Financial Collateral

by Simon Schwarz

1. Subject matter and purpose

The term financial collateral may be traced back to the Directive on Financial Collateral Arrangements (Dir 47/2002, Financial Collateral Directive, FCD) harmonizing the credit securing laws of the Member States in a financial area based on Art 114 TFEU/95 EC. The directive creates a Community-wide uniform legal framework for the provision of securities and cash deposits as collateral in the form of a limited right in rem or by way of an outright transfer of ownership (‘Financial Collateral Arrangement’, Art 2(1)(a)–(e)). Since 2009, it has also covered the security assignment of credit claims. The FCD aims to minimize legal risks associated with the (cross-border) use of collateral within the European internal market. It thus serves the stabilization and integration of the European financial system as the economic need for collateral and legal certainty in this regard is constantly increasing in globalized capital markets due to the fear of systemic risks in the event of an important market participant’s insolvency.

The FCD is a significant element of the acquis communautaire in the area of capital market law and banking law. At the same time, it represents one of the few legislative measures of the European Union with the objective of harmonizing substantive property law, namely the law of security rights in movable assets and the law of assignments. For this reason, the significance of the FCD for European private law in general goes beyond its immediate scope. Finally, it contains a choice of law provision and thus forms part of European private international law (PIL). The FCD is closely connected to other financial market-related legislative instruments, viz the directive on settlement finality in payment and securities settlement systems (Dir 26/1998, Settlement Finality Directive, SFD), the regulation on insolvency proceedings (Reg 1346/2000; insolvency, cross-border), the directive on the re-organization and winding up of credit institutions (Dir 24/2001), the directive on markets for financial instruments (Dir 9/2004, MiFID) including its implementing directive (Dir 73/2006) as well as the directives on capital adequacy of financial institutions (Dir 48/2006, Dir 49/2006).

With regard to content, the FCD is divided into five sections: scope of application and definitions (Arts 1, 2), substantive law of credit security (Arts 3–6), substantive insolvency law (Arts 7, 8), conflict of laws (Art 9), final provisions (Arts 10–13).

2. Scope of application

Considerable attention was paid to the personal scope of application since the special treatment of financial collateral (see 3.–5. below) has often been seen as an infringement of the basic principle of the equality of creditors in the debtor’s insolvency, resulting in the estate having insufficient assets for general creditors. This is due to the fact that the privileges laid down in the FCD apply only to specific collateral takers which are predominantly participants in the inter-banking markets (Art 1(2)(a)–(d)). In fact, other companies may also fall within its scope if their contracting partner qualifies as a professional financial institution (Art 1(2)(e)). However, the Member States were given an opt-out right in this regard (Art 1(3)). The latter has been fully exercised by one and partially exercised by five Member States while ten countries have, conversely, even extended their respective implementing measures to general market transactions that are not covered by the directive. This has led to considerable discrepancy as regards the level of substantive harmonization (COM (2006) 833 final).

The substantive scope of the FCD extends to all types of agreements whose object is the provision of credit accounts or financial instruments (ie virtually all instruments tradable on capital markets, Art 2(1)(e)) as collateral to secure a liability. It applies irrespective of the legal construction chosen by the parties as provided by national property law regimes (limited right in rem, transfer of full ownership, etc). The decisive factor is solely the economical purpose of securing credit so that, for example, repurchase agreements (repos) and similar transaction are also covered (Art 2(2)(b),(c)). This functional approach is implemented to prevent the risk of a re-characterization of an outright transfer of title by way of security as a mere security interest like a pledge by the applicable national law (which might then be ineffective due to formal or procedural deficiencies) (recital 13).

3. Substantive law of credit security

According to the rule of the FCD, financial collateral is validly provided once it is delivered to the secured party, has been credited to a designated securities account or the secured party has otherwise obtained possession or ‘control’ (Art 2(2)), and the provision is evidenced in writing or electronically (Arts 1(5), 2(3), 3(2)). Pursuant to Art 3(1), further formal requirements (eg registration, executed copy of specific documents) may not be stipulated by Member State law. First, one should note that the FCD thus introduces the concept of ‘control’ into European law as a functional equivalent to the traditional legal term of ‘possession’. This is in line with modern legal developments (eg Uniform Commercial Code, UNCITRAL Legislative Guide on Secured Transactions). ‘Control’ is usually obtained when the intermediary administering the asset (even without adjusting the book entries) undertakes to execute disposal instructions issued solely by the creditor. Secondly, Art 2(2) recognizes the crediting to a securities account as a means of disposing of ‘book-entry securities’ (Art 2(1)(g)). Again, this corresponds to modern legal developments (intermediated securities). In this regard, the FCD is supplemented by SFD stipulating rules on the irrevocability of credit transfer orders once they have been entered into a securities settlement system (Art 5 Dir 26/1998). Finally, it should be mentioned that the section on security rights in movable assets of the Common Frame of Reference (CFR) covers interests in intermediated securities even beyond the scope of the FCD (Art IX.-1:201(7), (8)). According to the CFR, the effectiveness of the security interest as against third parties is again dependent on the secured party exercising ‘control’ over the financial assets (Art IX.-3.204).

