Author: | Published: 30 Sep 2004
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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.


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.


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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