more effective than inefficient systems that rely on possession as a 

form of security. The efficient enforcement of security interests is central to an 

effective secured transactions system. It also promotes both informal and judicially 

supervised workouts. An efficient system will minimize the need for judicial 

assistance wherever possible and expedite the enforcement process. 

In the interaction between secured transactions and insolvency, the essential 

need is for insolvency law to respect the pre-existing priority rights of secured 

creditors. If the law poses unreasonable threats to secured lending, banks might 

increase transaction charges or restrict access to credit. In addition, when a company 

contemplating insolvency charges or mortgages assets to a creditor in exchange for 

identifiable value to the company, then as a general rule such charges or mortgages 

should not be voided by subsequent insolvency proceedings. Secured creditors 

should also be permitted to convert unsecured debts into secured debts, providing 

such transactions are completed substantially before the commencement of any 

insolvency proceedings. The law should provide that fraudulent or commercially 

unfair transactions that have a security component may be avoided. As a general 

rule, pre-petition interests should continue in post-petition proceeds, while postpetition 

grants of security should be permitted. Last, as a general rule, priorities in 

insolvency should be abolished. 

Overall, East Asian economies would benefit from enacting insolvency laws 

that respect the pre-existing rights of secured creditors. However, in deciding to 

what extent exceptions may be permitted and how best to balance the needs of 

secured transactions and insolvency, law-makers in East Asia must first determine 

which approach they believe most appropriate. 

C. Creditor Rights and Insolvency in East Asia 

The appraisals given in Table 7 acknowledge extra-legal regulatory guidance 

for collaborative multi-creditor practice, for example in Hong Kong, Indonesia, 

Malaysia and Thailand. Regulators in these jurisdictions have attempted to instill 

informal out-of-court corporate workout practices similar to the well-established 

"London Rules," or "London Approach," promoted in the 1970s by the Bank of 

England as an alternative to formal court-based corporate insolvency proceedings 

92. This is not universally accepted. For an example, see Schwartz, Security Interests, supra note 41, 

and Schwartz, Puzzle of Secured Debt, supra note 41 (questioning the economic efficiency of secured 

lending). 



VOL. 42:515 

involving multiple financial creditors. 9 After the onset of the Asian financial crisis, 

such out-of-court workout procedures were applied more frequently than courtbased 

formal reorganizations, although the results were not consistent in all 

jurisdictions. 9 4 Most jurisdictions also set up public administrative agencies to assist 

with the restructuring of domestic financial intermediaries and the disposal of nonperforming 

loans (NPLs). 

In both Hong Kong and Singapore, systems and practice are well-established 

and generally sophisticated, but legislative reform has tended to lag both market 

practice and the willingness of the courts to intervene creatively in cases of corporate 

distress. 

TABLE 7: DEVELOPMENT OF EFFECTIVE INSOLVENCY SYSTEMS 

Legal Corporate Effective 

framework orcroae insolvency Coporat decision- making and in isolvency 

for corporate implementation mkn n rciinr 

insolvency enforcement practitioners 

Cambodia NA NA 1 1 

China 95 2/3 1 1 1/2 

Indonesia 2/3 1 1 1/2 

Malaysia 4 4 4 4 

Philippines 2/3 2/3 2 2/3 

South Korea 4 3/4 3 3/4 

Taiwan 3 3 3 3 

Thailand 3 2/3 2/3 2/3 

Vietnam 1/2 1/2 1 1 

Hong Kong 4 5 5 5 

Singapore 4/5 5 5 5 

1. Insolvency: Pre-1997 Overview 

Among the jurisdictions in this study, only Singapore had an insolvency regime 

adequate to deal with a high number of corporate failures at the opening of the 

Asian financial crisis. All other jurisdictions were hampered by antiquated or 

inadequate laws and procedures, many of which dated from colonial times. None 

maintained an effective formal corporate rescue procedure. Hong Kong and 

Malaysian corporate insolvency procedures were modeled on mid-20th century 

English law. Thai law dating from 1940 was influenced by English personal 

93. Their precept is that financial creditors act in concert rather than any single creditor competitively 

advancing its position in ways that might provoke premature liquidation. 

94. See supra note 65 and accompanying text. Informal practice has tended to be successful where the 

courts have stood ready to support a consensus reached among creditors and debtors, and where debtors 

or their controlling owners have been unable to challenge the enforcement of foreign judgments. 

95. In regards to the recently enacted bankruptcy law that came into operation on June 1, 2007. 



bankruptcy laws, while Indonesian law was mainly Dutch in origin and dated from 

the late 19th century. South Korea's insolvency regime drew on Japanese law, which 

derived from German, Austrian, and U.S. principles and statutes. Taiwan's laws 

were also derived from Japan's laws and later, to a lesser extent from U.S. law, with 

the last pre-1997 amendments dating from the early 1980s. China's insolvency laws 

were written more recently, with bankruptcy provisions for state-owned enterprises 

(SOEs) enacted in 1986, and provisions for non-SOE enterprises with legal person 

status, in 1991. Vietnam's laws dated from 1994. These regimes used liquidationbased 

procedures, with the exception of Singapore. Cambodia still lacks an 

insolvency framework. For the most part, these insolvency laws were under-utilized. 

Insolvency law in Hong Kong, Malaysia, and Singapore share the same basic 

structure of detailed liquidation or winding-up procedures and an abbreviated 

scheme of arrangement procedure for use in corporate rescue. The liquidation 

procedures in these jurisdictions are still the region's most efficient, although in 

need of modernization, but the scheme of arrangement procedure is cumbersome 

and expensive. Hong Kong and Malaysian procedures do not provide for an 

automatic stay on creditor claims in the absence of a winding-up order; Singapore 

operates a stay only on unsecured creditors. In none of these three jurisdictions are 

there mechanisms to force uncooperative secured creditors to the bargaining table. 

The result is that prior the Asian financial crisis, the procedure was rarely employed, 

although it saw more use in Singapore than in Hong Kong and Malaysia.. Singapore 

also introduced judicial management procedures in 1987. These procedures may be 

initiated either by a debtor company or its creditors, and the procedure provides for 

an automatic stay while a judicial manager assumes the responsibility for running the 

company and proposing a plan of reorganization for creditor approval." 

The evolution of South Korea's insolvency regime has been more complicated. 

Until recently, the law had three parts, all dating from 1962, which concerned 

bankruptcy, composition, and reorganization. Rather than develop an insolvency 

solution, South Korea translated and enacted Japanese laws, so that the Bankruptcy 

Act was based on the Japanese Bankruptcy Act 1922, itself derived from German 

law. The Composition Act was based on a Japanese composition law taken from 

Austrian law; the Reorganization Act copied the Japanese Reorganization Act 1952, 

derived in turn from the U.S. Bankruptcy Act 1898. The composition law was 

triggered by a debtor's filing and only provided for temporary relief until creditors 

voted on a composition plan. The more complicated reorganization process was 

better suited for larger, public companies.. 

The Philippines civil law system has long-standing common law aspects, found 

also in some contemporary European jurisdictions, in that its supreme court 

decisions are binding as precedents. The pre-1997 Philippines insolvency law dated 

from 1909 and included a rarely used liquidation procedure and a corporate rescue 

suspension of payments process taken from Spanish law that was available only to 

solvent companies experiencing temporary cash flow problems. Any proposal for 

debt rearrangement required the full payment of debts, and so was rarely used. A 

rehabilitation procedure was introduced as an alternative to the inflexible suspension 

of payment process under a 1976 presidential decree, later amended in 1981. Rather 

96. Lee Suet Lin Joyce, Is Singapore's Insolvency Regime Excessively Pro-Creditor?, 12 INT'L 

INSOLVENCY REV. 37 (2003) (discussing Singaporean corporate insolvency law). 



VOL. 42:515 

than giving jurisdiction for rehabilitation and suspension of payments to the 

judiciary, however, the amendment granted jurisdiction to the Securities and 

Exchange Commission (SEC). The rehabilitation procedure provided few rules and 

contained curiosities, such as providing that creditors were not obliged to approve a 

rehabilitation plan, and at times treating secured and unsecured creditors alike. 

Indonesian and Thai insolvency law also provided for liquidation and 

suspension of payments procedures, which were also rarely used. Indonesian 

debtors are able to present a plan of composition even within the liquidation process. 

The suspension of payments process provides the debtor with additional time to 

finalize a repayment plan. Under Thai bankruptcy law, composition is possible 

either pre-petition or post-petition. An unusual aspect of the Thai Bankruptcy Act 

1940 is that its presumption of insolvency appears to have been influenced by the 

acts of bankruptcy in 191h century English law. 

Taiwanese bankruptcy law dates from 1935 and provides for both liquidation 

and composition. The reorganization law under the Company Law, applicable to 

public companies, was similar to that in Korea. The reorganization law had not been 

amended in many years and was over-reliant on the court. The effectiveness of the 

old law has been criticized for its inconsistency "due in part to a lack of commercial 

viability on the part of the companies undergoing reorganization." 97 The lengthy 

reorganization process also enabled some companies to avoid bankruptcy by abusing 

the reorganization procedures. 8 

China was spared the most severe economic problems of the Asian financial 

crisis, and as of 1997 was the only jurisdiction in the study group whose bankruptcy 

laws had recently been promulgated. Nevertheless, at the time of the financial crisis, 

China was affected by domestic concerns resulting from the poor financial condition 

of its SOEs and state-owned banks. The insolvency framework in China at that 

time was an overlapping patchwork that included: a forty-three provision 1986 

Bankruptcy Law for SOEs; eight provisions in Chapter XIX of the 1991 PRC Civil 

Procedure Law applicable to non-SOE enterprises with legal person status; judicial 

interpretations of these short laws, notably the 2002 interpretation by the Supreme 

People's Court; and most importantly, several policy decrees issued by the central 

government which are crucial in understanding the government's approach to 

insolvency issues. Although the number of insolvencies in China has been 

increasing, it is generally considered to be far lower than the number of insolvencies 

that would correspond to the true condition of most SOEs and banks, gauged by 

generally accepted accounting standards. A new bankruptcy law, under discussion 

for more than a decade, was finally enacted in August 2006 and is discussed below. 

Vietnam enacted a bankruptcy law in 1993 that came into operation in the 

following year. Unlike China's bifurcated approach-with separate laws for SOEs 

and non-SOE legal person enterprises,-Vietnam had a unified law. The 

Vietnamese law was also more expansive than the former Chinese act in that it also 

applied to enterprises lacking legal personality (e.g, partnerships and sole 

proprietorships).. In practice, however,, the law was cumbersome in application and 

rarely used. Its requirement that a debtor exhaust "all financial measures" before 

being eligible for bankruptcy effectively led to a two-year delay before a bankruptcy 

97. Eric Tsai & Hui-Erh Yuan, Taipei, China, in THE ASIA-PACIFIC RESTRUcTURING AND 

INSOLVENCY GUIDE 2006 154, 156 (2006). 

98. Id. 



could be commenced. A new Vietnamese bankruptcy law came into operation in 

2004." Cambodia is currently considering enactment of its first insolvency law. 

The profound impact of the 1997 crisis led to an immediate call to reform or 

replace archaic liquidation regimes and supplement them with modern corporate 

rescue procedures, including both formal court-based regimes and out-of-court and 

administrative procedures. Since the crisis, two waves of reform have crossed the 

region. The first included insolvency reforms in Indonesia, Malaysia, the 

Philippines, South Korea, Taiwan and Thailand. The second includes the new 

bankruptcy laws enacted in Vietnam in 2004 and China in 2006 and ongoing law 

reform efforts in Cambodia, Hong Kong, and Singapore, although the reform 

process in both China and Hong Kong began prior to mid-1997. 

2. Insolvency: Post-Financial Crisis Legal Reforms 

Thailand was among the states most severely affected by the 1997-98 financial 

crisis. A new chapter on business reorganization was added to the Bankruptcy Act in 

1998 to facilitate corporate rescues. One reform provided for the appointment of a 

bankruptcy planner to manage the affairs of the debtor company and prepare a plan 

of reorganization. The new procedure was intended for large corporate debtors 

owing at least BtlO million (US$273,000) to their creditors and further provisions 

would be appropriate to create an efficient procedure for smaller debtors. Further 

amendments were made to the bankruptcy law in 2000. 

An important part of the Thai reforms was the establishment of a bankruptcy 

court with exclusive jurisdiction for such cases pursuant to the 1999 Act for the 

Establishment of and Procedure for Bankruptcy Court. The act was amended in 

2004, while perceptions of the introduction of the bankruptcy courts have been 

varied. Initial views were positive, but concerns have increased as to the overall 

efficacy of these changes. There have been claims of inconsistency among individual 

courts; a fear that much of the expertise gained through the formation of the courts 

is lost when judges are rotated into other courts; an increasing backlog of cases; and 

there are concerns that corruption and fraud may be affecting the courts' work) 1 ° At 

present, these concerns appear to have eased somewhat and there is a re-emerging 

sense that the judicial reforms were for the best. 

Indonesia was more severely impacted by the 1997 crisis. In 1998, the 

Bankruptcy Ordinance was amended by a Government Regulation in Lieu of Law. 

Indonesia established a Commercial Court after the crisis to hear bankruptcy cases, 

but according to one commentator the court "has been beset by concerns of 

corruption and inconsistent application of the Bankruptcy Act"' 01 and "[t]he 

Indonesian Corruption Watch reports of corruption in the legal system is 

staggering."' ' 2 Many abuses have been publicized, with cases involving Canadian 

insurer Manulife and the Indonesian-controlled group APP (Asia Pulp & Paper) the 

99. See Charles Booth, Drafting Bankruptcy Laws in Socialist Market Economies: Recent 

Developments in China and Vietnam, 18 COLUM. J. ASIAN L. 93 (2004). 

100. Vassiliou, supra note 66, at 21. 

101. Lampros Vassiliou, The Asian Recovery: Progress and Pitfalls, Presented at the Global Forum on 

Insolvency Risk Management, Washington, DC (Jan. 28-29, 2003) at 6. 

102. Id. at 7. 



VOL. 42:515 

most well-known, having been the subject of much controversy and media coverage. 

However, the IMF and ADB funded a group of local lawyers and judges known as 

"Team 7" to address such problems and evaluate the Commercial Court's 

decisions." 3 Further amendments to Indonesian law were enacted in 2004. 

South Korea has made the most significant changes to the formal insolvency 

laws of all the jurisdictions in this study. Its corporate sector, especially the closelycontrolled 

chaebol conglomerates, was traditionally highly-leveraged, which proved 

an immediate burden in the light of a post-crisis withdrawal of available credit. South 

Korea agreed to enact substantial changes in law at the instigation of the IMF and 

World Bank in the form of amendments to its tripartite insolvency legislation 

covering liquidation, composition and reorganization. U.S. bankruptcy law 

influenced many of these changes. Among notable reforms was the inclusion of 

creditor committees in composition proceedings and management committees in 

reorganizations, while the time limit for reorganizations was halved from twenty to 

ten years. Many changes were intended to expedite reorganization procedures. 

Further amendments were made in 2000 and 2001, the latter including formalizing an 

out-of-court Workout Accord in the reorganization legislation to enable creditors to 

file proceedings to bind foreign creditors. A more recent major change to insolvency 

law was a Debtors' Rehabilitation and Bankruptcy Act (DRBA), which came into 

effect on April 1, 2006, and for the first time consolidated the three parallel 

insolvency acts. The new act further expedites corporate rescue processes, expands 

the reorganization system and abolishes the Composition Act. The task for South 

Korea may now be to ensure that its new legal framework is properly implemented, 

for which further practitioner training is likely to be necessary. 

Amendments to Philippines law were made in July 2000. Among the most 

significant changes was the transfer of jurisdiction for rehabilitation and suspension 

of payment cases from a state regulatory agency to the courts." Interim Rules of 

Procedure for Corporate Rehabilitation were promulgated in December 2000, in far 

more detailed form than the procedures under a prior Presidential Decree. 

Suspension of payment cases and corporate rehabilitation have become more 

common since the financial crisis, but delays remain a problem under the new regime 

obtaining post-petition financing has remained difficult. Other reforms are currently 

under discussion, notably a Corporate Recovery and Liquidation Act and a 

Corporate Recovery Act. It is hoped that the former includes a provision for fasttrack 

rehabilitation but congressional passage of these bills has been slow. The goal 

for the Philippines is also to increase the institutional capacity of the judiciary and of 

insolvency practitioners. Transferring jurisdiction for insolvency cases from the SEC 

to the courts is understandable, but it ensures that the Philippines is the sole 

jurisdiction in the study core where administrative and judicial enforcement capacity 

have decreased since the financial crisis. Another goal for the Philippines will be to 

better protect the rights of secured creditors. 

A reform of the Taiwanese Company Law in 2001 streamlined the 

reorganization procedures. These were the first major reforms to the procedures in 

roughly thirty years. Among the changes to the law were reducing the length of the 

reorganization process and requiring that companies using the procedures "be 

103. Id. at 35. 

104. See supra Part V(C)I. 



capable of being revived through reorganisation.' ' 5 It has been noted that several 

successful reorganizations have recently been carried out and that the changes have 

enhanced the viability of the new law as a restructuring tool and reduced the 

incentives for debtors to abuse the reorganization process.' Further changes to the 

insolvency laws are also being considered, including a proposal to unify the 

bankruptcy and reorganization laws into a single code. 

In August 2006, China enacted a new insolvency law that came into operation 

in June 2007. This new law is the result of an insolvency law reform process that 

dates back to 1994. This law applies to all legal person enterprises and unifies the 

existing patchwork of bankruptcy laws, decrees, and judicial interpretations. This 

new law radically improves both the liquidation and corporate rescue processes. At 

the heart of these reforms is the introduction of an office of the professional 

administrator to replace the current inefficient liquidation team model. The new law 

includes a detailed corporate rescue process that draws heavily on Chapter 11 of the 

U.S. Bankruptcy Act (for example, providing for post-petition financing and a 

limited cramdown). These procedures will allow for reorganizations led either by 

the administrator or a debtor-in-possession (under the supervision of the 

administrator). 

The main substantive issue delaying the enactment of the new law was a 

conflict as to how to resolve the interests of secured creditors and employees in cases 

where company funds prove insufficient to meet wages in full. A compromise was 

reached providing that secured creditors will have priority over all workers' claims 

arising after August 27, 2006, but that certain wage, medical, and insurance claims of 

workers arising before that date will have priority over the claims of secured 

creditors. Another controversial issue during the drafting process was whether 

SOEs should be made subject to the new law. The new law provides that special 

matters regarding the bankruptcy of SOEs shall no longer continue to be handled 

under State Council regulations. Time will tell whether that will be the case. 

In reforming its insolvency law, Vietnam was interested in China's approach to 

similar issues. When both Vietnam and China issued new draftlaws in 2002, the 

former was at an earlier stage of development. However, Vietnam avoided the 

contentious delays that occurred in China and enacted its law in 2004. This 

abolished the former requirements that a debtor must first exhaust "all financial 

measures" to become eligible for bankruptcy relief, and represents a significant 

reform. However, in comparison to China, Vietnam's reform approach was 

gradualist, lacks a "driver" of the new legal process (i.e., does not have an official 

equivalent to the Chinese administrator), and has fewer checks and balances. 

Attempts at Hong Kong insolvency law reform pre-date the 1997 financial 

crisis. In 1996 the Hong Kong Law Reform Commission set out the framework for a 

new regime, by which a qualified specialist called a "provisional supervisor" would 

after commencement of the process take control of the company and be responsible 

for drafting a proposal for creditor agreement. The first draft bill was gazetted in 

2000, and offered many advantages over current law, but a primary flaw has been a 

proposal that employees' salaries be paid in full or sufficient funds placed in trust for 

105. Tsai & Yuan, supra note 97, at 156. 

106. Id. 



VOL. 42:515 

the purpose. °7 Fortunately, in a line of cases beginning in 2002, the judiciary was 

receptive to the use of provisional liquidation as a mechanism to facilitate corporate 

rescue. However, the use of provisional liquidation to assist with corporate rescue 

was narrowly re-interpreted in the recent case of Re Legend International Resorts 

Ltd., which required that a company's assets first be in jeopardy for a provisional 

liquidator to be appointed." 8 The enactment of a provisional supervision regime in 

the foreseeable future is quite unlikely." 

Singapore's insolvency regime is currently the most comprehensive of the study 

group. For more than five years, schemes of arrangements have proven more 

popular than judicial management cases. Among the reasons are that a stay on 

unsecured creditor action in the scheme of arrangement procedure gives the debtor 

company sufficient time to proceed to propose such a scheme; it can remain in 

possession of assets and equipment; and less adverse publicity and commercial 

stigma appears to arise in relation to a scheme of arrangement than from many 

judicial management cases. As with Hong Kong and Malaysian law, a weakness of 

Singapore's model is the bifurcation of corporate insolvency procedures in company 

law, and the personal insolvency procedures in bankruptcy law. Singapore is 

considering the enactment of unified legislation to address this problem, but this will 

not take place in the short term. 

3. Insolvency: Post-Financial Crisis Out-of-Court Reforms 

Although legal insolvency reforms received much attention due to the needs 

created by the Asian financial crisis, the time taken to enact and implement any such 

legislation is inevitably protracted. While legislative reforms were first considered, 

other efforts began to save companies whose businesses could create value for 

creditors and other stakeholders. These efforts led to two types of reforms, the first 

being the promulgation of out-of-court workout procedures based on the London 

° 

Approach.' These included the Bangkok Approach, Malaysia's Corporate Debt 

Restructuring Committee (CDRC), the Hong Kong Approach, the Jakarta 

Initiative, and the Workout Accord in South Korea. In contrast to the general 

experience in Europe, this semi-formal approach has been successful in cases where 

the parties involved are overwhelmingly of a single domicile. Still, they have been 

only modestly helpful in Asia's many post-1998 cross-border multi-creditor 

restructurings, despite a large number of such cases being managed by banks 

operating in Hong Kong." 1 

More radically, where national banking sectors were severely affected by 

delinquent loans, the second alternative provided for establishment of administrative 

107. See Philip Smart & Charles Booth, Reforming Corporate Rescue Procedures in Hong Kong, 1 J. 

OF CORP. L. STUD. 485 (2001); Booth, supra note 99. 

108. [2006] HKCA 67; CACV000207/2005, Mar. 1, 2006. 

109. See Charles Booth, The Race of Two Tortoises: Insolvency Law Reform in Hong Kong and 

China, CHINA L. REP., Nov. 2006, at 3. 

110. See supra note 93 and accompanying text, but note that the "the effectiveness of such semivoluntary 

arrangements has been eroded by the growing use of loan sales and other forms of credit risk 

transfer"; see BERRY HSU ET AL., FINANCIAL MARKETS IN HONG KONG: LAW & PRACTICE 154 (2006). 

Outside Asia, the practice has influenced the recent development of protocols for the settlement of credit 

default swaps. 

111. Id. 



asset management agencies to assist with the restructuring and disposal of NPLs, 

including the Indonesian Bank Restructuring Agency (IBRA), Malaysia's 

Pengurusan Danaharta Nasional Bhd (Danaharta), and the Thai Asset Management 

Company (TAMC). For the most part, these entities were created as part of 

emergency measures and several are in the process of being shut down." 2 

Hong Kong established its Hong Kong Approach to Corporate Difficulties in 

1999, modeled on the London Approach, with the backing of the self-regulated 

Hong Kong Association of Banks and the government's Hong Kong Monetary 

Authority. 

South Korea established an out-of-court workout process in June 1998, in the 

form of a Workout Accord among financial intermediaries. The process was 

imperfect, though, as it excluded foreign creditors and provided no priority for postcommencement 

financing. In 2001 the Workout Accord procedure was promulgated 

as part of the reorganization law to address these two problems and formally expired 

on December 31, 2005. The Korean Asset Management Company (KAMCO) 

assisted in resolving the commercial banking sector's sizeable accumulation of NPLs. 

Unlike similar Asian asset management companies (AMCs), KAMCO was not a 

temporary entity established to deal with the 1997 crisis, and had been formed in 

1962. Indonesia established the Jakarta Initiative to assist with out-of-court 

restructuring and set up IBRA to deal with the impaired assets of Indonesian 

financial intermediaries. IBRA became very substantial, and was the largest 

national landowner before its dissolution in 2004."' Its results were less effective 

than those of state-sponsored AMCs elsewhere, notably KAMCO or Danaharta, in 

particular due to a policy of acquiring distressed assets at inflated balance sheet 

prices rather than establish a realistic market value-even though the payments 

made to the transferor banks were not necessarily of the same order. 

Malaysia established CDRC to assist with informal out-of-court rescues and an 

asset management entity (Danaharta) to assist with problems encountered by the 

financial sector. Danaharta had strong powers of enforcement and its results are still 

viewed as important in addressing post-crisis problems in Malaysia. 

In 1998, the Bank of Thailand established an informal out-of-court 

restructuring procedure for financial creditors known as the Bangkok Approach, 

headed by the Corporate Debt Restructuring Advisory Committee. TAMC was 

created pursuant to emergency legislation in June 2001 to assist in the disposal of 

financial sector NPLs. 

China established four AMCs to address accumulated NPLs at each of the 

largest state-owned commercial banks. The first, China Xinda Asset Management 

Company (Cinda) for Construction Bank of China and China Development Bank, 

was formed in April 1999. It was followed by China Huarong Asset Management 

Corporation for Industrial and Commercial Bank of China, Dongfang Asset 

Management Company (Oriental) for Bank of China, and China Great Wall Asset 

Management Company for Agricultural Bank of China. Regional AMCs were also 

112. The forerunner model of these entities was the U.S. Resolution Trust Corporation, which from 

1989-95 acted as a federal asset disposal conduit for failed savings and loan and other housing finance 

organizations. 

113. Vassiliou, supra note 101, at 35. 



VOL. 42:515 

established, including the important Guangdong Guangye Asset Management 

Company. 

Like China, Vietnam established AMCs connected to the commercial banks to 

dispose of NPLs. In addition, Vietnam established a national Debts and Assets 

Trading Company managed by the Ministry of Finance. 

Taiwan also has established AMCs to assist with the disposal of NPLs through 

the promulgation of the Financial Institutions Merger Act of 2000. 

4. Interaction between Creditor Rights and Insolvency 

A theme of this study is that effective insolvency regimes go hand-in-hand with 

effective secured transaction regimes. This parallel development of secured 

transaction laws is absent from most of the jurisdictions considered. The overall 

implementation of insolvency regimes throughout the region would benefit from the 

improvement or introduction of effective secured transactions systems, for it is 

within insolvency cases that the integrity of secured transactions and the rights of 

secured creditors are fully tested. 

The English system of company law adapted in Hong Kong, Malaysia, and 

Singapore puts secured creditors in a relatively strong position in insolvency matters, 

and there is thus a high level of predictability as to the rights of secured creditors in 

these three jurisdictions. Secured creditors act outside a liquidation and are not 

subject to a general stay against creditors. Unless agreed otherwise, they also act 

outside any scheme-of-arrangement process. It is only in judicial management cases 

in Singapore that secured creditors are made subject to the general stay. 

TABLE 8: COMPATIBILITY OF CREDITOR RIGHTS AND INSOLVENCY 

SYSTEMS 

Compatibility 

of systems 

relating to 

Principal source and Form of legal creditor rights 

system of current law' transplant and those 

permitting 

secured 

transactions 

Cambodia French civil Imposition NA 

China... Mixed (German civil; Adoption 1/2 

Socialist) 

Indonesia Dutch civil Imposition 1/2 

Malaysia English common Imposition 3/4 

114. For guidance only: questions of legal inheritance or transplant are beyond the direct scope of this 

article. The indications given in Table 8 take no real account of mixed jurisdictions, or of what has been 

termed "chthonic law," whether ancient or contemporary. See H. PATRICK GLENN, LEGAL TRADITIONS 

OF THE WORLD: SUSTAINABLE DIVERSITY IN LAW 58-114 (2004). 

115. In regard to the recently enacted bankruptcy law that came into operation in June 2007. 



Philippines Mixed (Spanish civil; U.S.) Imposition 1/2 

South Korea German civil Mixed 3/4 

Taiwan German, Japanese civil Imposition / 3/4 

adoption 

Thailand French civil Adoption 1/2 

Vietnam Mixed (French civil; Imposition / 1 

Socialist) 

adoption 

Hong Kong English common Imposition 4/5 

Singapore English common Imposition 4/5 

In China, the rights of a secured creditor historically have depended upon 

whether a bankruptcy case is entered pursuant to government policy decrees or 

bankruptcy laws, though the new bankruptcy law claims to bring this distinction to 

an end. Under the old regime, there was a traditional priority scheme in the 

bankruptcy laws whereby employee claims ranked after those of secured creditors. 

In contrast, in policy bankruptcies, secured creditors could lose priority in land-use 

rights and other secured assets to employees, so as to assist the latter with 

resettlement and other entitlements. However, as noted above, under the recently 

agreed compromise, the new Chinese bankruptcy law provides that secured 

creditors will have priority over all workers' claims arising after August 27, 2006, but 

that certain wage, medical, and insurance claims of workers arising before that date 

will have priority over the claims of secured creditors. Although secured creditors 

are subject to a stay in liquidations and reorganizations, they retain priority in 

payment to the extent of their collateral. 

In summary, China, Indonesia, the Philippines, and Vietnam adopt the U.S. 

approach by which secured creditors are subject to an automatic stay in both 

liquidations and reorganizations. In contrast, in South Korea, Singapore, and 

Thailand, secured creditors are subject to a moratorium in reorganizations, but not 

in liquidations or compositions. Last, secured creditors of companies in Hong Kong, 

Malaysia, and Taiwan may act unilaterally outside both bankruptcy and 

reorganization. In jurisdictions where secured creditors are subject to an automatic 

stay, the courts have rarely applied principles of adequate protection when those 

6 

creditors seek to be exempt. In the Philippines, less account is taken than 

elsewhere of the views of secured creditors in the preparation and sanction of 

reorganization plans. In some instances, secured creditors have been required to 

share pari passu with unsecured creditors. 

Two main areas of law in the interaction of secured creditors and insolvency 

needing improvement in most jurisdictions are first, protection for secured creditors 

seeking exemption from the automatic stay; and second, limiting employee priority 

in claims over properly established secured interests. 

116. Vasiliou, supra note 101, at 8. 



VOL. 42:515 

5. Summary 

In an immediate post-crisis review of regional insolvency law reforms, the ADB 

found that the number of insolvency cases remained low in Indonesia, Malaysia, the 

Philippines, South Korea, and Thailand, despite rising from pre-crisis levels. 

Indonesia, the Philippines, and Thailand were identified as having "extraordinarily 

low" liquidations, and Indonesia and Thailand were identified as jurisdictions in 

which the use of new formal reorganization laws was surprisingly low. Liquidations 

were most numerous in South Korea and Malaysia, with Malaysia having more. 

South Korea had by far the greatest number of reorganizations, but lower than 

might have been predicted based on national output losses in 1997-98. 

The review also found that out-of-court processes were used far more often 

than formal insolvency laws except in South Korea, where their overall use was also 

7 

"surprisingly low... Data for the study were obtained from observations up to mid- 

1999, but subsequent anecdotal observations support these findings. It remains 

difficult to obtain accurate insolvency case data from most jurisdictions in Asia, and 

harder still to locate accurate assessments of out-of-court workouts. However, case 

data may not be the sole benchmark of success. One benefit of enacting formal 

corporate rescue laws is that by setting outvoting minimums and implementation 

requirements for reorganization plans, a framework for extra-judicial negotiations 

is created that addresses problems of the type caused by intransigent holdout 

creditors, both before and since the region's financial crisis. If recalcitrant creditors 

currently use such tactics, a debtor or creditor may threaten formal insolvency 

proceedings so as to cause the holdout creditor to be outvoted. 

The ADB study demonstrates that the promulgation of new insolvency laws is 

only part of achieving an effective insolvency system. Although a new law may be 

modern in design and enacted to facilitate corporate rescue, its impact will take time 

to discern. In contrast, the benefits from enabling out-of-court rescue processes 

have typically been more immediate. 

Of the core jurisdictions discussed in this article, implementation of an effective 

corporate insolvency regime is best achieved in Singapore and Hong Kong, which 

are also the jurisdictions that have made the least changes to their laws since the 

1997-98 crisis. Hong Kong is unusual in that while it lacks an effective formal 

corporate rescue law, it scores highly, largely due to the adaptation of the provisional 

liquidation procedure and the creativity of judiciary and insolvency practitioners in 

crafting out-of-court corporate rescues. The main goals for both Hong Kong and 

Malaysia remain the need to enact modern corporate rescue systems and to update 

aspects of liquidation procedures. The latter is also relevant for Singapore and most 

other countries examined here. It is expected that Cambodia will soon enact a 

modern insolvency law. 

The demand following the enactment of formal insolvency laws is to stimulate 

human resources through greater judicial competence as well as training effective 

insolvency practitioners. Specialized courts or benches are valuable but experiences 

in Indonesia and Thailand demonstrate that the creation of such courts is not a 

panacea. It is important for the judiciary to strive for consistency, and to eliminate 

corruption and the trading of influence. Professional and judicial training are crucial 

in this process. Another important feature of strengthening the implementation of 

117. See Report on Insolvency Law Reforms, supra note 65, at 10-11, 70-75. 



the law is the development of a government agency to regulate insolvency processes. 

The Official Receiver's Office in Hong Kong and the Official Assignee's offices in 

Malaysia and Singapore each perform this function effectively. It is also crucial for 

practitioners to discuss regularly contemporary insolvency developments among 

themselves and with national regulators. Hong Kong currently offers a good 

example of such interaction, which contributes to the overall effectiveness of the 

sector. Lawyers and accountants meet regularly for training sessions run by the 

Insolvency Interest Group, housed in the Hong Kong Institute of Certified 

Professional Accountants. The latter runs insolvency training courses including an 

advanced diploma course that is recognized by the Official Receiver's Office. Such 

arrangements could serve as a model for the region. 

The activities of the World Bank and UNCITRAL show that there is no single 

set of provisions for an effective insolvency regime. Nonetheless, three issues have 

commonly caused difficulties in the implementation of new insolvency laws in the 

region. First, the granting of over-generous priority or preference to employees can 

lead to an unconstructive response by secured creditors and ultimately adversely 

affect bank lending and secured transactions. Second, it may be a serious 

disincentive for many officers and directors of distressed companies to be replaced 

immediately by an outside administrator, especially among smaller family-controlled 

companies that are seeking relief from creditors. Last, the commencement criteria 

should be as clear as possible, for example, avoiding balance sheet insolvency tests 

that may rely on imperfect accounting standards. 

VI. CONTRACT ENFORCEMENT AND DISPUTE RESOLUTION 

The most critical neglect throughout the region is in enforcement and 

implementation, with the partial exceptions of Hong Kong and Singapore. 

According to Haselman, Pistor, and Vig: 

The major function attributed to law is that it empowers creditors to 

enforce their contracts. Effective legal institutions reduce the risk of 

lending and therefore result in greater lending volume in an economy as a 

share of GDP. Implicit in this view of how law affects economic outcome 

is that all actors in the economy benefit from better law."' 

This may suggest that the law matters less than its enforcement. Both theory 

and experience support this position. Coase was first to describe the importance of 

delineation and enforcement of commercial contracts, in analyses based upon 

observations of industrial practice." 9 In an environment of imperfect markets with 

real transaction costs, parties will seek efficient results through contracting. 

Unfortunately, transaction costs extend to the expense of enforcement, without 

which contracting cannot produce solutions to market imperfections nor lead to 

stable long-term outcomes. Rather, contracting will tend towards sub-optimal 

instantaneous transactions such as barter, which is in part a state from which the 

least developed members of the study core have recently emerged. 

118. Haselmann, Pistor & Vig, supra note 38. 

119. See Coase, supra note 43; R. H. Coase, The Problem of Social Cost, 3J. L. & ECON. 1 (1960). 



VOL. 42:515 

The enforcement of contracts requires a system of governance capable of 

producing, applying, and policing effective solutions. Part II of this article showed 

that a range of such systems may be theoretically capable of producing this result, 

and history has provided many disparate examples. Enforcement of contracts is not 

synonymous with the existence of the rule of law, but just one component of a 

system that can be so described. The rule of law is not a precondition for a market 

economy, despite generally being considered an important factor in economic 

development and highly conducive to financial market development. Yet a 

governance system that enforces contracts and resolves commercial disputes in a 

credible and predictable manner is essential to a basic market economy, as well as 

allowing financial markets to develop beyond the simplest single instantaneous 

transactions. This is important for institutional concerns such as the enforcement of 

financial contracts, efficient insolvency, and collateral systems, and dispute 

resolution procedures. In this context, mechanisms for contract enforcement and 

resolving commercial disputes may also be more important than specific laws. 

There are four further concerns. First, broadening the availability of real 

property ownership and mechanisms to support its use, especially relating to 

enforcement and commercial dispute resolution mechanisms. Second, the need 

more simply to delineate the provisions for secured transactions, in particular to 

provide for security interests in intangible property. Third, the development of 

effective registration systems to cover a range of assets, including real property, 

security, and intangibles, and to simplify the use and availability of collateral and its 

enforcement, leading to reductions in transactions costs. Last, where judicial systems 

for enforcement and dispute resolution are ineffective, the support of appropriate 

mechanisms for creditor and debtor self-assistance deserve, provided that they are 

transparently fair and just. This includes encouraging greater use of commercial 

arbitration. 

The foregoing Tables 2, 5, 7, and 8 show that most jurisdictions addressed in 

this Article have developed generally acceptable laws relating to creditor rights and 

insolvency but have failed fully to reform their collateral and secured transaction 

regimes. At the same time, where such insolvency or collateral laws have been 

enacted, few jurisdictions have been effective in their implementation and 

enforcement. This is the concern to which legislative and administrative attention 

needs to be devoted and which clearly demonstrates the linkage between effective 

governance, economic, and legal systems and property, collateral, and creditor rights 

in East Asia. 


Negotiation in Letter of Credit Practice and 

Law: The Evolution of the Doctrine 

PROFESSOR JAMES E. BYRNE* 

ABSTRACT 

The concept of negotiation in letter of credit practice and law has evolved from being 

an appendage of the law of negotiable instruments to an independent discipline that 

often alters basic assumptions of negotiable instruments law. From playing a central 

role in the letter of credit process, the draft or bill of exchange has become incidental 

and atrophied. Indeed, with respect to banks nominated in the letter of credit to 

"negotiate," negotiation can occur without there being a draft or bill of exchange. 

Nonetheless, negotiation, as used in letters of credit, is an important aspect of letter of 

credit practice, enabling it to serve as a means of trade facilitation and finance. The 

latest revision of the Uniform Customs and Practice for Documentary Credits, 

UCP600, reflects the currency of this concept in its attempts to define "negotiation" 

and to clarify its role in letter of credit practice. 

This paper surveys and compares the concept of negotiation in both fields. It 

summarizes the law of negotiable instruments (Part I), studying, analyzing, and 

comparing negotiation in letter of credit practice (Part II), It then considers important 

issues that arise in the negotiation of LCs, such as the requirement of a draft, 

formalities, recourse, and letter of credit fraud (Part III), and ends by suggesting an 

approach to the definition of "negotiation" in letter of credit practice and law (Part 

IV). 

* Professor Byrne teaches law at George Mason University School of Law and directs the Institute of 

International Banking Law & Practice, Inc. He has played important roles in connection with the reform 

of letter of credit law and practice on the national and international levels, including the revision of U.C.C. 

Article 5, the International Standby Practices, and the United Nations Convention on Independent 

Guarantees and Stand-by Letters of Credit. The support of George Mason University School of Law and 

its Law & Economics Center in the research necessary to prepare this Article and the active collaboration 

of attorney Lee H. Davis, Senior Attorney for the Institute of International Banking Law & Practice, is 

gratefully acknowledged. While I have not consulted with colleagues regarding the text of this paper, their 

ideas and insights form a part of my thought process and, in this sense, they will recognize these things, 

hopefully well digested. In particular, Mr. James G. Barnes, Professor Boris Kozolchyk, Professor E. Peter 

Ellinger, and Mr. Vincent Maulella have over recent years discussed issues with me that are addressed in 

this paper and, while not seeking to taint them with the outcome, I thank them for their friendship, 

patience, and willingness to seek a conceptual consensus. Hopefully, this work will contribute to it. 



VOL. 42:561 

It suggests that negotiation - whether by a bank that undertakes to do so in its letter of 

credit undertaking or by a bank nominated to do so without having made such an 

undertaking-gives rise to a basis of liability that is separate and preemptive from, if 

sometimes parallel to, that which arises on negotiable instrument that may be involved. 

Although the letter of credit concept of negotiation readily borrows from the law of 

negotiable instruments with respect to protection of the right to a protected status, 

important differences arise based on the nature of the letter of credit undertaking. 

Where there is a letter of credit undertaking to negotiate, negotiation is the means by 

which the bank honors its letter of credit obligation to the beneficiary, taking up the 

documents presented and any draft, and discounting the amount due to present value 

in the event of a time obligation without any right to seek recourse against the 

beneficiary. Where there is no undertaking, a bank that negotiates pursuant to a 

nomination is the transferee of the right to the proceeds of the letter of credit. 

SUMMARY 

1. SURVEY OF NEGOTIATION OF DRAFTS IN THE LAW OF NEGOTIABLE 

IN STR U M EN TS ...................................................................................................... 563 

II. NEGOTIATION IN LETTER OF CREDIT PRACTICE ............................................ 565 

A . Pre-U CP400 Term inology .......................................................................... 565 

B. Post-UCP400 Term inology ................. ...................................................... 567 

III. ISSUES REGARDING NEGOTIATION OF LCs ..................................................... 570 

A . The Requirem ent of a D raft ....................................................................... 570 

B . Form ality R equirem ents ............................................................................. 572 

C . W ho N egotiates? .......................................................................................... 575 

D . H ow D oes Negotiation Occur? .................................................................. 575 

E . R eco u rse ....................................................................................................... 577 

F. Protection of Banks That Negotiate in the Event of LC Fraud .............. 579 

1. The Presumption of Entitlement ........................................................ 580 

2. What Defense is Good Against a Beneficiary? The LC Fraud 

Exception to the Independence Principle ......................................... 581 

3. The LC Exception to the Fraud Defense: Protected Persons ......... 584 

4. N om in ation ............................................................................................ 585 

a. Protected Status Where There Is Negotiation by the Issuing 

or C onfirm ing B ank ...................................................................... 586 

b. Protected Status Where There Is Negotiation by a 

N egotiating B ank .......................................................................... 588 

5 . V alu e ...................................................................................................... 588 

6 . N o tice ..................................................................................................... 593 

IV. TOWARDS A DEFINITION OF LC NEGOTIATION .............................................. 593 

V . C O N CLU SIO N ....................................................................................................... 594 


2007 

NEGOTIATION IN LETTER OF CREDIT PRACTICE AND LAW 

I. SURVEY OF NEGOTIATION OF DRAFTS IN THE LAW OF 

NEGOTIABLE INSTRUMENTS' 

Negotiation in the law of negotiable instruments is a special transfer of 

intangible rights in a negotiable instrument, which entitles the transferee to claim 

under the instrument as if it were payable directly to it, transfer it in a similar 

manner to others, and claim under appropriate circumstances that it takes free of 

certain defenses that could have been raised against the drawer or prior transferees. 2 

1. While both bills of exchange and promises can be negotiable instruments, this paper deals 

exclusively with the former since letters of credit (hereinafter LCs) do not use promissory notes in 

connection with their negotiability. For convenience, the term "draft" is used in this article rather than 

"bill of exchange," since it is the term that has been chiefly used in the Uniform Customs and Practice for 

Documentary Credits (hereinafter UCP). "Draft" is not used in the U.K. Bills of Exchange Act, 1882, 45 

& 46 Vict. c. 61, § 2, but is used in U.S. statutory law. See, e.g., U.C.C. § 3-104(e) (2006). A draft or bill of 

exchange is a formal order to pay money. Id. §3-104(a)-(b), (e). Although the first two versions of the 

UCP used the term "draft" without mention of the term "bill of exchange," see UCP82 (1933), UCP151 

(1951), the 1962 Revision used the term "bill of exchange," signifying that it meant "draft" by the use of a 

parenthetical and thereafter used the word "draft." UCP222 (1962). UCP222 General Provisions and 

Definitions (b) provides that "a bank ... is to pay, accept, or negotiate bills of exchange (drafts) drawn by 

the beneficiary .... " The 2007 Revision continues this tradition by inserting the parenthetical in Article 2 

(Definitions), paragraph 9, "Honour," providing that the meaning of "honour" includes "to accept a bill of 

exchange ('draft') drawn by .... " UCP600 (2007). Which term is used in practice depends on the 

discipline involved, tradition, and the names used in local law. The term "bill of exchange" is older, but 

"draft" has a long tradition of use. The word "bill" is derived from the Latin "bulla," which was used to 

describe an ornament or a bubble. A bulla was worn by aristocratic Roman youths until they assumed 

manhood. THE OXFORD ENGLISH DICTIONARY, (J.A. Simpson & E.S.C. Weiner eds., 2d ed. 1989) links 

its use in English to the seal with which documents were authenticated and reports the first use of it in the 

sense of an order to pay in 1579. The word "draft" is a derivative of the word "draught" (sometime 

rendered in later Medieval English as "drawt," which makes the linkage clearer). Its first reported use in 

the sense of an order to pay money was in 1633. Blackstone states that "[in common speech, such a bill is 

frequently called a draught, but a bill of exchange is the more legal as well as mercantile expression." 

WILLIAM BLACKSTONE, 2 COMMENTARIES *467. Although there are some technical differences, the 

terms are effectively interchangeable. The principal difference between a classical bill of exchange and a 

draft is that the bill of exchange is a four-party instrument stating the name of the remitter, whereas a draft 

is typically a three-party instrument stating only the name of the drawer, drawee, and payee. Except for 

emphasis where both terms are used, the term "draft" will be used in this paper to signify either a draft or 

bill of exchange. The terms "draft" and "bill of exchange" are used commonly (but not necessarily) to 

signify an undertaking that meets the formal requirements of negotiable instruments law to qualify as a 

negotiable instrument. 

2. See U.C.C. § 3-201 (2006) (stating that "'[n]egotiation' means a transfer of possession, whether 

voluntary or involuntary, of an instrument by a person other than the issuer to a person who thereby 

becomes its holder .... Except for negotiation by a remitter, if an instrument is payable to an identified 

person, negotiation requires transfer of possession of the instrument and its indorsement by the holder. If 

an instrument is payable to bearer, it may be negotiated by transfer of possession alone"); United Nations 

Convention on International Bills of Exchange and International Promissory Notes, G.A. Res. 43/165, art. 

13, U.N. Doc. A/RES/43/165 (Dec. 9, 1988) [hereinafter U.N. Bills of Exchange Convention] (stating that 

"[a]n instrument is transferred: (a) By endorsement and delivery of the instrument by the endorser to the 

endorsee; or (b) By mere delivery of the instrument if the last endorsement is in blank"); Bills of Exchange 

Act art. 31 (stating that "[a] bill is negotiated when it is transferred from one person to another in such a 

manner as to constitute the transferee the holder of the bill"); The Convention Providing a Uniform Law 

for Bills of Exchange and Promissory Notes, League of Nations, art. 11, June 7, 1930, reg. no. 3313 

[hereinafter Geneva Convention on Bills of Exchange] (stating that "[e]very bill of exchange, even if not 

expressly drawn to order, may be transferred by means of endorsement"); art. 14 (stating that "[a]n 

endorsement transfers all the rights arising out of a bill of exchange"). Negotiable instruments law marks a 

unique intersection of the law of property and commerce in which the rights of ownership are embodied or 

merged in the special piece of paper. See PETER ELLINGER, Negotiable Instruments, in 9 INTERNATIONAL 



VOL. 42:561 

While there are differences as to how one becomes entitled to exercise these 

rights, these differences have little practical significance in discussing negotiability in 

connection with letters of credit, and the common law and civil law identify this 

person as a "holder." 3 

Negotiation in the law of negotiable instruments has certain formal 

prerequisites. Not just any promise or order to pay can be negotiated. To be 

negotiated, it must be in the form of a negotiable instrument-it must meet certain 

formal requirements, which include being unconditional. 4 

Because the concept of negotiation necessarily involves the use of abstract 

terminology drawn from the major legal regimes, it is easier to explain how 

negotiation occurs than what it is. Negotiation of a negotiable instrument always 

entails the delivery of the instrument to an entity who becomes a holder. Where the 

instrument is issued in bearer form or indorsed in blank or to bearer, only delivery is 

required to effect a negotiation. Where the instrument is issued to the order of a 

named entity or entities or issued in bearer form and indorsed to a named entity or 

its order, the delivery must be accompanied by the indorsement of that entity 

By issuing a negotiable instrument as a drawer or by indorsing it, an entity 

makes certain promises to subsequent holders to whom the instrument is negotiated 

or who can claim as a transferee of such a person, namely that it will honor the 

instrument if it is dishonored on maturity by the drawee or a subsequent indorser 

provided that any necessary notice is given. 6 To disclaim this obligation on the 

instrument, it is necessary to indicate that the indorsement (or issuance) is "without 

recourse." An indorsement or issuance without recourse signifies that in the event 

of its dishonor by the drawee, there is no recourse available on the instrument 

against the indorser or issuer. Absent such a disclaimer, it is assumed that any 

person signing an instrument as drawer or indorser makes such an undertaking. 

In the case of a negotiable instrument, negotiation is undertaken by the entity 

that is in possession of the instrument to whom it runs (holder) and is transferring 

(negotiating) it. One would typically speak of negotiation by the transferor and not 

by the transferee. It is the transferee to whom the negotiable instrument is 

negotiated. 

ENCYCLOPEDIA OF COMPARATIVE LAW, (Jacob S. Ziegel ed., 2000). While some of the property law 

features of negotiable instruments are retained in letters of credit, they are less fixed, and the undertaking 

is closer to its commercial law antecedents. Id. 

3. See ELLINGER, supra note 2, §§ 404-27. 

4. U.C.C. § 3-104(a) (2006) (stating that "'negotiable instrument' means an unconditional promise or 

order to pay a fixed amount of money"); U.N. Bills of Exchange Convention, supra note 2, art. 3 (stating 

that "a bill of exchange is a written instrument which: (a) Contains an unconditional order whereby the 

drawer directs the drawee to pay a definite sum of money to the payee or to his order"); Geneva 

Convention on Bills of Exchange, supra note 2, art. 1 (stating that "[a] bill of exchange contains: ... 2. An 

unconditional order to pay a determinate sum of money"); Bills of Exchange Act art. 3 (stating that "[a] 

bill of exchange is an unconditional order in writing, addressed by one person to another, signed by the 

person giving it, requiring the person to whom it is addressed to pay on demand or at a fixed or 

determinable future time a sum certain in money to the order of a specified person, or to bearer"). 

5. The civil law, unlike the common law, would require only regularity of appearance in the 

indorsements regardless of whether they are genuine. ELLINGER, supra note 2, § 416. 

6. This obligation operates when a negotiable instrument is issued or negotiated by indorsement. 

Under some systems of law, it is impacted or even discharged by a subsequent acceptance of the 

instrument. See U.C.C. §§ 3-414(c)-(d), 3-415(d) (2006). 


2007 


II. 

NEGOTIATION IN LETTER OF CREDIT PRACTICE 

A letter of credit is not a negotiable instrument. 7 There are, however, 

negotiation credits-credits under which negotiation is permitted. 

Although letter of credit practice was originally linked with negotiable 

instrument practice, the ties between the two fields of commercial law have become 

increasingly attenuated. Under standard international letter of credit practice, with 

the exception of acceptances, negotiable drafts or bills of exchange are an 

anachronism. The declining status of the draft can best be viewed from the 

perspective of the doctrinal evolution of the letter of credit concept of negotiation in 

the rules of practice that are applicable to most commercial letters of credit, the 

Uniform Customs and Practice for Documentary Credits (hereinafter UCP).' 

A. Pre-UCP400 Terminology 

Negotiation is a concept that has been with modern letters of credit from the 

early twentieth century, the first point in time where LC doctrine can be reliably 

tracked. 9 LC undertakings at that time invariably involved a draft that was typically 

7. A letter of credit, unlike a negotiable instrument, is a promise to pay that is conditioned on the 

timely presentation of complying documents and not an unconditional promise or order to pay. Under the 

U.S. Negotiable Instruments Law, the predecessor to U.C.C. Article 3, a virtual acceptance was 

recognized. BRANNAN'S NEGOTIABLE INSTRUMENTS LAW, § 135 (Frederick K. Beutel ed., W.H. 

Anderson, 7th ed. 1948) [hereinafter Negotiable Instruments Law] ("[a]n unconditional promise in writing 

to accept a bill before it is drawn is deemed an actual acceptance in favor of every person who, upon the 

faith thereof, receives the bill for value"). A virtual acceptance was, in effect, a form of letter of credit. 

While Lord Mansfield recognized this aspect of negotiation in Pillans v. Van Mierop, (1764) 97 Eng. Rep. 

1035 (K.B.), subsequent English cases did not follow his lead. 

8. The UCP is promulgated by the Commission on Banking Technique and Practice of the 

International Chamber of Commerce headquartered in Paris, France. It articulates standard international 

commercial letter of credit practice. The current revision at the time this paper was written, January 2007, 

ICC Publication No. 500 (UCP500), became effective January 1994. This version will be replaced July 1 

2007 by ICC Publication No. 600, UCP600. Prior versions were issued in 1933 (UCP82), 1951 (UCP151), 

1962 (UCP222), 1974 (UCP290), and 1983 (UCP400). Although UCP500 has been translated into virtually 

every language in which international commerce is conducted, the official version is in English. See 

generally JAMES E. BYRNE, THE COMPARISON OF UCP600 & UCP500 (Institute of International Banking 

Law & Practice 2007); JAMES E. BYRNE, ISP98 & UCP500 COMPARED (2000): James E. Byrne, Ten Major 

Stages in the Evolution of Letter of Credit Practice, DOCUMENTARY CREDIT WORLD, Nov./Dec. 2003, at 

28, reprinted in 2004 ANNUAL SURVEY 19; Dan Taylor, The History of the UCP, DOCUMENTARY CREDIT 

WORLD, Dec. 1999, at 11, reprinted in 2000 ANNUAL SURVEY 201. 

9. Letters of credit are sometimes traced to ancient commerce. These undertakings, however, 

differed in important ways from the modern commercial LC. Most importantly, they were general LCs, 

that is, there was no named beneficiary. They were addressed to correspondents and requested payment in 

favor of the bearer who was a customer of the issuer. They resembled in form and function traveler's 

credits or even the modern credit card. The modern LC came into widespread use in post Napoleonic 

Wars trade between Europe and North America. These credits were special credits in that they were made 

in favor of a named beneficiary in the sense that the obligation to honor ran only to that named person and 

no one else. While there are reported LC cases that precede the 1920s, there is little literature and no 

serious doctrinal work. Most LC.business was dominated by the London clearing banks and there was 

little room for dispute within these networks. When London financial institutions lost their hegemony 

during World War I, the purchase of war material was financed by LCs and the banks of neutral countries 

or allies handled them through their relatively new export departments. During the War, no presentations 

were refused because of the high demand, but after it ended, there were numerous refusals. At that point, 



VOL. 42:561 

accompanied by documents." While the parties to the underlying transaction were 

interested in the documents, the focus of the banker's attention was on the draft that 

accompanied them." For a banker, the draft contained his or her instructions. The 

banker read the draft as a merchant would read the commercial invoice-as the 

compass for the transaction. The draft informed the banker who was to be paid, the 

terms of payment expected, the amount, the currency, and who was expected to 

make the payment. 

At the advent of the modern era, letters of credit required that a draft be drawn 

on the issuing bank. An LC contained one of two clauses. Straight credits, in which 

the draft was drawn on the issuing bank and could only be presented to the issuing 

bank, contained a clause of the following type: "We engage with the beneficiary that 

all drafts drawn under and in compliance with the terms of the credit will be duly 

honored on delivery of documents as specified if presented at your office on or 

before ... 19 . ..12 Where presentation could be made to another bank, the credit 

would contain a clause of this type: "We engage with the drawers, endorsers, and 

bona fide holders of drafts drawn under and in compliance with the terms of the 

credit that the same shall be duly honored on due presentation and delivery of 

documents as specified ... if negotiated or presented at ... on or before ... 19 .. ,13 

In effect, this latter engagement was understood to render the credit negotiable by 

this other bank. Where the bank was instructed to add its confirmation, that bank 

effectively engaged to negotiate drafts drawn on the issuer. 4 

a number of books were published describing this business and the first attempts at rules of practice were 

made. See generally Boris Kozolchyk, Letters of Credit, in 9 INTERNATIONAL ENCYCLOPEDIA OF 

COMPARATIVE LAW (Jacob S. Ziegel ed., 2000). 

10. However, an LC calling for only the presentation of a draft was and is possible. Credits of this 

type are generally referred to as "clean" or colloquially, "suicide" LCs. See INTERNATIONAL STANDBY 

PRACTICES (ISP98), ICC Publication No. 590, (1998) Rule 1.10(a)(5); JAMES E. BYRNE, THE OFFICIAL 

COMMENTARY ON THE INTERNATIONAL STANDBY PRACTICES 52 (1998) [hereinafter The Official 

Commentary]. 

11. There is a related banking function in which a draft is accompanied by documents, described by 

bankers as a collection and by US lawyers as a documentary collection (to distinguish it from a domestic 

check collection). There are also ICC Banking Commission Rules that are widely used in connection with 

them, the INTERNATIONAL CHAMBER OF COMMERCE, UNIFORM RULES FOR COLLECTIONS, URC 522 

(revised 1995). The essential distinction between these two operations is that the bank makes no 

undertaking to honor in the case of a collection whereas it does in the case of a letter of credit. 

Accordingly, the attitude of the bank towards the documents is quite different. In a collection, the bank 

counts the documents to see if the number indicated on the collection letter is present. In a letter of credit 

transaction, the bank will examine the documents to determine whether they comply on their face with the 

terms and conditions of the letter of credit. Even in a collection, however, the primary role is not accorded 

to the draft but to the collection letter. See URC 522 art. 4(a)(1)("All documents sent for collection must 

be accompanied by a collection instruction indicating that the collection is subject to URC 522 and giving 

complete and precise instructions. Banks are only permitted to act upon the instructions given in such 

collection instruction..."). The draft is not a source of instructions. This point is illustrated in a "clean 

check collection" in which the document being collected on is a check. In that case, the drawee of the 

collection is not the drawee of check but the entity indicated in the collection instructions. See SCADIF, 

S.A. v. First Union Nat'l Bank, 344 F.3d 1123, 1129 (11th Cir. 2003) (sustaining the district court's finding 

that a bank to whom a "clean check collection" is transmitted is a collecting bank, despite the check's 

designation of the bank as a drawee). 

12. WILBERT WARD, AMERICAN COMMERCIAL CREDITS 186 (1922). 

13. Id. at 187. 

14. See UCP600 art. 8(b) (2007) (stating "A confirming bank is irrevocably bound to honour or 

negotiate as of the time it adds its confirmation to the credit.) and UCP500 art. 9(b) (1993) (stating "[a] 

confirmation of an irrevocable Credit by another bank (the 'Confirming Bank') upon the authorisation or 

request of the Issuing Bank, constitutes a definite undertaking of the Confirming Bank, in addition to that 


2007 


Where the draft was payable at sight, negotiation consisted of paying the 

amount due under the letter of credit to the beneficiary after having examined the 

documents and concluding that they complied with its terms and conditions." Where 

the draft was a time draft, negotiation consisted of paying the amount due under the 

letter of credit to the beneficiary discounted to present value after having examined 

the documents. Where the bank had issued the credit or added its confirmation, it 

negotiated without recourse. 6 

B. Post- UCP400 Terminology 

The term "nominated" was first introduced in UCP290 (1974) and the concept 

of nomination seriously developed in UCP400 (1983)." A nomination entitles the 

person nominated to act under the credit and embodies an undertaking by the issuer 

and any confirmer to reimburse the nominated bank. The nomination empowers the 

nominated bank to act within the scope of the nomination and to undertake any act 

not inconsistent with it. 

Nomination can effect to whom presentation may be made, the status of the 

bank with respect to amendments, the status of the bank with respect to revocable 

credits, the status of the bank in the event of claims of fraud on the part of the 

beneficiary or forged or fraudulent documents, or the ability of the bank to effect the 

transfer of drawing rights, and the entitlement to reimbursement. Nomination of a 

bank under an irrevocable credit gives an irrevocable right to a beneficiary to 

present documents to that bank for purposes of satisfying the condition that 

of the Issuing Bank. . : iv. if the Credit provides for negotiation-to negotiate without recourse to drawers 

and/or bona fide holders, Draft(s) drawn by the Beneficiary and/or document(s) presented under the 

Credit"). A clause to the same effect appears in all versions of the UCP since 1951. 

15. See UCP82 art. 9 (1933) ("[w]hen an irrevocable credit is opened in the form of a Commercial 

Letter of Credit, the Letter of Credit itself must include notification of the opening of an irrevocable credit 

and constitute the definite engagement by the issuing Bank towards the beneficiary and holder in good 

faith to honour all drafts issued by virtue of and in conformity with the clauses and conditions contained in 

the document"). While payment at sight originally meant that the document was examined on 

presentation and either honored or dishonored, a bank now has time within which to examine documents. 

Under UCP500 Article 13(b), it has a reasonable time not to exceed seven banking days. Under UCP600 

Article 14(b), it has a maximum of five banking days. See also Seaconsar Far East Ltd. v. Bank Markazi 

Jomhouri Islami Iran, (1997) 2 Lloyd's Rep. 89 (Q.B.) (indicating and discussing the original meaning of 

'available by sight payment'). 

16. See UCP151 art. 5 (1951) (stating "[i]n case of credits available by negotiation of drafts, the 

confirmation implies only the undertaking of the confirming Bank to negotiate drafts without recourse to 

drawer"); UCP500 art. 9(b)(iv) (1993) ("A confirmation of an irrevocable Credit ... constitutes a definite 

undertaking ... if the Credit provides for negotiation-to negotiate without recourse to drawers and/or 

bona fide holders, Draft(s) drawn by the Beneficiary and/or document(s) presented under the Credit."). 

17. The term "nomination" was first introduced in reference to a bank in UCP290(e) (1974) (General 

Provisions and Definitions), which spoke of a bank being "authorized to pay or accept under a credit by 

being specifically nominated in the credit" or being "authorized to negotiate under a credit either i. by 

being specifically nominated in the credit, or ii. by the credit being freely negotiable by any bank." These 

references were developed in UCP400 (1983), which introduced and defined the term "Nominated Bank" 

in Article 11(b): "All credits must nominate the bank (nominated bank) which is authorized to pay 

(paying bank), or to accept drafts (accepting bank), or to negotiate (negotiating bank), unless the credit 

allows negotiation by any bank (negotiating bank)." The name was used more extensively in UCP500 

(1993) and is used throughout UCP600 (2007), which contains an article 12 entitled "Nomination" in 

addition to a definition of the term in article 2. 



VOL. 42:561 

documents be timely presented prior to the expiration of the letter of credit whether 

or not it takes up its nomination. A nominated bank is not obligated to act by virtue 

of being nominated and may elect not to do so. With the exception of a confirming 

bank, a nominated bank does not make any engagement by advising the credit or by 

receiving a presentation, examining the credit, or forwarding it to the confirmer or 

issuer unless it expressly so indicates.' 8 

Instead of distinguishing only between straight and circular (undertakings that 

were meant to circulate) as did earlier UCP versions, by UCP400 (1983) it was 

recognized that a bank could be nominated to confirm (confirming bank), pay 

(paying bank), 9 or negotiate (negotiating bank). 

These categories tended to overlap. Negotiation did not necessarily entail 

nomination and could be undertaken by the issuing bank which had engaged itself 

under its letter of credit. Nor was it confined to a negotiating bank since a 

confirming bank could make an undertaking to negotiate as well. Although not 

always fully grasped even by LC bankers, negotiation in post UCP400 LC practice 

encompasses two quite different functions. On the one hand, it represents a type of 

undertaking given by either an issuing or confirming bank to negotiate drafts drawn 

on either the applicant 0 or issuer respectively and the fulfillment or honor of that 

18. See UCP600 art. 12(a) (noting that "[ulniess a nominated bank is the confirming bank, an 

authorization to honour or negotiate does not impose any obligation on that nominated bank to honour or 

negotiate, except when expressly agreed to by that nominated bank and so communicated to the 

beneficiary"); id. 12(c) (stating "[rieceipt or examination and forwarding of documents by a nominated 

bank that is not a confirming bank does not make that nominated bank liable to honour or negotiate, nor 

does it constitute honour or negotiation"). 

19. The UCP has never systematically addressed the role of the paying bank. Neither a paying bank 

nor a negotiating bank make an undertaking to honor but if the paying bank acts, it is to pay as opposed to 

negotiate. When drafts are used, the draft would be drawn on a paying bank. As the drawee, its payment 

would be final since payment by the drawee would extinguish the draft without there being any right of 

recourse. On the other hand, the draft would be endorsed to the negotiatingbank and any negotiation by 

it would not be final unless it disclaimed its right to-recourse or the indorsement to it was without recourse. 

The UCP has always referred to the role of a paying bank however obscurely. UCP82 (1933) Article 10 

links a paying bank with the negotiating bank with respect to notice of refusal. Similar oblique references 

to the paying bank occur in UCP151 (1951) Article 43 (right to refuse presentation if unduly delayed), 

Article 49 (Transfer); UCP222 (1962) Articles 41 (same as UCP151 Article 43), Article 46 (Transfer); 

UCP290 (1974) Articles 13 (Reimbursement), 46 (Transfer); UCP400 (1983) Articles 11 (Nominated 

Banks) (which contains a parenthetical definition of the term), 21(a) & (c) (Reimbursement), 54(f) 

(Transfer); UCP500 Article 19 (Bank-to-Bank Reimbursement Arrangements). In addition, there have 

been regular references to payment (as opposed to negotiation) by a bank which have been understood to 

refer to a nominated bank other than the confirming bank. UCP600 has deleted express reference to a 

paying bank although it contains what might be regarded as oblique references to it. UCP600 (2007) 

Article 2 (Definitions) paragraph 11 "Negotiation" excludes banks on whom a draft is drawn which would 

include paying banks where the credit called for a draft drawn on the paying bank. UCP600 Article 12(a) 

(Nomination) refers to an authorization to pay in a context that makes it apparent that it is referring to a 

bank other than the confirming bank. Likewise, UCP600 Article 8(i)(b) can be read to refer to such a 

bank (although it could also encompass another confirming bank whom the confirmer was required to 

reimburse). 

20. A credit could provide for a draft drawn on an applicant in which case the issuer and any 

confirmer would undertake to negotiate without recourse. The consequences of expecting the applicant to 

accept or otherwise honor such a draft were not fully addressed in the UCP and concern about drafts 

drawn on the applicant arose as a result of claims made by some banks that they were not liable as an 

issuer where the draft was drawn on the applicant or accepted by the applicant. The ICC Banking 

Commission rejected this position but the concern lingered. See CHARLES DEL BUSTO, UCP 500 & 400 

COMPARED 23 (1993) (References to drafts on the applicant that "or payment will be made" in UCP400 

Articles 10(a)(i) and 10(a)(ii) were deleted because they "defined a less certain and less reliable promise 


2007 


undertaking." On the other hand, negotiation also consists of a nomination by the 

issuing bank of a bank that is authorized to negotiate drafts drawn under the credit 

but is not requested or authorized to add its own undertaking to the beneficiary. 

Such a nominated bank is characterized as a "negotiating bank" in LC practice. 

Although some writers and a few courts have confused the notion of nomination and 

negotiation with the doctrine of agency, agency is inapt to describe either. 22 While 

this designation is somewhat illogical since both issuers and confirmers can also 

negotiate when they so undertake and could have been described as negotiating 

banks, it serves to reinforce the distinction between a bank that is obligated on the 

LC and one that is not. Where a negotiating bank is involved, the drafts can be 

drawn on a paying bank, the confirming bank, the issuer, the applicant, or a third 

person but not the negotiating bank. 23 

than the Issuing Bank or Confirming Bank's irrevocable promise and primary liability 'to pay.' . . . A 

Beneficiary attempting to rely on such an undefined promise did not know who the primarily liable payor 

was, or when the bank's liability to pay was enforceable."). See also THE INTERNATIONAL CHAMBER OF 

COMMERCE, OPINIONS OF THE ICC BANKING COMMISSION 1995-1996, ICC Publication No. 565, Resp. 

205, at 25 (Gary Collyer ed., 1997). As is typical with UCP drafting, it addressed the issue obliquely and did 

not make an outright statement of the liability of the issuer or confirmer notwithstanding the draft being 

drawn on the applicant. UCP600 (2007) Article 6(c) (Availability, Expiry Date and Place for Presentation) 

turns this approach around. It states that "[a] credit must not be issued available by a draft drawn on the 

applicant." The UCP600 prohibition is stronger than the statement of UCP500 but, since the UCP is 

variable, a term in the credit requiring the presentation of a draft drawn on the applicant would expressly 

vary UCP600 Article 6(c). Where it is varied, the absence of direction regarding the impact of such a draft 

is regrettable, but is not fatal since it is apparent that the draft is peripheral to the issuer or confirmer's 

obligation. In that sense, it is just another document and should be so treated notwithstanding the silence 

of UCP600 on this point. Interestingly, where a bank issues a credit for its own account as permitted under 

UCP600 Article 2 (Definitions) paragraph 10 ("Issuing Bank"), a draft drawn on it is in effect dawn on the 

applicant. In such a situation, the draft would also be treated as a bank document. 

21. See UCP600 art. 2 para. 9 (artificially excluding negotiation from the meaning of "honour"). The 

ordinary sense of the term "honour" is the fulfillment of an undertaking which, in the case of an issuer or 

confirmer, would included an undertaking to negotiate. 

22. How can there be an agency relationship where the supposed "agent" cannot bind the principal? 

A negotiating bank has no ability under the UCP or international letter of credit practice to bind the 

issuing bank. Whether or not it acts is within its sole discretion. If it does so, it is able to do so with or 

without recourse against the beneficiary in the event that it has erred with respect to the compliance of the 

documents and with respect to issuer solvency or country risk. It can make its decision as to whether to act 

after it has examined the documents and, until it elects to act, is not bound by any time limits. While its 

right to be reimbursed may be affected if the documents do not comply, it has no duties to the issuing bank. 

See JAMES G. BARNES. JAMES E. BYRNE, & AMELIA H. Boss, THE ABCS OF UCC ARTICLE 5: LETrERS 

OF CREDIT 45 (1998) ("Nominated persons are best viewed as independent contractors whose various roles 

are defined by LC practice.... They may be viewed as agents for the issuer or as agents for beneficiaries or 

both, but application of agency law will often as not lead to the wrong conclusion. Nominated persons have 

little or no right to bind issuers or beneficiaries" ). See also RICHARD KING, GUTTERIDGE AND 

MEGRAH'S THE LAW OF BANKERS' COMMERCIAL CREDITS 106 (8th ed. 2001) ("A negotiating bank 

negotiates on the invitation contained in the credit and not as an agent..."); JOHN F. DOLAN, THE LAW 

OF LETTrERS OF CREDIT, para. 8.02[6] n.59 (2003) (noting "[tihat is not to say that the negotiating bank is 

an agent of the issuer."); Bank of N.S. v. Angelica-Whitewear Ltd., [2003] 1 S.C.R. 59, 86-87 (suggesting 

that the negotiating bank acts for itself, but it does so with the understanding that the issuer's undertaking 

runs to the negotiating bank and not just to the beneficiary"). 

23. There is another sense in which the term negotiation is used in letter of credit practice-the 

payment of any undertaking involving another bank. This use derives from the pre-UCP400 distinction 

between straight and circular credits. It is a use which has been officially discouraged. See ICC BANKING 

COMMISSION, UCP1974/1983 REVISIONS COMPARED AND EXPLAINED 12 (1984). Nonetheless, it still 

surfaces in the casual vocabulary of bankers because it offers a shorthand means of capturing the concept 

of reimbursement. 



VOL. 42:561 

Following the format of SWIFT MT700 messages, UCP600 distinguishes 

between the notions of "Available With. . ." and "Available By .. . A credit is 

"available with" the issuer, or a nominated bank which can include a negotiating 

bank. It can be "available by" payment, deferred payment, acceptance, or 

negotiation. Where the credit is "available by" negotiation, the bank it is "available 

with" the negotiating bank. 

III. ISSUES REGARDING NEGOTIATION OF LCs 

Under modern letter of credit practice and law, there are several issues which 

dominate the concept of negotiation and which, to an extent, mark the difference 

between negotiation under negotiable instrument law and under letter of credit 

practice and law. They are a. the requirement of a draft; b. formality requirements 

for a draft; c. who negotiates; d. how negotiation occurs; e. recourse; and f. 

protection of banks that negotiate in the event of letter of credit fraud. These issues 

overlap and, for clarity, there is some redundancy in explaining them. 

A. The Requirement of a Draft 

Under negotiable instrument law and practice, there must be a negotiable 

instrument (for our purposes, a draft) in order for negotiation to occur. 

In its evolution, letter of credit practice has deviated considerably from its 

original focus on the draft (to pay it or to accept it or to reimburse another bank 

who accepted or negotiated it) whether or not there was "negotiation." The early 

unwritten expectation that a draft would always be presented under an LC no longer 

obtains. With the exception of credits that contain an undertaking to accept, it is not 

uncommon for UCP commercial credits to dispense with the requirement of a draft. 

For standbys, a draft is unnecessary and irrelevant. Even with respect to an 

acceptance, the role of the draft has been supplanted by the deferred payment 

undertaking in which an obligation to pay over time is incurred under the terms of 

the credit. Properly understood, this undertaking is the functional equivalent of a 

acceptance.2 

24. See UCP600 art. 6(a)-(b) ("A credit must state the bank with which it is available or whether it is 

available with any bank. A credit available with a nominated bank is also available with the issuing bank.. 

• . A credit must state whether it is available by sight payment, deferred payment, acceptance or 

negotiation."). This data is contained in SWIFT MT700 Field 41a (Available With ... By ... ) which is a 

mandatory field. 

25. The deferred payment undertaking was first recognized in UCP400 (1983) article 10(a)(ii). Its 

emergence was noted in ROLF EBERTH & E.P. ELLINGER, Deferred Payment Credits: A Comparative 

Analysis of Their Special Problems, 14 J. MAR. L. & CoM. 387, 390-91 (1983). It emerged in Post World 

War II commerce to avoid stamp taxes or limitations on the term of finance imposed on drafts by central 

banks. Because the ICC Banking Commission never fully addressed the implications of the deferred 

payment undertaking, the questions of the right to an acknowledgment by the beneficiary of the obligation 

incurred and the implications of beneficiary LC fraud were not expressly addressed in the UCP. They 

were answered comprehensively in U.C.C. § 5-109(a) (Fraud and Forgery) (2006), which provided that 

[i]f a presentation is made that appears on its face strictly to comply with the terms and 

conditions of the letter of credit, but a required document is forged or materially fraudulent, or 

honor of the presentation would facilitate a material fraud by the beneficiary on the issuer or 

applicant: (1) the issuer shall honor the presentation, if honor is demanded by (i) a nominated 


2007 


Most importantly for this analysis, a draft is not even required under LC 

practice, where the LC contains an undertaking to negotiate or authorizes a 

nominated bank to negotiate. LC negotiation can be against the documents 

themselves without there being a draft at all. 2 ' UCP600 (2007) Article 2 

(Definitions) paragraph 2 states that "Negotiation" can be of "drafts (drawn on a 

bank other than the nominated bank) and/or documents." 

Even where a letter of credit requires a draft, its role is diminished. Under 

modern LC practice, a simple demand can suffice to indicate the tenor of the 

drawing. Moreover a draft is for the bank's internal records and banks retain them 

and do not regularly forward them to the applicant and, as will be discussed, there is 

some confusion about the status of a draft when it is required by the credit. 

person who has given value in good faith and without notice of forgery or material fraud, (ii) a 

confirmer who has honored its confirmation in good faith, (iii) a holder in due course of a draft 

drawn under the letter of credit which was taken after acceptance by the issuer or nominated 

person, or (iv) an assignee of the issuer's or nominated person's deferred obligation that was 

taken for value and without notice of forgery or material fraud after the obligation was 

incurred by the issuer or nominated person; and (2) the issuer, acting in good faith, may honor 

or dishonor the presentation in any other case. 

The problem forecast by Eberth and Ellinger surfaced in a series of cases in the 1990s starting with Banco 

Santander S.A. v. Bayfern Ltd. & Ors., [1999] 2 All E.R. (Comm.) (O.B.) 18, aff d, Banco Santander SA v. 

Banque Paribas, [2000] 1 All E.R. (Comm.) (C.A.) 776, in which the courts ruled that a confirmer that 

discounted its own deferred payment undertaking was not entitled to reimbursement where they was 

supervening LC fraud by the beneficiary before the maturity of the obligation. The English court in Banco 

Santander noted the absence of direction in the UCP. That direction has been provided by UCP600 

Article 7(c) (Issuing Bank Undertaking), 8(c) (Confirming Bank Undertaking), and 12(b) (Nomination). 

UCP600 Article 7(c) provides that 

[a]n issuing bank undertakes to reimburse a nominated bank that has honoured or negotiated a 

complying presentation and forwarded the documents to the issuing bank. Reimbursement for 

the amount of a complying presentation under a credit available by acceptance or deferred 

payment is due at maturity, whether or not the nominated bank prepaid or purchased before 

maturity. An issuing bank's undertaking to reimburse a nominated bank is independent of the 

issuing bank's undertaking to the beneficiary. 

26. The notion of negotiation of documents without drafts is not new. There is an ambiguous 

reference in UCP82 (1933) Article 45 that may indicate the early recognition of the negotiation of 

documents without drafts. It stated an extension of the deadline for shipment also extends the time "for 

presentation or negotiation of documents or drafts." The reference is not unambiguous as the words 

presentation/documents and negotiation/drafts could be in parallel instead of meaning that both 

"documents and drafts" could be subject to "presentation and negotiation." This provision is continued in 

similar form in UCPI51 (1951) Article 45. However, UCP290 (1974) Article 8(b) and UCP400 (1983) 

Article 16(a) speak of "[p]ayment, acceptance, or negotiation against documents." By this point, it is clear 

that the letter of credit community recognized that a draft was not necessary for letter of credit negotiation. 

UCP500 (1993) Article 9(a)(iv) defines negotiation as involving "Draft(s) drawn by the Beneficiary and/or 

document(s) presented under the Credit." UCP600 (2007) continues to recognize negotiation of 

documents without drafts in Article 2 (Definitions) paragraph 11 "Negotiation" which provides in part that 

it "means the purchase by the nominated bank of drafts and/or documents. ... To some extent, this 

practice can be said to have evolved from the requirement of a demand in lieu of draft but it readily came 

to be recognized that the demand could be fictionalized from the presentation of documents which was 

deemed to constitute a demand. 



VOL. 42:561 

B. Formality Requirements 

While there may be greater or lesser degrees of rigidity in the formal 

requirements for an undertaking to be a negotiable instrument under the various 

statutes or codes, each sets forth its own requirements with clarity and there is little 

doubt as to the necessary elements. 2 " The codes commonly require a signed writing, 

a promise to pay that is not conditioned on any event or term not stated in the 

undertaking, words of negotiability usually in an accepted formulation, a certain 

amount, and no other promise or obligation that affects these undertakings. There 

can be other requirements, but there are also default rules that imply some of these 

provisions, and there are often provisions that address various issues such as 

interest. 28 

Since the UCP does not address the contents of drafts, one might conclude that 

there are no LC formality requirements for a draft. 9 That conclusion is not correct 

for commercial letters of credit. There are requirements that are intermittently 

applied to drafts but they are not necessarily the requirements of negotiable 

instruments law. Some of these requirements are reflected in the International 

Standard Banking Practices (ISBP 2003) which are formal interpretations of 

UCP500 issued by the ICC Banking Commission. 30 

Unlike negotiable instrument law which implies a tenor, ISBP paragraph 45 

(Tenor) requires that the tenor of the draft correspond with that of the credit. 3 ' 

27. See generally ELLINGER, supra note 2, §§ 279-310. 

28. See, e.g., U.C.C. § 2-104(a)(2) (2006) (requiring that a negotiable instrument be on demand or for 

a definite time). On the other hand, it implies that the instrument is a demand instrument when it is silent. 

Therefore, this rule is only applicable where it is apparent on its face that the instrument is neither for 

demand nor for a definite time. An issue that has been recently of considerable interest is the use of an 

outside source such as a published rate provided that it is readily determinable. See U.C.C. § 3-112(b) 

(permitting reference to an objective source outside the "four corners" of the instrument for interest 

provided that it is objectively determinable). 

29. Banking practice is, in fact, of two minds about whether or not the draft, if required, is to be 

regarded as a "document" to be presented under the letter of credit. The distinction surfaced in UCP500 

Article 9(a)(iv) (Liability of Issuing and Confirming Banks) in addressing problems raised by LCs 

requiring documents drawn on the applicant or another entity other than the issuer or a nominated bank. 

It provides, in part, that "[i]f the Credit nevertheless calls for Draft(s) on the Applicant, banks will consider 

such Draft(s) as an additional document(s)." This verbiage is intended to signify that the issuer remains 

obligated under the LC, regardless of the draft. The implication is that in other credits, the draft is not just 

"another document." This notion, however, has little impact on the examination of the draft. For 

purposes of determining compliance of a required draft, the draft is to be examined as if it were another 

document. The real question is not whether it is to be examined but by what standard. 

30. At its May 2000 meeting, the Commission on Banking Technique and Practice of the International 

Chamber of Commerce (ICC Banking Commission) established a task force to document international 

standard banking practice for the examination of documents presented under documentary credits issued 

subject to the UCP. See ICC BANKING COMMISSION, INTERNATIONAL STANDARD BANKING PRACTICE 

FOR THE EXAMINATION OF DOCUMENTS UNDER DOCUMENTARY CREDITS 3 (2003) [hereinafter ISBP 

(2003)] (describing how the ISBP complements the UCP500 by filling in gaps and explaining the practices 

that underline UCP500). The ISBP is a statement of the "standard banking practice" referenced in 

UCP500 Article 13(a), sentence 2. The ISBP is based on ICC Banking Commission Opinions and 

Decisions and its understanding of the practices reflected in them. Revisions, finalized at the Spring 2007 

ICC Banking Commission Meeting, have been made to the ISBP to align it with and make it applicable to 

UCP600 [hereinafter ISBP (2007)]. 

31. There is no indication in the ISBP as to whether a credit that requires presentation of a sight draft 

would be satisfied by a draft that requires payment without stating that it is drawn at sight. Since the 

default rule would make such a draft payable at sight, it should be regarded as complying with such an LC 


2007 


ISBP paragraph 45(a) also requires that, except for a sight draft, it be possible "to 

establish the maturity date from the data in the draft itself" '32 and other 

subparagraphs and paragraphs provide detailed rules for calculation of the time. 

Thus, where the LC requires that the tenor of the draft be "30 days from B/L date," 

LC practice as reflected in the ISBP would require that the B/L date or the maturity 

date be stated in the draft in order to provide a basis for calculation since it would be 

necessary to look to the bill of lading (even if it was presented in tandem with the 

draft) to ascertain the date if it was not stated in the draft. This approach leads to 

the somewhat odd result that a draft that literally replicated the terms of the LC 

(draft drawn "30 days for bill of lading date" under an LC with precisely that 

requirement) would be regarded as non complying." 

This result is consistent with traditional negotiable instrument law. Although 

negotiable instrument law focuses on the draft itself, letter of credit practice need 

not do so since there are other documents that accompany the draft, namely the bill 

of lading which would enable the bank to make the calculation. This rule is 

particularly bizarre where the draft is not negotiated or accepted. Despite the rigid 

rule, where a draft is presented that does not contain the date from which the 

calculation of maturity is to take place, many banks to whom the documents are 

presented do such a calculation and note it on the draft. Such a practice should be 

given effect and not regarded as an alteration of the draft. 

ISBP paragraphs 52 and 53, 54 and 55, respectively, also require that drafts 

drawn under UCP500 letters of credit contain an amount reflecting the amount 

drawn under the LC, be drawn on the party stated in the LC, and be drawn by the 

beneficiary." 

As to the other requirements of local law regarding the formality requirements 

for a draft, banking practice is largely silent. There is, however, one additional 

respect in which a LC banker would probably require compliance, namely the 

presence of the "magic words" of negotiability, namely "order" or "bearer." 

Although this requirement is not reflected in the UCP or ISBP, the presence or 

absence of the words "or order" is arguably the only technical indicium of 

term. 

32. ISBP (2003), supra note 30, para. 45(a) (stating that "[i]f a draft is drawn at a tenor other than 

sight, or other than a certain period after sight, it must be possible to establish the maturity date from the 

data in the draft itself."). ISBP (2007), supra note 30, para. 43(a) is identical. 

33. This result is not only ironic in light of certain rigid interpretations of the strict compliance rule 

since there is a literal replication of the terms of the credit. It is unfortunate that the drafters did not 

structure an alternative in this situation, either permitting the banker to insert the date on the draft or 

permitting the bank to calculate it on the basis of the attached bill of lading. As long as the tenor is 

correctly calculated, the applicant should not be permitted to refuse documents because of the failure to 

reflect the actual date of the bill of lading in the way that the draft is drawn. For that reason, neither 

should the issuer since it is able to make the necessary calculation. As to the ability of anyone else to make 

the calculation, they can decide whether or not to purchase the draft. If they were to decide not to do so, it 

is the beneficiary whose options are reduced, but there is no impact on the issuer or applicant. 

34. See ISBP (2003), supra note 30, paras. 52-55 (stating that (52) "[t]he amount in words must 

accurately reflect the amount in figures if both are shown, and indicate the currency, as stated in the 

credit"; that (53) "[tlhe amount must agree with that of the invoice, unless otherwise stated in the credit or 

as a result of UCP sub-Article 37(b)" that (54) "[t]he draft must be drawn on the party stated in the 

credit"; and that (55) "[t]he draft must be drawn by the beneficiary"). These practices appear as ISBP 

(2007), supra note 30, paras. 50-53. 



VOL. 42:561 

negotiability (other than the correspondence of obvious data regarding parties, the 

tenor, and the amount with the terms of the LC) that registers with bankers. 35 

Where a court concludes that the requirement of a draft on an LC means a 

draft that meets the requirements of local law, the question of which law arises. 

While there are similarities under various legal regimes and while LC bankers 

usually do not insist on the specifics where they disagree, there are some issues that 

can impact the question of whether a draft is adequate under local law. Two that 

have arisen are the language in which the draft is written and whether there are 

corrections. 

Where the LC requires that all documents be written in English, a court has 

concluded that a required draft may be in French, where mandated by the law 

governing the beneficiary (who draws the draft). 36 While standard international 

letter of credit practice permits corrections or alterations to drafts provided that they 

are authenticated, the laws of some countries do not permit corrections or 

alterations to drafts. 37 

Whether the risk of the application of local law is to rest on the applicant, 

intermediary banks, or the beneficiary is not altogether clear. Absent a special 

requirement otherwise, it would seem that a beneficiary would be entitled to draw a 

draft in accordance with its own law and that doing so would not constitute a 

discrepancy. Had the applicant required another form, it should have so specified in 

the LC. It is clear that where a bank honors the presentation of such a draft, it is 

entitled to reimbursement since the UCP provides that the applicant bears the risk 

of the application of local law. 3 " 

The reality, however, is that the use of a legally negotiable instrument only 

matters in the discrete situation where there is to be acceptance financing. 

Accordingly, there are some cases that have recognized that a draft is simply an 

order to pay and concluded that such an order may be inferred from any demand to 

pay. 39 Absent these situations, there is little, if any, difference between a demand-a 

draft that does not qualify under applicable law as a negotiable instrument-and a 

draft that does so qualify. Indeed, it is possible to infer a demand from a 

presentation of documents. 

ISP98, the rules of practice for standby letters of credit, takes this approach to 

drafts. It provides that a required demand need not be separate from other 

documents presented, and, if a separate demand is required, it need not be in the 

35. Although, given banker's mania for having everything dated, see ISBP (2003) paras. 13-19 and 

ISBP (2007) paras. 13-18, the absence of a date may also register with them although at least some legal 

systems would imply that the date of the draft was the date on which it was issued. 

36. Credit Industriel et Commercial v. China Merchants Bank, (2002) 2 All E.R. (Comm.) 427,436-37 

(Q.B.). 

37. See ISBP (2003), supra note 30, para. 58 (warning that "[in some countries draft(s) showing 

corrections and alterations are not acceptable even with the drawer's authentication. Issuing Banks in such 

countries should make a statement in the credit to the effect that no correction or alteration must appear in 

the drafts(s)"). This practice appears as ISBP (2007), supra note 30, para. 56. 

38. See UCP600 art. 37(d) (2007) (stating that "[tihe applicant shall be bound by and liable to 

indemnify a bank against all obligations and responsibilities imposed by foreign laws and usages"). 

39. See, e.g., All Am. Semiconductor, Inc. v. Wells Fargo Bank Minnesota, N.A., 105 Fed.Appx. 886 

(8th Cir. 2004) af.d Civ. No. 01-1441, 2003 WL 22455502 (D. Minn. filed Jan. 3, 2003). 


2007 


form of a draft unless the standby expressly so requires, in which case, the required 

"draft" "need not be in negotiable form ...."' 

It is also unclear whether and to what extent an issuer can waive requirements 

about a draft or even presentation of a draft itself and retain its right to 

reimbursement. Since the draft is rarely, if ever, required by the applicant, and is 

retained by the issuer-except where it is drawn on the applicant-any objection to a 

defective draft by the applicant would be seizing on a fortuitous circumstance to 

avoid its obligation to reimburse. 

Where it is required, then, the position of the draft in LC practice is curious at 

best and ambiguous at worst. 

C. Who Negotiates? 

Under the law applicable to negotiable instruments, any entity to whom a draft 

is issued or indorsed and delivered, or who is in possession of it if it is in bearer form, 

can negotiate it. There need be no special designation or nomination of a person for 

it to do so. Generally speaking, this person is the transferor or negotiator. 

Under LC practice, however, it is only the bank that is nominated to do so (and 

not the beneficiary/drawer) that is said to negotiate. Absent nomination, there can 

be no LC negotiation of a draft. 

Where a bank is not nominated in the letter of credit to negotiate, negotiation 

does not occur even if the draft is in fact made payable to the beneficiary's order and 

legally negotiated (in the negotiable-instruments sense) to a non-nominated 

(collecting bank). In effect, in LC practice and law, negotiation is limited to banks so 

nominated. Negotiation of a draft under negotiable instrument law does not 

constitute LC negotiation unless the transferee is a nominated bank. 

D. How Does Negotiation Occur? 

Under negotiable instruments law, a negotiable instrument is negotiated by 

indorsement by the transferor and delivery if it is issued or indorsed to the order of a 

named entity or, if in bearer form, by delivery alone. Negotiation is a special form of 

transfer by which the rights inherent in the instrument are transferred in such a way 

that the transferee becomes a holder who is entitled to exercise them. A mere 

assignment of the instrument does not achieve this effect, although an assignee is 

able to succeed and exercise certain rights to the instrument of the assignor and 

indirectly shelter under the status of one to whom the instrument has been 

negotiated. 

The negotiation of a draft drawn under a letter of credit in accordance with the 

law of negotiable instruments not only is not LC negotiation, but it has no effect 

whatsoever with respect to rights under the LC. If the beneficiary of an LC draws a 

40. ISP98, supra note 10, Rule 4.16(c) (Demand for Payment) (stating that "[a] demand may be in the 

form of a draft or other instruction, order, or request to pay. If a standby requires presentation of a 'draft' 

or 'bill of exchange,' that draft or bill of exchange need not be in negotiable form unless the standby so 

states."). 



VOL. 42:561 

draft in accordance with the terms of the LC, makes the draft payable to itself, and 

indorses and delivers it to a person or entity not nominated in the LC as a 

negotiating bank, there has been negotiation under the law of negotiable 

instruments, but no negotiation under LC practice or law. 

In effect, LC negotiation starts at the other end, with the transferee. 

Negotiation under a letter of credit takes place when a nominated negotiating bank 

purchases the presentation (which need not include a draft) under a letter of credit. 

The nature of the exchange is linked to the meaning of LC negotiation and is 

addressed later in this paper. It is clear, however, that something more than the 

physical transfer of a draft with necessary indorsements is involved in LC 

negotiation. 

Indeed, indorsement is almost irrelevant to LC negotiation. Of course, where 

there is no draft, it is without meaning. Even where there is a draft, as indicated, LC 

practice hardly pays attention to it. There is no provision in the UCP regarding 

indorsement of a draft. Nor does the UCP indicate to whom the draft must be made 

payable, and it is rare for the LC to so specify. The general expectation is that a 

draft will be made payable to the order of the beneficiary or to its bank. 41 

Where the draft is payable to the named beneficiary, it is usually endorsed in 

blank, but credits requiring indorsement of a draft are virtually unknown, and no 

reported cases have been found in which dishonor of a credit was based on the 

absence of a necessary indorsement on a draft. 

When documents are forwarded, it is not uncommon for the issuer or 

confirming bank to demand that a nominated bank add its indorsement to the draft. 

Where the draft is indorsed in blank by the beneficiary, there is no basis for such a 

requirement in the UCP in letter of credit practice or in the law of negotiable 

instruments. The desire for such an indorsement is probably driven by the thought 

that it yields an additional right against the bank outside of letter of credit law and 

practice. The value of any such right, however, is tied up with the right of recourse, 

which is discussed in the next section. 

While addressing the issue obliquely, the drafters of the ISBP effectively 

ducked it. ISBP (2003) paragraph 51 provides that "[t]he draft must be endorsed, if 

necessary." It is unfortunate that the ISBP did not make it clear that refusal to 

honor or pay without adding an indorsement where the documents otherwise comply 

constitutes wrongful refusal, unless the letter of credit expressly requires that the 

draft contain the indorsement of the negotiating bank 2 

41. Where a draft accompanying documents is not payable to the named beneficiary or the bank 

processing the presentations, the concern is not with respect to negotiation, but rather that an indirect 

assignment of proceeds is taking place without paying required fees and adding to the risk of the bank that 

pays who is expected to pay the named beneficiary. While this point has not been tested, many banks 

would refuse to pay the LC proceeds to anyone but the named beneficiary or transferee absent an 

assignment of proceeds. See ISP98, supra note 10, Rule 4.13(b) (No Responsibility to Identify 

Beneficiary). 

42. The parallel provision of ISBP (2007) is para. 49. The ISBP should have provided that "unless the 

credit requires otherwise, no indorsement of a draft by a negotiating bank may be required unless the draft 

is issued to the order of the negotiating bank or indorsed to it or its order. In that case, the negotiating 

bank may indorse the draft without recourse." 


2007 


E. Recourse 

Where a draft presented under an LC is drawn on the issuer and the issuer 

refuses to honor or where it is drawn on the applicant and the applicant refuses to 

honor, questions arise concerning the ability of a bank that has negotiated it to 

obtain recourse against prior indorsers and the drawer. 

Under negotiable instruments law, the notion of recourse relates to the 

obligations that arise from signing an instrument. It signifies a right arising from the 

issuance or transfer of the instrument by indorsement that enables a transferee to 

recover from the transferor based on the transferor's obligation on the instrument 

itself that arises from signing it in the event that the instrument is dishonored or 

unpaid when it is due. 43 Recourse on a negotiable instrument operates unless 

affirmatively disclaimed" or, under some systems, the obligation of a person signing 

is discharged by an acceptance or by the failure to give any necessary notice or some 

other action. 45 

While recourse is mentioned in the UCP, the rules have never coherently 

addressed it-possibly for the same reasons that they have not addressed issues 

relating to drafts. Under letter of credit law and practice, recourse means the ability 

to reclaim the proceeds paid under a letter of credit presentation. There are 

significant differences between recourse under a LC and a negotiable instrument. 

In the first place, it operates with respect to LCs regardless of whether or not 

there is a draft. 

In the second place, under letter of credit practice and law, recourse against the 

beneficiary is not available to an issuer or confirmer regardless of whether or not 

there is an express disclaimer. While the unavailability of recourse for issuing and 

43. There may be other parallel theories of liability that are functionally similar, but that do not arise 

from obligations on the instrument. U.S. law, for example, posits warranties (a curiosity of the common 

law) that arise as a result of transfer and presentment that are not directly affected by whether or not one 

has indorsed. Under U.C.C. section 3-416(a) (2006), for example, a transfer warranty arises whether or not 

there is indorsement, but, if the transfer does not include an indorsement, only runs to the immediate 

transferee. An indorsement disclaiming liability on the indorsement ("without recourse") does not affect 

or otherwise limit warranties. 

44. ELLINGER, supra note 2, section 373 notes that the right of recourse must be be "'negatived' (viz. 

Excluded)" under section 16(a) of the U.K. Bills of Exchange Act, 1882, 45 & 46 Vict. c. 61. 

45. By signing a draft, an entity assumed liability on it unless disclaimed. The nature of the liability 

depended on the manner in which it was signed, whether as drawer, acceptor, or indorser. Under local 

negotiable instruments law, there were certain conditions to each type of liability. For example, the 

obligation of an indorser is typically conditioned on presentation of the draft and any necessary notice of 

dishonor. Under civil law, formal protest is necessary, Geneva Convention, supra note 2, Articles 44, 46, 

whereas it is necessary under the U.K. Bills of Exchange Act sections 4(1) and 51(1)-(2) only for a foreign 

bill and not at all under U.S. U.C.C. section 3-415. See generally, ELLINGER, supra note 2, § 443. Under 

LC law, when the beneficiary draws a draft, it incurs liability as the drawer in the event that it is 

dishonored. When the payee (sometimes also the beneficiary) indorses the draft in blank or to the 

negotiating bank or its order, it also incurs liability as an indorser. In the event of dishonor, the person 

entitled to enforce the draft has recourse on the instrument against prior indorsers and the drawer unless 

that liability has been disclaimed, waived, or discharged. Failure to give timely notice of dishonor of an 

instrument to an indorser who is not the principal obligor can result in discharge of the indorser's liability. 

See U.C.C. § 3-415(c). Since the indorser is typically in a zero-sum position, having paid and received 

funds for the instrument as it is received and subsequently transferred, the requirement of timely notice is 

proper so that it can move promptly to protect its position. Where there is a subsequent acceptance, under 

some local laws the liability of a prior indorser is discharged. See U.C.C. § 3-415(d). 



VOL. 42:561 

confirming banks has been stated in the various versions of the UCP, there is no 

right of recourse even were the UCP not to so state. 6 Having undertaken to honor, 

these banks are obligated on the credit, and payment by them is final in favor of the 

beneficiary. 47 The notion is therefore linked to finality. The issuer or confirmer 

bears the risk of paying against discrepant documents or obtaining reimbursement. 

Should the issuer or confirmer have made an erroneous or unlucky credit decision or 

have erred as to whether or not the documents are discrepant, it may not seek 

recourse against the beneficiary after it has negotiated. 8 

Were a draft indorsed without disclaiming recourse on the draft, the issue arises 

as to whether there is recourse under negotiable instruments law. Where recourse 

can be disclaimed other than on the face of negotiable instrument, the terms of the 

UCP could suffice as a disclaimer as to the issuer or confirmer who undertakes to 

negotiate. 9 Where they cannot be, there is a conflict between the two regimes. In 

such a situation, negotiable instrument law should be displaced by the law of letters 

of credit 5 ° 

A different result obtains where a bank other than the confirmer is nominated 

to negotiate under the letter of credit. The UCP does not address this situation. It is 

thought that the general rule of negotiable instruments-that there is recourse unless 

it is disclaimed-applies in such a situation, although its contours are debated." 

There is considerable debate over the scope of recourse, particularly whether or not 

46. Recourse was not mentioned in UCP82 (1933). It first appeared in UCP151 Article 5 (1951), 

which provided that "[i]n case of credits available by negotiation of drafts, the confirmation implies only 

the undertaking of the confirming Bank to negotiate drafts without recourse to drawer." UCP290 Article 3 

(1974) recognized that the issuer did not negotiate with recourse, and this approach continued until 

UCP600, which drops reference to negotiation by the issuer and seeks to forbid drafts drawn on the 

applicant-impotently, since the terms of the credit can vary the rules. UCP600 Article 8 (a)(ii) 

(Confirming Bank Undertaking) continues to recognize that a confirmer negotiates without recourse. 

Even without these references, payment under a letter of credit by a bank obligated as an issuer or 

confirmer is final. This principle will be relevant with respect to drafts drawn on the applicant, or a third 

person, under UCP600, which does not contain such a provision. 

47. An exception to this principle is letter of credit fraud on the part of the beneficiary. But the value 

of a right against the fraudster beneficiary is questionable. 

48. It is necessary, however, to distinguish between recourse against the beneficiary on the LC 

payment and any other rights that the applicant may have against the beneficiary that may be assigned to 

the bank or to which the bank may be subrogated. See Revised U.C.C. § 5-117 (revised 1995) (Subrogation 

of Issuer, Applicant, and Nominated Person) (offering a complete statement of subrogation). These rights 

depend on whether the beneficiary has breached its contract with the applicant and do not relate to the 

letter of credit or the documentary character of the presentation. 

49. See ELLINGER, supra note 2, § 373 n.817 (citing cases for the proposition that recourse may be 

disclaimed in a collateral document or even verbally). The omission from UCP600 of any reference to 

negotiation by an issuer and, correspondingly, negotiation without recourse, could be problematic where a 

UCP600 credit provided for a draft drawn on the applicant. The correct rule, however, is that negotiation 

under such a credit by the issuer is without recourse. 

50. See, e.g., Revised U.C.C. § 5-116(d) (showing a preference for the law of letters of credit by stating 

that "[i]f there is a conflict between this article and Article 3, 4, 4A, or 9, this article governs"). The two 

systems could be reconciled by reference to the UCP non-recourse provision. It could be concluded that 

this provision constitutes a disclaimer of the right to recourse. That theory, however, would not work with 

respect to negotiation by an issuer under UCP600. The failure of UCP600 to address negotiation by an 

issuer of a draft drawn on the applicant or another person gives rise to the question of whether the 

principle of finality will be applied without an express reference in the UCP. While it should be, a prudent 

beneficiary will require that the credit so state or draw and endorse the draft without recourse. 

51. A negotiating bank does not rely solely on reimbursement from the issuer or confirmer. In the 

event that the issuer and confirmer are insolvent and prevented by the laws of their countries from 

effecting reimbursement, it can have recourse against the beneficiary. U.C.C. § 5-110 (2006). 


2007 


it extends to errors regarding discrepancies on the part of the negotiating bank (or at 

least those discrepancies that could have been cured). 2 While practices differ, and 

banks are free to disclaim or waive their right to recourse, the concept itself admits 

of no such distinction. In effect, some banks distinguish themselves in their market, 

or are pressured by others in their market, by voluntarily assuming the risk of bank 

error with respect to missed discrepancies. Other risks include issuing bank risk, 

country risk, currency risk, and risk of beneficiary fraud. Unless expressly 

disclaimed, it is generally thought that these risks rest with the beneficiary instead of 

the negotiating bank. 

F 

Protection of Banks That Negotiate in the Event of LC Fraud 

One of the critical tests of the workability of any aspect of commercial law is 

the manner in which it addresses issues of fraud and balances the relative rights of 

various parties and broader commercial interests in the integrity of the institution it 

governs. 

It is with respect to fraud that negotiable instruments are most commonly 

distinguished from traditional contracts 3 The entity to whom a negotiable 

instrument is negotiated qualifies for greater rights that may have been possessed by 

the transferor. This abstraction of the rights inherent in the paper from the 

transaction that gave rise to it is the hallmark of the doctrine of negotiability. 

Letters of credit take this abstraction to a higher level. 

Generally speaking, under the common law of negotiable instruments, there is 

an entire apparatus of substantive and procedural law designed to support the notion 

of negotiability. On negotiation, a presumption can be said to arise that a person to 

whom a draft has been negotiated, or one who claims under that person, is entitled 

to recover on the instrument unless the person obligated on the instrument is able to 

prove a defense. The defense may be any defense that sounds in contract or 

recoupment. Once a defense is proven, the holder who has acted with good faith is 

entitled to a protected status either in its own right or in that of a person under 

whom it claims. Even if it is so entitled, there are certain defenses deemed so basic 

that this protection fails as to them. 4 

The law of fraud with respect to letters of credit is a relatively recent creation, 

dating its origins by most accounts to the 1941 decision of the New York Supreme 

Court (a trial court of general jurisdiction) in Sztejn v. J. Henry Shroeder Banking 

Corp. 55 

52. What the fees paid by beneficiaries for negotiation cover, if not examination for discrepancies, is a 

persuasive question. 

53. A stimulating revisionist study suggests that the doctrine of negotiability emerged from the 

common law system itself in response to economic requirements of the late 18th century, challenging the 

notion that it was an assimilation of the law merchant. JAMES S. ROGERS, THE EARLY HISTORY OF THE 

LAW OF BILLS AND NOTES (1995). Whatever the historical antecedents, there is no doubt that by the end 

of the nineteenth century, negotiable instruments were distinct from the traditional doctrine of assignment 

under contract law by which the assignee took subject to defenses against the assignor. 

54. See generally ELLINGER, supra note 2, § 417. 

55. 31 N.Y.S.2d 631, 634 (N.Y.Sup.Ct., 1941) 



VOL. 42:561 

When bankers hear of a bank being embroiled in a dispute between an 

applicant and a beneficiary, they sometimes express the wistful opinion that the 

letter of credit should operate without regard to fraud. Upon being pressed, 

however, they generally do not mean that it should be fraud-proof. With the 

possible exception of the U.K., 6 courts have generally grasped this point for the very 

good reason that an instrument that can be used with impunity by fraudsters loses its 

credibility as readily as one whose liquidity can be frozen based on any dispute over 

the transaction that gave rise to it. The challenge is to find a balance that favors the 

integrity of the letter of credit while providing a remedy for the rare case where 

letter of credit fraud is sufficiently demonstrated and the merits of judicial 

intervention are apparent. 57 

There are several dimensions to LC fraud that involve negotiation by issuers, 

confirmers, and negotiating banks under letter of credit practice and law that 

externally resemble the law of negotiable instruments, but that manifest significant 

differences. While the courts that have decided cases on this topic commonly recite 

or draw on principles of negotiable instruments law, it is not entirely clear that they 

appreciate the differences. 

1. The Presumption of Entitlement 

Under negotiable instruments law, it is the holder or a person claiming under it 

who is entitled to a presumption of entitlement (that they are entitled to exercise 

rights free of the transferor and recover), which narrowly circumscribes the defenses 

that can be asserted. On the other hand, where there is no transfer by negotiation, 

any defense between the drawer and the person to whom the draft is issued (usually 

the payee) can be asserted. 

Under letter of credit law, it is the beneficiary (in a situation roughly 

comparable to the payee) who is effectively so entitled and, unlike a negotiable 

instrument, even where there is no negotiation, the defenses that are able to be 

asserted against the beneficiary are severely circumscribed and effectively limited. 

The protected person in LC law and practice is immune to even these defenses, and 

thus, the scope of the doctrine of negotiability under a letter of credit is much 

broader than is the case with a negotiable instrument. 

Under letter of credit practice and law, the applicant bears the risk of disputes 

regarding the performance of the underlying transactions that gave rise to the letter 

of credit. In effect, the letter of credit represents an allocation of the risk of who 

holds funds pending the resolution of these disputes. In the ordinary case under a 

letter of credit, the beneficiary is entitled to hold the funds until things can be sorted 

56. While the English courts recite the proposition that injunctive relief is available in the event of 

letter of credit fraud, there is no case in which it has been awarded. Indeed, the approach of the English 

courts to letter of credit fraud has with few exceptions been an exercise in distorting letter of credit 

practice. See, e.g., Banco Santander S.A. v. Bayfern Ltd. & Ors., [1999] 2 All E.R. (Comm.) (Q.B.) 18, 

affd Banco Santander SA v. Banque Paribas, [2000] 1 All E.R. (Comm.) (C.A.) 776. The definitive study 

of English LC fraud law has yet to be written. What exists is either written by apologists or by treatise 

writers whose mission is to explain within the context of the system rather than to analyze in a critical 

mode. 

57. See generally GAO XIANG, THE FRAUD RULE ON THE LAW OF LETrERS OF CREDIT: A 

COMPARATIVE STUDY (2002) (examining the problems surrounding letter of credit fraud). 


2007 


out." Although payment to the beneficiary is final with respect to the letter of credit 

obligation, the obligation that gave rise to it remains and may be a basis for recovery 

by the applicant to the credit or any assignee of its rights in a post-payment action 

against the beneficiary on the underlying transaction. The abstract status of the 

beneficiary, therefore, can be understood as temporary or interim. That of the LC 

issuer or nominated bank is permanent. The rule protects these banks, as it should, 

if the system is to have currency, since where these banks, as intermediaries, have in 

good faith paid funds to the fraudster pursuant to their undertaking or nomination, 

they ought to be able to obtain reimbursement. Assuming that lending or credit 

decisions were sound, the loss will be thrown onto the applicant who either elected 

to deal with the beneficiary or used its credit to obtain the LC for the person who did 

SO. 

2. What Defense Is Good Against a Beneficiary? The LC Fraud Exception 

to the Independence Principle 

Under negotiable instruments law, the proof of a defense brings into question 

entitlement under a protected status. 59 Only if this status is present will the holder of 

the instrument recover, and then only with respect to certain defenses. Defenses are 

cut off by a protected holder. However, depending on the system, there are certain 

58. So potent is the abstract status afforded the beneficiary that the transferee beneficiary is immune 

from defenses, including LC fraud, that could be asserted against the original beneficiary. See Banca del 

Sempione v. Provident Bank of Maryland, 160 F.3d 992, 995-96 (4th Cir. 1998). The abstract explanation 

of LC transfers which differs considerably from assignment of a contract, see, e.g., ISP98, supra note 10, R. 

6.01-6.05, is beyond the scope of this paper. The letter of credit makes this allocation possible by providing 

that the beneficiary is entitled to honor provided that the documents comply on their face with the terms 

and conditions of the letter of credit and without regard to disputes about the underlying transaction. This 

principle is the independence doctrine, which captures the documentary and abstract character of the letter 

of credit. The principle is best formulated in ISP98 Rule 1.06(c) (Nature of Standbys), which provides: 

Because a standby is independent, the enforceability of an issuer's obligations under a standby 

does not depend on: i. the issuer's right or ability to obtain reimbursement from the applicant; 

ii. the beneficiary's right to obtain payment from the applicant; iii. a reference in the standby to 

any reimbursement agreement or underlying transaction; or iv. the issuer's knowledge of 

performance or breach of any reimbursement agreement or underlying transaction. 

It is also scattered throughout the UCP. See, e.g., UCP600 arts. 4 (Credits v. Contracts), 5 (Documents v. 

Goods, Services or Performance) (2007); see also U.S. Revised U.C.C. § 5-103(d) (revised 1995); United 

Nations Convention on Independent Guarantees and Stand-by Letters of Credit, G.A. Res. 50/48, art. 3, 

U.N. Doc. A/RES/50/48 (Jan. 26, 1996) [hereinafter U.N. LC Convention]. 

59. One of the chief differences between the common law and the civil law systems relates to the 

consequence of the proof of a defense. Under the Bills of Exchange Act, a holder in due course is 

distinguished from a holder for value or a mere holder. 1882, 45 & 46 Vict. c. 61, § 29. Under section 30(2) 

of the Act, every holder is presumed to be a holder unless the defense is fraud, illegality, or duress, in 

which case the holder must prove its entitled status. Under U.C.C. section 3-308 (2006), a holder is entitled 

to recover unless the person obligated on the instrument proves any defense good in contract, in which 

case the holder or person claiming under its rights must prove in all respects that it is a holder in due 

course. Under Article 16 of the Geneva Convention, supra note 2, the focus is on the regular acquisition of 

the instrument through a series of facially proper indorsements without regard to their authenticity. Only 

if it has acquired the bill in bad faith does the holder not acquire good title to the instrument. See generally 

ELLINGER. supra note 2, §§ 404-27. The differences between these presumptions and the relative burdens 

attendant on them sheds some light on the absence of uniformity with respect to the presumptions to be 

accorded to a nominated bank or an issuer, where the issuer arises under letter of credit law and practice. 



VOL. 42:561 

defenses based in public policy, such as incapacity, that can be asserted even against 

a protected holder. 6° Under the civil law, a person obligated on a bill "cannot set up 

against the holder defenses founded on their personal relations with the drawer or 

with previous holders, unless the holder, in acquiring the bill, has knowingly acted to 

the detriment of the holder." 1 In effect, defenses that are "personal defenses related 

to the bill and the underlying transaction" are excluded. 62 However, certain defenses 

are good even against a good faith holder. Ellinger lists them as incapacity, forgery 

of the drawer's signature, and duress. Under the American system, once a defense 

in contract or recoupment is proven, the burden of proof shifts to the holder to the 

prove holder in due course status. Even if proven, a holder in due course takes the 

instrument subject to "real" defenses (in rem) of infancy, duress, lack of capacity, 

illegality (which nullifies the undertaking under local law), and fraud resulting under 

excusable ignorance. 63 The English system differs in this respect. A holder's rights 

"are easily assailable."" A holder in due course takes the instrument free of title 

defects and fraud relating to the underlying transaction. 6 Ellinger characterizes the 

position as "iron-clad," subject only to defenses of capacity or consent, such as a plea 

of non est factum when a party is tricked into signing a bill, which closely resembles 

the defense of fraud due to excusable ignorance under U.S. law.' 

In an LC scenario, the beneficiary takes free of defenses that could be asserted 

under negotiable instruments law against a holder who had not proven its protected 

status. In effect, the level of abstraction for negotiable instruments is ratcheted up a 

notch and narrowed compared to the law of negotiable instruments. 

Under letter of credit law, it is the equivalent of one of these "real" defenses (as 

opposed to "personal" defenses) of negotiable instruments law 67 that gives rise to an 

excuse to the letter of credit obligation in the face a demand by the beneficiary. A 

defense that is "personal" to the applicant and beneficiary is not a defense to an LC 

unless it is LC fraud. The other "real" defenses to negotiable instruments are not, as 

a practical matter, likely to arise in the case of letters of credit.' As a result, 

defenses that can be asserted under letter of credit practice are limited to fraud on 

the part of the beneficiary that is so serious as to render the pretense of operating on 

the basis of documentary representations meaningless. There are a variety of names 

for this fraud, and even more descriptions of it. 69 For purposes of convenience, and 

60. See U.C.C. § 3-305(a)(1) (2006); U.N. Bills of Exchange Convention, supra note 2, art. 30(1)(c). 

See generally ELLINGER, supra note 2, §§ 417-27. 

61. Geneva Convention on Bills of Exchange, supra note 2. art. 17. 

62. ELLINGER, supra note 2, § 425. 

63. U.C.C. §§ 3-305(a), 3-308 (2006). 


65. Id.; Bills of Exchange Act, 1882, 45 & 46 Vict. c. 61, § 38(2). 

66. ELLINGER, supra note 2, § 418 n.903; U.N. Bills of Exchange Convention, supra note 2, art. 

30(1)(b). 

67. Real defenses are those that can be asserted even against a holder in due course. They include 

infancy, duress, lack of legal capacity, illegality that nullifies the transaction, essential fraud resulting from 

excusable ignorance, and discharge in insolvency. See, e.g., U.C.C. § 3-305(a)(1) (2006). 

68. Since letters of credit are not consumer devices, only the defense of fraud could be asserted by a 

bank issuing a letter of credit. Illegality is not a defense under letter of credit law or practice. If a bank has 

issued a letter of credit, it must live with the consequences, which may include regulatory or criminal 

sanctions, but its error should not excuse its obligation to a beneficiary. Illegal conduct by the beneficiary 

is a matter of local statutory or regulatory law. The definitive study of illegality with respect to LCs 

remains to be written. 

69. There is no definitive study of LC fraud. A valuable beginning has been essayed in XIANG GAO, 


2007 


to distinguish it from other types of fraud-including fraud in the inducement 

(procurement), securities fraud, and misrepresentation-this type of fraud is called 

"letter of credit fraud" (or "LC fraud") in this article. 

The word "fraud" is unfortunate. In the civil law system, the name "fraud" 

suggests criminal complicity, and what is meant by LC fraud perhaps is better 

captured by the notion of abusive drawing (abus de droit). In the common law 

system, it connotes scienter or intent on the part of the fraudster. It is this 

unfortunate connection that has led to a series of decisions by various courts to the 

effect that a beneficiary is entitled to recover from a bank where a required 

document that it presents is fraudulent (forged or otherwise fraudulent), but where 

the beneficiary is innocent of the fraud. 7 " This result reflects a misunderstanding of 

the undertaking inherent in a letter of credit. A letter of credit bank undertakes to 

honor a document that represents the underlying transaction. It does not undertake 

to honor a document that is fraudulent regardless of the innocence of the person 

presenting it. Where there is no question of reimbursement of a protected bank that 

has honored or negotiated against documents that on their face comply with the 

terms and conditions of the credit, the risk of documentary fraud is on the innocent 

beneficiary who dealt with the fraudulent document where the issuer or confirmer is 

able to prove its fraudulent character and resists payment on that basis. As to the 

issuer, confirmer, or other nominated bank, the beneficiary's obligation is to present 

a genuine document. The ability of the issuer or confirmer to refuse payment to a 

beneficiary or a collecting bank on the basis of letter of credit fraud should not be 

confused with its right to recover reimbursement, notwithstanding that fraud where 

it honors in good faith. 

supra note 58. Revised U.C.C. section 5-109(a) (Fraud and Forgery) (revised 1995) provides that LC fraud 

arises: 

[i]f a presentation is made that appears on its face strictly to comply with the terms and 



applicant .... 

U.N. LC Convention, supra note 58, article 19 states that it is present: 

[i]f it is manifest and clear that: (a) Any document is not genuine or has been falsified; (b) No 

payment is due on the basis asserted in the demand and the supporting documents; or (c) 

Judging by the type and purpose of the undertaking, the demand has no conceivable basis .... 

The Interpretation of the Sup. People's Ct. (PRC) [2005] No. 13 Article 8 states: 

The letter of credit fraud shall be determined as constituted under any of the following 

circumstances: (1)The beneficiary forges documents or provides documents containing 

fraudulent information; (2) The beneficiary maliciously refuses to deliver goods or delivers 

goods of no value: (3) The beneficiary provides false documents by colluding with the applicant 

or a third party and there isn't any true basic transaction: or (4) Other circumstances under 

which letter of credit fraud is conducted. 

70. See Credit Industriel et Commercial v. China Merchants Bank, (2002) 1 All E.R. (Comm.) (Q.B.) 



VOL. 42:561 

3. The LC Exception to the Fraud Defense: Protected Persons 

As indicated, the effect of protected holder status under negotiable instruments 

law entitles its occupant to recover notwithstanding certain defenses. Once a real 

defense such as fraud resulting from trickery is proven, a protected holder is subject 

to it under negotiable instruments law. 

Even where it is proven that there is Letter of Credit Fraud, recovery under an 

LC is not prevented for protected parties to the letter of credit transaction who are 

able to claim reimbursement notwithstanding beneficiary letter of credit fraud. 

There is no equivalent in negotiable instruments law, under which the protected 

parties only are protected against personal defenses, but not against real ones. The 

LC protection is, so to speak, supercharged. 

The protected status of banks under letter of credit practice must be pieced 

together from rules of practice and their implications. Bankers are rarely interested 

in formulating rules addressing pathological problems. 7 ' The foundation of this 

supercharged protected status, however, can be seen in UCP600 Article 34 

(Disclaimer on Effectiveness of Documents). It disclaims all liability and 

responsibility of banks for the "genuineness, falsification ... of any document(s), or 

for the general or particular conditions stipulated in a document or superimposed 

thereon; nor does it assume any liability or responsibility for the ... existence of the 

goods, services or other performance represented by any document, or for the good 

faith or acts or omissions, . . . performance ... of ... any other person." 72 The new 

provisions in UCP600 Articles 7(c) (Issuing Bank Obligation), 8(c) (Confirming 

Bank Obligation), and 12(b) (Nomination) also address the issue of the right to 

reimbursement in the event of LC fraud. In the absence of a statute, these 

provisions provide a useful framework for the fraud exception, but in the absence of 

a systematic treatment of LC fraud, it is doubtful that courts will be able to build a 

comprehensive jurisprudence, particularly where they have gotten off to a false start. 

While rules of practice cannot themselves create exceptions to the legal effect 

to be given to fraudulent or abusive drawings, they can allocate the risk of such 

actions, and modern commercial law typically gives effect to such an allocation if it is 

commercially reasonable. 73 Under standard international letter of credit practice, 

where an issuer or nominated bank acting pursuant to its nomination honors, the risk 

of fraud or forgery is allocated to the applicant. 

71. ISP98 Rule 1.05(c) (Exclusion of Matters Related to Due Issuance and Fraudulent or Abusive 

Drawing) defers to applicable law. But see The Official Commentary, supra note 10, Rule 1.05, cmt. 5(c), 

20-21 (delineating the exceptions that are implicit in LC practice). 

72. The first version of this article was UCP82 (1933) Article 11, followed by UCPI51 (1951) Article 

11, which was identical. The rule was rephrased and expanded slightly in UCP222 (1962) Article 9. 

UCP290 (1974) Article 9 and UCP400 (1983) Article 17 were identical to UCP222 Article 9. UCP500 

(1993) Article 15 again slightly rephrased and expanded the rule. 

73. See ISP98, supra note 10, R. 1.05(c) (Exclusion of Matters Related to Due Issuance and 

Fraudulent or Abusive Drawing) (stating that "[tihese Rules do not define or otherwise provide for: a. 

power or authority to issue a standby; b. formal requirements for execution of a standby (e.g. a signed 

writing); or c. defenses to honour based on fraud, abuse, or similar matters. These matters are left to 

applicable law"). Despite this provision, however, it is noted that "[w]hile ISP98 provides no systematic 

rule with respect to fraud or abuse, it does contain rules based on principles which would provide 

important guidance in determining whether and what remedy might be appropriate in the event of fraud." 

The Official Commentary, supra note 10, at 20-21. 


2007 


4. Nomination 

Under the law of negotiable instruments, any person to whom an instrument 

has been transferred by negotiation is eligible for protected status provided that they 

behave with the requisite good faith, give value, and act without notice of a defense 

or that the instrument is overdue. 

The availability of this protected status under LCs does not, in the first instance, 

turn on the relative culpability or innocence of the person or entity involved. As 

discussed above, a protected status is only available to those who have issued the LC 

or been nominated to act under the letter of credit. 7 " Thus, where the LC involves an 

undertaking to negotiate drafts by the issuer, confirmer, or a negotiating bank, 

protected status extends only to the nominated bank or the issuer. A bank that acts 

without nomination (a collecting bank) takes subject to any defense that can be 

asserted against the beneficiary. 

While the test of the bank's good faith and the burden of proving it are 

procedural matters under local law, whether a bank is nominated to negotiate will be 

apparent from the face of the credit or amendments. 75 

If an issuer or nominated bank acts pursuant to its nomination, the risk of the 

consequences of LC fraud of any other person is allocated to the applicant. The 

nominated bank is entitled to be reimbursed for any payment made pursuant to any 

obligation occurred provided that the nominated bank has not itself been a party to 

the fraud, abuse, or forgery. 

If the issuer, confirmer, or negotiating bank duly negotiates, it is entitled to 

protected status notwithstanding LC fraud. But what constitutes due negotiation 

differs between banks that are irrevocably obligated on the letter of credit and those 

that are not-that is, between issuing and confirming banks on the one hand and 

negotiating banks on the other hand. 

74. The entitlement of a transferee of a letter of credit to protection from the LC fraud of the 

beneficiary is a topic that is beyond the scope of this paper. It arises from what is, in effect, a separate or 

new LC and not from the process of negotiation of the documents under the original LC. As will be 

apparent, the transfer of a letter of credit differs greatly from the transfer of a chose in action under 

general commercial law. 

75. The question becomes somewhat more complex where the nominated bank is a negotiating bank. 

In such a situation, letter of credit law often becomes entangled with the law of negotiable instruments, and 

it is common for the courts to look to the procedures, allocations of burdens of proof, and presumptions 

related to the doctrine of holder in due course. While this doctrine is related, the presumptions 

surrounding acceptance financing are more useful than those of negotiable instruments law. That body of 

law reflects a situation where there is an established market and practice of trade finance through the sale 

and purchase of abstracted rights, and it has been less susceptible to concerns of issuers of commercial 

paper who are also consumers and invoke consumer protection doctrines to limit the effect of negotiability. 

It should be sufficient to establish a prima facie entitlement to recover if a negotiating bank provides a 

sworn statement of the facts surrounding its negotiation. 



VOL. 42:561 

a. Protected Status Where There Is Negotiation by the Issuing or 

Confirming Bank 

As indicated, under negotiable instrument law, a protected person is entitled to 

limited protection. Under all systems, even a protected person is vulnerable to 

certain defenses founded in trickery regarding the instrument or fraud in the factum. 

Under letter of credit practice and law, an issuing bank and a confirming bank, 

having undertaken to honor, are entitled to the enhanced protected status available 

under letter of credit practice and law, which enables them to be reimbursed 

regardless of the nature of the defense against the beneficiary where they have acted 

in good faith, that is, without actual knowledge of the fraud and for value. 76 

Where the issuer or confirmer have given their irrevocable promise, there is no 

question of value. The need to have given value can be said to be met by having 

made an irrevocable promise or to be irrelevant where there is such a promise." In 

either event, value is not an issue. 

Notice of default or that the undertaking is overdue, issues under the law of 

negotiable instruments, are inapt as letter of credit categories. If the default relates 

to the underlying transaction, the issuer or confirmer can ignore it unless they have 

actual indisputable knowledge of the default and are aware that the default is so 

serious that it disentitles the beneficiary to any conceivable right to draw. There is 

no notion of a LC being "overdue" applicable to letters of credit. If the credit has 

expired-that is, ceased to be available for a presentation-the obligation of an 

issuer or confirmer is discharged, and if a deadline has passed," 6 the documents do 

not comply, and the bank is not entitled to be reimbursed unless waived by the issuer 

or applicant respectively. 

As to notice of fraud, the right to reimbursement of an issuer or confirmer who 

has made an irrevocable undertaking to honor is not affected by notice of fraud 

provided that they act in good faith. 7 9 For this purpose, the notion of "good faith" is 

76. The risks of fraud, abuse, or false or forged documents are not assumed by any bank, including an 

issuer or confirmer. This protected status is implicit in the concept of negotiation under standard 

international letter of credit practice. See UCP500 (1994) art. 15; ISP98 art. 8.01(b). 

77. See U.C.C. § 3-303(a)(4) & (5) (2006) (stating that "[a]n instrument is issued or transferred for 

value if: ... (4) the instrument is issued or transferred in exchange for a negotiable instrument; or (5) the 

instrument is issued or transferred in exchange for the incurring of an irrevocable obligation to a third 

party by the person taking the instrument"). 

78. Letters of credit often contain various deadlines such as a period of time after the issuance of the 

transport document within which documents must be presented-the default rule is twenty-one days under 

UCP600 Article 14(c) (Standard for Examination of Documents)-and a deadline by which the transport 

document must be issued. 

79. U.C.C. Revised section 5-109(a) (revised 1995) provides: 

If a presentation is made that appears on its face strictly to comply with the terms and 



applicant: (1) the issuer shall honor the presentation, if honor is demanded by (i) a nominated 

person who has given value in good faith and without notice of forgery or material fraud, (ii) a 

confirmer who has honored its confirmation in good faith, (iii) a holder in due course of a draft 

drawn under the letter of credit which was taken after acceptance by the issuer or nominated 

person, or (iv) an assignee of the issuer's or nominated person's deferred obligation that was 

taken for value and without notice of forgery or material fraud after the obligation was 


2007 


limited severely. Under negotiable instruments law, the focus of the inquiry of 

whether one has acted in good faith is on the time when the purchase takes place. 

Under a letter of credit, an issuer or confirmer are already obligated, and their only 

focus is on the documents and not the underlying transaction. Their "good faith" 

relates only to what actual knowledge they have about the documents. They are 

under no duty to investigate allegations or suspicions. A bank acts in good faith 

unless it has actual and incontrovertible knowledge of letter of credit fraud, 

Therefore, the mere allegation of fraud by the applicant will not impede recovery by 

the issuer or confirmer. 8 ' 

This rule exists to protect the letter of credit system. If the mere allegation of 

fraud were sufficient to inhibit a letter of credit promise to pay, it would be of little 

more value than a simple contract. Banks do not and should not have the power to 

make a binding determination of the validity of claims of letter of credit fraud, and 

cannot compel the submission of evidence. Therefore, they should not be placed in 

the position of an investigator. The starkness of this result for the applicant is 

ameliorated by the ability of the applicant to seek extraordinary judicial relief in the 

form of a special court order attaching or freezing the presentation, payment, or 

proceeds.' 

incurred by the issuer or nominated person; and (2) the issuer, acting in good faith, may honor 

or dishonor the presentation in any other case. 

U.N. LC Convention, supra note 58, Article 19 provides: 

(1) If it is manifest and clear that: (a) Any document is not genuine or has been falsified; (b) No 

payment is due on the basis asserted in the demand and the supporting documents or (c) 

Judging by the type and purpose of the undertaking, the demand has no conceivable basis, the 

guarantor/issuer, acting in good faith, has a right, as against the beneficiary, to withhold 

payment. 

The Interpretation of the Supreme People's Court (PRC) [2005] No. 13 Article 10 provides: 

A people's court shall make a ruling to suspend the payment or a judgement to permanently 

stop the payment under a Credit when fraud is established, unless one of the following has 

happened: (i) The nominated person or the person authorised by the issuing bank has paid in 

good faith in accordance with the instructions of the issuing bank; (ii) The issuing bank or its 

nominated or authorized person has accepted the bills of exchange under the Credit in good 

faith; (iii) The confirming bank has paid in good faith; or (iv) The negotiating bank has 

negotiated in good faith. 

80. It has been properly suggested that such a situation would only arise when the documents are 

marked "fraudulent." Short of that, it is difficult to imagine a situation where actual knowledge of fraud 

could be visited on the issuer or confirmer, unless it or its employees have colluded in the fraud. 

81. The issuer or confirmer, however, may at its option refuse payment based on LC fraud. Should 

they do so, usually when the applicant has undertaken to indemnify them and hold them harmless from any 

losses or expenses, they are required to prove that there has been LC fraud. This action is discretionary 

except in the rare situation where the bank is certain of the existence of fraud. In most situations, the bank 

will not elect to expose itself-or its reputation-to the risk of having to prove fraud in relationship to a 

transaction in which it is not involved. 

82. U.C.C. § 5-109(b) (2006) provides: 

If an applicant claims that a required document is forged or materially fraudulent or that honor 

of the presentation would facilitate a material fraud by the beneficiary on the issuer or 

applicant, a court of competent jurisdiction may temporarily or permanently enjoin the issuer 

from honoring a presentation or grant similar relief against the issuer or other persons .... 



VOL. 42:561 

b. Protected Status Where There Is Negotiation by a Negotiating Bank 

A bank that is nominated to negotiate without adding its confirmation is a 

negotiating bank and, should it elect to negotiate and duly do so, is entitled to 

reimbursement by the issuer or confirmer." As to negotiation by a nominated 

negotiating bank other than the confirmer, a different regime exists, and it is 

necessary to revisit the elements of protected status. 

5. Value 

In the law of negotiable instruments, there is some confusion as to the 

relationship between value and negotiation. The absence of an exchange may in the 

common law systems constitute a defense to the enforceability of the instrument, but 

should be unrelated to the question of whether or not it has been negotiated. Only 

in the U.S. system, however, is this distinction made. There, value is a question that 

arises in regard to whether the person to whom the instrument has been negotiated 

is entitled to a protected status. What constitutes value is a matter of some interest 

in comparing the U.K. and U.S. system. 

U.S. negotiable instruments law distinguishes between "consideration" and 

"value," concluding that an executory promise is good consideration, but not "value" 

The U.N. Bills of Exchange Convention, supra note 2, Article 20 provides: 

(1) Where, on an application by the principal/applicant or the instructing party, it is shown that 

there is a high probability that, with regard to a demand made, or expected to be made, by the 

beneficiary, one of the circumstances referred to in subparagraphs (a), (b) and (c) of paragraph 

(1) of article 19 [Exception to Payment Obligation] is present, the court, on the basis of 

immediately available strong evidence, may: (a) Issue a provisional order to the effect that the 

beneficiary does not receive payment, including an order that the guarantor/issuer hold the 

amount of the undertaking, or (b) Issue a provisional order to the effect that the proceeds of 

the undertaking paid to the beneficiary are blocked, taking into account whether in the absence 

of such an order the principal/applicant would be likely to suffer serious harm. 

See Chinese LC Rules, supra note 79, art. 10; see also U.N. Commission on International Trade Law 

[UNCITRAL], Working Group on International Contract Practices, Independent Guarantees and Stand-by 

Letters of Credit: Discussion of Further Issues of a Uniform Law: Fraud and Other Objections to Payment, 

Injunctions and Other Court Measures: note by the Secretariat, paras. 90-114, U.N. Doc. 

A/CN.9/WG.II/WP.70 (Apr. 5, 1991). 

83. No distinction is made here between a bank that is specially nominated to negotiate and a freely 

negotiable credit since both operate identically with respect to negotiation. A freely negotiable credit 

permits negotiation without designating a specific bank, so that any bank may negotiate. As with 

negotiation, there is no required or typical manner of indicating that the credit is freely negotiable. Free 

negotiation may be indicated by a recital that the issuer undertakes to honor presentations by any bank or 

by stating that the credit is freely negotiable, by checking a box on a form, or by so stating in SWIFT Field 

41a (Available With... By... ). A variation on free negotiation is a credit that is freely negotiable within 

a stated geographical area (e.g., "negotiable by any bank in Singapore"). Under a freely negotiable credit, 

any bank is a nominated person under the credit, except that it may not effect a transfer of drawing rights 

unless it is specifically nominated as a transferring bank. There are operational risks associated with free 

negotiation regarding control of the documents and presentation in that the issuer and applicant rely on 

the good faith of any bank with whom the beneficiary may work without necessarily having a working 

relationship with that bank. There are also issues that affect negotiability where a draft is drawn on the 

paying bank. The paying bank would either pay or accept. The issues raised here, however, are beyond 

the scope of this paper. 


2007 


for purposes of determining protected status. ' The English Bills of Exchange Act 

does not make this distinction. It defines "value" as including "[a]ny consideration 

sufficient to support a simple contract."" 9 Apparently, the problem of executory 

promises in favor of fraudsters has not arisen in English cases or claimed the 

attention of the courts. 

As described by Ellinger, the civil law looks only to the regularity of the chain 

of title by which the instrument has been passed.' This approach must make aspects 

of the protected status under LC law confusing and explains why efforts to identify 

those entitled to that status have resulted in confusion. 

On being nominated to negotiate, a negotiating bank does not make an 

irrevocable commitment to negotiate under the LC. 87 With respect to letters of 

credit, the question to which giving value is an answer is a factor in determining 

whether or not there has been negotiation. The questions arise, then, whether or not 

and when it has purchased or given value for purposes of achieving protected status. 

This notion and related concepts have figured considerably in the efforts of the ICC 

Banking Commission to define "negotiation." At various times, it has been 

described as "negotiate/purchase,"" 8 "value," 89 and, once again in UCP600, 

"purchase." 90 

84. This provision is contained in the Model Uniform Commercial Code which is adopted in all fifty 

states with some variations. U.C.C. § 3-303(a) (2006) (stating that "[a]n instrument is issued or transferred 

for value if: (1) the instrument is issued or transferred for a promise of performance, to the extent the 

promise has been performed..."). Section 3-303(a) is based on section 54 of the predecessor statute, the 

Negotiable Instruments Law, supra note 7, which deviated in this respect from the U.K. Bills of Exchange 

Act, 1882, 45 & 46 Vict. c. 61. § 27. See also U.C.C. § 3-303, cmt. 2 (stating that "[t]he policy basis for 

subsection (a)(1) is that the holder who gives an executory promise of performance will not suffer an outof-pocket 

loss to the extent the executory promise is underperformed at the time the holder learns of 

dishonor of the instrument"). 

85. Bills of Exchange Act § 27(1)(a) (Value and Holder for Value). 


87. Where a nominated negotiating bank makes a separate undertaking to the beneficiary to negotiate 

drafts drawn under the letter of credit, such an undertaking is commonly (and incorrectly) described as a 

"silent confirmation." THE INTERNATIONAL CHAMBER OF COMMERCE, OPINIONS OF THE ICC BANKING 

COMMISSION 1995-1996, Resp. 207 at 27 (Gary Collyer ed., 1997) ( stating that "[slub-Article 10(c) takes 

note of the possibility that a nominated bank, not being a confirming bank, agrees with the beneficiary to 

assume a liability to pay, etc. Silent confirmation may be one of such undertakings"). UCP600 (2007) 

Article 12(a) also alludes to this possibility. While anticipated in UCP600 Article 12(b), which provides 

"[bly nominating a bank to accept a draft or incur a deferred payment undertaking, an issuing bank 

authorizes that nominated bank to prepay or purchase a draft accepted or a deferred payment undertaking 

incurred by that nominated bank," this practice is not regulated or standardized by the UCP. This 

undertaking is not one under the letter of credit. For more about Silent Confirmation, see Byrne, Barnes, 

& Maulella, Silent Confirmation (Institute of International Banking Law & Practice 2006) (Available via 

ON Line Replay or DVD). This topic is one that requires such extensive separate treatment that it is only 

tagged in this article as an area that is not included in this treatment of negotiation. 

88. UCP290 (1974) Article 3(a)(iii) stated: 

An irrevocable credit constitutes a definite undertaking of the issuing bank, provided that the 

terms and conditions of the credit are complied with: . . . iii to purchase/negotiate, without 

recourse to drawers and/or bona fide holders, drafts drawn by the beneficiary, at sight or at a 

tenor, on the applicant for the credit or on any other drawee specified in the credit, or to 

provide for purchase/negotiation by another bank, if the credit provides for 

purchase/negotiation. 

See CHARLES DEL BUSTO, UCP 500 & 400 COMPARED 29 (1993) 

(stating that "[n]egotiation in 



VOL. 42:561 

In light of negotiable instruments law, these questions are highly confusing. 

Under common law, negotiation is the act of transfer by which the transferee 

becomes a holder. Holder in due course status is a separate question. Under the 

civil law, one looks to the chain of transfers to determine whether or not it has been 

regular on its face. 

There are two different perspectives in which LC negotiation is viewed. 

Bankers view it as an entitlement to claim reimbursement. Lawyers tend to 

approach negotiation from the perspective of the implications of letter of credit 

fraud. This diverse approach is apparent with respect to "value" or "purchase." 

At the time UCP500 was drafted, it was thought that the reimbursement system 

was being abused by banks who merely examined documents and claimed 

reimbursement as negotiating banks without having negotiated, but merely having 

forwarded the documents. 9 ' The point of the UCP500 definition of negotiation as 

"value" was to make it clear that this practice was not proper. It soon became clear, 

however, that LC bankers in claiming reimbursement did not understand what was 

meant by "value" and, in particular, whether a promise to pay constituted value. To 

address the considerable concern that had been voiced, the Chair of the ICC 

Banking Commission issued Position Paper No. 2, which states that "'giving of value' 

in UCP500 Article 10(b)(ii) may be interpreted as either 'making immediate 

payment' (e.g., by cash, by cheque, by remittance through a Clearing System or by 

credit to an account) or 'undertaking an obligation to make payment' (other than 

giving a deferred payment undertaking or accepting a draft)." ' 

Unsatisfied with this approach, the drafters of UCP600 defined negotiation in 

Article 2 (Definitions) paragraph 11 as "the purchase by the nominated bank of 

drafts (drawn on a bank other than the nominated bank) and/or documents under a 

complying presentation, by advancing or agreeing to advance funds to the 

beneficiary on or before the banking day on which reimbursement is due to the 

nominated bank." Whatever else "purchase" connotes, it does include a promise to 

advance funds as well as the actual advance of funds, as stated. 

While this redefinition solved one problem, it gave rise to another, namely 

whether a negotiating bank could claim a protected status in the event of beneficiary 

fraud as a result of a simple executory promise running to the fraudster. 93 Unless the 

Documentary Credit practice means more than to examine the documents. When an Issuing Bank issues a 

negotiation Credit, it is inviting a Nominated Bank to negotiate or to give value in exchange for a 

Beneficiary's draft and/or documents"). 

89. UCP500 Article 10(b)(ii) (Types of Credit) (1994) (defining "negotiation" as "giving of value for 

Draft(s) and/or document(s) by the bank authorized to negotiate"). 

90. UCP600 Article 2 (Definitions) para. 11 (2007) states: 

Negotiation means the purchase by the nominated bank of drafts (drawn on a bank other than 

the nominated bank) and/or documents under a complying presentation, by advancing or 

agreeing to advance funds to the beneficiary on or before the banking day on which 

reimbursement is due to the nominated bank. 

91. Signaling the concern that led to the definition, UCP500 (1983) Article 10(b)(ii) provides that 

"[m]ere examination of the documents without giving of value does not constitute a negotiation." 

92. INTERNATIONAL CHAMBER OF COMMERCE, ICC BANKING COMMISSION POSITION PAPER NO. 2, 

reprinted in LC RULES AND LAWS at 107 (James E. Byrne ed., 3d ed. 2004). 

93. There is another complicating preliminary dimension, namely that the provision in UCP600 

admits of two divergent readings. UCP600 Article 7(c) (Issuing Bank Undertaking) sentence 2 states that 

"[r]eimbursement for the amount of a complying presentation under a credit available by acceptance or 


2007 


promise were in the form of a negotiable instrument that could be negotiated to 

innocent third persons or an irrevocable promise to an innocent person, the 

negotiating bank would have a complete excuse against a claim by the beneficiary in 

such a situation since fraud unravels all in every modern system of commercial law. 4 

In this scenario, would a court permit the negotiating bank that has not paid to 

recover from the issuer with a view to fulfilling in the future a promise to pay a 

fraudster or for fraudulent documents? 

The analysis is rendered more complex by the difference in common law 

systems with respect to whether executory promises constitute value. It may be 

expected that U.S. courts at least would refuse to accord protected status to a 

negotiating bank that merely promises to advance funds without having done so, and 

the same result should follow for whatever reason in other systems. On the other 

hand, where the negotiating bank has not yet paid but given a letter of credit to a 

third person or a negotiable instrument that may fall into the hands of an innocent 

third party, the negotiating bank has a complete defense if there is LC fraud. 

However it may be characterized, LC practice and law have sensed that there 

must be something additional to the mere transfer of the documents in order for 

there to be negotiation and that it must be a transfer that entitles the negotiating 

bank to assert rights to the documents. Such a transfer only takes place where the 

bank has purchased the documents in some fashion. 

While negotiation is typically thought of in the one-dimensional framework of a 

sight draft, time drafts can also be negotiated under letter of credit practice. Where 

a negotiating bank negotiates a time draft, it forwards the documents to the issuer or 

confirmer and engages in trade finance by discounting the amount due to its present 

value. The negotiating bank is then entitled to reimbursement at maturity. Where 

there is a time draft, there is always a possibility that LC fraud could be discovered 

or claimed in the interim period between the purchase of the draft or documents and 

the maturity date. In that situation, the question arises as to whether or not the 

negotiating bank is entitled to be reimbursed notwithstanding the fraud. 

This problem has been a serious difficulty with respect to deferred payment 

undertakings. The problem was highlighted by the English decision in Banco 

Santander SA v. Banque Paribas.'- Banco Santander intimated in dicta that the result 

deferred payment is due at maturity, whether or not the nominated bank prepaid or purchased before 

maturity." This sentence could mean that reimbursement is due at maturity provided that the promise to 

prepay or purchase was given before maturity or that the actual disbursal took place before maturity. 

James G. Barnes, whose suggestion lead to this provision but who was regrettably not consulted in its 

drafting, indicates that the latter interpretation is preferable. Some authorities, however, may interpret it 

in the former sense. 

94. The UNIDROIT Principles of International Commercial Contracts (2004) Article 3.8 provides: 

A party may avoid the contract when it has been led to conclude the contract by the other 

party's fraudulent misrepresentation, including language or practices, or fraudulent nondisclosure 

of circumstances which, according to reasonable commercial standards of fair 

dealing, the latter party should have disclosed. 

