Financial law facts for kids

Financial law is all about the rules and laws that guide how banks, stock markets, insurance companies, and investment groups work. It helps us understand how financial rules are made and how money works in general.

Financial law is a big part of business law. It's also a huge part of the world's economy. Having clear rules for money deals is super important. So, financial law covers both public rules (from governments) and private rules (between people or companies). Knowing the legal side of things like an indemnity (a promise to protect someone from loss) or an overdraft (when you spend more money than you have in your bank account) helps you understand how they work in money deals. This is what financial law is all about.

Financial law is different from general business law. It focuses mainly on money deals, the financial market, and the people and groups involved. For example, selling everyday items is part of business law, but it's not financial law.

Financial law is built on three main ideas, or pillars:

• Market practices (how people usually do things)
• Case law (rules from court decisions)
• Regulation (rules made by governments or official bodies)

These three pillars work together to create the framework for financial markets. Even though new rules (regulation) became very important after the financial crisis of 2007–2008, the roles of court decisions and market practices are still super important.

Financial law also uses key legal ideas like legal personality (the idea that a company can be treated like a person in law), set-off (canceling out debts), and payment. These ideas help experts sort financial tools and market structures into five main types, or silos:

• Simple positions
• Funded positions
• Asset-backed positions
• Net positions
• Combined positions

These types help us understand the legal rules and limits for different financial tools, like a guarantee (a promise to pay someone's debt if they can't) or an asset-backed security (a financial product backed by a group of assets).

How Financial Law Is Made

Financial law is shaped by three different ways of making rules. These ways come from different ideas about how financial markets should work.

Market Practices: How People Do Business

The way people usually do business in the financial world is a key part of financial law, especially in England & Wales. When people and companies create standard ways of doing things, they are actually setting their own rules. These market practices create unofficial rules that people follow. These rules then influence legal rules when market practices are broken or argued about in court.

Market practices often create "soft law." This means rules of conduct that aren't legally binding but have real effects. For example, groups like the Loan Market Association create standard contracts and guidelines. Courts often support these unofficial rules because the financial market relies on them. Soft law often defines what people expect from certain types of money deals.

Soft law is very important in a global world, for consumer rights, and alongside official rules. The FCA (a UK financial watchdog) plays a big role in regulating markets. But soft law, which is voluntary or based on common practice, is also vital. Soft law can help fill gaps where official laws are unclear.

For example, in 1997, a legal opinion by Potts QC changed the derivatives market. This helped derivatives become more common. Derivatives are financial tools whose value comes from something else, like a stock price. At the time, it wasn't clear if Credit Derivatives (a type of derivative) were insurance contracts under English law. If they were, they would have faced strict rules. But the Potts Opinion said they were not insurance contracts. This allowed them to grow without those limits.

Sometimes, soft law can become "hard law" (official law) if it's based on long-standing and proven practices. For example, in the past, courts in the UK often included the "custom of merchants" (how merchants usually did business) into common law. This helped financial markets work smoothly.

Case Law: Rules from Court Decisions

The second way financial law gets its practical rules is through court cases. Courts often try to find solutions that make good business sense. So, case law works like market practice in creating effective results.

Courts try to limit expectations to what reasonable business people would expect. They also support the idea of freedom of contract, meaning people should be free to make their own agreements. This freedom is very important for complex financial tools.

For example, in a case called Re Bank of Credit and Commerce International SA (No 8), a court supported a type of security charge (a legal claim on an asset) that a bank had over money it owed to a client. Even though it seemed complicated for a bank to have a claim on its own debt, the courts wanted to help market practices work. They are careful not to say that certain practices are impossible.

However, court cases don't cover everything. Rules for big international finance deals are often incomplete because people prefer to settle disputes through arbitration (a private way to solve disagreements) rather than going to court. This can slow down the development of financial law. But when big problems happen, like major bankruptcies or frauds, court cases become very important. The collapse of Lehman Brothers is a good example, leading to many court decisions.

Regulation and Legislation: Official Rules

The third way financial law is made is through rules from national and international governments and official bodies. These rules control how financial services operate. There are three main ways these rules look at financial relationships:

• Arm's length: Treating parties as separate and independent.
• Fiduciary: Where one party has a duty to act in the best interest of another.
• Consumerist: Protecting consumers.

