Close-Out Netting and Financial Collateral Arrangements
2005 Butterworths Journal of International Banking and Financial Law, n.º 7
On 11 March this year, the Spanish government enacted Royal Law-Decree 5/2005 (the ‘Decree’) and implemented Directive 2002/47/EC of the European Parliament and the Council of 6 June, 2002, on Financial Collateral Arrangements (the ‘FCAD’).
The Decree generally follows the draft law submitted by the Spanish Treasury on October 2004 (the ‘Draft Law’) which we examined in Volume 20 No 3 of JIBFL.
SCOPE OF APPLICATION
Financial Collateral Arrangements (FCAs)
Parties that are eligible to execute an FCA include public entities, financial institutions (including central and multilateral banks, investment firms and insurance undertakings), along with certain entities of the capital markets (exchanges, central counterparties, settlement agents or clearing houses) and institutional investors (certain mutual, securitisation and pension funds and their management companies). FCAs can also be entered into by any legal entity provided that the counterparty is one of the above. Natural persons may enter into an FCA provided the other party is an exchange, central counterparty, settlement agent or clearing house.
FCAs may secure payments of cash or delivery of financial instruments. As seems to be the case in France (Ordonnance no 2005-171) and the United Kingdom (Financial Collateral Arrangements (No 2) Regulations 2003), it could be argued that the Decree has expanded its scope of application to encompass security over any kind of debt obligation, including those arising under loan agreements. Some practitioners have claimed this interpretation is inconsistent with the FCAD, as the Directive was only meant to provide the legal framework to secure transactions over financial instruments, and not loan agreements, even if they are secured with financial instruments.
The Decree also widens the type of assets that may be provided as financial collateral (FC), so that it includes money credited to an account in any currency, negotiable securities, financial instruments and any direct or indirect right over assets. Under the literal language of the Decree, for example, any kind of shares in corporations, irrespective of whether they are listed or not, could serve as FC. Furthermore, the Decree does not implement the opt-out possibilities, established in the FCAD, applicable to FCAs over the collateral-provider’s own shares and shares in affiliated undertakings where their exclusive purpose is a means of providing security in relation to the collateral-provider’s business or real estate. (A provision that, we understand, was introduced to prevent the unintended application of the FCAD to real estate under certain Finnish mortgage practices by which householders use shares in companies as collateral in their domestic mortgage purchase transactions.)
The Decree disapplies all formal requirements (including, inter alia, the provision of evidence in a specific form with regard to the date of execution of the FCA, provided in art 1.865 of the Spanish Civil Code), other than evidencing the execution of the FCA and the provision of the FC in writing. The Decree considers FC as being ‘provided’ when it has been delivered, transferred, held, registered or credited in any 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’. The Decree, however, leaves ‘control’ undefined (whether the collateral-taker should have sole control over the account or just the right to realise the FC without the aid of the collateral-provider). In addition, it does not identify the relationship that needs to be established between the collateral-taker and the ‘person acting on the collateral-taker’s behalf’. Thus, it is unclear if – as stated in Article 8 and (§ 8-104 (c) y [d]) and Article 9 (§ 9-104 (a) (2) § 9-106 (b) (2)) of the US Uniform Commercial Code, and proposed by the UK Law Commission’s consultation paper amending the Companies Act 1985 – the FC should be considered ‘provided’, when transferred to a person bound by a control agreement executed with the collateral-taker, whereby the collateral-taker is entitled to give instructions to the depositary for the purpose of disposing, or realising, the FC without the assistance of the collateral-provider. Furthermore, deviating from 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 on the relevant account.
Close-out Netting Arrangements (CONAs)
CONAs are defined as agreements where netting and close-out is agreed in connection with certain financial transactions (FCAs, lending of securities, repos, spot foreign-exchange transactions, derivatives – including derivatives on raw-materials and on emission allowances – and fiduciary assignments of public debt, financial instruments or cash, among others).
With regard to the parties, at least one of them should be one of the ‘regulated’ entities that are eligible to execute an FCA (see above). The other party or parties may be any legal entity or even a natural person.
One important shortcoming of the Decree, though, is that it fails to stress that CONAs will operate notwithstanding any purported assignment or attachment of the rights involved in that arrangement (see art 7.1(b) of the FCAD).
