Cash and securities collateral are often a key component of
managing risk in a structured transaction. Unfortunately, as with
many security or quasi-security arrangements, cash and securities
collateral structures raise numerous legal risk issues. Now,
though, help is at hand in the unlikely guise of an EU Directive,
which changes the rules for taking and enforcing collateral. These
changes will help collateral takers simplify their documentation
and due diligence procedures, assist collateral providers by
reducing the costs associated with credit and enabling a wider
variety of transaction structures, and give credit support
arrangements greater legal certainty.
The EU Collateral Directive
The main source of reform is the EU Collateral Directive. The
Directive is designed to simplify taking and enforcing financial
collateral arrangements. As such, its main objectives are:
- the abolition of formalities relating to the creation and
enforcement of financial collateral arrangements;
- to allow the enforcement of financial collateral
arrangements notwithstanding any moratorium applicable in
corporate reorganization proceedings;
- that collateral takers be allowed to re-use collateral as
if they owned it;
- that title transfer of collateral arrangements and
close-out netting structures be legally recognized and
enforceable;
- that zero hour and other retroactive insolvency rules no
longer be applied in relation to the provision of financial
collateral; and
- that various questions (typically ownership questions)
relating to book entry securities collateral be governed by the
law of the country where the securities account is
maintained.
How the Directive helps
The Collateral Directive offers solutions to some of the
difficulties encountered until now with collateral structures in
the EU (depending on the jurisdiction concerned). These
include:
- whether insolvency law permits set-off of cash collateral
against what the collateral taker is owed. The Collateral
Directive requires member states to permit this;
- what method of enforcement is appropriate: in a two-party
cash collateral arrangement, the collateral taker will just
wish to set off (that is, cancel the countervailing entries in
his books, safe in the knowledge that he can no longer be held
liable to return the cash deposited with him); in a three-party
arrangement, the collateral taker will wish to collect the
deposit from the third-party bank. Some collateral enforcement
laws require a sale of collateral to third parties, which is
artificial when applied to such arrangements. The Collateral
Directive allows enforcement by appropriation;
- whether a title transfer securities collateral arrangement
is in danger of being recharacterized as a pledge and rendered
void for want of proper perfection. The Collateral Directive
requires recognition of title transfer as a valid
technique;
- whether a charge over an account to which securities are
credited requires registration, for example under section 395
of the UK Companies Act 1985. The Collateral Directive
abolishes registration requirements;
- whether enforcement of a securities charge can be blocked
by a moratorium. The Collateral Directive permits enforcement
notwithstanding a moratorium; and
- which country's laws apply in determining what perfection
steps to take where a securities account to be charged contains
securities issued in many countries. The Collateral Directive
restricts the relevant jurisdictions to the place where the
securities account is maintained.
When does the Collateral Directive apply?
The Collateral Directive applies to financial collateral
arrangements between qualifying parties. Such arrangements
comprise:
- title transfer (whereby the collateral provider essentially
repossesses the collateral to the collateral taker, and, upon
default, the value of the collateral is set off against the
amount which the collateral provider owes) and security (that
is, charges, more commonly referred to as pledges)
arrangements; involving
- cash or financial instruments (which is widely defined);
where
- the collateral has been provided by being delivered,
transferred, held, registered or otherwise designated so as to
be in the possession or under the control of the collateral
taker; and
- the provision can be evidenced in writing; for which
purpose
- the collateral must be identified, and this can be done by
a credit to an account.
For the collateral arrangements to qualify, the parties must be
financial institutions, government entities, central banks or
supra-nationals - but collateral arrangements involving an
unregulated, non-governmental corporate can also qualify, subject
to the following conditions:
- if neither party is a financial or government entity,
member states do not have to extend the reforms to cover that
type of collateral arrangement (the UK has decided, in
implementing the Collateral Directive, to disregard this
restriction, so that collateral arrangements that involve two
non-natural persons would benefit from the reforms);
- member states have the option to exclude collateral
arrangements involving unregulated, non-government entities
altogether, thereby restricting the usefulness of the reforms
in any member state exercising this option - although few, if
any, member states are expected to take this course; and
- collateral arrangements involving individuals never qualify
under the Directive.
Implications for structured transactions
Banking has long had a tendency to adopt a cautious approach
when considering whether to register security over cash or shares,
because of concerns that the security may encompass book debts.
