Collateral Becomes More Lender-Friendly in Spain
The implementation of the Directive on Financial Collateral Arrangements has improved the legal framework for lenders. Gabriel Núñez and Juan Martín Perrotto explain
On March 11 2005, the Spanish Government enacted Royal Decree Law 5/2005 and implemented the EU Directive on Financial Collateral Arrangements (FCAD).
The Decree establishes an effective and simple regime to create, perfect and enforce pledge and title transfer securing financial transactions. It also protects those market practices that have been recognized as sound techniques to manage credit risk and increase market liquidity. This includes long-standing practices, for example, the collateral-provider’s covenant to provide additional collateral upon variations of the value of the secured obligations or of the collateral itself, or the right of the parties to use the collateral while the secured obligations are outstanding.
In general terms, the Decree has taken a liberal approach to the implementation of the FCAD. The Spanish Government not only refused to exercise any significant opt-out right granted by the FCAD, such as the right granted to Member States to narrow the scope of application of the FCAD to certain regulated entities. It also went beyond what was required by the FCAD and previously provided under the existing Spanish regulations and expanded the personal and objective scope of application of this special regime. Despite this, the transposition of the FCAD into Spanish law has certain drawbacks. These derive from a technique of implementation that may fall short when it comes to clarifying the areas that are conceptually new in the Spanish legal environment. For example, it would have been useful to define when “control” is attained for the purposes of perfecting the collateral, particularly when the collateral-provider is entitled to withdraw the collateral.
Scope of application
The Decree applies to Financial Collateral Arrangements (FCAs) and Close-out Netting Arrangements (CONAs) complying with the requirements of the Decree. In addition, the Decree not only covers the financial collateral (FC) derived from a contract as was intended by the FCAD, but also any FC arising from regulations governing secondary markets, book-registry systems, clearing systems and counterparty entities. In either case, FC is defined as cash, negotiable securities, financial instruments and any direct or indirect right over such assets.
The Decree takes a liberal approach to the parties that are eligible to execute an FCA or a CONA, In this regard, it does not exercise the opt-out rights provided in this area by the Directive (i.e., the right to limit the application of the FCAD to FCA entered into by certain regulated entities). Moreover, it expands the application of the regime instituted by FCAD and by the current regulations applicable to CONAs, which shall be applicable to:
- public entities, financial institutions (including central and multilateral banks, investment firms and insurance undertakings), certain players of the capital markets (supervisors, central counterparties, settlement agents or clearing houses) and institutional investors (certain mutual, securitization and pension funds and their management companies).
- any legal entity provided that the other party is one of the institutions referred to above.
- natural persons, provided that the other party is a secondary market supervisor, central counterparty, settlement agent or clearing house or, in the case of CONAs, any of the institutions referred to in the first paragraph.
Obligations that may be secured under this type of arrangement include:
- in the case of FCAs, obligations to deliver financial instruments or to make cash payments;
- with regard to CONAs, obligations arising from FCAs, lending of securities, repos, spot foreign exchange transactions, derivatives (including derivatives on derivatives and on-emission allowances) and fiduciary assignments of public debt, financial instruments or cash, among others.
Again, the Decree purports to take a liberal approach in this area and expands the transactions covered by the FCAD and by the existing regulations governing CONAs. In this regard, an interesting debate has been opened. On the one hand, some scholars and practitioners sustain that the Decree is only applicable to secure the obligation to deliver financial instruments or to make a “cash settlement” which will be construed, in the context of the ISDA’s terminology and a historical analysis of the FCAD, as the settlement in kind or in cash of transactions ancillary to the capital markets and, thus, only be applicable to certain transactions such as derivatives, repos, etc. On the other hand, other scholars and practitioners argue that, as has been the case in France (Ordonnance no. 2005-171) and in the UK (Financial Collateral Arrangements (No.2) Regulations 2003), the Decree may have expanded its scope of application to encompass any kind of payments in cash, and, as a result, security interests granted to secure any kind of loan agreements should benefit from the simplified regime instituted by the Decree to create, perfect and foreclose security interests over FC, as well as of the special protections granted by the Decree in case of bankruptcy of the collateral-provider.
Just a formality?
As intended by the FCAD, the Decree removes all formal requirements provided for the execution, validity, evidence and foreclosure of FCA and FC, other than evidencing in writing the execution of the FCA and the provision of the FC. As compared with the current regime, the scheme implemented by the Decree results in a much more simpler, faster and cheaper mechanism to establish and perfect a security interest over financial instruments and cash accounts.
But market participants should take special care by in their attempts to comply with these formalities.