95. See Banco Santander S.A. v. Bayfern Ltd. & Ors., [1999] 2 All E.R. (Comm.) (Q.B.) 18, affd 

Banco Santander SA v. Banque Paribas, [2000] 1 All E.R. (Comm.) (C.A.) 776; James G. Barnes & James 

E. Byrne, Letters of Credit: 2000 Cases, 56 Bus. LAW. 1805, 1813 (2001) (criticizing Banco Santander). See 

also Sinotani Pac. v. Ag. Bank of China, 4 S.L.R. 34 (1999); Czarnikow Rionda Sugar Trading v. Standard 

Bank, (1999) 2 Lloyd's Rep. (Q.B.) 187, 202; Bundesgericht [BGer] [Federal Court] June 1, 2004. 130 



VOL. 42:561 

would be different had there been negotiation of a draft by a nominated negotiating 

bank. 96 However, a recent decision by the French Cour de Cassation concluded that 

under French negotiable instruments law, a confirming bank that discounted its own 

acceptance was not entitled to reimbursement as a protected party where letter of 

credit fraud had emerged after the discount and before maturity. 9 7 One would have 

thought that an acceptance would be entitled to a higher level of abstraction than 

negotiation. But then one might have thought that a confirming bank that had 

discounted its own confirmation would be entitled to a higher level of abstraction 

than a negotiating bank. 

In any event, UCP600 addresses this matter in three articles intended to 

preserve the rights of banks that discount to reimbursement." Although the term 

"discount" is not used, probably in order to emphasize that it is not every 

discounting bank, but only a nominated bank to which it applies, the terms 

"purchase" and "prepay" achieve the same end. 99 Under UCP600, a negotiating 

bank that negotiates a time draft should have added comfort with respect to its 

Entscheidungen des Schweizerischen Bundesgerichts [BGE] III 462 (Switz.) (for English translation, see 

DOCUMENTARY CREDIT WORLD, 2006 ANNUAL SURVEY at 477). 

96. The Banco Santander v. Bayfern Ltd. & Ors. court noted that the confirming bank's "submission 

was that there was no good reason why the effect of established fraud should differ in the case of 

acceptance credits and deferred payment credits. An acceptance credit, however, expressly involves 

authority from the Issuing Bank to the Confirming Bank to accept drafts and pay them at maturity," 

whereas a deferred payment credit was not so authorized. Banco Satander, 2 All E.R. (Comm.)(Q.B.) 18. 

97. See Cour de cassation [highest court of ordinary jurisdiction] Cass. com., Oct. 11, 2005, Bull. civ, 

IV, No. 1246 (Fr.). See also Jean Stoufflet, May a Bank Contest the Authenticity of Documents After 

Accepting the Beneficiary's Draft and Refuse Payment of a Documentary Credit?, in DOCUMENTARY 

CREDIT WORLD, Feb. 2006, at 12. 

98. In addition to the definition of "Negotiation" in UCP600 Article 2 paragraph 11, Articles 7(c) 

(Issuing Bank Undertaking) and 8(c) (Confirming Bank Undertaking) address reimbursement of 

nominating banks. UCP600 Article 8(c), for example, states: 

A confirming bank undertakes to reimburse another nominated bank that has honoured or 

negotiated a complying presentation and forwarded the documents to the confirming bank. 

Reimbursement for the amount of a complying presentation under a credit available by 

acceptance or deferred payment is due at maturity, whether or not another nominated 

bank prepaid or purchased before maturity. A confirming bank's undertaking to reimburse 

another nominated bank is independent of the confirming bank's undertaking to the 

beneficiary. 

99. UCP600 (2007) Article 12(b) (Nomination) states that nomination of a bank to incur a deferred 

payment undertaking or to accept authorizes that bank "to prepay or purchase a draft accepted or a 

deferred payment undertaking incurred by that nominated bank." Although not explained, "prepay" and 

"purchase" are quite different in their meaning and implications. While a bank can purchase a draft or 

documents presented under an LC whether or not it is nominated and whether or not it is obligated on an 

LC, only a bank that is obligated can prepay its own obligation because prepayment signifies discharge of 

the obligation whereas an obligation that is purchased is not discharged by the purchase. A further step is 

required to discharge the obligation. While negotiation without recourse by a confirming bank discharges 

its obligation under a letter of credit, it is not "prepayment" because negotiation occurs when the 

documents are presented and negotiation is not a prepayment. That the negotiation is in advance of the 

time when reimbursement is due does not constitute "prepayment" for purposes of UCP600. The term 

"purchase" is further explained in the UCP600 Article 2 paragraph 11 definition of negotiation by the term 

"advance," which occurs "by advancing or agreeing to advance funds to the beneficiary on or before the 

banking day on which reimbursement is due to the nominated bank." "Advance" connotes a temporal 

relationship to something it precedes, namely the reimbursement by an issuer or confirmer. The addition 

of the phrase limiting the time within which the advance must occur indicates that negotiation may not 

occur after reimbursement is due. What it does not clarify is whether or not the actual advance of funds 

must have occurred by the time that reimbursement is due. 


2007 


entitlement to reimbursement in the event of intervening discovery of letter of credit 

fraud. 

6. Notice 

Since negotiating banks have not made any irrevocable undertaking to honor 

under the letter of credit, an allegation of fraud of which they have notice operates 

differently on them than it would on an issuer or confirmer. A bank has not duly 

negotiated if it has notice of letter of credit fraud prior to negotiating. While a mere 

accusation of LC fraud subsequent to the issuance or confirmation of the credit will 

not defeat the right of an issuer or confirmer to reimbursement since they are 

obligated to pay, a negotiating bank that has no irrevocable letter of credit 

obligation can refuse to negotiate if notified before it does so and bears the risk if 

LC fraud is proven. On the other hand, notice of LC fraud after the negotiating 

bank duly negotiates does not affect its status.' 00 

IV. TOWARDS A DEFINITION OF LC NEGOTIATION 

The UCP600 Article 2 (Definitions) paragraph 11 definition of negotiation 

suffers from the problems of the general UCP600 approach to definitions and 

drafting, namely the use of interlocking definitions and the avoidance of substance. 

With respect to the concept of negotiation, at least, the fault cannot be attributed to 

the drafters. The ICC Banking Commission is constitutionally incapable of 

addressing such serious doctrinal issues in a coherent manner. Being fundamentally 

a political body, it is only able to endorse a solution that has achieved consensus 

among controlling political interests. No such preparatory work has been done with 

respect to negotiation. Therefore, the "solution" to problems is to shuffle words. 

One of the problems in understanding negotiation in LC practice is the 

tendency to place too much emphasis on the term "negotiation" and the conceptual 

and political inability of bankers to address problems of letter of credit fraud in a 

coherent and objective manner. Negotiation in negotiable instruments law is merely 

the transfer of a negotiable instrument in such a manner that the transferee becomes 

the person entitled to exercise special rights under the instrument as its "holder" in 

the law of negotiable instruments. 

In letter of credit practice, when there is negotiation by a nominated 

negotiating bank, it is the right to be paid the proceeds under the LC that is 

transferred to the negotiating bank in its own right as the entity entitled to the 

proceeds under the LC. The transfer involved is similar to the transfer of drawing 

rights in that it is to be distinguished from a mere assignment of proceeds.' Because 

a letter of credit is a "special" undertaking in that it runs only to the named 

beneficiary, the right to draw or perform is restricted to the named entity, although 

100. To the extent that the value given by the negotiating bank is executory, a possible issue arises. 

See supra note 84. 

101. Unlike the general law of consensual obligations, "transfer" and "assignment" are distinguished 

in letter of credit practice and law. See UCP600 (2007) Articles 38 (Transferable Credits) and 39 

(Assignment of Proceeds); ISP98, supra note 10, Rule 6 (Transfer, Assignment, and Transfer by Operation 

of Law); G.A. Res. 50/48, supra note 58,_arts. 9-10; Revised U.C.C. §§ 5-112-5-114. 



VOL. 42:561 

payment-as opposed to performance-is less rigidly controlled. There are 

important practical reasons for this limitation. As a documentary undertaking 

involving payment against representations, neither the applicant nor the issuer want 

to incur the risk of performance by a stranger to the underlying transaction absent 

their express permission. 

Although less clearly appreciated, the same principle applies to payment of the 

proceeds of a letter of credit. A mere LC assignment does not confer a right to the 

proceeds, but a transfer does. Yet a transfer is not the only mode by which the right 

to proceeds can be conveyed. 

Absent a transfer to it, the negotiating bank cannot perform under the credit. 

But once there is performance, a negotiating bank that has duly negotiated has a 

separate independent right to the proceeds being paid to it in its own name and not 

as an assignee of the beneficiary. In effect, LC negotiation is the transfer of the right 

to the proceeds of the LC. 

Unlike the transferee beneficiary, the negotiating bank is not automatically 

entitled to an independent status from the beneficiary; it must have negotiated for 

value, in good faith, and with no notice of the LC fraud. Unlike a LC transfer of 

drawing rights, the negotiating bank is not entitled to draw in its own name, only to 

receive the proceeds in its own name. In this sense, negotiation can be understood 

as the transfer (as opposed to LC "assignment") of the right to proceeds. 12 Whether 

the negotiating bank, when it is the transferee of proceeds, is entitled to them in the 

face of beneficiary LC fraud depends on the answer to a different question, namely 

its bona fide status. 

V. CONCLUSION 

This paper lists and identifies detailed technical differences between 

negotiation with respect to negotiable instruments and negotiation with respect to 

letters of credit. These differences are substantial and themselves warrant the 

conclusion that the law of negotiable instruments is inadequate as a basis for 

governing issues with respect to negotiable instruments presented under letters of 

credit. 

This paper follows the evolution of the letter of credit from an appendage of 

negotiable instrument law to a separate system in its own right with some remaining 

vestiges of negotiable instrument law, albeit in new guise. In one sense, the various 

matters discussed are elementary. In another sense, comparison between them and 

analysis of their differences and their significance is challenging. This paper does not 

claim to be a definitive or systematic study of this area, but is intended to provoke 

further efforts that will hopefully lead to such a study. 

One of its themes is that letter of credit practice and law have evolved as a 

separate legal discipline. As a result, letter of credit law has become decoupled from 

the law of negotiable instruments. Where a negotiable instrument is involved, there 

may be another cause of action or theory of liability or available recovery-in 

102. This approach elects not to frame the question in terms of reimbursement rights. That 

appellation is appropriate for entities that are obligated on the LC such as the confirmer or issuer. It is 

also appropriate for a paying bank. It is less so for a negotiating bank, which retains its right of recourse 

and acts more independently than do the other nominated banks. 


2007 


addition to that under letter of credit law-but the two are separate and distinct 

areas of law. 

The failure to recognize the existence in letters of credit of a system that is 

parallel, different, and separate from that of negotiable instruments will lead to 

confusion and defeat the reasonable expectations of the commercial community. 

This result has been apparent in cases regarding acceptances arising under letters of 

credit where a rigid interpretation of the abstract character of an acceptance led the 

court to the conclusion that payment must be made to a fraudster simply because of 

the existence of the acceptance.' 3 This approach results in bad policy, not only with 

respect to letters of credit, but also with respect to negotiable instruments. 

The attraction of negotiable instruments law as a means of resolving letter of 

credit issues is, in part, that it represents a codified body of law and, also in part, that 

lawyers and judges are familiar with it-whereas in many countries, letter of credit 

law is not codified, and most lawyers and judges are not familiar with it. As a result, 

it becomes easy to apply the highly technical rules of negotiable instruments as a 

means of reaching a decision in cases involving letters of credit without delving into 

the policies which underlie these rules and the appropriateness of their application to 

a problem involving letters of credit. Without a clear understanding of the policy 

behind rules, however, it is no longer possible to apply rules in an intelligent manner 

because it becomes impossible to determine when the rule ceases to achieve the end 

for which it is designed. 

Under letters of credit, the undertaking embodied in the letter of credit extends 

beyond bringing into existence a draft to be presented. While there may be a 

separate set of obligations which arise with respect to the draft, even where it has 

been accepted, there remain in place obligations concerning the letter of credit 

undertaking that are not subsumed by the acceptance. Indeed, where there is a 

conflict, it is the letter of credit obligation that subsumes that which arises with 

respect to the draft.' " 

There is, however, a further point to which attention should be drawn. The 

letter of credit takes the concept of negotiability beyond that which is achieved 

under the regime of negotiable instruments. Negotiable instruments shackle the 

concept of negotiability to the paper with which it is merged, and for historical 

reasons, immerse it in formal and technical rules. While it may be necessary that a 

general instrument of debt and credit be surrounded by such technicalities, it is not 

inevitable. Indeed, an equivalent level of abstractness has been achieved at least in 

U.S. commercial law with respect to leases of personal property and their hell-orhigh-water 

clauses'"" and security interests in personal property, whereby an 

assignment can be given the effect otherwise achieved by a negotiable instrument. ' 6° 

With letters of credit, however, a higher degree of negotiability has been 

achieved. In this sense, negotiability consists of a free transfer of obligations without 

or with limited encumbrances. Letters of credit have thus achieved a relatively high 

103. See All Services Exportacao, lmportacao Comercia v. Banco Bamerindus Do Brazil, 921 F.2d 32, 

35-36 (2d Cir. 1990); First Commercial Bank v. Gotham Originals, Inc., 475 N.E.2d 1255, 1260 (N.Y. 1985). 

104. U.C.C. § 5-116(d) (2006). 

105. See, e.g., U.C.C. § 2A-407 (Irrevocable Promises: Finance Leases). 

106. See Revised U.C.C. § 9-403 (revised 2000) (Agreement Not to Assert Defenses Against 

Assignee). 



form of liquidity. In particular, in the form of standby letters of credit, they have 

achieved an incomparable level of liquidity-coupled with flexibility in an 

instrument whose integrity has, on the whole, not been diminished. This remarkable 

achievement, having arisen historically and conceptually from the doctrine of 

negotiability, has become a central feature of letter of credit practice and law. 


Theorizing Transnational Commercial Law 

Ross CRANSTON* 

SUMMARY 

I. G LO BA LISA TIO N ................................................................................................. 600 

II. THE RULE OF LAW AND ITS CONSEQUENCES .................................................. 607 

III. THE POW ER OF THE M ARKET ............................................................................ 610 

IV. IMPLEMENTING THE NEW TRANSNATIONAL COMMERCIAL LAW ................. 614 

V . C O N C LU SIO N ....................................................................................................... 616 

Over recent decades we can see the emergence of a new transnational 

commercial law. It consists of international conventions, model laws, and statements 

of principle (or standards). A recent compilation consists of some sixty instruments 

divided into twelve subject areas as diverse as contract law, electronic commerce, 

sales, agency and distribution, international credit transfers and bank payment 

undertakings, secured transactions, cross-border insolvency, conflict of laws, 

international civil procedure, and international commercial arbitration.' Even this 

comprehensive collection is not exhaustive, as will be evident from later discussion. 

The new transnational commercial law is driven by international institutions 

ranging from UNCITRAL, UNIDROIT, and the World Bank; regional 

governmental or economic bodies like the European Union or MERCOSUR; 

specialist international bodies such as the Basel Committees on Banking Supervision 

and Payment and Settlement Systems, and the International Organization of 

Securities Commissions (IOSCO); and industry bodies such as the International 

Chamber of Commerce (ICC).' There is a great deal of overlap in the application of 

their work in practice. Take, for instance, the area of transnational financial law: the 

* QC; Centennial Professor of Law, London School of Economics and Political Science. President, 

International Academy of Commercial and Consumer law, 2004-2006. This paper draws to an extent on 

How Law Works (Oxford, 2006) and has benefited from being presented in various guises at the National 

Law School, Bangalore, India, and the National Autonomous University of Mexico, Mexico City. 

1. E.g., ROY GOODE, ET AL., TRANSNATIONAL COMMERCIAL LAW: INTERNATIONAL INSTRUMENTS 

AND COMMENTARY at v (2004); see Gbenga Bamodu, Extra-national Legal Principles in the Global Village: 

A Conceptual Examination of Transnational Law, 7 INT'L ARB. L. REV. 6 (2001). 

2. E.g., UNIDROIT 75 "h Anniversary Congress on Worldwide Harmonisation of Private Law and 

Regional Economic Integration, I UNIFORM L.REV. 1ff. (2003). 



VOL. 42:597 

Financial Stability Forum brings together national authorities responsible for 

financial stability around the world. In order to further its aims, the Forum advances 

a compendium of twelve key standards concerning transparency of policy making in 

the financial system, sound institutional and market infrastructure, and adequate 

financial regulation.' The standards are drawn from a range of international bodies, 

including the International Monetary Fund (standards on macroeconomic policy and 

data transparency), the World Bank (insolvency and credit guidelines), Organisation 

for Economic Co-operation and Development (principles of corporate governance), 

the Basel Committee, IOSCO, and Financial Action Task Force on Money 

Laundering. As well as providing a fine overview of the area, Professor Mario 

Giovanoli has argued that the new transnational financial law is mainly stand-alone 

"soft law," independent of any international framework of binding legal rules and 

sometimes lacking the degree of precision indispensable to a legally enforceable 

rule. 4 In addition to classifying the new transnational commercial law according to its 

subject matter or institutional source, one may classify it by the juridical nature of 

the instrument. Thus it is possible to divide transnational commercial law into 

principles (or standards), model laws, and international conventions. A very longstanding 

set of principles is the Uniform Customs and Practice for Documentary 

Credits, first published by the ICC in 1933. However, such principles of 

transnational commercial law extend well beyond trade. The well known 

UNIDROIT Principles of International Commercial Contracts are mentioned at 

greater length below.' The standards collected by the Financial Stability Forum have 

been referred to. In the area of dispute settlement there are the ALI/UNIDROIT 

Principles of Transnational Civil Procedure.' The lex mecatoria is more difficult to 

identify, as we shall see, but it consists of principles like good faith, reasonableness, 

the duty to negotiate, set-off, and the obligation to compensate on expropriation. 

Among the model laws of transnational commercial law-a second category of 

instrument-are those of UNCITRAL, which now has Model Laws on International 

Commercial Arbitration, Cross-Border Insolvency, and International Credit 

Transfers. 7 The model laws used by bodies like the World Bank and IMF in their 

technical assistance work are not always publicly available nor are records of which 

countries have adopted them and in what form. In effect, these World Bank Model 

Laws extend beyond the financial sector to matters such as insolvency and security. 

As to international conventions relating to transnational commercial law, these 

began in the first part of the twentieth century. To take just the financial area, 

conventions were drawn up for a Uniform Law on Bills of Exchange and Promissory 

3. Financial Stability Forum, www.fsforum.org; see also THE ROAD TO INTERNATIONAL FINANCIAL 

STABILITY: ARE KEY FINANCIAL STANDARDS THE ANSWER? (Benu Schneider ed., 2003). 

4. Mario Giovanoli, A New Architecture for the Global Financial Market: Legal Aspects of 

International Financial Standard Setting, in INTERNATIONAL MONETARY LAW, 40 (Mario Giovanoli ed., 

2000). 

5. Michael J. Bonell, The UNIDROIT Principles and Transnational Law, 2 Uniform L. Rev. 199 

(2000); Juirgen Basedow, Uniform Law Conventions and the UNIDROIT Principles of International 

Commercial Contracts, 1 UNIFORM L. REV. 129 (2000). 

6. American Law Institute & UNIDROIT, ALI/UNIDROIT Principles of Transnational Civil 

Procedure xxix (2006). 

7. The first-mentioned has been adopted by over fifty states: Pieter Sanders, UNCITRAL's Model 

Law on International and Commercial Arbitration: Present Situation and Future, 21 ARB. INT'L 443 (2005). 


2007 

THEORIZING TRANSNATIONAL COMMERCIAL LAW 

Notes and a Uniform Law Concerning Cheques. International conventions from 

recent decades include the United Nations Convention on Contracts for the 

International Sale of Goods (CISG) (1980)', the Convention on the Recognition and 

Enforcement of Foreign Arbitral Awards (the New York Convention) (1958)0o and 

the United Nations Convention on the Assignment of Receivables in International 

Trade (2001)." 

It is possible to explore how these different types of instrument are given force. 

First, uniform principles have effect in as much as they are consciously invoked by 

parties engaged in international transactions (primarily by incorporation by 

reference in their contracts) or by those settling disputes between such parties 

(primarily arbitrators). Thus, the Uniform Customs and Practice for Documentary 

Credits are widely incorporated by international banks in the letters of credit they 

issue. Although the confidentiality of arbitration proceedings makes it difficult to be 

definite about the matter, it seems that international arbitrators are making 

increasing reference, if only informally, to the UNIDROIT Principles of 

International Commercial Contracts. Secondly, as the name suggests, a model law is 

designed for adoption by national legislatures. While it is not always easy to 

determine whether a model law has been adopted since it may be dressed up as local 

law reform, it is evident that the UNCITRAL Model Law on Cross-Border 

Insolvency is being widely implemented. Thirdly, a convention is a treaty, to which 

states can choose to be a party. Model laws can obviously be modified in their 

adoption or adopted in part, whereas parties to a convention must enter reservations 

if there are to be departures from it. The New York Convention has had almost 

universal success and is one explanation for the popularity of international 

commercial arbitration - by contrast to the situation with foreign court judgments, 

almost every country is committed to enforcing foreign arbitral awards. 

The purpose of this essay is not so much to describe the institutions or to 

analyse the substantive provisions of the new transnational commercial law. Rather 

what this essay explores is whether it can be said that there is any legal theory which 

helps explain the emergence of this new transnational commercial law and its 

adoption by national systems. This essay suggests that there are several bodies of 

legal theory which throw light on these two issues. The first uses globalisation as an 

explanatory factor. It arises in particular in accounts of the new lex mecatoria and 

also in explanations of the emergence of the uniform principles, model laws, and 

international conventions drawn up under the auspices of bodies such as 

UNCITRAL, UNIDROIT, the World Bank, and the ICC. A second is rule of law 

8. Manley 0. Hudson & Abraham H. Feller, The International Unification of Laws Concerning Bills 

of Exchange 44 HARV. L. REV. 333, 333-34 (1931); Abraham H. Feller, The International Unification of 

Laws Concerning Checks 45 HARV. L. REV. 668, 668 (1932); see also the so-called Hague Rules - the 

International Convention for the Unification of Certain Rules of Law Relating to Bills of Lading (Brussels, 

1924); Jirgen Basedow, Global Life, Local Law? in LIBER AMICORUM EN HOMENAJE AL PROFESSOR DR. 

DIDIER OPERTI BASTAN 825-26 (2005). 

9. United Nations Convention on Contracts for the International Sale of Goods, Apr. 10, 1980, 1489 

U.N.T.S. 3, available at http://www.uncitral.org/en-index.htm. 

10. United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards, 

June 10, t958, 21 U.S.T. 2517, 330 U.N.T.S. 38. 

11. United Nations Convention on the Assignment of Receivables in International Trade, G.A. Res. 

56/81, U.N. GAOR, 56th Sess., U.N. Doc. A/RES/56/81 (Dec. 12, 2001), available at 

http://www.uncitral.org/pdf/english/texts/payments/receivables/ctc-assignment-convention-e.pdf. 



VOL. 42:597 

theory, which is especially popular with the World Bank and related bodies like the 

IMF. According to this strand of thinking, economic development demands a legal 

system which protects contractual and property rights both in terms of substantive 

rules and judicial administration. A legal system built on the rule of law is said to do 

this. One aspect of the rule of law is a substantive law which reflects the principles of 

the new transnational commercial law. A third body of theory plays to market 

forces. Countries fall along a spectrum from pro-creditor to pro-debtor in terms of 

their commercial laws. Where countries are on the spectrum turns in part on 

whether they have adopted the legal standards, codes, and principles of the new 

transnational commercial law. Whether a country is pro-creditor or pro-debtor feeds 

into market assessments of its economy and that influences the behaviour of foreign 

investors. Finally, there is the theory which helps explain the adoption of the 

conventions, model laws, and standards. One aspect of this is whether the legal 

principles incorporated in them have resonance with legal practitioners and 

institutions so that they use them to structure commercial transactions. Another 

aspect is legal transplant theory, which bears on whether these codes and standards 

are implemented by national legislation. Legal transplant theory is only part of the 

explanation for successful adoptions, for, as we will see, there must also be the 

political will within each jurisdiction to enact these into law. 

I. GLOBALISATION 

Globalisation is a slippery concept but encompasses objective developments in 

the economic, cultural, political, and technological spheres. 12 People's consciousness 

about the phenomenon is as important as these objective developments. That 

sometimes leads to resistance to what globalisation entails. In some contexts, 

globalisation is being used to describe a process of social change, a world being 

transformed so that there are greater contacts across national boundaries and growth 

or intensification 'of new networks and interdependencies. In other contexts-it 

means the condition where geographical boundaries are rendered less relevant by 

the existence of these cross-border connections and arrangements. Globalisation 

gives rise to apparent paradoxes. The fact that globalisation is multidimensional 

makes it all the more difficult to analyze. Depending on how it is defined, the 

globalisation label may be applied to eras earlier than our own. 13 Those dedicated to 

resisting globalisation often use its products, such as global communications and 

media outlets, to further their aims. 

For the purposes of analysing the new transnational commercial law we can 

ignore the complexities and paradoxes of globalisation. Our focus is mainly its 

economic dimension. In this regard, globalisation is largely confined to international 

trade and financial markets and often does not implicate multinational institutions 

such as the North America Free Trade Area or the European Community. The 

global economic order we are interested in takes its form in the huge flows of goods, 

services, and capital around the world." The international nature of trade and the 

12. ANTHONY GIDDENS, RUNAWAY WORLD (2000); DAVID HELD ET AL., GLOBAL 

TRANSFORMATIONS 1 (1999); THE GLOBALIZATION READER 1 (Frank Lechner & John Boli eds., 2000). 

13. E.g., Ross Cranston, Globalisation: Its Historical Context, in COMMERCIAL LAW AND 

COMMERCIAL PRACTICE 3-4 (Sarah Worthington ed., 2003). 

14. See, e.g., GLOBAL CAPITALISM (Will Hutton & Anthony Giddens eds., 2000); ROBERT GILPIN, 

GLOBAL POLITICAL ECONOMY (2001). 


2007 


liberalisation of financial transactions have created an enhanced role for the 

international institutions identified earlier. These bodies have promoted the 

harmonized rules which constitute the new transnational commercial law to channel 

and govern international trade and financial transactions. As the World Bank has 

put it: 

Beyond reducing transaction costs, adoption of international standards can 

also facilitate domestic policy reform when local interest groups have 

conflicting preferences. Adoption of international standards can also 

signal to firms, consumers, and other groups the application of high 

regulatory standards. The tensions between local customization and 

international harmonization play out in proposals to develop common 

international rules and standards on a wide range of issues relevant to the 

investment climate. Efforts to develop uniform standards to ease 

international commerce have long been a focus of private bodies such as 

the International Chamber of Commerce. Complementary efforts at the 

intergovernmental level include those of the United Nations Commission 

on International Trade Law (UNCITRAL) and a variety of other 

international agencies.'" 

So, in this analysis, globalisation means international commerce, which in turn 

demands facilitative law, and this, it is said, is best derived from the new 

transnational commercial law, itself a product of globalisation. 

Those invoking globalisation as an explanation for the new transnational 

commercial law frequently draw inspiration from the medieval lex mercatoria, which 

evolved from the practices of the merchants as they traded at international trade 

fairs, held in the great medieval cities and ports of Europe. It was globalisation and 

globalised law, but in a different era. Berman provides an account of the 

development of what "came to be viewed as an integrated, developing system, a 

6 

body of law.' In his analysis it was a consequence of the enormous social and 

economic transformation which Europe underwent from the late eleventh and 

twelfth centuries." Its principles began initially with the merchants themselves, in 

the mercantile courts they founded.' Later, the principles spread.' 9 Some were 

compiled into codes of mercantile practice; in other instances, the mercantile courts 

themselves kept records of their decisions, which could be used in subsequent cases. 

Additionally, documents like bills of exchange and bills of lading, designed for 

particular transactions, circulated widely. 20 Among the distinctive characteristics of 

European mercantile law which Berman identifies are: 1) the distinctions between 

real and personal property and between ownership and possession; 2) the creation of 

security interests in personal property; 3) the recognition of the rights of the goodfaith 

purchaser of goods and bills of exchange; 4) the creation of documents, such as 

15. World Bank, World Development Report 2005: A Better Investment Climate for Everyone 181 

(2004). 

16. HAROLD BERMAN, LAW AND REVOLUTION: THE FORMATION OF THE WESTERN LEGAL 

TRADITION 333 (1983). 

17. Id. (emphasis omitted). 

18. See id. at 333-56. 

19. See id. 

20. See id. 



VOL. 42:597 

negotiable instruments and bills of lading, which embodied rights distinct from any 

underlying transaction; and 5) the development of new business forms such as 

partnership and the commenda (which he describes as a kind of joint stock company, 

with the liability of each investor limited). 2 ' Ultimately this medieval lex mercatoria 

lost its international character as it was incorporated into domestic law. In English 

conventional wisdom, this was a happy process because of the role of Lord 

Mansfield. 22 

The notion of a medieval lex mercatoria-globalised, objective, and based on a 

reciprocity of rights between the parties-does not bear close scrutiny. One form of 

criticism is that the lex mercatoria was never completely divorced from state power. 

In theoretical terms, this was because whatever independent merchants might want 

in regulating the terms of trade, they needed the rule of law administered by a 

national legal system to protect the market from the local ruler's whim. However 

desirable an independent mercantile law might be, merchants had to accept a 

second-best solution where mercantile and state law were fused in national courts. 23 

In historical terms, despite a widespread belief in its existence, a general lex 

mercatoria is not easy to uncover. 4 There are examples of merchants winning some 

privileges from the exercise of state power. For example, in England there were 

separate procedures for mercantile disputes apart from the common law courts; thus, 

shipping cases were handled by the separate Admiralty Court." However, until the 

great constitutional struggles of the seventeenth century, the lex mercatoria as used 

in England was apparently not a term describing a body of substantive law; rather, it 

stood for the separate judicial procedure for settling mercantile disputes. 26 The 

distinct principles of mercantile law which existed for shipping and trade were far 

from universal-the various maritime laws of Europe provided different solutions to 

the same problems. As Cordes argues, "Lord Mansfield's 'one and the same law' 

that according to him existed in all countries and at all times in an identical form did 

not exist even in the field of the maritime law of freight," which was quintessentially 

an area where it should have. 27 The body of transnational rules of law as postulated 

in the lex mercatoria can be detected only by choosing to focus on overly general 

issues." 

21. Id. at 349-50. 

22. E.g., Thomas E. Scrutton [one of England's great commercial judges], A General Survey of the 

History of the Law Merchant, in 3 SELECT ESSAYS IN ANGLO-AMERICAN LEGAL HISTORY (1909), J.H. 

Baker, The Law Merchant and the Common Law Before 1700, 38 CAMBRIDGE L.J. 295 (1979); JAMES 

OLDHAM, ENGLISH COMMON LAW IN THE AGE OF MANSFIELD 124 (2004); Christopher P. Rodgers, 

Continental Literature and the Development of the Common Law by the King's Bench: c 1750-1800, in THE 

COURTS AND THE DEVELOPMENT OF COMMERCIAL LAW 162 (Vito Piergiovanni ed., 1987); see MICHAEL 

LOBBAN, THE COMMON LAW AND ENGLISH JURISPRUDENCE 1760-1850, 109 (1991). 

23. ROBERTO UNGER, LAW IN MODERN SOCIETY 73-76 (1976). 

24. Oliver Volckart & Antje Mangels, Are the Roots of the Modern Lex Mercatoria Really Medieval? 

65 S. ECON. J. 427, 435-46 (1999). 

25. HENRY J. BOURGUIGNON, SIR WILLIAM SCOTr, LORD STOWELL, JUDE OF THE HIGH COURT OF 

ADMIRALTY 1798-1828 5-6, 59-60 (1987). 

26. GERARD MALYNES, LEX MERCATORIA OR THE ANCIENT LAW MERCHANT (1622) may be seen 

in the context of these struggles. 

27. Albrecht Cordes, The Search for a Medieval Lex Mercatoria, 5 OXFORD U. COMP. L. FORUM 9, at 

http://ouclf.iuscomp.org/articles/cordes.shtml (2003). 

28. See id.; Emily Kadens, Order Within Law, Variety Within Custom: The Character of the Medieval 

Merchant Law, 5 CHI. J. INT'L. L. 39, 40-41, 56 (2004). 


2007 


The importance of this for present purposes is that, as with commercial law in 

medieval times, globalisation may not provide a complete explanation of the new 

transnational commercial law. Certainly advocates of a modern lex mecatoria see a 

definite continuity with the medieval law merchant or at least an inspiration to be 

derived from it. 29 One of the most effective English proponents of the new lex 

mecatoria was Professor Clive Schmitthoff. Schmitthoff argued that international 

trade law developed in three stages - the medieval lex mercatoria, the period of its 

incorporation into national legal systems, and the modern period. He saw the third 

phase as a conscious and deliberate return to the international spirit of the medieval 

lex mercatoria. In this view the new lex mercatoria is global. Schmitthoff rejects the 

second, national phase of international trade law where the lawyer must resort to 

national rules in the conflict of laws to discover the law that is governing the 

contract. That was an attempt at localising an international relationship in a national 

legal setting, an approach modern thinking rejected. In Schmitthoff's view modern 

trade demanded an autonomous international trade law, founded on uniform rules 

accepted in all countries, making the localisation of a transaction in a national 

jurisdiction superfluous. This would be "a new lex mercatoria. ' 3 , 0 While Schmitthoff's 

views had been anticipated by others such as Berthold Goldman, 3 ' it was he who 

gave academic respectability to the idea in the English speaking world. 2 

A variety of scholars have taken up the cudgels for the new lex mercatoria. 

Perhaps the most active proponent today of a new lex mercatoria is Dr. Peter Berger 

of the Center for Transnational Law (CENTRAL) at the University of Cologne. In 

his book The Creeping Codification of the Lex Mercatoria, Berger argues that the 

concepts of transnational commercial law already used in contract drafting and 

dispute resolution are now being transformed into concrete principles. 3 The 

UNIDROIT Principles of International Commercial Contracts are an example? 

Berger argues that the process is gradual-the lex mercatoria is living law-and that 

the result comes not from above through formal codification but from below through 

the private work of academics and practitioners." Thus, the new lex mercatoria is a 

response to the commercial demands of globalisation. Based on Professor Berger's 

discussion in Creeping Codification, CENTRAL now has an impressive collection of 

29. LEON E. TRAKMAN, THE LAW MERCHANT: THE EVOLUTION OF COMMERCIAL LAW 30-40 

(1983). 

30. CLIVE M. SCHMITTHOFF, COMMERCIAL LAW IN A CHANGING ECONOMIC CLIMATE 20 (2d ed. 

1981); see generally J(rgen Basedow, The Effects of Globalization on Private International Law, in LEGAL 

ASPECTS OF GLOBALIZATION (Jargen Basedow & Toshyuiki Kono eds., 2000). 

31. E.g,. Berthold Goldman, "Frontires du Droit et Lex Mercatoria," Archives de Philosophie du 

Droit, 1964, 177; see also Berthold Goldman, The Applicable Law: General Principles of Law - The Lex 

Mercatoria. in CONTEMPORARY PROBLEMS IN INTERNATIONAL ARBITRATION 114-16 (Julian Lew ed., 

1987): Aleksander Goldstajn, The New Law Merchant, 1961 J. BUS. L. 12. 12. 17 (1961). 

32. See John Adams, Clive Macmillan Schmitthoff (1903-1990), in JURISTS UPROOTED; GERMAN- 

SPEAKING EMIGRt LAWYERS IN TWENTIETH CENTURY BRITAIN (Jack Beatson & Reinhard 

Zimmermann eds., 2004); THE SOURCES OF THE LAW OF INTERNATIONAL TRADE 374-76 (Clive 

Scmitthoff ed., 1964). 

33. KLAUS P. BERGER, THE CREEPING CODIFICATION OF THE LEX MERCATORIA (1998). 

34. M. Bonell, Do We Need a Global Commercial Code? 106 DICK. L. REV. 87, 98-99 (2001); see 

generally PRINCIPLES OF EUROPEAN CONTRACT LAW PARTS I AND II xxi-xxvii (Ole Lando & Hugh Beale 

eds., 2000); http://www.unilex.info/dynasite.cfm?dssid=2377&dsmid=13618&x=l. (The UNILEX website 

lists only twenty-three cases where the UNIDROIT principles have been cited as of March 1, 2006.) 

35. BERGER, supra note 33, at 210-11; Jeremy K. Sharpe, The Creeping Codification of Transnational 

Commercial Law: An Arbitrator's Perspective, 45 VA. J. INT'L L. 199 (2001). 



VOL. 42:597 

lex mercatoria principles, rules, and standards. 3 6 These are divided into fifteen 

chapters, including chapters on good faith, reasonableness, the duty to negotiate, 

damages for breach of contract, set-off, unjust enrichment, and the duty to 

compensate on expropriation. Each principle is supported by detailed references to 

scholarly writings, court decisions, arbitration awards, international conventions, and 

national laws. 37 

International commercial arbitration has been seen by some as the key avenue 

for the enunciation of the substantive rules of the new lex mercatoria." Its growth is 

partly a product of globalised trade and financial transactions. The work of the Iran- 

United States Claims Tribunal in applying general principles such as force majeure is 

also said to have contributed considerably. 39 Some critics raise both theoretical and 

practical objections to the use of the lex mecatoria as a choice of law for international 

contracts. 0 There is no need to enter that debate since the empirical evidence 

suggests that parties do not specifically apply the general principles of the lex 

mercatoria as the proper law in their arbitration agreements or, if so, do it to 

supplement rather than displace national law. 4 Thus, only one to two percent of 

clauses giving rise to ICC arbitration between 2000-2003 provided for transnational 

or other non-national law as the governing law. 42 As indicated, however, 

international arbitrators seem to use the principles of the new lex mercatoria 

increasingly in resolving difficult points arising in the course of disputes, although 

43 

there is no systematic evidence of the extent to which this occurs. 

At this point, a definitional issue arises: is the new lex mercatoria to be equated 

with the principles, rules, and standards such as those developed by Berger? At the 

outset, is Lord Mustill's critique, that such principles, rules, and standards may be 

too vague for legal analysis in the practical world of dispute resolution for the global 

commercial activity?' Then there are arguments that the Berger approach is both 

too wide and too narrow. As to the first, some would confine the term lex mercatoria 

to international trade practice which arises through transnational commercial usage. 

The issue then becomes one of identifying usage or practice which is spontaneously 

36. BERGER, supra note 33. 

37. See CENTRAL - Center for Transnational Law, available at www.central-koeln.de. 

38. E.g,. Ole Lando, The Lex Mercatoria in International Commercial Arbitration, 34 Int'l & Comp. 

L.Q.747, 747-48 (1985); see Thomas E. Carbonneau, Rendering Arbitral Awards with Reasons: The 

Elaboration of a Common Law of International Transactions, 23 COLUM. J. TRANSNAT'L L. 579, 614 

(1985); LEX MERCATORIA AND ARBITRATION: A DISCUSSION OF THE NEW LAW MERCHANT, (Thomas 

E. Carbonneau ed., rev. ed. 1998). 

39. Maurizio Brunetti, The Lex Mercatoria in Practice: The Experience of the Iran-United States 

Claims Tribunal, 18 ARB. INT'L 355,359-67 (2002). 

40. Peter Flanagan, Demythologising the Law Merchant: The Impropriety of the Lex Mecatoria as a 

Choice of Law, 15 INT'L COMPANY & COMM. L. REV. 297 (2004). 

41. Christopher R. Drahozal, Contracting out of National Law: An Empirical Look at the New Law 

Merchant, 80 NOTRE DAME L. REV. 523, 538-39 (2005); Klaus P. Berger et al., The CENTRAL Enquiry on 

the Use of Transnational Law in International Contract Law and Arbitration - Background, Procedure and 

Selected Results, in THE PRACTICE OF TRANSNATIONAL LAW (Klaus P. Berger ed., 2001) (a survey of 

practitioners' experience). 

42. BERGER, supra note 33. 

43. Id. 

44. Michael Mustill, The New Lex Mercatoria: The First Twenty-Five Years, LIBER AMICORUM FOR 

LORD WILBERFORCE 151-53 (Maarten Bos & Ian Brownlie eds., 1987); see also Bruce L. Benson, The 

Spontaneous Evolution of Commercial Law, 55 S. ECON. J. 644 (1989); Christopher R. Drahozal, 

Commercial Norms, Commercial Codes, and International Commercial Arbitration, 33 VAND. J. 

TRANSNAT'L L. 79, 94-110 (2000). 


2007 


generated in global commercial transactions. The doyen of academic commercial 

lawyers in England, Professor Sir Roy Goode, argues that the main focus of inquiry 

should not be the Berger-type principles, but rather the practices surrounding typical 

international commercial transactions. 5 

Though it is common to treat the lex mercatoria as including general 

principles of law, and I myself used to follow this approach, it seems to me 

on further reflection that these principles - for example pacta sunt 

servanda, the nemo dat rule and the duty to mitigate loss suffered from a 

breach of contract - are not particular to international trade or even to 

commercial contracts, are qualified by numerous exceptions and tell us 

nothing about the process of spontaneous lawmaking which is said to be 

the hallmark of the lex mercatoria. If we look at the lists of rules of the lex 

mercatoria propounded by modern scholars and remove from it general 

principles of law, we find that almost nothing is left, while on the other 

hand there is a conspicuous absence of references to important modern 

usages in relation to documentary credits, demand guarantees, and 

clearing and settlement systems for the transfer of funds and investment 

securities. 46 

Either way-the Berger principles or the Goode trade usage-the lex 

mercatoria is only a small aspect of the new transnational commercial law, which 

extends to the uniform principles, model laws, and international conventions already 

outlined. These are neither confined to custom and practice in global transactions 

nor the type of principles incorporated in the UNIDROIT Principles of International 

Commercial Contracts. 

Putting aside these definitional issues and taking a broad view of the new 

transnational commercial law, how is all this activity explained in theoretical terms? 

As far as the lex mercatoria is concerned, its advocates have as a prime contention 

that it is autonomous and transnational. Not only is it free from the conflicting 

principles of national law, but as a corollary, through the complexities of private 

international law, it avoids the problems of choosing between those principles. 

Berger argues that it has grown up in this way because of the trend towards a "global 

civil society," in which there is an erosion of national boundaries in markets and a 

relative decline of state power to steer national or international economic factors. 47 

The upshot is the growth of party autonomy and the privatisation of international 

commercial law-making, notably through arbitration. So the modern lex mercatoria, 

in this view, is a spillover of the complex institutional processes connected with the 

phenomenon of globalisation. 8 The codification of the lex mecatoria, as 

incorporated into uniform principles such as the UNIDROIT commercial contract 

45. Roy Goode, Usage and its Reception in Transnational Commercial Law, 46 INT'L & COMP. L.Q. 

1(1997). 

46. Roy Goode, Rule, Practice and Pragmatism in Transnational Commercial Law, 54 INT'L & COMP. 

L.Q. 539, 548 (2005); See also Goode, supra note 45, at 32-33. 

47. Klaus P. Berger, The New Law Merchant and the Global Market: A 21' Century View of 

Transnational Commercial Law, 3 INT. ARB. L. REV. 91 (2000). 

48. Id. at 100; see also Gunther Teubner, 'Global Bukowina': Legal Pluralism in the World Society, in 

GLOBAL LAW WITHOUT A STATE 40 (Gunther Teubner ed.. 1997). 



VOL. 42:597 

principles, can therefore be regarded as responding to the demand believed to exist 

amongst the business community working in this globalised environment. 

Apart from the lex mercatoria, there is the wider field of transnational 

commercial law promulgated under the auspices of bodies such as UNCITRAL, 

UNIDROIT, and the ICC. Here, harmonisation has been a typical goal, with the 

rules of different legal systems being replaced by a uniform law, which can either be 

incorporated in international contracts or adopted by national legal systems (either 

through adoption of a model law or adherence to an international convention). In 

recent times, the aim has been not only harmonization, but also to improve rules in 

situations where the national legal rules are non-existent, underdeveloped, or 

unsuitable to international transactions. 49 A good illustration of the latter is the 

Cape Town Convention on International Interests in Mobile Equipment, which is 

designed to overcome the problems of financiers obtaining a secured interest over 

what could be categorized as global assets-aircraft, railway rolling stock, and space 

assets that by their nature regularly move across national borders. The Convention 

and its attendant protocols create an international interest, recognised in all 

contracting states and registerable in a public international register, which neatly 

side-steps the diversity of national laws on secured transactions and confers on 

financiers an enforceable priority in the event of the debtor's insolvency: ° 

Outsiders to the process of formulating the new transnational commercial law 

have sometimes had a more jaded view of its application and development. For 

example, Dezalay and Garth see the lex mecatoria not so much as a response to 

globalisation but in terms of the rent-seeking, material interests of international 

arbitrators and their clients." In their analysis of the evolution of modern 

international commercial arbitration, they identified two main areas of tension. 

First, there was a struggle between those offering arbitration services - on the one 

hand was an older cadre of mainly continental academics, adherents of the lex 

mercatoria, and on the other, increasingly, Anglo-American legal practitioners, 

adherents to the doctrines and techniques of the common law. Secondly, there was a 

north-south tension: foreign investors did not want resort to local courts and law if 

disputes arose over construction and other projects but had to accommodate the 

objection of developing countries to the use of western law and courts. International 

arbitration using the lex mercatoria became the way through for both the European 

pioneers of international arbitration and for foreign investors. So the lex mecatoria 

not only permitted foreign investors to win time when confronted with the escalation 

of demands of developing countries, but also allowed its investors to preserve their 

position for a period vis-A-vis the challenge provided by Anglo-American law firms." 

49. Roy Goode, Rule, Practice and Pragmatism in Transnational Commercial Law, supra note 46, at 

556; see Jeffrey Wool, Rethinking the Notion of Uniformity in the Drafting of International Commercial 

Law: A Preliminary Proposal for the Development of a Policy-based Unification Model, 2 UNIFORM L. 

REV. 46, 46-47 (1997); Kazuaki Sono, The Rise of Anational Contract Law in the Age of Globalisation, 75 

TUL. L. REV. 1185, 1191-92 (2001). 

50. Roy Goode, The Cape Town Convention on International Interests in Mobile Equipment: a 

Driving Force for International Asset-Based Finance, 7 UNIFORM L. REV. 3, 4 (2002); Roy Goode, Official 

Commentary on the Convention on International Interests in Mobile Equipment and the Protocol thereto, on 

Matters Specific to Aircraft Equipment (2002). 

51. YVES DEZALAY & BRYANT G. GARTH, DEALING IN VIRTUE: INTERNATIONAL COMMERCIAL 

ARBITRATION AND THE CONSTRUCTION OF A TRANSNATIONAL LEGAL ORDER 41 (1996) 

52. Id. at 89; see also LEX MERCATORIA AND ARBITRATION, supra note 38. 


2007 


In this account the time of the lex mercatoria is coming to an end as the "European 

pioneers" are being replaced by the Anglo-American law firms. 3 

Similarly, the forces behind the cluster of international conventions, model 

rules, and principles can be seen in a more materialistic light. Thus, the "political 

economy" of the Cape Town Convention on International Interests in Mobile 

Equipment includes the privatisation of many national airlines, and some railways, 

with finance increasingly from private rather than state sources and the consequent 

demand by global financial institutions for recognition and protection of their 

secured interests in such high value assets. It is said that in the process leading to the 

Convention, interest groups representing industry, especially the aviation industry, 

were particluarly active." In this account, their involvement led to "bright line" rules 

in the Aircraft Protocol protective of secured interests. The danger is said to be a 

perception that the rules fit the preferences of the more powerful nations likely to be 

host to the banks providing secured finance." 

While there is an element of truth in this type of analysis, it certainly does not 

stand up in its entirety. In relation to the lex mercatoria, there is a plausibility to the 

argument that those practicing as international commercial arbitrators need to 

attract work. Whether expertise in the lex mercatoria was ever the way of doing this 

is open to argument unless it is seen as just one part of the arbitrator's reputation. 

Moreover, any argument that the lex mercatoria was used as the way of meeting 

developing-country demands does not fit some important facts, such as the regular 

appearance of English and New York law as the governing law of investment and 

finance contracts involving those countries. As to the forces behind international 

conventions, model laws, and statements of principle, there is certainly a case for 

closer inquiry of the process in this important area of law-making. This paper is one 

attempt at doing that. But if, say, the aviation industry had a heavy input into the 

Aviation Protocol of the Cape Town Convention, that should not be a surprise nor 

necessarily a cause for condemnation. If a commercial instrument is to meet its 

professed aim, then those most affected by its operation need to be part of the 

process of formulating it. What is necessary is that the process must be transparent 

and must accord all interests an opportunity to have an influence. With international 

commercial lawmaking, the input of developing counties is especially important, not 

least if an instrument is to have legitimacy and be widely adopted. 

II. 

THE RULE OF LAW AND ITS CONSEQUENCES 

That the rule of law has prominence in the so-called Washington consensus is in 

part a response to the changes associated with the process of economic globalisation, 

6 

the spread of democracy, and the enhanced authority of international human rights. 

In recent decades, a conventional wisdom has also evolved linking the rule of law 

53. DEZALAY & BRYANT, supra note 51, at 89. 

54. Iwan Davies, The New Lex Mercatoria: International Interests in Mobile Equipment, 52 INT'L & 

COMP. L.Q. 151, 162 (2003). 

55. Id. at 175. 

56. Julio Faundez, The Rule of Law Enterprise: Promoting a Dialogue Between Practitioners and 

Academics, 12 DEMOCRATIZATION 567,568 (2005). 



VOL. 42:597 

with economic growth, sustainable development, and poverty alleviation. 7 

Multilateral financial institutions like the World Bank, regional development banks 

like the Asian Development Bank, and some industry organisations and NGOs 

advocate for national principles of good governance, including a legal system of a 

type associated with the rule of law." It is said that law can have an impact on 

development by facilitating economic activity through encouraging savings and 

assisting in the allocation of capital." It can do this by having predictably 

transparent and enforceable rules for the economy, which ensure well-functioning 

and regulated markets, appropriate business forms with high standards of corporate 

governance, and efficient methods for dealing with default and insolvency in markets 

and businesses.6 Government subject to law is part of the equation, to guarantee 

that insiders cannot use state power to trump arbitrarily property and contractual 

rights recognised by law. 6 

In modern accounts, the rule of law has both procedural and substantive 

aspects-a legal system with an independent, impartial, and non-corrupt judiciary; 

laws that are clear, publicly available, and in accordance with the constitution and 

human rights; and an accessible, efficient court system which protects contractual, 

property, and human rights and provides for judicial review of government action. 62 

Some like Professor Armartya Sen would contend that rule of law reform along 

these lines must be valued in itself as part of the development process, not just for 

the way it may aid economic or any other type of development. 63 Another line of 

argument is that rule of law reforms by themselves are only part of the story. For 

development to occur, what is also needed is legal empowerment of the 

disadvantaged, which will benefit them in a broad array of fields that may not have a 

strict legal dimension, such as education, public health promotion, and agriculture.' 

Both glosses on the basic argument have great force. 

Even if all this is accepted, there is still the difficulty of identifying what follows 

from rule of law analysis in relation to specific laws, particularly commercial laws. 

Many of the early advocates of rule of law for promoting economic development 

were economists, so it is not surprising that their concern with legal detail was 

minimal. Early on, their focus was technical assistance for reform of the 

infrastructure and administration of courts and judicial training. Suffice to say that, 

in relation to commercial law, what has happened is that the new transnational 

commercial law has generally been accepted as containing the prescriptions 

necessary for domestic reform consistent with the rule of law model. This should not 

57. There is a growing body of literature about economic growth that is "pro-poor." See Martin 

Ravallion, Pro-Poor Growth: A Primer (World Bank Policy Research Working Paper 3242, 2004). 

58. E.g., Ibrahim F. I. Shihata, Democracy and Development, 46 INT'L & COMP. L.Q. 635 (1997); 

Thomas Carothers, The Rule of Law Revival, 77 FOREIGN AFF. 95 (1998); Promoting the Rule of Law 

Abroad, (Carnegie Endowment, Democracy and Rule of Law Project, Working Paper No. 34, 2003). 

59. Richard A. Posner, Creating a Legal Framework for Economic Development, 13 WORLD BANK 

RESEARCH OBSERVER 1 (1998). 

60. Id. at 1 (1998). 

61. Id. 

62. E.g., Paul P. Craig, Formal and Substantive Conceptions of the Rule of Law, 1997 PUB. LAW 467 

(1997); T.R.S. ALLAN, CONSTITUTIONAL JUSTICE (2001); William Whitford, The Rule of Law, 2000 WIS. 

L. REV. 723 (2000). 

63. AMARTYA SEN, DEVELOPMENT AS FREEDOM 37 (1999). 

64. Legal Empowerment: Advancing Good Governance and Poverty Reduction 8 (Asian Development 

Bank RETA 5856, 2001). 


2007 


be surprising when important components of the new transnational commercial law 

have been generated under the auspices of rule of law advocates like the World 

Bank. Whatever the defects of some of the analysis, the rule of law matters. That 

means that along with a transparent and democratic political system, efficient 

bureaucracy, and developed public institutions, reforms in the commercial sector 

which will encourage investment, reduce corruption and cronyism, and generally 

contribute to social and economic development." So what is the evidence that law 

matters-that the effort to give legislative force to the prescriptions of the new 

transnational commercial law is worthwhile? 

There is some historical evidence of a link between the rule of law and 

economic development.' Over the last decade, there have also been a number of 

large, cross-country studies which, by using proxies for rule of law measures such as 

the quality of legal institutions, lend support to the thesis. 67 Yet it is no use 

pretending that the relationship between rule of law reform and economic 

development is simple; as always, real world contingency must be taken into account. 

It may be that, in some respects, it is economic development which facilitates a 

better-functioning legal system or that factors such as investment or political change 

move both economic development and legal reform in the same direction.' Another 

difficulty with the rule of law-economic development causation is identifying the 

relevant factors in the relationship. Is the key to economic growth the symbolic 

value of new law on the books, or is the effectiveness in practice of legal institutions, 

such as commercial law as practiced and market and financial regulation, more 

significant? Is governmental accountability, not least through the courts, a necessary 

element of the rule of law, and if so, how do we explain the East Asian model of 

economic development (best exemplified these days by China)? 6 There is also the 

puzzle of foreign investors, who are important in bridging the gap between 

investment and savings. While they may say that they desire a legal system with a 

clear framework for contracting, one which both protects property-including 

intellectual property rights-and provides for the timely resolution of disputes; in 

practice, the existence of business opportunities means that they may invest heavily 

in countries where these basic features of the rule of law are absent." 

65. On the earlier law and development movement, see David Trubek & Mark Galanter, Scholars in 

Self-Estrangement: Some Reflections on the Crisis in Law and Development, 1974 Wis. L. REV. 1062 (1974); 

Brian Z. Tamanaha, Review Article: The Lessons of Law-and-Development Studies, 89 AM. J. INT'L. L. 470 

(1995): Julio Faundez, Legal Technical Assistance, in GOOD GOVERNMENT AND LAW, 1 (Julio Faundez 

ed., 1997). 

66. E.g., P.S. ATIYAH, THE RISE AND FALL OF FREEDOM OF CONTRACT (1979); DOUGLAS NORTH, 

INSTITUTIONS, INSTITUTIONAL CHANGE AND ECONOMIC PERFORMANCE (1990); KATHARINA PISTOR & 

PHILIP A. WELLONS, THE ROLE OF LAW AND LEGAL INSTITUTIONS IN ASIAN ECONOMIC DEVELOPMENT 

1960-1995 (1999). 

67. See Rafael La Porta et al., Legal Determinants of External Finance, 52 J. FIN. 1131 (1997); Rafael 

La Porta et al., Law and Finance, 106 J. POL. ECON. 1113 (1998). 

68. Richard E. Messick, Judicial Reform and Economic Development: A Survey of the Issues. 14 

World Bank Resource Observer 117,122 (1999). 

69. See Frank K. Upham, Mythmaking in the Rule of Law Orthodoxy, (Carnegie Endowment for 

International Peace, Rule of Law Series, Working Paper No. 30, 2002); Carol A. G. Jones, Capitalism, 

Globalization, Rule of Law, 3 SOC. & LEGAL STUDIES 195 (1994). 

70. Amanda Perry-Kessaris, Finding and Facing Facts About Legal Systems and Foreign Direct 

Investment in South Asia, 2003 LEGAL STUDIES 649, 651-52 (2003). 



VOL. 42:597 

Moreover, the law's contribution to development in practice is a long-term and 

tortuous process. As a matter of public policy, it demands a sensitivity to its inherent 

limits, the context in which it operates, and the force of other social and economic 

factors. 7 ' There is always the potential for unintended consequences. A helpful 

illustration pertinent to the issue of credit and security law is provided by the 

colonial courts in India, which were superimposed on a system where informal 

sanctions operated in rural areas to guarantee the repayment of credit, but which 

also encouraged money-lenders to carry debtors in difficult times. In one account, 

new creditors, with access to the enforcement mechanisms of the colonial courts, 

entered the market and forced down margins, which in turn reduced the capacity of 

local money-lenders to accommodate debtors in difficulty. 7 The same unintended 

consequences are bound to occur in certain contexts on the domestic adoption of the 

new transnational commercial law. 

How the law actually operates is at least as important as the law in the books. 

Using law such as commercial and financial law for utilitarian ends means 

acknowledging, for example, the importance of non-state norms such as commercial 

custom, informal methods of social control, and alternative mechanisms of dispute 

resolution. Also, it should not be forgotten that the law's outcomes are not valuefree 

and that the law can be part of the struggle for power in society. Protecting 

contractual and property rights may simply shield what a powerful, and possibly 

corrupt, elite have seized under the cover of state power. Even more benign 

societies recognize the need for legislative controls and well-oiled regulatory 

agencies to curb the abuses associated with free contracting and markets. Apart 

from equity concerns, the state must police markets to curb corrupt and predatory 

practices which undermine their very integrity. Additionally, creating a system 

which works for private economic interests does not mean overlooking values such 

as equality before the law, the wider public interest, and protecting the more 

vulnerable in society. 

III. THE POWER OF THE MARKET 

Financial markets respond favourably to whether a society controls public debt 

and inflation, restricts state control of enterprises, and facilitates rather than hinders 

foreign trade. Legal categorisation of a society can also affect market perceptions. 

Consider the rather simplistic characterisation of legal systems along a spectrum 

from pro-creditor to pro-debtor. 3 The more pro-creditor a society, the more 

favourable the market perceptions become, which can lead internationally to greater 

foreign investment and economic activity. The nature of a country's commercial and 

financial laws is an important factor affecting where a country falls along the 

spectrum. Adoption of many of the prescriptions of the new transnational 

commercial law, despite the regulatory bent of some of it, would generally move a 

country along the spectrum in the pro-creditor direction. The World Bank's 

guidelines on insolvency and creditor rights are a good illustration. Take, as an 

71. Patrick McAuslan, Path Dependency, Law and Development, 1 J. COMMONWEALTH L.& LEGAL 

ED. 51,58 (2001). 

72. Rachel E. Kranton & Anand V. Swamy, The Hazards of Piecemeal Reform: British Civil Courts 

and the Credit Market in Colonial India, 58 J. DEV. ECON. 1, 12-15 (1999). 

73. See Rafael La Porta et al., Legal Determinants of External Finance, supra note 80; Rafael La Porta 

et al., Law and Finance, supra note 80. 


2007 


aspect, the provision of credit, in particular the role of security (collateral) in 

facilitating this. Broadly, secured transactions law gives creditors and investors a 

priority claim against the debtor's property (the collateral) should the debtor be 

unable or unwilling to pay in accordance with the credit or investment contract. The 

nature of an effective security law for an economy is advanced in the World Bank 

Guidelines in this way: 

The legal framework should provide for the creation, recognition, and 

enforcement of security interests in movable and immovable (real) property, arising 

by agreement or operation of law. The law should provide for the following 

features: 

Security interests in all types of assets, movable and immovable, tangible 

and intangible, including inventory, receivables, and proceeds; future or 

after-acquired property, and on a global basis; and based on both 

possessory and non-possessory interests; 

Methods of notice that will sufficiently publicize the existence of security 

interests to creditors, purchasers, and the public generally at the lowest 

possible cost; 

Clear rules of priority governing competing claims or interests in the same 

assets... 

Enforcement procedures should provide for prompt realization of the 

rights obtained in secured assets, ensuring the maximum possible recovery 

of asset values based on market values. Both nonjudicial and judicial 

enforcement methods should be considered. 74 

As we see below, the force of the guidelines is enhanced by their use by the 

IMF and World Bank as international best practice in financial sector assessments of 

individual countries. A recent study of the Asian Development Bank underlines the 

importance of small- and medium-sized enterprises to sustainable economic growth. 75 

It argues that the key to their success is access to readily available, cheap, long-term 

74. World Bank, Principles and Guidelines for Effective Insolvency and Credit Rights Regimes, excerpt 

in [2003] World Bank Leg R627, Principles 3 & 5; see also U.N. Comm. on Int'l Trade Law, Working 

Group 6 Security Interests. Draft Legislative Guide on Secured Transactions A/CN.9/WG.VI/WP.24/Add. 2 

(Nov. 24, 2005); Spyridon V. Bazinas, UNCITRAL's Work in the Field of Secured Transactions, in 

EMERGING FINANCIAL MARKETS AND SECURED TRANSACTIONS (Joseph Norton & Mads Andenas eds., 

1998). 

75. Ross Cranston. Credit Security and Debt Recovery: Law's Role in Reform in Asia and the Pacific, 

in EMERGING FINANCIAL MARKETS AND SECURED TRANSACTIONS (Joseph Norton and Mads Andenas 

eds., 1998). 



VOL. 42:597 

credit that turns on a legal framework enabling small borrowers to give security over 

their movable property; unlike larger enterprises, they are less likely to be able to 

offer land and buildings as security. 76 That security must be readily enforceable on 

default. 

Enhancing creditors' rights in this way has considerable intuitive appeal. That 

security rights under credit and investment agreements are readily enforceable, 

possibly without resort to the court, means that lenders and investors can more 

accurately manage and control the risk of default. It encourages discipline on the 

part of debtors. Disputes are more readily resolvable in the shadow of the law. By 

contrast, if enforcement of a credit or investment contract is doubtful, creditors and 

investors cannot price the risk of default accurately. A premium needs to be 

extracted to compensate for the uncertainty or for the risk of non-performance. In 

some cases, the confidence of creditors and investors may be so eroded that credit is 

altogether unavailable." 

Perhaps the best example in the legal literature of a categorisation of legal 

systems in a manner relevant to market perceptions has been advanced by Philip 

Wood. Beginning in 1995, Wood developed a comprehensive and sophisticated 

analysis that eschews a simplistic pro-creditor/pro-debtor division and instead 

divides the financial law world according to five key criteria: 1) the availability of 

insolvency set-off; 2) the marketability of contracts, receivables, and claims; 3) the 

availability and scope of security interests; 4) the availability of the commercial trust; 

and 5) whether tracing delinquent money is possible. 8 Wood concedes that his 

mapping is not exact, is in some respects incomplete, and relies to an extent on 

subjective judgment. 79 Nonetheless, he says that the differences between 

jurisdictions are striking. ° The criteria are tested mainly on insolvency and go to the 

efficiency of the financial system, the extent to which risks are reduced, and whether 

the legal system facilitates economic development. 8 ' Wood concludes, 

controversially, that the traditional Napoleonic systems are negative on all of these, 

the Roman-Germanic systems are negative on just over half of them and positive on 

the other half, and the Anglo-American systems are positive on all five. 82 While he 

concedes substantial similarities across large areas of law, on these five aspects of 

commercial law, there still remain significant differences. 3 

Not surprisingly, given the huge task which would be involved, Wood's 

taxonomy does not include the impact of the rules, their actual implementation, or 

compliance with them in practice. 8 ' Of course, laws in themselves have symbolic 

significance. Yet in any society, law works against a background of social factors. 

Unless this context is taken into account, the workings of the law will not be properly 

understood, and efforts at reform will be misguided. One aspect is that a problem 

might not lie in inadequate laws or legal procedures but in the way law is enforced or 

76. Id. 

77. Barry Adler, Secured Credit Contracts, in 3 NEW PALGRAVE DICTIONARY OF ECONOMICS AND 

THE LAW 405 (Peter K. Newman ed., 1998). 

78. PHILIP R. WOOD, PRINCIPLES OF INTERNATIONAL INSOLVENCY 10-12 (1995). 

79. Id. 

80. Id. 

81. Id. 

82. Id. 

83. See id. at 59. 

84. See generally WOOD, supra note 78, at 13. 


2007 


operates in a society. Thus, it is well known that in Japan, litigation is relatively rare, 

and parties seek to avoid court." 5 This could mean that it is more likely that when, 

say, a borrower is having difficulty repaying, a Japanese bank may not invoke the 

very wide powers conferred on it by the loan agreement. Rather, the borrower 

might receive visits from the bank and find its freedom of action curtailed as the 

bank prescribes a remedial course. Whether this has also resulted in Japanese banks 

implicitly promising to rescue troubled but viable firms-the conventional wisdom 

86 

now under fierce challenge-is beyond the scope of the present inquiry. 

Regarding law reform, what will be needed is a careful and painstaking 

identification of the problems in a particular jurisdiction and the possible legal 

solutions. There will be no easy answers. Sensitivity to the context of the law is 

essential. A blanket introduction of "pro-creditor" laws without taking this into 

account could result in yet more ineffective laws. Indeed, it could well be 

counterproductive: schemes, both simple and sophisticated, will be devised to avoid 

their impact, and in extreme cases courts will simply refuse to apply what they see as 

draconian laws in their impact on debtors, further undermining the rule of law. And 

there will also be social justice issues if adequate protections are not incorporated 

into creditor laws, notably in favour of consumer debtors. 

There can be little doubt that perceptions of whether a country is pro-creditor 

or pro-debtor, or where they fall along the spectrum in more sophisticated analyses 

like Wood's feed into decisions by international markets, especially foreign investors 

and lenders. Rating agencies, so important in channelling international capital, are 

one influence and have some version of a pro-creditor or pro-debtor model as part 

of their assessment processes. This is reinforced by FSAP and ROSC assessments of 

countries by the IMF and World Bank. 7 The Financial Sector Assessment Program 

(FSAP) involves the IMF and World Bank working together to prevent financial 

instability in one country threatening others. To do this, a system of benchmarks is 

used as an early warning mechanism-at an international level, as minimum 

standards for transparency, market efficiency, and financial discipline-and at a 

national level to guide policy reform. Countries are then evaluated against the 

benchmarks in Reports on the Observance of Standards and Codes (ROSCs); 

among the benchmarks are some of the key parts of the new transnational 

commercial law. 8 

From the academic point of view, pro-creditor/pro-debtor mapping is a useful 

heuristic device in considering the issues that any national system of commercial law 

must address. Recall that in practice it will be difficult to place a country accurately; 

recall also that the purpose of the exercise is not to make moral judgments, but to 

isolate problems and then to suggest possible legal reforms; recall that a legal 

85. E.g., CARL F. GOODMAN, THE RULE OF LAW IN JAPAN (2003), 230-32; Yukiko Hasebe, Civil 

Justice Reform: Access, Cost and Expedition. The Japanese Perspective, in CIVIL JUSTICE IN CRISIS 248 

(Adrian Zuckerman ed. 1999). 

86. E.g., Yoshiro Miwa & J. Mark Ramseyer, The Myth of the Main Bank: Japan and Comparative 

Corporate Governance, 27 L. & SOC. INQUIRY 401 (2002). 

87. Duncan E. Alford, Core Principles for Effective Banking Supervision: An Enforceable 

International Financial Standard? 28 B.C. INT'L & COMP. L. REV. 237, 273-74 (2005) (extensive information 

about the International Monetary Fund's Financial Assessment Programme); see The World Bank Group, 

Reports on the Observance of Standards & Codes (ROSC), available at www.worldbank.org/ifa/rosc.html 

(details of the "Report on Observance of Standards and Codes"). 

88. Id. 



VOL. 42:597 

system's economic effectiveness may actually decline if it becomes too "procreditor"; 

and recall, finally, that social justice issues cannot be ignored. Despite 

these qualifications, issues such as the free transfer of contracts and receivables are 

crucial if the law is to respond flexibly to new methods of financing and doing 

business. This is equally true with respect to important parts of the package of 

measures falling under the rubric of the new transnational commercial law. 

IV. 

IMPLEMENTING THE NEW TRANSNATIONAL COMMERCIAL LAW 

Some aspects of the new transnational commercial law need to be adopted by 

private parties if they are to be effective. For decades banks have incorporated the 

Uniform Customs and Practice for Documentary Credits, issued by the International 

Chamber of Commerce, into their standard documentation for letters of credit. 

Similarly, UNIDROIT's Principles of International Commercial Contracts will need 

to be referred to in international contracts as the proper law if they are to be 

invoked on a regular basis in international commercial arbitration. Otherwise, 

although an international arbitrator may still refer to the Principles as guidelines, he 

will have a difficult task of overtaking national systems of law as the key factors in an 

arbitrator's decision making. 9 Before the bulk of the new transnational commercial 

law can take effect, however, it needs to be adopted legislatively in domestic 

jurisdictions. For example, private parties have only limited scope to choose the 

insolvency or regulatory law to govern their transactions. 

What has been said already militates against a notion that economic 

development follows from a blind legislative adoption into domestic law of the 

standards, codes, and principles of the new transnational commercial law. It cannot 

be assumed that their introduction will automatically occasion economic stability, 

facilitate sophisticated economic transactions, foster the establishment of complex 

enterprises, or further the resolution of legal disputes. This is quite apart from the 

adverse reaction which could follow as a result of transplantation of these models 

being interpreted as a form of neo-colonial domination. Ideally, an incremental 

approach is desirable, drawing on theory and international best practice, and over 

time melding the prescriptions of the new transnational commercial law to local 

conditions in the light of accumulated experience. 9 " In many cases, copying foreign 

models is unavoidable because of the pressure of time, the lack of expertise, and the 

demands of outside interests for immediate action. 91 It might also be that a window 

of opportunity for fundamental law reform presents itself; the ideal in these 

circumstances is a counsel of perfection and will thus miss this window of 

opportunity. 

At the level of theory, Montesquieu argued that it was unlikely that the laws of 

one nation would suit another, given the variety of environmental factors making up 

89. Anthony S. Winer, The CISG Convention and Thomas Franck's Theory of Legitimacy, 19 Nw. J. 

INT'L L. & Bus. 55, 55-56 (1998); see also THOMAS M. FRANCK, THE POWER OF LEGITIMACY AMONG 

NATIONS (2002). 

90. See generally Ann Seidman & Robert B. Seidman, Using Reason and Experience to Draft Country- 

Specific Laws, in MAKING DEVELOPMENT WORK (Ann Seidman et al. eds., 1999). 

91. Thomas W. Walde & James L. Gunderson, Legislative Reform in Transition Economies: Western 

Transplants: A Short-cut to Social Market Economy Status?, in MAKING DEVELOPMENT WORK, 92-95 

(Ann Seidman et al. eds., 1999). 


2007 


"the spirit of the law." 92 In a more modern account, Professor Otto Kahn-Freund 

thought it possible to transplant law, but emphasised the very great difficulties. 93 

Factors, which in his account are especially important, are political institutions, 

ideologies, and the power structure. 4 Professor Alan Watson's contrary thesis is that 

transplants can readily be made. 95 The law has a strong autonomy from societal 

forces, such as the culture of the legal elite-legislators, jurists, or judges-who have 

control of the accepted mechanisms of legal change. Watson accepts that although 

legal institutions will not exist without corresponding social institutions, law evolves 

from the legal tradition rather than the social context. 9 6 Lending support to 

Watson's view are Roman law and other major episodes of legal transplantation: 

Napoleon carried his code to other parts of Europe; in the nineteenth and first part 

of the twentieth century, imperial powers, like Britain, took their laws to other parts 

of the world, like India; and in recent decades, as we have seen, international 

financial institutions like the World Bank have successfully marketed their models to 

developing and emerging economies. 

So at a purely formal level, law can be transplanted. The obvious issue is: does 

a transplanted law become living law, and if so, how? There are no easy answers. 

Taxonomies in which certain families of law transplant efficiently and other 

ineffectively are not especially convincing. 97 Nor are some of the massive empirical 

studies that give them some support. What can be said is that a transplanted law is 

changed in use: it will be transformed through interpretation and application, and 

amended formally to take in local conditions. Secondly, whatever the law, 

commercial activity goes on. Thus, in England and the United States, informal 

norms, as with commercial customs, have always been part of the working of the law. 

In some situations, transplanted law may have a greater chance in some areas, in 

particular the investment and financial sectors, because receptivity and demand are 

present, especially among foreign investors. 8 But commercial laws which trench on 

rights in the wider community may be more likely to be resisted. The examples of 

security and insolvency law fall into this category if they threaten employees' 

continued employment in a jurisdiction which has comparatively little in the way of a 

social security system. Nonetheless, criminal and family laws have been successfully 

transplanted, even those laws which were initially forced onto a jurisdiction. 99 Such 

transplants may have had a catalytic effect. It seems that the positive attitude of 

92. J.W.F. ALLISON, A CONTINENTAL DISTINCTION IN THE COMMON LAW 12-13 (1996). 

93. Otto Kahn-Freund, On Uses and Misuses of Comparative Law, 37 MOD. L.REV. 1, 7-10 (1974). 

94. Id.; see also Andrew Rosser, The Political Economy of Institutional Reform in Indonesia, in LAW, 

CAPITALISM AND POWER IN ASIA: THE RULE OF LAW AND LEGAL INSTITUTIONS (Kanishka Jayasuriya 

ed., 1999). 

95. ALAN WATSON, THE EVOLUTION OF LAW 119 (1985). 

96. Id.; see also ALAN WATSON, SOCIETY AND LEGAL CHANGE 98-111 (2d ed. 2001). 

97. See generally Daniel Berkowitz et al., Economic Development, Legality and the Transplant Effect, 

47 EUR. ECON. REV. 165 (2003); see also Ugo Mattei, Efficiency in Legal Transplants: An Essay in 

Comparative Law and Economics, 14 INT'L REV. L. & ECON. 3 (1994); Ugo Mattei, Three Patterns of Law: 

Taxonomy and Change in the World's Legal Systems, 45 AM. J. COMP. L. 5 (1997); Malcolm D. H. Smith, 

Comparative Law and Legal Culture, 15 BOND L. REV. 20 (2003). 

98. Frederick Schauer, The Politics and Incentives of Legal Transplantation (Center for International 

Development at Harvard University, Working Paper No. 44, 2000). 

99. Andrew Harding, Global Doctrine and Local Knowledge: Law in South-East Asia, 51 INT'L & 

COMP. L.Q. 35. 44-45 (2002). 



VOL. 42:597 

local and legal elites cannot be underestimated.lw In all, the transplant of law is a 

very mixed picture, but context cannot be underestimated. 

V. CONCLUSION 

My argument is that there are legal theories which help explain some aspects of 

the emergence and adoption of modern transnational commercial law. They cannot 

explain the full picture by any means. The efforts of bodies like UNCITRAL, 

UNIDROIT, and the World Bank have at base a concern with solving practical 

problems in transnational commercial law, particularly where globalisation creates 

gaps in the ability of national legal systems to solve them. There are many examples, 

but perhaps the best in recent times is the way the Cape Town Convention addresses 

a modern problem of how financiers and investors can take effective security over 

valuable, privately and state-owned mobile property such as aircraft, railway stock, 

and space assets like satellites. The work of the International Monetary Fund over 

the years in relation to central banking law-and more recently that of the Basel 

bodies with respect to the adequate supervision of the financial sector-the core 

principles for effective bank supervision and the rules for capital adequacy and 

sound risk management of banks can be seen broadly as motivated by a pragmatic 

concern with the stability of the international financial system, risk reduction, and 

efficiency. 1 1 

As we have seen, there are examples of standards from the new transnational 

commercial law suggested for adoption in domestic legal systems, consistent with the 

rule of law and pro-creditor/pro-debtor models. The World Bank, the International 

Monetary Fund, and regional development banks like the Asian Development Bank 

have all been engaged in this work. It is natural to consider carefully international 

commercial law having its pedigree in such a model. The forces behind the 

provisions consequently spun off, and their impact may be reasons for pause. 

Another may be the point already made that however splendid these laws may be 

"on the books," they may simply be an illusion of progress if there is not the 

administrative machinery to give them force in practice. Perhaps most important are 

social justice issues such as the protection of consumers and employees. If these 

concerns are addressed, however, it can be strongly argued that important aspects of 

the new transnational commercial law are as important for the poor as for others. In 

his book The Mystery of Capital, Professor Hernando de Soto observes that in 

developing countries, although the poor may have capital such as growing crops or 

possibly land, it is "dead" economically-it lacks adequate legal protection and, 

crucially, cannot be used as collateral for credit."" Access to ready finance is the 

preserve of the elite. Modern laws relating to credit and security are therefore 

needed.' 3 Whether so benign a view of the new transnational commercial law can be 

taken in general as opposed to this one example, depends in every case on the 

100. Frank B. Cross, Law and Economic Growth, 80 TEx. L. REV. 1737, 1774 (2002). 

101. E.g., JOSEPH J. NORTON, DEVISING INTERNATIONAL BANK SUPERVISORY STANDARDS (1995); 

GEORGE A. WALKER, INTERNATIONAL BANKING REGULATION: LAW, POLICY AND PRACTICE (2001); 

Mamiko Yoko-Arai, Financial Stability Issues: The Case of East Asia (2002). 

102. Id. 

103. HERNANDO DE SOTO, THE MYSTERY OF CAPITAL: WHY CAPITALISM TRIUMPHS IN THE WEST 

AND FAILS EVERYWHERE ELSE (2000). 


2007 THEORIZING TRANSNATIONAL COMMERCIAL LAW 617 

circumstances. Each measure must be tested not only in terms of its contribution to 

economic development, but also to social justice. 



Developing a New Commercial Court in 

Ghana 

KOFI DATE-BAH* 

There has been a demand in Ghana for a Commercial Court for a long time. 

Indeed, while at the Commonwealth Secretariat in London, I led a team (in 1995-96) 

to undertake a diagnostic survey of the Ghanaian legal system with a view to 

identifying impediments to the development of the private sector. That team also 

came to the conclusion that a Commercial Court needed to be established for 

Ghana.' 

The Judiciary of Ghana responded to the growing pressure for a Commercial 

Court by establishing one in 2005.2 Judicial power is vested exclusively in the 

Judiciary under the Constitution of Ghana.' Accordingly, the Judiciary had the 

right, without primary legislation, to establish a Commercial Division of the High 

Court, the High Court being a constitutionally established superior court. The High 

Court in Ghana, as in England, is a court of first instance with unlimited jurisdiction. 4 

The current High Court is descended from a colonial High Court by which the 

British administration sought to replicate the English High Court in the Ghanaian 

jurisdiction. 

The establishment of the Commercial Court as a High Court was a step in the 

process of reforming the judicial sector. There has been such widespread 

dissatisfaction with the justice system in Ghana that the Government established the 

Legal/Judicial Sector Reform Project about a decade ago. One of the results of this 

Project was the establishment of an automated Fast Track Division of the High 

Court of Ghana to expedite the hearing of suits. To illustrate the need for this 

reform, it is useful to draw attention to the following passage from the Diagnostic 

Report of the Commonwealth Secretariat team of 1995-96: 

A.1. The time taken by judicial processes has been a source of complaint 

by business people in Ghana for a long time. The perception is not held by 

* Justice of the Supreme Court of Ghana. 

1. Economic and Legal Advisory Services Division of the Commonwealth Secretariat [ELAS], 

Diagnostic Survey of Laws Affecting Private Sector Development in Ghana: A Selective Analysis (on file 

with author) [hereinafter ELAS Report]. 

2 Republic of Ghana Budget Statement and Economic Policy of the Government of Ghana (Feb. 21, 

2002) at 118-22, available at http://siteresources.worldbank.orgIGHANAEXTN/Resources/bud2002.pdf. 

3. CONSTITUTION OF THE REPUBLIC OF GHANA (1992), available at 

http://www.parliment.gh/const-constitution.php. 

4. Id. §130. 

5. See Supreme Court Ordinance 1876 of the Gold Coast Colony, reprinted in LAWS OF THE GOLD 

COAST (1937). 



VOL. 42:619 

business people alone; it is found with persons from all walks of life who 

have sought the assistance of the courts in the resolution of their disputes. 

A.2. At the outset, it must be pointed out that the complaint is not 

directed at the intellectual content or correctness of judgments of the 

courts. No question has been raised about the basic fairness or justice of 

judicial decisions. The persistent complaint is over delays in the 

dispensation of justice. The causes of dissatisfaction are many and various: 

examples are the operation (and, in some cases the substance) of the 

procedural rules, especially the opportunities they give for obstruction and 

adjournment; the inability of court bailiffs, sometimes in incredible 

circumstances, to serve writs or other court process on parties to court 

actions; the manual recording of court proceedings, especially the evidence 

at a hearing; the number of judicial officers staffing the courts; the lack of 

specialised knowledge by the judges of the world of business; judicial 

working hours and the length of the legal term; the time judges take over 

the writing of their judgments; the quality and numbers of support staff; 

and the lack of appropriate equipment and their users for expedition of 

the judicial process. 6 

The automated Fast Track Division of the High Court of Ghana was 

established to enable modern information and communication technology to be 

applied to its processes and to relieve its judges from the drudgery of manual 

recording of evidence in long hand. 

After the Fast Track Courts had been imbedded into the judicial system, it 

became clear that the next step in the improvement in the justice delivery system 

should be the establishment of a commercial court to enhance the relevance of the 

judicial system to the business community. Accordingly, the Ghana Judiciary sent a 

delegation, sponsored by DANIDA, the Danish development agency, to Tanzania in 

November 2002 to observe the Tanzanian Commercial Court which had been 

established a few years before. 7 This mission, led by Justice Acquah, a Justice of the 

Supreme Court who later became the Chief Justice, was impressed by the Tanzanian 

precedent and, on its return, recommended the establishment of a Commercial 

Court in Ghana. 

Among the recommendations made by the mission on its return were the 

following: 

* Six High Courts should be set aside to constitute the Commercial Court 

of Ghana; 

* The Commercial Court should handle general commercial disputes 

involving investments, tax, and banking matters, among others; 

* Special rules should be enacted for the use of the Commercial Court; 

* Alternative Dispute Resolution processes should be integrated into the 

adjudication process of the Court; 

6. ELAS Report, supra note 1. 

7. Judicial Service of Ghana, Mission to Tanzania. 


2006 

DEVELOPING A NEW COMMERCIAL COURT IN GHANA 

" Judges and supporting staff should be selected immediately to undergo 

training; and 

* Information and communication technology, including the use of audio 

recording, should be integrated into the court's processes.' 

These recommendations were accepted by the Judicial Service and 

implemented. DANIDA provided support to the implementation process. 9 It 

funded a study tour by the six High Court judges selected to start the Commercial 

Court and their key support staff."' The tour took the selected judges to Tanzania, 

Uganda, Denmark, and the United Kingdom. The judges inspected the operations 

of the commercial courts in these countries and interacted with their judges and 

other staff. DANIDA also funded the construction of a modern purpose-built 

courthouse for the Commercial Court." The Commercial Court was formally 

commissioned by the President of Ghana on March 4, 2005, and is now in 

operation. 2 

The court known as the Commercial Court is technically the Commercial 

Division of the High Court of Ghana. Its judges are therefore High Court judges. 

However, the new civil procedure rules for the High Court, which came into force on 

January 3, 2005, enacted some special rules which are applicable only to the 

Commercial Court. 3 

Order 58 of the new rules, which contains these special rules, provides, for 

instance, for compulsory pre-trial settlement procedures. 4 It also authorises the use 

of not more than two assessors by a Commercial Court judge during a trial. At the 

end of the trial, the assessors may state their opinion, but their opinion is not binding 

on the judge. The 1995-96 team that prepared the Commonwealth Secretariat 

Report, invited by the Ghana Government (through the Ministry of Finance and 

Economic Planning), had a much broader focus than the judicial system. 5 

Nevertheless, the mission's report did have some observations relating to the courts. 

The Report recommended the use of assessors in commercial cases and 

recommended changes in the Rules of Court to achieve this. Clearly, this 

recommended reform has now been achieved with the promulgation of the new 

High Court (Civil Procedure) Rules, 2004 (CI 47), Order 58, rule 10, which 

authorises the judges of the Commercial Court to appoint not more than two 

assessors to assist them in any particular case. 6 The Commonwealth Secretariat 

recommendation went a little further than the new rule, in that it recommended that 

the appointment of assessors should be mandatory, where the parties request it or, 

even without such application, in specialised and complicated cases. It may be that 

8. Id. 

9. DANIDA, Ghana Legal and Judicial Reform Component Fact Sheet, 

http://www.danidadevforum.um.dk/NR/rdonlyres/679FDE29-DCFA-41CD-956C- 

BDDFE118CD5C/0/LegalJudicialReform FactSheet.pdf. 

10. Justice George Kingsley Acquah, Lord Chief Justice of the Ghanaian Supreme Court, Speech of 

the Lord Chief Justice on the First Anniversary of the Commercial Court, available at 

http://www.judicial.gov.gh/archives/com%20court/cc_3.htm. 

11. DANIDA, supra note 9. 

12. Justice George Kingsley Acquah, supra note 10. 

13. Ghana High Court Civil Procedure Rules, 2004 C.l. 47, Order 58. 

14. Id. 

15. See ELAS Report, supra note 1. 

16. Ghana High Court Civil Procedure Rules, supra note 13. 



VOL. 42:619 

after an initial trial period of the system of assessors, the Judicial Service ought to 

consider expanding the role of assessors along the lines of the Commonwealth 

Secretariat recommendation. Currently, the use of assessors is entirely dependent 

on the discretion of the judges of the Commercial Court. 

Order 58 also incorporates court-based alternative dispute resolution (ADR) 

processes into commercial dispute resolution. 7 After the close of pleadings, the 

Administrator of the Commercial Court is obliged, within three days, to refer the 

case to one of the Commercial Court judges to conduct a pre-trial settlement 

conference.' 8 The pre-trial judge is, in turn, obliged to invite the parties, within thirty 

days, to settle the issues for trial and to endeavour to achieve a settlement of the 

dispute. 9 At the pre-trial settlement conference, the parties may be represented by 

their counsel. ° Experts may be invited by the pre-trial judge to assist the settlement 

process." All disclosures made or documents presented at the pre-trial conference 

are without prejudice. 2 Where a dispute is settled at the pre-trial settlement 

conference, the settlement is entered as the judgment of the court. 23 

The special Order 58 rules apply to commercial claims, which are defined as 

''any claim arising out of trade and commerce and includes any claim relating to: 

i. The formation or governance of a business or commercial organization. 

ii. The winding up or bankruptcy of a commercial or business organization or 

corporate person. 

iii. The restructuring or payment of commercial debts by or to business or 

commercial organization or person. 

iv. A business document or contract. 

v. The export or import of goods. 

vi. The carriage of goods by sea, air, land or pipeline. 

vii. The exploration of oil and gas reserves. 

viii. Insurance and re-insurance. 

ix. Banking and financial services. 

x. Business agency. 

xi. Disputes involving Commercial Arbitration and other settlement awards. 

xii. Intellectual property rights, including patents, copyrights, and trademarks. 

xiii. Tax matters. 

xiv. Commercial fraud. 

xv. Application under the Companies Code, 1962 (Act 179). 

xvi. Other claims of commercial nature." 24 

17. Id. 

18. Id. 

19. Id. 

20. Id. 

21. Id. 

22. Ghana High Court Civil Procedure Rules, supra note 13. 

23. Id. 

24. Id. 


2006 

DEVELOPING A NEW COMMERCIAL COURT IN GHANA 

The Commercial Court's jurisdiction over these claims is not compulsory. 

Litigants may still go to the ordinary High Court with commercial claims if they wish. 

Indeed, the fees payable for the use of the Commercial Court are higher than in the 

ordinary courts. The belief, nevertheless, is that businessmen will pay a premium for 

the quicker and more focused service provided in the Commercial Court. This belief 

has in fact been borne out by experience. The statistics from the first year of 

operation of the Commercial Court show a healthy patronage by the business 

community and expeditious disposal of cases by the judges. 

An innovation, in relation to the Ghanaian jurisdiction, that has been 

introduced in connection with the Commercial Court is the Users Committee of the 

Court. The Users Committee consists of a Supreme Court Judge, representing the 

Chief Justice (who is the Chairman of it and who happens to be the current author); 

all the judges of the Commercial Court; one representative from the Attorney- 

General's Office; one representative of the Ghana Bar Association; one 

representative of the Revenue Institutions in Ghana; one representative from the 

Ghana Investment Promotion Council; one representative from the Association of 

Non-Banking Financial Institutions; one representative of the Bank of Ghana; one 

representative of the Ghana Association of Bankers; one representative of the 

Association of Ghana Industry; three representatives of the private sector, 

nominated by the Private Enterprise Foundation; the Administrator of the 

Commercial Court; the Registrar of the Commercial Court and the Director, Judicial 

Reform Programme of the Judiciary. The Committee is intended to operate as a 

watchdog of the Commercial Court and to liaise between the Court's Management 

Committee on the one hand and the Court's users and the general public on the 

other. 

This institutional framework for a feedback on the work of the Commercial 

Court is an interesting model which may repay study for more general incorporation 

into the Judicial Service. It is, of course, not intended as a forum for redress or 

complaint on individual cases before the Court. There are other avenues in the 

Judicial Service for that. Rather, its task is to serve as a channel for mobilizing the 

support of the commercial community and the general public in facilitating the 

activities of the Commercial Court, while at the same time ensuring that such 

community support does not infringe the independence of the judiciary and the 

impartiality of the learned Commercial Court judges. This task implies a role in 

providing feedback to the administrators of the Commercial Court of community 

impressions and reactions to the justice delivered by the Commercial Court. 

Reciprocally, the Committee has a role in communicating to the commercial 

community and the general public the essence of the concept of a Commercial 

Division of the High Court and what may be expected of it and what may not be 

expected of it. There should thus be a two-way flow of communication between the 

Commercial Court and its stakeholders, with the Users Committee, hopefully, 

facilitating this vital interactive process. 

The establishment of the Commercial Court in Ghana and its development thus 

far are steps in the right direction with regard to the evolution of an appropriate 

institutional framework for economic development. While it is still early, it is 

already an institutional development worth drawing attention to. 



Developing Global Transnational 

Harmonization Procedures for the Twenty- 

First Century: The Accelerating Pace of 

Common and Civil Law Convergence 

Louis F. DEL DUCA 

SUMMARY 

I. PROCEDURAL OPTIONS -THE NEW CHALLENGE .......................................... 626 

A. General Considerations - Key Actors - Selecting Harmonization 

A reas and P rocedures ................................................................................. 627 

B. Conventions: CISG and European Convention on Human Rights ........ 629 

C . M o d el L a w s ................................................................................................. 63 1 

D . G u id elin es ................................................................................................... 63 1 

E. Voluntary Contractual Applicability Texts: Incoterms, Uniform 

Customs and Practices, Arbitration Rules ................................................ 632 

F. Use of Regulations, Directives, and 'Mutual Recognition' Procedures 

in the E uropean U nion ............................................................................... 633 

G. Use of Conventions, Recommendations, and Exchange of Views in 

the C ouncil of E urope ................................................................................. 637 

H . A chieving Uniform ity in Practice .............................................................. 638 

II. SPECIFIC H ARMONIZATION A REAS .................................................................. 641 

A . Case Law as a Source of Law .................................................................... 641 

1. The "Goodhart" and "Zweigert-K6tz-Cappelletti" Eras and 

Entry into the Third M illennium ........................................................ 641 

2. G oodhart E ra ........................................................................................ 642 

3. Zweigert-K otz-Cappelletti Era ........................................................... 642 

4. Entry into the Third M illennium ........................................................ 645 

5. Experience of Constitutional Courts in Europe and Case Law in 

C ivil L aw System s ................................................................................. 646 

6. Case Law Experience of the European Union: An Example of 

Civil and Common Law Convergence in Practice ............................ 647 

7. Other Perspectives: The Role of Precedent in Mexico .................... 648 

B. Status of Selected Current Substantive Harmonization Projects ............. 650 

1. Principles of European Contract Law ................................................ 650 

2. E uropean C ivil C ode ............................................................................ 651 

3. UNIDROIT Principles 2004: A Further Step Toward a Global 



VOL. 42:625 

C ontract L aw ........................................................................................ 654 

4. G lobal Com m ercial Code .................................................................... 655 

5. Other International Regimes' Impact on Convergence: 

UNCITRAL and the World Trade Organization ............................. 656 

C. Principles and Rules of Transnational Civil Procedure - An ALl and 

UNIDROIT Cooperative Harmonization Project ................................... 657 

D. Impact of Electronic International Reporting Systems on 

C on vergen ce ................................................................................................. 659 

I. PROCEDURAL OPTIONS - THE NEW CHALLENGE 

Transnational harmonization results from either planned changes in legal 

systems aimed at achieving harmonization or from interaction that spontaneously 

occurs between different legal systems. The latter phenomenon may be described as 

'osmotic' harmonization. 

Unique challenges and opportunities were presented to comparative and 

international lawyers after the transition year of 1990 generated by the collapse of 

the Soviet system. With the twenty-first century upon us, the globalization of the 

world economy continues unabated and profound geopolitical changes continue to 

simultaneously occur. 

European developments by themselves suggest the vast scope of the changes 

involved. The phenomenon of Eastern European countries and the former republics 

of the former Soviet Union moving from controlled to free economies and 

developing multi-party democratic governments is only an example of these changes. 

The unification of Germany also generated a wave of public and private comparative 

and international legal problems all demanding instant attention. Massive 

privatization and democratization issues had to be addressed. More recently the 

effort of the European Union to implement a constitution for twenty-five member 

states, with twenty-one different languages, over four hundred fifty million people, 

and individual national cultural traditions, continue to require coordination of the 

legal systems of the member states. 

Commenting as early as 1978 on the pervasive importance of Community Law 

to member states, Lord Denning stated: 

... all this shows that the flowing tide of Community Law is coming in fast. 

It has not stopped at the high water mark. It has broken the dykes and the 

banks. It has submerged the surrounding land. So much so that we have 

to learn to become amphibious if we wish to keep heads above the water. 

What do such developments mean for comparative lawyers? A plethora of 

constitutional and administrative (that is, taxation, environmental law, labor law, 

social security, and so on) public law issues arose as new governments were created 

or old governments were restructured. Simultaneously a plethora of private law 

issues arose with the use of new trading entities and new contract procedures as free 

economies replaced controlled economies. These issues have generated rethinking 

1. Shields v. E. Coomes Holding Ltd., (1978) 1 W.L.R. 1408, 1416 (A.C.) (Eng.). 


2007 DEVELOPING GLOBAL TRANSNATIONAL HARMONIZATION PROCEDURES 627 

of traditional categories of international and comparative law. A half century ago 

Phillip Jessup stated: 

The subject to which these chapters are addressed is the law applicable to 

the complex interrelated world community which may be described as 

beginning with the individual and reaching on up to the so called "family 

of nations" or "society of states". . . Part of the difficulty in analyzing the 

problems of the world community and the law regulating them is the lack 

of an appropriate word or term for the rules we are discussing. Just as the 

word "international" is inadequate to describe the problem, so the term 

"international law" will not do .... I shall use, instead of "international 

law", the term "transnationa law" to include all law which regulates actions 

or events that transcend national frontiers. Both public and private 

internationalaw are included, as are other rules which do not wholly fit into 

such standard categories.' 

Are the traditional techniques and categories of law for producing harmonized 

international legislation responsive to the needs of the twenty-first century? 

A. General Considerations - Key Actors - Selecting Harmonization Areas and 

Procedures 

Primary actors in the process of producing transnational harmonized legislation 

such as the Hague Conference, 3 UNIDROIT, 4 UNCITRAL, the International 

Chamber of Commerce, 6 the Council of Europe, 7 the European Union," and so on, 

2. PHILLIP C. JESSUP, TRANSNATIONAL LAW 2-3 (1956)(emphasis added). 

3. Willis L. M. Reese, The Hague Conference on Private International Law, 19 Int'l L.. 881, 881 (1985); 

Kurt H. Nadelmann, The United States Joins the Hague Conference on Private International Law, 30 Law & 

Contemp. Probs. 291, 291-92 (1965). 

4. UNIDROIT is composed of sixty-one member states, namely: Argentina, Australia, Austria, 

Belgium, Bolivia, Brazil, Bulgaria, Canada, Chile, China, Columbia, Croatia, Cuba, Cyprus, Czech 

Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Greece, Holy See, Hungary, India, Iran, 

Iraq, Ireland, Israel, Italy, Japan, Latvia, Lithuania, Luxembourg, Malta, Mexico, The Netherlands, 

Nicaragua, Nigeria, Norway, Pakistan, Paraguay, Poland, Portugal, Republic of Korea, Romania, Russian 

Federation, San Marino, Serbia and Montenegro, Slovakia, Slovenia, South Africa, Spain, Sweden, 

Switzerland, Tunisia, Turkey, the U.K., the U.S., Uruguay, Venezuela, available at 

http://www.unidroit.org/english/members/main.htm. Over a period of eighty years, UNIDROIT has 

engaged in many significant projects such as preparatory work for the United Nations Convention on 

Contracts for the International Sale of Goods. See JOHN 0. HONNOLD, UNIFORM LAW FOR 

INTERNATIONAL SALES UNDER 1980 UNITED NATIONS CONVENTION (1982); M. J. Bonell, The 

UNIDROIT Initiative for the Progressive Codification of International Trade Law, 27 INT'L & COMP. L. Q. 

413 (1978). 

5. Gerold Herrmann, The Contribution of UNCITRA L to the Development of International Trade 

Law, in 2 THE TRANSNATIONAL LAW OF INTERNATIONAL COMMERCIAL TRANSACTIONS (Norbert Horn 

& Cliver M. Schmitthoff eds., 1982). 

6. The International Chamber of Commerce was formed in Paris on June 24, 1920. International 

Chamber of Commerce, World Peace Through World Trade - ICC 1919 - 1979 4 (1979). 

7. The Council of Europe is a political intergovernmental organization. Its permanent headquarters 

are in Strasbourg, France. It represents forty-six European pluralist democracies, with five observers 

(Canada, the Holy See, Japan, Mexico and the United States of America). The aims of the Council are: to 

protect human rights and the rule of law in all member states; to consolidate democratic stability in Europe 



VOL. 42:625 

have attempted to identify the need for proposed legislation and the likelihood of its 

acceptance and adoption before allocating limited resources to such projects. These 

organizations have generally avoided the pitfalls created in attempting to harmonize 

areas of law primarily to achieve logical symmetry or to achieve limited purposes not 

important to a sufficiently large base of proponents. They have instead first 

generally established real need for the harmonization project and the existence of 

proponents and a climate likely to assure acceptance of the finished product. 

After completing the process of identifying an area for preparation of 

harmonized transnational legislation, a choice must be made regarding the form, 

which such legislation should take. Traditional techniques involve use of 

Conventions or Model Laws. However, effective use has been made of other 

techniques involving preparation of (1) restatements of principles or uniform 

practices which contracting parties may incorporate into their contracts, or (2) 

publication of "Guidelines" which can be consulted by contracting parties in drafting 

by backing political, legal, and constitutional reform nationally, regionally and locally; to seek solutions to 

social problems such as intolerance, discrimination against minorities, human cloning, drugs, terrorism, 

corruption, and organized crime: to promote and develop a European cultural identity, with special 

emphasis on education; and to promote social cohesion and social rights. The structure of the Council of 

Europe is as follows: The Committee of Ministers, the decision-making body, comprising the Foreign 

Ministers of the forty-six member states or their permanent diplomatic representatives; The Parliamentary 

Assembly, the deliberative body, grouping 315 members (and 315 substitutes) from the 46 national 

parliaments and delegations from non-member states The Congress of Local and Regional Authorities of 

the Council of Europe - two chambers, one for local and one for regional authorities; The European Court 

of Human Rights, based in Strasbourg, permanently in session and dealing with all procedures from 

admissibility to final judgment. The Parliamentary Assembly elects judges for a six-year term. The Treaty 

of London, establishing the Council of Europe, was signed on May 5, 1949 by ten states, namely: Belgium, 

Denmark, France, Ireland, Italy, Luxembourg, the Netherlands, Norway, Sweden, and the U.K. See 

http://www.coe.int/T/E/Com/AboutCoe/Brochures/At-a-glance.asp. 

8. The European Union (European Community) is composed of twenty-five member states, namely: 

Austria, Belgium, Czech Republic, Cyprus, Denmark, Estonia, Finland, France, Germany, Greece, 

Hungary, Ireland, Italy, Latvia, Lithuania, Luxemburg, Malta, the Netherlands, Poland, Portugal, Slovakia, 

Slovenia, Spain, Sweden, and the UK. Initially formed with the Treaty Establishing the European 

Community (previously known as European Economic Community - EEC), which was signed in Rome on 

March 25, 1957, followed by Treaty on European Union, signed in Maastricht in 1992 and then followed by 

amendments in both Treaties by the Treaty of Amsterdam in 1997 and the Treaty of Nice in 2001. In June 

2004, a Treaty Establishing a Constitution for Europe was adopted and on October 29, 2004 was signed by 

the heads of state of each Member Country and the three candidate countries (Bulgaria, Romania and 

Turkey). It is currently undergoing ratification process in the member states. For more information and 

text of the Treaty, see Towards a Eurropean Constitution, http://europa.eu.int/constitution/indexen.htm. 

The Council of the European Union (formerly known as the Council of Ministers of the European 

Community) is the Union's main decision-making institution. Each member state presides over the 

Council for a six-month period on a rotational basis. Every Council meeting is attended by one minister 

from each of the member states. Which ministers attend a meeting depends on which topic is on the 

agenda. It is composed of the twenty-five member states, namely: Austria, Belgium, Czech Republic, 

Cyprus, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, 

Luxemburg, Malta, The Netherlands, Poland, Portugal, Slovakia, Slovenia, Spain, Sweden, and the U.K. 

The Council meets in nine different configurations. The preparatory work for Council meetings is done by 

the Permanent Representatives Committee (Coreper), made up of the member states' ambassadors to the 

EU, assisted by officials from the national ministries. Decision-making in the European Union involves 

the European Commission, the European Parliament and the Council. The European Commission 

proposes new legislation, but it is the Council and Parliament that pass the laws. There are three main 

procedures for enacting new EU laws: co-decision; consultation; and assent. The main difference between 

them is the way Parliament interacts with the Council. Under the consultation procedure, Parliament 

merely gives its opinion; under the co-decision procedure Parliament genuinely shares power with the 

Council. See The Union's Decision Making Procedures, [hereinafter Union Decision Making Procedures], 

http://europa.eu/scadplus/europeanconvention/procedures-en.htm. 



contracts. Use of "recommendations" and "exchange of views" by the Council of 

Europe should also be noted. 

B. Conventions: CISG and European Convention on Human Rights 

Preparation of international rules in the form of conventions requires states to 

ratify or accede to language identical to the terms of the convention, subject only to 

reservations, which the convention might permit. If properly administered and 

interpreted a convention provides uniformity and predictability for contracting 

parties. 

The United Nations Convention on Contracts for the International Sale of 

Goods (CISG), ratified by sixty-seven states as of June 7, 2006, " ) is one of the major 

9. United Nations Convention on Contracts for the International Sale of Goods, Apr. 10, 1980, 1489 

U.N.T.S. 3, available at http://www.uncitral.org/en-index.htm. The Convention entered into force on Jan. 1, 

1988. For a lengthy inclusive bibliography of the voluminous literature on the CISG, see 

http://cisgw3.law.pace.edu/cisg/biblio/biblio.html. For a selected list of materials on the CISG, see THE 

DRAFT UNCITRAL DIGEST AND BEYOND: CASES, DECISIONS, AND UNRESOLVED ISSUES IN THE U.N. 

SALES CONVENTION (Franco Ferrari, Harry Flechtner & Ronald Brand eds., 2004) (the final text of the 

UNCITRAL Digest may be found at http://cisgw3.law.pace.edu/cisg/text/digest-toc.html-an update of the 

digest is pending); COMMENTARY ON THE UN CONVENTION ON THE INTERNATIONAL SALE OF GOODS 

(CISG) (Peter Schlechtriem & lngeborg Schwenzer eds., 2d ed. 2005); HERBERT BERNSTEIN & JOSHEPH 

LOOKOFSKY UNDERSTANDING THE CISG IN EUROPE (2d ed. 2004); JOHN 0. HONNOLD, UNIFORM LAW 

FOR INTERNATIONAL SALES UNDER THE 1980 UNITED NATIONS CONVENTION (3d ed. 1999): ALBERT H. 

KRITZER GUIDE TO PRACTICAL APPLICATIONS OF THE UNITED NATIONS CONVENTION ON CONTRACTS 

FOR THE INTERNATIONAL SALE OF GOODS (1993-95)(an updated edition co-edited with Ziegfried Eiselen 

is pending). On March 15-18, 2006, UNCITRAL convened a symposium marking the twenty-fifth 

anniversary of the CISG featuring thirty-seven CISG scholars evaluating and updating case law reported in 

the UNCITRAL Digest. For papers presented at this meeting, see 25 J. L. & COM. 1 and 25 J. L. & COM. 2 

10. L. Del Duca & P. Del Duca, The New Convention on the International Sale of Goods - An 

Introductory Primer for Attorneys and International Traders, COMP. L. ANN. 553, 556 (1991). The 

Convention was unanimously approved by a diplomatic conference of sixty-two states in Vienna on Apr. 

11, 1980. UN Doc. A/Conf. 97/18, reprinted in 19 International Legal Materials 668 (1980). L. Del Duca 

and P. Del Duca, Practice Under the Convention on International Sale of Goods (CISG): A Primer for 

Attorneys and International Traders (Part 1), 27 UCC L.J. 331 (1995), L. Del Duca and P. Del Duca, 

Practice Under the Convention on International Sale of Goods (CISG): A Primer for Attorneys and 

International Traders (Part 11) 29 UCC L.J. 99 (1996). The seventy states which have ratified the 

Convention as of February 20, 2007 include Argentina (July 19, 1983), Australia (Mar. 17, 1988), Austria 

(Dec. 29, 1987), Belarus (Oct. 9, 1989), Belgium (Oct. 31, 1996), Bosnia and Herzegovina (Jan. 12, 1994), 

Bulgaria (July 9, 1990), Burundi (Sept. 4, 1998), Canada (Apr. 23, 1991), Chile (Feb. 7. 1990), China (Dec. 

11, 1986), Colombia (July 10, 2001), Croatia (June 8, 1998), Cuba (Nov. 2, 1994), Cyprus (Mar. 7, 2005), 

Czech Republic (Sept. 30, 1993), Denmark (Feb. 14, 1989), Ecuador (Jan. 27, 1992), El Salvador (Nov. 27, 

2006), Egypt (Dec. 6, 1982), Estonia (Sept. 20 1993). Finland (Dec. 15, 1987). France (Aug. 6, 1982), Gabon 

(Dec. 15, 2004), Georgia (Aug. 16, 1994), Germany (Dec. 21, 1989), Ghana (signed on Apr. 11, 1980;not yet 

ratified), Greece (Jan. 12, 1998), Guinea (Jan. 23, 1991), Honduras (Oct. 10, 2002), Hungary (June 16, 

1983), Iceland (May 10, 2001), Iraq (Mar. 5, 1990), Israel (Jan. 22, 2002), Italy (Dec. 11, 1986), Kyrgyzstan 

(May 11, 1999), Latvia (July 31, 1997), Lesotho (June 18, 1981), Liberia (Sept. 16, 2005), Lithuania (Jan. 18, 

1995), Luxemburg (Jan. 30, 1997), the former Yugoslav Republic of Macedonia (Nov. 22, 2006). 

Mauritania (Aug. 20, 1999), Mexico (Dec. 29, 1987), Mongolia (Dec. 31, 1997), Montenegro (Oct. 23, 

2006), Netherlands (Dec. 13, 1990), New Zealand (Sept. 22. 1994), Norway (July 20, 1988), Paraguay (Jan. 

13, 2006), Peru (Mar. 25, 1999), Poland (May 19, 1995), Republic of Korea (Feb. 17, 2004), Moldova (Oct. 

13, 1994), Romania (May 22, 1991). Russian Federation (Aug. 16, 1990). Saint Vincent and the Grenadines 

(Sept. 12, 2000), Serbia (Mar. 12, 2001), Singapore (Feb. 16, 1995), Slovakia (May 28, 1993), Slovenia (Jan. 

7, 1994), Spain (July 24, 1990). Sweden (Dec. 15. 1987), Switzerland (Feb. 21, 1990), Syrian Arab Republic 



VOL. 42:625 

harmonization achievements involving use of the convention technique. It is worth 

noting that over a period of more than fifty years, three major organizations (that is, 

UNIDROIT, the Hague Conference, and UNCITRAL) were involved in gradually 

developing the consensus required for its preparation." The advantages of 

harmonizing such text and the resulting facilitation of achieving certainty and 

predictability in the law governing sales transactions are obvious. However, the 

more than half-century required to achieve consensus on the text is a matter of 

concern. Future demands for operative uniform rules may not afford the luxury of 

such a long lead-time between conception and finalization of projects. 

Another example of how the convention technique could be used for achieving 

harmonization is the European Convention on Human Rights. 2 It was adopted 

under the auspices of the Council of Europe and established the first international 

legal instrument safeguarding human rights. 3 

The European Court of Human Rights was established with the Convention.' 4 

Any person who feels their rights have been violated under the Convention by a 

state party can take a case to the Court. 5 The decisions of the Court are legally 

binding and the Court has the power to award damages. State Parties can also take 

cases against other State Parties to the Court, although this power is rarely used. 

The Convention has five main sections. The main rights and freedoms are 

contained in Section I, which consists of Articles 2 to 18.16 Originally, Section II 

(Article 19) set up the Commission and the Court, Sections III (Articles 20 to 37) 

and IV (Articles 38 to 59) included the high-level machinery for the operation of, 

respectively, the Commission and the Court, and Section V contained various 

concluding provisions. 7 Many of the Articles in Section I are structured in two 

paragraphs: the first sets out a basic right or freedom (such as Article 2(1) - the right 

to life) but the second contains various exclusions, exceptions or limitations on the 

basic right (such as Article 2(2) - which excepts certain uses of force leading to 

death). 8 

The Convention has been amended several times by means of protocols. The 

protocols required universal ratification to enter into force, in order to maintain the 

institutional unity of the Convention machinery. For example, prior to the entry into 

(Oct. 19, 1982), Uganda (Feb. 12, 1992), Ukraine (Jan. 3, 1990), United States of America (Dec. 11, 1986). 

Uruguay (Jan. 25, 1999), Uzbekistan (Nov. 27, 1996), Venezuela (signed on Sept. 28, 1981; have not ratified 

yet), Zambia (June 6. 1986), available at 

http://www.uncitral.orgluncitral/en/uncitral-texts/sale-goods/1980CISG-status.htm. 

11. L. Del Duca and P. Del Duca, supra note 10 ('The Secretary-General of the United Nations is 

hereby designated as the depository for this Convention"); L. Del Duca and P. Del Duca, Practice Under 

the Convention on International Sale of Goods (CISG): A Primer for Attorneys and International Traders 

(Part 1) 27 UCC L.J. 331 (1995); L. Del Duca and P. Del Duca, Practice Under the Convention on 

International Sale of Goods (CISG): A Primer for Attorneys and International Traders (Part I1) 29 UCC 

L.J. 99 (1996). 

12. See The Council of Europe Convention for the Protection of Human Rights and Fundamental 

Freedoms was signed in Rome on Nov. 4, 1950, [hereinafter Coucil of Europe Convention], available at 

http://conventions.coe.int/Treaty/en/Treaties/Html/005 .htm. 

13. For an overview discussion of the creation and structure of the Council of Europe, see supra note 

7; infra note 59. 

14. Coucil of Europe Convention, supra note 12, art 19. 

15. Id. arts. 34-35. 

16. Id. arts. 2-18. 

17. Id. 

18. Id. 



force of Protocol 11, individuals did not have direct access to the Court; they had to 

apply to the European Commission on Human Rights, which if it found the case to 

be well-founded would launch a case in the Court on the individual's behalf. 

Protocol 11 abolished the Commission, enlarged the Court, and allowed individuals 

to take cases directly to it. 

However, in some instances fundamental, irreconcilable differences in national 

legal systems may mandate use of a model law rather than a convention 

harmonization process. 

C. Model Laws 

In 1985, UNCITRAL adopted a Law on International Commercial Arbitration 

as a model law rather than a convention.' 9 Legislation based on it has been enacted 

in Australia, Azerbaijan, Bahrain, Bangladesh, Belarus, Bermuda, Bulgaria, Canada, 

Chile, in China: Hong Kong Special Administrative Region, Macau Special 

Administrative Region; Croatia, Cyprus, Egypt, Germany, Greece, Guatemala, 

Hungary, India, Iran (Islamic Republic of), Ireland, Japan, Jordan, Kenya, 

Lithuania, Madagascar, Malta, Mexico, New Zealand, Nigeria, Oman, Paraguay, 

Peru, Republic of Korea, Russian Federation, Singapore, Spain, Sri Lanka, Thailand, 

Tunisia, Ukraine, parts of the United Kingdom (the overseas territory of Bermuda 

and Scotland); five states of the United States: California, Connecticut, Illinois, 

Oregon and Texas; Zambia, and Zimbabwe." Since it is a model law, legislative 

bodies of the enacting states can therefore enact it as is, or with changes. This 

flexibility gives states enacting model laws the option of incorporating changes they 

deem desirable. In addition, in contrast to cumbersome procedures needed to 

modify a convention, future changes can be made as needed in a model law simply 

by using the existing normal legislative process of the enacting state. 

D. Guidelines 

Use of the Guidelines procedure is illustrated by the UNCITRAL Legal Guide 

on Drawing Up International Contracts for the Construction f Industrial Works. 2 

These Guidelines are neither a set of rules nor of principles. They are instead a 

systematic treatment of matters to be addressed in large-scale construction contracts, 

with specific suggestions on the matter in which they may be treated. Evidence thus 

far available on the use of the Guidelines indicates that they are particularly helpful 

to developing countries involved in large-scale construction contracting. 

19. Report of United Nations Commission on International Trade Law on the Work of Its Eighteenth 

Session, 40 GAOR Supp. (No. 17), U.N. Doc. A/40/17 (1985). 

20. See UNCITRAL Web Site, http://www.uncitral.org/uncitral/en/index.html. Also, updated 

information can be obtained by contacting the Treaty Section of the United Nations Office of Legal 

Affairs, available at 

http://www.uncitral.org/uncitral/en/uncitraltexts/arbitration/1985Modelarbitration status.html. 

21. See U.N. Publication (1988), A/CN9/Scv. B/2; Basmayable, The Work of UNCITRAL in the Field 

of Industrial Contracts, The International Construction Law Review 273 (1989), at 

http://www.uncitral.org/en-index.htm. 



VOL. 42:625 

E. Voluntary Contractual Applicability Texts: Incoterms, Uniform Customs and 

Practices, Arbitration Rules 

The UNIDROIT project on Principles of International Contracts involved 

preparation of a Restatement of international contract law. 22 This project fulfilled 

several practical needs. Professor Joachim Bonell has noted that the Principles can 

elaborate general principles and rules relating to the law of contract in order to 

provide the necessary legal environment for the interpretation of uniform laws 

governing special types of transactions. 23 He noted that harmonization of specific 

areas of law such as sale of goods, negotiable instruments, modes of transport, 

intellectual property, and so on had been effective on a sectoral basis. 24 However, as 

discussed by Ren6 David, the limited nature of unification poses the problem of how 

to use national rules and techniques which have escaped unification to supplement 

uniform law. 25 The Principles supplement areas of law, which have been harmonized 

on sectoral basis. 

The Principles also serve as a guideline for national legislative bodies 

(particularly in developing countries) in enacting a basic code of contract law. In 

addition, having been prepared by a prestigious independent international 

organization in co-operation with a broad base of other academic, governmental, 

and private groups, parties to international contacts may see fit to incorporate the 

Principles into their contracts as applicable law even though they might not be 

enacted as legislation. 

Widespread recognition and use of rules drafted by respected and prestigious 

international organizations on a voluntary basis by contracting parties is an 

important source of harmonized international rules. This procedure is further 

exemplified by the International Chamber of Commerce through its Incoterms 26 and 

Letter of Credit Uniform Customs and Practices. 2 Similarly, the much used 1976 

UNCITRAL 'Arbitration Rules' offer parties the option of making applicable a 

carefully prepared set of arbitration rules to initiate a private arbitration process, in 

lieu of utilizing institutional arbitration offered by organizations such as the 

International Chamber of Commerce, American Arbitration Association, and other 

institutionalized arbitration centers in major cities of the world. 8 

This voluntary application technique is an alternative procedure by which 

parties have achieved order and predictability in their international contracting. The 

22. UNIDROIT Principles: A New Edition of the UNIDROIT Principles for International 

Commercial Contracts (2004), available at http://www.unidroit.org/english/principles/contracts/main.htm. 

23. Michael Joachim Bonell, UNIDROIT Principles 2004 - The New Edition of the Principles of 

International Commercial Contracts adopted by the International Institute for the Unification of Private 

Law, 9 UNIF. L. REV. 5 (2004). 

24. See Michael Joachim Bonell, A "Restatement" of Principles for International Commercial 

Contracts: An Academic Exercise or A Practical Need?, 7 INT'L Bus. L. J. 873 (1988). 

25. Ren6 David, The International Unification of Private Law, in 2 INTERNATIONAL ENCYCLOPEDIA 

OF COMPARATIVE LAW ch. 5 at 123-24 (Ren6 David et al. eds., 1971). 

26. International Chamber of Commerce (ICC) INCOTERMS, 22 Y.B. INT'L L. COMM'N 399, U.N. 

Doc. A/CN.9/348. 

27. See ICC Banking Commission, UCP 1974/1983 REVISIONS COMPARED AND EXPLAINED: 

DOCUMENTARY CREDITS (1984). 

28. Report of United Nations Commission on International Trade Law on the Work of Its Ninth 

Session, 31 U.N. GAOR Supp. (No. 17) para. 57, U.N. Doc A/31/17 (1976). 



'Principles of International Contracts' provide an additional source of orderly 

contract rules for interested parties. 

F 

Use of Regulations, Directives, and 'Mutual Recognition' Procedures in the 

European Union 

The artificial cleavage often made between public and private law 

harmonization efforts is blurred by the intensely pragmatic work of the European 

Community 9 and the Council of Europe (with its historic European Convention on 

Human Rights" and its many private law accomplishments). The framework of the 

Union, initially provided by the 1957 Treaty of Rome 3 was later amended by the 

Maastricht Treaty 32 (subsequent amendments followed with the Treaty of 

Amsterdam in 1997 and the Treaty of Nice in 2001). In October 2004 a Treaty 

Establishing a Constitution for Europe was signed. The ratification process 

continued with ten states having ratified the constitution prior to the negative votes 

in the referendum in France on May 29, 2005 and in Holland on June 1, 2006. No 

further action has been taken subsequent to these negative votes. 33 The treaties 

create a unique division of legislative, executive, and judicial powers, which 

facilitates the effective use of the Union's institutions for achieving harmonization or 

unification of legislation in areas where the Union has power (i.e. competence). 

Under the current treaties, the European Commission has executive power coupled 

with the power to initiate legislative proposals. 34 Its primary roles are to propose and 

enact legislation, and to act as guardian of the treaties. It currently consists of 

twenty-five Commissioners, one from each member state. Each Commissioner takes 

responsibility for a particular area of policy, and heads a department called a 

Directorate General. The Commission is headed by a President." The Council is 

the Union's main decision-making body. The main roles of the Parliament are to 

share with the Council the power to legislate, to exercise democratic supervision 

over all EU institutions, in particular the Commission, and it to authorize the budget 

together with the Council. 

Much of the EU legislation is adopted jointly by the Council and Parliament. 

As a rule, the Council only acts on a proposal from the Commission, and the 

Commission normally has responsibility for ensuring that EU legislation, once 

adopted, is correctly applied. The rules and procedures for EU decision-making 36 

are laid down in the treaties. Every European law is based on a specific treaty 

29. The Treaty on European Union signed on Feb. 7, 1992 in Maastricht between the members of the 

European Community led to the creation of the European Union. The Maastricht Treaty, Feb. 7, 1992, 

1992 O.J. (C191) 1. The European Community now constitutes one of the "three pillars" of the European 

Union. 

30. See European Convention on Human Rights, reprinted in INTERNATIONAL HUMAN RIGHTS 

INSTRUMENTS, 500.1-500.17 (Richard B. Lillich ed., 2d ed. 1990). 

31. See Treaty of Rome Establishing the European Economic Community, Mar. 25, 1957, 298 

U.N.T.S. 79. 

32. See The Maastricht Treaty, supra note 29. 

33. See supra note 8 and accompanying text. See also http://europa.eu.int/constitution/indexen.htm. 

34. The term "the Commission" is generally used to refer both to the administrative body in its 

entirety, and to the team of Commissioners who lead it. 

35. As of Nov. 2004, the President is Jos6 Manuel Dur~o Barroso of Portugal. 

36. See Union Decision Making Procedures, supra note 8. 



VOL. 42:625 

article, referred to as the "legal basis" of the legislation. 7 The main procedures for 

enacting new EU laws are co-decision, consultation, and assent. The main difference 

between them is the way Parliament interacts with the Council. As a rule the 

European Commission proposes new legislation, but it is the Council and Parliament 

that pass the laws. 

The most common legislative procedure in the Union is so called "codecision." 

38 Under the co-decision procedure, the Parliament and the Council share 

legislative power. The Commission sends its proposal to both institutions. They 

each read and discuss it twice in succession. If they cannot agree on it, it is put 

before a "conciliation committee," composed of equal numbers of Council and 

Parliament representatives. 

Under the consultation procedure, the Commission sends its proposal to both 

the Council and Parliament, but it is the Council that officially consults Parliament 

and other bodies. 9 In some cases, consultation is compulsory because the legal basis 

requires it, and the proposal cannot become law unless Parliament has given its 

opinion. In other cases consultation is optional and the Commission will simply 

suggest that the Council consult Parliament. In all cases, Parliament has the option 

of approving the Commission proposal, or rejecting it, or asking for amendments. 

Under the assent procedure the Council has to obtain the European 

Parliament's assent before certain very important decisions are taken. 40 The 

procedure is the same as in the case of consultation, except that Parliament cannot 

amend a proposal. It must either accept or reject it. The acceptance (assent) 

requires an absolute majority of the vote cast. 

The European Union has a unique system of internal law that has direct effect 

within the legal systems of its member states. The sources of Union law 1 are the 

primary legislation-the treaties, the secondary legislation 2 -regulations, directives, 

decisions, recommendations and opinions made by the Union's institutions in 

accordance with the treaties, and the decisions of the European Court of Justice and 

the Court of First Instance. 

37. See Consolidated Version of the Treaty Establishing the European Community art. 253, Dec. 12, 

2002, 2002 O.J. (C 325) 135 [hereinafter EC Treaty]. 

38. See EC Treaty, supra note 32, art. 251. See also Union Decision Making Procedures, supra note 8. 

39. See EC Treaty, supra note 32, art. 252. See also Union Decision Making Procedures, supra note 8. 

40. See supra note 36. 

41. A distinction should be made between European Community law and European Union law, as it 

is only European Community law that is held to be dominant over contrary domestic legislation of member 

states by the European Court of Justice. 

42. See EC Treaty, supra note 32, art. 249. However, under the Treaty Establishing a Constitution for 

Europe in Article 1-33 as legal acts of the Union are described European Laws, European Framework 

Laws, European Regulations, European Decisions, Recommendations and Opinions. European Laws are 

described as legislative acts of general application that are binding in their entirety and directly applicable 

in all member states. European Framework Laws are described as legislative act binding as to the result to 

be achieved upon each member state they are addressed to. They leave to the national authorities the 

choice of form and methods for achieving the objectives addressed with the European Framework Laws. 

European Regulations are non-legislative acts of general application for the implementation of legislative 

acts and of certain provisions of the Constitution. They can be either binding in their entirety and directly 

applicable in all member states, or be binding as to the result to be achieved upon each member state they 

are addressed to but leave the national authorities the choice of form and methods for pursuing the 

objectives set in them. European decisions are non-legislative acts binding in their entirety. If they specify 

whom they are addressed to, they are binding only on them. Recommendations and opinions have no 

binding force. See http://europa.eu.int/constitution/indexen.htm. 



Regulations and directives bind everyone. Regulations have direct effect, i.e. 

they are binding as part of the national law, while directives require implementation 

in the national legislation in order to be effective. If a member state fails to 

implement directives through national law it could be subjected to a financial 

sanction by the European Court of Justice. Regulations have a general scope and 

are obligatory in all their elements; therefore they are directly applicable in all 

member states. Directives, on the other hand, are binding upon each member state 

to which they are addressed, but leave to the national authorities the choice of forms 

and methods. They allow member states considerable discretion in deciding how to 

implement the rules required by the directive. 43 

Decisions also have binding effect, but only on the parties to whom they are 

addressed, which can be individuals, corporations, or member states. 

Recommendations and opinions differ from regulations, directives and 

decisions, however, in that they have no binding force and are instruments of 

indirect action. 

The Union has also developed the important concept of Mutual Recognition. 4 

Under this concept, harmonization will be required in areas where health, safety, 

environmental, consumer protection, or similar concerns so mandate. Otherwise 

standards of each member state will be mutually recognized where national 

differences do not jeopardize health, safety, or other paramount concerns. 

In 2001 the Commission of the European Community launched a process of 

consultation and discussion about the way in which problems resulting from 

divergences in national contract laws in the EU should be dealt with at the European 

level. Based on this discussions, in 2003 the Commission adopted an action plan 

suggesting both regulatory and non-regulatory measures in an attempt to resolve 

these problems. 4 " The plan proposes measures to increase the coherence of the EC 

acquis in the area of contract law, 46 to promote the elaboration of EU-wide general 

contract terms, and to examine further whether problems in the European contract 

law area may require non-sector-specific solutions such as an optional instrument. 47 

The Commission proposed the establishment of a Common Frame of Reference as 

means to achieve an improvement in the contract law acquis4 8 Through the 

establishment of common principles and terminology in the area of European 

contract law. As a follow up to the 2003 Action Plan, in 2004 the Commission issued 

a communication to the European Parliament and the Council. 49 

43. EC Treaty, supra note 32, art. 249. 

44. The first application of this concept was in the decision of the European Court of Justice 'Casis de 

Dijon.' Case 120/78, Rewe-Zentral AG v. Bundesmonopolverwaltung fur Branntwein, 1979 E.C.R. 649. 

See Laurence Gormley, Casis de Dijon and Communication from the Commission, EUROPEAN LAW 

REVIEW 454 (1981). For an example of the application of the principle by the legislative body, see Council 

Resolution of 7 May 1985 on technical harmonization and standards, 1985 O.J. (C 136) 1. 

45. Communication from the Commission to the European Parliament and the Council, A More 

Coherent European Contract Law: An Action Plan, COM (2003) 68 final (Feb. 12, 2003) , available at 

http://ec.europa.eu/comm/consumers/policy/developments/contract-law/com_2003-68en.pdf. 

46. All documents concerning European contract law are available on the Commission's website, 

http://europa.eu.int/comm/consumers/cons-int/safe-shop/fair-bus-pract/cont-law/index-en.htm. 

47. Rewe-Zentral AG v. Bundesmonopolverwaltung fur Branntwein, 1979 E.C.R. 649. 

48. Communication from the Commission to the European Parliament and the Council, A More 

Coherent European Contract Law: An Action Plan, supra note 45, at 15-21. 

49. Communication from the Commission to the European Parliament and the Council, European 



VOL. 42:625 

Harmonization efforts outside of the Union might profit by more careful 

definition and delineation of the precise area requiring harmonization and those 

areas best left to individual jurisdictions and the principle of mutual recognition. 

The great progress made possible by adoption of the harmonization-mutual 

recognition process is illustrated by the Union experience in dealing with the matter 

of diploma recognition." The partial failure of the sectoral approach to the question 

of access and practice to a profession in a member state without any national 

discrimination led the Commission to propose a new system based on the general 

recognition of diplomas awarded in any member country. As a matter of fact, 

previous experience showed that it was not realistic to hope for the free movement 

of self-employed persons by continuing to apply the sectoral system. 5 ' Indeed, some 

twenty-six years were required to promulgate the directive pertaining to architects. 52 

The directive that promotes the general system of recognition of diplomas was 

accordingly adopted by the Council on December 21, 1988. Directive 89/48 was to 

enter into force at the beginning of 1991.51 It covered all diplomas that were not 

affected by 'sectoral' directives already in force, and which were awarded on 

completion of a course of higher education at the university level or higher, 

comprising at least three years full-time study or the equivalent. Subsequently that 

Directive, and several others, were replaced by the Directive 2005/36/EC of the 

European Parliament and of the Council of September 7, 2005 on the recognition of 

professional qualifications, in OJ (L 255/22) of September 30, 2005. 

This system is general in character, that is, it applies to all regulated activities 

not covered by sectoral directives. For instance, beneficiaries are teachers, 

engineers, opticians, lawyers, and so on. It is based on mutual confidence between 

member states and on assumed compatibility between levels of education and 

training. When a person is qualified to practice in a member state, having obtained a 

diploma and undergone any additional training required, he or she has the right to 

access the same profession in any other member state. A diploma obtained in a 

third country is accepted if recognized by a member state and supplemented by three 

years professional experience in that member state. 

In instances of important differences between types of education and training, 

the host member state may impose compensatory requirements as follows: (a) If the 

difference is more than a year, additional professional experience may be requested, 

but must be limited to twice the length of the missing training period; (b) in case of 

differences in course content the migrant may choose either an adaptation period of 

up to three years under the supervision of a qualified professional, or an aptitude 

Contract Law and the Revision of the Acquis: The Way Forward, COM (2004) 651 final (Oct. 11, 2004), 

available at 

http://ec.europa.eu/comm/consumers/cons-int/safe-shop/fair-bus-pract/cont -law/com2004-en.pdf. 

50. See Malcolm Ross, Mutual Recognition of Professional Qualifications, 14 EUROPEAN LAW 

REVIEW 162, 162 (1989). 

51. See Rolf Waegenbaur, Free Movement In The Professions: The New EEC Proposal on 

Professional Qualifications, 23 COMMON MKT. L. R. 91. 97-100 (1986). 

52. Council Directive 85/384, 1985 O.J (L 223) 15 (EC). 

53. See Council Directive 89/48/EEC 1988 O.J. (L 019) 1 (EC), art. 12 (discussing a general system for 

the recognition of higher education diplomas awarded on completion of professional education and 

training of at least three years' duration). 

54. Id. art.1. 



test based on all or some of the missing material." As an exceptional measure, the 

host member state may make the choice, and impose an examination for the legal 

professions-members of which need a detailed knowledge of national law-and, 

with the agreement of the Commission, for other occupations. 5 1 

According to Directive 98/5/EC of the European Parliament and of the Council 

of February 16, 1998 to facilitate practice of the profession of a lawyer on a 

permanent basis in a member state other than that in which the qualification was 

obtained, lawyers may become integrated into the profession in the host member 

state, as provided for in Directive 89/48/EEC, in the language of the host member 

state. No condition of nationality remains. It allows duly qualified EU lawyers 

registered with an EU Bar to establish themselves in another member state. 

G. Use of Conventions, Recommendations, and Exchange of Views in the Council 

of Europe 

Conventions, recommendations to governments, and exchanges of views 

provide various means of achieving harmonization among the members of the 

Council of Europe. The particular means employed depends upon many variables, 

including the nature of the change that is desired, the legally binding effect of the 

instrument, and the time available to prepare the instrument. An excellent report by 

the Council of Europe entitled Methods and Instruments of Co-operation in the 

Council discusses the advantages, disadvantages, and circumstances under which 

each of these means is utilized."' The need to obtain the requisite number of 

ratifications to bring a convention into force and possible extended length of the 

preparation phase were noted as possible disadvantages. However, once a 

convention is ratified, it has the merit of being legally binding and therefore can have 

far-reaching effects. For example, the Council of Europe's historic European 

Convention on Human Rights, though a single convention, requires the 

constitutional systems of all forty-six member states who have ratified or acceded to 

the Convention to conform with the law of human rights set forth in its text. 9 

55. Id. art.4. 

56. Id. arts. 4, 10. 

57. European Parliament and Council Directive 98/5/EC, 1998 O.J. (L 77) 36 (to facilitate practice of 

the profession of a lawyer on a permanent basis in a member state other than that in which the 

qualification was obtained). 

58. The entire subject is reviewed in detail in an excellent article by Ferdinando Albanese, former 

Deputy Director of Legal Affairs and current Director of Environmental and Local Authorities, the 

Council, at Le Processus Legislative au Conseil de I'Europe. Ferdinando Albanese, Le Processus Ldgislatif 

au Conseil de l'Europe, in 3 REVUE TRIMESTRIELLE DE DROIT EUROPEEN 391 (Jan.-Mar. 1986). 

59. As of Oct. 2006, the forty-six member states of the Council of Europe are: Albania (July 13, 1995), 

Andorra (Nov. 10, 1994), Armenia (Jan. 25, 2001), Austria (Apr. 16, 1956), Azerbaijan (Jan. 25, 2001), 

Belgium (May 5, 1949), Bosnia and Herzegovina (Apr. 24, 2002), Bulgaria (May 7, 1992), Croatia (Nov. 6, 

1996), Cyprus (May 24, 1961), Czech Republic (June 30, 1993), Denmark (May 5, 1949), Estonia (May 14, 

1993), Finland (May 05, 1989), France (May 5, 1949), Georgia (April 27, 1999). Germany (July 13, 1950). 

Greece (Aug. 9, 1949), Hungary (Nov. 6, 1990), Iceland (Mar. 7, 1950), Ireland (May 5, 1949), Italy (May 5, 

1949), Latvia (Feb. 10, 1995),Liechtenstein (Nov. 23, 1978), Lithuania (May 14, 1993), Luxembourg (May 5, 

1949), Malta (Apr. 29, 1965), Moldova (July 13, 1995). Monaco (Oct. 5, 2004). Netherlands (May 5. 1949). 

Norway (May 5, 1949). Poland (November 26, 1991), Portugal (September 22, 1976), Romania (Oct. 7. 

1993), Russian Federation (Feb. 28, 1996), San Marino (Nov. 16, 1988), Serbia (Apr. 3, 2003), Slovakia 

(June 30, 1993), Slovenia (May 14, 1993), Spain (Nov. 24, 1977), Sweden (May 5, 1949), Switzerland (May 



VOL. 42:625 

Recommendations of the Council of Europe's Committee of Ministers to the 

Members are easier to prepare or amend since they are actions of the Committee of 

Ministers and no further act of agreement by member states is necessary. However, 

while such Recommendations may exert some pressure, the member states are not 

required to follow them. The legal duty to act on recommendations goes no further 

than to consider in good faith its possible implementation. 

Unlike conventions and recommendations, exchanges of views are not 

expressly mentioned in the Statute of the Council of Europe. But they are 

nevertheless used to produce important practical results. In fact, due to their 

informal nature, exchanges of views entail a less arduous drafting process than that 

involved in the preparation of convention or recommendation. Generally suitable in 

generating discussion of new and unexplored topics or of new problems surfacing in 

familiar areas where there is a need to compare opinions and share experiences, they 

particularly serve as means to an end, such as development of a convention or a 

recommendation to governments. 

H. Achieving Uniformity in Practice 

Measures will need to be taken to make the transition from successful 

convergence of language in uniform acts to actually achieving uniformity in practice. 

For example, while the Vienna Sales Convention is a major achievement in adopting 

uniform law, problems with achieving uniform application and interpretation of its 

provisions are likely. 61 To some extent this is addressed by inclusion of statutory 

construction provisions in the convention itself, which attempt to guarantee the 

achievement of uniformity in practice. 62 Incorporated into the Convention is the 

notion that in the event a problem is not readily answered by the text itself, resort 

should be to the principles of the Convention rather than to domestic law for its 

resolution. 63 Along with course-of-dealing standards of construction,' usages-oftrade 

65 criteria are also built into the Convention-as is a requirement of good faith 6 6 

interpretation. While these provisions are helpful and desirable, and may provide 

resolutions to some of the problems of achieving uniformity of interpretation in 

practice, experience teaches that such uniformity is not easily achieved. 

For example, in the United States, we have built into our uniform acts rules of 

statutory construction that are comparable to those of the Convention. 

Additionally, we have had the benefit of a legal tradition, which is essentially the 

same in each of the forty-nine or fifty jurisdictions (Louisiana, which has a civil-law 

tradition, excepted). Notwithstanding that we have a core of similarity of tradition 

6, 1963),former Yugoslav Republic of Macedonia (Sept. 11, 1995), Turkey (Aug. 9, 1949), Ukraine (Sept. 

11, 1995), United Kingdom (May 5, 1949). "With effect from 3 June 2006, the Republic of Serbia is 

continuing the membership of the Council of Europe previously exercised by the Union of States of Serbia 

and Montenegro (CM Decision of 14 June 2006)." Council of Europe Member States, available at 

http://www.coe.int/T[E/Com/AboutCoe/Memberstates/default.asp. 

60. Council of Europe, available at http://www.coe.int. 

61. CISG, supra note 9. 

62. Id. arts. 7, 8, 9. 

63. Id. art. 7(2). 

64. Id. art. 9. 

65. Id. art.9. 

66. See CISG, supra note 9, art. 7(1). 



in teaching and practicing law and in our sources of law, we have encountered 

significant obstacles in achieving uniformity. In part, one of the reasons for 

developing the Uniform Commercial Code was the fact that the individual statutes 

that preceded it had been interpreted and reinterpreted so many times and so 

differently that there was massive confusion as to what they meant. 6 1 

The fact that a convention is already in force in states that have different legal 

traditions and a variety of techniques and sources of law from which they derive 

their principles and canons of construction and usage, creates an even greater 

possibility for non-uniform application of identical provisions. 68 

Because of these concerns, it is desirable to set in place an institutional 

framework to review the manner in which uniform laws are being applied after a 

consensus on the text of that uniform law has been adopted. 

Experience in the United States teaches that in attempting to restate basic 

principles that may be extracted from a large, expanding body of law, it is helpful to 

restate the principles in a summary fashion and to indicate the alternatives utilized in 

the fifty states. This technique helps to provide a broad outline of available 

alternatives. In this way, while restatements are not compulsorily imposed upon any 

of the state supreme courts, they nevertheless are available to be considered. If a 

preferred view is established, the fact that it is presented after a careful consensusbuilding 

approach seeking a recommended solution to the problem may be 

persuasive to courts as they interpret the language of a uniform law. 

This technique has not been utilized as frequently in the case of uniform acts as 

it has with case law in fields such as contracts, conflicts of law, property, and so on. 

It has been very helpful in achieving some degree of uniformity in the resolution of 

our case law problems. The procedure could also be applied to case-law-interpreting 

conventions or model laws. There are several groups presently involved in setting 

up reporting services to cover the case law for the Vienna Convention." 

When such decisions are collected, efforts should not stop at mere reporting. It 

would be of additional benefit if the decisions were systematically objectively 

analyzed so that problem areas could be identified and possible preferred 

interpretations could be developed. Of course, such interpretations could not be 

forced upon any national independent sovereign entity that is working with that 

body of law; rather it would be available as a persuasive source of authority as to 

what the desirable interpretation should be. 7 " 

Non-uniformity in application of European Community Law as it is 

incorporated into the domestic law of the member states also sometimes develops. 

The Union, however, has something working in its favour that is not available in 

other types of harmonization efforts. The European Court of Justice possesses the 

authority to interpret Union legislation and provide the ultimate legal norm to be 

67. See William A. Schnader, Uniform Commercial Law - How Soon?, 13 PERS. FIN. L. 68 (1959). 

68. See John Henry Merryman, On the Convergence (and Divergence) of the Civil Law and the 

Common Law, 17 STAN. J. INT'L. L. 357,379 (1981). 

69. See UNILEX, available at http://www.unilex.info; PACE, available at www.cisg.law.pace.edu; 

CLOUIT, available at http://www.un.or.at/uncitral/htm. 

70. See id. 



VOL. 42:625 

applied. 7 Neither the international community nor the member states of the United 

States have that kind of centralized authority to resolve such problems. 

It is apparent then that in refining our harmonization procedures for future use, 

resources need to be allocated to achieving uniformity in practice as well as on the 

printed page. The type of institutional framework noted above is one step. 

We also need to be continuously sensitive to the quality and quantity of 

comparative and international law courses taught in law schools and in continuing 

legal education courses in each of our countries. 

Expansion of specialized comparative and international law courses and a 

programme of supplementing such courses with comparative and international 

components to be included in traditional law-school courses is needed. 

Development of materials to be used in teaching the content and practice of law 

under uniform laws in the law schools of the world and in international seminars for 

practicing attorneys, law professors, and judges should complement such a 

programme. 7 ' Having harmonized codes or restatements in place does not achieve 

harmonization in practice in the absence of competent legal technicians sharing a 

common frame of reference and standards, which they can utilize in applying and 

interpreting the harmonized language. 

71. See PAOLO MENGOZZI, IL DIRITTO DELLA COMUNITA' EUROPEA 88-134 (1990). 

72. See Dean R. C. Clark, Building a World Law School, 42 HARV. L. BULL. 5 (1991); L. Del Duca, 

Comments at pp.141-44, International Uniform Law in Practice - Acts and Proceedings of the Third 

Congress on Private Law Held by the International Institute for the Unification of Private Law 

(UNIDROIT) in Rome, Italy 1987 (1988). Dean Robert C. Clark has also stated "I have reported 

previously that we are also planning to become a world law school by including an international facet in 

nearly all of our courses . ..," Robert C. Clark, Preparing for the 21st Century, Harvard Law School, A 

Supplement to the Harvard University Gazette, 7 Dec. 1990, at 1. Evolving implementation of 

these early aspirational statements are traced in papers presented in a series of symposia conducted in 

recent years at the annual meetings of The Association of American Law Schools and subsequently 

published. See Symposium, Emerging Worldwide Strategies in Internationalizing Legal Education, 18 

DICK. J. INT'L L. 411 (2000); Toni M. Fine, Symposium on Working Together: Developing Cooperation in 

International Legal Education, Introduction and Overview, 20 PENN ST. INT'L L. REV. 1 (2001); 

Symposium, Working Together: Developing Cooperation in International Legal Education, 20 PENN ST. 

INT'L L. REV. 7 (2001); Symposium, Continuing Progress in Internationalizing Legal Education - 21st 

Century Global Challenges, 21 PENN ST. INT'L L. REV. 1 (2002); Symposium, Developing Mechanisms to 

Enhance Internationalization of Legal Education, 22 PENN ST. INT'L L. REV. 393 (2004); Symposium, 

Globalizing Legal Education Symposium: Educating Lawyers for Transnational Challenges, 23 PENN ST. 

INT'L L. REV. 741 (2005); James H. Carter, Transnational Law: What Is It?: How Does It Differ from 

International Law and Comparative Law? 23 PENN ST. INT'L L. REV. 797 (Spring 2005); Workshop on 

Integrating Transnational Legal Perspectives Into the First Year Curriculum - What Is Transnational Law 

and Why Does It Matter? - Institutional Support and Approaches to Integration, 24 PENN ST. INT'L L. REV. 

(forthcoming 2007); Techniques to Internationalize the First Year Curriculum, 24 PENN ST. INT'L L. REV. 

(forthcoming 2007). 



II. 