After the 2008 financial crisis, new rules like MiFiD II in the EU became very important. The Financial Conduct Authority also made clear rules. However, sometimes it's hard to make these new rules fit with existing market practices.

Financial Collateral Rules

Besides national and international rules, there are also special rules to make financial markets stable by making collateral (assets pledged to secure a loan) more useful. In Europe, there are rules like the Financial Collateral Directive. This directive helps make it easier to transfer and use assets quickly in the market. These rules work well for short-term deals like repos (repurchase agreements) or derivatives.

Key Ideas in Financial Law

Several important legal ideas support financial law. One of the most central is legal personality. This is the idea that the law can create "non-natural persons" like companies. This is a clever invention for finance because it helps limit risk. It creates separate legal entities, so if a company goes bankrupt, its owners' personal money is usually safe.

Other ideas like set-off and payment are also very important. They help prevent big risks by reducing how much money a financial participant might owe or be owed in a deal. This is often done using collateral. If financial law is about the rules for financial tools and deals, then it's also about how those deals share out risk.

Limited Liability and Legal Personality

A limited liability company is a special creation of the law. It helps limit the amount of risk a person or company takes on. Lord Sumption explained it well: a company is a separate legal entity from its owners. It has its own rights and debts. Its property belongs to the company, not its owners. This applies even if one person owns and controls the whole company.

For financial markets, sharing out financial risk through separate legal personality allows people to enter financial contracts and transfer credit risk (the risk that someone won't pay back a debt). This idea is fundamental to business because limited companies have been the main way businesses operate for over a century. Their separate identity and property are why others can deal with them.

Financial Collateral: Protecting Deals

Financial markets have developed special ways to take security for deals. This is because collateral is a main way for parties to reduce the credit risk when dealing with others. Derivatives often use collateral to secure deals. Large amounts of money owed can be reduced to smaller, net amounts. This helps reduce the credit risk one party faces.

Two main forms of financial collateral have developed from Lex Mercatoria (merchant law):

• Title transfer: Ownership of the asset is transferred.
• Granting a security interest: A legal claim on an asset.

There's a growing reliance on collateral in financial markets. This is partly due to rules for derivatives and borrowing from central banks. The more collateral is required, the higher the demand for good quality collateral. For lending, good quality collateral is usually:

• Liquid (can be easily turned into cash)
• Easily priced
• Low credit risk

Having financial collateral rules has several benefits. It reduces credit risk, which means the cost of borrowing and doing deals goes down. It also reduces the insolvency risk (risk of going bankrupt) of the other party. This means more credit is available, and the party taking the collateral can take more risk without relying as much on the other party. Overall, it helps make the market more stable by increasing liquidity (how easily assets can be bought or sold).

Financial Collateral Regulations

The main goal of the Financial Collateral Directive was to reduce big risks, make deals more consistent, and reduce legal uncertainty. It did this by allowing certain "Financial collateral arrangements" to skip formal legal steps, like registration and notification. It also gives the party taking the collateral the right to use it. And, very importantly, traditional insolvency rules that might stop a financial collateral arrangement (like freezing assets when a company goes bankrupt) are put on hold. This lets the collateral taker act even if the collateral provider goes bankrupt.

In England, the rules for a "financial collateral arrangement" to qualify under the FCARs (Financial Collateral Arrangement Regulations) are that the deal must be in writing and relate to "relevant financial obligations." The purpose of these rules is to make markets more efficient and lower the costs of doing business.

There has been a lot of discussion about the meaning of "possession or control" in these regulations. Courts have said that possession means more than just holding something; it means you must have legal control over it, and the other party must not be able to freely use it.

Set-off: Canceling Debts

Another key idea in financial markets is set-off. This is when a debtor can cancel out what they owe to a creditor with something the creditor owes to them. This is very important for reducing credit risk and stopping big problems when someone goes bankrupt.

For example, if you have money deposited in a bank and you also owe the bank money (maybe for a guarantee), you can use your deposit to cancel out what you owe.

