Jurisprudence for prudential measures in international trade in financial services
iv TABLE OF CONTENTS Abstract ii I. Introduction 1 II. Background 5 1. Liberalization of financial services 5 2. Cross-border trade in financial services 10 3. Trade in financial services and investment 26 III. Prudential Measures In Financial Services 36 1. Definition of prudential measures 36 2. Prudential measure and international standard 50 3. Status of prudential measures under the GATS 60 IV. Development Of Standard Of Review For Jurisprudence On Prudential Measures 82 1. Introduction 82 2. Standards of review about abuse of discretion 86 3. Standard of review for jurisprudence on prudential discretion 113 4. Burden of proof 126 5. Conclusion 130
V. Regulatory Expropriation In Financial Services 133 1. Introduction 133 2. General understanding about regulatory expropriation 136 3. Regulatory expropriation and police power 158 4. Police power and prudential regulation 175 5. Conclusion 180 VI. Conclusion: Answers to Practical Questions 183 Appendices 196 1. Core principles For Effective Banking Supervision (Basel Committee) 196 2. General Agreement On Trade in Services 200 3. North American Free Trade Agreement Chapter Fourteen: Financial Services 231 Bibliography 245
1 I. Introduction This paper is written in order to suggest guidelines on jurisprudence for prudential measures in financial services which could be disputed before international tribunals including the World Trade Organization (WTO) Disputes Settlement Unit and tribunals of various Free Trade Agreements (FTAs). Prudential measures are financial regulations in place for prudential reasons such as consumer protection, soundness of financials institution and stability of financial markets. For example, disclosure regulations and prohibition on predatory lending are designed for consumer protection. Minimum capital requirements4 and quantity limitation on lending to one person5 are prudential regulations for the soundness of financial institutions. Monetary policy and deposit insurance system are related with stability of financial markets. Prudential measures by a state are absolutely necessary for many reasons, including the following: (i) the failure of an individual financial institution may have adverse effects on systemic stability and cause loss to individual depositors; (ii) individual consumers are unable to judge the safety and soundness of financial institutions with which they are dealing; 1 Lazaros E Panourgias, Banking Regulation and World Trade Law: GATS, EU and 'Prudential' Institution Building 9-14 (Portland: Hart Publishing Co. 2006); See the GATS Annex on Financial Services 2(a). 2 Jonathan R. Macey, Geoffrey P. Miller, Richard Scott Carnell, Banking Law and Regulation 176 (. Gaithersburg: Aspen Law & Business 3rd. ed. 2001). 3 Id. at 179. 4 James R. Barth, Gerard Caprio, Jr. & Ross Levine, Rethinking Bank Regulation till Angels Govern 52 (New York: Cambridge University Press 2008). 5 Id.
2 (iii) There is a potential claim on a deposit insurance fund under the supervision of a state; and (iv) Financial suppliers must be subject to continuous monitoring in order to secure the value of customers' contracts, however, the individual customers themselves are not in a position to do the monitoring.6 These prudential measures can be used as non-tariff barriers because foreign financial suppliers cannot trade with consumers of a host state if the host state maintains or introduces heavy prudential measures. For example, minimum capital requirements that are too high prevent foreign financial investors from establishing a branch or a subsidiary in a host state. A host state has wide discretion in establishing and maintaining prudential measures because financial services are special compared to other services.7 Furthermore, prudential measures are carved out from obligations and commitments of the General Agreement on Trade in Services (GATS) of the WTO and most of FT As as long as they are not abused. However, it does not mean that prudential measures are not subject to the jurisprudence of international tribunals because abuse of prudential discretion violates international treaties. The issue is what criteria should be used to determine whether a measure falls within prudential discretion. This paper will prove that a good-faith principle of customary international law can be applicable to jurisprudence on prudential discretion. 6 Charles Goodhart et al., Financial Regulation: Why, How and Where Now? 5 (Oxford: Routledge, 1998). 7 Regarding specialty of financial services, see Corrigan, Are Banks Special? (Ann. Rpt, Fed. Res. Bank Mpls. 1982), available at http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3527(last visited April 2, 2009). 8 See GATS Annex on Financial Services 2(a); See North American Free Trade Agreement(NAFTA) Article 1410(1),32 I.L.M. 289, 605(1993)
