FMLC proposes clarifications to Financial Collateral Arrangements Regulations

What has happened?

On 25 October 2023, the Financial Markets Law Committee published a letter addressed to HM Treasury in which it proposed several changes to the Financial Collateral Arrangements (No. 2) Regulations 2003.

Under the Financial Services and Markets Act 2023, the Regulations will be repealed in due course, and replaced with new rules. The replacement rules are likely to be similar to the Regulations, but the FMLC considers that the replacement process would provide a good opportunity to address certain long-standing areas of uncertainty under the Regulations.

In light of this, the FMLC has proposed changes to clarify:

• the meaning of "possession" and "control" in relation to a security financial collateral arrangement;
• the meaning of "excess" financial collateral in relation to a security financial collateral arrangement; and
• inconsistencies in the treatment under the Regulations and other legislation of collateral received after the insolvency of the collateral provider.

The letter also suggests drafting to effect the proposed changes.

What are the Financial Collateral Arrangements (No. 2) Regulations 2003?

The Regulations were introduced in December 2003 to implement the EU Financial Collateral Directive¹ in the UK. Their purpose includes the following:

1. to disapply certain provisions of UK insolvency law that might otherwise interfere with the enforcement of security or the application of close-out netting upon insolvency;
2. to remove the UK perfection requirements applicable to the valid creation of security;
3. to provide statutory protection for rights of use and the remedy of appropriation in security interests; and
4. to clarify certain conflict of law issues relating to book-entry securities,

in each case in respect of a financial collateral arrangement.

A financial collateral arrangement can be either a title transfer financial collateral arrangement or a security financial collateral arrangement.

A title transfer financial collateral arrangement is, broadly:

• a written agreement or arrangement between two entities;
• the purpose of which is to secure or otherwise cover financial obligations owed to the collateral taker;
• under which the collateral provider transfers financial collateral to the collateral taker on a title transfer basis – i.e. full transfer of legal and beneficial title, with no rights to the collateral retained by the collateral provider;
• and the collateral taker is required to transfer equivalent financial collateral to the collateral provider once the financial obligations have been discharged.

A security financial collateral arrangement is, broadly:

• a written agreement or arrangement between two entities;
• the purpose of which is to secure financial obligations owed to the collateral taker;
• under which a security interest is created over financial collateral to secure the obligations;
• where the collateral is transferred so as to be in the possession or under the control of the collateral taker or a person acting on its behalf.

It is usually fairly straightforward to determine whether a particular arrangement constitutes a title transfer financial collateral arrangement. However, determining whether an arrangement is a security financial collateral arrangement can be more nuanced, and it is this nuance, and the interpretation of certain undefined terms used in the Regulations, that have prompted the FMLC's proposals.

Proposed changes

We consider the issues identified by the FMLC as requiring clarification below.

A blackline of the proposed amendments is included in the Annex to this briefing, for reference.

"Possession" and "control"

As indicated in the description above, interpretation of the terms "possession" and "control" is critical when analysing whether an arrangement constitutes a security financial collateral arrangement. However, they are not defined in the Regulations and there is no official guidance as to their meanings.

These terms are not always easy to interpret in the context of today's collateral arrangements. For example, the Regulations explicitly state that collateral provider rights to (i) substitute financial collateral, (ii) withdraw excess financial collateral, or (iii) collect the proceeds of credit claims would not prevent the collateral being "in the possession or under the control of" the collateral taker. However, there is no acknowledgement that other rights customarily conferred on collateral providers under modern-day triparty collateral arrangements, where the collateral taker does not actually possess the collateral, would not vitiate control. Such rights might include, for example, the right to receive interest paid in respect of the collateral, the right to exercise voting rights, the right to determine valuations of collateral, and the right to have the collateral returned on the insolvency of the collateral taker.

To clarify that neither the existence of any such rights under a relevant arrangement nor the use of a triparty structure incorporating any such rights would "cause the collateral-taker not to have possession or control of the financial collateral", the FMLC has suggested amendments to the "Interpretation" section of the Regulations. The proposed amendments state that, subject to certain conditions (discussed further below), a collateral taker would have "control" notwithstanding the existence of certain, specified, rights, including those described above.

