The Financial Collateral Arrangements (No.2) Regulations 2003

What do they do?

The Financial Collateral Arrangements (No.2) Regulations 2003 affect the validity and enforceability of some charges which are over cash or financial instruments. A particularly striking aspect is the radical departure from the usual rules of insolvency. The Regulations came into force on Boxing Day.

Broadly speaking, it will no longer be necessary to register charges over cash (e.g., in blocked deposit accounts) or over financial instruments such as bonds and other similar items defined by the Regulations. Note that the Regulations do not affect the registration of any other type of security or charge. It is advisable to have a clear power to appropriate the financial collateral in favour of the collateral-taker included in the security document.

Why were they introduced?

The Regulations were introduced to implement the EU Directive on Financial Collateral which was intended to increase legal certainty by making some security arrangements easier to enter into and enforce. The intention of having robust arrangements in place was to lower the cost of capital in the EU, making it a more attractive place in which to do business.

Where have they come from?

In its original form, the draft Directive applied to the substitution and sale (re-hypothecation) of shares provided as security, most commonly in the context of securing derivatives with credit support arrangements for fluctuating exposures, and similar financial instruments. It was originally intended to apply only to large financial institutions (corporates with a capital base in excess of EUR 100 million or whose gross assets exceed EUR 1000 million) and the Central Banks. Under discussion at European level, it was even agreed that further thought should be given to extending the reform beyond financial collateral such as shares, to any form of asset taken as security. Clearly at that stage, the practical implications of a power of substitution of security in the context of residential house mortgages had not been thought through. In its final form, the Directive provided that at least one of the parties had to be a financial institution but the Regulations have gone further than that.

Who do they affect?

Under the Regulations, the collateral-provider and the collateral-taker both have to be corporate bodies or unincorporated firms or partnerships or bodies with legal personality. The Regulations do not apply to individuals. Having provided security over cash or financial instruments, the collateral-provider can secure financial obligations which are present or future, actual, contingent or prospective and owed to the collateral-taker or to a third party.

What is the detail?

Because of their EU origins, the Regulations use terminology which is not particularly helpful or familiar in the context of English security law. Security is "Collateral"; a "Financial Collateral Arrangement" means the provision of security over cash or financial instruments given by a collateral-provider to a collateral-taker; "Financial Instruments" include shares in companies, bonds and other tradeable debt instruments.

They apply to:

1. "security financial collateral arrangements" (which are generally charges, liens, mortgages or pledges, see below); and
2. "title transfer financial collateral arrangements",

which in each case:

1. are between non-natural persons (broadly any entity or corporate body (including partnerships) and not individuals); and
2. involve either cash or financial instruments.

A "security financial collateral arrangement" ("Security FCA") is any legal or equitable interest or any right in security (except a title transfer financial collateral arrangement, see below) which is evidenced in writing and can be by way of pledge, mortgage, lien or fixed charge.

The important thing is that in all cases the collateral (the asset which is to be the subject of the security) is delivered, transferred, held, registered or otherwise designated so as to be in the possession or under the control of the collateral holder or a person acting on his behalf.

This means that as floating charges over cash and financial instruments are not specifically included by the Regulations, they will only cover a floating charge where the asset which is the subject of the security is sufficiently under the control of the person with the benefit of the security or his agent. It will not therefore cover floating charges which have not crystallised and permit the chargor to deal with the assets in the ordinary course of business. The regulations do not cover security over securities held in the CREST system: a system charge held by a CREST settlement bank is a floating charge when the chargor retains the right to deal in the securities to which the charge relates (which happens in most cases).

This lack of clarity in the Regulations about the position of floating charges stems presumably from too literal (and hasty) an application of the EU Directive, which given its legislative origins did not think to cover the more obscure aspects of English law and its floating charges.

A "title transfer financial collateral arrangement" ("Title Transfer FCA") is an arrangement evidenced in writing where legal and beneficial ownership in the collateral is transferred to the collateral holder upon terms that when the relevant financial obligations are discharged, it or its equivalent will be transferred back: for example, repo (repurchase) agreements.

• Relaxation of the formalities and of registration

In relation to applicable collateral arrangements, the Regulations relax the body of law which has grown up since the seventeenth century on how to create a charge. For an FCA to be perfected and enforceable, it only has to be in writing. It does not need to be registered under s 395 Companies Act 1985 (or s 409 if the collateral provider is incorporated outside Great Britain and has a place of business in England and Wales).

Naturally, if the security comprises a floating charge which does not fall within the scope of the Regulations, it will be safer to continue to register it. Also, although charges on shares are not within the categories of registrable charges listed in s 396 Companies Act, it is usual to register them if they extend to distributions on the shares, and it will be safer to continue to do this notwithstanding the Regulations.

