Court of Justice of the European Union for the first time decides questions of scope of the Financial Collateral Directive

Background to the issues

Aim of the FCD

The FCD aims to facilitate financial collateral arrangements used in the European financial markets by requiring EU Member States to remove formalities to the creation, perfection or enforcement of financial collateral arrangements, and to ensure that provisions of EU Member States' insolvency law preventing enforcement of security do not apply to collateral arrangements meeting certain requirements. The FCD also safeguards other contractual rights such as close out netting and rights of use, establishes a right of appropriation for the collateral taker and permits enforcement of a financial collateral arrangement notwithstanding the imposition of a moratorium on insolvency by a national court.

Possession or control

The FCD reduces the administrative burdens on collateral takers by the removal of formal perfection requirements (such as registration) but only if the financial collateral is "provided" to the collateral taker and that provision is evidenced in writing. Collateral is "provided" for the purpose of the FCD if it is "delivered, held, registered or transferred so as to be in the possession or under the control of the collateral taker". However, the Directive does not define the meaning of "in the possession or under the control" for this purpose, and there has thus far been no decision at an EU level as to what the expression means.

Existing case-law in English courts

The English courts have considered this issue – notably in the decisions in Gray and Others v G-T-P Group Ltd [2010] EWHC 1772 (Ch) ("Gray") and Re Lehman Brothers International (Europe) (in administration) [2012] EWHC 2997 (Ch) ("Extended Liens"). Both cases considered the meaning of "possession" and "control" for the purpose of the Financial Collateral Arrangements (No.2) Regulations 2003 (the "FCA Regs"), which implemented the FCD in the UK. In Gray, the court held that mere administrative control of the collateral was insufficient to establish "possession or control" and that a legal right to prevent the collateral provider from withdrawing the collateral was required. This decision cast doubt over whether an English-law floating charge could ever amount to a financial collateral arrangement due to the collateral provider's ability to deal with the charged property, as it is well established under English law that a high degree of control is required to create a fixed charge over intangible assets such as book debts including cash on account, following the difficulties identified in the line of cases culminating in National Westminster Bank plc v Spectrum Plus Limited and others [2005] UKHL 41 ("Spectrum"). The decision also suggested that "possession" could not apply to an intangible asset.

In the UK at least, those issues were then partly removed by amendments made to the FCA Regs in 2010, which provided that "possession" of financial collateral in the form of cash or financial instruments includes the case where the collateral "has been credited to an account in the name of the collateral taker or a person acting on his behalf … 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."

This confirmed that a financial collateral arrangement in reliance on possession of collateral in the form of an intangible asset, such as a right over a book debt e.g. a bank account, is possible. It also seemed to suggest that a charge which may not amount to a fixed charge due to there being insufficient control for the purpose of the requirements of Spectrum could still in principle amount to a financial collateral arrangement. However, as a typical floating charge used in financial markets collateral arrangements would allow the collateral provider other rights (e.g. income and voting rights, the right to value the collateral for determination of the excess, etc.), there remained difficulties in reconciling a typical charge used in the financial markets with the requirement that "any rights … are limited to …" rights of substitution or withdrawal of excess collateral in the wording above.

The Extended Liens case confirmed the approach to the requisite degree of "possession" or "control" in Gray – i.e. that a delivery or transfer of the collateral alone is not sufficient to establish possession or control, and that a degree of legal restriction on dealings is required, which may be established if the collateral provider is prevented from removing the collateral other than by way of substitution or withdrawing excess collateral. However, the case demonstrated the continuing difficulties surrounding determination of the requisite level of possession or control following the amendment to the FCA Regs, including questions surrounding how and by whom the determination of an "excess" of collateral must be made, and how documentation governing margin exchange must provide for this.

The CJEU has now ruled on the issue of possession or control, largely confirming the approach taken in Extended Liens, as well as dealing with additional questions of scope of the FCD, as outlined below. Note however that certain difficulties identified in the Extended Liens case remain undecided, as the judgment of the CJEU did not address those points.

The facts

In 2007, PEIG's predecessor ("P") opened a standard current account with Swedbank. The account agreement provided that monies in the account were pledged to Swedbank as financial collateral for all debts owed by PEIG to Swedbank. In October 2010, P was declared insolvent. Subsequently, the insolvency administrator entered into a new current account agreement which contained an identical pledge.

In June 2011, Swedbank debited an amount from the current account in satisfaction of a debt owing to it. P's insolvency administrator then brought an action against Swedbank for recovery of that amount, invoking principles of Latvian law of equal treatment of creditors in insolvency proceedings and the Latvian equivalent of the anti-deprivation principle (which is common to many jurisdictions and under which contractual provisions may not have the effect of transferring property on insolvency to the prejudice of other creditors).

