Freezer burn: United States extraterritorial freeze orders and the case for efficient risk allocation.

• Author: Gerstenhaber, Rachel R.

Consider the record of recent American asset freezes(1):

1990: Iraq, upon the invasion of Kuwait; 1988: Panama, before American intervention; 1986: Libya, after a spate of terrorist actions; 1979: Iran, after the seizure of American hostages; 1975: South Vietnam, after the fall of Saigon.(2)

This list extends further back,(3) and is certain to continue into the future, but with what alarming regularity and with what detrimental impact on the Eurodollar market(4) and its participants?

International political crises often throw financial markets into a tailspin, especially one so reliant upon the speed of transactions and liquidity of funds as the Eurodollar market. The turmoil increases and lingers with continued litigation which has as yet been unable to provide clear rules enabling parties to international financial transactions to bargain efficiently and allocate political risk. The problem is especially acute given the vast sums involved.

This Comment will focus on the primary issues arising from the use of executive freeze orders(5) to block extraterritorial Eurodollar accounts:(6) the uncertainty of the outcome of litigation and the inefficient allocation of risk. Courts have spurned an economic analysis of risk allocation and have instead manipulated legal doctrines, thus producing variable and inefficient outcomes in cases arising from Eurodollar transactions.(7) Consequently, the United States government has been slow to acknowledge and internalize the costs of imposing its will overseas: increased transaction costs in the Eurodollar market and removal of capital from American banks and branches. To find a framework providing a clear rule of risk allocation, this Comment will address the essential question and its corollary: (1) who should bear the risk of an extraterritorial freeze order, the depository institution or the target country depositor?; and (2) what are the consequences and ramifications of such an allocation decision?

The discussion will in turn consider freezes, defenses asserted by bank branches impaired by them, an alternative economic analysis, and the ramifications of such a risk allocation analysis. The first section will provide background on Eurodollar transactions necessary for analysis of the issues which arise in a freeze. The second section will discuss the process of imposing an executive freeze order and its scope. The third section will critique the standard legal analyses used in evaluating international deposit disputes. The fourth section will propose an efficient rule of risk allocation derived from economic analysis, focusing on interest rate differentials between domestic dollar and Eurodollar accounts. Lastly, the fifth section will address the consequences of the rule in foreign policy terms, evaluating the benefits and disadvantages of extraterritorial freeze orders.

1. AN INTRODUCTION TO THE EURODOLLAR MARKET

   To discuss the issues involved, it will be useful to outline some basic aspects of the Eurodollar market: (1) What are Eurodollars and how are they created? (2) Why is the Eurodollar market significant? (3) How is the typical Eurodollar transaction effected? and (4) What are the risks involved in dealing in Eurodollars?

   1. Eurodollars Defined and Created

      A Eurodollar is a deposit liability(8) denominated in dollars of a banking office located outside the United States,(9) whether or not in Europe.(10) Eurodollars are a subset of Eurocurrency deposits, those liabilities of banks generally, denominated in any currency,(11) outside the jurisdiction of that currency.(12) Eurodollar deposits may be fully liquid, or of a longer duration, negotiable or non-negotiable.(13)

      The creation of a Eurodollar deposit may be illustrated best by a streamlined example:(14) IBM Corporation decides to transfer $1 million out of its account at Chase Manhattan Bank in New York and deposit the funds with Barclays Bank in London, to take advantage of the higher interest rate offered on Eurodollar accounts.(15) In transferring the payment obligation on IBM's demand deposit to Barclays from Chase, a Eurodollar deposit is created which substitutes for an equivalent demand deposit in the United States.(16) Barclays will then utilize these funds to grant a loan to a borrower, or else place the $1 million in the Eurodollar interbank market.(17) Eurodollar deposits are thus "linked" to demand deposits in the United States, in that they "represent claims to demand deposit liabilities of a bank in the U.S. which can be mobilized at a specific future date."(18)

