Roosevelt’s words aptly echo the world of financial markets whereby the concept of risk can be pivotal in oiling the wheels of financial institutions yet alarmingly lethal if not properly managed or mitigated. Philip Wood explains that legal risk, together with an array of other forms of risk innate in the financial sector, are addressed by financial law, which aims to appease the unjustifiable notion that law is the enemy, rather than the ally.
Financial collateral is construed as the use of financial assets in security, quasi security, or title transfer collateral arrangements to minimise the risk of financial loss to the lender if the borrower fails to meet its obligations. It has become increasingly essential in the financial arena because, inter alia, it helps creditors manage their exposures, it reduces their burdensome capital requirements, supports the supply of credit in the economy, and reinforces the liquidity of the securities market. The key test of collateral is its ability to operate effectively without legal ambiguity and for that purpose, the Directive 2002/47/EC on Financial Collateral Arrangements (“FCD”) was enacted.
Besides improving legal certainty, the FCD provides a harmonised legal framework across the EU member states for the receipt and enforcement of financial collateral. Its catch-22 is the dilemma between the protection of the general creditors and the very rationale for taking collateral. The chief legal concerns, which all circle around the tension between conflict of laws and legal enforceability, range from complications related to insolvency laws, complexities rendered by indirect holdings of investment securities, and inflexibilities due to bureaucratic formalities.
There are several differences in the perfection requirements for the enforcement of collateral arrangements across the different Member States. Court orders, notarisations or submissions of forms are all formalities which decelerate the rapidity of the dealings as expected by the market. The FCD caters for a non-formalistic environment by rejecting the dependence on formal acts for the creation, validity, perfection, enforceability or admissibility in evidence of a collateral arrangement. The Directive while alleviating the parties’ administrative burdens, it ensures mutual recognition by Member States of the validity of financial collateral arrangements by curtailing procedural requirements.
It is key to mention the restrictive rules of traditional secured lending regulating the formalities to enforcement. Several legal frameworks prescribe notice periods and other requirements which either delay the enforcement of security or freeze it altogether during administration and voluntary arrangements. To accommodate the timely enforceability of collateral, the swift realisation of assets and retaining collateral value, the Directive provides for the collateral taker to realise security collateral arrangements by sale, appropriation, set-off of the financial instruments or in terms of cash collateral, by setting the amount against or applying it in discharge of the relevant financial obligations.
Legal risks are also linked to the fact that the enforceability of collateral arrangements is often impeded by legal restrictions voiding or limiting the disposition of assets, which in functional terms, safeguard the insolvent estate from being unfairly depleted. Liquidators’ powers to avoid property dispositions, the imposition of suspect periods, and zero-hour rules are often the sword of Damocles for transactions entered into shortly before insolvency proceedings. The Directive acknowledged that the market would not function properly if shrouded in legal doubt, and therefore strived to guarantee a consistent cross-border framework. Member States are in fact prohibited from applying their national insolvency rules to financial collateral arrangements while rejecting the retrospective effect of winding-up and reorganisation measures, thereby putting an end to zero-hour rules.
Article 8 also protects the provision of margining and substitution arrangements. Such procedures, established through market practice are vital to avoid that the lender becomes under-secured or over-secured as a consequence of market changes. Parties agree either to continually adjust values of the collateral by adding or deducting the pool of collateral assets, or to provide alternative collateral assets respectively, so as to preserve the agreed margin of values.
Considering that top-ups or substitutions give rise a new security interests, they raise an increased risk of unenforceability (particularly in the context of insolvency) as they might fall within scope of insolvency displacement rules, and therefore be prone to avoidance. FCD stipulates that margining or substitution obligations in financial arrangements shall not be treated invalid or reversed on the sole basis that the financial collateral was provided on the same day at when the winding-up proceedings or reorganisation measures commenced or that the relevant financial obligations were incurred prior to the date of the provision of the collateral.