3 Prudential measures may cause substantial economic damage to foreign financial investors, for example, if a host state's financial authority prohibited a foreign branch from conducting retail services or required mandatory lending to small and medium size companies. This paper will examine whether regulatory expropriation can be applicable to prudential measures when prudential measures interfere with a foreign investor's property. Regulatory expropriation occurs when a host state substantially interferes with a foreign investor's property to the point where interference is too severe to fall within the host state's police power.9 However, the exercise of police power for public purposes such as social welfare and security is not subject to a duty to pay compensation.10 The key issue is to determine the criteria that would facilitate the process of differentiating between regulatory expropriation and police power. This paper will prove that prudential measures can be covered by police power as long as the measures meet a good-faith principle. This paper, in chapter II, broadly touches upon concerns about cross-border trade in financial services and determines whether regulatory expropriation can be applicable to a cross-border trade. Chapter III explains prudential measures in detail and gauges the status of prudential measures by comparing them with market access obligation, domestic regulations and general exceptions of the GATS. Chapter IV reviews various criteria for discretion and proves that a good-faith principle should be the standard of review of prudential discretion. Chapter V distinguishes between regulatory expropriation and 9 See OECD, Working paper on International Investment: Indirect Expropriation and the Right to Regulate in International Investment Law, at 10-11 (September 2004), http://www.oecd.org/dataoecd/22/54/33776546.pdf (last visited April 28, 2009) [hereinafter OECD Working paper on International Investment]. 10 Id. at 9.
4 police power and proves that a good-faith principle also can be used to determine whether prudential measures can fall within police power. Finally, chapter VI concludes by answering practical questions which international tribunals would deal with in the near future.
5 II. Background 1. Liberalization of financial services There are arguments about whether liberalization is good for a host state's economy. The mercantilists believed that appropriate restriction on international trade could distribute an economy's resources to a greater extent than possible under free trade, and thus some material welfare must be sacrificed to attain that objective.11 In the same context, Keynes believed increasing import tariffs was the best policy to increase employment among three policy options: devaluation, nominal wage reduction, and import tariffs. He believed that devaluation would undermine already weak confidence in a host state's financial markets. He rejected wage reduction because it would certainly lead to social injustice and violent resistance. However, he insisted that imposing import duties would increase employment by inducing substitution of home-produced goods for goods previously imported.12 However, many studies, including one by the World Bank (1987), have shown that countries with open-market policies perform better than those that do not, although free trade may be correlated with other market-oriented economic policies or institutions.13 Taussing also insisted in the free trade doctrine that international trade brings about gains and that restricting it presumably brings about a 11 Dauglas A. Irwin, Against the Tide: An Intellectual History of Free Trade 217-18 (Princeton: Princeton University Press 1996). 12 Id. at 194. 13 Id. at 224.
6 loss.14 This free trade doctrine is applicable to financial services. Cross country data analysis results indicate that regulatory restrictions on bank activities, impediments to the entry of new banks, government ownership of banks, and reliance on powerful official supervisors in overseeing banks have adverse effects on the operation of banks.15 Statistically, expanding competition by easing restrictions on financial markets reduces funding costs; lower costs, in turn, reduce product prices and results in the enhancement of corporate competitiveness in the international market.1 However, developing countries are reluctant to liberalize their financial markets because of the following reasons: (i) financial crises are associated with internationalization or the wrong sequence of such liberalization ; (ii) financial services provide such an important function to a nation's economy that financial services are believed to be best when they are owned and controlled by domestic interests; (iii) the introduction of competition threatens the interests of the local financial industry and weakens the bureaucratic power.17 Due to the concerns of free-riding by developing countries which did not open their financial markets, even advanced countries were reluctant in committing themselves to an MFN-based multilateral agreement on trade in financial services.18 However, the presence of foreign financial institutions can be expected to increase the system's efficiency and the stability of financial markets.1 In fact, Jayaratne and Strahan (1998) proved that when individual states within the United 14 Id. at 227. 15 Barth, supra note 4, at 14. 16 Wendy Dobson & Pierre Jacquet, Financial Services Liberalization in the WTO 18 (Washington, D.C.: Institute for International Economics 1998). 17 Id. at 8. With respect to financial crises, Kaminsky and Reinhart state that banking crises in 18 of 25 cases studied occurred within five years after financial liberalization. 18 Id. at 81.