SPECIFIC HARMONIZATION AREAS 

A. Case Law as a Source of Law 

1. The "Goodhart" and "Zweigert-Kotz-Cappelletti" Eras and Entry into 

the Third Millennium 

In 1934, Arthur Goodhart, the renowned English comparatist, stated that the 

fundamental difference between common and civil law was the common law 

doctrine of stare decisis, i.e. the binding force of precedent. 73 Konrad Zweigert and 

Hein K6tz disputed this fundamental difference advocated by Goodhart. 74 They 

argued that the methods of finding law in common and civil law systems were 

gradually moving closer together and leading to the same result. 75 

Mauro Cappelletti, in a substantially concurring but to some extent dissenting 

perspective, maintained that not as much convergence had occurred as Zweigert and 

Kotz suggested. He argued that major differences continue to exist between the two 

traditions leading to varied precedential weight of case law. 76 Today, some would 

contend that convergence has accelerated at an unprecedented rate due to recent 

developments in European and International law. In addition, the creation of 

constitutional courts in civil law nations has led to a virtually binding force of their 

decisions. 77 Additionally, European Union member-states, who originate from both 

common and civil law traditions, are collaborating by using aspects of both traditions 

to achieve identical goals. Vigorous efforts are also underway to develop a 

European Civil Code, a European Contract Code, and even a Global Commercial 

Code, which will further advance the convergence of the two traditions. 

UNIDROIT has also developed Principles of International Commercial Contracts. 

In addition, other international organizations like UNCITRAL and the World Trade 

Organization, made up of both common and civil law participants, have contributed 

to the accelerating convergence. Harmonization of common and civil procedural law 

has also advanced in recent years. The joint project of the American Law Institute 

and the UNIDROIT Working Group has furthered this harmonization through the 

creation of the Principles and Rules of Transnational Civil Procedure. New 

technology is also significantly impacting the convergence of common and civil law. 

Development of electronic reporting systems, such as those already in existence for 

the Convention on Contracts for the International Sale of Goods, will further 

facilitate harmonization of legal norms. 6 

73. A.L. Goodhart, Precedent in English and Continental Law, 50 L. Q. Rev. 40, 42 (1934), in K. 

ZWEIGERT ET AL., AN INTRODUCTION TO COMPARATIVE LAW 256, 259 (3d ed. 1998). 

74. Seeid.at271. 

75. Id. 

76. See Mauro Cappelletti, The Doctrine of Stare Decisis and the Civil Law: A Fundamental 

Difference - or No Difference at All?, Festschrift Zweigert, 387-88 (1981). 

77. Id. at 392. 

78. United Nations Commission on International Trade Law (UNCITRAL), United Nations 

Convention on Contracts for the International Sale of Goods, 

http://www.uncitral.org/uncitral/en/uncitral-texts/sale-goods/1980CISG.html. 



VOL. 42:625 

2. Goodhart Era 

In 1934, Professor Goodhart discussed the differences between common and 

civil law. He believed that the fundamental difference between civil and common 

law is the binding force of precedent. 79 The common law doctrine of stare decisis 

states that every court is bound by the decisions of courts superior to it in hierarchy. 8 , 

A previous decision is binding even if it was decided a century earlier or if the rule 

seems inappropriate. 8 ' There is no equivalent doctrine in civil law; thus, civil law 

judges are free to decide each case independently by applying their domestic code 

without being bound by previous decisions. 

3. Zweigert-K6tz-Cappelletti Era 

The era that followed Goodhart produced new practices and customs of 

common and civil law. The dependence on case law was greatly reduced in the 

United States during the New Deal Era when Congress passed a tremendous 

amount of legislation to deal with social problems. Civilian courts, on the other 

hand, were developing new practices that began to rely on the persuasive weight of 

previous cases. Konrad Zweigert and Hein K6tz believed the doctrine of stare 

decisis no longer represented a fundamental difference between the common and 

civil law. 82 The methods of finding law in common and civil law generally led to the 

same result. 3 Mauro Cappelletti disputed Zweigert and K6tz' analysis and argues 

that not as much convergence had taken place as they suggest.8 

Based on new practices in common and civil law, Zweigert and Kbtz recognized 

that civil and common law methods of finding law were gradually moving closer 

together. 5 Despite the existence of the doctrine of stare decisis and the absence of 

an equivalent civil law doctrine, the practice of both court systems generally led to 

the same result. 6 They stated: 

To sum up: on the Continent the days of absolute pre-eminence of 

statutory law are past; contrariwise, in the common law there is an 

increasing tendency to use legislation in order to unify, rationalize, and 

simplify the law. On the Continent, law is increasingly being developed by 

the judges and consequently there is more room for an inductive method 

and style related to the actual problems; contrariwise, the common law is 

seeing the need to bring the rules developed by the judges into systematic 

order by means of scholarly analysis and legislative action, so as to make 

them easier to understand and master. There are therefore grounds for 

believing that although the common law and the civil law started off from 

79. Goodhart, supra note 73, at 259. 

80. Id. 

81. Id. at 260. 

82. See id. at 271. 

83. Id. at 263. 

84. Mauro Cappelletti, The Doctrine of Stare Decisis and the Civil Law: A Fundamental Difference - 

or No Difference at All?, Festschrift Zweigert, 388 (1981). 


86. Id. at 263. 



opposite positions, they are gradually moving closer together even in their 

methods and techniques." 

Furthermore, in England, the doctrine of stare decisis is not as widely accepted 

as it had been years earlier.m In 1966, the Lord Chancellor issued a Practice 

Statement recognizing the importance of certainty in the law but abandoning the 

rule that the House of Lords was strictly bound by its own previous decisions. 9 He 

declared: 

Their Lordships regard the use of precedent as an indispensable 

foundation upon which to decide what is the law and its application to 

individual cases. It provides at least some degree of certainty upon which 

individuals can rely in the conduct of their affairs as well as a basis for 

orderly development of legal rules. 

Their Lordships nevertheless recognize that too rigid adherence to 

precedent may lead to injustice in a particular case and also unduly restrict 

the proper development of the law. They propose, therefore, to modify 

their present practice and, while treating former decisions of this House as 

normally binding, to depart from a previous decision when it appears right 

to do so. 

In this connection they will bear in mind the danger of disturbing 

retrospectively the basis on which contracts, settlements of property and 

fiscal arrangements have been entered into and also the special need for 

certainty as to the criminal law. 

This announcement is not intended to affect the use of precedent 

elsewhere than in this House. ([1966] 1 WLF 1234). 0 

In response to the Lord Chancellor's Practice Statement, support increased in 

England for further restriction of the doctrine of stare decisis." Lord Denning 

continuously advocated that the Court of Appeal should also be free to depart from 

strictly following previous decisions. 92 He contended that if adhering to precedent 

too rigidly leads to injustice and restricts the development of the law in the House of 

Lords, it will do the same in the Court of Appeal. 93 However, Lord Denning's view 

was ultimately rejected by a unanimous House of Lords in Davis v. Johnson in 

1979. 9 ' 

87. Id. at 271. 

88. Id. at 261. 

89. See id. at 261-62. 

90. Id. 


92. Id. 

93. Id. 

94. Id. 



VOL. 42:625 

Mauro Cappelletti advocated a different position in the matter of the 

convergence of common and civil law. He maintained that not as much convergence 

had occurred as Zweigert and Kotz suggest and the precedential authority of civil 

law decisions do not compare to the common law doctrine of stare decisis. 9 " Major 

differences continue to exist between the two systems that lead to varied 

precedential authority of previous decisions. 96 

The first difference, according to Cappelletti, exists in the organization of 

higher courts in common and civil law systems. 9 While common law nations have a 

compact unitary system with a single highest court, civil law nations do not have a 

similar court structure. 98 Rather, civil law nations have a diffuse court system with 

numerous high courts. 99 France and Italy have three different court systems, one for 

ordinary civil and criminal matter, one for administrative matter, and a 

constitutional court.'" ° The Constitutional Court in Italy, La Corte Costituzionale, 

has the authority to resolve controversies on the constitutionality of laws and 

enactments issued by the State and the various regions, to resolve conflicts arising 

from allocation of powers, and to deal with accusations made against the President 

of the Republic."" The constitutional court in France, le Conseil Constitutionnel, has 

limited constitutional power, but has consultative powers as well as judicial authority 

over normative and abstract proceedings and electoral and referendum disputes. 

Germany has five different court systems, one each for ordinary civil and criminal, 

administrative, tax, labor and social matters. 1 3 Germany also has a constitutional 

court, the Bundesverfassungsgericht, whose sole task is judicial review.'" This 

diffuse organization leads to diffuse authority of high court decisions. 1 " 5 

A second difference that leads to varied precedential authority of previous 

decision is civil law's historical bias against judicial discretion."' 6 Traditionally, civil 

law nations distrust judges, and therefore, do not want to grant them too much 

power. ' 7 No writ of certiorari exists in civil law high courts that gives judges 

discretion to choose certain cases to hear."" Rather, civil law courts are courts of 

mandatory jurisdiction, must hear every case brought before them and decide 

thousands of cases each year." The result of the tremendous number of cases 

decided yearly by civil law high courts is that many of the cases are unpublished, 

unknown, and forgotten.' The minimal precedential authority of civil law high 

95. See Cappelletti, supra note 76, 387-88. 

96. See id. at 382-83. 

97. Id. at 383. 

98. Id. at 383-84. 

99. Id. at 383. 

100. Id. 

101. COST. Art. 134 (Italy), available at www.cortecostituzionale.it. 

102. Const. Title VII, Art. 56-63 (France), available at www.conseil-constitutionnel.fr. 

103. Cappelletti at 383. 

104. Bundesverfassungsgericht web site, http://www.bverfg.de/en/organization/task.html. 

105. Cappelletti, supra note 76, at 383. 

106. Id. 

107. Id. at 384. 

108. Id. at 385. 

109. Id. at 384. 

110. Id. at 386. 



court decision does not compare to the precedential authority of common law high 

court decisions decided under the doctrine of stare decisis.", 

The third difference, cited by Cappelletti, is the use of sociological 

considerations regarding the judiciary in common and civil law Systems." 2 He 

contends that civil law career judges are trained to develop technical skills to 

mechanically apply the law."' 3 The judges are neither trained nor equipped to make 

policy-related decisions. 114 

4. Entry into the Third Millennium 

The era following the writings of Zweigert, Kotz and Cappelletti reveal an 

accelerated convergence of common and civil law due in part to developments in 

European Union and International law. In addition, the development of 

constitutional courts in Europe provides judges with the power to deliver decisions 

with great precedential weight." 5 Additionally, the decisions of ordinary and 

administrative courts in civil law nations have gained greater persuasive weight over 

the years."' 

The European Union is an example of convergence of common and civil law in 

practice. Judges and lawyers from both traditions are working together in the 

European Court of Justice. The development and discussion of European Principles 

of Contract Law, a European Civil Code, and a Global Commercial Code further 

facilitate harmonization of common and civil law. Additionally, international 

organizations, such as UNCITRAL, UNIDROIT, and the World Trade 

Organization, have contributed to the accelerated convergence by joining 

representatives from both common and civil law traditions to create international 

policies for the benefit of all contracting states. The harmonization of common and 

civil procedural law has made less progress compared to its substantive 

counterpart." 7 However, harmonization in this area is occurring and has been 

accelerated by the joint project between the American Law Institute and the 

UNIDROIT Working Group creating Principles and Rules of Transnational Civil 

Procedure. 

Technological revolution is also significantly impacting the convergence of 

common and civil law. The emergence of electronic reporting systems of texts and 

cases in areas such as the Convention on Contracts for the International Sale of 

Goods, enhances access to statutory material and case law. The development of 


112. Id. at 383. 

113. Id. at387. 

114. Id. 

115. See id. at 392. 

116. See JOHN HENRY MERRYMAN & DAVID S. CLARK, COMPARATIVE LAW: WESTERN EUROPEAN 

& LATIN AMERICAN LEGAL SYSTEMS, 551-86 (1978). 

117. Joint American Law Institute/UNIDROIT Working Group on Principles and Rules of 

Transnational Civil Procedure, International Institute for the Unification of Private Law 2003, Study 

LXXVI - Doc. 10, 2, available at http://www.unidroit.org/english/publications/proceedings/2003/study/76/s- 

76-10-e.pdf. 



VOL. 42:625 

these reporting systems in other areas of international law will ultimately lead to 

greater convergence of legal systems. 

5. Experience of Constitutional Courts in Europe and Case Law in Civil Law 

Systems 

The development of a centralized system of judicial review in civil law nations 

has accelerated the convergence of common and civil law. The experience of 

constitutional courts in Europe has led to greater precedential weight of decisions 

emanating from those constitutional courts, giving them a "stare-decisis like 

authority." ' ... While civil law nations have a centralized system of judicial review 

with power entrusted to a special constitutional court, common law nations have a 

decentralized system of judicial review with all courts given the power of judicial 

review." 9 Constitutional courts have developed in civil law nations like Austria, 

Germany, Italy, and Spain because ordinary and administrative courts are not 

prepared to participate in judicial review. 2 

Civil law differs from common law because judicial decisions are generally not a 

source of law and the doctrine of stare decisis does not formally exist. However, 

some civil law nations, including France and Mexico, both informally and formally 

recognize the persuasive effect of previous decisions in ordinary and administrative 

courts. France explicitly rejects the doctrine of stare decisis because the principle of 

separation of power prevents French courts from formally creating legal rules. 2 ' The 

role of French courts is to solve disputes brought before them, not to make law.' 22 

However, judicial precedents may be cited in court and often affect French courts' 

ultimate decisions because there is a natural tendency to follow precedent, despite 

Article 5 of the French Civil Code. 3 In Mexico's civil law tradition, the doctrine of 

stare decisis is likewise not formally recognized, but the Supreme Court and collegial 

circuit tribunals can establish a binding precedent by issuing five consecutive 

decisions, with no incompatible rulings in between, on a certain point of law. 4 This 

binding precedent, known as Jurisprudencia, is binding on the court that establishes 

it and all lower state and federal courts that lie within the court's geographic 

jurisdiction. 2 " 

However, not all civil law nations have recognized the persuasive weight of 

previous decisions even though in practice, attorneys look to reported cases in 

interpreting statutes and codes. The sources of Italian law are statutes, regulations, 

corporative norms, and usage. 6 The Italian Code makes no mention of judicial 

decisions as a source of law; thus, the Doctrine of stare decisis is in theory rejected. 7 


119. Id. at 391. 

120. See id. 

121. MERRYMAN & CLARK, supra note 116, at 561. 

122. Id. 

123. Id. at 562; "Judges are forbidden to decide cases submitted to them by way of general and 

regulatory provisions." Civ., Preliminary Title, Art. 5 (Fr.) 


125. Id. at 575. 

126. See THE ITALIAN CIVIL CODE AND COMPLEMENTARY LEGISLATION, Booklet 2, Chap. 1 

(Susanna Beltranmo ed. and trans., 2003). 

127. See id. 



Italian law officially emphasizes strict separation of power, which justifies restricting 

courts to mere interpretation and application of the law, not making the law.1 2 

6. Case Law Experience of the European Union: An Example of Civil and 

Common Law Convergence in Practice 

An example of the convergence of common and civil law in practice is the 

European Union. The European Court of Justice (ECJ) is the judicial branch of the 

European Union. The ECJ plays a significant role in European integration.' 2 9 Its 

formal role is to ensure that the interpretation and application of European Union 

treaties are within the proper bounds of the law. 3 ' Today, the ECJ consists of 

twenty-five judges, one selected from each member-state, and eight advocates 

general."' Thus, judges come from both common and civil law traditions because, 

while most of the member-states have a civil law tradition, England and Ireland are 

common law nations. Therefore, judges from different legal traditions must 

accommodate and work together in the European Court of Justice. 

There are two stages of procedure in the European Court of Justice, a written 

stage and an oral stage.' 32 The written stage of the proceeding is the most thorough 

and most important stage in the proceeding, which is consistent with civil law 

tradition.' 33 The oral stage of the proceeding is limited and short, in which the 

interested parties merely restate their positions already presented in their written 

submissions. The ECJ may even propose to cancel the oral proceeding if the 

parties agree.' 35 During the oral stage, the judges and the advocate-general ask the 

advocates questions to clarify and focus the issues that are specifically important to 

them.' 36 This practice is also consistent with civil law tradition. Additionally, 

consistent with civil law judicial decisions, no dissent or concurring opinions are 

permitted in the European Court of Justice.' 37 The deliberations of the Court are 

kept secret and the decision is made by consensus and given in a unanimous opinion 

of the Court.38 

The common law doctrine of stare decisis does not formally exist in the 

European Court of Justice's practice; therefore, the Court is not bound by its own 

precedent. 9 However, precedent has become increasingly important in the ECJ 

since the United Kingdom entered the European Community in 1973.1'4 Although 

precedent is not a formal source of ECJ law, the Court often specifically refers to 

128. Merryman & Clark, supra note 116,at 557. 

129. See DEREK BEACH, BETWEEN LAW & POLITICS: THE RELATIONSHIP BETWEEN THE 

EUROPEAN COURT OF JUSTICE & EU MEMBER STATES 17 (2001). 

130. See id. at 23. 

131. See id. at 24. 

132. See id. at 29-30. 

133. See id. at 29. 

134. See id. at 30. 

135. Beach, supra note 129, at 30. 

136. See id. at 30. 

137. See id. at 31. 

138. See id. 

139. See id. at 85. 

140. Id. at 85. 



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previous decisions' 1 and advocates cite cases freely in written briefs and during the 

oral stage of the proceeding. Thus, the procedure and practice of the European 

Court of Justice is a practical example of the convergence of common and civil law 

necessary for a successful judicial system in the European Union. 

7. Other Perspectives: The Role of Precedent in Mexico 

While Goodhart believes that the application of the doctrine of stare decisis is 

the major difference in the common and civil law system, Zweigert and Kotz point 

out that because of the evolution of the two systems they may not be as divergent as 

once believed. The Mexican system is an additional example of the convergence 

occurring between civil and common law systems. By definition, Mexico is a civil 

law country, relying on codes and statutes to provide legal sources. However, it has 

adopted and adapted some of the practices of its northern neighbors. Through the 

process of convergence, the antithetical aspect of civil law, the doctrine of stare 

decisis, is being absorbed into Mexican legal culture. 

The structure of the Mexican legal system is similar to that of its civil law 

brethren. Historically, there has been a strict division of legislative and adjudicative 

functions of government.' 2 The Mexican Supreme Court has had the power to 

create precedent in circumstances of amparo" ' decisions since 1909, but the 

Constitution did not recognize this power until the 1950-1951 amendments." When 

the Constitution was further amended in 1968, the precedent-creating power was not 

specifically mentioned. 

However, it was taken as an assumption and extended to include Collegial 

Circuit Tribunal decisions. 4 ' Though there has never been consensus concerning the 

exact application and use of precedent, the 1951 amendments made the precedents a 

legitimate source of law. This explicit recognition is a unique feature in a civil law 

country and a large step toward convergence of civil and common law traditions. 

Though Mexico has adopted the unique blend of civil and common law, the law 

created by the courts does not hold the same status as judge made law does in 

common law countries. The Mexican Supreme Court has recognized that the 

application of jurisprudecia should never encroach into legislative functions. The 

jurisprudencia must only 

6 

be used to interpret, never create law.' As Merryman and 

Clark state, jurisprudencia is always to be considered an "auxiliary," never an 

"autonomous" source of law."' 7 Though the jurisprudencia may appear to be of 

similar weight and influence of that of the U.S. Supreme Court decisions, civil law 

traditions still constrain the application of the decisions to impact far less than the 

decisions of American courts. Mexican jurisprudencia has been effectively used to 

141. Beach, supra note 129, at 85. 


143. The juicio de amparo, or amparo for short, is a writ of protection that secures individual rights 

protected in the Constitution. It allows individuals to protect their rights against the government in 

criminal, civil, administrative and labor disputes. Alexis James Gilman, Making Amends with the Mexican 

Constitutions: Reassessing the 1995 Judicial Reforms and Considering Prospects for Further Reform, 35 

GEO. WASH. INT'L. L. REV. 947, 951-52 (2003). 


145. Id. at 571. 

146. Id. 

147. Id. at 572. 



clarify ambiguities and fill in gaps, but it could not be used to create law as seen in 

American courts. 

Precedent plays a unique role in Mexico's civil law system. The Mexican model 

draws from the rich traditions of both civil and common law countries. Civil law 

countries do not follow the doctrine of stare decisis. Mexico has blended the 

doctrine of stare decisis into its civil law tradition. While not technically binding, 

higher court decisions based on similar facts and law carry very persuasive 

authority.' 4 ' These persuasive decisions are known as ejecutorias. If an ejecutoria is 

followed the requisite number of times and with the proper procedure, it can create 

precedent.' 49 

Cases decided by the Supreme Court and Federal Circuit Collegiate Courts 

have the ability to create jurisprudencia. A jurisprudencia is a "term of art used to 

refer to the event whereby five uninterrupted and consecutive judicial resolutions 

rendered by the Supreme Court of Justice, or by a Circuit Collegiate Tribunal, 

sharing the same legal holding, become obligatory to all lower courts, provided that 

said federal resolutions had been approved by eight of the eleven Justices 

(Ministros) when decided by the Supreme Court en banc, or by four Justices of the 

relevant panel when generated by a Supreme Court Chamber."' 50 If a case is decided 

by a Collegial Circuit Tribunal, the decision must be unanimously approved by all 

three magistrates. 51 As each ejecutoria is repeated in its progression toward 

jurisprudencia it gains persuasive authority on the lower courts.' 52 If an ejecutoria is 

interrupted in its progression toward becoming jurisprudecia, the process must begin 

anew. There must be five more consistent opinions for that point of law to become 

binding as jurisprudencia. Once a jurisprudencia is created, however, a decision that 

contradicts its holding can have the effect of repealing it.' 3 To overrule a 

jurisprudencia, the contradictory ruling must be supported by at least fourteen 

Ministros. 

Once a court is authorized with the power of creating jurisprudencia, that court 

is bound by its own internal decisions, but not decisions by other courts."' 

Jurisprudencia of the Supreme Court is binding on all lower courts. Jurisprudencias 

created by the Collegial Circuit Tribunals are binding on lower district courts.' 55 

Though the jurisprudencias created by higher courts are binding upon the 

subordinate judiciary, this binding effect does not extend past the court systems. 

Unlike common law systems where judicial decisions will influence, if not bind the 

executive or legislative functions, the jurisprudencias in Mexico do not reach past the 

judiciary." 6 For example, if the Mexican Supreme Court declared a legislative act to 

be unconstitutional, it is unlikely that the legislative branch would be inclined to 

conform its legislation with the judicial decision unless there was a policy reason for 

148. Jorge A. Vargas, Moral Damages Under the Civil Law of Mexico: Are These Damages Equivalent 

to U.S. Punitive Damages?, 35 U. MIAMI INTER-AM. L. REV. 183,241. 

149. Id. 

150. Id. at 242. 


152. Vargas, supra note 148, at 243. 


154. Id. at 575. 

155. Id. 

156. Id. 



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doing so." 7 When a Mexican court has declared a law unconstitutional and one of 

the other branches has failed to comply with this determination, a person aggrieved 

by this action has no choice but to file another amparo action. 

The 1995 reforms expanded the Supreme Court's authority. 158 These 

amendments granted the Supreme Court, when approved by a majority of eight 

judges, the power to create precedent in a single decision. This power was limited, 

however, to four types of cases: 

(1) a controversy between the executive and legislative branches; (2) a 

conflict between two authorities of a single state regarding the 

constitutionality of acts of general provisions; (3) a dispute between two 

authorities of the federal legislative district; or (4) controversies involving 

the federal government violating the general provisions of Mexican states 

of municipalities. 9 

Without the requisite vote and in all other types of cases, the Supreme Court's 

decision is binding only on the parties presently in litigation.'6 

B. Status of Selected Current Substantive Harmonization Projects 

The following is a comment on the Principles of European Contract Law, a 

European Civil Code, a Global Commercial Code, and the UNIDROIT Principles of 

International Commercial Contracts and how they facilitate common and civil law. 

1. Principles of European Contract Law 

The discussion and development of the Principles of European Contract Law is 

an effort by the Lando Commission to harmonize the varying contract laws of 

European countries. 16 ' Harmonization of European commercial law is necessary 

because economic pressures exist in the European Union concerning the open 

market and facilitation of trade. Similar economic pressure and need for uniformity 

accelerated the establishment of the National Conference of Commissioners on 

Uniform State Laws when the first efforts were made in 1889 to unify individual 

state law in the United States.' 62 The Conference of Commissioners on Uniform 

State Laws began its effort to develop uniform state laws to facilitate interstate 

commerce. 63 In response to major commercial problems in the United States, the 

Conference decided in 1940 to create comprehensive legal solutions to those 

problems and began a project to produce the Uniform Commercial Code."' The 

157. Id. at 576. 

158. Gilman, supra note 143, at 958. 

159. Id. at 958. 

160. Id. 

161. See Andrea Pinna, Drafting a Civil Code for Europe: Aims & Methods 2 (2001), available at 

http://palissy.humana.univ-nantes.fr/msh/prog/ssn/SSN02.pdf. 

162. See Uniform Law Commissioners; The National Conference of Commissioners on Uniform State 

Laws available at http://www.nccusl.org (the Conference's first meeting was held in 1892). 

163. See id. 

164. See Id. 



UCC took ten years to complete; it took another fourteen years before every state in 

the United States, with the exception of Louisiana, enacted it with or without 

modification. 9 

The purpose of developing the Principles of European Contracts is to provide a 

restatement of the law of contracts, similar to the Restatements in the United States 

and to enact the Principles and give them the force of law.'6 The Principles are not 

the codification of existing contract law, but rather are a new, complete set of rules 

to govern all aspects of contracts. 167 The drafters attempt to modernize existing 

European contract law with solutions that may exist in some European States, but 

tend to be a desirable development of European contract law." 

2. European Civil Code 

Since 1997, the idea of a European Civil Code has been actively discussed by 

Europeans. 9 The discussion surrounding the development of a European Civil 

Code focuses on unification and harmonization of all aspects of European private 

law, which would in turn lead to unification and harmonization of common and civil 

law systems. In 1997, the symposium Towards a European Civil Code occurred in 

Den Haag.' 70 The Minister of Justice marked the opening of the symposium with a 

speech advocating the need for a European Civil Code' According to the Minister, 

overall harmonization of private law in Europe is both possible and necessary to 

strengthen Europe's internal market .' However, he recognized that a European 

Civil Code must bridge the gap between different legal traditions in Europe, 

including the common and civil law.17 

Unification seems possible and most urgent in the law of obligations and 

movable property.' 74 On the other hand, unified rules relating to immovables, family 

law, and succession law seem less realistic and less urgent.' The purpose of 

developing a Civil Code for Europe is similar to the purpose for developing 

European Principles of Contract Law, but on a broader scale. The goal is to provide 

a Restatement of the various civil laws throughout Europe and eventually enact the 

Civil Code, giving it the force of law.' 76 A reason asserted for codification of 

European Private Law is to reduce high transaction costs and enhance legal security 

165. See id. (Louisiana enacted various articles of the Code individually. It completed actual adoption 

of the Code in 1990, but only implemented Revised Article 9 in 2001). 

166. Pinna, supra note 161, at 4. 

167. ld. at 2. 

168. MERRYMAN & CLARK, supra note 116, at 2-3. 

169. See Ulrich Drobnig, Unified Private Law for the European Internal Market, 106 Dick. L. Rev. 

101,107 (2001). 

170. Ewoud Houdinus, Towards a European Civil Code, in TOWARDS A EUROPEAN CIVIL CODE 3, 3- 

20 (Arthur Hartkamp et al. eds., 2004). 

171. See id. 

172. Id. 

173. Id. 

174. Drobnig, supra note 169, at 107. 

175. Id. 




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within Europe. 77 Codification would reduce transaction costs because civil laws in 

each member state differ and the uncertainty surrounding each member state's 

particular law hinders cross-boarder exchange in the European Union. 8 

Furthermore, unifying European civil law will increase the effectiveness of a single 

European market. 7 " 

However, not all Europeans are convinced that a European Code is desirable. 8 ° 

Some skeptics fear the cultural identity of individual European States will be 

endangered if its own civil law is supplemented and absorbed by European law. 8 ' 

Another source of opposition deals with the potential difficulties of working within 

two legal cultures.'8 Many argue that common law nations will reject the idea of a 

Code based on their tradition of predominance of case law. However, common law 

nations in the European Community, including England and Ireland, are 

increasingly accepting the written law, while the influence of case law in civil law 

nations is increasing. 83 Furthermore, the two opposing legal systems work together 

in the application of the Convention on Contracts for the International Sale of 

Goods,' which shows that they are able to work together in the application of a 

European Civil Code as well. 

While the majority of academics in Europe agree that the current acquis in that 

area is inconsistent and fragmented and that this is the inevitable effect of the 

"piecemeal approach" towards harmonization in the civil law area, the opinions 

regarding the Common Frame of Reference, its contents and its role-as well as the 

possibility of creating some kind of codified instrument based on it at a later stagevary 

greatly. Professor Pierre Legrand directly opposes the idea of a European Civil 

Code and represents the group of academics in Europe who believe that Europe 

should be the way it is-a continent that consists of multiple legal orders."' Others, 

like Professor Jan Smits are against the idea for the creation of a European Civil 

Code in a wrong way and for the wrong reasons. Professor Smits opposes the idea of 

a binding European Civil Code forced from above-the institutions of the Union. 6 

But he embraces the idea of the creation of an optional code, a "26 h regime," which 

the contracting parties will be free to choose if they so desired. He takes a very 

economic and competitive view-that the best solution for the parties should emerge 

through free competition of the legal orders in the Union. This will benefit both the 

parties and the national legal systems. The parties will benefit from the fact that 

they are able to choose freely the best option for themselves. The national legal 

systems will be forced to improve their regimes in order to make their environment 

more attractive for businesses and thus will become more competitive and constantly 

self-improve. In other words, "[t]hose for whom the law exists should decide which 

177. Id. at 4-6. 

178. See id. at 5. 

179. Id. 

180. See Drobnig, supra note 169, at 108. 

181. Id. 


183. Id. at 6-7. 

184. Id. at 7. 

185. Pierre Legrand, Against a European Civil Code, 60 MOD. L. REv. 44 (1997). 

186. Jan M. Smits, European Private Law: A Plea for a Spontaneous Legal Order 19-20 (Maastricht 

Faculty of Law Working Paper 2006/3, 2006), available at 

http://www.unimaas.nl/default.asp?template=werkveld.htm&id=F60BL5POOMJ0466V63M6&taal=nl. 



rules serve their interests best.""'" Professor Smits also doubts the ability of the 

Common Frame of Reference to solve the problems with the current acquis and to 

improve the future acquis. Instead, his proposal centers around the idea of 

combining all relevant directives in the area into a single "codified" directive. 

Professor Norbert Reich expresses pessimistic views on the possible creation of 

a European Civil Code but for other reasons. According to him, the competence of 

the Community in the area of contract law is limited to certain areas where contract 

law may have a specific impact on other Community policies like internal market, 

competition, consumer protection, and social policy.' 88 Thus, no horizontal 

competence in contract law exists for the European Community. 8 9 However, he 

proposes an idea like that expressed by Professor Smits, that competition of legal 

orders and not harmonization might actually be a solution to the problems raised in 

the Commission's Communication of 2001.1"° 

The group of optimists on this initiative consists mainly of the academics 

involved in the research teams throughout Europe. Their belief is that the twentyfive 

different legal orders present an obstacle to cross-border transactions mainly 

through the fact that it increases the costs of transactions and because the parties are 

unfamiliar with the other legal system. Thus, the twenty-five different legal systems 

can hinder the functioning of the internal market. According to this group of 

academics, creating a codified instrument that will employ common terms, principles, 

and definitions will be able to solve those problems. However, internally, this group 

is divided into small groups. While some believe that a mandatory code is needed 

for the problems to be solved,' 8 ' others like Professor Martijn Hesselink, think that 

while the drafting of European Civil Code involves many choices that are essentially 

political, the technocratic approach adopted by the Commission in its Action Plan of 

2003 effectively excludes most stakeholders from expressing their views.' 9 He 

suggests that the Commission should try to re-politicize the process and thus increase 

the democratic basis of the European Civil Code and consequently its legitimacy.' 9 

Professor Christian von Bar, the Chairman of the Study Group on a European 

Civil Code, expressed the joint view of the group by stating that 

the partial and fragmentary nature of EU competence in the field of 

private law encourages a segmental approach to harmonization which 

disturbs the coherence of the interlocking concepts and principles in the 

national jurisdictions. A general and transparent empowerment of the EU 

in this field is needed to facilitate general measures on the basis of a wider 

187. Id. at 20. 

188. Norbert Reich, Some Critical Comments on the Commission Communication of 11.07.2001, 

COM(2001) 398 final "On European Contract Law," at 2 (Sept. 2001), available at 

http://ec.europa.eu/consumers/policy/development/contract-aw/comments/5.1 4.pdf. 

189. Id. at 2. 

190. Id. at 4. 

191. See, e.g., UGO MATrI, Hard Code Now! A Critique and a Plea for Responsibility in the 

European Debate over Codification, in THE EUROPEAN CODIFICATION PROCESS: CUT AND PASTE, 107, 

107 (2003). 

192. Martijn W. Hesselink, The Politics of a European Civil Code, 10 EUR. L. J. 675, 675 (2004), 

available at http://www.europeanlawjournal.com/contents-detail.asp?JournallD=43. 

193. Id. at 675-76. 



VOL. 42:625 

and more systematic vision which do not cut across or undermine the 

existing sophisticated apparatus of private law in the Member States. ' 9 

3. UNIDROIT Principles 2004: A Further Step Toward a Global Contract 

Law 

The Principles of International Commercial Contracts created by the 

International organization UNIDROIT (UNIDROIT Principles) address contracts 

between merchants in an international context. The UNIDROIT Principles attempt 

to present rules common to most existing legal systems, but also select the most 

adaptable solutions to the requirements of international trade. 9 The majority rule is 

not necessarily chosen; rather, the Principles reflect the most persuasive rule that is 

best suited for cross-border transactions. 9 6 In drafting the UNIDROIT Principles, 

the group considered national codifications or compilations of law, such as the 

United States Uniform Commercial Code, the Restatement (2nd) of the Law of 

Contracts, and other similar efforts.' 97 The 1980 United Nations Convention on 

Contracts for the International Sale of Goods was also referred to in drafting the 

UNIDROIT Principles. 99 The UNIDROIT principles are drafted in the style of the 

European Codes, rather than the elaborate style of common law statutes. 9 9 The 

UNIDROIT Principles also avoid using terminology peculiar to any specific legal 

system. °° The scope of the UNIDROIT Principles is limited to International 

Contracts because great differences continue to exist between nations and regions 

regarding the contract law applicable to their economic and political structure."' 

The UNIDROIT Principles are used in practice as a model for legislators, a 

guide for drafting international contracts, a choice by parties to govern their 

contract, and applications in judicial proceedings. 2 Other nations have referred to 

the UNIDROIT Principles in reports or interpretive rules and some have even used 

the Principles as a model to reform domestic law. 2 3 In addition, if international 

parties use the terminology present in the UNIDROIT Principles, they will have 

neutral terminology with a uniform definition to control their contract." ° 

Furthermore, if international parties agree that UNIDROIT Principles govern their 

contract, a choice between competing domestic laws to govern the contract will be 

unnecessary."' Finally, the UNIDROIT principles are often cited in arbitration 

proceedings and in domestic courts. 2 " 

194. Christian von Bar, The Contribution of the Study Group on a European Civil Code to the 

European Convention (Apr. 4, 2004), available at http://www.sgecc.net (last visited Apr. 17, 2007). 

195. Michael Joachim Bonell, The Unidroit Principles of International Commercial Contracts: 

Towards a New Lex Mercatoria?, 2 INT'L Bus. L.J. 145,147 (1997). 

196. Id. 

197. Id. 

198. Id. at 148. 

199. Id. at 149. 

200. Id. at 150. 

201. Bonell, supra note 195, at 150-51. 

202. Id. at 152-55. 

203. Id. at 152-53. 

204. Id. at 153. 

205. Id. at 154. 

206. Id. at 155. 



4. Global Commercial Code 

In 1970 the Secretariat of UNIDROIT submitted a note to the newly 

established United Nations Commission on International Trade Law (UNCITRAL) 

in justification of a code of international trade law." 7 The proposed code was 

composed of two parts. Part one would deal with the law of obligations generally. 

Part two would relate to specific kinds of commercial transactions. 2 "' The 

UNIDROIT note did not address which type of instrument (i.e., convention, model 

law, soft law, etc.) should be used by the proposed code. The Progressive 

Codification was not given priority due to limited resources and skepticism as to its 

feasibility."" However, support remains for the idea that globalization of the world 

entails a need for uniform rules. 

In 2000, Gerold Hermann, long time Secretary of UNCITRAL, proposed the 

idea of a global commercial code to compile special rules governing the most 

important commercial transactions . 2 " He proposed something different from the 

original UNIDROIT proposal."' The code should be composed of the existing rules 

of international conventions and model rules. He conceived of it as an open-ended 

instrument intended "to weld together into a logical and integrated work" existing 

and future uniform laws in the field of international trade law. In Hermann's 

proposed code there could also be a provision permitting parties to an international 

contract to choose the UNIDROIT Principles as the law applicable to their contract. 

Alternatively the code could provide that the UNIDROIT Principles are applicable 

unless parties explicitly exclude them by choosing another applicable law or 

otherwise. 2 3 However, Herrmann envisioned that the code would become a model 

law adopted by States. He cited the adoption of the U.C.C. by the states in the 

United States as support for his idea that the code could "advance international 

codification .. .by serving as an example of a successful unification of the laws of 

many jurisdictions., 21 4 

Michael Joachim Bonell followed up on this idea of a Code to apply to crossborder 

transactions between business people and between individuals. Leaving open 

the question of its applicability to so-called consumer contracts, he suggests that the 

Global Commercial Code should avoid interfering with existing or future domestic 

rules for the protection of consumers."' It should not be a strict commercial code 

conceived as a special set of rules conceived for merchants distinct from the general 

civil code because no such civil code exists at the international level and also because 

207. See Progressive Codification of the Law of International Trade: Note by the Secretariat of the 

International Institute for the Unification of Private Law (UNIDROIT), [1968-70] 1 U.N. COMM'N ON INT'L 

TRADE L. Y.B. 285-86, U.N. Doc. A/CN.9/L.19. 

208. Michael Joachim Bonell, Do We Need a Global Commercial Code?, 106 DICK.L. REV. 87, 87 

(2001). 

209. Id. 

210. Gerold Hermann, The Role of UNCITRAL, in FOUNDATIONS AND PERSPECTIVES OF 

INTERNATIONAL TRADE LAW 28,35 (Ian Fletcher et al. eds., 2001). 

206. Bonell, supra note 208, at 88. 

212. Id. 

213. Id. at 91, 98. 

214. Id. at 89 n.9. 

215. Id. at 91. 



VOL. 42:625 

of the difficulties of distinguishing between "civil" and commercial parties and 

216 

transactions. Unlike Hermann, he felt that the existing instruments would have to 

be coordinated, rather than just transplanted into the Code, and should include the 

general contract law. 2 7 He agreed that the Global Commercial Code should be 

model law like the UCC but should be different than the UCC in that its scope 

should be limited to cross-border 

2 8 

transactions. This Global Code would be binding 

among nations that adopted it. He stressed that it should not be a comprehensive 

code that purports to provide answers to all legal disputes. 2 19 Additionally, he 

advised that the Global Commercial Code should not be mandatory and nations 

should not be prevented from modifying it. 22 Nations should be free to adopt it as 

proposed or modify it to account for the varying legal traditions and already adopted 

regional or universal laws dealing with identical areas. Something such as the 

UNIDROIT Principles of International Contracts 2004 (UPICC) would remain as 

soft law separate from the Global Code. These features would prevent such a Code 

from being overly ambitious. 

Ole Lando supports Bonell's ideas that the existing instruments will need to 

incorporate the general law of contracts in order to achieve the uniformity that is the 

underlying goal of the Code. 222 However, Lando seems to envision a less flexible 

version of the code and insists that if uniformity is to be achieved it would be 

necessary to make existing rules like the UNIDROIT Principles part of the Code 

and binding on the courts. 223 Lando suggests in detail the scope, substance and 

content, interpretation, mandatory rules, and other specific topics of the Code. 22 He 

argued that the Code should be limited to private law and analyzed the way the 

international law should interact with the laws of different countries.22 He proposes 

that some of the rules of the CISG be adopted along with rules now contained in 

UNIDROIT Principles of International Contracts 2004 (UPICC) and the Principles 

of European Contract Law (PECL) to become part of the Code. 226 

5. Other International Regimes' Impact on Convergence: UNCITRAL and 

the World Trade Organization 

The United Nations Commission on International Trade Law (UNCITRAL) is 

a body of member-states representing various regions which was established in 1966 

to further the harmonization and unification of the law of international trade. 227 

216. Id. at 90-91 

217. Bonell, supra note 208, at 92, 95. 

218. Id. at 94. 

219. Id. at 92-93. 

220. Id. at 93. 

221. See generally Michael Joachim Bonell, A Further Step Towards Global Contract Law: From 

UNIDROIT Principles 1994 to UNIDROIT Principles 2001, 37 UCC L.J. 49 (2004). 

222. See generally Ole Lando, A Vision of A Future World of Contract Law - Impact of European and 

UNIDROIT Contract Principles, 37 UCC L.J. 3 (2004). 

223. Id. at 9. 

224. Id. at 10-46. 

225. Id. at 11. 

226. Id. at 10-46. 

227. United Nations Commission on International Trade Law (UNCITRAL), FAQ - Origin, 

Mandate and Composition of UNCITRAL, http://www.uncitral.org/uncitral/en/about/origin-faq.html. 



Since its creation, UNCITRAL has established conventions, model laws, and other 

instruments to modernize laws. 22 These instruments are utilized by private parties in 

international trade transactions. 22 UNCITRAL creates solutions acceptable in 

different legal systems, including common and civil law systems. 3 ' One of the five 

regional groups within UNC1TRAL is "Western European and Other States," which 

includes both common and civil law nations such as the United States, the United 

211 

Kingdom, France, Italy, Spain, and Germany. Once a text is adopted by 

UNCITRAL consensus, the choice of whether a State will officially adopt it is made 

by lawmakers of the individual States. 232 

An example of a text adopted by UNCITRAL that has been widely accepted 

and led to harmonization of opposing legal systems is the CISG, adopted in 1980. 

The CISG focuses on the development and unification of international trade. The 

CISG adopts uniform rules which govern contracts for the international sale of 

goods. 

Another international organization which facilitates convergence of common 

and civil law systems is the World Trade Organization (WTO). The WTO is an 

international organization established in 1995 that develops global rules of trade 

between nations. 233 The WTO has 150 members, coming from all legal systems, 

including common and civil law, which account for over 97% of world trade. 234 

These members must work together towards the primary objectives of the 

organization-helping trade flow smoothly, freely, fairly, and predictably. 235 Major 

functions of the WTO are to administer WTO trade agreements, provide a forum for 

trade negotiations, handle trade disputes, monitor national trade policies, provide 

technical assistance and training for developing countries, and cooperate with other 

international organizations. 3 ' These activities require cooperation of all members 

and facilitate the convergence of legal systems. 

C. Principles and Rules of Transnational Civil Procedure - An ALl and 

UNIDROIT Cooperative Harmonization Project " 

While the harmonization of substantive law has made great progress, 

harmonization of procedural law has been less successful. 237 While differences in 

common and civil law procedure may seem great, Professor Vincenzo Varano 

contends that harmonization is occurring and the procedural models are less at odds 

228. Id. 

229. Id. 

230. Id. 

231. Id. 

232. Id. 

233. World Trade Organization (WTO), http://www.wto.org/english/thewtoe/whatise.htm. 

234. Id. 

235. Id. 

236. Id. 

237. G. C. Hazard et al.. Draft Principles of Transnational Civil Procedure with Comments and Draft 

Rules of Transnational Civil Procedure with Comments 2 (Int'l Inst. For the Unification of Private Law - 

Joint American Law Institute/UNIDROIT Working Group on Principles and Rules of Transnational Civil 

Procedure, UNIDROIT Study LXXVI - Doc. 10, 2003), available at 

http://www.unidroit.org/english/publications.proceedings/2003/study/76/s-76-10-e.pdf. 



VOL. 42:625 

than they were made out to be in the past. 238 Both systems attribute the same 

purpose to civil procedure, which is to reach the efficient and just resolution of 

private disputes. 239 Although differences still exist between the two models, these 

differences, according to Varano, no longer have the importance they once had. 2 40 

The major difference between the two systems is based on the central feature of 

common law procedure: the jury. 2 ' The jury has produced features of the common 

law model of procedure that are distinct from the civil law approach, such as the 

importance of the oral stage of the proceeding, the sharp separation between the 

pre-trial state and the trial state, the passive role of the judge, and the detailed rules 

of evidence. 42 However, Varano contends that the jury's importance in common law 

procedure has been diminishing. 24'3 The jury has disappeared in the English system 

and the written elements of procedure have acquired a greater importance in the 

United States procedural system. 244 Additionally, recent reforms in common law 

nations, such as England, Australia, and the United States, grant the judge greater 

directional and management power, which decreases the adversarial nature of the 

proceeding. 245 

Procedural models vary not only between common law and civil law systems 

246 

but also among civil law nations. Some nations rely heavily on the written 

elements of procedure, while others emphasize the oral element. 2 47 Likewise, some 

civil law models are more inquisitorial while others are heavily influenced by the 

adversarial model. 2 4 Thus, differences not only exist between common and civil law 

systems, but also exist among the civil law procedural systems. 49 

Despite the harmonization of common and civil law procedural systems that 

Varano contends has taken place, differences continue to exist which cause problems 

when legal conflicts cross these procedural boundaries. A joint project by the 

American Law Institute and UNIDROIT has produced the Principles and Rules of 

Transnational Civil Procedure which attempts to harmonize these procedural 

differences. The Project emerged due to the negative consequences, such as the costs 

and distress, of working within various procedural systems. 20 These negative 

consequences can be mitigated by reducing the procedural differences so the same 

procedural rules apply wherever the conflict may be adjudicated. 251 The Principles 

and Rules provide a system that nations can adopt and employ when faced with 

238. Vincenzo Varano, Some Reflections on Procedure, Comparative Law, and the Common Core 

Approach, 3 GLOBAL JURIST TopIcs, No. 2, at 1-2, available at 

http://www.bepress.com/cgi/viewcontent.cgi?article=1101&context=gj. 

239. Id. at 2. 

240. Id. 

241. Id. 

242. Id. 

243. Id. 

244. Varano, supra note 238, at 1-2. 

245. Id. 

246. See id. 

247. Id. 

248. Id. 

249. Id. 

250. ALI/UNIDROIT PRINCIPLES OF TRANSNATIONAL CIVIL PROCEDURE, AMERICAN LAW 

INSTITUTE (2006). 

251. Id. 



adjudication of international commercial disputes." The objective of these 

Principles and Rules is to offer a fair procedure to all parties and to reduce the 

uncertainty and anxiety resulting from litigation in unfamiliar surroundings. 253 

The Principles and Rules attempt to combine the best elements of the common 

law adversarial procedure with the best elements of the civil law judge-centered 

inquisitorial system. 25 ' The project recognizes numerous fundamental similarities as 

well as differences in the two procedural systems and tries to harmonize these 

aspects into a single set of Principles and Rules. An example of an issue addressed 

by the Principles and Rules is the rules for the formulation of claims. 256 The 

Principles and Rules require details with particulars regarding the basis of the claim; 

the particulars must also reveal a set of facts that would entitle the claimant to a 

favorable judgment. 27 The Principles and Rules regarding the exchange of evidence 

requires disclosure of sources of specific proof supporting the allegations set forth in 

the pleadings, such as relevant documents, expert reports, and summaries of 

expected witness testimony before the plenary hearing. 2 9 Therefore, the parties 

must have sufficient evidence to support their claims and be prepared to reveal all 

their evidence to the opponents without the opponents having to demand particular 

information. 2 9 Additionally, the rules provide a limited right to document discovery 

and deposition. 26 0 The Principles and Rules also address the procedure at the 

plenary hearing, second-instance review, and finality of decisions. 26 ' 

D. Impact of Electronic International Reporting Systems on Convergence 

The worldwide revolution in communication technology has injected a new 

potential and momentum for substantial progress in planned and spontaneous 

harmonization of legal systems. The successful emergence of transnational 

electronic reporting systems facilitates harmonization of common and civil law 

systems. Enhanced capacity to communicate across borders and among different 

legal systems and cultures fosters achievement of desirable policy goals in public and 

private law. It also leads to greater efficiency and lowered costs in the exchange of 

information, documents, and ideas, and lower transaction costs for the commercial 

world. In some instances it provides information that otherwise would not be 

available to areas of the world that cannot afford to maintain voluminous hard copy 

libraries. 

Transnational electronic reporting systems facilitate universal access to legal 

systems. The data for identification of similarities and differences between legal 

systems is instantly available across distant borders and cultures for discussion and 

252. Id. at 3. 

253. Id. at 8. 

254. Id. at 7. 

255. See id. at 4. 

256. ALI/UNIDROIT, supra note 250, at 5. 

257. Id. at 5-6. 

258. Id. at 6. 

259. See id. at 6. 

260. Id. at 6. 

261. Id. at 7. 



VOL. 42:625 

analysis, and it facilitates development of the consensus which is indispensable to 

achievement of successful harmonization. 

Ever-improving sophisticated electronic reporting is already available for the 

Convention on Contracts for the International Sale of Goods. Existing reporting 

systems include the Pace Law School CISG Database 255 , UNILEX 256 , and 

UNCITRAL CLOUT (Case law on UNCITRAL Texts) 257 . These linked 

transnational electronic reporting systems provide updated legislative text, 

legislative history, case law, and access to the voluminous CISG literature. These 

pioneering systems can serve as a prototype for worldwide electronic reporting 

systems covering other areas of harmonized transnational law as they develop to 

meet the needs of an increasingly globalized world. 

255. See Pace Law School, The Autonomous Network of CISG Websites, 

www.cisg.law.pace.edu/network.html. This database contains a list of The Autonomous Network of CISG 

Websites from twenty-five countries, twenty-three of which can be viewed by hypertext links. 

256. See UNILEX, UNILEX on CISG and Unidroit Principles, www.unilex.info/dynasite.cfm. 

257. See United Nations Comm'n on Int'l Trade L. (UNCITRAL), Case Law on UNCITRAL Texts. 

www.uncitral.org/uncitral/en/caselaw.html. 


Canadian Preference Law Reform 

ANTHONY DUGGAN' AND THOMAS G.W. TELFER' 

SUMMARY 

I. In tro d u ctio n ......................................................................................................... 66 1 

II. The Evolution of Preference Law and Policy .................................................. 662 

A . The D ebtor Deterrence Rationale .............................................................. 662 

B. The Creditor D eterrence Rationale ............................................................ 664 

C. The Equal Sharing Rationale ..................................................................... 665 

D . Finality of Transactions .............................................................................. 667 

E. Facilitating the Provision of Credit to Financially Distressed Debtors ..667 

F. The Trade-O ffs ............................................................................................ 668 

III. C urrent C anadian Law ....................................................................................... 670 

A . In trod uction ................................................................................................. 670 

B . Pressure and D iligence ................................................................................ 674 

C . A ssessm ent ................................................................................................... 676 

IV . L aw R eform Initiatives ...................................................................................... 679 

V . C o n clusion ........................................................................................................... 684 


The preference provisions in the Canadian Bankruptcy and Insolvency Act' 

(BIA) have been virtually unchanged since the legislation was enacted in 1919,2 and 

many of their features derive from the nineteenth century and earlier English law. 

There have been various reform proposals over the years, but until now they have 

come to nothing. Most recently, in 2003 a Senate Committee recommended 

t Faculty of Law, University of Toronto. 

f Faculty of Law, University of Western Ontario. 

1. Bankruptcy and Insolvency Act, R.S.C., ch. B-3, §§95-6 (1985). 

2. There was an amendment the following year to exclude the doctrine of pressure. AN ACT TO 

AMEND THE BANKRUPTCY ACT, 10-11 George V (1920), 123. See also Part 111(b), infra. 



VOL. 42:661 

amendments "to ensure consistent and simplified rules for challenging fraudulent 

preferences," but without explaining what was wrong with the current laws and how 

they should be changed? Recently enacted amendments aim to put the Senate 

Committee's recommendation into effect, but there is still no clear sense of the 

underlying objective' In any event, there are drafting problems, which will be 

explained later, and these will have to be fixed if the amendments are to have any 

impact at all. The drafting problems were at least in part a function of the failure to 

address policy objectives. 

This paper argues that: (1) the current Canadian preference provisions are 

deficient because: (a) they lack a clear policy foundation, (b) judicial glosses on the 

statutory text mean that the statute itself is an incomplete statement of the law; and 

(c) the amount of discretion the provisions give the courts results in inconsistent and 

unpredictable case outcomes; (2) these problems should be fixed, but meaningful 

reform is impossible unless we first decide what we want the preference laws to 

achieve;' and (3) Canada's lawmakers should address the policy choices before 

proceeding further with the current reform initiative. 

Part II surveys the evolution of preference law in common law countries and 

the competing policy objectives. Part III provides an overview of the current 

Canadian provisions and critically analyzes them with reference to the policy 

objectives identified in Part II. Part IV describes the most recent reform initiative 

and critically analyzes it with reference to the policy objectives identified in Part II. 

Part V concludes. 

II. 

THE EVOLUTION OF PREFERENCE LAW AND POLICY 

A. The Debtor Deterrence Rationale 

Broadly speaking, a preference is a payment of money or a transfer of property 

made by a debtor to a creditor on the eve of the debtor's bankruptcy, representing 

more than the amount the creditor would recover in the debtor's bankruptcy 

distribution. Early preference law developed through case authority. In The Case of 

Bankrupts (Smith v. Mills), Lord Coke stated the rationale for the avoidance of 

preferences in terms of the need to preserve the principle of equal distribution 

underlying the bankruptcy laws: "there ought to be an equal distribution ...... [for] 

if, after the debtor becomes a bankrupt, he may prefer [a creditor] and 

defeat and defraud many other poor men of their true debts, it would be unequal 

3. Standing S. Comm. on Banking, Trade and Com., 37th Parl., Debtors and Creditors Sharing the 

Burden: A Review of the Bankruptcy and Insolvency Act and the Companies' Creditors Arrangement Act 

at 123 (2d. Sess. 2003) [hereinafter Senate Committee Report]. 

4. An Act To Establish the Wage Earner Protection Program Act, to Amend the Bankruptcy and 

Insolvency Act and the Companies' Creditors Arrangement Act and to Make Consequential Amendments 

to other Acts, 28 C. Gaz. 5, at 203 (Nov. 25, 2005) [hereinafter BIA Amending Act of 2005]. Proclamation 

of the BIA Amending Act 2005 has been postponed for at least six months to allow time for further 

deliberation. 

5. Commenting on the provincial preference legislation, Dunlop makes a similar point. "The first step 

is to decide what attitude the law should take to fraudulent preferences and then construct a statute which 

clearly and simply represents that policy. Patchwork amendment is not enough." C.R.B. Dunlop, 

Fraudulent Conveyances and Preferences: A Feasibility Study 10 (Uniform Law Conference of Canada 

2004), available at http://www.ulcc.ca/en/poam2/FraudulentPreferencesEn.pdf. 


2007 

CANADIAN PREFERENCE LAW REFORM 

and unconscionable, and a great defect in the law.", 6 Lord Mansfield expressed a 

similar view in Alderson v. Temple. According to Dickson J. in Hudson v. 

Benallack, this is still the policy of Canadian preference law: 

The object of the bankruptcy law is to ensure the division of the property 

of the debtor rateably among all his creditors in the event of his 

bankruptcy ....... The Act is intended to put all creditors upon an equal 

footing. Generally, until a debtor is insolvent or has an act of bankruptcy 

in contemplation, he is quite free to deal with his property as he wills and 

he may prefer one creditor over another but, upon becoming insolvent, he 

can no longer do any act out of the ordinary course of business which has 

the effect of preferring a particular creditor over other creditors. If one 

creditor receives a preference over other creditors as a result of the debtor 

acting intentionally and in fraud of the law, this defeats the equality of the 

bankruptcy laws. 8 

The following statement from Re Norris, an Alberta Court of Appeal decision, 

makes the point even more clearly: 

... [the fraud lies in] the accompanying intent of the insolvent debtor who 

in the face of imminent bankruptcy is moved to prefer or favor, before 

losing control over his assets, a particular creditor over others who will 

have to wait for and accept as full payment their rateable share on 

distribution by the Trustee in the ensuing bankruptcy. It is called 

fraudulent because it prejudices other creditors who will receive 

proportionately less, or nothing at all, and upsets the fundamental scheme 

of the Act for equal sharing among creditors. 9 

Although these explanations are all framed in terms of equal distribution in 

bankruptcy, they cannot mean that the objective of preference laws is to ensure 

equal distribution per se. The emphasis on the debtor's state of mind and the 

reprehensibility of the debtor's conduct is inconsistent with the objective of 

preserving equality of distribution per se. All transactions having the effect of 

favouring a particular creditor disrupt the equal treatment of creditors in 

bankruptcy, regardless of whether the debtor intended that result and regardless of 

the moral character of the transaction. Lord Coke's statement discloses the real 

6. The Case of Bankrupts (Smith v. Mills) (1584) 76 Eng. Rep. 441, 473 (K.B.). Strictly speaking, this 

case concerned the relation back principle (i.e., that the court had the power to avoid transfers after the 

debtor had committed an act of bankruptcy), but it provided the general principle from which the law on 

fraudulent preferences would develop. Robert Weisberg, Commercial Morality, the Merchant Character 

and the History of the Voidable Preference, 39 STAN. L. REV. 3, 40-41 (1986). 

7. [1768] 98 Eng. Rep. 165 (K.B.). Lord Coke's statement referred to payments made after the debtor 

had become bankrupt, but Lord Mansfield's doctrine extended to transactions on the eve of bankruptcy. 

See Harkness v. P'ship Pac. Ltd. [1997] 41 N.S.W. L.R. 204, 237 (Aust.). 

8. [1976] 2 S.C.R. 168, para. 21 (Can.). Earlier authorities also emphasized the debtor deterrence 

rationale. Can. Credit Men's Trust Ass'n v. Umbel [1931], 13 C.B.R 40, paras. 28, 31 (Can.) 

9. [1997] 2 W.W.R. 281, para. 16 (Can.). For more recent statements to the same effect, see 

Krawchenko (Trustee of) v. Minister of Nat'l Revenue [2005] 11 C.B.R. (5th) 238, para. 23 (Can.); St. 

Anne-Nackawic Pulp Co. (Trustee of) v. Logistec Stevedoring (Atlantic) Inc. [2005] 255 D.L.R. (4th) 137, 

para. 11 (Can.). 



VOL. 42:661 

concern, namely that it is wrong for the debtor to play favourites among creditors in 

defiance of the bankruptcy laws: paying out friends," 0 relatives and business 

connections ahead of other creditors is wrong because, given the debtor's impending 

bankruptcy, it deprives "other poor men of their true debts." This is where the fraud 

lies. Another way of making the same point is to say that the debtor may not "set 

himself up as the law-giver in bankruptcy distribution."'" That is how Lord Mansfield 

expressed it in Alderson v. Temple." 2 

In summary, according to the old cases the rationale for the preference laws is 

"debtor deterrence." Under this model, it is the debtor's conduct that is viewed with 

suspicion." The debtor deterrence rationale presupposes sanctions against the 

preference-giving debtor. The main burden of the preference laws falls on the 

creditor rather than the debtor. What penalty does the debtor suffer? In former 

times, the giving of a preference was a criminal offence for which the bankrupt 

would be pilloried and have an ear cut off. 14 This, along with other barbaric features 

of the bankruptcy laws, has long since disappeared, but there are vestiges of a penal 

strategy in the modern law. For example, in Canada the giving of a preference is a 

ground for denying or suspending the debtor's right of discharge. 5 

B. The Creditor Deterrence Rationale 

Jackson offers a quite different justification for the preference laws. 6 In his 

view, the debtor's insolvency creates a common pool problem. In the absence of 

bankruptcy laws, once individual creditors learned about the debtor's insolvency, 

each creditor would have an incentive to engage in a race for the debtor's assets both 

to make sure of being paid in full and also because, if a creditor does not race and 

the other creditors do, it will be left with nothing. This self-interested behaviour is 

against the interests of the creditors collectively because it is likely to result in the 

piecemeal dismemberment of the debtor's estate, and it is often the case that the 

debtor's estate will be worth more if it can be sold intact. Moreover, the prospect of 

a race to judgment would require creditors to engage in costly monitoring of not only 

the debtor's financial situation but also other creditor's activities to make sure they 

did not gain a head start if a race were to eventuate. Bankruptcy law addresses 

theses concerns by substituting a mandatory system of collective debt collection for 

the individual, winner-take-all collection system that operates outside bankruptcy. 

The preference laws are an integral part of the transition from one system to the 

other. This is because, in the absence of the preference laws, creditors who find out 

about the debtor's impending bankruptcy may take advantage of the information to 

have their own claims satisfied, thereby opting out of the collective proceeding 

10. "Thus, payment to a creditor who is a family member or friend is more apt than not to qualify as a 

fraudulent preference...." St. Anne, supra note 9, para. 11. 

11. Weisberg, supra note 6 at 41. 

12. Alderson, supra note 7, at 166. 

13. See J.J. Morrison, The Impact of Bankruptcy Preference Rules on Commercial Secured Financing 

in the United States and Canada, in DEBTOR-CREDITOR LAW: PRACTICE AND DOCTRINE 590 (E. Gertner 

& M.A. Springman eds., 1985). 

14. 1623, 21 Jac. 1, c. 19, §7 (Eng.), cited in Charles Jordan Tabb, Rethinking Preferences, 43 S.C. L. 

REv. 981,996 (1992). 

15. Bankruptcy and Insolvency Act, R.S.C., ch. B-3, §173(1)(h) (1985). 

16. Thomas H. Jackson, THE LOGIC AND LIMITS OF BANKRUPTCY LAW, 122-50 (1986). 


2007 


altogether. "By the time the bankruptcy petition is actually filed, those creditors 

that remain would have to share in the 'tag ends and remnants' of the [debtor's] 

assets."' 7 In short, preference law is "part of the attempt to ameliorate the effects of 

a common pool problem that justifies a collective proceeding in the first place."' 8 

Lord Coke's justification for the preference laws looks to the debtor's conduct 

in giving the preference. By contrast, Jackson's justification looks to the creditor's 

conduct in receiving it. While Lord Coke's approach provides a debtor deterrence 

rationale for the preference laws, Jackson's approach provides a creditor deterrence 

rationale. 9 Under the creditor deterrence model it is the creditor's conduct that is 

viewed with suspicion. 0 In the United States over the years, "the focus of the 

preference laws has shifted from the culpability of the debtor, to the culpability of 

creditors, to the present day standard of strict liability."'" These changes all reflect 

different ways of thinking about the preference laws: debtor culpability is consistent 

with the debtor deterrence rationale; creditor culpability is consistent with the 

creditor deterrence rationale; strict liability is consistent with the idea that the 

purpose of the preference laws is to promote equality of distribution per se. 

C. The Equal Sharing Rationale 

In 1978, the United States moved away from a creditor culpability model. 

Congress eliminated the requirement that the creditor recipient have reasonable 

cause to believe that the debtor was insolvent and, in its place, introduced a strict 

liability regime. The move was justified in the following terms: 

Whether or not a creditor knows or believes that his debtor is sliding into 

bankruptcy is important if the only purpose of the preference section is to 

deter the race. However, a creditor's state of mind has nothing 

whatsoever to do with the policy of equality of distribution, and whether 

or not he knows of the debtor's insolvency does little to comfort other 

creditors similarly situated who will receive that much less from the 

debtor's estate as a result of the prebankruptcy transfer to the preferred 

creditor. To argue that the creditor's state of mind is an important 

element of a preference and that creditors should not be required to 

disgorge what they took in supposed innocence is to ignore the strong 

bankruptcy policy of equality among creditors. 22 

17. Id. at 125, quoting Collier's on Bankruptcy, 744 §60.01 (14th ed., 1977). 

18. Id. See also Richard H. McLaren, Voidable Transactions in Bankruptcy: The Canadian 

Perspective, in CURRENT DEVELOPMENTS IN INTERNATIONAL AND COMPARATIVE CORPORATE 

INSOLVENCY LAW 372 (J. Ziegel ed., 1994). 

19. In Hudson v. Benallack [1976] 2 S.C.R. 168 (Can.), the Supreme Court of Canada emphasized the 

requirement in the BIA preference provisions for proof of the debtor's intention, while at the same time 

denying any requirement for proof of the creditor's concurrent intention. Both aspects of the decision are 

consistent with the debtor deterrence rationale for the preference laws. 

20. See Morrison, supra note 13, at 590. 

21. Scott Blakeley, A History of Bankruptcy Preferences 1 (American Bankruptcy Reform Study 

Project, 1995). 

22. H.R. Rep. No. 595 at 178 (1977). The United States had earlier (in the 19th century) abandoned 

debtor deterrence in favour of a creditor culpability model. See Weisberg, supra note 6, at 85; Tabb, supra 



VOL. 42:661 

In other words, strict liability supports a policy of equal sharing. The reference 

to equality cannot be taken literally because the principle of equality, as embodied in 

the pari passu rule, is largely a myth in modern bankruptcy law. The exceptions 

(insolvency set-off, preferential claims, deferred claims and so on, in conjunction 

with the prevalence of secured credit) are so extensive that they all but swallow the 

rule. The only claimants subject to the pari passu rule are the general unsecured 

creditors, but in the overwhelming majority of bankruptcy cases there is nothing left 

to distribute among the general unsecured creditors once secured and preferred 

creditors have been paid out. Bearing these considerations in mind, the equal 

sharing rationale presumably means that creditors should share in accordance with 

the overall scheme of distribution provided for in bankruptcy laws. 3 

In any event, contrary to the impression the quoted passage creates, the current 

United States preference provisions do not unequivocally embrace the equal sharing 

rationale (whatever equal sharing might mean). The Bankruptcy Code, § 547(c)(2) 

creates an exception to preference liability for transfers in the ordinary course of 

business. The purpose of the ordinary course exception has been explained in the 

following terms: 

The purpose of this exception is to leave undisturbed normal financial 

relations, because it does not detract from the general policy of the 

preference section to discourage unusual action by either the debtor or his 

creditors during the debtor's slide into bankruptcy. 24 

In other words, "only extraordinary behavior by creditors who are seeking to 

'opt out' of the bankruptcy scheme should be condemned by preference law." 25 So, 

it seems that the aim of the preference laws is not to promote equal distribution 

between creditors. Creditor deterrence is still the objective. It is true that the 1978 

law eliminated the "reasonable cause to believe" test on the express ground that the 

creditor's intentions are irrelevant to the goal of equal distribution. However, "by 

creating the ordinary course exception in the 1978 law, Congress indirectly 

resurrected the same core principle of culpability. 2 6 

There is similar ambivalence in other common law countries about the goals of 

the preference laws. For example, according to the Australian Law Reform 

Commission, the preference laws reflect "two fundamental principles of insolvency 

law - that of equal sharing between creditors and that of promoting an orderly 

process both during and immediately preceding the formal insolvency 

administration." 27 However, the Australian preference provisions focus on creditor 

note 14 at 982 n.1. 

23. Rizwaan Jameel Mokal, CORPORATE INSOLVENCY LAW: THEORY AND APPLICATION 96-100, 

326-28 (2005); Jay Lawrence Westbrook, The Control of Wealth in Bankruptcy, 82 TEX. L. REV. 795, 822-24 

(2004); see also Roy Goode, PRINCIPLES OF CORPORATE INSOLVENCY LAW 411 (3d ed., 2005). 

24. H.R. Rep. No. 595, supra note 22, at 373. 

25. Charles Jordan Tabb, THE LAW OF BANKRUPTCY 383 (1977). 

26. Id. Elsewhere Tabb goes so far as to say that the ordinary course of business exception does 

"extreme violence to the "equality" goal of the preference law. Charles Jordan Tabb, The Brave New 

World of Bankruptcy Preferences, 13 AM. BANKR. INST. L. REV. 425, 440 (Winter 2005); see also New 

Zealand Ministry of Economic Development, Insolvency Law Review: Tier One Discussion Documents at 

68 (2001) (defences inherently undermine pari passu goal of a strict liability regime). 

27. Australian Law Reform Commission, General Insolvency Inquiry Report No. 45, at 267 (1988). 


2007 


culpability and this is inconsistent with the equal sharing rationale."' The ALRC 

went on to say that abandoning the preference laws "would deliberately favour and 

encourage creditors who quite legally extracted payments from the debtor - even at 

the eleventh hour." 29 This last statement implies that creditor deterrence is the real 

objective and that current legislation is consistent with the creditor deterrence 

rationale. By contrast, the English preference provisions focus on debtor 

culpability, 3 ' reflecting a commitment to the debtor deterrence rationale." However, 

the English provisions have been criticized for being out of step with modern 

bankruptcy policy. 32 

D. Finality of Transactions 

There is tension between the goals of preference laws and the need for finality 

of transactions. "From a commercial perspective, it is appropriate to encourage 

debtors to pay creditors. It is also important that a creditor be able to rely on the 

validity of a payment. Commercial transactions should not be lightly interfered 

with." 33 Another possible explanation for the ordinary course exception in United 

States preference laws is that it represents a trade-off between the goals of equal 

sharing and finality of transactions?' A strict liability preference law threatens the 

finality of transactions because it means that creditors can never be sure that their 

payments will be immune from attack. This uncertainty adds to creditors' costs and 

it is likely to be reflected in the cost and availability of credit. The ordinary course 

exception addresses this problem in part by limiting liability to cases where the 

creditor knows about the debtor's insolvency. 

It has been suggested that a better response to the finality of transactions 

concern might be to shorten the review period." However, while a shorter review 

period may limit creditors' exposure, it does not assist them in managing the risk. 

This is because creditors may have no way of knowing at the time of receiving the 

payment whether it falls within the review period. 

E. Facilitating the Provision of Credit to Financially Distressed Debtors 

The finality of transactions concern is a function of the strict liability preference 

law model. It does not arise if the law requires proof of either debtor or creditor 

culpability because in both these regimes creditors have the means of knowing in 

28. Bankruptcy Act no. 33 1966 § 122(1)(a), Commonwealth Consolidated Acts (Austl.); 

Corporations Act 2001, § 588FG(2). 

29. Australian Law Reform Commission, supra note 27, at 267. 

30. Insolvency Act, supra note 15 (1986) § 239. 

31. Insolvency Law Review Committee, Insolvency Law and Practice, June 1982, at 285, paras. 1254 et 

seq. 

32. Goode, supra note 23, at 456-57. 

33. Law Reform Commission of British Columbia, Report on Fraudulent Conveyances and 

Preferences (LRC No. 94, 1988), 120. 

34. Tabb, THE LAW OF BANKRUPTCY, supra note 25, at 385; but see the difficulties New Zealand 

encountered with the ordinary course of business exception, discussed infra notes 114 and ll5and 

accompanying text. 

35. Id. 



VOL. 42:661 

advance whether a payment may be subject to attack. A possible conclusion is that 

an ordinary course exception is unnecessary unless strict liability is the rule. 

However, this presupposes that the purpose of the ordinary course exception is 

to facilitate the provision of credit outside the review period. There is an alternative 

construction, namely that the purpose is to facilitate the provision of credit inside the 

review period. "Allowing creditors to obtain ordinary course payments actually 

encourages them to do business on a credit basis with a financially distressed debtor. 

As a result, the debtor may be able to stay afloat and avoid bankruptcy entirely, or 

at least hold a stronger financial condition when it does go into bankruptcy. 3 6 In 

other words, the function of the ordinary course exception is to maximize the value 

of the debtor's estate for the benefit of all the creditors and current United States 

bankruptcy law trades off this objective against the equal sharing goal. 

On this analysis, the ordinary course exception is not simply a function of the 

strict liability rule and may have a role to play in other regimes as well. For example, 

lawmakers who opt for a debtor culpability regime may want to incorporate an 

ordinary course exception in order to strike a trade-off between debtor deterrence 

on the one hand, and facilitating the provision of credit to financially distressed 

debtors on the other. Likewise, the incorporation of an ordinary course exception in 

a creditor culpability regime may signal a willingness to sacrifice some creditor 

deterrence in exchange for the stimulus to lending the exception provides. 

Still, it is not certain that such trade-offs yield net benefits. Some 

commentators argue that the ordinary course exception may have perverse incentive 

effects and that, far from encouraging creditors to deal with financially distressed 

debtors, it may actually discourage them. The argument is that a creditor who gets 

paid in the ordinary course need not co-operate further with the debtor because if 

the debtor goes into bankruptcy, the creditor can simply keep the payment and not 

extend more credit. 7 A related argument is that the ordinary course exception may 

have a chilling effect on the provision of credit to financially stable debtors, and this 

more than offsets the benefits of more freely available credit to debtors who are 

financially distressed. 3 " 

F. The Trade-Offs 

There are different schools of thought in the United States on the trade-offs the 

ordinary course exception involves. Some favour the present law, with or without 

relatively minor modifications? 9 Others argue that the exception should be repealed 

36. Id. at 384. 

37. Id. 

38. Id. at 384-85. 

39. This school of thought represents the prevailing wisdom. The Bankruptcy Abuse and Consumer 

Protection Act of 2005, Pub. L No.109-8, Stat.23 (2005) [hereinafter BAPCPA] extensively amended the 

Bankruptcy Code, but made only relatively minor changes to the preference provision. In particular, the 

ordinary course exception was retained subject only to removal of the requirement for the creditor to show 

that the transaction was made both "in the ordinary course of business or financial affairs of the debtor and 

the creditor" and "made according to ordinary business terms." Id. Under the new provision a creditor 

will only have to show that the transaction was made "in the ordinary course of business or financial affairs 

of the debtor and the transferee" or that it was made "made according to ordinary business terms." In the 

past, courts have interpreted the first part of the test as referring to ordinariness in a subjective sense and 

the second part of the test as incorporating an objective standard in relation to industry at large. Tabb, 


2007 


to recognize the goal of equal sharing among creditors is paramount." At the 

opposite end of the spectrum, some argue for a repeal of preference laws on the 

ground that they are not cost-effective. 

For example, McCoid contends that the objective of preference laws is creditor 

deterrence, but the laws fail to deter because the sanction is inadequate. If the 

trustee brings a successful preference action, the only consequence is that the 

creditor must return the payment. Except to the extent that the creditor has 

expended resources either obtaining the preference in the first place or defending 

the action, it is no worse off after returning the preference than it would have been 

had it never received the preference in the first place.' A possible rejoinder is that 

the argument over-states the case for abolition. Creditors' expenditure on obtaining 

the preference in the first place and subsequently fighting to keep it are dead-weight 

costs. The prospect of incurring these costs has some deterrent effect, and so the 

problem is one of under-deterrence rather than no deterrence at all. Underdeterrence 

is better than no deterrence at all, which would certainly be the result if 

the preference laws were repealed. 

In the course of its General Insolvency Inquiry, the Australian Law Reform 

Commission received a submission from Justice Pincus, a judge of the Federal Court 

of Australia, recommending repeal of preference provisions on the ground that the 

costs of litigating preference claims defeat the underlying policy objectives. 3 Alan 

Schwartz offers a more sophisticated version of the same argument:"' 

(1) The creditor deterrence rationale for preference laws is misguided because 

creditors cannot force a financially distressed firm to pay preferences. Creditors can 

threaten attachment to try and force the debtor to pay, but the debtor can credibly 

respond by threatening to file for bankruptcy and thus stay all attachments. 

Therefore, if preference laws were repealed, distressed debtors would pay 

preferences because they wanted to, not because they had to; 

(2) The debtor deterrence rationale has no purchase unless the debtor expects 

to be liquidated. Otherwise, the debtor will want to settle with its creditors, and 

non-preferred creditors will not accept in settlement an amount less than their pro 

rata bankruptcy payoffs. "In other words, "the pro rata rule precludes a firm 

interested in survival from paying today what are defined as preferences. 

Consequently, a separate prohibition against preferences does not materially 

increase a financially distressed firm's commitment to the pro rata rule"; 5 

(3) If a debtor firm expects to be liquidated, it will be indifferent as to how its 

assets are distributed among creditors because the firm will disappear with certainty. 

However, the firm's principals may not be indifferent. They may cause the firm to 

pay particular creditors to ensure goodwill for themselves, in consequence of a 

Brave New World, supra note 26, at 440-42. 

40. See, e.g., Tabb, Rethinking Preferences, supra note 14, at 987. 

41. John C. McCoid, II, Bankruptcy, Preferences and Efficiency: An Expression of Doubt, 67 VA. L. 

REV. 249 (1981). 

42. Jackson, supra note 16, at 137-38. 

43. Australian Law Reform Commission, supra note 27, at 267. 

44. Alan Schwartz, A Normative Theory of Business Bankruptcy, 91 VA. L. REV. 1199, 1224-31 

45. Id. at 1226. 



VOL. 42:661 

personal relationship or to avoid liability exposure if a principal has guaranteed the 

firm's debt; 

(4) Actions to recover preferences paid in these circumstances are inefficient 

both ex post and ex ante. They are ex post inefficient because they cost money, 

thereby diminishing the value of the bankruptcy estate: "redistributing the assets of a 

failed firm among its general creditors amounts to redecorating the Titanic's salon";1 6 

(5) Abolition of the preference laws would save the costs of redistributing the 

firm's assets, thereby increasing the collective returns to creditors in future. The 

prospect of higher collective returns in bankruptcy should result in lower borrowing 

costs. Conversely, preference laws increase borrowing costs and are ex ante 

inefficient. 

Critics might take issue with step (1) of Schwartz's argument on the ground that 

it too readily assumes a debtor's willingness to play the bankruptcy card. Unless the 

debtor expects to be liquidated, it will want to maintain good relations with its key 

suppliers and creditors. Threatening to file for bankruptcy in response to a creditor's 

demand for payment is not conducive to maintaining good relations. Of course, if 

the debtor realizes its hopes of staying in business, the preference question will go 

away. On the other hand, the debtor's hopes may not be realized. Financially 

distressed debtors have a tendency to over-estimate their chances of recovery and 

creditors may exploit the debtor's self-deception to extract preferential payments. 47 

Step (4) amounts to an implicit rejection of both the debtor deterrence rationale and 

the equal sharing rationale for the preference laws; critics might take issue with this 

because it summarily discounts non-economic arguments in support of preference 

laws. 48 It is worth noting that the Australian Law Reform Commission rejected 

Justice Pincus's proposal for repeal of preference laws on the ground that it "would 

do much to undermine two fundamental principles of insolvency law - that of equal 

sharing between creditors and that of promoting an orderly process both during and 

immediately preceding the formal insolvency administration." 49 

A. Introduction 

III. CURRENT CANADIAN LAW 

The Bankruptcy and Insolvency Act, § 95 provides in part as follows: 

1) Every transfer of property, every charge made on property, every 

payment made, every obligation incurred and every judicial proceeding 

taken or suffered by any insolvent person in favour of any creditor or of 

any person in trust for any creditor with a view to giving that creditor a 

preference over the other creditors is, when it is made, given, incurred, 

46. Id. 

47. See Canadawide Fruit Wholesalers Inc.(Trustee of) v. Hapco Farms Inc. [1998] A.C.W.S.J. 522010 

(Que. CA). 

48. See, e.g., Tabb, Rethinking Preferences, supra note 14 (arguing for preference laws on distributive 

grounds). 

49. Australian Law Reform Commission, supra note 27, at 267. For a similar response in the United 

States, see Charles Jordan Tabb, Panglossian Preference Paradigm? 5 AM. BANKR. INST. L. REV. 407, 420 

(1997). 


2007 


taken or suffered within the period beginning on the day that is three 

months before the date of the initial bankruptcy event and ending on the 

date the insolvent person became bankrupt, both dates included, deemed 

fraudulent and void as against, or in the Province of Quebec, may not be 

set up against, the trustee in the bankruptcy. 

(2) If any transfer, charge, payment, obligation or judicial proceeding 

mentioned in subsection (1) has the effect of giving any creditor a 

preference over other creditors, or over any one or more of them, it shall 

be presumed, in the absence of evidence to the contrary, to have been 

made, incurred, taken, paid or suffered with a view to giving the creditor a 

preference over other creditors, whether or not it was made voluntarily or 

under pressure and evidence of pressure shall not be admissible to support 

the transaction. 

Section 96 provides: 

If the transfer, charge, payment, obligation or judicial proceeding 

mentioned in section 95 is in favour of a person related to the insolvent 

person, the period referred to in subsection 95(1) shall be one year instead 

of three months. ° 

50. Bankruptcy and Insolvency Act, R.S.C. c. 27 (1992) G39, § 4(2) provides in part as follows: 

(2) For the purposes of this Act, persons are related to each other and are "related persons" if 

they are 

(a) individuals connected by blood relationship, marriage, common-law partnership or 

adoption; 

(b) a corporation and 

(i) a person who controls the corporation, if it is controlled by one person, 

(ii) a person who is a member of a related group that controls the corporation, or 

(c) two corporations 

(iii) any person connected in the manner set out in paragraph (a) to a person 

described in subparagraph (i) or (ii); or 

(i) controlled by the same person or group of persons, 

(ii) each of which is controlled by one person and the person who controls one of 

the corporations is related to the person who controls the other corporation, 

(iii) one of which is controlled by one person and that person is related to any 

member of a related group that controls the other corporation, 

(iv) one of which is controlled by one person and that person is related to each 

member of an unrelated group that controls the other corporation, 

(v) one of which is controlled by a related group a member of which is related to 

each member of an unrelated group that controls the other corporation, or 



VOL. 42:661 

These provisions have survived virtually unchanged for nearly a century, and 

they have generated a substantial amount of litigation." 

The main features of the provisions, as amplified by the case law, are as 

follows: 5 2 

(1) For the sections to apply, there must be both a preference in fact and an 

intention on the debtor's part to prefer the creditor; 

(2) The test for determining the debtor's intention is an objective one, in other 

words, the courts infer the debtor's intention from its conduct and the surrounding 

circumstances; 53 

(3) It follows that "fraudulent" does not mean actual fraud, but constructive or 

legal fraud. Constructive fraud is conduct the law characterizes as fraudulent, not 

because it is actually dishonest, but because it is against the public interest; 4 

(4) The evidentiary burden is on the trustee to prove a preference in fact, but it 

is on the creditor to prove that the debtor did not have the necessary intention;" 5 

(5) A creditor cannot rebut the presumption of intention by leading evidence 

that the creditor pressured the debtor into making the transfer; 5 6 

(6) On the other hand, the law does not penalize a diligent creditor and 

evidence showing that the debtor made the payment to stay an aggressive creditor 

may be enough to rebut the presumption.; 5 1 

(vi) one of which is controlled by an unrelated group each member of which is 

related to at least one member of an unrelated group that controls the other 

corporation. 

51. Houlden and Morawetz speculate that "[tihere have probably been more reported cases on § 95 

than on any other section of the Bankruptcy and Insolvency Act." Lloyd W. Houlden and Geoffrey B. 

Morawetz, THE 2006 ANNOTATED BANKRUPTCY AND INSOLVENCY ACT (2006), para. F § 89. There are 

numerous cases from England and cases decided under the provincial preference provisions as well: see 

M.A. Springman, Fraudulent Conveyances, Fraudulent Preferences, and Other Voidable Transactions, 

Law Society of Upper Canada, Special Lectures, 59, 61 (1988). 

52. See Houlden and Morawetz, supra note 51, at para. F §§ 89,106.4; Melvin A. Springman et al., 

FRAUDULENT CONVEYANCES AND PREFERENCES (1994), ch. 20. 

53. See, e.g., St Anne, supra note 9, at 142. Not all cases have adopted an objective test. See 

Springman et al., supra note 52, at 20-31 to 20-36 (noting four different views of the nature of intent to 

prefer but arguing that, on balance, the authorities support an objective test). 

54. See generally Lloyd W. Houlden, O.C., Fraudulent Bankrupts and Bankruptcies, 5 Can. Bankr. 

Rep. 207 (1963) (on the different types of fraud in bankruptcy). 

55. In order to raise the presumption that there has been a fraudulent preference the trustee must 

prove three things: (a) payment must have been made within three months of bankruptcy; (b) the debtor 

was insolvent at the time of payment; and (c) as a result of the payment the creditor must have in fact 

received a preference over the other creditors. Re Van der Like, [1970] 14 C.B.R. (N.S.) 229, 299 (Can.). 

When the trustee has proven these three elements, "he need proceed no further and the onus is then on the 

creditor to satisfy the court, if he can, that there was no intent on the part of the debtor to give a 

preference." Id. at 230. 

56. Bankruptcy and Insolvency Act, supra note 50, at § 92(5). For applications, see St. Anne, supra 

note 9, at 142; Re Bridal Boutique Ltd., [1980], 36 C.B.R. (N.S.) 134, 135 (Can.); Medler-McKay Holdings 

Ltd. (Trustee of) v. Teac Canada Ltd., [1994] 26 C.B.R. (3d) 147, para. 3 (Can.); see also N. German, 

Bankruptcy-Pressure as a Defence-Fraudulent Preferences, 8 ALTA. L. REV. 154 (1970). 

57. See, e.g., Re Norris [1994] 28 C.B.R. (3d) 167, para. 9-10 (Can.), rev'd on other grounds [1996] 2. 

W.W.R. 281,287 (Can.); see also Re Houston and Thornton [1973], 18 C.B.R. (NS) 102, 104 (Can.); Re Les 

Bois de la Malbaie Lt6e [1980] 36 C.B.R. (N.S.) 85, 86 (Can.); cf Krawchenko, supra note 9, para. 22-23. 


2007 


(7) Alternatively, the creditor may rebut the presumption of intention with 

leading evidence to show that the transaction was in the ordinary course of the 

debtor's business." There is an element of tautology here because the absence of an 

intention to prefer is a sine qua non of the conclusion that the transaction was in the 

ordinary course of business. Typically, payments in the ordinary course of business 

are made for one of two reasons: (1) so that the debtor can take advantage of 

favourable payment terms; or (2) to ensure that the creditor continues to supply the 

debtor with goods or services so the debtor can continue in business; 9 

(8) The debtor's belief that the payment will allow it to continue in business 

must be a reasonable one. The reasonableness of the debtor's belief is a matter for 

the court, having regard for the evidence.;' 

(9) Proof that the debtor did not know it was insolvent at the time of the 

transaction is admissible to rebut the presumption of intention, but it is not 

conclusive given that' the courts apply an objective test in determining the debtor's 

intention; 6 

(10) Proof that the creditor intended to receive a preference is neither a 

necessary nor a sufficient requirement for avoidance of the transaction; 6 1 

(11) On the other hand, evidence that the creditor knew of the debtor's 

insolvency is admissible as tending to show that the transaction was not in the 

ordinary course of business and that the debtor's intention was to prefer the 

creditor; 63 and 

(12) If the creditor is related to the debtor, the review period is one year instead 

of 3 months and, in addition, the courts will require stronger evidence to support the 

bona fides of the transaction.' 4 

58. See, e.g., Re Pac. Mobile Corp. [1985] 1 S.C.R. 290 (S.C.C.); see also St. Anne, supra note 9, at 146; 

Re Claude Cayouette Inc. [1983] 48 C.B.R. (N.S.) 89, 96 (Can.). The ordinary course of business is an 

"abstract" standard that requires the court "to evaluate the particular circumstances of each case in order 

to determine the quality of a given transaction." Re Pacific Mobile [1985] 1 S.C.R. 290, 291 (Can.) (trans. 

from French). In Re Pacific Mobile the Supreme Court of Canada refrained from giving a "comprehensive 

definition of the term 'ordinary course of business' for all transactions." Id. The court preferred to 

"consider the circumstances of each case and to take into account the type of business carried on between 

the debtor and creditor." Id.; see also Cargill v. Compton Agro Inc. [1998] 7 C.B.R. (4th) 132 (Can.), rev'd 

on other grounds [2000] 16 C.B.R. (4th) 35 (Can.); Deloitte Touche Inc. v. White Veal Meat Packers Ltd. 

[2000] 16 C.B.R. (4th) 74, para. 12 (Can.), affd 21 C.B.R. (4th) 234 (Can.). 

59. Re Norris, supra note 57, para. 7. 

60. Re Yorkville Homes Ltd. [1986], 62 C.B.R. (N.S.) 70, 73 (Can.); Re Spectrum Interiors (Guelph) 

Ltd. [1979] 29 C.B.R. (N.S.) 218 (Can.); Principal Group Ltd. (Trustee of) v. Anderson [1994] 29 C.B.R. 

(3d) 216, paras 52-58 (Can.), affd on other grounds [1997] 46 C.B.R. (3d) 101 (Can.); Canadawide Fruit, 

supra note 47. However, there is a line of cases that adopt a more subjective approach. See infra note 84. 

61. See, e.g., Cargill Ltd., supra note 58; see also Re Moureaux, Hauspy, Forrest Design Inc. [1995], 33 

C.B.R. (3d) 42, para. 15 (Can.). 

62. See, e.g., Benallack, supra note 19 (discussing that concurrent intent on the part of the debtor and 

creditor is not required). 

63. See, e.g., Re Royal City Chrysler Plymouth Ltd. [1995], 30 C.B.R. 3d 178, paras. 66-69 (Can.); 

Kisluk v. B.L. Armstrong Co. [1982], 44 C.B.R. (N.S.) 251, para 57 (Can.). 

64. See §§ 96, 4(2) (definition of related person). See, e.g., Re Garrett [1979], 30 C.B.R. (N.S.) 150, 

paras. 18-19 (Can.); see also Re Litvack [1962], 3 C.B.R. (N.S.) 272 (Can.); and Re Norris, supra note 57, 

paras. 20-21. 



VOL. 42:661 

B. Pressure and diligence 

As indicated above, a creditor cannot rebut the presumption of intention by 

demonstrating that the creditor pressured the debtor into making the payment. This 

is a statutory rule, and its legislative history is instructive. 

Parliament eliminated the doctrine of pressure in 1920.65 The doctrine enabled 

a more aggressive, active or insensitive creditor to "reap the benefits of his 

harassment of the debtor" at the expense of more patient or hesitant creditors. 66 

Fraudulent preference law, as developed by Lord Mansfield, required the debtor's 

transfer or payment to be a voluntary one. According to Lord Mansfield, if a 

creditor demands payment, "or sues [the debtor], or threatens [the debtor], without 

fraud, the preference is good., 67 

Prior to 1920 Canadian courts followed the English doctrine of pressure holding 

that there was no voluntary act on the part of the debtor where payment is "brought 

about by the active influence of the creditor., 68 However, what amounted to 

pressure in any particular case was "always a question of fact and one difficult to 

make out. ' 69 A mere request by a creditor, which induces action on the part of the 

debtor, might amount to pressure in the eyes of the court." Where the debtor and 

creditor knew each other and were familiar with the law collusion remained a real 

possibility. 7 ' Courts accepted that the doctrine of pressure validated the transaction 

even if this had the effect of giving one creditor a preference over another. 72 

In 1919, Parliament debated a comprehensive bill to restore a national 

bankruptcy regime. 73 Bill 18 proposed to "eliminate entirely the doctrine of pressure 

as a defence to a preferential transaction." 74 However, abolition of the doctrine did 

not prove easy and legislative history of the 'no pressure' clause provision illustrates 

the extent to which the doctrine of pressure had benefited creditors. In the course of 

65. An Act to Amend, supra note 2, at 123. 

66. See Springman, Fraudulent Conveyances, supra note 51, at 141. 

67. Alderson, supra note 7, at 166. 

68. Stephens v. McArthur [1891] 19 S.C.R. 446, para. 12 (Can.). After Parliament repealed the 

national Insolvent Act of 1875, many provinces enacted Assignments and Preference legislation. Pressure 

remained relevant under the provincial case law. Id. 

69. Brayley v. Ellis [1884], 9 O.A.R. 565,573 (Can.); Ivey & Co. v. Knox, Morgan & Co. [1885], 8 OR. 

635, 646 (Can.) ("The earlier cases no doubt are rather lax with respect to what will constitute pressure.. 

."); Re Hurst [1876] O.J. No. 441 at para. 47 (Ont. P.C.); see also C.B. Labatt, "The Doctrine of Pressure" 

[1899] 35 C.L.J. 322; R.S. Cassels, "Mercantile Preferences" [1891] 11 C.L.T. 61. 

70. Molson Bank v. Halter [1890] 18 S.C.R. 88, para. 6 (Can.); Stephens, supra note 68, para. 13; see 

also Springman et. al., supra note 52, at 18-22. For the Chief Justice of the Ontario Court of Appeal, 

extending the doctrine of pressure to a mere demand "amounted in some cases to a scandal." Webster v. 

Crickmore [1898], 25 O.A.R. 97, 105 (Can.). 

71. Meriden Silver Co. v. Lee & Chillas [1882], 2 OR. 451 (Can.) (where the court discovered actual 

collusion). See also Re Carson [1924], 4 D.L.R. 492, para. 17 (Can.). 

72. See Gordon v. Young [1866], 12 Gr. 318, para. 5 (Can.). See also Davidson v. Ross [1876], 24 Gr. 

22, para 144 (Can.) (The Court of Chancery of Ontario rejected the doctrine of pressure on the basis that it 

was opposed to the principle of equal treatment of creditors). But see McCrae v. White [1883] 9 S.C.R. 22, 

para. 10 (in which the Supreme Court of Canada disapproved the decision in Davidson v. Ross). 

73. Bill 18, An Act Respecting Bankruptcy, Second Session, 13th Parliament, 9-10 George V, 1919 

(First Reading March 6, 1919). In 1888, Parliament had repealed the Insolvent Act of 1875 (repealed S.C. 

1880, c.1), leaving Canada without a national bankruptcy regime for nearly forty years. 

74. H.P. Grundy, "Synopsis of the Canadian Bankruptcy Act" (1920-21), 1 C.B.R. 325, 338. H.P. 

Grundy was the original drafter of the Bill. See Bill 18, cl.31(3). 


2007 


parliamentary hearings, the "'no pressure"' clause was struck out leaving the 

doctrine of pressure as the status quo. 75 During the hearings, commercial groups and 

the banking industry objected to the abolition of the doctrine. They advocated the 

retention of the English model which would enable creditors to invoke the doctrine 

to validate transactions." In 1920 Parliament restored the "no pressure" clause, and 

since then the statutory preference provision has largely remained the same. 7 1 

Although Parliament intended to eradicate the doctrine of pressure by 

specifically legislating that evidence of pressure is not admissible to support the 

transaction, the courts have since allowed indirect evidence of what might otherwise 

be considered pressure. For example, the courts have read a creditor diligence 

defence into the statute: a creditor may lead evidence of its own diligence to rebut 

the presumption of the debtor's intention to prefer. In Re Totem Painting Company 

Limited," 8 the court attempted to distinguish between diligence and pressure. A 

creditor had accepted an overdue payment on account with knowledge of the 

debtor's financial position. The court concluded that the creditor: 

"... may have applied some pressure but, while pressure is no longer a 

defence to a charge of fraudulent preference, it has not yet been shifted to 

the opposite pole of being considered proof of fraud. Creditors may be 

penalized for dishonesty, but surely not for diligence." 9 

On the other hand, contrary to what this statement implies, there is no sharp 

dividing line between pressure and diligence and so the creditor diligence defence 

may be a means of reintroducing the doctrine of pressure by the back door." 

However, the scope of the defence is unsettled. In Re Hewston & Thornton, 81 the 

court concluded that 

there was no intention on the part of the debtors to prefer the two respondents. 

I find that the debtors were hopeful ... that they would be able to keep their 

business in operation. The only reason for making the payment to the 

75. Debates of the Senate (June 5, 1919), at 650; House of Commons Debates (May 15, 1919), at 2470- 

71. 

76. House of Commons Debates (15 May 1919), at 2470-71(referring to a number of protests including 

submissions from commercial bodies). H.P. Grundy, "Synopsis of the Canadian Bankruptcy Act" (1920- 

21), 1 C.B.R. 325, 337 (referring to opposition of banking interests). 

77. See An Act to Amend, supra note 2, at 123. Pressure continues to remain relevant under some 

provincial Assignment and Preferences legislation. See, e.g., Bank of Montreal v. Ngo [1985], 56 C.B.R. 

(N.S.) 66 (Can.). 

78. [1960] 32 W.W.R. 143 (Can.). 

79. Id. at 144. 

80. Cf. Labatt, supra note 69, at 356 ("the theory upon which the law recognizes [pressure] viz., that 

the active, diligent creditor who is prompt to secure himself the moment his debtor falls into difficulties is a 

highly meritorious personage, is certainly not beyond dispute" (emphasis added)). In Alderson, supra note 

7, at 168, Lord Mansfield asked of whether in any particular case a debtor prefers a creditor: "[b]ut that 

will depend upon the act. As, if a bankrupt, in course of payment pays a creditor; this is a fair advantage, in 

the course of trade: or, if a creditor threatens legal diligence, and there is no collusion; or begins to sue a 

debtor: and he makes an assignment of part of his goods; it is a fair transaction..." (emphasis added). See 

also Harman v. Fishar [1774] 98 Eng. Rep. 998, 1001 ([o]r suppose legal diligence used by a creditor, and an 

execution ... and under terror of that he makes an assignment and delivery of his effects, it would be valid; 

the object not being to give a preference, but to deliver himself" (emphasis added)). 

81. [1973] 18 C.B.R. (N.S.) 102 (Can). 



VOL. 42:661 

respondents was because the respondents were pressing more vigorously than 

other creditors for payment of their accounts.2 

So stated, the diligent creditor defence is inconsistent with the express statutory 

provision excluding evidence of pressure. On the other hand, in Re Norris," the 

court held that for the diligent creditor defence to apply, there must be an imminent 

threat of crisis unless the debtor responds to the creditor's demand. In Re Norris 

itself, the defence failed because the court found that the creditor had not acted 

aggressively enough." In other words, evidence of pressure may or may not be 

admissible to support the transaction depending on the amount of pressure the 

creditor has applied. 

The courts have also been prepared to excuse transactions in the ordinary 

course of business and this trend, too, compromises the rule that evidence of 

pressure is not admissible to support the transaction. For example, a creditor may 

refuse to ship goods until the debtor pays for earlier deliveries. This is clearly a form 

of pressure, but the court may uphold the transaction on the ground that the 

payment was not to prefer the creditor but, rather, to obtain the supply of goods or 

services." 

C. Assessment 

According to Dickson J. in the Benallack case, the policy underlying the 

Canadian preference provisions is debtor deterrence.8 6 However, while it is true that 

§ 95(1) makes debtor culpability the focal point, in some other respects the 

provisions are inconsistent with the debtor deterrence rationale. The following are 

some examples of the ambivalence in § 95. 

(1) Liability turns on proof of the debtor's intention and this is consistent with 

the debtor deterrence rationale. On the other hand, to the extent that courts 

determine the debtor's intention objectively, they treat the reference in § 95(1) to 

fraud as meaning constructive fraud. 87 This approach dilutes the key requirement of 

debtor culpability. The more readily the courts are prepared to infer the debtor's 

intention from the surrounding circumstances, the closer they move the regime 

82. Id. at 103. 

83. Norris, supra note 57, para 9. 

84. Id.; see also Re Advent Sales & Mktg. Corp. [20031, 46 C.B.R. (4th) 163, para. 12 (Can.); Re 

Chung [2006] CarswellOnt 975 (Can.); Coopers v. Lybrand Ltd. v. O'Brien Elec. Co. [1983], 47 C.B.R. 

(N.S.) 243 (Can.). Cf Krawchenko, supra note 9, para 25 (calling into question the requirement for proof 

of an imminent business crisis). 

85. See, e.g., Econ. Consulting Ltd. (Trustee of) v. Deloitte, Haskins & Sells Ltd. [1984] 53 C.B.R. 

(N.S.) 292 (Can.), affd [1985] 56 C.B.R. (N.S.) 60 (Can.); Re Kovalick [1973] 18 C.B.R. (N.S.) 69 (Can.); 

Davis v. Duncan Indus. Ltd., [1983] 45 C.B.R. (N.S.) 290 (Can.). Cf. Re Halls (Dalor Paper Co.) [1983] 45 

C.B.R. (N.S.) 81 (Can.) (evidence of threats and ultimatum regarding shipment of goods; presumption not 

overcome, but no reference by the court to non-relevance of pressure). 

86. Benallack, supra note 8. 

87. For applications of an objective approach, see, e.g., St Anne, supra note 9; Coast Wire Rope & 

Supply Ltd. (Trusee of) v. Trans Pacific Hardware [1999] 9 C.B.R. (4th) 255 (Can.); Principal Group Ltd. 

(Trustee of) v. Anderson [1994] 29 C.B.R. (3d) 216 (Can.) affd on other grounds, [1997], 46 C.B.R. (3d) 

101 (Can.). 


2007 


towards strict liability, where the goal is equal sharing, rather than debtor 

deterrence.m 

(2) Once the trustee has proved a preference in fact then, by virtue of § 95(2), 

the burden shifts to the creditor to prove that the debtor did not intend to give a 

preference. At first glance, this looks like no more than an evidentiary concession in 

the trustee's favour. On the other hand, some courts have taken a harder line than 

others in reaction to evidence the creditor leads. 9 The more difficult it is for 

creditors to rebut the presumption, the closer the evidentiary concession comes to a 

rule of law. Dilution of the debtor culpability element is inconsistent with the debtor 

deterrence rationale, but it might make sense in terms of either the creditor 

deterrence or the equal sharing rationales. 

(3) Section 95(2) states that evidence of pressure is not admissible to support 

the transaction. This provision is inconsistent with the debtor deterrence rationale 

because evidence of pressure negates the debtor's culpability, which is the key 

element from a debtor deterrence perspective." The provision would make sense if 

the creditor deterrence rationale applied, because evidence of pressure goes to the 

creditor's culpability, which is the key element from a creditor deterrence 

perspective. On the other hand, as previously mentioned, the express reference in § 

95(1) to the debtor's state of mind and the characterization of the debtor's conduct 

as fraudulent are inconsistent with the creditor deterrence rationale. 

(4) The creditor diligence defence compromises the rule that evidence of 

pressure is inadmissible to support the transaction, but the scope of the defence is 

uncertain as indicated by Re Hewston & Thornton and Re Norris. 9 ' In Re Hewston & 

Thornton, the court applied the defence robustly. This approach supports the debtor 

deterrence rationale but it is inconsistent with the express statutory provision 

excluding evidence of pressure. On the other hand, in Re Norris, 92 the court 

attempted to limit the defence to cases of extreme aggression on the creditor's part. 

This approach cuts both ways in policy terms. In so far as it limits the diligent 

creditor defence, it supports the creditor deterrence rationale. On the other hand, in 

so far as it ties the availability of the defence to the creditor's level of aggression, it is 

perverse from a creditor deterrence perspective because it means that the more 

culpable the creditor's actions, the more likely it is that the court will uphold the 

transaction. 93 

88. Law Reform Commission of British Columbia, supra note 33, at 122 ("In practice, intent-based 

schemes tend to produce unpredictable results. Personal views held by judges determine whether a 

disposition should be protected or set aside. The competing policies of treating creditors even-handedly 

and of protecting commercial transactions are given different weight by different judges"). Not all courts 

have adopted a purely objective view and in some instances the debtor's subjective belief has been taken 

into consideration. See, e.g., Re W. Slaunwhite & Sons Devs. Ltd., [1982] 45 C.B.R. (N.S.) 37 (Can.). 

Springman et al., supra note 52, at xx (analyzing four cases and finding "four different views on the nature 

of intention to prefer"). 

89. Springman et al., supra note 52, at xx. 

90. See supra text accompanying note 67. 

91. See supra text accompanying notes 81-84. 

92. Norris, supra note 57, paras. 9-10. 

93. In other words, the creditor diligence exception creates a race among creditors, but this is the very 

outcome the bankruptcy laws were designed to prevent. See, e.g., W. R. Parker, FRAUDS ON CREDITORS 

AND ASSIGNMENTS FOR BENEFIT OF CREDITORS 109 (the common law, outside of bankruptcy "rewarded 

the diligent creditor"). 



VOL. 42:661 

(5) Liability does not turn on the creditor's state of mind in receiving the 

preference. This is consistent with the debtor deterrence rationale. On the other 

hand, evidence of the creditor's state of mind is admissible as tending to show that 

the transaction was not in the ordinary course of business. The more weight a court 

attaches to such evidence, the further it pushes the regime in the direction of the 

creditor deterrence rationale. 

In summary, the current law lacks a clear policy foundation and in this sense it 

is indeterminate. Judicial glosses on the statutory text mean that the statute itself is 

not a complete statement of the law; this is a second sense in which the law is 

indeterminate. For example, there is no ordinary course of business defence in the 

statute, nor is there any reference to diligent creditors. However, the courts have 

imported both concepts, and there is a large body of cases, not all of them 

reconcilable, on the evidence a creditor must produce in order to establish the 

defences. 

A third source of indeterminacy is inconsistency in the way the courts exercise 

the discretion given to them by the judicially glossed statute. For example, in 

connection with the ordinary course of business defence, evidence is admissible to 

show that the debtor made the payment with a view to staying in business. However, 

the courts require proof that the debtor's hope of staying in business was a 

reasonable one, and the question of what amounts to a reasonable hope is one on 

which courts may differ. 94 As Wilson J. noted in Re Totem Printing Company Ltd., 

many of the fraudulent preference decisions are "so divergent in thought as to offer 

a wide scope of choice to a court seeking a precedent. ' 

There is a fourth sense in which the current law is indeterminate. Bankruptcy 

and Insolvency Act, §§ 95 and 96, are not a complete code. Provincial fraudulent 

preference laws apply concurrently. This means that if a transaction falls outside the 

review period §§ 95 and 96 specify, the trustee may still be able to attack it relying on 

the provincial laws instead. The concurrent operation of provincial law is open to 

criticism on at least two grounds: first, it potentially undermines the policies reflected 

in the federal provisions; and secondly, it raises the possibility of non-uniform case 

outcomes from province to province. 96 In the Senate Committee's words, the 

concurrent operation of provincial law results in "a lack of fairness, uniformity, and 

predictability." 91 

94. Compare St. Anne, supra note 9 (debtor's hope a reasonable one), with Canadawide Fruit, supra 

note 47 (debtor's hope an unreasonable one). Notwithstanding this objective approach, a number of courts 

have been willing to adopt a more subjective approach and have taken into account the debtor's bona fide 

belief even if that belief of continuing in business was "hopeless" or if the chances of saving the business 

were "very slim." E.g., Re Consolidated Seed Exports Ltd. [1986] 62 C.B.R. (N.S.) 156, para. 23 (Can.); 

see also Re AR Colquhoun & Son Ltd., [1936] 18 C.B.R. 124, para. 2 (Can.). 

95. [1960] 32 W.W.R. 143, para. 1 (Can.). The Newfoundland Supreme Court indicated that each case 

must stand on its own facts and "previous cases are not of much help, except for the principles of law as 

applied to the facts in them." In Re Lee & Ryan Ltd., [1966], 9 C.B.R. (N.S.) 281, para. 20 (Can.); see also 

Ronald C.C. Cuming, Canadian Bankruptcy Law: A Secured Creditor's Heaven, [1994] 24 CAN. BUS. L. J. 

17, 32 (1994) ("[Section 95 creates] a low level of predictability of outcome and the concomitant need to 

litigate almost every instance of an alleged preferential transfer."). 

96. See Dunlop, supra note 5. 

97. Senate Committee Report, supra note 3, at 122. 


2007 


IV. 

LAW REFORM INITIATIVES 

The Senate Committee in its 2003 Report recommended amendments to 

"ensure consistent and simplified rules for challenging fraudulent preferences." 9 In 

part, this recommendation was directed to the repeal of the provincial provisions 

with a view to establishing a "national standard" 9 for preference challenges. 

However, it is clear that the committee also had in mind amendments to §§ 95 

and 96 of the BIA themselves. The report touched on the question of whether the 

debtor's intent should continue to be the test, or whether it would be better to move 

to an effects-based test as other jurisdictions have done but it reached no conclusion, 

save for noting a concern expressed by the IIC and CAIRP Joint Task Force that 

"transactions made in good faith are not necessarily protected from an 'effectsbased' 

standard .... 100 

In the wake of the Senate Committee Report, a Joint Task Force Working 

Group formulated detailed recommendations for preference law reform, the central 

features of which are as follows:' 

(1) In the case of a non-arm's length transaction, the review period would be 

five years from the date of the original bankruptcy event or the initial application, 

while in the case of an arm's length transaction, the review period would be one 

year. 

(2) In the case of a non-arm's length transaction occurring within one year 

before the date of the initial bankruptcy event or the initial application, the trustee 

or monitor would need to prove only that the transaction amounted to a preference 

in fact. 

(3) In the case of a non-arm's length transaction occurring between one and 

five years before the date of the initial bankruptcy event or the initial application, 

the trustee or monitor would need to prove that: (a) the transaction amounted to a 

preference in fact; and (b) the debtor was insolvent at the time of the transaction or 

the transaction made the debtor insolvent. 

(4) In the case of an arm's length transaction, the trustee or monitor would 

need to prove that: (a) the transaction amounted to a preference in fact; and (b) the 

debtor intended to prefer the counterparty. There would be a rebuttable 

presumption of intention in the three months preceding the date of the initial 

bankruptcy event or the date of the initial application. 

(5) It would be a defence for the counterparty to prove that: (a) the debtor was 

solvent on the transaction date and not rendered insolvent by the transaction; or (b) 

the counterparty was entitled to receive the transfer in priority to other creditors. 

98. Id. at 123. 

99. Id. at 122. 

100. Id. The Insolvency Institute of Canada (IIC) and the Canadian Association of Insolvency and 

Restructuring Professionals (CAIRP) are the two peak bodies representing insolvency professionals in 

Canada. They formed a Joint Task Force in 2001for the purpose of making a detailed submission to the 

government on business insolvency law reform. 

101. IIC and CAIRP Joint Task Force on Business Insolvency Law Reform, Working Group on 

Preferences, Discussion Paper (2004) [hereinafter JTF Preferences Working Group Paper]. 



VOL. 42:661 

Recently enacted amendments, not yet in force, replace § 96 of the BIA with 

the following provision: 

If the transfer, charge, payment obligation or judicial proceeding referred 

to in section 95 has the effect of giving a creditor who is not at arm's length 

a preference over other creditors, the review period referred to in 

subsection 95(1) is one year instead of three months.'9 

Under the previous version, the extended review period applied if the creditor 

was related to the debtor. Under the new version, the extended period applies if the 

creditor is not at arm's length, whether because it is related to the debtor or for some 

other reason. That is the extent of the change. The new provision does nothing to 

address the concerns outlined in Part III. However, it seems that the amendment 

was supposed to go further and that the real intention was to implement the JTF 

Working Group's Recommendation (3) by substituting an effects-based test for nonarm's 

length transactions. 1 1 3 Even if the new version is amended to reflect the actual 

intention, it still goes nowhere near addressing the concerns raised in Part III. There 

would still be the same indeterminacy problems as there are now. The only reason 

given in support of the proposed change was that it would "make it considerably 

easier for trustees to recover preferences from non-arm's length parties."' ' It is 

impossible to know whether this would be a good or bad thing in the absence of a 

benchmark for the desirable amount of recovery. 1 5 In any event, if the policy 

objective really is to facilitate preference recovery, the more logical response would 

be to move to a strict liability regime with no defences. It is also worth noting that 

the government's reason for the amendment conflicts with the JTF Working Group's 

main concern, which was to draft a set of provisions that did not unduly threaten the 

finality of transactions. 

For these reasons, it was a mistake for the government to cherry-pick from the 

JTF Working Group's model. This raises the question of whether the government 

should instead adopt the model in its entirety. There are several reasons why it 

should not do so. The main one is that the Working Group failed to articulate what 

it thought the governing policy considerations should be and this lack of a clear 

policy direction flows through into its recommendations. The JTF's stated concern 

was to "strike a balance between the ability of the debtor to conduct its affairs in the 

period prior to the commencement of insolvency proceedings and the ability of 

trustees, receivers and creditors to recover value where a transaction has given a 

preference contrary to the statute. 10 6 However, this statement fails to specify the 

purpose the preference laws are supposed to serve. The purpose might be one of 

102. Bankruptcy and Insolvency Act, supra note 50, as am. by R.S.C. 2005, c. 47, s.73. 

103. Email from Dave Stewart, Senior Project Leader, Office of the Superintendent of Bankruptcy, to 

Tony Duggan (Oct. 5, 2005). 

104. Id. 

105. In this connection, it is interesting to note that in Australia provisions were introduced to meet 

concerns that liquidators may have insufficient funds to bring preference actions. See Andrew Keay, An 

Exposition and Assessment of Unfair Preferences, 19 MELB. U. L. REv. 545, 577-79 (1994). However, 

recent amendments to the preference provisions in the United States were motivated by concerns that 

creditors might not have the resources to defend preference claims. See Tabb, Brave New World, supra 

note 26, at 425-26. 

106. Insolvency Institute of Canada and Canadian Association of Insolvency and Restructuring 

Professionals, Report on Business Insolvency Law Reform, (2002), Commentary on Recommendation 66. 


2007 


debtor deterrence, creditor deterrence or equal sharing. As the discussion in Part 11 

indicates, a choice must be made because the purpose determines the shape of the 

legislation. An even more basic choice is whether to retain the preference laws at 

all. It is surprising that the JTF does not appear to have canvassed this option, given 

the importance it attached to the finality of transactions. 

The most distinctive feature of the JTF Working Group's model is that it 

requires proof of the debtor's intention to prefer, but only if the transaction is an 

arm's length one. In the case of a non-arm's length transaction, the test is an effectsbased 

one. No reasons were given in support of this approach. A possible 

explanation is that, if the transaction is a non-arm's length one, the debtor is more 

likely to have intended a preference. 7 However, this consideration at most supports 

a rebuttable presumption of intention." 8 It might be argued that an irrebuttable 

presumption saves litigation costs by forestalling inquiry into the debtor's state of 

mind. On the other hand, an irrebuttable presumption, like all bright-line rules, is 

potentially over-inclusive and the Working Group does not address the competing 

costs and benefits. 

A more fundamental concern is that, on this reading of the Working Group's 

model, the underlying rationale is debtor deterrence. However, the Working Group 

does not explain why it favours the debtor deterrence rationale over creditor 

deterrence or equal sharing. One challenge advocates of the debtor deterrence 

rationale face is to explain the absence of sanctions against the preference-giving 

debtor." 9 If the preference laws put the burden on the creditor, rather than the 

debtor, how can it be plausibly claimed that the objective is debtor deterrence? 

Another challenge is to address Schwartz's point that preference laws based on the 

debtor deterrence rationale are inefficient."" Advocates of the debtor deterrence 

rationale might claim that the objective is not efficiency, but fairness."' However, 

this would require a balancing of fairness gains against efficiency losses which the 

Working Group does not do. 

An alternative explanation of the Working Group's model is that the 

requirement for proof of the debtor's intention in the case of arm's length 

transactions was motivated by finality of transaction concerns, rather than debtor 

deterrence. If this is right, though, it takes us back to the starting point: assuming 

finality of transactions matters, and debtor deterrence is not the objective, why have 

preference laws at all? The creditor deterrence and equal sharing rationales are 

both possible explanations, but the Working Group does not say which of these it 

had in mind. If it was creditor deterrence, the model is deficient because there is no 

element of creditor culpability. If equal sharing, rather than creditor deterrence, was 

the goal there are efficiency concerns which should have been addressed. 

Furthermore, one way of reducing the finality of transactions concern is to shorten 

the review period: the shorter the review period, the lower the creditor's exposure." 

The Working Group does not explain why it did not take this step instead of, or 

perhaps as well as, relying on the proof of intention requirement as a controlling 

107. Australian Law Reform Commission, supra note 27, paras. 268-69. 

108. Id. paras. 272-73. 

109. See supra text accompanying notes 14-15. 



112. But not eliminating the finality of transactions concern. See supra text accompanying note 35. 



VOL. 42:661 

factor. As it happens, the Working Group's model substantially lengthens the 

standard review period from the current three months to one year. By way of 

contrast, in the United States, the standard review period is three months, and in 

Australia, England and New Zealand it is six months. The Working Group does not 

explain how the longer review period is reconcilable with its concern for finality of 

transactions. 

Professor Cuming has proposed an alternative model, based substantially on 

the United States approach: an effects-based preference test coupled with various 

safe harbour provisions, the most important being an exception for "non-exceptional 

payments." 113 ' The following are non-exceptional payments: (1) the payment of a 

business debt under a running account arrangement; (2) the payment of a business 

debt if made within thirty-five days from the date the debtor received the property 

or service to which the debt relates; and (3) the payment of a loan where the period 

between the date the obligation was incurred and the date of the payment is not 

greater than thirty-five days." ' The non-exceptional payments exception replaces 

the United States ordinary course of business defence, which Cuming rejected as 

being too imprecise.' 5 

There are grounds for this concern. For example, in 1993 New Zealand 

implemented an effects-based preference test coupled with an ordinary course of 

business exception, the immediate consequence of which was to substantially 

increase the volume and complexity of preference litigation. Among other things, 

the courts struggled with the questions of: (1) whether the ordinary course of 

business was to be assessed by reference to the debtor's industry at large or by 

reference to the debtor's relationship with the creditor in particular; and (2) what are 

the relevant variables for determining ordinariness."' The government is now in the 

process of repealing the ordinary course of business exception." 7 

In the United States, the ordinary course provision has recently been amended 

to clarify the law in relation to Question (1)."' In Canada, where the courts have 

read an ordinary course of business defence into the statute, Question (2) is 

addressed in part by reference to whether the debtor made the payment in the 

expectation of being able to stay in business and, if so, whether the debtor's 

expectation was a reasonable one. The level of case-by-case inquiry involved makes 

litigation outcomes difficult to predict." 9 

113. Ronald C.C. Cuming, Unfair Preferences: Reformulation of Section 95 of the Bankruptcy and 

Insolvency Act (paper prepared for Industry Canada Corporate Law Policy Directorate, December 1997) 

[hereafter Unfair Preferences Report], subsequently published in abridged form as Ronald C.C. Cuming, 

Transfers at Undervalue and Preferences under the Bankruptcy and Insolvency Act: Rethinking Outdated 

Approaches, 37 CAN. Bus. L. J. 5 (2002) [hereinafter Cuming, Transfers]. 

114. Unfair Preferences Report, supra note 113, recommendation 6. 

115. Cuming, Transfers, supra note 113, at.28-29. 

116. Thomas G.W. Telfer, Voidable Preference Reform: A New Zealand Perspective on Shifting 

Standards and Goalposts, 12 INT'L INSOLVENCY REv. 55, 75-80 (2003); New Zealand Ministry, Tier One 

Discussion, supra note 26, at 59 (citing uncertainty and costs as major reasons for repeal of the ordinary 

course of business exception). 

117. Insolvency Law Reform Bill, 2005 Bill [14-1] (N.Z.) 2006, cl. 478, amending the Companies Act 

1993. The proposal is to replace the ordinary course of business exception with a defence based on 

§588FG(2) of the Australian Corporations Act 2001. The Australian provision is discussed infra in text 

accompanying note 119. 




2007 


The Cuming model rests on the equal sharing rationale. Cuming says that a 

preferential transfer: 

"if left intact, frustrates implementation of the policy of bankruptcy 

legislation, equitable treatment of all creditors. The fact that the debtor 

intended or did not intend this result should not be relevant. The actual or 

presumed intentions of the debtor when making a preferential transfer are 

not important. What is important is the effect that such a transaction has 

on the position of creditors with claims in bankruptcy. What matters to 

them is that a central policy of bankruptcy law is not frustrated by a 

preferential payment or transfer which, by definition, results in material 

loss to them."' 2 

The preference provisions in the Australian Corporations Act of 2001 (Cth), 

which are based on recommendations the Australian Law Reform Commission 

made in its General Insolvency Inquiry Report, provide yet another model for 

reform. The Australian model incorporates an effects-based preference test coupled 

with a broadly stated good faith defence: it is a defence to a preference action if the 

creditor proves that: (1) it acted in good faith; (2) it had no grounds for suspecting 

that the debtor was insolvent or close to insolvency on the transaction date and a 

reasonable person in the creditor's circumstances would have had no reasonable 

grounds for so suspecting; and (3) the creditor provided valuable consideration or 

changed its position in reliance on the transaction.1 2 ' The Australian approach is 

different from the Cuming model in two important respects: (1) whereas the Cuming 

model rests on the equal sharing rationale, the goal of the Australian provisions is 

creditor deterrence as the good faith creditor defence makes clear; 2 2 and (2) the 

Cuming model's non-exceptional payments defence is rules-based, whereas the 

Australian good faith creditor defence is a standards-based one. 

Jackson claims that "preference law has never felt comfortable with any 

balance between a rule and a standard. During this century, the basic thrust of 

3 

preference law has been in the direction of a rule.', However, as he goes on to 

point out, in the United States the commitment to rules is substantially eroded by 

the ordinary course of business exception."' The Australian approach is also 

standards-based, with the various costs that a standards-based approach entails, but 

it is more specific about what the creditor must prove and, for this reason, it is 

arguably better targeted than the ordinary course of business exception. 25 The 

Cuming model's rules-based approach avoids the case-by-case inquiry the Australian 

provisions involve and so it is more predictable. On the other hand, the thirty-five 

day cut-off point, like all bright line rules, is potentially both over- and underinclusive. 

To the extent that it is over-inclusive, it threatens the finality of 

120. Cuming, Transfers, supra note 113, at 23. 

121. Corporations Act 2001, c. 5 §588FG(2) (Austl.). Ironically, the course of United States law 

reform has flowed in precisely the opposite direction: the Bankruptcy Act of 1898 introduced a 

requirement for proof of creditor intention, but the requirement was dropped in 1978 and replaced by the 

ordinary course exception. See Tabb, Rethinking Preferences, supra note 14, at 1007-15. 


123. Jackson, supra note 16, at 130-31. 

124. Id. at 131. 

125. Australian Law Reform Commission, supra note 27, at 272; cf. Keay, supra note 105, at 545. 



VOL. 42:661 

transactions; to the extent that it is under-inclusive, it undermines the objective of 

26 

the preference laws.1 

The JTF Working Group made no reference to either the Cuming model or the 

Australian model. Perhaps the Working Group rejected the Cuming model because 

it disagreed with the equal sharing rationale or perhaps it thought that Cuming's 

non-exceptional payments exception was an insufficient safeguard for the finality of 

transactions. However, this is not explicitly provided by the Working Group. 

Likewise, the Working Group may have disliked the Australian model because it 

disagreed with the creditor deterrence rationale or, alternatively, because it thought 

that the good faith creditor defence was too imprecise. Again, though, these are 

simply speculations in the face of the Working Group's silence. 

V. CONCLUSION 

Preference law design implicates five key questions: 

(1) What is the objective: debtor deterrence, creditor deterrence or equality of 

distribution? 

(2) How much weight should the law give to competing concerns, such as 

finality of transactions and facilitating the provision of credit to financially distressed 

debtors? 

(3) What, if any, evidentiary concessions should the law make in favour of 

either the trustee or the creditor? 

(4) What form should the law take: bright-line rules, at the risk of over- and 

under-inclusiveness, or standards, at the risk of increased uncertainty? 

(5) What role, if any, is there for the concurrent application of provincial laws? 

Current Canadian preference law suffers from the failure to have systematically 

addressed any of these questions. The government's most recent reform initiatives 

are subject to the same criticism. The purpose of this paper has been to demonstrate 

that wholesale reform is necessary, and that tinkering of the kind the most recent 

reforms represent is at best insufficient and at worst counter-productive. There 

seems to be a general consensus on the need for reform, but there is as yet no 

consensus on how the questions listed above should be answered. Perhaps that is 

because until now policy makers and stakeholders have not given them sufficient 

thought. If this paper succeeds in raising the level of awareness about what the 

choices are, then it will have done its job. The choices themselves can then be left to 

others. 

126. Cuming's idea for the thirty-five-day cut-off point appears to derive from the United States 

Bankruptcy Reform Act of 1978, Pub. L. No.95-598, §547 (c)(2), which limited the ordinary course of 

business defence to transfers made not later than forty-five days after the debt was incurred. The1984 

reforms took out the forty-five-day cut-off point. See Tabb, Rethinking Preferences, supra note 14, at 

1014-16. Jackson favours its reintroduction, subject to making the time run from the date the debt was first 

due, rather than when it was incurred. Jackson, supra note 16, at 131. 


Recent International Developments in the Law 

of Negotiable Instruments and Payment and 

Settlement Systems 

BENJAMIN GEVA* 

SUMMARY 

I. O V E R V IEW ........................................................................................................... 685 

II, THE CHECK PAYMENT AS AN ELECTRONIC FUNDS TRANSFER ..................... 687 

A . In trod uction ................................................................................................. 687 

B. The "Electronic Check": Check as an EFT Authorization ..................... 689 

C. A Rem otely Created Check ........................................................................ 690 

D . E lectronic P resentm ent ............................................................................... 691 

E . E lectronic N egotiation ................................................................................ 694 

III. PAYMENT CARDS -THE PAYROLL CARD AS AN ACCESS DEVICE ............... 699 

IV. 

SECURITIES TRANSFERS IN THE INDIRECT HOLDING SYSTEM -LAW 

REFORM IN CANADA IN THE FOOTSTEPS OF UCC ARTICLE 8 ....................... 705 

V. EU PROPOSED LEGAL FRAMEWORK FOR A SINGLE PAYMENT MARKET.... 712 

A . Introduction ................................................................................................. 712 

B. Licensing of Non-Bank Payment Service Providers ................................ 714 

C. Transparency of Conditions for Payment Services .................................. 716 

D. Rights and Obligations of Users and Providers of Payment Services .... 718 

E . F inal R em arks .............................................................................................. 725 

V I. C O N C LU SIO N ....................................................................................................... 725 

I. OVERVIEW 

This paper surveys four recent major developments worldwide in the areas of 

negotiable instruments and payment and settlement systems. Only private or 

LL M, SJD, Harvard Law School; Professor of Law, Osgoode Hall Law School York University, 

Toronto, Canada [2005-2006: Adjunct Professor and Visiting Scholar, Northwestern University School of 

Law, Chicago, IL]. 



VOL. 42:685 

commercial law aspects are considered; regulatory and public law issues are outside 

the scope of the present discussion. Topics covered are checks, payment cards, 

securities transfers, and payment transactions. A common theme is the adaptation 

by statute of the law to the world of electronic banking as it keeps evolving. 

The first development, outlined in Part II, is concerned with the ongoing 

transformation of the check payment into an electronic funds transfer. The check 

has been characterized as the paper-based payment system par excellence. Recently, 

this view has been eroded in several ways. Principal developments outlined in this 

paper consist of the "electronic check" in the United States; the remotely created 

check in the United States and Canada; electronic presentment in the United States, 

UK, recent law reform in Sri Lanka and a proposal in Canada; and "electronic 

negotiation" under "Check 21 Act" in the United States. A procedure in which the 

physical movement of checks is curtailed or eliminated, being replaced, in whole or 

in part, by electronic transmission of information is called "check truncation." To a 

large extent, check truncation reflects a partial conversion of the check collection 

process to an electronic funds transfer. 

The second development, covered by Part III, is the evolving legal framework 

applicable to payment cards. A fundamental distinction has been known to exist 

between access and stored-value payment cards. The recent emergence in the 

United States of payroll, remittance and gift cards has required their classification in 

that framework. A recent amendment in the United States placed the payroll card 

under Regulation E governing access device. Yet earlier parameters established by 

the Federal Reserve Board, to which no reference was made in connection with the 

recent amendment, but which are followed in the literature and banking parlance, 

would have suggested the payroll card is a stored-value card. With the view of 

eliminating future confusion, Part III endeavors to reconstruct these earlier 

parameters, to clarify the distinction between access and stored-value cards, and thus 

to facilitate an appropriate framework for future developments. Specifically, Part III 

is designed to justify the treatment of the payroll card as an access device as 

conceptually sound. 

The third development, outlined in Part IV, is the acceleration in the 

modernization of the law of securities transfers. Recent Canadian legislation 

modeled on Article 8 of the American Uniform Commercial Code, passed in May 

2006, provides for a comprehensive framework dealing with all modes of securities 

holdings and transfers. Particularly, it covers the indirect-tier holding, namely, the 

transfer and pledge of "security entitlements" credited and debited to "securities 

accounts" maintained with "securities intermediaries" such as brokerage firms which 

in turn maintain securities accounts with a Central Depositary of Securities (CDS). 

The fourth development, outlined in Part V, is the European march towards a 

Pan-European common payment law. With the view of creating a Single Payment 

Market where improved economies of scale and competition would help to reduce 

cost of the payment system, the Commission of the European Communities 

proposed in December 2005 to establish a common framework for the Community 

payments market creating the conditions for integration and rationalisation of 

national payment systems. Focusing on electronic payments, the Commission made 

a proposal for a Directive on payment services in the internal market, designed to 

provide for a harmonised legal framework. Intended to leave maximum room for 

self-regulation of industry, the Proposed Directive purports to harmonise only what 

is necessary to overcome legal barriers to a Single Euro Payment Area (SEPA). 


2007 INTERNATIONAL DEVELOPMENTS IN THE LAW OF NEGOTIABLE INSTRUMENTS 687 

II. 

THE CHECK PAYMENT AS AN ELECTRONIC FUNDS TRANSFER' 


By its nature, a check is an order to pay given by a customer to a bank with 

which the customer maintains an account. It is a paper instrument, embodying an 

unconditional order in writing, signed by a drawer, instructing a drawee bank to 

make payment to or to the order of a designated payee, or to the bearer. 2 The 

person to whom a check is payable and who is in possession of the check is its 

holder. 3 A check is issued when the drawer delivers it to the first holder. 4 Once 

issued, a check may circulate from hand to hand, namely be negotiated, by delivery 

from one holder to another; in the case of a check payable to order, negotiation 

consists of delivery accompanied by the signature of the holder, called 

"indorsement." ' To obtain payment, the last holder is to have the check physically 

presented to the drawee bank. 6 

Typically, a holder will not present the check to the drawee bank in person. 

Rather, the holder is likely to have the check deposited with and collected by a 

depositary bank, with which the holder maintains an account. The depositary bank 

will then either present the check directly to the drawee bank, or negotiate it to an 

intermediary bank. There may be one or more negotiations to one or more 

intermediary banks. The last intermediary bank will present the check for payment 

to the drawee. In that process, all banks other than the drawee, namely the 

depositary bank and each intermediary bank, are collecting banks, the drawee bank 

is the payor bank, and the collecting bank that presents the check for payment to the 

drawee bank is the presenting bank.' 

The normal process thus entails a series of physical deliveries of the piece of 

paper embodying the check. First, the check is physically issued by the drawer to the 

first holder. Second, there may be one or more physical negotiations outside the 

banking system. Third, there is the physical delivery of the check by the holder to 

the depositary bank. Fourth, there may be one or more deliveries of the check to 

intermediary bank(s). Fifth, the process concludes with a physical presentment of 

the check to the drawee. Following payment, there is possibly a sixth and postconcluding 

stage, in which the cancelled check is delivered by the payor bank to the 

drawer, together with the periodic statement containing it. Conversely, where the 

drawee dishonors the check, the check is returned in a reversed itinerary. 

1. See generally BENJAMIN GEVA, THE LAW OF ELECTRONIC FUNDS TRANSFERS § 1.07 (1992-2006) 

[hereinafter GEVA, LAW OF EFT]. 

2. U.C.C. § 3-104(f) (2006); Bills of Exchange Act, R.S.C., ch. B-4, §§ 165(1), 17(1) (1985) (Can.). 

Canadian Bills of Exchange Act provisions cited in footnotes 2-6 and 12 have parallels in all statutes 

modeled on the England's Bills of Exchange Act. Bills of Exchange Act, 1882, 45 & 46 Vict., c. 61 (Eng.). 

3. U.C.C. § 1-201(b)(21)(B); Bills of Exchange Act, R.S.C., ch. B-4, § 2. 

4. U.C.C. § 3-105; Bills of Exchange Act, R.S.C., ch. B-4, § 2. 

5. U.C.C. §§ 3-201, -204; Bills of Exchange Act, R.S.C., ch. B-4, §§ 2, 59 (substituting "endorsement" 

for "indorsement"). 

6. A point implied, though not specifically provided for, in the U.C.C., speaking of the exhibition of 

the check to, and its handling by, the drawee. U.C.C. § 3-501(b)(2). However, the Bills of Exchange Act is 

straightforward on this point. Bills of Exchange Act, R.S.C., ch. B-4, § 84(3). 

7. See U.C.C. §§ 4-104 to -105 (providing applicable definitions). 



VOL. 42:685 

Modern law facilitates variations by agreement; as may be necessary it may 

further provide for the position of third parties under the law of checks where such 

variations have been agreed. First, a check may be given as a source of information 

to be used to initiate a one-time electronic fund transfer, in which case it is often 

described as an "electronic check." Second, a check may be remotely created. Third, 

a check may be negotiated to a collecting bank, whether by its customer the holder, 

or another collecting bank, by means of electronic transmission. Fourth, a check 

may be presented for payment electronically. At the same time, no practice of 

electronic negotiation to non-banks has developed so that no provision for such 

electronic transmission has been made. 

As a source of information, a check may be given to the payee with the 

authority to convert it to an electronic image. A remotely created check is drawn by 

the payee, as an agent of the drawer, on the basis of information provided by the 

drawer to the payee, typically, over the telephone. Both electronic negotiation and 

presentment consist of the transmission of an electronic image instead of the physical 

transfer of the paper check. In the United States, inter-bank transmission of check 

images takes place over dedicated telecommunication channels, provided by both 

Federal Reserve Banks, 8 and the private sector9 

All four procedures involve check truncation, namely a procedure in which the 

"physical movement of [checks] is curtailed or eliminated, being replaced, in whole 

or in part, by electronic [transmission of information]."' ' Inasmuch as it constitutes 

the transmission of payment information other than by the delivery of paper check, 

each of the four procedures results in an electronic funds transfer for the pertinent 

stage of the check transaction. The ensuing discussion will outline proposed and 

existing legislative and regulatory frameworks to govern all four procedures. It will 

commence with the "electronic check," discuss the remotely created check, move on 

to the electronic presentment, and conclude with the electronic negotiation, the 

latter being the most elaborate scheme. 

To a large extent, these variations reflect a partial conversion of the check 

collection process to an electronic funds transfer. To that end, one may roughly 

describe the process as a whole as the "dematerialization" of the check, or perhaps 

better, as its immobilization," namely the substitution of any stage in its physical 

transfer, by the transmission of its information or electronic image. By analogy then, 

8. See FEDERAL RESERVE BANKS, GUIDE TO CONNECTIVITY OPTIONS FOR FEDFORWARDRM , 

FEDRETURN", AND FEDRECEPTRM SERVICES (VERSION 2) (2005), available at 

http://www.frbservices.org/Retail/pdf/C21ConnectivityGuide.pdf. 

9. A major player is SVPCO, which is the Check and Electronic Clearing Service of The Clearing 

House Payments Company. SVPCO, About Us, http://www.svpco.com/about/000162f.php (last visited 

May 10, 2007). The service covers electronic check presentment and check imaging. Id. Its "SVPCO 

Image Payments Network is an industry utility for all financial institutions [which] lets each participant 

transmit images directly to other participants." SVPCO Image Payments Network, 

http://www.svpco.com/payment-services/check-image-exchange/000093.php (last visited May 10, 2007). 

"SVPCO Image Payments Network facilitates "peer-to-peer" exchanges without going through a central 

processing facility." Id. 

10. COMM. ON PAYMENT & SETTLEMENT SYS., BANK FOR INT'L SETTLEMENTS, A GLOSSARY OF 

TERMS USED IN PAYMENTS AND SETTLEMENT SYSTEMS 50 (2003), available at 

http://www.bis.org/publ/cpss0Ob.pdf (stating one example of the definition of "truncation). 

11. These are terms borrowed from the law of securities transfers, which is discussed in Part III of this 

Paper. For the use of "dematerialization" in the present context, I am obliged to Bradley Crawford. My 

own preference to "immobilization" stems from the fact that as in the immobilization of securities, the 

process involves the conversion and not elimination of paper. 



the entire transformation of the paper-based payment system into an electronic 

funds transfer may be viewed as the "decertification" of the check. In the process, 

the law of checks is being transformed into the law of electronic funds transfers. The 

ensuing discussion covers developments in the legal framework for each of the four 

variations outlined above; it does not go as far as to introduce an overall theory 

encompassing the entire transformation process. 

B. The "Electronic Check": Check as an EFT Authorization 

On occasion, a check may not be "issued" so as to give the payee rights thereon 

to enforce payment in discharge of the underlying obligation; 2 rather, contrary to 

the usual presumption of conditional payment by check, 3 a check may be given to 

the payee merely as a source of information to be used to initiate a one-time 

electronic fund transfer from the drawer's account in payment of the obligation. The 

check is then used as a source document to collect the drawer's routing number, 

account number, check's serial number and the sum payable. In effect, the check is 

thus converted to a single debit entry which is then input to the ACH (Automated 

Clearing House) Network. This arrangement is particularly common in consumer 

transactions. Where the check is mailed to the payee-merchant, the check is 

converted to an ARC-Accounts Receivables Entry. Where the check is given to 

the payee-merchant in a face-to-face transaction the check is converted to a POP- 

Point-of-Purchase Entry. Once converted, the check itself is voided; in a face-to-face 

transaction it is typically returned to the consumer-drawer. 14 

The electronic image created by the merchant, usually at the point-of-sale, is 

often colloquially referred to as an "electronic check." In fact this is a misnomer; 

what is generated on the basis of the information derived from the check is not a 

"check" but rather an ACH debit entry. Payment is then not governed by UCC 

Articles 3 and 4, but rather is brought into the ambit of Regulation E, issued by the 

Federal Reserve Board, governing consumer electronic fund transfers." 9 Regulation 

E requires the merchant to "provide a notice that the transaction will or may be 

processed as an electronic fund transfer, and obtain a consumer's authorization for 

each transfer."'" 

12. See U.C.C. § 3-105(a) (2006) (defining "Issue" as "the first delivery of an instrument by the maker 

or drawer, whether to a holder or nonholder, for the purpose of giving rights on the instrument to any 

person."); Bills of Exchange Act, R.S.C., ch. B-4, § 2 (1985) (Can.) (to a similar effect, defining "issue" as 

the first delivery to a holder). 

13. See U.C.C. § 3-310(b) (stating the presumption which states that "[u]nless otherwise agreed.,. if. 

.. an uncertified check is taken for an obligation, the obligation is suspended ... until dishonor of the 

check or until [the check] is paid or certified."); In re Charge Card Services Ltd., [1988] 3 W.L.R. 764 (CA) 

(Eng.) (discussing the conditional payment presumption in the common law). 

14. See NACHA, ACH Operating Rules, §§ 3.7-3.8 (2007). For bulk electronic payments processed 

through the ACH (Automated Clearing House) Network and for NACHA (National Automated Clearing 

House Association), as well as for NACHA Operating Rules and Guidelines, see GEVA, LAW OF EFr, 

supra note 1, ch. 5. 

15. Regulation E excludes from the term "electronic fund transfers" .[any transfer of funds 

originated by check ...." 12 C.F.R. § 205.3(c)(1) (2006). However, the theory of the check conversion is 

that the transfer is initiated by the converted debit entry, rather than the check, that has been used as a 

mere source of information. Id. § 205.3(b)(2). 

16. Id. § 205.3(b)(2) (codifying 71 Fed. Reg. 1638 (Jan. 10, 2006)). Briefly stated, the underlying 



VOL. 42:685 

It should, however, be pointed out that in principle there is nothing to preclude 

the issue of a paper check by a drawer-buyer of goods or services in payment or 

discharge of the obligation to the payee-merchant 7 and its subsequent electronic 

presentment to the drawee bank by the merchant through the depositary bank. The 

banking operation involved may not be different than that of the current "electronic 

check" collection procedure as outlined above; and yet, it would be governed by the 

law of checks," 8 in which case it is hard to rationalize any disclosure or authorization 

requirement as under Regulation E. Indeed, the check collection is a regular debit 

transfer; the "electronic check" collection scenario lends further support to the view 

that a separate law to govern check collection is outdated. 

C. A Remotely Created Check 

A remotely created check is typically generated when the drawer authorizes the 

payee to produce a check drawn on the drawer's account. The drawer does not sign 

the check, which generally bears either the drawer's printed or typed name or a 

statement as to the issue of the check under the drawer's authority. The check is 

deposited by the payee at a depositary bank, under an agreement under which the 

payee warrants the drawer's authority. Authorization to the payee is typically given 

over the telephone; the remotely created check is thus a useful mechanism to make a 

one-shot "last minute" and yet a timely payment. 

The issue or creation of the remotely created check is a matter between the 

drawer and the payee. Its deposit is a matter to be agreed between the payee and 

the depositary bank. Obviously however, a customer will not authorize the drawee 

to honor any remotely created check that merely purports to emanate under that 

customer's authority; the customer is not to be charged with checks not actually 

issued under that customer's authority. Yet, inasmuch as remotely created checks do 

not bear signatures or other ready means to verify authority, they are vulnerable to 

fraud. In the absence of specific protection measures discussed immediately below, a 

drawee bank that pays a remotely created check thus pays it at its peril, bearing the 

risk of unauthorized payment out of a customer's account. 

Regulatory and legal response providing protection to the drawee bank against 

the fraud risk dramatically varies between Canada and the United States. In 

Canada, the Canadian Payments Association (CPA)" 9 prohibits the clearing of 

remotely created checks, or "tele-cheques" in the Canadian terminology. 20 In the 

theory of the requirement is that conversion may change the consumer's position, insofar as payment is 

likely to be speedier and the cancelled check will not prove payment. 

17. As will be the normal procedure. See supra note 13 and accompanying text. 

18. See discussion infra Part II.D-E (electronic presentment and negotiation under the law of checks). 

19. Canadian Payments Act, R.S.C., ch. C-21 (1985), amended by 2001 S.C., ch. 9 (Can.) (establishing 

the Canadian Payments Association (CPA)). The CPA's membership consists of financial institutions and 

is mandated to "establish and operate national systems for the clearing and settlement of payments and 

other arrangements for the making or exchange of payments .. " Id. § 5(1)(a). Its Board may make rules 

"respecting payment items acceptable for exchange, clearing or settlement .. " Id. § 19(1)(a). CPA Rule 

Al identifies payment items that are eligible for clearing. CPA, Rule Al-General Rules Pertaining to Items 

Acceptable for Exchange, for the Purpose of Clearing and Settlement (2004), available at 

http://www.cdnpay.ca/rules/pdfsrules/rule-al.pdf. 

20. In fact, there is no explicit prohibition in a specific Rule. Rather, it is the CPA's Policy Statement 

that effectively prohibits tele-cheques. CPA Policy Statement, Prohibition of Tele-cheques in the Clearing 

& Settlement System (June 3, 2003), available at http://www.cdnpay.ca/news/tele.asp. Rule A4 outlines the 



absence of a pre-existing written and signed authorization by the drawer, fraud, due 

to the inability of the drawee bank to verify the authority of its customer, is cited as 

the "key risk associated with a tele-cheque." 2 In short, protection is afforded to the 

drawee bank in the form of a ban on the practice. 

In contrast, the remotely created check is an accepted practice in the United 

States. To protect the payor bank from the fraud risk, and still facilitate the use of 

the remotely created check, that otherwise may have not been honored by that bank, 

both the UCC 22 and Regulation CC 23 create transfer and presentment warranties. 

Thereunder, the depositary bank warrants that the remotely created check, which it 

is transferring or presenting, is authorized by the person on whose account the check 

is drawn. Loss caused by a check issued without proper authority of the person on 

whose account the check purports to be drawn thus falls on the depositary bank, 

which is the bank that dealt directly with the payee, who is the party that created the 

check. " It is then up to that bank to shift by contract the risk to its customer, the 

payee, from whom the bank accepted the check for collection. 

D. Electronic Presentment 

Electronic presentment is provided for by UCC Section 4-110. Thereunder, the 

presentment of a check may be made pursuant to an agreement for presentment. 

"Agreement for electronic presentment" could be in the form of an agreement, 

clearing-house rule, or Federal Reserve regulation or operating circular." The 

agreement is to provide "that presentment ... may be made by the transmission of 

an image of [a check] or information describing [it] . . .rather than delivery of the 

[check] itself." 6 The transmission of the image or information constitutes a 

"presentment notice"; its receipt is the actual presentment. Other elements that may 

be covered by the agreement for electronic presentment are "procedures governing 

retention, . . . payment, dishonor and other matters . . .., Arguably, return 

return time-frame for tele-cheques, which "may be returned for the reason 'Not Eligible for Clearing' up to 

and including 90 days after being received by the Drawee." CPA, Rule A4-Returned and Redirected Items 

§ 6(g) (2005), available at http://www.cdnpay.ca/rules/pdfs-rules/rule-a4.pdf. 