Security that constitutes a charge over book debts should generally
be registered under the UK Companies Act 1985 to ensure its
enforceability in the event of insolvency of the chargor. The
Collateral Directive should help to remove some of the uncertainty
by abolishing the requirement to register security in circumstances
where the financial collateral is in the possession or under the
control of the secured party.
The Collateral Directive makes clear that the right of the
chargor to substitute collateral or withdraw any surplus will not
undermine the control of the secured party (notwithstanding that
this would defeat a fixed charge in the absence of a requirement
for specific consent).
One of the other effects of the Collateral Directive is to
remove the moratorium on the enforcement of security arising on
administration. The floating-charge holder whose security meets the
necessary requirements of the Collateral Directive may thereby
enjoy better treatment than they would otherwise receive under the
general law if they are able to enforce their security when the
chargor is in administration. It may be possible that the
Collateral Directive could ameliorate some of the restrictive
effects of the Enterprise Act, which has diminished the ability of
secured parties to block the effects of administration. This would
be an unexpected result - not least for administrators.
Securities collateral consisting of a portfolio of collateral
emanating from different issuers in different countries has
historically raised a challenging cross-border perfection problem.
If the collateral taker seeks to perfect the security in all the
potentially relevant jurisdictions, an immense amount of due
diligence and expense would ensue. The Collateral Directive should
help simplify this, insofar as securities of EU origin are
concerned, by restricting the relevant jurisdiction to the place
where the account in which the securities are held is
maintained.
Complex structured transactions are often shaped by the
competing forces of tax law, accounting treatment and pressure on
regulatory capital. One solution to the regulatory capital
component is to use cash or Zone A government securities as
collateral, because this reduces the risk weighting and large
exposure treatment of a credit exposure, often to zero; and a zero
weighting means less capital has to be allocated to the
transaction.
Where the structure requires collateral to be passed from one
party to another, it can fall foul of rules restricting re-use.
Historically re-use has been possible where collateral is situated
in New York, but this can be a constraint in some cases. The
Collateral Directive will help by liberalizing the rules on re-use,
thereby opening up greater choice of jurisdictions that can be used
for such transactions.
Interplay with other reforms
The Collateral Directive is not the only event that needs to be
taken into account. On the European front, there have also been
changes to insolvency law, in the form of the EU Insolvency
Regulation and the Winding-up Directives. These measures also
affect collateral arrangements, because collateral is about
managing credit risk, which is itself about the effects of
insolvency proceedings.
The EU Insolvency Regulation applies to companies, partnerships
and individuals that are not regulated under financial services
legislation: organizations that are insurance undertakings, credit
institutions, investment undertakings that provide services
involving the holding of funds or securities for third parties, or
collective investment undertakings are carved out from its scope,
but everything else is covered, provided that its centre of main
interests is in an EU member state, including the 10 new states
that joined the EU in May 2004. (The only exception is Denmark,
which has opted out of the EU Insolvency Regulation.) Its principal
purpose is to impose a set of conflicts of law rules for
cross-border insolvencies. The Winding-up Directives apply to EU
insurance undertakings and EU credit institutions and have a
similar purpose to the EU Insolvency Regulation.
These EU insolvency measures each contain two provisions that
affect collateral arrangements:
- Set-off is a useful technique for cash collateral
arrangements. Set-off arrangements are subject to a carve-out,
which says that the opening of insolvency proceedings does not
affect the right of creditors to demand a set-off, provided
that the set-off is permitted by the law applicable to the
insolvent person's claim. Various controversies surround this
rule, including whether the concept of set-off can embrace
close-out netting, but the central point of the carve-out is
that contractual set-off is protected from some species of
insolvency attack if it works under the law of the insolvent
person's claim. Some rights of attack are, nonetheless,
preserved. The wording of the carve-out has an important
implication for cash collateral arrangements that depend on
set-off: to take advantage of the carve-out the set-off clause
should be in the deposit agreement rather than in other
documentation.
- Security arrangements, typically used for securities
collateral but also useful for cash collateral deposited at a
third-party bank, are also subject to a carve-out. This
carve-out says that the opening of insolvency proceedings does
not affect rights in rem, which should include creditors'
security interests, where the subject matter of the security is
located in a different member state from that where the
insolvency proceedings were opened. This rule has the effect
that security interests over foreign assets are enforceable
notwithstanding a moratorium applicable in the insolvent
entity's home state. As with the set-off carve-out, some rights
of attack under insolvency laws are preserved.