7 States created a more competitive banking sector by liberalizing their banking regulations, the rate of economic growth within those states accelerated and the quality of bank lending improved.20 Nevertheless, special caution is required in liberalizing financial services because financial services conduct the following important functions: (i) the financial system is the medium through which most of the transactions of a market economy are conducted; (ii) banks play a key role in the transmission of monetary policy to the economy; (iii) financial services improve risk management by pooling and diversifying the risks faced by the providers and the users of funds; (iv) banks monitor the behavior of corporate managers, evaluating their performance and compelling them to act in the best interests of the firms; (v) and the degree of development of the financial system affects the long- term growth and development of the economy. In this context, it is wrong to understand that deregulation of financial services simply means a decrease or elimination of prudential regulations.22 Competition in deregulation may cause a race to the bottom as countries adopt lenient polices to attract banks and thus may give rise to more money laundering, fraud, and other illegal activities. Particularly, deregulation of capital markets may make developing countries much more exposed to the speculative movements of funds. Cross-border trade through advance technologies such as the Internet enables investors to move funds more easily, when coupled with deregulation of 20 Jayaratne, Jith & Philip E. Strahan, Entry Restrictions, Industry Evolution and Dynamic Efficiency: Evidence from Commercial Banking 49, 239-74 (Fed. Res. Bank. N.Y 1998), available at http://www.newyorkfed.org/research/staff_reports/sr22.pdf (last visited April 2, 2009). ; Barth, supra note 4, at 50. 21 Dobson & Jacquet, supra note 16, atl5, 44. 22 Id. at 3. 23 Barth, supra note 4, at 161.
8 emerging capital markets, and thus paradoxically makes emerging markets more risky rather than less. 4 Therefore, the liberalization of financial services in a sequenced manner is very important. There are a variety of possible reform sequences depending on the country's macroeconomic, financial, legal, political, and sociological conditions. However, the following sequence can be a way to minimize the potential for malfunction in the liberalization process: (i) macroeconomic adjustment, (ii) trade liberalization, (iii) reform of financial markets, and (iv) liberalization of the capital account.25 In addition, the establishment of an appropriate prudential supervision system is one of prerequisites to a successful liberalization of financial services.26 Under the WTO, the liberalization of financial services has been significantly improved through the GATS. The GATS consists of text of the Agreement and the schedules of liberalization which the WTO members are scheduled to submit to the WTO and shall form the integral part of the GATS.28 The structure of the GATS was established at the conclusion of the Uruguay Round (UR) in December 1993. The text 24 Robert Grosse, The Future of Global Financial Services 22 (Maiden: Blackwell 2004). 25 Dobson & Jacquet, supra note 16, at 62-63. 26 Id. at 65-66. 27 General Agreement on Trade in Services, WTO (1994), http://www.wto.org/ (last visited April 28, 2009). The WTO agreements broadly consist of the following general agreements: General Agreement on Trade and Tariff (GATT) dealing with trade in goods, the GATS for trade in services, and Trade-Related Aspects of Intellectual Property Rights (TRIPS) dealing with the intellectual property, and the Agreement on Trade- Related Investment Measures (TRIMs Agreement) prohibiting trade-investment measure, such as local content requirements, that are inconsistent with basic provisions of GATT. 28 See the GATS Article XX (Schedule of Specific Commitments): 1. Each Member shall set out in a schedule the specific commitments it undertakes under Part III of this Agreement... 3. Schedules of specific commitments shall be annexed to this Agreement and shall form an integral part thereof. 29 James Gillespie, Financial Services Liberalization in the World Trade Organization: Prepared for Professor Howell Jackson 6 (Harvard Law School April 29, 2000)
9 of the Annex on Financial Services to the GATS was also made at the end of UR. However, the negotiations on the schedule of liberalization of financial services took a longer time because WTO members were concerned with the possibility that the liberalization of financial services would impair the safety and soundness of their own domestic financial systems. Two more financial service negotiations on January 1994- July 1995 and on April 1997-December 1997 were conducted after the conclusion of the UR.32 It was on March 1, 1999 that the current schedules of financial services were annexed to the Fifth Protocol to the GATS and became effective. Seventy Members participated in the 1997 financial services negotiations.34 Three of them (Brazil, Jamaica and the Philippines) had not ratified their commitments as of June 1, 2008.35 The GATS facilitates the liberalization of financial services by providing an