FCD also introduced the obligation on Member States that close-out netting provisions can take effect according to its terms, notwithstanding the onset of insolvency or other similar events, and without regard to certain other matters that might otherwise affect close-out netting. It is also worth noting that FCD also protects close-out netting from interveners and stipulates that such arrangements will still be effective notwithstanding any assignment.
While the above analysis focused on several success stories which the Directive brought about in the context of FC arrangements, there are still some instances of the FCD which are still rife of legal risks. Repos and securities lending face enforcement issues or stability concerns particularly in a cross-border context, one of which being that financial instruments used as collateral to be delivered and transferred between the parties and that in a cross-jurisdictional scenario, such transfer would not be clear-cut and prone to the risk of avoidance. Paech highlights how this may then result in a domino effect wherein the first defective transfer would contaminate ensuing acquisitions of the same assets. It thus relevant to note that FCD does not cater for transfers which do not occur in the same jurisdiction. A similar flaw in the Directive is that it is not functional with respect to the enforcement of repo and securities lending collateral involving insolvent financial institutions from third-countries.
The holding of securities in the financial market is commonly indirect holding through intermediaries, with no direct link between the investor and issuer. Such structuring diminishes the security of transfers and gives rise to security interests in favour of the intermediaries (concurrently with the collateral taker) whereby each intermediary would be able to enforce its interest before the bank is paid. Benjamin outlines that despite the fact that episodes of fraud are not so frequent, a lax level of security of transfer in terms of formalities is not so helpful to the collateral takers. Conflict-of-laws related to indirect holdings are also not tackled well by the Directive. The FCD’s conflict-of-laws framework specifies that the applicable law for collateral arrangements is the law of the jurisdiction where the relevant account of the collateral taker is maintained. However, the FCD was criticised as ambiguous and does not specify which intermediary is to be considered. Therefore, the Directive leaves the market in limbo without an effective means to determine the location of a securities account.
Another legal risk is associated with managed collateral portfolios and relates to the aforementioned right of use. The collateral giver would face an issue of re-characterisation of its interest to a floating charge, if bestowed with an unfettered right of use of the managed assets. In that case, the re-characterised interest would fall out of scope of the FCD.
Benjamin explains that ‘legal uncertainty cannot be eliminated: it can only be managed’. She suitably presents the reality that despite the strong efforts of the FCD, it does not provide a fool-proof system. The FCD was intended to manage the majority of risks associated with FC through several support measures which inter alia reject insolvency law provisions, and which augment the integration and cost-efficiency of financial markets. Through the removal of the administrative encumbrances and formalities used in the traditional context and which hampered collateral procedures, the FCD has made the enforcement of collateral obligations and taking of financial collateral and simpler more straightforward. Moreover, one should underline that the EU repo market experienced exponential growth following the enactment of the Directive. Statistics are testimony to the fact that despite its deficiencies and possibly limited scope, which might cast shadow on its achievements, the Directive was a positive step towards the establishment of a harmonised legal framework and the promotion of a sound single market, which is ultimately one of the building blocks of the EU acquis.
By way of an update, the EU Commission has published in March 2018, a communication on the law applicable to the proprietary effects of transactions in securities. The objective of this Communication was to help increase cross-border transactions in securities by providing legal certainty on the conflict of laws rules at Union level. These FCD, the Settlement Finality Directive and the Winding-up Directive include conflict of laws rules that cover the most important aspects of securities transactions. In a nutshell, these Directives apply to book-entry securities and instruments, the existence or transfer of which presupposes their recording in a register, an account, or centralized deposit system. All three Directives state that the law to apply is the law of the place of the relevant register or account. However, their wording gives rise to different national interpretations, thereby making cross-border transactions costlier due to some residual legal uncertainty around which law is applicable. The Communication basically confirms that the terms “maintained” and “located” used in these Directives mean the same thing and that the different ways across the EU of determining where the account or register is “maintained” or “located” are valid. The Commission’s views are subject to any potential future decisions of the Court of Justice of the European Union on these issues. The Commission will be monitoring developments in this area and assess whether any further action is necessary.