New legislation set to address Hammersmith concerns

David Craig, Partner | December 2003

Ever since the House of Lords decision in Hammersmith was handed down in 1991, financial institutions have been wary of dealing with statutory corporations - particularly in relation to derivative transactions. Likewise, lawyers giving enforceability opinions for these dealings have had to interpret some ambiguous, and often archaic, legislation and yet reach a "yes" or "no" conclusion.

The issue is one of legal capacity. Specifically, does a particular statutory corporation have the capacity to enter into derivative transactions? Parliament is currently considering legislation dealing with this issue, a step that should be welcomed by financial institutions and those who advise them.

The Bill - background

The Public Finance (State Sector Management) Bill (the Bill) had its first reading in Parliament on 16 December 2003. The Bill is the culmination of a review of the current legislation governing public finances and management of the state sector in New Zealand.

Among other things, the Bill creates a new Crown Entities Act (the Act). Very broadly, the intention of the Act is to be an umbrella statute that provides generic rules for all "Crown entities" (which include statutory corporations). However, the establishment of those entities is left to the individual Acts that currently govern New Zealand's statutory corporations.

The part of the Act that may be of most interest to financial institutions is that regulating the capacity of Crown entities to borrow, invest, guarantee and enter into derivative transactions. This note focuses on the latter issue as this is unquestionably the one that has been the most problematic in the past.

Capacity to enter into derivative transactions

The Act sets out a comprehensive definition of "derivative transaction". It then provides a general prohibition on a Crown entity entering into derivative transactions, except pursuant to:

• regulations made under the Act; or
  
  
• the joint approval of that entity's responsible Minister and the Minister of Finance; or
  
  
• the legislation establishing that entity; or
  
  
• an exemption granted under the Act.

In respect of the last of these exceptions, a select few Crown entities (mainly statutory corporations whose principal role is to administer public funds) are exempt from the general prohibition. Accordingly, these entities should, in practice, have greater freedom to enter into derivative transactions than should other Crown entities. The rationale for this is, presumably, that it is appropriate to impose statutory restrictions on entities for whom the entry into derivative transactions is merely an incidental part of their business. But it is not appropriate to do so where the entry into derivative transactions is, itself, part of an entity's core business.

Ultra vires transactions

Currently, a transaction that is ultra vires (or outside the capacity of) a statutory corporation is unenforceable. The Act will change that position (in part, at least) by borrowing concepts from the Companies Act 1993 that seek to protect innocent parties dealing with companies. For example:

• Certain types of ultra vires transactions (including, expressly, derivative transactions) will be enforceable against a statutory corporation unless its counterparty "had, or ought reasonably to have had, knowledge" of the impropriety. Lawyers will, no doubt, have an interesting time determining whether the proviso applies to the particular circumstances of their case. For example, should the act of seeking legal advice, in and of itself, disentitle a party from protection?
  
  
• A counterparty is entitled to assume the due authority of certain employees and officers of a statutory corporation unless (once again) that counterparty knows, or ought reasonably to know, that the person is not in fact so authorised.
  
  
• It is irrelevant to the validity of an act that the act is not in the best interests of the statutory corporation concerned. In other words, any residual corporate benefit rule that would otherwise have applied to statutory corporations is displaced.

Existing derivative transactions

The Act will provide that existing derivative transactions that would be restricted under the new legislation are unaffected by it. However, those transactions may not be amended, and options under them may not be exercised, without the permission of the Minister of Finance.

Some thoughts

• The select few Crown entities who will not be subject to statutory restrictions on their ability to enter into derivatives are some of the most active public sector counterparties. For them, and for those who transact with them, the capacity issue will become much simpler.
  
  
• However, for the other Crown entities, the position may not change much. Lawyers may still find themselves pouring over establishing legislation trying to read into generic empowering provisions the capacity to enter into derivatives.
  
  
• Even where a Crown entity does have capacity to do an act (such as entering into a derivative transaction), it may only do so for the purpose of performing its functions. What exactly this means in practice for a prospective counterparty is not clear.
  
  
• The move to protect counterparties of statutory corporations acting ultra vires is encouraging. But why is the protection not available to a person who "knows, or ought to know", of the impropriety? There is no such proviso in the equivalent Companies Act provision. And what do these words actually mean?

When will the Bill become law?

The Bill has had its first reading. However, Parliament will not sit next until 10 February 2004. Assuming that the Bill is referred to a Select Committee, it seems reasonable to expect that the Bill will not come into force until the second or third quarter of 2004.