Understanding on Commitments in Financial Services (hereinafter Understanding) which is an optional variant to scheduling of the liberalization of financial services. If a WTO member country adopts the Understanding, the country is expected to broadly liberalize cross- border trade and implement a standstill principle. Under the standstill principle, restrictions reserved in the schedules should not be more severe than it would be under the status-quo. In other words, the liberalization schedule of the country should reflect the level of openness that existed at the time the country made its schedule. Most OECD countries with the exception of South Korea, Mexico, and Poland have, in principle, 30 Apostolos Gkoutzinis, International Trade in Banking Services and the Role of the WTO, 39 INT'L LAW 891 (Winter 2005). 31 See Id. arf884. 32 See Id. at 891. 33 Id. 34 WTO, Financial Services Background, http://www.wto.org/english/tratop_e/serv_e/finance_e/finance_e.htm (last visited April 28, 2009).
10 chosen this variant. For reference, after the failure of the Ministerial Conference in Cancun (September 2003), the Hong Kong Ministerial Conference in December 2005 motivated services negotiations participants to submit a plurilateral request on financial services. The main objectives of the request includes commitments in a defined list of sub-sectors such as reinsurance and asset management in Mode 1 (services supplied from one country to another) and Mode 2 (consumers or firms making use of a service in another country). However, since negotiations were suspended in July 2006, no WTO members have submitted a offer in responding to the request. 2. Cross-border trade in financial services Cross-border trade in services refers to the form of international trade where foreign suppliers located in a home state transact with consumers of a host state through the use of various communication tools such as the Internet, the telephone, the fax machine and the telegraph. Cross-border trade consists of cross-border supply (Mode 1) and consumption abroad (Mode 2) under the GATS and the GATS Scheduling on guideline. GATS Article I (Scope of Definition) 2: (a) from the territory of one Member into the territory of any other Member (Mode 1); (b) in the territory of one Member to the service consumer of any other Member(Mode 2); (c) by a service supplier of one Member, through commercial presence in the territory of any other Member(Mode 3); See Dobson & Jacquet, supra note 16, at 75. 37 WTO, supra note 34. 38 See Barth, supra note 4, at 63 n.26; OECD Secretariat, Insurance and Private Pensions Compendium for Emerging Economies Book 1 part 1:6: Cross-Border Trade in Financial Services: Economics and Regulation 3 (OECD 1999), http://www.oecd.Org/dataoecd/58/0/1815131.pdf (last visited April 28, 2009). 39 GATS Scheduling guideline: The WTO Secretariat circulated a guideline to assist Member countries participating in Uruguay Round negotiation in preparation of their schedule in 1993 and revised it in 2001.
11 (d) by a service supplier of one Member, through presence of natural person of a Member in the territory of any other Member(Mode 4). Cross-border trade is different from trade through foreign direct investment (FDI) in that cross-border trade does not require a commercial presence such as a branch or a subsidiary.40 Thanks to the development of the Internet, cross-border trade in financial services increased significantly. Consumers can now transfer money, purchase auto insurance policies, and trade securities on-line.41 WTO statistics show that financial services except insurance and insurance services, comprises 14 % and 4% respectively, of total world export of commercial services in 200542 In the case of the United States, the export of cross-border financial services increased from 12.4 billion dollars in 1997 to nearly 27.4 billion dollars in 200443. Cross-border trade has been a hot issue under WTO negotiations because developing countries were reluctant to liberalize cross-border trade due to concerns dealing with consumer protection problems, a decrease of FDI, and the ambiguous distinction between Mode 1 and Mode 2.44 Developing countries believe that cross- border trade makes it difficult to protect consumers because services suppliers are located in a foreign country. The supplier is therefore outside of the country's jurisdiction altogether or, at the very least, beyond where the country's judgment could be enforced.45 OECD Secretariat, supra note 16, at 3. 41 See Id. 42 WTO, Trade in Commercial Services by Category, http://www.wto.int/english/res_e/statis_e/its2007_e/its07_trade_category_e.pdf (last visited April 28, 2009). 43 See Erin Nephew, Jennifer Koncz, Maria Borga & Michael Mann, US International Services, Cross-Border Trade in 2004, at 45 (BEA 2005). 44 See C. Christopher Parlin, Current Developments Regarding the WTO Financial Services Agreement (May 16, 2002), available at http://www.imf.org/external/np/leg/sem/2002/cdmfl/eng/parlin.pdf (last visited April 28, 2009). 45 Aaditya Matto, Financial Services and the World Trade Organization: Liberalization Commitment of the Developing and Transition Economies 6 (World Bank Trade Research Report September 1999).