Conditions relating to return of collateral on collateral taker insolvency

In the letter, the FMLC proposes that a collateral provider's right to have the collateral returned on the insolvency of the collateral taker should be subject to the following conditions:

• certification by the collateral provider that the secured obligations have been discharged;
• provision of the certification to both the collateral taker and the relevant account holder, with the right of return arising only after a specified period has elapsed;
• where the certification is based on collateral provider valuation, the collateral provider having acted reasonably and in good faith when performing the valuation; and
• the collateral taker having the right to verify the collateral provider's valuation and a right to veto the return of the collateral if the valuation cannot be verified.

These conditions are intended to give comfort to the collateral taker that posted collateral will not be released until the secured obligations have been properly discharged. However, from a practical perspective, the collateral provider's ability to obtain verification of its valuation could be hampered by the collateral taker's insolvency. More generally, in our view, the inclusion of prescriptive conditions should be considered carefully to avoid inadvertently excluding arrangements which parties may previously have considered to be included. It would be undesirable if there were a widespread need to amend documentation in order to comply with any revised regulations. Furthermore, the interaction between these requirements and the requirement under mandatory margining rules for timely return of collateral on the insolvency of a collateral taker would benefit from clarification.

Collateral provider as valuing party

The FMLC also notes that it is not currently clear whether any right or obligation of the collateral provider to value the collateral would undermine the collateral taker's control. The proposed amendments clarify that any such right or obligation would not preclude collateral taker control, provided that either:

• the exercise of any substitution or withdrawal right is subject to verification of the collateral provider’s determinations by the collateral taker or a third party (such as the custodian with which the collateral is held); or
• the collateral taker has the right to carry out such verification (or procure that it is carried out) and veto any substitution or withdrawal right if the valuations cannot be confirmed.

These conditions attempt to strike a balance between the need for collateral taker control and a commercial bargain giving the collateral provider a role in determining collateral valuations. The provisions do not appear to cover the situation in which the collateral provider determines the exposure under the transaction in addition to the value of collateral, nor do they cover rights to dispute a valuation. As discussed in Conditions relating to return of collateral on collateral taker insolvency, there may also be difficulties in obtaining the collateral provider's verification if it is in default or insolvent. Again, the introduction of prescriptive conditions should, in our view, be done in such a way as to minimise the need for market participants to amend or re-document existing arrangements.

Floating charges and Gray

The Regulations specifically provide that a floating charge can constitute a security financial collateral arrangement, provided that the charged collateral is "delivered, transferred, held, registered or otherwise designated so as to be in the possession or under the control of the collateral-taker or a person acting on its behalf".

However, in Gray v G-T-P Ltd, Re F2G Realisations Ltd², it was held that administrative control of the collateral was not sufficient for the purposes of the Regulations, and that "legal control" (i.e. the right to prevent the collateral provider from dealing with the collateral), akin to that required for a fixed charge, was required. The implications of this are that, if seeking to establish a floating charge as a security financial collateral arrangement, the concepts of "possession" and "control" need to be carefully considered.

The proposed amendments to the "Interpretation" section of the Regulations discussed at "Possession" and "control" above include amendments that may make the position regarding some floating charges clearer.

Right of re-use

Regulation 16 provides that, if the terms of a security financial collateral arrangement permit use of the transferred collateral by the collateral taker, that provision is enforceable (subject to a requirement for the collateral taker to deliver equivalent financial collateral on or before the date for performance of the secured obligations).

The FMLC notes here that, in a situation where the collateral taker is acting as an intermediary under a particular client transaction, and exercises its right of re-use to meet an obligation in respect of that transaction, the collateral would no longer be "in its possession". Therefore, for the Regulations' test to be met, the taker must be able to demonstrate control. The Regulations give no comfort that, in these circumstances, the collateral taker has sufficient control for the purposes of the Regulations.

The FMLC has proposed amendments to address this, which, if adopted, would be a welcome clarification.

Excess financial collateral

As discussed above, the Regulations provide that any right of the collateral provider to withdraw "excess financial collateral" will not prevent the collateral from being "in the possession or under the control of" the collateral taker. Unfortunately, "excess financial collateral" is not defined, and there is no official guidance or case law to help determine its meaning. One possible interpretation is that the excess should be calculated by comparing the value of collateral provided with the amount of the secured liabilities.