FC Arising From Regulation
The Decree does not only cover FC derived from the contract, as was intended by the FCAD and the Draft Law, it also applies to FCs arising from the regulations governing secondary markets, book-entry registry systems, clearing systems and counterparty entities.
The Two-track approach
The Decree maintains the ‘two track approach’, adopted by the FCAD, allowing for two distinct types of collateralisation techniques: security FCAs (SFCAs) and title transfer FCAs (TTFCAs) (which include repos and title transfer arrangements such as the ISDA Credit Support Annex).
While the express recognition of TTFCAs helps to remove the risk of recategorisation of TTFCAs as SFCAs, the Decree does not contain any express provision to ensure that, as required by the FCAD, a TTCFA ‘can take effect in accordance with its terms’. In any event, the most notable differences between SFCAs and TTFCAs are effectively removed: while collateral-takers under SFCAs are entitled to use and dispose the FC (as is the case under TTFCAs), collateral-takers under TTFCAs are accountable for any surplus FC that may remain available after foreclosure (as is the case under SFCAs).
Right to use FC
As long as it is contractually agreed, the right to use the FC is extended to SFCAs. This new feature should not only increase the market’s liquidity, but also enable the collateral-taker to generate income from the re-use of the FC and, as a result, offer better financing terms to the collateral-provider. Where this right is exercised, on or before the due date of the secured obligation, the collateral-taker should transfer equivalent FC to replace the original FC or, if the SFCA so provides, set-off the value of the equivalent FC against the secured obligations. The above obligation may be the subject of a close-out netting provision if an enforcement event occurs while this obligation is outstanding.
Similarly, if the FCA so provides, the collateral-provider is entitled to withdraw the FC and replace it with other equivalent FC. This feature 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.
In both cases, the equivalent FC will be treated as having been provided under the FCA from the date the original FC was first provided.
Following the FCAD, the Decree favours modern credit risk management techniques, whereby the provision of additional FC is permitted upon changes of the mark-to-market value of the collateral-taker’s credit exposure to the debtor and of the value of the FC. When such a possibility is provided in the FCA, the additional FC provided by the collateral-provider, should be deemed to be simultaneously provided with the original FC and, thus, exempt from nullification rules under insolvency law. As is the case in the FCAD, top-up FC in response to changes in the debtor’s creditworthiness, is not protected by the Decree.
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 does not require prior notice, court or administrative approval, public auction or any other prescribed manner (including waiting periods). When the FC is held by a third-party, the Decree establishes a procedure that allows the liquidation or appropriation of the FC upon the collateral-taker’s first demand. Moreover, the Decree disapplies certain stay periods that may be applicable under Spanish Insolvency Law and states that, notwithstanding any insolvency procedure, FCAs may be enforced separately and immediately.
The Decree implements the opt-in possibilities authorised by the FCAD, and requires that the valuation of FC, and the calculation of the secured financial obligations, should be conducted in a ‘commercially reasonable manner’. In this respect, valuations and calculations must be carried out in line with the current market value of the FC and that after the enforcement of the FCA, the collateral-taker returns any surplus FC to the collateral-provider.
The Decree states that termination and enforcement rights, agreed under CONAs, are unaffected by the commencement of an insolvency procedure, as would generally be the case under Spanish Insolvency Law.
Furthermore, the Decree states that FCAs (and the provision of FC thereunder) and CONAs (and the financial transactions to which they refer) should not be rescinded on the sole grounds that such transactions took place before the initiation of an insolvency proceeding or what is considered to be the ‘avoidance period’. This provision effectively disapplies Spanish Insolvency Law under which certain transactions are presumed to be harmful and, thus, avoided (for example, rescission of new collateral granted during the avoidance period). This leaves the possibility of nullification if the insolvency trustees effectively prove that a given transaction has been carried out to harm creditors.
The Decree also limits the application of ‘zero hour rules’ (i.e. the insolvency procedure is effective as of the midnight immediately preceding the date of the decision opening such procedure), as long as the collateral-taker can prove that he was not aware, nor should have been aware, of the commencement of the insolvency procedure.
When Laws Conflict
The Decree adopts the PRIMA principle contained in the Settlement Finality Directive. It provides that the law of the country where the principal account is located, will govern matters such as the legal nature and proprietary effects of book-entry securities collateral, perfection and rank of the FCA, protection of good faith acquirers, and the procedure to enforce a FCA. The Decree defines ‘principal account’ as the account where the provision of the FC is registered.