12 In addition, they are worried that developed countries would withdraw their commercial presence once cross-border trade is allowed because non- resident foreign suppliers would be able to trade directly with consumers of a host state via the Internet.46 The difficulty in distinguishing between Mode 1 (cross-border supply) and Mode 2 (consumption abroad) was another hurdle for the liberalization of cross-border trade. It is unclear whether transactions via the Internet falls within Mode 1 or Mode 2 because a consumer located in a host state is able to purchase financial products from a foreign supplier of a home state by using the Internet as if the consumer traveled to the home state. The concern that the liberalization of Mode 2 could result in the inadvertent opening of Mode 1 made WTO members unwilling to make a commitment even to Mode 2. 1) Difficulty in consumer protection via juridical approach Consumer protection through juridical procedure is difficult in cross-border trade because a foreign financial supplier is not located in consumer's country. First of all, it is not easy to determine which country has an authority to rule over a defendant (financial supplier), particularly, in transactions via Internet. No case under the GATS has not addressed the jurisdictional issue relating to cross-border transaction47 However, the research regarding Internet jurisdiction as applied by the US courts suggests one answer to this jurisdictional questions. In general, to be subject to personal jurisdiction in the US, a defendant must have a minimum contact (sufficient level of personal or business A Brazil financial negotiator's statements at the WTO Financial Services Committee (May 2003). 47 Bernard M. Hoekman & Michel M.Kosteck, The Political Economy of the World Trading System: The WTO and Beyond 265 (New York: Oxford University Press 2001).
13 contact) with a state in which the court sits. In this regard, Section 402 of Restatement (3rd) of the Foreign Relationship Law of the United States describes: a country has personal jurisdiction to preside over with respect to: (1) "conduct" that, wholly or in substantial part, takes place within its territory; (2) the status of persons, or interests in things, present in its territory; (3) conduct outside its territory that has or is intended to have substantial effect within its territory; (4) the activities, interests, status, or relations of its nationals outside as well as in its territory; and (5) certain conduct outside its territory by persons who are not its nationals that is directed against the security of the country or against a limited class of other national interests.49 However, the traditional minimum contact analysis cannot always apply to Internet based transaction. It is because the Internet can allow consumers in the world to search and access to information from a publicly available site anywhere else in the world.5 The US courts found that Internet jurisdiction could be determined based on the level of activities of a supplier's website In Zippo Mfg. Co. v. Zippo Dot Com. Inc., the court created a sliding scale for measuring websites, which fall into one of three general categories: i) passive, ii) interactive, and iii) integral to the defendant's business.51 The "passive" website posts general information and does not have communicative tools such as e-mail. Courts do not exercise personal jurisdiction based solely on a passive website.52 The "integral" website is used actively by the operator to conduct transactions with persons in the forum 48 International Shoe Co. v. Washington, 326 U.S. 310 (1945). 49 RESTATEMENT(3RD) OF THE FOREIGN RELATIONS LAW OF THE U.S. §402 (American Law Institute Publishers 1986). 50 Roy Whitehead & Pam Spikes, Determining Internet Jurisdiction, CPA J (2006), available at http://www.nysscpa.org/cpajournal/2003/0703/features/f072403.htm (last visited March 28, 2009). 51 Denis T. Rice, Problems in Running a Global Internet Business: Complying with Laws of Other Countries, 797 PLI/Pat 11,12 (2004); Zippo Mfg. Co. v. Zippo Dot Com. Inc., 952 F. Supp. 1119, 1124 (W.D. Pa. 1996).