As a consequence of its functional approach, the FCD obliges Member States to acknowledge such collateral arrangements which have been implemented by way of an outright transfer of title (movable goods) (Art 6). Since most legal systems, as a matter of general property law, do not recognize the idea of a title transfer for security purposes only (Sicherungsübereignung), and some do not (fully) accept a security assignment (Sicherungszession) either (eg France, Italy, the Netherlands), this provision constitutes a novelty for several Member States. Thus, the FCD overcomes traditional national regulatory structures in this respect and could pave the way for a general European property law.

Another innovation flows from Art 4 according to which the collateral taker may be granted a unilateral right of appropriation which may be exercised immediately without prior notice or other measure in the event of default of the debtor (Art 4(1)–(4)). Such a so-called ‘forfeiture clause’ was invalid according to almost all European legal systems prior to the implementation of the FCD as a matter of creditor protection. This prohibition of a pactum commissorium had already been enshrined in Roman law (C.8, 34,3). Accordingly, the Member States were initially given an opt-out possibility (Art 4(3)). However, this option has not been used in a single implementation measure, and it has now been deleted altogether (COM(2008) 213 final, Art 2 Dir 44/2009).

A last innovation derives from Art 5. This rule allows the parties to grant the creditor an extensive ‘right of disposal’ (German language version) or ‘right of use’ (most of the other language versions) of the collateral provided for the duration of the security agreement (see also Art 19 Dir 73/2006). For the purposes of re-financing, the secured party may then either itself encumber the assets pledged to it or dispose of them as the owner (Art 5(1), 2(1)(m)). The collateral taker is freed from the obligation to return the same item to the debtor and may simply provide the same kind of financial asset instead (Art 5(2)(I)) (pignus irregulare). If applicable, it may even set off its return obligation against the secured debt (Art 5(2)(II)). The Europe-wide recognition of this market practice known as ‘re-hypothecation’ is primarily intended to increase market liquidity. From a functional point of view, the right of use leads to a hybrid concept falling between an outright transfer of ownership and a traditional pledge.

4. Substantive insolvency law

The FCD rejects important principles of the substantive national insolvency laws to collateral transactions covered by its scope (Arts 4(5), 7(1), 8). In particular, the so-called ‘close-out netting’ (Art 2(1)(n)), which is pivotal to the risk management of financial market participants, is to be protected by insolvency law (Art 7(1)). The rule is addressed to those legal systems which, in principle, do not allow the off-setting of contracting claims against an insolvent party (eg Greece, Spain and Luxembourg in part). Close-out netting is defined as an undertaking to set off all existing liabilities and claims between the parties in the event of insolvency (irrespective of their maturity) and to compensate the net balance only. This technique reduces the credit exposures and risks involved considerably (recital 14). Another privilege of financial collateral in insolvency is laid down in Art 8 according to which a collateral transaction may not be declared invalid on the ground that it was entered on the day of the commencement of winding-up proceedings or shortly before (Art 8(1)-(3)). However, the general principles on the voidance of transactions under national insolvency remain unaffected (Art 8(4) FCD, Arts 4(2)(m), 5(4) Reg 1346/ 2000).

The rules of the FCD supplement the principles already stipulated by the SFD, which aims to prevent domino effects within payment or security settlement systems triggered by a participant’s insolvency. To this end, Dir 26/98 imposes an obligation on national insolvency laws to recognize the irrevocability of transfer orders entered into a settlement system and the effectiveness of arrangements on intra-system reciprocal netting (Arts 3, 5). In addition, insolvency proceedings relating to a system participant may not affect the latter’s rights and duties arising from the system participation retroactively (abolition of the so-called ‘zero hour rules’ of some national insolvency laws) (Art 7).

5. Extension to credit claims

According to Dir 44/2009, amending Dir 26/1998 and Dir 47/2002, the aforementioned principles on financial collateral (except for the right of use, Art 5(6) rev) also apply to credit claims (Art 1(4) (a) rev).