This may be a workable test in the case of a traditional secured loan. However, the FMLC notes in its letter that, in certain circumstances, including where collateral is used to cover derivative exposures, calculation of collateral requirements can be more complex and may be based on sophisticated modelling. In such cases, the exposure to be collateralised may not be objectively or easily determined. Furthermore, the Regulations are silent on whether the collateral taker is able to specify a required amount of collateral, such that there is an "excess" if that amount is exceeded. Consequently, it may not always be clear what constitutes "excess" financial collateral.

To address this, the FMLC has suggested incorporating a new provision, clarifying that excess financial collateral arises where the value, or estimated value, of the posted collateral exceeds the amount of collateral required to be posted under the arrangement:

"[…] “excess financial collateral” arises where the value (or estimated value) of the collateral exceeds the amount of collateral required to be posted from time to time under the agreement between the collateral-provider and the collateral-taker."

This is a pragmatic approach which seeks to avoid the uncertainties that can arise in determining the value of the secured liabilities and instead focusses on the amount of collateral required to be provided under the agreement. It would therefore follow that any collateral above that amount would be "excess", and available for withdrawal by the collateral provider.

One area that might require further clarity is the meaning of "value", as parties often agree valuation discounts or "haircuts". This means that the value of a particular type of asset for contractual purposes is less than the actual market value of the collateral. This may be complicated by the use of different agreed percentage discounts for different types of asset. In addition, it is worth noting that excess collateral can only be determined after comparing the value of the collateral with the collateralised exposure.  As noted in "Collateral provider as valuing party" above, the provisions do not appear to cover the situation in which the collateral provider determines the exposure.

Collateral received after insolvency

The final point raised by the FMLC relates to conflicting approaches under the Regulations and the Financial Markets and Insolvency (Settlement Finality) Regulations 1999 to collateral received after the commencement of insolvency proceedings in respect of the collateral provider.

As a general rule, collateral received by a collateral taker after the commencement of insolvency proceedings in respect of the collateral provider is not covered by the Regulations. However, if the collateral is received on the day on which proceedings commence, it is covered - unless the collateral taker was aware, or should have been aware, of the proceedings. The emphasis is therefore on (i) the date and time of collateral receipt and (ii) the knowledge of the collateral taker.

In contrast, under the Settlement Finality Regulations, which apply to the payment, clearing, and settlement systems used to transfer collateral, the emphasis is on the time and date of transfer initiation. If a transfer order is initiated and becomes irrevocable on the day on which proceedings commence, that collateral transfer is valid regardless of when the collateral is actually received (subject to a similar proviso that the operator did not have notice of the insolvency).

The FMLC notes that this could result in a disconnect, leading to a collateral taker successfully receiving, on a T+1 or T+2 basis, collateral from an insolvent collateral provider, but not receiving the protection of the Regulations in respect of that collateral.

An addition to Regulation 13 is proposed to address this, providing that, in these circumstances, if a transfer is binding under the Settlement Finality Regulations, it is also protected under the Regulations.

Other issues

There are some other areas that might be considered in the context of any replacement regulations, which we discuss below.

Definition of "financial collateral"

Since the Regulations entered into force, the financial markets have evolved such that a far broader range of assets is now used for collateralisation purposes than is contemplated by the Regulations. For example, commodities, digital assets, and emissions allowances may all be accepted as eligible collateral under a range of financing arrangements, but are not included in the Regulations' definition of "financial collateral". There seems to be no real policy reason for excluding such asset classes, although there may be greater complexity in relation to identifying the possession or control of certain types of digital asset (a matter which was considered in the Law Commission's Final Report on Digital Assets earlier this year). 

The definition can create legal uncertainty where security is taken over a portfolio comprising different types of asset, some of which qualify as financial collateral and some of which do not. In these circumstances, it is not clear whether the portfolio as a whole would be treated as a "security financial collateral arrangement", whether the arrangement would qualify in part only, or whether the whole arrangement would fail to qualify. HM Treasury might therefore consider broadening the definition of "financial collateral" beyond cash, financial instruments, and credit claims.