21. CPA Policy Statement, supra note 20. 

22. U.C.C. §§ 3-416(a)(6), 3-417(a)(4), 4-207(a)(6), 4-208(a)(4) (2006). 

23. 12 C.F.R. §§ 229.2(fff), 229.34(d) (2006) (having consequential amendments in sections 210.5, 

210.6, 210.9). Federal law purports to mirror the aforesaid U.C.C. provisions and is designed to rectify the 

lack of their universal adoption throughout the entire country. 

24. See Collection of Checks and Other Items by Federal Reserve Banks and Funds Transfers 

Through Fedwire and Availability of Funds and Collection of Checks, 70 Fed. Reg. 71,218 (Nov. 28, 2005) 

(codified at 12 CFR pts. 210 & 229; 70 Fed. Reg. 10,509 (March 4, 2005) (codified at 12 C.F.R. pts. 210 & 

229); Federal Reserve Bank of New York, Request for Comment on Proposed Rule Governing Remotely 

Created Checks - Regulation CC, Circular No. 11688 (Mar. 8, 2005), available at 

http://www.newyorkfed.org/banking/circulars/11688.html. 

25. See, e.g., Regulation J, 12 C.F.R. § 210.2 (defining "item" in section 210.2(i) to include "electronic 

item," such as an "electronic image" of a check or any other paper item); see also Federal Reserve Bank, 

Operating Circular No. 3: Collection of Cash Items and Returned Checks § 5 & apps. E, E-E3 (July 1, 

2004), available at http://www.frbservices.org/OperatingCirculars/pdf/Oc3.pdf (stating that electronic access 

to Reserve Bank's Services is governed by Section 5 and Appendices E (MICR Presentment Services), El 

(Truncation Service), E2 (MICR Presentment Plus Service), and E3 (Basic MICR Presentment Service)). 

26 U.C.C. § 4-110. 

27 Id. 



VOL. 42:685 

procedures fall in the ambit of the agreement. An interbank voluntary agreement 

may be either bilateral or multilateral. 8 In any event, per the language quoted 

above, "agreement for electronic presentment" under Section 4-110 may for 

example be constituted by means of a regulation or a circular issued by the Federal 

Reserve and thus may not be entirely consensual; this is however in line with UCC 

Section 4-103(b) under which "Federal Reserve regulations and operating circulars, 

clearing-house rules, and the like have the effect of agreements . . ., whether or not 

specifically assented to by all parties interested in items handled." '2 9 

At the same time, the scheme that was introduced in England in 1996 appears 

to have stronger compulsory features. Under Section 74B of the Bills of Exchange 

Act, 3° "a banker may present a cheque for payment to the banker on whom it is 

drawn by notifying him of its essential features by electronic means or otherwise, 

instead of by presenting the cheque itself."'" However, in the final analysis, the 

option is not entirely in the hands of the presenting bank: 

if, before the close of business on the next business day following 

presentment of a cheque under this section, the banker on whom the 

cheque is drawn requests the banker by whom the cheque was presented 

to present the cheque itself-(a) the presentment under this section shall 

be disregarded, and (b) this section shall not apply in relation to the 

subsequent presentment of the cheque. 32 

The obligations of a banker making and receiving an electronic presentment that has 

not been timely rejected are stated to "be subject to the same duties in relation to 

the collection and payment of the cheque as if the cheque itself had been presented 

for payment," except that "[an electronic] presentment need not be made at the 

proper place or at a reasonable hour on a business day." 33 

Along similar lines, a more detailed scheme was recently adopted in Sri 

Lanka. 3 ' It goes further in containing the following elements. First, it specifically 

28. One such multilateral agreement is under the rules of the check truncation program of NACHA 

for electronic images of truncated checks input to the ACH Network. Check truncated items input to the 

ACH Network are TRC/TRX entries referred to as a category of Payment Applications in NACHA 

Operating Guidelines (as well as in the ACH Primer preceding NACHA Operating Rules), and are 

governed by the NACHA Operating Rules. NACHA, ACH Operating Rules, supra note 14, § 1(2)(c); 

NACHA, A CH Rules Primer, § (c)(3); NACHA, Operating Rules of the National Association for Check 

Safekeeping art. 10 (2007). For bulk electronic payments processed through the ACH Network and for 

NACHA, as well as for NACHA Operating Rules and Guidelines, see GEVA, LAW OF EFT, supra note 1, 

ch. 5. 

29 U.C.C. § 4-103(b). 

30. Bills of Exchange Act, 1882, 45 & 46 Vict., c. 61, § 74B (Eng.); Deregulation (Bills of Exchange) 

Order, 1996, S.I. 1996/2993, art. 4(1). 

31. Bills of Exchange Act, 1882, 45 & 46 Vict., c. 61, § 74B (Eng.). "Essential features" are defined to 

consist of "(a) the serial number of the cheque, (b) the code which identifies the banker on whom the 

cheque is drawn, (c) the account number of the drawer of the cheque, and (d) the amount of the cheque is 

entered by the drawer of the cheque." Id. § 74B(6). 

32. Id. § 74B(3). 

33. Id. §§ 74B(2), (5) (as otherwise required under section 45(3)). Also, physical exhibition of the 

check, otherwise required for a lawful presentment under section 52(4), is dispensed with under section 

74C. Id. §§ 52(4), 74C. 

34. Payment and Settlement Systems Act, No. 28 of 2005, §§ 33-37 (Sri Lanka), available at 

http://www.cbsl.gov.lk/pics-ndocs/09I r/_docs/acts/Paymt-&-setmt-sys-act.pdf. Under section 36(3): 

"The provisions of [Part II1] shall, in so far as it is possible be read and construed as one with the Bills of 



requires the electronic presentment of the check to consist of the transmission of its 

"image ... along with ... stipulated electronic payment information ..... .Second, 

it limits the right to decline electronic presentment and request a physical one only in 

the case of technical failure. 36 Third, it provides for an "image return document," 

stated to "be deemed to be the cheque to which it relates," 37 to be returned to the 

presenting bank in the case of the dishonor of the check. Fourth, it provides for 

warranties and indemnities made by the banker making an electronic presentment as 

well as the banker issuing an image return document. 3 Finally, and subject to "rules, 

directions or instructions issued by the Central Bank," the scheme authorizes its 

implementation by means of interbank agreements, "including those in the form of 

clearing house rules." 3 9 

Electronic check presentment is now on the legislative agenda in Canada. A 

proposal of the Canadian Payments Association (CPA)" to amend the Bills of 

Exchange Act 4 follows the English precedent 2 and further clarifies 43 that electronic 

Exchange Ordinance (Chapter 82)." Id. § 36(3). 

35. Id. § 33(1). In comparison, the English provision requires the notification of the essential features 

of the check "by electronic means or otherwise ...." Bills of Exchange Act, 1882, 45 & 46 Vict, c. 61, § 

74B (Eng.). On this point, in Sri Lanka, similarly as in the UK, the stipulated information consists of the 

serial number of the check, the code identification of the presenting bank, the drawer's account number, 

the amount of the check, as well as (in departure from the English provision) "any other matter as may 

from time to time be prescribed by regulation." Payment and Settlement Systems Act, No. 28 of 2005, § 

33(8) (Sri Lanka). 

36. Payment and Settlement Systems Act, No. 28 of 2005, §§ 33(3), (5) (Sri Lanka). 

37. Id. § 34(2). 

38. Id. § 35. Briefly stated, the presenting banker's warranties relate to the accuracy of the image and 

the information. Id. § 35(1). "He shall also indemnify the drawer against any loss incurred due to the 

[electronic] presentment ...." Id. Loss is likely to be rare, as for example where the original check, 

needed as a piece of evidence to establish forgery that cannot be proved otherwise, cannot be retrieved. 

The issuer of an image return document warrants the accuracy of the document "and shall also indemnify 

the drawer against any loss in the event of the cheque itself being paid or sued on." Id. § 35(2). All 

warranties and indemnities are in favor of the drawee bank, its customer, the holder who delivered the 

check for collection, and any other endorser. Id. § 35(3). The person stated to be the drawer may recover 

directly from the drawee banker, who is then subrogated to the claim against the warrantor or the person 

liable on the indemnity obligation. Id. § 35(4). 

39. Payment and Settlement Systems Act, No. 28 of 2005, § 37 (Sri Lanka). Unlike under the U.C.C., 

interbank agreements are stated to be "binding [only] between the parties thereto." Id. Conversely, legal 

pronouncements issued by the Central Bank "are deemed to bind and benefit [all] parties liable on and 

entitled to enforce a cheque .... Id. 

40. See CPA, Submission to the Department of Finance in Response to the Call for Comments on "An 

Effective and Efficient Legislative Framework for the Canadian Financial Services Sector" (May 26, 2005) 

[hereinafter CPA, Submission to the Department of Finance], available at 

http://www.cdnpay.ca/publications/pdfs-publications/2006%2OFinancial%2OLegislative%2Review.pdf. 

For the CPA and its mandate, see supra note 19. 

41. Bills of Exchange Act, R.S.C., ch. B-4 (1985) (Can.). 

42. For an effective electronic presentment under proposed section 165.1(3), 

"the essential features of a cheque must be transmitted in a form that is intelligible or easily 

decipherable by the drawee bank and, at a minimum, must identify the sum ordered to be paid, 

the serial number of the cheque, the account against which it is drawn, and the code or number 

that identifies the bank on the which the cheque is drawn." 

Canadian Bankers Ass'n., The 2006 Financial Services Legislation Review: Improving the Legislative 

Framework for Canadian Consumers, app. C (June 1, 2005), available at 

http://www.cba.ca/en/content/general/050617 % 20- % 2oBankActsubFlNALbookmarked% 20- % 20mckj.pdf. 



VOL. 42:685 

conversion does not trigger statutory provisions dealing with lost" or intentionally 

cancelled instruments." There is however no provision dealing with a "fallback" to 

physical presentment upon the failure of an electronic presentment or otherwise. 

An innovative aspect of the Canadian approach is the amendment of the standard 

definition of a check 6 to include 

digital data and a display, printout, or other output of that data, provided 

the digital data, display, printout or other output was created by or from 

digital imaging of such bill by or on behalf of a bank by a computer system 

conforming to bylaws, rules or standards of the Canadian Payments 

Association or from the application of another technology or process 

conforming to bylaws, rules or standards of the Canadian Payments 

Association. 47 

It is submitted that the expansion of the definition of "cheque" is an 

unsatisfactory aspect of the Canadian proposal. Certainly it is not necessary to 

attach to the data or its output all the attributes of a "cheque." And, while the 

proposed definition is limited to data or output created "by or on behalf of a bank," 

it is not limited to its transmission within the interbank check clearing system. A real 

statutory vacuum will thus be created for the transmission of the data or its output 

outside the interbank check clearing system. 48 Furthermore, within the interbank 

check clearing system, there is nothing to preclude the use of such data or its output 

not for presentment, but rather for negotiation, for which there is no provision in the 

proposal. The treatment of electronic negotiation in the United States, discussed 

immediately below, is an indication to the further detail and complexity required for 

a fair statutory treatment of electronic negotiation. 

E. Electronic Negotiation 

The most elaborate statutory and regulatory scheme is that in the United States 

covering the electronic negotiation to a collecting bank. The scheme is governed by 

the Check Clearing for the 21t Century Act (Check 21 Act) 49 and implemented by 

Regulation CC subpart D. 5 ° In essence, the Check 21 Act authorizes a collecting 

bank to create a substitute check, being a paper reproduction of the original check, 

for further negotiation or presentment. Upon compliance with specified 

requirements, the substitute check is to become "the legal equivalent of the original 

Electronic presentment must be made under the proposal "in accordance with the by-laws, rules and 

standards of the Canadian Payments Association." Id. 

43. See id. 

44. Bills of Exchange Act, R.S.C., ch. B-4, §§ 155-56. 

45. Id. § 142. 

46. Check is presently defined in the Bills of Exchange Act as "a bill [of exchange] drawn on a bank, 

payable on demand." Id. § 165(1). 

47. See CPA, Submission to the Department of Finance, supra note 42 (internal quotation marks 

omitted). 

48. Nor can this vacuum be filled by CPA pronouncements. For the jurisdiction of the CPA, see 

supra note 19. 

49. Check 21 Act, 12 U.S.C. §§ 5001-5018 (2004). 

50. 12 C.F.R. § 229 (2006). 



check for all purposes. '' The Check 21 Act further includes warranty and 

indemnity provisions, as well as expedited re-credit procedures, designed to protect 

substitute check recipient." 

In practice, the creation of a substitute check by a collecting bank is predicated 

upon the existence of two preconditions. First, the creating bank must have received 

the transmission of an image of the original check instead of the check itself. 

Second, to receive the substitute check the bank must have not agreed to accept 

electronic transmission of an image. 

The sender of the transmission of the original check image could be either a 

customer, the payee-holder of the check, or a collecting bank. Either way, the 

creating bank is a collecting bank; it is the depositary bank where the sender is the 

customer, and an intermediary bank where the sender is a prior collecting bank. On 

its part, the bank to receive the substitute check is typically a small bank that does 

not have the required processing equipment. It could be either a subsequent 

intermediary bank or the drawee bank. 3 

Stated differently, the Check 21 Act does not require banks to accept electronic 

transmission of check information or image. Rather, it requires a collecting bank 

that agreed to accept the electronic transmission, whether from its customer or a 

prior collecting bank, to issue a substitute check, to be processed onward as if it were 

the original check. A bank, either a subsequent collecting/intermediary bank or the 

drawee bank, must accept the substitute check as the equivalent of the original 

check. By the same token, a customer who received original checks with the 

periodic statement cannot object to receiving substitute checks in lieu of original 

checks that have been so truncated in the collection process." 

In practice, by truncating the paper check, the Check 21 Act eliminates longdistance 

transport of physical checks, though effectively it does not eliminate or 

bypass intra-city or local transportation for paper. The following hypothetical 

example will demonstrate the circumstances governed by the Check 21 Act. 

Suppose Drawer has a bank account with a Payor (drawee) Bank in New York. 

Drawer sends a check drawn on that account to Payee in California who deposits the 

check in Payee's account with a California Depositary Bank. The latter is a large 

institution that has equipment for the transmission of the image of the check. At the 

same time, Payor (drawee) Bank is a small institution that does not have processing 

equipment capable of receiving the electronic transmission of a check. There is 

51. Check 21 Act § 4(b), 12 U.S.C. § 5003(b); see also 12 C.F.R. § 229.51(a). 

52. For a comprehensive overview, though written prior to the promulgation of the final text for 

Regulation CC Part D, see PAUL S. TURNER, ANALYSIS OF THE CHECK CLEARING FOR THE 21' r 

CENTURY ACT ("CHECK 21") (2004). For more on the background to the Check 21 Act, see Availability 

of Funds and Collection of Checks, 69 Fed. Reg. 1470 (Jan. 8, 2004) (codified at 12 C.F.R. pt. 229) and 69 

Fed. Reg. 47,290 (Aug. 4, 2004) (codified at 12 C.F.R. pt. 229). See also Press Release, Federal Reserve 

Board, Final Amendments to Regulation CC and its Commentary to Implement Check 21 Act (July 26, 

2004), available at http://www.federalreserve.gov/boarddocs/press/bcreg/2004/20040726/default.htm; Press 

Release, Federal Reserve Board, Board Announces Final Amendments to Regulation J (October 22, 2004), 

available at http://www.federalreserve.gov/boarddocs/press/bcreg/2004/20041022/default.htm. 

53. For the various roles of banks in the check collection and payment system, see supra note 7 and 

accompanying text. 

54. An agreement of the recipient is dispensed with for a substitute check deposited, presented, sent 

for collection, or returned, "so long as a bank has made the warranties in [section 5] with respect to such 

substitute check." See Check 21 Act § 4(a), 12 U.S.C. § 5003(a). 



VOL. 42:685 

nothing in the UCC, the Check 21 Act, or anywhere else, to force Payor (drawee) 

Bank to accept electronic transmission; hence, electronic presentment is not an 

option for Depositary Bank. Rather, Depositary Bank may transmit the image of 

the check to an Intermediary Bank in New York, which is capable of accepting such 

transmission. 5 In effect, this is an electronic negotiation of the check. Having agreed 

to accept the electronic transmission, the New York Intermediary Bank is now 

required under the Check 21 Act to create a paper substitute check. The Act further 

requires Payor (drawee) Bank to accept the presentment of the substitute check as if 

it were the original check. Finally, any requirement, either by statute or agreement, 

to provide the canceled check, as under the contract between Drawer and Payor 

(drawee) Bank, is to be satisfied, under the Check 21 Act, by providing the 

substitute check. 

In that hypothetical example, coast-to-coast physical transportation was 

eliminated; only local delivery of the substitute check in New York was not avoided. 

A substitute check is a paper production of the original check that contains the 

image of the front and back of the original check, bears a MICR line containing 

information appearing on the MICR line of the original check, conforms, 

particularly in paper stock and dimension, with generally applicable for substitute 

checks, and is suitable for automated processing in the same manner as the original 

check. 56 To be the legal equivalent of the original check, a substitute check must 

"accurately represent ... all of the information on the front and back of the original 

check as of the time the original check was truncated" and bear the legend: "This is a 

legal copy of your check. You can use it the same way you would use the original 

check." 57 

As in the example above, a substitute check is typically created by a collecting 

intermediary bank. It, however, can also be created by the depositary bank, where it 

agreed to receive the deposit of the check from the payee by means of electronic 

transmission. Furthermore, a substitute check may be created even by the 

payee/holder; such would be the case for a large organization that receives checks in 

various locations but would rather deposit them in one place. The organization may 

then arrange for the electronic transmission of check images to one place where 

substitute checks will be created for deposit. In general, a check could be 

transformed from electronic form to substitute checks form several times in the 

course of the collection and return process. 

In connection with a substitute check, the Check 21 Act provides for warranties 

and an indemnity. The warranties are, first, that the substitute check meets the 

requirements for legal equivalence, and second, against double payment on the 

original check or any other representation of it." The indemnity is "to the extent of 

any loss incurred . . . due to the receipt of a substitute check instead of the original 

check." Other than for costs, expenses, and reasonable attorney's fees, the amount 

to be indemnified is to the extent of loss proximately caused by the breach of 

55. Interbank settlement between California Depositary Bank and New York Intermediary Bank may 

take various forms. For example, it may be either bilateral (on a correspondent account one bank has with 

the other), or part of multilateral clearing house settlement. If the check is collected through the Reserve 

Banks, settlement will take place on the books of the Reserve Banks. Check 21 Act does not deal with 

interbank settlement arrangements. See Check 21 Act, 12 U.S.C. §§ 5001-5018 (2004). 

56. Check 21 Act § 3(16), 12 U.S.C. § 5002(16); 12 C.F.R. § 229.2(aaa) (2006). 

57. Check 21 Act § 4(b)(2), 12 U.S.C. § 5003(b)(2); 12 C.F.R. § 229.51(a). 

58. Check 21 Act § 5,12 U.S.C. § 5004; 12 C.F.R. § 229.52(a). 



warranty. In the absence of a breach of a warranty amount of indemnity is limited 

though to the amount of the substitute check. Either way, amount of loss to be 

indemnified is reduced by amount representing loss resulting "from the negligence 

or failure to act in good faith on the part of an indemnified party." 6 An example of 

loss incurred notwithstanding the lack of any breach of warranty is the case where 

forgery, proof of which would have allowed a purported drawer to avoid liability, 

cannot be proved on the substitute check, but allegedly could have been proved on 

the original. 

Substitute check warranties are given by each bank "that transfers, presents, or 

returns a substitute check and receives consideration for the check." 6 In turn, 

indemnity liability is incurred by "[a] reconverting bank and each bank that 

subsequently transfers, presents, or returns a substitute check in any electronic or 

paper form, and receives consideration for such transfer, presentment, or return... 

.96" A "reconverting bank" is defined as "the bank that creates a substitute check" or 

where "a substitute check is created by [the depositor], the first bank that transfers 

or presents [the] substitute check," namely, the depositary bank. 62 Surprisingly, the 

reconverting bank is not listed as one of the warrantors; it can hardly be described as 

a "bank that transfers ... a substitute check," unless "transfer" is to include the first 

delivery or issue; this indeed appears to be the view of the Federal Reserve. 63 In any 

event, the reconverting bank is listed as one to become liable to indemnify for loss 

caused by the breach of warranty. 

As indicated, a substitute check need not necessarily be created by a bank; 

rather it may be by a person other than a bank, typically a large organization-payee. 

In such a case warranties and indemnity liability emanate under the Check 21 Act 

not from the payee, the creator in fact of the substitute check, but rather from the 

first bank that transfers or presents such substitute check; such a bank, being the 

depositary bank, is then considered to be the "reconverting bank" in the collection 

process. 

Both substitute check warranties and the indemnity are stated to run to the 

benefit of the transferee, any subsequent collecting or returning bank, the depositary 

bank, the drawee, the drawer, the payee, the depositor, and any endorser. 6' Since a 

check could be transformed from electronic form to substitute checks form several 

times in the course of the collection and return process, it is possible that there could 

be multiple substitute checks, and thus multiple reconverting banks, with respect to 

the same payment transaction. A subsequent participant may thus benefit from 

warranties and indemnity of more than one reconverting bank. As well, a collecting 

59. Check 21 Act § 6(c), 12 U.S.C. § 5005(c); see also 12 C.F.R. § 229.53. 

60. Check 21 Act § 5, 12 U.S.C. § 5004. 

61. Check 21 Act §§ 5-6, 12 U.S.C. §§ 5004-5005 ; see also 12 C.F.R. §§ 229.52-.53. 

62. Check 21 Act § 3(15), 12 U.S.C. § 5002(15); see also 12 C.F.R. § 229.2 (zz). 

63. Check 21 Act § 3(15), 12 U.S.C. § 5002(15); see also 12 C.F.R. § 229.2 (zz). Regulation CC 

Commentary to section 229.52(a) states "the reconverting bank starts the flow of warranties when it 

transfers, presents, or returns a substitute check .... 12 C.F.R. 229 App. E XXXI (2006). The reference 

in the Check 21 Act to [a] bank that transfers" (section 5), as opposed to "each bank that subsequently 

transfers," (section 6) (which does not purport to cover the reconverting bank which is separately referred 

to in section 6) re-enforces this interpretation; yet, generally speaking, for a check, "issue" and "transfer" 

are two distinct concepts and the Act would have been clearer had it distinguished between the original 

issue of a substitute check and its subsequent transfer. Check 21 Act § 5-6, 12 U.S.C. § 5004-5005. 

64. Check 21 Act § 5-6,12 U.S.C. § 5004-5005. 



VOL. 42:685 

bank receiving an electronic representation of a substitute (rather than original) 

check will both receive and pass on the reconverting bank's Check 21 Act warranty 

and indemnity protections. 

The Check 21 Act further contains provisions covering expedited re-credit for 

consumers 65 and banks. First, Section 7 permits a consumer to challenge a debit for a 

substitute check either where the check was not properly charged to the consumer's 

account or where the consumer has a warranty claim. In each case the consumer 

must have suffered a resulting loss and the production of the original check or a 

better copy of it is necessary to determine the validity of the challenge or claim. 

Second, Section 8, governs a claim by a bank that is obligated to provide an 

expedited re-credit to the consumer or that has otherwise suffered loss, in 

circumstances where "production of the original check ... or a better copy of [it] is 

necessary to determine the validity of the charge to the customer account or any 

warranty claim connected with such substitute check." 6 The claim is a claim for 

indemnity from another bank that incurred the indemnity liability to the claimant 

bank under Section 8.67 

The Check 21 Act allocates losses only among banks that handle a substitute 

check. However, it is possible that the problem giving rise to liability under the 

Check 21 Act was created prior to the creation of a substitute check; for example, 

electronic information derived from the check may have consisted of a poor image of 

the original check, which would preclude the reconverting bank from creating a 

legally equivalent check, and thus caused it to be in breach of a substitute check 

warranty. Or else, a substitute check created by the payee and deposited at the 

depositary bank may have been deficient in one way or another. At the same time, 

neither warranties nor indemnity liabilities are provided in the Check 21 Act in 

connection with the electronic transmission of check image or information. 

Similarly, no warranties or indemnity liability are fastened on a payee that creates a 

substitute check. Responsibilities of transmitters of electronic information and 

depositors of substitute checks are thus to be provided by their respective contracts 

with the immediate recipients of electronic information and substitute checks. This 

indeed is quite consistent with the overall position under the Check 21 Act, under 

which no bank is to be required to receive electronic transmission of check data and 

no depositary bank is under an obligation to accept for deposit substitute checks. 

Having nevertheless agreed to accept such information or substitute checks, it is up 

for the collecting banks to do so under contractual arrangements that provide them 

with adequate protections. 

However, contract is not the exclusive source of regulating responsibilities 

outside the Check 21 Act; under Regulation J, a sender of an electronic item derived 

directly from the original check makes two sets of warranties for the electronic item. 

First, the sender makes transfer warranties as if the item was a paper check governed 

by the UCC. Second, the sender makes warranties as if the item were a substitute 

check governed by the Check 21 Act. 6 ' For checks handled by Reserve Banks 

65. "Consumer" is defined by reference to the meaning of "consumer account" in the Expedited 

Funds Availability Act. Check 21 Act § 3(8), 12 U.S.C. § 5002(8). A "consumer account" being "any 

account used primarily for personal, family, or household purposes." Expedited Funds Availability Act § 

602(10), 12 U.S.C. § 4001(10). 

66. Check 21 Act §§ 8, 12 U.S.C. §§ 5007. 

67. See 12 C.F.R. §§ 229.54-.55 (2006) (implementing Check 21 Act §§ 7-8, 12 U.S.C. §§ 5006-07). 

68. 12 C.F.R. § 210; See id. §§ 210.2-210.6, 210.12. 



governed by Regulation J an end-to-end combined UCC and Check 21 liability 

structure is thus provided. 69 

In the final analysis, however, by reconverting an electronic image to a new 

piece of paper, Check 21 Act is a step backward in the process of the 

"immobilization" of the check. ° Rather, the Act implements the "materialization" 

or "certification" of the electronic image. The Act reflects a legislative policy of not 

forcing banks either to have their check processing facilities automated, or to 

outsource or contract out the function of automated processing, whether to a large 

bank, or a third-party processor. The result is a move away from an EFT payment, 

at the additional cost of a complex piece of legislation with no counterpart anywhere 

else in the world. 

III. PAYMENT CARDS - THE PAYROLL CARD AS AN ACCESS DEVICE 

Payment cards have been classified as either access devices or stored-value 

products (SVPs). 7 ' Briefly stated, a payment by means of an access device is 

reflected in a debit to an account maintained with a financial institution. At the 

same time, a payment by means of an SVP is reflected in the reduction of value 

stored on the card, as recorded on the card itself. Value stored on an electronic 

device embodied in a stored-value card is often referred to as e-money. 

In both access and stored-value systems, payment is initiated by having the card 

inserted to a terminal, 72 usually with the payment details, 73 with or without a secret 

code such as a PIN, entered into the terminal. Information is then read at the 

terminal from either a magnetic stripe or a microchips processor embodied in the 

card. The former reflects a cheaper technology and is typically associated with either 

an access card, or a low-amount stored-value card. Conversely, the latter, turning 

"memory card" into a "smart-card," is typically associated with the more 

sophisticated form of a stored-value card. The use of 'smart card' technology 'only' 

to enhance security features of an access card, without converting it to a store-value 

card, is possible, but not in use in Canada and the United States. 74 

69. See generally Collection of Checks and Other Items by Federal Reserve Banks and Funds 

Transfers Through Fedwire, 69 Fed. Reg. 62,553 (Oct. 27, 2004) (codified at 12 C.F.R. pt. 210); Federal 

Reserve Bank of New York, Final Amendment to Regulation J: Collection of Checks and Other Items, 

Circular No. 11653 (October 25, 2004). 

70. For the borrowed use of "decertification," "dematerialization," and "immobilization" in this 

context, see supra note 11 and accompanying text. 

71. For the basic distinction between access devices and stored-value products, see, e.g. COMM. ON 

PAYMENT & SETTLEMENT SYS., SECURITY OF ELECTRONIC MONEY 3 (1996). See generally, Benjamin 

Geva & Muharem Kianieff, Reimagining E-Money: Its Conceptual Unity with Other Retail Payment 

Systems, in 3 CURRENT DEVELOPMENTS IN MONETARY AND FINANCIAL LAW 669 (2005). 

72. A public access terminal can be either at a point of sale (POS) for the payment of goods or 

services purchased, or at an automated teller machine (ATM) for strictly cash withdrawals, with or without 

other banking operations. Where on the top of cash withdrawals additional banking operations are 

facilitated, the terminal may be referred to as an automated banking machine (ABM). 

73. It is, however, possible, though not common, to have the terminal programmed to charge payment 

in a specified amount. This is the case for telephone and transit cards, and often for cards inserted to 

unattended terminals at parking lots. 

74. See Benjamin Geva, Consumer Liability in Unauthorized Electronic Funds Transfers, 38 CAN. 

BUS. L. J. 207, 212-23 (2003) [hereinafter Geva, Consumer Liability] (detailing various methods of 

authorization and the evolution of retail card payment systems). 



VOL. 42:685 

Where the card is an access device, information read from the card at the 

terminal is then transmitted from the terminal to a central facility of the financial 

institution where the account associated with the card is maintained; both card 

authentication and the debit to the account take place at such a central facility. 

Conversely, where the card is stored-value, no information is transmitted from the 

terminal to any central facility; both authentication and the posting of the debit 

occur at the terminal. 

In the United States, access devices are either credit cards, governed by the 

Consumer Credit Protection Act 7 5 and implemented by Regulation Z, 76 or debit 

cards, governed by the Electronic Fund Transfer Act 77 and implemented by 

Regulation E." 8 While payment by credit card is to be debited to a credit account 

maintained with a financial institution, 79 payment by debit card is to be debited to an 

asset, such a deposit, account, maintained with a financial institution. 

8 0 Payment 

recorded on an SVP is not debited to an account maintained at the financial 

institution; the SVP thus falls outside the ambit of an existing specific legislation. 

In practice, multi-participant stored-value ("open") systems have not made a 

breakthrough in North America where the typical stored-value card is still associated 

with a "closed" system such as telephone or transit. 8 ' On its part, the typical debit or 

credit card envisages access by the cardholder to his or her account maintained by 

the financial institution. In recent years, however, various systems have arisen in the 

United States under which a deposit account is specifically set up for an exclusive 

access by a card;2 in turn, the asset account may be held or set up at a financial 

institution by a person other than the cardholder. Such is the case with respect to a 

payroll, remittance, or gift cards, as well as reloadable general spending cards. Thus, 

a card provider or marketer establishes a "pooled" or master account with its 

financial institution. The financial institution issues cards and assumes fiduciary or 

trust obligations for the benefit of the cardholders, as designated or recruited by the 

card provider or marketer. A third-party service provider may be charged with 

transaction processing, program administration, and customer services. For 

example, a payroll cardholder is an employee whose wages are deposited by the 

employer, acting as the card provider, to a "pooled" or master account from which 

the employee can make payments up to the value associated with the card, as capped 

by his or her wages. A remittance or gift card gives access to value deposited in a 

master account held by a money transmitter. In each case, the account relationship 

75. 15 U.S.C. § 1631 (approved in 1968). 

76. Truth in Lending, 12 C.F.R. § 226 (2006). 

77. 15 U.S.C. § 1693 (implemented in 1978). 

78. 12 C.F.R. § 205. 

79. Note that the issuer of a credit card need not necessarily be financial institution. See 12 C.F.R. §§ 

226.2(a)(14)-(15) (defining "credit" and "credit card"). 

80. See 12 C.F.R. §§ 205.2(b)(1), 205.3 (defining "account" and "coverage"). 

81. For the distinction, as well as for development in the United States and a legal perspective, see 

Task Force on Stored-Value Cards, A Commercial Lawyer's Take on the Electronic Purse: An Analysis of 

Commercial Law Issues Associated with Stored-Value Cards and Electronic Money, 52 Bus. LAW. 653 

(1997). In contrast, a multi-participant stored-value ("open") system has been successful for small-value 

transactions, for example, in Hong Kong. For a Canadian perspective, see Shameela Chinoy, Electronic 

Money in Electronic Purses and Wallets, 12 BANKING & FIN. L. REV. 15 (1996); Bradly Crawford, Is 

Electronic Money Really Money?, 12 BANKING & FIN. L. REV. 399 (1996). 

82. As of 1996, "[s]o far as [the FDIC was] aware, the systems of this type [were] not currently being 

utilized by depository institutions." Notice of FDIC General Counsel's Opinion No. 8, 61 Fed. Reg. 40,490 

n.1 (Aug. 2, 1996). 



with the financial institution in which the master account is held envisages access 

only by means of the card, but the relationship is between the financial institution 

and the holder of the master account, the card provider or marketer, who is a person 

other than the cardholder; yet, it is each cardholder who is entitled, at least vis-A-vis 

the person who set up the master account, and as facilitated by the financial 

institution in which the master account is maintained, to the value attached to the 

card. Indeed, a direct relationship may be established between the financial 

institution and the cardholder as to the use of the card; at the same time, the overall 

account relationship is between the financial institution and the card provider or 

marketer who set it up, such as the money transmitter or employer. Stated 

otherwise, the cardholder is a sub-account holder; his or her sub-account relationship 

is, however, with the account holder, the card provider or marketer who is the 

employer or money transmitter in the previous examples, and not directly with the 

financial institution. 83 

It is submitted that, fundamentally, such an arrangements is an access system; 

indeed, a recent amendment to Regulation E expands the scope of Regulation E to 

cover payroll cards, 8' subject only to some incidental modifications, reflecting the 

lack of direct account relationship between the cardholder and the financial 

institution." Unfortunately, however, both in the literature and banking parlance, 

cards accessing non-cardholder master accounts, are referred to as prepaid or storedvalue 

cards.' It is submitted that this is conceptually wrong, which may lead to 

confusion and misunderstandings. 

It seems that the source of this misconception is a classification of the Federal 

Reserve Board under which stored-value systems may be offline accountable, offline 

unaccountable, and online stored value; 87 arguably, the third category, that of online 

stored value, could be referred to as online accountable. According to the Board, in 

an offline accountable system, payment does not involve an online authorization; 

transaction data is however periodically transmitted to the financial institution and 

recorded in an account maintained there for the cardholder. An offline 

83. See, e.g., Sherrie L.W. Rhine & Sabrina Su, Stored Value Cards as a Method of Electronic Payment 

for Unbanked Consumers, 9-11 (2005), available at 

http://www.newyorkfed.org/regional/StoredValue-Card-Paper-August-2005.pdf; see also Julia S. 

Cheney, Payment Cards and the Unbanked: Prospects and Challenges 11-12 (2005), available at 

http://www.philadelphiafed.org/pcc/conferences/2005/PaymentCardsandtheUnbankedSummary.pdf; James 

C. McGrath, The Cost Effectiveness of Stored-Value Products for Unbanked Consumers 4-11 (2005), 

available at http://www.philadelphiafed.org/pcc/papers/2005/D2005MarchUnbankedCover.pdf; Samuel 

Frumkin, William Reeves & Barry Wides, Payroll Cards: An Innovative Product for Reaching the 

Unbanked and Underbanked 1-6 (June 2005), http://www.occ.treas.gov/cdd/payrollcards.pdf. 

84. See 12 C.F.R. § 205.2(b)(2) (effective July 1, 2007) (defining "Account" to include "payroll card 

account" which is "an account that is directly or indirectly established through an employer and to which 

electronic fund transfers of the consumer's wages, salary, or other employee compensation ... are made on 

a recurring basis ... whether the account is operated or managed by the employer, a third-party payroll 

processor, [or] a depositary institution .... "); see also Final Rule, 71 Fed. Reg. 51,437, 51437-51,439 (Aug. 

30, 2006) (codified at 12 C.F.R. pt. 205). 

85. See 12 C.F.R. § 205.18 (effective July 1, 2007) (stating that financial institutions need not provide 

periodic statements under 12 C.F.R. § 205.9, if they make required information available to the consumer 

via telephone, the Internet, or in writing upon request). 

86. See Geva, Consumer Liability, supra note 74. 

87. See Electronic Funds Transfers, 61 Fed. Reg. 19,696, 19,699-19,703 (May 2, 1996) (codified at 12 

C.F.R. pt. 205). 



VOL. 42:685 

unaccountable system does not involve online authorization; record of value is 

maintained only on the card itself. Finally, an online stored value (or accountable) 

system involves both online authorization and transmission of data to a centralized 

account with no record of value being maintained on the card. 

In my view, the Board's classification ought to apply to both access and storevalue 

systems. Along these lines I disagree with the classification of the offline 

accountable and online accountable systems as stored-value. According to my 

revised classification, card payment systems may well be classified as offline 

unaccountable, offline accountable, or online accountable. The online/offline 

distinction addresses the existence or absence of communication between the 

terminal and a central facility with regard to authorization. In the former case the 

system is "online"; in the latter it is "offline." The accountable/unaccountable 

distinction addresses the debiting of either an account held by an institution 

(typically the issuer) or a "decentralized" account maintained on the card in the 

form of a decrease of the value "loaded" on it. In the former case the system is 

"accountable"; in the latter it is "unaccountable." Whether a product is an access or 

stored-value depends on whether it is accountable or unaccountable; it is an access 

product in the former and an SVP in the latter case. 

Practically speaking, an online system is bound to be accountable. This is so 

even though the central facility for the online authorization may not be same as the 

central facility posting entries to the account; once communication to the central 

facility occurs, there is simply no incentive for bypassing "centralized" 

accountability. At the same time, bypassing altogether online authorization is only 

likely, but not bound, to lead to non-accountability; technological limitations 

inherent in the card, such as those associated with the magnetic stripe technology, 

may preclude or limit the bypassing of accountability. In this context, one source of 

confusion is what could be characterized as a "quasi accountable" system, in which 

value is both reduced from the card, at the time payment is made, but also from an 

account at a central facility, to which the information is subsequently transmitted 

periodically. 

The proposed revised classification, covering access and stored-value cards, 

takes into account the above in making the following options available: 

1) An "online accountable" system. This is the typical credit and debit card 

system, utilizing magnetic stripe cards; it is an access system in which each payment 

made from a terminal typically involves communication between the terminal and a 

central facility and results in a debit to an account held by a financial institution. In 

my view, also the payroll card (as well as the remittance and gift card) falls into this 

category; it is immaterial that the account maintained by the central facility at the 

financial institution and to be debited is a master account set up by the employer 

rather than the cardholder. The card is thus an access device; while I agree with the 

Board that the value attached to this card is limited to a specified amount and is to 

be accessed only by the card, I do not see this as a feature which changes the basic 

nature of the account containing the value as an asset account; limitations on the 

withdrawals facilities of an account have nothing to do with its fundamental nature. 

In effect, the Board's view to the contrary is fraught with inconsistencies; having 

classified the system as stored-value, the Board nevertheless concluded that the 



account to be debited on an online stored-value system is an asset account "covered 

by Regulation E." ' 

2) An "offline unaccountable" system. This is e-money loaded on an SVP pure 

and simple. Typically, the card is a "smart card." Authorization occurs at the 

terminal and value is reduced only from the card. There may be later 

"accountability" in the sense of ability to match value paid (by cardholder-payor) 

and value deposited (by payee) and attributed to a given card-but this is not part of 

the payment process; rather, this is a method to track down payments as may be 

required. Hence, this "accountability" is to be disregarded for our purposes.' 

3) An "offline-accountable" system. In my view, an example to the point may 

be that of the credit card authorized only at the terminal with subsequent off-line 

communication to the central facility that debits the cardholder's (credit) account. 

The card is however an access device as no value is deducted in the process of the atthe-terminal 

authorization. Typically, the card utilizes the magnetic-stripe 

technology, which has only limited capacity to be "loaded" with value. As explained 

below, what is described by the Board as "offline accountable" is fact "offline quasiaccountable"; 

to the extent that value recorded on the card is available on its own 

the periodic transmission to the financial institution is only for verification. 

4) An "offline quasi accountable" system. This is likely to be the case for 

telephone and transit cards; value is reduced at the terminal (as part of the offline 

authorization process); the process is however followed by an off-line 

communication in batches to a central facility that debits a "centralized" "shadow" 

account attached to the card. Typically, cards that fall into this category are not 

smart cards but rather those bearing "magnetic stripe." This is so since the 

information they carry is limited: there is no PIN and value is rather low. But it is 

this "inferior" technology that results in enhanced opportunities for counterfeiters 

and hence the need for an ongoing verification of authenticity in the form of the 

offline communication to a central facility. In the final analysis, however, so far as 

the cardholder is concerned, available value was reduced at the terminal and the 

subsequent debit of the shadow account is to confirm authenticity; the system is thus 

to be classified as a sub-category of an "unaccountable" rather than "accountable" 

system. Stated otherwise, a "quasi accountable" system is not truly "accountable" 

and the system is an SVP. 

5) Either an "online unaccountable" or "online quasi accountable" system 

exists only in theory; once online communication takes place, there is no point to 

bypass the posting of entries to the account held at the financial institution; stated 

otherwise, there is no business case for "unaccountability." 

On its part, the Federal Deposit Insurance Corporation (FDIC) proposes to 

"promulgate a regulation that would clarify the insurance coverage of funds subject 

to transfer or withdrawal through the use of stored value cards and other 

nontraditional access mechanisms." '9 Covering "nontraditional access mechanisms," 

88. Id. at 19,699. 

89. See Alan L. Tyree, The Legal Nature of Electronic Money, 10 Journal Banking & Fin. L. & Prac. 

273, 276 (1999) (describing "accounts" maintained on devices which are under the control of the customer, 

such as cards, as "decentralized" or "distributed" so as to distinguish it from the centralized account run in 

a central facility in an access system). 

90. See Deposit Insurance Coverage; Stored Value Cards and Other Nontraditional Access 



VOL. 42:685 

the proposed Regulation describes a card falling into this category as a mechanism 

providing "access to funds received and held by an insured depository institution for 

payment to others."'" Purporting to cover in section 330.5 (c)(2) of the proposed 

Regulation e-money purchased from and held at the issuer depository institution, 

the FDIC proposed that "funds placed at an insured depository institution by one 

party for transfer or withdrawal by same party... shall be deposits belonging to the 

same party." ' This appears to cover funds paid for the purchase of e-money loaded 

on a stored-value card, which remain at the institution available for redemption. 

With respect to "funds placed at an insured depository institution by one party 

for withdrawal by other parties," the FDIC proposes in section 330.5(c)(3) that 

unless two conditions are to be satisfied, funds will be insurable to the party that 

places the funds and not the actual cardholders. These conditions are first, "the 

account records of the insured depository institution reflect the fact that the first 

party is not the owner of the funds," and second, either the party that places the 

funds or the depository institution "maintains records reflecting the identities of the 

persons holding the [cards] and the amount payable to each person., 93 Only when 

these conditions are fulfilled, insurance will benefit the cardholders. 94 Accordingly, 

insurance will benefit holders of payroll cards but not anonymous purchasers of gift 

cards; under the same logic, insurance will also not cover anonymous cardholders of 

remittance cards, and in fact merchants and other payees paid by cards governed by 

the proposed new regulation. 9 

In effectively dealing separately with "true" stored value cards (under 

paragraph (c)(2)) and cards accessing funds placed by marketer or card provider 

(under paragraph (c)(3)), the FDIC did not fail to see that the two situations are 

distinct. Yet, it purports to promulgate one rule applicable to both situations. 

Furthermore, the language of paragraph (c)(2), covering "funds placed at an insured 

depository institution by one party for transfer or withdrawal by same party," 

appears to apply to not only to funds paid for the purchase of e-money loaded on a 

stored-value card, which remain at the institution available for redemption, but also 

to funds accessed by a debit card accessing the cardholder's account. Thus, the 

FDIC did not go far enough to highlight the nature of the stored-value card as 

distinct from the "traditional" access card, issued to an account holder. In the final 

Mechanisms, 70 Fed. Reg. 45,578, 45,578-45,580 (Aug. 8, 2005) (proposing to amend 12 C.F.R. § 330.5 by 

adding a new paragraph in which "access" is used by reference to specific funds deposited as opposed to 

the account under which they are managed). 

91. Id. at 45,580. 

92. But see Notice of FDIC General Counsel's Opinion No. 8, 61 Fed. Reg. 40,490, 40,491-40,494 

(Aug. 2, 1996). The Notice states that such funds are not insured for the benefit of the cardholder where 

they are placed in a reserve account rather than frozen in the cardholder's account. Id. The proposed rule 

does not seem to follow that distinction. Id. 

93. Id. 

94. Id. 

95. Cf. 12 U.S.C. § 1822(c) (limiting protection to depositors whose name appears on bank records). 

But cf 12 C.F.R. § 330.5(b)(4) (2006) (providing insurance coverage for deposits evidenced by a negotiable 

instrument such as "certificate of deposit, negotiable draft, negotiable cashier's or officer's check, 

negotiable certified check, [or] negotiable traveler's check" whose holder is not on bank records). 

Certainly, identifying cardholders of "low value" cards not on bank records may be a costly and laborintensive 

task. The question is whether exclusion from insurance coverage on such grounds is nevertheless 

justified for anonymous cardholders and payees with "high value" claims as well as of anyone actually 

coming forward by presenting a valid claim for redemption. Payee's claim to insurance may arise where 

payment on the card, as opposed to the redemption of its value, could not have been stopped. 



analysis, while being cognizant of the distinction, and yet in focusing on the 

communality, between the two "nontraditional access mechanisms" to be governed 

by the proposed Regulation, the FDIC may have inadvertently blurred the 

distinction between access to stored-value cards. 

No comprehensive legislation regarding SVPs is forthcoming in the United 

States. The expansion of Regulation E to cover the payroll card is a laudable 

pragmatic step taken in the right direction; yet, in my view, it is important to 

recognize that action taken is not the application of debit card law to a stored-value 

card. Rater, it is a recognition that the payroll card is an access device. Similarly, 

lumping up stored-value and funds placed by a third party into one category of 

"nontraditional access mechanisms," as was done by the FDIC, does not enhance 

clarity. In the long run it is important to either repudiate or reconstruct the 

conceptual framework set out by the Federal Reserve Board expanding the storedvalue 

category to cover situations that do not belong to it. 

IV. SECURITIES TRANSFERS IN THE INDIRECT HOLDING SYSTEM - 

LAW REFORM IN CANADA IN THE FOOTSTEPS OF UCC ARTICLE 896 

Historically, securities 9 ' were issued solely directly, by their issuers to securities 

holders, in a form of bearer, order, or registrable certificate. A transfer of a 

registrable security was "perfected," so as to confer on the transferee ownership and 

legal title to the security, by registration on the issuer's books. A transfer by a 

holder of a registered security required the physical delivery of the certificate 

accompanied by an endorsement. It was completed by the following steps: (i) the 

surrender by the transferee of the transferor's certificate to the issuer, (ii) the 

cancellation of the transferor's certificate by the issuer, (iii) the replacement of the 

transferor's name by that of the transferee on the books of the issuer, and (iv) the 

issue by the issuer of a new certificate to the transferee, in the transferee's own 

name. Typically, the transferor would deliver the certificate and an indorsement in 

blank to his or her broker, who would deliver this documentation to the transferee's 

broker, for further action. 

In the original form of the direct holding system, possession and delivery of 

physical certificates were key elements. 98 One response to the resulting paper crisis 

was immobilization or uncertification. For immobilized or uncertificated securities, 

no certificate was to be issued to registrable securities holders, whose rights were 

thus to be evidenced solely by the registration on the issuer's book. In any event, the 

new system did not supersede altogether, and in practice, hardly challenged, the 

96. See generally Benjamin Geva, Promoting Stability in International Finance-Legislative and 

Regulatory Reform of Payment and Settlement Systems, in 18 THE REFORM OF THE INTERNATIONAL 

FINANCIAL ARCHITECTURE 247-81 (Rosa M. Lastra ed., Intern'l Banking, Fin. & Econ. Law Series No. 18, 

2001). 

97. See BLACK'S LAW DICTIONARY 1358 (7th ed. 1999) (broadly speaking, "security" denotes an 

obligation of or an equity in an issuer which is of a type dealt in or traded on financial or exchange markets 

or is otherwise a medium of investment). 

98. See Colonial Bank v. Cady, (1890) 15 App. Cas. 267 (H.L.) (U.K.) (providing a classic common 

law case on the effect of possession of the endorsed certificate); see also ALBERTA LAW REFORM INST., 

TRANSFERS OF INVESTMENT SECURITIES 67 (1993) (giving the historical evolution of securities from a 

Canadian perspective). 



VOL. 42:685 

traditional certificated one. Rather, in principle, both systems co-exist, and 

depending on the terms of the issue, new securities could be issued in either 

certificated or uncertificated/immobilized form. In practice, the certificated system 

has remained prevalent. 99 

In any event, the uncertificated system has been a direct holding variant. In its 

framework, the transfer of a registrable security still contemplates registration on the 

book of the issuer, albeit on the basis of an instruction sent to the issuer, without the 

mechanism of delivering, surrendering and cancelling a certificate and the issue of a 

new one. Immobilization or uncertification has thus proved to be a mere partial 

solution which failed altogether to address the crux of the matter, that of the 

emergence of the indirect (or tiered) holding system. Thereunder, securities, 

whether in a certificated or uncertificated form, are issued to a clearing corporation 

or agency such as a central depository of securities (CDS) which then allocates rights 

in them to financial intermediaries, such as securities brokers and banks, as 

purchased by the intermediaries from the issuer. In turn, each financial intermediary 

then sells rights to investors. In such a system, the CDS remains the registered 

securities holder. Neither change in the registration on the books of the issuer, nor 

in the context of a certificated system, the issue of a new certificate, effectuates the 

subsequent transactions. Rather, the rights acquired by a purchaser are reflected as 

a credit or book-entry in an account held by that purchaser with an upper tier 

financial intermediary. To pursue our example, a brokerage firm purchasing a 

defined quantity of securities from the issuer will have its account with the CDS 

credited to that extent. Similarly, an investor, client of such a brokerage firm, will 

have his or her account with the brokerage firm credited, to the extent of the amount 

purchased. Transactions among brokers are effectuated on the books of CDS. 

Transactions among customers are effectuated on books held by brokers or other 

financial intermediaries. Interests in securities are thus held indirectly, through 

securities intermediaries. 

A few important characteristics of this indirect holding system could be 

elaborated as follows: 

1) The system does not preclude the registration of any interest on the books 

of the issuer. Stated otherwise, an interested holder can require, through the 

intermediary who maintains the interest holder's account, the establishment of a 

direct relationship with this intermediary's upper-tier institution, and ultimately, 

with the issuer. In fact, only a direct relationship with the issuer will secure to an 

investor a direct access to dividends or interest as well as the exercise of membership 

rights in the assembly or otherwise in management of the issuer, per the terms 

attached to the security. Yet, registration on the books of the issuer so as to 

establish such a direct relationship is a costly and timely process, in which most 

investors are not interested. This explains the popularity of the indirect holding 

system. 

99. Thus, in both the United States and Canada, the uncertificated system has not made significant 

inroads. In the United States, the uncertificated system, though accommodated by the 1978 revision of 

U.C.C. Article 8, has not developed for most categories of securities. It was thus observed that "[mlutual 

funds shares have long been issued in uncertificated form, but virtually all other forms of publicly traded 

corporate securities are still issued in certificated form." U.C.C. revised art. 8, Prefatory Note I(B) (1994). 

In Canada, uncertificated securities have been even less widespread. Regardless, in both the United States 

and Canada, mutual funds securities are not transferable, only redeemable. Hence they do not raise any 

issue relating to transferability. 



2) The pattern set out above should not mislead the reader to assume that the 

indirect holding system is necessarily exclusively a two-tiered one. In fact, further 

extensive financial intermediation may take place, particularly in the context of 

international finance. 

3) Typically, in the indirect holding system, where a certificate is issued to the 

CDS, the original certificate so issued by the issuer to the CDS, is a "jumbo 

certificate," reflecting the entire issue. In the normal course of events, that is, where 

no remote investor seeks to establish a direct relationship with the issuer, this 

certificate will remain stored with and untouched by the CDS. In this context, we 

speak of the "dematerialization of the security." Unlike immobilization or 

uncertification which exclude the issue of a certificate in the first place, 

dematerialization contemplates the issue of an original certificate which is put out of 

use. 

4) A holder of an interest has no entitlement to any specific security. Rather, 

the entitlement is to a specific quantity of a fungible asset as credited to the security 

holder's security account. Inter-financial intermediary transactions are thus not 

cleared and settled individually, but rather, in a fashion similar to the clearing and 

settlement of money transfers. 

Not surprisingly, the law governing securities transfers has been concerned with 

the direct holding system. This law is thus ill-fit to provide a comprehensive and 

clear framework for the indirect holding system. While the law relating to the direct 

holding system focuses on the relationship between the issuer and the security 

holder, the indirect holding system revolves around relationships involving 

intermediaries. Put another way, in the direct holding system the asset under 

discussion is the security itself. Conversely, in the indirect holding system, the asset 

under discussion is the entitlement to a security as reflected in an account 

maintained by a financial intermediary. 

To accommodate the indirect holding system in the context of laws governing 

securities transfers Guynn set out four fundamental principles of law reform:"" 

[1)] Interests in securities held through a financial intermediary should be 

defined ... as [an] interest in a pro-rata portion of the pool of securities or 

interests in securities held by the intermediary with whom the interest 

holder has a direct contractual relationship . . . . The interest should 

exclusively be reflected as a credit to the interest holder's account with the 

intermediary, and not as a traceable property right in individual securities 

or a mere contractual claim. 

[2)] The pool of securities or interests in securities held by a financial 

intermediary to satisfy the interest of its interest holders should be 

protected against the claims of the intermediary's general creditors .... 

This can be done either by defining the interest as a type of property or coproperty 

right or by amending existing.., laws governing the insolvencies 

of "financial intermediaries to give explicit effect to this policy. 

100. Randall D. Guynn, Modernizing Securities Ownership, Transfer and Pledging Laws: A 

Discussion Paper on the Need for International Harmonization 33-37 (Capital Markets Forum. Intern'l Bar 

Assoc. 1996), available at http://www.dpw.com/iba.modernization.pdf. 



[3)] Conflicts of laws rules should be interpreted or modernized to reflect 

the development of the [indirect holding] system [to accommodate] 

holding, transferring and pledging interests in securities by [means of] 

book-entry to accounts with financial intermediaries so that the selection 

of the law governing the [rights in such a system ought to be] determined 

by agreement, [and] in the absence of such agreement, by reference to 

where the office of the financial intermediary maintaining such accounts is 

located or otherwise by reference to the intermediary's jurisdiction. 

[4)] Procedures for creating and enforcing a pledge of [or security] 

interests in securities credited to accounts with intermediaries should be 

simplified. 

1 

Guynn enumerated three enactments that appear already to satisfy these four 

basic principles so as to be models for reform. One such enactment is Revised 

Article 8 (1994 Official Text) of the Uniform Commercial Code in the United 

States." An important update 0 3 is the adoption by the Canadian provinces of 

Alberta" ° and Ontario 5 of a Uniform Securities Transfers Act (USTA), ° closely 

modelled on UCC Revised Article 8. 

101. Id. at 33-34 (asserting that this principle is consistent with an informed application of the lex situs 

rule). Guynn goes on to elaborate several applications as follows: 

[i] the substantive law governing the validity of securities and the rights and duties of issuers 

should be the law of the issuer's jurisdiction"; [(ii)] the law governing any contest between the 

rights of any person identified as the holder of an interest in dematerialized securities directly 

on the books of an issuer or its agent and the rights of any adverse claimant in such interest 

should be the law where the books are located (typically the issuer's jurisdiction)"; [(iii)] "the 

law governing any contest between the rights of persons that have actual possession of physical 

securities and those of any adverse claimant in such physical securities should be the law where 

the physical securities are located"; [(iv)] "the law governing the rights and duties of an 

intermediary with respect to interests in securities credited to accounts with it, as well as any 

contest between the rights of any person identified as the holder of such an interest on the 

books of the intermediary and those of any adverse claimant in such interest, should be the law 

where the intermediary's office maintaining such accounts is located or otherwise by the law of 

the intermediary's jurisdiction. 

Id. at 36. 

102. See id. at 43-45 (explaining that the two other enactments are (i) "the Belgian Royal Decree No. 

62 dated November 10, 1967 Facilitating the Circulation of Securities (as amended, April 7, 1995)"; and 

(ii) the Luxembourg Grand-Ducal Decrees of February 17, 1971, December 18, 1991 and June 8, 1994"). 

103. See generally UNIDROIT Study Group, Harmonised Substantive Rules Regarding Indirectly 

Held Securities (2003), available at 

http://www.unidroit.org/english/publications/proceedings/2003/study/78/s-78-08-e.pdf (discussing such 

issues from a more global perspective). For subsequent developments and comments, see generally 

UNIDROIT Web-site, Intermediated Securities - Study LXXVIII, 

http://www.unidroit.org/english/workprogramme/study078/iteml/main.htm (last visited May 16, 2007). 

104. Securities Transfer Act, S.A. 2006, ch. S-4.5 (Alberta), available at 

http://www.canlii.org/ab/laws/sta/s-4.5/20070312/whole.html. 

105. Securities Transfer Act, S.O. 2006, ch. 8 (Ontario) [hereinafter Ontario Securities Transfer Act], 

available at http://www.canlii.org/on/laws/sta/2006c.8/20070307/whole.html. 

106. See generally CANADIAN SECURITIES ADMINISTRATORS' UNIFORM SECURITIES ACT TASK 

FORCE, PROPOSAL FOR A MODERNIZED UNIFORM LAW IN CANADA GOVERNING THE HOLDING. 

TRANSFER AND PLEDGING OF SECURITIES (May 28. 2004). available at 

http://www.osc.gov.on.ca/MarketRegulation/SpecialProjects/usta/usta-20040528_consultation-paper.pdf; 



Article 8 and USTA are not limited to indirect securities holding. Rather, they 

are comprehensive pieces of legislation covering also the direct holding of 

certificated and uncertificated securities. The ensuing discussion will outline the 

principal features of Article 8 and the Ontario Securities Transfer Act (OSTA) as a 

model for legislative reform.' 7 

Both Revised Article 8 and OSTA abandon any attempt to describe all of the 

complex relationships in the indirect holding system using the simple concepts of the 

traditional holding system. For example, the investors' interests are not described as 

co-ownership in securities held for their benefit by a broker. Instead, vis- -vis a 

"securities intermediary" maintaining for him or her a "securities account," the 

"entitlement holder," such as an investor or another "securities intermediary," has a 

''security entitlement" to a "financial asset" held by that "securities intermediary." 

In turn, the "financial asset" held by the "securities intermediary" to meet its 

obligations to satisfy the "security entitlements" of its customers, namely those for 

whom it maintains "securities accounts," is itself a "security entitlement" to a 

"financial asset" held by another "securities intermediary." Only ultimately, the 

"financial asset" held by the clearing corporation (such as a CDS) to whom the 

security was originally issued, is the security itself. 1 " 8 

The specific provisions of Part 5 of Revised UCC Article 8 and Part VI of 

OSTA, each bearing the title "security entitlement" and dealing with the indirect 

holding of securities, can be outlined as follows. In principle, the acquisition of a 

financial asset is to be reflected as a credit in a securities account.'0 9 An action based 

on an adverse claim to a financial asset may not be asserted against a person who 

acquires a security entitlement for value and without notice of the adverse claim." 0 

Financial assets held by a securities intermediary to satisfy securities entitlements 

"are not property of the securities intermediary, and are not subject to claims of 

creditors of the securities intermediary.""' Rather, entitlement holders share them 

pro rata."' A securities intermediary is required to maintain a financial asset in a 

see also Eric T. Spink & Maxime A. Par6, The Uniform Securities Transfer Act: Globalized Commercial 

Law for Canada, 19 BANKING & FIN. L. REV. 321 (2004); Benjamin Geva, Legislative Power in Relation to 

Transfers of Securities: The Case for Provincial Jurisdiction in Canada, 19 BANKING & FIN. L. REV. 393 

(2004). 

107. See generally James Steven Rogers, Policy Perspectives on Revised U.C.C. Article 8, 43 UCLA L. 

REV. 1431 (1996) (providing detailed discussion on article 8 by the reporter to the revised article 8 drafting 

committee). 

108. Pertinent definitions are set out in U.C.C. sections 8-102 and 8-501 as well as in OSTA section 1. 

Briefly stated, a "securities intermediary" is either "(i) a clearing corporation; or (ii) a person, including a 

bank or broker, that in the ordinary course of its business maintains securities accounts for others ...." 

U.C.C. § 8-102(a)(14 (2006): Ontario Securities Transfer Act, S.O. 2006, ch. 8, § 1. A "securities account" 

is "an account to which a financial asset is or may be credited ...." U.C.C. § 8-501(a); Ontario Securities 

Transfer Act, S.O. 2006, ch. 8, § 1. A "financial asset" is either "a security [or] property that is held by a 

securities intermediary for another person in a securities account ...." U.C.C. § 8-102(a)(9); Ontario 

Securities Transfer Act, S.O. 2006, ch. 8, § 1. "Security entitlement" is the rights and property interest of 

an entitlement holder with respect to a financial asset. U.C.C. § 8-102(a)(17). An "entitlement holder" is 

"a person identified in the records of a securities intermediary as the person having a security entitlement 

against the securities intermediary." U.C.C. § 8-102(a)(7); Ontario Securities Transfer Act, S.O. 2006, ch. 

8,§ 1. 

109. U.C.C. § 8-501(b): Ontario Securities Transfer Act, S.O. 2006, ch. 8, § 95. 

110. U.C.C. § 8-502: Ontario Securities Transfer Act, S.O. 2006, ch. 8, § 96. 

111. U.C.C. §8-503(a). 

112. U.C.C. §8-503(b); Ontario Securities Transfer Act, S.O. 2006, ch. 8, § 97(2); see also U.C.C. § 8- 



VOL. 42:685 

quantity corresponding to the aggregate of all security entitlements it has established 

in favour of its entitlement holders with respect to that financial asset." 3 Stated 

otherwise, unlike a bank account, a securities account is backed by 100% reserve. A 

securities intermediary is responsible to its entitlement holders to obtain and 

distribute any payment made by the issuer of the financial asset and is further 

obliged to exercise rights with respect to a financial asset as directed by the 

entitlement holder.1 4 A securities intermediary is further required to comply with 

the entitlement holder's instructions as to the transfer or redemption of an 

underlying financial asset as well as to change entitlement holder's position to other 

form of security holding." 5 Finally, a purchaser of a security entitlement, who 

obtains control of it for value and without notice of any adverse claim to the security 

entitlement or the underlying financial asset, takes that security entitlement free 

from the adverse claim." 6 

Both UCC Article 8 and OSTA further provide for coherent choice of law rules 

to apply to the indirect holding system. In the direct holding system, a key factor in 

determining the governing law of a transaction is the location of the security. This 

location is not always easy to determine." 7 Furthermore, particularly in the context 

of globalization, the lex situs of the security may not fit the expectations of an 

entitlement holder and a securities intermediary located other than where the 

security is located. Indeed, as indicated, both Revised Article 8 and OSTA focus on 

the "security entitlement," and consequently, on the bilateral relationship between 

an entitlement holder and the securities intermediary. This, rather than the 

"security," or the link between an investor and the issuer, constitutes the foundation 

of the legal regime governing the indirect holding system. Consistently with this 

approach, the key factor in determining the governing law in the indirect holding 

system has been stated in UCC 8-110(b) and OSTA Section 45(1) to be the law of 

the securities intermediary's jurisdiction."' Such law is stated to govern the 

acquisition of a security entitlement from the securities intermediary, the respective 

rights and duties arising from a security entitlement, and rights of an adverse 

claimant. In the absence of a specific agreement, a "securities intermediary's 

jurisdiction" is the jurisdiction where the securities account is maintained." 9 

Finally, in conjunction with corresponding amendments to UCC Article 9 and 

to the Ontario Personal Property Security Act (OPPSA)' ° governing secured 

511; Ontario Securities Transfer Act, S.O. 2006, ch. 8, § 105 (providing for the priority of entitlement 

holders over the securities intermediary's creditors, other than secured parties (of the securities 

intermediary) having "control" over the financial asset). 

113. U.C.C. § 8-504; Ontario Securities Transfer Act, S.O. 2006, ch. 8, § 98. 

114. U.C.C. §§ 8-505 to 8-506; Ontario Securities Transfer Act, S.O. 2006, ch. 8, §§ 99-100. 

115. U.C.C. §§ 8-507 to 8-508; Ontario Securities Transfer Act, S.O. 2006, ch. 8, §§ 101-02. 

116. U.C.C. § 8-510; Ontario Securities Transfer Act, S.O. 2006, ch. 8, § 104. 

117. See Geva, Consumer Liability, supra note 74. 

118. Cf. Hague Convention on the Law Applicable to Certain Rights in Respect of Securities Held 

with an Intermediary, July 5, 2006, http://hcch.e-vision.nl/indexen.php?act=conventions.pdf&cid=72; see 

also Bradley Crawford, The Hague "PRIMA" Convention: Choice of Law to Govern Recognition of 

Dispositions of Book-Based Securities in Cross Border Transactions, 38 Can. Bus. L.J. 157 (2003). 

119. U.C.C. § 8-110(e). The Ontario Securities Transfer Act states that if the law is not agreed upon, 

it is the law of the jurisdiction where the securities intermediary's office maintaining the particular 

securities account is located, as such office is identified by contract, or otherwise, in an account statement. 

Ontario Securities Transfer Act, S.O. 2006, ch. 8, § 45(2). In the absence of any such identification, it is the 

law of the jurisdiction in which the chief executive office of the securities intermediary is located. Id. 

120. See Personal Property Security Act, R.S.O. 1990, ch. P.10, c. 8, §§ 123-141 (coming into force Jan. 



transactions, rules applying to security interests in investment securities have been 

provided for. In general, as for any other form of personal property, a security 

interest in securities is to be created by agreement between the debtor and the 

secured party. A new collateral category, "investment property," was introduced to 

cover securities, security entitlements and security accounts."' Under UCC 9-314(a) 

and OPPSA Section 22.1, a security interest in investment property may be 

perfected 2 by "control." 

With respect to a security entitlement, "control" is achieved under UCC 8- 

106(d) and OSTA Section 25(1) by becoming an entitlement holder. Under both 

provisions, "control" may alternatively be achieved by the securities intermediary's 

agreement that it will comply with entitlement orders, namely, with directions to 

transfer or redeem the pertinent financial asset, originated by the secured party (or 

any other purchaser), without further consent of the entitlement holder. A third 

alternative under OSTA Section 25(1) as well as under a proposed addition to UCC 

8-106(d) is by the control of another person on behalf of the purchaser. Both UCC 

9-106(a) and OPPSA Section 1(2)(c) specifically incorporate UCC 8-106 and OSTA 

Section 25. 

Perfection by control is in line with the broad principle underlying UCC 8-106 

(as well as in effect OSTA Sections 23 to 26), under which "'[o]btaining control' 

means that the purchaser [including a secured party] has taken whatever steps are 

necessary, given the manner in which the securities are held, to place itself in a 

' 

position where it can have the securities sold, without further action by the owner. 

Both Article 8 and OSTA do not preclude perfection of a security interest in 

investment property other than by control;' and yet, under UCC. 9-328(1), 

"control" provides the utmost priority in investment property: "A security interest 

held by a secured party having control of investment property under Section 9-106 

has priority over a security interest held by a secured party that does not have 

control of the investment property."' 2 5 OPPSA Section 30.1 is to the same effect. 

1, 2007 as the most recent amendment to the OPPSA) [hereinafter Ontario Personal Property Security 

Act]. 

121. U.C.C. § 9-102(a)(49) (encompassing "security[ies]," "security entitlement[s]," and "securities 

account[s]," as well as "commodity contract" and commodity account" under Article 8). 

122. In general, under both U.C.C. Article 9 and OPPSA, a "security interest" is an interest in 

personal property, created by agreement, securing payment of a debt or the performance of an obligation. 

Id. § 1-201(b)(35) & art. 9; Ontario Personal Property Security Act, R.S.O. 1990, ch. P.10, c. 8, § 1. 

"Collateral" is the property subject to the security interest. U.C.C. § 9-102(a)(12); Ontario Personal 

Property Security Act, R.S.O. 1990, ch. P.10, § 1. The "secured party" is the holder of a security interest. 

U.C.C. § 9-102(a)(12); Ontario Personal Property Security Act, R.S.O. 1990, ch. P.10, c. 8, § 1. 

"Perfection" denotes the completion of all required steps designed to protect the secured party from claims 

of third parties such as buyers from and creditors of the debtor. U.C.C. § 9-308; Ontario Personal Property 

Security Act, R.S.O. 1990, ch. P.10, c. 8, § 19. For the perfection of security interests in investment 

property other than by "control," see generally infra note 123. 

123. U.C.C. § 8-106, cmt. 1 (1994); Ontario Securities Transfer Act, S.O. 2006, ch. 8, §§ 23-26; see 

generally U.C.C. § 8-106(a)-(d) (2006) (offering various definitions of "control"). 

124. See also Ontario Personal Property Security Act, R.S.O. 1990, ch. P.10, § 23 ("Registration 

perfects a security interest in any type of collateral."): id. § 22(3) ("[A] security interest in a certificated 

security in registered form is perfected by delivery when delivery of the certificated security occurs . 

U.C.C. §§ 9-310(a), 9-313(a) (paralleling Ontario Personal Property Security Act §§ 23, 22(3)). 

125. U.C.C. 9-328(1). 



VOL. 42:685 

V. EU PROPOSED LEGAL FRAMEWORK FOR A SINGLE PAYMENT 

MARKET 


In its proposal for a Directive on payment services in the internal market 

(Proposed Directive), the Commission of the European Communities (the 

Commission) purported to provide for "a harmonised legal framework" designed to 

create "a Single Payment Market where improved economies of scale and 

competition would help to reduce the cost of the payment system. ' 26 Being 

"complemented by industry's initiative for a Single Euro Payment Area (SEPA), 

aimed at integrating national payment infrastructures and payment products for the 

euro-zone," the Proposed Directive is designed to "establish a common framework 

for the Community payments market creating the conditions for integration and 

rationalisation of national payment systems.' ' 127 Focusing on electronic payments, 

and designed to "leave maximum room for self-regulation of industry," the Proposed 

Directive purports to "only harmonise what is necessary to overcome legal barriers 

28 

to a Single Market, avoiding regulating issues which would go beyond this matter.' 

Stated otherwise, the measure will fall short of providing for a comprehensive 

payment law. 

The scope of the Proposed Directive is stated in Article 2(1) to "apply ... to 

business activities," referred to as "payment services," listed in the Annex, and 

"consisting in the execution of payment transactions on behalf of a natural or legal 

person . . . where at least one of the payment service providers is located in the 

Community."' 29 A "payment transaction" is defined to "consist in the act, initiated 

by the payer or the payee, of depositing, withdrawing or transferring funds 3 ' from a 

payer to a payee,' irrespective of any underlying obligations between the payment 

service users."' 32 "Payment services" listed in the Annex 3 are cash deposits and 

withdrawals in and from payment accounts;. execution of payment transactions in 

funds held on deposit in a payment account; execution of direct debits; execution of 

payment transactions through a payment card (or a similar device); execution of 

credit transfers (including standing orders); execution of payment transactions in 

funds covered by a credit line; execution of direct debits (including one-off direct 

126. Commission of the European Communities, Commission Proposal for a Directive of the 

European Parliament and of the Council on Payment Services in the Internal Market 2 (Dec. 1, 2005) 

[hereinafter Commission Proposal], available at http://eurlex.europa.eu/LexUriServ/site/en/com/2005/com2005_0603en01.pdL 

127. Id. 

128. Id. at 8. 

129. Id. art. 2(1). 

130. Id. art. 4(8) (defining "funds" as "cash, scriptural money and electronic money . . 

131. Id. art. 4(4)-(5) ("'[Player' means a natural or legal person who has the right of disposal of funds 

and who allows them to be transferred to a payee [and] 'payee' means a natural or legal person who is the 

intended final recipient of funds which have been the subject of a payment transaction .... "). 

132. Commission Proposal, supra note 126, art. 2 (describing what constitutes a "payment 

transaction"); id. art. 4(6) (including payer and payee as payment service users). 

133. The Annex is quite disorganized and repetitive. For example, the terms "payment card," "direct 

debit," and "credit transfer" are each enumerated at least twice. Id. at 54. 

134. Id. art. 4(7) ("'Payment account' means an account held in the name of a payment service user 

which is used exclusively for payment transactions."). 



debits)' 3 ; issuing of payment cards; execution of payment transactions in e-money; 

money remittance services in funds accepted for the sole purpose of carrying out the 

payment transaction; and execution of certain payment transactions by any means of 

communication at a distance such as mobile telephones or other digital or IT 

devices. ' 

Article 3 deals with the outer limits of the Proposed Directive. Thereunder, 

cash payments, collections, delivery and transport, as well as certain cash refunds 137 

are specifically excluded. Also excluded from the coverage of the Proposed 

Directive are change of foreign currency in the form of cash-to-cash operations; 

paper checks, vouchers, traveller's checks and promissory notes;' 38 payment 

transactions carried out within a payment or security clearing and settlement system; 

payment processing services; payment by instruments which are not redeemable 

within a limited network or affiliated service providers; certain payment transactions 

executed by means of a mobile telephone or any other digital or IT device;' 39 and 

payment transactions carried out between payment service providers as well as tied 

agents or subsidiaries.' 

Coverage of payment transactions by any means of communication at a 

distance requires further analysis. The "Execution of a payment transaction by any 

means of communication at a distance such as mobile telephones or other IT 

devices" is a payment service listed in the Annex and is thus covered by the 

Proposed Directive, "where the service provider operating the telecommunication or 

IT system or network," 

* "is facilitating the payment of goods or services that are not digital goods 

or electronic communication services and so are provided through the 

device itself"; or 

* "simply arranges a transfer of funds for the payment of digital goods or 

electronic communication services provided through the device, without 

any other intervention in the service provided."'' 

Conversely, under Article 3(j), "Payment transactions executed by means of a 

mobile telephone or any other digital or IT device" is to be excluded from the 

Proposed Directive, "where all the following conditions are met": 

135. "Direct debit," "credit transfers," and "payment card" are not defined in the Directive. 

136. Although the "execution of payment transactions ... at a distance" are generally covered by the 

Directive, an exception exists in Article 3(j), as discussed below. Id. ann. at 54. 

137. Id. art. 3(d) (excluding "cash refunds provided by the payee to the payer after a payment 

transaction following an explicit request by the payment service user made just before the execution of a 

payment transaction through a payment card and completely independent of the cost of the good or 

services purchased .... ). 

138. See id. at 13 ("This [proposed] Directive should not apply to payment transactions made in cash 

or to those based on paper cheques since, by their nature, they cannot be processed as efficiently as other 

means of payment, in particular electronic payments."). In light of Part I of this Paper, the reasoning 

underlying this statement ought to be taken with a grain of salt, at least insofar as checks are concerned. 

139. For the conditions under which payment transactions executed by mobile phone or digital or 

other IT devices are covered under the Annex and excluded under Article 3(j), see next paragraph. 

140. Commission Proposal, supra note 126, art. 4(16) ('"ITlied agent' means a natural or legal person 

which acts on behalf of a payment institution in carrying out payment services .... 

141. Emphasis added 



VOL. 42:685 

(i) 

(ii) 

"the service provider operating the telecommunication or IT system 

or network is closely involved in the development of the digital 

goods or electronic communication services provided"; and 

"the goods and service cannot be delivered in the absence of the 

service provider." 

These provisions distinguish between "digital goods or electronic 

communication services" (digital products) and other goods and services (non-digital 

products). Language and rationale of these provisions are not entirely clear. For 

example, for the Proposed Directive to apply, why does the language quoted in the 

first bullet limited to non-digital products provided "through the device itself"? And 

if they are not provided "through the device itself," can they still be covered under 

another more general "payment service"? Second, exclusion under Article 3(j) is 

limited to digital products covered under the second bulleted quoted language. Yet, 

the rationale of this exception is not self explanatory; moreover, there is a gray area 

between the second bulleted quoted language (under which service is covered) and 

the exclusion under Article 3(j); thus, any "intervention in the service provided," 

beyond the arrangement of the funds transfer, will exempt the transaction from 

coverage under the second bulleted quoted language; at the same time, to fall within 

the exclusion under Article 3(j), the service provider's involvement must exceed 

mere intervention; he must be "closely involved in the development of the digital 

goods or electronic communication services provided." 

Title I of the Proposed Directive provides for subject matter, scope and 

definitions. It is followed by three substantive components. First, Title II covers 

payment service providers. Second, Title III deals with transparency of conditions 

for payment services. Third, Title IV governs rights and obligations in relation to the 

provision and use of payment services. Under Article 2, both Titles III and IV are 

limited to payment transactions of up to EUR 50,000; stated otherwise, they provide 

for payment law for retail funds transfers. While large-value payments are thus 

excluded, payments of up to EUR 50,000 taking place on wholesale transfer systems, 

particularly targeted at large-value payments, remain nevertheless covered.' 42 The 

three substantive components are followed by Titles V and VI dealing with 

amendments, Payment Committee, and final provisions. 

The ensuing discussion outlines the statutory scheme set out in the three 

substantive parts, namely Titles II, III and IV, covering licensing, transparency, and 

transaction rights and obligations. 

B. Licensing of Non-Bank Payment Service Providers 3 

Title II establishes a legal framework for a single license for all providers of 

payment services which are not connected to taking deposits or issuing e-money, and 

regulated under existing EU directives.'" Payment service providers falling into this 

residuary category are referred to in the Preamble and the head-note to Chapter 1 of 

142. Id. at 13 ("[P]ayment[s] above this amount are not generally processed [in] the same way, are 

often channelled through different networks and are submitted to different technical and legal procedures 

that should be maintained."). 

143. Cf. UNIF. MONEY SERVICES ACT art. 2 (2001). 

144. See generally Council Directive 2000/12, 2000 O.J. (L 126) 1; Council Directive 2000/46, 2000 O.J. 

(L 275) 39. 



Title II as "payment institutions," which otherwise, are not defined in the Proposed 

Directive. Title 11 is designed to "create a level-playing field, instil more competition 

in national markets and reflect market developments in recent years, triggering 

market entry of a new generation of providers." '45 To that end it is further designed 

to harmonize market access, also with the view of facilitating "the gradual migration 

of . . . providers from the unofficial economy to the official sector. 14 6 In the 

language of Paragraph 9 of the Preamble: 

The conditions for the granting and maintenance of authorisation of 

payment institutions should include prudential requirements 

proportionate to the operational and financial risks faced by such bodies in 

the course of their business. Those requirements should reflect the fact 

that payment institutions engage in more specialised and restricted 

activities, thus generating risks that are much narrower and easier to 

monitor and control than those that arise across the spectrum [or deposittaking] 

credit institutions. In particular, payment institutions should be 

prohibited from accepting deposits from users and permitted to use only 

funds accepted from users for rendering payment services. 4 7 Provision 

should be made for client funds to be kept separate from the payment 

institution's funds for other business activities."' Payment institutions 

should also be made subject to effective anti-money laundering and antiterrorist 

financing requirements. 4 9 

Authorization is to be valid in all Member States. 5 ' 

However, to prevent the 

forcing out into the "black economy" of those unable "to meet the full range of 

conditions for authorisation as payment institutions," provision is made for the 

registration "of payment institutions while not applying all of the conditions for 

authorisation," but only as long as derogation is limited to the provision of payment 

services within the Member State of registration and is "subject . . . to strict 

requirements relating to volume of transactions and importance for the public 

interest.". 5 ' 

Activities permitted to payment institutions are enumerated in Article 10(1). 

They consist of (i) 

the provision of payment services; (ii) the provision of operational 

and related ancillary services such as the guaranteeing of the execution of payment 

transactions, foreign exchange services, safekeeping activities, and storage and 

processing of data; and (iii) accessing and operating payment systems.. 2 for the 

145. Commission Proposal, supra note 126, at 7. 

146. Id. 

147. "[Flunds received by payment institutions from payment service users with a view to the 

provision of payment services shall not constitute a deposit or other repayable funds within the meaning of 

Article 3 of Directive 2000/12/EC, or electronic money within the meaning of Directive 2000/46/EC." Id. 

art. 10(1). The former Directive governs deposit-taking by credit institutions and the latter governs 

electronic money institutions. See supra note 144. 

148. Article 10 codifies the separation of payment service users funds from non-payment service 

funds. Commission Proposal, supra note 126, art. 10(2). 

149. Id. at 12. 

150. Id. art. 6. 

151. Id. at 12-13; see infra note 160. 

152. See Commission Proposal, supra note 126, art. 4(3) ("'[P]ayment system' means a funds transfer 

system with formal and standardised arrangements and common rules for the processing, clearing and/or 



VOL. 42:685 

purpose of transferring, clearing and settling funds, including any instruments and 

procedures relating to the systems. Under Article 10(3), all such activities "shall be 

non-exclusive and shall not be restricted to payment services, having regard to the 

53 

applicable national and Community law.' 

Specific provisions deal with the authorization process;' 5 " govern the use of 

third-parties by payment institutions; ' require record-keeping,' 56 registration of 

head office 57 and professional secrecy;' 58 provide for supervision; " and regulate the 

derogation from authorization and its substitution by registration requirements.'6 

Finally, equality of treatment throughout the Community between the different 

categories of payment service providers is provided for. 16 ' 

C. Transparency of Conditions for Payment Services 

Title III governs transparency of conditions for payment services for payment 

transactions throughout the Community that do not exceed EUR 50,000.162 It is 

stated to aim at providing users with standardized "high level of clear information" 

enabling them "to make well-informed choices and be able to shop around within 

the EU" and yet to ensure that "[m]icro payments should be a cheap and easy-to-use 

alternative in the case of low-priced goods and services and should not be 

overburdened by excessive requirements."' 63 

Title III has separate rules for single payment transactions (Articles 24-28) and 

for framework contracts (Articles 29-38). Common provisions (Articles 39-40) cover 

the selection of currency. A "framework contract" is defined in Article 29 to refer to 

an agreement which "commits a payment service provider to execute in the future 

successive payment transactions or individual payment transactions on the order of 

the payer if the agreed conditions are met."' ' No requirements are laid out as to 

settlement of payment transactions .... 

153. Id. art. 10(3). 

154. Id. arts. 5-9. 

155. Id. arts. 11-12. 

156. Id. art. 13. 

157. Id. art. 14. 

158. Commission Proposal, supra note 126, art. 17. 

159. Id. arts. 15-16. 

160. Id. arts. 21-22. Derogation is where registration is necessary for the effective implementation of 

anti-money laundering and terrorist financing rules and mechanisms, for an institution whose business 

activity generates "a total amount of funds outstanding which were accepted for the provision of payment 

services and which does not exceed EUR 5 million on average over a month and EUR 6 million at any 

given point in time," and which plays a vital role in financial intermediation, providing access to payment 

services for underprivileged social groups. Id. art. 21(1). A person benefiting from the exception shall be 

treated as a payment institution but may provide payment services only within the Member State of 

registration and may be permitted to engage only in certain of the activities listed in Article 10. Id. art. 

21(2). 

161. Id. art. 23 ("[R]ules on access to and operation of payment systems shall be objective and 

proportionate and shall not inhibit access more than is necessary to safeguard against specific risks and to 

protect the financial safety of the payment system."). 

162. Commission Proposal, supra note 126, arts. 2, 24-40; see also id. art. 84 (providing for the repeal 

of Council Directive 97/5, 1997 O.J. (L 43) 25). 

163. Id. at 13-14; see also id. art. 38(1) (defining "micro payment" as one not exceeding 50 Euro). 

164. Id. art. 29. 



either the medium in which such a contract is to be contained or as to whether the 

contract must be express. 

There is some overlap in disclosure requirements for both single payment 

transactions and framework contracts. For both, conditions are to be "set out in 

easily understandable words and in a clear and readable form," "on paper or on 

another durable medium, ' and "in good time before the payment service user is 

bound .... ."'6 In each case, 67 conditions consist of description of respective 

obligations and liabilities which include information or unique identifier' 68 to be 

provided by user in order for a payment order' 60 to be properly executed; execution 

time; and where applicable or appropriate, conditions such as safekeeping 

requirements for and risks associated with a payment verification instrument,' 70 and 

how to notify the service provider in case of loss or theft of the instrument. 

Conditions to be disclosed further consist of a clear reference to the point of time of 

acceptance of a payment order; 7 ' pertinent charges and "where applicable," relevant 

exchange rate; indication as to the governing law and competent court; indication of 

the redress and complaint procedure; and "an indication of where any other 

information may be made available and be consulted." 

In addition to such common disclosures for both categories, for a single 

payment transaction specific disclosure requirements are set out in Article 26(1).171 

They address liability for the execution of the payment transaction, "information to 

be provided in accordance with Directive 2005/. . ./EC,"' 173 and the availability of 

appropriate funds. 74 By the same token, and in addition to the common disclosures 

165. "'[D/urable medium' means any instrument which enables information addressed personally to 

the payment service user to be stored in a manner accessible for future reference for a period of time 

adequate to the purposes of the information and which allows the unchanged reproduction of the 

information stored; in particular, durable medium covers printouts by account printers, floppy disks, CD- 

ROMs, DVDs and hard drives of personal computers on which electronic mail is stored but excludes 

internet sites, unless such sites meet the criteria specified in the first sentence of this point." Id. art. 4(19). 

166. Id. arts. 25(1), 26; see also id. arts. 30(1), 32 (describing the communication of conditions to the 

payment service user with regard to framework contracts). 

167. See Commission Proposal, supra note 126, art. 26(1), 31(1). 

168. Id. art. 4(15) ("'[U]nique identifier' means the information specified by the payment service 

provider and to be provided by the payment service user to identify unambiguously the other payment 

service user involved in a payment transaction, and consisting of the IBAN (International Bank Account 

Number), the BIC (Bank Identifier Code), a bank account number, a card number or a name .... "). 

169. Id. art. 4(10) ("'[Payment order' means any instruction by a payer or payee to his payment 

service provider requesting the execution of a payment transaction .... "). 

170. Id. art. 4(17) ("'[P]ayment verification instrument' means any personalised device(s) and/or set of 

procedures used by the payment service user in order to enable the payment service provider to 

authenticate a payment order. If it is not provided by the payment service provider, the payment service 

provider and the payment service user may agree on the use of any other instrument for the authentication 

of payment orders which may also serve other purposes .... "); id. art. 4(13) ("'[A]uthentication' means a 

procedure which allows the payment service provider to verify that the user issuing the payment order is 

authorised to do so .... "). 

171. Id. art. 54 (time of acceptance is established only after the payment service provider has received, 

authenticated, and explicitly or implicitly accepted the obligation to execute the payment order). 

172. Commission Proposal, supra note 126. art. 26(1). 

173. See id. art. 26(1)(a)(v) (the blank reference ought to be taken as referring to a directive in 

preparation). 

174. Id. art. 4(9) ("'[A]vailability offinds' means that the funds on a payment account may be used by 

the payment service user without fees being charged .... "). 



VOL. 42:685 

set out above, for a framework contract specific disclosure obligations are set out in 

Article 31(1)." 7 " They relate to the technical requirements with respect to user's 

equipment, termination rights, blocking of a payment verification instrument in case 

of suspicion of fraud, and spending ceilings. For a framework contract, explicit 

information on execution time and charges is to be disclosed before the execution of 

each payment transaction.176 

For each payment transaction, whether it is single or pursuant to a framework 

contract, subsequent to the acceptance of payment order for execution, the payment 

service provider is mandated 17 7 to make available to the payer a reference enabling 

the identification of the payment transaction, "where appropriate" information 

relating to the payee, amount of payment as well as of fees and charges, and "where 

relevant" exchange rate. Subsequent to making funds, received for the payee, 

available to him, the payment service provider is required 17 to make a similar 

disclosure to the payee, 179 though obviously with information as to the payer 

replacing information as to the payee. For a framework contract specific provisions 

are made in Articles 33 and 34 to govern changes in contractual provisions and 

termination. 

Under Article 38, disclosure requirements are substantially reduced in 

connection with "a [framework] contract concerning payments where no individual 

payment can exceed EUR 50 . . .,. In a case of a contract for such "micro 

payments," "the payment service provider shall communicate to the payment service 

user ... only the main characteristics of the payment service to be provided, the way 

in which it can be used and all charges applicable.''. Further required information is 

to be provided "in an easily accessible manner."" Subsequent to the execution of 

such a payment transaction, a service provider is to communicate "at least a 

reference enabling the ... user to identify the payment transaction, the amount... 

and the fees. ,183 

D. Rights and Obligations of Users and Providers of Payment Services 

Title IV provides for substantive law for major aspects of payment transactions 

not exceeding EUR 50,000. It covers the authorization of payment transactions, the 

execution of payment transactions, data protection, and penalties and procedures for 

settlement disputes. 

Authorization of payment transactions is governed by Chapter 1 consisting of 

Articles 41-53. Article 2(1) defines a "payment transaction" to "consist in the act, 

initiated by the payer or the payee, of depositing, withdrawing or transferring funds 

175. Id. art. 31(1). 

176. See id. art. 35. 

177. See id. art. 27 (single payment transaction); see also id. art. 36 (payment transaction executed 

pursuant to a framework contract). 

178. See Commission Proposal, supra note 126, art. 28 (single payment transaction); see also id. art. 37 

(payment transaction executed pursuant to a framework contract). 

179. See id. arts. 25(1), 26(2), 30(1), 31(2) (disclosure requirements). 

180. Id. art. 38. 

181. Id. 

182. Id. 

183. Id. Quare as to whether these requirements are specific enough to guide payment service 

providers as to what they ought to do. 



from a payer to a payee . . ."; this includes both payer-initiated "credit-push" and 

payee-initiated "debit-pull" transfers." Article 41. however equates authorization 

only with the payer's consent, which is obviously required also for "debit-pull" 

withdrawals by the payee from the payer's account. Arguably, then, Chapter 1 is 

concerned only with the payer's authorization, for payment transactions initiated by 

either the payer or the payee. 

Article 42 envisages that an authorization for a payment transaction is to be 

subject to a procedure agreed between the payer and the payer's payment service 

provider, that it may be communicated directly to the payer's payment service 

provider or indirectly via the payee, and that it may (though not must) be 

transmitted by means of a "payment verification instrument....85 As well, 

authorization must specify the exact amount and identify the payee; it also must be 

in an amount expected from a reasonable payer in that position.' 86 

The following summary outlines the exposure to payment transactions 

purported to emanate under the authority of a payment service user as a payer: 

1.) Under Article 41, a payer is bound only for payment transactions explicitly 

authorized by him. 87 Otherwise, "a payment transaction shall be considered to be 

unauthorised." Curiously, there is no provision for implied or apparent authority.'" 

Authorization may be given either prior or subsequent to the execution of the 

payment transaction. Under Article 43, where it is transmitted by means of a 

payment verification instrument it may vary with respect to prescribed spending 

limits. 

2.) A payment service user may further be liable under Article 50(1) for the loss 

up to EUR 150 "resulting from the use of a lost or stolen payment verification 

9 

instrument' and occurring before he has fulfilled his obligation to notify his 

184. In a credit transfer, such as a direct payroll, benefit deposit, or a wire transfer, the payer's 

instructions are communicated to the payer's bank directly, so as to 'push' funds to the payee's account. 

Conversely, in a debit transfer, such as the deposit of a check for collection or the collection of insurance 

premiums, loan installments, or taxes, the payee, acting under the payer's authority, instructs the payee's 

bank to 'pull' or collect funds from the payer's account. In a credit transfer, the banking operation 

commences with a debit to the payer's account. In contrast, in a debit transfer, the banking operation 

typically commences with a credit, albeit temporary and provisional (pending collection from the payer), to 

the payee's account. See, e.g., Benjamin Geva, International Funds Transfers: Mechanisms and Laws, in 

CROSS-BORDER ELECTRONIC BANKING: CHALLENGES AND OPPORTUNITIES 1, 2-3 (Chris Reed, Ian 

Walden & Laura Edgar eds., 2nd ed. 2000). 

185. Commission Proposal, supra note 126, art. 4(17) ("'[Playment verification instrument' means any 

personalised device(s) and/or set of procedures used by the payment service user in order to enable the 

payment service provider to authenticate a payment order. If it is not provided by the payment service 

provider, the payment service provider and the payment service user may agree on the use of any other 

instrument for the authentication of payment orders which may also serve other purposes .... "). 

186. Id. arts. 52-53 (governing refund for authorized payments that do not meet these requirements, 

for other than large enterprises). Per Preamble paragraph 23, "refund rights should not affect the liability 

of the payer vis-A-vis the payee .... " Id. at 14. 

187. I follow the language of the Proposed Directive which uses "he" and "him" to include "she" or 

"her." 

188. As a matter of agency law, authority can be actual or apparent. Actual authority may be express 

or implied. See, e.g., BLACK'S LAW DICTIONARY, supra note 97, at 67, 142. 

189. A Member State may reduce that maximum amount for payment service providers authorized by 

it. Id. 



VOL. 42:685 

payment service provider" of the loss or theft. 90 Under Article 46(b), the obligation 

is "to notify . . . without undue delay on becoming aware of loss, theft or 

misappropriation of the payment verification instrument or of its unauthorised 

1 

use.'' Presumably then, the payer is not liable for loss occurring prior to learning 

the loss or theft since until then he has not been in breach of his notification 

obligation. 

3.) Notwithstanding no. 2 above, the payment service user "shall bear all the 

losses on unauthorised transactions if he incurred them by acting fraudulently or 

with gross negligence with regard to his obligations under Article 46. ' 92 It is 

noteworthy that Article 45 requires the user to keep safe security features of a 

payment verification instrument and use it in accordance with the terms governing 

its issuing and use, and to give timely notification of loss or theft. It is however not 

explicitly stated that loss caused by breach of such duties, other than that of the duty 

to promptly notify covered by Article 46(b), is to be allocated to the payment service 

user. 

4.) Under Article 49, the payment service provider is to refund the payment 

service user "forthwith" the amount of an unauthorized payment transaction; 

presumably this applies to any amount for which the user is not responsible under 

no. 2 and 3 above. The provision goes on to state: "Further financial compensation 

may be determined in accordance with the law applicable to the contract concluded 

between the payment service provider and the payment service user. 

' 

5.) Where a payment service user disputes an alleged authorization, under 

Article 48(1), "the payment service provider is to provide at least evidence that the 

payment transaction was authenticated,' 94 accurately recorded, entered in the 

95 

accounts and not affected by a technical breakdown or some other deficiency.' 

Presumably, such facts give rise to a presumption of authorization. Arguably, in this 

context, the payment service provider is to prove compliance with obligations 

fastened on him with respect to the payment verification instrument under Article 

47. These obligations are to protect the security features of a payment verification 

instrument, to refrain from sending unsolicited payment verification instruments, 

and to ensure that appropriate means are available to enable users to make 

notification. 

6.) To rebut this presumption, the payment transaction user is required under 

Article 48(2), to "provide factual information or elements to allow the presumption 

that he could not have authorised the payment transaction and that he did not act 

fraudulently or with gross negligence with regard to the obligations incumbent upon 

him ....,,196 

7.) In any event, under Article 48(3), "the use of a payment verification 

instrument recorded by the payment service provider shall not, of itself, be sufficient 

190. Commission Proposal, supra note 126, art. 50(1). 

191. Id. arts. 45(1), 46(b). However, under Article 50(4), the payment service user who has not acted 

fraudulently is dissolved of any responsibility if the payment service provider "does not provide adequate 

means for the notification ...... Id. art. 50(4). For the payment service provider's record-keeping 

obligations, see id. art. 44. 

192. Id. art. 50(2); see also id. art. 50(3). 

193. Id. art. 49. 

194. For the definition of "Authentication," see supra note 170. 


196. Id. art. 48(2). 



to establish either that the payment was authorised by the payment service user or 

that the payment service user acted fraudulently or with gross negligence .... 

Two exemptions are provided for in Article 51. First, under Article 51(2), 

protections against unauthorized use are limited in the case of e-money. 

Particularly, responsibility for unauthorized use continues notwithstanding of giving 

notice of theft or loss, as long as payment service provider is technically incapable to 

freeze or prevent further spending of the e-money stored on the electronic device. 

Second, Article 51(1) exempts large enterprises " ' from Articles 49-50, dealing with 

respective liabilities of provider and user for losses in respect of unauthorized 

payment transactions. The exemption is however unclear and not self-explanatory. 

So far as Article 49 is concerned, does the exemption mean that large enterprises are 

not entitled to a refund for unauthorized payments? This is absurd. Does it only 

mean they are not entitled to refund "forthwith"? Exemption from Article 50 is 

even more enigmatic; does it mean that large enterprise is released from the EUR 

150 minimum liability for no-fault unauthorized use? Presumably, per Preamble 

Paragraph 22, the intent has been to exempt large enterprises from the entire 

unauthorized use loss allocation scheme, "since such enterprises are normally in a 

position to assess the risk of fraud and take countervailing measures."' 9 Arguably, 

the theory may also be that large enterprises are in a position to bargain with 

payment institutions for a favorable loss allocation scheme. 

Chapter 2 of Title IV, consisting of Articles 54-74 deals with various aspects 

relating to the execution of a payment transaction. It is divided to three Sections. 

Section 1, consisting of Articles 54-58, deals with payment orders, fees, and amount 

transferred. Section 2, consisting of Articles 59-64, deals with execution time. 

Section 3, consisting of Articles 65-70, deals with availability of funds and liability. 

For all these stages and aspects, the point of acceptance is of fundamental 

importance. Section 1 identifies for a payment order, the point of both the loss of its 

revocability by the payment service user, 2°° as well as arguably, of the loss the refusal 

right by the payment service provider."" Either loss occurs upon the acceptance by 

the payment service provider. As well, as will be seen further below, under Section 

2, permissible execution time is as of the acceptance of the payment order. Finally, 

under Section 3, upon acceptance, a payment service provider incurs strict liability 

for non-execution or defective execution. 

"Acceptance" is, however, not defined; presumably it denotes the binding 

agreement of the payment service provider to carry out the payment order, which, in 

turn, is defined in Article 4(10) to mean "any instruction by a payer or payee to his 

payment service provider requesting the execution of a payment transaction." 

Under Article 54, acceptance of a payment order covered by a payer's authorization 

197. Id. art. 48(3). 

198. Defined by reference to Articles 1 and 2(1) and (3) of Title I of the Annex to Recommendation 

2003/361/EC. Id. art. 51(1). 

199. Id. at 14. 

200. See id. art. 56 ("[T]he payment service provider and the payment service user may agree on a 

date of irrevocability that falls within the three working days preceding the point in time of acceptance for 

the order."). 

201. See Commission Proposal, supra note 126, art. 55 (providing some limits and requiring prompt 

advice "in any case, within three working days" of the refusal and related information). Unlike Article 56. 

Article 55 is not explicit as to the loss of the right of refusal upon the acceptance of the payment order. 



VOL. 42:685 

may not occur prior to its receipt, complete authentication, 2 ° and the explicit or 

implicit acceptance of the obligation to execute the payment transaction ordered, by 

the payment service provider. Making acceptance contingent in part on the 

occurrence of explicit or implicit acceptance is however an awkward way to state 

that acceptance may be either explicit or implicit; the provision thus goes on to state 

that acceptance (whether explicit or implicit) may not occur prior to the receipt of 

the payment order and its authentication. Article 54(1) further states that 

acceptance "shall not be later than the point in time when the payment service 

provider starts to execute the payment transaction"; presumably then, the 

commencement of "execution" is the mode par excellence for an implicit acceptance. 

Further under Article 54(2), where the payment transaction is "electronically 

initiated, 2 °3 the payment service provider is to inform the payment service user of 

the acceptance, "without undue delay and, in any case, before the end of the next 

working day after the point in time of acceptance .... ,2 Such notice is however to 

be given after the acceptance, and is not part of the acceptance itself. 

For an intra-Community transfer, and in the absence of currency exchange, fees 

are to be charged to each payment service user only by his payment service provider; 

intermediaries are precluded from deducting fees from the amount transferred. 

Section 2, consisting of Article 60-64, deals with execution time. Article 59 

states that the Section applies "only if the payment service providers of both the 

payer and the payee are located in the Community" and not to apply to micro 

payments, presumably, those of EUR 50 and below. 2 0 6 Limits are set for both payer 

and payee initiated payment transactions; per Article 64 such limits may be 

shortened for "purely national payment transactions., 20 7 

For both payment transactions initiated by the payer and payment transactions 

initiated by or through the payee, under both Articles 61 and 62, execution is to be 

completed not later than at the end of the first working day following the point of 

time acceptance. Execution is completed typically by having the amount credited to 

the payee's account, and in the case of a payment transaction initiated by or 

through the payee, also by having the funds made available to the payee. 2 9 

Unfortunately, there is no provision explicitly linking the completion of the 

execution of a payment transaction initiated by or through the payee with the 

posting of an irrevocable and final debit to the payer's account. 

In any event, this one-day time limit for the execution of a payment transaction, 

rationalized on the need "to improve the efficiency of payments throughout the 

Community," 2 ' ° is, however, partially compromised as follows: 

202. For the definition of "Authentication," see supra note 170. 

203. Neither execution nor electronic initiation is defined. 


205. See id. arts. 57-58. 

206. Id. art. 59; see supra notes 154, 183-183 and accompanying text. 


208. Though, per Article 62, the deadlines remain effective even in the absence of payee's payment 

account with the payment service provider. Per Article 63, the one-day execution deadline also applies to 

credit given for cash deposits by the payment service user to his own account. 

209. Stated otherwise, provisional credit will not satisfy the deadline requirement. 

210. Id. at 15. 



For payment transactions initiated by the payer, "up to I January 2010, a payer 

and his payment service provider may agree on a period no longer than three 

days." , 2 1 

For payment transactions initiated by the payer, and for all payment 

transactions initiated by or through the payee, an explicit agreement between the 

initiator and his payment service provider may agree on a longer (or in theory, 

shorter) execution period. 

For a payment transaction initiated by or through the payee, his payment 

service provider has the option of refusing to release the funds to the payee, but is to 

inform the payee of the refusal within the time for execution. Presumably, this is 

designed to provide for the case of dishonor by the payer's payment service 

provider. 

Section 3, consisting of Articles 65-70, deals with funds availability and liability. 

So far as liability is concerned, it covers misdescription of payee and liability for nonexecution 

or defective execution. 

In principle, under Article 65, funds are to be become available to the payee, at 

no additional fees, as soon as they are credited to the payee's account. No provision 

is made for provisional credit to the payee's account in connection with debit-pull 

transfers initiated by the payee. Similarly, funds cease to become available to the 

payer once they are debited to the payer's account. The point in time at which an 

account is debited or credited is respectively the debit value date for the payer's 

payment account and the credit value date for the payee's payment account. 212 

Article 66(1) appears to protect a payee's payment service provider that 

executed a payment order "in accordance with the unique identifier" 3 provided by 

the user." ' An account number, or more specifically an IBAN, 2 5 specified as the 

unique identifier "take[s] precedence over the name of the payee if it is provided 

additionally. 216 These absolute statements are however immediately qualified, since 

the payment service provider is required "where possible" to verify the consistency 

of the account number with the name. Certainly, the provision is not to be taken to 

protect a service provider that either neglected that duty or that credited an account 

knowing it does not belong to the named payee." 7 

Under Article 66(2), "If the unique identifier provided by the payment service 

user is incorrect, the payment service provider shall not be liable for the nonexecution 

or defective execution of the transaction." It is not clear however whether 

"incorrect" includes "inconsistent" under Article 66(1) and if so what effect has the 

verification duty as well as its fulfillment on the defense available to the service 

provider under Article 66(2). In any event, notwithstanding this defense, a payment 

service provider that misdirected payments on the basis of an incorrect unique 

identifier is required to "make a bona fide effort to recover the funds involved in the 

211. Id. art. 60(1). 

212. Id. art. 65. 

213. See supra note 168 and accompanying text (defining "unique identifier"). 


215. IBAN is an acronym for the International Bank Account Number. Id. art. 4(15). 

216. Id. art. 66(1). 

217. id. art. 66. 



VOL. 42:685 

payment transaction." 2 8 No provision is made for errors in the amount of a payment 

transaction. 

Subject to that, under Article 67, upon acceptance, a payment service provider 

incurs strict liability "for the non-execution or defective execution of a payment 

transaction" that cover also additional fees and interest charges. Per Article 69, 

additional compensation under national law applicable to the contract between the 

payment service provider and user is not precluded. There is, however, no provision 

for privity nor for its dispensation; no chain of liability is provided for so that it is not 

clear who is liable to whom. There is also no express provision for money-back 

guarantee, namely, for the refund obligation of the payer's payment service 

provider, in case execution has not been properly completed. At the same time, 

liability is excused under Article 70 in case of force majeure or "where a payment 

service provider is bound by other legal obligations expressly covered by national or 

Community legislation, such as money laundering and anti-terrorist financing 

provisions. '' " 9 Under Article 68, where the payment service provider of the payee is 

not located in a Member State, "the payment service provider of the payer shall be 

liable for the execution of the payment transactions only until the funds reach the 

payee's payment service provider."" 2 Quare as to the scope of the responsibility of 

the payer's payment service provider beyond that point, in the case in which the 

payee's payment service provider is located in a Member State. It may also not be 

clear as to whether in any event the payer's payment service provider's responsibility 

under Article 67 amounts to a money-back guarantee. At least so far as the second 

question is concerned, the language appears to be broad enough to cover an 

unlimited money-back guarantee obligation of the payment service provider of the 

221 

payer. 

Chapter 3 of Title IV dealing with data protection consists exclusively of Article 

71 which permits the processing of personal data by payment systems and payment 

service providers "when this is necessary to safeguard the prevention, investigation, 

2 

detection and prosecution of payment fraud. The effect is to provide for an 

exemption from rules governing data protection. 

Finally, Chapter 5 of Title IV, consisting of Articles 72-75, deals with penalties 

and dispute settlement. It provides a framework for setting up complaint 

procedures, penalties for violations, enforcement by competent authorities, and outof-court 

redress. 

218. Id. art. 66(2) 

219. Id. art. 70. 

220. Id. art. 68. 

221. This is to be contrasted with the 12,500 limit to the qualified money-back guarantee obligation 

under Council Directive 97/5, art. 8, 1997 O.J. (L 43) 25. On its treatment of the money-back guarantee, 

see Benjamin Geva, Cross-Border Credit Transfers in Euros: Legal and Operational Aspects, in 

YEARBOOK OF INTERNATIONAL FINANCIAL AND ECONOMIC LAW 173, 173-98 (Joseph J. Norton ed.. 

1999). 


223. The provision goes on to require processing to be carried out according to Directive 95/46. 

Council Directive 95/46, 1995 O.J. (L 281) 31. 



E. Final Remarks 

Purporting to facilitate the establishment of a Single Payment Market where 

improved economies of scale and competition would help to reduce costs of the 

payment system, the Commission proposed to establish a common framework for 

the Community payments market, creating the conditions for integration and 

rationalisation of national payment systems. Focusing on electronic payments, the 

Commission made a proposal for a Directive on payment services in the internal 

market, designed to provide for a harmonised legal framework. Intended to leave 

maximum room for self-regulation of industry, the Proposed Directive purports to 

harmonise only what is necessary to overcome legal barriers to a Single Euro 

Payment Area (SEPA). 

However, in the final analysis, steps taken towards Pan-European common 

legal principles are quite modest. Payment amount ceilings and a narrow range of 

selected topics, primarily focusing on the payer-bank and payee-bank relationships, 

resulted in a scheme whose scope and contents cannot be compared for example to 

of UCC Article 4A. Arguably, too much room was left for national general laws to 

fill in blanks. Nevertheless, the proposal goes beyond consumer aspects. As for 

payment transactions covered, besides credit transfers, the proposal covers debit 

transfers. Its solutions are reasonable in meeting the needs of the various 

participants. Hence, the proposal is a noteworthy milestone in the march to a 

comprehensive payment law. There is however still a long way to go to such a final 

destination. It remains to be seen how much will and determination exist to go 

further, and if so, how far. 

VI. CONCLUSION 

The four topics covered in this survey are the transformation of the check 

payment into an electronic funds transfer, the payroll card as an access and not 

stored-value device, the emergence of indirect holding for securities and the ensuing 

evolution of "security entitlement" as a principal form of investment property, and 

the march towards a Pan-European common payment law covering electronic retail 

funds transfers. A common theme is the adaptation of the law by statute to 

accommodate the world of electronic banking as it keeps evolving. 

Regarding the electronic presentment of checks, Canada did not proceed to 

adopt the proposal of the Canadian Payments Association discussed in Part II.D. 

Rather, it amended the Bills of Exchange Act 24 to permit... a bank to present for 

payment an "official image" of an "eligible bill", 26 including a check, "electronically 

in accordance with by-laws, rules or standards made under the Canadian Payments 

224. Section 398 of An Act to amend the law governing financial institutions and to provide for 

related and consequential matters S.C. 2007, c. 6, which received Royal assent on March 29, 2007. Section 

398 came into force April 20, 2007. It adds Sections 163.1-163.6 to the Bills of Exchange Act, note 41, 

supra. Unless indicated otherwise, statutory references in this Addendum are to the Bills of Exchange Act 

as amended. 

225. New Section 163.3. 

226. Defined in New Section 163.1 as: "a bill that is of a class specified by a by-law, a rule or a 

standard made under the Canadian Payments Act." 



VOL. 42:685 

Act" in which case the requirements of the Bills of Exchange Act respecting the 

presentment for payment of the check "are deemed to have been complied with." 

An "official image" is defined in New Section 163.1 as: 

"an image of [an] eligible bill created by or on behalf of a bank in 

accordance with bylaws, rules or standards made under the Canadian 

Payments Act, together with any data in relation to the eligible bill 

prepared in accordance with those. by-laws, rules and standards, and 

includes a display, a printout, a copy or any other output of that image and 

that data created by or on behalf of a bank in accordance with those bylaws, 

rules and standards. " 

An official image of a check "may be dealt with and used for all purposes as 

though it were the [check]"; 27 together with the check it is discharged "if payment in 

due course is made by or on behalf of the drawee after the electronic presentment 

for payment of the official image.. . '' 22 . An official image further benefits from 

presumptions of authenticity 229 and of being a true and complete copy of the original 

check; 23° it is also admissible in evidence. 2 1 ' A properly destroyed check, for which 

there is an official image, is not considered lost, materially altered or intentionally 

cancelled; its lawful destruction does not affect the rights, powers, duties and 

liabilities of any person, by virtue of lack of possession or otherwise. 32 

Finally, a bank that creates an official image warrants its authenticity, accuracy, 

and compliance with all requirements and is liable for damages suffered by any 

person as a result of the breach of this warranty. 233 

The new provisions do not cover electronic presentment made outside the 

check clearing system operated by the Canadian Payments Association. 


228. New Section 163.3(2). 

229. New Sections 163.4(1) 

230. New Section 163.4(3). 

231. New Section 163.4(2) 




Secured Lending and Its Poverty Reduction 

Effect 

BORIS KOZOLCHYK* 

SUMMARY 

I. THE ECONOMIC EFFECTS OF COMMERCIAL SECURED LENDING ................. 728 

II. POVERTY, MICRO, CONSUMER AND COMMERCIAL CREDIT ......................... 729 

A. Micro-Credit and Its Non-Title Collateral ................................................ 730 

B. Commercial Lending and the Self-Liquidating Loan .............................. 732 

1. Key Features of Commercial Collateral and the Immateriality of 

Its T itle ................................................................................................... 7 3 2 

C. Commercial Lending and Debtor and Creditor Protection .................... 736 

III. CULTURAL AND LEGAL FACTORS .................................................................... 737 

A. The Relative Importance of Legal Title ..................................................... 737 

B. Duties Toward Family, Friends, and Strangers ........................................ 739 

C. The Legal Protection of Strangers or Third Parties and the Credit 

M arketp lace ................................................................................................. 741 

1. The Wrong Choice of Protected Third Parties ................................. 741 

2. The W rong Choice of Protection ........................................................ 742 

3. Factors in the Choice of the Right Third Parties and Their 

P rotection .............................................................................................. 743 

IV. 

LEGAL FACTS OF SECURED LENDING AND THEIR GUIDING PRINCIPLES....744 

A. The Universality of Effective Secured Lending Practice and Its 

P rin cip les ...................................................................................................... 744 

B. The N L CIFT Principles .............................................................................. 745 

President and Director, National Law Center for Inter-American Free Trade (NLCIFT), Evo 

DeConcini Professor of Law, James E. Rogers College of Law, University of Arizona. This Articleoriginally 

intended for presentation to the International Academy of Commercial and Consumer Law 

August 2006 meeting in Austin, Texas-was enlarged to incorporate portions of the Author's keynote 

address to the November 16, 2006 Federal Reserve Bank of Atlanta (Miami, Florida) forum, "Latin 

America Looks East - Issues, Trends, and Progress in the Global Economy." The Author gratefully 

acknowledges research materials provided by Wade Channell, Esq. (Senior Legal Advisor to USAID), and 

the editorial and research assistance of his NLCIFT colleagues, Kevin O'Shea, J.D.; Dr. Mariana Silveira; 

Mina Goldberg; Marek Dubovec, L.L.M.; and Lic. Joaquin Picado, L.L.M. candidate, Professor of Law at 

the University of Costa Rica Law School and Member of the Costa Rican Bar Association. 



VOL. 42:727 

V. CONCLUSIONS AND A CORRECTIVE STRATEGY .............................................. 748 

I. THE ECONOMIC EFFECTS OF COMMERCIAL SECURED LENDING 

Commercial loans (also known as secured loans or as secured transactions) are 

loans particularly suited to satisfy the credit needs of small- and medium-sized 

enterprises. While their key features will be described in detail in the following 

sections, their economic significance must be appreciated from the outset. Because 

secured lending reduces commercial risks, it increases the borrowers' access to credit 

and lowers the rates of interest. The role that the risk of non-payment plays as a 

component of the rates of interest is apparent in a 1999-2000 study by the Central 

Bank of Brazil: 1 One-third of the approximately forty percent per annum interest 

rate paid at that time by Brazilian commercial borrowers was attributable to the 

legal uncertainties of collection. 2 

On the other hand, World Bank studies demonstrate that in a competitive 

lending environment, the risk reduction that results from adopting an effective 

secured lending system can be passed on as savings to the borrower in the form of 

lower interest rates. For example, in Albania, adoption of a modern secured lending 

system in 2001 reduced risk premiums by half and lowered interest rates by five 

percentage points, while in Romania, the rate of interest dropped by twenty percent 

since the new system was introduced in 2000.' Similarly, Mexico's 2003 amendments 

to its secured transactions law, which reduced some of the risks of collection, helped 

its economy grow "at a 4% rate during 2004 and ... all credit sectors are growing at 

an annual rate exceeding 20%."' Speaking to a bankers' meeting in 2005, Alfonso 

Garcfa Tames, then Mexico's Deputy Secretary of the Treasury, noted that: 

Commercial credit showed a favorable rate of growth during the last 

three trimesters of 2004. In fact, between 2003 and 2004, the increase in 

1. Departamento De Estudios E Pesquisa, Banco Central Do Brasil, Juros e Spread Bancdrio no 

Brasil (1999-2000) [hereinafter Central Bank of Brazil Study]. 

2. Id. 

3. See generally Mehnaz Safavian, Heywood Fleisig & Jevgenijs Steinbuks, Unlocking Dead Capital: 

How Reforming Collateral Laws Improves Access to Finance, 307 WORLD BANK PUB. POL'Y J., Mar. 2006, 

available at http://rru.worldbank.org/documents/publicpolicyjournal/307Safavian-Fleisig-Steinbuks.pdf; see 

also Wade Channell, Presentation at the Annual Conference of the Economic Freedom of the World 

Network, Nov. 2-5, 2006, Costa Rica, Freedom to Pledge: Expanding the Realm of Property Rights for 

Increased Access to Credit (Nov. 3, 2006), available at http://www.inlap.org/efn/Papers/Wade%20Channell-- 

paper.htm. 

4. Bancos prevgn expansi6n sostenida del crdito en Mxico, REUTERS, Mar. 3, 2005. The article 

states: 

ACAPULCO, M6xico (Reuters) - El cr6dito bancario volverfa a crecer cerca de 25 por ciento 

en el 2005 en M6xico, por encima de las expectativas iniciales de la banca y apoyado en la 

expansi6n de la economia local, estim6 el jueves Manuel Medina Mora, presidente de la 

Asociaci6n de Bancos de M6xico (ABM). La economia mexicana creci6 4.4 por ciento en el 

2004 .... "Se sigue acelerando el crecimiento del cr6dito y creemos que dada la expansi6n 

econ6mica de nuestro pais, podemos esperar crecimientos importantes," dijo Medina Mora en 

rueda de prensa, durante la 68 Convenci6n Bancaria en el balneario de Acapulco, que organiza 

la ABM. "Por primera vez en una d6cada crecen todos los circuitos de cr6dito y todos por 

encima del 20 por ciento .... Cada mes, el crecimiento porcentual es mayor," ahiadi6. 


2007 

SECURED LENDING AND ITS POVERTY REDUCTION EFFECT 

this portfolio was 16.8% in real terms. In turn, the credit to consumers 

also showed great dynamism, with annual rates of growth of 38.6% in the 

last four years. In the last trimester of 2004, the percentage of real 

growth was 41 percent in relation to the growth during the same 

trimester in the preceding year. 

These findings were consistent with the studies by another World Bank economist 

who estimated that the absence of commercial credit amounts to a loss of three to 

nine percent of a Latin American country's GDP. 6 

The effects of a sound secured lending law are felt also in other economic 

sectors beyond those traditionally associated with small- and medium-sized 

commerce, such as in the securitization of the revenues derived from constructionand 

especially housing projects. This type of financing is made possible by the sale in 

secondary markets of low- and middle-income housing mortgages and deeds of trust. 

Hence, it contributes hundreds of billions of dollars of construction financing 

annually to the economies of the United States and other developed nations, 

especially in Europe. Directly or indirectly, securitization relies on the personal 

property security afforded by the possession of documents that incorporate 

creditors' (security holders') rights in the underlying properties. 

II. 

POVERTY, MICRO, CONSUMER AND COMMERCIAL CREDIT 

From an economic development standpoint, poverty has been defined as a 

"lack of access to essential goods, services, assets and opportunities to which every 

human being is entitled." 7 Having lived among many who have experienced it 

firsthand, I would add despair and distrust for social institutions as predominant 

feelings among the poor. Unfortunately, those who experience such feelings have 

little impetus for self-improvement. What is even more unfortunate is that despair 

5. Alonso Garcia Tames, Mexico Deputy Secretary of the Treasury, Versi6n Estenogrifica de la 

Mensaje del Act. Alonso Garcia Tamds, Subsecretario de Hacienda y Cr6dito Ptiblico, Durante la 

Ceremonia de Clausura de la 68 Convenci6n Bancaria, Efectuada en el Sal6n de Sesiones del Hotel 

Acapulco Princess (Mar. 4, 2005) (transcript available at 

http://www.natlaw.com/interam/mx/bk/sp/spmxbkl2.pdf). The article states: 

El crddito comercial vigente mostr6 un crecimiento favorable durante los tOltimos tres 

trimestres de 2004. De hecho, entre 2003 y 2004 el incremento de esta cartera fue de 16.8 por 

ciento en t6rminos reales. Por su parte, el crddito al consumo ha presentado un gran 

dinamismo, con crecimientos anuales en promedio del 38.6 por ciento en los tjltimos cuatro 

afios. En el tercer trimestre de 2004, el crecimiento de esta cartera fue de 41 por ciento en 

t6rminos reales con relaci6n al mismo trimestre del afio anterior. Por otra parte, el cr~dito 

hipotecario present6 al cierre de 2004 un crecimiento anual real de 4.8 y 24.5 por ciento sin 

considerar la cartera asociada a programas de reestructura. 

Id. at4. 

6. See Heywood W. Fleisig, Assessing the Economic Cost of Deficiencies in the Framework for Secured 

Transactions: Examinations of Argentina and Bolivia (Center for Economic Analysis of Law, Working 

Paper, 1996) [hereinafter Fleisig, Assessing the Economic Cost of Deficiencies], available at 

http://www.ceal.org/ceal-org/working.asp; Heywood Fleisig, Secured Transactions: The Power of Collateral, 

FIN. & DEV., June 1996, at 44, available at http://www.imf.org/external/pubs/ft/fandd/1996/06/pdf/fleisig.pdf. 

7. Asian Development Bank, Enhancing the Fight Against Poverty in Asia and the Pacific: The 

Poverty Reduction Strategy of the Asian Development Bank 1 (2004), available at 

http://www.adb.org/Documents/Policies[Poverty-Reduction/2004/prs-2004.pdf. 



VOL. 42:727 

and distrust need not prevail. Even if poverty may never be completely eradicated, 

it can be significantly alleviated by legal institutions that make it possible for micro-, 

small-, and medium-sized businesses to obtain commercial and consumer credit at 

reasonable rates of interest. 

A cursory review of recent literature of economic development reveals hopeful 

signs. For example, a December 2004 study by the Asian Development Bank 

(ADB) identified rapid, broad-based economic growth as the single most important 

factor in attaining poverty reduction. 8 It showed that business growth, in particular, 

increases the demand for labour and the level of wages-further reducing poverty. 

Similarly, properly financed opportunities for self-employment have been proven to 

make an important contribution to poverty reduction. 9 

The above study is one among many serious economic and social science 

analyses conducted by various research institutions in the last two decades. They 

have confirmed that access to commercial and consumer credit is one of the essential 

elements of business and economic growth. Thus, it is becoming increasingly clear to 

economists and social scientists that the availability of commercial credit to smalland 

medium-sized merchants and their customers not only boosts overall economic 

growth (as reflected in significant gains in GDP), but it also reduces poverty. '° 

Accordingly, a 2004 World Bank study, using a broad cross-country sample, 

concluded that: "Financial intermediary development reduces income inequality by 

disproportionately boosting the income of the poor and therefore reduces poverty."" 

A. Micro-Credit and Its Non-Title Collateral 

Some of this intermediation is attributable to "micro-credit," a credit that 

enables individuals in the lowest income sectors of the economy to run very small 

businesses-micro-enterprises-that, in turn, increase household income and assets. 

Thus, micro-enterprise programs become effective fighters of poverty, and one of 

these programs has recently been rewarded with a Nobel Prize for its success in 

stemming despair and starvation in Bangladesh 2 In a nutshell, these programs 

8. Id. at 6. 

9. See id. 

10. Fleisig, Assessing the Economic Cost of Deficiencies, supra note 6 (estimating the GDP 

improvement up to nine percent). 

11. See Thorsten Beck, Asti Demirgtiq-Kunt & Ross Levine, Finance, Inequality and Poverty: Cross- 

Country Evidence (World Bank Policy Research Working Paper No. 3338, June 2004), available at 

http://www.econ.worldbank.org (follow "Research Website" hyperlink; follow "Working Papers" 

hyperlink; and then search by paper no.). According to these authors, "a broad sample of 52 developing 

and developed countries, with data averaged over the period 1960 to 1999" establishes a direct relationship 

between "financial intermediary development and changes in income distribution." Id. at 3. They add 

that: 

This relationship is crucial in understanding the linkage between financial development and 

poverty alleviation since poverty reduction in any given country is determined by the growth of 

mean income and changes in income distribution. Given that there is already significant 

evidence that financial development is pro-growth, we seek to determine whether financial 

development is also pro-poor. By pro-poor, we mean does financial development significantly 

improve income distribution by disproportionately boosting the incomes of the poor? 

Id. 

12. See U.S. Agency for International Development (USAID), Accelerated Microenterprise 


2007 


make "'cashew shellers in Senegal, avocado growers in Kenya, makers of hand-made 

paper in Bangladesh, and street vendors in Mexico less vulnerable to devastating 

crises. 

' 

Micro-credit does not rely on the borrower's title to his or (more frequently) 

her assets as collateral or as a source of repayment to the lender. It relies on the 

borrower's appreciation of the importance of the loan and corresponding willingness 

to repay it. Appreciation and willingness are such that many borrowers are often 

willing to cover for each other's liabilities. 4 Yet, micro-entrepreneurs operating in 

the large informal economy-including many businesses owned by women-lack 

adequate financing to grow once their enterprise can start employing more than a 

handful employees. As a result, micro-enterprises "have less of an impact on 

economic growth than they might otherwise have."'" 

Significantly, where commercial credit is available to small- and medium-sized 

enterprises, micro-enterprises can also become its beneficiaries and poverty is 

thereby further alleviated. As shown by the above-referenced World Bank Study, 

"the income of the poorest quintile grows faster than average GDP per capita in 

countries with better-developed financial intermediaries" (i.e., commercial or 

"mainstream" lenders). 6 What is more, "income inequality ... falls more rapidly in 

countries with higher levels of financial intermediary" lending." Not surprisingly, 

then, countries with developed financial intermediaries experience larger reductions 

in infant mortality and lesser reliance on child labor. 8 Hence, as concluded by 

another World Bank economist, microfinance and finance of small- and mediumsized 

businesses are complementary, rather than competing, alternatives, especially 

when addressing the problem of poverty." 9 

Advancement Project (AMAP), Poverty Assessment Tools, http://www.povertytools.org (last visited Apr. 

18, 2007); see also Grameen Website, www.grameen-info.org (last visited Apr. 18, 2007) (on the work of 

the 2006 Bangladeshi Nobel Prize-winning economics professor and banker Mohammed Yunnus who won 

the Nobel Peace Prize and whose methods have been used in fifty-eight countries). 

13. IRIS Center, IRIS Helps Ensure that Microenterprise Funds Reach the Very Poor (2005) (quoting 

Dr. Thierry van Bastelaer, Director, IRIS Center's Enterprise Development Group), available at 

http://www.iris.umd.edu/Reader.aspx?TYPE-HTMLARTICLE&ID=b7fd59e-9651-4696-accb- 

070fa88969f8. 

14. See Rania El Gamal, Microfinance: Fighting World's Poverty Through Investment, KUWAIT 

TIMES, June 12, 2006, available at http://www.businessdayonline.com/?c=44&a=7017. 

15. Removing Obstacles for African Entrepreneurs Before the Subcommittee on Africa, Global Human 

Rights and International Operations of the Committee on International Relations, 109th Cong. 3 (2006) 

(prepared statement of Christopher H. Smith, Chairman, House Subcommittee on Africa, Global Human 

Rights and International Operations), available at 

http://www.internationalrelations.house.gov/archives/109/27989.pdf. 

16. Beck, Demirgiiq-Kunt & Levine, supra note 11, at 4. 

17. Id. 

18. Id. at 12 (concerning infant mortality); id. at 4 (concerning child labor, which refers to the World 

Bank's recent work that analyzes the link between financial development and child labor). 

In a cross-country sample, Dehejia and Gatti (2002) find that the incidence of child labor is 

lower in countries with greater financial depth and that financial deepening dampens the 

impact of income volatility on child labor. Similarly, using a panel dataset of Tanzanian 

households, Beegle, Dehejia and Gatti (2003) find that child labor is used to buffer transitory 

income shocks less when households have access to credit. 

Id. at 5. 

19. Patrick Honohan, Financial Sector Policy and the Poor: Selected Findings and Issues 30-33, 43-44 



VOL. 42:727 

B. Commercial Lending and the Self-Liquidating Loan 

Unlike micro-credit, commercial lending enables the "mobilization" of the 

debtor's assets as collateral and thereby facilitates repayment. This method of 

lending-institutionalized in eighteenth century England" 0 and fully developed in the 

twentieth century United States-stands in sharp contrast to the lending methods 

that prevail in most developing nations. 2 ' In these nations, the debtors' assets are 

pledged and immobilized either by the creditors' possession or by their "safe" 

storage with third parties. Once immobilized, the release of these assets for resale, 

re-pledge, or transformation is only possible upon full repayment of the debt. In 

contrast, the Anglo-American commercial lending practice relies upon the 

mobilization of the assets by allowing the debtor to remain in possession of these 

assets and authorizing their use, transformation, exchange, or sale, thereby enabling 

the "self-liquidation" of the loan. As stated by the NLCIFT's First Principle of 

Secured Transactions Law in the Americas, and as implicit in the OAS Model Law 

and the Latin American statutes and legislative drafts inspired by these principles: 

Secured commercial and consumer credit is an effective tool for economic 

development because it allows the debtor's use, transformation, sale or 

barter of collateral (mobilization). The mobilization of these assets 

leading to their sale or disposition makes possible the payment or selfliquidation 

of the loan ... 22 

1. Key Features of Commercial Collateral and the Immateriality of Its Title 

Because of the self-liquidating nature of the commercial loan, its collateral has 

peculiar features. Firstly-and in contrast with the collateral in a home mortgage, 

(World Bank, Working Paper No. 43, 2004), available at 

http://wwwl.worldbank.org/finance/assets/images/0821359673-Financial-Sector-Policy-and-the Poor.pdf# 

search=%22%22Financial%20Sector%20Policy%20and%20the%2OPoor%22%22. 

20. The view of commercial loans (extended to "able" men) as self-liquidating, and of retail trade and 

consumption loans as dependent upon the honesty of "good" men, which became part of the Bank of England's 

credit policies, was articulated in the following excerpt: 

There are Two sorts of Credit; the one, is Grounded upon the Ability of the Buyer the other, 

upon the Honesty: The first is called a Good Man, which implys an Able Man he generally 

buys upon short Time; to pay in a Month, which is accounted as ready Mony, and the Price is 

made accordingly. The other is accounted an Honest Man; He may be poor; he Generally buys 

for three and Six Months or longer, so as to pay the Merchant by the Return of his own Goods; 

and therefore, the Seller relys more upon the Honesty of the Buyer, than his Ability: Most of 

the Retail Traders buy upon this Sort of Credit, and are usually Trusted for more than double 

they are worth. 

NICHOLAS BARBON, A DISCOURSE OF TRADE 19 (Jacob H. Hollander ed., Lord Baltimore Press 1905) (1690). 

21. See generally Boris Kozolchyk & Dale B. Furnish, The OAS Model Law on Secured Transactions: 

A Comparative Analysis, 12 Sw. J. L. & TRADE AM. 235 (2006). For an analysis of the status of law and 

lending practice in Latin America, and for surveys of the law and practice in other regions, see Safavian, 

Fleisig & Steinbuks, supra note 3. See also Channell, supra note 3. 

22. See National Law Center for Inter-American Free Trade, 12 Principles of Secured Transactions 

Law in the Americas, princs. 1 (2006) [hereinafter NLCIFT Principles], available at 

http://www.natlaw.com/bci9.pdf. 


2007 


which is immobile, long-lasting, and retains or increases its value during the life of 

the loan-the collateral of a commercial loan is mobile, perishable, and usually 

depreciates quickly in value. Consequently, and secondly, any moveable (tangible or 

intangible) object with sufficient market value to facilitate quick repayment of a 

commercial loan by its transformation, exchange, or resale can be collateral. 

Contrast this open number (numerus apertus) feature of commercial lending with the 

prevailing restrictive or closed number (numerus clausus) approach to collateral that 

prevails in developing countries. 23 Thus, as pointed out by Safavian and Fleisig, 

Nigeria (among many other developing nations) recognizes only ten percent of the 

types of assets used in the United States as acceptable security for a loan. 24 

Thirdly, this open-numbered collateral can secure the loan of not one but many 

possible creditors simultaneously and successively. Consider, for example, the case 

of a retail merchant who seeks credit to purchase inventory goods such as shirts. 

These shirts, and the proceeds from their resale to the public, could be the collateral 

or part of the collateral that will secure the credit extended to him by a wholesaler or 

manufacturer, or by his bank. The proceeds of the sale of the shirts could also be 

collateral. These proceeds could be either moneys deposited in the retail merchant's 

cash register after each sale, or they could be purchase orders, invoices, checks, 

promissory notes, or credit card receipts deposited in his creditors' bank accounts, all 

as a result of daily, weekly, or monthly sales. Alternatively, they could be other 

inventory or other goods acquired as replacements for the originally-financed shirts. 

This revolving (including future-acquired) inventory and proceeds can serve as 

collateral for many creditors, with rights in them that can exist at the same time or be 

subsequently acquired. This "sharing" of present and future collateral by present 

and future creditors is possible because, from a legal standpoint, the ownership of 

the collection of goods that comprise the inventory and of their proceeds is 

fragmented into diverse possessory rights of specified scope or inclusiveness and 

duration. The enforcement of these rights requires that information be provided on 

the perfection of the possessory rights and their priorities to creditors or purchasers 

who may have an interest in relying on the same assets as collateral or in purchasing 

them. For this information to serve as effective and functional notice it must be a 

summary of the lien that is reliable, timely, and as public or widely accessible and as 

transparent as possible. Commercial and secured lending has no worse enemy than 

hidden or secret liens-i.e., rights that are either unrecorded or whose possession for 

security purposes is not apparent to a potential creditor or purchaser. Finally, 

enforcement of these possessory rights requires a quick, inexpensive, and 

extrajudicial procedure of repossession and resale. 

Let us now observe the interaction between the fragmentation of ownership of 

the collateral and the possessory and malleable nature of the creditors' rights in a 

typical U.S. financing scheme. Assume that the goods that will be manufactured will 

be the above-mentioned shirts. For ease of explanation (and contrary to what has 

become the U.S. commercial practice of outsourcing of most manual labor), let us 

23. In the Central American region, see, for example, the C6digo Civil and the C6digo de Comercio. 

See, e.g., COD. CIV. [Civil Code] art. 441 (Costa Rica) (the "traditional" or possessory pledge (prenda con 

tenencia)); COD. COM. [Commercial Code] art. 442 (Costa Rica) (the "pledge of a credit" (prenda de un 

crddito)): id. arts. 530, 533 (the "commercial pledge" (prenda comercial)); id. art. 537 ("pledge with 

dispossession" (prenda sin tenencia)); COD.CIv. arts. 880-903 (Guatemala) (the pledge (prenda)). 

24. Safavian, Fleisig & Steinbuks, supra note 3. 



VOL. 42:727 

assume that the shirts are manufactured in the United States. The manufacturer will 

need credit with which to purchase his raw materials and equipment. Accordingly, 

he will seek a loan from a bank and will grant this bank as a secured creditor a 

security interest. The security interest will typically include not only the raw 

materials and equipment but also the present and future inventory of shirts and their 

proceeds. Similarly, the wholesaler and retailers who will purchase the manufactured 

shirts from the manufacturer will need credit for their respective acquisitions. 

In each acquisition, present and future inventories as well as their proceeds will 

serve as collateral. Yet, during the time the manufacturer's shirts are being shipped 

by the manufacturer to the wholesalers or retailers, the bank that issued a letter of 

credit to pay for the shipped shirts on behalf of the wholesaler or retailer will also 

acquire a possessory right in these shirts. This security interest will be perfected by 

the manufacturer-shipper's endorsement of a negotiable bill of lading, which attests 

to shipment of the goods, to the bank that issued or confirmed the letter of credit. 

This negotiable bill of lading will be issued to the shipper by the ocean carrier in 

charge of transporting the shirts to the wholesale or retailer. In endorsing the 

negotiable bill of lading, the manufacturer-shipper is not only creating the bank's 

security interest, but is also providing notice of the existence of the security interest 

to the world at large. The reason for this notice is that by transmitting possession of 

a document that provides an exclusive right to claim the shirts from the carrier to the 

person holding the bill of lading, no one else can make such a claim. Hence, the 

bank's possession of this bill of lading will entitle it to claim the delivery of the shirts 

from the carrier with a higher priority than that enjoyed by most other claimants of 

the shirts. 

Among the claimants whose possessory rights or security interests are inferior 

to those of the bank that issued the letter of credit are: a) the sellers of the raw 

materials or equipment to the manufacturer of the shirts who are still owed part or 

all of their purchase prices, or the financiers for the manufacturer's acquisition of the 

raw materials or equipment who are still owed all or a portion of their loans; b) the 

manufacturer who is still owed the purchase price of the shirts by the wholesale 

buyer of the shirts; c) the wholesaler who is owed the purchase price of the shirts 

sold to the retailer or the wholesaler's bank, who has not been paid the amount lent 

to the wholesaler or retail merchant for their respective purchases of shirts; and d) 

the retail merchant who has paid part of the purchase price of the shirts to the 

manufacturer or wholesaler. These creditors or purchasers could not seek 

possession of the shirts or of the proceeds of their sale until the bank in possession of 

the bill of lading has been paid what it is owed for its issuance of the letter of credit. 

On the other hand, there are two claimants whose possessory right to the shirts 

is superior to that of the bank. One of these claimants is the ocean carrier who has 

not been paid his freight charges and who is still in possession of the transported 

shirts. The other claimant is the consumer-buyer of the shirts who bought them from 

the retail or wholesale merchant in the ordinary course of their respective 

businesses. Where such a buyer exists, none of the pre-existing unpaid secured 

lenders or commercial purchasers can repossess or recover the shirts from him. The 

creditors' secured claims could only be made effective against the proceeds obtained 

by the retailers, wholesalers, or manufacturers from the sales of the shirts to the 

consumers. 

The above rights to the possession of the collateral are more malleable (if not 

ephemeral) than those of a typical home-mortgagee. Moreover, the only party 


2007 


whose right to the possession of the shirt approximates the right of ownership of a 

home-mortgagor is that of the consumer-buyer in the ordinary course of business. 

Yet, unlike the home owner, the possessory right of the consumer is not the product 

of a "historical" or linear chain of transactions or being the holder of a Hernando de 

Soto's talismanic ownership document. 25 The consumer-purchaser's possessory right 

is a product of the lawmakers' decision to protect a third party who is a stranger to 

the preceding chain of transactions. Without such a protection (which means 

providing the stranger with immunity against pre-existing possessory rights), the 

viability of a marketplace whose participants are predominantly strangers would be 

undermined as they would fear buying, borrowing, exchanging, or otherwise 

participating in the marketplace. 26 

What matters in the law of commercial lending, then, is not who is the 

"historical" owner of the shirts or who is the creditor with the best chain of title to 

the shirts, but who has the best right to their possession or to their market value at a 

given point during the transactional and useful life of the shirts or of their proceeds. 

Accordingly, the "being" of rights in a collateral such as the original inventory shirts, 

which can become cash or commercial paper and reappear as tangible goods (such as 

new shirts or other inventory) or be transformed into intangible goods (such as 

accounts or wire transfers), resembles that of the river described by the Greek 

philosopher Heraclites as: "You cannot step twice into the same river, for other 

waters and yet others go ever flowing on." 27 Accordingly, when a merchant pledges 

his inventory, title to this collateral is, in the words of the Uniform Commercial 

Code, "immaterial." 28 In the final analysis, then, the meaning of collateral in 

commercial lending is not a "thing" or group of things but the right to the possession 

of what becomes a stream of income generated by the use, transformation, sale, or 

exchange of commercial assets. And by assets we mean any object, tangible or 

intangible, deemed valuable in the marketplace by those who participate in it. 

The economic and legal policies that determine who has the best right to the 

possession of that stream of income are, in the final analysis, those that make the 

river of commerce flow best by encouraging contributions to its stream. These 

contributions could be by sellers of raw materials, financiers of equipment, providers 

of services, or providers of financing with which to acquire any or all of the above 

25. See Boris Kozolchyk, A Roadmap to Economic Development Through Law: Third Parties and 

Comparative Legal Culture, 23 ARIZ. J. INT'L & COMP. L. 1 (2006) [hereinafter Kozolchyk, A Roadmap]. 

26. See Boris Kozolchyk, The Transfer of Personal Property by a Nonowner: Its Future in Light of its 

Past, 61 TUL. L. REV. 1453, 1455 (1987). 

The need to protect the bona fide purchaser who acquired from an entrusted intermediary is 

justified by market economics. Unless buyers are assured that they will not be deprived by an 

unknown owner or creditor of what they honestly acquired in the open market, they will be 

afraid to buy. On the other hand, unless the entrusting owners' expectations of recovering the 

value of entrusted property are protected, they will hesitate to entrust their property. These 

economic realities explain the apparent coexistence of the ancient Roman law maxim 'Nemo 

dat quod non habet' with the mercantilistic Bourjon principle of [possession is considered 

equivalent to a title, as found first among civil codes in] article 2279 of the French Civil Code of 

1800. 

Id. at 1455, 1455 n.4. 

27. See GREEK PHILOSOPHY AND HERACLITUS (William Harris trans., 2005) (360 BC), available at 

http://community.middlebury.edu/-harris/PhilosophyfHeraclitus.html. 

28. See U.C.C. § 9-202 (2000). 



VOL. 42:727 

items of value. The value of their contribution can be determined or ascribed by the 

lawmaker or by the parties to the loan on a quantitative or a qualitative basis, or as a 

combination thereof. It is now time to discuss the legal components of an effective 

system of secured lending. 

C. Commercial Lending and Debtor and Creditor Protection 

Fairness in the treatment of debtors and creditors is one of the most important 

components of an effective law of secured transactions. Poor debtors lack the 

bargaining power of most of their creditors and, hence, become vulnerable to 

exploitive and abusive lending practices. A lack of protection against these practices 

often leads to the debtors' insolvency and to their inability to function as productive 

members of society. Where ordinary or bona fide debtors are treated as criminals, 

the result is not only inhumane but also counterproductive-the availability of credit 

does not improve, and the cost of credit continues to climb. 29 For these reasons, 

debtor protection-particularly of those who are most vulnerable-contributes to 

the availability of credit for micro-, small-, and medium-sized businesses. 

On the other hand, since credit is only extended when lenders are willing to 

lend, adequate creditor protection is key to the availability of finance for small- and 

medium-sized businesses as well as for micro finance. In the words of Chilean 

Central Bank economic researchers who studied the effect of inadequate monitoring 

of bank loans on poorer debtors: "[Ilnefficient [creditor] legal protections, 

disproportionately increase financial restrictions for creditors that have less 

wealth." 3 The main reason for this restriction is the fixed cost of monitoring debtor 

performance by the lending banks. Because these costs are fixed and larger loans 

are more profitable, lending banks do not monitor the performance of smaller 

borrowers as carefully as they do that of their larger borrowers. Inadequate 

monitoring of small borrowers makes it easier for these borrowers to adopt riskier 

business and repayment practices. These practices, in turn, lead to a higher 

probability of insolvency. 

Likewise, inefficiencies in bankruptcy procedures have a greater effect on 

small businesses than on large ones. Using a survey of practices in sixty-two 

countries, the same Chilean researchers explored the impact of creditor protection 

on the availability of bank credit to small- and medium-sized enterprises. They 

found that better protection of all creditors reduced the financing gap between 

29. See Ley de Jurisdicci6n Constitucional No. 7135, La Gaceta No. 198, art. 113 (1989) (amended in 

La Gaceta No. 212 on Nov. 9, 1989), available at http://www.asamblea.go.cr/ley/leyes/7000/7135.doc (stating 

the reasons in favor of the abolition of Costa Rica's Civil Code's apremio corporal). 

30. Arturo Galindo & Alejandro Micco, Bank Credit to Small and Medium Sized Enterprises: The 

Role of Creditor Protection 1 (Banco Central de Chile, Working Paper No. 347, 2005), available at 

http://www.bcentral.cl/eng/stdpub/studies/workingpaperhtm/347.htm. Galindo and Micco add: 

Id. at 15. 

The degree to which smaller firms are constrained depends on the quality of the regulatory 

framework, suggesting that in countries where creditor rights are protected (and enforced), 

smaller firms have greater access to bank credit to finance investment. In our sample this effect 

is large. In common law countries (where creditor protection is high), the difference in the 

share of investment financed with bank credit between large and small firms is approximately 9 

percentage points. In non-common law countries this difference is 25 percentage points. 


2007 


small and large firms. 31 In light of the above findings, we need to examine the role of 

legal and cultural factors in making commercial and consumer credit available at 

reasonable rates of interest in developing nations. 