On the one hand, the Decree considers a FC as being “provided” when it has been delivered, transferred, held, registered or credited in any other way, so “as to be in the possession or under the control of the collateral taker or of a person acting on the collateral taker’s behalf”. As stated above, the Decree, however, leaves “control” undefined (that is, whether the collateral taker should have exclusive control over the account or just the right to realize the FC without the aid of the collateral provider) and does not identify the relationship that needs to be established between the collateral taker and the “person acting on the collateral taker’s behalf” (that is, whether this relationship could consist of a control agreement allowing the collateral taker, at least, to instruct the depositary to dispose, transfer or foreclose the FC, without the consent of the collateral provider – as is the case under UCC eight and nine and suggested in the UK Law Commission’s consultation paper amending the Companies Act 1985). If lenders take a conservative approach towards this uncertainty, many of the benefits that intended by the FCAD will be lost as, for example, the collateral providers ability to use, withdraw, transfer or “control” the collateral in any other manner may be limited.
Furthermore, and in contrast to what is provided in the FCAD, the Decree requires that book-entry securities should only be considered “constituted and provided” upon registration of the security interest in the relevant account. Thus, lenders should be aware that, as the FCAD is implemented in Spain, perfection by control or possession does not suffice to establish security interest over book-entry securities but, as it is the case under the current regime, they will need to record the existence of the FCA in the relevant register.
The Decree adopts the two-track approach provided in the FCAD by recognizing two distinct types of collateralization techniques: security FCAs (SFAs) and title transfer FCAs (TTFCAs) (which include repos and title transfer arrangements such as the Isda Credit Support Annex).
As long as it is contractually agreed, the right to use the collateral is extended to SFCAs. This new feature is expected to increase the liquidity of the market and directly benefit both parties: the collateral taker will be able to generate income from the re-use of the FC and, as a result, offer better financing terms to the collateral provider.
Similarly, if the FCA so provides, the collateral provider is entitled to withdraw the FC and replace it with other equivalent FC. This provision will enable the collateral provider to continue to trade in the securities provided as FC, increasing both the intrinsic value of the securities and the liquidity of the financial markets.
Furthermore, the Decree protects the provision of additional FC as a result of changes of the mark-to-market value of the credit exposure and of the value of the FC. In this case, the Decree strictly follows the principles laid down by the FCAD and does not protect changes in the creditworthiness of the parties to the FCA.
In all cases, the equivalent or additional FC will be deemed as having been provided with the original FC and exempt from avoidance under insolvency law.
Enforcement of FCAs
Enforcement of FCAs will be made by way of sale or, as long as the agreement so provides and establishes a valuation mechanism, appropriation. In both cases, enforcement is not subject to prior notice, court or administrative approval or public auction. As a result, collateral takers under the Decree benefit from a mechanism to foreclose collaterals that is much more expeditious and cheaper than the general procedures available to any other type of collateral takers.
The Decree states that FCAs will be enforced separately and immediately, notwithstanding the initiation of any insolvency procedure. As a result, the foreclosure of FC granted under the Decree shall not be conducted in the context of the insolvency procedures after the expiration of the stay period that is generally applicable under the Spanish Insolvency Law to the foreclosure of certain other types of collateral.
As permitted by the FCAD, the Decree requires that the valuation of FC and the calculation of the secured financial obligations should be conducted in a “commercially reasonable manner” (that is, proper valuation of FC pursuant to its current market value and obligation to return to the collateral provider any surplus FC). While these obligations should not be deemed as a requirement necessary to foreclose the FC, lenders should be aware that the failure to comply with this duty may generate ex post liability vis a vis the collateral provider or, as the case may be, its creditors.
Certain insolvency provisions removed
As provided in the FCAD, the execution of FCAs or of the provision of FC could not be avoided in a bankruptcy scenario on the sole grounds of having been executed or provided on a date prior to the initiation of an insolvency proceeding or during the avoidance period (as is the case, for example, when new or additional collateral is granted during the avoidance period). Likewise, the operation of a CONAs is unaffected by the start of an insolvency procedure (as is generally the case under Spanish bankruptcy law that does not allow early termination and set-off in the context of an insolvency procedure).
As a result, the transactions governed by the Decree are not subject to the presumptions provided in the Spanish Insolvency Law whereby certain transactions are deemed to be harmful to the creditors and, thus, subject to avoidance. However, this protection does not apply if the insolvency trustees effectively show that FCA or related transactions were carried out to harm creditors.
The Decree also limits the application of so-called zero hour rules. The application of this may derive in limited retroactive effects of the decision opening an insolvency procedure (i.e., midnight immediately preceding the date of such decision) and, thus, jeopardize the FC perfected on the same date the insolvency procedure was opened. The Decree renders these rules inapplicable in respect of those collateral takers that can prove that they were not aware, nor should have been aware, of the start of the insolvency proceeding.