14 state, receiving on-line orders and pushing confirmation or other messages directly to specific customers. In case of the "interactive" website, the personal jurisdiction is determined based on the level of interactivity and the commercial nature of the site.54 In Digital Equipment Corp. v. AltaVista Technology, Inc., the court held that it had personal jurisdiction over a nonresident company whose website solicited its products and communicated to local users through the site.55 In addition, in Young v. New Haven Advocate, the court said that something more than posting and accessibility was needed to indicate that the defendant purposefully availed itself in the targeted territory.5 Similarly, in Gator. Com Corp. v. L.L. Bean, Inc., the court recognized its personal jurisdiction over a retailer that conducted extensive marketing and sales via the Internet in California even though the retailer had no official agent in California, was not authorized to do business there, and paid no taxes there.57 . The US cases above indicates that the court of a consumer's country can have personal jurisdiction when a foreign financial supplier conducts substantial and constant business activities via the Internet in a consumer's country. Therefore, for example, in the case where a German foreign financial supplier sells an insurance policy to a US resident through solicitation via the Internet, the US court would have personal jurisdiction in the case. 53 id. 54 id. 55See Jason H. Eaton, J.D., Effect of Use, or Alleged Use, of the Internet on Personal Jurisdiction in, or Venue of, Federal Court Case, 155 A.L.R. Fed. 535, 17 (West Law page: publication page references are not available for this document., p.l7:West law ) (1999); Digital Equipment Corp. v. AltaVista Technology, Inc., 960 F. Supp. 456 (D. Mass. 1997). 56 Panavision Int'l, L.P. v. Toeppen, 141 F.3d 1316, 1321 (9*011. 1998). 57 Eaton, supra note 55, at 23(West Law Page); Gator.Com Corp. v. L.L. Bean, Inc., 341 F.3d 1072 (9th Cir. 2003).
15 For reference, the EU regulation on jurisdiction and the recognition and enforcement of judgment in civil and commercial matters provides for jurisdiction in the State of the consumer if an enterprise, as the offeror, has committed an act purposely directed toward the forum State.59 EU's criterion is similar to the US 'purposeful availability approach.60 However, personal jurisdiction can be, in practice, decided in favor of a foreign financial supplier through "forum selection clauses" in transaction contracts. Many electronic commercial contracts including financial services contain forum selection clauses which, in advance, designate a supplier's court as the forum to preside over potential disputes. In general, courts respect forum selection clauses because they are the result of negotiations between contracting parties.61 While equal bargaining power of contracting parties is required in terms of fairness and reasonableness, US courts tend to enforce forum selection clauses unless they are egregiously unfair.62 For example, in Carnival Cruise Lines, Inc. v. Shute, the Supreme Court required a Washington resident, injured in a fall on the defendant's cruise ship, to sue in a Florida court based on nonnegotiable fine print on the back of a steamship ticket issued by a Florida corporation but purchased in Washington.63 Even though the sole basis of decision on the Carnival Cruise Line decision was that it was especially important for a cruise line to be able to 58 Council Regulation on Jurisdiction and the Recognition and Enforcement of Judgments in Civil and Commercial Matters of 22 December 2000,44/2001 EC, O.J. L 12/1 16.1.2001. 59 Legal Issues in Electronic Banking 8 (Norbert Horn ed., New York: Wolters Kluwer 2002). 60 Id. 61 Bremen v. Zapata off-shore co., 407 U.S. 1, 92 (S.Ct. 1907), 32 L. Ed.2d 513 (1972). "This case involves a freely negotiated international commercial transaction between a German and an American corporation for towage of a vessel... As noted, selection of a London forum was clearly a reasonable effort to bring vital certainty to this international transaction and to provide a neutral forum." 62 David Epstein, Charles S. Baldwin, IV & Ronald A. Brand, International Civil Dispute Resolution 65-67 (St. Paul: Thomson/West 2005). 63 Id. at 65.