The Law of Financial Collateral by Geoffrey Yeowart and Robin Parsons

The global financial crisis of 2008-2009 resulted in a flood of litigation concerning financial collateral much of it connected with the collapse of Lehman Brothers International (Europe) as well as attempts to reform the law and regulatory practice to avoid institutions seeking state support in the future as being ‘too big to fail’.   Financial collateral has become a crucial tool to enable market participants and central counterparties to manage credit risk. Its use will grow further as the European Markets Infrastructure Regulation (‘EMIR’) is implemented. Both centrally cleared and non-centrally cleared transactions will need to be supported by collateral. The law of financial collateral, particularly in cross-border transactions, is relatively new deriving in Europe from the European Financial Collateral Directive (‘FCD’) implemented in the UK by the Financial Collateral Arrangements (No 2) Regulations 2003 (‘FCARs’). Geoffrey Yeowart and Robin Parsons explain some of the questions arising.

—

Clearing and EMIR

The financial crisis of 2008-2009 and its aftermath highlighted the importance of clearing in financial markets as a means of managing risk and improving transparency.

With clearing, a central counterparty (‘CCP’) interposes itself in defined classes of financial transactions acting as the buyer to every seller and the seller to every buyer, in order to protect participants from the risk of counterparty default.

There has been a huge increase in the volume of over-the-counter (‘OTC’) derivative contracts required to be cleared through an authorised CCP as a result of the G20 commitment at the Pittsburg Summit in September 2009. The commitment is being implemented by the European Union (‘EU’) through EMIR.

In relation to derivative contracts alone, gross notional amounts outstanding on cleared transactions are expected to be 77 trillion euros and those on non-cleared transactions are expected to be 74 trillion

EMIR places prudential requirements on a CCP to collect eligible margin from clearing members when predetermined thresholds are exceeded and to limit its exposure to them and other CCPs with which it has interoperability arrangements.

EMIR also contains a general obligation on financial counterparties (‘FCs’) and non-financial counterparties which are above the clearing threshold (‘NFC+s’) to put in place risk-management procedures requiring the ‘timely, accurate and appropriately segregated exchange of collateral with respect to uncleared OTC derivative contracts’.

The FCD and the FCARs

Financial collateral consists of cash (including deposits in any currency with the counterparty or a bank), financial instruments (including bonds, shares and securities) and credit claims (bank loans).

The FCARs recognise two different structures: a security financial collateral arrangement (‘FCA’) and a title transfer FCA.

Under a security FCA, the collateral-taker takes the financial collateral by way of security (for example, a mortgage or charge by the collateral-provider to the collateral-taker). Under a title transfer FCA, it is taken by way of title transfer (an absolute transfer by the collateral-provider to the collateral-taker with an obligation on the collateral-taker at some future date to re-transfer to the collateral-provider equivalent securities).

Where there is a title transfer FCA, the collateral-provider takes the risk that the collateral-taker may become insolvent. Where there is a security FCA, this is not the case unless the collateral-taker is granted and exercises a right of use (which would include the right to dispose of the collateral to a third party).

A security or title transfer FCA recognised by the FCARs confer certain benefits on the collateral-taker. In the case of a security FCA, these include:

.                 that the security, even if created by a UK company, need not be registered at the UK Companies Registry,

.                 that the security may be enforced by the new remedy of appropriation,

.                 that the security can be enforced even after administrators are appointed to the collateral-provider notwithstanding the usual stay on enforcement imposed by the Insolvency Act and

.                 that, if the security is a floating charge, it will not be invalidated if the collateral-provider goes into liquidation shortly after the charge is granted.

Possession or control

In order to be a security FCA, the collateral must be in the possession or under the control of the collateral-taker.

The great majority of corporate and government securities traded on UK and Irish regulated markets, as well as UK money market instruments, are held in uncertificated form in the CREST system. CREST is primarily a direct holding system. It is not interposed as an intermediary between the issuer of the securities and the investor.

On the other hand, most non-UK traded bonds, equities and investment funds are held through indirect holding systems such those operated by Euroclear and Clearstream. Here, in contrast to CREST, one or more intermediaries stand between the issuer and the investor.

It may be difficult to determine whether financial instruments held by an intermediary in an indirect holding system are in the possession or under the control of the collateral-taker; for example, where they are held in an account with a third party custodian in the name of the collateral-provider.

“Possession” is partially defined, but the definition contemplates that the account is held in the name of the collateral-taker or a person acting on his behalf, not in the name of the collateral-provider.

“Control” is not defined at all and the FCD simply indicates that this must involve some form of dispossession of the collateral provider. Case law indicates that there must be some form of legal control; administrative control is not enough.

The FCD and the FCARs do state that the following rights (‘excepted rights’) of the collateral-provider will not prevent financial collateral being in the possession or under the control of the collateral-taker:

.                 any right to substitute financial collateral of the same or greater value,

.                 any right to withdraw excess financial collateral and

.                 any right to collect the proceeds of credit claims until further notice.

Difficult questions can arise when the collateral-provider is granted rights other than the excepted rights which may indicate that the financial collateral is not in the possession or under the control of the collateral-taker.

For example, financial instruments may be held in an account with a third party custodian and charged to the collateral-taker, but:

.                The charge may not extend to the income or the collateral-provider may be given the right to withdraw income before the security is enforced, or

.                 the collateral-provider may be entitled to exercise any voting rights attached to the financial instruments before the security is enforced.

Conclusion

The new regime introduced following the 2008-2009 global financial crisis seeks to manage risk and improve transparency through clearing. CCPs need to limit their exposure to their clearing members and to other CCPs with which it has interoperability arrangements. The new regime also places obligations on FCs and NFC+s to put in place risk-management procedures in relation to non-centrally cleared transactions. Exposures under both centrally cleared and non-centrally cleared transactions will need to be reduced by the use of financial collateral. The use of financial collateral will grow exponentially as EMIR is implemented. The EU has already introduced through the FCD measures for facilitating the efficient use of financial collateral whether through title transfer or security structures, but there remains considerable uncertainty on certain fundamental questions arising on the implementation of those measures in the UK. These questions are examined in detail in the above book

Geoffrey Yeowart, is of Hogan Lovells International LLP, London and Robin Parsons, was until very recently of Sidley Austin LLP, London.

The foreword and preface of Yeowart and Parsons’ Law of Financial Collateral can be downloaded for free on