Payment: When an Obligation is Met

Payment is another core legal idea in financial law. It determines when a party has fulfilled their duty to another party. In finance, especially with set-off or guarantees, the definition of payment is crucial for knowing how much risk parties face. Many of these rules come from English and U.S. law, based on old merchant laws, especially from maritime trade.

In English and U.S. law, payment usually needs both sides to agree. It's a "consensual act," meaning both the person paying and the person being paid must agree. Payment is based on the law of contract. For a contract to be valid, it usually needs "consideration" (something of value exchanged).

Payment is vital because it decides when duties are discharged. For example, in the case of Lomas v JFB Firth Rixson Inc, the court looked at when a debtor could fulfill their duty to pay under a standard agreement for derivatives. Payment usually means giving money, but it just needs to satisfy the creditor.

Payment needs mutual agreement at two points:

• Before the contract (ex ante): When parties agree on how the payment will be made.
• After the contract (ex post): When the person being paid agrees to accept the payment offered.

Even if the person paying offers the correct amount, it's not considered "payment" until the creditor accepts it. Mere receipt of money isn't enough. However, the standard for acceptance is lower than for forming a contract. If the payer puts the money unconditionally at the creditor's disposal, and the creditor's actions show they accept, then payment has happened.

Types of Financial Deals

Financial law can sometimes seem confusing because the financial industry has been divided into different sectors, each with its own rules and institutions. The legal approach to financial law changes depending on the type of financial tool. For example, the legal protections for a guarantee are different from those for an indemnity.

The main goal of financial law is to move risk from one person to another. It also changes the type of risk a person takes. Financial deals are often grouped into five categories based on how they handle the credit risk of the person taking the risk.

Simple Financial Positions

This category includes things like Guarantees, insurance, standby letters of credit, and performance bonds. The word Simple can be misleading, as these deals are often quite complex. They are called simple because they don't directly deal with the credit risk of the person buying protection. Instead, the buyer simply takes the risk of the seller not being able to pay. Derivatives often fall into this group because they transfer risk from one party to another.

Derivatives Law

Derivatives are a key part of simple transactions. There are four basic types of unfunded derivatives. Legally, the main risk with a derivative is that it might be re-classified as a different type of legal structure. If this happens, there can be big legal problems. So, courts have been careful to clearly define what a derivative is.

Basically, a derivative is a contract where future payments are linked to another asset or index (like a stock price or interest rate). The actual asset is rarely delivered; instead, parties usually just pay the difference in value. In English law, a derivative is a contract where future duties are linked to another asset or index. Its value comes from that underlying asset.

Derivatives are two-sided contracts where the rights and duties of the parties are based on a specific asset, company, or benchmark. The deal is usually completed much later than when the contract is made.

There are many types of derivatives. English law clearly separates two basic types: Forwards and Options. Parties often set limits on interest rate differences in trades, known as "Caps & Collars," which reduce the cost of the deal. Rules have helped make this market more open, which is good for small and medium-sized businesses.

Swaps and Credit derivatives also have different legal functions. A credit derivative is a contract designed to take on or share credit risk from loans or other financial tools. Payments from the seller are triggered by specific credit events, like a bankruptcy. In a swap, one party pays regular amounts based on a fixed price or rate, and the other party pays amounts based on the performance of a stock, index, or group of stocks.

Recharacterisation: What if a Deal is Misunderstood?

Because simple positions can seem similar in their economic effects, they are often at risk of being "recharacterised." This means a court might decide that a contract, even if called one thing, is actually another type of legal structure. When this happens, there can be major legal problems because each legal tool has different consequences.

For example, a guarantee and an indemnity might seem similar, but the law treats them differently. An indemnifier (the one giving the indemnity) has less protection than a guarantor. Similarly, a derivative or guarantee must not be recharacterised as an insurance contract, because insurance contracts are very strictly regulated. If a contract is recharacterised as insurance, it could be invalid if the parties aren't licensed to issue insurance.

Courts look at the real substance of an agreement, not just what it's called. So, just saying a contract is a derivative doesn't make it one.