These EU insolvency measures will have some impact on cash and
securities collateral structures, particularly where the Collateral
Directive does not apply. Cash collateral arrangements will benefit
from the specific protection of set-off clauses and rights in rem
over foreign assets against insolvency attack. As for securities
collateral arrangements, the protection of rights in rem will
provide some assistance in respect of charges.
Unfortunately, though, there is a muddle over the rules for
which system of law applies to questions about entitlement to
securities in the EU insolvency measures and the Collateral
Directive. These rules ensure that the validity of the collateral
arrangements is checked out against the correct legal system. It is
no use knowing that the collateral arrangements are effective under
English law if the collateral provider's liquidator can
successfully challenge them on the ground that German law governs
the arrangements and essential German requirements were not
complied with. Article 2(g) of the EU Insolvency Regulation locates
"property and rights ownership of or entitlement to which must be
entered in a public register" in the place where the register is
kept, and claims in the place where the obligor has the centre of
its main interests. Arguments can be made that some registered
securities fall within the first of these categories and bonds in
the second, but the rule was probably not formulated with a view to
securities.
The Winding-up Directive for credit institutions states that the
enforcement of proprietary rights in instruments recorded in a
register, account or centralized deposit system in a member state
is governed by the law of the state where the register, account or
system is held or located. This is likely to coincide in many cases
with the place where the account is maintained (the wording used in
the Collateral Directive), but there could be instances where the
two are at variance. It is hoped that the EU Commission will make
proposals to harmonize the various pieces of legislation in time to
prevent the differences causing practical difficulties.
On top of this, in the UK there has also been local reform under
the Enterprise Act 2002 and new case law relating to collateral
taking the form of receivables in the Spectrum case. Collateral
arrangements that fall within the scope of the Collateral Directive
will be enforceable notwithstanding the moratorium applicable in a
new-style Enterprise Act administration. This may facilitate
structures that rely on a cash or securities collateral element.
Uncollected receivables are, however, unlikely to qualify as cash
for the purposes of the Collateral Directive, so it is improbable
that securitizations can use the Directive as an alternative to
structuring transactions as capital market arrangements to
circumvent the effects of the Enterprise Act.
What happens next?
The Collateral Directive was due to be transposed into the laws
of the EU member states by December 27 2003. The UK met this
deadline, but many of the original 15 member states missed it.
Since May 1 2004 the 10 new member states have also been obliged to
implement the Collateral Directive. During the rest of 2004 we can
expect to see most of the EU countries catch up. Once the major EU
economies have taken the necessary steps, the rules for taking and
enforcing collateral will have a good degree of uniformity and
predictability across Europe.
The new legal structure is unlikely to make anything worse for
any provider or taker of financial collateral, and should make for
some substantial improvements. As far as cash collateral is
concerned, there will not be much difference in practice. A useful
boost is the abolition of doubt over the need to make precautionary
registrations against UK cash and securities collateral providers
under Section 395 of the Companies Act 1985.
For securities collateral arrangements, the reforms will have
greater impact. Cross-border securities collateral arrangements
have historically been fraught with complex legal issues,
particularly as identifying which legal systems are relevant has
itself been difficult. The Collateral Directive selects a single
legal system for the analysis. Being allowed to re-hypothecate
pledged/charged collateral will also help.
So the Collateral Directive will reduce risk and complexity,
save costs and help the markets - and is extremely welcome. Where
the Collateral Directive is not applicable, some benefits may flow
from the other EU insolvency measures. Collateral can now become a
more useful component in structured transactions.
Author
biography
Dermot Turing
Clifford Chance
Dermot Turing is a partner in Clifford Chance's finance
practice, in the financial institutions and risk management group.
Dermot advises on regulatory matters, clearing and settlement,
financial institutions, derivatives and risk management generally.
Dermot has been following the implementation of the EU Financial
Collateral Directive and EU proposals to reform the regulation of
clearing and settlement. Dermot joined Clifford Chance in 1990 and
became a partner in 1999. He is the author of The Risk Management
Handbook published by Butterworths in March 2000 and the chapter on
set-off in Tolley's Insolvency Law.
Contact details:
Dermot Turing
Clifford Chance
10 Upper Bank Street
London E14 5JJ
United Kingdom
Tel: +44 20 7006 1630
Fax: +44 20 7006 5555
Email:
dermot.turing@cliffordchance.com
Web:
www.cliffordchance.com