EU consultation on the Financial Collateral Directive

The European Commission (the "Commission") is conducting a consultation (the "Consultation") on the functioning of the Financial Collateral Directive¹  (the "FCD" or the "Directive"), in conjunction with a mandated review of the Settlement Finality Directive (the "SFD")². The Consultation closes on 7 May 2021 and is an opportunity for several areas of uncertainty within the FCD to be clarified.

The Consultation is split into seven sections and covers:

• the scope of the FCD;

• the meaning of "possession" and "control" in the context of financial collateral;

• recognition of close-out netting provisions across the EU;

• the scope of eligible collateral under the FCD;

• the status of debtors' set-off rights in respect of credit claims provided as collateral to central banks; and

• the interaction of the FCD with other EU legislation.

The principal points discussed in the Consultation are summarised below.

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Summary of FCD provisions

The FCD distinguishes between arrangements under which collateral is provided by way of a security interest ("security financial collateral arrangements") and those under which title to collateral is transferred outright subject to a right to receive equivalent collateral ("title-transfer financial collateral arrangements"). Both forms of collateralisation are critically important in the financial markets in managing risk and improving liquidity.

The aim of the Directive, which entered into force in 2002, was to facilitate financial collateral arrangements by requiring EU Member States to (i) remove formalities that would otherwise apply to the creation, perfection and/or enforcement of financial collateral arrangements, and (ii) ensure that domestic insolvency law provisions, such as stays or moratoria, which would otherwise restrict the enforcement of financial collateral arrangements, are disapplied.

It also safeguards other contractual rights, such as close-out netting, rights of use, and rights of appropriation for the collateral taker, and contains provisions on conflicts of law, regulating which law applies to the creation and perfection of security in book-entry securities collateral.

As an EU Directive, the FCD is not directly applicable across the EU and was therefore implemented into each EU Member State independently, through national legislation. In the UK, this was achieved through the Financial Collateral Arrangements (No 2) Regulations 2003 (the "Regulations"). As the Regulations are part of UK law, rather than directly applicable EU legislation, their application in the UK was unaffected by the UK's departure from the EU.

This approach to implementation has led to inconsistencies in the application of the FCD across the EU. For example, the FCD permits (i) deviations in scope across EU Member States (see Scope of the FCD below) and (ii) the exclusion by EU Member States of credit claims from the scope of eligible collateral (see Financial collateral – potential amendments to scope and removal of debtors' set-off rights in credit claims below)³. The Consultation aims to assess some of these inconsistencies and seeks respondents' input on how they might be rectified.

Scope of the FCD

In order for a financial collateral arrangement to benefit from the protections conferred by the FCD, both the collateral taker and the collateral provider must fall within its scope. At present, financial institutions, public authorities, central banks, central clearing counterparties ("CCPs"), clearing houses and settlement agents ("Core Entities") are all in scope.

The Consultation asks respondents whether the scope should be extended to also include:

• payment institutions;
• e-money institutions;
• central securities depositories; and/or
• other entity types.

The FCD also applies to non-Core Entities, but only when transacting with a Core Entity. However, when implementing the FCD into national law, EU Member States were able to disapply this broader definition, effectively limiting the scope of the FCD in that jurisdiction to wholesale financial markets only.

The Consultation asks whether the resulting inconsistency across the EU is problematic for the cross-border provision of collateral, and whether the FCD scope should be narrowed so that it only applies to the wholesale market, across the whole of the EU.

Meaning of "possession" and "control"

In the case of security financial collateral arrangements, the FCD only applies to arrangements that involve the provision of cash, financial instruments and/or credit claims, and only where such provision can be 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 FCD does not define the meaning of "in the possession or under the control", an omission which has given rise to considerable uncertainty since its entry into force.

The issue was considered under English law in Gray and Others v G-T-P Group Ltd [2010] EWHC 1772 (Ch) and later in Re Lehman Brothers International (Europe) (in administration) [2012] EWHC 2997 (Ch), both of which confirmed that, without more, delivery or transfer of the collateral, and mere administrative control of the collateral, is not sufficient to confer "control" or "possession" for the purposes of the FCD; some degree of legal restriction on the use of the collateral by the collateral provider is required to demonstrate sufficient control by the collateral taker. However, the level or degree of control required remains unclear, and is largely fact-dependent.

The issue was also considered by the Court of Justice of the European Union in Private Equity Insurance Group SIA v Swedbank AS [2016] EUECJ C-156/15 ("Swedbank"). The decision in Swedbank confirmed that, where the financial collateral is in the form of cash deposited in a bank account, the requisite control is only conferred on the collateral taker where the account agreement allows the collateral taker to restrict cash withdrawals by the collateral provider (which control, in Swedbank, was not present).