III. CULTURAL AND LEGAL FACTORS 

A. The Relative Importance of Legal Title 

The importance of culture in bringing about economic development has been 

questioned-if not discarded-in the influential writings of the Peruvian economist 

Hernando de Soto. 32 He points to the negative effect of legal uncertainty, especially 

with respect to land titles and other "property document[s]." 33 In his opinion, "the 

suggestion that it is culture that explains the success of such diverse places as Japan, 

Switzerland and California and culture again that explains the relative poverty of 

such equally diverse places as China, Estonia, and Baja California, is worse than 

inhumane; it is unconvincing." 3 

De Soto focuses instead on "representational systems," meaning the things or 

languages that embody legal certainty for the holder of rights, either to property or 

contractual rights, as contrasted with the culture that creates such things or 

languages. In de Soto's words: 

In the West, by contrast, every parcel of land, every building, every piece 

of equipment, or store of inventories is represented in a property 

document that is the visible sign of a vast hidden process that connects all 

these assets to the rest of the economy. . . . The single most important 

source of funds for new businesses in the United States is a mortgage on 

the entrepreneur's house." 

The preceding examination of the meaning of collateral in micro and 

commercial lending showed that title was immaterial for both loans. In the case of 

micro lending the likelihood of repayment was caused mostly by the debtors' 

appreciation of what he received and his strong desire to continue to receive this 

credit. With commercial lending, the above-quoted statement and especially "every 

piece of equipment, or store of inventories is represented in a property document" is 

equally untrue. 36 Furthermore, what prompts the lender's willingness to loan is not 

the borrower's title to the collateral, but the self-liquidating nature of the collateral 

and his right to its possession as protected by a system of public notice-regardless 

of who is or was the historical owner of the collateral. Even with respect to lending 

secured by land or real estate in Latin America and elsewhere, the role of title is not 

31. Id. at 2. 

32. See generally HERNANDO DE SOTO, THE MYSTERY OF CAPITAL: WHY CAPITALISM TRIUMPHS IN 

THE WEST AND FAILS EVERYWHERE ELSE (2000); Kozolchyk, A Roadmap, supra note 25 (discussing 

some of Hernando de Soto's writings). 

33. DE SOTO, supra note 32, at 6. 

34. Id. at 4. 

35. Id. 

36. DE SOTOsupra note 32, at 6. 



VOL. 42:727 

as necessary and sufficient as may be inferred from de Soto's writings. As concluded 

by Erica Field and Maximo Torero in their Harvard University study: 

Detailed data collected on loans from different financial institutions also 

enables us to compare the impact of title acquisition among banks with 

alternative lending strategies. We find that land titling [in Peru's land 

titling program inspired by Hernando de Soto's studies] is associated with 

a 9-10 percentage point increase in loan approval rates from the public 

sector bank for housing construction materials, while there appears to be 

37 

no effect on the loan approval rate of private sector lenders .... 

Similar studies were conducted in Argentina by Professors Sebastian Galiani 

and Ernesto Schardgrodsky. 8 These scholars found that while secure land rights 

encourage the poor to build their homes, 

even in a relatively advanced country such as Argentina, title is not 

enough in itself to animate the dead capital interred in land and property.. 

. T]he titled households enjoyed no better access to bank loans, credit 

cards or bank accounts, and only 4% of them managed to acquire a 

mortgage . 39 

Finally, an April 2006 study, The Effects on Property Titling in Langa Township 

South Africa, conducted by Karol Boudreaux of George Mason University, 

confirmed the findings of the studies conducted in Peru and Argentina, where 

commercial lending was concerned: 

Today, most homes-though not shacks-have titles. . . . Has this 

government policy led to economic growth and poverty alleviation for 

Langa's residents? The answer is a qualified yes. By creating secure 

property rights in houses, the South African government has created 

incentives for owners to improve their homes and to use them for homebased 

businesses, thus creating jobs and income in poor communities. 

However, more needs to be done. Few Langa residents use their titles as 

collateral for commercial loans, still preferring to rely on personal savings 

and savings clubs. Titling is not enough. Institutional weaknesses make 

the use of title as collateral too risky for many Langa residents . . . and 

regulatory burdens make it costly to grow and expand small businesses. ' ° 

Even if graphic representations of the rights of ownership to land carried with 

them talismanic effects causing credit and investment certainty to prevail, such 

effects were inseparable from the culture that attributed certainty to the 

37. ERICA FIELD & MAXIMO TORERO, Do PROPERTY TITLES INCREASE CREDIT ACCESS AMONG 

THE URBAN POOR? EVIDENCE FROM A NATIONWIDE TITLING PROGRAM 1 (2003) (emphasis added), 

available at http://econ.ucsd.edu/seminars/sevenssrc/FieldTorero9l4.pdf. 

38. The Mystery of Capital Deepens, THE ECONOMIST, Aug. 26, 2006, at 62, available at 

http://defeatpoverty.com/articles/Economist%20Mystery%2ODeepens.pdf. 

39. Id. 

40. KAROL BOUDREAUX, THE EFFECTS OF PROPERTY TITLING IN LANGA TOWNSHIP, SOUTH 

AFRICA (Mercatus Policy Series Policy Comment No. 4, 2006) (emphasis added) (stated in the executive 

summary). 


2007 


representation in question. Consequently, cultural-legal factors must be taken into 

account. Considering that commercial credit takes place mostly among strangers, it 

is especially important to focus on the cultural values that shape the debtors' duties 

toward creditors who are neither the debtors' family nor friends. 

B. Duties Toward Family, Friends, and Strangers 

The 1999 study of the Central Bank of Brazil estimated that one-third of the 

approximately forty percent per annum interest rate paid by Brazilian commercial 

borrowers was attributable to the difficulties and risks of loan collection and nonrepayment. 

1 This is neither an unusual finding nor a recent phenomenon, either in 

Brazil or in other Latin American countries. For example, my 1967 RAND 

Corporation study Law and the Credit Structure in Latin America showed that the 

percentages of discounted bills of exchange or drafts protested for lack of payment 

in Chile from 1958 to 1962 were, respectively, 31.5%, 26%, 34.4%, 37%, and 

39.1%.4' This meant that out of, say, one hundred negotiable and credit instruments 

in circulation in Chile in 1962, almost forty had not been paid at maturity. While 

during the same period, the protests of negotiable instruments by Argentine banks 

fluctuated between one-third and one-half of the Chilean figures, the percentages of 

the aggregate uncollected secured and unsecured loans and discounted negotiable 

instruments in Argentina (gathered under the rubric of "quasi money") were, 

respectively, 2.5%, 2.7%, 6%, 9.5%, and 22.9%. 3 In other words, of the total 

number of bank loans, direct or indirect extensions of credit, and negotiable 

instruments, as many as twenty-two percent during a peak year were in default. 

Neither creditors nor debtors are well-served by a legal culture that makes 

collection so difficult and risky for creditors and so expensive for debtors. In 

fairness, however, the fault does not lie entirely with the legal culture. Underlying 

the legal culture, there is a business culture of "winner take all, loser take none" and 

a commerce practiced as a "tricky" or "picaresque" occupation. 4 Such an attitude 

toward business has much to do with the cost of credit. The tricky or picaresque 

aspects of dealing with checks, drafts, and promissory notes as credit instruments 

were reflected in responses given to this writer by Argentine bankers and merchants 

as part of the same study. 

My first question was: "Why, if protests of negotiable instruments are so 

common and their collection so difficult, are you still willing to take checks, drafts, or 

notes in payment of what is owed to you?" In response, several of my businessmenrespondents 

referred to what they described as the "false-money psychology." This 

"psychology" encouraged taking these instruments in payment with the 

understanding that as with other "false" money, they would be passed on to 

someone else in payment of what the taker owed to them. The next, inevitable 

41. See Central Bank of Brazil Study, supra note 1. 

42. BORIs KOZOLCHYK, LAW AND THE CREDIT STRUCTURE IN LATIN AMERICA (RAND 

Memorandum 4918, 1966). For a somewhat shortened version of the RAND study, see Boris Kozolchyk, 

Law and the Credit Structure in Latin America, 7 VA. J. INT'L L. 1, tbl. 6 (1967) [hereinafter Kozolchyk, 

Law and the Credit Structure in Latin America] (shortened version). 

43. Kozolchyk, Law and the Credit Structure in Latin America (shortened version), supra note 42. 

44. Kozolchyk, A Roadmap, supra note 25, at 4. 



VOL. 42:727 

question was: "Yet, what if that someone else is equally aware of the falseness of the 

money, why would he or she take it?" The answer was: "Because the falsity is 

factored into the prices everyone charges for their goods or services." In other 

words, a merchant would be willing to take a likely "false" check after he had 

charged his customer a much higher price than he would for a cash sale. He would 

demand a sufficiently large cash down payment to cover a substantial part of his cost; 

he would then gamble on the likelihood of collecting the remainder of the check by 

negotiating it to someone else, who would, in all likelihood, engage in the same 

picaresque calculation. I recall the interest that these answers evoked among my 

RAND Corporation economist-colleagues: picaresque or tricky commercial 

behavior acquired an unforeseen economic importance as an explanation for the 

ever-increasing levels of prices in Argentina's hyperinflation. 

The business culture of "winner take all, loser take none" is not peculiar to 

Latin America; it is present in those developing nations that continue to be guided 

by standards of fairness particular to agricultural survival-tribal societies." In these 

societies, only the members of one's tribe, clan, family, or circle of friends are 

considered insiders, and are legally entitled to duties of fair dealing by their fellow 

insiders. In contrast, those who belong to other tribes, clans, families, or circles of 

friends are deemed outsiders ("strangers") and, as such, are not entitled to the duties 

of fair dealing owed to insiders. 46 

This is not to say that creditors-strangers are totally without protection in 

developing nations. They are usually allowed to "purchase" a temporary protected 

status by paying a bribe. Yet this status is only temporary because it only applies to 

a specific transaction or event. It is also temporary because it lasts until the same or 

a better protection is made available to another (often competing) stranger willing to 

pay a similar or higher bribe. At this point, the stranger's protection either 

disappears or becomes subject to a bidding war. 

The effects of a business and legal culture in which only the most minimal 

business duties are owed to strangers, and the widespread feeling of distrust it 

inspires in market participants, were apparent in the responses provided by middle 

class Costa Ricans in a 1968 questionnaire on their investment practices. When 

asked why the respondent, as a potential investor, preferred to invest in real estate 

mortgages that offered a smaller return on invested capital than that yielded by the 

dividends of stock issued year after year by an industrial company, many 

respondents provided variants of the same answer: if the industrial company's 

dividend return is such a good deal, why would it be offered to me, neither a 

member of the family nor a friend of those who run this company? 

45. See Kozolchyk, A Roadmap, supra note 25, at 4; Boris Kozolchyk, Fairness in Anglo and Latin 

American Commercial Adjudication, 2 B.C. INT'L & COMP. L. REV. 219, 257 (1979). 

46. The first time I discussed the findings in my study, Boris Kozolchyk, Toward a Theory on Law in 

Economic Development: The Costa Rican USAID-ROCAP Law Reform Project, 1971 LAW & SOC. 

ORDER 681, with the late and lamented father of legal anthropology, E. Adamson Hoebel, he recalled an 

incident he witnessed that illustrates the predicament of the stranger in a tribal environment. Hoebel was 

watching a ritual snake dance that involved an actual snake in the hands of a Native American ritual 

dancer. This took place at a Native American reservation located near a U.S. national park in the western 

United States. At one point, the park ranger asked the tribal dancer to stop his dance so that he could 

have the visitors move back from one of the nearby cliffs, lest the snake dart out and scare a visitor who 

could then easily fall off the cliff. Somewhat annoyed at the interruption, the dancer asked the ranger: 

"Why are you so concerned, are these your family, or are they your friends, do you even know these 

people?" 


2007 


C. The Legal Protection of Strangers or Third Parties and the Credit Marketplace 

The present-day commercial marketplace is comprised of countless strangers or 

contracting parties who are most often unknown to each other, and who also lack 

any connection to transactions entered into by their contracting parties with their 

contractual predecessors. These strangers could be investors, lenders, borrowers, 

sellers, buyers, carriers, shippers, consignees, insurers, insureds, brokers, credit card 

issuers or holders, and so on. As different forms of trade and credit emerge, the list 

grows almost endlessly. 

These contractual strangers would not be willing to provide or acquire goods or 

services, lend, borrow, exchange, or pay, unless they were protected from the claims, 

defenses, and equities derived from transactions in which they had not participated 

in or been given adequate notice. Many of these strangers are referred to by the 

applicable law as protected third parties. In our day, the economic importance of 

these third parties is such that no viable commercial or financial marketplace can 

exist without providing these third parties adequate legal protection. 

1. The Wrong Choice of Protected Third Parties 

The provision of adequate legal protection to third parties is not as easy as it 

appears. The choice of the wrong party for protection purposes as well as the 

excessive or deficient protection of those chosen can be quite costly to society and its 

economy. First, the law must determine who-among the many competitors for the 

status-qualifies as a third party that is entitled to protection. Second, the law must 

establish a form of protection that is deemed fair by the participants in the various 

transactions. Case statutory law is not explicit as to who qualifies as a third party 

entitled to protection; courts or legal commentators must fill this gap. 

Unless courts or commentators are familiar with the transaction or legal 

institution in question, their choice of a wrong party may carry serious negative 

consequences. Consider, for example, a Costa Rican provincial court decision that 

assumed that a given holder of a negotiable draft qualified for the status of holder in 

due course entitled to sue a party whose name appeared in the drawee-acceptor's 

column of the draft. 7 The party whose name appeared on the face of a draft had 

never signed or otherwise accepted such a draft. By allowing such a cause of action, 

this decision conferred upon the holder of a draft the right to sue practically anyone 

47. Case of the Nonsigned Bill of Exchange by the Accepting-Drawee of Cartago, Costa Rica, Oct. 10, 

1966, Juzgado Contencioso Administrativo of the City of Cartago (Costa Rica). See Boris Kozolchyk, 

Jurisprudencia Mercantil, Separata Revista de Ciencias Jurfdicas, Universidad de Costa Rica. In January 

1968, while preparing summaries of all the reported commercial court decisions by Costa Rican courts 

from 1900-1966, Lic. Rodrigo Oreamuno of the San Jose Bar (and much later Vice-President of Costa 

Rica), at that time one of the Costa Rican researchers, alerted the Author to a decision by a lower court in 

the city of Cartago dated October 10. 1966, which had worried commercial lawyers in San Jose. A few days 

later the Author visited with the judge and clerk responsible for this decision. The description of facts and 

reasoning that appears in the principal text is part of the notes taken by the Author during these 

interviews. These notes are available at http://www.natlaw.com/intlcases.htm (an electronic archive of the 

National Law Center for Inter-American Free Trade, "significant comparative commercial law cases and 

comments"). 



VOL. 42:727 

whose name appeared in the drawee-acceptor's column, even though that party had 

not assumed such a liability. 

As it turned out, the draft in dispute was the first draft the judge had ever seen. 

Hence, he did not understand how this three-party instrument functioned or why it 

was necessary when most of the merchants he knew used a two-party instrument 

such as a promissory note. The cost of such an unjustified over-protection of 

creditors-holders of drafts was quickly apparent. Very few merchants or their 

customers were willing to become parties to such a dangerous instrument. 

Consequently, a very useful three-party credit instrument such as the draft stopped 

being used in one of Costa Rica's principal credit markets for a good number of 

years. 

Conversely, underprotection of deserving third parties may reduce the number 

of willing potential market participants. A group of decisions by the Mexican 

Supreme Court accomplished this result, drastically reducing the number of 

protected third party creditors and purchasers of land. 4 " These decisions noted that a 

purchaser or creditor who acquired land or rights in rem could only be protected as a 

third party if he acted in good faith by doing a diligent search of the land registry 

records. 9 However, to do a diligent search, the third party had to examine the entire 

chain of title, from the first to the very last recording of the parcel, and the chain or 

"successive tract" had to be unbroken. Given the serious difficulties of searching 

most land records at the time of these decisions, very few purchasers or creditors 

could have qualified as protected third parties-especially with respect to properties 

with long or complicated title chains. Similarly, many developing nations still deny 

protection to contracting parties and to parties who acquired rights based upon their 

contracts, if those contracts did not fulfill certain ad solemnitatem (solemn) 

requirements. This is true regardless of whether one of or both of the parties 

performed their part of the bargain, or acted in reliance on the other party's promise 

of performance." 

2. The Wrong Choice of Protection 

Similar difficulties and negative consequences are apparent with the manner in 

which the law or its adjudicators have protected creditors. Consider, for example, 

the creditor remedy known as "apremio corporal" 5 popular in Costa Rica during a 

good part of the twentieth century until it was abrogated as unconstitutional." This 

remedy entailed the imprisonment of defaulting debtors, with its purpose to bring 

about certainty to its commercial and consumer credit market. The reasoning 

behind this remedy was callous but straightforward: if many debtors ordinarily 

48. For a translation and discussion of these decisions, see Boris Kozolchyk, The Mexican Land 

Registry: A Critical Evaluation, 12 ARIz. L. REV. 308, 336-38 (1970). 

49. Id. at 336. 

50. See BORIS KOZOLCHYK, LA CONTRATACION COMERCIAL EN EL DERECHO COMPARADO 214-52 

(2006). 

51. See COD. COM. art. 568 (1964) (now abrogated); COD. CIV. arts. 1002-1003 (1888) (now 

abrogated). 

52. Ley de Jurisdicci6n Constitucional No. 7135, La Gaceta No. 198, art. 113 (1989) (amended in La 

Gaceta No. 212 on Nov. 9, 1989), available at http://www.asamblea.go.crley/leyes/7000/7135.doc. For a 

discussion of the apremio corporal prior to its abrogation in Costa Rica, see Kozolchyk, supra note 21, at 

259-60. 


2007 


default in their credit obligations and most of them fear imprisonment, why not 

legislate the defaulting debtors' imprisonment? Thus, the Costa Rican legislature 

authorized an action that resulted in debtors' imprisonment for a period of two 

months to two years, unless the debtor complied with a court order to pay the debt 

or return the collateral. 

Contrary to the belief among legislators and judges that if this remedy were 

deemed unconstitutional Costa Rica's credit system would collapse, 53 no collapse 

occurred even though the sanction was rarely enforced. What happened instead was 

that creditors continued to extend credit, albeit at ever-increasing rates of interest. 

When a researcher asked one of the bailiffs-who roamed the city of San Jose 

looking for defaulting debtors- why he reported that no debtors were found after 

the most perfunctory of searches, his answer was revealing: if this sanction were 

enforced, most Costa Ricans, including the politicians who enacted it and the judges 

in charge of applying it, would all wind up in jail. 4 

3. Factors in the Choice of the Right Third Parties and Their Protection 

As illustrated by the wrong choices of protected third parties, for the legal 

choice to be effected properly, the lawmaker or adjudicator must fully understand 

the transaction in question-especially its purpose, its mechanics, and the reasonable 

expectations of participants. Only with this understanding is the lawmaker or 

adjudicator in a position accurately to assess the good faith standards used to 

measure the parties' performance and their qualifications for protection. 

The same is true with respect to the determination of the proper protection of 

third parties. As discussed earlier, it is not enough to invoke the truism of legal 

certainty and simply assume either that credit will necessarily be granted to those 

merchants who can exhibit a legally enforceable title, or that a penal enforcement of 

contract rights will generate larger volumes of consumer or micro-credit. Even if 

title is an important component of real estate-based credit, how effective a 

component will it be if courts adopt a standard of good faith that disqualifies most 

purchasers or creditors from the protection of the registry? A successful protection 

of creditors and debtors depends upon the manner in which the lawmakers and 

adjudicators handle the legal and socioeconomic facts that surround commercial and 

consumer lending. 

53. In a conversation with the Author during October 1968, the late Justice Ulises Odio of the Costa 

Rican Supreme Court expressed his constitutional misgivings but pointed to data that indicated that more 

than one thousand debtors in the city of San Jose (whose population was then approximately 250,000) were 

imprisoned for apremio corporal. Interview with Ulises Odio, Costa Rica Supreme Court, in San Jose, 

Costa Rica (Oct. 1968). Yet a field study of actual arrests conducted by team members of the Law Reform 

Project, under the Author's direction, showed that no more than four debtors were actually in jail for this 

action. The remainder in the Justice's printout were reported by the respective bailiffs as "not found" in 

their residences or places of business. 

54. Kozolchyk, Toward a Theory, supra note 46, at 731 n.183. 



VOL. 42:727 

IV. LEGAL FACTS OF SECURED LENDING AND THEIR GUIDING 

PRINCIPLES 

A. The Universality of Effective Secured Lending Practice and Its Principles 

Secured lending has proven its effectiveness in improving a country's GDP as 

well as in reducing its poverty. By now, the secured lending practices that lead to 

commercial and consumer credit at reasonable rates of interest have been 

sufficiently tested in many of the world financial marketplaces, thus enabling the 

distillation of their guiding legal principles and formulas for creditor and debtor 

protection. Moreover, as with other commercial transactions, some key practices 

and legal principles of secured lending have gained universality. 

The universality of some of its practices results from the inherently limited 

methods that can be used by lenders when extending secured credit to strangers. The 

inherent limitation of effective practices is caused by the cooperative nature of 

commerce in general and of lending in particular. Accordingly, "winner take all, 

loser take none" as well as bad faith practices are incompatible with secured lending, 

as is the lack of transparency vis-A-vis third party creditors or purchasers. Since the 

advent of the contemporary financial marketplace, any commercial activity 

conducted with strangers requires as much reliable, timely, and easily accessible 

information as possible on the market participants. In the case of secured lending, if 

borrowers wish to rely on certain assets as the collateral that will help repay their 

borrowings, they must assure both known and unknown lenders of the availability of 

a desirable minimum, or cushion, of such assets. 

In secured lending practice it is thus indispensable to provide actual or potential 

lenders with a public, transparent, and accurate record of the borrowers' 

encumbered and unencumbered collateral. Any practice that results in hiding 

collateral or secured loans from the public eye is similarly incompatible with this 

transparency. Where the collateral is quickly perishable or depreciable in value, as is 

the case with most commercial assets, the creditor's ability to repossess and foreclose 

on these assets must also remain unimpeded, and cannot be tied up in lengthy court 

proceedings. Unless this is done, the creditor will lose the reassurance of his 

collateral cushion and will simply refuse to become a secured lender. 

It is for this reason that when I was asked by a Mexican NAFTA negotiator 

why Mexico's law of secured transactions had to resemble that of the United States 

and Canada, my reply was that the proper question was not what law Mexico had to 

emulate, but whether Mexico in fact desired secured lending. If it did, its law had to 

be based on principles that reflected those tried and tested practices in active 

financial marketplaces, and were thus capable of universal usage. Where some of 

these practices are not followed-such as the practice of recording the security 

interest in a public registry-it is because lenders have their own system of private 

notice that is available to a small number of participants, but is unsuitable for 

markets with a larger number of participating strangers." 

55. For example, bankers in some markets resort to private informal organizations referred to in some 

Latin American countries as "risk clearing" offices (centrales de riesgo) which allow them to exchange 

information on individual debtors' loans and payment or performance records. Such organizations do not 

create rights with regard to non-participating third parties such as other creditors or purchasers of debtors' 

assets. Neither can they assure the participants that all the rights in the debtors' collateral have been taken 


2007 


B. The NLCIFT Principles 

The principles discussed hereafter informed the drafting of the Model Law on 

Secured Transactions adopted by the Organization of American States (OAS) in 

2002" and by member nations in different versions, such as by Mexico 7 and Peru." 

Local versions of this Model Law are currently being considered for adoption by 

Guatemala, " El Salvador," 0 Honduras, Costa Rica, and Chile. 6 , As drafted by the 

National Law Center for Inter-American Free Trade (NLCIFT), these principles 

cover the creation, perfection, priority, and enforcement of security interests 

(garantias mobiliarias) in personal or moveable property. 

into account by the compilers of risk information. Mutatis mutandis, some countries resort to the 

conveyance of proprietary-fiduciary rights to certain creditors, or to their "retention of title rights," which 

are not recorded. This information is unavailable to other creditors or to potential creditors, considerably 

reducing the number of willing lenders. 

56. MODEL INTER-AMERICAN LAW ON SECURED TRANSACTIONS (2002) (adopted by the Sixth 

Inter-American Specialized Conference on Private International Law (known as CIDIP-VI, for its Spanish 

acronym) on February 8, 2002 (Final Act, 3(F), CIDIP-VI) [hereinafter Model Law]. Its name in Spanish 

is Ley Modelo Interamericana sobre Garantias Mobiliarias. 

57. Decreto por el que se reforman, adicionan y derogan diversas disposiciones de la Ley General de 

Tftulos y Operaciones de Crbdito, del C6digo de Comercio y de la Ley de Instituciones de Cr~dito [Decree 

Reforming, Amending, or Derogating Various Dispositions of the General Law on Negotiable Instruments 

and Credit Transactions, the Commercial Code, and the Law on Credit Institutions], Diario Oficial de la 

Federaci6n [D.O.]. 23 de mayo de 2000 (Mex.) [Reform Law of 2000]. and Decreto por el que se reforman, 

adicionan y derogan diversas disposiciones de la Ley General de Tftulos y Operaciones de Cr~dito, del 

C6digo de Comercio, de la Ley de Instituciones de Cridito, de la Ley del Mercado de Valores, de la Ley 

General de Instituciones y Sociedades Mutualistas de Seguros, de la Ley Federal de Instituciones de 

Fianzas y de la Ley General de Organizaciones y Actividades Auxiliares del Credito [Decree Reforming, 

Amending, or Derogating Various Dispositions of the General Law on Negotiable Instruments and Credit 

Transactions, the Commercial Code, the Law on Credit Institutions, the Securities Market Law, the 

General Amending, or Derogating Various Dispositions of the General Law on Negotiable Instruments 

and Credit Transactions, the Commercial Code, the Law on Credit Institutions, the Securities Market Law, 

the General Law on Insurance Companies, the Federal Law on Bonding Institutions, and of the General 

Law of Organizations and Activities Ancillary to Credit], Diario Oficial de la Federaci6n [D.O.], 13 de 

junio de 2003 (Mex.). While these decrees adopt some of the NLCIFT principles, others were disregarded 

much to the detriment of these important reforms. 

58. Ley de la Garantfa Mobiliaria, Ley 28677 (2006) (Peru). This law, however, does disregard 

important NLCIFT principles. 

59. See Vinicio Sic, Controlar6n mfis a cooperativas y ONG, May 2, 2006, available at 

http://www.sigloxxi.com/index.php?link=noticias&noticiaid=982. 

60. Professor Dale B. Furnish, a senior researcher at the NLCIFf, has been acting as an advisor to the 

government of El Salvador in its enactment of an OAS Model Law-inspired statute and expects enactment 

of it in the near future. The draft of this law is still in a preliminary stage and is not available for public 

discussion. 

61. The process of adoption of laws inspired in the OAS Model Law is, as of this writing, on its way in 

Honduras, Costa Rica, and Chile although at different stages of consideration. During October 2006, a 

drafting group was convened at the NLCIFT to prepare a revised draft of a Honduran decree-law to be 

submitted to the Honduran Congress during November 2006. In December 2006, members of the 

Honduran Supreme Court of Chamber of Commerce will also meet at the NLCIFT to discuss this draft 

and plan the drafting of regulations for a commercial-electronic registry. In the case of Costa Rica, during 

August 2006, President Oscar Arias appointed Ing. Jorge Woodbridge, Vice Minister of the Economy, to 

head a drafting commission of a Costa Rican law of secured transactions and a commercial electronic 

registry. Minister Woodbridge, in turn, appointed the legal advisors to the drafting commission; drafting is 

expected to commence in the immediate future. Chile's Ministry of the Treasury has approached the 

Chilean International Legal Center and the NLCIFT (its counterpart in the United States) for advice in the 

drafting of a law of secured transactions for submission to the Chilean Congress in the near future. 



VOL. 42:727 

The NLCIFT principles define commercial credit as an effective tool for 

economic development based upon the self-liquidating nature of its collateral. 6 2 

They describe a security interest as a "preferential right to possession or control of 

personal property [which] does not require that the debtor . . . have title to the 

personal property collateral ... ,,63 As discussed earlier, since this right is not of 

ownership, it can coexist with other possessory rights. In addition, the personal or 

moveable property that can be collateral must be open in number and can be present 

or future, tangible or intangible.' 

According to the principles, "[s]ecurity interests may be created by contract or 

by law." 65 However, to perfect a security interest vis-A-vis third parties, other 

requirements must be met, especially the requirement of giving functional notice to 

66 

these parties. The concept of functional notice includes either the creditor's 

possession in the case of the possessory pledge or a public notice system one of 

whose purposes is to eliminate secret liens. 67 

The principles strongly recommend the adoption of a registry system, in which 

all known or future security devices become part of a unitary security interest, 

thereby facilitating the ranking of priorities mostly based upon the rule of first to 

file, first in right. 6 Registration should be inexpensive, and should take place in a 

public registry that is easily accessible to third parties, regardless of nationality or 

economic sector (if at all possible by electronic means). In standardized fashion, the 

filing should contain only the essential data to identify the parties and the amount of 

the loan or line of credit and collateral-consistent with the needs of actual and 

potential third parties to discover all recorded liens against the debtor's assets. 

Generic descriptions of collateral such as inventory or accounts receivable should 

suffice. The registry should be indexed generally by the debtor's name and, only 

exceptionally, by the serial number of the goods. 

"A 'purchase money', or 'acquisition' security interest should take priority, to 

the extent that the credit provided is used directly to acquire the collateral, over 

prior existing perfected security interests in the same kind of collateral, as an 

incentive to those wishing to provide timely, valuable and needed loans and as a 

safeguard against the monopolization and immobilization of the collateral available 

by one or more secured creditors." 69 Perfection of a purchase money security 

interest should require-in addition to the appropriate filing-a special notice to 

pre-existing security interests. 

Taking into account the importance of consumer purchases as the originators of 

the stream of income that underlies commercial lending, a buyer in the ordinary 

course of business takes free of a perfected security interest created by his seller, 

even when the buyer may know of that security interest. However, "if the sale 

occurs outside the ordinary course of business, then the buyer takes subject to the 

security interest even if he pays a fair purchase price. ' 

62. See NLCIFT Principles, supra note 22, princ. 1. 

63. Id. princ. 2. 

64. Id. princ. 3. 

65. Id. princ. 4. 

66. Id. princs. 5, 6, 7. 

67. Id. 

68. NLCIFT Principles, supra note 22. 

69. Id. princ. 8. 

70. Id. princ. 9. 


2007 


Self-liquidation of the security interests requires that repossession of the 

collateral and foreclosure take place by means of contractual and extrajudicial 

enforcement. The principles strongly suggest adoption of an enforcement mechanism 

that "confers upon the creditor or agreed-upon fiduciary the power to repossess or 

retain and foreclose on the collateral privately or by means of a highly expeditious 

judicial foreclosure." 7 

Extrajudicial enforcement without breach of peace and subject to subsequent 

judicial review is gaining increasing acceptance by legislators and legal 

commentators throughout the developing world. The Supreme Court of Mexico, 

for example, has upheld the constitutionality of an extrajudicial remedy associated 

with the Fideicomiso de Garantia, the Mexican version of the United States deed of 

trust." In addition, the Costa Rican Supreme Court has validated the legality of a 

Fideicomiso de Garantia much along the lines of its Mexican counterpart. 7 " Highly 

respected constitutional law scholars, including one of the drafters of the 

Guatemalan constitution, concur on the constitutionality of the extrajudicial 

remedies of the proposed draft of the Guatemalan law of secured transactions. 75 

Because bankruptcy laws are often used as devices to evade debt collection in 

many developing nations-except where the bankruptcy law in question reflects 

contemporary creditor and debtor protection legislative trends-the principles 

recommend the exclusion of perfected security interests from the bankruptcy 

76 

estate. This is also a World Bank recommendation. 77 Exceptionally, where the 

71. Id. princ. 10. 

72. See, e.g., Law Amending the Civil Code, Notarial Law, and Other Laws art. 151j (Jan. 1, 2003) 

(Slovk.) (amending the Civil Code of 1964) (providing that creditor may not agree with debtor on the 

appropriation of the collateral prior to default). By contrast, no prohibition of the Pactum Commissorium 

exists after the default. Id.; accord UNMIK Regulation No. 2001/5, art. 19.12 (Kosovo). For Eastern 

European doctrinal opinions on the legality of the Pactum, see Ganka Ivanova, Bulgaria, in CTR. FOR INT'L 

LEG. STUD., INTERNATIONAL SECURED TRANSACTIONS 35 (2003) (stating that "acceptance of 

encumbered assets in satisfaction of the secured obligation is provided by the Civil Procedure Code in 

favor of the mortgagee or the pledgee under court foreclosure"). See also Chrysta Bdn, Hungary, in 

INTERNATIONAL SECURED TRANSACTIONS, supra, at 29. She writes that "following default, the secured 

creditor may propose to accept the encumbered assets in full or in partial satisfaction of the secured 

obligation. A pre-default agreement that automatically vests ownership of the encumbered assets in the 

secured creditor on default is null and void and unenforceable." The Author is indebted to NLCIFT staff 

member Marek Dubovec for supplying the above sources. 

73. For a discussion of this decision, see Dale Beck Furnish, El Debido Proceso y Derecho de 

Audiencia en la Ejecuci6n Contra de los Bienes del Deudor en los Estados Unidos Mexicanos y los Estados 

Unidos de Amrica: Un Andlisis Comparado, 17 EL FORO 119 (Barra Mexicana, Colegio de Abogados, 

Mdxico, 2004). 

74. Vistamarina, Vimasa S.A., Banco BCT Panama, y Banco de San Jos6 S.A., 00005-F-2003, 02- 

000086-0004-CI, 15:10, Sala Primera Civil Costa Rica (Jan. 15, 2003). I am grateful to Lic. Joaquin Picado, 

staff member of the NLCIFT, for the text of this important opinion. 

75. E-mail from Lic. Carlos Molina Mencos, Doctor en Derecho, Molina Mencos, Pineda y Asociados 

to Boris Kozolchyk, Director, National Law Center for Inter-American Free Trade (Jan. 6, 2005) (on file 

with author). 

76. See NLCIFT Principles, supra note 22, princ. 11. 

77. WORLD BANK & INT'L FIN. CORP., DOING BUSINESS IN 2006, at 67, available at 

http://www.doingbusiness.org/documents/DoingBusines2006_fullreport.pdf ("Reformers in poor countries 

would do better to focus on improving foreclosure of secured debt outside of bankruptcy, thus reducing 

reliance on the courts"); see also Kenneth W. Dam, Credit Markets, Creditors' Rights and Economic 

Development 26 (John M. Olin L. & Econ. Working Paper No. 281, 2006), available at 

http://www.law.uchicago.edu/LaweconfWkngPprs-251-300/287.pdf. 



VOL. 42:727 

bankruptcy takes the form of a business reorganization, collateral may become part 

of the bankruptcy estate-subject to the exclusive jurisdiction of the bankruptcy 

court to confirm the perfection of the security interest and establish its priority 

against the claims of other creditors-to determine the extent and value of the 

security interest, and ultimately also to decide whether the collateral is essential to a 

feasible reorganization that will protect valid security interests. 

V. CONCLUSIONS AND A CORRECTIVE STRATEGY 

The proposition that the financial plight of the poor in developing nations is 

hopeless deserves reconsideration in light of the repeated findings on the impact of 

commercial and consumer credit at reasonable rates of interest upon economic 

growth and reduction of poverty. Similarly, the conclusion that the massive 

distribution of legal titles to real or personal property is a necessary and sufficient 

condition to economic development also deserves reconsideration. At best, it may 

be a necessary but not a sufficient condition for certain-mostly real estate 

secured-loans. The transition from a micro to a commercial loan requires from 

either real or personal property collateral more than simple ownership or title: it 

requires self-liquidation and everything associated with this essential feature of the 

commercial loan. 

However, a corrective strategy for making commercial and consumer credit 

available at reasonable rates of interest in developing nations by adopting an open 

system of secured lending is still a work in progress. Much depends upon special 

features of the business and legal cultures of the country in question and upon the 

answers to critical legal and socioeconomic questions, such as: how valuable are its 

goods and services in local and international markets; how large is its consumer and 

borrowers' class; how skilled and educated are its craftsmen acting as small- and 

medium-sized businesses; how picaresque or tricky are the business practices 

associated with credit sales or with purchase money loans; how picaresque or tricky, 

or honest and reliable are its accounting practices (can lenders truly rely on what 

appears on financial statements?); how reliable are its collateral value appraisals or 

commercial insurance; how corrupt is its administration of justice; are there 

knowledgeable and honest bankruptcy trustees; are creditors' committees truly 

representative and trustworthy; how developed and reliable are its means of 

communication; and how dependable and costly are its transportation, warehousing 

and communications systems? These, and other variables, can become responsible 

for the viability of an OAS Model Law-inspired statute and the rapidity of its 

success. 

The experience with commercial lending in Latin America suggests some 

common normative problems whose solution deserves consideration as part of a 

successful strategy. These are: 

1. A secured lending law ought not be treated as an isolated legal enactment. 

Its success depends upon the enactment of equally effective and market-sensitive 

laws of bankruptcy, insolvency, electronic commerce (including an electronic registry 

of security interests in personal and real property) and more functional (and less 

formalistic) laws of contracts, negotiable instruments, and documents of title. 

Otherwise, whatever legal protection of third party creditors is obtained through the 

law of secured transactions will be lost by a "loose" or otherwise non-existing 

bankruptcy or e-commerce law. Similarly, whatever transactional speed and lower 


2007 


cost of operation is achieved by the law of secured transactions will be lost by 

imposition of costly formalities by the law of contracts, negotiable instruments, 

documents of title, or by the laws that govern the notarial or governmental 

formalities of these and other transactions. 

2. As was done in the case of Guatemala and HondurasT-and will hopefully 

be done in Costa Rica and Chile-a careful evaluation of the most valuable and 

liquid collateral in the marketplace should precede the drafting of the provisions on 

perfection, priority and enforcement of security interest. For example, assuming the 

agricultural nature of such collateral in Guatemala and Honduras, perfection, 

priority, and enforcement rules should take into account the ad hoc type of 

documents or electronic records, ones that could convey rights to the collateral in 

question to bankers and purchasers in major spot and futures markets for the goods 

in question. 79 

3. Best practice guides should be developed and their use carefully monitored. 

Training and regular monitoring of performance should apply not only to secured 

lenders and borrowers, but also to the financial statement and reporting practices of 

accountants, appraisers, and business inspectors-whether they are acting as the 

parties' staff or independent contractors. The importance of reliable financial 

statements and certifications of value -particularly with regard to the required 

amount of collateral-cannot be overstated, especially in a picaresque business 

culture. 

4. Lawyers, judges, registrars, mediators, and arbitrators should be trained in 

the market and third party protection-sensitive interpretation and administration of 

the secured transactions, bankruptcy, e-commerce, contracts, and registry laws. 

78. See Draft Guatemalan Law arts. 27-29; Draft Honduran Law arts. 36-38. 

79. See, e.g., Marek Dubovec, Commodity Contracts as Hedging and Security Tools (NLCIFT 

Occasional Paper, 2006) (on file with author and the NLCIFT). 



Securitization in Israel 

SHALOM LERNER* 

SUMMARY 

I. IN T R O D U CT IO N .................................................................................................. 75 1 

II. SECURITIZATION OF MORTGAGES IN ISRAEL .................................................. 753 

A . D escrip tion ................................................................................................... 753 

B. Securitization as an Assignment of Rights ................................................ 755 

C. Registration of the A ssignm ent ................................................................... 757 

D . N otice to the D ebtors ................................................................................... 758 

E . The B ank as Trustee .................................................................................... 759 

III. MAKING THE SECURITY INTERESTS AVAILABLE TO THE SPV ...................... 759 

IV . SUMMARY AND CONCLUSIONS ......................................................................... 764 


Securitization is a financing instrument that has been used in the West for many 

years. In transactions of this kind, a business that has many debtors sells all or some 

of the indebtedness of its debtors to a third party. These debts are repaid in monthly 

installments to the third party over many years, and the third party pays the seller a 

lump sum. The third party, the buyer, is usually a corporation created specifically 

for the purpose of the securitization transaction. This corporation has no business 

history, and the certificate of incorporation prohibits any future transactions, apart 

from the securitization transaction for which the corporation was created. This 

designated corporate entity, generally known as a special purpose vehicle (SPV), 

issues debentures or stock to raise money on the capital market. From the legal 

perspective, the issuance of debentures on the stock exchange constitutes a loan. 

The SPV borrows money from the public and creates a security interest in the only 

asset it owns-the financial rights it acquired from the seller. As in other issuances 

of debentures, the security interest is created by appointing a trustee. In some cases, 

the money is raised on the stock exchange through the issuance of stock. Either way, 

Professor of Law, Bar Ilan University, Israel. 

Hebrew University, Jerusalem, Israel (1981). 

LL.B, Bar lan University, Israel (1975); S.J.D, 



VOL. 42:751 

the SPV uses the money borrowed or raised to pay the seller for the interests it 

acquires. 

As mentioned, the SPV's certificate of incorporation bars the SPV from 

transacting any other business other than the purchase of financial assets from a 

specific seller; these are the only assets that the SPV owns. Therefore, the SPV is 

not expected to post any financial losses or have any new creditors. Given the low 

risk involved in SPVs, they normally receive a relatively high credit rating, which 

facilitates the distribution of SPV stock or debentures. 

In addition to the sale agreement, the seller and the SPV also execute a service 

agreement. The SPV has no employees and is unable to collect the debts it acquired 

from the seller independently. The seller, on the other hand, is specialized in its 

field, has communication channels with its debtors, and has an efficient collection 

system. The seller and the SPV enter a service agreement whereby the seller 

provides the SPV with collection services in consideration of an agreed payment. 

Under this agreement, the seller continues to collect the debts, holds the money in 

trust for the SPV, and transfers the money to the SPV as soon as possible. This trust 

structure bars the seller's creditors from arguing that the SPV is an ordinary creditor, 

rather than simply a holder of a property right. 

The seller does not issue stock or debentures to the investors directly, because 

this would expose the investors to the risks inherent in the seller's general and 

ongoing operations and create competition between the investors and the seller's 

other creditors. The SPV isolates the seller's rights against the debtors from the 

seller's other assets, and prevents the SPV's ordinary creditors from collecting 

against these rights. 

Securitization started in the mortgage sectors of Great Britain and the United 

States. These transactions were called "secondary mortgages," rather than primary 

mortgages, which are secured loans granted by banks or other lenders to home 

buyers. Securitization then spread to other businesses that had financial means or 

long term accounts receivables. Examples of securitized assets include the 

indebtedness owed to suppliers by issuers of credit card transactions and the 

financial rights of an industrial plant against its existing and future customers. 

The first securitization transactions in Israel took place a few years ago, mostly 

in the mortgage sector. The first part of this paper will focus on the securitization of 

mortgages and will also explain the problems characteristic of such transactions. The 

second part of this paper describes the standard structure of securitization 

transactions in Israel, analyzes them from a legal perspective, and addresses 

additional questions, such as registration and notice to borrowers. The third part of 

this paper deals with an issue of great practical significance: the need to register the 

SPV as a mortgagee in order to perfect the mortgage. 

Securitization is seen in Israel in two other areas. First, automobile leasing 

companies and local governments have recently started securitizing their accounts 

receivables. Leasing companies lease various assets, mainly cars, in consideration of 

monthly payments by the lessees, for an average period of three to five years. 

Several leasing companies started to securitize this indebtedness. This securitization 

takes place through an SPV. The SPV creates a buffer between the leasing company 

and the investors. The competition in the leasing industry in Israel is fierce, and a 

leasing company might face financing problems if it is unable to lease all of its fleet. 

These problems do not affect the SPV, which is not exposed to the company's 

general business operations; the SPV only acquires the rights that the leasing 


2007 

SECURITIZATION IN ISRAEL 

company has against existing customers. At the end of 2004, a small leasing 

company collapsed after the controlling shareholder embezzled the money he had 

received from lessees, which the leasing company was supposed to hold in trust for 

the SPV. This affair exposed the need for appropriate monitoring and slowed down 

the securitization process in the leasing industry. The investors, however, did not 

suffer any materially adverse effect and continued to receive the leasing fees paid by 

lessees thereafter. 

The second sector in which securitization transactions have become popular in 

Israel is local government. The local government initiates development programs 

and then requires financing that exceeds the income it generates from both taxes and 

the contribution of the central government. Until recently, the exclusive source of 

financing used in these cases was loans from commercial banks. A few years ago, 

many local governments encountered financial difficulties, causing the banks to 

increase their interest rates. Consequently, the local governments started to raise 

money on the capital market. A strong local government can issue municipal bonds 

without collateral. Several local governments have recently securitized their income 

from the municipal tax revenue expected over the next few years, or on the future 

income from real estate, such as parking lots. Once local governments discovered 

this alternative method of financing, the banks reduced their interest rates almost 

immediately.' 

As noted, securitization only started in Israel a few years ago. The relevant 

legislation is scarce, and most problems that emerge in this field must therefore be 

resolved through the general body of law. The most important law in this context is 

the 1969 Transfer of Obligations Law. There is still no case law addressing 

securitization, except for one case relating to the securitization of rights against 

lessees of automobiles. 2 The securitization transactions that took place in Israel in 

the last few years were not as complex as those implemented in other countries. The 

Tel Aviv Stock Exchange has yet to issue debentures or shares of SPVs. When SPVs 

were being created, the players did not raise money from the general public through 

the stock exchange, but rather from institutional investors through private channels. 

It seems, however, that the first public issuance in the mortgage sector is 

forthcoming. 

II. 

SECURITIZATION OF MORTGAGES IN ISRAEL 

A. Description 

In Israel, mortgage banks are not authorized to provide general banking 

services, only loans to the public for the purpose of buying real estate. Most of these 

banks are subsidiaries of commercial banks. Recently, two mortgage banks were 

merged into their parent companies, so that the mortgage area is now managed by a 

separate division within the bank. 

1. I believe that the securitization of future tax earnings by these governments gives rise to serious 

legal issues, because the debtors whose indebtedness is being transferred are unspecified debtors who will 

reside in that locality in the future. However, that issue extends beyond the scope of this paper. 

2. CC 2146/04, Civil Motions 8120/04, Deloitte & Teuche (Israel) Brightman Almagor Trusts Ltd. v. 

Israel Discount Bank Ltd., Takdin, DC 2005(3) 10575. 



VOL. 42:751 

The banks lend money to the public for the purchase of real estate-homes in 

most cases. Against the loan, the bank receives a mortgage on the borrower's 

property, usually the real estate acquired with the loan. In a securitization 

transaction, the mortgage bank sells rights it has against specific borrowers to an 

SPV which is created for the securitization transaction. Under the rules of the Bank 

of Israel (Israel's central bank), a mortgage bank may not sell only strong loans-i.e., 

loans with a low probability of default-and maintain only the weak loans, because 

this might undermine the bank's stability. The bank must therefore sell the SPV a 

portfolio representative of all its borrowers. An exhibit attached to the sale 

agreement specifies the names of the borrowers whose obligations to make future 

payments are sold to the SPV. In the standard securitization transaction in Israel, 

the mortgage bank and SPV stipulate that if a borrower defaults, the SPV will have 

no recourse against the bank. 

The SPV has no tools to handle the logistics of loans. The bank thus provides 

these services for the SPV for an agreed fee. The services include management of 

the loans, ongoing communications with the borrowers, collection of the debts, and 

foreclosure of the mortgages. Since the sale agreement transfers the ownership of 

the loans portfolio to the SPV, the bank acts as an agent for the SPV. The service 

agreement provides, generally, that the bank will collect the money from the 

borrowers on behalf of the SPV and transfer the money collected to the SPV on 

agreed dates. 

Securitization offers the banks various advantages. The immediate payment 

enables the bank to expand its business. There is also an advantage to the bank's 

accounting, since the loans no longer appear on the balance sheet. The institutional 

entities that finance the SPV are corporations with high liquidity and substantial 

resources-such as pension funds and insurance companies-that are always looking 

for new investment avenues. Under the securitization agreement, the mortgage 

bank acts as a mediator in the financing sector and entitles the investors to 

repayment of the loans and the interest acquired by the borrowers. 

The SPV and its lenders, the debenture holders, want to make sure that events 

that might take place after the transaction will not have an adverse effect on the 

future cash flow from the borrowers. The SPV is concerned about the following 

scenarios: 

Insolvency of the bank. The goal here is to prevent a receiver or an 

administrator from taking possession of the money paid by the borrowers. The SPV 

seeks to stop this money from becoming part of the receivership asset pool, and to 

make sure that it both belongs to the SPV and is available to the debenture holders. 

The SPV also wants to ensure that the bank's creditors cannot impose liens on the 

money owed by the borrowers. 

A conflicting transaction by the borrower. The borrower might execute a 

transaction in violation of the mortgage with the bank, such as a transfer of 

ownership or any other right in the property to a third party. The bank will prevail 

over such competition because it is named as mortgagee in the Land Registry. The 

SPV seeks to have the same priority. 

Insolvency of the borrower. Before the securitization, the bank is a secured 

creditor, and has priority over the borrower's other creditors upon insolvency. This 

priority is guaranteed by the mortgage, which enables the bank to foreclose on the 


2007 


mortgage directly without having to first obtain court approval.' The SPV seeks the 

same protection. 

B. Securitization as an Assignment of Rights 

To check whether the SPV and the investors can accomplish these goals, the 

transaction between the bank and the SPV must be analyzed in accordance with the 

set of laws governing it. To this end, I will now provide a brief review of the laws 

regulating the assignment of rights. 

Generally, a creditor can sell his rights or use them as a security interest. That 

is, a creditor can either sell his rights or take a loan, submitting his rights against his 

debtors to the lender as collateral. In a sale of rights, as in the sale of movable or 

immovable property, the object of sale ceases to be the property of the seller, and 

becomes that of the buyer. Ownership of the right transfers to the assignee even 

without any notice to the debtor. 4 

The other transaction, in terms of security interests, is known as a pledge, 

meaning "a charge on property as security for an obligation." 5 In the law of Transfer 

of Obligations it is called a "transfer of a right by way of a charge", 6 In a sale of 

rights, the assignee is the buyer; whereas in an assignment by way of a charge, the 

assignee is a secured creditor, and the assignor's other creditors are unsecured 

creditors. Under the laws regulating security interests, a secured creditor prevails 

over all other creditors if its security interest is registered in a public registry. 7 

After the assignment, a creditor of the assignor cannot impose a lien on the 

transferred rights. In a true sale, the assignor is no longer the owner of the rights, 

which are henceforth no longer exposed to the imposition of liens by the assignor's 

creditors.' An assignee who is a secured creditor and has registered the security 

interest also prevails over the holder of a lien. 

Insolvency of the assignor is not supposed to have any adverse effect on the 

assignee. The assignor's receiver cannot add the assigned rights to the general asset 

pool, because these rights have become the property of the assignee. This rule 

applies even if the payment of the assigned debts is due only after the receivership 

order is handed down against the assignor. 9 The same is true of an assignment by 

way of a charge. 

3. Pledges Law, 5727-1967, 17 LSI 44 (1967)(Isr.) § 17 (stating "a pledge deposited as specified in 

section 4(2) and serving as security for an obligation towards a banking institution, within the meaning of 

the Bank of Israel Law, 5714-1954)[sic], can be realized by such institution without an order as aforesaid"). 

4. CA 5578/93 Nadav v. Sargovi [1995] IsrSC 49(2) 459, 470 (holding that under Israeli law, ownership 

of the right transfers upon execution of the assignment agreement, and there is even no need to notify the 

debtor in order for the transaction to be completed). 

5. Pledges Law § l(a). 

6. Transfer of Obligations Law, 5729-1969, 23 LSI 277 (1968-69) (Isr.) § 1(b). 

7. Pledges Law, supra note 3, § 4(3); Companies Ordinance (New Version), (1983) (lsr.) § 178. 

8. CA 165/75 Levinger v. Ramat Gan Zoology Park Ltd., IsrSC 30(2) 75: CA 568/85 Bank Hapoalim 

(Switzerland) Ltd. v. First International Bank of Israel's Trust Company Ltd., IsrSC 32(4) 507; CA 2328/97 

Kochavi v. Arenfeld, 53(2) 353. 

9. CA 142/70 Shmueli v. Receivers of the Iron Company Ltd., IsrSC 24(2) 446. 



VOL. 42:751 

However, the status of the assignee as a buyer is better than the assignee's 

status as a secured creditor. For instance, the court has the power-as part of the 

process of helping a company under receivership to recover-to suspend the exercise 

of security interests, provided that the secured creditor's rights are adequately 

protected. ° Yet the court has no authority to violate, even temporarily, the rights of 

an assignee who purchased the company's rights against third parties. Also, if the 

rights are assigned via a security interest, the assignee must repay the assignor any 

money collected from the debtors in excess of the loan." 

It is not easy to define the criteria with which to distinguish between a true sale 

from a security interest. Israeli case law on this matter is scarce. According to the 

existing case law, if the assignment agreement provides that an assignor who is 

unable to collect the debt from the debtor has no recourse against the assignor, then 

the transaction is a true sale, and if the assignee can collect against the assignor, it is 

a security interest. 2 

Indeed, if under the assignment agreement, an assignee who is unable to collect 

the debt has no recourse against the assignor, the transaction fails to satisfy all the 

elements of the laws of security interests. Under the Pledges Law a security interest 

is incidental to the debt-it secures the debt but does not replace the debt.' 3 A 

lender who received a security interest and whose debt is not wholly satisfied may 

exercise the security interest and collect its debt from the proceeds, file a regular suit 

against the lender to repay the debt, or do both.' 4 That is, a lender that received a 

security interest may, at its discretion, seek repayment of the loan from the borrower 

without exercising the security interest. If the assignee may not sue the assignor, 

then their relationship is not one of lender and borrower. Israeli law does not 

recognize an in rem security interest, under which there is no duty upon the 

borrower to repay the debt. Parties cannot create such an interest in contract, 

because the list of property rights protected by law is finite-the courts are not 

authorized to recognize a property interest that was not recognized by the 

legislature." 

I will now analyze the securitization transaction under the principles governing 

the transfer of obligations. The bank has contractual rights under the loan 

agreements to receive various amounts of money from the borrowers and may assign 

these rights to the SPV. "The right of a creditor . . . is capable of being transferred 

without the consent of the debtor, unless its transferability is negated or restricted by 

10. Companies Law, 5759-1999, 44 LSI 1 (1999) (Isr.) § 350(b). 

11. See, e.g., Major's Furniture Mart Inc. v. Castle Credit Corp., 602 F. 2d 538, 542 (1978) (analyzing 

the Pennsylvania Code, which states that "[ilf the security agreement secures and indebtedness, the secured 

party must account to the debtor for any surplus, and unless otherwise agreed, the debtor is liable for any 

deficiency"). 

12. See, e.g., CC 3113/88 Prinir Ltd. (In Receivership) v. Bank Leumi Ltd., IsrDC (unpublished) ("If 

this were an absolute assignment, then upon its execution, the assignor's obligations are terminated; but 

this transaction allows for the bank to collect against the assignor in case the assigned right is defaulted 

upon."); see also CA 3966/01 Yehoshua TBWA v. Bon Mart Millennium Ltd. (In Receivership), IsrSC 

57(4) 952; see generally S. Lerner, Assignment of Obligations, in LAW OF OBLIGATIONS-GENERAL PART 

284-90 (2002) (stating that recourse against the assignor does not necessarily mean the transaction is a 

security interest rather than a true sale). 

13. Pledges Law § 7. 

14. Id. § 23. 

15. See CA 46/74 Mordov v. Schechtman, IsrSC 29(1) 477 (regarding property rights as a finite list): 

accord J. WEISMAN, LAWS OF PROPERTY: GENERAL PART 75-87 (1993). 


2007 


law, by the nature of the right or by agreement between the debtor and the 

6 

creditor.' Therefore, if the agreement between the borrower and the bank does 

not prohibit the latter from transacting in the rights, the bank may assign its rights 

against the borrowers to an SPV. In this transaction, the bank is the assignor, the 

SPV is the assignee, and the borrowers are the debtors. The outcome of the 

assignment is that the assignor ceases to be the debtor's creditor, and the assignee 

becomes the debtor's only creditor. After the agreement between the bank and the 

SPV is executed, the SPV is the creditor of the borrowers, who now have no 

obligation toward the bank. From a contractual perspective, the SPV becomes the 

borrowers' creditor-instead of the bank. From the perspective of property law, the 

SPV becomes the owner of the rights. 

As a creditor of the various borrowers, the SPV may assign its rights without 

their consent. The pledging of the rights to the investors who lend money to the 

SPV constitutes an additional assignment. But this assignment is by way of a charge. 

The issuance of debentures on the stock exchange is a loan that the SPV receives 

from the investors, and the SPV transfers the rights it has against the borrowers as a 

security interest. 

The assignment of the bank's rights to the SPV protects the latter from an 

exposure to any insolvency of the assigning bank or the imposition of a lien by one 

of its creditors. This protection also applies in the case of an assignment by way of a 

charge. However, as a purchaser, the rights of the SPV are better protected, as are 

the interests of its investors. In fact, it is in the bank's best interest to perform a true 

sale, because of accounting considerations. After a true sale the bank no longer 

needs to include the rights against the borrowers in its balance sheets, which in turn 

may improve its capital adequacy ratio. 

In mortgage securitizations in Israel, it is standard to include a provision that 

expressly stipulates that if the SPV is unable to collect the debt from the borrowers, 

the SPV will not be entitled to demand that the bank repay the entire principal-the 

money it paid to the bank for the assignment. Typically, the bank only assumes 

liability for a very small portion of the principal. Only a full right of recourse that 

would expose the bank to an obligation to repay the entire amount will be 

interpreted as a security interest transaction. The typical securitization transaction 

in Israel is structured as a true sale. 

C. Registration of the Assignment 

In case of bankruptcy or receivership, the interests of a secured creditor will not 

be protected unless the assignment has been registered. Section 97 of the 

Bankruptcy Ordinance stipulates the following: 

(a) Where a person has transferred existing or future rights to another and 

is subsequently adjudged bankrupt, the transfer shall be of no effect 

against the trustee as regards claims which were not settled before the 

commencement of the bankruptcy unless the transfer was registered at the 

time and in the manner prescribed by regulations. 

16. Transfer of Obligations Law § l(a). 



VOL. 42:751 

(b) The provisions of subsection (a) shall not apply to a transfer of claims 

against debtors specified in the instrument of transfer and the due date of 

settlement of which coincides with or precedes the time of the transfer, or 

in existing or future rights under contracts specified in the instrument of 

transfer, or of rights the transfer of which is included in the transfer of a 

business in good faith and for consideration. 7 

Section 97 imposes a duty of registration with respect to a general assignment 

that does not specify the contracts to which the assignment applies or the names of 

the debtors. The registration requirement does not apply where the contracts or 

debtors are specified in the instrument of assignment." 8 If the names of the 

borrowers whose debts are assigned are adequately specified, the true sale 

transaction does not have to be registered. Typically, an addendum to the 

agreement between the bank and the SPV specifies the names of the borrowers and 

the dates of their contracts with the banks. 

D. Notice to the Debtors 

As a rule, the agreement between the bank and the SPV does not require the 

borrowers' consent. The laws governing the assignment of rights do not obligate the 

assignor or the assignee to notify the debtor of the assignment. However, notice to 

the borrowers of the assignment could strengthen the SPV's protection. A debtor 

may not raise claims against the assignee arising from other transactions he has with 

the assignor if these claims accrued after notice of the assignment was given. 9 Some 

borrowers, especially those who also have savings plans or provident funds at the 

bank, may also have various causes of action against the bank. Notification to the 

borrowers regarding the assignment protects the SPV against any new arguments 

that the borrowers may have against the bank. 

A special provision passed into law in 2003 with respect to the securitization of 

mortgages states the following: "Should a mortgage be registered under this Section, 

the transferring corporation shall immediately give notice of the transfer to the 

borrower and the owner of the real estate securing the registered mortgage." 20 The 

notice requirement applies regardless of whether the mortgage registry is amended. 

The purpose of the law is to protect the borrower/owner of the real estate that serves 

as mortgage in the case of securitization. The notice affects the protection granted 

by law to the borrower/owner, and therefore the borrower/owner must be notified. 

Under the laws of assignments, "[t]he transfer of a right does not alter the right 

or the conditions thereof." 2 ' Therefore, provisions allowing early mortgage payoff 

will remain in full force and effect. The duty to send the borrowers periodic reports 

no longer rests with the bank, but with the SPV. Such reporting is not an 

independent duty of the bank but an incidental duty to the ownership of the right 

17. Bankruptcy Ordinance (New Version), 5740-1980, 3 NV 131 (1981) (Isr.) § 97. 

18. Regarding the cancellation of a general, unregistered assignment, see CA 596/86 Yehudit Ben 

Zion v. Gorni-Trustee for the Assets of Yehoshua Ben Zion, IsrSC 43(2) 460. 

19. Transfer of Obligations Law § 2(c). 

20. Settlement in the State Economy (Amendments Designated to Accomplish the Budget and 

Economic Policy Goals for the Fiscal Year of 2003), 2002, § 46(b). 

21. Transfer of Obligations Law § 2(a). 


2007 


against the borrowers, and the duty transfers to the SPV accordingly. 

service agreement, reporting will continue to be carried out by the bank. 

Under the 

E. The Bank as Trustee 

The bank and the SPV execute a service agreement under which-in 

consideration of an agreed fee-the bank will continue to collect the money from the 

borrowers, and transfer it to the SPV shortly thereafter. The bank might be liable 

toward the SPV if it is negligent in collecting the money. This liability has no effect 

on the classification of the assignment agreement as a true sale or as a security 

interest. Keeping the service agreement as separate from the sale agreement might 

help thwart any allegation that the transaction was not a true sale. 

From a property law standpoint, the money held by the bank is the property of 

the SPV. In one instance, Israel's Supreme Court expressed its opinion that where 

the debtor paid the debt to the assignor instead of the assignee, the assignor was 

holding the money in trust for the assignee. 22 The standard service agreement used 

in Israel expressly stipulates that the bank is a trustee for the issuer. 

The creditors of a trustee have no recourse against the assets held in trust. The 

Trust Law states: "Trust property shall not be distrained save for debts resting on 

that property or arising out of activities of the trust." 2 Thus, the bank's creditors 

have no access to the money that the bank holds in trust for the SPV: "A trust has 

effect vis-A-vis any person who knows or ought to know about it, and where a note 

has been entered under section 4, vis-A-vis the whole world." 2 If the bank is 

dissolved, the receiver might argue that the trust agreement between the bank and 

the SPV is not binding upon the receiver, because the receiver was not aware of its 

existence. 

In order to protect the trust, the following actions can be taken: 

a. Incorporating a provision in the service agreement that expressly states that 

the bank will hold the money obtained from the borrowers in trust for the issuer or 

the investors; 

b. Holding the money received in a separate trust account and prohibiting the 

bank from transacting in this money in any way-apart from a transfer to the SPV; 

c. Registering the transaction between the bank and the SPV with the 

Companies' Registrar. Such registration could inform third parties of the SPV's 

rights and thus satisfy the requirement regarding third parties' knowledge as 

required to protect the trust. 

III. MAKING THE SECURITY INTERESTS AVAILABLE TO THE SPV 

The underlying loan agreement between the bank and the borrower gives the 

bank a mortgage over the borrower's real estate. This mortgage is evidenced in the 

Land Registry and grants the bank priority over the other creditors if the borrower 

22. CA 4724/90 ESHET Finance Ltd. v. United Mizrahi Bank Ltd., IsrSC 46(3) 570, 577. 

23. Trust Law, 5739-1979, 33 LSI 154 (1978-79) (Isr.) § 3(b). 

24. Id. § 5. 



VOL. 42:751 

becomes insolvent. Also, if the borrower executes a transaction that conflicts with 

the mortgage the bank will prevail. This section discusses the ways that the SPV can 

get such priority as well. 

Under the laws governing transfers of obligations, along with the assigned right, 

the assignee also receives incidental rights. Unless the parties expressly stipulate 

otherwise, incidental rights and obligations transfer along with the principal right 

that is being transferred. Section 5 of the Transfer of Obligations Law states: 

Subject to the transfer agreement, the transfer of a right includes 

any guarantee or charge given as security for it and any other 

right concomitant to the transferred right, as far as they are 

transferable; and the creditor shall, upon the demand of the 

transferee, do the acts necessary in order that the transfer of the 

said rights may be valid in all respects.' 

This provision implies that the security interest is transferable under the law, 

regardless of the consent of the debtor in the underlying transaction. 26 An 

assignment that does not include the security interests securing the right reduces the 

value of the transferred right. Requiring a debtor's consent conflicts with the key 

principle of the laws of transfer of obligations- that rights can be transferred swiftly 

without the debtor's consent. 7 

The SPV is therefore entitled to be the named mortgagee in the Land Registry, 

and may ask the Land Registry to amend the registration in accordance with Section 

87 of the Land Law. The 1974 Land Regulations (Fees)' stipulate the fee payable 

for such an amendment. Under Section 87 of the Land Law, a mortgage cannot be 

transferred if the underlying loan agreement between the bank and the borrower 

prohibits the transfer. 29 However, the language of most loan agreements in Israel 

does not include such prohibition. In practice, the Land Registrar does not check 

the terms of each loan agreement and makes do with a confirmation by the company 

and an affidavit drafted by its legal counsel certifying that "[under] the terms of the 

mortgage, the consent of the owner of the land is not required in order to transfer 

the mortgage. ' Once the Registry is amended, the SPV becomes the mortgagee 

and has the same legal status as the bank did prior to the transfer. The SPV's 

mortgage is considered a continuation of the original mortgage, rather than a new 

31 

one. 

25. Transfer of Obligations Law § 5. 

26. For example, the SPV will be assigned guarantees that third parties have made to secure the 

borrowers' loans. 

27. CA 886/97 Burstein v. Hudad, IsrSC 52(4) 68 (holding that the debtor's consent is not required in 

order to assign the incidental rights). This proposition is reflected in U.S. law, according to which a 

mortgage securing a specific debt transfers to the assignee to whom the debt is assigned, even if the 

assignee is unaware of the existence of the mortgage based on the documentation. See RESTATEMENT 

(THIRD) OF PROPERTY § 5.4 cmt. c (1997) (stating "the obligation will 'follow' the mortgage even if not 

expressly mentioned in any document of transfer .. .this section is designed to carry out the parties' 

intention even though they, through ignorance or inadvertence, have not fully documented it"). 

28. The Land Regulations (Fees), 1974, add. § 2(b)(1). 

29 Land Law, 5729-1969, 23 LSI 283 (1968-69) (Isr.) § 87. 

30. Settlement in the State Economy Law § 46(a)(1). 

31. Motion 859/95, CC (TA) 1898/94 In Re Dov Fischler, Adv. v. Shekel Leasing Ltd., Takdin, DC 


2007 


That said, an amendment of thousands of mortgage registrations involves a 

considerable fee, possibly hindering the use of securitization transactions. It is 

therefore important to understand the legal status of an SPV that decides not to 

amend the Registry, leaving the bank as the named mortgagee. This subject has not 

been addressed by the courts yet. It is my opinion that the SPV is a secured creditor, 

whether or not the Registry is amended to state that the SPV is the mortgagee 

instead of the bank. 

Section 5 of the Transfer of Obligations Law says that security interests that the 

assignor had transfer to the assignee as part of the assignment. The law adds that 

"the creditor shall, upon the demand of the transferee, do the acts necessary in order 

that the transfer of the said rights may be valid in all respects." 32 This language 

seems to indicate that various complementary actions are required in order to give 

the security interest full force and effect in the hands of the assignee. According to 

this reading, the assignee is secured by the security interest only after the Registry is 

amended. I argue that this interpretation is undesirable and should therefore be 

rejected. 

The mortgage transfers to the SPV under Section 5 and under the agreement 

between the bank and the SPV. At this point the SPV is the holder of an 

unregistered mortgage. In 1999, Israel's Supreme Court opined that the purchaser 

of real estate has a right in equity even before the Registry is amended to reflect the 

new ownership or before a warning (a "caveat," known in Hebrew as he'arat azhara) 

to third parties that a contract has been executed for the sale of the property is 

entered in the Registry. 33 Based on this logic, the Court prioritized a purchaser over 

a creditor of the seller that has a lien on the property.' This decision changed the 

previous precedent, according to which until the transaction was entered in the Land 

Registry, a purchaser of land was not considered to have a proprietary right but only 

a contractual right. In another decision, delivered toward the end of 2003, the court 

held that the equitable right that a buyer had before the transaction that was 

perfected by registration also protects such buyer against insolvency of the seller. 5 

The buyer has priority over the other creditors of the insolvent seller and is entitled 

to receive the title to the real estate. In other words, the execution of an agreement 

for the sale of real estate in and of itself gives the buyer priority, and the transacted 

real estate will not be part of the pool of assets available to the creditors. 

The above case law raises questions about the unregistered mortgage. The 

Supreme Court deduced the existence of an equitable right from Section 9 of the 

Land Law, which, in addition to sale transactions, also governs a covenant to register 

a mortgage. 36 The Supreme Court has not addressed this issue yet, and the district 

96(3) 3792. 

32 Transfer of Obligations Law § 5. 

33. CA 189/95 Bank Otsar Ha-Hayal v. Aharonov, IsrSC 53(4) 199. 

34. Id. 

35. CA 3911/01 Caspi v. Shlomo Ness as Trustee in A Creditor Workout for "Diyur La-Oleh", lsrSC 

56(6) 752. 

36. Land Law § 9 (stating "[wihere a person has undertaken to effect a transaction in immovable 

property, and before it is completed by registration he undertakes towards another person to effect a 

conflicting transaction, the right of the party to the first transaction shall prevail: Provided that if the party 

to the second transaction has acted in good faith and for consideration, and such transaction is registered 

while he is still in good faith, his right shall prevail."). 



VOL. 42:751 

courts have expressed varying views. 37 I agree with the approach that recognizes the 

enforceability of an unregistered mortgage. The case law supporting the other 

approach does not offer any theoretical basis for the distinction between the 

unregistered right of a buyer and the unregistered right of a mortgagee. 

The SPV's priority also arises from Section 4(3) of the Pledges Law. According 

to this Section: "A pledge shall be effective against other creditors of the debtor... 

upon the registration of the pledge in accordance with regulations made under this 

Law: Provided that against a creditor who knew or should have known of the pledge 

it shall be effective even without registration." 38 Registration of the bank as 

mortgagee in the Land Registry gives the borrower's creditors knowledge of the 

transaction. Therefore, even if the right is assigned to the SPV but the mortgagee as 

named in the Land Registry is still the bank, the mortgage is deemed an unregistered 

security interest-which has full force and effect if the borrower becomes insolvent. 

The original registration informs third parties of the mortgage. Entries in the Land 

Registry are according to parcels and blocks, and the fact that there is now a 

different creditor is irrelevant to the fact that a mortgage on the same parcel or block 

still exists. 

There is similar case law regarding subrogation in favor of a guarantor. A 

guarantor that repaid the debt has a right to claim the payment from the principal 

debtor, and the security interests that secured the creditor henceforth protect the 

guarantor instead. 9 Like Section 5 of the Transfer of Obligations Law, Section 12 of 

the Guarantee Law provides that "the chargor and the creditor shall, at the 

guarantor's request, do the acts necessary to make the transfer valid in all respects."" ° 

In one case it was argued that unless the security interest was not registered to the 

guarantor in the appropriate registry, the guarantor had no recourse against the 

collateral. 41 The Court ruled that the assignment of the collateral is consistent with 

the sense of justice and that such assignment has full force and effect even before it 

is reflected in the registry. 42 This decision reflects the policy of recognizing the effect 

of the security interest even before it is registered to the new creditor. This 

approach, in the Court's view, does not prejudice the rights of the debtor's other 

creditors, because even before the assignment they could not collect against the 

collateral 3 

Similar case law exists regarding security interests. The Pledges Law enables 

the debtor, or any other person who would be adversely affected by the liquidation 

37. See, e.g., CA 1370/01 Kidma Ltd. V. Levy-Tuhrer, Attorneys at Law, Isr Dinim DC 32(10) 461; 

CC 1256/02 Sharon, Adv. v. Alphasi Shimon, IsrDC 2002(3) 7502. Cf CC (Jer) 2247/03 Reshef v. Levy, 

Takdin DC 2004(1) 6761. 

38. Pledges Law § 4(3). 

39. Guarantee Law, 5727-1967, 21 ISR 41 (1966-67) (Isr.) §§ 9, 12. 

40. Id. § 12. 

41. CA 108/59 Pritzker v. Niv. Ltd. (In Liquidation), IsrSC 14, 1545. 

42. Id. 

43. See, e.g., CA 306/68 The Official Receiver v. Receiver of Palkoltil Ltd., IsrSC 23(1) 256. (holding 

that a guarantor that repaid a debt that has priority by law, such as taxes, is entitled to the same priority). 

"Actually, what would the debtors be losing if the priority passes from the creditor to the guarantor? 

Nothing. The creditors' rights are not violated by the prioritization of a guarantor who paid the debt, 

because the debt that he paid had priority over their debts in the first place, and the change in the identity 

of the payee has no effect on their interests."). 



VOL. 42:751 

IV. 

SUMMARY AND CONCLUSIONS 

This paper reviewed the introduction process of securitization to the Israeli 

marketplace. This process started in three areas: mortgages, securitization of the 

indebtedness in leasing transactions, and securitization of tax money owing to local 

government. We focused on the securitization of mortgages and the legal issues 

surrounding such transactions. 

The popularity of securitization depends on economic factors. A low financial 

margin in the mortgage sector would hinder securitization, because it would leave no 

profit to be divided between the bank and the SPV. But economic factors are not 

the only possible hindrance-judicial uncertainty might also hold back the 

development of this market. Since the legislature has not given much thought yet to 

this financing instrument, an analysis must be made based on the general provisions 

of the law. 

In 2005, a government committee examined the local securitization market and 

recommended the adoption of a designated statute that would regulate the field. 

Such special legislation would answer the main issues reviewed above: 

Protection of the debtors whose indebtedness has been securitized. This 

protection is particularly important in the mortgage industry. Generally, when 

borrowers default on their loans, mortgage banks work out arrangements with the 

borrowers-such as debt rescheduling-which help borrowers avoid final breach. 

The loan agreement does not oblige the bank to make such concessions, but this is 

nevertheless standard practice. Securitization transactions give rise to the concern 

that the SPV would not be as considerate to the borrower. The bank intends to stay 

in the mortgage industry in the long-term, and looks out for its reputation. The SPV, 

on the other hand, is an outsider that has no incentive to make any concessions. 

Protection of the borrowers should therefore be regulated by statute. 

Clear criteria distinguishing between a true sale and a security interest. A true 

sale protects the SPV more effectively, and such protection would incentivize the 

securitization market. 

The SPV as a secured creditor even though the named mortgagee in the Land 

Registry remains the bank. Uncertainty might seriously undermine the securitization 

of mortgages because the cost of amending the registration to name the SPV as 

mortgagee with regard to all the assigned rights would be very high. 

We hope that the committee's recommendations are accepted and that a 

comprehensive arrangement regulating the securitization sector passes into law. 

Such an arrangement would certainly give this sector a serious boost. 


Japan's Personal Insolvency Law 

JUNICHI MATSUSHITA* 

SUMMARY 

I. OVERVIEW OF JAPAN'S PERSONAL INSOLVENCY LAW: BANKRUPTCY 

PROCEEDINGS AND SPECIAL REHABILITATION PROCEEDINGS FOR 

IND IVID U A L D EBTO RS ....................................................................................... 766 

A. Overview of Japan's Personal Insolvency Law ........................................ 766 

B. Bankruptcy Proceedings of Individual Debtors ....................................... 766 

C. Special Civil Rehabilitation Proceedings for Individual Debtors ........... 768 

1. O ff icers .................................................................................................. 768 

2. C laim V erification Process .................................................................. 768 

II. 

DEBTORS WITH ABILITY TO REPAY AND POSSIBILITY OF ABUSIVE 

F IL IN G S ................................................................................................................. 769 

A. Issues Discussed in the Legislative Process ............................................... 769 

B. Possibility of A busive Filings ..................................................................... 770 

III. C O N C LU SIO N ....................................................................................................... 771 

The project involving the comprehensive reform of Japanese insolvency law 

started in October 1996, and was finished in November 2004. There are now two 

types of judicial proceedings for personal insolvencies under Japanese insolvency 

law. The first is straight bankruptcy proceedings based on the Bankruptcy Law, in 

which the debtor can be discharged; the other is special civil rehabilitation 

proceedings for individual debtors. In Part I of this Article, I offer a brief discussion 

of personal insolvency law, as well as bankruptcy proceedings and special civil 

rehabilitation proceedings, both for individual debtors. In Part II, I present an 

overview of the legislative discussion concerning the treatment of debtors, who 

might be able to repay more from future income than that which would be 

distributed in bankruptcy proceedings. 

Professor at the University of Tokyo, Tokyo, Japan. I would like to express special thanks to 

Professor Jay Westbrook for organizing the 13 h Conference of the International Academy of Commercial 

and Consumer Law. This research was financially supported by the Ministry of Education, Culture, Sports, 

Science and Technology (MEXT), Grant-in-Aid for Scientific Research on Priority Areas (2), 16090207, 

2005. 



VOL. 42:765 

I. OVERVIEW OF JAPAN'S PERSONAL INSOLVENCY LAW: 

BANKRUPTCY PROCEEDINGS AND SPECIAL REHABILITATION 

PROCEEDINGS FOR INDIVIDUAL DEBTORS 

A. Overview of Japan's Personal Insolvency Law 

I start by providing a general description of the Bankruptcy Law and the Civil 

Rehabilitation Law before focusing on personal insolvency. 

The Bankruptcy Law (Hasan Ho) 1 was comprehensively amended in 2004, and 

became effective on January 1, 2005. The Bankruptcy Law provides for bankruptcy 

proceedings, which are applicable to both individuals and legal entities. 2 A 

bankruptcy proceeding is a sell-out proceeding where a debtor gives up all assets 

(except for those exempt in the case of an individual debtor), the court-appointed 

trustee sells these assets, and the proceeds are distributed to creditors on a pro-rata 

basis. 3 In 2005, there were 227,053 bankruptcy cases terminated; 216,582 of those 

cases involved bankruptcy proceedings of individual debtors. 

The Civil Rehabilitation Law (Minji Saisei Ho) 4 was enacted in 1999, and 

became effective on April 1, 2000. This law provides for civil rehabilitation 

proceedings, which are also applicable to both individuals and legal entities. 5 A 

rehabilitation proceeding is a pay-out proceeding where a debtor can propose to 

keep all assets in exchange for promising to pay off debts from future income over a 

period of time according to a rehabilitation plan. 6 A rehabilitation plan becomes 

effective upon its acceptance by a majority of unsecured creditors and court 

approval. 7 In 2005, there were 27,478 rehabilitation cases terminated; 26,644 of those 

cases comprised special rehabilitation proceedings for individual debtors. 

B. Bankruptcy Proceedings of Individual Debtors 

There are several rules applicable to individual debtors, such as exemption and 

discharge. The law provides that exemptions shall include the debtor's household 

furnishings, household goods, apparel, household appliances, cash of up to Y990,000, 8 

and the debtor's right to receive unpaid salary of up to Y330,000 9 per month. In 

addition, the court may, when petitioned by the debtor or at its own discretion, 

1. Hasan Ho [Bankruptcy Law], Law No. 75 of 2004. The old Bankruptcy Law, Law No. 71 of 1922, 

was basically modeled upon the old German Bankruptcy Law of 1877, Konkursordnung. Although many 

provisions were amended when the new law was enacted, its basic structure has changed little. 

2. Id. 

3. Id. 

4. Minji Saisei Ho [Civil Rehabilitation Law], Law No. 225 of 1999. When the Civil Rehabilitation 

Law became effective, the Composition Law (Wagi Ho), which was modeled upon the Austrian 

Composition Law of 1914, was repealed. 

5. Id. 

6. Id. 

7. Id. 

8. Approximately US$8,390 (US$1=¥118). The cap amount was V210,000 before the amendment, and 

was raised dramatically-mainly to protect the debtor and dependents thereof. 

9. Approximately US$2,797 (US$1=¥118). 


2007 

JAPAN'S PERSONAL INSOLVENCY LAW 

extend the scope of exemption in consideration of certain factors, including the 

following: the total amount of other exempted properties, whether the debtor is 

employed, and the number and age of family members. Typical examples of 

exemption extensions are bank account deposits up to a particular amount, and 

ownership of a motor vehicle in cases in which the debtor lives in an area (where the 

public transportation system is not well-established or where the debtor runs a 

carrier business). There is no homestead exemption in Japan, so the debtor has to 

give up real estate. 

A filing for a bankruptcy proceeding by the debtor is deemed to be a filing for 

discharge. The court grants a debtor a discharge-except in certain instances. 

Grounds for denial of discharge include the debtor's wrongdoing in or in connection 

with bankruptcy cases-such as concealment of assets to defraud creditors or making 

false statements feigning solvency when borrowing money-and refusal of the 

debtor to testify or cooperate with the trustee or court.'" The discharge is also 

denied if the debtor was granted a discharge in a previous bankruptcy case or 

rehabilitation case within certain time limits. Under the old Bankruptcy Law, a 

debtor could not receive a discharge in a bankruptcy proceeding if a prior discharge 

had been received within ten years of the new filing." It was argued that this period 

must be shortened to further protect debtors in the modern economy; although 

moral hazards must also be minimized. The new Bankruptcy Law provides that a 

debtor cannot presently receive a discharge if a prior discharge was received within 

seven years (rather than ten) of the new filing.' 3 Even in one of the above cases, the 

court may grant a discharge at its discretion in consideration of the grounds for 

financial failure.14 

Under the old Bankruptcy Law, a discharge order did not discharge an 

individual debtor from debts for: (1) taxes; (2) compensation for damage caused by 

willful tort; (3) wages; or (4) penalties and fines." The new Bankruptcy Law, 

however, adds two categories of debts which cannot be discharged: (5) debts for 

personal injury or death caused by an intentional or reckless act of the debtor; and 

(6) debts to a spouse, former spouse, or child of the debtor, for alimony, 

maintenance, or support for the spouse or child 6 

In the legislative discussion, it was argued that a cap should apply to debts 

under the above categories (5) and (6) to protect the debtor from unlimited 

obligations. However, the new Bankruptcy Law provides for no such limit or cap to 

discourage moral hazards. 

In practice, most debtors who would satisfy the criteria for the commencement 

of bankruptcy proceedings never progress to being formally liquidated because it 

appears to creditors that there are no non-exempt assets in the estate with which to 

fund the administration of the bankruptcy proceeding, mainly compensation for the 

trustee. The Bankruptcy Law provides that a bankruptcy proceeding be commenced 

and then terminated simultaneously (often called "simultaneous termination"), and 

10. Hasan Ho [Bankruptcy Law], Law No. 75 of 2004. 

11. Id. 

12. Hasan Ho [Bankruptcy Law], Law No. 71 of 1922 (amended 2004). 


14. Id. 





VOL. 42:765 

no trustee be appointed." In 2005, of 216,582 bankruptcy cases involving individual 

debtors, there were 194,865 simultaneous termination cases (ninety percent). It is 

argued that because no investigation by the trustee is conducted in these cases, the 

debtor's wrongdoing that might otherwise lead to denial of discharge could be 

overlooked and a discharge could be granted. Recently, the court has appointed a 

trustee in some consumer bankruptcy cases, and awarded a comparatively lower 

amount of compensation to the trustee by limiting the scope of investigation that the 

trustee needs to conduct. Most of these cases turn out to be assetless cases, and are 

terminated after the trustee's investigation. In 2005, among 216,582 bankruptcy 

cases of individual debtors, there were 15,897 cases (seven percent) where trustees 

were appointed and terminated because of an assetless estate. 

C. Special Civil Rehabilitation Proceedings for Individual Debtors 

Because civil rehabilitation proceedings were originally intended mainly for 

small- and medium-sized businesses, due to the cost involved, they are rather 

burdensome for consumers and individuals who run a business as an individual 

proprietorship. In the year 2000, the Civil Rehabilitation Law was amended to add 

new chapters, one of which specified simplified procedures for individual and 

regularly salaried debtors owing ¥50 million or less, with a three-year duration for 

the rehabilitation plan in principle. 8 Under special circumstances, the duration of a 

plan can be extended to up to five years. 9 Two major features of the simplified 

proceedings are as follows: 

1. Officers 

In most regular civil rehabilitation cases, the court appoints a supervisor, while 

debtors continue to have rights to administer and dispose of the debtor's assets, 

subject to a broad range of supervision by the supervisor. On the other hand, they 

must remain inexpensive and simple, because such proceedings only deal with small 

cases. The court may appoint a Rehabilitation Officer for Individuals (Kojin Saisei 

Iin), whose function is limited to investigating the debtor's assets and income, 

assisting the court in reviewing the legitimacy or amount of claims to which the 

debtor or other creditor may object, and advising the debtor in drafting an 

appropriate plan. 

2. Claim Verification Process 

When an objection is raised to a claim filed by the debtor or other creditors, the 

court reviews the legitimacy or amount of the claim in summary, rather than plenary, 

proceedings. The court makes a binding decision only on the amount of voting 

rights for creditors' meetings-allotted to the creditor whose claim is objected toand 

there are no provisions for appeal. This decision, however, does not have the 

17. Id. 

18. Minji Saisei Ho [Civil Rehabilitation Law], Law No. 225 of 1999. 

19. Id. 


2007 


same effect as a judgment, in the sense that the decision has no binding effect on the 

substance of the claim. 

Chapter 13 of the Civil Rehabilitation Law provides for two kinds of simplified 

Civil Rehabilitation proceedings for individual debtors. 'The first type is for 

individual debtors with a generally regular income, and is referred to as "small size 

individual rehabilitation." 20 There were 18,567 cases of such proceedings in 2005. In 

these proceedings, a rehabilitation plan may become effective with the creditors' 

acceptance and the court's confirmation. A plan is accepted if the creditors that 

reject the plan in writing are owed half or less of the total allowed claims and 

number less than half of all the creditors. This "negative approval standard" 

assumes that creditors who do not reject a plan in writing accept the plan. Major 

requirements for court confirmation are: (1) a "best interest test," under which each 

creditor should receive an amount no less than that which he or she would receive if 

the debtor's assets were liquidated under bankruptcy proceedings; and (2) a 

minimum payment rate, basically twenty percent, depending on the total amount of 

debt. 2 ' 

The second kind of proceeding is intended for individual debtors with regular 

stable income, such as wages, and is called the "wage earners rehabilitation." The 

most important feature of such a proceeding is that the rehabilitation plan becomes 

effective with the court's confirmation, and without the necessity for creditors' 

approval. There were 8,428 cases of such proceedings in 2003, and 8,077 in 2004. 

Major requirements for confirmation are not only (1) and (2), as aforementioned, 

but also a "disposable income standard," under which the debtor must repay his or 

her debts (as modified by a plan) from his or her regular income, less taxes, social 

insurance premiums, and permissible living expenses provided by the cabinet order. 

II. 

DEBTORS WITH ABILITY TO REPAY AND POSSIBILITY OF ABUSIVE 

FILINGS 

A. Issues Discussed in the Legislative Process 

One of the issues most intensively discussed in the legislative process was the 

ability of the debtor to opt for bankruptcy proceedings, regardless of the amount of 

expected future income. The tentative draft that was publicized for comment in 

June 2000 proposed three alternatives: (1) the debtor would be able to choose 

between either bankruptcy proceedings or simplified rehabilitation proceedings; (2) 

the debtor would be discharged in bankruptcy proceedings only after attempting to 

20. Id. 

21. The following shows the minimum payment rate or amount based on total amount of debt: 

Total Amount of Debts 

Minimum Payment Rate/Amount 

0 -V1,000,000 100% 

¥1,000,000 - ¥5,000,000 V1,000,000 

V5,000,000 - V15,000,000 20% 

V15,000,000 - V30,000,000 

V3,000,000 

V30,000,000 - V50,000,000 10% 



VOL. 42:765 

repay his or her debts in rehabilitation proceedings, if his or her expected disposable 

income exceeded a certain amount; and (3) the debtor would be discharged in 

bankruptcy proceedings only once he or she had repaid his or her debts to the 

amount receivable by each creditor if the debtor chose simplified rehabilitation 

proceedings (where the "minimum payment rate standard" or "disposable income 

standard" would apply), if the expected disposable income of the debtor exceeded a 

certain amount. 

As long as a debtor chooses a rehabilitation proceeding, creditors will be able 

to receive an amount no less than what they would receive if the debtor's assets were 

liquidated under bankruptcy proceedings, because a "best interest test" applies when 

a rehabilitation plan is confirmed. On the other hand, if a debtor with the ability to 

repay more than hypothetical bankruptcy distribution chooses a bankruptcy 

proceeding and is discharged, it could be argued that the interest of creditors is 

damaged in the sense that they lost an opportunity to be repaid from the debtor's 

future income. This concern is serious when a debtor has minimum assets to 

maintain his or her life now but where high and regular future income is definitely 

expected. 

An argument for the second and third alternatives is that creditors-namely 

consumer financing and credit card companies -usually look to debtors' future 

income rather than, or at least in addition to, debtors' current assets. Under the 

second and third alternatives, debtors would be forced, directly or indirectly, to pay 

more than what would be distributed in bankruptcy proceedings. 

The Bankruptcy Law Committee finally chose the first alternative, mainly 

because both the second and third were rather impractical. Calculating the expected 

disposable income means having to initially estimate the debtor's income in the near 

future, and then deducting tax, social insurance, and necessary expenses of the 

debtor and dependents, which may vary based on the number and age of 

dependents. Calculation would have to be done by neutral court-appointed officers, 

and hearings of debtors would also be necessary. Although there is no empirical 

study on the ability of debtors who filed for bankruptcy proceedings to repay, it is 

said that only a small portion of debtors would be able to repay more from their 

future income. Calculating the expected disposable income to pick up debtors with 

the ability to repay more in all personal bankruptcy cases,2 numbering as many as 

two hundred thousand, would be time-consuming and not at all cost-effective. This 

gate-keeping difficulty was critical in making the decision. Therefore, under the 

current law, a debtor can choose between either bankruptcy proceedings or 

rehabilitation proceedings, regardless of the amount of expected disposable income. 

B. Possibility of Abusive Filings 

Some practitioners argue that current laws allow petitions for bankruptcy 

proceedings to be dismissed through abusive use (general clause in Japanese law), if 

the amount of the expected disposable income of the debtor is relatively high. As 

far as I know, however, there has been no reported case in which a petition for a 

22. One of the related issues is whether calculating the expected disposable income is required for all 

personal bankruptcy cases or only in cases where creditors request it. Under the latter scheme, the 

required cost would be less, but there is a concern that a particular type of creditors would request it 

abusively. 


2007 


bankruptcy proceeding was dismissed because of the amount of the debtor's 

disposable income. It is pointed out that an argument for dismissal based on abusive 

filing is problematic because there are no clear criteria for judging whether a certain 

filing is an abuse and judgments could vary from judge to judge. 23 

Should Japanese insolvency laws be amended in the future to introduce a new 

legal scheme to prevent abusive filings? In order to answer this difficult question, I 

first focus on who will bear the burden of defaults in a legal scheme to prevent 

abusive filings. On the one hand, under current law, the cost of defaults of 

individual debtors could be passed along to other persons who borrow money from 

consumer financing companies (some of which are financially related to mega 

banks), in the form of higher interest rates; 24 the cost could even be passed on to all 

other people, in the form of higher interest rates and higher prices. On the other 

hand, if the second or third of the aforementioned alternatives (Part I.A) is 

introduced, the cost of gate-keeping in bankruptcy or rehabilitation proceedings 

would be a burden to courts, and ultimately to all tax payers. It would also cause a 

delay in insolvency proceedings and other regular civil cases. It could be argued that 

a solution to the cost problem is a legal scheme under which gate-keeping- that is, 

calculation of debtors' future income-is needed only in cases in which one or more 

creditors request it, and the cost for gate-keeping is borne by the creditors who 

requested it. But this idea cannot be an answer, because those creditors can easily 

pass along the cost they paid to the court to other people in the form of higher 

interest rates and higher prices. 

Should the view that a legal scheme is needed to prevent abusive filings prevail, 

it should first be discussed whether it can be justified to help creditors (mainly 

consumer financing companies and credit card companies) in collecting their loans, 

by establishing a threshold to sort out debtors and by imposing costs to apply the 

court system to all taxpayers. Would this be cost effective? Even if it were, could we 

call it justice? 

III. CONCLUSION 

The consumer credit industry has developed dramatically for several decades, 

and it has both a bright and dark side. To enjoy the bright side of consumer credit, 

we need to pay the cost that inevitably accompanies its development. When we 

design a legal scheme for personal insolvency, we must decide how to allocate the 

cost and whether it can be justified from the viewpoint of justice. I hope this paper 

interests commercial lawyers and consumer lawyers worldwide. 

23. There was a judge who rendered many decisions to deny discharge, most of which were reversed 

in appellate courts. Although these are exceptional and extreme cases, bankruptcy attorneys are 

concerned about arbitrary decisions. 

24. In this context, it is interesting that there was recently a legislative discussion to lower interest rate 

caps from 29% a year to 15-20% a year. 



The Landmark 2005 Hague Convention on 

Choice of Court Agreements 

VED P. NANDA* 

SUMMARY 

I. INT R O D U CTIO N ................................................................................................... 774 

II. SCOPE OF THE CONVENTION .............................................................................. 777 

III. JU R ISD ICT IO N ...................................................................................................... 780 

IV. RECOGNITION AND ENFORCEMENT ................................................................. 782 

V . SELECTE D ISSU ES ................................................................................................ 783 

A. Preliminary Questions and Intellectual Property Rights ......................... 783 

B . Transition P rovisions .................................................................................. 784 

C. Contracts of Insurance and Reinsurance ................................................... 784 

D. Relationship with Other International Instruments .................................. 785 

VI. IMPLEMENTATION OF THE CONVENTION IN THE UNITED STATES ................ 786 

VII. APPRAISAL AND RECOMMENDATION .............................................................. 787 

Vice Provost, Evans University Professor, Thompson G. Marsh Professor of Law, and Director, 

International Legal Studies Program, University of Denver Sturm College of Law. This is an expanded 

version of the author's presentation on August 11, 2006, at the 13th Biennial Conference of the 

International Academy of Commercial and Consumer Law, University of Texas School of Law, Austin, 

August 9-12, 2006. 



VOL. 42:773 


The Convention on Choice of Court Agreements,' adopted at the twentieth 

session of the Hague Conference on Private International Law on June 30, 2005, is 

an important step toward international harmonization of national conflicts rules on 

forum selection clauses. The Convention both strives to ensure the recognition and 

enforcement of international choice of court clauses in the context of international 

business by providing uniform rules, and validates the parties' choice of forum as the 

single basis for jurisdiction. At the same time, it provides sufficient safeguards for 

governmental interests and for rendering and enforcing courts. 

It is worth recalling that the United States Supreme Court had validated party 

autonomy as early as 1972 in MIS Bremen v. Zapata Off-Shore Co., 2 by giving effect 

to "the legitimate expectations of the parties, manifested in their freely negotiated 

agreement, by specifically enforcing the forum clause." 3 By eliminating uncertainties 

regarding the place of suit by forum selection in advance, such contractual 

stipulations were found by the Court to constitute an "indispensable element in 

international trade, commerce, and contracting."' 

The Court approved of what it called a recent trend in adopting "a more 

hospitable attitude" toward choice of forum clauses, and called upon federal district 

courts sitting in admiralty to follow this as "the correct doctrine." 5 The Court 

established a reasonableness test to determine the validity of forum selection 

clauses, as it held that "such clauses are prima facie valid and should be enforced 

unless enforcement is shown by the resisting party to be 'unreasonable' under the 

circumstances." 6 A strong showing could indeed be made for setting aside the forum 

selection clauses "for such reasons as fraud or overreaching" or if the enforcement 

would be "unreasonable and unjust" or contrary to "a strong public policy of the 

forum."' The Bremen Court's reasoning that "[w]e cannot have trade and commerce 

in world markets and international waters exclusively on our terms, governed by our 

laws, and resolved in our courts,"" would certainly apply equally in every other 

country. 

1. See Convention on Choice of Court Agreements, June 30, 2005, reprinted in 44 I.L.M. 1294 (2005), 

available at http://www.hcch.net/index-en.php?act=conventions.pdf&cid=98 [hereinafter Hague 

Convention]; see generally, e.g., SAMUEL P. BAUMGARTNER, THE PROPOSED HAGUE CONVENTION ON 

JURISDICTION AND FOREIGN JUDGMENTS, (2003); see also Ronald A. Brand, Introductory Note to the 2005 

Hague Convention on Choice of Court Agreements, 44 I.L.M. 1291 (2005); Trevor C. Hartley, The Hague 

Choice-of-Court Convention, 31 EUR. L. REV. 414 (2006); Thalia Kruger, The 20th Session of the Hague 

Conference: A New Choice of Court Convention and the Issue of EC Membership, 55 INT'L & COMP. L.Q. 

447 (2006); Andrea Schulz, The Hague Convention of 30 June 2005 on Choice of Court Agreements, 2 J. 

PRIVATE INT'L L. 243 (2006); Louise Ellen Teitz, The Hague Choice of Court Convention: Validating Party 

Autonomy and Providing an Alternative to Arbitration, 53 AM. J. COMP. L. 543 (2005); Peter D. Trooboff, 

International Law: Foreign Judgment, NAT'L L.J., Oct. 17, 2005, at 13, available at 

http://www.hcch.net/upload/bibl37-pt.pdf. 

2. MIS Bremen v. Zapata Off-Shore Co., 407 U.S. 1 (1972). 

3. Id. at 12. 

4. Id. at 13-14. 

5. Id. at 10. 

6. Id. at 10. 

7. Id. at 15. 

8. Bremen, 407 U.S. at 9. 


2007 

THE LANDMARK 2005 HAGUE CONVENTION 

Bremen was a case in admiralty; although both federal and state courts have 

generally followed the Bremen holding in non-admiralty cases as well. However, 

were the U.S. to become a contracting party to the Choice of Court Convention, the 

Convention may have impact, not only on cases in U.S. courts involving 

international forum selection clauses, but eventually even in the domestic setting as 

jurisdictional law may be harmonized by federal legislation. 9 

Although the Hague Convention was adopted in June 2005, the actual drafting 

of the document began at the Hague Conference in 1992 with the United States' 

initiative to create a global convention on jurisdiction and the recognition and 

enforcement of judgments in civil and commercial matters.' 0 The United States' 

interest in such a convention is driven by the obvious need it perceives for a legal 

structure to "support the growth of global markets" and promote international 

cooperation." Moreover, since the United States is not a party to any treatybilateral 

or multilateral-on recognition and enforcement of foreign judgments, the 

U.S. finds itself at a major disadvantage, for re-litigation becomes a prerequisite for 

the enforcement of U.S. judgments abroad. The U.S. courts are perceived to be 

more hospitable to the enforcement of foreign judgments than foreign courts are to 

U.S. judgments. 2 

The negotiation process was lengthy and cumbersome. A Preliminary Draft 

Convention on Jurisdiction and Foreign Judgments in Civil and Commercial Matters 

was finally adopted at the October 1999 meeting of the Hague Conference, 3 which 

generally mirrored in its structure and content the prior European Union 

instruments on the topic-the Brussels Convention of September 27, 1968," and the 

9. See Kevin M. Clermont & Kuo-Chang Huang, Converting the Draft Hague Treaty into Domestic 

Jurisdictional Law, in A GLOBAL LAW OF JURISDICTION AND JUDGMENTS: LESSONS FROM THE HAGUE 

191, 192-93 (John J. Barcelo, III & Kevin M. Clermont eds., 2002) (advocating federal legislation 

standardizing jurisdictional rules for state and federal courts). 

10. See Peter H. Pfund, The Project of the Hague Conference on Private International Law to Prepare 

a Convention on Jurisdiction and the Recognition/Enforcement of Judgments in Civil and Commercial 

Matters, 24 BROOK. J. INT'L L. 7, 8 (1998). 

11. See Letter from Jeffrey D. Kovar, U.S. Dept. of State, Assistant Legal Advisor for Private Int'l 

Law, to J.H.A. van Loon, Sec'y Gen., Hague Conference on Private Int'l Law 2 (Feb. 22, 2000), available at 

http://www.cptech.org/ecom/hague/kovar2loon22022000.pdf. 

12. See, e.g., Kevin M. Clermont, Jurisdictional Salvation and the Hague Treaty, 85 CORNELL L. REV. 

89, 89 (1999) (stating "the United States eagerly gives appropriate respect to foreign judgments, despite 

sometimes getting no respect in return"); see also Peter D. Trooboff, Ten (and Probably More) Difficulties 

in Negotiating a Worldwide Convention on International Jurisdiction and Enforcement of Judgments: Some 

Initial Lessons, in A GLOBAL LAW OF JURISDICTION AND JUDGMENTS: LESSONS FROM THE HAGUE 263, 

263 (John J. Barcelo, III & Kevin M. Clermont eds., 2002); Stephen B. Burbank, The Reluctant Partner: 

Making Procedural Law for International Civil Litigation, 57 LAW & CONTEMP. PROBS. 103, 138-39 (1994) 

(stating "[tihe problem with unilateral generosity is that it may weaken U.S. bargaining power when, other 

countries having chosen not to follow our example, it attempts to work out mutually acceptable 

agreements. That looms as a difficulty for the United States in pursuing a multilateral convention on the 

recognition and enforcement of foreign judgments") (footnotes omitted). 

13. See Report on the Preliminary Draft Convention on Jurisdiction and Foreign Judgments in Civil 

and Commercial Matters, drawn up by Peter Nygh & Fausto Pocar, Preliminary Document No. 11 of 

August 2000, available at http://www.hcch.net/upload/wop/jdgmpdll.pdf. 

14. See Convention of 27 September 1968 on Jurisdiction and the Enforcement of Judgments in Civil 

and Commercial Matters, 1968, 1990 O.J. (C 189) 2; see also Council Regulation (EC) No. 44/2001 of 22 

December 2000 on Jurisdiction and the Recognition and Enforcement of Judgments in Civil and 

Commercial Matters, 2001 O.J. (L 12) 1 (supplanting the 1968 Brussels Convention on March 1, 2002) 

[hereinafter Brussels Convention 2000]. 



VOL. 42:773 

Lugano Convention of September 16, 1988." Subsequent consultations showed 

serious differences among the delegates on the text of this ambitious project, parts of 

which had been adopted by narrow majorities and, consequently, would not have 

received wide approval. 

A lack of consensus on the text was coupled with the concern that in the era of 

special issues raised by e-commerce and intellectual property rights, the rules based 

on the Brussels and Lugano conventions, adopted so long ago, would not meet 

contemporary needs. Thus, formal negotiations on the 1999 draft were suspended. 16 

Subsequent informal discussions between 2000 and 2002 led to the realization that a 

consensus could not be reached on a global convention of such a wide scope as 

envisaged earlier; the decision was made to scale down the project and use a 

"bottom-up-approach," starting with choice of court clauses on business-to-business 

cases, on which there already was broad agreement. 7 After several sessions of an 

informal working group during 2002-2003, the group prepared a draft that it 

submitted to the Commission on General Affairs and Policy of the Hague 

Conference in April 2003. The Commission met in December 2003 and April 2004 

and produced a Preliminary Draft Convention, and, after further deliberations and 

work, a diplomatic session convened in June 2005 unanimously adopting the 

Convention. 8 

Three basic rules that ensure the effectiveness of the Hague Convention form 

its core. First, the court specified by an exclusive and valid choice of court 

agreement must hear the case.' 9 Second, pursuant to limited exceptions, all other 

courts must suspend or dismiss the case. 2 ' Third, the resulting judgment of the 

chosen court must generally be enforced by courts in other Contracting States. 2 ' In 

addition to these three rules, the Convention contains a fourth optional rule on 

reciprocal declarations, that Contracting States may declare that they will recognize 

and enforce judgments of other Contracting States resulting from non-exclusive 

choice of court agreements. These provisions will be elaborated later. 

15. See Convention of 16 September 1988 on Jurisdiction and the Enforcement of Judgments in Civil 

and Commercial Matters, 1988 O.J. (L 319) 9. 

16. See Schulz, supra note 1, at 244-48 (detailing the negotiations). As First Secretary at the 

Permanent Bureau of the Hague Conference on Private International Law, Schulz was in charge of the 

negotiations beginning in 2002. 

17. Id. 

18. See Preliminary Documents to Convention of 30 June 2005 on Choice of Court Agreements, 

available at http://www.hcch.net/index-en.php?act=conventions.publications&dtid=35&cid=98 (pertaining 

to the Convention and providing pertinent details regarding the process leading to its adoption); e.g., The 

Impact of the Internet on the Judgments Project: Thoughts for the Future, Preliminary Document No. 17 

of Feb. 2002; Choice of Court Agreements in International Litigation: Their Use and Legal Problems to 

Which They Give Rise in the Context of the Interim Text, Preliminary Document No. 18 of Feb. 2002; 

Report on the Work of the Informal Working Group on the Judgments Project, In Particular on The 

Preliminary Text Achieved at Its Third Meeting March 2003, Preliminary Document No. 22 of June 2003; 

Draft Report on the Preliminary Draft Convention on Exclusive Choice of Court Agreements, Drawn up 

by Trevor C. Hartley & Masato Dogauchi, Preliminary Document No. 26 of Dec. 2004; Comments on the 

Preliminary Draft Convention on Exclusive Choice of Court Agreements, Preliminary Document No. 29 of 

May 2005; The Future Convention on Exclusive Choice of Court Agreements and Arbitration, Preliminary 

Document No. 32 of Jun. 2005. 

19. Hague Convention, supra note 1, art. 5. 

20. Id. art. 6. 

21. Id. art. 8. 


2007 


This discussion will begin in the next section on the scope of the Convention. 

The third section will review the jurisdictional issues, which will then lead to a 

section on recognition and enforcement. Selected issues will be discussed next, and 

issues related to the Convention's implementation in the United States will be 

reviewed after that. The final section will cover an appraisal of the Convention. 

II. 

SCOPE OF THE CONVENTION 

Article 1 defines the Convention's scope. It applies only to international cases, 

only if there is an exclusive choice of court agreement, and only in civil and 

commercial matters. The definition of "international" varies between the 

Convention's application regarding jurisdiction and its application regarding 

recognition and enforcement. A case is international unless the parties are residing 

in the same Contracting State and all relevant elements except the location of the 

chosen court are connected only with that State. Thus, merely the choice of a 

foreign court in an otherwise totally internal case does not make it international. 

The Convention's reach is expansive, however, for the purpose of recognition 

and enforcement, as the mere fact that a judgment is given by a foreign court suffices 

to make it international. To illustrate: assume that the parties, both residents of 

France, a Contracting State, enter into an exclusive forum selection agreement, 

choosing the courts in Italy to resolve their disputes and that all elements relevant to 

the dispute are connected with France. For jurisdictional purposes, this is not an 

international case. If a court in Italy, however, renders judgment, and the judgment 

is taken by one of the parties to Germany or France (assuming that France, Italy, 

and Germany are all Contracting States), both Germany and France will be 

obligated to recognize and enforce the judgment. Recognizing this anomalous 

situation, the Convention does authorize the State, namely France in this example, 

to declare that it will not recognize or enforce such judgments. 22 

The Convention defines an entity or person other than a natural person is as a 

resident of a state-where it has its statutory seat, central administration, or 

principal place of business, or the State under whose law it was formed or 

incorporated. 3 A judgment under the Convention follows the traditional meaning of 

"judgment" for recognition purposes-namely that it is given by a court on the 

merits and does not include interim measures of protection, 24 which are not covered 

under the Convention.2 

To provide further clarity, the Convention explicitly states that it does not 

govern interim measures of protection and that it "neither requires nor precludes the 

grant, refusal or termination of interim measures of protection by a court of a 

Contracting State and does not affect whether or not a party may request or a court 

should grant, refuse or terminate such measures. 2 6 

The Convention uses the term "State" or "Contracting State" to include states 

with two or more territorial units with different legal systems, such as Canada, the 

22. Id. art. 20. 

23. Id. art. 4(2). 

24. Id. art. 4(l). 

25. Hague Convention, supra note 1. art. 7. 

26. Id. 



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United Kingdom, and the United States, as well as "Regional Economic Integration 

Organizations," such as the European Union. 27 As to the former, the Convention 

provides that the term "State" or "Contracting State" applies, where appropriate, to 

"the relevant territorial unit," that is, either the larger entity (say the United 

Kingdom), or its sub-unit (say Scotland). 28 Thus, the choice of a Scottish court would 

mean that Scotland would be the "Contracting State. 

As to the Regional Economic Integration Organizations, the Convention 

authorizes such an entity to become a party to the Convention if the organization's 

member states have granted it "competence over some or all of the matters 

governed by [the] Convention." 3 Such an organization may also declare that it 

alone and not its member states individually will be party to the Convention but that 

they will also be bound by virtue of the organization's adherence. 3 " 

An exclusive choice of court agreement is defined as an agreement that "must 

be concluded or documented (i) in writing; or (ii) by any other means of 

communication which renders information accessible so as to be usable for 

subsequent reference." 32 Accompanying this rather limited form requirement is the 

provision that the agreement designate "the courts of one Contracting State or one 

or more specific courts of one Contracting State to the exclusion of the jurisdiction 

of any other courts" to resolve past and future disputes. 3 Assuming that the United 

States ratifies the Convention to apply federally as well as to all its states, an 

agreement could, for example, specify the federal courts of the United States, or the 

Federal District Court of Colorado, or the state courts of Colorado. 

The Convention validates party autonomy, presuming exclusivity for a choice of 

court agreement "unless the parties have expressly provided otherwise." 34 Thus, an 

agreement designating the courts of a non-Contracting State is excluded from the 

Convention's coverage. Finally, the Convention provides severability of a choice of 

court agreement from the rest of a contract so that the validity of the exclusive 

forum selection clause "cannot be contested solely on the ground that the contract is 

not valid." 35 

The Convention appropriately confines its scope to exclusive choice of court 

agreements, although it does provide for reciprocal declarations by Contracting 

States that their courts will recognize and enforce judgments of other Contracting 

States resulting from non-exclusive choice of court agreements. 36 Otherwise, it 

27. Id. art. 25. 

28. Id. 

29. Id. 

30. Id. art. 29. 


32. Id. art. 3(c); see also Schulz, supra note 1, at 248 (explaining that article 3(c)(ii) of the Hague 

Convention is drawn from the UNCITRAL Model Law on Electronic Commerce); c.f, Convention on the 

Recognition and Enforcement of Foreign Arbitral Awards art. Il(1), June 10, 1958, 21 U.S.T. 2517, 330 

U.N.T.S. 38 (providing a contrast to the flexible language of The Hague Convention art. 3 with the rigid 

requirement in the 1958 Convention that the "agreement [be] in writing under which the parties undertake 

to submit to arbitration all or any differences" between them regarding "a defined legal relationship, 

whether contractual or not, concerning a subject matter capable of settlement by arbitration") [hereinafter 

New York Convention]. 

33. Hague Convention, supra note 1, art. 3(a). 

34. Id. art. 3(b). 

35. Id. art. 3(d). 

36. Id. art. 22. 


2007 


would have to address the issue of parallel proceedings and consequently the rigid 

rule of priority, which is the practice in Europe, but on which there is no wide 

consensus. The United States, for example, rejects the priority concept and instead 

follows the forum non conveniens approach; thus, the United States courts routinely 

apply public and private law factors in exercise of their broad discretion to 

determine whether they should or should not hear the case. 

The presumption of exclusivity resolves an issue fraught with difficulty in the 

United States courts, where generally forum selection clauses are not presumed to 

be exclusive absent explicit language to that effect. Furthermore, courts in the 

United States differ on what makes a forum selection clause mandatory and hence 

enforceable, or permissive and hence discretionary. A Tenth Circuit case decided in 

2002, K & V Scientific Co., Inc. v. BMW, aptly makes the point: "Mandatory forum 

selection clauses contain clear language showing that jurisdiction is appropriate only 

in the designated forum. 37 In contrast, permissive forum selection clauses authorize 

jurisdiction in a designated forum, but do not prohibit litigation elsewhere." 8 The 

clause in question read: "[j]urisdiction for all and any disputes arising out of or in 

connection with this agreement is Munich. All and any disputes arising out of or in 

connection with this agreement are subject to the laws of the Federal Republic of 

Germany." 3 9 The Tenth Circuit's conclusion was that "is Munich" does not 

sufficiently imply "is [only] Munich." 4 

The court added that "where venue is specified [in a forum selection clause] 

with mandatory or obligatory language, the clause will be enforced; where only 

jurisdiction is specified [in a forum selection clause], the clause will generally not be 

enforced unless there is some further language indicating the parties' intent to make 

venue exclusive.' 

Among the U.S. circuit courts, the Second, Fifth, Seventh, Ninth, and Eleventh 

Circuits have also held such clauses to be permissive, while the Sixth Circuit has 

concluded otherwise. 

Regarding the third limit on the Convention's scope-that it applies only in 

civil or commercial matters-the rapporteurs note that the use of both terms was 

necessary because in some legal systems "civil" and "commercial" are considered 

separate and mutually exclusive categories. 42 However, as will be discussed next, 

several issues normally considered to fall within the civil and commercial categories 

are excluded from the scope of the Convention. 

In addition to the exclusion of forum selection clauses in consumer and 

employment contracts, which obviously do not belong in a convention aimed at 

promoting "international trade and investment, ' 43 article 2 enumerates sixteen 

subject matters for exclusion." Several of these excluded matters are of special 

governmental interests or are subject to regional or international treaties or national 

37. K&V Scientific Co., Inc. v. BMW, 314 F.3d 494 (10th Cir. 2002). 

38. Id. at 498 (internal quotations omitted). 

39. Id. at 496. 

40. Id. at 498-501. 

41. Id. at 499 (citations omitted). 


43. Id. pmbl., art. 2. 

44. See id. arts. 2(2)(a)-(p). 



VOL. 42:773 

rules. 45 These include the status and legal capacity of natural persons and family law 

and succession matters." Other excluded matters include insolvency, the carriage of 

passengers and goods, marine pollution, anti-trust (competition) matters, torts, rights 

in rem in immovable property, the validity of intellectual property rights other than 

copyrights and related rights, limited proceedings regarding infringement of 

intellectual property rights, and the validity of entries in public registers." However, 

the scope of the Convention does include proceedings where one of the excluded 

matters "arises merely as a preliminary question and not as an object of the 

proceedings." 8 

Also specifically excluded are arbitration and related proceedings. 9 Specifically 

not excluded are proceedings involving a government, a government agency, or any 

person acting on behalf of a government. 0 The Convention does not "affect 

privileges and immunities of States or of international organisations." 51 

Also, a State is authorized to declare that it will not apply the Convention to a 

specific matter in which it has a strong interest. 2 However, the Convention does 

provide adequate safeguards: first, it requires the State making such a declaration to 

define it "clearly and precisely" in order to ensure that the declaration is "no 

broader than necessary; , 5 1 second, the State is to notify the Depositary (the 

government of the Netherlands) which will inform the other States; 4 third, such a 

declaration will not take effect for at least three months if the Convention is already 

in force for the State making it; 5 fourth, it will not apply to contracts concluded 

before the Convention takes effect; 56 and fifth, acknowledging reciprocity, the 

Convention provides that where the chosen court is in the State making the 

declaration, other States are not required to apply the Convention regarding the 

matter in question. 7 III. JURISDICTION 

Articles 5 and 6 prescribe jurisdictional rules. Under article 5, the designated 

court of a state must decide the case "unless the agreement is null and void under 

the law of that state , ''5 which includes its choice of law under its conflict of laws 

rules. This provision will have a considerable impact in the United States because 

once the Convention is ratified, the United States courts will no longer be able to use 

the familiar doctrine of forum non conveniens, under which they currently have the 

discretion to dismiss the proceedings in favor of another court. 

45. See Schulz, supra note 1, at 247; see also Brand, supra note 1 at 1292. 

46. Hague Convention, supra note 1, arts. 2(a), 2(2)(b)-(d). 

47. Id. arts. 2(2)(e)-(p). 

48. Id. art. 2(3). 

49. Id. art. 2(4). 

50. Id. art. 2(5). 

51. Id. art. 2(6). 

52. Hague Convention, supra note 1, art. 21(1). 

53. Id. art. 21(1). 

54. Id. arts. 32, 33. 

55. Id. art. 32(4). 

56. Id. art. 32(5). 

57. Id. art. 21(2)(b). 



2007 


However, under article 19, the freedom to do so is partly restored as a State 

may declare that its courts, if chosen in an exclusive choice of court agreement, may 

refuse to "determine disputes" if there is no other connection with that State except 

the location of the chosen court." After having made a declaration under article 19, 

a State may conceivably mandate its courts to refuse jurisdiction under these 

circumstances. Similarly, the doctrine of lis pendens, familiar on the European 

scene, will not apply because the designated court cannot refuse to hear the case 

under the rationale that another court was seised first. 

60 

Rules on subject matter and venue remain unaffected under this provision. 

Thus, the choice of court agreement has no effect if the chosen court lacks the 

subject matter or if the venue is improper. The chosen court of a Contracting State 

may transfer the case to another court in that State under its law. 6 ' As an example, 

such a chosen court may be federal courts in the United States or the Federal 

District Court of Colorado. In either case, the chosen court is authorized to transfer 

the case according to U.S. law. 62 Similarly, the Convention provides that a court with 

the discretion to transfer should give due consideration to the choice of the parties. 63 

Article 6 requires the court that is seised, but not located, in the state of the 

chosen court to suspend or dismiss proceedings unless one of the followings 

exceptions applies: 64 The agreement is "null and void" under the law of the chosen 

court; the capacity is lacking under the law of the court seised; giving effect to the 

agreement would lead to "manifest injustice" or be "manifestly contrary to public 

policy" of the court seised; the agreement cannot reasonably be performed because 

of exceptional circumstances beyond the control of the parties; or the chosen court 

has decided not to hear the case. 63 This rule will also apply where the chosen court 

transfers the case to another court in the same state as permitted under the 

Convention. 6 ' 

Pursuant to the "null and void" exception as noted above in connection with 

article 6, the Convention prescribes that the choice of court agreement's substantive 

validity must be examined under the law of the chosen court, including the choice of 

law rules of the state of the chosen court, as the Convention does not prescribe its 

own independent rule on substantive validity. 67 

59. Id. art. 19. 

60. Id. art. 5(3). 

61. Id. art. 5(3)(b) 

62. See 28 U.S.C. § 1404 (stating that a federal district court may, for the convenience of the parties 

and in the interest of justice, transfer any civil action to any other district or division where it might have 

been brought). 

63. Id. art. 5(3)(b). 

64. See Hague Convention, supra note 1 art. 6(a)-(e). 

65. Id.; c.f, New York Convention, supra note 32, art. 11(3) (providing for similar exceptions as those 

found in article 6, except that the Hague Convention provides that the court seised may hear the case (but 

it is not obligated to do so) if the chosen court has decided not to hear the case). 

66. See Schulz, supra note 1, at 253. 

67. Hague Convention, supra note 1, art. 6(a). 



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IV. 

RECOGNITION AND ENFORCEMENT 

Article 8 requires the recognition and enforcement of the judgment of a chosen 

court in other Contracting States.' No review of the judgment on merits is allowed 

by the court addressed, which is bound by the court of origin's findings of fact unless 

it is a default judgment. 69 Also, the status of the judgment in the court of originwhether 

it has effect and whether it is enforceable-determines whether it will be 

recognized or enforced. 7 ° Similarly, if the judgment is under review in the state of 

origin or if the time limit for seeking review there has not expired, the addressed 

State may postpone or refuse recognition or enforcement." 

Article 9 enumerates exceptions when recognition or enforcement may be 

refused. 2 Several of these are similar to those contained in Article 6 on jurisdiction, 

such as when the agreement is "null and void"; capacity of a party to the agreement 

is lacking under the law of the requested State; and "enforcement would be 

manifestly incompatible" with the public policy of the requested State. 73 Other 

exceptions include fraud in obtaining the judgment, and defective service. 7 " As to 

inconsistent judgments between the same parties, the mere fact that the inconsistent 

judgment is from the requested State suffices as an exception. 75 If, however, the 

inconsistent judgment is from another State, the Convention requires that it must be 

earlier, involve the same cause of action, and fulfill the conditions needed for its 

recognition in the requested State. 

Article 11 states another exception. Judgments awarding damages, including 

exemplary or punitive damages, may be refused to the extent that they "do not 

compensate a party for actual loss or harm suffered. 7 The court is to "take into 

account whether and to what extent the damages awarded by the court of origin 

serve to cover costs and expenses relating to the proceedings. 78 

As mentioned earlier, a State may declare under article 20 that if the parties' 

residence, their relationships, and all other elements relevant to the dispute except 

the location of the chosen court, are connected only with the requested State, its 

courts will refuse to recognize or enforce a judgment of a court of another 

Contracting State. 7 9 

68. See id. art. 8(1); see also id. art. 8(5) (including judgments pursuant to transferred cases except that 

"where the chosen court had discretion as to whether to transfer the case to another court, recognition or 

enforcement of the judgment may be refused against a party who objected to the transfer in a timely 

manner in the State of origin"). 

69. Id. art. 8(2). 

70. Id. art. 8(3). 

71. Id. art. 8(4). 

72. Hague Convention, supra note 1, arts. 9(a)-(g). 

73. Id. arts. 9(a), (b), (e). 

74. Id. arts. 9(c), (d). 

75. Id. art. 9(f). 

76. Id. art. 9(g). 

77. Id. art. 11(1). 


79. Id. art. 20. 


2007 


V. SELECTED ISSUES 

A. Preliminary Questions and Intellectual Property Rights 

Articles 2(3) and 10 address the treatment of preliminary questions. If 

excludable subject matter arises under article 2(2), or is excludable pursuant to an 

article 21 declaration, and the subject matter is not an object of the proceedings but 

is merely a preliminary question, those "proceedings are not excluded from the 

scope of [the] Convention. ' "" Furthermore, if the excluded matter is not an object of 

the proceedings but arises by way of defense, such proceedings are not excluded 

from the Convention. 8 ' For example, in a dispute between a licensor and a licensee 

on an alleged breach of contract regarding royalties due to the licensor, the licensee 

should not escape the application of the Convention to the contract by raising the 

defense of the alleged invalidity of the intellectual property right. 

Article 10, in conjunction with the excluded matters, provides that the 

preliminary ruling given by the court in the example above on the validity of the 

intellectual property right "shall not be recognized or enforced under [the] 

Convention" in other Contracting States. 82 This is an issue the court might have had 

to decide, for the obligation to pay royalties might have depended on the validity of 

the intellectual property right. Paragraphs 2 and 4 provide that recognition or 

enforcement of the judgment, as for example to pay the licensor, "may be refused if, 

and to the extent that, the judgment was based on a [preliminary] ruling on [an 

excluded] matter." 83 ' 

Article 10(3) adds that the recognition or enforcement authorized under 10(2) 

and 10(4) (for payment of royalties in the example used above regarding the dispute 

between the licensor and the licensee) may be refused only where the ruling on 

which the judgment was based, namely the validity of the intellectual property rights 

(other than a copyright or a related right), is inconsistent with the judgment or 

decision of the competent authority in the requested State or another State where 

that intellectual property right is granted 4 This means that the judgment may be 

refused only if the State where the intellectual property right is granted finds the 

purported right to be invalid. 8 " 

Moreover, the decision on recognition and enforcement of the judgment 

mentioned above may be postponed if at the time of request for such recognition or 

enforcement, proceedings on the validity of the intellectual property right in 

question are still pending in the State that granted the right. 86 

As noted, the Convention provides a balanced approach to the extremely 

sensitive issues of intellectual property rights respecting State sovereignty while 

rejecting party autonomy to determine the validity of most intellectual property 

rights. The compromise reached, which seems to have satisfied the intellectual 

80. Id. arts. 2(3), 10(1). 

81. Id. art. 2(3). 

82. Id. art. 10(1). 

83. Id. arts. 10(2), (4). 


85. Id. art. 10(3)(a). 

86. Id. art. 10(3)(b). 



VOL. 42:773 

property community, excludes the validity of intellectual property rights from its 

coverage with the exception of copyright and related rights."' Accordingly, the 

Convention does not apply to infringement of these excluded rights unless 

infringement proceedings are brought or could have been brought for breach of a 

contract between the parties related to such rights." 

B. Transitional Provisions 

To meet the parties' expectations and to validate party autonomy, the 

Convention states transitional provisions. 9 First, the Convention does not apply if it 

is not in force for the State of the chosen court under the exclusive choice of court 

agreement when the agreement is concluded. 9 In other words, parties may not avail 

themselves to the benefits of the Convention through choice of court agreements if 

the Convention is not yet in force in the chosen jurisdiction. Conversely, if the 

Convention is in force in the chosen jurisdiction, the chosen court must hear the 

case, all other courts must decline jurisdiction, and all other Contracting States must 

recognize and enforce the judgment of the chosen court. 9 

Second, if the Convention is not yet in force in the State of the chosen court, 

the Convention does not apply to proceedings that take place there. 92 Accordingly, 

any court requested to recognize and enforce the judgment of the chosen court is not 

obliged to do so under article 8." Nor is the court seised on the merits required to 

dismiss the case as required under Article 6 of the Convention. 9' 

These provisions, however, do not apply to non-exclusive choice of court 

agreements authorized under article 22. These reciprocal declarations by 

Contracting States allow that their courts will recognize and enforce judgments of 

other Contracting States resulting from non-exclusive choice of court agreements. 

States may set specific time limits in such declarations pertaining to the application 

of the Convention. 

C. Contracts of Insurance and Reinsurance 

Article 17 will be most helpful to the insurance industry. Under its provisions, 

proceedings under a contract of insurance (or reinsurance) fall within the scope of 

the Convention and are not excluded on the ground that such a contract relates to a 

matter to which the Convention is inapplicable. 95 For example, although marine 

pollution is excluded from the Convention's coverage under Article 2(2)(g), a 

contract of insurance for marine pollution falls within the Convention's coverage. 

Assuming that marine pollution has occurred and the insured brings a case against 

87. Id. art. 2(2)(n). 

88. Id. art. 2(2)(o). 

89. See id. art. 16. 


91. Id. arts. 5,6.8, 16(1). 

92. Id. art. 16(2). 

93. See id. art. 8(1). 

94. Id. art. 16(2). 

95. Id. art. 17(1). 


2007 


the insurer under an exclusive choice of court agreement for refusing her 

indemnification, the Convention allows the suit. 

Assume further that the insured secures a judgment on her suit. Recognition 

and enforcement of that judgment may not be limited or refused on the ground that 

the contract includes liability indemnification of the insured or reinsured regarding 

an excluded matter or an award of damages to which Article 11 on noncompensatory 

damages might apply. 

D. Relationship with other International Instruments 

Article 26 provides rules regarding the relationship of the Hague Convention to 

other treaties or instruments. 96 First, the Convention aims at reaching compatibility 

with other treaties. 97 It also does not affect the application of the rules of a regional 

arrangement that is a party to the Convention. 8 However, the issue of 

incompatibility could arise when the Hague Convention and the Brussels I 

Regulation, would both apply. The Convention would claim exclusive jurisdiction of 

the chosen court and the latter Brussels I Regulation would prescribe a rigid rule of 

priority of the seised court and the recognition and enforcement of a judgment given 

by the court of a Member State in all others without examining the jurisdictional 

basis of the first court. Under Article 23 of the Brussels I Regulation, the 

Regulation would apply if one of the parties is domiciled in an E.C. Member State. 

However, under Article 26(6) of the Hague Convention, in such a situation the 

Hague Convention will apply, while the Brussels I Regulation will apply where none 

of the parties is resident in a Contracting State that is not an E.C. Member State. As 

to the recognition and enforcement of judgments, the Brussels I Regulation will 

apply where both the court granting the judgment and the one in which enforcement 

is sought are located in the E.C. 

The Hague Convention generally follows the 1969 Vienna Convention's 

framework which prescribes rules of international law pertaining to treaties. 99 

Specifically, Article 30(2) of the Vienna Convention approaches the problem of 

inconsistency and incompatibility between treaties by providing that, "when a treaty 

specifies that it is subject to, or that it is not to be considered as incompatible with, 

an earlier or later treaty, the provisions of that other treaty prevail."'' 

Under a provision of Article 26, when a Contracting State is a party to a treaty 

and all the parties are residents in Contracting States which are all parties to that 

treaty, the treaty applies." 1 Moreover, states that are party to the Hague Convention 

as well as prior instruments, are authorized to comply with their previous obligations 

to any non-Contracting State.' 0 ' The prior treaty may continue to apply with the 

provision that recognition or enforcement may not be granted "to a lesser extent 


97. Id. art. 26(1). 

98. Id. art. 26(6). 

99. United Nations Convention on the Law of Treaties, opened for signature May 23 1969, entered into 

force Jan. 27, 1980. 1155 U.N.T.S. 331, reprinted in 8 I.L.M. 679 (1969). 

100. Id. art. 30(2). 


102. Id. art. 26(3). 



VOL. 42:773 

than under [the Hague] Convention." ' 3 Treaties on specific subject matters, 

whether concluded before or after the Hague Convention, may also apply, provided 

that "the Contracting State has made a declaration" to that effect.' ° 

VI. IMPLEMENTATION OF THE CONVENTION IN THE UNITED STATES 

Assuming that implementing legislation will be required in the United States, ' 

Professor Curtis Reitz has advocated implementation through the uniform state law 

process rather than federal legislation, on the rationale that uniform state legislation 

appropriately harmonizes treaty provisions with pertinent state law.' °6 In response, 

Professor Stephen Burbank first analyzes the restrictive powers of the federal 

government and the states regarding the issues addressed in the Hague Convention 

and second, discusses and evaluates the "considerations that bear on the wise use of 

these powers."'" 7 He notes Congressional enactment of federal legislation for the 

New York Convention for Arbitral Agreements and Arbitral Awards as well as 

Congressional ratification of the Hague Service Convention and the Hague 

Evidence Convention after the Congressional determination that a federal response 

was necessary to address the problems of international litigation.' He adds: "[T]he 

interests of US participants in the global marketplace would be well served by 

uniform international standards for the recognition and enforcement of US 

judgments in other nations and of foreign-country 

9 

judgments in the United States."' 

Professor Burbank identifies the issues on which the Hague Convention 

provides for disuniformity: 1) the law governing the validity of contract; 2) the law 

governing the capacity to enter into contract; 3) public policy norms; and 4) 

procedures regarding service of process and of "procedural fairness" that are 

considered fundamental."' He then provides cogent arguments in favor of uniform 

federal norms rather than state legislation."' On "public policy" he appropriately 

refers to the American Law Institute's Project on Recognition and Enforcement of 

Foreign Judgments: Analysis and Proposed Federal Statute. 2 as proposing a model 

statute that points to state law in some situations: 

(a) A foreign judgment shall not be recognized or enforced in a court in 

the United States if the party resisting recognition or enforcement 

establishes that: ... (vi) the judgment or the claim on which the judgment 

is based is repugnant to the public policy of the United States, or to the 

103. Id. art. 26(4). 

104. Id. art. 26(5). 

105. See Stephen B. Burbank, Federalism and Private International Law: Implementing the Hague 

Choice of Court Convention in the United States, 2 J. PRIVATE INT'L L. 287, 289-292 (2006) (discussing 

whether implementing legislation in the United States is necessary or appropriate). 

106. Curtis R. Reitz, Globalization, International Legal Developments, and Uniform State Laws, 51 

LOYOLA L. REV. 301, 319-27 (2005). 

107. Burbank, supra note 105, at 293-308. 

108. Id. at 296-97. 

109. Id. at 297. 

110. Id. at 300-01. 

111. Id. at 301-07. 

112. PROJECT ON RECOGNITION AND ENFORCEMENT OF FOREIGN JUDGMENTS: ANALYSIS AND 

PROPOSED FEDERAL STATUTE (Proposed Final Draft 2005). 


2007 


public policy of a particular state of the United States when the relevant 

legal interest, right, or policy is regulated by state law." 3 

Similarly, he prefers federal determination rather than state-by-state decisions 

regarding partial declarations on jurisdiction and enforcement as authorized in 

articles 19 and 20 as discussed earlier.' I concur with his conclusion that based on 

the need for certainty, efficiency, and uniformity, "federal implementation through 

legislation prescribing federal law that is mostly uniform, but a few provisions of 

which may borrow designated state law, would impose lower transaction and 

administrability costs, with no loss of accessibility, than would state 

' 

implementation. 

VII. APPRAISAL AND RECOMMENDATION 

The presumption of exclusivity established in the Hague Choice of Court 

Convention is of special significance in the United States. The major reason is that 

notwithstanding the U.S. Supreme Court's ruling in Bremen in 1972, which validates 

forum selection clauses, U.S. courts have not generally held forum selection clauses 

to be exclusive without explicit language showing that jurisdiction is exclusively in 

the designated forum." 6 

Thus, following the ratification and implementation of the Hague Convention 

in the United States, there should be no uncertainty that choice of court agreements 

will be held exclusive by U.S. courts. As the existing uncertainty on this issue is 

removed and there is predictability that a decision by the chosen U.S. court will be 

recognized and enforced abroad, a foreign business should find no disincentive in 

choosing a U.S. court as a forum to resolve potential disputes in business-to-business 

transactions. 

The importance of the Hague Convention is not limited just to the United 

States, for it is widely seen as a viable alternative to the 1958 New York Convention 

on the Recognition and Enforcement of Foreign Arbitral Awards, under whose 

provisions not only arbitration awards but arbitration clauses are recognized and 

enforced abroad." 7 However, the Hague Convention should not be seen as 

competing with the New York Convention, as evidenced by the International 

Chamber of Commerce (ICC) and its International Court of Arbitration's strong 

support for this new development. 

The Hague Convention has gained wide support. For instance, the intellectual 

property community considers the Convention to be an important instrument, as it 

will make licensing agreements easier to enforce." 9 Similarly, the Convention will be 

113. Id. § 5(a)(vi), cited at Burbank, supra note 105, at 307. 

114. See Burbank, supra note 105, at 309. 

115. Id. 


117. See New York Convention, supra note 32, art. 11(3) (obligating courts of Contracting States to 

enforce arbitration agreements as well as arbitration awards). 

118. See Schulz, supra note 1, at 266. 

119. See Hartley, supra note 1, at 424. 



VOL. 42:773 

equally important for the insurance industry.' The legal profession has also 

enthusiastically endorsed it: professional associations, including the American Bar 

Association, the International Bar Association, the International Law Association, 

and the American Society of International Law, have all featured the Convention at 

their conferences.' The ABA's Section of International Law stated in its August 

2006 report: 

The Choice of Court Convention addresses a specific perceived need for 

facilitating global transactions and providing certainty for US parties and 

litigants. It can be understood as a contract drafting tool and should be 

part of cross-border planning starting today. The Convention is also a 

means of dispute resolution, providing a viable alternative to arbitration. 

122 

It recommended that the ABA urge the U.S. government "promptly to sign, 

ratify and implement the Hague Convention on Choice of Court Agreements. '' 123 At 

its annual meeting the ABA resolved to make that recommendation.' It is in the 

interest of the United States to ratify the Convention and implement it through 

federal legislation. 

120. See id.; see also Schulz, supra note 1, at 260-61. 

121. See Schulz, supra note 1, at 266 and n.65. 

122. American Bar Association, Recommendation, Adopted by the House of Delegates Aug. 7-8, 

2006, available at http://www.abanet.org/intlaw/policy/investment/hcca0806.pdf. 

123. The author was in attendance for these proceedings. 

124. American Bar Association, Recommendation, supra note 122. 


Banking Law Reform and Users-Consumers in 

Developing Economies: Creating an 

Accessible and Equitable Consumer Base from 

the "Excluded" 

JOSEPH J. NORTON* 

SUMMARY 


II. 

EVALUATING BANKING SECTOR LEGAL REFORM FOR DEVELOPING 

COUNTRIES: THE PAST FIFTEEN YEARS ........................................................... 792 

A. Modern Banking Sector Legal Reform as G7/G8 Mandated and as 

P art of N IFA ................................................................................................ 792 

B. NIFA and the Role of International Standards: An Industrialized 

C ountry Initiative ........................................................................................ 795 

III. 

WORLD BANK'S NEW AGENDA ON FINANCIAL ACCESS AND EQUITY 

ISSU E S ................................................................................................................... 7 98 

A . The C ountry Studies .................................................................................... 800 

B. FSAPs: One Possible Supporting Pillar for the "Next Generation" of 

Financial Sector Legal Reform .................................................................. 804 

IV. 

Two CURRENT DEVELOPMENTS OF SIGNIFICANCE: MICROFINANCING 

AND PRIVATE INDUSTRY PARTICIPATION ....................................................... 806 

A . M icrofinancing ............................................................................................ 806 

1. B ackground ............................................................ 

807 

2. Im provem ent of M icrofinance ............................................................ 807 

3. The R egulatory R eform ...................................................................... 809 

B. An Example of Non-Regulatory Public-Private Initiative: The Case 

of South A frica ............................................................................................ 810 

1. B ackground ........................................................................................... 811 

* SJD (Mich.), Dipl. (Hague), DPhil. (Oxon), LLD (Lond), LLD (hc;Stockh). James L. Walsh 

Distinguished Faculty Fellow and Professor in Financial Institutions Law at the SMU Dedman School of 

Law, Dallas, Texas; formerly the Sir John Lubbock Professor of Banking Law, University of London 

(1993-2005). This article is derived from a presentation prepared for the 13th Biennial Conference for the 

International Academy of Commercial and Consumer Law, August 9-12, 2006, Austin, Texas and from 

work on an internal study for the World Bank. 



VOL. 42:789 

2. Responding to the Challenge: The Financial Sector Charter .......... 811 

3. Im plem entation M echanism s .............................................................. 812 

V. CONCLUDING OBSERVATIONS: THE NEED FOR A SUITABLE LEGAL- 

INSTITUTIONAL INFRASTRUCTURE AND POLICY REORIENTATION .............. 814 


The subject-matter of this article was originally conceived of as consumer 

protection issues in banking sectors of developing countries. In first approaching 

this topic area, the author had on his "industrialized country hat" which 

automatically assumes that there preexists a broad consumer base from which to 

work. But in stepping back and putting on his "developing country legal reform 

hat," the author came to realize that approximately two-thirds of the world's people 

are effectively excluded from the mainstream banking and financial sectors of their 

respective countries, thus denying them an ability to meet basic financial needs and 

any realistic prospects of wealth creation, and foregoing the mainstream financial 

systems in these countries from more fully maturing in the sense of contributing 

more fully to the developmental needs of these countries. As such, what consumer 

base would exist in a developing country would only encapsulate the top of the 

socioeconomic pyramid of that country. Thus, the critical, foundational issue that 

needs to be addressed respecting consumer banking issues in developing countries is 

that of "inclusion." 

The primary proposition being set forth in this article is that, notwithstanding 

the plethora of global banking sector reform over the past two decades, the equitable 

and accessible provision of banking services has never been a core component of 

modern banking sector legal reform and assessment in the developing world. As 

such, before one can sensibly talk about a viable banking and financial sector 

framework in a developing country, a reasonably broad user (i.e., consumer) base 

needs to be developed. In effect, the banking and financial system of the developing 

country needs to become accessible to the "excluded": serving just the top of the 

economic pyramid is shortsighted and, in the long term, counterproductive. Once a 

broad and equitable base is established, a developing country can sensibly and 

effectively address the formulation of an adequate consumer protection framework 

so that new entrants and those still remaining outside the mainstream financial 

sector are not discriminated against or treated unfairly. While these conclusions 

seem to be obvious, it is only most recently that the International Financial 

Institutions (IFIs), particularly the World Bank, have begun to more systematically 

address these fundamental deficiencies in developmental legal reform agendas 

respecting the banking/financial sector.' 

1. Certain abbreviations and acronyms used in this article include: anti-money laundering (AML); 

Basel Committee on Banking Supervision; Bank for International Settlements (BIS); World Bank's 

Country Assistance Strategies (CAS); Consultative Group to Assist the Poor (CGAP); counterterrorism 

financing; European Bank for Reconstruction and Development (EBRD); European Union; Financial 

Action Task Force; Financial Sector Assessment (FSA); Financial Sector Assessment Program (FSAP); 

Financial Stability Forum (FSF); Group of 7 (G7); Group of Eight (G8); Group of Ten (G10); Group of 

Twenty (G20); General Agreement on Trade in Services; International Association of Deposit Insurers 

(IADI); International Association of Insurance Supervisors (IAIS); International Accounting Standards 


2007 BANKING LAW REFORM AND USERS-CONSUMERS IN DEVELOPING ECONOMIES 791 

From this author's perspective of over two decades of study and practical 

involvement with financial sector reform in developing, transitioning, and emerging 

economies, he is of the considered view that: (i) the modern banking and financial 

sector law reform policies and infrastructures process is of relatively recent vintage; 

(ii) this reform process has been largely crisis-oriented and reactive by necessity and 

has become driven largely by industrialized countries' systemic objectives of 

preventing financial crises and related contagion, fostering global financial stability, 

and more recently, maintaining financial sector integrity; and (iii) this "first 

generation" of reform has never had the luxury of being clearly thought through in 

terms of how developmental factors such as access, equality, and user protection can 

be incorporated into the overall financial sector legal reform processes in an 

integrated and coherent manner that promotes the United Nations' Millennium 

Development Goal of alleviating poverty. 2 

It is the general view of this author that the future banking and financial sector 

legal policy and infrastructure reform process of the IFIs and others in the economic 

development arena should systematically and thoughtfully undertake this reform 

process within, or alongside of, a complementary framework and context of 

meaningful and relevant economic-social development policy objectives, including 

the object of making the financial base broader and more inclusionary. Quite 

simply, such reform should be coordinated on the policy, implementation, and 

assessment levels, with the broader economic development objectives and policies of 

the particular developing country. 

Part II of this article will attempt to evaluate banking sector legal reform efforts 

as to developing countries over the past decade and a half. Part III will consider 

recent selective efforts of the World Bank in addressing the access and equity issues 

respecting the banking sector. Part IV will consider two current developments of 

relevance: the rise of microfinancing and the efforts to engage private industry's 

cooperative efforts. Part V will provide some concluding reflections on the 

importance of the legal infrastructural, institutional, and policy reorientation 

dimensions of such reform efforts. 

Committee (IASC); International Federation of Accountants; International Financial Arrangement (IFA); 

International Finance Corporation (IFC); International Financial Institution (IFI); International Monetary 

Fund (IMF); International Organization of Securities Commissions (IOSCO); Joint Forum (JF); Legal 

Vice Presidency of the World Bank (LVP); Microfinance Institutions (MFI); New International Financial 

Architecture (NIFA): Organisation for Economic Co-operation and Development (OECD); Regional 

Financial Institution (RFI); Reports on the Observance on Standards and Codes (ROSC); Small and 

Medium-sized Enterprises (SME); International Bank for Reconstruction and Development and the 

International Development Association (WB, or World Bank); and World Trade Organization (WTO). 

2. See generally U.N. Millennium Development Goals, available at 

http://www.unmillenniumproject.org. 

3. As will be pointed out throughout this paper, modern "financial sector development" is not 

necessarily consistent with or supportive of what should be a developing country's broader "economic 

development" planning and policies. But cf., Thorsten Beck, Ash Demirguc-Kunt and Maria Soledad 

Martinez Peria, Reaching Out: Access To and Use of Banking Services Across Countries (World Bank 

Policy Research Working Paper No. 3754, Oct. 2005). 



VOL. 42:789 

II. 

EVALUATING BANKING SECTOR LEGAL REFORM FOR 

DEVELOPING COUNTRIES: THE PAST FIFTEEN YEARS 

Banking sector legal reform as a mandate for domestic and international 

financial authorities of developing countries is clearly of recent vintage, and is 

largely the reactive byproduct of the major industrialized countries' concern over 

financial crises and the quest for global financial stability during the 1990s,' the new 

transitioning economies arising from the collapse of the Soviet Union, the 

enlargement of the European Union, and the ongoing onslaught of economic 

globalization -each of which are interconnected in various ways. 5 More specifically, 

this reform over the past decade has been largely driven by the G7/G8 grouping of 

industrialized countries. 

A. Modern Banking Sector Legal Reform as G7/G8 Mandated and as Part of NIFA 

In terms of becoming a major concern of the IFIs, banking sector, and other 

financial sectors, legal reform as to developing countries began gaining credence and 

taking shape as part of the G7/G8 6 invention of the notion of a New International 

Financial Architecture. NIFA in fact is a misnomer of sorts and in some sense a 

public relations ploy to dress over an ongoing quandary of what to do with an 

international financial "non-system." 8 Yet, even if no true "architecture" had 

existed to be replaced by NIFA, and though NIFA is itself probably not a true 

architecture or system, a working base did come to exist through the NIFA, from 

which a new architecture and a next generation of banking and financial sector legal 

reform could be developed. 