• Unusual relationship to Insolvency Law: a special regime

The Directive aimed to protect FCAs from being avoided or otherwise rendered ineffective on insolvency. A special regime will now apply under the Regulations to FCAs in insolvency.

Notably:

1. the security will be valid and enforceable even if it was entered into in a prescribed period prior to the commencement of a winding-up;
2. the security may be enforced notwithstanding an administration, CVA or moratorium;
3. an administrator may not deal with the charged asset in accordance with his powers under section 15 (1) and (2) Insolvency Act 1986 ("IA") in the case of security before the coming into force of the Enterprise Act 2002 ("EA") or (after EA came into force) paragraphs 70 and 71 of Schedule B1;
4. if a fixed charge receiver is appointed under an FCA, the administrator cannot require him to vacate office under section 11(2) for pre-EA security, and paragraph 41(2) of Schedule B1 for post-EA security;
5. if the charge is floating, it may be enforced without accounting for the prescribed part, the ring-fenced share of assets for unsecured creditors under s 176A IA;
6. the security will not be liable to be invalidated or avoided by virtue of:
   1. section 127 (avoidance of property dispositions after commencement of winding up);
   2. section 245 (avoidance of certain floating charges), even where the security was created in favour of a "connected" party; or
   3. section 88 (avoidance of share transfers, etc after winding-up resolution);
7. nor may it be disclaimed by a liquidator under section 178 (power to disclaim onerous property).

Does the FCA have a close-out netting provision?

Where the arrangement includes a close-out netting provision, it will take effect in accordance with its terms even if the giver or the taker of the security is subject to winding up proceedings or reorganisation measures. The exception to this is if the arrangement itself was entered into at a time when the relevant party was aware or should have been aware that the insolvency procedure had already commenced.

Even if there is a conflict with the mandatory set-off provisions under Rule 4.90 (for liquidation) or Rule 2.85(4) (for administration), it appears that the Regulations will prevail and it will be possible to bring into account sums which became due after the commencement of the administration or winding up. This point continues to be under discussion between interested parties and the drafters of the legislation.

• Conversion of debts in foreign currency

If either the giver or the taker of security to which the Regulations apply goes into liquidation or administration, then Regulation 14 disapplies the normal Insolvency Rules which require debts in a foreign currency to be converted at the middle exchange rate of the London Foreign Exchange Market. The exception to this is if the arrangement provides for an unreasonable exchange rate.

• Right of use in Security FCAs

The right of use originally envisaged by the Directive in the case of shares provided as security, most commonly in the context of securing derivatives with credit support arrangements for fluctuating exposures, has been extended to Security FCAs. If a Security FCA provides for the collateral-taker to use and dispose of any financial collateral provided under the arrangement, as if it were the owner of it, the collateral-taker may do so in accordance with the terms of the arrangement .

If the collateral-taker takes advantage of the right, it is obliged to replace the collateral with equivalent collateral on or before the date on which performance of the relevant financial obligations covered by the arrangement were due. Or the collateral-taker may set off the value of the collateral against the amount of the obligations.

• Appropriation of collateral: a revival of foreclosure?

A particularly useful feature of the Regulations is that if the collateral-taker is granted the power to appropriate the financial collateral in the terms of the security document, then the taker may exercise that power in accordance with its terms. A court order for foreclosure is not necessary. In practice, this may mean that banks and other collateral-takers increasingly simply take possession of and sell the collateral.

If the collateral-taker does appropriate the financial collateral, it must value the financial collateral "in accordance with the terms of the arrangement" and in any event "in a reasonably commercial manner". The valuation of private company shares in these circumstances may prove an interesting exercise.

• Conflict of Law and book entry securities

The Regulations set a standard test to deal with the applicable law for book entry securities financial collateral arrangements. The situation this is designed to deal with is for financial collateral arrangements provided over securities held through an intermediary such as Clearstream and Euroclear. The title to the securities is evidenced by entries in an account or register maintained by or on behalf of the intermediary. The intermediary may be holding the book entry securities in one jurisdiction, but the underlying securities may relate to several different jurisdictions.

In such cases, the Regulations provide that the domestic law of the country in which the relevant account or register is maintained will determine how to create, perfect and enforce the security. Note the potential imposition of e.g., German law on securities of e.g., an English company.

For further information please contact Ruth Pedley [email protected] at or on +44 (0) 20 7367 2098 or Kirsty Jefferies at [email protected] or on +44 (0) 20 7367 2725.