"Tradeable on the capital market"

For the purpose of the Regulations, "financial collateral" comprises cash, financial instruments and credit claims. The definition of "financial instruments" includes "bonds and other forms of instruments giving rise to […] indebtedness […] if these are tradeable on the capital market."

"Tradeable on the capital market" is an extremely vague concept, which gives little guidance as to what requirements, if any, need to be met in order for a bond or other instrument to fall within this definition, other than that they must be capable of being traded on "the capital market". Historically, market participants have interpreted this phrase broadly, but removal or clarification in this area would be welcomed.

Credit claims as collateral

As discussed above, "financial collateral" includes credit claims, being "pecuniary claims which arise out of an agreement whereby a credit institution, as defined in [the EU Capital Requirements Regulation], including the institutions listed in [EU Capital Requirements Directive] grants credit in the form of a loan".

In our view, this definition is deficient in a number of ways:

• it would be helpful if HM Treasury were to broaden the definition of "credit claims" to make it explicit that it includes syndicated lending;
• due to the nature of credit claims, demonstrating "possession" or "control" is challenging, given the customary transfer notification requirements. The Regulations provide that a collateral provider's right to collect the proceeds of a credit claim would not vitiate control, but, in our view, an element of restriction of the collateral provider's ability to dispose of the claim is required. The terms of syndicated loans, practices in that market, and the sensitivities of market participants will sometimes make it difficult to conclude that the control test in its current form has been satisfied. Clarification of the level of restriction required to fulfil the control requirement would be welcomed; and
• as explained above, one of the criteria for an arrangement to constitute a title transfer financial collateral arrangement is the requirement for an obligation on the collateral taker to return "equivalent financial collateral" to the collateral provider upon satisfaction of the covered obligations. The term "equivalent financial collateral" is defined, but only in respect of cash and financial instruments: there is no definition for equivalent financial collateral where the financial collateral is a credit claim (although there is a general "catch-all" element to the definition providing that the original collateral (i.e. the original credit claim) can be transferred as "equivalent" financial collateral). This omission may have been an oversight on the part of HM Treasury when they amended the Regulations in 2011 to include credit claims. In any event, it would be helpful if the definition were updated to cover all eligible types of financial collateral.

Commentary

It remains to be seen whether the proposals will be adopted in their current form, or indeed, in any form. The Regulations have already been amended a number of times, most recently in 2021, but, despite multiple requests by the FMLC for changes to clarify key concepts, not all of these have been implemented. Explicit clarification in the areas highlighted by the FMLC would be a welcome development for market participants and lawyers alike, who need to be able to accurately interpret the legislation for structuring and regulatory purposes. Even more welcome would be amendments that also address the additional areas that we have identified above.

However, as the Regulations derive from an EU Directive, similar requirements have also been  implemented across the EU. Clarification of areas of legal uncertainty in the Regulations would be welcome, but a requirement to include additional contractual terms could discourage or complicate the use of English law in relevant contracts in a cross-border context if the same terms are not also required under the law of EU jurisdictions. When replacing the Regulations, if amendments are anticipated, HM Treasury should bear this in mind so that any changes strike the right balance.

We will monitor developments and provide updates when they are available.

<sub>1. EU Directive 2002/47.
2. Gray and others v G-T-P Group Limited: Re F2G Realisations Limited (in liquidation) [2010] EWHC 1772 (Ch)</sub>

Annex

Proposed Amendments for the current FCARs to mitigate areas of uncertainty

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3 Interpretation

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(2) For the purposes of these Regulations “possession” of financial collateral in the form of cash or financial instruments includes the case where financial collateral has been credited to an account in the name of the collateral-taker or a person acting on his behalf (whether or not the collateral-taker, or person acting on his behalf, has credited the financial collateral to an account in the name of the collateral-provider on his, or that person’s, books) provided that any rights the collateral-provider may have in relation to that financial collateral are limited to the right to substitute financial collateral of the same or greater value or to withdraw excess financial collateral shall not cause the collateral-taker not to have possession or control of the financial collateral.