Three main types of recharacterisation can happen to simple positions:

• Guarantees or Indemnities: A guarantee is a secondary duty to pay (if someone else doesn't), while an indemnity is a primary duty (you pay directly).
• Guarantees or Performance bonds: Performance bonds are like a promise to pay, and they depend on whether the duty is primary or secondary. Courts are very careful about applying performance bonds to parties that aren't banks.
• Guarantees or Insurance: Both protect people from loss, but a guarantee is narrower. Insurance is a business contract where coverage is given for a fee (a premium). Guarantees are often given without payment. Also, an insurer usually deals with the insured person, not the person or thing being referenced. An insured person must tell the insurer all important facts, while a guarantor usually finds out facts for themselves.

In England, before the Gambling Act 2005, courts sometimes saw contracts as gambling and avoided them. However, any contract under the Financial Services and Markets Act 2000 is not affected by old gambling laws. This is partly thanks to the Potts Opinion, which argued that derivatives were legally different from gambling and insurance contracts.

Funded Positions: Lending and Borrowing

Lending is perhaps the most central part of the financial system. As Joanna Benjamin explains, the law tries to share out risk in ways that are acceptable to everyone involved. Bank loans and capital market deals fall into this category. It means that the person taking the risk is providing money to another party. If the risk happens, the risk-taker doesn't just have an obligation to pay; they risk losing the money they already put in. In other words, a funded position means taking the risk that money won't be paid back. When a bank makes a loan, it gives money and risks not getting it back.

Differences in Funded Positions

You might wonder what the difference is between an asset-backed security and funded positions. The answer is that funded positions are taken without being backed by other specific assets.

The real difference is between funded positions and simple positions. Simple positions, like guarantees or derivatives, involve risk as a promise. The risk-taker agrees to pay if certain events happen. This relies on being exposed to credit risk. Funded positions involve risk as a payment that needs to be returned. The risk is that it might not be repaid. This includes bank and non-bank lending, like syndicated loans (loans made by a group of lenders).

There are two main forms of funded positions: debt and equity. Companies can raise money in several ways:

• Equity shares: Selling parts of the company (shares) to investors.
• Debt financing: Borrowing money (like bank loans).
• Retained profits: Using money the company has already earned.

Few companies can rely only on equity and retained profits. It's also not good business to do so. Debt is a very important part of how companies get money. This is because taking on debt can help a company grow faster and maximize returns for shareholders. Debt must be repaid according to the terms, while equity usually gives shareholders rights like getting reports, accounts, and voting on big company decisions.

Debt Financing: How Companies Borrow Money

Bank lending can be grouped in many ways, like the type of borrower, the reason for the loan, and the type of loan. When a bank makes a loan, it usually asks for a business plan and might need security if it's worried about credit. A commitment letter might be created during loan talks, but these are usually not legally binding.

A loan facility is an agreement where a bank agrees to lend money. It's different from the loan itself. Using a loan facility, a company writes to the bank, and the bank makes the loan.

Three important types of loan facilities are:

• Overdraft facilities
• term loan facilities
• revolving facilities

These can be further divided into two main types of bank lending, based on how long the loan is for and how it's repaid:

• On-demand lending: (like overdrafts and other short-term loans)
• Committed lending: (like revolving facilities or term loans)

Syndicated loans (loans from a group of banks) are also a traditional way of lending in the debt market.

On-Demand Lending

If a loan agreement says it's repayable "on demand," it means it can be asked for back at any time, even if both the bank and borrower thought it would last longer. In England & Wales, the time limit for repayment doesn't start until the demand is made. This means a debt, like an overdraft, isn't repayable without a demand but becomes repayable if asked for.

Courts have said that a "reasonable time" to repay an on-demand loan can be very short in business matters. For example, 45 minutes or 60 minutes have been considered enough time. If the borrower says they can't pay, the bank might be justified in taking action right away.

Banks usually freeze a customer's account if a company is going bankrupt to stop money from being moved around. Money paid into an overdrawn account (where the company owes the bank) is seen as giving the bank the company's property. But money paid into an account that has a positive balance is not seen this way. Banks often freeze accounts and make bankrupt parties open new ones.