4. In fact, when one reviews the annual intergovernmental Communiques of the G7/G8 from 1975 

through the mid-1990s, one notes, by conspicuous absence, that the financial sector infrastructure 

(including its legal dimensions) is left unattended. Globally significant macroeconomic issues were the rule 

of the day for the annual agendas. 

5. It is true one can find specific anecdotal examples of financial law-related reforms during the 1960s 

and 1970s, but these were largely isolated reforms designed to facilitate a certain development project. An 

IFI-related example was in the early years of the EBRD, which views itself more as an International 

Finance Corporation-type of commercially oriented development institution: in the 1990s any institutional 

or legal reform in its mandate countries was specifically project-focused. It was only by the mid-1990s, that 

the EBRD set up a law reform component of its General Counsel's Office, but the component tended to 

look at more generic law reform issues, such as a model secured transaction law. See, e.g., EMERGING 

FINANCIAL MARKETS AND SECURED TRANSACrIONS (Joseph J. Norton & Mads Andenas eds., 1998). 

6. Inaugurated in 1975 by the then-heads of the French and German governments for the purpose of 

creating a more meaningful forum for Heads of State Summits of the major industrialized countries, the 

G8 (known as the G7 from 1976 until 1998, when Russia was fully admitted) has met annually to consider 

the major global macroeconomic and political issues. See the major G8 Information Centre website 

maintained by the University of Toronto, available at http://www.g7.utoronto.ca. 

7. The first use of the specific term "New International Financial Architecture" is often attributed to 

Mr. Michel Camdessus, former Managing Director of the IMF, who began regularly to use this term in 

1998. E.g., Michel Camdessus, Toward a New Financial Architecture for a Globalized World, Address at 

the Royal Institute of International Affairs (May 8, 1998), available at 

http://www.imf.org/external/np/speeches/1998/O50898.htm); J. J. Norton, A 'New International Financial 

Architecture'?: Reflections on the Possible Law-Based Dimensions, in A NEW INTERNATIONAL FINANCIAL 

ARCHITECTURE: A VIABLE APPROACH 135-182 (J.B. Attanasio & J.J. Norton eds., 2002). 

8. Norton, supra note 7, at 180-82. 



NIFA, as it has unfolded through the various G7/G8 annual summits over the 

past decade, has endeavoured to coordinate and direct a wide grouping of different, 

though related, international bodies that have their own mandates, jurisdictions, and 

powers: (i) multilateral agencies (IMF, WB, BIS, OECD); 9 (ii) policy formulation 

groups (G7/G8, G10, G20);' and (iii) international regulatory and standard-setting 

authorities and arrangements (IFAs) (Basel Committee, IAIS, IOSCO, IASC, JF, 

FSF)." In addition, in various and increasing ways, NIFA has brought the private 

financial industry sectors into the equation. 2 As such, NIFA might be viewed as an 

evolving policy construct moving towards a new governance structure which reflects 

a public-private partnership among governments, financial sector authorities, 

international financial institutions, and private international financial institutions in 

the search of a stable, viable global financial environment. However, the main focus 

of this "public-private partnership" is, for the most part, on global financial stability 

issues and on deepening financial markets rather than on broadening such markets 

in terms of greater financial inclusion or serving the socioeconomic development 

needs of the majority of the population of developing countries. 3 

At its 1994 Naples Summit, the G7 Heads of State made financial sector reform 

issues a major agenda item for its 1995 Halifax Summit. 4 But it was really not until 

the Birmingham (1998), Cologne (1999), and Okinawa (2000) Summits that the 

NIFA began to be fleshed out. 15 The G7 Finance Minister Reports in Cologne (June 

1999) and Okinawa (June 2000) specifically followed up, in some detail, on the 

following NIFA components: 

- Strengthened Macroeconomic Policy for Emerging Economies; 

- Strengthened and Reformed IFIs; 

- Accurate and Timely Informational Flows and Transparency; 

- Strong Financial Regulation in Industrial Countries; 

- Strong Financial Systems in Emerging Markets; 

- Exchange Rate Policies; 

- Sound Accounting Standards; 

- Legal Infrastructure; 

9. See, e.g., Andrew Sheng, The New International Financial Architecture: Is There a Workable 

Solution?, in A NEW INTERNATIONAL FINANCIAL ARCHITECTURE: A VIABLE APPROACH, supra note 7, 

ch. 1. 

10. See IMF, A Guide to Committees, Groups, and Clubs (2006), available at 

http://www.imf.org/external/np/exr/facts/groups.htm.. 

11. See generally GEORGE ALEXANDER WALKER, INTERNATIONAL BANKING REGULATION LAW 

POLICY AND PRACTICE (2001); JOSEPH JUDE NORTON, DEVISING INTERNATIONAL BANK SUPERVISORY 

STANDARDS (1995). 

12. Virtually all of the international bodies involved directly or indirectly included the financial 

industry sectors (as they are direct subjects of such standards) in their devising, revising, and implementing 

of international financial sector standards. 

13. See, e.g., Joseph J. Norton, A Perceived Trend in Modern International Financial Regulation: 

Increasing Reliance on a Public-Private Partnership, 37 INT'L L. 43 (2003). 

14. See Group of Seven [G7], Naples Summit Communique (July 9, 1994), available at 

http://www.g7.utoronto.ca/summit/1994naples/communique/introduction.html. 

15. See generally Heads of State and Related Communiqubs from the Various Summits from 1975- 

2006, available at http://www.g7.utoronto.ca/summit. 



VOL. 42:789 

- Corporate Governance; 

- Anticorruption/Money Laundering; 

- Technological Innovation/Adaptation; and 

- Risk Management.' 6 

An integral element of all this would be a significant law-based dimension 

evolving around global principles and standards setting (codes) as to the following: 7 

- Banking Regulation; 

- Capital Markets Regulation; 

- Insurance Supervision; 

- Corporate Governance; 

- Financial Conglomerates; 

- Payment, Settlement and Custody Mechanisms; 

- Pension Funds and Collective Investment Schemes; and 

- Accounting and Auditing Standards. 

Though the G7 singled out treatment of emerging economies as to financial 

sector reforms, the bottom line appears to be that these economies needed to adopt 

and implement the unfolding "international standards and best practices," with the 

IFIs playing a major role (directly and indirectly) in the implementation, 

transmission, and related technical assistance processes. Otherwise, the focus of the 

G8 heads of state and finance ministers at Birmingham, Cologne, and Okinawa as to 

developing countries was mainly on debt alleviation for the poorest of the 

developing countries and on integration of the developing world into the "global 

environment."'" The underlying assumption appears to be that sustained global 

growth, increased trade, and investment liberalization will bring increased economic 

growth for developing countries and that a strengthened international financial 

system will foster such global growth. 9 

From 2000 to the present, the G8 appears to have been consumed with a 

proliferation of international political and security crises. As to financial sector 

reform, the use of Financial Sector Assessment Programs and greater IFI 

cooperation is encouraged, and there is increased concern as to financial crimes, 

corruption, and fighting terrorism financing. 2° Debt relief for the poorest countries 

gained traction with the 2005 Gleneagles Summit. 2 ' 

16. See infra notes 20-22 and acccompanying text. 

17. The FSF oversees these standards and codes and has compiled the series of key standards and 

codes into a working Compendium. See FSF, Compendium of Standards, available at 

http://www.fsforum.org/compendium/about.html. 

18. See, e.g., G7 Finance Ministers, Cologne, Germany, June 18-20, 1999, Report of the Koln 

Economic Summit, available at http://www.g8.utoronto.ca/finance/fm06l999.htm. 

19. Id. 

20. See, e.g., G7 Finance Ministers, Fukuoka, Japan, July 8, 2000, Report 

to the Heads of State and Government: Strengthening the International Financial Architecture, available at 

http://www.g7.utoronto.ca/finance/fm20000708-st.html. 

21. See generally Uofr G8 Information Centre: Gleneagles Documents, 

http://www.g7.utoronto.ca/summit/2005gleneagles/index.html. 



This author suggests that the thrust of the G7/G8 financial sector reform 

mandates over the past decade can be seen as geared to the following policy 

concerns: 

- Financial Crisis Avoidance and Resolution; 

- Financial Stability; 

- Financial Services Liberalization; and 

- Regional and Global Cooperation. 

More recently, financial sector reform also has been driven by industrialized 

country concern for financial sector integrity, which has come to embrace the 

following: 

- Anti-Money Laundering (drug dealing and other criminal activities); 

- Combating Terrorism Financing; 

- Anti-Corruption; 

- Corporate Governance of Financial Institutions; 

- Transparency and Accountability; and 

- Greater Availability of Information and Enhanced Disclosure." 

While one can reasonably and in good faith rationalize that these focal points 

are directly related to the economic development processes of developing countries, 

the truth is that these concerns have been engendered as a result of industrialized 

country interests, and that in many of these instances the interconnection with 

substantive development goals of poverty reduction is indirect and sometimes 

tenuous at best. 23 

That said, the bottom line is that the role of the IFIs in the area of financial 

sector reform over the past decade has been mandated largely by the G7/8 global 

policy determinations and directives. 

B. NIFA and the Role of International Standards: An Industrialized Country 

Initiative 

As alluded to above, the G7/G8 directed a number of international 

organizations to develop and implement international prudential standards 

("codes") in order to encourage and improve confidence in and viability of domestic 

financial systems. Such standards were aimed at promoting sound financial 

institutions, minimizing systemic risk, and encouraging savings and investment 

activity through increased confidence in financial markets, both domestically and 

22. World Bank, World Bank and AML/CFT, http://wwwl.worldbank.org/finance/html/amlcft/ (last 

visited Oct. 12, 2006). 

23. For example, having "Basel-compliant" banking systems is a good goal for all countriesdeveloped 

and developing-but for a developing country it does not really get to the core issue of how the 

banking and financial system should best be structured to serve optimum country-specific socioeconomic 

development needs. Also, while of key concern to the U.S. and other highly industrialized countries' 

efforts in their so-called "global war on terrorism," it is quite dubious that the amount of efforts 

development banks now spend on the areas of anti-money laundering and counterterrorism financing 

produces any real development benefits that would justify the cost and effort. 



VOL. 42:789 

internationally. It must be noted at the outset, however, that these international 

principles and standards were to be just that: minimum internationally accepted 

guidelines that leave latitude in their implementation. 24 

The G7 Finance Ministers were impressed with the prior work of the Basel 

Committee and IOSCO on developing "international standards for prudential 

supervision" of banks, securities firms, and markets, as well as payment and 

settlement systems. In particular, the Ministers approved joint Basel 

Committee/IOSCO work on market risk and capital adequacy, as well as derivatives 

and futures exchanges-sophisticated areas of concern for the industrialized 

countries. The Ministers also recognized the cooperation among the bank, 

securities, and insurance supervisors through the Joint Forum and recommended 

better vehicles for increased institutional cooperation. With hindsight, one can see 

from this thread the subsequent increased importance and spread of international 

standards and codes and the later formation of the international standards 

coordinator, the Financial Stability Forum." 

Quite clearly, the development of international banking standards by the Basel 

Committee long predates the emergence of the NIFA. In fact, in 1974 the Ministers 

of Finance and Central Bank Governors of the "Group of 10,,26 became concerned 

with possible development of international bank supervisory standards in response 

to the interrelated insolvencies of two small international banks (the German 

Bankhaus Herstatt and the American Franklin National Bank) that had resulted 

from excessive exchange rate risks and the lack of coordinated supervision by the 

concerned regulatory authorities to address this problem. Therefore, in 1975, they 

established what is now the Basel Committee. 27 Regarding this incident, the 

governors of the Central Bank were not concerned about any specific systemic crisis. 

However, it dawned on them that there was no established mechanism for 

coordinating cross-border supervision of banking institutions that faced increased 

international risks in the new 1970s era of global floating exchange rates. In 

addition, the governor of the Bank of England was becoming concerned that capital 

adequacy of banking institutions was turning into an issue of international import; 

traditionally, bank regulators/supervisors were primarily concerned with institutional 

liquidity. As such, the first tasks of the Basel Committee were to consider cross- 

24. See G7 Finance Ministers, Lyon, France: June 27-29, 1996, Report to the Heads of State and 

Government on International Monetary Stability, http://www.g7.utoronto.ca/summit/19961yon/finance.html 

(last visited Sept. 29, 2006). 

25. See id. 

26. The G10 Group came about in 1974 as a consequence of the establishment in 1962 of the General 

Agreement to Borrow (GAB) pursuant to decision of the Executive Board of the International Monetary 

Fund. The Group was informally established with the support of the IMF, OECD, the Bank for 

International Settlement, by the finance ministers of Belgium, Canada, France, Germany, Italy, Japan, the 

Netherlands, Sweden, the United Kingdom, and the United States for the primary purpose of 

intergovernmental consulting regarding implementation of calls upon the lines of credit extended to the 

IMF under the GAB-the scope of such consultation being broadened over the years. Subsequently, 

Switzerland has become an active member of the Group, rendering the "G10" designation a misnomer. 

The G10 Group operates through the respective finance ministers on the highest level, but also on specific 

subject-matters through various ad hoc committees. See generally Group of Ten homepage, available at 

http://www.oecd.org/document/32/0,2340,en_2649_34115_36191264_1_1_1_1,00.html. 

27. Reference to the founding mandate for the Basel Committee from the Governors of the Central 

Banks of the GIO countries can be found in a Press Communiqu6 of the G10 Central Bank Governors of 

Feb. 12, 1975, issued through the BIS. 

28. See NORTON, supra note 7, ch. 4, sec. IIA. 



border supervision and capital adequacy. The objects of this focus were 

international banks of the industrialized countries comprising the membership of the 

Basel Committee. 9 

During the 1980s, the Basel Committee produced a revised framework, 

"Concordat," for attempting to allocate international bank supervisory authority 

among the host and home regulator/supervisor; a rather sketchy version had been 

quietly put together in 1975.30 This framework was revised on several occasions 

during the remainder of the 1980s and the 1990s, largely as a reaction to specific 

bank failures exposing the framework's inadequacies." Also, during the mid-1990s, 

it became apparent that the "international banking institution" was an incomplete 

notion for supervision of the large industrialized banks as they tended to operate 

more and more within the structure of banking and financial "conglomerates." 

Thus, a supervisory framework for dealing with these conglomerates also was 

developed. 32 This, in turn, led to a consideration of the issue of the "lead regulator" 

as to such conglomerates. 33 

The most significant efforts of the Committee from the 1980s to present have 

been on risk-based capital adequacy standards. After extended, and at times 

contentious, internal deliberations, a risk-based "Capital Adequacy Accord" was 

promulgated by the Committee in 1988. 3 1 While a non-binding, non-official 

document, this Accord soon (through a complex, informal, and uncoordinated 

transmission matrix) became the international benchmark for bank capital adequacy 

within the developed and then-developing world. 35 Prior to this Accord, the capital 

approach taken by most bank regulators/supervisors was a basic initial capitalization 

requirement and then an ongoing requirement of some form of fixed capital-based 

ratio (e.g., capital to assets). 36 At the time, the 1988 Accord was thought to be a most 

complex approach, while today it is considered a basic, rudimentary framework 

when compared to the Committee's current proposal, the Basel II Accord. 37 

In a sense, the 1988 Capital Accord opened Pandora's box as to the future 

formulation of international bank standards. Once a risk-based approach became 

the guiding measure, it became logical for the Basel Committee to delve into a range 

of other risks, such as exchange rates, interest rates, and other market-based and 

29. See W.P. Cooke in Basle Supervisors Committee (June 21, 1984) (providing discussion of role of 

Committee in document for external distribution). 

30. The first public appearance of the 1975 Concordat was as an Annex ("Supervision of Banks' 

Foreign Establishments") to R.C. Williams and G.G. Johnson, International Capital Markets: Recent 

Developments and Short-Term Prospects, 29-32 (IMF Occasional Paper No. 7, 1981). 

31. See, e.g., DOUGLAS ARNER, FINANCIAL STABILITY, ECONOMIC GROWTH AND THE ROLE OF 

LAW (forthcoming 2007). 

32. See George A. Walker, The Law of Financial Conglomerates: The Next Generation, 30 INT'L LAW. 

57, 57 (1996). 

33. See George A. Walker, Conglomerate Law and International Financial Market Supervision, 17 

ANN. REV. BANKING L. 287,293 (1998). 

34. Basel Committee, International Convergence of Capital Measurement and Capital Standards (July 

1988), available at http://www.bis.org/publ/bcbsclll.pdf. 

35. See Joseph Jude Norton, Capital Adequacy Standards: A Legitimate Regulatory Concern for 

Prudential Supervision of Banking Activities?, 49 OHIO ST. L.J. 1299,1342 (1989). 

36. See, e.g., JOSEPH JUDE NORTON & SHERRY CASTLE WHITLEY, BANKING LAW MANUAL, ch. 3 

(1995). 

37. See Basel Committee, supra note 34; But cf, Basel Committee, International Convergence of 

Capital Measurement and Capital Standards (June 2006), available at http://www.bis.org/publ/bcbs128.pdf. 



VOL. 42:789 

operational risks. These activities resulted in a series of other detailed Committee 

pronouncements. Beginning in the late 1980s and continuing on to today, the 

Committee became concerned with money laundering 38 and related counterterrorism 

regulatory standards. 9 Then, in the late 1990s, the Committee began to address the 

issues of institutional governance more formally as to banking institutions." 

Under the NIFA context, international standards and codes have evolved, 

increasing as to subject-matter and continuing to be refined on the basis of global 

and industrial country experiences and expectations. In this sense, they represent 

the model components for a country's "modern" financial system, and they may be 

utilized for multiple purposes. For example, an individual country may use 

international standards to reform its domestic financial system. These codes and 

standards may also comprise a part of IMF and Bank "conditionality" programs. 

Additionally, they might be employed by an IFI in fulfilling requests for technical 

assistance packages. Or, they might be used by the IMF in its ROSCmacroeconomic 

surveillance efforts, or, more flexibly, by the Bank to assess 

domestic financial infrastructures for development projects. No matter what the 

application, on-the-ground reform work over the past two decades has shown 

repeatedly that the introduction of standards and codes is a top-down model, that 

each country's situation is sui generis, and that these standards and codes have not 

been designed as developmental access instruments.' 

III. THE WORLD BANK'S NEW AGENDA ON FINANCIAL ACCESS AND 

EQUITY ISSUES 

Inherently, the IFIs/RFIs represent an enormous repository of accumulated 

knowledge of policies, theories, issues, and practices concerning the Developing 

World. They are in a real sense socioeconomic and legal development knowledge 

banks. As such, they should be in the best position to help influence and guide the 

much-needed connection between financial sector development and meaningful 

economic development goals respecting their developing client countries. This is 

often easier said than done for a variety of overriding practical reasons. For 

example, these RFI/IFIs tend to be complex bureaucracies, with enormous internal 

and external competition over their limited human and financial resources. These 

institutional demands have expanded exponentially over the past several decades, 

covering not simply traditional macroeconomic development concerns, but also a 

broad range of microeconomic matters, macro- and micro-financial sector concerns, 

human capital development issues (the encapsulating one of which is poverty 

alleviation), societal dilemmas such as gender issues, global human migration, and 

fundamental human rights concerns. As can been seen, financial sector issues are 

only one of many pressing demands upon IFI/RFI resources. 

38. See, e.g., Basel Committee, Prevention of Criminal Use of the Banking System for the Purpose of 

Money Laundering (Dec. 1988) available at http://www.bis.org/publ/bcbsc137.pdf. 

39. See, e.g., Basel Committee, Initiatives by the BCBS, IAIS and IOSCO to Combat Money 

Laundering and the Financing of Terrorism: Update (Jan. 2005), available at 

http://www.bis.org/publ/jointll.pdf. 

40. See, e.g., Basel Committee, Enhancing Corporate Governance for Banking Organisations (1999), 

available at http://www.bis.org/publ/bcbs56.pdf; see also Feb. 2006 revision, available at 

http://www.bis.org/publ/bcbs122.pdf. 

41. See generally NORTON, supra note 7. 



Coherent and forward-looking institutional priority-setting by the IFI/RFIs is 

difficult, time-consuming, and often contentious. These various institutions may 

have differing mandates and approaches to these mandates. Historically, 

collaboration among these institutions has been marginal at best. In addition, as 

discussed above, the IFI/RFI general focus on financial sector reform and specific 

focus on the legal-institutional aspect thereof is a relatively recent "add-on" 

dimension of these institutions, mandated by the G7/G8 and arising in large part as a 

reaction to financial crises, the need for global financial stability, and concerns over 

money laundering and terrorist financing. In addressing these financial sector 

demands, the IFIs/RFIs have largely looked to standards of industrialized countries, 

engaging in large measure staff and consultants drawn from the industrialized world 

(people, incidentally, having significant financial sector experience in their country, 

but little, if any, development background and experience). 

A bright light in this quagmire is that most recently the IFIs/RFIs, in particular 

the World Bank, are beginning to focus in a more comprehensive way on the 

"missing component" to viable banking and financial sector legal reform in 

developing countries: the inclusion of the Developing World population. Through 

this focus reorientation, it may be possible for these institutions to better set and 

develop their own internal priorities in this area of reform. This will allow them to 

be of greater assistance to their Developing Country members in developing and 

coordinating meaningful policies, institutions, and legal infrastructure with a view to 

building more relevant, accessible, and equitable financial sectors. 

In this context, it is of significance that the World Bank dedicated its entire 

World Development Report 2006 to the theme of "Equity and Development." 42 This 

Report, the work-product of the Bank's staff, considers equity in terms of "two basic 

principles": equal opportunity and avoidance of income deprivation. 43 The report 

highlights that legal and regulatory frameworks and equitable justice systems can do 

much to level the playing field in the political, economic, and sociocultural domains, 

but can also reinforce existing inequalities.' In addition, in anticipation of this 

report, the Bank's Legal Vice Presidency (LVP), then under Hon. Roberto Dafiino, 

perceptively held an extended high-level forerunner conference in December 2005 

on "Law, Equity and Development." The primary purpose of this event was to 

explore ways the LVP and the Bank should best approach matters of legal and 

justice reform, including how to move the LVP forward to the next generation of 

financial sector legal reform." This event was followed up and expanded upon by 

another major World Bank Conference in spring 2006 on a wide range of issues 

concerning "access and equality" in economic and financial development. 6 

For illustrative purposes, Part III highlights two other significant developments 

at the World Bank with respect to financial sector access issues. First, the Bank 

recently commissioned a series of reports concerning access to financial services in 

42. World Bank, World Development Report 2006: Equity and Development (2005). 

43. Id. 

44. Id. 

45. This conference was held on Dec. 1-2, 2005 at the IFC in Washington, DC. 

46. See World Bank (Financial Sector), Global Conference on Access to Finance: Building Inclusive 

Financial Systems (Washington, D.C., May 30-31. 2006). available at 

http://web.worldbank.orgfWBSITE/EXTERNALIWBIWBIPROGRAMSIFSLP/0,,contentMDK:2061156 

0-pagePK:64156158-piPK:64152884-theSitePK:461005,00.html. 



VOL. 42:789 

Latin America. Hopefully, these and other country reports from the Bank will 

provide a good comparative data- and policy base for the Bank and its LVP to begin 

to formulate a "next generation" approach to bank/financial sector legal reform 

respecting developing countries. The second Bank development is the expanded 

actual and potential role that the Bank, with the IMF, is beginning to make of its 

FSAPs and related country Financial Sector Assessments for purposes of fostering 

financial sector access and equity. 

A. The Country Studies 

The thematic strand that unifies the four World Bank studies discussed below, 

which previous studies have glossed over, is that the definition of financial access 

must be broadened. The definition is now seen not only to include the ability for 

small businesses or individuals to obtain loans, but also to hold checking and savings 

accounts, utilize debit and credit cards, pay for services at a branch or ATM instead 

of only at a downtown office, and gain access to investment opportunities. These 

studies all examine the methods of savings and how cultural, environmental, and 

socioeconomic factors come into play in creating poverty. Government policies, 

such as excessive reserve requirements, play a large role in reinforcing cycles of 

poverty. Further, the studies find that access to technology can play a large role in 

alleviating cycles of poverty by allowing the poor easier access to services. These 

four studies are the following: 

Poverty Reduction and Growth: Virtuous and Vicious Circles, 

47 which examines 

the essential question of how cycles of poverty reinforce themselves and what 

policies can be put into place to break those cycles; 

Access to Financial Services in Brazil, 

48 which examines specific issues in Brazil 

and highlights their implications to government policy; 

Access to Financial Services in Colombia: The "Unbanked" in Bogota, 9 which 

lie outside the formal economy and why inclusion is necessary to economic 

development and progress in Columbia and 

Urban Unbanked in Mexico and the United States, ° which compares the 

differences between access to financial services for the poor in both countries. 

1. Virtuous and Vicious Circles. Written in 2005, this study explores in depth 

the search for pro-poor growth. It is well known that such growth can increase 

income to the poor and alleviate poverty. 

The reverse thesis has not been sufficiently explored and provides the thesis for 

this study: that vicious circles exist where low growth results in high poverty and high 

poverty, in turn, results in low growth." The more novel thesis of the report is that 

47. GUILLERMO E. PERRY ET AL., POVERTY REDUCTION AND GROWTH: VIRTUOUS AND VICIOUS 

CIRCLES (2006). 

48. ANJALI KUMAR, ACCESS TO FINANCIAL SERVICES IN BRAZIL (2005). 

49. Tova Maria Solo & Astrid Manroth, Access to Financial Services in Colombia: The "Unbanked" in 

Bogotd, (World Bank Policy Research, Working Paper No. 3834, 2006), available at 

http://web.worldbank.orgfWBSITE/EXTERNALIWBI/WBIPROGRAMS/FSLP/0,,contentMDK:2061 162 

8-pagePK:64156158-piPK:64152884-theSitePK:461005,00.html. 

50. John Caskey et al., The Urban Unbanked in Mexico and the United States (World Bank Policy 

Research, Working Paper No. 3835, 2006), available at http://ideas.repec.org/p/wbk/wbrwps/3835.html. 

51. See PERRY ET AL., supra note 47, at 41. 



Latin America's persistent poverty may itself be impeding the achievement of higher 

growth rates, implying that there are reinforcing vicious circles keeping the poor in 

poverty and from contributing to national growth. 2 

In light of the study's findings, the question of whether financial policies should 

emphasize pro-growth or pro-poor can be answered simply: "Yes." Strategies that 

do not focus on growth ignore the greatest means that governments and institutions 

have at their disposal for improving human well-being. These same institutions and 

governments must also take into account the constraints facing the impoverished to 

enable the poor to fully participate in any growth, thereby contributing back to the 

wave of growth. This study describes the process of redressing these constraints and 

brings to light an under-examined dimension of policy analysis that might be called 

pro-growth poverty reduction. 3 

This study shows that in order to achieve the greatest reduction in poverty, the 

relative emphasis on growth versus redistribution should vary depending on the 

individual country's initial conditions." Poor countries with relative equality, such as 

Bolivia, Haiti, and Honduras, "have little to distribute [and] need first and foremost 

high and sustained growth, even at the expense of some increases in inequality." 55 

The paper compares this kind of growth to the growth recently experienced in 

China." In contrast, countries with relatively greater wealth and inequality, 

including much of Latin America-particularly Argentina, Brazil, Colombia, and 

Mexico- need both higher growth and significant redistribution to begin the process 

of reducing poverty. 7 

The poverty traps described in chapter six of this study apply to both national 

and regional areas equally. 8 Regional traps must take into account that within 

countries, labor does not move freely. This creates large wage gaps of up to fifty 

percent from region to region. 9 

This study shows that the disparity in income inequality between Latin America 

and contemporary Organisation for Economic Co-operation and Development 

countries is due in part to "differences in returns to factors of production-the result 

of the unequal distribution of human and other capital in Latin America." 6 ° Another 

reason for this disparity is "the generally unprogressive nature of Latin America's 

system of transfers." 61 Countries in Latin America heavily fund both progressive and 

regressive programs, which offset each other. 62 The study's conclusion is that a 

country's financial history is not its destiny. The decline in Latin America's income 

position in the last fifty years, compared with the OECD member nations' sharp 

reductions in inequality during the same period, demonstrates that choices of 

policies and institutions can lead to major improvements along both dimensions. 63 

52. See id. 

53. See id. 

54. Id. at 4. 

55. Id. 

56. Id. 

57. PERRY ET AL., supra note 47, at 4. 

58. See generally id. at 103-26. 

59. Id. at 138. 

60. Id. at 4. 

61. Id. 

62. Id. at 5. 

63. PERRY ET AL., supra note 47, at 4. 



VOL. 42:789 

For example, increased access to education and infrastructure has encouraged 

growth, inequality, and poverty reduction; other policies, such as trade opening, have 

encouraged growth while increasing inequality and poverty in the short run. 4 These 

short-term issues can be mitigated by better policy considerations so that, in the long 

run, these pro-growth policies will lead to more financial equality. 6 1 

2. Access to Financial Services in Brazil. The objective of the present study is 

to identify ways of expanding access while acknowledging the risks and costs 

involved and providing measures to mitigate their impact. The largest financial 

system in Latin America is Brazil; "beyond its sheer size, the overall depth of 

financial intermediation in Brazil, at almost 140% of gross domestic product, is 

greater than those of its large neighbors in the region such as Mexico and Argentina, 

despite their higher average per capita income." 66 With numerous banks in decline 

since the late 1990s, concern about financial exclusion has increased over the last 

decade despite Brazil's size. An estimated sixty million, or approximately one-third, 

67 

of Brazil's population have bank accounts. 

Brazil's policies, which attempt to provide credit to the poor, have a high cost. 

These costs have another unintended result: the government's large borrowing 

needs have a negative impact on private credit. Large reserve requirements add to 

implicit taxation. Some more conservative estimates suggest that concessions and 

support could amount to several billion Reais. 68 Unfortunately, Brazil's policies 

themselves may also be ineffective in reaching the poorest and those most in need of 

financial access. 

An example of the cost and failure of Brazil's policies is the National Program 

to Strengthen Family Agriculture (PRONAF) which is estimated to cost R$1.1 

billion. 69 The top two percent of borrowers receive fifty-seven percent of loans in 

agriculture, whereas the lowest seventy-five percent of borrowers receive only six 

percent of credit. 70 As illustrated by the analysis of rural finance programs, many 

such programs fail to reach their intended targets, instead they are captured by a few 

individuals, to the detriment of broad-based access. 

There is a role for more proactive government policies toward access to 

financial services. However, the success of these policies will be the greatest if they 

are backed by fundamental changes in overall approach to access. This approach 

must be delivered through broad-based financial sector reforms that limit constraints 

on the price and quantity of credit. Finally, the role given to the relatively small 

number of public institutions charged with delivering these policies must be reduced 

in order to ensure fair access. 

3. Access to Financial Services in Colombia: The "Unbanked" in Bogota. 

Supported by the Colombian Bank Association, this study finds that access to 

financial services is a determinant in a country's development and that access to 

financial services translates into progress. 7 The study quotes Ross Levine's 

statement that "[n]o shortage of evidence exists to suggest that the level of financial 

64. Id. 

65. Id. 

66. KUMAR, supra note 48, at xxviii. 

67. Id. at xxi. 

68. Id. at xxii. 

69. Id. at 280. 

70. Id. 

71. See generally Solo & Manroth, supra note 49. 



development is a good indicator of economic growth, capital accumulation and of 

the technological change of the future economy." 72 The study takes a specific look at 

the financial situation in Bogota and what life is like outside the formal financial 

system. For example, one family who moved to Bogota in the 1950s attempted to 

build their home through self-help and ended up paying twice the cost of their 

home. 73 

The study is harshly critical of the continuation of the government's tax on 

financial transactions that was originally intended to be a temporary solution to the 

banking crisis in Columbia. The tax has now been made a permanent one and has 

been increased from 0.2% to 0.4%. Financial exclusion in the country has created 

significant welfare losses, a declining savings rate, and a financial system that caters 

to the wealthy through monthly fees that equal 5-10% of the minimum wage." 

The study explains that an effective financial sector reduces the cost of 

information sharing between economic agents and that the current trend does not 

look positive for the country. Though the unbanked are often paid by check, they 

have no access to financial institutions. As a result, they are forced to pay large 

check cashing fees and do business in remote central bank locations. Further, to 

obtain credit, every individual or small business must approach potential lenders one 

by one to obtain the amount and terms that they require. 

The costs of these factors inhibit growth in general. This has created an 

alternative system whereby many individuals save and borrow primarily through 

friends and family, and their primary savings is tied to home ownership. This 

alternative method cuts off their financial resources from the nation or region and 

hinders growth. 

4. The Urban Unbanked in Mexico and the United States. This study examines 

how impoverished households in the United States and Mexico obtain basic financial 

services. It also examines the efforts that the private sector and government have 

taken to provide access to these services, both in terms of cost and quality. The 

different ways in which the unbanked operate in the United States and Mexico 

provides an instructive contrast, illustrating how policies can be effective and how 

policies must differ based on cultural differences in saving and investing. 

The differing private sector approaches by the U.S. and Mexico illustrate the 

link between broader coverage of financial services and economic growth. The 

savings and loan crisis experienced in the U.S. in the 1980s did not cause a major 

sector collapse because U.S. banks had spread their business over a wider gamut and 

depended on a variety of population sectors in addition to the wealthy. This can be 

contrasted with the similar situations experienced in Mexico and Colombia that did 

cause major financial crises. 

Experience also shows that financial institutions catering to low-income clients 

can be good businesses. Recent studies by the U.S. Federal Reserve have favorably 

compared the profitability of investments under the Community Reinvestment Act 

credits to commercial investments. These studies have also shown the profitability 

72. Id. at 10 (citing Ross Levine, Financial Development and Economic Growth: Views and Agenda, 

35 J. ECON. LITERATURE 688 (1997)). 

73. Id. at 7. 

74. Dr. Mauricio Herra-Baquero, financial and economic development law expert, of the Externado 

University Law faculty in Bogota has advised the authors of these subsequent events. 



VOL. 42:789 

of community development financing institutions as favorable to other start-up 

banks. 7 

The differences between the unbanked in Mexico and the United States are 

striking. One study showed that in the United States, where there are multiple 

alternatives, check cashing services can often charge a fee of 2-3%. 7 1 In Mexico, 

where there are few practical alternatives, there are no fees for check cashing 

services. 7 ' This shows that significant differences exist and any approach to solving 

issues must take into account those differences: there is no one-size-fits-all solution. 

Consider the above studies; the challenges facing the impoverished in obtaining 

financial assistance are at best difficult and at worst impossible. The collective 

observations of these four studies reaffirms that although the poor face challenges, 

there is much work that can be done to alleviate the severity of these cycles of 

poverty. There are common policies that can be implemented across Latin America 

which would go a long way to improving the situation the unbanked in those 

countries face. 

B. FSAPs: One Possible Supporting Pillar for the "Next Generation" of Financial 

Sector Legal reform. 

Coming out of the 1998 Birmingham and 1999 Cologne G8 Summits, the IFIs 

received mandates to both internally evaluate the effectiveness of their IFI reform 

programs, and more broadly to develop assessment mechanisms concerning the 

condition of the financial sector as a whole with recommendations for reform. 

Underlying the policy is the thought that identification of financial system strengths 

and vulnerabilities will help promote financial stability and reduce the potential for 

crisis. These mandates have led to the enhancement of IMF surveillance 

mechanisms, to the establishment of independent internal offices, and to the 

establishment of a joint IMF-World Bank Financial Sector Assessment Program 

(FSAP), beginning with a joint pilot program in 1999.8 Based on the initial success 

of the pilot program, the joint FSAP program was refined and formalized on an 

ongoing basis, with this initiative being coordinated through an IMF-World Bank 

Financial Sector Liaison Committee. 79 As conceived, the FSAP 

... is widely recognized by participating countries and by the international 

community as an important instrument for diagnosis of potential 

vulnerabilities and analysis of development priorities in the financial 

sectors of member countries .... One objective of the FSAP is to help 

countries map a transition to a more diversified and competitive financial 

sector without creating vulnerabilities. A well-functioning financial 

75. See generally, William C. Apgar and Mark Deida, The Twenty-fifth Anniversary of the Community 

Reinvestment Act: Past Accomplishment and Future Regulatory Challenges, FED. RES. ECON. POL. REv. 

169 (June 2003). 

76. Caskey et al., supra note 50, at 8, 22. 

77. Id. at 41. 

78. See Staff of IMF and World Bank, Financial Sector Assessment Program (FSAP)- A Review: 

Lessons from the Pilot and Issues Going Forward, available at 

www.imf.org/external/np/fsap/2000/review.htm#tabl. 

79. IMF & World Bank, Financial Sector Assessment Program -Review, Lessons, and Issues Going 

Forward 5 (Feb. 24, 2003), available at http://www.imf.org/external/np/fsap/2003/review.pdf. 



services sector is essential for sustained economic development and 

poverty reduction. The existence of a wide and diversified set of sound, 

well-managed institutions and markets also reduces the likelihood and 

magnitude of a financial crisis. 

Thus, from its inauguration, in order to accommodate the differing institutional 

missions of the IMF and the Bank, the FSAP initiative has been articulated in terms 

of bifurcated objectives: (i) financial crisis prevention and financial stability and (ii) 

economic development and poverty reduction. 8 This author suggests that these 

objectives are not necessarily coextensive nor fully compatible. Further, this author 

would note that in terms of the Bank's mandate, these objectives gloss over what a 

well-functioning financial services sector should mean in terms of economic 

development and poverty reduction. Moreover, the causal linkage between the 

modern financial sector model envisioned by the FSAP criteria and instruments and 

actual poverty reduction has never been empirically substantiated. This being said 

the Bank's stated FSAP objective might provide the context within which to 

determine how best the FSAP process can be utilized as a catalytic and supportive 

vehicle for the next generation of financial sector reform. 

Functionally, FSAP is requested voluntarily by a country and is normally 

effected over several joint IMF-Bank team missions. 2 Upon completion, the team 

prepares an aide-memoir presenting the findings. 83 This non-published, confidential 

document will be used by the IMF to prepare a Financial Sector Stability 

Assessment (FSSA) for presentation to its Executive Board, and is often used also in 

connection with the Fund's surveillance role under its biennial Article IV 

consultations. The Bank staff will use the aide-memoir to put together a Financial 

Sector Assessment for its Executive Board 5 

The FSAP itself entails three main components: (i) systematic analysis of 

financial soundness indicators (FSIs) and stress tests; (ii) assessments of standards 

and codes; and (iii) assessment of the broader financial stability framework, 

including systemic liquidity arrangements, governance and transparency, and 

financial safety nets and insolvency regimesYi The FSAP work has come to support 

the IMF's role in the standards and code area and to support the Bank's 

development efforts (particularly as to technical assistance), including its Country 

Assistance Strategies. 

The FSAP is separate from, but substantively linked to, the IMF's role as to the 

Reports on Observance of Standards and Codes initiative (ROSC initiative). 

According to the Bank, there are three reasons for its participation in the ROSC 

initiative: 

80. ld. at 4, para 1. 

81. G7 Finance Ministers, supra note 18. 

82. Id. at 25. 

83. These are not published. Prior to March 2003, FSAP teams prepared more lengthy FSAP reports. 

84. The author has been advised by a World Bank official experienced with FSAPs that this is the 

procedure that has been internally developed. 

85. On the nature and workings of the FSAPs, see generally World Bank/IMF, FINANCIAL SECTOR 

ASSESSMENT: A HANDBOOK (2005). 



VOL. 42:789 

- "[The] structural and institutional underpinnings of a market economy are an 

important complement to sound macroeconomic policies for both successful 

integration with the world economy and for sound development[;]" 

- "[Ijmplementation of standards can help countries establish these 

foundations, in turn contributing to national and global financial stability[;]" and 

- "[P]artnership with the IMF provides the basis for a comprehensive approach 

and broad-based effort on the implementation of standards." '' 

However, the FSAP, at least for the Bank, utilizes particular codes and 

standards selectively and more flexibly (in consultation with the host country), and 

may deal with standards not formally under the ROSC (e.g., creditors rights and 

corporate insolvency, deposit insurance and bank insolvency), and will deal with 

cross-sectoral issues. In recent years, the Bank has been attempting to integrate the 

FSAP, FSA, and ROSC processes into its evolving development agenda.m Notably, 

this integration effort has begun to address the developmental context of the overall 

financial legal infrastructures and issues of access. 

The FSAP process for the Bank has its limitations in addressing the 

developmental context and content of the "next generation" of financial sector legal 

reform. The process is a joint institutional effort with divergent overall objectives. It 

is conducted by a joint institution team and is a complex technical process. 

However, the FSAP is also a flexible data gathering process that most probably can 

be better and more broadly utilized by the Bank and its LVP in evaluating, revising, 

and prioritizing its financial sector reform policy objectives and related technical 

assistance. Certainly, this is well worth serious consideration by the Bank and its 

LVP and the IMF. 

IV. Two CURRENT DEVELOPMENTS OF SIGNIFICANCE: 

MICROFINANCING AND PRIVATE INDUSTRY PARTICIPATION 

In looking selectively at recent developments in the financial access area as to 

developing countries, two potential institutional developments are worth noting for 

present purposes: (i) the rise of microfinancing and (ii) private banking industry 

initiatives in South Africa. 

A. Microfinancing 

With the recent Nobel Peace Prize award to Muhammad Yunus of the Grameen 

Bank in India for his and his bank's work with developing microfinance products for 

the poor and expanding the use of such products on a commercially viable basis,9 it 

seems microfinance is a new discovery. The reality, however, is that microfinancing 

has been around at least since the 1950s, having a very spotty record of success until 

86. IMF & World Bank, Assessing the Implementation of Standards: A Review of Experience and Next 

Steps 26 (Jan. 11, 2001), available at http://www.imf.org/external/np/pdr/sac/2001/eng/review.pdf. 

87. Id. ch. 5. 

88. Id. ch 4. 

89. See generally NobelPrize.org, The Nobel Prize 2006, 

http://nobelprize.org/nobel-prizes/peace/laureates/2006. 



more recent times. 90 The recently formed Consultative Group for Assisting the 

Poorest, a consortium of donor countries affiliated with the World Bank, has 

brought microfinancing into the mainstream of the IFI development agenda. 

1. Background 

Microfinance, along with credit and national savings structures for small- and 

medium-sized enterprises has come to be viewed as of major importance for 

enhancing the social and economic impact of the financial sector of developing 

countries. 9 Microfinance today is seen as a vital tool against poverty since it directly 

provides to low-income people the tools to build assets, increase and protect their 

source of income, and reach self-sufficiency. For example, in Latin America (which 

will be the geographic focus of Part IV(A)), microfinance institutions started being 

established in the 1980s with the arrival of non-governmental organizations (NGOs) 

making loans to poor "microentrepreneurs." In 1992, the Bolivian NGO, 

PRODERM, was converted into the first regulated MFI in Latin America- 

BancoSol, a regulated commercial bank. 92 

Today, it is probably safe to argue that Latin America has the longest tradition 

of commercially viable microfinance. In fact, competition tends to be intense in 

some countries, especially in urban areas, and interest rates in some countries have 

declined dramatically as a result of that competition. For instance, in Bolivia, 

market pioneer BancoSol charged a combination of interest and fees equivalent to a 

sixty-five percent annual percentage rate when it began operating as a bank in 1992. 

Today, BancoSol operates in a highly competitive environment and has brought its 

interest rate down to twenty-two percent. " In addition, "leading institutions are 

increasingly offering a variety of financial services to their clients, including savings 

and management of international and domestic funds transfers."" 

2. Improvement of Microfinance 

Despite some degree of market penetration to date and a variety of financial 

services offered in some Latin American countries, there remains significant 

opportunities in larger Latin American countries where little microfinancing is 

currently occurring (e.g., Mexico and Brazil), in secondary cities and in rural areas. 95 

Despite media hype, only a small percentage of SMEs at the moment have access to 

90. For a discussion on microfinancing, see generally the CGAP's extensive website on the matter, 

available at http://cgap.org/portal/site/cgap. 

91. See generally International Year of Microcredit, E.S.C. Res.1998/28, U.N. ESCOR, 45th mtg., 

U.N. Doc. A/RES/53/197 (Feb. 22, 1999). 

92. On BancoSol generally, including its history and development, see 

www.bancosol.combo/en/historia/htm. In addition, on this site there is a separate link 

"historiamicro.e.pdf" that contains a detailed discussion of the history of microfinance in Latin America. 

Though some trace this development to the 1960s creation of ACCION International, then a student-run 

NGO in the shantytowns of Caracas, Venezuela, the actual practical development really began in the 

1980s. 

93. See bancosol.combo/en/historia.htm. 

94. BRIGIT HELMS, ACCESS FOR ALL: BUILDING INCLUSIVE FINANCIAL SYSTEMS 9 (2006). 

95. Id. 



VOL. 42:789 

formal financial services in Latin America. 96 Even in Chile, which has one of the 

most developed financial markets of the continent, only large and well-established 

firms have access to the range of financial instruments available. 97 

The large number of excluded people in Latin America will gain access only if 

financial services for low-income people are integrated into all three levels of the 

financial system: micro (financial service providers), meso (support services and 

infrastructure), and macro (legislation, regulation, and supervision). 98 Therefore, it 

will be necessary to coordinate public and private reforms in order to enhance the 

equality and access to financial systems. 

First, it is important to understand client demand and to translate this "into 

high-quality, affordable, and convenient financial services offered by a range of 

providers." 99 Today, microfinance is about building sound domestic financial 

intermediaries that can provide services to low-income clients on a permanent basis. 

Sustainability ensures that low-income clients have permanent access to services." ° 

Second, to ensure sustainability, it is necessary to have a strong financial 

infrastructure (the meso level), which includes a complex and varied set of 

procedures and instruments "consist[ing] of systems that allow for electronic 

payments and service providers, such as auditors, raters, consulting services, 

information and point-of-sale technology vendors, specialized technical support, and 

professional associations." ' ' 1 "Accurate, standardized, and comparable information 

on financial performance is imperative for integrating microfinance into the financial 

system."' ' Finally, the government (the macro level) needs to offer a policy 

environment that allows competitive and diverse financial service providers to 

flourish. The key actions for governments are maintaining macroeconomic stability, 

avoiding interest rate caps, and refraining from distorting the market with 

unsustainable, subsidized, and high-delinquency loan programs. Governments can 

also adjust banking-sector regulation and supervision to facilitate microfinancing 

while also protecting low-income people's deposits. "Governments can further 

support financial services . . . by improving the legal framework for contract 

enforcement and collateral rights, ensuring practically and legally feasible systems of 

land titling, and ensuring that tax systems do not discriminate against different types 

of institutions engaged in microfinance." 3 

96. See Alvaro Ramfrez, The Microfinance Experience in Latin America and the Caribbean 5 (2004). 

available 

at 

http://www.ruralfinance.org/servlet/BinaryDownloaderServlet?filename=1126101177627_Microfinance-ex 

perience-inLAC.pdf. 

97. See Sophie Sirtaine, Access to Finance by Chilean Corporations 3,89 (World Bank Policy 

Research, Working Paper No. 3845, 2006), available at http://ideas.repec.org/p/wbk/wbrwps/3845.html. 

98. See HELMS, supra note 94, at 13-14. 

99. Id. at 140. 

100. Id. at 56. 

101. Id. at 140. 

102. Id. at 73. 

103. Id. at 92. 



3. The Regulatory Reform 

"[T]he pressure for regulatory reform has been building on several fronts in 

[Latin America] since 1995."" Such pressure has led some countries in the region to 

create new types of financial institutions, precisely for the purpose of enabling 

nonprofit foundations to transform into financial intermediaries. 9 

Bolivia, for example, has a special law governing private financial funds or 

Fondos Financieros Privados (FFPs) that permits NGOs to become specialized 

financial institutions.' As of April 2005, the minimum capital for these NGOs 

required was only $1 million, while the minimum capital required for banks was $3 

million. 7 Like banks, FFPs are subject to prudential supervision and are monitored 

by the Banking Superintendency."' "The Superintendency requires all deposittaking 

institutions (including FFPs) to submit their financial statements on a daily 

basis, an administrative burden that may discourage FFPs from entering into more 

°9 

remote rural areas with weak telecommunications infrastructure.' 

There are two situations in which it may be appropriate to create a new 

type of institution to facilitate the transformation of nonprofit microcredit 

foundations into licensed and supervised financial intermediaries. First, if 

the minimum capital requirement for existing institutional forms . . . is 

very high it could prevent . I . mature and well-managed foundations from 

entering the formal financial system. Second, if the existing institutional 

form that has the lower minimum capital requirement . . . is severely 

limited in the type of operations it can carry out-particularly in the area 

of savings mobilization -then it may simply be an unattractive form of 

institution for those microcredit foundations that want to enter the formal 

financial system." ° 

In some Latin America countries, "[t]he bad reputation of finance companies 

has sometimes been mentioned as a reason to create a new institutional form for 

non-profit foundations that want to transform into formal financial 

intermediaries.""' 

Creating new institutions for microfinance, even when well-justified and 

structured, is not enough to provide a regulatory framework for microfinance. The 

first and perhaps most important step to this end is to design appropriate regulations 

for microlending as such, in which the regulation "should be guided by three 

principles: flexibility, simplicity, and automaticity-flexibility in interest rates, 

collateral and internal credit processes; simplicity in client documentation, loan 

delinquency and recuperation of collateral; and automaticity in portfolio 

104. Tor Jansson, Microfinance Regulation Sweeping Latin America, MICROENTERPRISE DEV. REV. 

(Inter-American Development Bank), Aug. 2002, at 4, available at 

http://www.esglobal.com/pdf/PrivateCapitalforMicrofinanceHowtoTurn.pdf. 

105. Id. 

106. See HELMS, supra note 94, at 88, Box 5.6. 

107. Id. 

108. Id. 

109. Id. 

110. See Jansson, supra note 104. at 6. 

Ill. ld. at 6. 



VOL. 42:789 

classification, loan loss provisions and write-offs."". In conjunction, such "basic rules 

provide room for innovation, lower the regulatory costs of compliance and subject 

microlending to a strict recognition of revenues, expenses and risks."" ' 3 

Finally, although the regulatory framework is relevant, it constitutes only part 

of the story. The remaining part is supervision. "Since most of the regulatory 

initiatives are still quite recent (apart from Bolivia and Peru), supervisory authorities 

have not yet developed effective processes, tools and practices of supervision.""1 4 

"Ineffective supervision may be worse than none at all, because poor (and other) 

clients could be lulled into a false sense of security."" ' 5 "Achieving the proper mix of 

regulations and supervisory practices that foster competitive and sound 

microfinance" is the key, and it "will require a sustained commitment on the part of 

supervisory authorities."" 6 

Developing countries that are pursuing reforms to improve microfinance need 

to analyze all levels of the financial system, avoid distortion in other areas, and 

maintain the stability of the financial system as a whole. 

Importantly, the private sector should be brought to the table to participate in 

the microfinance process, seeing such participation as a commercial opportunity, and 

not as a money-loser or subsidized competition. The government, in turn, should 

foster competition and facilitate chartering of financial institutions specialized in 

lower-income segments of the population. 

B. An Example of Non-Regulatory Public-Private Initiative: The Case of South 

Africa 

South Africa, as a developing country, faces the general challenge of providing 

basic financial services to the poor. Specifically, the country is searching for ways to 

reduce the entrenched inequality of incomes, economic opportunities, and access to 

services left over from years of apartheid. Ironically, apartheid did leave South 

Africa with a developed banking system that served the dominating white 

population." 7 In the author's view, the "trick" is how to bring this banking sector 

into the developmental agenda of the country. With over half of the South African 

population living on $2 per day or less, it is imperative that the major financial 

institutions help redress the historically weak system of services for lower-income 

people. 

Facing impending regulation (i.e., a community reinvestment-type of legislation 

similar to that in the United States), the South African financial sector recently has 

responded to this demand for the expansion of access to financial services to a 

broader segment of the population in the form of the Financial Sector Charter (the 

Charter). This negotiated document was adopted by the financial sector in October 

112. Id. at 8. 

113. Id. 

114. Id. 

115. See HELMS, supra note 94, at 87. 

116. See Jansson, supra note 104, at 8. 

117. See generally Tito Mboweni, Governor, South African Reserve Bank, Address at the Year End 

Media Cocktail Function, The South African Banking Sector: An Overview of the Past 10 Years 1 (Dec. 

14, 2004), available at http://www.bis.org/review/r041231f.pdf. 



2003 and brought into effect on January 1, 2004."' The Charter represents an 

important private sector response to the broader challenges of transformation 

within, and transformation initiatives by, the financial sector. 

1. Background 

As mentioned above, South Africa has a well-developed and highly 

sophisticated formal banking system." 9 At the end of 2004, there were thirty-eight 

registered banks in South Africa.12 For historical reasons, a large proportion of the 

South African population has not been adequately served by the formal banking 

system.21 Mainly the poorest sectors of the population and rural areas have fallen 

outside of the net of the services provided by the formal banking system.' 22 Prior to 

the adoption of the Charter, the major banks were pressured to extend financial 

services-including credit for low-income housing to the poorest sectors of the South 

African population-and to desist from discriminatory lending practices. However, 

the government's response to the challenge of expanding access to financial services 

and access to housing finance for low income households has, from an early stage, 

been characterized by the search for constructive partnerships between the private 

sector and the public sector. The state would take measures to encourage the 

resumption of payments for goods and services, reinstating the rule of law, whereas 

the private sector would support the government in its efforts to bring about 

financial stability. In pursuing the goal of partnership with the private sector, it 

would seem as though there has been an almost studious avoidance of prescription 

to the private sector while at the same time maintaining subtle and overt pressure on 

the private sector lending institutions to participate more meaningfully in the 

transformation process. Two major legislative acts, the Home Loan and Mortgage 

Disclosure Act 23 and the draft Community Reinvestment (Housing) Bill of 2002, 2' 

' 

were developed by the Government but never actually implemented. This failure to 

implement legislation further reinforces the notion that the Government preferred 

to operate within a collaborative, as opposed to a prescriptive, framework with the 

financial sector. 

2. Responding to the Challenge: The Financial Sector Charter 

The Charter identifies a number of challenges facing the Sector, primarily the 

Sector's "inadequate" response to the increasing demand for access to financial 

118. The Financial Sector Charter, Jan. 1, 2004 (Financial Sector Charter), available at 

http://www.treasury.gov.za/press/other/2003101701.pdf. 

119. Gill Marcus, An Approach to the Consideration of Bank Merger Issues by Regulators: A South 

African Case, 4 BIS PAPERS 133 (2001), available at http://www.bis.org/publ/bispap04o.pdf. 

120. Tito Mboweni, supra note 117. 

121. Black Economic Empowerment Commission, BEECom Report 19 (2001), available at 

http://www.capegateway.gov.za/Text/2004/5/beecomreport.pdf. 

122. Id.; see also Marcus, supra note 119. 

123. Home Loan and Mortgage Disclosure Act 63 of 2000. 

124. Draft Community Reinvestment (Housing) Bill, 20002, Gazette 23423, Notice 747 (May 17, 

2002). 



VOL. 42:789 

services.' 2 ' The expansion of access to financial services is seen as "fundamental to 

[Black Economic Empowerment] BEE and to the development of the economy as a 

whole." '26 The broad commitment assumed in paragraph 8 of the Charter is to 

"increase effective access to first-order retail financial services to a greater segment 

of the population, within LSM 1-5. '' 127 

It is important to understand the two key concepts-"effective access" and 

"first order financial resources"-used in the Charter. The concept of "effective 

access" as utilized in the Charter has five dimensions: 1) Financial service 

infrastructure must be located within 20 kilometers of potential users; 2) The range 

of products must be sufficiently diverse; 3) The products must be offered nondiscriminatorily; 

4) The products offered must be appropriate and affordably priced; 

and 5) The products must be structured and described in an way that is easily 

accessible . 

"First-order retail financial services" as defined in the Charter include: 1) 

Transaction products and services, which serve the function of day-to-day purposes; 

2) Savings products and services, which serve the function of providing "a basic and 

secure means of accumulating funds over time"; 3) Credit for low-income housing;, 2 

and 4) Insurance products and services, which provide a cushion against defined first 

order basic risks. 130 

These provisions, and indeed the Charter as a whole, effectively depict the 

process of forming a constructive partnership between the Government and the 

private sector to meet the challenges of transformation. 

Additionally, the broad Charter commitment referred to above is made more 

concrete by a set of specific undertakings which can broadly be divided into two 

categories: those whose implementation is sector-centric in that the responsibility for 

their implementation rests solely with the Sector ("sector-centric undertakings"), 

and those whose implementation depends on negotiated arrangements reached with 

the Government and other actors ("collaborative undertaking"). Furthermore, the 

Charter parties undertake to establish, in collaboration with the Government, a 

monitoring and review mechanism "for the ongoing evaluation and review of the 

3 

impact of [the financial sector's initiatives] on access.'' This strengthens the notion 

of a partnership between the sector and the Government. 

3. Implementation Mechanisms 

An independent council with a broad mandate to oversee the implementation 

of the Charter is to be established.' 32 The Charter Council is required to undertake 

125. See Financial Sector Charter, supra note 118. 

126. Id. para. 8.1. 

127. Id. para. 8.3. LSM 1-5 refers to the Living Standards Measure designed by the South African 

Advertising Research Foundation; see generally http://www.saarf.co.za. 

128. See The Financial Sector Charter, supra note 118, para. 2.22. 

129. It should be noted that low-income housing in the context of first order financial services is 

aimed at households with a stable income of at least R$500 per month but below R$7500 per month. Id. 

paras. 2.27.3, 2.34.3. 

130. See id. para. 2.27 (examples of the first order risks mentioned are death and associated funeral 

costs, household insurance, and health insurance). 

131. Id. para. 8.6. 

132. Id. para. 15.1.1. 



periodic reviews of the implementation of the Charter and is empowered to make 

decisions regarding the implementation of the Charter in its second term (2009- 

2014).' 33 The Charter Council is to be comprised of industry association 

representatives and other interested parties.1 4 Government representatives and 

other interest groups are among the "other" interest groups to be represented on the 

Charter Council. The Charter Council is specifically required to "fairly reflect the 

interests of all the financial institutions," suggesting that there was a concern that the 

independent body might undermine such interests. 9 

The decision-making mechanism in the Charter Council is consensus. This may 

be a mechanism for ensuring that the interests of financial institutions are not 

undermined in the Charter Council. It seems however that consensus is the primary, 

but not exclusive, mode of decision making within the Charter Council. An absolute 

consensus requirement would imply the possibility of institutional paralysis in 

circumstances where the Charter Council fails to reach consensus, especially on 

matters of importance. The Charter states that a dispute breaking mechanism will 

be agreed upon within the Charter Council, including the possibility of arbitration or 

mediation. 136 This suggests that it might be possible to have definitive outcomes on 

contentious issues arising out of the deliberations of the Charter Council, lessening 

the institutional implications of the consensus requirement. 

The Charter requires each financial institution to report its progress in 

implementing the provisions to the Charter Council on an annual basis.' 37 Financial 

institutions are required to publish an annual report for general information.' 38 This 

annual report is to include an audited scorecard and an account of the progress that 

the institution has made in discharging the unquantified responsibilities set out in the 

Charter. 9 

Although the Charter is non-binding in a hard, formal sense as it sets 

aspirational goals and standards of conduct, this does not undermine its importance. 

The primary value of the Charter lies in the voluntary assumption, by private parties, 

of part of the responsibility for making transformation work within a framework of 

collaboration and partnership with the public sector. The Charter parties have 

already begun to implement some of the provisions of the Charter relating to the 

expansion of financial services to low and moderate income households. In recent 

times some of the major banks have begun to open operating units in townships and 

remote rural areas.' 0 An important development in this regard was the creation and 

133. See id. paras. 15.1.1.,4.3. 

134. The industry associations that were involved in the formulation and adoption of the Charter were 

the Association of Black Securities and Investment Professionals (mandated by the Black Business 

Council), Banking Council of South Africa, Association of Collective Investments, Bond Exchange of 

South Africa, Foreign Bankers Association of South Africa, Institution of Retirement Funds, Life Offices' 

Association of South Africa, South African Insurers Association, Investment Managers Association of 

South Africa, JSE Securities Exchange South Africa, South African Reinsurance Offices' Association, 

South African Insurers Association. 

135. See The Financial Sector Charter, supra note 118, para. 15.1.1. 

136. Id. 

137. Seeid. para. 15.2.1. 

138. Id. para 15.2.2. 

139. See id. para. 15.2.4. 

140. John Reed, SA Takes Banks to the Townships: Banks are Responding to Laws at Correcting 

South Africa's Racially Skewed Financial Sector, FIN. TIMES, Oct. 12, 2004. 



VOL. 42:789 

launch, on October 25, 2004, of the Mzansi Account by the major banks together 

with Postbank (a government institution). The Mzansi Account is designed 

specifically to meet the needs of previously ignored communities.'' The first set of 

quantitative data on the Mzansi Account suggests that that it is a runaway success."' 

According to the data, as of February 2005, over half a million Mzansi Accounts had 

been opened.' Furthermore, an average of six thousand accounts was being opened 

across the country each day.'" 

In sum, the adoption of the Charter and the apparent impetus of the Sector to 

collaborate with the Government in implementing the Charter's provisions vindicate 

the Government's partnership-seeking approach in dealing with the banking sector 

to achieve the extension of financial services and housing finance to low to moderate 

income borrowers/depositors. The financial sector's initiatives in response to the 

Charter have proven successful thus far and indicate a real potential for the 

meaningful extension of financial services. 

V. CONCLUDING OBSERVATIONS: THE NEED FOR A SUITABLE 

LEGAL-INSTITUTIONAL INFRASTRUCTURE AND POLICY 

REORIENTATION 

The world of the IFIs and Regional Financial Institutions (RFIs) has 

historically been a world of economists, a large portion of whom are 

macroeconomists, while law and lawyers traditionally have played a very minimal 

role. But, during the 1990s, the IFIs/RFIs came to learn and appreciate the 

importance of the legal-institutional infrastructure of a country in supporting the 

domestic financial system by: 1) establishing the requisite institutional and 

administrative capacities; 2) developing the desired supporting linkages between the 

public and private sectors; 3) putting in place clear rights, responsibilities, and 

liabilities of parties in a transaction; 4) maintaining the appropriate incentives and 

adequate information that espouse market forces; and 5) providing adequate and 

fair means to enforce legal obligations and claims effectively. 

This author recognizes that for over a decade, institutions such as the World 

Bank and the IMF have expended considerable efforts on "deepening" financial 

sector legal-institutional infrastructure reform in developing countries (e.g., as to the 

legal aspects focusing on the importance of property and contract rights and 

remedies, secured transactions, corporate governance, and corporate and bank 

insolvency;... and as to the institutional aspects focusing on modern administrative, 

enforcement, and judicial bodies1 46 ). Such legal-institutional and infrastructural 

141. Media Release, The Banking Council of S. Afr., Mzansi will Put Full Service Banking within 

15KM of the Vast Majority of South Africans (Oct. 15, 2004), available at http://www.banking.org.za. 

142. Media Release, The Banking Council of S. Afr., The First Set of Data Shows Mzansi Hit the Spot 

(Feb. 9, 2005), available at 

http://www.banking.org.za/documents/2005/FEBRUARY/MzansiData_090205.asp. 

143. Id. 

144. Id. 

145. See, e .g., World Bank, Principles and Guidelines for Effective Insolvency and Creditor Rights 

Systems (April 2001), available at http://www.worldbank.org/ifa/Insolvency Principles and Guidelines April 

2001.pdf 

146. In the latter part of the 1990s and currently, the World Bank has been most active in the area of 

judicial reform. 



reforms are indeed a prerequisite to a sound foundation for building a viable 

financial sector. However, these reforms fail to consider what a country wishes its 

financial system to embrace, the base of participants to include, or what policies, 

institutions, and additional legal infrastructure to implement in order to achieve 

these developmental objectives. 

For the legal system to achieve these objectives, key legislation needs to be put 

into place, i.e., at a minimum, modern contract, corporate, bankruptcy, private 

property, and commercial laws, as well as modern banking and investment securities 

laws (and even, most probably, a basic asset securitization law). These latter legal 

provisions specifically governing financial activities need to be rule-based and 

transparent while preserving a required degree of flexibility necessary to adapt to 

innovations and changing market conditions. The financial legislation/regulations 

should promulgate disclosure of information so as to enable market forces to 

discipline the activities of financial institutions and "market players." Clarity of 

entry and exit standards of financial institutions reduces uncertainty within the 

financial markets. A well-defined exit policy is especially imperative since this is the 

time when the market is likely to act rashly and to cause self-fulfilling bank runs."' 

In addition, administrative and judicial procedures need to be sufficiently clear 

and to be backed up with quality enforcement entailed to them. The problem for 

many emerging economies is the lack of any effective administration and 

enforcement. Thus, ensuring that enforcement is carried out extends the 

appropriate incentives for market participants to act normatively. Two specific 

priorities are seen as improving the enforcement of financial contracts: 1) Effective 

means to take possession of collateral exist; and 2) Revision and updating of legal 

codes are carried out to reflect new market realities. 

The lack of legal remedies in the case of non-compliance can paralyze the 

market and discourage foreigners from investing in emerging markets. The 

uncertainty surrounding the outcome of legal procedures and processes also inhibits 

the robustness of financial markets. 148 

Other key components for building modern international financial best 

practices/standards might include the twelve key standards set out by the Financial 

Stability Forum. ' 14 

9 All these reform components serve to strengthen and deepen the 

stability base of the preexisting financial sector, which is only representative of the 

top of the socioeconomic pyramid. However, they are not designed to broaden the 

financial sector base. 

As mentioned above, the G7/8 views the "robustness" of a financial system is 

an essential characteristic of a stable system. To promote this, the G10 Working 

Group has identified three crucial actions that should be taken by each country 

according to their specific situation: 

147. See Ernesto Aguirre, The World Bank-Bank Insolvency Regim and the Global Bank Insolvency 

Initiative (2003) (discussing bank insolvency principles), available at 

http://info.worldbank.org/etools/docs/library/83870/aguirre.pdf. 

148. Cf., John Hewko, Foreign Direct Investment: Does the Rule of Law Matter? (Carnegie 

Endowment for International Peace, Working Paper No. 26, 2002); Jeswald W. Salacuse, From Developing 

Countries to Emerging Markets: A Changing Role for Law in the Third World, 33 INT'L LAw. 875 (1999). 

149. See NORTON, supra note 11, ch. 2; but cf., FSF, Compendium of Standards, available at 

http://www.fsforum.org/compendium/about.html. 



VOL. 42:789 

[1)] Creation of an institutional setting and financial infrastructure 

necessary for a sound credit culture and effective market functioning[;]... 

[2)] Promotion of the functioning of markets so that owners, directors, 

investors and other actual and potential stakeholders exercise adequate 

discipline over financial institutions[; and] . . . [3)] Creation of regulatory 

and supervisory arrangements that complement and support the operation 

of market discipline.' 

This would entail improving the infrastructural aspects of the financial system, 

namely, the legal and judicial framework, accounting and disclosure standards, and 

market structure. When viewed in this way, financial legal sector reform becomes a 

deep, complex, and long-term matrix of reform efforts, presenting truly awesome 

challenges for, and demands on, the IFI resources and personnel at a time when they 

are being pressured to react to ongoing, immediate financial crises."' Yet, the 

deepness of this reform process is not directed toward broadening the reform base to 

be more inclusive as to access or as to serving true developmental objectives. 

What is rightly asserted by Claessens and Perotti now seems self-evident for 

those who have been involved with financial sector reform: the relationships 

between inequality and finance seem to be becoming clearer at the beginning of the 

twenty-first century. Important research conducted so far has suggested that to 

reduce inequality, financial systems need to be broadened, not just deepened. 

"Financial reform will only reduce inequality . . . if it improves access to growth 

opportunities for more individuals. Reforms thus need to broaden, not just deepen 

financial systems." ' 2 Certainly, in logically and pragmatically following through on 

Sen's paradigm of "choice (freedom) and development," choice presupposes 

meaningful and effective "access.'. 53 Access, in turn, presupposes the existence of 

suitable supporting governmental policies and financial sector infrastructure, which 

presumes the presence of appropriate, supporting policies, institutions, legal 

infrastructure, and legal instruments. 

However, the need to broaden is not simply about creating greater access to the 

financial system for the currently disenfranchised population, but should also 

address broadening the financial system itself so that it is not structurally geared only 

to the elite economic, business, and social elements of a developing country's society. 

The financial system should also be systemically structured in terms of suitable 

development policy to provide appropriate institutions, laws, and instruments for 

accommodating the poor, low-income, and other excluded elements of the country's 

population. For instance, it becomes critical to identify the particular sectors of a 

society that need priority development (e.g., agriculture, small business, housing, 

social safety net components, etc.), to assess the extent the existing financial sector 

and institutions might be better utilized in furthering such developmental objectives, 

and to determine what new institutions, laws, regulations, and instruments might be 

required. To achieve all this in a coherent, sequenced, and long-term sustainable 

150. Working Party on Financial Stability in Emerging Market Economies, Financial Stability in 

Emerging Economies, 3-4 (Apr. 1997). 

151. See, e.g., early discussion of the problems in EMERGING FINANCIAL MARKETS AND THE ROLE 

OF INTERNATIONAL FINANCIAL ORGANIZATIONS (Joseph J. Norton & Mads Andenas eds., 1996). 

152. Stijn Claessens & Enrico Perotti, The Links Between Finance and Inequality: Channels and 

Evidence 1 (World Bank, Background Paper for the 2006 World Development Report, 2005). 

153. See generally AMARTYA SEN, DEVELOPMENT As FREEDOM (2000). 



manner is indeed an enormous challenge for any country and for the supporting 

IFIs/RFIs. But, without having a financial system that is relevant to a country's 

developmental stage and objectives, and designed to bring in and to serve the 

excluded in meaningful ways, a country's financial system cannot effectively 

contribute to optimum, meaningful, and sustainable socioeconomic development. 

Nor can such a system provide a broad, stable platform for achieving stability with 

robust and sustained growth in the financial sector. 

As indicated in the first paragraph of this Article, this author originally had 

intended to address in detail the types of protection banking and financial sector 

users-consumers in developing countries might require, until it became apparent that 

the more fundamental need was the creation of a suitable user-consumer base, which 

is currently lacking in developing countries. Should there also be consumer 

protection in the financial sector of developing economies? Certainly, the answer 

must be yes. In creating greater access to the financial sector, consumer protection 

should be achieved in an equitable manner, and part of this equity needs to be the 

assurance that both new users-consumers and those not yet included are fairly 

treated and protected from predatory, overreaching, and abusive practices (formal 

and informal). The provision of such protection should not be viewed as an 

afterthought or as a subsequent level of reform, but should be an integral and 

contemporaneous part of the access-equity financial sector reform agenda. 



Group Insolvencies - Some Thoughts About 

New Approaches 

CHRISTOPH G. PAULUS* 

SUMMARY 

I. G ENERAL O BSERVATIONS ................................................................................. 819 

II. INCREASE OF E FFICIENCY .................................................................................. 820 

III. THE EUROPEAN D EVELOPMENT ....................................................................... 821 

IV . FURTHER CONSIDERATIONS .............................................................................. 825 

I. GENERAL OBSERVATIONS 

It is remarkable that one phenomenon within insolvency law has caught 

relatively little attention in the past among academics and legislators when put in 

relation to its practical importance and to the dramatically increased attention 

towards insolvency law in general. This increase reaches back roughly ten years-it 

began when the bubble of the so called tiger states' economies in East Asia began to 

burst, spread to Japan and Russia, and came finally to a stand-still in Brazil. In those 

days, in the middle of the 90s of the last century the globe came irritatingly close to a 

world economy crisis. The G-7 States reacted and established the Financial Stability 

Forum whose task was-and still is-to build up safeguards against a repetition of 

such a risky development. This Forum spotted twelve topics that it sees as critical 

for the financial stability of an economy-one of them being insolvency law.' It 

entrusted its observation and assessment to the World Bank, which in turn is 

supported by the United Nations Commission on International Trade Law 

(UNCITRAL) with respect to insolvency laws' implementation. 2 

. Christoph G. Paulus is Professor of Law at the Humboldt University in Berlin. He is member of the 

International Insolvency Institute, the American College of Bankruptcy, and the International Association 

of Procedural Law, and has also worked as a Consultant to both the International Monetary Fund and the 

World Bank. He wishes to express his deep gratitude to Professor Jay Westbrook, who read through the 

draft of the manuscript and gave invaluable comments. 

1. See generally Christoph G. Paulus, The Global Insolvency Law and the Role of Multinational 

Institutions, BROOK. J. INT'L L. (forthcoming 2007). 

2. See Financial Stability Forum, 12 Key Standards for Sound Financial Systems, 



VOL. 42:819 

However, the increased importance of insolvency laws is best documented 

through the published papers of the three big Multilaterals, which give legislators 

more or less detailed advice on how to draft a modern and effective insolvency law. 

The International Monetary Fund (IMF) was the first to publish in 1999, 3 followed 

by the World Bank in 2001,' and finally by UNCITRAL 5 in 2004. During this time 

the American Law Institute was tackling how to better coordinate cross-border 

insolvencies resulting from an increased number of bankruptcies where creditors and 

assets were located in more than one North American Free Trade Agreement 

(NAFTA) country. 6 Within those five years insolvency law mutated from an area of 

law reserved for centuries to a rather isolated circle of specialists, to one of practical 

global importance. 

Irrespective of this development, astonishingly little work was put into 

deliberations about how to deal with the insolvency of not only a single legal entity 

but with that of a group of such entities as a whole. This neglect is reflected in the 

previously mentioned papers-the UNCITRAL Legislative Guide is the only one 

that even touches on this topic, and still devotes only a chapter to it. The substance 

of this chapter is to bring attention to the important role this issue plays in practice, 

and to illustrate the need for further consideration and research. Such consideration 

is being undertaken by a Working Group, which has recently (Dec. 2006) been 

established. It is generally well known that the insolvency of a company, which is a 

member of a group of companies, will often initiate a domino effect, leading to the 

subsequent downfall of the other group members. The consequence is that there are 

as many insolvent companies (and insolvency proceedings) as there are group 

members; the rule is "one company, one insolvency, one proceeding." This 

phenomenon is particularly prevalent when cross-border issues are at stake. It is 

therefore not surprising that, at least in continental Europe, the need and necessity 

for intensified deliberations has been recognized in the wake of the European 

Insolvency Regulation enactment in mid-2002. 

II. 

INCREASE OF EFFICIENCY 

Before describing this development, it might be appropriate to pause for a 

moment and to observe the factual and legal situation in the case of multiple 

insolvencies. What has been a more or less coherent economic unit' becomes, so to 

http://www.fsforum.org/compendium/key-standards for -sound financial-system.html. 

3. See International Monetary Fund, Modern & Effective Insolvency Proceedings (1999), available at 

http://www.intemationalmonetaryfund.com/external/pubs/ft/orderly/index.htm. 

4. See The World Bank, Principles for Insolvency and Creditor Rights Systems 1 (Dec. 21, 2005), 

available 

at 

http://web.worldbank.org[WBSITE/EXTERNAL/TOPICS/LAWANDJUSTICE/GILD/0,,contentMDK:2 

0774193-pagePK:64065425-piPK:162156-theSitePK:215006,00.html. The World Bank's original Principles 

were developed in 2001 in response to the financial crises in emerging markets in the late 1990s. In 2005, 

the Principles were thoroughly reviewed and revised. See id., at 1-3. 

5. See UNCITRAL, 2004 UNCITRAL Legislative Guide on Insolvency Law (June 25, 2004), 

www.uncitral.org/uncitral/en/uncitral-texts/insolvency/2004Guide.html. 

6. See generally Lance Liebman, Forward to AM. LAW INST., PRINCIPLES OF COOPERATION AMONG 

THE NAFTA COUNTRIES xv, xv- xvii (2003) (noting that the bankruptcy systems of NAFTA countries- 

Canada, Mexico, and the United States-were the primary focus of the ALI's PRINCIPLES). 

7. To be sure, what is presented here is somewhat simplified, as the appearances of groups are 

manifold. See GERARD HERTIG & HIDEKI KANDA, Creditor Protection, in THE ANATOMY-OF 

CORPORATE LAW 71, 75 (Renier R. Kraakman et al. eds., 2004) (for an analysis of the intricacies and 


2007 GROUP INSOLVENCIES - SOME THOUGHTS ABOUT NEW APPROACHES 821 

speak, a pile of shards-each separate legal entity is subject to its own insolvency 

proceeding as the decision to open a proceeding for each entity is determined 

separate and independent of the others. 8 The consequence is that there are many 

insolvency administrators to be appointed, many creditors' assemblies and 

committees to be conducted, and many investigations to be initiated into potential 

pre-proceeding transactions of the debtor-to the detriment of the creditors as well 

as into potential violations of directors' duties. This is only a brief overview of the 

activities to be initiated after the economic and legal breakdown of the group 

entities; it makes sufficiently clear that the real topic behind any considerations 

about the law of group insolvencies is the desire and need for greater efficiency. 

Like the parallel set of intricacies in the field of cross-border insolvency law where 

the universality principle is gaining more and more ground internationally due to its 

greater efficiency prospect, one should approach the intricacies of a group insolvency 

law, too, from the perspective of increased efficiency. 

A closer look at this statement-as convincing as it might appear at first 

glance-reveals that there are some traps better avoided at the outset. One has to 

ask, namely, what is meant by "greater efficiency?" This question touches on the 

fact that not all insolvency laws in this world are premised on the same policy 

objectives. Thus, some laws declare it as their highest priority to achieve the best 

possible satisfaction of the creditors. Some say almost the contrary-namely to give 

the debtor the chance of a fresh start, or to foster entrepreneurialship in general. 

Still others view efficiency as preserving the work place, the integrity of the 

economic unit, or ensuring payment of certain creditors in that very state. Efficiency 

under these diverse circumstances thus comes to have different meanings, which 

must be kept in mind for possible solutions to the problem of group insolvencies. As 

a working hypothesis, I define efficiency in this text as asset maximization by 

preserving the debtor companies to the utmost while obtaining the best possible 

satisfaction of the creditors. I emphasize this hypothesis will be fine-tuned in the 

future, and should be treated as a hypothesis in its infant stage of development. 

III. THE EUROPEAN DEVELOPMENT 

It is fair to say that the English administrators and courts have taught the 

continent a lesson in how to interpret the written law. The European Insolvency 

Regulation is built on the concept of what is usually called "modified universality." 

Under such a regime, an insolvency proceeding opened in one of the member states 

is automatically recognized in all other member states. As a general rule, the 

insolvency law of the opening state-the so called lex concursus-is to be applied in 

all other member states. This universalistic approach, extending to the territory of 

twenty-five member states, is subject to some exceptions. 9 The most important one 

complexities of corporate groups). 

8. Henry Peter describes this phenomenon as privileging "form over substance." Cf Henry Peter, 

Insolvency in a Group of Companies, Substantive and Procedural Consolidation: When and How?, in THE 

CHALLENGES OF INSOLVENCY LAW REFORM IN THE 21' CENTURY 199 (Henry Peter et al. eds., 2006). 

9. For a general discussion of the European Insolvency Regulation (EIR), see CHRISTOPH G. 

PAULUS, EUROPAISCHE INSOLVENZVERORDNUNG-KOMMENTAR 57 ff. (2002); GABRIEL MOSS, IAN 

FLETCHER, & STUART ISAACS, THE EC REGULATION ON INSOLVENCY PROCEEDINGS 155 (2002); and 

Miguel Virg6s & Francisco Garcimartfn, The Normative Model, in THE EUROPEAN INSOLVENCY 



VOL. 42:819 

in the present context is the possibility to have secondary proceedings opened in 

every member state where the debtor has an establishment. The effect of this 

insolvency proceeding, however, is restricted to this member state, for it follows the 

territoriality principle. 

This distinction between the types of proceedings necessitates a rule according 

to which one proceeding is the main one and the other the secondary one. For the 

latter, the "establishment" is decisive, whereas the main proceeding is to be opened 

pursuant to Article 3 paragraph 1 of the European Insolvency Regulation (EIR) in 

the member state where the debtor has its "centre of main interests." This standard 

was adopted by the drafters of the UNCITRAL model law on cross-border 

insolvencies, turning the standard's designation into something of a global standard." 

Many in Europe thought that this is quite a precise definition requiring not 

much interpretation"-particularly when seen in combination with the further rule 

that this centre is to be presumed where the company has its registered seat, unless 

proven to the contrary." By contrast, the professionals from the Island declared, 

occasionally in a superficial and a bit far-fetched manner, the centre of a group 

subsidiary to be located at the seat of the mother company when and if it exercised 

the "head office functions." The English courts generally accepted this 

interpretation so that an astonishing number of cross-border group insolvency 

proceedings were opened in England. Needless to say, the reaction in the rest of 

Europe was rather harsh, even though (or better perhaps because of) there was not 

much maneuvering available due to the automatic recognition rule in the 

Regulation. However, after some grumbling, the lawyers on the continent followed 

this approach and declared the location of the mother company as the centre of main 

interest for the mother's subsidiaries. Courts in Italy, 3 Germany, 4 Hungary,' 5 and 

most recently France 16 have followed this line of argument and decided accordingly. 

REGULATION: LAW AND PRACTICE 11, 11-14 (2004). As to possible and desirable improvements, see 

Gabriel Moss & Christoph G. Paulus, The European Insolvency Regulation - The Case for Urgent Reform, 

19 INSOLV. INT. 1, 1 (2006). 

10. For a discussion of this term and the problems created thereby, see Jay Westbrook, Locating the 

Eye of the Financial Storm, BROOK. J. INT'L L. (forthcoming 2007); Gabriel Moss, Group Insolvency - 

Choice of Forum and Law: The European Experience Under the Influence of English Pragmatism, BROOK. 

J. INT'L L. (forthcoming 2007). 

11. This formulation is modeled after Section 3.1 of the German Insolvency Ordinance, which reads: 

The insolvency court in whose district the debtor has his usual venue shall have exclusive local 

jurisdiction. If the centre of the debtor's self-employed business activity is located elsewhere, 

the insolvency court in whose district such place is located shall have exclusive jurisdiction. 

Insolvenzordnung [Insolvency Statute], Oct. 5, 1994 I.S. 2866, § 3.1 (F.R.G.). It is obvious that this 

determination of the competent court causes few (if any) problems within one and the same jurisdiction. 

12. Some authors argue that this presumption should become the unrebuttable rule. See, e.g., Horst 

Eidenmuiller, Free Choice in International Company Insolvency Law in Europe, 6 EUR. Bus. ORG. L. REV. 

423 (2005). 

13. See Cecilia Carrara, The Parmalat Case, 70 RABELS ZEITSCHRIFr FOR AUSLANDISCHES UND 

INTERNATIONALS PRIVATRECHT [F.R.G.] 538 (2006). 

14. See District Court of Munich, May 4, 2004, available at 

http://ww9184.wb09.de/eirdatabase/adminlbilder eir/123-1_EMTEC.pdf. 

15. See Commercial Court of Nanterre, Feb. 15, 2006, available at 

http://ww9184.wb9.de/eirdatabase/admin/bilder-eir/47-1-PARMALAT%20Hungary-Slovakia.pdf. 

16. See Fejer, June 14, 2004, available at http://ww9184.wb09.de/eirdatabase/admin/bildereir/123- 

1_EMTEC.pdf. 


2007 

GROUP INSOLVENCIES - SOME THOUGHTS ABOUT NEW APPROACHES 

After all, the English approach was a step towards developing a group 

insolvency law, since now the group as a whole was in the hands of one administrator 

in one insolvency proceeding-a much more efficient way of handling the insolvency 

of a group than the one envisaged by the Regulation. Its approach is the 

aforementioned rule: "one company, one insolvency, one proceeding." Moreover, 

even if a subsidiary could be seen as an establishment which would justify the 

commencement of a secondary proceeding, EIR Art.3 par. 3(2) says that this 

proceeding has to be a liquidation proceeding from the outset, excluding from the 

outset the possibility of a reorganization of the group as a whole or even of coherent 

parts of it. 

What so far sounds as a success story of the English approach was confronted 

only a few months ago with serious irritations. The well-known Parmalat case 7 

opened the stage for a recent decision of the European Court of Justice (ECJ). 

Parmelat, the huge and world-wide acting group, had one affiliate in Dublin, Ireland. 

For tax purposes it was founded there under the name Eurofood; the company's task 

was to collect financial means for the group as a whole. Like all the other group 

related companies-and typically for the aforementioned domino effect-Eurofood 

also went into an insolvency proceeding; the question of which national law exactly 

governs this proceeding as lex concursus, however, gave rise to a dispute between 

the Irish and the Italian courts. The issue finally became settled by the court in 

Luxemburg. The chain of events started namely with a filing in Dublin which 

initiated a preliminary proceeding; the proceeding included some protective 

measures to the benefit of the creditors, with the peculiarity that, pursuant to Irish 

law, the date of filing shall be assumed as the date of the opening of the insolvency 

proceeding when and if the court later concludes that the filing requirements are met 

and that the company is in fact insolvent. 

However, before the Irish insolvency court came to this conclusion the relevant 

insolvency court in Parma had also opened the insolvency proceeding over 

Eurofood-with almost no delay. Eurofood, thus, had the dubious position to be 

subject to two mutually excluding insolvency regimes. After considering Advocate 

General Jacobs' opinion, 8 the ECJ decided May 2, 2006'" that the commencement of 

the Irish proceeding-irrespective of its preliminary nature and lack of an officially 

determined insolvency-was the earlier proceeding. Hence the Italian proceeding, 

according to the priority rule, was to be closed. 0 

This, however, is the decision given only in this particular case. Its reasoning 

leaves room for further interpretation. In its heavy reliance on the Regulation's 

Consideration No. 13 and its repetition in the Virg6s/Schmit report, the court 

emphasizes the need for the recognizability of the centre of main interests for third 

persons. They would, in the case at hand and under the given circumstances, find 

that centre in Ireland. The court offers additional explanations, one of which is that 

17. For a detailed description of this case, see Carrara, supra note 13, at 538. 

18. See Christoph Paulus, Professor Paulus on Advocate General Jacobs' Opinion in the Eurofood 

case, 70 GLOBAL TURNAROUND 10 (Nov. 2005), available at 

http://www.globalturnaround.com/article.php?issue-number=70. 

19. See generally Eurofood IFSC Lid, 2006 O.J. (C 341) 4, available at http://curia.europa.eu/jurisp/cgibin/form.pl?lang=en&Submit=Submit&alldocs=alldocs&docj=docj&docop=docop&docor=docor&dcj= 

docjo&numaff=&datefs=&datefe=&nomusuel=eurofood&domaine= &mots=&resmax=100. 

20. For a more detailed discussion of this decision, see Moss, supra note 10. 



VOL. 42:819 

the "mind of management," or head office functions, might be acceptable in evident 

cases such as a mere letterbox company or the like. 

Taking into account that there is no definition of what constitutes the "centre of 

main interests," it is astonishing that the decision (as well as the Regulation and the 

report of M. Virg6s and E. Schmit) abstains from any explanation as to who 

constitutes "third persons." Depending on how one answer this question, however, 

great differences might result there from. Given the fact that the debtor company is 

a legally separate entity, the members of the board of directors, for instance, are 

"third persons," as are all employees. It is fair to assume that they regularly know 

about the group relationship-at least in most cases. But even further, creditors are 

"third persons"-at least the bigger ones (the Bank of America in the Eurofood 

case 2 ") do very well know about the group structure. They all do not matter, 

according to the ECJ judgment. The example of the mail box company given by the 

ECJ indicates the mailman's irrelevance. 22 We may have to conclude that the third 

persons are the judges. The decision states that "the mere fact that its economic 

choices are or can be controlled by a parent company in another Member State is 

not enough to rebut the presumption laid down by the Regulation." 23 

The previous statement suggests that, if additional facts had been added, the 

decision could have come out differently. 24 The letterbox company need not 

necessarily be taken as the only possible example-it is in fact an extreme case (note 

the decision's use of "in particular"). 5 To save the progress in group insolvency law 

which had been achieved in- Europe before the Eurofood decision, the search for 

additional facts is justified. I am convinced that the decision would have been 

decided differently if the name of the filing debtor had been Parmalat Finance 

Support and not Eurofood. Had Parmalat Finance Support filed, the company 

locale would be evident to the judges. The locale might also have been evident if the 

commercial advertisements for the company hinted towards the group to which the 

company belonged (i.e., member of the X group). Probably many more iterations 

might be thought of to justify this result which the ECJ-only on first sight-seems 

to exclude. 

In sum: the English interpretation has shown a better way to come to grips with 

insolvency proceedings in a group of companies versus the traditional way. The 

Eurofood decision is not necessarily a backdrop; the reasoning can be interpreted in 

a way that reconciles the two allegedly opposing old and new views. The "mere 

fact" that the mind of management is abroad does not suffice anymore; however, if 

objective, third parties deem that recognizable facts hint towards the adherence to a 

group, the parent company can be seen as the affiliate's centre of main interests. To 

be sure, this interpretation does nothing to provide a clearer rule than the existing 

one with its continuation of the "centre of main interests" language. 26 Improvements 

21. Note that the "driving force" behind the Eurofood case was a creditor that wanted to have the 

insolvency proceeding opened in Ireland. See Carrara, supra note 13. 

22. See Eurofood, supra note 19, para. 35. 

23. Id. para. 36. 

24 But see Christoph G. Paulus, The Aftermath of "Eurofood" - BenQ Holding B.V. and the 

Deficiencies of the ECJ Decision, 20 Insolvency Intelligence 2007, 85 et seq. (commenting a decision of the 

Amsterdam Arrondissement Court from Jan. 31, 2007). 

25. Id. para. 35. 

26. See Jay Lawrence Westbrook, Multinational Financial Distress: The Last Hurrah of Territorialism, 

41 TEx. INT'L L.J. 321, 332, 334 (book review) (rightly pointing out that the COMI approach is a generally 

well functioning "first step" that provides a "good, although not perfect, level of predictability and 



are possible and desirable-for example, by requiring a purely objective fact, rather 

than a "third party" subjective perception of the existence of an objective fact. It 

should be assumed, however, that the decision of the ECJ will have some impact on 

foreign jurisdictions such as the U.S., which also rely on the "centre of main 

interests" due to the influence insofar with the UNCITRAL Model Law. 27 

IV. FURTHER CONSIDERATIONS 

This Paper has thus far been more or less descriptive-i.e. reporting about facts 

and developments. These facts shall form the basis for further considerations about 

what appears to be feasible with respect to group insolvency law and what is 

desirable. 

However, before turning to further considerations, we should contemplate the 

justification of the traditional maxim "one company, one insolvency, one 

proceeding." The maxim has the enormous advantage of clarifying legal 

relationships-an advantage which brings us back as far as to ancient Roman law. 

From a bird's eye view, one of its greatest achievements is that it reduced the 

complexity of real life dramatically by constructing a parallel legal world which splits 

this very complexity more or less into relationships between two persons. This is 

roughly true for substantive law as well as procedural law; still today our basic legal 

instruments in private law are the debtor-creditor relationship and the plaintiffdefendant 

relationship. To be sure, we can add many more actors but that does not 

exclude that the basic legal denominator is such relationship between two persons. 

By sticking to this elementary rule, the traditional maxim offers the valuable clarity 

of designating the debtor and its creditors. 

Some scholars add another justification: the claim that the creditors' trust in 

legal realities must be respected; these scholars seem to indicate that the creditors 

have selected their debtor with deliberation and have thus acquired the right that the 

law must respect their decision for this particular debtor. However, a legal argument 

based upon trust alone is shaky. Its psychological undertone has, to the best of my 

knowledge, never really been examined-let alone tested. Additionally, is it not 

equally justifiable to state that the Bank of America, as Eurofood's main creditor, 

had more trust in the then-powerful Parmalat parent company than the new and 

quite dependent Eurofood? Therefore, this argument can at best be used for either 

side, limiting its persuasiveness. 

A third justification brings us back to more solid ground. The said clarity of a 

two-person relationship is well at place when the issue is who gets what from whom. 

In terms of insolvency law, this is when a liquidation proceeding is at stake in which 

the debtor's assets are sold piecemeal or as a whole to a third party (i.e. not to the 

creditors) so that the creditors receive at least their quota from their debtor's estate. 

If all companies in a group undergo this type of proceeding, it might be easier to 

liquidate all assets within just that recently opened proceeding that has been opened 

over the legal entity that is (or has been) owner of these assets. As a general rule, it 

is fair to assume that the sum of proceeds from each group member's piecemeal 

control."). 

27. 11 U.S.C. § 1302(4) (2007). 



VOL. 42:819 

liquidation sales is about equal to the sum of proceeds from one collective 

liquidation sale. 

However, the advantage of transparency and clarity of two-person relationships is 

not as important when the sale of a going concern is at stake (whereby "going 

concern" in the present context means the added value of the group as a whole, or at 

least certain parts of it). A recent European example is the Collins & Aikman case 

which concerned some twenty-four companies in ten different member states of the 

EIR. 28 In a remarkable effort to keep the proceedings of over ten companies in 

different jurisdictions together, the court promised the local creditors the dividend 

(notably: in the English main proceeding) they would presumably have received 

under a local (secondary) proceeding - provided they would abstain from filing 

petitions for opening secondary proceedings. 29 The result of this promise and the 

creditors' trust in it was a considerable increase of the sales price. 

Finally, when the debtor's reorganization is at stake in the insolvency proceeding, 

the clarity of the two-person-relationship is of little or no help. The reason being 

that reorganization concentrates primarily on the rescue of the debtor; hence the 

advantage for the creditors is in fact just a kind of reflex of such rescue. 30 Only then, 

when the rescue is successful, will the creditors have the chance to recover what they 

have lost due to their debtor's insolvency. This mechanism is hard to describe or 

regulate in terms of a two-person-relationship-this model just does not work in 

such a context. 

In summary, the traditional maxim "one company, one insolvency, one 

proceeding" certainly does have its advantages and justifications. However, when 

the debtor's reorganization is at stake-be this the reorganization of the economic 

unit," or the reorganization of the legal entity itself 32 -holding on to this maxim 

threatens the result of achieving the highest value maximization. 

Thus the task is to find alternatives to the traditional rule which are better 

adapted to the modern insolvency law's prioritization of reorganization over 

liquidation. 33 For a German, the often celebrated and quite frequently copied 

approach of a unitary proceeding 3 " reveals a certain disadvantage. Without the 

initial division between these two types of proceedings, it is harder to ex ante predict 

the evolution of the case at hand and how it will be organized. 

Nevertheless, two options for a modernized treatment of group insolvencies are 

recognizable: the first is of a procedural aggregation, the second option is of a 

substantive aggregation. Option one proposes the procedural aggregation of the 

multiple proceedings. Numerous models exist so far. A rather prominent model is 

28. In the Matter of Collins & Aikman et. al, (2006) EWHC 1343 (Ch), available at http://www.eirdatabase.comldownload/cases/145/134-1_Collins-&-Aikman-IIl.pdf. 

29. See generally Natasha Watson, Comments on Collins & Aikman Europe SA and Other 

Companies, 11 INT'L CASE L. ALERT (2006) (providing an overview of the case), http://www.eirdatabase.com/download/caselaw/7/International-Caselaw---Alert-No-11-IV-2006-August-27,-2006.pdf. 

30. For an insightful discussion of this mechanism, see MANFRED BALZ, SANIERUNG VON 

UNTERNEHMEN ODER VON UNTERNEHMENSTRAGERN (1986). 

31. For example, the liquidation through the sale of the whole unit. 

32. Or, the debtor's reorganization in the strict sense. 

33. The following observation of Hertig and Kanda is noteworthy: "Creditors of the members of 

corporate groups are arguably more vulnerable to the opportunism and negligence of controlling 

shareholders than the creditors of... independent companies." HERTIG & KANDA, supra note 7, at 74 n.7. 

34. See Christoph G. Paulus, The New German Insolvency Code, 33 TEX. INT'L L.J. 141,143 (1998). 



the appointment of just one insolvency administrator for all proceedings of the group 

members." The main advantage of that model is that frictional losses, through the 

cooperation of several administrators, are avoided. There is no need to exchange 

information to coordinate the proceedings or to cooperate in general. 36 Some 

experience with cases under the umbrella of the EIR leave the impression that the 

written version of these obligations is sweeter than their practical realization. The 

handling of the multiple proceedings is considerably more efficient. However, the 

main disadvantage of this approach is the administrator's potential loss of neutrality 

and independence; there is a certain realistic threat of a collision of interests. This 

might become visible when, for example, tort claims within the group structure are 

to be pursued or when one company possibly has a claw-back claim against the 

other. The appointment of a special examiner in such cases usually serves as a 

solution; but this does not always erase the appearance of conspiracy. 

A variant of this approach has been tested twice by the Insolvency Court of 

KIln (Cologne). After the opening of a main proceeding over the assets of the 

parent company in England, and the opening of a secondary proceeding over the 

assets of a subsidiary in Germany, the German judge declared that the English 

administrators were debtors in possession. This means under the relevant German 

rules 37 a custodian (Sachwalter) has to be appointed to monitor the debtor's actions 

and transactions. 38 In both proceedings, the judge in Cologne selected for this task 

an experienced German administrator, thereby leaving the English administrators 

sufficient freedom to act according to their overall plans and at the same time 

safeguarding the compliance with German law. 

Another way of combining the proceedings on a procedural level is to designate 

a single insolvency court as competent for the opening of the proceedings of all 

members of the group; usually this is the court in whose district the parent company 

is situated. Some modern laws, such as the Spanish one, do have such a rule; the 

EIR does not. As previously described, the attempt initiated by the English courts 

to interpret the EIR, nevertheless, as if it had this rule has received the 

aforementioned backlash through the ECJ's "Eurofood" decision. 

Finally, some commentators propose to cope with the problem of group 

insolvency law by means of cooperation duties among administrators. This implies, 

of course, that there are as many main proceedings as there are insolvent members 

of the group-thereby upholding the abovementioned traditional rule of "one 

company, one insolvency, one proceeding." This proposal has merit in that it avoids 

the somewhat tricky construction used quite often under the European Insolvency 

Regulation, which divides the insolvency proceedings of the group members into one 

main and several secondary proceedings despite the fact that each company is 

individually a legally separate entity. The proposal respects the separation of 

proceedings, and thus keeps the interference with existing concepts to a minimum. 

Pursuant to Art. 31 EIR, for instance, cooperation duties exist only between 

35. For an example from the U.S., see generally Blackwell v. Rio Mgt., Inc. (In re Blackwell),, 267 

B.R. 732 (Bankr. W.D. Tex. 2001). 

36. See generally art. 31 EIR, supra note 9, and 11 U.S.C. § 1525 ff. 

37. lnsolvenzordnung [Insolvency Act], Jan. 1, 1999 BGBI § 270 et seq. (F.R.G.). 

38. For a similar approach, see generally Maxwell Commc'n Corp. v. Societ6 Generale (In re Maxwell 

Commc'n Corp.), 170 B.R. 800 (Bankr. S.D. N.Y. 1994), affd 186 B.R. 807 (S.D. N.Y.), affd 93 F.3d 1036 

(2d Cir. 1996). 



VOL. 42:819 

administrators in a main proceeding and the corresponding secondary proceedings. 

However, the concern remains that cooperation duties are more easily prescribed 

than fulfilled in practice. 

There might exist further possibilities to include even solvent group members 

into the procedural unity: One would be to establish a modification of the insolvency 

trigger "imminent insolvency". This would be a trigger which transforms the 

experience with the aforementioned domino effect into statutory language - for 

instance, "A member of an incorporated group shall be deemed to be faced with 

group-related insolvency if it is likely to be affected by the opened insolvency 

proceedings of other group members." 39 Another of the indicated possibilities is to 

have the phenomenon of group insolvency dealt with in a particular plan proceeding; 

thereby the solvent members of the group could be included into the group-wide 

plan without pulling them individually into an insolvency proceeding. A somewhat 

mitigated third possibility would be to establish for inter-group claims a particular 

avoidance rule or to declare group members throughout related entities - thereby 

alleviating the application of the existing avoidance rules." 0 

The second option-a substantive aggregation-is the thornier one. Under the 

term "substantive consolidation," substantive aggregation is admitted in the U.S. 4 ' 

only when due to prior mismanagement the assets of the group members are so 

confused that the estates cannot be kept separate. One could call such a situation a 

kind of force majeure; factual obstacles impede compliance with the legal attribution 

of each individual right and duty to each individual legal entity. 

The question arises whether substantive consolidation should in fact be 

restrained to such force majeure or whether one should go a step further and extend 

this approach-of course, with all caution. 4 ' To be sure, asking this question does 

make sense only when and if there are advantages of consolidation over the mere 

procedural aggregation of the separate proceedings. The answer is positive because 

of increased efficiency which has supra been described as driving force behind the 

modernization of insolvency law. The increase of efficiency results not only from the 

appointment of just one administrator-this is achievable through a mere procedural 

aggregation as well, as shown supra-but also from the general applicability of just 

one law, the lex concursus. 

To be sure, even this is achievable through the designation of one competent 

court whose order commences the proceedings over each one of the group members. 

However, the threat remains that the single proceeding would be broken up into 

several secondary proceedings when local creditors file respective petitions. This 

threat could possibly be eliminated if the insolvency administrator of the one and 

only proceeding were given the exclusive right to file such petitions. However, so far 

such a rule does not exist. 4 3 A recent decision of the English Chancery Division in 

39. To be sure, this is meant to be just as a starting point for further necessary considerations. 

40. A somewhat harsher version of this proposal would be to declare inter-group claims as being 

generally subordinated to the claims of the general unsecured creditors. 

41. See generally David A. Skeel, Groups of Companies: Substantive Consolidation in the U.S., in THE 

CHALLENGES OF INSOLVENcY LAW REFORM IN THE 21' CENTURY 229 (Henry Peter et al. eds., 2006). 

42. See, e.g., Peter, supra note 8, at 205. For the argument against substantive consolidation for 

principal reasons, see Daniel Staehelin, No Substantive Consolidation in the Insolvency of Groups of 

Companies, in THE CHALLENGES OF INSOLVENCY LAW REFORM IN THE 21" CENTURY 213 (Henry Peter 

et al. eds., 2006). 

43. In the course of the discussion before the enactment of the EIR, the European Parliament wanted 


2007 

GROUP INSOLVENCIES - SOME THOUGHTS ABOUT NEW APPROACHES 

the Collins & Aikman case" illustrates the advantage of a unitary proceeding. In 

order to prevent the opening of secondary proceedings, the English administrators 

of the main proceeding promised the local creditors the dividend that they were 

supposed to receive in case of their opened local insolvency proceeding despite the 

fact that the only applicable English insolvency provides for a different distribution 

scheme. What Justice Lindsay permitted would barely be acceptable under 

continental European law outside a plan proceeding; but the outcome of the case 

was a sale of the whole at a remarkably higher sales price. Thus, to apply just one 

law meant greater efficiency. 

The idea to explore extension of the substantive consolidation approach at all is 

the result of cases such as KPNQwest, which concerned a company that owned 

cables across Europe. Most of these cables formed networks; one of the bigger ones 

ran through Belgium, France, Germany, and the Netherlands. Notably, this 

particular network was-in terms of ownership-subdivided into four parts: the 

Belgian one was held by a Belgian subsidiary, the French one by a French subsidiary, 

and so on. Under such circumstances-would it not make sense to keep such an 

economic unit (this need not necessarily be the group as a whole) together with its 

respective insolvencies, at least when reorganization is at stake? The same principle 

could apply when a group (or parts of it) creates one product the components of 

which are built in subsidiaries. 

Posing these questions provokes deliberations about how much insolvency law 

is restricted to tools designed for use in times of economic success. Possible reasons 

for the creation of groups are: tax considerations; the need for rationalization or 

other organizational grounds; or a somewhat opaque complexity for various 

reasons. 4 ' These and other justifications can accumulate-as they often do when a 

group expands beyond the borders of a single jurisdiction. Eurofood is a typical 

example: the company was domiciled in Dublin for tax reasons, and its purpose was 

to serve the group as a whole. Therefore-once again the question: is it appropriate 

when the insolvency lawyer is bound to look only at each of the pieces of the jigsaw 

puzzle rather than seeing the picture as a whole? 

The answer is even less easy when this insolvency lawyer looks at his 

accumulated experiences: how often is the net number of group members used for 

purposes of shifting gains or losses from here to there-subsidiary x has to buy goods 

for a rather high price in order to sell it at a rather low price to subsidiary y which 

shall thereby (through an improved statement of financial conditions) be prepared 

for sale at a rather high price. German administrators term this strategy "to 

decorate the bride," for increasing the bride price. This is but one example of how - 

seen from an ex post perspective of an insolvency lawyer-the separation of legal 

independent entities is fairly often (ab)used for purposes that make sense only when 

the group is seen and understood as a whole. 

In sight of that, it is somewhat artificial to imply that creditors are creditors of 

just a particular debtor. If obligations and rights are shifted back and forth within 

to have Article 29 restricted in this way. See Christoph G. Paulus, A Theoretical Approach to Cooperation 

in Transnational Insolvencies: A European Perspective, 11 EUR. BUSINESS L.R., 435 (2000). 

44. See Re Collins & Aikman Europe SA, [2006] EWHC 1343 (Ch.) (U.K.). 

45. See Neil Cooper, GRIP 21, Corporate Groups & Insolvency (Jan. 12, 2005). 

http://www.grip2l.org/uk/actualites/actualites.php?idactualite=41. 



VOL. 42:819 

the group during its time of successful economic performance, it is more often than 

not accidental whether the particular debtor is still the real debtor and whether it is 

solvent. In general, the concentration on the debtor-creditor relationship (stemming 

from one of the most fantastic inventions of ancient Roman law) has become 

outdated in modern time when looked at from the global trade of both performing 

as well as non-performing loans. These observations, however, lead right into a wide 

field of further very fundamental questions about the law's role in general. This is 

not the place to present additional outlooks. Such discussions must be left for 

separate treatises on philosophy of law as well as methodology of law. 

Therefore, suffice it to conclude that it is possible to extend the concept of 

substantive consolidation in reorganization proceedings beyond the confusion of 

assets and estates. This, however, is certainly not yet the end of the necessary 

deliberations; after all, to pack all assets into one estate does not necessarily 

correspond with the economic realities. There is some fine-tuning necessary that 

shall not be developed here to its full extent; this requires additional thought and 

discussion. As an indication of how such fine-tuning could look, consider an 

obligatory formation of creditors' groups in a plan of a group insolvency. 

Accordingly, all creditors of each member company necessarily form one group. 

Another tool would be to provide inter-group claims with a certain ranking system 

such as the one that exists under German law, where claims of shareholders based on 

equity replacing loans to the company are subordinated. 

These are just two examples of many other possibilities. I hope that I have 

shown that it appears to be worthwhile to keep thinking along these lines and to add 

to increasing insolvency law's overall efficiency. 


Legal Mercantile Evolution from the 

Twentieth Century to the Dawning of the 

Twenty-First Century 

ARCELIA QUINTANA-ADRIANO* 

SUMMARY 


II. GENERAL AGREEMENT ON TARIFFS AND TRADE .......................................... 834 

III. W ORLD TRADE O RGANIZATION ...................................................................... 836 

IV . BY W AY OF SYNTH ESIS ...................................................................................... 840 

V . C O N C LU SIO N ....................................................................................................... 84 1 


The need to establish commercial regulations in the foreign arena became 

manifest at the turn of the twentieth century and the beginning of the twenty-first 

century, mainly as a result of the problems brought about by internal regulations of 

nation states devoted to international trade. The nation states played an active and 

marked role in establishing their own commercial regulations in order to maintain a 

good balance in this area and to boost an incipient domestic industry. Nonetheless, 

all of these national laws proved that there was no adequate regulation for 

commercial transactions at a world-wide level. The lack of such international 

regulations was a reflection of the commercial policies in use by the nation states 

which, far from boosting commercial activities, restricted global commercial turnover 

and prevented foreign economies from profiting from comparative costs. In other 

words, they denied the possibility to acquire imported goods in areas where such 

goods were produced at lower costs. 

' Doctor of Law, Universidad Nacional Aut6noma de M6xico (UNAM). Permanent professor of 

Commercial Law, Economic Law, and History of Economic Thinking for degree level; Commercial Law 

and Financial Law at the Postgraduate Studies Section of the Faculty of Law and the Faculty of 

Accountancy and Management, UNAM. Professor at the UNAM. Permanent researcher by examination 

in Commercial Law at the Institute of Law Research, UNAM. Member of the National System of 

Researchers (SNI) of the National Council for Science and Technology (CONACYT), Mexico. 



VOL. 42:831 

Consequently, the methods or policies employed by national governmentssuch 

as restrictions of certain fields in domestic industries, the benefit of exportsthe 

commercial privileges for dominant countries over colonies, the increase of 

customs barriers, and the direct control of imports and financial regulation-not only 

damaged and impoverished developing countries, but also became the main reason 

for initiating international trade regulations, with the fundamental purpose of 

developing alternative courses against governmental-driven measures. 

The first attempts to establish the aforementioned commercial regulations were 

consolidated through the signing of bilateral and regional treaties, with the aim of 

reducing tariffs and other restrictions. However, in order for these agreements to 

come into effect and to avoid any kind of possible international discrimination-as 

they only included commercial benefits for the few signing countries-it was 

necessary for these treaties to be signed on multilateral grounds. 

It was only after World War I, when the League of Nations was established in 

1919, that a movement for the systematic regulation of international trade on a 

multilateral basis began. Although the League of Nations had limited duties in the 

economic field, it had no responsible body for commerce. Mercantile affairs were 

still conducted with traditional methods, that is, bilateral negotiations and 

international diplomatic conferences. The failure of the League of Nations-due to 

the United States' refusal to become a member, even though its president had been 

the driving force behind the foundation of this society-had a deep impact on the 

negotiations of all international treaties that did not receive support from the United 

States, at the time one of the leading world powers. 

This was the reason why the world economy experienced a profound, dramatic, 

and memorable crisis in the 1920s, which gave rise to, among other things, the 

outbreak of World War .II, a conflict that might have been prevented had the 

economy succeeded in becoming both a thriving commercial growth and an 

expansionist world system. From 1920 to 1930, however, the most significant 

attempts to reinstate world economy were the Brussels Financial Conference, held in 

1920 to establish the financial and economic principles for the governments to 

follow, and the Conference for the Abolition of Prohibitions and Restrictions on 

Imports and Exports, held in 1927, where some decisions were made concerning a 

reduction of tariffs and other trade barriers, along with the approval of an 

Agreement for the abolition of prohibitions and restrictions on imports and exports. 

However, the Conference failed, and the Agreement never really came into effect. 

The Great Depression-a result of, among other things, low foreign trade 

growth, in contrast with high production taxes-led to an industrial contraction, a 

deep financial crisis, and an increase in protectionist measures assumed by the nation 

states. Protectionism was varied and widespread. The main industrialized countries 

increased tariffs and introduced quantitative restrictions and change controls, while 

bilateral agreements on clearing exchange multiplied, seemingly decreasing the 

possibility of establishing multilateral foundations to regulate foreign trade. Given 

the 1929 depression and financial crisis, governments adopted measures to safeguard 

their economies and products, neglecting the potential effects of such policies on 

other nations and creating new commercial restrictions, such as a direct quantitative 

control on imports, economic restrictions, preferential areas, bilateral commercial 

agreements, higher tariff barriers, strengthening of commercial areas with 

discriminatory protection, and establishment of direct subsidies to a number of 

industries destined to help national economies. This protectionism prevailed 


2007 

LEGAL MERCANTILE EVOLUTION 

throughout the 1930s. In 1941, both the Unites States and the United Kingdom 

attempted to establish a series of basic principles to regulate world trade exchange 

after the war, but to no avail. 

After World War II, nation states became aware of the impending need to 

prevent commercial restrictions. An international consensus was reached, declaring 

that to restore non-discriminatory commercial conditions, commerce should be 

liberalized and freed from the protectionist measures that had been in effect since 

the 1930s. The Nation Sates were also concerned with the devastating effects of 

World War 1I. In order to avoid another conflict of this magnitude, they decided to 

create a substitute for the "Society of Nations," called the United Nations, whose 

tasks included international cooperation toward the solution of international 

financial problems. 1 

Having the reorganization of world economy as its main objective, the United 

Nations' Monetary and Financial Conference, known as the Bretton Woods 

Conference, was held in 1944.2 Through the creation of three international bodies, a 

strategy was established to reorganize the world economy and foreign trade. These 

bodies were the International Monetary Fund (IMF), the International Bank for 

Reconstruction and Promotion-better known as the World Bank (WB)-and the 

International Trade Organization (ITO). Each of the bodies in this tripartite 

international economic system had a specific goal. The original idea contemplated 

specific tasks for each of these bodies: 

The IMF would only deal with macroeconomic issues of the concerned 

country-that is, its budget deficit, its monetary policy, its inflation, its commercial 

deficit, and its foreign debt-thereby guaranteeing order and stability in 

international financial transactions. 

The WB would seek to promote investment and would also deal with structural 

issues. It would not regulate the public expenditure, financial institutions, labour 

market, and commercial policies of each nation state. 

The ITO was to lay out commercial rules to facilitate the liberalization of 

multilateral trade, including employment regulations, agreements on basic products, 

restrictive trade practices, foreign investment, and services. 

On December 27, 1945, the Articles of Agreement of the IMF were signed.' 

However, it was not until October 15 of that year that it became a specialized body 

of the United Nations. Its aims were to contribute to the creation of an adequate 

and more stable international monetary system by decreasing payment balance 

problems in participating countries. 

The WB came into operation at the beginning of 1947. In its origins, the Bank 

had the purpose of funding the need for reconstruction of European countries after 

1. The term "United Nations" was first used on January 1, 1942, during World War II, when 

representatives of twenty-six nations approved the Declaration of United Nations by virtue of which their 

respective governments committed to struggle in tandem against the Axis Powers (Germany, Japan, and 

Italy). However, it was only until 1945 that the representatives of fifty countries gathered in San Francisco, 

California, at the United Nations Conference for International Organization to write the UN Charter. The 

United Nations Organization officially began its duties on October 24, 1945. See generally U.N. CHARTER. 

2. See United Nations Monetary Fund Financial Conference (Bretton Woods, N.H., July 1-22, 1944) 

Proceedings and Documents 94, U.S. Dept. of State Pub. No. 2866. 

3. See International Monetary Fund (IMF) Web site, http://www.imf.org. 



VOL. 42:831 

Wold War II, granting equal consideration and facilities for projects and resources 

devoted to development and reconstruction. 

The negotiations for the creation of the ITO began at the United Nations 

Conference on Trade and Employment, held in 1947 in Havana, Cuba (Havana 

Conference).' The Havana Charter, a product of this Conference, listed four main 

aspects for trade liberalization: (1) economic development and reconstruction; (2) 

equal conditions for market accessing, supply resources, and production means; (3) 

elimination of commercial barriers; and (4) cooperation within the International 

Trade Organization.' The Havana Charter additionally established the General 

Agreement on Tariffs and Trade (GATT]), to be regulated by the ITO. This 

document had been under negotiation since December 1945 to decrease and 

consolidate customs duties. The IMF was also to regulate this document, defining 

respective jurisdictions and, above all, safeguarding the IMF's authority over 

macroeconomic and monetary issues. It also considered a division of responsibilities. 

The Final Act of the Havana Conference was signed by fifty-three countries, with an 

appendix of the resolutions taken by the Internal Commission of the International 

Trade Organization. 6 The validity of this Final Act was conditioned to an 

international ratification by the countries comprising at least eighty-five percent of 

all world trade.' 

Ratification by the United States was decisive. Yet Congress, which appeared 

to be the party most interested in establishing the ITO, refused to sign the Charter 

because it was not liberal enough. 8 As a result, some governments, unwilling to 

submit their regulations to an organization which could have power over their trade 

regulations, did not ratify the Act either. The Charter to establish the ITO was not 

ratified by the requisite number of countries, and all attempts to establish a 

multilateral trading organization were abandoned. 

II. 

GENERAL AGREEMENT ON TARIFFS AND TRADE 

Concerned with safeguarding the tariff concessions negotiated during the 

Havana Conference, twenty-three governments called for their provisional approval 

while the ITO was being consolidated. As a result, in October 1947, Australia, 

Belgium, Brazil, Burma, Canada, Cuba, Czechoslovakia, Chile, China, France, India, 

Lebanon, Luxembourg, the Netherlands, New Zealand, Norway, Pakistan, South 

Africa, South Rhodesia, Syria, Sri Lanka, the United Kingdom, and the United 

States approved the GATT, which had been under negotiation since the end of 1945 

and during the Havana meetings. 9 The GATT" established regulations on mutual 

tariffs, traffic trade, tariff valuation, free trade areas, subsidies, fees, and non-tariff 

barriers. It went into effect on January 1, 1948.1° 

4. See United Nations, Conference on Trade and Employment, Havana, Cuba, Nov. 21-24, 1948, Final 

Act and Related Documents, UN Doc. E/Conf.2178 (1948), 21.7.3(b). 

5. See United Nations Conference on Trade and Employment, March 1948, Havana Charter for an 

International Trade Organization, art. 11(2), U.N. Sales No. 48.II.D.4, E/CONF.2/78 (1948). 

6. See id. 

7. See id. 

8. See id. 

9. General Agreement on Tariffs and Trade (GATT), Oct. 30, 1947, art. III, para 8(b), 61 Stat. A-11, 

55 U.N.T.S. 194, available at http://www.gatt.org. 

10. Id. 


2007 


Without the ratification of the Havana Charter, the ITO never came into being. 

Consequently the GATT became a provisional mechanism to govern foreign trade 

and the only multilateral framework that established foreign exchange regulations. 

GATT negotiations were of little value for poor countries because very few efforts 

were aimed at eliminating trade restrictions of elaborate products or at protecting 

agriculture. Such difficulties drove developing countries to ask the UN to create an 

organization in charge of examining world trade issues. 

Taking the position of developing countries into account, the UN Economic 

and Social Council (ECOSOC) decided in 1942 to convene a Conference on Trade 

and Development, which was hosted in Geneva, Switzerland in 1964. All members 

of the United Nations attended. The Conference established the United Nations 

Conference on Trade and Development (UNCTAD)" to deal with foreign trade 

problems. Hence, two independent organizations for international trade arose, but 

with no clear distinction between them: the GATT and the UNCTAD. 

The GAIT ultimately turned out to be a formal provisional agreement that 

made the 1947-approved tariff concessions possible, as it required no ratification. 2 

However, the adoption of some regulations related to certain points did not match 

the domestic legislation of several contrasting parties, so they reached an agreement 

on a "Protocol of Provisional Application," known as the Grandfather Clause. 3 This 

clause stipulated that each State was to put GATT principles into practice insofar as 

they were compatible with their current legislation.'" 

Despite having been conceived as a provisional commercial agreement, the 

GATT helped establish a stable and thriving multilateral trade system. 

Nevertheless, and possibly due to its provisional nature, some regional integration 

processes continued; for example, with a view to liberalizing trade, Latin American 

countries established the Latin American Free Trade Association (LAFTA) in 

1960."5 Twenty years later, LAFTA would become the Latin American Integration 

Association (LAIA). 6 

Eight rounds of negotiations were held during the GATT's nearly fifty years of 

existence. The rounds were aimed at specific subjects of foreign trade, such as tariff 

duties, commercial policies, trade barriers, subsidies, antidumping, safeguards, and 

technical assistance to developing countries, among others. Negotiations throughout 

the first four rounds were bilateral. From the Dollon, Switzerland Round in 1960 

onward, the European Economic Community acted on behalf of all its 

representatives, and thus the negotiations took on a multilateral nature. 

Nevertheless the GATT evidently was in need of reorganization, which led to the 

Uruguay Round in the 1980s and, finally, to the establishment of the World Trade 

Organization (WTO). 

11. During the Geneva Conference, it was resolved that UNCTAD would meet on a four-year basis, 

with a possibility to hold intergovernmental meetings among conferences. Also, it was decided that a 

permanent Secretariat would provide any needed support. 

12. See generally GATT, supra note 9. 

13. Protocol of Provisional Application, T.I.A.S. 1700, 55 U.N.T.S. 308. 

14. Id. 

15. Treaty of Montevideo, Feb. 18. 1960, 2 B.D.I.E.L. 54. 

16. See Treaty of Montevideo, Aug. 12, 1980,1329 U.N.T.S. 255, 20 I.L.M. 672 (1981). 



VOL. 42:831 

III. WORLD TRADE ORGANIZATION 

The GATT Ministerial Meeting held in 1982 in Geneva laid the foundations for 

the negotiation program set out at the Punta del Este, Uruguay Round, in 

September 1986. The goals of this Round were focused on the liberalization and 

expansion of world trade, updating and strengthening GATT regulations by 

improving the multilateral system, promoting international cooperation to 

strengthen the interplay of commercial policies and those affecting the growth of 

world trade, and expanding its application to new areas in international commerce, 

such as services, agriculture, textiles, and intellectual property. 17 The Ministerial 

Statement, a product of the 1982 meeting, turned out to be the mandate governing 

the negotiations of Uruguay's 1986 Round. This Statement focused on two main 

aspects-the first being negotiations about trade in goods, whereas the second 

referred to the characteristics and goals of negotiations regarding foreign trade in 

services. 

Coincidentally, in the 1980s, the changes in world trade since the GATT was 

signed in 1947 became self-evident. Economic globalization was developing, as was 

trade in services, for which the GATT had not established any regulations. 

Moreover, there had been an increase in the number of and interest in foreign 

investments. 

The Uruguay Round-which lasted from 1986 to 1994, with the participation of 

108 countries-represented an opportunity for liberalizing trade, reinforcing 

discipline, and improving the openness of the multilateral trade system. In addition, 

it sought to constitute a mechanism to settle commercial controversies. With a view 

to fulfilling the goals established in the Ministerial Statement, thirteen negotiation 

groups were created, together with a special group for trade in services-related 

negotiations, which included customs duties, non-tariff measures, tropical products, 

products obtained from the exploitation of natural resources, textiles and clothing, 

agriculture, articles from the Agreement, safeguards, agreements on multilateral 

trade negotiations, 8 subsidies and compensatory measures, trade-related aspects of 

intellectual property rights, antidumping, and measures for trade-related 

investments. 

Finally, after almost forty-seven years of planning a multilateral organization to 

regulate world trade, the agreements of the Uruguay Round were finally signed in 

Marrakech, Morocco in April 1994.'9 The international community was at long last 

able to consolidate the creation and operation of the World Trade Organization 

(WTO)! 

17. See generally Final Act Embodying the Results of the Uruguay Round of Multilateral Trade 

Negotiations, Apr. 15, 1994, LEGAL INSTRUMENTS -RESULTS OFTHE URUGUAY ROUND, vol. 1 (1994)1 33 

I.L.M. 1125 (1994) [hereinafter Uruguay Round Final Act]. 

18. As for the WTO, the term multilateral describes all activities on a world basis, specifically between 

all members of the WTO; they are to be distinguished from regional activities or those carried out by 

smaller countries. 

19. See Uruguay Round Final Act, supra note 17. 

20. See generally Marrakesh Agreement Establishing the World Trade Organization, Apr. 15, 1994 

LEGAL INSTRUMENTS-RESULTS OF THE URUGUAY ROUND vol. 31,33 I.L.M. 1144 (1994), 1867 U.N.T.S. 

154, Pub. L. 103-465, 108 Stat. 4809 (1994), 19 U.S.C 3501. The approval decree of the Final Act from 

GAT]r Uruguay Round was published in Mexico on August 4, 1994, in the Diario Oficial de la Federaci6n. 

On December 30 of the same year, all agreements were put into effect and therefore the validity of the 

World Trade Organization in Mexican law became applicable as well. 


2007 


The signing of the Final Act by representatives of the 128 member countries, 

the result of long years of negotiations, culminated with the creation of the World 

Trade Organization. 2 Several agreements, understandings, and statements were 

thus formalized that undoubtedly constitute the regulating legal instrument of trade 

at a multilateral level. The WTO became the most significant modification to the 

1947 GATT and, in turn, managed to consolidate itself as an actual multilateral trade 

organization, a goal that the GATT was never able to accomplish. 

The Agreement through which the World Trade Organization was established 

holds the following tenets, already considered by the GATT' in 1947, and which are 

to be abided by the world trade domain: 1) a discrimination-free trading system; 2) 

promotion of loyal competition; 3) fewer trade barriers; and 4) promotion of 

development and economic reform. 3 

As a seminal part of its commercial policy, the WTO also keeps a nondiscriminatory 

treatment principle, according to which all members of the 

organization are equals and abide by the same trade parameters, regardless of their 

economic or governmental system. This tenet is expounded through two basic 

clauses. The Most-Favoured Nation Clause states that any privilege or advantage 

granted by a WTO member to a country shall be extended or accorded to other 

members. 24 The National Treatment Clause states that all imported products from 

any contracting party into another one's territory shall not be directly or indirectly 

be subject to taxation or internal charges higher to those applied for similar domestic 

products. 29 

The multilateral legal regime created through the establishment of the World 

Trade Organization has broadened, as more clauses and goals in new trade areas 

have been included, such as services and intellectual property. Rights and 

obligations assumed by contracting parties under the earlier GATT scheme were 

also significantly modified by the WTO. 

The WTO was created to guarantee the development of trade relations 

between members and to negotiate and monitor the performance of the new 

obligations they have assumed. Consideration is given to the multilateral trade 

institutional legal basis and the common framework for the development of such 

relations, as well as to its role as a forum for multilateral negotiations, designed to 

raise standards of living and to increase production and trade in services and goods. 

The main purpose of the World Trade Organization is to develop a more 

feasible multilateral trade system than the one established by the GATT in 1947. 

The WTO has established as one of its essential goals that developing and leastdeveloped 

countries may benefit from the growth of international trade. 6 

The means by which the WTO plans to fulfil its purposes are established in the 

signing of agreements directed to obtain-on a reciprocity basis-a significant 

21. See Uruguay Round Final Act, supra note 17. 

22. Vincent Ferraro, Anna Cristine Santos, & Julie Ginocchio, The Global Trading System, available 

at http://www.mtholyoke.edu/acad/intrel/bush/tradepaper.htm. 

23. See PETER VAN DEN BOSSCHE. THE LAW AND POLICY OF THE WORLD TRADE ORGANIZATION 

39-44 (2005). 

24. GATT supra note 9, art. 1, para. 1. 

25. GAT supra note 9, art. III, para. 2. 

26. Marrakesh Agreement Establishing the World Trade Organization, pmbl., para. 2, available at 

http:/www.wto.org/English/docs-e/legal-e/04-wto.pdf 



VOL. 42:831 

decrease in tariffs and other trade barriers. This includes developing a lasting, 

integrated multilateral trade system, comprising the 1947 GAT, the results of 

previous efforts for trade liberalization, as well as the results from the Uruguay 

Round. 

As established, the Uruguay Round's Final Act puts an end to the provisional 

nature of the 1947 GATT through the creation of the World Trade Organization, 

with the purpose of facilitating cooperation among its members for the development 

of business relations and with legal status, organs of its own, and ample functions. 7 

The organic structure of the WTO is constituted by a Ministerial Conference acting 

as its main organ, overseeing the Dispute Settlement Body, the General Council, and 

the Trade Policy Review Body. 

The relevance of this Act stems from the fact that it integrates three major 

agreements under the same structure: (1) GATT, the merchandise agreement 28 ; (2) 

the General Agreement on Trade in Services (GATS) 29 ; and (3) the Agreement on 

Trade-related Aspects of Intellectual Property Rights (TRIPS). 3 " These agreements 

are managed by three Councils-Trade in Goods, Trade in Services, and Trade- 

Related Aspects of Intellectual Property Rights, which in turn are managed by the 

General Council, with the main task of supervising the performance and application 

of their respective multilateral agreements. 

At the same time, two international mechanisms were considered-an 

understanding concerning the regulations and procedures to settle differences, as 

well as a mechanism to analyze business policies. In addition, cooperation between 

the WTO and other specialized foreign organizations, mainly the IMF and the WB, 

were foreseen. 

The incorporation of regulations for trade in services under the legal apparatus 

of the WTO undoubtedly made a difference between the GATT's proposed system 

and its own. The GATS is the first and only set of multilateral regulations governing 

foreign trade in services. It came into being in response to the huge growth of the 

economy of services during the thirty years prior to the formalization of the WTO 

and the trade increase in this field, largely brought about by the revolution in 

communications. 

The GATS is the framework for the performance of both governments and 

individuals, and it is divided into two parts: the main agreement containing 

regulations and general controls, and national lists including concrete commitments 

by each country regarding access to foreign suppliers in domestic markets. 31 Still, 

regardless of commitments with certain service sectors, the GATS allows 

governments to control foreign suppliers' activities in the domestic market. This 

control takes the form of restricting market access and domestic regulatory changes 

established in the list of a country's commitments. 

27. See generally, Uruguay Round Final Act, supra note 17. 

28. GATT, supra note 9, art. VII. 

29. General Agreement on Trade in Services, Apr. 15, 1994, Marrakesh Agreement Establishing the 

World Trade Organization, supra note 26, Annex lB. 

30. Agreement on Trade-Related Aspects of Intellectual Property Rights, Apr. 15, 1994, Marrakesh 

Agreement Establishing the World Trade Organization, supra note 26, Annex IC [hereinafter TRIPS], 

available at http://www.wto.orglenglish/docs-e/legal-e/27-trips_01_e.htm. 

31. See GATS, supra note 29, Parts II-III. 


2007 


The GATS comprises all services subject to foreign trade, except for those 

supplied to the public according to governmental power and, in the field of air 

transport, traffic rights and all services directly related to the exercising of traffic 

rights. In this context, encouraged by the rapid and significant business opening of 

different foreign markets, a regulation of financial services was decided to be 

included into the World Trade Organization during the Uruguay Round 

negotiations, specifically under the GATS. These services involved banks, 

insurance, values, factoring, leasing, finance, or any other related or auxiliary service. 

Regulation of trade in services by the WTO has proved to be a deciding factor 

and is currently considered one of the main features of every trade agreement. 

Hence, the WTO, acting as the main multilateral trade-oriented organization, has 

established the principles the financial services sector must follow through the 

GATS, within a framework directed to governments and individuals. 

The GATS allows countries to concede additional credibility to their financialsystem 

liberalization programs. GATS specifically facilitates the organization of 

reforms made in the international arena. 

Regulations governing foreign trade in services, established in the GATS, 

include three main elements: 1) an agreed framework stipulating basic obligations 

applicable to all member countries; 2) national lists of commitments where other 

specific domestic commitments are considered and subject to a constant 

liberalization process; and 3) appendices concerning the particular state of affairs of 

different service sectors. 32 

The appendix on financial services, chiefly banks and insurance services, 

establishes the rights of parties, notwithstanding what has been stated elsewhere, to 

adopt cautionary measures-such as security measures for investors, depositors, and 

policy-holders-and to guarantee the integrity and stability of the financial system. 

There is, however, still another financial service-related understanding that allows 

interested competitors to make commitments related to financial services by means 

of a different process. 

Regarding access to markets, this understanding involves more detailed 

obligations, such as the following: 1) monopoly rights and cross-border trade; 2) 

signing of particular insurance and reinsurance policies; 3) processing and transfer of 

financial data; 4) rights to establish or expand trade presence; and 5) temporary 

entry of people." 3 

Domestic treatment-related dispositions expressly concern both access to 

payment systems and compensation managed by public bodies, as well as official 

means for funding and refunding. At the same time, consideration is given to 

affiliation or access to self-regulating institutions, futures and stock markets, and 

compensation organizations, or their mutual participation. 

Since trade in services is closely linked to circulating capital, the boundary 

between particular instruments of monetary policy and the necessary regulation is 

too narrow, resulting in the importance of clarifying these issues. Due to the 

susceptibility of the economical apparatus to financial imbalances, more caution for 

its liberalization must be taken than in other sectors. Therefore, when negotiating 

32. See id. 

33. See Understanding on Commitments in Financial Services 325, 33 I.L.M. 1168 (1994) 



VOL. 42:831 

these services, both domestic policies and the degree of development of different 

members are to be considered. 

The GATS includes a stipulated exception, the "chain-exclusion effect," that is 

likely to (1) lead to differing interpretations, whether a dispute-settling procedure is 

used or whether new negotiations are undertaken to define and specify the features 

of services provided by means of governmental power, and to (2) determine services 

not provided under commercial conditions. This exception is only defined regarding 

the financial services sector. Thus, "services provided by means of governmental 

power" are defined in Section b, Article 1 of the financial services appendix as (1) 

activities performed by a central bank or monetary authority or any other public 

body in pursuit of monetary or foreign exchange policies, (2) as part of a legal 

system of social security or public retirement plans, and (3) any related activity 

carried out by public bodies either on its own or under State guarantee or with 

financial resources provided by the State. As to "services," this term will imply the 

aforementioned activities when a member allows its financial service suppliers to 

carry out these activities in competition with a public entity or with another financial 

service supplier. 

Thus, instead of defining services and adding a list of services covered by the 

GATS, the decision was made to include all services, except for those supplied by 

means of governmental power, and to formulate a four-fold classification for trade in 

services, allowing members to take on specific commitments concerning the different 

ways to conduct such services in the different included sectors. 

IV. By WAY OF SYNTHESIS 

Trade between different nations has played a fundamental economic and 

cultural role. It has given rise to institutions, such as the bill of exchange, which in 

foreign trade bears extraordinary significance.' Yet, because of its own nature, it 

has been forced to face the problem of diverse legal regimes from different countries 

under which mercantile traffic has taken place. It is in connection with this that a 

consistent and integrated movement emerged based on mercantile law. 

The frequency of transactions among nation states gave rise to a need to 

orchestrate some regulations regarding world trade, as is the case with contracts. 

Consequently, throughout the twentieth century and until the dawning of the 

twenty-first, such States have focused on seeking an integrated world trade 

regulation. 35 

Ever since the Middle Ages, and remarkably since the end of the nineteenth 

century and the beginning of the twentieth century, nation states devoted to 

commerce have intervened to maintain favourable trade balances abroad and to 

promote the development of a budding domestic industry. The policies in use 

damaged and impoverished developing countries, and the establishment of trade 

regulations at a multilateral scale was deemed essential. This regulation first 

materialized after World War II with the creation of the League of Nations, which 

was restructured after the war and gave way to the United Nations. The economic 

34. Explanatory Note by the UNCITRAL Secretariat on the United Nations Convention on 

International Bills of Exchange and International Promissory Notes, para. 5. Dec. 9, 1988. 

http://www.jus.uio.no/Im/un.bills.of.exchange.and.promissory.notes.convention.1988/doc.html#634. 

35. See VAN DEN BOSSCHE, supra note 23, at 35-38, 78-85. 


2007 


protectionism between both world wars, however, led to an increase in tariffs and a 

multiplication of bilateral agreements of compensated exchange." 

By the end of World War II, and with a view to avoid a similar crisis to that of 

1929, a United Nations Monetary and Financial Conference was held, with the aim 

to create a tripartite international economic system, encompassing the IMF, the WB, 

and the ITO. 

The International Monetary Fund and the International Bank for 

Reconstruction and Development began working in 1945 and 1947, respectively. 

The ITO, on the other hand, was never able to materialize, due to a denial by the 

United States to ratify the Agreement. In its place, to safeguard previously 

negotiated tariff concessions, a General Agreement on Tariffs and Trade (GAF) 

was ratified in 1947 with provisional status. 

The GATT enabled the implementation of tariff duties agreed therein. In 

addition, it also contributed to establish a thriving, sound multilateral trade system. 

However, expansion of world trade and enormous technological breakthroughs has 

made it increasingly necessary to update and strengthen GATT regulations. 

The 1982 GATT Ministerial Meeting held in Geneva agreed to host a Round in 

Punta del Este, Uruguay-the eighth to be held at the time. The Uruguay Round 

began in 1986 and negotiations came to an end in 1994 with the signing of the Final 

Act, which finally led to the creation a multilateral organization to regulate 

international trade-the World Trade Organization. 

V. CONCLUSION 

As noted, the development of a multilateral trade organization was a process 

that lasted over fifty years, beginning with the creation of the League of Nations in 

1919 until the establishment of the World Trade Organization in 1994. Its relevance 

within foreign trade stems not only from its having been constituted as the 

multilateral institutional legal basis and shared framework for the development of 

commercial relations among its members, but also from having integrated three 

agreements into a single structure of great relevance for foreign trade: the 

Merchandise Agreement (GAT), the Services Agreement (GATS), and Trade- 

Related Aspects of Intellectual Property Rights (TRIPS). 

During the twentieth century, trade developed to the extent that it became an 

international phenomenon. As such, States have needed to take this into 

consideration by not only opening their borders to foreign merchandise, but also 

signing international agreements and taking part in multinational bodies and 

organizations that have been increasingly consolidated within the regulation arena of 

foreign trade. 

Markets have been driven by globalization and internationalization these last 

years, which is nothing but a search for mutually beneficial and productive 

specializations. Nevertheless, opening up to free trade requires a solid foundation to 

guarantee loyal competition within the arena of foreign trade. Nation states have 

attempted to work in consonance with the world order of commercial laws, evolving 

36. See generally Douglas A. Irwin, Historical Perspectives on U.S. Trade Policy, 

http://www.nber.org/reporter/winter99/irwin.html. 



to the rhythm of legal international trade harmonization. Hopefully, future regional 

and multilateral negotiations generations will be able to keep on developing for the 

benefit of emerging economies. 


The Agricultural Exemption in Antitrust Law: 

A Comparative Look at the Political Economy 

of Market Regulation 

ARIE REICH* 

In Memory of Shlomo Lubin 

SUMMARY 

I. INTR O D U CTIO N ................................................................................................... 844 

II. THE AGRICULTURAL EXEMPTION IN U.S. LAW .............................................. 846 

III. THE AGRICULTURAL EXEMPTION IN EC LAW ............................................... 849 

IV. THE AGRICULTURAL EXEMPTION IN THE UNITED KINGDOM ...................... 854 

V. THE AGRICULTURAL EXEMPTION IN ISRAELI LAW ....................................... 857 

A. Background: Israel's Competition Law .................................................... 857 

B. The Statutory Agricultural Exemption ...................................................... 858 

C. Exemption of Statutory Marketing Boards ............................................... 858 

D. Historical Background: The Special Role of Agriculture ........................ 859 

E. The A gricultural Cooperatives ................................................................... 860 

F. The Impact of the Exemption ..................................................................... 861 

G. A ttempts to A bolish the Exemption ........................................................... 865 

H. The Exemption in Light of International Agreements ............................. 867 

V. CONCLUSION: IS THERE A JUSTIFICATION FOR AN AGRICULTURAL 

E X E M PT IO N ? ........................................................................................................ 87 1 

Vice Dean, Faculty of Law, Bar Ilan University, Israel; Visiting Professor, Faculty of Law, 

University of Toronto. E-mail: reicha@mail.biu.ac.il. This article has benefited from the research 

assistance of Elad Ofir, and from the comments and suggestions of Professors Adi Eyal, Israel Finkelstein, 

Michal Gal, Yoav Kislev, Yael Kachel, Tali Margalit, Joel Trachtman and Michael Trebilcock. I am also 

indebted to several people involved in agricultural trade who agreed to answer my questions and share 

their experience with me, and among them: Arik Baruchin, Jacob Ben-Dor, Benjamim Korman, and 

Gershon Shlissel. The research for the article started with a seminar paper in Hebrew written under my 

supervision and encouragement by my student Shlomo Lubin, who passed away shortly after he submitted 

the paper. While Shlomo's paper focused on the agricultural exemption in Israeli law, and not on its 

comparative aspects like this article, his enthusiasm with the topic was nevertheless a source of inspiration. 

May this article be a tribute to his memory. 



VOL. 42:843 


Using comparative law as an aid to the legislator can be a very enlightening 

exercise, in particular when countries with no experience in a particular field try to 

learn from those with more experience than themselves. However, it can also lead 

to unfortunate outcomes if the comparison is not done meticulously-viewing the 

particular foreign law that is being imitated within its full legal context and social, 

political and economic circumstances. Legal transplantation from a "donor" 

jurisdiction with a regulatory environment and market structure that is very different 

from that of the "recipient" jurisdiction is a recipe for rejection, as has been learned 

the hard way by many well-meaning law reformers. Sometimes the reference to 

foreign laws is only used as a convenient justification for the adoption of inefficient 

or unjust laws in order to conceal the real lobbying efforts and narrow interests that 

are behind them. This seems to be the case with the agricultural exemption in 

Israel's competition law. 

Indeed, special exemptions of the agricultural sector from the full application of 

competition rules can be found in many jurisdictions. Most developed countries 

consider agriculture as a special sector of the economy requiring intensive 

intervention by means of regulation, such as quota systems, price support 

mechanisms and protection from imports. These policies are felt strongly in the 

international trade arena, where agriculture has always been considered-at least by 

the developed countries-as a "special case" not amenable to the regular liberal 

trade rules. 1 The refusal of these countries to open up their agricultural sectors to 

more international competition, especially for produce from developing countries, 

has caused the long impasse in the current Doha Round of multilateral trade 

negotiations within the World Trade Organization. Along with these policies, the 

developed countries also grant exclusions or partial exemptions to their farmers 

from domestic competition law.' Economic, as well as non-economic rationales 

(such as the need to preserve rural communities), are claimed to preclude regulation 

of the agricultural sector by means of market mechanisms, and to mandate 

government regulation of this sector. Inelastic demand, unpredictable and seasonal 

supply, and the inability in many cases to store the produce for long time, call for 

government intervention and special market organization. Thus, it is argued, rules 

founded on and aimed at free and unobstructed competition cannot be applied to 

the agricultural sector and hence the need to exempt this sector from antitrust laws. 

In the United States (U.S.), the special exemption for the agricultural sector was 

enacted as early as in 1922-the Capper-Volstead Act In the European 

Community (EC), the exemption is included in the Treaty Establishing the EC, in 

Article 36 (ex Article 42), ever since its inception in 1957.' In the United Kingdom 

(UK), the Restrictive Trade Practices Act of 1956, which was quite influential in the 

1. For a discussion of these claims and their critique as well as of the modern history of the attempts 

to regulate international trade in agriculture, see MICHAEL J. TREBILCOCK & ROBERT HOWSE, THE 

REGULATION OF INTERNATIONAL TRADE 321-348 (3d ed. 2005). 

2. For an overview, see OECD, DIRECTORATE FOR FOOD, AGRICULTURE AND FISHERIES 

COMPETITION POLICY AND THE AGRO-FOOD SECTOR (1999). 

3. Capper-Volstead Act, 7 U.S.C. §§ 291-292 (1922). 

4. Consolidated Version of the Treaty Establishing the European Community, art. 36, Dec. 24, 2002, 

2002 O.J. (C 325) 50 [hereinafter EC Treaty]. 


2007 

THE AGRICULTURAL EXEMPTION IN ANTITRUST LAW 

legislation process of Israel's first competition law in 1959, was also subject to such 

an exemption! 

Considering these circumstances, it was only natural that Israel's first 

competition law-The Restrictive Trade Practices Act, 1959 would also include such 

an exemption. Indeed, in the course of the deliberations of the proposed act in the 

Knesset (Israel's parliament), when the agricultural exemption was criticized by the 

opposition, it was defended by the ruling party through reference to its existence in 

other jurisdictions as well. 6 "If other economies, much more developed than our 

own and with longer experience with competition law, have chosen to exempt their 

agricultural sector from the rules on restrictive agreements - why shouldn't we do 

the same?" was in essence the striking argument of the ruling party. 

As striking as it may be, the facts are somewhat different. As I will show, none 

of the agricultural exemptions in these foreign jurisdictions is nearly as wide as that 

adopted-and what is worse, as that maintained until today-by the Israeli 

legislature. I will argue that in fact what most probably stood behind the adoption of 

this wide agricultural exemption were strong economic interests of the Labor 

Movement, which at the time dominated the agricultural sector. As in the EC, the 

exemption was part of a general agricultural policy that favored heavy involvement 

of the government in this sector and protection of certain farmers' interests, often at 

the expense of consumers. What is surprising, however, is that even after this policy 

has changed and regardless of the fact that the agricultural sector has been quite 

liberalized and opened up to private market forces, the exemption has remained and 

managed to withstand several attempts to abolish or amend it. 

