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
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
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
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
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
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
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.
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
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.
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
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