Overdrafts

An Overdraft is a type of loan that is usually repayable on demand. It's a running account facility, similar to revolving loans. A bank only has to provide an overdraft if it has clearly agreed to do so. Legally, if a client overdraws their account, they are not breaking their contract with the bank. If it were a breach, the fees charged by the bank would be considered penalties, which are not allowed. When a customer asks for payment when there's no money in their account, they are simply asking for an overdraft. This is different from credit cards, which usually have a strict credit limit. With overdraft requests, the bank can choose not to agree, but this is rare because banks want to maintain their reputation for paying on behalf of clients. Often, the bank agrees and then charges a fee to create the loan.

Banks can charge interest on an overdraft. The key legal point of an overdraft is that it's repayable on demand. However, payment instructions within the agreed overdraft limit must be honored until the bank says the overdraft facility is withdrawn.

Committed Lending

A committed facility means the bank promises to lend money for a certain period.

• Term loan: All the money is given at once or in parts. It can be repaid all at once (a "bullet" payment) or in installments (amortizing).
• Revolving facility: You can borrow, repay, and borrow again.
• Swingline facility: A committed facility for short-term advances.

Most committed lending facilities will be written down, either in a facility letter or a loan agreement. These documents can be simple or complex, depending on the size of the loan.

Sometimes, a bank employee's oral promise to lend can create a duty to lend even before documents are signed. Most facility letters and loan agreements will have rules to protect the lender from the borrower's credit risk. This usually includes:

• Conditions precedent: Things that must happen before the loan is given.
• Restrictions: Limits on what the borrower can do.
• Information covenants: Rules about sharing financial information.
• Set-off provisions: Rules for canceling debts.
• Events of default: What happens if the borrower breaks the agreement.

Lenders will also usually take real or personal security (collateral). These rules are designed to protect the lender from:

• Not getting back interest and capital.
• The borrower going bankrupt.

These goals are met by setting up events that make non-payment or bankruptcy unattractive, or by moving the risk to a third party.

Material Adverse Change Clauses

A common rule in loan agreements is the "material adverse change" clause. This means the borrower promises that their financial situation hasn't gotten much worse since the loan agreement was signed. This clause isn't often used or argued in court, so its meaning can be unclear, and proving a breach is hard. If a lender wrongly uses this clause, the consequences can be serious.

The meaning of the clause depends on its specific wording. The lender has to prove that a breach happened. The clause cannot be triggered based on things the lender already knew when they made the agreement. It's usually checked by comparing the borrower's financial information from then and now. Other strong evidence might also be enough. A change is "material" if it significantly affects the borrower's ability to repay the loan.

In summary, a change will be "material" if it greatly affects the borrower's ability to repay the loan. This is usually checked by comparing the borrower's financial records.

Net Positions: Offsetting Debts

A net position is a financial situation where a debtor can "off-set" what they owe to a creditor with something the creditor owes to them. In financial law, this often happens in deals like securities lending, where mutual duties cancel each other out. Three important types of netting are:

• Novation Netting
• Settlement Netting
• Transaction Netting

Each party can use their claim against the other to clear their debt. Each party faces credit risk that can be offset. For example, a guarantor who has money deposited in a bank can use their deposit to cancel out what they might owe the bank under the guarantee.

Asset-Backed Positions: Using Assets as Security

Proprietary securities like mortgages, charges, liens, pledges, and retention of title clauses are financial positions that use specific assets as collateral. This helps reduce the risk for the person taking the collateral. The main goal is to manage credit risk by identifying certain assets and setting aside claims to those assets.

Combined Positions: Complex Financial Structures

Combined positions use many parts of the other four types of positions. They put them together in different ways to create large, often complex, financial structures. Examples include CDOs and other structured products. For instance, a synthetic collateralised debt obligation uses derivatives, syndicated lending, and asset-backed positions to separate the risk of the underlying asset from other risks. The laws for CDOs are especially important because they use legal ideas like legal personality and risk transfer to create new products.

The importance of combined positions in financial markets means that the legal foundations of these deals are very important for them to work and be enforced.

See also

In Spanish: Derecho financiero para niños