Accordingly, existing case law (decided prior to the UK's departure from the EU) supports the view that the collateral taker must have the legal right to prevent withdrawals of collateral from the account and that administrative or practical control is insufficient. It might be argued that this approach is unduly restrictive and excludes arrangements from the scope of the Directive which should benefit from its protections.

Against this backdrop, section 2 of the Consultation asks respondents whether they consider it necessary to clarify the concepts of "possession" and "control" as used in the FCD, and, if so, how.

Other aspects of this issue that would be worthy of clarification, and which respondents may choose to raise in the "Other Issues" section at the end of the Consultation, include the following:

• whether a right for the collateral provider to receive dividends or coupons paid in respect of the financial collateral is inconsistent with the requirement for possession or control of the collateral by the collateral taker;
• whether the exercise of voting rights or the making of other types of election in respect of charged property is inconsistent with the requirement;
• the meaning of "excess" collateral and whether this has an objective meaning or can be defined by the parties in the relevant agreement. For example, it is unclear whether the parties can apply their own valuation haircuts or other valuation metrics (such as ratings requirements); and
• how value is determined for the purposes of substitutions of collateral or withdrawal of excess collateral. It is unclear whether the Directive permits such determinations to be made by the collateral provider or a third-party collateral manager, or requires that only the collateral taker make such determinations.

The Consultation does not directly address the tension between the FCD requirement for sufficient "control" to be conferred on the collateral taker and the potentially conflicting requirement under the EU EMIR Margin Rules⁴  that initial margin provided by a derivative counterparty must be "freely transferable" to the collateral provider "in a timely manner" on the default of the collateral taker. However, section 6 of the Consultation asks for feedback on the interaction of the FCD and other EU legislation (see Interaction with other EU legislation below), giving respondents the opportunity to raise this issue and request clarification on how these two fundamental requirements are to be reconciled in practice.

Section 2 also asks for feedback on how the provision of financial collateral consisting of "claims relating to or rights in or in respect of" financial instruments (i.e. dividends or interest) should be evidenced, and whether the concept of a "good faith acquirer" of collateral under a title transfer financial collateral arrangement should be clarified in the FCD, given the lack of harmonisation across the EU of rules in this area.

Awareness of insolvency proceedings

Where a financial collateral arrangement has been created or collateral has been provided on the same day on which winding-up proceedings or reorganisation measures are initiated in respect of the collateral provider or the collateral taker, in order for the arrangement to be enforceable, the collateral taker must prove that it was not aware, nor should have been aware, of this. The Consultation notes that, in practice, it is difficult for a collateral taker to prove this, and asks respondents whether this requirement should be clarified and, if so, how.

Recognition of "close-out netting provisions" across the EU

The FCD recognises the importance of close-out netting to the functioning of the financial markets by requiring EU Member States to ensure that close-out netting provisions can take effect in accordance with their terms notwithstanding the commencement of winding-up proceedings or reorganisation measures in respect of the collateral provider and/or the collateral taker.

Despite this overarching requirement, the Consultation states that inconsistencies in the implementation of the FCD across EU Member States mean that contracting parties often need to carry out specific due diligence in order to ascertain whether a close-out netting provision would, in fact, be enforceable against a counterparty in a particular jurisdiction. This uncertainty is exacerbated by the fact that the FCD is silent on the application (or otherwise) of domestic insolvency avoidance actions. In contrast, these are explicitly disapplied in such context by the SFD.

In order to determine the extent of the issue, the Consultation asks respondents whether:

• they have encountered issues with the recognition of close-out netting provisions;
• if so, whether this was in a cross-border context;
• how the issue could be resolved; and
• what (if any) legal uncertainties persist with regard to the enforceability of close-out netting provisions given the FCD's lack of express disapplication of domestic insolvency avoidance actions.

It is also notable that the Directive does not clarify whether the contractual terms of a close-out netting provision should override in all cases any mandatory insolvency netting or set-off provisions which apply under the domestic law applicable to a relevant insolvency proceeding. This means that, where mandatory netting or set-off laws apply, there may be differences in the basis of calculation between the mandatory provisions and those applicable under the contract, even if the contract constitutes a financial collateral arrangement. As this can lead to uncertainties, this could be an area for clarification.