Central to the revision is the abolition of formal impediments to the effective use of ‘credit claims’ (Art 2(1)(o) rev) as collateral. Since January 2007 they are now eligible as credit security for financing transactions within the Eurosystem (European Central Bank). For a corresponding (security) assignment to be effective, several Member States provide for a special act of publicity such as registration (eg Belgium, Greece, Spain) or notification of the debtor (eg Finland, Greece, Ireland, Italy, Luxembourg, the Netherlands, France), while others require neither (eg Germany). Pursuant to the first draft of the Commission, the national publicity requirements are to be rejected with a view to credit claims (Art 3(1)(II) COM(2008) 213 final). Hence, the original proposal again envisaged a harmonization of the law of assignment beyond national legal traditions (assignment). However, the European Parliament has argued for a preservation of the formal requirements as far as they relate to the effectiveness of the assignment vis-à-vis the debtor of the claim and other third parties. In the end, only an obligation to review the national provisions after five years was included (Art 3(1)(III) rev). According to the PECL and DCFR, in principle, priority among the creditors also depends on the notification of the debtor (Art 11:401 PECL, Art III.-5:121 DCFR); the DCFR, however, explicitly excludes security transactions from this requirement (Art IX.-2:301(2)).

Finally, the economic value of credit claims as collateral may be enhanced considerably by agreement: the debtor of the credit claim (third-party debtor) may validly waive in writing any right of set-off vis-à-vis its creditor (assignor) and any future assignee (Art 3(3)(i) rev). In addition, the third-party debtor can waive its rights arising from banking secrecy rules (Art 3(3)(ii) rev), enabling the creditor to transmit to third parties the information necessary for re-financing transactions. The provisions relating to (commercial) credit claims do not affect the consumer rights as guaranteed by EU consumer credit law (Art 3(3), 9a rev).

6. Private international law

Traditional private international law (PIL) relating to securities (ie shares, bonds, negotiable instruments, etc) distinguishes between the law governing the obligation (Wertpapierrechtsstatut) and the law applicable to the certificate (Wertpapiersachstatut). The former regulates the type and precise content of the obligation physically embodied in a certificate (or entered into a register). The latter defines the possible rights in rem with regard to the certificate as a res and dictates how the corresponding interests may be transferred; it thus adjudicates the question of the proprietary allocation of the asset. The law applicable to the obligation depends on the origin of the right (lex societatis for corporate rights, company law (international); lex contractus for contractual obligations (PIL)) while the law governing the proprietary issues is traditionally determined by the connecting factor of the place where the property (certificate/register) is located (lex rei sitae or lex cartae/libri sitae, property law (international)).

Today, however, investors no longer physically hold their financial instruments themselves. Instead, the certificates (if any) are permanently deposited with a central securities depositary (CSD) and are held by the investors indirectly through intermediaries (custodians) (see also Art 17 Dir 73/2006). Within this intermediated securities holding system disposals are actually only effected via debits and credits in securities accounts (intermediated securities). Therefore, the concept of lex rei sitae causes considerable problems with a view to modern financial markets. This is due to the fact that the actual place of retention of the certificate is more or less accidental and often cannot be determined precisely in the event of internationally traded securities due to several (jumbo) certificates being deposited in different countries. In the context of the transferring of internationally diversified portfolios (as collateral), the connecting factor of the situs thus points to several different property laws simultaneously and causes high transaction costs.

For these reasons the FCD provides for an account-related connecting factor as to ‘book entry securities’ (Art 2(2)(g)), which has been labelled as the ‘place of the relevant intermediary approach’ (PRIMA). In substance, it had already been implemented by earlier directives (Art 9(2) Dir 26/1998, Art 24 Dir 24/2001). As to the legal nature and the proprietary effects of credits to securities accounts, including the transfer, pledging and realization of the interest (Art 9(2)), the FCD refers to ‘the law of the country in which the relevant account is maintained’ (Art 9(1)). The relevant account is defined as the account (register) ‘in which the entries are made by which that book entry securities collateral is provided to the collateral taker’ (Art 2(2)(h)). Hence, the transferee’s account is chosen as the decisive connecting factor for a transfer of financial instruments. There are, however, no rules as to the localization of the account or relating to priority conflicts in the event of multiple dispositions; choice of law by the parties is not permitted. In December 2010, in the course of a public consultation on a future securities law directive (intermediated securities), the Commission submitted a proposal locating the account at ‘the branch which handles the relationship with the account holder in relation to the securities account’; any choice of law by the parties shall still be excluded. Contrary to the FCD, the draft no longer defines the ‘relevant’ account, which is likely to trigger the same debate as under the HSC (see 7. below).

The FCD does not contain a conflicts provision on insolvency matters so that they have to be determined according to general principles with the result that the lex fori concursus rule applies (insolvency, cross-border). The rights and obligations of the parties to a payment or settlement system or to a financial market are to be governed by ‘the law applicable to that system or market’ without the specification of any connecting factor for that latter law (Art 8 Dir 98/1998, Art 9(1) Reg 1346/2000). In any case, the opening of insolvency proceedings does not affect vested rights in rem (Art 8(1) Dir 98/1998, Art 5(1) Reg 1346/2000, Art 8(1)–(3) Dir 47/2002).