   2. The Eurodollar Market and Its Growth

      Seemingly as abstract as Eurodollars, the Eurodollar interbank market, alluded to above, is a forum comprising financial institutions (Eurobanks(19)) which compete for depositors' dollars and make loans to borrowers, outside the United States.(20) Primarily a wholesale market, transactions denominated in sums of $1 million or more(21) are effected by bankers(22) at an ever-increasing number of financial centers(23) outside the United States,(24) preeminently London.(25) The increased creation of Eurodollars and the enormous growth of the Eurodollar market in recent decades(26) is largely attributable to United States banking and loan regulations,(27) international monetary shocks,(28) technological advances,(29) opportunities for diversification and higher interest rates,(30) and convenience to customers.(31)

      A Simple Eurodollar Transaction and Clearing House Settlement

      A Eurodollar transaction, requiring the transfer of funds from IBM's new account at Barclays to Citicorp's London branch, to pay a European servicer, British Airways (BA), for example,(32) warrants illustration, as the mechanism has been pivotal to the defense of non-payment of frozen assets.(33) When IBM asks Barclays to pay out to BA, Barclays will telex its correspondent bank in the United States,(34) Manufacturers Hanover Trust (MHT) and request the transfer of dollars from its account in favor of BA's account at Citicorp/London. MHT will then submit instructions to the Clearing House Interbank Payment System (CHIPS) to credit dollars from its account, in favor of Citicorp's New York office, the corresponding bank of Citicorp/London.(35) At the end of the day, CHIPS nets out all the transactions of the various member banks, and credits Citicorp's New York office, which then telexes its London branch to notify it of the credit received in its favor.(36) Citicorp's and Chase's reserve accounts with the Federal Reserve Bank of New York (Fed) are similarly adjusted.(37)

      Although just one of a number of clearing systems(38) which settle a mind-boggling variety of international transactions,(39) CHIPS is the clearinghouse most significantly related to dollar transfers initiated in international markets.(40) The clearing system allows the netting of debits and credits of participant banks, and through them, as illustrated above, of participants' correspondent institutions, so that Eurodollar transactions can occur at high volumes daily.(41)

   4. Risk, Very Briely

      International transactions are subject to two types of risk, political and credit, and parties pay each other to assume these risks. Credit risk is the risk of default: the risk "that the borrower will not be able to pay interest on his loan and repay the principal when it becomes due."(42) Political risk, the risk of foreign governmental action, has been defined as "the risk incurred by lenders and/or investors that the repatriation of their loan and/or investment in a particular country . . . is restricted by that country for political reasons only."(43)

      Eurodollars are potentially subject to the inimical acts of three different governments:(44) (1) the currency-issuing country (the country in whose currency the deposit is denominated); (2) the host country (where the branch is located); and (3) the bank chartering country (where the head office is incorporated).(45) Indeed, the case law reveals that just such risks have materialized, prompting litigation arising from such actions as revolution followed by expropriation of bank branches(46) or accounts,(47) exchange controls,(48) and of course, freeze orders, extraterritorial or domestic.

2. THE EXTRATERRITORIAL REACH OF EXECUTIVE FREEZE ORDERS AND THEIR LEGAL REPERCUSSIONS

   Given the extent of the Eurodollar market, it is clear why any disruption in its smooth flow causes great worry in financial sectors: the amounts involved are gargantuan, the liquidity relies on swift, electronically-effected transactions, and the risk exposure is omnipresent. American freeze orders are about as welcome as the plague.

   Nonetheless, the United States has long used freeze orders as a foreign policy tool in response to aggression;(49) a glance through the federal regulations noted above would easily supplement a brief lesson in adversarial American foreign relations.(50) Although some of the regulations have lasted for decades,(51) the recent freezes against Iran, Libya, and Iraq have had the most significant effects on the Eurodollar market.

   1. Yelling Freeze!

      The President(52) possesses broad power to impose an immediate economic freeze under the International Emergency Economic Powers Act (IEEPA).(53) Executive orders directed at freezing offending nations' assets delegate authority to the Treasury Department to issue regulations to enforce the orders. These regulations prohibit all transactions with the target nation without prior authorization in the form of a license from the Treasury Department's Office of Foreign Asset Control (OFAC).(54) Of such executive power,(55) one participant in the financial negotiations during the Iranian crisis noted that, "[b]y a stroke of his pen, the President of the United States had immobilized over $5 billion in deposits in other countries and kept them immobilized for 14 months."(56)

   2. Blocking Target Countries' Assets

      The language of the Iranian freeze(57) mandated the blocking of assets...