(3) In a security financial collateral arrangement, the collateral-taker shall be treated as having “control” of the collateral for the purposes of these  Regulations notwithstanding: 

(a) its exercise of a right of use as described in regulation 16; 

(b) any right of the collateral-provider to substitute collateral of the same or greater value, withdraw excess collateral or collect the proceeds of, or  otherwise service, a credit claim until further notice; 

(c) any right of the collateral-provider to receive income or notices, or  exercise any voting rights, in relation to collateral in the form of securities; 

(d) any right or responsibility of the collateral-provider to determine the value  of the collateral (or any assets which may be substituted for the  collateral), provided that: 

(i) the exercise of any right of substitution or withdrawal of excess  collateral depends on the collateral-provider’s determinations being  verified by the collateral-taker or a third party (such as the custodian  with which the collateral is held); or 

(ii) the collateral-taker has the right to carry out such verification (or procure that it is carried out) and veto any exercise of a right of  substitution or withdrawal of excess collateral if the collateral-provider’s valuations cannot be confirmed; 

(e) any right of the collateral-provider to require release of the collateral from  the collateral arrangements if the collateral-taker becomes insolvent upon  certification that the secured obligations have been discharged, provided  that: 

(i) where the certification depends on a valuation that has been carried  out by the collateral-provider, the collateral-provider is required to  act reasonably and in good faith in undertaking such valuation; and 

(ii) the collateral-provider is required to provide its certification to both  the collateral-taker and the person with which the relevant account is held, with the right to withdraw collateral from the account arising  only after a specified period has elapsed; 

(ii) the collateral-taker has the right to carry out such verification (or procure that it is carried out) and veto any exercise of a right of  substitution or withdrawal of excess collateral if the collateral-provider’s valuations cannot be confirmed; and 

(f) the fact that the collateral may be held in an account in the name of a  third party (including the collateral-provider) where the collateral-taker has an agreement with the person with which the account is held that  contains the features set out in sub-paragraphs (b) to (e). 

(4) For the purposes of paragraphs (2) and (3), “excess financial collateral” arises  where the value (or estimated value) of the collateral exceeds the amount of  collateral required to be posted from time to time under the agreement between  the collateral-provider and the collateral-taker. 

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13 Financial collateral arrangements to be enforceable where collateral-taker not aware of commencement of winding-up proceedings or reorganisation measures

(1) Where any of the events specified in paragraph (2) occur on the day of, but after the moment of commencement of, winding-up proceedings or reorganisation measures those events, arrangements and obligations shall be legally enforceable and binding on third parties if the collateral-taker can show that he was not aware, nor should have been aware, of the commencement of such proceedings or measures.

(2) The events referred to in paragraph (1) are–

(a) a financial collateral arrangement coming into existence;

(b) a relevant financial obligation secured by a financial collateral arrangement coming into existence; or

(c) the delivery, transfer, holding, registering or other designation of financial collateral so as to transfer its legal and beneficial ownership to, or be in the possession or under the control of, the collateral-taker.

(2A) Where, on the day of winding-up proceedings or reorganisation measures– 

(a) a transfer order is entered into a designated system and becomes  irrevocable in accordance with the Financial Markets and Insolvency (Settlement Finality) Regulations 1999/2979; and 

(b) such transfer order meets the conditions set out in regulation 20(2) of the Financial Markets and Insolvency (Settlement Finality) Regulations 1999/2979, 

any delivery, transfer, holding, registering or other designation of financial  collateral so as to transfer its legal and beneficial ownership to, or be in the possession or under the control of, the collateral-taker pursuant to such  transfer order shall be legally enforceable and binding on third parties. 

(3) For the purposes of paragraph (1)–

(a) the commencement of winding-up proceedings means the making of a winding-up order or, in the case of a Scottish partnership, the award of sequestration by the court; and

(b) commencement of reorganisation measures means the appointment of an administrator, whether by a court or otherwise or, in the case of a Scottish partnership, the date of registration of a protected trust deed.

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16 Right of use under a security financial collateral arrangement

(1) If a security financial collateral arrangement 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.

(2) The exercise by a collateral-taker of a right of use as described in paragraph (1)  shall not render invalid or unenforceable any right of the collateral-taker under  such a collateral arrangement. 

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