Furthermore, EU Directive 2014/59 on Bank Recovery and Resolution (the "BRRD") and EU Regulation 2021/23 on the Recovery and Resolution of Central Counterparties (the "CCP R&R Regulation") amended the FCD such that the protection that it affords to close-out netting arrangements is disapplied in respect of close-out netting arrangements that become subject to the exercise of any stay power available to a relevant resolution authority under the BRRD or the CCP R&R Regulation, on the basis that such arrangements are subject to specific safeguards under those instruments. The Consultation notes that these carve-outs, while intended to reconcile the operation of close-out netting arrangements with the effective resolution of financial institutions and CCPs, give rise to uncertainty as to whether a close-out netting arrangement is enforceable under the FCD in the context of the resolution of a financial institution or a CCP.

In light of this, the Consultation asks respondents whether legal opinions that they have obtained on the enforceability of close-out netting in certain jurisdictions have required amendment since the entry into force of the BRRD and/or the CCP R&R Regulation and, if so, how.

The same section also asks respondents whether the treatment of contractual netting, and close-out netting in particular, should be further aligned across the EU.

Scope of eligible collateral

As mentioned above, the FCD only applies to financial collateral arrangements that involve the provision of cash, financial instruments and/or credit claims. In the Consultation, the Commission suggests that this list of collateral should be updated and/or broadened, including to encompass stablecoins once these are regulated in the EU (notwithstanding the inevitable challenges around establishing "possession" and "control" of such assets in a distributed ledger technology environment).

The Consultation also notes that the definition of "financial instruments" in the FCD differs from that of MiFID II⁵, noting in particular that the FCD definition does not include certain derivatives that are covered by MiFID II, nor does it include emission allowances, which have only recently been developed and brought within the MiFID II definition.

It could be argued that for this purpose there should be no distinction between securities, such as shares and bonds, on the one hand, and instruments consisting of contractual rights only, such as futures and options, on the other hand.

The Consultation requests respondents' views on:

• whether collateral other than cash, financial instruments and credit claims should be brought within scope, and, if so, what type of collateral;
• whether the existing definitions of cash, financial instruments and/or credit claims should be updated, and, if so, how;
• whether emission allowances should be included in the definition of financial instruments;
• if crypto-assets were to constitute financial instruments, whether the FCD ownership, possession and control requirements would need be tailored to achieve legal certainty as to whether such instruments fell within scope; and
• whether the concepts of "account" and "book-entry" should be retained, replaced or amended to allow for the evidencing of the provision of cash or securities collateral through distributed ledger technology.

Status of debtors' set-off rights in credit claims

The Consultation also considers credit claims as financial collateral and raises the possibility of amending the FCD to remove debtors' set-off rights in respect of credit claims provided as collateral to central banks. The Consultation notes the importance to debtors of such rights upon the insolvency of a creditor, and asks respondents to weigh up (i) the implications for consumer protection of effectively transferring bank insolvency risk from the central bank to the debtor by removing the debtor's right of set-off, against (ii) the risk to central banks of accepting as collateral credit claims in respect of which set-off rights have not been disapplied, and the associated valuation difficulties (noting that, in fact, many central banks do not currently accept such claims as collateral in any event).

The Consultation specifically asks:

• whether the existing provisions on set-off create a problem for the provision of credit claims as collateral, and in what context (i.e. national, cross-border, or both); and
• whether debtors' set-off rights should be removed and, if so, why, and under what circumstances.

Interaction with other EU legislation

Section 6 asks for respondents' input on the interaction of the FCD with other legislation, including the EU Insolvency Regulation⁶, the BRRD and the CCP R&R Regulation. Input is requested in particular where it is not clear how the FCD interacts with other EU legislation, and/or vice versa.

Next steps

The Consultation closes on 7 May 2021 and responses will be taken into consideration by the Commission when deciding whether, and how, to amend the FCD.

As the UK is no longer an EU Member State, if the FCD is amended, the UK will not be obliged to reflect the changes in the Regulations. However, given that many of the issues raised in the Consultation are not EU-specific, it is possible that the UK will undergo a similar consultation in respect of the Regulations in due course.

Authors: Sana Dossa, Jonathan Haines and Kirsty McAllister-Jones

1. EU Directive 2002/47.
2. EU Directive 98/26.
3. An approach adopted by the UK.
4. EU Delegated Regulation 2016/2251 on risk-mitigation requirements applicable to non-cleared OTC derivatives, implemented under EU Regulation 648/2012 (EMIR).
5. EU Directive 2014/65 on markets in financial instruments.
6. EU Regulation 2015/848 (recast).