7. Uniform law projects

The (draft) Convention on Substantive Rules regarding Intermediated Securities adopted in October 2009 in Geneva (Geneva Securities Convention) has been elaborated under the auspices of UNIDROIT and aims to harmonize the substantive property law on intermediated securities. Largely in line with the FCD, the Convention allows for effective pledging by way of credit to the collateral taker’s securities account (Art 11(4)). Furthermore, a security interest may be perfected through a control agreement or a designating entry, provided the contracting state has made a corresponding declaration (Art 12(1)). Due to this opt-in reservation, the level of harmonization achieved by the Convention falls behind that of the European rules. Further important issues covered by the FCD (ie title transfer collateral, right of appropriation, right of use, close-out netting) are dealt with in an additional (merely optional) chapter on collateral transactions (Arts 31–38).

The Convention on the Law Applicable to Certain Rights in Respect of Securities held with an Intermediary of 5 June 2006 (Hague Securities Convention, HSC) provides for a uniform choice of law regime which was elaborated under the auspices of the Hague Conference on PIL. However, the HSC has not yet come into force and has only been signed by three states (the United States, Switzerland and Mauritius). Its conflicts rules comprehensively cover the proprietary issues relating to the crediting and debiting of securities accounts, in particular the legal nature of such book entries and the disposition of the interests therein (Art 2(1), (2)). Contrary to the purely objective PRIMA rule embodied in European law, the HSC primarily points to the law chosen by the parties in an account agreement with the ‘relevant intermediary’ (Arts 4(1) (1), 1(1)(e)) but only if the latter has a qualified office in that state (Art 4 (1)(2)). ‘Relevant’ refers to the intermediary maintaining the securities account for the account holder (Art 1(1)(g)). It is under debate whether this means the intermediary of the transferor, of the transferee, or of both (ie each intermediary is relevant) with the result of a split connecting factor or dépeçage (prevailing opinion). According to the preparatory documents, the accessory connection to the law chosen in the account agreement is due to the fact that neither have securities accounts materialized nor do uniform country codes exist (such as the IBAN for cash accounts), so that, in particular, accounts of globally active investors can hardly be localized. Thus, in principle, the HSC allows for a (limited) choice of law by the parties for issues of property law. This possibility, however, does not amount to party autonomy in the traditional sense as the parties to the transaction are not the ones determining the applicable law. Rather, the HSC rules point to a contract made with a third party. Moreover, a subsequent amendment of the law chosen in the account agreement entails no erga omnes effects (Art 7). In the absence of a choice of law in the account agreement, Art 5 stipulates a cascade of objective connecting factors each of which refer to the relevant intermediary (office in which the account agreement was concluded, lex incorporationis, principal place of business). The solution adopted by the HSC differs from the European model. The Commission has nonetheless argued for a signature of the HSC by the EU (external competence of the EU) and a corresponding adjustment of the directives (COM (2003) 783 final, SEC(2006) 910 final). Yet, some Member States massively objected to this proposal and it was therefore subsequently withdrawn (SEC(2008) 491 final, OJ EC 2009 C 71/17). The Commission is instead looking into a revision of the European solutions (see 6. above).

Literature

François T’Kint and Werner Derijke, ‘La directive 2002/47/CE concernant les contrats de garantie financière au regard des principes généraux du droit des sûretés’ [2003] Euredia 41; Roy Goode, Hideka Kanda and Karl Kreuzer, Explanatory Report on the Hague Convention on the Law Applicable to Certain Rights in Respect of Securities Held with an Intermediary (2005); Thomas Keijser, Financial Collateral Arrangements (2006); Stefan Saager, Effektengiroverkehr und Internationals Privatrecht (2007); James Steven Rogers, ‘Conflict of Laws for Transactions in Securities Held Through Intermediaries’ (2006) 39 Cornell International Law Journal 285; Klaus Löber and Ewa Klima, ‘The Implementation of Directive 2002/47 on Financial Collateral Arrangements’ [2006] Journal of International Banking Law and Regulation 203; Dorothee Einsele, ‘Security Interests in Financial Instruments’ in Horst Eidenmüller and Eva-Maria Kieninger (eds), The Future of Secured Credit in Europe (2008) 350; Louise Gullifer, Goode on Legal Problems of Credit and Security (4th edn, 2008) paras 6-34 ff; Peter von Wilmowsky, ‘Europäisches Kreditsicherungsrecht’ in Peter Derleder, Kai-Oliver Knops and Heinz Georg Bamberger (eds), Handbuch zum deutschen und europäischen Bankrecht (2nd edn, 2009) § 75; Hideki Kanda, Charles Mooney, Luc Thévenoz and Stéphane Béraud (eds), Draft Official Commentary on the Draft Convention on Substantive Rules regarding Intermediated Securities (2009).