This paper will discuss the agricultural exemptions in the jurisdictions of some 

of the major developed economies-namely, the U.S., the EC and the UK-against 

the backdrop of their respective market structures. It will then discuss Israel's 

agricultural exemption and its history and compare it to those discussed in the 

previous sections. It will show how political forces and narrow economic interests 

shaped the wide scope of the exemption and allowed anti-competitive practices to 

prevail way into the new era of an open market-based economy. I will then discuss 

the possible rationales for a special exemption for the agricultural sector and its 

5. The exemption was originally found in the Agricultural and Forestry Association Act, 1962, which 

provides that Part I of the Restrictive Trade Practices Act, 1956, shall not apply to certain agreements in 

the agricultural and forestry sector. Agricultural and Forestry Association Act, 1962, 11 & 12 Geo. 6, c. 38 

(Eng.). It would seem that even before the enactment of the Agricultural and Forestry Association Act of 

1962, the sector was partly exempt from the application of the Restrictive Trade Practices Act by virtue of 

Section 8(1) thereof, which exempts agreements authorized by any enactment or scheme made under an 

enactment. See Restrictive Trade Practices Act, 1956, 4 & 5 Eliz. 2, c. 68, § 8(1) (Eng.), reprinted in LORD 

WILBERFORCE, ALAN CAMPBELL & NEIL ELLES, THE LAW OF RESTRICTIVE TRADE PRACTICES AND 

MONOPOLIES § 1103 (2d ed. 1966). Since the Agricultural Marketing Act 1958 made provisions for 

approved marketing schemes in agriculture, restrictive trade practices implemented in furtherance of such 

schemes would seem to fall under this exemption. 

6. Divrey HaKnesset, minutes of the 368h session (Dec. 3, 1957) 328. MK Zeev Tzur (Labour Unity- 

Poaley Zion party): "Surely you know just like me that also in England the anti-cartel supervision does not 

apply to the councils for production and marketing of agricultural produce." (My translation - A.R.). 

Similarly during the deliberations in 1959, the exemption was defended several times by reference to the 

situation in other countries, such as England, United States, Germany and Austria. While the claims with 

regards to England were disputed by the opposition, the fact that the other jurisdictions mentioned had 

similar agricultural exemptions as that proposed was not disputed. See Divrey HaKnesset, minutes of the 

686h session (July 28, 1959) 33-2739. 



VOL. 42:843 

desirable limits and mechanics. Based on this normative analysis, amendments to 

the existing exemptions will be proposed. 

II. 

THE AGRICULTURAL EXEMPTION IN US LAW 

The agricultural exemption in U.S. federal law was granted by Congress 

through the Clayton Act of 1916 and the Capper-Volstead Act of 1922.' They were 

preceded by many state laws with similar content and objectives -namely to 

authorize the existence of agricultural cooperatives and to exempt them from 

antitrust liability. 8 The background to the exemption was the atomistic nature of the 

farming industry and the inability of individual farmers to bargain on a leveled field 

with the few firms that dominated the processing and marketing of agricultural 

produce. The farmers were many and scattered, isolated from each other and from 

their consumers, making them easy prey for cunning middlemen. The prevailing 

situation was described by Baumer et al.: 

As the physical and economic distance between farmer and consumer 

widened, a growing lack of complete supply and demand information 

made it increasingly difficult for individual farmers to make accurate 

market predictions before locking themselves into production decisions for 

the next harvest. The generally high perishability of agricultural products, 

the technological inability to store them for very long, and the absence of 

efficient transportation left many individual farmers dependent on one or 

a few handlers (processors and distributors). On many occasions the 

middlemen abused this power. In an effort to force down prices, the 

middlemen could simple threaten not to buy; the prospect of rotten 

vegetables or spoiled milk was often enough to make the farmer 

capitulate. In the dairy industry, where individual farmers were 

dependent on handlers for weighing milk to specify its volume and for 

testing its butterfat content, short-changing was a common practice. 9 

To countervail the power of the marketing firms and improve their lot, farmers 

sought to organize themselves in cooperatives. These organizations were intended 

to provide both transportation and marketing services for the farmers, thus 

connecting them better with the consumers. This would allow them to obtain fairer 

prices for their produce and establish a more efficient and equitable system of 

production and distribution. However, such organization of farmers was 

problematic from an antitrust standpoint: the cooperation between farmers for the 

sake of fixing common prices for their produce and marketing it jointly would seem 

to be in violation of the Sherman Act's prohibition of agreements in restraint of 

trade.' Indeed, a few cooperatives were found guilty of antitrust violations by the 

7. Capper-Volstead Act § 291. 

8. See A. Ladru Jensen, The Bill of Rights of U.S. Cooperative Agriculture, 20 ROCKY MTN. L. REV. 

181, 191 n.29 (1948) (collecting broad state agricultural cooperative association statutes). 

9. David L. Baumer, Robert T. Masson & Robin Abrahamson Masson, Curdling the Competition: An 

Economic and Legal Analysis of the Antitrust Exemption for Agriculture, 31 VILL. L. REV. 183, 186-187 

(1986). 

10. The Sherman Act provides: "Every contract, combination in the form of trust or otherwise, or 

conspiracy, in restraint of trade or commerce among the several states, or with foreign nations, is declared 

illegal...." Sherman Act of 1890, 15 U.S.C § 1. 


2007 


courts." The situation of the agricultural cooperatives in this regard was somewhat 

similar to that of the labor unions, in that both were necessary to put the individual 

workers/farmers on a level playing field with the more powerful firms that procured 

the fruits of their labor, but nevertheless may have been considered in violation of 

antitrust laws. Congress therefore came to their rescue through Article 6 of the 

Clayton Act of 1916, which provides: 

The labor of a human being is not a commodity or article of commerce. 

Nothing contained in the antitrust laws should be construed to forbid the 

existence and operation of labor, agricultural or horticultural 

organizations, instituted for the purpose of mutual help, and not having 

capital stock or conducted for the profit, or to forbid or restrain any 

individual members of such organizations from lawfully carrying out the 

legitimate objects thereof; nor shall such organization, or the members 

thereof be held or construed to be illegal combinations or conspiracies in 

restraint of trade, under the antitrust laws." 

This law provides merely an authorization for farmers to organize themselves in 

cooperatives (and to workers in unions) "for the purpose of mutual help."'" As long 

as they "lawfully carry[... ] out the[ir] legitimate objects" they cannot be held illegal 

under the antitrust laws.' But what type of "mutual help" may they extend to their 

members, and what exactly are their "legitimate objects"? In order to clarify that, 

and also in order to allow the cooperatives to raise the capital necessary for their 

efficient operation, Congress passed the Capper-Vollstead Act in 1922." The Act 

identified the legitimate objects of agricultural cooperatives as "collectively 

processing, preparing for market, handling and marketing" the agricultural products 

of its members for their mutual benefit. 6 Producers of such products were defined 

as "Persons engaged in the production of agricultural products as farmers, planters, 

ranchmen, dairymen, nut or fruit growers."' 7 While the Act allowed such 

cooperatives to issue capital stock, it also imposed several conditions aimed to 

ensure that the organization would retain its nature as a true cooperative for the 

benefit of its farmer members: (1) that no member of the association should have 

more than one vote because of the amount of stock or membership capital he may 

own therein; or (2) that the association should not pay dividends on stock or 

membership capital in excess of eight percent per annum; and in any case (3) that 

the association shall not deal in the products of non-members to an amount greater 

in value than such as are handled by it for members.' 8 An association that meets 

these conditions is allowed to act cooperatively in setting prices and selling 

conditions, and even cooperate with other such associations in setting up common 

11. Ford v. Chicago Milk Shippers' Ass'n, 39 N.E. 651 (1895); Reeves v. Decorah Farmers' Coop. 

Soc'y, 140 N.W. 844 (1913). 

12. Clayton Antitrust Act, 15 U.S.C. §§ 12-27 (1914). 

13. Id. at §6. 

14. Id. 

15. Capper-Volstead Act, 7 U.S.C. §§ 291-292 (1922). 

16. Id. at §291. 

17. Id. 

18. Id. § 291. The first two conditions are alternative, and it is enough if a cooperative complies with 

one of them. The third is mandatory. 



VOL. 42:843 

marketing agencies-in manners which otherwise would have been considered 

illegal under the Sherman Act.' 9 

However, the Capper-Vollstead Act also added an important safety valve. It 

charged the Secretary of Agriculture with the responsibility of taking action if he 

believes that any such association "monopolizes or restrains trade . . . to such an 

extent that the price of any agricultural product is unduly enhanced." 2 In such cases, 

a decree can be issued against the association that requires it to cease and desist 

from such acts. In other words, the exemption is not an unfettered authorization to 

engage in anti-competitive behavior to the detriment of consumers. While the 

objective was to protect farmers from monopsonist buying power, it was recognized 

that this should not be done at the expense of the consumers. Congress was not 

willing to grant such immunity to farmers associations-so as to permit them to 

develop monopoly power over the consumers-thus substituting one market 

distortion for another. As stated in the House Report on the Act: 

In the event that associations authorized by this bill shall do anything 

forbidden by the Sherman Antitrust Act, they will be subject to the 

penalties imposed by that law. It is not sought to place these associations 

above the law but to grant them the same immunity from prosecution that 

corporations now enjoy so that they may be able to do business 

successfully in competition with them. 2 

The U.S. courts also considered themselves authorized under the Act, along 

with the Secretary of Agriculture, to prevent abuse of the exemption. In Maryland 

& Virginia Milk Producers Association v. Unites States, for instance, the U.S. 

Supreme Court held that section 2 of the Capper-Volstead Act was not intended to 

give the Secretary of Agriculture exclusive jurisdiction over abuses, thereby 

excluding any prosecutions under the Sherman Act. 2 ' Thus, when there is anticompetitive 

behavior on the part of the agricultural association that unduly enhances 

prices, it can be prosecuted by the courts under the existing antitrust laws. The 

Maryland & Virginia Milk Producers Association, for instance, which had been 

found to attempt to monopolize and entering several anti-competitive agreements, 

was ordered to cancel all those contracts and to divest itself of all assets purchased 

from a competing dairy. The Supreme Court limited the exemption granted by the 

Capper-Volstead Act to the formation of cooperatives and did not extend it to their 

anticompetitive activities, such as combining with competitors that are not exempt 

cooperatives or using their dominant position to suppress competition with 

independent producers and processors. 2 3 

19. Id. 

20. Id. 

21. H.R. REP. No. 24, at 3 (Apr. 27,1921). 

22. Maryland & Virginia Milk Producers Ass'n v. United States, 362 U.S. 458, 462-63 (1959). Similar 

rulings were made in United States v. Borden Co. 308 U.S. 188, 206 (1939); and in Sunkist Growers v. 

Federal Trade Commission, 464 F.Supp 302, 309-310 (1979). It is possible that these rulings reflect some 

misgivings about the ability (or willingness) of the Secretary of Agriculture to strike the proper balance 

between competition and cooperation, and between the interests of the farmers and those of the 

consumers. The Supreme' Court therefore preferred that anti-competitive behavior continued to be 

monitored by the antitrust authorities, and not only by the Department of Agriculture. 

23. Maryland & Virginia Milk Producers Ass'n, 362 U.S. 472 (stating "the privilege the Capper- 

Volstead Act grants producers to conduct their affairs collectively does not include a privilege to combine 

with competitors so as to use a monopoly position as a lever further to suppress competition by and among 


2007 


To sum up: the agricultural exemption in U.S., antitrust law was enacted in 

order to correct distortion of competition in the agricultural sector and to allow 

farmers to countervail the monopsonist or oligopsonist market power of middlemen. 

Hence, it only extends to the formation of cooperatives among farmers, and only 

among them 24 and to the legitimate activities of such cooperatives, including joint 

processing, handling and marketing. A cooperative must act to the mutual benefit of 

its members and divide its profits among them up to a ceiling of eight percent each, 

and they are not immune from administrative or judicial supervision where they 

engage in anticompetitive activities, such as combinations with competitors, abuse of 

dominant position, and mergers. 

III. THE AGRICULTURAL EXEMPTION IN EC LAW 

The agricultural exemption in the EC is similar in its contours to the U.S. one. 

Here too the main concern seems to be to allow the efficient functioning of 

associations of farmers in the form of agricultural cooperatives. In the absence of 

such an exemption, these associations could be considered as violating Article 81 of 

the EC Treaty. 2 ' The background is the atomistic nature of the agricultural sector, 

which was made up of a multitude of small family-run farms, and the urgent need to 

encourage the establishment of cooperatives in order to improve the efficiency and 

competitiveness of the sector. In addition, and unlike the U.S., the exemption aims 

to allow the proper functioning of central governmental policies in the agricultural 

sector, mainly the EC's Common Agricultural Policy (CAP), and occasionally 

Member States' national policies. In other words, agricultural policy, and in 

particular the Treaty's rules on agriculture takes precedence over its competition 

policy. 2 6 The exemption was enacted in 1962 by the EC Council in Regulation 267 

independent producers and processors."). However, in Alexander v. National Farmers Organization, the 

Court of Appeal for the Eighth Circuit held that farmers may, through a single cooperative "or in 

combination with other exempt cooperatives, obtain monopoly power in a given market so long as it is 

achieved through natural growth, voluntary confederation and without resort to predatory or 

anticompetitive practices." Alexander v. National Farmers Organization, 687 F.2d. 1182. 

24. These associations may not have members that are not agricultural producers. In re Midwest Milk 

Monopolization Litigation held that a co-operative association which wishes to claim Capper-Volstead 

exemption must take appropriate action to police its membership so that not even one of its members is a 

non-producer (a person who is not engaged in production of agricultural products). In re Midwest Milk 

Monopolization Litigation, 510 F.Supp. 381 (WD Mo 1981). The law also provides that a firm that has 

both agricultural production activities as well as other activities (such as packing and marketing), may only 

be a member to the extent of its agricultural production and in relation to that activity. 

25. Article 81 of the EC Treaty prohibits "agreements between undertakings [which could include 

individual farmers], decisions by associations of undertakings and concerted practices which ... have as 

their object or effect the prevention, restriction or distortion of competition within the common market, 

and in particular those which: (a) directly or indirectly fix purchase or selling prices or any other trading 

conditions...." EC Treaty, supra note 4. art. 81. Farmers that organize themselves within cooperatives 

normally fix their selling prices and other trading conditions as a natural consequence of pooling their 

marketing activity. Instead of each and every one of them competing with each other and taking marketing 

and pricing decisions independently, they now cooperate and coordinate their entire marketing activity, 

thus in effect restricting competition. That is why an exemption is needed. 

26. See EC Treaty. supra note 4: Case C-280/93, Germany v. EU Council, 1994 E.C.R. 1-04973 (finding 

that the first paragraph of Article 42 of the Treaty recognizes both the priority of the agricultural policy 

over the objectives of the Treaty in the field of competition and the power of the Council to decide to what 

extent the competition rules are to be applied in the agricultural sector). 



VOL. 42:843 

pursuant to an express Treaty authorization . 2 

provides: 

Article 2(1) of the Regulation 

Article [81(1)] of the Treaty shall not apply to such of the agreements, 

decisions and practices [which relate to production of or trade in the 

products listed in Annex [I] to the Treaty] as form an integral part of a 

national market organization or are necessary for attainment of the 

objectives set out in Article [33] of the Treaty. In particular, it shall not 

apply to agreements, decisions and practices of farmers, farmers' 

associations, or associations of such associations belonging to a single 

Member State which concern the production or sale of agricultural 

products or the use of joint facilities for the storage, treatment or 

processing of agricultural products, and under which there is no obligation 

to charge identical prices, unless the Commission finds that competition is 

thereby excluded or that the objectives of Article [33] of the Treaty are 

jeopardised." 

This exception relates only to Article 81 of the EC Treaty. Thus, Article 82, on 

the abuse of dominant position, as well as the merger regulations, applies in the 

agricultural sector just like in any other sector. Furthermore, even the application of 

the exception to arrangements falling under Article 81 has been significantly 

curtailed by the restrictive interpretation given by the Commission and the 

European Court of Justice (ECJ). 30 It has been held to apply, as stated in the 

Regulation, only to the products listed in Annex I to the Treaty, and not to all 

agricultural products, as defined in Article 32(1) of the Treaty. 3 ' The first part of the 

exemption (national market organization) has only been found to apply once, 32 and 

has almost no significance today, since most national market organizations have 

been replaced by common organizations set up under EC Council Regulations. 

The second part of the exemption (necessary for Article 33 objectives) has been held 

to require that all the objectives of Article 33 (i.e. the objectives of the CAP) must 

be fulfilled before it can apply, and it is not enough that the restrictive agreement 

fulfills the main objectives enumerated in this provision?' The Commission also 

requires that it be proven that the agreement is the best means for achieving those 

objectives and that there is no other way, less restrictive of competition, to attain 

them. 35 As noted by Bellamy and Child, in practice it would appear difficult to show 

27. Council Regulation 26/62, Applying Certain Rules of Competition to Production of and Trade in 

Agricultural Products, 1959-1962 O.J. SPEC. ED. 129. 


29. Council Regulation 26/62, supra note 27, art 2(1). 

30. MICHEL WAELBROECK & ALDO FRIGNANI, EUROPEAN COMPETITION LAW 51 (F. Gamet-Pol 

trans., 1999). 

31. See Case 61/80, Cooperatieve Stremsel-en Kleurselfabriek v. Comm'n, 1981 E.C.R. 851 (holding 

that rennet of animal origin, which is a product of first-stage processing and is used in making cheese, was 

not deemed to be covered by the exemption); Case T-61/89, Dansk Pelsdyravlerforening v. Comm'n, 1992 

E.C.R. 11-1931 (finding that furskins were also outside the exemption's scope, even if they are ancillary to 

the production of another product which itself comes under Annex I). 

32. Commission Decision 88/109/EEC, 1987 O.J. (C 159) 2; WAELBROEK & FRIGNANI, supra note 30, 

at 52. 

33. BELLAMY & CHILD, COMMON MARKET LAW OF COMPETITION 827 (4th ed. 1993). 

34. Case 71/74 Frubo v. Commission [1975] ECR 563, paras. 24-26; Case C-399/93 Oude Luttikhuis v. 

Coberro [1995] ECR 1-4515, para. 25. 

35. Frubo, 1975 O.J. (L 237) 16, para. III (3). 


2007 


that an agreement meets this requirement, unless the common organization of the 

market expressly contemplates or impliedly permits such an agreement. 36 

Thus, the most important and commonly used part of this provision is the 

second sentence. Like the U.S. exemption, but unlike the Israeli one, it applies 

only to farmers and their associations and not to marketing firms as such. It is, 

however, somewhat broader in that it is not limited to the agreements required for 

the establishment and proper functioning of the association, but extends also to any 

other arrangements between farmers, as well as to arrangements between farmers' 

associations, or associations of such associations. There are, however, important 

qualifications. Firstly, these associations can only include farmers belonging to a 

single Member State. A situation where large parts of the Common Market are 

dominated by pan-European farmers' associations is thus precluded. Secondly, the 

regulation expressly prohibits price fixing (presumably, horizontal). " Finally, as in 

the U.S., there is a safety valve in the form of anauthorization of the Commission to 

declare the exemption inapplicable if it finds that competition is excluded by the 

arrangement in question or that the objectives of Article 33 of the Treaty are 

jeopardized. As in the U.S., this authority can also be used by national courts 

whenever they are asked to apply the competition rules of the Treaty. 3 They too can 

decide-taking into account the relevant case law of the European Court of Justice 

(ECJ) and the previous decisions and policies of the Commission-that the 

arrangement in question excludes competition, or jeopardizes the objectives of the 

CAP, and thus declare it void. 4 " 

Based on these principles, the Commission, the ECJ and national courts have 

examined various restrictive arrangements in the agricultural sector in order to 

determine which ones fall under the exemption, and which ones are overly 

restrictive.' In particular, the Commission has withheld the exemption from 

36. BELLAMY & CHILD, supra note 33, at 828. 

37. Lambros Papadias, Agriculture, in COMPETITION LAW OF THE EUROPEAN COMMUNITY 15-8, 15- 

11 (V. Korah ed., 2d ed. 2001). For many years it was unclear whether this second sentence was indeed an 

independent exception, or merely an illustration of the first sentence exception. The Commission had 

mostly held that it was an independent exception, and this interpretation was confirmed by the Court in 

Dijkstra, infra note 40. 

38. In other words, it probably does not apply to minimum prices fixed between the farmers and their 

cooperatives through which they sell their produce, otherwise it would be virtually impossible for most 

cooperative arrangements to benefit from the Art. 2(1), second sentence, exemption. See BELLAMY & 

CHILD, supra note 33, at 829; Papadias, supra note 37, 15-12 n.26. Rather, it applies to horizontal price 

fixing arrangements between individual farmers, or between two or more farmers' associations, or between 

one such association and other independent farmers. 

39. Such as those based on art. 81(1) of the EC Treaty, supra note 4, 

40. Joined Cases C-319/93, C-40/94 & C-224/94, Dijkstra v. Friesland, 1995 E.C.R. 1-4471 (holding that 

if the national court finds that the agreement excludes competition or jeopardizes the objectives of Article 

39, it may declare the agreement void pursuant to Article 85(2) of the Treaty if it is incapable under any 

circumstances of qualifying for an exemption decision under Article 85(3)). 

41. See, e.g., Oude Luttikhuis, Case C-399/93 Oude Luttikhuis v. Coberro para. 25 [1995] ECR 1-4515. 

(examining the statute of a milk cooperative that imposed excessive fees on its members upon their 

withdrawal from the cooperative, and holding that the cumulative effect of clauses in statutes tying the 

members to the association for long periods, and thereby depriving them of the possibility of approaching 

competitors, jeopardizes one of the objectives of the common agricultural policy, namely that of increasing 

individual earnings in the agricultural sector, and may therefore be prevented from enjoying the 

exemption). Likewise, in the matter of a large Dutch dairy milk cooperative (Campina), the exemption 

was considered to apply to an exclusive supply obligation, only after the cooperative amended its statutes 

so as to allow its members to terminate their membership on three different dates during the year, by 



VOL. 42:843 

arrangements involving persons other than farmers and their associations, such as 

processors and traders of agricultural products, even if concluded with farmers. In 

Meldoc it was held that an agreement between five parties, four of which were 

farmers' associations and only one of which was a private company, did not fall 

under the exemption . The validity of this exception has even been challenged by a 

number of traders in agricultural products and their associations who claimed that 

the second sentence of Article 2(1) discriminates between producers of and traders 

in agricultural products, by excluding the latter from its benefits. The application 

was held inadmissible, based on the rule that individuals could not challenge 

regulations, only Member States. 3 It has not been challenged ever since, and it is 

unlikely that such a challenge could be successful, considering that there are 

excellent reasons to distinguish between farmers and traders in this regard." 

The distinction has been further strengthened by another important 

regulation -Regulation 2200/96 on the common organization of the market in fruit 

and vegetables. 45 One of the objectives of this regulation is to strengthen the 

position of the producers in the market in the face of "ever greater concentration of 

demand", 46 i.e., in the wholesale and retail trading sectors which purchase from the 

farmers. To counter this concentration and the market power that comes with it, 

"the grouping of supply through [producer] organizations is more than ever an 

economic necessity. 4 7 Thus, the Regulation encourages the establishment of such 

organizations by giving them a central role in the regulation of the market, 

entrusting them with special powers to intervene in the supply and demand side of 

the market, and channeling financial support to the farmers through them. They are 

authorized to withdraw from the market certain quantities of produce in order to 

protect domestic prices. ' This can be done either by purchase and destruction of 

produce, or through other means of removal from the market, such as subsidized 

exportation. 9 Moreover, Member States may in certain circumstances extend the 

rules made by a representative producer organization to non-members of such 

organizations located in their region. 0 Thus, rules on production, marketing, quality 

standards, environmental protection, and withdrawal of produce 5 may be imposed 

giving two years notice, without having to pay any compensation, unless they gave three months notice, in 

which a resignation fee of 4% of the price received by them for milk delivered prior to the year of their 

withdrawal had to be paid. Commission of the European Communities, XXf' Report on Competition 

Policy 1991, at 67-68, paras. 83-84. 

42. Commission Decision 86/596/EEC (Meldoc), 1986 O.J. (L 348) 50. 

43. Joined Cases 19/62-22/62, F6d6ration Nationale De La Boucherie En Gros et du Commerce en 

Gros Des Viandes and Others v. Council of the European Economic Community, ECR 491-92, (English 

ed.) 491. 

44. Almost all of the special considerations that are invoked in support of the claim that agriculture is 

a "special case", such as the atomistic nature of the farming sector, unpredictable growing conditions, 

seasonal supply, are only applicable to the farmers, not to the big marketing firms. See further discussion 

infra Sect. V. 

45. Council Regulation 2200/96, On the Common Organization of the Market in Fruit and 

Vegetables, 1996 O.J. (L 297) 1 (EC) (applying to all the fruits and vegetables produced in the EC, except 

for potatoes, wine, grapes, bananas, sweet corn, olives and peas and beans for animal feed). 

46. Id. at 2, para 7. 

47. Id. 

48. Id. at 3, paras. 16-17, tit. IV, art. 23. 

49. Id. tit. IV, arts. 25, 30, tit. V, art. 35. 

50. Council Regulation 2200/96, supra note 45, tit. II, art. 18. 

51. Id. Annex III. Non-members may be required to notify the producer organization on their 

growing intentions, anticipated tonnages and probable cropping dates. They may be bound by rules on, 


2007 


on such non-members in order to boost the producer organization's control of the 

market, to ensure uniform quality standards and to prevent free-riding by nonmembers. 

However, these rules must be notified to the Commission, and if the 

Commission finds that they exclude competition in a substantial part of the internal 

market, that they jeopardize free trade or that they fall under article 81(1) (i.e., that 

they have as their object or effect the prevention, restriction or distortion of 

competition within the common market), it may order the Member State to repeal 

them. 52 Regulation 2200/96 also provides for the recognition of "inter-branch 

organizations," which are organizations made up of representatives of economic 

activities linked to the production, trading, and processing of fruits and vegetables. 

However the tasks of these organizations is to improve, in general, the production 

and marketing of fruits and vegetables by undertaking research and market studies 

and improving knowledge and transparency of production and the market." While 

Article 20 of the Regulations provides that Article 81(1) of the EC Treaty shall not 

apply to agreements of recognized interbranch organizations intended to implement 

these type of measures, this exemption only applies if the measures have been 

notified to the Commission and the Commission has not found that they are 

incompatible with Community rules. The Regulations order the Commission to 

declare agreements, decisions, and concerted practices of such organizations as 

contrary to Community rules, whenever they may lead to partitioning of markets in 

the Community, or may affect the sound operation of the market organization, or 

may create distortions of competition which are not essential in achieving the 

objectives of the CAP pursued by the organization. 4 Agreements that entail price 

fixing, in particular, shall be declared incompatible. 5 These provisions are meant to 

ensure that interbranch organizations-i.e., those bodies that include actors other 

than the farmers-are not used in a manner that may harm competition, and that 

they will be under constant supervision in that regard. 

To sum up: while the European Community has a much regulated and heavily 

subsidized agricultural sector, 6 it has made efforts to ensure that some competition is 

maintained in the sector. It has decided that the agricultural policy, with its strong 

emphasis on protecting the income of farmers and ensuring a steady supply of food, 

will take precedence over competition rules, but only insofar as is necessary to 

achieve the CAP objectives and to protect the farmers. A clear distinction is made 

in this regard between farmers and traders, so that only the former are exempt from 

some of the competition rules, but are nevertheless under the potential scrutiny of 

the Commission and of national courts so as to prevent disproportional distortion of 

among others, choice of seeds to be used, specified dates for commencement of cropping, staggering of 

marketing, minimum quality and size requirements, and rules of withdrawals of produce adopted under 

Article 23. 

52. Id. art. 18(5). Similar rules apply to the common organization of raw tobacco (Council Regulation 

(EEC) No 2077/92 concerning inter-branch organizations and agreements in the tobacco sector, O.J. L 215 

80(1992)). 

53. Id. art. 19.1. 

54. Id. art. 20.3. 

55. Id. 

56. The EU common agricultural policy is in the process of several reforms which will make it more 

market-oriented and less distorting. Support is shifting from price support to "single-farm payments" 

which are decoupled from actual production decisions. 



VOL. 42:843 

competition. The objectives of both Regulations 26 and 2200/96 are to improve the 

efficiency of the atomistic farming sector and to strengthen the farmers vis vis the 

traders and processors who buy from them. The competition rules are compromised 

only insofar as is necessary for that purpose and to achieve other CAP objectives. 

IV. THE AGRICULTURAL EXEMPTION IN THE UNITED KINGDOM 

The first enactment in English Law imposing judicial supervision over 

restrictive agreements was the Restrictive Trade Practices Act of 1956." 7 Part I of 

this Act provided that the details of a wide range of restrictive agreements must be 

entered on a public register and examined by the Restrictive Practices Court. The 

Court then had to decide in the light of the criteria laid down in Section 21 of the 

Act whether all or any of the restrictive provisions in those agreements are in the 

public interest. 8 A similar, but amended, act was enacted in 1968 bearing the same 

name. 9 Art. 8(1) of the 1956 Act exempts agreements authorized by any enactment 

or scheme made under an enactment, which could apply also to authorized 

marketing schemes in the agro-market. 60 

In 1962, the Parliament passed the Agricultural and Forestry Associations Act, 

1962 (AFA Act) 6 " which provided that Part I of the 1956 Act shall not apply to 

certain agreements in the agricultural and forestry sector (with the fisheries sector 

added later 62 ). Here again, as in the U.S. and the EC, the exemption is meant to 

enable farmers to organize themselves in cooperatives in order to market and 

process their produce and to make collective procurement of the supplies needed to 

run their farms. Thus, the AFA Act applies only to associations of persons 

occupying land used for agriculture or forestry, in which at least ninety percent of 

the voting power is attached to shares held by such farmers or foresters. 63 The only 

business, or the principal business, carried on by the association can be marketing or 

preparation for market of produce produced by its members on land occupied by 

them and used as aforesaid, the supply to its members of goods required for the 

production of such produce on such land, and, in the case of a forestry association, 

the carrying out of forestry operations for its members on such land.' The type of 

agreements that are exempted by the AFA Act are only agreements made by the 

members of such associations, or between the association and other persons, for the 

purpose of, or in connection with, the marketing or preparation for market by the 

association of agricultural produce produced by its members, or for the supply by the 

association to its members of goods required for the production of agricultural 

57. 4 and 5 Eliz. 2, c. 68. Reprinted in Lord Wilberforce, Alan Campbell & Neil Elles, The Law of 

Restrictive Trade Practices and Monopolies §1103 (2d ed., 1966). 

58. Organisation for Economic Co-operation and Development, Guide to Legislation on Restrictive 

Business Practices vol. II. United Kingdom (GB) 4 (1976). 

59. Restrictive Trade Practices Act, 1968, c. 66 (Eng.). 

60. See infra, note 73 and accompanying text. 

61. Agricultural and Forestry Association Act, 1962, 11 and 12 Geo. 6. c. 38. ("An act to provide that 

certain agreements made by or between members of associations of persons occupying land used for 

agriculture or forestry shall be exempted from the application of Part I of the Restrictive Trade Practices 

Act, 1956"). 

62. Agriculture (Miscellaneous Provisions) Act of 1968, s. 44 (Eng). 

63. Id. art 1(1) chapeau, para. b. 

64. Id. art l(1)(c). 


2007 


produce. Finally, the AFA Act grants powers to the Ministers of Agriculture 65 to 

exclude various classes of agreements or various classes of associations by issuing an 

order to that effect.6 

Such an order was issued shortly after the enactment of the AFA Act, 67 

imposing several requirements in relation to the provisions that must be included in 

the memorandum or articles of association of these agricultural cooperatives, in 

order for them to be eligible for the exemption. These are meant to ensure that the 

exemption will be restricted to true agricultural cooperatives, where only farmers are 

members and where profits are shared out according to agricultural production. 68 

Thus, the profits of the cooperative must be divided among its members in 

proportion to the aggregate value of the produce bought from or marketed for each 

member; each member can be entitled to one vote only; and the association cannot 

market more than one third of the produce marketed by it for non-members of the 

association. 69 Furthermore, the association may not be required to sell its produce, 

or to buy goods, only to or from a specified person or class of persons. Restrictive 

agreements between different associations are also excluded, as are agreements in 

relation to various manufactured agricultural products, as specified in a Schedule to 

the Order. 70 

Along with this exemption for agricultural cooperatives, U.K. Law also 

provides for special exemptions for approved marketing schemes. Under section 45 

of the Agriculture (Miscellaneous Provisions) Act of 1968, 7 ' agricultural marketing 

boards may notify their agreements to the appropriate Minister and obtain 

exemption from the Restrictive Trade Practices Act if the Minister does not object. 

The types of agreements that may be exempt in this way are only agreements 

entered into by marketing boards in the exercise of their powers under sections 20(1) 

and 36 of the Agricultural Marketing Act 1958,72 agreements that are required for 

the implementation of officially approved marketing schemes. 7 However, the 

65. Namely, the Minister of Agriculture, Fisheries and Food and Secretaries of State respective 

concerned with agriculture in Scotland and in Northern Ireland, acting jointly. Id. art. 2(1). 

66. Id. art 1(3). 

67. The Agricultural and Forestry Associations (Exceptions) Order, 1962, S.I. 1962/1892 [hereinafter 

The Order]. 

68. A common problem with many such cooperatives is that members who once were farmers, but 

who have ceased to work in agriculture, continue to be shareholders in the cooperative and demand 

dividends from its profits. The Order is meant to prevent this from happening, by precluding the 

application of the agricultural exemption from such cooperatives. 

69. The Order, supra note 67, § 3. 

70. Id. § 4(b)-(c). The excluded products listed in Schedule 1 include: butter, cheese and other milk 

products; canned, bottled, sliced, pulped or cooked fruit and vegetables, or such vegetables preserved by 

sterilizing, freezing, dehydrating, heat or chemical process; slaughtered cattle, sheep, lambs and pigs and 

any parts of such animals; building timber and wood pulp; and wool. Schedule 2 also excludes cars, car 

accessories and petrol from the goods that me be purchased collectively by the associations. 

71. Agriculture (Miscellaneous Provisions) Act, supra note 62, c. 34. 

72. See Agricultural Marketing Act, 1958, 6 & 7 Eliz. 2, c. 47 § 1 (Eng.). 

73. Agricultural Marketing Schemes are schemes regulating the marketing of agricultural product by 

the producers thereof, which has been approved Minister of Agriculture. They can be submitted by the 

representatives of the producers of the product in question in the area to which the scheme is applicable. 

See Agricultural Marketing Act, supra note 72, § 1. Under section 20(1) of this Act, marketing boards have 

the powers, by virtue of the provisions of such a scheme, to buy the regulated product, to produce 

commodities from that product and to sell it or any commodity so produced. They may also determine the 



VOL. 42:843 

Minister is required under the Act to safeguard the public interest and to consider 

the competition law aspects of the agreement and make appropriate directions to 

cure any harmful aspects of the agreement. 

The Restrictive Trade Practices Act of 1956 was repealed and replaced by the 

Restrictive Trade Practices Act of 1976. Under this law, registrable agreements that 

were not registered with the authorities were declared void and their parties could 

be sued in tort by anyone harmed by them. 7 This new act also granted a special 

exemption to various agreements affecting agriculture, fisheries and forestry, which 

is essentially identical to the exemption that existed under the previous act. 76 In 

2000, all the existing legislation is this field was again repealed and replaced by a new 

act-the Competition Act of 1998. 7 ' This law, which is now in force in the United 

Kingdom, is modeled on Articles 81 and 82 of the EC Treaty and therefore imposes 

a competition regime that is quite similar to that of the European Community. 7 ' The 

same applies to the agricultural exemption, which also has been modeled on the EC 

exemption. It excludes from the prohibition of Chapter I (parallel to Article 81 of 

the EC Treaty) agreements that fall outside Article 81 by virtue of Regulation 

26/62. 7 ' The readers are therefore referred to the discussion of the EC exemption in 

section III above. 

Until this amendment in 1998, the agricultural exemption in force in the United 

Kingdom was very similar to that of the U.S., and one may assume that there was a 

certain amount of influence on the AFA Act of 1962 by the Capper-Vollstead Act of 

1922. Both acts were targeted on farmers' cooperatives and they had rather similar 

provisions meant to ensure that the beneficiaries of the exemption would be true 

cooperatives of real farmers."' However, the UK exemption was more limited than 

its U.S. counterpart: it did not apply to collective processing of the agricultural 

produce, but only to' marketing and preparing for market. 8 ' Unlike its U.S. 

counterpart, it also did not permit restrictive agreements between different 

quantity of the regulated product which any producer may-sell, prescribe maximum or minimum prices, 

terms of sale, to whom they may sell, etc. Id § 20(1). 

74. See Agricultural Marketing Act, supra note 72, § 20(2). 

75. RICHARD WHISH, COMPETITION LAW 94 (1st ed. 1985). 

76. Restrictive Trade Practices Act, 1976, c. 34, § 33 (Eng.). See also WHISH, supra note 75, at 120; 

NICHOLAS GREEN, COMMERCIAL AGREEMENTS AND COMPETITION LAW: PRACTICE AND PROCEDURE 

IN THE UK AND EEC 46 (1986). 

77. Competition Act of 1998, c. 41 (Eng.). 

78. Even though the United Kingdom is of course a Member State of the EC, the EC competition 

rules do not apply to commercial activity within the United Kingdom (or another Member State) that does 

not affect trade between Member States. Such purely domestic activity is subject to U.K. domestic 

competition law. 

79. Competition Act, supra note 77, sched. 3, para 9. This provision also provides that if the 

European Commission decides than an agreement is not excluded from Article 81 by Regulation 26/62, the 

exclusion from paragraph 9 of Schedule 3 ceases on the same date. One may wonder why a parallel 

authority to deny the exemption from certain harmful agreements or practices has not been given to U.K. 

competition authorities. 

80. Under both U.K. and U.S. law, each member of the cooperative can be entitled to one vote only, 

and the cooperatives are not permitted to deal with more than a certain percentage of non-member 

produce (one third in the United Kingdom and one half in the United States). Under both laws, the 

association may not pay dividends on stock or membership capital in excess of a certain percentage: 8% 

per annum in the United States, and 7% in the United Kingdom. 

81. See Agricultural and Forestry Associations Act, supra note 61, § 1:1(c); the Order, supra note 67, 

§§ 4(b)-(c) (expressly excluding most processed agricultural products). 


2007 


associations.' On the other hand, it lacked the safety valve of judicial and 

administrative supervision by competition authorities that is an important 

component of both the U.S. and the EU regimes. Of course, now that the United 

Kingdom has adopted an exemption modeled on the EU regime, this component has 

been introduced as well. 

V. THE AGRICULTURAL EXEMPTION IN ISRAELI LAW 

A. Background" Israel's Competition Law 

Israel's current antitrust law, the Restrictive Trade Practices Law, 1988 (the 

"Law"), 3 deals with three different types of trade restraints: Restrictive 

Arrangements, Mergers, and Monopolies. Restrictive Arrangements are agreements 

between two or more parties wherein at least one of the parties restricts itself in a 

manner liable to eliminate or reduce business competition." This is usually 

understood to include both horizontal and vertical arrangements that may have anticompetitive 

effects. Article 2(b) of the Law has been interpreted by the Israel 

Supreme Court 85 as creating irrebuttable presumptions regarding the anticompetitive 

effects of certain types of restrictive provisions, such as those relating to price, 

profits, division of the market and the quantity, quality or type of assets or services 

in the business.' Israeli law thus has a wide range of arrangements that are 

prohibited per se. A restrictive arrangement is prohibited unless it obtains the 

approval of the Antitrust Tribunal, or an individual exemption by the Antitrust 

Authority, or if all restraints in the arrangement are exempt in accordance with a 

block exemption issued by the Antitrust Authority. 7 The first two types of 

exemptions require the filing of a petition by the parties to the arrangement, unlike 

the third one, where the arrangement is automatically exempt if it fulfills all the 

conditions of the block exemption. However, the Law also includes a list of 

statutory exemptions (in Article 3), which grants quite broad exemptions to various 

types of arrangements by declaring them to be not restrictive. 88 These exemptions 

are usually unconditional and leave no discretion to any of the antitrust authorities 

82. The Order, supra note 67, § 3. 

83. Restrictive Trade Practices Law, 1988, 42 L.S.I. 135, (1987-88). 

84. See id. § 2(a). 

85. CA 6222/97 Tiv'ol (1993) Ltd. v. The State of Israel et al. [1998] IsrSC 52(3) 145. 

86. Article 2(b) provides: 

Without derogating from the generality of the provisions of subsection (a), an arrangement 

involving a restraint relating to one of the following issues shall be deemed to be a restrictive 

arrangement:(1) The price to be demanded, offered or paid; (2) The profit to be obtained; (3) 

Division of all or part of the market, in accordance with the location of the business or in 

accordance with the persons or type of persons with whom business is to be conducted; (4) The 

quantity, quality or type of assets or services in the business. 

87. Restrictive Trade Practices Law, supra note 83, § 4. 

88. The opening sentence of Article 3 of Restrictive Trade Practices Law, supra note 75, provides: 

"Notwithstanding the provisions of section 2, the following arrangements shall not be deemed restrictive 

arrangements .. 



VOL. 42:843 

to withdraw the exemption in cases of abuse or when severe anticompetitive 

consequences ensue.89 

B. The Statutory Agricultural Exemption 

One of these statutory exemptions is the agricultural exemption (Article 3(4)). 

It extends to: 

An arrangement involving restraints, all of which relate to the growing or 

marketing of domestic agricultural produce of the following kinds: fruits, 

vegetables, field crops, milk, honey, cattle, sheep, poultry or fish, provided 

all parties thereto are growers or wholesale marketers of such produce; the 

above provision shall not apply to goods manufactured from such 

agricultural produce[.] 9 ° 

Thus, the exemption extends to practically all types of agricultural products, but 

only to the produce itself, and not to goods manufactured from such produce. It 

exempts any types of arrangements, whether horizontal or vertical, from the 

prohibition against restrictive arrangements, but not from the other prohibitions and 

provisions of the Law. Mergers between companies in the agricultural sector are not 

exempt from the Law's provisions subjecting them to the prior approval of the 

Antitrust Authority, nor are they exempt from its chapter on monopolies. 

Unlike the U.S. Capper-Volstead Act and the EC exemption discussed above, 

this provision exempts not only the growers of agricultural products, but also the 

wholesale marketers of such products, even if these marketers are not involved in 

the growing or production of such products. Also, the provision grants a broad 

exemption to all types of arrangements made in relation to the growing and 

marketing of agricultural products, not only to collective arrangements between 

farmers, as in the U.S. exemption. Finally, the exemption is absolute and is not 

subject to supervision or possible withdrawal by the authorities or the courts in cases 

of harmful anticompetitive behavior. 

C. Exemption of Statutory Marketing Boards 

Another statutory exemption that has been important for the agricultural sector 

in Israel and in the past virtually insulated it from any type of competition is found in 

Article 3(1) which exempts arrangements "involving restraints, all of which are 

established by law." The agricultural policy since the fifties was based on central 

planning of both production and marketing and strong regulatory involvement. For 

89. The Restrictive Trade Practices Law, supra note 83, provides that "the [Minister of Industry and 

Trade] may, by order with the agreement of the Minister of Agriculture and the approval of the Knesset 

Economic Committee-add or detract categories of agricultural produce .. " Id. § 3(4). This authority, 

that has never been used, could probably not be used against specific cases of abuse or severe harm to 

competition, since it authorizes only to delete (or to add) types of products, and not types of behavior or 

specific parties, from the exemption. It appears thus more like a mechanism to determine the definition of 

the types of products that will be considered as "agricultural products" in case of uncertainty in this regard. 

The onerous legislative process that is required in order to make such an order also supports this 

understanding and helps to explain why it has never been used. 

90. Restrictive Trade Practices Law, supra note 83, art. 3(4). 


2007 


this purpose statutory marketing boards were established for the various agricultural 

sectors, such as the Citrus Fruit Board, the Vegetables Board, the Flowers Board 

and the Milk Board. " ' These bodies were authorized by law to allocate production 

quotas, set prices and regulate marketing of the products within its mandate. They 

also established an export monopoly- Agrexco Ltd.-with exclusive rights to export 

Israeli agricultural produce to other countries. The members of the marketing 

boards were representatives of the producers, of the marketing firms, of the 

government and of the consumers, with the producers having at least 50% of the 

membership (and often more) and hence effective control of the boards. These 

arrangements, which otherwise would be incompatible with the prohibition against 

restrictive arrangements, were thus exempt under Article 3(1.) as restraints 

"established by law." There is almost no parallel to such elimination of competition 

in the U.S. system, but it is quite similar to the European system of central planning 

in some of the agricultural sectors, especially in the past. 

D. Historical Background: The Special Role of Agriculture 

To understand the agricultural exemptions in Israel's antitrust law, one must 

turn to the history of agriculture in the young state and of the political and economic 

role that it has played in the Zionistic movement. The agricultural sector has been 

pivotal in the resettlement of the Land of Israel ever since the end of the 19 h 

century, in the defense of its borders and in the development of its economy. 

Indeed, working in agriculture was perceived as a major means in achieving the 

greatest of Zionist ideals-the return of the nation to its land and redemption of the 

land of the forefathers. 9 " It represented the very essence of the Zionistic ethos of 

conquering the desolation, greening the desert, and building a new type of "strong 

and healthy" Israeli attached to the land, different from the detached, ghetto-like 

Jew of the exile. 93 The prevalent form of cooperative settlement of the land, in the 

form of Kibbutzim and cooperative Moshavim," was also the embodiment of the 

socialist ideology that permeated much of the Zionistic movement in those years. 

Thus, it was only natural that the agricultural sector would have a special status 

in relation to other economic sectors and enjoy special treatment from the 

authorities. After the establishment of the State in 1948, agriculture became even 

more important and central to its national strategy of settling the land and taking 

control of its territories. Security concerns and the conflict with its Arab neighbors 

required settlement along the long borders and in remote areas with sparse 

population. There was an urgent need to ensure a rapid increase in the supply of 

food to the growing population, as Jews were flocking into the land from Europe and 

North-Africa. Agriculture also played an important role in providing work for all 

the new immigrants, whether as settlers or as employees of the farmers. And there 

91. While the Milk Board is not formally a Statutory Board, but rather a private corporation 

established pursuant to a government decision, in the past its director or deputy director had statutory 

authority to establish production quotas for the milk sector. Such quotas would therefore come under the 

exemption of Article 3(1) of the Restrictive Trade Practices Law. 

92. YAIR AHARONI, THE ISRAEL ECONOMY: DREAMS AND REALITIES 202 (1991). 

93. ALEX BEIN, THE RETURN TO THE SOIL: A HISTORY OF JEWISH SETTLEMENT IN ISRAEL (trans. 

Israel Schen, 1952). 

94. For an explanation of these forms of settlement, see infra note 98. 



VOL. 42:843 

was an ideological-political affinity between the financing bodies (the Ministry of 

Agriculture and Rural Development, and the Jewish Agency) and the settlement 

movements, such as the Kibbutz movements and the Moshav movement. They were 

all members of the Socialistic-Zionistic movement. 9 Indeed, Israel is unique in the 

world in having almost all of its agricultural settlements organized under the 

umbrella of political movements. 96 To receive allocation of land and means of 

production, farmers had to be organized by a settlement movement, all of which 

were affiliated with one or another political party." 

In later years, when industry took over as the more important foundation of the 

young economy and agriculture was losing its centrality (in particular because of the 

limited availability of water supply), it became difficult to change policies and 

abolish special rights and privileges acquired by the agricultural sector. It had 

established a very strong and coherent lobby with much power within the political 

parties. Its central role in the Zionistic ethos, as well as its importance for national 

security, continued to have a significant effect. This power was used to obtain 

government subsidies and import protection and to secure the political interests 

entrenched in the existing institutional arrangements. 

E. The Agricultural Cooperatives 

Unlike the United States, where the agricultural exemption was adopted as a 

counterweight to the marketing firms in order to allow the farmers to organize 

themselves in cooperatives, in Israel agricultural marketing was organized in 

cooperatives almost from the outset. 98 At the time of the enactment of the 

Restrictive Trade Practices Law in 1959 (which first introduced the agricultural 

exemption and on which the 1988 Law is based), these cooperatives were already 

major forces in the market. 

95. Yonathan Shapiro, The Historical Origins of the Israeli Democracy, in ISRAELI DEMOCRACY 

UNDER STRESS 65-80 (Larry Diamond and Ehud Sprinzak eds., 1993). 

96. Aharoni, supra note 92, at 207. 

97. For a strong critique of this situation, see Ezra Sohar, ISRAEL'S DILEMMA: WHY ISRAEL IS 

FALLING APART AND How To PUT IT BACK TOGETHER 210-225 (1989). The political affiliation with a 

"settlement movement" was crucial not only for the establishment of the village itself, but also in order to 

get allocation of water and production quotas. These were allocated according to movement affiliation 

pursuant to agreements between the political parties. Individual private farms were almost non-existent 

until some 20-30 years ago. Since then, the strength of the political parties and their affiliated settlement 

movements in agricultural settlement has been in decline. 

98. Not only marketing, but most of the Jewish agricultural settlement in Israel was organized in 

cooperative structures. These took four main forms: 1. Workers' Moshav, a village with some 60-150 

farmers organized in a cooperative for the purpose of selling their agricultural produce and common 

purchase of all needs, both for private purposes and for the agricultural production; 2. Kibbutz, a large 

cooperative settlement of some 80-250 families based on common ownership of all property, private and 

productive, common work by everyone and equal sharing of all income. All members eat in a common 

dining room, where the food is prepared by a common kitchen, and all needs are supplied by common 

storerooms according to rules decided by the Kibbutz assembly and secretariat; 3. Cooperative Moshav, a 

hybrid of the former two: the production and marketing is common and proceeds are shared out equally, as 

in a Kibbutz, but each family runs their own household individually, as in a Workers' Moshav; 4. Private 

Farms, organized in different forms, but where each farmer is the owner of his own farm and runs his 

business privately. 6 ENCYCLOPAEDIA HEBRAICA 837-838 (1957) (Hebrew). However, even in the noncooperative 

agricultural sector, many farmers became members of large marketing cooperatives for the 

purpose of marketing their produce or exporting it. 


2007 


One of them in particular, Tnuva-Cooperative Center for the Marketing of 

Agricultural Produce Ltd. (Tnuva), incorporated the entire Labor Movement 

settlement, i.e. the agricultural production of all of the Kibbutzim and Moshavim, 

and held some 75% of the market in many products. 99 Its involvement spanned the 

entire spectrum of agricultural production, from milk, meat and fish, to vegetables 

and fruit. Another cooperative, Tene, incorporated many private farmers and held 

market shares of between fifteen percent and twenty percent in some products.'" 

These cooperatives were very powerful and politically well connected.'' Tnuva, in 

particular, was considered as part and parcel of the Labor Movement and the Labor 

party, which was in power uninterruptedly since the establishment of the State in 

1948 until the electoral victory of the Likud party in 1977. The ruling party until 

then thus saw it as its natural mandate to protect the interests of Tnuva and the 

agricultural establishment, while the opposition from the right tried unsuccessfully to 

prevent such protection. That this was the background to the adoption of the 

agricultural exemption is very clear from the parliamentary discussions in connection 

with this exemption.' 2 This explains why the exemption is not limited to 

arrangements between farmers, but extends to marketers, as well. Also, at the time, 

the marketers and the farmers were almost the same, since it was the farmers, in 

particular those of the Kibbutzim and cooperative Moshavim, who controlled the 

largest marketing firms, i.e., the cooperative marketing organizations. As a result of 

this exemption, Tnuva could enter any type of restraining arrangements, both 

horizontal, with competing marketing firms, as well as vertical, with its suppliers, the 

farmers, and (in the past) with its downstream customers, the retailers.' Examples 

of problematic vertical agreements are those prescribing exclusivity of supply, i.e. 

that the farmer is precluded from selling any of his produce to any other marketer, 

or that the retailer is precluded from carrying products of any other marketing firm. 

F. The Impact of the Exemption 

As a result of the heavy regulation and lack of competition, the Israeli 

agricultural market was characterized by very high marketing margins, with huge 

differences between the consumer price and what the farmer actually received for 

99. Id. at 947. 

100. Divrey HaKnesset, Minutes of the 368 ' h Session (Dec. 3, 1957), 325 (speech of MK Benjamin 

Avniel, Herut Party); 6 ENCYCLOPAEDIA HEBRAICA, supra note 98, at 832 (according to this source, Tene 

was a cooperative marketing organization established to serve so-called "Rasco settlements", which were 

private middle-class agricultural settlements established between 1935-1945 by the Rasco Settlement 

Company). In the mid-fifties, while Tnuva controlled the marketing of some seventy-two percent of the 

Jewish agricultural produce, Tene together with three other cooperatives marketed another 12% of this 

produce. Id. at 947. 

101. On the power of the agricultural lobby and its sources, see AHARONI, supra note 92, at 212. 

102. Divrey HaKnesset, Minutes of the 368h Session (Dec. 3, 1957), DK (1957) 325-28 (argument 

between MK Benjamin Avniel of the market-oriented Herut Party and MK Zeev Tsur of the ruling 

Labour Unity-Poaley Zion party); DK (1959) 2733 (argument between MK Benjamin Avniel and MK 

Shmuel Shoresh of the coalition). 

103. It should be noted that the original agricultural exemption that was found in the Restrictive 

Trade Practices Law of 1959 did not limit the exemption to wholesale marketers. Thus restrictive 

agreements between a wholesaler like Tnuva and retail marketers would also come under the exemption. 

This was changed in 1963. when the law was amended so that all parties to a restrictive arrangement had to 

be either wholesale marketers or farmers. 



VOL. 42:843 

his produce.'04 In citrus products, for instance, the individual grower received only 

about fifteen percent of the price paid by the final consumer. 5 Under the marketing 

board system, in most sectors production quotas were allocated by the boards, and 

marketing was allowed only through "licensed marketers." Exportation could only 

be done through the monopoly Agrexco Ltd. or through the marketing boards. 

Thus, with much of the marketing heavily regulated and subject to quotas and price 

arrangements that were strictly enforced, the impact of the agricultural exemption 

itself was probably limited, although not insignificant,'0 6 that is, until the market was 

deregulated and opened up to private market forces. 

Towards the end of the eighties, the Israeli agricultural sector found itself in a 

serious crisis. The many boards and cooperative organizations involved in 

purchasing, production and marketing had grown into inflated and inefficient 

bureaucracies. Cheap financing and subsidized water led to imprudent choices of 

production venues. In addition, some irresponsible investment and loan decisions by 

the cooperative purchasing organizations caused heavy losses that put unbearable 

debts on all of its members. When interest rates went up, farmers were unable to 

repay their debts. The government was forced to step in to prevent total collapse of 

many Kibbutzim and Moshavim. This was done by legislation that provided for debt 

adjustments and partial relinquishment by the banks. 7 The crisis, along with the 

switch to market-oriented ideologies, convinced the policy makers that serious 

reforms were needed in the agricultural sector. 

This process started with the decision in 1991 to allow private firms to engage in 

the marketing of citrus fruits, both for export and in the domestic market. The 

process continued with other fruits and vegetables, and culminated with the 

dissolution of most of the marketing boards in favor of privatization and freer 

competition.9' Thus, for the first time, the Agrexco export monopoly was faced with 

competition. 

104. STATE OF ISRAEL, MINISTRY OF FINANCE, ECONOMIC POLICY 2007, EXPLANATORY 

MEMORANDUM TO THE BUDGET LAW OF 2007, 19. 

105. AHARONI, supra note 92, at 213. 

106. For instance, it would seem that if not for Section 3(4), the collective agreement by all of the 

marketing boards to establish a single export monopoly (Agrexco) may also have been problematic under 

the Restrictive Trade Practices Law. See ITZCHAK YAGUR, RESTRICTIVE TRADE PRACTICES LAW 345 

n.44 (2002) (Hebrew). 

107. Law on Arrangements in the Family Agricultural Sector, 1992, S.H. 118. 

108. In 2003, all of the marketing boards in the fruit, vegetable and flower sectors (the Fruit Board, 

the Citrus Fruit Board, the Vegetables Board, and the Flowers Board) were amalgamated into one board 

(the Plants Board), and their establishing legislation was repealed and substituted by one law: the Plants 

Board Law (Production and Marketing), 1973, S.H. 310 (as amended by the Law for the Improvement of 

the Israeli Economy (Statutory Amendments for Achieving the Budget and Policy Targets for FYs 2003 & 

2004), 2003)). The law transferred most of the regulatory powers of the Boards to the Minister of 

Agriculture, thus taking away these powers from the farmers and their organizations, and giving it to the 

government. It, in turn, used these powers much more sparingly than had previously be done by the 

Boards, thus in essence, ushering in much more competition to the sector. The reform was unsuccessfully 

challenged by the boards and many of the farmers' associations before the High Court of Justice. For the 

judgment, see HCJ 4885/03 Org. of the Chicken Growers, et al. v. Gov't of Israel 59(2) 14. The economic 

reform of the marketing in the agricultural sector is described in detail in the judgment. In July 2006, the 

Minister of Agriculture, Shalom Simchon, decided to reevaluate the need for the Plants Board, and 

therefore refused to sign the order allowing the Board to impose charges on the farmers, thus in essence, 

freezing its ability to function. Press Release, Ministry of Agric. (July 24, 2006), available at 

http://www.moag.gov.il. 


2007 


As a result of these developments, the anticompetitive impact of the exemption 

has increased. There is evidence of several attempts of cartelization, some of which 

may have been successful. For instance, for many years Tnuva, which was the coowner 

of two of the largest poultry slaughterhouses, had an arrangement with four 

of the other poultry slaughterhouses whereby it would be the sole marketer of all the 

produce of these six producers."' ° Due to this arrangement, Tnuva could control a 

major share of the poultry and turkey-meat market, and prevent any competition 

between these major producers. Pursuant to the agreement, Tnuva sold the produce 

of all the slaughterhouses at the same prices, paid them the same commissions, and 

determined their production quotas." ° The policy in this regard, was agreed at 

regular weekly meetings between the parties. For years, Tnuva claimed that its 

actions were exempt under the Agricultural Exemption of Article 3(4),"' and only in 

2003 did the Antitrust Authority decide to challenge this position in court, arguing 

that packed meat was a manufactured product and therefore fell outside the 

exemption. This legal disagreement on the scope of the exemption was never 

resolved by the Court, because the parties eventually decided themselves to 

discontinue the arrangement and pursue independent marketing." 2 Thus, the Courtorder 

requiring its discontinuance was issued with the consent of all the parties 

involved." 3 

Interviews by the present author with some senior actors in the agricultural 

market have revealed that the exemption has enabled cartels and other restrictive 

arrangements in several agricultural sectors. For instance, in the potato sector, 

following the abolition of the statutory quota regime, there were several attempts to 

create cartels, to coordinate prices and share markets between the marketers, not all 

of whom were also potato growers. ' 4 Many of these arrangements were 

unsustainable and therefore quite unsuccessful, as often is the case with cartels, 

109. Press Release, Antitrust Auth., Antitrust Court Issues Agreed Decision to Discontinue 

Restrictive Agreement between Tnuva and Several Slaughterhouses (Nov. 24, 2003), Publication No. 

3018918. 

110. Id. 

111. Already in 1995 the question whether this cartel was exempt under Section 3(4) came up in legal 

proceedings before the Antitrust Tribunal in connection with a proposed acquisition by Tnuva of one of 

the slaughterhouses. CA 2/94 Tnuva v. Antitrust Auth. [1995], ch. D. In those proceedings, Tnuva 

appealed the Authority's refusal to approve the merger and one of its arguments was that it fell under the 

Agricultural exemption. Because of judicial economy, the Tribunal did not rule on the question whether 

the exemption could have any impact on mergers or on whether the product in question was considered an 

agricultural or manufactured product. However, it did mention the restrictive agreements in the sector, 

raised serious doubts on their legality and called upon the Authority to challenge them in court, so that its 

position on the proper limits of the exemption could be established. 

112. However, in Appeal (Jerusalem) 1/00 Food Club v. Antitrust Supervisor, the Antitrust Tribunal 

expressed its opinion that slaughtered chickens were within the exemption, and did not amount to 

"manufactured agricultural products". Nevertheless, the slaughterhouses could not come within the 

exemption because they were not "marketers". See also CrC (Jer) 960/05 Gen. Dir. of the Antitrust Auth. 

v. Avi Margalit [2006] (pending appeal to the Supreme Court in Cr. A. 7128/06). 

113. HCJ 8009/03 Antitrust Supervisor v. Tnuva Coop. Ctr. for the Mktg. of Agric. Produce Ltd. 

[2003]. 

114. Information obtained from Mr. Benjamin Korman, a former CEO of Yevulim, Sh. Sharon Ltd.; 

and Mr. Gershon Shlissel, who at the time served as the business manager of Kibbutz Alumim, one of the 

large producers and marketers of potatoes. Yevulim is a large private wholesale marketer of agricultural 

products. It is not a cooperative of farmers [hereinafter Korman & Shlissel]. 



because of the Prisoners' Dilemma involved for each participant."' There were 

however several successful arrangements to eliminate surpluses, so as to keep the 

domestic price of potatoes high. This was achieved either by destruction of this 

surplus or through its subsidized export.' 1 6 In either case, funds were needed to pay 

the growers whose produce was destroyed or exported. These funds were 

successfully collected from all of the marketers and thus the surplus was removed 

from the market." 7 Similar arrangements were achieved and executed in the carrot 

sector and in the banana sector." 8 Moreover, in the potato sector the largest 

marketing firm (an agricultural cooperative" 9 ), is known for binding its growers with 

very restrictive agreements, which precludes them from selling any of their produce 

(whether potatoes or other produce marketed by the firm) through any other 

outlet. 2° A grower who wants to leave the cooperative may be severely fined by 

losing all of its invested capital. A similar arrangement can be found in the wine 

growing sector, where members of the largest and oldest wine production 

cooperative, the Carmel Winery,"' are legally required under the by-laws of the 

cooperative, to sell all of their produce to the winery, and can be punished by high 

fines if they fail to do so.' 22 

In the milk sector, there is a strict regime of production quotas, minimum 

prices, barriers to entry, surplus elimination and other restrictive arrangements. It is 

supervised and enforced by the Milk Sector Board, which is not a statutory body, but 

rather a corporation that is run by representatives of the dairy farmers, the milk 

production plants and the government.' 23 Some of the arrangements in this sector 

115. The reason cartels are faced with the Prisoners' Dilemma is that while each participant in the 

game can gain much from colluding with the others, she can gain even more from cheating, for example, 

from a situation where all the other parties to the cartel abide by it except for herself. See KEITH N. 

HYLTON, ANTITRUST LAW: ECONOMIC THEORY AND COMMON LAW EVOLUTION 68-69 (2003). 

116. Such export subsidies may be problematic under various international trade agreements. See 

generally Multilateral Agreements on Trade in Goods, Results of the Uruguay Round of Multilateral 

Trade Negotiations, Apr. 15, 1994. Whether or not they are is a complicated question that is outside the 

confines of the current article. 

117. In order to collect the funds, the marketers received assistance from the Plants Board, which 

collected them and paid them out according to the criteria that had been agreed upon by the members of 

the cartel. While the Plants Board is a statutory body entrusted to regulate the plants and vegetable sector, 

it does not have the authorization to initiate on its own such an arrangement as described here. Only the 

Minister of Agriculture can do so by issuing regulations. See The Plants Board Law, supra note 83. Thus, 

in the absence of such regulations, the arrangement could not have been legally achieved and executed 

without the agricultural exemption. Restrictive Trade Practices Law, supra note 83, § 3(4). 

118. See Korman & Shlissel, supra note 114. In the carrot sector, a fund was established in order to 

subsidize export of surpluses, so as to remove them from the domestic market. In the banana sector, a 

successful cartel was established between the producers of about 80% of the produce. 

119. The Maon District Settlements Agricultural Cooperative for Regional Development Ltd., is a 

cooperative of Kibbutzim, Moshavim and other farmers in the western Negev area. The firm is the owner 

of the brand-name "Uncle Moshe" and the biggest exporters of potatoes to Europe. See 

www.dodmoshe.co.il. 

120. See Korman & Shlissel, supra note 114. 

121. Its official name is Societe Cooperative Vigneronne des Grandes Caves Richon le Zion & 

Zichron Ya'acov Ltd. See The Ups and Downs of Israel's Most Famous Winery, ISRAEL WINES, Sept. 2005, 

http://www.israelwines.co.il/ArticlesEng/Article.asp?ArticlelD=1349&CategorylD=82. 

122. Information obtained from Mr. Jacob Ben-Dor, business manager of Moshav Beit Yatir, a 

member of the cooperative. 

123. Amiram Cohen, The Milk Producers Threaten to Exacerbate their Struggle Against the 

Privatization of Tnuva: Threaten to Create Blocking Minority, HA'ARETZ, Nov. 5, 2006 (Hebrew), available 


2007 


are sanctioned under the Israel Dairy Sector Planning Law, 1992124, but many others 

can only exist by virtue of the Agricultural Exemption."2 Here too, the large 

marketing firms often use their market power to tie the dairy farmers to them and to 

prevent sales to other firms.' Similarly, the fish growers are organized in a 

voluntary organization which for some time marketed all of their produce for them, 

and wherein lately agreements on minimum prices were concluded. 27 These 

arrangements could not be legally maintained without the Agricultural Exemption. 

The courts have usually interpreted the exemption narrowly, thus breaking up 

many cartels in the agricultural manufacturing sectors. 2 8 Recently, the Jerusalem 

District Court convicted the participants of a cartel in the frozen vegetable sector.' 

It ruled that frozen vegetables are industrially processed products and hence fall 

outside the exemption. However, for the production and marketing of the 

agricultural produce itself the exemption has remained intact. 

G. Attempts to Abolish the Exemption 

One would expect that the same policy considerations that led the government 

to dissolve the marketing boards would lead it to abolish, or at least limit, the 

provision that prevents full application of competition rules to the agricultural 

sector. And indeed the government, especially under the leadership of the more 

free-market oriented Likud party, has attempted several times to do so, with the 

strong encouragement of the Antitrust Authority and the consent of the Ministry of 

Agriculture. The first attempt was in 2002, when the Government decided to limit 

the exemption to growers, and exclude marketers. " ' The second was in 2003, when 

the same decision was taken again,' and in 2004 the same ritual was repeated for 

the third time.1 2 All these attempts, however, have failed as the bills in this regard 

have been met with staunch opposition in the Knesset. Strangely, the opposition has 

come from both Opposition and Coalition parties. 3 Analysis of the discussions 

indicates that the Knesset members in doing so seemed to be convinced that they 

http://www.haaretz.co.il/hasite/pages/ShArtPE.jhtml?itemNo=562985&contrassID=2&subContrasslD=6& 

sbSubContrasslD=0. 

124. Sefer Hachukim, 1992 S.H. 139; amendment: Sefer Hachukim, 2002 S.H. 135. 

125. Yael Kachal & Israel Finkelstein, Restrictive Trade Practices Laws in the Agricultural Sector in 

Israel, United States and the European Union: A Comparative Analsis 7 (May 2005) (Hebrew) available at 

http://departments.agri.huji.ac.il/economics/previous-2005.html. 

126. Tnuva, for instance, extends long-term loans to the farmers under beneficial terms, under the 

condition that they sell all their produce to it. Should a farmer choose to switch to a competing firm, he is 

required under the loan agreement to return the loan immediately with significantly higher interest than if 

he had remained with Tnuva. 

127. Kachal & Finkelstein, supra note 125, at 8. 

128. See, e.g., CC 1633/94 Y. Katz Agric. Supply Ltd. v. HaLulan, Small Farms Agric. Coop., [19981. 

129. CrC (Jer) 960/05 Gen. Dir. of the Antitrust Auth. v. Avi Margalit [2006] (pending appeal to the 

Supreme Court in Cr. A. 7128/06). 

130. Government of Israel, Decision of July 30, 2002, approving the economic policy for FY 2003. 

131. Government of Israel, Decision of Sept. 15, 2003, approving the economic policy for FY 2004. 

132. Legislative bill amending the Restrictive Trade Practices Law, 2003, ch. 13 art. 60. 

133. See DK (2005) 396 (Economy Committee Member Daniel Benlulu: "Mr. Chairman, today we are 

going with the Opposition. We proposed [to take it out of the Law] not MK Avshalom Vilan [from the 

Opposition; Member of left-wing Meretz Party]."). 



VOL. 42:843 

were acting for the protection of the farmers. 3 1 What they did not seem to realize is 

that by maintaining the exemption for the marketing firms they are in effect harming 

the farmers by empowering the marketing firms to coordinate purchasing policies vis 

A vis the farmers. This can allow them to exercise oligopsonistic market power 

against the farmers and dictate prices to their detriment. It is possible that there are 

lobbying efforts by powerful firms such as Tnuva and industrial food conglomerates 

that are behind this voting pattern. It may also be the power of inertia and habit 

that cause the politicians to continue to identify farmers' interests with those of 

former agricultural cooperatives, even though this is no longer the case. Not only is 

Tnuva no longer the only or even the major player in the agricultural marketing 

sector, but it has also ceased to be a true cooperative of farmers, since many of its 

shareholders have long ago abandoned farming, it is run like any other corporate 

conglomerate, and recently it was sold off to a global private equity group.' 36 

Lately, the Government has again decided to try to limit the exemption. 

However, this time a much less ambitious amendment is being proposed, namely to 

exclude from the exemption wholesale marketing firms that are connected to retail 

marketers (by holding five percent or more of their stock). "7 The reasons given are 

that an examination of the excessive differences between the producer and the 

consumer prices in the fruit and vegetable market shows that much of it originates in 

the retail phase. The government analysts suggest that it may be a result of the 

mounting concentration in the retail market, as a result of the growing market power 

of the large food retailers. 38 Since most of these retailers have set up their own 

wholesale marketing firms, they are able to take advantage of the exemption of 

134. Id. See, e.g., the statement by MK Rochama Avraham, of the Likud Party: "This Law is too 

complicated and I must admit I need to study it... I think we have to separate it from the Arrangements 

Law ... and besides I am for the agriculture and if it may harm the farmers at this time, even if only a little, 

we have to stand firm and not allow it." When the Chairman of the Committee, MK Amnon Cohen, 

explained the Committee's decision to take it out from the Law before the Knesset plenary, he said: 

"[S]ince we are dealing with a topic that it has been said may have wide repercussions, including harming 

the farmers, and thereby [harming] the agriculture in Israel, the Committee has decided to request that the 

bill should be separated." Once this amendment is separated from the main law, it gets postponed to some 

undefined date in the future and, in practice, never reaches the floor. 

135. While industrial food conglomerates are of course not included under the exemption, if the large 

marketing firms bring the prices down, the food conglomerates that process agricultural produce will also 

be able to purchase this produce for less. It also seems that the farmers' organizations are afraid of the 

"slippery slope" syndrome, and believe that once the exemption it limited, it may get abolished altogether. 

136. These original shareholders, which represent a large part, perhaps even a majority, of the current 

shareholders, have been pushing for the payment of dividends from the cooperative's profits and for a 

corporate reform, under which Tnuva will be converted into a regular commercial corporation and part of 

it will be sold to a financial investor. Their efforts were successful and in November 2006, following an 

international auction, the control of Tnuva was sold off for over $1bn to Apax Partners Worldwide LLP, a 

British buyout firm. See http://www.foodanddrinkinsight.com/file/41872/apex-triumphs-in-tnuva-biddingwar.html 

137. Economic Policy 2007, supra note 104, at 19. The proposal uses the term "Interest Holder" and 

refers to the Companies Law, 1999 for the definition of the term. There it is defined as five percent 

holding (art. 1). According to the proposal, both if the wholesale marketer has such an interest in a retail 

marketer, or that the retail marketer has such an interest in the wholesale marketer, such a marketer will 

be excluded from the exemption. 

138. In 2005, one of the food retail chains, Clubmarket, which had attempted to challenge the 

dominant position of the two other large chains, collapsed and went into bankruptcy. It was eventually 

sold by the receiver to one of these two chains, causing a significant increase in the concentration in the 

food retail market. See Anat Roeh & Chaim Bior, Court Okays Supersol-Clubmarket Deal, Lock, Stock 

and Collective Work Agreement, HA'ARETZ 


2007 


wholesale marketers from the antitrust rules,' 39 even though they are in essence 

retailers. They can therefore leverage their market power in the retail sector against 

the growers to their detriment and to the detriment of consumers who are forced to 

pay higher prices for fruits and vegetables. 

Indeed, there is no reason to doubt the wisdom of precluding the retail chains 

from taking advantage of an exemption that was not meant for them. However, this 

official explanation does not explain why other wholesale marketers can continue to 

take advantage of the exemption, allowing them to collude against the farmers and 

use their market power to gain excessive rents from both farmers and consumers. 

The most likely explanation of the fact that the more extensive amendment of the 

exemption has not been attempted at this time is that the Government has resigned 

itself to the reality of the strong agricultural lobby, and is therefore trying now a 

more limited amendment. Eventually, however, even this limited amendment was 

opposed by members of the "agricultural lobby" and failed to get approved by the 

Knesset. 140 

H. The Exemption in Light of International Agreements 

Israel's agricultural exemption appears to be problematic from another 

perspective as well, namely that of International Trade Law. The problem stems 

from the fact that the exemption applies only to "the growing or marketing of 

domestic agricultural products.'' 

4. This means that imported agricultural products 

are not covered by the exemption and may not benefit from them. Such 

discrimination between domestic and imported products, which did not exist under 

the previous law,' 42 would seem to be inconsistent with several international trade 

agreements to which Israel is a party, in particular the General Agreement on Tariffs 

and Trade (GATT).' 43 Article 111:4 of GATT provides: 

139. See Restrictive Trade Practices Law, supra note 83, § 3(4). 

140. See Protocol of the Finance Committee of the Knesset, Dec. 24, 2006, on the Economic 

Arrangements Law (Statutory Amendments to Achieve the Budget Targets and the Economic Policy for 

FY 2007), 5767-2006, www.knesset.gov.il/protocols/data/rtf/ksafim/2006-12-24-05.rtf. As can be seen from 

the protocol, the main opponent of the amendment of the agricultural exemption was MK Avshalom 

Vilan, from the left-wing Meretz Party, who serves as the Chairman of the Agricultural Lobby in the 

Knesset, and formerly served as the Secretary-General of one of the three Kibbutz movements 

("HaKibbutz Ha'Artzi"). He was joined by several Knesset members from the Labor Party. Eventually, 

the amendment was separated from the Economic Arrangements Law and hence never reached the 

Knesset for a final reading, just as happened with all the previous attempts to limit the exemption. 

141. Restrictive Trade Practices Law, supra note 83, art. 3(4). 

142. The previous 1959 Restrictive Trade Practices Law also had an agricultural exemption (in 

Section 8), but it was not confined to domestic produce. Restrictive Trade Practices Law, 5719-1959, 13 LSI 

159 (1958-59) (Isr.). 

143. General Agreement of Tariffs and Trade, Oct. 30, 1947, 61 Stat. A-11, 55 U.N.T.S. 194 

[hereinafter GATT]. It should be pointed out, that even though agriculture is considered a "special case" 

in international trade law, the "agricultural exemptions" in this field do not have any bearing on the case at 

hand. These "exemptions" are embodied in the Agreement on Agriculture, which is one of the WTO 

agreements. This agreement deals with the generally high tariffs and subsidies in the agricultural sector. It 

provides for progressive reduction of these tariffs and subsidies (both domestic support and export 

subsidies). Sanitary and phytosanitary import measures that affect agriculture are dealt with in the 

Agreement on Sanitary and Phytosanitary Measures. See Agreement on the Application of Sanitary and 

Phytosanitary Measures, Art. 2.1, Final Act Embodying the Results of the Uruguay Round of Multilateral 

Trade Negotiations, Apr. 15, 1994, 33 I.L.M. 1125 (1994) [hereinafter SPS Agreement], available at 



VOL. 42:843 

The products of the territory of any contracting party imported into the 

territory of any other contracting party shall be accorded treatment no less 

favorable than that accorded to like products of national origin in respect 

of all laws, regulations and requirements affecting their internal sale, 

offering for sale, purchase, transportation, distribution or use."' 

In Korea - Various Measures on Beef, the Appellate Body of the World Trade 

Organization (WTO) explained that there are three elements of a violation of this 

provision: (1) That the imported and domestic products at issue are "like products"; 

(2) that the measure at issue is a "law, regulation, or requirement affecting their 

internal sale, offering for sale, purchase, transportation, distribution or use"; and, (3) 

that the imported products are accorded "less favorable" treatment than that 

accorded to like domestic products."" 14 

The first element, "like products," is not an issue in this case because the legal 

provision in question-Article 3(4) of the Restrictive Trade Practices Law-extends 

the exemption to a wide range of products provided that they are domestic 

agricultural products. It is not hard to find a wide range of foreign agricultural 

products that are similar in all relevant aspects to the domestic products that 

currently are enjoying the benefits of this exemption and therefore fulfill the 

requirement of "like products," but nevertheless are precluded from enjoying the 

same benefits just because they are not domestic. As for the second element, clearly 

Israel's Restrictive Trade Practices Law is a "law", and it would also seem that its 

prohibition against restrictive agreements is a law that affects "the internal sale, 

offering for sale [or] purchase" of imported agricultural products. Pursuant to this 

prohibition-that only applies to imported agricultural products, but not to like 

products of domestic origin-firms that market these products in the Israeli market 

are not permitted to make cartels and other restrictive agreements with their 

competitors, suppliers or customers in relation to these products. Such agreements, 

by definition, affect the internal sale, offering for sale or purchase of such products: 

they may fix their prices, divide the areas or type of customers to which they are to 

be sold, or coordinate other trading conditions, such as credit terms. Clearly, then, a 

law prohibiting such agreements affects "their internal sale, offering for sale, 

purchase, transportation, distribution or use."' 46 

Also the third element of "less favourable treatment" seems to exist here, even 

by virtue of the mere fact that imported products are subject to more stringent rules 

than like products of national origin. While in Korea - Various Measures on Beef, 

the Appellate Body stressed that different treatment in itself is not necessarily 

inconsistent with Article 111:4, however, if the different treatment is also "less 

http://www.wto.org/English/docs-e/legal-e/15-sps.pdf. However, none of these agreements provides any 

exemption from the disciplines of GATT art. III discussed in the text above. 

144. GATT, supra note 143, art 111:4. 

145. Appellate Body Report, Korea-Measures Affecting Imports of Fresh, Chilled and Frozen Beef, 

para. 133, WT/DS161/AB/R (Dec. 11, 2000) [hereinafter Korea -Various Measures on Beef]. 

146. In Canada-Certain Measures Affecting the Automotive Industry, a WTO Panel held that "the 

ordinary meaning of 'affecting' implies a measure that has 'an effect on' and thus indicates a broad scope of 

application." Panel Report, Canada-Certain Measures Affecting the Automotive Industry, para. 10.80, 

WT/DS139/R (Feb. 11, 2000). In Korea-Various Measures on Beef, the Appellate Body considered a 

Korean measure that established a dual retail distribution system for the sale of beef as a "measure 

affecting the internal sale etc." of such products. Under this system, imported beef had to be sold either in 

specialized stores selling only imported beef or, in the case of larger department stores, in separate sales. 

See Korea - Various Measures on Beef, supra note 145. 


2007 


favorable", then the element is fulfilled.' 7 This should be assessed by examining 

whether the measure modifies the conditions of competition in the relevant market 

to the detriment of imported products.1 8 

If marketing firms could enter into cartels and other restrictive agreements in 

relation to domestic agricultural products, and thus benefit from higher prices and 

better sales conditions, but are precluded from making the same agreements in 

relation to like imported products, then the latter products will be less profitable and 

less attractive to them. Such difference in treatment would therefore modify the 

conditions of competition in the relevant market to the detriment of imported 

products. 9 On the other hand, under accepted WTO jurisprudence, there is no need 

to show that this difference in treatment actually leads to protection of domestic 

production. As held by the Appellate Body in EC-Bananas III: 

Article 111:4 does not specifically refer to Article 111:1. Therefore, a 

determination of whether there has been a violation of Article 111:4 does 

not require a separate consideration of whether a measure 'afford[s] 

protection to domestic production."" ° 

Article 3(4) of Israel's Restrictive Trade Practices Law may also be problematic 

under some of its bilateral free trade agreements.'' For instance, the prohibition of 

"measures having equivalent effect"-equivalent to the effect of quantitative 

restrictions on imports-which is included in most of these trade agreements,' 2 may 

147. See Korea-Various Measures on Beef. supra note 145, para. 135. See also Report of the Panel, 

United States -Section 337 of the Tariff Act of 1930, para. 5.11, L/6439. 

148. Korea Appellate Body Report, supra note 145, para. 137. See also Appellate Body Report, 

Japan- Taxes on Alcoholic Beverages, 16, WT/DS8/AB/R (Oct. 4, 1996) (quoting GATT, supra note 143, 

Art. 111(1-2)); Panel Report, Japan-Measures Affecting Consumer Photographic Film and Paper, para. 

10.379. WT/DS44/R (Mar. 31, 1998). 

149. One could of course make the argument that due to the fact that restrictive agreements between 

the marketing firms in relation to imported products are not allowed, competition on the consumer market 

is bound to go up, and prices for consumers will come down. This then would actually improve the 

competitive conditions of imported products, in relation to like domestic agricultural products, and not 

vice versa. This argument can be dismissed based on two reasons: 1. If real competition exists between 

domestic and imported products, domestic products are bound to come down as well. There is nothing in 

the Law that prevents the marketing firms from lowering the prices of domestic produce, in order to 

compete better. 2. The situation on the consumer level of the market may be as it may, but on the 

wholesale level imported agricultural produce clearly suffers from less favourable treatment by the Law. 

This situation is likely to lead to a competitive disadvantage of imported produce in relation to domestic 

produce, in that the wholesale firms have good reasons to prefer the latter. 

150. Appellate Body Report on European Communities - Regime for the Importation, Sale and 

Distribution of Bananas, WT/DS27/AB/R, para. 216 (Sept. 9, 1997). This ruling rejects, therefore, the 

approach of the Panel on Canada - Certain Measures Concerning Periodicals, where the Panel examined 

whether a measure at issue "afford[ed] protection to domestic production." Panel Report, Canada- 

Certain Measures Concerning Periodicals, para. 5.38, WT/DS31/R (Mar. 14, 1997). 

151. There are also bilateral agreements that include National Treatment obligations similar to 

GATT Article III. See, e.g., Article 4.1 of the Free Trade Agreement between the Government of Canada 

and the Government of the State of Israel. Free Trade Agreement between the Government of Canada 

and the Government of Israel, 1997 Can. T.S. No. 49. There are some exceptions to this prohibition that 

are listed in Annex 4.1 of the Agreement, but the measure discussed here is not one of them. Id. 

152. See, e.g., Euro-Mediterranean Agreement Establishing an Association between the European 

Communities and their Member States, of the one part, and the State of Israel, of the other Part, art. 16, 

2000 O.J. (L147) 3 [hereinafter EC-Israel Association Agreement]; Agreement on the Establishment of a 

Free Trade Area between the Government of Israel and the Government of the United States of America, 



VOL. 42:843 

preclude this type of discriminatory treatment. The phrase "measure of equivalent 

effect" has been interpreted by the European Court of Justice ever since the famous 

Dassonville case' 5 3 as including "all trading rules enacted by member States which 

are capable of hindering, directly or indirectly, actually or potentially" trade between 

states. While this interpretation relates to the term as it appears in the Treaty 

Establishing the European Community' 54 and is not formally binding on states 

outside the EC and in relation to other agreements, it is nevertheless instructive as to 

the possible meaning of the term. In any case, if it could be shown that the more 

stringent competition rules that apply to imported agricultural products actually 

serve to hinder, obstruct or reduce the importation of such products, this would 

certainly prove that the prohibition has been violated. Article 3(4) would also seem 

to be in violation of the competition rules that are included in the EC-Israel 

Association Agreement, which provides that "all agreements between undertakings, 

decisions by associations of undertaking and concerted practices, which have as their 

object or effect the prevention, restriction or distortion of competition" shall be 

"incompatible with the proper functioning of the Agreement."' 55 One could argue 

that by permitting such restrictive agreements in the agricultural sector, but not 

allowing the same for imported products, the Law in effect causes restriction and 

distortion of competition in this sector. 5 6 

The problem described above is mostly connected to the exemption of the 

marketers, and not of the producers, of the agricultural products. The reason for this 

is that the producers of imported agricultural products are by definition located in 

foreign countries. They, therefore, are in any case outside the territorial scope of 

Israel's antitrust law and are not in need of its agricultural exemption. Since most 

developed countries have their own agricultural exemption for producers, they are 

likely to benefit from such exemptions. It would therefore be much harder to make 

a case for a violation of GATT Article 111:4 if all that Article 3(4) of Israel's 

Restrictive Trade Practices Law did was to exempt growers of domestic agricultural 

products. For that to be possible there would have to be an attempt on Israel's part 

to apply its antitrust law extra-territorially to foreign growers, something which is 

extremely unlikely both legally and politically.' 57 Thus, if my proposal to abolish the 

art. 4, 24 I.L.M. 653 (1985); Agreement Establishing a Free Trade Area between the State of Israel and the 

Republic of Turkey, art. 7, KAV 1322. available at http://www.moital.gov.il/NR/exeres/0740267B-3FAD- 

4875-A445-95416E4793F6.htm The provisions of the two latter agreements are confined to "new" 

measures. Id. One could therefore argue that since the exemption is not new, the prohibition does not 

apply. However, this argument may only be used for trade agreements concluded after 1988 (when the 

Law was enacted), because in the previous law of 1959, the agricultural exemption was not confined to 

domestic produce. Since the agreement with the United States was concluded in 1985, this defense could 

not be used. Also, in the EC agreement, the prohibition is not confined to "new" measures. Id. 

153. Case 8/74, Procureur de Roi v. Dassonville, 1974 E.C.R. 837, 851. 


155. EC-Israel Association Agreement, supra note 152, art. 36. 

156. This argument is strengthened by the fact that Article 36:4 expressly excludes agricultural 

products from the prohibition that appears in paragraph 1(iii) of Article 36. This paragraph refers to 

public aid which distort or threatens to distort competition. This implies that the other paragraphs of 

Article 36(1) (including the one that prohibits restrictive agreements between undertakings) do apply to 

agricultural products. 

157. Application of one State's law, in particular criminal law, on citizens of another State for acts 

committed within the territory of that other State is usually considered contrary to International Law and 

an infringement on that State's territorial sovereignty. Occasionally, however, some states, such as the 

United States and the EC, claim the right to apply their competition laws on acts committed outside their 


2007 


agricultural exemption insofar as it applies to marketers were accepted, the problem 

under international law would also be solved. 

V. CONCLUSION: IS THERE A JUSTIFICATION FOR AN AGRICULTURAL 

EXEMPTION? 

The rationale of competition law is that competition is good for the economy 

and for the consumers and that attempts by firms to restrict competition should be 

prevented by law. Competition is seen as the pillar of modern market economies 

and the foundation of capitalism, in that it stimulates innovation, encourages 

efficiency, and drives down prices. According to microeconomic theory, in general, 

no system of resource allocation is more efficient than competition. It causes 

commercial firms to develop new products, services, and technologies, which in turn 

gives consumers greater selection and better products. The greater selection 

typically causes lower prices for the products compared to what the price would be if 

there was no competition. While competing firms have a clear interest in restricting 

competition to capture monopoly or monopsony rents at the expense of consumers 

or suppliers, respectively, the general efficiency of a society requires that such 

strategic behavior is prevented so that competition is preserved. 

The question that has to be asked is whether there is anything peculiar to the 

agricultural sector that justifies departure from this rationale in countries where it is 

followed and implemented in all other economic sectors? One such peculiarity 

which, as we have seen, seems to have motivated legislators in the U.S., EU and the 

UK to grant certain exemptions to farmers, is the atomistic nature of the farming 

industry, which often is made up of family-run farms and other relatively small units 

of production. This nature is sometimes contrasted with the concentration in the 

agricultural marketing and processing sector. Under such conditions-and under the 

assumption that countries have an interest (usually, for non-economic reasons) in 

preserving these traditional characteristics of the farming industry-there may be 

efficiency and distributive justice rationales for cooperation and coordination among 

farmers. Efficiency may be promoted by allowing farmers to organize in 

cooperatives so as to rationalize their production, transportation and distribution 

processes, provide the farmers with up to date information on market trends, 

consumer preferences and agricultural know-how, and to establish common brands 

and quality standards. 5 ' Such cooperation may also help put the farmers on a more 

equal footing with marketing and processing firms, thus allowing a more efficient 

bargaining outcome and preventing oligopsonistic rents in the pockets of the latter. 

Organization into cooperatives in effect serves as an alternative to corporate 

mergers of small farmers into larger farming conglomerates, which in any case would 

territory if such acts have a negative effect on their market. Such claims are highly controversial and quite 

rare, in particular among smaller countries. 

158. The setting of quality standards can be seen as a means to overcome market failure due to lack of 

sufficient information among consumers at the point of sale on the quality of the produce. While both in 

the EU and the United States there is legislation enabling farmers' organizations to establish quality 

standards, it is not clear why such a function should be entrusted exclusively with farmers-whose interests 

do not necessarily coincide with those of the consumers-and not with an independent standard setting 

organization, where along with the farmers, consumers and government representatives also have a say. 



VOL. 42:843 

not be prevented under most merger regimes. 9 Preserving the livelihood of familyrun 

farms would also be more in line with distributive justice, considering the 

generally hard living conditions of small farmers in relation to large marketing firms. 

Finally, by preserving family farms and traditional farming communities, we would 

also be serving communitarian values as well as contributing to the protection of the 

environment.' 6° 

However, such rationales could only be invoked to permit small or perhaps 

medium-sized farmers to organize into cooperatives. It certainly cannot justify 

exempting marketing firms as such from the regular competition rules. And even as 

far as farmers are concerned, the exemption can be justified only under certain 

conditions, similar to those described. Thus, an exemption must be granted by a 

very fine-tuned instrument that sets appropriate conditions for the right to invoke it. 

Such conditions should include provisions to ensure that the cooperative does not 

obtain market power (for instance, that the exemption is limited by a maximum 

market share of the cooperative), that only small- or medium-sized farms or 

agricultural producers can benefit from the exemption, that the cooperative only 

incorporates active farmers and deals almost exclusively with the produce of its 

members; and that the cooperative is managed by and for the benefit of its members. 

One should also ensure continuous supervision by competition authorities and 

courts, who ought to be authorized to withdraw the exemption whenever it is used to 

excessively restrict competition or distort markets. 

Another peculiarity of the agricultural sector is the relatively inelastic demand 

for its produce, the unpredictable and seasonal supply, and the inability in many 

cases to store the produce for long periods of time. However, these problems can 

hardly be solved by merely allowing coordination between growers. If these 

problems exist, and to the extent that they cannot be overcome by regular market 

mechanisms, they would require government intervention and special market 

organization. If, for instance, there is justification for regulation of production 

quantities and allocation of quotas, surely this cannot be effectively done by 

voluntary agreements between the producers. Such quotas would need to be 

imposed and enforced on all of the producers in the market, in particular on those 

producers who have an incentive to produce more than their allocated quotas and 

would therefore never join a voluntary arrangement that restricts their ability to do 

so. Even if agreement could be reached between all the producers, because of the 

Prisoners' Dilemma involved, it would be a very fragile agreement that would be 

159. Since the acquisition of each individual farm usually falls under the prevailing value thresholds of 

merger supervision, unless the acquiring firm has acquired a market share that gives it a dominant position 

in the market, the merger will not be precluded by most merger regulations. Under Israeli law, for 

instance, a merger falls under merger supervision only if it fulfills at least one of three conditions: 1. If the 

merger will lead to a market share of over 50%; 2. That the joint turnover of the merging entities is more 

than 150 Million Shekel and that each entity has a turnover of at least 10 Million Shekel (1 Million 

Shekel=approx. US$ 230,000); 3. That one of the merging entities is already a monopoly (Article 17 of the 

Act). In the EU, a "Community Dimension" is required, which means that the combined aggregate 

worldwide turnover of all the undertakings concerned is more than 5 Billion, and that this turnover of 

each of them is at least 250 Million. Council Regulation 139/2004, EC Merger Regulation, art. 1(2), 2004 

O.J. (L 24) 6 (EC). An alternative criteria requires a lower worldwide threshold of "only" 2.5 Billion, a 

turnover of 100 Million in each of at least three EU Member States, and individual turnovers of 25 

Million in those three Member States, and worldwide turnover of at least 100 Million each. Id. art. 1(3). 

Clearly, any farm acquisition would fall under this threshold. 

160. In many countries, preservation of farms and agricultural land is one of the major factors that 

prevent large-scale urbanization and gradual elimination of green areas and natural habitats. 


2007 


extremely hard to enforce. Therefore, states that have reached the conclusion that 

they want to impose such special centralized market organization have done so by 

means of mandatory regulation in one form or another.'' Such regulation, to the 

extent that it is in conflict with existing competition rules, would usually be exempt 

by a general exemption of statutory mandated arrangements 62 and not by a specific 

exemption for restrictive agreements in the agricultural sector. In any case, such 

specific market regulation, which often has the effect of almost eliminating 

competition altogether, ought to be pursued with utmost caution, after extensive 

study of the market and only after the regulators are completely convinced than no 

other market-based solution is possible. Certainly, there is no place for a 

comprehensive elimination of all competition in the agricultural sector, as can be 

learnt from the Israeli (and the EU) experience. 

In light of this analysis, all of the agricultural exemptions discussed in this 

article would require some amendments. The U.S. exemption, found in the Capper- 

Volstead Act of 1922, could benefit from some more clear-cut market-share caps, 

which would ensure that the exemption is not utilized whenever it leads to marketpower 

by the parties to the arrangement. In this connection, it should be kept in 

mind that the Act permits not only agreements between the farmers and their 

respective cooperatives, but also agreements between various cooperatives,' 63 

something that could lead to cartelization of the market. The same applies to the 

EU exemption, which also permits arrangements between farmers' associations, or 

associations of such associations," 6 ' but fails to set market-share caps or other clear 

limitations. Since both the U.S. and EU exemptions, unlike the U.K. and Israeli 

exemptions, extends not only to joint marketing and preparation for market (sorting, 

packaging etc.), but also to processing, there is also a risk that the exemption will be 

used by industrial food producers, owned by various farmers cooperatives, to restrict 

competition between them. While such problematic developments could be 

thwarted by the authorities or the courts if they discovered them, it would seem 

much more effective to define expressly the scope of the exemption so as to remove 

doubts and to make prosecution and civil proceedings in case of abuse easier. 

Clearly defined rules also create a more predictable business environment which is 

an important component of an efficient market. As for the U.K. exemption (prior to 

its harmonization with the EU regime in 1998), it lacked the safety valve of judicial 

and administrative supervision by competition authorities and the courts, to ensure 

that the exemption is not used to restrict competition and distort markets 

excessively. 

This last shortcoming (lack of supervision) is also one that the Israeli exemption 

suffers from. In addition, there can be no justification for an extension of the 

exemption to marketing firms. The exemption should therefore be amended so that 

it is confined to farmers. It should be modeled upon the previous UK exemption, so 

that only farmers' cooperatives are exempted under similar conditions as provided 

161. For example, in the EC through the Common Agricultural Policy, which provides for an 

extremely regulated market in the agricultural sector. In the United Kingdom, mainly prior to its joining 

the EC, through the Agricultural Marketing Act of 1958, supra note 72, and in Israel through the various 

marketing boards legislation, as discussed above. 

162. Examples include § 3(1) of Israel's 1988 Restrictive Trade Practices Law, supra note 83, and § 

8(1) of the UK Restrictive Trade Practices Act of 1956, supra note 5. 

163. See supra note 19 and accompanying text. 

164. Provided that they belong to a single Member State. See supra note 37 and accompanying text. 



VOL. 42:843 

for therein. In fact, in order to achieve a well-balanced and fine-tuned exemption in 

line with the principles elaborated above, it would be best if the exemption was 

removed from the Law itself, and incorporated into a new block exemption. Such 

exemptions can be issued by the General Director of the Antitrust Authority, with 

the consent of the Advisory Exemptions and Mergers Committee, and are the more 

appropriate instruments for granting fine-tuned exemptions to specific sectors or to 

certain categories of agreements. 16 ' They are often restricted by market-share caps 

and other sector-specific conditions. Another advantage of using a block exemption 

is that it remains in force for a maximum period of five years only, after which it can 

be renewed as is or in an amended formula, if it is still deemed necessary. This 

mechanism ensures periodical reviews of the exemption, of the structure of the 

market to which it applies, and of its continuing necessity. Also, by taking the 

exemption out of the law once and for all, required amendments to it will no longer 

be blocked by the agricultural lobby. Instead, the exemption will be designed and 

amended by the Antitrust Authority, in conjunction with the Advisory Committee, 

which is made up of independent civil servants and antitrust experts. 1 ' 6 Finally, by 

using a block exemption, instead of a statutory exemption as is done today, we 

would achieve the safety valve that today is missing. Under Article 15A(g) of the 

Law, the General Director has the authority to withdraw the exemption from a 

specific restrictive arrangement, and would do so presumably if she finds that the 

competition is being excessively restricted to the detriment of consumers or other 

market participants. 

165. See art. 15A of Restrictive Trade Practices Law, supra note 83. According to this provision, a 

block exemption can be issued, provided that all of the following conditions are met: 

(1) That the restraints in the restrictive arrangement do not reduce competition in a 

considerable share of the market affected by the arrangement, or that they may reduce the 

competition in a considerable share of the market, but do not result in a substantial reduction 

of the competition in such market. 

(2) That the objective of the arrangement is not the reduction or elimination of competition, 

and that the arrangement does not include any restraints which are not necessary in order to 

fulfill its objectives. 

166. See Restrictive Trade Practices Law, supra note 83, art. 23. 


Disclosure as a Public Policy Instrument in 

Global Capital Markets' 

JANIS SARRA* 

ABSTRACT 

Globally, most jurisdictions use a disclosure-based system instead of a merit-based 

system in their securities law regimes. Disclosure enhances capital market efficiency 

through effective dissemination of information that is material to investor decisions, in 

turn facilitating the raising of capital in a cost-effective and timely manner. This article 

examines selective aspects of disclosure in securities law across numerous jurisdictions, 

specifically, how it serves as a public policy instrument in capital markets. It explores 

whether the current regulatory framework encourages "full, true, and plain" 

disclosure, concluding that the increasing complexity of products and the rapid growth 

in electronic-based disclosure offers both upside potential and downside risks to 

market integrity. The article also considers "materiality" as the standard for disclosure, 

including the interplay between statutory requirements and deference to business 

judgment by regulators and the courts. 

SUMMARY 

I. INTR O D UCTIO N ................................................................................................... 876 

II. DISCLOSURE AS A PUBLIC POLICY INSTRUMENT ............................................ 877 

III. FULL, TRUE, AND PLAIN D ISCLOSURE ............................................................. 854 

IV. 

ELECTRONIC DISCLOSURE AS A KEY ASPECT OF ENHANCED 

D ISCLO SU RE R EG IM ES ....................................................................................... 884 

1 This article is part of a larger project under two research grants, the first by the UBC Faculty of 

Law, examining securities law changes in the Pan-Pacific Region and the second, part of a research study 

commissioned by the Task Force to Modernize Securities Legislation in Canada as a background study for 

its report, CANADA STEPS UP, http://www.tfmsl.ca. See JANIS SARRA, TASK FORCE TO MODERNIZE SEC. 

LEGISLATION IN CANADA, CANADA STEPS UP: MODERNIZING DISCLOSURE IN CANADIAN SECURITIES 

LAW: AN ASSESSMENT OF RECENT DEVELOPMENTS IN CANADA AND SELECTED JURISDICTIONS (2006), 

http://www.tfmsl.ca/docs/V2(lA)%2OSarra.pdf. 

Associate Dean and Associate Professor, University of British Columbia Faculty of Law and 

Director of the National Centre for Business Law. 



VOL. 42:875 

V . M A TER IA LITY ...................................................................................................... 888 

VI. 

INTERPLAY BETWEEN BUSINESS JUDGMENT AND DISCLOSURE 

O B LIG A TIO N S ...................................................................................................... 893 

VII. 

DEVELOPMENT AN ELECTRONIC INTEGRATED MARKET DISCLOSURE 

D O CU M E N T .......................................................................................................... 895 

V III. C O N CLU SIO N ....................................................................................................... 897 


Disclosure is a critically important public policy instrument in securities law. 

Globally, most, if not all, jurisdictions use a disclosure-based system instead of a 

merit-based system. A disclosure-based system allows securities to be issued and 

traded where regulators and stock exchanges are satisfied that an issuer meets 

disclosure requirements. Disclosure is aimed at providing timely, accurate, and 

complete information to the market, so that investors can make informed choices 

based on relevant information about the issuer's activities. It places responsibility 

for accurate disclosure in the hands of those with the information, who are seeking a 

wide market in which to raise capital. Disclosure enhances capital market efficiency 

because it can ensure effective dissemination of information that is material to 

investor decisions, in turn facilitating the raising of capital in a cost-effective and 

timely manner. In such a system, judgments about the "merits" of a particular 

product or issuer are left to the purchaser. 

Information about an issuer is a valuable good that drives market moves, with 

securities trading based largely on a standard of fair access to information. 2 

However, equal access to information is not a guarantee that information is a 

ubiquitous good that necessarily leads to fairness in the market, as retail investors 

have different time, resources, and capacities to digest and make use of the 

information.' Yet as a normative starting point, access to information that is full, 

true, plain, and timely does create the potential for equal use of that information by 

market participants. Since the premise of securities law is that the market will 

reward issuers engaged in effective governance, appropriate risk taking, and wealth 

maximizing activities through the value of shares in the market, consequent credit 

ratings and other measures, information creates the conditions for those activities to 

be rewarded.' 

Implicit in the linking of disclosure with investor protection is the assumption 

that investors with fair access to information will make rational choices, rational in 

this context meaning the capacity to use the disclosed information to act in their own 

best interests in market transactions.' However, behavioral economics has 

2. SARRA, supra note 1, at 19. 

3. Id. 

4. Id. 

5. Id. at 20. 


2007 

DISCLOSURE AS A PUBLIC POLICY INSTRUMENT 

questioned whether disclosure in itself is sufficient to overcome particular human 

decision-making tendencies that inhibit the ability to be rational in market 

transactions.' Hence, it is unlikely that there is a model that perfectly protects 

investors. Moreover, investors draw different conclusions about the same data, 

which is why there are both buyers and sellers of a stock on a given day. The real 

issue in respect of disclosure is whether the information is of sufficient quality and 

quantity to allow investors to make informed investment decisions or assess 

investment advice. 

This article examines selective aspects of disclosure in securities law, 

specifically, how it serves as a public policy instrument in capital markets. It 

explores whether the current regulatory framework encourages "full, true, and 

plain" disclosure, concluding that while the full and true aspects have received 

considerable attention in recent years, the increasing complexity of products creates 

challenges for achieving plain and accessible disclosure. This article also examines 

the potential and limits of electronic-based disclosure, suggesting that the market is 

ahead of the regulatory system in terms of how disclosure is made and that new 

measures may be required to protect the integrity of web-based disclosures. It also 

considers "materiality" as the standard for disclosure, including the interplay 

between statutory requirements and deference to business judgment in determining 

what information is considered material information such that it must be disclosed! 

Finally, as a mechanism to deal with some of the issues raised in the article, the final 

part proposes a new integrated market disclosure document as a means to enhance 

disclosure as a public policy instrument and create greater uniformity and 

accessibility to disclosure across multiple jurisdictions. 

II. 


Disclosure is a key policy instrument in three respects: it serves as a transaction 

cost control device, a regulatory tool, and a governance-signaling device. 8 

As a policy instrument to control transaction costs, disclosure can serve to 

reduce the cost of access to capital and thus enhance efficiency in capital markets. 9 

Standardized and uniform disclosure requirements reduce transaction costs for 

issuers bringing securities to the market by reducing the costs of contracting for 

securities, including the cost of contracting contingency claims. These costs include 

third party costs incurred in the raising of capital, such as fees and the pricing of new 

capital in the market. Transaction costs, however, can vary given the frequency of 

rule changes, the amount of codification, and whether a rule change enhances 

confidence in the market. A particular level of codification can increase certainty 

and reduce costs; however, over-codification or rapidly changing standards can 

increase transaction costs as issuers try to understand and meet new requirements or 

6. Id. For a discussion of this issue, see JOHN R. NOFSINGER, THE PSYCHOLOGY OF INVESTING 8-17 

(2005); MARY G. CONDON, ANITA ANAND & JANIS SARRA, SECURITIES LAW IN CANADA: CASES AND 

COMMENTARY (Emond Montgomery ed., 2005). 

7. While another important question for exploration is whether the disclosure paradigm should be the 

framework used to protect investors, that question is beyond the scope of this article. 

8. For a full discussion, see SARRA, supra note 1, at 21. 

9. Id. 



VOL. 42:875 

market participants seek premiums for investment.'" Increased codification could 

result in an attendant increase in costs of disclosure compliance, which in turn means 

a higher cost of capital. Alternatively, a high level of codification could avoid 

making disclosure more costly but could create a "tick the box" compliance culture if 

it drives the system to a level of prescribed disclosure with little thought and time 

directed to compliance. In contrast, a well-designed, accessible system can facilitate 

issuer disclosure and investor decision making, resulting in more efficient trading. 

Second, disclosure is a policy instrument in that it serves as a measure of 

compliance with regulatory requirements." In Canada and the United States, as in 

many jurisdictions, securities regulators assess fitness for market based on whether 

the issuer meets disclosure requirements. Disclosure is also the regulatory 

instrument for sanctioning or removing market participants. In addition, it is a tool 

for the creation of incentives for appropriate capital market participant behavior. 

For example, those issuers with recognized experience in the market and a history of 

compliance with securities law requirements have less onerous regulatory conditions 

imposed on them in bringing a new offering to the market. Hence there is an 

incentive to comply in order to reduce costs of future offerings. In this sense, 

disclosure is a regulatory tool to facilitate creating a culture of both pro-active 

disclosure and of compliance. 

Finally, disclosure has a corporate governance role as a signaling device that 

communicates messages to capital market participants about the issuer's governance 

effectiveness. 2 It serves as a signaling device for investors in respect of operational 

efficiency, director oversight, and managerial skills. Increased disclosure of 

corporate governance under "comply or explain" policies of stock exchanges and 

securities regulators means that there is increased information about governance 

practices, contingency processes, insider trading decisions, executive compensation, 

and board independence measures. It is also a signaling device for corporate 

directors, as requirements to disclose corporate governance practices force corporate 

boards to assess and report on upside and downside risks, which facilitates the 

board's own process of adjusting strategic planning and oversight of corporate 

officers accordingly. 13 

The quality of disclosure can influence market behavior, as the willingness of 

investors to expend their capital on a particular economic activity is affected by 

whether investors have confidence in the disclosures being made. Failure to achieve 

effective disclosure can reduce market efficiency because the cost of capital is higher 

and public confidence and willingness to invest are diminished. 

In Canada, there have been two normative directions in disclosure policy for 

capital markets. On the one hand is the clear move by most regulators towards 

increased codification through national instruments, policies, and local rules, aimed 

at certainty in quality of information. 4 In this respect, Canada has followed its 

10. Id. 

11. Id. 


13. Id. 

14. See, e.g., Continuous Disclosure Obligations, National Instrument 51-102 (April 2, 2004), 

Acceptable Accounting Principles, Auditing Standards and Reporting Currency, National Instrument 52- 

107 (Jan. 16, 2004), Certification of Disclosure in Issuers' Annual and Interim Filings, Multilateral 

Instrument 52-109 (Jan. 16, 2004), Audit Committees, Multilateral Instrument 52-110 (Mar. 26, 2000), 

available at http://www.osc.gov.on.ca/Regulation/Rulemaking/Current/rrn-part5-index.jsp. 


2007 


largest trading partner, the United States, in large measure because of the highly 

integrated nature of the two countries' capital markets. One concern is whether 

current codification initiatives are an overreach of regulation of primary offerings. It 

is estimated that currently twenty-five percent of all securities regulation in Canada 

is aimed at the primary market, yet this market accounts for only about six percent 

of all trading.' 5 

The other normative direction is a Continuous Market Access (CMA) model, 

proposed by the British Columbia Securities Commission (BCSC), which is premised 

on the notion that principles/standards-based regulation, rather than detailed 

codification, will better promote the goals of investor protection, efficient markets, 

and public confidence in capital markets. The BCSC model aligns itself with 

initiatives in the United Kingdom, which the United Kingdom's Financial Services 

Agency (FSA) calls a hybrid of high-level principles and detailed rules and guidance 

that focus on best practices more than rules, with the aim of continuing to change the 

6 

balance "towards a more principles-based and less rules-based approach.' 

To date, these divergent approaches have created a barrier to implementing a 

single national securities law regime in Canada, to replace the existing thirteen 

provincial and territorial securities law systems. 7 Both normative views have 

benefits and limitations. There is a risk to accessibility for both issuers and investors 

in terms of understanding the nature of highly-codified obligations. At the same 

time, if Canadian regulatory requirements do not align to a certain extent with 

highly codified U.S. disclosure requirements, there could be difficulties with 

continued access to U.S. markets. There is also a risk of issuers missing market 

windows, given time delays in bringing an offering to the market where approval of 

multiple regulators is required. The BCSC conducted a cost-benefit analysis that 

suggested that the CMA model provides more expeditious and less expensive access 

to capital without sacrificing investor protection, and that completion of an IPO 

under CMA would be up to nineteen percent faster and up to fifty one percent 

cheaper.' Offerings after initial IPO could be up to fifty six percent faster and 

eighty two percent cheaper, depending on size of the issuer.' 9 Issuers would get to 

market faster, reducing the risk of missing market windows." The CMA is aimed at 

15. Proposal for a Statutory Civil Remedy for Investors in the Secondary Market and Response to the 

Proposed Change to the Definitions of "Material Fact" and "Material Change," Canadian Securities 

Administrators Notice 53-302 (Nov. 3, 2000), 23 OSCB 7383. 

16. FINANCIAL SERVICES AUTHORITY, BETTER REGULATION ACTION PLAN: WHAT WE HAVE 

DONE AND WHAT WE ARE DOING (2005), http://www.fsa.gov.uk/pubs/other/better-regulation.pdf. The 

FSA writes that it is "committ[ed] to implementing directives in a sensible and proportionate way. [The 

FSA] must implement the minimum requirements, even if they would fail a cost-benefit analysis from the 

viewpoint of the UK. [The FSA] will not gold-plate EU requirements [and].. .will only add requirements 

when these are justified in their own right." 

17. There have been a considerable number of studies, wise persons committees, and reports on 

whether Canada should have a national regulatory system or a passport system that recognizes different 

jurisdictions. For a discussion of these issues, see CONDON, ANAND & SARRA, supra note 6; and CANADA 

STEPS UP, supra note 1. 

18. CHRISTINA WOLF, BETTER DISCLOSURE, LOWER COSTS: A COST-BENEFIT ANALYSIS OF THE 

CONTINUOUS MARKET ACCESS SYSTEM 7. 11 (Deregulation Project 2002), 

http://www.bcsc.bc.ca/uploadedFiles/CBA-Report.pdf. 

19. /dat8,11. 

20. Id. The study suggested that prospectus costs for issuers listed on the Toronto Stock Exchange 

(TSX) are directly related to length, each page of additional prospectus disclosure costs an issuer about 



VOL. 42:875 

benefiting investors by improving disclosure and benefiting issuers by significantly 

lowering their capital-raising costs. 

While there is not yet convergence of these normative approaches, there has 

been some loosening of the views regarding principles-based versus rules-based 

approaches to disclosure regulation. For example, in the United States, the SEC has 

recently recognized the need for at least a partially principles-based approach. To 

date, regulatory change in the United States has been highly rules driven, 

particularly in the years after Enron and other corporate failures. Yet the SEC has 

adopted a partially principles-based approach to its new requirements on executive 

compensation disclosure, effective December 2006. The new Compensation 

Discussion and Analysis (CD&A) document aims to provide clear and complete 

disclosure of senior officers' compensation, using both the SEC requirements that it 

be in plain language and principles-based requirements to explain all material 

elements of compensation. 2 ' 

III. FULL, TRUE, AND PLAIN DISCLOSURE 

A critical challenge in thinking about disclosure as a public policy instrument is how 

truly to make information accessible while also ensuring that issuers disclose the 

level of detail and depth necessary for analysts to make informed decisions. This 

question implicates three principal parties to the disclosure: the issuer, the investor, 

and the market intermediaries. 22 For the issuer, disclosure requirements must be 

sufficiently clear so that the issuer can, with some certainty, meet the requirements 

without unreasonable transaction costs. For the investor, disclosure must allow for 

informed decisions. Because retail investors are increasingly involved in the market 

both through on-line facilities and managed investment funds, the nature of investor 

interest lies more along a continuum of interests, information, and sophistication, 

rather than a two-tier dichotomy between retail and institutional investors. 

Institutional investors also run along that continuum: while they are sophisticated 

investors, institutional investors have different interests, time horizons, and priorities 

in their market activity, and thus may have different disclosure needs. 23 For 

example, institutional investors interested in long-term investments view governance 

disclosure as important. For investment analysts, retail stock brokers, fund 

managers, and other intermediaries, there are obligations to responsibly digest, 

filter, and provide opinions on disclosure. Parts of the market are highly dependent 

on the ability of these intermediaries to decipher complex disclosures and deliver 

skilled advice to the market. 

Disclosure documents should clearly identify their purpose and provide "full, 

true, and plain" information in an accessible form. "Full" disclosure requires a level 

of completeness in material information such that investors can make informed 

decisions. "True" denotes a level of correctness and honesty. "Plain" includes clear, 

simple, and readily understood. While plain language may be necessary for 

unsophisticated retail investors or those investors without the resources to analyze 

$29,000. 

21. SEC News Release 2006-123, SEC Votes to Adopt Changes to Disclosure Requirements 

Concerning Executive Compensation and Related Matters (July 26, 2006). 

http://www.sec.gov/news/press/2006/2006-123.htm. 


23. Id. at 37. 


2007 


all disclosure documents, disclosure requirements must nevertheless continue to 

provide analysts, institutional investors, and other market participants with the level 

of detail necessary to make informed judgments about investment advice and to 

provide regulators with the level of transparency necessary for regulatory approval 

or monitoring. 

Although many regulatory systems have focused on the "full and true" aspects 

of disclosure, only more recently has the "plain" aspect of disclosure received 

attention. This is partially because of the size, complexity, and variety of securities 

offerings, as well as the increased codification of requirements. In part, it is because 

electronic filing or required disclosure of particular information has been added 

incrementally to the system without sufficient consideration of the overall 

implications for full, true, and plain disclosure. This creates new problems of 

access." The FSA in the United Kingdom and the SEC in the United States have 

both recently stated that plain language will be a priority for their future regulatory 

requirements in respect of disclosure." 5 

Internationally, there are numerous plain language initiatives aimed at 

providing meaningful full, true, and plain disclosure. The International Organization 

of Securities Commissions (IOSCO) has had a series of initiatives towards plain 

language disclosure, which are referred to by regulators of numerous jurisdictions to 

inform their initiatives. For example, the European Union's Prospectus Directive 

requires that information disclosed in prospectus documents be presented in an 

easily understandable and comprehensible form. 26 The summary to the prospectus is 

limited to 2,500 words that convey in a brief manner and in non-technical language 

the "essential characteristics and risks associated with the issuer, any guarantor and 

the securities." 27 While the required plain language summary statement is an 

important initiative, the European Union has determined that the summary must 

contain a warning that it should be read as an introduction to the prospectus, and a 

summary sheet to a prospectus will not attract liability unless it is misleading, 

inaccurate, or inconsistent when read together with other parts of the prospectus. 2 " 

That raises the question of whether the liability line has been drawn in the 

appropriate place for such summaries. The EU Prospectus Directive does impose 

certainty across the European Economic Area (EEA) in that regulators cannot opt 

out of the liability protections afforded to issuers completing the summary, which 

fosters the efficient market goal of securities regulation. 

24. Id. at 39. 

25. Financial Services Authority, Getting Investment Disclosure Right (2006),, 

http://www.fsa.gov.uk/pubs/other/disclosure-factsheet.pdf; Christopher Cox, Chairman, U.S. Sec. and 

Exch. Comm'n., Videotaped Remarks to the San Jose, CA XBRL Conference (Jan. 18, 2006) (transcript 

available at http://www.sec.gov/news/speech/spch011806cc.htm). 

26. Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003 on the 

Prospectus to be Published when Securities are Offered to the Public or Admitted to Trading and Amending 

Directive 2001/34/EC, 2003 O.J. (L 345) art. 5(1)[hereinafter EU Prospectus Directive]; Commission 

Regulation (EC) No. 809/2004, 2004 O.J. (L 149) para. 30. The EU Prospectus Directive has as its purpose 

the harmonization of requirements for creation and distribution of prospectuses when securities are to be 

offered to the public or an issuer admitted to trading on a regulated market. 

27. EU Prospectus Directive, supra note 26, pmbl. § 21, art. 5(2). 

28. Id. art. 5(2). There is no requirement to provide a summary where the securities relate to nonequity 

securities having a denomination of EUR 50.000, except when requested by a member state. 

29. Once a prospectus is approved in one EEA country, it can be used to issue in any other EEA 

country. In the EU, a significant recent development for primary market disclosure is the move in 2005 



VOL. 42:875 

Many jurisdictions lack integration between primary and secondary market 

disclosure requirements. Consequently, information overlap, duplication, and 

fragmentation create issues of clarity and accessibility. In Canada, for example, 

primary market disclosure is contained in the prospectus and the Annual 

Information Form (AIF). For specialized offerings, such as the prompt offering 

prospectus, the information is disclosed in the prospectus, the AIF, the financial 

statements, and any material change reports." In secondary market disclosure, 

information is disclosed in financial statements, AIFs, Management Discussion and 

Analysis (MD&A), proxy circulars, and material change reports. The different 

statutory disclosure requirements between primary and secondary market disclosure 

means that information is often inaccessible to retail investors because it is located in 

different places during different periods of the issuer's distribution and continuous 

disclosure life cycles. The upsurge in the quantity of information in recent years 

often means that the information is publicly disclosed through multiple sources, and 

it is difficult for investors, particularly some retail investors, to acquire a full and 

accurate picture of the issuer's activities and business risks. It can also be difficult to 

assess how material or significant the disclosure is. Although the periodic disclosure 

documents such as financial statements, AIFs, and MD&As are required to give a 

full picture, in the interim periods, material change and other reporting can be 

located in a myriad of places, and can give mixed messages to investors about the 

risk and return decisions faced by an issuer." 

There are signs of a move toward more integrated disclosure in Canada. In 

2006, the change to short form prospectus requirements illustrated the move toward 

recognizing a continuous disclosure record, whether for the primary or secondary 

market. Short form prospectuses were historically only available to issuers with 

considerable market experience or sizable capitalization, which allowed those issuers 

to bring an offering to market quickly and with less cost. The new national 

instrument regulating short form prospectus offerings has eliminated many 

seasoning and minimum market capitalization requirements, thus expanding 

eligibility criteria for accessing short form offerings to include most Canadian listed 

issuers. 32 These changes facilitate access to capital markets by permitting issuers to 

rely increasingly on their continuous disclosure record. Broader qualification 

requirements enable more issuers to take advantage of the short form prospectus 

system. With 3,800 issuers listed on the TSX and TSX Venture Exchange, 33 the new 

requirements will allow several thousand more issuers to use short form 

prospectuses, and thus give many small and mid-cap issuers access to a national 

market on a more expeditious and cost-effective basis. 

from a recognition system to a full passport system for prospectus offerings throughout the European 

Economic Area (EEA), which is comprised of all EU member states plus Norway, Iceland and 

Liechtenstein. Id. art. 1(1). 

30. CONDON, ANAND, & SARRA, supra note 6. 


32. SHORT FORM PROSPECrUS DISTRIBUTIONS, NATIONAL INSTRUMENT 44-101, ONTARIO SEC. 

COMM'N, available at http://www.osc.gov.on.ca/Regulation/Rulemaking/Current/Part4/rule_20061222_41- 

101gen-pro-requirements.pdf; CONTINUOUS DISCLOSURE OBLIGATIONS, NATIONAL INSTRUMENT 51- 

102, ONTARIO SEC. COMM'N., available at 

http://www.osc.gov.on.ca/Regulation/Rulemaking/Current/Part5/rule_20031219_51-102_con-dis.pdf. 

33. WISE PERSONS' COMMITTEE TO REVIEW THE STRUCTURE OF SECURITIES REGULATION IN 

CANADA, IT'S TIME 5 (Ottawa Dept. of Finance, 2003), http://www.wiseaverties.ca/reports/WPC%20Final.pdf. 


2007 


In the United States, recent changes are aimed at enhancing timely delivery of 

information to investors while controlling costs to market. The Securities Offering 

Reform Rules, effective December 2005, created a new class of "well-known 

seasoned issuers" (WKSIs) comprised of issuers that are widely followed in the 

marketplace." WKSIs can use a new "automatic shelf registration" process, which 

allows them to register unspecified amounts of specified types or classes of securities 

on immediately effective registration statements, without allocating between primary 

and secondary offerings, and can exclude more information from the base 

prospectus. WKSIs eliminate the delivery requirement for final prospectuses, 

liberalizing issuer communications so that more information goes to the market 

earlier in the process. 3 5 The shelf registration rules for WKSIs allow more flexibility 

and faster issuing. As in Canada, the United States is now distinguishing between 

those issuers well known to the market and those that are new, in terms of the extent 

of additional disclosures required to bring a new issue to the market. While these 

developments in Canada and the United States are important for time to market, 

they do not address potential fragmentation of information and the question of 

access to full, true and plain disclosure. 

Investor education is another aspect of the disclosure system because it can 

enhance investor knowledge and provide skills to assess disclosures. While 

education does not remedy an individual's capacity to digest and apply information, 

it can serve to reduce disparities in processing information and reduce the incidence 

of completely uninformed decision making. Education can provide investors with a 

greater appreciation of their own limits (time, resources and information) with 

respect to investment decisions without the assistance of knowledgeable advisors. 

Realistically, the vast majority of investors do not make investments themselves; 

instead, they retain retail stock brokers, mutual fund managers, or others to provide 

them with advice or to direct their investment portfolio. Although technically 

individual retail investors make the actual decision to buy, sell, or hold, in reality the 

analyst is often the de facto investment decision-maker. In the United Kingdom, 

there has been a requirement since June 2005 that analysts give investors two 

'keyfacts' documents at the start of the advice process, in order to provide retail 

investors "...with clear and understandable information about the products and 

services offer[ed], and the cost of advice...", as well as information about "...all 

options that are available in the market, not just what [the firm] offers." 36 These 

requirements acknowledge the limitations of disclosure in terms of how retail 

investors may rely on the advice of intermediaries in the marketplace, and places 

some obligation on advisors to disclose the scope and limits of their own services 

within the market for disclosure and investment advice. 

In summary, the objective of full, true, and plain disclosure is hindered by 

fragmentation of information, the complexity of products now offered in the market, 

a lack of integration between primary and secondary market disclosure 

34. Securities Offering Reform, SEC Release No. 33-8591 (19 July 2005) 70 FR 44722; Rules 415, 424, 

430B, Registration Procedures for United States public offerings. 

35. Id. Rule 163. 

36. Getting Investment Disclosure Right, supra note 25. These documents are: Keyfacts About Our 

Services - also known as the initial disclosure document or IDD: and Keyfacts About The Cost Of Our 

Services - also known as the menu (or fees and commission statement) or a combined initial disclosure 

(CIDD) document instead of an IDD. 



VOL. 42:875 

requirements, the incremental and often unplanned nature of new disclosure 

requirements added to pre-existing rules, and the filtering that occurs as information 

changes hands before the investment decision is made. 

IV. ELECTRONIC DISCLOSURE AS A KEY ASPECT OF ENHANCED 

DISCLOSURE REGIMES 

Methods of disclosure communication have radically changed. Whereas 

historically, the paper prospectus was the principal protection device, paper 

generally has been replaced by electronic and web-based communication. The 

exponential increase in the use of web-based platforms and other technology has 

quite literally revolutionized access to information. In Canada, for example, 

investors can access information about issuers through the System for Electronic 

Document Analysis and Retrieval (SEDAR), the System for Electronic Disclosure 

by Insiders (SEDI), stock exchange listings, company web-sites, electronically posted 

information about legal actions that the issuer is involved in, and a host of other 

portals through which information is now disseminated. 37 

However, the material information contained in these systems is not always 

easily accessible. Disclosures are posted in multiple places on the website and it 

takes a certain amount of time, talent, and tenacity to find all material information. 38 

Some investors may believe that they are making decisions based on full and 

complete information, but they may have missed an important material change 

report buried within the site. Liberal access to web-based information has thus 

created a new tension in the disclosure debate. On one side of this debate, electronic 

and web-based disclosures are enhancing the ability of issuers to make full, timely, 

and material disclosure to a broader range of market participants. This protects 

investors because both primary and secondary market disclosures are more 

accessible. Timely disclosure increases market efficiency because it allows the 

market to respond to earnings statements or material changes rapidly, and alerts all 

market participants to developments that may influence their investment decisions. 

While in some countries there may be concern regarding access to web-based 

disclosure, this concern is less likely to be a justification for maintaining the current 

paper-based system because those engaged in securities markets are increasingly 

likely to have access to web-based information. 

On the other side of the debate, there is a risk that accessible but extensive 

information will reduce true access to information for investors, particularly with the 

use of hyper-links and different web-platforms that can obscure access to 

information for investors. Hyper-links can perform an important disclosure role in 

directing the investor to the appropriate place in the disclosure documents, where an 

issue is more fully discussed. The more sophisticated and exciting the delivery, for 

example, shifting back and forth from formal disclosure documents to video-footage 

of recent resource discoveries, however, the greater the risk of missing important 

information. Hyper-links can also take the investor to related web-sites where other 

parties are responsible for the disclosure content. In such cases, it is not always clear 

37. System for Electronic Document Analysis and Retrieval (SEDAR), National Instrument 13-101, 

Ontario Sec. Comm'n, http://ftp.sfsc.gov.sk.ca/scripts/ssc/files/nat-inst/13-101niamendedasof-mar3O-04.pdf; 

Canadian Securities Administrators SEDI Home Page, http://www.csa-acvm.ca/htmlCSA/sedi.html. 



2007 


that the investor is leaving a web-site for which the issuer assumes responsibility and 

exiting to another site not within the issuer's control in terms of accuracy and 

completeness of information. The issue of transparency needs to be addressed in 

thinking about the move to a primarily web-based disclosure regime. The choice of 

where to locate all disclosure information is a critical one that may affect the market. 

If a "one-click full access" system was the responsibility of individual issuers, the 

costs could become quite onerous in terms of IT support. Yet more than 90% of 

Toronto Stock Exchange (TSX) listed companies already maintain web-based 

disclosure, suggesting that the market has determined this is a timely way to ensure 

disclosure to the market. 

Web-based communication also allows investment dealers and other 

intermediaries to access information and to digest, analyze, and disseminate that 

information to their client base in a timely manner. Historically, the market was 

structured so that these participants were able to access disclosures more readily 

than retail investors and hence differential access created a market demand for their 

services. Increased direct access may diminish that traditional market. At the same 

time, there is a growing demand for investment advice as the range and diversity of 

products increases. Hence, better discipline in respect of web-based disclosure 

should enhance market choices overall. Electronic disclosure may also create 

greater incentives for analysts and other market participants to maintain or enhance 

the quality of their advice, as retail investors will have the option of accessing the 

market directly. 9 

A number of web-based, electronic, or technology-based initiatives have 

enhanced access to disclosure in recent years. Electronic road shows are increasingly 

available, allowing investors from remote locations to access information meetings 

and ask questions about securities being brought to the market. In China, such 

electronic road shows are now mandatory with any new offering. Another example 

is the growing practice of advance notice of earnings announcements, with the 

electronic capacity to be on-line for the announcement or to hear the announcement 

on a deferred basis but first-hand. Electronic disclosure is now part of the market, 

and regulators should use these advances to promote enhanced quality and 

timeliness of issuer disclosure. Creating access to analyst calls, where the issuer 

discusses particular issues with analysts, is also a positive development in disclosure 

access. While most retail investors do not have the time or resources to follow 

analyst calls, the participation of intermediaries and those investors able to 

participate is likely to help ensure that inappropriate or unfairly advantageous 

disclosure does not occur. 

Many jurisdictions are moving to an "access equals delivery" system such as the 

delivery of WKSI disclosure in the United States. Notwithstanding that there may 

be a lingering concern that some investors do not have consistent access to webbased 

disclosure, the system could shift to a default-based system where investors 

receive notice that documents have been posted with the appropriate web-links and 

an option to receive paper-based disclosure. Web-based communications platforms 

can allow for the reduction of information asymmetries and can enhance timely, 

extensive disclosure that is accessible to everyone seeking to participate in the 

market. 

39. Id. at 46. 



VOL. 42:875 

If web-based disclosure access is to equal delivery of information for purposes 

of meeting market disclosure requirements, it is important to build in a high degree 

of investor protection, including measures that guard against information tampering. 

It is also important that regulators are able to monitor disclosure, given its function 

as a regulatory tool. The design of a system that allows certainty in tracking, 

especially disclosure as ephemeral as electronic information, will require some care. 

Attention will also have to be paid to how securities holders can establish delivery or 

non-delivery of information where they seek remedies for breach of disclosure 

requirements. While statutory deemed reliance provisions will alleviate some of this 

concern, it may become a practical challenge in establishing the timing of issuer 

disclosure on a particular matter. 0 Requiring all continuous disclosure to be housed 

in one location, perhaps the issuer's web-page, would, address the fragmentation 

problems discussed earlier. 

One question is whether there should be a market for centralizing data for 

investors. While this might provide an accessible service for investors, there is also 

the public policy issue of preservation, storage, and retrieval of that data in case of 

compliance or civil liability issues. Even without the use of centralized data services, 

investors may face difficulty in pursuing civil liability claims based on electronic 

documents that they did not download at the point in time for which they later seek 

to impugn the disclosure conduct. Without paper-based copies, the system design 

will need to ensure timely and cost-effective access to that point-in-time disclosure or 

there will be enormous transaction costs associated with litigating access to 

"disclosure of the point-in-time disclosure." 

Similarly, while some technology would allow for particular investors to 

customize document disclosure, one needs to be concerned about disclosure that, in 

customizing data for investors, alters the first-hand disclosure by issuers. The 

second-hand reporting may diminish the ability of investors to hold issuers 

accountable for disclosure information on which they based their investment 

decisions. While issuers in such circumstances should be protected, there may need 

to be a liability regime that holds the service customizing data responsible for the 

integrity of the disclosures. Adoption of new technological strategies must take 

account of these concerns. The issue is what use of technology will enhance 

disclosure and promote the objectives of securities legislation. The responsive 

capacity exists; it needs to be implemented in a manner that allows issuers costeffective 

disclosure delivery while protecting investors of all kinds along the 

continuum of sophistication and interest. 

Another issue is whether there should be a private market for electronic 

disclosure that operates above the publicly regulated structure. For example, in 

Canada, CDS INC., which operates SEDAR on behalf of the Canadian securities 

regulatory authorities, offers a new service on its own web-site called SEDAR- 

SCRIBE, a service that gives subscribers immediate disclosure of SEDAR filings 12- 

24 hours before they are posted for the general public." Arguably, this could create 

a two-tiered electronic disclosure system with more timely disclosure for those 

market participants that can afford to pay. If disclosure is a good that we want to be 

40. Technological developments can reduce the cost of delivery for issuers. However, it is unlikely to 

be an overall cost savings, as moving to a fully integrated web-based or electronic disclosure system 

requires full-time ongoing IT and IP support to ensure that continuous disclosure is accurate and timely. 

41. SEDAR-SCRIBE: CDS Innovations Inc. Filing Information Home Page, 

http://www.cdsinnovations.ca/cdsinnovationshome.nsf[Pages/-EN-Filinginformation?Open. 


2007 


uniformly accessible as a public policy matter, then the appropriateness of such 

services may have to be examined. 42 

In the European Union, issuers are to ensure that where a prospectus is 

published in electronic form, safety measures are to be used to maintain the integrity 

of the information, and to avoid manipulation or modification from unauthorized 

persons. "3 The prospectus must be easily accessible when entering the web-site: it 

must not contain hyper-links, with the exception of links to the electronic addresses 

where information incorporated by reference is available, and the investor must be 

able to download and print the prospectus.' The prohibition on most hyper-links is 

an interesting regulatory choice, particularly when other jurisdictions are exploring 

allowing the use of hyper-links to amplify disclosure information. While the EU has 

made a fulsome shift towards electronic disclosure, it still provides investors with a 

basic right to return to paper-based delivery free of charge. 4 

In the United States, the SEC is promoting a new electronic platform called 

eXtensible Business Reporting Language (XBRL), developed by an international 

consortium of 400 major companies and government agencies. About 30 U.S. filers 

with US$1 trillion in capital are currently using XBRL on a pilot basis. 46 XBRL is 

also being tested in Europe, Canada and other jurisdictions. XBRL attaches 

standardized electronic tags to elements of information on financial statements. The 

tagged data can then be pulled out of the comprehensive electronic disclosures, 

allowing investors to draw out the information they are interested in examining on a 

selective basis. It also allows software programs to calculate ratios and perform 

other analyses without having to re-input financial data, providing enhanced access 

to information for analysts and other financial intermediaries. The express objective 

of XBRL is to "level the playing field for tens of millions of average investors." 47 

The drive behind the initiative is the SEC's conclusion that the solution to 

accessible disclosure for retail investors is not to eliminate detailed information and 

replace it with summaries, but rather to allow each investor to order up his or her 

own custom information instantly to one page, removing the necessity of culling 

through data where originally entered. If the platform is as accessible as the SEC 

believes, this could revolutionize electronic disclosure. In September 2006, the SEC 

announced that it will expend $54 million to makes its disclosure system, EDGAR, 

interactive using the XBRL computer language. 8 Currently, the EDGAR public 

disclosure system houses 700,000 new disclosure documents per year, and the project 

is aimed at allowing investors and advisors to search information more efficiently 

and effectively. 49 

42. For a discussion of this issue, see SARRA, supra note 1, at 47. 

43. EU Prospectus Directive, supra note 26. 

44. Id. art. 14(7). 

45. Id. para. 31, art. 14(7). 

46. Christopher Cox, Videotaped Remarks to the San Jose, CA XBRL Conference, supra note 24. 

47. Christopher Cox, Chairman, U.S. Sec. and Exch. Comm'n., Opening Remarks to the Practicing 

Law Institute's SEC Speaks Series (Mar. 3, 2006) (transcript available at 

http://www.sec.gov/news/speech/spch030306cc.htm). 

48. SEC News Release 2006-158, SEC to Rebuild Public Disclosure System to Make it 'Interactive.' 

(Nov. 29, 2006), http://www.sec.gov/news/press/2006/2006-123.htm. 

49. Id. 



VOL. 42:875 

The sheer volume of disclosures makes it apparent that electronic disclosure 

does not necessarily guarantee full and true disclosure. The SEC has recognized this 

in its new initiatives. In China, regulators have moved quite aggressively into use of 

technology in market disclosure. Financial statements, interim announcements and 

other relevant documentation of companies are required to be entirely disclosed on 

the websites of the stock exchanges. ° While the use of internet-based disclosure has 

resulted in a significant expansion of the amount of disclosure, the technological 

advances have also amplified the risks in the market. China faces new challenges of 

data quality, reliability and the potential abuse of the internet to disseminate 

misleading information, provide false advice, defraud investors and manipulate the 

market. Its regulators are currently engaged in a process to improve the integrity of 

electronic disclosures. 

V. MATERIALITY 

Material fact, material change, and material information - these terms denote 

the scope and timing of information that is to be brought to the market. Not all 

information of an issuer should be disclosed to the market because it would create an 

inordinate burden on issuers if they were required to report continually their 

activities and financial condition, and would flood the market with excessive and 

transient information. Hence, regulators throughout the world have adopted the 

approach that it is material information that must be disclosed. Investors are to be 

given information that can inform their decisions to buy, sell, or hold. In some 

jurisdictions, "material" is defined as what a reasonable investor would consider 

important to his or her investment decision, referred to as the reasonable investor 

test. In other jurisdictions, it is information that is likely to affect the value of the 

securities, referred to as the market-impact test. In reality, there is overlap between 

these tests: what is considered material because it has the potential of affecting the 

value of securities will always be information that a reasonable investor would want. 

There are issues, however, in determining materiality, particularly as some 

jurisdictions make distinctions between material facts and material changes in terms 

of disclosure requirements. Corporate officers determine materiality, yet there can 

be an uncomfortable fit between statutory standards of materiality and whether 

deference should be given to corporate officers in their determination that particular 

information is not material. 

The EU Prospectus Directive specifies that the prospectus is to contain all 

information that is necessary to enable investors "to make an informed assessment 

of the assets and liabilities, financial position... and prospects of issuers..." based on 

a materiality standard." There is optional disclosure of financial forecasts, but such 

forecasts must be presented in a consistent and comparable manner that is not to be 

confused with disclosure of known trends or other factual data with material impact 

on the issuer's prospects." Supplements to the prospectus are required for "every 

significant new factor, material mistake or inaccuracy relating to the information 

50. China Securities Regulatory Commission, Collection of Laws and Regulations of Securities and 

Futures of the People's Republic of China (2002), http://www.csrc.gov.cn. 

51. European Union Prospectus Directive, supra note 26 art. 5(1) (stating the information is to be 

according to the particular nature of the issuer and of the securities offered to the public or admitted to 

trading on a regulated market.). 

52. Id. para. 8. 


2007 


included in the prospectus that is capable of affecting the assessment of the 

securities," if it arises between the time the prospectus is approved and the final 

closing of the offer to the public. 3 No distinction is made between material fact and 

material change in the disclosure obligations. 

In Canada, a distinction continues to be made between material fact and 

change in securities statutes. A major contested point in Canada is whether the 

current distinction between material fact and material change ought to be 

eliminated. Material fact is defined as "a fact that would reasonably be expected to 

have a significant effect on the market price or value of the securities".' Material 

change is defined as "a change [or decision to change] in the business, operations or 

capital of the issuer that would reasonably be expected to have a significant effect on 

the market price or value of any of the securities of the issuer." 55 Once a prospectus 

is given a receipt by securities regulators, there is no obligation to update material 

facts during the offering period, whereas there is an obligation to disclose material 

changes. 56 Hence the delineation between material fact and material change 

becomes significant. The Ontario Court of Appeal in Kerr v. Danier Leather 

recently held that a prospectus is only required to provide full, plain and true 

disclosure of all material facts as of the date of the prospectus, not the date of 

closing. 57 This is a less rigorous standard than under the European Union's 

Prospectus Directive. The judgment in Kerr v. Danier Leather indicates that 

investors' expectations of accuracy in prospectus disclosure may be incongruent with 

the statutory provisions. Canadian judgments suggest that there is still not a clear or 

shared understanding by regulators, market participants, and the courts regarding 

the difference between material fact and material change. The Supreme Court of 

Canada has granted leave to appeal in the Kerr v. Danier Leather case and the 

matter is pending as this article goes to press."' 

Here, the law lags behind market developments. Issuers listed on the Toronto 

Stock Exchange (TSX) are required to disclose to a material information standard. 59 

For these issuers, the material fact/change distinction only becomes significant if 

there is a claim of failure to meet statutory requirements or a civil liability claim. At 

that point, the issuer may try to categorize changes as material facts if not disclosed, 

in order to avoid liability. This after-the-fact apportioning of materiality to 

"disclosure boxes" seems an inappropriate way to determine statutory compliance. 

For many issuers, the difficulty is whether and at what point the information is 

material, not whether it is a fact or a change. The relatively new National Policy 51- 

201 Disclosure Standards recommends a material information standard, but to date, 

Canadian statutes have not been amended to align. The proposed Continuous 

Market Access model, aimed at creating consistency in reporting material 

information, would eliminate the distinction between material fact and material 

53. Id. art. 16(1). 

54. Ontario Securities Act, R.S.O. 1990, ch. S5, as amended, §1(1). For the Qu6bec provisions, see 

Quebec Securities Act, R.S.Q. ch. V-1.1 §§ 25, 68, 73. 

55. Ontario Securities Act, §1(1). 

56. Kerr v. Danier Leather Inc., [2005] O.J. No. 5388 (Ont. C.A.), leave to appeal to the Supreme 

Court of Canada granted, Kerr v. Danier Leather Inc. [2006] SCCA No. 56 (Can.). 

57. Id. 

58. Id. 

59. Toronto Stock Exchange, Policy Statement on Timely Disclosure and Related Guidelines, 

http://www.tsx.com/en/pdf/PolicyStatementOnTimelyDisclosureNotes.pdf. 



VOL. 42:875 

change and require continuous up-to-date disclosure of all material information 

about issuers, whether or not issuers raise capital in a given year. 

To satisfy the United States' materiality standard in disclosure obligations, 

there must be a substantial likelihood that a fact "would have been viewed by the 

reasonable investor as having significantly altered the 'total mix' of information 

made available." 60 This is a common law, not statutory, test of materiality. Hence in 

terms of material disclosure, Canada has a market impact test and the United States 

and the European Union have a reasonable investor test. 

Other countries have attached disclosure requirements to a materiality 

standard. In Japan, continuous disclosure obligations include disclosure of financial 

and other information that will significantly affect investors' decisions, and 

announcements of business results and material corporate information to public 

investors. 6' Each issuer must designate a "Corporate Information Handling Officer" 

to enhance timely disclosure. 6 There is a general obligation to disclose in a manner 

that is "swift, accurate and fair." Issuers are also required to have a system in place 

capable of supporting continuous, timely, and adequate legally required periodical 

disclosures. 63 The Tokyo Stock Exchange (TSE) requires listed companies to 

disclose immediately to the public "any information that might be expected to 

materially affect the prices of its stocks," including financial results, capital changes, 

occurrence of a material fact such as a major change to shareholders, legal action or 

decision.6 However, one of the most serious challenges for secondary market 

disclosure in Japan is the lack of enforcement mechanisms, and Japan also has no 

mechanism for private enforcement through class-action lawsuits. 6 

As China moves into global capital markets, it has increasingly codified 

materiality disclosure requirements in an effort to remedy earlier failures to capture 

market confidence and to demonstrate to international investors that a rapidly 

emerging capital market can still provide a degree of certainty and completeness in 

its disclosure regime. The Collection of Laws and Regulations of Securities and 

Futures of the People's Republic of China, compiled by the China Securities 

Regulatory Commission (CSRC) in 2002, is comprised of 71 regulations and 

regulatory documents. 66 However, codification of materiality may not address 

longstanding cultural norms that do not value disclosure and hence may not comply 

with regulatory requirements. While this topic is beyond the scope of this discussion, 

it does point out that imposition of materiality standards is only one part of the 

equation, and there must be both a culture of compliance and enforcement 

mechanisms for disclosure to be effective as a public policy instrument. 

60. For a discussion, see CONDON, ANAND, & SARRA, supra note 6, at 269-270. 

61. See generally TOKYO STOCK EXCHANGE, RULES ON TIMELY DISCLOSURE OF CORPORATE 

INFORMATION BY ISSUER OF LISTED SECURITY AND THE LIKE (2002), 

http://www.tse.or.jp/english/guide/regulations/data/securitylisting.pdf. 

62. TOKYO STOCK EXCHANGE, SUPPLEMENTARY RULES TO SECURITY LISTING REGULATIONS, Dec. 

10, 2003, at Part III, Disclosure Requirements after Listing. 

63. Tokyo Stock Exchange Application Checklist, http://www.tse.or.jp/english at 49. 

64. Tokyo Stock Exchange Organization, http://www.tse.or.jp/english/about/organization.html. 

65. Although recently there are more accessible corporate law remedies through new provisions that 

facilitate derivative actions in Japan. 

66. Collection of Laws and Regulations of Securities and Futures of the People's Republic of China, 

supra note 50. 