The Latvian court referred several questions of scope and interpretation of the FCD to the CJEU.

Does the FCD apply to cash on deposit in normal current accounts?

The court considered whether the provisions of Article 4 of FCD, which allows enforcement of financial collateral arrangements notwithstanding the insolvency of the provider, must be interpreted as applying only to accounts which are used for settlement in payment and securities settlement systems, or as applying equally to any bank account, including a current account which is not used for securities settlement.

The AG's Opinion had noted that as:

• "cash" is defined in FCD as money credited to an account and similar claims for the repayment of money; and
• "relevant financial obligations" as defined in the FCD clearly includes ‘all monies’ arrangements, where the collateral is provided for any present or future liability of the provider to the taker,the question of whether that account is used in payment and securities settlement systems in accordance with the Settlement Finality Directive was not relevant.

The CJEU agreed with the Advocate General, adding that the FCD specifically excludes banknotes from the definition of "cash" and does not provide for any other form of exclusion. It must therefore be concluded that a financial collateral arrangement can extend to collateral in the form of monies deposited in a bank account, and is not confined to monies deposited in accounts used in payment and securities settlement systems.

Furthermore, as the definition of "relevant financial obligations" includes obligations which give a right to cash settlement, this must be understood as covering ordinary pecuniary debts owed by an account holder to his bank and therefore an "all-monies" security interest can qualify as a security financial collateral arrangement.

What is required in order to establish possession or control?

A collateral arrangement may be classified as a "financial collateral arrangement" within the FCD only if the collateral has been provided so as to be in the possession or under the control of the collateral taker. The AG's Opinion referred to the difficulties encountered with these provisions, and the problems caused by the decision in Gray and Extended Liens that the collateral taker must have "legal" control over the object of the collateral for the arrangement to fall within the FCA Regs.

The Advocate General took the view that the requirement of the collateral being "in the possession" or "under the control" of the collateral taker for the purposes of the FCD would become entirely ineffective if it were interpreted as covering a situation where the collateral provider is able to continue to dispose of collateral freely. As a result, the FCD meaning of "provided" must be interpreted to the effect that the provision of financial collateral in the form of cash deposited in a bank account requires the collateral taker having the legal right to limit the use of monies deposited in that account in so far as is necessary to guarantee the relevant obligations.

The CJEU agreed, adding that the exception in Article 2(2) of FCD for rights of substitution or withdrawal of excess financial collateral in favour of the collateral provider would lack any force if the collateral taker were also to be regarded as having acquired "possession or control" of the collateral where the account holder may freely dispose of it.

Consequently the CJEU held that the taker of collateral in the form of monies lodged in an ordinary bank account has acquired "possession or control" of the monies only if the collateral provider is prevented from disposing of them. Here the account agreement did not contain a clause permitting Swedbank to limit withdrawals or requiring that a certain amount must remain blocked in the account, and as a result, Swedbank did not have the requisite possession or control for the arrangement to qualify as an FCA.

This decision confirms that, in order to ensure that a security arrangement constitutes a security financial collateral arrangement, a clause should be included restricting withdrawals of collateral.

Is realisation of the collateral under the FCD contrary to the principle of equal treatment of creditors in insolvency proceedings?

The Latvian Supreme Court had also referred the question of whether the priority granted to the financial collateral taker by the FCD might seem contrary to the principle of equal treatment of creditors in insolvency proceedings.

On this question, the Advocate General took the view that the FCD must be interpreted as seeking to exempt financial collateral from the application of restrictions provided by national insolvency law. The FCD has the effect that the collateral taker has the right to realise financial collateral provided under a financial collateral arrangement notwithstanding the commencement or continuation of winding-up proceedings or reorganisation measures in respect of the collateral provider, and that this right applies to collateral provided before the commencement of such proceedings. The reasons for this view were as follows:

• The FCD gave Member States the option to exclude financial collateral arrangements where one of the parties is not an authority, a public body, a financial institution or a central counterparty, settlement agent or clearing house;
• The FCD regime applies only to collateral where there is some form of "dispossession" of the collateral provider and where the collateral taker has "possession" or "control" of the collateral; and
• Article 8 of FCD expressly sets out certain limitations on the application of national insolvency rules for collateral provided before the commencement of insolvency proceedings and exceptionally for collateral provided after the commencement of insolvency proceedings, where the collateral taker was unaware of the commencement of those proceedings.

