Europe's Directive on Financial Collateral Arrangements,
implemented by the UK at the very end of 2003, will make it easier
to take and enforce collateral in a variety of financial
transactions. The drafting of the implementing regulations,
however, creates some new legal uncertainty as well.
The UK implemented the new rules through the Financial
Collateral Arrangements (No 2) Regulations 2003, which took effect
on December 26 2003. Although only the UK and Denmark met the
deadline for implementation (December 27 2003), the necessary
legislation should be passed by the other member states in the EU
in due course.
The Regulations modify certain formalities required to create
and perfect financial collateral arrangements. They modify
insolvency law in relation to the enforcement of financial
collateral arrangements. They modify certain rights (such as the
rights to use and appropriate collateral) in relation to financial
collateral arrangements. They also create a standard test as to
which country's domestic law is applicable to book entry securities
financial collateral arrangements.
The Regulations were primarily directed at the over-the-counter
financial product market, but their actual scope is much wider.
They will cover most security interests over, or outright transfers
of, financial instruments or cash, to secure or otherwise provide
collateral for a financial obligation. This will include a wide
range of transactions, from a straightforward loan secured, or
otherwise collateralized, by cash or securities, to structured
over-the-counter financial products. The broad scope of the
Regulations is beneficial to banks, and will open up opportunities
to develop new structures to take full advantage of the new
law.
Scope
The Regulations will apply to any financial collateral
arrangements (FCAs), covering both title transfer arrangements
(which specifically include repurchase agreements) and security
arrangements involving financial collateral. Financial collateral
is defined as either cash or financial instruments (which include
equity, bonds and other specified instruments).
There are specific tests required for floating charges to
constitute an FCA, which, broadly, require that the collateral is
transferred to, or is otherwise in the possession or under the
control of, the collateral taker. This raises the question of what
in the possession or under the control means. The hallmark
of a floating charge is that control remains with the chargor,
rather than the chargee.
The Regulations provide that a right of the collateral provider
to substitute collateral or withdraw excess collateral will not
mean that the collateral taker will not have sufficient possession
or control for these purposes, although this is exactly the type of
issue that turns what would otherwise be a fixed charge into a
floating charge. The definition appears to seek to address the
situation where title to the assets is actually transferred (by way
of security), but the security transfer fails to be a fixed
security interest because of rights by the chargor to deal with the
asset. It seems to be trying to exclude a general floating charge
over a pool of assets, where no transfer is involved at all.
To fall within the Regulations, the purpose of the arrangements
must be to secure or cover relevant financial obligations. The
definition of relevant financial obligations is wide and covers
present and future, actual, contingent and prospective obligations,
including obligations of a class. Despite the name of the
Regulations, and the defined terms used, it does not appear that
the obligations strictly need to be financial.
The scope of the Regulations is wider than is required by the
Directive, and will apply where both parties are non-natural
persons (for example, companies or partnerships).
Main provisions
The Directive provides that the only formality that may be
required for an FCA to be perfected and enforceable is that the
arrangement is evidenced in writing. Accordingly, the Regulations
disappy certain legislation that would have the contrary
effect.
The requirement to register certain types of security interest
at Companies House under Section 395 of the Companies Act 1985 is
also disapplied in relation to a security FCA or any charge created
or otherwise arising under a security FCA. This is of particular
significance to financial institutions, which have regulatory
concerns that make such registrations unattractive.
Regulation 8 disapplies those provisions of the Insolvency Act
1986 that prevent enforcement of security interests when a company
or partnership is in administration or subject to a voluntary
arrangement, including Schedule B1 paragraph 43(2), which prohibits
any steps being taken to enforce security over a company's property
except with the consent of the administrator or with the permission
of the court.
Regulation 10 disapplies certain provisions of the Insolvency
Act 1986 regarding disclaiming onerous contracts and the avoidance
of floating charges. In addition, it disapplies the provisions
prescribing a ring-fenced fund of up to £600,000 ($1.1 million) for
unsecured creditors out of assets subject to a floating charge,
which was introduced under the Enterprise Act 2002.
Close-out netting
Regulation 12(1) provides that a close-out netting provision in
an FCA will take effect in accordance with its terms even if a
party to the arrangement is being wound up or is in administration
or subject to a voluntary arrangement. This blanket provision is
subject only to Regulation 12(2), which provides that the other
party may not enforce if it had notice of certain steps (or was or
should have been aware of certain steps) leading to insolvency
proceedings or measures at the time when it entered into the
arrangement or when the relevant financial obligations came into
existence.
Regulation 12(4) disapplies certain legislative provisions that
would conflict with these timing requirements.
It is unclear how broad ranging the effect of Regulation 12(1)
is intended to be. Unlike other parts of the Regulations, which
disapply specific statutory provisions, Regulation 12(1) simply
states that close-out netting provisions will (subject to the
notice issues described above) be effective. It is therefore
unclear to what extent the requirements other than those relating
to notice are disapplied.
Rights
Regulation 16 provides that, where a security FCA provides a
right of use for the collateral-taker over the collateral, that
term is to be enforceable. Where a right of use is exercised, the
collateral-taker is obliged to replace the collateral with
equivalent financial collateral, unless he sets off the value of
the collateral in discharge of the relevant financial obligations
in accordance with the terms of the arrangement. The equivalent
financial collateral is subject to the same terms as the original
financial collateral. Obligations arising under right of use
provisions in the arrangement may be the subject of a close-out
netting provision.
This means that for the first time the holder of collateral will
have the right to use the collateral for its own purposes, for
example to sell or use the assets to collateral himself. The exact
legal effect of exercising this right may not be entirely clear for
some time.
Regulation 17 provides that, where a collateral-taker under a
security FCA has a mortgage over the collateral provided under the
arrangement, it may enforce any right of appropriation of the
collateral that the arrangement provides for (that is, take the
collateral for itself), without applying to the court for an order
for foreclosure. Under the pre-existing law, the security-taker's
right of enforcement without court consent was limited to sale of
the asset to a third party.
Book entry securities
Regulation 19 imposes a test to determine which domestic law
will apply to book entry securities that are held through one or
more intermediaries (that is, securities held in an account with a
custodian in a clearing system) and provided as collateral under an
FCA, where there is a conflict of laws issue to be decided. The
test is that certain specified matters will be governed by the
domestic law of the country in which the relevant account (as
defined in Regulation 3) is maintained. Such matters include the
legal nature and proprietary effects of book entry securities
collateral and the steps required for the realization of book entry
securities collateral after the occurrence of an enforcement
event.
This is a helpful development in the context of, for instance,
repackagings, because security interests will typically be granted
over underlying securities held in book entry form in the issuer's
account with the custodian. This standard test provides extra
certainty as to which law will apply in which circumstances.
Isda documentation
If the right of use is provided for under its terms, the
collateral-taker will have the right to use the collateral granted
under a Credit Support Deed (the security version of the standard
form Isda collateral document). In practice, however, a significant
increase in the use of the credit support deed in transactions is
not expected.
Benedict James is a partner and Will Nevin an associate of
Linklaters in London.
This article first appeared in the March 2004 issue of
IFLR.
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