2007 


In the European Union, secondary market disclosure initiatives have been 

aimed at creating uniformity of secondary market disclosure, but have also been 

developed to respond to the United States' Sarbanes-Oxley Act materiality 

requirements. 67 The objective of the European Commission Directive on the 

Harmonization of Transparency Requirements in Relation to Information about 

Issuers whose Securities are Admitted to Trading on a Regulated Market 

(Transparency Directive) is "to ensure investor confidence through equivalent 

transparency in disclosure throughout the [European] Community." 6 The 

Transparency Directive specifies that "the disclosure of accurate, comprehensive and 

timely information about securities issues builds sustained investor confidence and 

allows an informed assessment of issuers' business performance and assets." 9 

In the United States, there have been extensive revisions to secondary market 

disclosure with the Sarbanes-Oxley Act (SOX) and subsequent regulatory 

amendments." Sarbanes-Oxley was enacted to mandate a number of reforms to 

enhance corporate responsibility and financial disclosure, and to combat corporate 

and accounting fraud. SEC rules since 2002 have included, but are not limited to, 1) 

certification of disclosure by the issuer's executive and financial officers, 7 2) new 

disclosures regarding audit committee financial experts," 3) requirements regarding 

disclosure of off-balance sheet arrangements in MD&A and aggregate contractual 

obligations; 73 and 4) electronic filing and web-site posting of requirements for insider 

transactions." One question is whether, as a result of SOX requirements, issuers 

have been disclosing many more minor announcements that do not materially 

impact financial statements, in order to reduce liability risk. 

Given the need to defer to decisions by corporate officers as to what 

information is material such that it must be disclosed, U.S. regulators have imposed 

assurance requirements on corporate officers, which has the effect of deferring to 

corporate officers the decision about what information is considered material for 

disclosure. The Sarbanes-Oxley Act section 404 directs the SEC to adopt rules 

requiring issuers to include in their annual reports "a statement of management's 

responsibility for establishing and maintaining adequate internal control over 

financial reporting" and assess the effectiveness of those internal controls. 75 The 

company's auditors are to attest to and report on this management assessment. 76 

The objective of the provisions is to enhance confidence in financial reporting 

67. Opinion of the European Economic and Social Committee on the 'Proposal for a Directive of the 

European Parliament and of the Council on the Harmonization of Transparency Requirements with Regard 

to Information about Issuers whose Securities are Admitted to Trading on a Regulated Market and 

Amending Directive 2001/34/EC, O.J. (C 80/128), para. 1.2. 

68. Directive 2004/109/EC of the European Parliament and of the Council of 15 December 2-4 on the 

Harmonization of Transparency Requirements in Relation to Information about Issuers whose Securities are 

Admitted to Trading on a Regulated Market and amending directive 2001/34/EC, O.J. (L 390), para. 41. 

69. Id. pmbl, para. 1. The directive is aimed at greater harmonization of periodic and ongoing 

information requirements throughout the Community. 

70. Sarbanes-Oxley Act, 15 U.S.C. § 7241 s. 302(a) (2002). For an example, see the 2002 revised 

Uniform Securities Act, aimed at further harmonization of federal and state securities law. 

71. Sarbanes-Oxley Act, § 7241 s. 3 0 2 (a). 

72. Id. §§7241 ss. 302, 7265 s. 407. 

73. Id. § 7261 s. 401(a). 

74. Securities Exchange Act of 1934, 15 U.S.C.A. 15 U.S.C. § 78p s. 16(a) (2002). 

75. Sarbanes-Oxley Act, 15 USC §7262. 

76. Id. 



VOL. 42:875 

because internal controls over that reporting would be effective and timely. 7 The 

original compliance date for SOX section 404 has been delayed several times. 78 In 

part, the delay has resulted from compliance costs being much greater than 

anticipated. The SEC cites a study that found that "second year total costs of 

reporting, after initial development of controls reporting, for public companies with 

a market capitalization of $75-700 million was on average $900,000.,, 7 ' 

Smaller companies have had difficulty in working towards compliance with 

SOX section 404 rules, specifically because of a lack of guidance in the requirements 

in terms of application to smaller companies; a compliance model that discourages 

use of business judgment, and a disproportionate cost burden that some scholars 

have suggested could pose significant risks to economic growth in United States 

capital markets. 0 The SEC Advisory Committee on Smaller Public Companies has 

recommended adopting a disclosure system that integrates disclosure rules that 

apply to WKSIs, but based on capitalization. 8 ' It also suggests that management 

representations as to the effectiveness of internal controls should be sufficient for 

micro and small cap issuers, without external audit involvement. 82 The premise is 

that micro cap and small cap companies account for 78.5% of all U.S. public 

companies, but represent only 6% of total market capitalization, and that the 

offering requirements, as well as SOX section 404 requirements, create a 

disproportionate compliance burden on smaller issuers. 83 

Mote recently, however, the SEC has announced its intention to proceed with 

deadlines for SOX section 404 compliance, offering new interpretive guidance aimed 

at enabling public companies of all sizes to focus on risk and materiality in evaluating 

their disclosure processes and controls, while reducing unnecessary compliance costs 

for smaller companies. It also merits note that some market participants, such as 

private equity funds, hold smaller issuers to the higher SOX section 404 

requirements, even where they have not yet been required to comply under U.S. 

securities law, as this serves as a governance check on their activities. 

Another example of evolving transparency norms is Australia, which has 

embarked on a series of regulatory changes aimed at enhancing disclosure. The 

Corporate Law Economic Reform Program (Audit Reform and Corporate 

Disclosure) Act (CLERP 9) focuses on transparent and open communication to 

create equal access to material information, continuous disclosure, financial 

reporting, audit reform, and auditor independence and enforcement.' CLERP 9 is 

aimed at "new, clear, concise and effective disclosure obligations" in the issuing of 

77. SEC Release No. 33-8238, (June 5, 2003) 68 FR 36636; SEC Release No. 34-49884 (June 17, 2004) 

69 FR 35083. 

78. SEC Release No. 33-8545 (Sept. 22, 2005) 70 FR 11528. 

79. SEC Release Nos. 33-8666, 34-53385, Exposure Draft of the Final Report of the SEC Advisory 

Committee on Smaller Public Companies (Mar. 3, 2006) at 29. 

80. William J. Carney, The Costs of Being Public After Sarbanes-Oxley: The Irony of 'Going Private, 

available at http://ssrn.com/abstract=672761; Roberta Romano, The Sarbanes-Oxley Act and the Making of 

Quack Corporate Governance, 114 Yale L. J. 1521 (2005). 

81. Exposure Draft of the Final Report of the SEC Advisory Committee on Smaller Public 

Companies, supra note 79, at 15. 

82. Id. at 40-41, 44. 

83. Id. at 5,25-50. 

84. Corporate Law Economic Reform program (Audit Reform and Corporate Disclosure) Act, (July 

2004), amending the Corporations Act, 2001, enacted July 2004, http://www.asic.gov.au. 


2007 


securities, which includes a new remedy in the form of an infringement notice for 

breaches of continuous disclosure obligations." 

There are different normative views as to whether a full rules-based system 

creates a climate of compliance or generates a "tick-the-box view" of compliance 

without market participants really acquiring a sense of responsibility for their 

disclosures." One point of divergence is whether principles/standards-based, lesscodified 

requirements can better foster a climate of compliance and integrity once 

the issuer is known to the market and regulators, and whether the 

principles/standards-based approach instills a concern for market participants based 

on an enshrined sense of responsibility. One view is that less codification raises the 

level of uncertainty for issuers in terms of the standards they must meet; for 

investors in determining the availability of a remedy for particular conduct; and for 

regulators in allocating resources for compliance and enforcement initiatives. A 

different view is that less certainty can mean that issuers and their principal officers 

must consciously make disclosure decisions on the basis of standards and their best 

judgment on materiality and investor protection. 

Given the high level of court deference to securities regulators and the fact that 

the courts themselves are not experts, a further question is whether less codification 

would really just relegate rule-making in many jurisdictions to securities 

administrators, as uncertain standards are enforced at the first instance by regulators 

and lack of codification could leave securities regulators as the de facto law-makers. 

While there may be some risk of that outcome, one notes that securities regulators 

are already rule-makers at first instance, and that a principles/standards-based 

approach may shift that slightly by encouraging issuers to cultivate best disclosure 

practices. The principles/standards-based approach to disclosure does not eliminate 

rules; instead, it reduces the degree of specificity in some instances so that issuers can 

develop disclosure practices based on their size, sector, and governance structure. 

VI. INTERPLAY BETWEEN BUSINESS JUDGMENT AND DISCLOSURE 

OBLIGATIONS 

Issuers are required to disclose material information as a condition of access to 

capital markets. Determining what information is considered material is, however, a 

judgment that is to be made by corporate officers. Hence, statutory standards of 

materiality are complied with judgments regarding what aspects of the issuer's 

activities or financial condition are material. The interplay between statutory 

standards and corporate decisions as to when and what to disclose is a key issue in an 

effective disclosure regime. 

In considering the relationship between disclosure requirements and the 

business judgment rule, it is important to distinguish between the notion of 

deference to business judgment and the so-called "business judgment rule" as it has 

85. AUSTRL. SEC. & INV. COMM'N, CONTINUOUS DISCLOSURE OBLIGATIONS: INFRINGEMENT 

NOTICES 3 (2004), 

http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/infringement-notice-guidelines.pdf/$file/infring 

ementnotice-guidelines.pdf; AUSTRL. SEC. & INV. COMM'N, CORPORATE LAW ECONOMIC REFORM 

PROGRAM 4 (2004), http://www.treasury.gov.au/documents/264/PDF/clerp.pdf. 

86. Compare, e.g., the approaches of the United States and United Kingdom to compliance. 



VOL. 42:875 

been articulated in United States caselaw. In the United States, the business 

judgment rule is a rule of "judicial non-review" of business decisions, creating a 

rebuttable presumption that directors are meeting their duty of care, and that in 

performing their duties, are honest, well-meaning, and their decisions are informed 

and rational. The business judgment rule limits judicial review of directors' business 

decisions in order to limit the amount of interference in business affairs by the 

judiciary. 87 Hence, the rule shields directors from personal liability and shields the 

decisions of corporate boards from judicial review. 

In Canada, there has been long-standing court deference to business judgments. 

More recently, the Supreme Court of Canada recognized a "business judgment rule" 

in Canadian corporate law. Unlike the U.S. rule, Canada's approach is aimed at 

providing a defence to duly diligent directors from allegations that they have failed 

to meet their statutory and common law obligations to act in the best interests of the 

corporation. 88 There must first be evidence that corporate officers have been duly 

diligent. Such deference, however, is complicated where there are statutory 

standards that corporate officers are to meet. The Ontario Court of Appeal in Kerr 

v. Danier Leather held that the business judgment rule applies to director decisions 

with respect to primary market disclosure obligations." It held that reasonableness 

is the centerpiece of the business judgment rule, involving a range of 

reasonableness. ° There are important differences between the United States' and 

Canadian tests and thus a key issue is how business judgment is treated when 

measured against statutory disclosure requirements in securities laws. 9 ' 

Clearly, there are business judgments involved in an issuer determining what is 

considered material information. Given that directors and officers have the greatest 

knowledge and understanding of their business, operations, and capital, they are the 

most likely to be able to determine accurately what is or is not material information. 

Disclosure decisions can involve difficult business judgments, and in distinguishing 

between material fact and material change reporting in Canadian securities law, the 

determination of where particular information fits within those differing obligations 

is arguably a matter of business judgment. However, such business judgment bumps 

up against clear statutory disclosure requirements. Where the law specifies a 

particular disclosure, there is no business judgment to be made: the issuer must 

comply with the law. It is where judgment is called for that market participants may 

need some guidance of the scope of any deference that may be granted. 

The judgment issue is complicated when there are determinations about when 

to disclose material facts, such as early merger discussions, transactions under 

negotiation, or consideration of moving into new markets or different product lines. 

Disclosure too early may be highly premature and have a negative effect on a 

proposed transaction or direction that the issuer is considering taking. It may also 

cause investors to make decisions prior to the particular matter having actually 

crystallized, which in turn could harm investors' interests and create uncertainty in 

the market." While the issuer can make confidential disclosure to the regulator in 

87. Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984); Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 

(Del. 1971). 

88. Peoples Dep't. Stores Inc. v. Wise, [2004] 3 S.C.R. 461 (Can.). 

89. Kerr, supra note 57. 

90. Id. 

91. Hopefully this will be a question that the Supreme Court of Canada clarifies on appeal. 

92. See Re YBM Magnex Int'l Inc., [2003] 26 O.S.C.B. 5285, para. 29 (Ont. Sec. Comm'n.). 


2007 


many jurisdictions, this does not prevent the disclosure from entering the market, it 

only delays the release. Where early discussions regarding transactions or mergers 

do not crystallize but are disclosed on a delayed basis, this could send 

misinformation to the market. Another view is that early disclosure does not send 

misinformation, particularly if the disclosure is accurately couched in language that 

reflects the degree of uncertainty. It is the information being presented as more 

certain than it actually is that creates misinformation. If this problem were 

addressed, early disclosure could have an explanatory and mitigating effect on 

market disruption. 

However, if deference to business judgments is too high, it will create incentives 

for issuers not to disclose and then seek the protection of the business judgment rule 

to justify business decisions not to disclose material changes. In turn, this may 

prevent material information from being disclosed in a timely manner and would 

create barriers for investors in establishing claims of breach of statutory disclosure 

requirements. 

As a result, some express statutory language addressing this issue may be 

warranted, as business judgment is an area that is likely to generate different judicial 

approaches to the deference question across jurisdictions. This differing approach 

may result in increased uncertainty for all market participants. The objective of the 

disclosure requirement is to ensure that the issuer deals with disclosure of good news 

and bad news with equal urgency. Deference to business judgment should apply 

only to judgments that are made on a reasonable basis after a duly diligent process. 

Given current information asymmetries, it may be necessary to place an onus on the 

issuer's officers to establish their due diligence, as has occurred in the context of 

takeover bid cases. Any deference given as a judicial interpretation tool or device 

should be carefully limited so as not to detract from both the express disclosure 

requirements in securities law and the goals of investor protection, market efficiency, 

and public confidence in capital markets. 

VII. DEVELOPMENT AN ELECTRONIC INTEGRATED MARKET 

DISCLOSURE DOCUMENT 

Any initiatives to modernize disclosure as a public policy instrument should 

build in mechanisms that test the effectiveness of whether outcomes of proposed 

rule changes are clear and likely. One Canadian securities regulator has observed 

that rules should also be tested for their neutrality in order to not favor particular 

types of market participants, for their flexibility in order to require market 

participants to exercise judgment and place responsibility on officers to establish and 

apply adequate systems and controls to meet regulatory requirements, for scope so 

that rules should prescribe only what is necessary to achieve the intended outcome, 

and for clarity so that the rules are accessible, understandable, and able to be 

applied practically. 93 

One option to address many of the issues raised in this article is to locate 

disclosure in one "living" electronic integrated market disclosure document (IMDD) 

that investors can access at any point in the life cycle of the issuer, whether it is 

93. British Columbia Securities Commission Home Page, http://www.bcsc.ca. 



VOL. 42:875 

making an offer of securities to the market or meeting its continuous disclosure 

obligations." ' The integrated market disclosure document (IMDD) could combine 

financial statements, MD&As, AIFs, and proxy circulars into one document. These 

financial and other disclosures are called by different names in different jurisdictions, 

but they increasingly align in the nature of their disclosure requirements globally and 

thus could be integrated into a living IMDD. 

Such an integrated disclosure document could contain four parts. The first part 

of a new IMDD could be an executive summary of no more than four to five pages, 

with a substantive and informative summary of material information regarding the 

issuer conveying in brief, non-technical language the essential characteristics and 

risks associated with the issuer and the securities. Modeled after the European 

Union summary document, it would provide specific references to relevant materials 

in the remainder of the document. The executive summary would not provide "full 

disclosure," as that is what the remainder of the document would provide; however, 

it would be fulsome because it would flag the material information. This part would 

be required to meet the threshold of reporting material information in a way that 

investors could both rely on the information and seek remedies where the issuer 

failed to flag it. It could caution that investors are to make any investment decisions 

based on the IMDD as a whole, and that no civil liability will attach to any person 

solely on the basis of the summary, unless it is misleading, inaccurate, or inconsistent 

when read together with other parts of the IMDD. 

The second part of the proposed IMDD would contain the financial statements, 

as well as information that is currently disclosed in the AIF, providing extensive and 

substantive financial and operational disclosure. While an effort would be made 

towards plain language disclosure, this part would provide the level of detail 

necessary for analysts and other market participants to make an informed 

assessment of the issuer, and provide an integrated snapshot of the issuer's capital, 

business, and operations. 

The third part of the IMDD would contain MD&A-type descriptions by senior 

officers, but would directly reference previous parts to eliminate duplicative 

information, with a specified standard on which to measure the quality of disclosure. 

The new Compensation Disclosure and Analysis (CD&A) required in the United 

States (effective in 2006) could also form part of this section. 9 " It may also be timely 

to require disclosures in this part for corporate social and environmental 

responsibility measures, as part of the corporate governance disclosures. Corporate 

social responsibility disclosures are increasingly prevalent in EU member states and 

other countries. Canada's requirements in this respect are minimal at best, although 

a number of issuers, particularly in the resource sector, are routinely disclosing 

environmental sustainability measures. This corporate social and environmental 

responsibility disclosure could be pegged to a standard developed by private actors, 

such as the "comply or explain" standard pegged to the principles of the Global 

Compact, or it could merely impose a general requirement to disclose practices in 

respect of the issuer's social and environmental responsibility practices. 

94. I first proposed this idea as part of the background research report for the Task Force to 

Modernize Securities Law in Canada, see SARRA, supra note 1, at 11-12. 

95. SEC News Release, SEC votes to Adopt Changes to Disclosure Requirements Concerning 

Executive Compensation and Related Matters, http://www.sec.gov/news/press/2006/2006-123.htm. 


2007 


The final part of the IMDD would comprise Future Oriented Financial 

Information (FOFI), separated because of the particular nature of forecast 

disclosure. While FOFI would be optional, as it is under many current systems, it 

too would have clear standards, whether based on a reasonableness standard or 

reasonable investigation standard. 

Subsequent material change reporting would then be integrated directly into 

the IMDD as one document, flagging the date of the change in disclosure. Press 

releases and the revised IMDD with the material change incorporated would clearly 

signal to market participants at the front of the document the nature of the change 

and location in the document. The IMDD as a whole would be the living disclosure 

document, and would include electronic "tags" specifying when the particular 

material change or information disclosure was integrated into the document. 

This notion of a dynamic current and accessible document is possible given 

technological developments. Instead of investors having to access numerous 

documents, plus trying to ascertain whether there have been material change 

reports, all information publicly available to the market would be contained in one 

document at all times, including a "last updated" reference. This model would place 

the emphasis on disclosure to meet the principal goals of informing and protecting 

investors, while generating efficiencies in capital markets. The transaction costs of 

converting to a single document would eventually be offset by the streamlined 

nature of the disclosure. 

The IMDD could be held to a standard of disclosure of all material 

information, thus aligning many jurisdictions. The uniformity in requirements would 

promote harmonization of standards and certainty for issuers. A less rigorous option 

is that the IMDD would hold the issuer to a standard of disclosure of material 

information at the time the IMDD is first presented to the market, with material 

changes integrated on an ongoing basis, and then requiring a semi-annual update to 

include all material information, with the summary clearly specifying the last update 

period. Micro and small cap issuers could be required to undertake the update 

annually if there are concerns about the costs of semi-annual compliance for these 

issuers. 

The proposed IMDD does meet a number of the indicia of effective rule 

changes. It would be flexible, in terms of issuers creating an IMDD that allows the 

issuer to meet a standard of disclosure. It would eliminate duplication in primary 

and secondary market disclosures. It would provide all market participants with 

single portal access to current material information about the issuer. It could be 

designed with stock exchanges so that issuers are required to meet only one set of 

disclosure standards. 

VIII. CONCLUSION 

This article raises a number of issues in respect of disclosure, particularly with 

the growth of global capital markets. Disclosure is the public policy instrument of 

choice for most countries for the protection of investors and the efficiency of capital 

markets. However, with the rapid changes in the number and types of securities 

offerings, the exponential growth in web-based paperless disclosure, and the 

international nature of securities trading, there needs to be further exploration of 



how regulatory structures can adjust to ensure that disclosure requirements continue 

to foster fair and efficient capital markets. 


Avoidance of Pre-Bankruptcy Transactions in 

Multinational Bankruptcy Cases 

JAY LAWRENCE WESTBROOK* 

SUMMARY 

I. B A CK G RO U N D ..................................................................................................... 900 

I1. FRAM ING THE PROBLEM .................................................................................... 900 

A . Choice of Bankruptcy Law ........................................................................ 900 

B . N onbankruptcy L aw ................................................................................... 904 

III. T H E FREN CH C A SE ............................................................................................. 905 

A. The Presumption Against Extraterritoriality ............................................ 906 

1. Significant C ontacts .............................................................................. 906 

2. C ongressional Intent ............................................................................ 907 

3 . C o m ity ................................................................................................... 908 

IV . M ID LA N D ............................................................................................................. 910 

V . A L SA BA H ............................................................................................................ 911 

V I. O NE STEP FA RTHER ........................................................................................... 913 

A. Conflict Between Avoidance Law and Other Law Governing the 

C hallenged Transaction .............................................................................. 913 

B. Nonbankruptcy Avoidance Law ................................................................ 914 

V II. C O N C LU SIO N ....................................................................................................... 915 

From the perspective of planning commercial transactions, the application of 

the avoiding powers may be the single most important aspect of multinational 

insolvency/bankruptcy cases.' Yet there have been remarkably few reported cases 

dealing with those issues. The present author was guilty of an article on the subject 

* Benno C. Schmidt Chair of Business Law, The University of Texas School of Law. I am indebted to 

Look Chan Ho for a helpful critique. I am grateful to Erin Murdock, Texas '08, for expert research 

assistance. I must claim the remaining errors. 

1. Although I use the United States term "bankruptcy" throughout, the analysis is meant to apply 

primarily to corporate insolvency proceedings. 

899 



VOL. 42:899 

some fifteen years ago . Very few cases have been reported since that time, until the 

three fraudulent conveyance cases I discuss in this article. The French case is a 

Court of Appeals case that applies United States law to avoid a pre-bankruptcy 

transfer of real estate in Bermuda.' In the Midland Euro Exchange case, the Los 

Angeles bankruptcy court comes to the opposite conclusion about a transnational 

payment in the context of a Ponzi scheme.' In the third case, Al Sabah, the Privy 

Council applied Cayman Islands law to permit a Bahamian trustee in bankruptcy to 

undo two Cayman Islands trusts Relatively speaking, our cup runneth over. 

I. BACKGROUND 

As I have noted in a prior paper for the Academy, many issues in a 

multinational bankruptcy case require two distinct choice-of-law analyses: one to 

determine the proper nonbankruptcy law and the other to choose the applicable 

bankruptcy law. 6 Thus, for example, nonbankruptcy law might determine if a party 

has a valid contract claim against the debtor in bankruptcy, while bankruptcy law 

would determine the priority, if any, that claim would receive in a bankruptcy 

distribution. The contract law would be chosen by "the proper law of the contract" 7 

in most cases, while the choice of applicable bankruptcy law would depend on 

whether the jurisdiction followed a more territorial or a more universalist approach 

in multinational bankruptcy cases. 8 

II. 

FRAMING THE PROBLEM 

A. Choice of Bankruptcy Law 

The ancient law review article I mentioned above was devoted exclusively to 

the second determination, the choice of bankruptcy law. In that article, I surveyed 

the few existing cases concerning choice of law for avoidance actions and performed 

2. Jay L. Westbrook, Choice of Avoidance Law in Global Insolvencies, 17 BROOK. J. INT'L L. 499 

(1991) [hereinafter Westbrook, Global]. 

3. In re French, 440 F.3d 145, 148 (4th Cir. 2006), cert. denied, 127 S. Ct. 72 (2006). 

4. In re Midland Euro Exch. 347 B.R. 708, 708-09 (Bankr. C.D. Cal. 2006). 

5. Al Sabah v. Grupo Torras S.A. [2005] UKPC 1, [2005] 2 W.L.R. 904. 

6. Jay Lawrence Westbrook, Universalism and Choice of Law, 23 PENN ST. INT'L L. REV. 625 (2005) 

[hereinafter Westbrook, Universalism]. Cf In re Aerovias Nacionales de Colombia S.A. Avianca and 

Avianca, Inc., 345 B.R. 120 (Bankr. S.D.N.Y. 2006) (applying nonbankruptcy law of Columbia, without 

noting the bankruptcy/nonbankruptcy distinction). 

7. Westbrook, Universalism, supra note 6, at 634. 

8. See generally, AM. LAW INST., PRINCIPLES OF COOPERATION AMONG THE NAFTA COUNTRIES 8 

(2003) [hereinafter ALI Principles] (I had the privilege of serving as the U.S. Reporter for the project). See 

also Jay Lawrence Westbrook, A Global Solution to Multinational Default, 98 MICH. L. REV. 2276, 2297 

(2000); Donald T. Trautman, Jay Lawrence Westbrook & Emmanuel Gaillard, Four Models for 

International Bankruptcy, 41 AM. J. COMP. L. 573, 576-78 (1994)[hereinafter Four Models]; Evelyn H. 

Biery et al., A Look At Transnational Insolvencies And Chapter 15 Of The Bankruptcy Abuse Prevention 

And Consumer Protection Act Of 2005, 47 B.C. L. REV. 23, 26-30 (2005). Lord Hoffman has recently 

written an eloquent and insightful statement of the basis for a universalist approach. Cambridge Gas 

Transport Corporation v. The Official Committee of Unsecured Creditors (Navigator Holdings PLC) 

[2006] UKPC 26, paras. 16-20 (appeal taken from Isle of Man). 


2007 

AVOIDANCE OF PRE-BANKRUPTCY TRANSACTIONS 

a detailed analysis as to the choice of the proper avoidance law in multinational 

cases. I refer the reader to that article for a more elaborate discussion. 

Because all three of the recent cases have involved what Americans would call 

a "fraudulent conveyance," I will focus on that aspect of the problem. We start with 

the fact that a court following a traditional territorial approach to multinational 

bankruptcies will have difficulty fashioning a defensible choice-of-law rule for 

avoidance of multinational transactions. Territorialists grab what local assets are 

available and apply local law to them. They then distribute any proceeds of an 

avoiding action under the local priority system.' They would normally not seek to 

recover assets located in foreign jurisdictions, but they may control assets that have 

arguably been transferred in fraud of creditors. The literature does not reveal any 

coherent approach to the application of foreign avoidance law under a territorialist 

system. 

However, courts in the United States and a number of other countries are 

moving in the direction of a modified universalism in multinational bankruptcies, 

seeking to cooperate with other courts in achieving a pragmatic result as close as 

possible to the ideal of a single worldwide proceeding." Those courts are forced to 

consider which country's bankruptcy laws should be applied to a particular issue in a 

multinational bankruptcy system. For example, if a creditor subject to personal 

jurisdiction in two countries, such as a multinational bank, engages in behavior that 

violates the moratorium (stay) of the country where a bankruptcy proceeding is 

pending, yet the behavior takes place entirely in the second country where there is 

no proceeding, which law should apply to the creditor's conduct? 

The most difficult choice-of-law issue is determining which avoidance law to 

apply to a given pre-bankruptcy transaction. The first step in fashioning a sound 

approach is to understand that the avoidance provisions in every country reflect a 

balance between two conflicting values: 

a) the need to return to the estate certain property transferred prior to 

bankruptcy for redistribution according to the statutory scheme of priority; 3 

b) the need to avoid imposing too much uncertainty in the marketplace with 

regard to transactions that are normally unobjectionable. 

Countries draw the balance quite differently at the margins. Almost all 

bankruptcy laws would permit avoidance of a gift given with the intent to evade 

creditors at a time when the transferor was insolvent and the transferee had the 

9. See generally Lynn M. LoPucki, The Case for Cooperative Territoriality in International Bankruptcy, 

98 MICH. L. REV. 2216, 2218-21 (2000). 

10. Id. at 2219. 

11. See ALI Principles, supra note 8, at 3. But see McMahon v. McGrath (In re HIH Casualty and 

General Insurance Ltd.) [2006] EWCA (Civ) 372, [2006] All. E.R. (D) 65 (Jun) (denial of cooperation with 

Australian reorganization scheme). 

12. ALI Principles, supra note 8, Principle 5 and Illus., at 49-50. 

13. This factor is often stated as satisfying the goal of "equality of distribution," but in fact distribution 

is highly unequal in all systems because of statutory priorities. At most, equality means nondiscrimination 

within a class of creditors. See R. J. Mokal, CORPORATE INSOLVENCY LAW: THEORY AND APPLICATION 

xx (2005); L. C. Ho, On Pari Passu, Equality and Hotchpot in Cross-Border Insolvency, 1 LLOYD'S MAR. & 

COMMERCIAL LAW QUARTERLY 95, (2003), 5-7, available at 

http://papers.ssrn.com/sol3/papers.cfm?abstract-id=365660; Westbrook, Global, supra note 2, at 506-07. 



VOL. 42:899 

intent to cooperate in the evasion. 14 However, jurisdictions are sharply divided as to 

the relevance of the transferee's state of mind-some regarding it as a crucial 

element or defense, while others are prepared to avoid the transfer regardless of the 

transferee's knowledge or intent. 5 Where there is some consideration for a transfer 

by an insolvent, but what the transferor gets falls well short of equaling the value of 

the property, some laws would make avoidance dependent upon the state of mind 

and knowledge of the transferor, the transferee, or both. 6 Other laws (for example, 

the Bankruptcy Code in the United States 7 ) would for the most part ignore the state 

of mind of either party in determining avoidability. 

The case for avoidance is often compelling. A pre-bankruptcy transfer by an 

insolvent debtor for little or no consideration may well impact the rights of creditors 

in a serious way and often will be ill-motivated in fact. On the other hand, 

fraudulent conveyance laws often reach far back in time, and avoidance of a transfer 

made to an innocent party years before bankruptcy may impose a serious and costly 

uncertainty on the market and be seen as quite unfair to the transferee.' 8 

It will fairly often be true that one country with significant contacts with a 

payment or other transaction would hold it avoidable while a second relevant 

country would not. In this common situation, which law should be applied? I have 

argued that those courts following the approach of modified universalism should 

apply the avoidance law of the debtor's home country. 9 In broad and brutal 

summary of a complex analysis, there are two key reasons for this conclusion. The 

first reason is that no other rule can be predictable and transparent in its 

application. 0 The modern conflicts literature has long since demonstrated that a rule 

depending on the "place" in which the transaction occurred is manipulable and 

unpredictable. 2 ' In every difficult case, the transaction has elements in more than 

one jurisdiction; therefore, it is easy to choose either place as the relevant location 

and apply its law. 

In reaction to this defect, modern conflicts analysis looks at significant conflicts 

and the interests of the states involved. 22 However, modern analysis applied on a 

case by case basis can also raise serious problems of predictability, 23 making it hard 

for parties to know if their transactions might run afoul of bankruptcy laws in 

14. See generally J. H. DALHUISEN, DALHUISEN ON INTERNATIONAL INSOLVENCY AND 

BANKRUPTCY, Vol 1, Part II, § 1.01 (1986). I deliberately write a bit loosely, because the various laws are 

endlessly nuanced as to intent and knowledge. 

15. ld. at § 1.04. 

16. Id. 

17. 11 U.S.C. §§ 548, 550 (2006). 

18. One might think of the debtor's children being asked to return their bicycles, dolls, and action 

figures-but, then again, one might think of the debtor's spouse being allowed to keep a chateau in the 

south of France. 

19. See Westbrook, Global, supra note 2, at 500. 

20. Id. at 530. 

21. RUSSELL WEINTRAUB, COMMENTARY ON THE CONFLICT OF LAWS § 1.5 (2001); LUTHER L. 

McDOUGAL, III, ROBERT L. FELIX, RALPH U. WHITTEN, AMERICAN CONFLICTS LAW § 2 (2001). 

22. See BRAINERD CURRIE, SELECTED ESSAYS ON THE CONFLICT OF LAWS 180 (1963). 

23. See Jay Lawrence Westbrook, Extraterritoriality, Conflicts of Laws, and Transnational Regulation 

of Business, 25 TEX. INT'L L. J. 71, 87 (1990) [hereinafter Westbrook, Extraterritoriality]; Ralph U. Whitten, 

U.S. Conflict-of-Laws Doctrine and Forum Shopping, International and Domestic (Revisited), 37 TEX. 

INT'L L. J. 559, 572 (2002); Ralph U. Whitten, Curing the Deficiencies of the Conflicts Revolution: A 

Proposal for National Legislation on Choice of Law, Jurisdiction, and Judgments, 37 WILLAMETrE L. REV. 

259, 277 (2001). 


2007 


another country. A home-country rule provides the best result we can currently 

hope to achieve in that it is relatively difficult to manipulate and produces 

reasonably predictable outcomes. 24 No other approach can produce as good results 

at an acceptable cost. 25 

The second reason for applying home-country law turns on the fact that the 

whole purpose of avoiding powers in a bankruptcy proceeding is to redistribute the 

debtor's assets according to certain statutory priorities. 26 Because of the link 

between avoidance and priority, an interests analysis supports a home-country rule. 

Let's take the example of a transfer of personal property made by X, a citizen and 

resident of Country A, to Y, a citizen and resident of Country B. At all times the 

property is located in Country B. Shortly after the transfer, X files for bankruptcy in 

Country A. There is no bankruptcy filed as to X in Country B. The bankruptcy law 

of Country A provides that all bankruptcy distributions will go to Creditor Group 1, 

including all proceeds of avoidance actions. Country B's bankruptcy law gives all 

such distributions to Creditor Group 2. The transfer is not avoidable under the laws 

of Country A, but is avoidable under the laws of Country B. We may also assume 

that there are creditors from each creditor group in each of the two countries. 

In this situation, it seems obvious that the Country A court should refuse a 

request by X's trustee in bankruptcy to avoid the transaction. It cannot be avoided 

under the local law in Country A. If the Country A bankruptcy court avoids the 

transfer by applying the law of Country B, the result would be a windfall for 

Creditor Group 1, even though neither country would avoid the transaction for the 

benefit of Group 1. Nothing would go to Creditor Group 2 because of the priority 

24. Professor LoPucki would disagree, because he regards the home-country court determination as 

inherently unpredictable. Lynn M. LoPucki, Universalism Unravels, 79 AM. BANKR. L.J. 143, 158-59 

(2005). I have suggested that modified universalism increases the predictability of the forum that will be 

chosen, and therefore the law that will be applied, even though it falls well short of the universalist ideal. 

Jay Lawrence Westbrook, Multinational Financial Distress: The Last Hurrah Of Territorialism, 41 TEX. 

INT'L L.J. 321, 327 (2006); Jay Lawrence Westbrook, Locating the Eye of the Financial Storm, 32 BROOK. 

INT'L L.J._(forthcoming 2007) (copy on file with the author) [hereinafter Westbrook, Storm]. 

25. It must be conceded that a fairly predictable result might be obtainable by adopting the 

unfortunate rule in the European Insolvency Regulation, but only at a considerable cost. Commission 

Regulation 1346/2000, art. 13, 2000 O.J. (L 160) 1. The effect of the rule is that the transaction will often 

escape avoidance unless it would be avoidable under the laws of both the home country and the country 

whose laws otherwise govern the transaction. (The actual language is opaque, but the foregoing is a 

reasonable interpretation). See Miguel Virgos & Etienne Schmidt, Report on the Convention on 

Insolvency Proceedings, paras. 35-39. The effect of such a rule must be to narrow greatly the applicability 

of the avoiding powers and thus weaken the policies of fairness and priority that underlie them. 

Westbrook, Global, supra note 2, at 519, n.82; Four Models, supra note 8, at 586. 

26. Professors Duggan and Telfer, discussing Canadian law, draw a sharp distinction between 

preference and fraudulent conveyance law. Canadian Preference Law Reform, 42 TEX. J. INT'L L.J. 661 ( 

2007). They view the former as having the purpose stated in the text, but understand fraudulent 

conveyance law to be directed at protecting each individual creditor against debtor wrongdoing. While I 

agree with them with regard to fraudulent conveyance laws operative outside of bankruptcy. See 

DALHUISEN, supra note 14. 1 think the purpose of fraudulent conveyance avoidance in bankruptcy 

necessarily becomes collective and focused on the publicly determined priority system. Our views may 

differ in part because in the United States preference recovery is also available outside of bankruptcy as 

against insiders, removing one of the distinctions that influences their views. Unif. Fraudulent Transfer 

Act § 5(b). 7A U.L.A. 2 (2006). In addition, the seminal fraudulent conveyance case, Twyne's Case, 3 

Coke 806, 76 Eng. Rep. 809 (1601), involved a preferential payment, as did the famous (or infamous) case 

of Dean v. Davis in the United States Supreme Court, 242 U.S. 438 (1916). Those cases suggest the close 

association of the two doctrines, even though they have diverged in many ways. 



VOL. 42:899 

system in Country A. The lawmakers in Country A expressly decided that avoidance 

in such a case as this would impose excessive costs on the commercial community, 

even though the result would benefit their favored Creditor Group 1. On the other 

hand, the lawmakers in Country B overcame any concerns about commercial effects 

because of the perceived importance of protecting Creditor Group 2. They seem to 

have no concern for Creditor Group 1. Country B lawmakers might even protest 

imposing costs on their commercial community to produce proceeds for Group 1. 

Neither country's interests would be served by applying Country B's avoidance law 

in this case. If we make Creditor Group I secured creditors and Group 2 employees 

or taxing authorities, the example is not unrealistic, albeit greatly simplified. 

This example illustrates that the best rule for choice of avoiding powers is the 

law of the country that will distribute the proceeds of any avoidance recovery. 7 In 

an ideal universalist system, that court would be the home-country court for all 

creditors throughout the world. Thus the powers would be used when the recoveries 

would benefit those who were given priority under the home-country's laws. But 

universalism is currently only an ideal. A pragmatic court committed to modified 

universalism, such as we find in the United States, should try to come as close to the 

universalist result as it practically can. " Thus, it should generally choose the 

avoiding power of the home-country court: the transaction is avoidable if, and only 

if, it is avoidable under home-country law. Only one of the three cases I discuss 

came to that result, although it has the most important precedential force under 

United States law. 

B. Nonbankruptcy Law 

Ordinarily, this part of the analysis follows the same path as in a nonbankruptcy 

context, using the choice-of-law rules generally applied in the jurisdiction to 

determine if local law or some other law should apply to the nonbankruptcy 

elements of the case. As noted above, in the instance of an ordinary contract claim 

filed in the bankruptcy case, the proper law of the contract determines the validity 

and amount of the claim, while bankruptcy law determines its priority. 29 

Occasionally, the problem becomes more complicated because the bankruptcy 

law reflects a policy different from nonbankruptcy law. For example, in a purely 

domestic case within the United States, nonbankruptcy law may give landlords a 

much bigger claim than United States bankruptcy law will permit." The bankruptcy 

law simply overrides the nonbankruptcy law in that case. But if the nonbankruptcy 

law is that of another country, the correct answer may not be so clear. The French 

case does not appear to raise such an instance, but it suggests how the problem can 

arise. I will address that point later in this article. 

27. This article does not address the particularly tricky problem that arises when the debtor's COMI 

has allegedly changed since the transfer under attack. For a general discussion of COMI and its 

manipulation, see Westbrook, Storm, supra note 24, at 24-25. 

28. One example of a pragmatic exception would be a refusal to avoid a payment to a small local 

creditor in another jurisdiction, where local interests might be too gravely hurt by the threat of distant 

litigation. Westbrook, Global, supra note 2, at 531. 

29. Westbrook, Universalism, supra note 6, at 634. See generally Rosalind Mason, Choice of Law in 

Cross-Border Insolvencies: Matters of Substance and Procedure, 9 JNSOLV. L.J. 69 (2001). 

30. United States Bankruptcy Code, 11 U.S.C. § 502(b)(6) [hereinafter BC] (limiting the amount a 

lessor may claim in bankruptcy). 


2007 


A second relevance of nonbankruptcy law is found in avoidance statutes that 

may be used without a pending bankruptcy proceeding. A well-known example is 

the Uniform Fraudulent Transfer Act 3 ' in the United States. It is a uniform law 

adopted in most states that can be used by a single creditor to avoid a fraudulent 

conveyance and to reap the recovery for the payment of that creditor's debt. I 

address that wrinkle in the discussion of Al Sabah below. 

III. THE FRENCH CASE 32 

The facts in French were simple. Mrs. French gave the deed to her Bermuda 

real estate to her children at a Christmas party in 1981. However, the children failed 

to record the deed at that time, apparently to avoid taxes. In mid-2000, the children 

became concerned about her declining financial situation and filed the deed. Mrs. 

French then became the subject of an involuntary Chapter 7 (liquidation) petition in 

October of that year. Her trustee in bankruptcy brought an action to avoid the 

transfer as a fraudulent conveyance. 3 All the parties were citizens and residents of 

the United States at all times. 34 

Because the United States Bankruptcy Code treats the transfer as having 

occurred on the date of recordation, the transfer fell within the one-year avoidance 

period for fraudulent conveyances under section 548 of the Code. 35 The trustee in 

bankruptcy apparently did not claim an actual intent to defraud creditors, but rather 

"constructive fraud," similar to the British idea of a "transaction at an undervalue." 36 

Absent actual intent to defraud, the most commonly invoked avoidable conveyance 

attack in the United States contains two required elements: the debtor-transferor 

was insolvent at the time of the transfer and the transfer was for less than 

"reasonably equivalent value. 3 7 Here both elements were conceded. Thus if section 

548 applied to this transaction, it was voidable and the transferees could be required 

to reconvey the property to the trustee in bankruptcy. 38 On the other hand, it was 

assumed that Bermuda law required an actual intent to defraud creditors as a 

condition of avoidance of a conveyance, so the transfer would not be avoidable if 

Bermuda law applied. 

The Court of Appeals affirmed the actions of the lower courts by finding that 

United States law applied and the transaction should be avoided. In determining 

that the United States fraudulent conveyance provision applied to the transfer of the 

31. Unif. Fraudulent Transfer Act, ULA § 7(a)(1), 7A U.L.A. 2 (2006). 

32. In re French, 440 F.3d 145 (4th Cir. 2006), cert. denied, 127 S. Ct. 72 (2006). 

33. Id. at 148-49. 

34. Id. at 150. 

35. 11 U.S.C. § 548(a)(1) (one-year reachback when the French bankruptcy was filed; now two years). 

Section 548(d)(1) of the Bankruptcy Code provides that, for the purposes of section 548, a transfer takes 

place when it is so "perfected" that it cannot be attacked under non-bankruptcy law by a bona fide 

purchaser for value. It appears there was no dispute in French about the fact that this transfer would be 

held to be within a year of the October, 2000, petition, so presumably recordation is necessary under 

Bermuda law to prevent attack on a transfer by a bona fide purchaser. Thus Bermuda nonbankruptcy law 

was tacitly applied as to the perfection of a real estate transfer. 

36. French, 440 F.3d at 148. 

37. 11 U.S.C. § 548(a)(1)(B). Other grounds include undercapitalization. 

38. 11 U.S.C. § 550(a)(1). 



VOL. 42:899 

Bermuda property, the court focused on the applicability of the "presumption 

against extraterritorial effect" and on comity among courts.39 

A. The Presumption Against Extraterritoriality 

It is worth noting that the court implicitly began with the assumption that 

section 548 applies in any United States bankruptcy case. It then had to determine if 

that assumption was inaccurate here because of the so-called presumption against 

extraterritoriality. The United States Supreme Court has said the presumption 

represents a "longstanding principle of American law 'that legislation of Congress, 

unless a contrary intent appears, is meant to apply only within the territorial 

4° 

jurisdiction of the United States.' The Court's rule could be understood as 

requiring Congress to state explicitly that each provision it enacts applies to foreign 

transactions if it wishes that provision to have effect where any foreign element is 

found. 4 ' However, the lower courts have generally interpreted the presumption 

more narrowly. 42 They have done so in two ways. First, they have applied a choiceof-law 

analysis to determine if the conduct is "extraterritorial." If not, the 

presumption does not apply. 3 Second, they have held the presumption to be 

overcome where they find that Congress intended the provision to apply on the facts 

presented. They ascertain the Congressional intent from the language of the 

provision and from the policy behind the provision. ' The French court used both 

methods. 

1. Significant Contacts 

The court first counted and weighed contacts in classic American choice-of-law 

analysis. It found that the great majority of important contacts were in the United 

States, including the parties, the bankruptcy case, and all but one creditor. 46 On that 

basis, it was inclined to find that the transfer was not extraterritorial; therefore, the 

presumption did not apply, leaving section 548 applicable as in any domestic case. 7 

However, it was troubled by the presence of one significant contact on the Bermuda 

side: the property in question was Bermuda real estate. 4s For obvious and sensible 

39. French, 440 F.3d at 149. 

40. Equal Employment Opportunity Comm. v. Arabian American Oil Co., 499 U.S. 244, 248, 111 

S.Ct. 1227, 1230, 113 L.Ed.2d 274 (1991) ("Aramco") (quoting Foley Bros., Inc. v. Filardo, 336 U.S. 281, 

285, 69 S.Ct. 575, 577-78, 93 L.Ed. 680 (1949)). See generally William S. Dodge, Understanding the 

Presumption Against Extraterritoriality, 16 BERKELEY J. INT'L L. 85 (1998). 

41. But see Hartford Fire Ins. Co. v. California, 509 U.S. 764, 813 (1993); Smith v. United States, 507 

U.S. 197 (1993). See generally David M. Green & Walter Benzija, Spanning the Globe: The Intended 

Extraterritorial Reach of the Bankruptcy Code, 10 AM. BANKR. INST. L. REV. 85 (2002). 

42. See Dodge, supra note 40, at 95-98. 

43. In re Interbulk, 240 B.R. 195, 199 (Bankr. S.D.N.Y. 1999); In re Florsheim Group, Inc., 336 BR. 

126 (Bankr. N.D. Ill. 2005) (in preference action contact counting showed center of gravity in United States 

where title passed in the United States and payment made from the United States). 

44. In re French, 440 F.3d 145, 151-2 (4th Cir. 2006), cert. denied, 127 S. Ct. 72 (2006). 

45. WEINTRAUB, supra note 21, § 1.5; McDOUGAL, supra note 21, § 84. See also In Regus Business 

Centre Corp., 301 B.R. 122 (Bankr. S.D.N.Y. 2003). 

46. French, 440 F.3d at 150. 

47. Id. 

48. Id. 


2007 


reasons, all choice-of-law rules recognize that real estate is almost always governed 

by the law of its location. 9 Yet it is also clear that this rule is not absolute. So, for 

example, decisions in domestic relations cases have applied the law of the domicile 

of the marriage to questions of ownership of real estate as between husband and 

wife." Nonetheless, the court was sufficiently concerned about the countervailing 

weight of the real estate rule that it turned to the second argument for finding the 

presumption inapplicable: the wording and policy of the Bankruptcy Code." 

2. Congressional Intent 

The discussion of the Code was largely a restatement of the contacts counting 

and weighing discussion that preceded it. That part of the court's discussion was of 

limited analytical value. The interpretive ground for avoiding the presumption is 

not, after all, about choosing one law or the other; instead, it rests on whether the 

Congress intended this United States law to apply under these circumstances. If not, 

no choice of law is presented. The analysis should turn on whether a Congress 

anxious to undo fraudulent conveyances would want to permit them whenever the 

property involved was foreign real estate, but the court did not focus on that specific 

question. 

On the other hand, a close examination of the statutory language was more 

fruitful. The court worked through section 541(a)(1) of the Bankruptcy Code, which 

defines property of the bankrupt estate in the broadest possible terms, 52 and section 

1334 of Title 28 of the United States Code, which gives the bankruptcy courts 

jurisdiction of "all property, wherever located, of the debtor." 53 The awkwardness of 

that phrase reflects the fact that "wherever located" was added to the bankruptcy 

law precisely to make it clear that the United States bankruptcy courts were to claim 

worldwide jurisdiction of the debtor's property, 4 without distinction between real 

and personal property (immovables and movables). The court reasonably concluded 

that the combination of these two provisions demonstrated Congress' intent to 

include the debtor's worldwide property in the estate, and therefore, that they likely 

intended to include foreign property transferred before bankruptcy within the reach 

of the bankruptcy avoidance powers. 55 That conclusion was buttressed by a similar 

analysis by the Fifth Circuit Court of Appeals, albeit in a different context. 6 

Oddly enough, neither the Fourth nor the Fifth Circuits cited or discussed 

section 541(a)(3) of the Bankruptcy Code which explicitly includes in the property of 

49. WEINTRAUB, supra note 21, § 8.2; MCDOUGAL, supra note 21, § 153. 

50. See WEINTRAUB, supra note 21, § 8.14. 

51. But see In re Florsheim Group, Inc., 336 B.R. 126 ((Bankr. N.D. Ill. 2005) (will not reach the 

presumption issue if center of gravity of transfer in United States). 

52. 11 U.S.C. § 541(a)(1) (2006). 

53. 28 U.S.C. § 1334(e)(1) (2006). 

54. See, e.g., In re Globo Comunicacoes E Participacoes S.A. (Globopar), 317 B.R. 235, 250-51 (2004); 

see generally, Pub. L. No. 95-598, § 541, 92 Stat. 2594 (1978); K. Nadelman, Revision-of Conflicts Provisions 

in the American Bankruptcy Act, 1 INTL COMP. L.Q. 484, at 484-86 (1952) [hereinafter Nadelman, 

Revision]; K. Nadelman, The National Bankruptcy Act and the Conflict of Laws, 59 HARV. L. REV. 1025 

(1946) (discussing the uncertainty that existed before the Bankruptcy Act of 1952 regarding whether 

property located abroad was part of the bankruptcy estate under American law). 

55. In re French, 440 F.3d 145 (4th Cir. 2006), cert. denied, 127 S. Ct. 72 (2006). 

56. Cullen Ctr. Bank & Trust v. Hensley (In re Criswell), 102 F.3d 1411, 1417 (5th Cir.1997). 



VOL. 42:899 

the estate all property that the trustee in bankruptcy recovers under the avoiding 

powers. That provision strongly suggests that Congress intended the reach of those 

powers to be co-extensive with the broad, global embrace of its definition of estate 

property, although the bankruptcy court in Midland disagreed." 

3. Comity 

Having determined that section 548 did apply to the transfer of the Bermuda 

property, the French court then turned to the defendants' argument that "comity" 

required the court to defer to Bermuda law. 8 The court's rejection of the argument 

involved going back through the same contact-counting and weighing it had done 

twice before. 59 

This sort of unhelpful comity analysis arises from a confusion of the roles of the 

comity doctrine and choice-of-law rules. A full treatment of that subject would be 

another article, but a brief discussion is warranted. Generally, comity is a doctrine of 

deferral to the actions of a foreign court while choice-of-law rules govern deferral to 

the laws of a foreign state. The confusion between deferring to judicial actions and 

deferring to statutes arose at the start in the classic formulation in Hilton v. Guyot.,o 

In that case, the United States Supreme Court defined comity broadly: 

"Comity," in the legal sense, is neither a matter of absolute obligation, on 

the one hand, nor of mere courtesy and good will, upon the other. But it is 

the recognition which one nation allows within its territory to the 

legislative, executive, or judicial acts of another nation, having due regard 

both to international duty and convenience, and to the rights of its own 

citizens, or of other persons who are under the protection of its laws. 

Notwithstanding the formulation in Hilton, comity has been used primarily in 

the context of enforcement of judgments-the issue presented in Hilton-or other 

situations, like parallel litigation, in which the United States courts have decided to 

defer to the actions of foreign courts. 62 That application is far preferable to using 

comity as a choice-of-law rule, because the comity doctrine has both the virtues and 

the deficiencies of a highly flexible, case-by-case doctrine. That flexibility is just 

what is needed for deference to foreign courts, while choice-of-law rules should 

strive for some level of generality and predictability. 63 

57. In re Midland Euro Exch., 347 B.R. 708, 720 (Bankr. C.D. Cal. 2006). 

58. French, 440 F.3d at 152. 

59. Id. at 153-54. 

60. Hilton v. Guyot, 159 U.S. 113,141 (1895). 

61. Id. at 163-64 (emphasis added). 

62. See generally Steven R. Swanson, The Vexatiousness of a Vexation Rule: International Comity and 

Antitrust Injunctions, 30 G.W. INT'L L. & ECON. 1 (1996); Louise Ellen Tietz, Both Sides of the Coin: A 

Decade of Parallel Proceedings and Enforcement of Foreign Judgments in Transnational Litigation, 10 

ROGER WILLIAMS U. L. REV. 1, at 9-10 (2004); Joel R. Paul, Comity in International Law, 32 HARV. INT'L 

L. J. 1, at 2 (1991); Molly Warner Lien, The Cooperative and Integrative Models of Judicial Comity: Two 

Illustrations Using Transnational Discovery and Beard Scenarios, 50 CATH. U. L. REV. 591 (2001); Michael 

D. Ramsey, Escaping International Comity, 83 IOWA L. REV. 893 (1998). 

63. See generally, Westbrook, Extraterritoriality, supra note 23, at 75. 


2007 


The confusion between these two uses of comity is sadly illustrated by the 

decision in Maxwell,' 4 still the classic case for choice of avoidance law in the United 

States courts. 5 In that case, the debtor filed for bankruptcy in both the United 

Kingdom and the United States, although de facto the two courts agreed to treat the 

United Kingdom as the home-country court.' The upshot of the case was a 

worldwide liquidation plan, perhaps the first such plan ever achieved. But an 

important legal issue remained unresolved even after the plan was adopted. The 

debtor had made substantial payments to its lenders shortly prior to its twin 

bankruptcy filings. 67 It was conceded that the payments would be recoverable from 

the lenders as avoidable preferences under United States bankruptcy law, but would 

not be recoverable under United Kingdom law.' The joint administrators brought 

suit to recover the payments under United States law. 69 The bankruptcy court found 

that United Kingdom law applied and dismissed the suit.' The district court and 

court of appeals affirmed. 7 ' 

The two lower courts addressed the choice-of-law problem by counting and 

weighing contacts to determine if the presumption against extraterritoriality applied 

in that case; they found it did and dismissed. 72 The court of appeals seemed to agree 

with that approach, but then veered off sharply, resting its affirmance not on the 

choice-of-law analysis, but on comity. 73 It was persuaded that the overall good result 

in the case, marked by wonderful cooperation between the courts of the two 

countries, suggested that the United States should defer to the English courts (and 

therefore the English law) as a matter of comity." The result was to aggravate the 

confusion between choice of law and comity as a ground for applying foreign law. 

There was no similar element in the French case. There was apparently no 

proceeding of any kind in Bermuda with which to cooperate or to which to defer. 

Thus, the comity discussion in French was simply off the point. The succinct and 

well-reasoned opinion in 

75 

another recent international preference case, Florsheim, 

noted that no parallel proceeding was pending in another country, but still discussed 

choice-of-law policies a second time in the context of comity. The only effect of this 

approach is to create a risk of confusion and error. 

64. In re Maxwell Commc'cns Corp., 93 F.3d 1036 (1996). See generally Jay Lawrence Westbrook, 

The Lessons of Maxwell Communications, 64 FORDHAM L. REV. 2531 (1996); Paul L. Lee, Ancillary 

Proceedings Under Section 304 and Proposed Chapter 15 of the Bankruptcy Code, 76 Am. Bankr. L. J. 115, 

154-155 (2002); David Costa Levenson, Proposal for Reform of Choice of Avoidance Law in the Context of 

International Bankruptcies from a U.S. Perspective, 10 AM. BANKR. INST. L. REV. 291, 338-340 (2002). 

65. For this confusion, see also In re PSINet Inc., 268 B.R. 358 (2001) (choice-of-law issue discussed as 

comity question per Maxwell). 

66. The company's headquarters were in England but its largest subsidiaries were in the United 

States, so either country could make a claim to be its home country. See Westbrook, Maxwell, supra note 

64, at 2541, n.44; Westbrook, Universalism, supra note 6, at 635, n.42. 

67. Maxwell, 93 F.3d at 1041. 

68. Id. at 1043. 

69. Id. 

70. Id. at 1044. 

71. Id. at 1044, 1054-55. 

72. Maxwell, 93 F.3d at 1044. 

73. Id. at 1046-50. 

74. Id. at 1053. 

75. In re Florsheim Group, Inc., 336 B.R. 126, 133 (Bankr. N.D. Il. 2005) 



VOL. 42:899 

IV. MIDLAND 

In Midland, 76 the United States debtor ran a Ponzi scheme, which meant that 

all its transfers were presumptively made with fraudulent intent under United States 

law. The trustee in bankruptcy sought to avoid about $900,000 in transfers to 

"SFC," an English company based in London." The transfers were made from the 

London account of the debtor's Barbados subsidiary to the New York account of 

SFC, although the money ended up back in London. 78 It was agreed that if section 

548 of the Bankruptcy Code applied, the transfer was likely avoidable, but that it 

was unlikely to be avoidable under English law, which required that the trustee show 

that SFC, as transferee, had a guilty state of mind. 79 The analysis of the case was (or 

should have been) complicated by the fact that the corporate group was 

substantively consolidated in the United States bankruptcy proceeding., 

For some reason the trustee in bankruptcy conceded that avoidance would 

require extraterritorial application of section 548. 8 ' Thus, the court had only to 

mention in passing the English contacts with the transaction. With the trustee's 

concession, the court had no difficulty in determining that the presumption against 

extraterritoriality applied, and United States avoidance law could not be used; hence 

the transfer was not avoidable.' As the earlier analysis suggested, it seems to me 

that the so-called presumption is really code for a choice-of-law analysis, so 

conceding that point dictates the conclusion: if the challenged transaction was so 

predominantly connected with England that English law should be applied, one can 

feel comfortable that Congress would not have intended to apply United States law. 

If it were much more connected with the United States, as in French, then the court 

should reasonably conclude Congress likely intended to apply United States law. 

The merit of that analysis is illustrated by the Midland court's note that the 

result was bad policy, vindicating dishonest conduct by debtors. 83 Why ascribe bad 

policy to Congress by saying United States avoidance law does not apply? If good 

policy would be application of United States law, then it should be applied as 

Congress would wish. If, on the other hand, a choice-of-law analysis leads to the 

conclusion that English law and policy should apply, then that jurisdiction's 

balancing of fraud recovery versus transactional stability should rightly prevail. The 

result is good United States policy in that we properly vindicated our ally's 

commercial policy in a circumstance where it had more at stake than we did. Thus, 

we come back always to choice of law. 

From my perspective, the key point is the identity of the debtor. If we ignore 

substantive consolidation in this case," and take the debtor's home country ("center 

76. See In re Midland Euro Exch., 347 B.R 708, 710-711 (Bankr. C.D.Cal. 2006). 

77. Id. at 713-14. 

78. Id. at 712-13. 

79. Id. at 715. 

80. Id. at 711. Substantive consolidation means that the entire group of companies is treated as if it 

were one debtor company, with both claims and assets pooled in the bankruptcy. 8A C.J.S. Bankruptcy § 

410 (2007). The case presents the complex question of the effect of substantive consolidation on choice of 

avoidance law, a problem we put to one side for present purposes. 

81. Midland, 347 B.R. at 715. 

82. Id. at 720. 

83. Id. at 719. 

84. Substantive consolidation would amount to a finding that the affiliated corporations were 

essentially divisions within the parent corporation, so the corporate form could be ignored. 2-105 COLLIER 


2007 


of main interest")" to be in Barbados, I would apply Barbados law. 86 On the other 

hand, if we take substantive consolidation as representing a finding that the 

subsidiaries in this case were not independent corporations but merely divisions of 

the United States debtor, then the transferor was the debtor, its home country was 

the United States, and section 548 should apply. There would be no theory under 

which English insolvency law would apply in a universalist court on these facts. 

V. AL SABAH 7 

A Kuwaiti sheikh was found liable in an English court for massive frauds.' He 

was a resident of the Bahamas and entered bankruptcy in that jurisdiction. 89 He had 

created two trusts that, at the time of bankruptcy, were governed by Cayman Islands 

law. His trustee in bankruptcy sought to avoid the creation of these trusts as 

"settlements," that is, gratuitous transfers that in the United States would be 

attacked as fraudulent conveyances. 9 " Bahamian law provided for avoidance of such 

settlements, but only if they were created by traders. 91 Being reluctant to litigate the 

question of the debtor's status as a "trader," the trustee wanted to use Cayman 

avoidance law which applied whether the debtor was a trader or not. 92 The 

Bahamian court in the "main proceeding" 93 duly requested that the Cayman court 

permit the trustee to use the Cayman avoiding power to avoid the settlements. The 

Cayman court agreed to apply Cayman law. 94 The case was then appealed to the 

Privy Council, which affirmed the application of Cayman law. 9 " 

Most of the opinion was devoted to a close analysis of statutory provisions 

which need not detain us. The ultimate question was whether a particular provision 

was applicable in Cayman bankruptcy law and whether it operated in substance like 

section 426 of the British Insolvency Act, giving a court broad authority to apply 

local bankruptcy law in favor of a foreign trustee in bankruptcy as if it were being 

ON BANKRUPTCY 105.09 (15th ed. rev.). That finding would negate any finding of that the debtor's center 

of main interest was in Barbados. See generally In re Tri-Continental, 349 B.R. 627 (Bankr. E.D. Cal.). 

85. The phrase identifies the country where pends a "main" or primary bankruptcy proceeding under 

the Model Law on Cross-Border Insolvency, the EU Regulation, and the Code. United Nations 

Commission on International Trade Law (UNCITRAL), Model Law on Cross-Border Insolvency, art. 17, 

§ (2)(a), G.A. Res. 52/158, Annex, art. 10, U.N. Doc. A/RES/52/158 (Jan. 30, 1998); Commission 

Regulation 1346/2000, supra note 25, art. 3.1; 11 U.S.C. 1502 (2006). 

86. I have not researched Barbados law on this point. It is likely to be, although not necessarily, 

similar to English law. 

87. Al Sabah v. Grupo Torras S.A. [2005] UKPC 1, [2005] 2 W.L.R. 904. 

88. Al Sabah v. Grupo Torras S.A., [2000] Court of Appeal (Civil Division), available at 

http://www.ucc.ie/law/restitution/archive/englcases/al-sabah.htm [2000]. 

89. Al Sabah v. Grupo Torras S.A. [2005] UKPC 1, [2005] 2 W.L.R. 904., at 907. It is not clear when 

the debtor became a Bahamian resident and I ignore that point for purposes of this discussion, interesting 

as it is. 

90. There might have been other grounds for attack, but they are not addressed here. 

91. Al Sabah v. Grupo Torras S.A. [2005] UKPC 1, [200512 W.L.R. 904, at 908. 

92. Id. 

93. See United Nations Commission on International Trade Law (UNCITRAL), Model Law on 

Cross-Border Insolvency, art. 17, § (2)(a), G.A. Res. 52/158, Annex, art. 10, U.N. Doc. A/RES/52/158 (Jan. 

30, 1998). 

94. Al Sabah v. Grupo Torras S.A. [2005] UKPC 1, [2005] 2 W.L.R. 904, at 908-09. 

95. Id. at 922. 



VOL. 42:899 

applied in a local bankruptcy proceeding. 96 

Thus, it permitted the Bahamian trustee 

to appear in the Cayman court and invoke the relevant Cayman avoidance power. 

The statutory framework necessarily focused the Privy Council's attention on 

questions of jurisdiction and forum rather than choice of law as such, although the 

effect of the decision was to apply a Cayman avoiding power to obtain a recovery for 

distribution in a Bahamian bankruptcy. 

The choice-of-law question was not an important part of the result. Lord 

Walker's judgment concluded with a brief reference to the admonition in section 

426(5) that the "requested" (Cayman) court take into consideration private 

international law in deciding whether to grant the foreign trustee the use of local 

avoidance powers, but the reference was passing and in the context of an exercise of 

discretion in choice of forum. 97 Thus the choice-of-law result was incidental to those 

other elements. 9 " 

The result of the statutory structure was the merging of choice of forum with 

choice of law and a lack of a place for analysis of the policies at stake in the latter 

choice. 99 Of course, I would argue that Bahamian law should have been applied, and 

thus the trusts would not be avoidable. 0 0 My argument would rest on the disconnect 

between the Cayman avoidance policy and the Bahamian priority and distribution 

policy. The priority rules in the two jurisdictions might differ in ways important in 

this case, just as their avoidance rules do. Bahamian rules might benefit Creditor 

Groups A-D, while Cayman rules might distribute the recovery to Groups C-H. 

With regard to avoidance of settlements, the legislators for the two jurisdictions 

may have come to different conclusions in balancing the risk of fraud on creditors 

versus disruption of ordinary expectations. The legislators for the Bahamas might 

have thought that persons in business (traders) were more likely to be slippery 

rogues, so for their transactions, the risk of fraud outweighed the costs of market 

disruption. If they saw nontraders as less likely to engage in such manipulations, 

they might conclude the balance swings the other way with them. By contrast, the 

legislators for the Cayman Islands may have thought all debtors were inclined to 

trickery in evading creditors. In making their decisions, the Bahamas policy maker 

may have concluded that benefiting the A-D groups of creditors was not worth a 

broad disruption of transactions, while the Cayman Island's policymakers may have 

been anxious to protect the vulnerable C-H groups of creditors entitled to priority 

under Cayman law. Yet the recovery in Al Sabah might flow to Creditor Groups A 

and B, disrupting Cayman transactions for the benefit of creditors whom neither 

policymaker thought important enough to justify that disruption. 

In Al Sabah, the configuration of rules was such that the law applied was that of 

the place of transacting."' In another case, the place of transacting might have the 

96. Id. at 918-20. 

97. Id. at 923. 

98. For the relationship between choice of law and choice of forum, see Jay Lawrence Westbrook, 

Theory and Pragmatism in Global Insolvencies: Choice of Law and Choice of Forum, 65 AM.BANKR.L.J. 

457 (1991). 

99. Something similar seems to have happened in a 2001 Florida bankruptcy case involving German 

and Florida fraudulent conveyance law, although the opinion is too elliptical to be sure of the exact 

holding. In re Wachsmuth, 272 B.R. 766 (Bankr. M.D. Fla. 2001). 

100. I assume for this purpose that the Bahaman Islands were the debtor's center of main interest, as 

the judgment suggests. 

101. More precisely, it was the law under which the trusts were created and the law chosen in the 


2007 


weaker avoidance rule and might have been chosen for trust creation for just that 

reason. Specifically, the next case might involve a Bahamian bankruptcy under 

circumstances where the Bahamian avoidance rule was stronger than the avoidance 

rule in the Cayman Islands where the trusts were created. Of course, the Bahamian 

trustee would not seek help from the Cayman courts in that situation, having the 

stronger rule at home. Would the trustee be permitted to apply the stronger 

Bahamian rule in this new case? If so, then the rule of law would be that a 

transaction will be avoided if it is avoidable under the law of any state with 

reasonable contacts to the transaction or the bankruptcy. Such a general rule strikes 

me as almost as bad as the rule under the European Insolvency Regulation, which 

appears to provide that the transaction is not avoidable unless it would be avoidable 

under both relevant laws." 2 VI. ONE STEP FARTHER 

Two special situations concerning the role of nonbankruptcy law are worthy of 

further discussion, even though they did not arise in any of these cases. In one 

situation, the nonbankruptcy law represents a strong local policy squarely 

inconsistent with the home-country bankruptcy policy, creating a "true" conflict. In 

the second, the nonbankruptcy law is itself an avoidance law, but one that can be 

applied outside of a bankruptcy proceeding. 

A. Conflict Between Avoidance Law and Other Law Governing the Challenged 

Transaction 

There was no indication in French that Bermuda real estate law had any special 

policy against avoidance of a fraudulent conveyance as against a duly recorded deed. 

Indeed, it appeared that Bermuda would avoid such a conveyance if made with 

actual intent to defraud, so any imposition on Bermuda nonbankruptcy law and 

policy by the avoidance of the transfer in French would seem relatively minor. It is 

instructive, however, to consider what might have happened had the case presented 

a substantial conflict of policies between Bermuda real estate law and United States 

bankruptcy law. 

Suppose that Bermuda had a strong rule that record title for real estate was 

controlling: no attack by way of fraudulent conveyance or constructive trust or other 

similar action could undo the effect of a recorded deed. Bermuda might have 

adopted such a rule because much of its property is owned by people in other 

countries, and it might deplore having many foreign avoidance laws, unknown to its 

judges and real estate experts, threaten the integrity of its real estate recordation 

system. Thus it might adopt a nondiscriminatory rule that no avoidance power, 

domestic or foreign, can undo or contravene a deed. Under those circumstances, 

should a. United States court on the facts in French avoid the transfer? If it did, 

would its judgment be enforceable? 

instruments creating the trusts. 

102. Commission Regulation 1346/2000, supra note 25. 



VOL. 42:899 

This circumstance would present what the modern choice-of-law literature calls 

a "true" conflict.' 3 The interests of the two countries are squarely contrary. The 

United States has a substantial interest in protecting the American creditors of this 

American debtor from this fraudulent conveyance. 104 Yet we have supposed that 

Bermuda might also have a powerful and defensible policy reason for its rule. When 

such a conflict is presented, it is most difficult to develop a principled basis for its 

resolution. 0 5 

The universality of bankruptcy should be the trumping principle, a view that 

appears to have been shared by the French court." 6 It underlies the general rule I 

have suggested, that the avoidance law of the home country should generally be the 

law applied. Where the policies of the two jurisdictions are in equipoise, it would 

seem a strong ground for tipping the balance in favor of the home-country rule. 

However, we must also consider the enforceability of the avoidance judgment 

in French. It is well-settled that courts do not ordinarily enter judgments they know 

will be unenforceable. 7 In our hypothetical situation, it seems likely that the 

Bermuda court would refuse to enforce a United States court order transferring the 

deed to the United States trustee in bankruptcy. However, it is quite possible that 

the United States court could achieve its desired result without the intervention of 

the Bermuda court. The United States court could order the United States 

defendants, the record owners of the Bermuda property, to transfer the deed 

themselves. They would presumably be within the personal jurisdiction of the 

United States court and subject to contempt sanctions if they failed to comply. This 

remedy has been used in Europe in similar cases.' 

B. Nonbankruptcy Avoidance Law 

Many jurisdictions have avoidance laws that may be used without depending 

upon the existence of a bankruptcy proceeding. 9 These nonbankruptcy avoidance 

laws require a somewhat different analysis. These laws are intended for the benefit 

of a particular creditor rather than being part of collective enforcement in 

bankruptcy. The key question there is whether a trustee in bankruptcy is authorized 

103. See generally CURRIE, supra note 22; Patrick Borchers, The Choice-of-Law Revolution: An 

Empirical Study. 49 WASH. & LEE L. REV. 357, 361 (1992). 

104. Note that it was a concealed conveyance, not recorded until almost twenty years after it was 

made. We do not know if the French couple carried it on their financial statements or not. 

105. WEINTRAUB, supra note 21, §§ 3.1, 3.6; MCDOUGAL, supra note 21, § 85. One could argue that 

there is no true conflict on the particular facts presented, because there was only one Bermuda creditor of 

the debtor and it would actually benefit from avoidance. Conversely, it appears there were no Bermuda 

creditors of the children/transferees who would have been prejudiced by the re-transfer of the property to 

the debtor's trustee in bankruptcy. On the other hand, the hypothetical Bermuda rule rests on a policy 

relating to real estate deeds generally and that hypothetical policy would have been weakened by the result 

in French, so it seems to me to be a real conflict. 

106. In re French, 440 F.3d 145, 152 (4th Cir. 2006), cert. denied, 127 S. Ct. 72 (2006). 

107. See generally DOUGLAS LAYCOCK, MODERN AMERICAN REMEDIES 855-72 (3d ed. 2002) 

108. See X v. Schenkius (Receiver For Y), Court of Appeal of 'S-Hertogenbosch, 6 July 1993 KG 

1993, 406; NIPR 1993 No. 469; NJ 1994, 250 reported in 42 NETH. INT'L L. REV. 121 (1995), reprinted in 

edited version, Elizabeth Warren & Jay Lawrence Westbrook, THE LAW OF DEBTORS AND CREDITORS 

845 (2005). 

109. J.H. DALHUISEN, DALHUISEN ON INTERNATIONAL INSOLVENCY AND BANKRUPTCY, Vol 1, 

Part 11, § 2..05 (1986). 


2007 


to use such a law by both the bankruptcy laws of the home country and the local 

avoidance law. In the United States, for example, the trustee in bankruptcy is 

authorized to use such statutes enacted under state nonbankruptcy law." 1 Thus in Al 

Sabah, if the Cayman Islands settlement-avoidance law was not part of its 

bankruptcy law, and if the Cayman courts had interpreted their law to permit its use 

by a trustee in bankruptcy, a United States trustee could avoid the settlement under 

Cayman law and distribute the proceeds in the United States proceeding without the 

policy anomalies I have asserted above. The analysis is different from the earlier 

one because the Cayman nonbankruptcy avoidance law would be intended to benefit 

any creditor, not to protect the creditors specified in a bankruptcy distribution 

scheme. Thus, there may be no policy anomaly in distributing the proceeds to 

creditors generally under whatever priority scheme may exist in the home-country. 

VII. CONCLUSION 

The three cases discussed here present interesting factual settings for thinking 

about choice of law for the avoiding powers, although only French really provides a 

rule. It adopts the home-country rule, but without a general theory. Midland turns 

on a trustee's concession and ignores the effect of substantive consolidation, while Al 

Sabah applies a very broad avoidance rule based on a statute that may not have been 

drafted with that result in mind. Thus we still await a case that will give us 

predictable results. 

The power of avoidance actions and the importance of the policies they serve 

make it essential that we move toward a more predictable choice-of-law rule for such 

actions. As things stand, a creditor or other transferee of a cross-border transfer 

faces a risk of action under a law with seemingly little contact with the transaction or 

the debtor. It also faces the risk of liability for the transfer in multiple courts. On 

the other hand, the lack of effective actions to avoid cross-border transfers, including 

enforcement of avoidance judgments in other jurisdictions, offers an opportunity for 

parties to maneuver around the avoidance laws of all the interested jurisdictions, 

defeating their bankruptcy policy goals. 

The home-country rule suggested here is far from perfect and only moderately 

predictable. Anything better must await international agreements that are likely to 

be a long time coming. In the meantime, this choice-of-law rule will bring some 

coherence and a greater possibility of coordination to multinational insolvencies. It 

is a pragmatic goal and an achievable one. 

110. 4 ALAN N. RESNICK ET AL, COLLIER ON BANKRUPTCY, paras. 502.03(2)(a), 502.03(2)(b)(ii). 



The Disappearing Divide Between Property 

and Obligation: The Impact of Aligning Legal 

Analysis and Commercial Expectation 

SARAH WORTHINGTON* 

SUMMARY 

1. EXPANDING THE NOTION OF PROPERTY: TURNING OBLIGATION INTO 

P R O PE R TY ............................................................................................................ 919 

II. ATTRIBUTES SAID TO DISTINGUISH PROPERTY FROM OBLIGATION ........... 923 

A . Property Term inology ................................................................................. 924 

B. The Am bit of Property Rights .................................................................... 924 

C. Property Rights May Take Only a Limited Number of Forms- The 

N um erus C lausus Principle ........................................................................ 925 

D. "Excludability". Property Rights are "Good Against the World ......... 927 

E . P roperty is A ssignable ................................................................................ 927 

F. Property is Accorded Superior Legal Protection ..................................... 928 

G. Property Carries an Entitlement to Proceeds ............................................ 929 

H. Property Rights Run with the "Asset"....................................................... 932 

L Property Rights Attract Insolvency Protection ......................................... 936 

III. 

Is DISAPPEARANCE OF THE DIVIDE BETWEEN PROPERTY AND 

O BLIGATION SIGNIFICANT? ............................................................................... 939 

"There is nothing which so generally strikes the imagination, and engages the 

affections of mankind, as the right of property[]"' 

The thesis of this article is simple and startling: equity, acceding to persistent 

commercial pressure, has effectively eliminated the divide between property and 

obligation, or between property rights and personal rights. Equity has achieved this 

This material was first published in Equity in Commercial Law (Simone Degeling & James Edelman 

eds., Thomson Lawbook Co. 2005), and is republished with very minor amendments here with the 

permission of the publishers and editors. 

1. WILLIAM BLACKSTONE, 2 COMMENTARIES *2. 



VOL. 42:917 

in partnership with the common law and statute, but equity initiated the process and 

played a dramatic and innovative developmental role. 

This idea that there has been a collapse of boundaries is no mean assertion, 

especially given the widely perceived importance of property, and the general 

assumption that there is a sharp doctrinal and functional divide between property 

and obligation. Most lawyers are familiar with Professor Sir Roy Goode's 1987 

article on ownership and obligation. He notes that all legal systems sharply 

distinguish "property rights from mere personal rights to the delivery or transfer of 

an asset. I own property; I am owed performance of a transfer obligation." 2 

Important consequences follow from the distinction, or so we always assume. 

Lawyers are not the only ones to observe the division. Economists, too, are passionate 

advocates:' 

Property rights . . . are among the most critical social institutions, 

providing the basis for resource-use decisions and for the assignment of 

wealth and political power. As such, the property regime profoundly 

influences both economic performance and income distribution in all 

economies. Property rights define the accepted array of resource uses, 

determine who has decision-making authority, and describe who will 

receive the associated rewards and costs of those decisions. Accordingly, 

the prevailing system of property rights establishes incentives and time 

horizons for investment in physical and human capital, production, and 

exchange. Cross-country differences in property rights result in important 

differences in economic development and growth .... The property-rights 

structure is also critical for the environment and natural resource use... 

[and] for establishing and protecting individual social and political rights 

within a society. 4 

All this warms the hearts of property lawyers. But doubts soon surface. Fifteen 

pages later, this same economist notes that "[i]t is useful to view property rights as 

contractual outcomes negotiated by parties . . . ."' And Goode, still focusing on the 

divide between "owe" and "own," observes a mere five pages into his analysis that 

"most obligations owed by B to A to transfer an asset to A are proprietary in nature 

rather than merely personal .... ,6 He puts this down to equitable developments. 

The difficulties are equally clear to many undergraduates. The typical common 

law classification scheme suggests that property is divided into real and personal 

property; personal property is, in turn, divided into choses in possession and choses 

in action (tangible and intangible property respectively). 7 And then comes the rub. 

2. Royston M. Goode, Ownership and Obligation in Commercial Transactions, 103 LAW Q. REV. 433, 

433 (1987). 

3. Gary D. Libecap, A Transactions-Cost Approach to the Analysis of Property Rights, in THE 

ECONOMICS OF CONTRACTS: THEORIES AND APPLICATIONS 140, 140 (Eric Brousseau & Jean Michel 

Glachant eds., 2002). 

4. Id. (citation omitted). 

5. Id. at 155. 

6. Goode, supra note 2, at 438 (emphasis added). 

7. It is possible to make the scheme more specific by dividing personal property first into chattels real 


2007 

THE DISAPPEARING DIVIDE BETWEEN PROPERTY AND OBLIGATION 

Not all choses in action are property: put more starkly, not all obligations are 

property. Those "choses" that are not property, or "property rights," are merely 

personal rights, or personal obligations. The boundary is never defined. Indeed, it is 

often described as subject to revision according to social and political norms. 

Lack of a definitive boundary does nothing to diminish academic vigour in 

asserting the importance of the divide. This is not a matter of pure semantics or 

irrelevant jurisprudence. The distinction is critical for the very practical reason that 

property rights appear better protected than personal rights. Criminal law, tort law, 

and public/constitutional law may all afford property rights additional protection, 

but the starkest illustrations of the benefits of property rights are seen as insolvency 

protection, and as the opportunity to recover windfall gains (or unauthorised profits) 

when property rights have been misused. These special protective rights are not 

unqualified, but the general perception is that they operate to protect property 

rights, not personal rights. 

It contradicts this perception to suggest that the supposed divide between 

property and obligation (and especially between proprietary and non-proprietary 

intangibles) is no longer sustainable. In supporting this claim, this chapter proceeds 

in two parts. The first part considers the historical development of a dramatically 

expanded notion of property. It shows how obligations, or personal rights, have 

been increasingly treated as property. The second and longer part demonstrates 

how each of the traditional tests commonly regarded as useful in distinguishing 

between property and obligation is disintegrating. Attributes once thought to be 

specific to "property" are increasingly being accorded to all manner of rights. In 

sum, these two parts suggest that not only is the class of property rights expanding, 

but that rights that continue to be labeled as "personal" are receiving "proprietary" 

protection. In short, the doctrinal and functional divide between property and 

obligation is disappearing. 

I. EXPANDING THE NOTION OF PROPERTY: TURNING OBLIGATION 

INTO PROPERTY 

The goal in this section is simply to show that, over time, certain types of once 

purely personal obligations have come to be treated as property. The transition has 

been largely the result of equity's incursions, although common law and statutory 

developments have supported and reinforced the change. The assertion is not 

controversial, and the detail needs only to be summarised here. 8 Of course, the 

assertion depends on the definition of property. This issue is revisited in the next 

section, where some of the most commonly accepted divisions between property and 

obligation are examined. For the moment, it is enough to adopt the widely accepted 

notion that property is "usable wealth." From amongst a long list of rights of 

(leases) and chattels personal (other), and then dividing the latter into choses in possession and choses in 

action. Choses in action can then be further subdivided into documentary intangibles and pure intangibles, 

but neither of these complications affects the point being made. 

8. For further detail, see SARAH WORTHINGTON, EQUITY 51-86 (2003) [hereinafter WORTHINGTON, 

EQUITY] (arguing that equity has dramatically expanded the notion of property, not that there is no longer 

a division between proprietary and personal rights). See also SARAH WORTHINGTON, PERSONAL 

PROPERTY LAW: TEXT AND MATERIALS chs.1, 8 (2000) [hereinafter WORTHINGTON, PERSONAL 

PROPERTY LAW] (providing a more general discussion). 



VOL. 42:917 

enjoyment typically associated with ownership or other proprietary interests, 9 the 

choice is made that the truly essential features of property rights are that rightholders 

can transfer their rights, and can exclude third parties from interfering with 

their rights. These twin attributes of "transferability" and "excludability" 

characterise property rights." 0 Put another way, those with property rights can 

control allocation and access. 

The early common law approach was to accord proprietary status to real 

property (land) and to tangible personal property (goods), but not to intangible 

property. Intangible property was not assignable; it was not usable wealth. This 

boundary between property and obligation accords with the (now crude) view of 

property as a "thing." Tangible. "things" were accorded proprietary advantages and 

proprietary protection; intangible "things" were characterised as personal rights 

against specific parties, and were not regarded as proprietary. 

Equity completely overturned this state of affairs. It dramatically expanded the 

category of "property," or proprietary rights, by acting on two fronts. The story is 

well known." First, it permitted the assignment of "personal obligations" that were 

unassignable at common law. Debts, shares, and other contractual claims thus 

became usable wealth. The possibility was further extended to include rights to 

future benefits: claims to future dividends, interest payments, royalties and such 

could all be sold immediately for value, in advance of entitlement to the underlying 

payment. 2 In this way, future benefits could be capitalised immediately and put to 

their most efficient use by those agreeing to the exchange. 

Sceptics might suggest that this expansion is too limited to contribute to the 

agenda suggested here. It permits the assignment of the benefits of personal 

contracts; the burdens remain with the original obligor. To take the simplest of 

examples, a creditor can assign the benefit of the debt owed to her, but the debtor 

cannot assign his obligation to pay his creditor unless, of course, his creditor consents 

to substitute performance from the transferee. 3 However, this rather limited form 

of assignment of benefits, not burdens, accords with the predominant commercial 

pressure to convert these contractual rights into "usable wealth." It is the benefits, 

not the burdens, that the parties are keen to assign, so as to capitalise their value. 

Indeed, precisely analogous rules apply to transfers of tangible property, where it is 

exceedingly difficult (although not impossible) to ensure that positive burdens run 

with the property.' Buyer One may agree with his Seller that the fire breaks will be 

cleared annually on his newly acquired farm, or that an artistic object will be 

displayed only in certain ways. If the farm or the artwork is transferred to a new 

buyer, Seller can rarely insist that Buyer Two comply with the same restrictions, 

9. See Anthony M. Honor6, Ownership, in OXFORD ESSAYS IN JURISPRUDENCE 107 (A.G. Guest ed., 

1961). 

10. See Kevin Gray, Property in Thin Air, 50 CAMBRIDGE L.J. 252, 301-02 (1991). 

11. See WORTHINGTON, EQUITY, supra note 8, 51-86 (explaining that all of these new rights are 

uncontroversially regarded as assignable, and also as attracting some powers to exclude third parties). 

12. It is important to take care, of course, not to contract to transfer the money to be received in the 

future, but rather to transfer the existing right to the future income stream. See Norman v. Fed. Comm'r of 

Taxation (1963) 109 C.L.R. 9 (Austl.). 

13. The three-way agreement between debtor, creditor, and transferee is typically achieved by 

novation of the original debtor/creditor contract. 

14. See Bernard Rudden, Economic Theory v. Property Law: The Numerus Clausus Problem, in 

OXFORD ESSAYS IN JURISPRUDENCE 239, 241-43 (John Eekelaar & John Bell eds., Third Series, 

Clarendon Press, 1987). 


2007 


unless the two have contracted directly with each other to that effect. In some 

circumstances, this inability to ensure that positive burdens run with tangible and 

intangible assets can reduce the economic value of the assets in question. The next 

section makes it clear that all three branches of the law-equity, common law, and 

statute-have made advances to improve matters on this front, while balancing the 

need to protect Buyer Two from unexpected burdens. But the difficulties across the 

board only serve to reinforce the similarities in treating tangible and intangible assets 

as "property." 

As ' well as expanding the class of rights that were assignable, equity's second 

strategy was simply to create completely new forms of property. It did this by 

permitting novel divisions of certain "bundles of rights" (property rights) that the 

common law had previously regarded as indivisible, and then, over time, reclassifying 

these novel bundles as "property" rather than "obligation." 

To understand this second strategy, it is necessary to go back a step. Dividing 

property between different parties is commercially attractive. At common law, such 

divisions are possible. Tangible things (land and goods) can be co-owned, with 

several owners sharing the sum total of the relevant property rights. In the simplest 

case, a division of rights between co-owners can give them interests that are 

qualitatively the same, even if quantitatively different. Co-ownership of a horse, for 

example, might divide ownership rights : 'A: 4. More sophisticated strategies allow 

different parties to have different types of interests in the same asset, not merely 

different shares of the interest. With tangible personal property, the common law 

allowed the parties to split ownership and possession between different parties. 

With land, the common law went even further and allowed different parties to have 

sequential ownership interests along a time-line, via the doctrine of estates. In this 

way, the practical and commercial benefits of divided property ownership were 

recognised and accommodated by the common law. Although these common law 

options for divided ownership appear limited (especially for tangible personal 

property), their innovative potential should not be underestimated. For example, 

the simple division of ownership and possession of goods permits different forms of 

leases (with all manner of associated covenants), hire-purchase agreements, pledges, 

contractual liens, retention of title sales, bailments, and more. 

Equity dramatically expanded upon these rather meagre common law 

possibilities for divided interests. It did this through the creation of trusts and 

charges. These two structures are often assumed to be equity's greatest legacy to the 

law. Their enormous commercial significance goes without saying. These devices 

began as contractual arrangements ("personal obligations"), and slowly evolved 

until they were unequivocally recognised as delivering new (divided) property 

interests in the underlying tangible or intangible assets." The terms "trust" and 

"charge" disguise the enormous flexibility permitted within these categories. Taking 

each in turn, "trusts" permit the division of interests according to the common law 

model (that is, shared and sequential ownership) regardless of the nature of the 

underlying asset. But this is just the start. Trusts enable endless innovation and 

division, limited only by the imagination of interested commercial parties. Assets 

can be subdivided at will, and different types of rights can be parcelled out to 

15. See WORTHINGTON, EQUITY, supra note 8. "Asset" is used very loosely as shorthand for bundles 

of rights, whether proprietary or personal. 



VOL. 42:917 

different parties.' 6 Using the trust, for example, rights associated with company 

shares can be divided to give certain parties the voting rights, others the dividend 

rights, and still others the rights to bonus issues. Even this does not exhaust the 

divided rights that are possible because of the trust. Consider the many formal and 

informal arrangements that are now considered to deliver trust structures of divided 

ownership. The best known include Quistclose trusts," building retention trusts,' 

and constructive trusts arising in response to contracts of sale 9 or, occasionally, 

family agreements. 0 

"Equitable charges" are a more recent legal innovation. They evolved in a 

similar fashion to trusts, however, and now provide enormous flexibility in enabling 

contracting parties to structure security arrangements that accommodate their 

individual needs and circumstances. The rapid evolution and growing commercial 

significance of equitable charges can be seen clearly in the evolving debates 

surrounding the granting of security over after-acquired assets, 2 ' the recognition of 

floating charges 22 and automatic crystallisation clauses, 23 and, most recently, the 

possibility that a lending bank could take a charge (a "charge back") over the 

debtor's account with the same bank. 24 The ability of well-advised creditors to 

protect themselves against their debtor's insolvency using such devices quickly led to 

parliament providing statutory protection for certain classes of unsecured third 

parties, especially against floating charge holders. 25 This, in turn, led to a fresh round 

of debates (still on-going) about the accurate characterisation of parties' 

arrangements as creating these vulnerable floating charges rather than some other 

form of proprietary protection such as a fixed charge, 26 a contractual lien in the 

context of construction contracts, 27 or legal ownership or a trust in the context of 

retention of title agreements. 8 For our purposes, the outcomes of these debates are 

16. See generally Henry Hansmann & Ugo Mattei, The Functions of Trust Law: A Comparative Legal 

and Economic Analysis, 73 N.Y.U. L. REV. 434 (1998); Sarah Worthington, The Commercial Utility of the 

Trust Vehicle, in EXTENDING THE BOUNDARIES OF TRUSTS AND SIMILAR RING-FENCED FUNDS 135,135- 

162 (David Hayton ed., 2002). 

17. See generally THE QUISTCLOSE TRUST: CRITICAL ESSAYS (William Swadling ed., 2004) (exploring 

the foundations of the Quistclose trust and subjecting it to a searching analysis). 

18. See Mac-Jordan Construction Ltd. v. Brookmount Erostin Ltd., [1992] B.C.L.C. 350 (Eng. 1991). 

19. Other than sales of goods, where the Sale of Goods Act 1979 (Eng.) and its Commonwealth 

equivalents provide an even more aggressive default rule, so that legal property is rebuttably presumed to 

pass to the buyer at the time of the contract of sale, notwithstanding that delivery and payment of the price 

occur at some later stage. See Sale of Goods Act, 1979, 28 & 29 Eliz. 2, c. 54, § 18 (Eng.). 

20. See SARAH WORTHINGTON, PROPRIETARY INTERESTS IN COMMERCIAL TRANSACTIONS, 43-70, 

187-221 (1996) [hereinafter WORTHINGTON, PROPRIETARY INTERESTS] (listing and discussing the relevant 

cases); WORTHINGTON, PERSONAL PROPERTY LAW, supra note 8, chs. 3.9, 4.10-4.14. 

21. See Holroyd v. Marshall, [1862] 11 Eng. Rep. 999 (H.L.). 

22. See In re Yorkshire Woolcombers Ass'n, [1903] 2 Ch. 284. 

23. See In re Brightlife Ltd., [1987] Ch. 200. 

24. See In re Bank of Credit & Com. Int'l S.A. (No 8), [1998] A.C. 214. 

25. Insolvency Act, 1986, c. 45, §§ 40, 175(2)(b), 176A. 

26. In In re Spectrum Plus Ltd., the House of Lords finally affirmed the analysis advanced by the 

Author. See In re Spectrum Plus Ltd., [2005] UKHL 41, [2005] 2 A.C. 680 (overruling In re Spectrum Plus 

Ltd., [2004] Ch. 337); Sarah Worthington, An "Unsatisfactory Area of the Law"-Fixed and Floating 

Charges Yet Again, 1 INT'L CORP. RESCUE 175 (2004). 

27. See In re Cosslett (Contractors) Ltd., [1998] Ch. 495 (analysis not affected by the subsequent 

appeal to the House of Lords, Smith (Administrator of Cosslett (Contractors) Ltd) v. Bridgend County 

Borough Council, [2002] 1 A.C. 336). 

28. See Borden (U.K.) Ltd. v. Scottish Timber Prods. Ltd., [1981] Ch. 25. 


2007 


not important in themselves. What is important is that they serve to reinforce, 

rather dramatically, the notion that "obligations" between parties often count as 

"property" of one sort or another. 

To summarise, this section suggests that, over time, equity made two very 

significant moves. It treated common law obligations as property, simply by 

permitting their assignment and providing some protection for the assignees. It also 

treated obligations to divide property rights as being in themselves new forms of 

property. Put bluntly, equity converted obligations into property. 9 

The previous assertion tests "property' by the twin attributes of assignability 

and excludability, but even measured in this simple way, there has been a radical 

change in what is assigned to the "obligations" box and what to the "property" box. 

In itself, of course, this is not sufficient to establish that the divide between 

obligation and property has disappeared. The divide may simply have moved to a 

different place. The next section seeks to advance the case for disappearance. 

II. 

ATTRIBUTES SAID TO DISTINGUISH PROPERTY FROM OBLIGATION 

In the previous section it was suggested that the hallmarks of property are 

"assignability" and "excludability"; in other words, property rights are assignable, 

and they entitle their holders to exclude others from their enjoyment. Neither 

characteristic needs to be absolute. Indeed, short reflection suggests that there are 

no assets that entitle their holder to absolute rights to enjoy, to transfer, and to 

exclude others. The burden of this section is to show that these two attributes, along 

with several other attributes commonly regarded as indicative of "property" rather 

than "obligation," no longer successfully serve this function. None of the attributes 

discussed below provides a criterion for confidently allocating an asset to either the 

"property box" or the "obligations box." Whatever may have been true in the past, 

it now seems that these attributes are, to varying degrees, apt to describe all manner 

of assets; there is no clear distinction between property and obligation. In this sense, 

the divide between property and obligation is disappearing. 

The discussion proceeds in a fashion that reflects a further oddity in the 

orthodox property/obligation divide. Rights are either specifically categorised as 

"property," or they are not. If they are not, then they are merely personal-they are 

"obligations." From this it follows that all the standard tests focus on the attributes 

of "property." Absence of the attributes means the asset is "not property" and so is 

merely "obligation." The argument in this part is therefore that these property 

attributes no longer provide any defensible means of distinguishing between two 

types of assets, one "property" and one "obligation." 

29. This might be expected to cause problems on at least two fronts: the types of interests that are 

recognised as "proprietary" appear to become infinitely variable as the particular contractual terms differ, 

so offending the nunerus clausus rule and its justifications; and third parties may seem to be treated 

unfairly in being expected to recognise such a vast spectrum of property rights, and facing liability for 

unwittingly infringing them. 



VOL. 42:917 

A. Property Terminology 

Lawyers must be careful with language, and clearly, loose language does not 

mean that implicit inaccuracies automatically become legal doctrine. Nevertheless, 

some usages are instructive. When we talk of a company's property, for example, we 

certainly do not mean to refer only to the tangible "things" owned by the firm, as 

distinct from all the other rights owed to it by third parties. In the same vein, when 

we say that a trust cannot be created unless there is "trust property" held by the 

trustee on trust for the beneficiaries, we include within the notion of "trust property" 

both tangible "things" owned by the trustee as well as every type of obligation owed 

to the trustee for the benefit of the trust. And when either a company or a trustee 

becomes insolvent, the assets available for division amongst the creditors include all 

the relevant tangible and intangible assets (i.e. the entire pool of property and 

obligations). Recent doctrinal and functional discussion of "asset partitioning," 3 or 

divided patrimonies (in civil law jurisdictions), involves a similar bundling of 

property and obligation. The "asset partitioning" does not discriminate at all 

between different assets, or different forms of wealth. With affirmative asset 

partitioning, all corporate wealth or trust wealth is partitioned, segregated as a pool 

dedicated to service the claims of the corporate or trust creditors rather than the 

shareholders' or beneficiaries' creditors; conversely, with defensive asset 

partitioning, all the shareholders' or beneficiaries' wealth, in whatever form, is 

partitioned, preserved intact against the claims of the corporate or trust creditors. In 

short, our common use of language affords no help in distinguishing between 

property and obligation. This is so even when we appear to use the distinction 

technically, as in requiring identification of trust "property," or an insolvent's 

"property." 

B. The Ambit of Property Rights 

Professor Honor6 described ownership as "the greatest possible interest in a 

thing which a mature system of law recognizes."'" Perhaps derived from this, there is 

increasing currency given to the notion of property as a bundle of rights which 

includes residual incidents operating in favour of the owner once all other claims 

have been met. Rights are proprietary if they encompass this broad scope; otherwise 

they are personal. Again, however, the approach does not appear to assist in 

distinguishing between property and obligation. 

This claim is best shown by example, and the clearest modern example comes 

from corporate law scholarship. There the notion of residual rights is frequently 

used, admittedly, more often by economists rather than by lawyers. The analysis 

usually proceeds along the following lines: residual rights indicate ownership; the 

shareholders have residual rights to the company's property on insolvency, so the 

shareholders own this property; as owners, they have the right to control its use, and 

to do so by controlling the board of directors. This is clearly too crude. Either we 

have misconceived the meaning of residual rights (perhaps employees and creditors 

also have such rights?), or these rights do not invariably suggest property ownership. 

30. See generally Henry Hansmann & Reinier Kraakman, The Essential Role of Organizational Law, 

110 YALE L.J. 387 (2000) (discussing various aspects of asset partitioning). 

31. Honor6, supra note 9, at 108. 


2007 


By contrast, the accepted analysis, at least for lawyers, is that the shareholders 

do not own the company's assets: they do not need to, and there are significant 

advantages if they do not. Because of express or default rules in their share contract, 

however, they have ultimate residual rights to the company's property on its 

insolvency. The vulnerability of this residual claim provides the necessary 

motivation for shareholders to monitor the corporate managers. Other groups are at 

risk of poor corporate management, but their risk is not quite so great (they are 

further up the chain), and their coordination costs are much higher, especially if their 

interests are diverse. This analysis explains why the monitoring role might 

reasonably be left to shareholders. However, it does not provide automatic 

justification for shareholder control of corporate management or the managers' need 

to run the company exclusively in the shareholders' interests." Some other 

justification is needed for that. And, finally, it delivers all this without the need to 

differentiate between property and obligation: the consequences follow because the 

shareholders, as a group, have uniform residual contract/obligation rights. 

So, again, identifying residual rights may indicate "property," but equally it may 

indicate "obligation"; it is not a distinguishing attribute. 

C. Property Rights May Take Only a Limited Number of Forms-the Numerus 

Clausus Principle 

It is commonly observed that most legal systems recognise only a limited (and 

non-expanding) number of property interests. Personal rights, by contrast, can be 

structured in an infinite number of ways to suit the parties' personal needs. This 

alleged restriction on the possible forms of property is known as the numerus clausus 

(closed number) rule. Civil law jurisdictions certainly have such a rule, and it is 

supposedly the reason why trusts do not exist in these jurisdictions. The common 

law rule, if there is one, is much more ambivalent. Equity's permitted subdivision of 

interests in assets, and the concomitant creation of new forms of property, especially 

forms that can be specially tailored by the parties to suit their own personal 

requirements, appears to offend the numerus clausus rule. In this respect, at least, 

equitable property rights appear much more like personal rights, and it is not at all 

evident that the numerus clausus rule places any real restrictions on the 

property/obligation divide in common law jurisdictions. 

In any event, the rationale for the rule has been shown to be suspect. If the 

goal is simply to reduce the number of property options because of some perceived 

efficiency in this, then it fails. The desired variety of rights which might operate in 

relation to property can usually be achieved by contract in any event, although with 

greater effort and therefore greater inefficiency. 33 The principle thus serves as an 

ineffective (and inefficient) restraint. Indeed, jurisdictions that did not expand the 

variety of their property rights by incremental development have generally sought to 

32. See Sarah Worthington, Shares and Shareholders: Property, Power and Entitlement, Part 1, 22 

COMPANY LAWYER 258 (2001) (exploring the nature and extent of a shareholder's legal entitlement to 

have a company's business conducted so as to maximize shareholder value); Sarah Worthington, Shares 

and Shareholders: Property, Power and Entitlement, Part 11, 22 COMPANY LAWYER 307 (2001) (exploring 

the nature and extent of a shareholder's legal entitlement to have a company's business conducted so as to 

maximize shareholder value). 

33. Rudden, supra note 14, at 239. 



VOL. 42:917 

do this later, via statute, and to do so in a manner that accords these rights 

proprietary status, or at least some measure of protection from interference by third 

parties." For example, civil law jurisdictions are increasingly adopting trusts 

legislation;" the United States, which did not initially grant judicial recognition to the 

floating charge, now achieves the same ends via the United States Uniform 

Commercial Code Article 9; and several jurisdictions, including Hong Kong, recently 

legislated to ensure the validity of charge backs. 

Alternatively, if the reason for the principle is to prevent the multiplication of 

sub-interests in assets, so as to ensure that dealings do not become difficult and 

inefficient, then it also fails. It controls the types of interests that may be created, but 

not the numbers of parties who may hold such (restricted) interests, and it is the 

latter that is likely to make dealings inefficient. 36 

Finally, if the principle is designed to protect property owners by alerting 

strangers to the property rights they must respect, and does so by affording third 

parties easy notice 37 or easy verification" of these property packages, then it also 

fails. Once we examine the strategies the law employs to protect property owners 

(and, indeed, all right owners), it becomes clear that the strategy is not to limit the 

number of recognised property rights (adhering to the numerus clausus principle), 

but to limit the number of risks to which a stranger can be exposed and which might 

count as unauthorised interference with the rights of others." A large degree of 

flexibility as between the originating parties, A and B, could be accommodated 

without increasing the information costs for C if the broad rules of liability imposed 

on C are few and simple. This means that there is no need to adhere to the numerus 

clausus principle, as long as a simple philosophy is applied in constructing the 

remedial regime. The approaches usually adopted are described later in this essay." 

In summary, the numerus clausus characteristic does not enable common 

lawyers to differentiate between property and obligation, and in any event the 

perceived advantages of the rule appear overrated. 

34. For other approaches, see George L. Gretton, Trusts without Equity, 49 INT'L & COMP. L.Q. 599 

(2000) (assessing trusts as patrimony). 

35. See Hansmann & Mattei, supra note 16, at 458; David Hayton, English Trusts and Their 

Commercial Counterparts in Continental Europe, in EXTENDING THE BOUNDARIES OF TRUSTS AND 

SIMILAR RING-FENCED FUNDS, supra note 16, at 23. 

36. See Henry Hansmann & Reinier Kraakman, Property, Contract, and Verification: The Numerus 

Clausus Problem and the Divisibility of Rights, 31 J. LEGAL STUD. 373, 418 (2002). 

37. See Thomas W. Merrill & Henry E. Smith, Optimal Standardization in the Law of Property: The 

Numerus Clausus Principle, 110 YALE L.J. 1, 43 (2000). 

38. See Hansmann & Kraakman, supra note 36. 

39. See Merrill & Smith, supra note 37, at 25 (taking the view that the numerus clausus principle plays 

an important role here). 

40. Here a simple example suffices. All the characterisation and recharacterisation problems 

associated with floating charges-especially in the context of construction contracts and retention of title 

agreements-are at root related to the proper treatment of certain third parties, and to determining 

whether they have statutory rights in the underlying asset (since the Insolvency Act 1986 (U.K.) gives 

preferred creditors rights against assets subject to floating charges). They are not related to determining 

whether the charge agreement between A and B is limited to a known form of property interest. 


2007 


D. "Excludability": Property Rights are "Good Against the World" 

Property rights are commonly described as "rights in rem," "good against the 

world" (or at least a section of it), and "multital."' Personal rights, by contrast, are 

4 ' 2 

described as "rights in personam," only good against the obligee, and "paucital. 

This is a formal, but perhaps less informative, assertion of the idea of excludability. 

Restated as they are here, two ideas may be unwittingly confused in these 

descriptions (or maybe wittingly). First, property rights are still often described as 

rights in an asset, not simply rights to an asset (orthodoxy suggests the latter would 

be rights in rem, and personal rather than proprietary)." This distinction now lacks 

force or accuracy. Equity has ensured that rights to assets are commonly accorded 

all the attributes of property rights." The evolution was described earlier in this 

article. In truth, this now outdated notion of "rights in rem" replicates the equally 

outdated early idea of property as a "thing." The more modern conception of 

property is as a "bundle of rights," and, moreover, a bundle of rights exercisable 

against people, even if in relation to a thing. 

The second theme in this labelling emerges in the multital/paucital distinction: 

rights in rem are good against the world; purely personal rights can usually only be 

enforced against mutually consenting parties. But this focus is on something other 

than our property/obligation divide. Under this classification, all tort claims are in 

rem since they bind all the world in relation to trespass, nuisance, negligence, and 

such like. "Things" are protected by these general defensive claims, but so too are 

personal rights: we now have the tort of inducing a breach of contract, for example, 

interfering with obligation, rather than with property. 5 This means that rights may 

be classified as in rem, or good against the world, even though we would not usually 

think of them as "property" in any real sense, but rather as "obligations" that are 

simply and similarly protected by claims that may be advanced against the whole 

world. 

Once again, the familiar "property attribute" no longer provides a reliable 

distinction between property and obligation. 

E. Property is Assignable 

As noted earlier, it is no longer possible to suggest that "property" is 

assignable, but "obligations," or contract rights, are not. The modern rule is that 

both are assignable, but both may have specific practical or procedural limitations on 

assignment imposed by common law or statute for reasons of public policy. These 

limitations do not serve to distinguish "property" from "obligation." Indeed, greater 

41. WESLEY NEWCOLMB HOHFELD, FUNDAMENTAL LEGAL CONCEPTIONS As APPLIED IN JUDICIAL 

REASONING 111-14 (Walter Wheeler Cook ed., Greenwood Press 1978) (1919). 

42. Id. at 69-74. 

43. Goode, supra note 2, at 433-34. 

44. See id. at 438. 

45. See Lumley v. Gye, (1853) 118 E.R. 749; see also Daniel Friedmann, Restitution of Benefits 

Obtained Through the Appropriation of Property or the Commission of a Wrong, 80 COLUM. L. REV. 504, 

513-29 (1980). 

46. See, e.g., Royston M. Goode, Notes of Cases, Inalienable Rights?, 42 MOD. L. REV. 553, 553-57 

(1979). 



VOL. 42:917 

restrictions apply to the assignment of some forms of tangible property (the clearest 

elements in the "property" category) than apply to the assignment of most 

"obligations." Consider the restrictions on assignment of certain categories of land, 

or certain categories of goods (such as national art treasures, or petrol in periods of 

national shortage). Put another way, public policy determines whether a particular 

bundle of rights is assignable, and it does this without regard to the 

property/obligation divide. And when public policy determines whether it is 

appropriate to sell human beings into slavery, cell lines to research laboratories, or 

rights to litigate to the highest bidder, it does not first decide whether these rights 

are property. It moves immediately to the core controversies. Once again, the 

attribute does not serve to define a given right as property rather than obligation. 

F. Property is Accorded Superior Legal Protection 

We commonly assume that property is better protected by the legal system than 

contract, or obligation. This remedial insight was articulated more formally by 

Calabresi and Melamed almost thirty years ago. 47 They suggested that property 

rights are distinguishable because they are protected through "property rules," not 

merely through "liability rules." Put in more familiar language, injunctions and 

specific performance are the norm in protecting property rights, rather than mere 

payment of compensation. 48 Once again, however, this preferential remedial 

approach no longer seems to track any meaningful property/obligation divide. 

Take some obvious examples. Rights that we might classify as purely personal 

(that is, as "obligations," rather than "property") often seem to be protected by 

"property rules." For example, tort claims of all types are typically remedied by 

compensation, but also, quite commonly, by positive or negative injunctions. The 

difference in remedy does not turn on whether the damage has already been done, 49 

nor, any longer, on whether the rights that have been infringed are "proprietary." ' 5 ' 

Contract rights, too, are enforced using the full panoply of remedies. This remains 

true even when the rights infringed appear to be especially "personal," rather than 

"proprietary," such as those requiring personal services to be performed by the 

defendant for the claimant." Generalising, it seems that "obligations" are 

47. Guido Calabresi & A. Douglas Melamed, Property Rules, Liability Rules, and Inalienability: One 

View of the Cathedral, 85 HARv. L. REV. 1089 (1972). 

48. Robert Chambers, The Importance of Specific Performance, in EQUITY IN COMMERCIAL LAW 

(Simone Degeling & James Edelman eds., 2005) (discussing this issue at length, while also discussing these 

two cases: Smelhago v. Paramedevan, (1996) 136 D.L.R. (4th) 1 & Tanwar Enterprises Pty Ltd v. Cauchi, 

(2003) 217 C.L.R. 315). 

49. Even if the damage is still only threatened, the claimant may be obliged to take compensation for 

the likely harm that will be caused, rather than be afforded an injunction. Lord Cairns' Act (Chancery 

Amendment Act), 1858, 21 & 22 Vict., c. 27 (U.K.) (now re-enacted in the Supreme Court Act 1981, § 54). 

50. Proprietary in the sense that the tort interferes with the claimant's rights, and those rights are 

proprietary rather than personal (property rather than contract). At another level, all tort "rights" are 

sometimes considered "proprietary," since they can be enforced against all the world-that is they are 

rights in rem. See discussion supra Part lI.D. 

51. Co-operative Ins. Soc'y Ltd. v. Argyll Stores (Holdings) Ltd., [1998] A.C. 1. But see Lumley v. 

Wagner, (1852) 42 Eng. Rep. 687 (where the courts were prepared to order an injunction, but not specific 

performance). 


2007 


sufficiently commonly protected by "property rules" for this form of enhanced legal 

protection to be of little use in distinguishing property from obligation. 2 

The inability of this remedial attribute to provide a distinguishing test appears 

all the more stark when the issues are examined form the property perspective. 

Then we notice that our legal system does not necessarily protect some of the most 

uncontroversial "property" forms by means of property rules, but prefers, instead, to 

limit protection to liability rules. This is the approach taken by the common law in 

protecting goods (that is, tangible personal property). These assets are clearly 

property, but they are not (or not necessarily) protected by property rules: an owner 

whose goods have been converted by another is entitled to compensation rather than 

to specific recovery (unless the court exercises its statutory discretion to order the 

latter) .53 

Generalising, the more accurate analysis seems to be that the special protective 

regimes that deliver performance rather than damages (Calabresi and Melamed's 

"property rules") are not afforded exclusively to property rights. Rather, they are 

afforded to all scarce rights, whether those rights are classified as property or as 

obligation. Once again, this aspect of the law's remedial regime does not enable us 

to distinguish between property and obligation. 

G. Property Carries an Entitlement to Proceeds 

Property rights are commonly associated with automatic entitlement to any 

proceeds derived from the property. An owner can sell her car and keep the 

proceeds; she can hire the car out and the income is hers. The same is equally true 

of assets that are more on the margins of property and obligation: owners of shares 

or debts may sell these assets and keep the proceeds; 54 and before such sale, they are 

entitled to the dividends or interest payments. But the same is also true of rights we 

class as pure obligations. Contracts of supply, or service, or hire can all be sold, and 

the proceeds belong to the seller; 55 and if these personal rights are not sold, then any 

benefits that accrue from them belong to their owner. It seems that all assets carry 

with them an entitlement to proceeds, and this is equally true whether the assets are 

classed as property or obligation. This is not controversial. 

Much more controversial, however, is whether this same entitlement to gains 

applies when the gains are made by third parties making unauthorised use of the 

rights, rather than made by the right-owner herself. In these circumstances, can the 

owner still insist that she is entitled to the benefits derived from her asset? In 

making this claim, the owner is asking for a "disgorgement" remedy (or 

"restitutionary damages" or "an account of profits"). Does this remedy map the 

property/obligation divide? 

52. See Lionel Smith, Understanding Specific Performance, in COMPARATIVE REMEDIES FOR 

BREACH OF CONTRACT 221, 223 (Nili Cohen & Ewan McKendrick eds., 2005) (coming to a similar 

conclusion). 

53. Torts (Interference with Goods) Act, 1977, ch. 32 (U.K.). 

54. Sometimes the sale is subject to restrictions, or even prohibitions, but this is equally true of 

tangible property. 

55. Again, the sale may be subject to restrictions, or even prohibitions, but this is no different from 

the earlier property examples. 



VOL. 42:917 

This is difficult, because there is as yet no firm consensus on the availability of 

disgorgement as a remedy. The possibility of such a claim can arise in a variety of 

circumstances, and involve a wide range of assets. Depending upon the 

circumstances, different analyses are possible, and none has so far attracted 

consistent judicial (or academic) following. In an earlier essay, I discussed the 

paradigm case of a third party using a £1 coin to purchase what turned out to be the 

winning lottery ticket. -6 The lottery winnings represent the "proceeds" from the £1 

coin. Must these winnings be paid over to the original owner of the £1 coin? Does it 

matter whether the original owner remains the legal (or equitable) owner of the 

money throughout (that is, has a property right), or whether she has only a personal 

claim for recovery of its value from the third party (in unjust enrichment, for 

example)? Does it matter whether the third party was from the start a trustee of the 

money, or stole it, or received it completely innocently, perhaps by way of gift? 

Contract law and tort law can compensate the original owner for any harm suffered; 

the law of unjust enrichment can restore expropriated gains. But these remedies, if 

they are available, will rarely deliver much more than £1 (the original asset, perhaps 

plus some further amount for loss of use of the money for some period of time). Is 

there a rule that will also restore the third party's windfall gains to the claimant? 

If it is clear that the original owner has retained a property interest in the asset 

despite its transfer to the third party, then (at least in the UK) it is often assumed 

that she will be able to recover windfall gains from interfering third parties. A 1997 

Court of Appeal decision suggests this conclusion follows naturally from the nature 

of property rights themselves: owners are entitled to the productive capacities of 

their assets, even when the gains are derived through the efforts of third parties. 

Many academic commentators reach the same conclusion, but explain it on the basis 

of unjust enrichment."' I confess to remaining sceptical. Neither approach seems to 

be sufficiently discriminating. Both lead to results which strip gains equally from 

thieves and from innocent donees who fortuitously invest the mistaken gift 

profitably, even though they might just as readily have invested their own funds for 

their own benefit and left the gift untouched. I prefer an analysis that requires third 

parties to disgorge gains only when they have been made in defiance of some 

fiduciary obligation to manage the underlying assets in the owner's interests. 9 The 

weight of precedent also favours a more restrictive approach: barring the Court of 

Appeal case already noted, and one House of Lords case, 60 other instances of true 

disgorgement 6 ' all seem to arise in fiduciary contexts. 6 2 

56. Sarah Worthington, Justifying Claims to Secondary Profits, in UNJUST ENRICHMENT AND THE 

LAW OF CONTRACT 451, 452-53 (E.J.H Schrage ed., 2001). 

57. Trustee of the Property of FC Jones & Sons v. Jones, [1997] Ch. 159. 

58. See, e.g., Peter Birks, Property, Unjust Enrichment and Tracing, 54 CURRENT LEGAL PROBLEMS 

231 (2001); ANDREW BURROWS, THE LAW OF RESTITUTION (2d ed. 2002). 

59. WORTHINGTON, EQuITY, supra note 8, at 98-102; Worthington, Justifying Claims to Secondary 

Profits, supra note 56, at 451. 

60. In Foskett v. McKeown, Lord Millett based his conclusions primarily on the property analysis 

adopted in Trustee of the Property of FC Jones, but he also indicated that a fiduciary analysis (which was 

possible on the facts) delivers the same conclusions. Foskett v. McKeown, [2001] 1 A.C. 102; Trustee of 

the Property of FC Jones & Sons v. Jones, [1997] Ch. 159; see also Lord Millett, Proprietary Restitution, in 

EQUITY IN COMMERCIAL LAW, supra note 48. 

61. This is rather than compensation (measured by "use value") or restitution for subtractive unjust 

enrichment. See Sarah Worthington, Reconsidering Disgorgement for Wrongs, 62 MOD. L. REV. 218 

(1999). But see, e.g., JAMES EDELMAN, GAIN-BASED DAMAGES: CONTRACT, TORT, EQUITY AND 

INTELLECTUAL PROPERTY (2002). 


2007 


Clearly this area of the law is most unsettled. But the arguments need not be 

analysed in detail here. The goal here is simply to determine whether there is a 

difference between the legal protections delivered to property and those delivered to 

obligation. In the UK at least, this area of the law has prompted vehement debate. 

In seeking to protect obligation, commentators have advocated what amounts to 

analogous application of the House of Lords' property analysis. They suggest that 

contract rights and property rights deserve equivalent protection; that expropriation 

of either is inappropriate; and that interference with either should be remedied by 

disgorgement in appropriate circumstances. 3 The argument has been used to 

support both disgorgement and performance interest damages for breach of 

contract; 6' and disgorgement to remedy profitable torts or other wrongs. The cases 

do not yet go so far. Disgorgement is available. It is commonly awarded to remedy 

fiduciary and other equitable breaches of the claimant's personal right to 

confidential or loyal service, even where the fiduciary has not interfered with any 

property owned (in equity) by his beneficiary. 6 ' These breaches might be regarded 

as interference with the claimant's (personal) right to a particular form of service 

from his agent. Early cases suggested that disgorgement was limited to the initial 

wrongful gain made by the defaulting fiduciary, and, moreover, that the remedy was 

restricted to a personal claim to the value of the gain.' But this approach has now 

been radically revised. Full disgorgement of the initial gain and any proceeds 

derived from it is favoured; and the remedy is now considered to be proprietary 

(delivering insolvency protection to the injured claimant principal). 67 The change in 

approach has attracted vocal adherents and equally vocal dissentients. 6 ' 

Disgorgement has also been advocated as the appropriate remedy for torts, 

especially proprietary torts. Some cases can be read as supporting this stance, but it 

is equally possible to interpret them as supporting either compensation or 

autonomous unjust enrichment claims in respect of the unauthorised use of the 

claimant's asset. 6 ' Finally, disgorgement is also available for breach of contract, 

62. But see Attorney-General v. Blake (Jonathan Cape Ltd. Third Party), [2001] 1 A.C. 268 (justified 

as being a relationship that was very close to fiduciary). This less strict approach is criticised by the Author 

and Roy Goode. Sarah Worthington & Roy Goode, Commercial Law: Confining the Remedial 

Boundaries, in LAW'S FUTURE(S): BRITISH LEGAL DEVELOPMENTS IN THE 21ST CENTURY 281 (David 

Hayton ed., 2000). 

63. See Lionel D. Smith, Disgorgement of the Profits of a Breach of Contract: Property, Contract and 

"Efficient Breach," 24 CAN. BUS. L. J. 121 (1994); Daniel Friedmann, The Efficient Breach Fallacy, 18 J. 

LEGAL STUD. 1 (1989). 

64. See I.M. Jackman, Restitution for Wrongs, 48 CAMBRIDGE L.J. 302 (1989); Daniel Friedmann, The 

Performance Interest in Contract Damages, 111 LAW Q. REV. 628 (1995). 

65. Boardman v. Phipps, [1967] 2 A.C. 46. 

66. Lister & Co. v. Stubbs, [1890] 45 Ch. D. 1. 

67. Att'y Gen. for H.K. v. Reid, [1994] 1 A.C. 324. 

68. Some suggest that the remedy should not be proprietary. See, e.g., Roy Goode, Property and 

Unjust Enrichment, in ESSAYS ON THE LAW OF RESTITUTION 215 (Andrew Burrows ed., 1991); Roy 

Goode, The Recovery of a Director's Improper Gains: Proprietary Remedies for Infringement of Non- 

Proprietary Rights, in COMMERCIAL ASPECTS OF TRUSTS AND FIDUCIARY OBLIGATIONS 137 (Ewan 

McKendrick ed., 1992). Others suggest that it should perhaps be subordinated to the claims of the 

defendant's other creditors. See, e.g., Peter Jaffey, Restitutionary Damages and Disgorgement, 

RESTITUTION L. REV. 30, 44 (1995); Vanessa Finch & Sarah Worthington, The Pari Passu Principle and 

Ranking Restitutionary Rights, in INSOLVENCY AND RESTITUTION 1, 1-20 (Francis Rose ed., 2000). 

69. Wrotham Park Estate Co. Ltd. v. Parkside Homes Ltd., [1974] 1 W.L.R. 798; Penarth Dock Eng'g 

Co., Ltd. v. Pounds, [1963] 1 Lloyd's Rep. 359: Whitwham v. Westminster Brymbo Coal & Coke Co., 



VOL. 42:917 

although the courts insist that this remedy is available only in exceptional 

circumstances. 0 

What conclusion can be drawn from all of this? Even though the state of the 

law remains unsettled, it is clear that there is no sharp divide between property and 

obligation in allowing right-holders access to the proceeds of unauthorised 

interference with the right. A narrow reading of the authorities (and my preferred 

reading) is that both property and obligation are protected in the same way. Both 

are typically protected from interference by either compensatory remedies (for torts 

or breach of contract) or by restitution (for unjust enrichment); exceptionally, both 

are also protected by disgorgement remedies, but only when the infringement is the 

result of interference by the right-holder's own fiduciary. The more common, wider, 

reading of the authorities reaches quite different conclusions, but is equally strong in 

aligning the treatment of property and obligation. This alternative approach sees 

both property and obligation as routinely protected by disgorgement remedies. In 

short, this attribute of entitlement to proceeds is, like all the others, equally 

inadequate in differentiating between property and obligation. 

H. Property Rights "Run with the Asset" 

Relatively recently, a further distinguishing characteristic of property rights has 

been suggested: a property right, unlike a personal right, "'runs with the asset.' 7 . 

This sounds promising. It captures an attribute that we do regard as a characteristic 

of property. If a thief steals A's car and sells it to C, A's ownership of the car (A's 

property rights in the car) run with the car, and can be enforced against C. It does 

not matter that A and C are strangers, and have reached no agreement between 

themselves about A's rights. 

This attribute of rights "running with the asset" is especially attractive if owners 

want to divide rights in an asset between several parties, and then allow the 

individual parties to deal with their respective rights independently of the other 

interest holders. Put generally, if A shares proprietary rights in an asset with B, and 

B then transfers the asset to C, will A's interests in the asset persist and be 

enforceable against C? The commercial attractions of this result, at least to A, are 

clear. This is one of the classical attractions of property rights. But the concomitant 

risks to C are equally evident, especially if C is ignorant of A's interests. 

In the context of this chapter, two issues need to be resolved. The first is 

whether this idea of rights that run with the asset is a characteristic of property 

rights; the second is whether the same attribute is also evident with personal rights. 

To anticipate, it seems that both property and obligation are, once again, very 

similar. 

[1896] 2 Ch. 538 (especially 541-2 per Lindley U_). In Strand Electric & Engineering Co. v. Brisford 

Entertainments Ltd., it was commented that if the defendant had profited from the use, then disgorgement 

of those profits would not be required (per Somervell UJ) or might be (per Denning LJ). Strand Elec. & 

Eng'g Co., Ltd. v. Brisford Entm'ts Ltd., [1952] 2 Q.B. 246, 252, 255. 

70. Att'y Gen. v. Blake (Jonathan Cape Ltd. Third Party), [2001] 1 A.C. 268; Worthington & Goode, 

supra note 62, at 281 (criticizing Att'y Gen. v. Blake); see also Mitchell Mclnnes, Account of Profits for 

Common Law Wrongs, in EourrY IN COMMERCIAL LAW, supra note 48, at 405,405-30. 

71. Hansmann & Kraakman, supra note 36, at 374. 


2007 


At first sight it seems that the common law, at least, does consider property 

rights to run with assets. The earlier example of the theft of A's car is illustrative. 

Closer examination shows something different, however. Across a range of property 

interests, the real focus seems to be better described as one protecting A only to the 

extent that this is consistent with preserving C's rights, unless C knew or ought to 

have known of A's competing interests: C is really in the line of sight, not A. 

Examples make this clearer. If the subject matter is tangible property, then C 

can often be put on notice that others have rights to the asset simply because she 

knows that she does not hold those rights: the mere fact of the property's existence is 

sufficient indication that other people have rights that need to be respected. 72 She 

does not need to know who has those interests; all she needs to know is that she does 

not. The physical reality of the property acts as its own form of notice to the world 

that someone has interests that merit protection. This form of public notice, or some 

marginal variant of it, is used quite commonly. The rule applies to real and personal 

tangible property. It also applies to intangible rights that are "marked" by 

trademarks or copyright symbols. Strangers are liable, often strictly liable, for 

infringements of these ownership or possessory property rights. 

But this type of rule has its limits. It works tolerably well in cases of potential 

theft, conversion, or trespass to tangible property, where C is made liable for 

unilaterally interfering with property rights she knows are not hers, even if she is 

unaware of the real owner's identity. The rule seems less apt, however, when an 

intermediate party, B, purports to sell or give property rights to C, and C is then 

visited with the same remedial consequences because B turns out to be a thief or 

fraudster. The physicality of tangible property, or of copyright or trademark 

symbols, cannot serve as adequate notice to C if C intends a legitimate acquisition 

rather than a unilateral invasion of the relevant rights. 73 

The law has developed further strategies to deal with this difficulty. The choice 

of different approaches to suit different circumstances appears designed to balance 

the fairness and costs of imposing the risk on one party as against the other. There 

are two extremes. The first confirms the merits in protecting A's interests, but 

recognises the difficulties for C in discovering that these interests exist. The 

preferred strategy is then one that enables A to give better notice to the world of his 

interests by filing them on a public register. It matters little, it seems, whether the 

registry details A's precise interests, 74 or merely provides notice that A has some sort 

of interest. 7 " The filing system works because C can then be presumed to know of 

72. Merrill & Smith, supra note 37. 

73. Notwithstanding this, the common law imposes strict liability for the tort of conversion. See 

Andrew Tettenborn, Conversion, Tort and Restitution, in INTERESTS IN GOODS 825 (2d ed., Norman 

Palmer & Ewan McKendrick eds., 1998), for a suggestion that conversion's separate functions should be 

divided, and liability modified, so that there could be strict liability for recovery (a surrogate vindicatio); 

fault based tort liability, based on dishonesty or lack of good faith, enabling compensation for loss from 

misuse of the property; and strict liability enabling reversal of unjust enrichments arising from either the 

owner's property or its proceeds. In this way, the common law tort-style liability would be brought into 

line with the equitable liability for "knowing receipt." 

74. As now happens in the U.K. when companies file charges with Companies House. See Companies 

Act, 1985, ch. 1, §§ 395-96 (Eng.). 

75. This is what happens now in the United States when U.C.C. Article 9 security interests are filed. 

The U.K. Law Commission proposes adopting this strategy in a reformed U.K. regime. See Law 

Commission, Company Security Interests: A Consultative Report, Consultation Paper No. 176 (2004). 



VOL. 42:917 

A's filed interests, whether or not she makes the effort to check the registry. C is 

said to have constructive notice of A's filed interests, and A's interests will then 

prevail over C's if there is a conflict, even if C has acquired her interests innocently 

and for value. There are many illustrations of this strategy in operation: there are 

registries of interests in land, certain classes of security interests granted by 

corporate borrowers, and ownership of second hand cars. 

The second approach is almost the complete reverse of the first. It favours C's 

interests over A's, and allows C's interests to prevail so long as she is a bona fide 

purchaser for value without notice of A's rights. The rule operates without a register 

of A's interests. The burden is thus on A to inform third parties or, more often, to 

control the behaviour of his agent, B, to ensure that B does not do anything 

unauthorised to defeat A's interests. Put another way, where A and B choose 

particular organisational structures to enable them to divide property interests 

efficiently between them, then they, not the outsiders (i.e. C), should shoulder the 

risk that poor internal management might enable B to deal with C in unauthorised 

ways. In these circumstances, A should lose his rights, not C. This protective 

strategy is the primary rule that operates when A is a company, B the board of 

directors, and C a party dealing with the company. By and large C is allowed to 

assume that all of B's advances in dealing with A's assets are authorised, unless C is 

either a donee or on notice that the transfer is in defiance of A's legitimate interests. 

The same rule applies when A is the beneficiary of a trust, B is a trustee, and C is a 

stranger dealing with the trustee over the transfer of the trust assets. 

Context helps to define commercial needs, and hence the appropriate style of 

rule. Contrast the protection afforded to C in any dealings with currency (the 

second style of rule) with those applying to her dealings with goods (the first style of 

rule, and with very few registers to assist in improving the protection offered). 

As noted earlier, neither the magnitude of this problem, nor the ease of solving 

it, is assisted by the numerus clausus rule. As soon as parties wish to divide rights 

and deal with them independently, some form of verification or protection is 

necessary. This clearly increases the costs well beyond those necessary to operate a 

scheme of sole and undivided ownership, but the commercial advantages of division 

are overwhelming. Once this is conceded, then, as between a small and large 

number of possible divisions (or types) of property rights, the same verification rules 

are equally apt. 6 This is easily illustrated. Consider the practicalities of filing: it is 

expensive because a registry needs to be established and the parties will incur costs 

in filing and in searching, but these costs are not further increased simply because 

what is filed is a novel form of private arrangement between A and B. 

All of this can be summarised briefly. Property rights may indeed "run with the 

asset," so A's rights may be enforceable against C, but only if certain specific 

verification or protective rules permit this. These rules aim to balance the burdens 

and benefits of a system that permits bundles of rights to be divided, and the divided 

parcels to be transferred independently of the other co-owners. 

The next issue is the important one for this chapter. Can obligations also "run 

with the asset"? Can the same protective strategies be used to achieve similar ends 

with obligations as with property? 

76. Hansmann & Kraakman, supra note 36. 


2007 


There is no theoretical or doctrinal reason why the law should not permit this to 

happen. Nevertheless, the commercial attractiveness of this in relation to obligations 

is far more limited than it is in the case of orthodox property rights. This is because 

"contract bundles" are less commonly the object of unauthorised dealings in 

defiance of the original contract-holder's rights (as happened in our stolen car 

example), and they are less frequently the object of commercially attractive subdivision 

that gives different co-owners different interests in an asset. This is when 

verification and protective regimes are especially useful. Nevertheless, although the 

need for contract rights to run with the asset is less extreme, there are situations 

where this would be commercially attractive. 

Does the law then allow for this possibility, and adopt the protective strategies 

already noted in the context of property? Consider each of the earlier approaches in 

turn. Since contract rights are intangible, simple physical notice to the world is 

difficult (although there is a sense in which copyright and trademark labels might be 

regarded as protecting contract rights, rather than orthodox property rights). That 

leaves verification and protective strategies. First consider the use of registers of 

intangible assets. These do exist. As with registers of orthodox property rights, 

there is no need for registers to record every possible interest in every possible asset. 

This is a cost-benefit game. Registers are worth their costs if the rights being filed 

are especially valuable, even if the number of filings is relatively small over time 

(consider registers of land, ships and aircraft engines), or if the register is used often 

and by large numbers of the trading community (consider registers of security 

interests or second hand car ownership). Are there registers of "contracts"? 

Registers of intellectual property interests, such as patents, can be viewed in this 

way. So too can registers of security interests, especially in the United States, where 

the courts had denied the proprietary possibility of floating charges. Yet such 

contractual arrangements could be effectively enforced by filing under Article 9 of 

the United States Uniform Commercial Code. Filing certainly increases the variety 

of rights that can be accorded "proprietary" status, in the sense that they run with 

the asset. For example, there have been suggestions that negative pledges could 

usefully be filed." 

The protective strategy is also used with contract rights. This strategy is the 

more efficient option where the contract rights are sufficiently valuable to warrant 

protection, but the dealings are sufficiently unique to make filing impractical. The 

types of contract rights that might warrant this protection are A's right to use B's 

assets in a particular manner (as in a contract of hire), or A's claim against B that B 

use his property in specified ways, as defined by negative pledge agreements or 

agreements to vote shares in a pre-determined manner. In these circumstances, can 

A prevent C from using the asset in a manner that is inconsistent with A's 

contractual rights? The law remains uncertain, but a line of cases suggests that A 

might obtain a negative injunction against C to prevent interference, provided C had 

notice of A's rights when she acquired her own interests in the asset. 8 

77. Id. at 414 n.79 (citing Barry E. Adler, Financial and Political Theories of American Corporate 

Bankruptcy, 45 STAN. L. REV. 311. 336-39 (1993); Barry E. Adler, Secured Credit Contracts, in 3 THE NEW 

PALGRAVE DICTIONARY OF ECONOMICS AND THE LAW 405-10 (Peter Newman ed., 1998)). 

78. De Mattos v. Gibson, [1858] 45 Eng. Rep. 108 (Ch. 1858); see also WORTHINGTON, PROPRIETARY 

INTERESTS, supra note 20, at 101-16. 



VOL. 42:917 

When rights recognised by equity were regarded as operating in personam, and 

so were seen as personal rather than proprietary, both equity's bona fide purchaser 

for value without notice rules and knowing receipt rules could also have been 

regarded as major components of the protective regime. This would ensure that 

contract rights "ran with the asset" in an appropriate manner. 79 

There is a downside to all of this. Any regime that enables rights to run with 

the asset also enables increasing fragmentation of rights between different owners, 

and this is widely regarded as inefficient. It hampers advantageous dealings with the 

underlying asset because it leads to increased transaction costs and the risk of 

holdout problems, and these can soon become so large that they frustrate the 

efficient use of the asset.8 ° The problem is tempered somewhat by devices like the 

rule against perpetuities and limitations of actions. Moreover, registries of rights 

promote a market in re-bundling the rights, in much the same way as in the market 

for corporate control. Finally, the protective notice regime by its very nature is 

unlikely to produce significant fragmentation since A's rights will generally only 

persist if C has adequate notice of their existence. 

Once again, there seems to be no sharp divide between the law's treatment of 

property and obligation in allowing rights to "run with the asset." The differences 

that do exist appear to be more closely related to commercial needs than to legal 

limitations. The risk of interference and the commercial attractiveness of divided 

interests are both greater with orthodox property rights than with purely personal 

rights. Where this generalisation does not hold, the law seems to treat both types of 

interests in similar ways. 

I. Property Rights Attract Insolvency Protection 

Insolvency priority is widely regarded as the lynchpin of proprietary 

characteristics. Property rights are accorded insolvency protection; personal rights 

are not. In reality, this may be the least significant characteristic in making, or 

losing, the argument that there is a disappearing divide between property and 

obligation. This is because the logic of the property/insolvency link is not associated 

in some fundamental way with an attribute that distinguishes property from 

obligation. Rather, the distinction depends utterly on current insolvency policy. 

Consider two simple examples. 

First, suppose X is an individual, but is also the trustee of a trust and the sole 

director of a one-man company. If X becomes bankrupt, all the assets that appear to 

be his will have to be characterised as relating to one or other of his three different 

roles. Some will be personal assets, available to his creditors in his bankruptcy. 

Some will relate to the trust. They will not be distributable on X's bankruptcy, but 

will be partitioned off and preserved for the trust beneficiaries. Others will belong 

to the company. First claim to them will be accorded to the company's creditors, not 

79. See generally Lionel Smith, Unraveling Proprietary Restitution, 40 CAN. Bus. L.J. 317 (2004) 

(applying a different analysis). 

80. In the United States, this is known as the "problem of the anticommons." See Hansmann & 

Kraakman, supra note 36, at 417-18 (citing Michael A. Heller, The Tragedy of the Anticommons: Property 

in the Transition from Marx to Markets. 111 HARv. L. REV. 621 (1998); and Frank I. Michelman. Ethics, 

Economics and the Law of Property, in NOMOS XXIV: Ethics, Economics, and the Law 3 (J. Ronald 

Pencock & John W. Chapman eds., 1982)). 


2007 


to X's personal creditors: X's personal interest will be limited to the net value of his 

shareholding. This common form of asset partitioning is effected without any 

thought of distinguishing between property and obligation. X's personal assets will 

include both types of wealth. So too will the trust and corporate assets. Asset 

partitioning on insolvency, in this sense, is simply allocating patrimonies to their 

appropriate owners (X and the company), and dividing patrimonies between 

different roles (X's personal activities and his activities as trustee). In doing this, 

there is no property/obligation divide in any sense that is relevant in this chapter. 

Take a second case. This tests the property/obligation divide more severely. 

Consider the distribution of X's personal assets amongst his own creditors. On X's 

insolvency, all his wealth (proprietary and personal) is realised for the benefit of his 

creditors. If no creditors have proprietary claims, the entire asset pool will simply be 

shared amongst the claimants pro rata. This is regarded as the fairest way to 

proceed. By contrast, creditors who can identify an asset as "theirs" can take it, 

often in full satisfaction of their claims. The more privileged property-owning 

creditors there are, the smaller the pool for the unprivileged personal claimants, and 

the smaller the proportion of their losses that will be recovered. Insolvency losses 

are thus shifted from the privileged to the unprivileged. If a showroom owner 

becomes insolvent, for example, the paid-up purchaser of "the only pink car in the 

showroom" can take her car; the paid-up purchaser of "one of the four green cars in 

the showroom" cannot. 8 ' Moreover, the latter purchaser cannot specifically recover 

his purchase payment, even assuming (rather unrealistically) that he can identify 

either it or its traceable substitutes amongst the debtor's assets. 82 Many creditors are 

in this unsecured position, unless they take security to preserve their interests. 

Why does insolvency law permit this difference in treatment between different 

creditors, and, in our example, between different purchaser creditors? Elsewhere, I 

have called this the "musical chairs" element of insolvency law: the result for 

different creditors depends entirely on the timing of the debtor's insolvency (that is, 

on the timing of when the music stops). 83 The justification is relatively simple. The 

task of insolvency law is to maximise returns to all creditors by effecting an orderly 

distribution of the debtor's assets. This goal is best achieved by a co-coordinated 

distribution process. Furthermore, viable enterprises should not be tipped into 

insolvency; this is unnecessarily costly for all concerned. The best mechanism to 

ensure these twin goals are met, and that creditors have no incentive to steal a march 

by acting unilaterally or to tip the debtor into early insolvency, is to insist that the 

pre- and post-insolvency rights of all creditors remain the same. There is then no 

situational advantage for anyone in moving the debtor into insolvency. This 

reasoning means that pre-insolvency property rights must be preserved, and in turn 

post-insolvency priority given to property owners. 

The ability of creditors to take legal security (by means of proprietary interests) 

to preserve their priority is subjected to the same form of insolvency justification. In 

the end, security is seen as advantageous because it increases commercial activity. 

81. Sale of Goods Act, 1979, 28 & 29 Eliz. 2, c. 54, §§ 16-18 (Eng.). 

82. In re Goldcorp Exchange Ltd. (in rec.), [1995] 1 A.C. 74 (P.C. 1994) (appeal taken from New 

Zealand). 

83. Sarah Worthington, Proprietary Remedies and Insolvency Policy: The Need for a New Approach, 

in COMMERCIAL LAW: PERSPECTIVES AND PRACTICE 191 (John Lowry & L Mistelis eds., 2006) 

[hereinafter Worthington, Proprietary Remedies and Insolvency Policy]. 



VOL. 42:917 

Parties who would not otherwise have access to funds for business (or domestic) 

expansion and development can make use of these resources. In any event, 

pragmatism suggests that commercial parties would make arrangements designed to 

achieve the same ends, at greater cost, if the law did not provide a structured 

mechanism. Nevertheless, parliament restricts the availability of this form of 

insolvency protection by imposing registration requirements and, in some cases, 

timing, vulnerability, and claw-back limitations." 

All of this makes perfect sense, and yet there is a gnawing reluctance to push 

this preferential proprietary analysis too far. As already noted, the Insolvency Act 

1986 (U.K.) itself imposes limitations on the effectiveness of security. It also accords 

preferential status to certain contract rights, especially employee rights, on 

insolvency. 85 And when property priority is delivered in the form of a proprietary 

remedy from the debtor, the courts are increasingly alert to the adverse implications 

for the unsecured creditors. 86 Civil law jurisdictions are much happier to insist that 

some of these remedial property claims are contingent, not privileged. The United 

States is more restrictive than the United Kingdom. Indeed, the United States 

Uniform Commercial Code Article 9 filing regime, for all its assertions that property 

rights are proprietary, has effectively replaced the common law proprietary system 

of security with a statutory priorities system for obligations. Priority rules have 

replaced property rules. This makes it easier for the legislature to amend priorities 

without affecting non-insolvency property rights. 

This complicated common law and statutory hierarchy of insolvency rights 

could be changed. There is nothing inevitable about the insolvency protection 

accorded to property rights.7 Theoretically, the system could deliver preferential 

status according to some completely different regime, perhaps according to the type 

of claim being advanced by the creditor. This would involve prioritising certain 

forms of claim over other forms, and ignoring whether or not they have traditionally 

been regarded as proprietary or not. This would overcome the problem that some 

claims, by their very nature, can never attach to any specific part of the pool of 

debtor's assets, and yet these claims may well be thought more worthy than others 

that are able to assert such an attachment. Elsewhere I have argued that this sort of 

analysis may suggest that unjust enrichment claims should be given insolvency 

privileges above those accorded to compensation claims.' Put more generally, 

insolvency is all about policy, and sharing losses amongst innocent parties. As a 

matter of policy, it is important to consider carefully the pre- and post-insolvency 

goals, and decide which rights should legitimately be privileged. 

84. Companies Act, 1995, §§ 395-96 (Eng.); Insolvency Act 1986, c. 45, § 245, sched. B1 para. 70 

(Eng.). 

85. See Insolvency Act 1986, c. 45, §§ 40, 175(2)(b), 176A (§ 176A is a recent addition to the Act). 

86. Recall the excitement over Att'y Gen. for H.K. v. Reid, [1994] 1 A.C. 324 (P.C. 1993) (appeal 

taken from New Zealand). See, e.g., In Re Goldcorp Exchange Ltd. (in rec.), [1995] 1 A.C. 74 (P.C. 1994) 

(appeal taken from New Zealand); Westdeutsche Landesbank Girozentrale v. Islington London Borough 

Council, [1996] A.C. 669 (H.L.); Agnew v. Comm'r of Inland Revenue, [20011 2 A.C. 710 (P.C.). But see In 

Re Polly Peck Int'l PLC (in admin) (No 4), [1998] 3 All Eng. Rep. 812, 826-27 (opinion by Mummery LJ, 

varying in analysis from previously cited cases). 

87. See generally Lucian Arye Bebchuk & Jesse M. Fried, The Uneasy Case for the Priority of Secured 

Claims in Bankruptcy, 105 YALE L.J. 857 (1996); Worthington, Proprietary Remedies and Insolvency 

Policy, supra note 83; see also Sarah Worthington, Property, Obligation and Insolvency Policy: Cutting the 

Gordian Knot, 20 J. INT'L BANKING & FINANCIAL LAW 100 (2005) (making a shorter version of the same 

argument). 

88. Finch & Worthington, supra note 68. 


2007 


In summary, insolvency priority is currently treated as a defining characteristic 

of property, distinguishing it from obligation. The implications for the respective 

right holders are dramatic. Those with property rights often recover in full. This 

leaves a disproportionately diminished pool of assets for the personal right holders 

to share. The result is that they often receive nothing. This is all the more worrying 

when, as the rest of this chapter shows, we are becoming increasingly uncertain 

about how to classify rights as falling on one side of this privileged dividing line. 

III. Is DISAPPEARANCE OF THE DIVIDE BETWEEN PROPERTY AND 

OBLIGATION SIGNIFICANT? 

The significance of the conclusion that there is no longer any sharp divide 

between property and obligation depends upon your perspective. If given any 

credence, it will end the search for the Holy Grail, and that in itself might liberate a 

significant amount of academic effort. 

Why do we have property? It is said to be necessary for all advanced and 

advancing societies to ensure greater productivity and commitment to effort. Parties 

who own assets know that they will derive the fruits of their labour, and they are 

then prepared to expend greater efforts. It is immediately obvious, however, that 

property is surplus to this equation, aside from making the point that common or 

community ownership does not work. Ensuring that not all wealth or property is 

held in common provides an incentive. This is as true of personal rights as it is of 

property rights. 

On other fronts, too, the news of a merger is not dramatic. But this is not 

because the news itself lacks dramatic impact. Rather it is that we arrived at this 

position quite some time ago and have had time to adjust to the consequences. 

Centuries ago, commercial parties saw that all rights, whether contract or property, 

could perform as usable wealth. They then adapted their practices accordingly. 

Economists were next to appreciate that these rights have merged. The lawyers 

have lagged behind. 8 9 Perhaps it is time to catch up. 

89. But c.f ROSCOE POUND, AN INTRODUCTION TO THE PHILOSOPHY OF LAW 236 (1922) ("Wealth, 

in a commercial age, is made up largely of promises.")

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