Again, the CJEU agreed, noting also that:

• It is a general principle of equality before EU law which requires that comparable situations should not be treated differently and that different situations should not be treated in the same way, unless such different treatment is objectively justified. A difference in treatment is justified if the difference relates to a legally permitted aim pursued by the legislation in question, and it is proportionate to the aim pursued by the treatment.
• The FCD confers an advantage on financial collateral by comparison with other types of security which fall outside the scope of the Directive. This different treatment is based on an objective criterion that relates to the legitimate aim of the FCD, which is to improve the legal certainty and effectiveness of financial collateral to provide stability in the financial system.
• There is nothing to suggest that the different treatment in question is disproportionate to the aim pursued by the FCD, and account should be taken that the FCD applies only if the collateral is provided before the commencement of insolvency proceedings.
• Under Article 8, where collateral has been provided after the commencement of insolvency proceedings, the collateral arrangement will be legally enforceable and binding on third parties only in exceptional circumstances, namely only if the collateral was provided on the day of commencement and the collateral taker provides evidence that he was not aware, nor should have been aware, of the commencement of the proceedings.

However, the court held that those requirements were not met on the facts of this case. The monies debited by Swedbank were deposited in the account in question only after the date on which the insolvency proceedings commenced and, second, that the account agreement did not contain any clause to the effect that P was prevented from disposing of the monies after they had been deposited in the account.

This highlights that collateral takers cannot rely on the FCD for collateral received after commencement of insolvency of the provider. However, this is mitigated to an extent by the protections afforded to participants in settlement and clearing systems under the Settlement Finality Directive, which preserves the effectiveness of any instruction for the transfer of collateral made prior to the insolvency of another participant or the system.

Validity of national law implementing the FCD

The Latvian court had also referred to the CJEU the question of whether an extension of the scope of the FCD under Latvian law to apply to arrangements made between natural persons is consistent with Article 1(2)(e) of the FCD, which expressly excludes arrangements where either party is a natural person. However the dispute at hand did not, in fact, concern natural persons, and as a result the CJEU declined to rule on this question.

The Latvian court also asked for a preliminary ruling from the CJEU on the issue of whether, in the event that the scope of the FCD is more limited than the national law transposing it, to interpret the FCD as invalidating a financial collateral clause based on that national law. Again, the court declined to rule on this issue, on the basis that the Latvian court had not given sufficient explanation for the basis of its question.

However, these points are of interest in that they raise related issues of construction in relation to local-law implementation of the FCD to those discussed in the Privy Council decision in Cukurova Finance International Limited and Cukurova Holding A.S (Appellants) v Alfa Telecom Turkey Ltd (Respondent) [2013] UKPC 2, ("Cukurova") which was an appeal from the Court of Appeal of the BVI.

In Cukurova, the Privy Council considered whether the United Kingdom Treasury had acted ultra vires in including within scope of the FCA Regs not only arrangements in which one counterparty was an ordinary non-natural person (i.e. other than a financial institution, central bank, sovereign entity, etc.) as expressly permitted in FCD, but also to arrangements in which both parties were ordinary non-natural persons.

The Privy Council was therefore asked to consider the interpretation and application of the FCA Regs as between parties to which the FCD, as a matter of European Union law, neither required nor contemplated that its terms would apply.

The Privy Council held the FCA Regs should be interpreted in their full scope against the background of the Directive, so as to give effect between ordinary non-natural persons to a similar scheme to that which is contemplated under European Union law to apply to transactions involving public authorities, central banks and financial market institutions. "This is so not because European law has any immediate relevance to transactions between ordinary companies, but on conventional principles of domestic construction. The Regulations were at their core rooted in the Directive, and they must in their extended domestic reach have been intended to operate on the same basis as at their core."

However, the decision was concerned chiefly with the scope of the European Communities Act 1972, and not whether a provision of domestic law could be invalidated if it went beyond the scope of the FCD. It remains to be seen what approach the CJEU will take to such questions if they are referred to it in other cases.

Where does this leave the law in the UK and in the EU on possession and control?

As mentioned above, the amendments to the FCA Regs made in 2010 following the Gray case have provided some degree of clarity in the UK to the effect that it is possible that intangible assets such as cash in an account can be the subject of a financial collateral arrangement as possession can be established by legal restrictions on the collateral provider's ability to withdraw monies from the accounts. This approach has now been supported by the CJEU and should therefore also be the position across Member States.

However, the difficulties identified in the Extended Liens case around the meaning of possession and control remain, particularly with respect to the basis of any valuation underlying the collateral provider's ability to withdraw excess amounts of collateral, to substitute financial collateral of the same or greater value, to exercise voting rights in respect of posted collateral, and to receive any income and distributions from posted collateral.

One area which is left open is exactly how protections given to collateral providers under the margin rules made under Article 11(3) of EMIR are to be reconciled with the requirements for restrictions on dealing by the collateral provider under the FCD.