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Minimising legal uncertainty in cross-border collateral transactions
Despite technological advances and the ubiquity of computers in homes and offices, the paper-less era has yet to materialise. Most of us are still overwhelmed by the ever-mounting piles of paper sprawled across our desks and floors.We have not yet weaned ourselves off "hard-copies". Do we simply enjoy the feel and perceived permanency of paper in our hands or do we subconsciously subscribe to the belief that tangible copies, as opposed to words on a screen, more effectively substantiates or validates the contents of the document?
Despite our inability to part with paper on a day-to-day basis, there is a significant area in the modern world where the paper-less age has indeed arrived -- securities' holding and trading. As investors, we have successfully weaned ourselves off the need to hold securities' certificates. Gone are the days when an investor (or a pledgee of securities) took either actual possession of physical securities or became the owner of record of the security as evidenced by the register maintained by or on behalf of the issuer. A large majority of the worlds securities are now held, transferred and pledged by means of a computerised book-entry annotation on the records maintained by financial intermediaries. These financial intermediaries act as a link in a long, complex and usually international chain through which ownership interests are held and recorded. Interposed between the true owners and the issuer of securities are multiple layers of intermediaries in different jurisdictions all maintaining their individual records of ownership. In our modern cross-border securities holding system, intermediaries are substituted for the investor as holder of record and the investor's entitlement in the securities is against the applicable intermediary, not the issuer.
Unfortunately, the law in many jurisdictions regarding ownership, transfer, pledge and enforcement of securities still subscribes to the simple, traditional paradigm whereby the nexus between the issuer and investor is direct and his ownership interest in the issuer's securities unambiguous. The failure of many legal jurisdictions to modernise their laws to reflect commercial realities has caused significant legal uncertainty with respect to the fundamental question as to the nature of an investor's interest in a book-entry annotation on the books of a financial intermediary and the practical aspects of how such interests can be effectively transferred, pledged and perfected.
Fortunately, some jurisdictions have adopted legislation designed to address the legal nature of book-entry interests and how such interests can be transferred, pledged and perfected. 48 of the 50 states in the U.S. have adopted the revised Articles 8 and 9 of the Uniform Commercial Code (U.C.C.). In addition, Belgium and Luxembourg, the places of organisation respectively of Euroclear and Cedelbank, the two international central securities depositories, have adopted legislation which has reduced significantly some of the uncertainty associated with conflict of law issues governing the transfer and pledge of securities held through financial intermediaries. In addition, the European Union's Directive on Settlement Finality in Payment and Securities Systems (the finality Directive’) aims to clarify the conflict of law rules governing collateral transactions in European Union ('EU') settlement systems.
With billions of dollars in securities held in cross-border securities holding systems being pledged daily as collateral for loans and credit advances, financial institutions and other market participants require legal certainty as to the nature and the enforceability of such collateral. Specifically, collateral takers need absolute assurance that the collateral being pledged by their counterparts is enforceable against third parties. In the event of the insolvency of either the counterparts (as collateral provider), or the financial intermediary, the collateral taker needs assurance that it has a perfected interest (either through outright ownership or a valid security interest) in the collateral, free from the grasp of the collateral provider's, or the financial intermediary's, other creditors.
The multi-jurisdictional nature of securities’ held through financial intermediaries raises complex conflict of law issues when such securities are transferred and pledged as collateral. Since the interests in the securities will frequently have a nexus with multiple jurisdictions -- that of the issuer's place of organisation, the place where the underlying securities are physically located (assuming the issue is certificated), the place where the register recording the interests is maintained (assuming the securities are in registered form), the place where each intermediary maintains its records evidencing the book-entry interest and the place where the investor is located - conflict of law issues arise as to which law should govern the transfer and pledge of such interest.
Many market participants may erroneously believe that New York or English law, as the law chosen to govern the agreement granting the collateral, will apply to their transaction to the exclusion of any other law. Unfortunately, the governing choice of law agreed between the parties will provide neither guidance nor comfort in the event of the insolvency of the collateral provider. The jurisdiction of the place of organisation of the collateral provider, not the choice of law of the underlying agreement, will govern the insolvency proceedings of the collateral provider. In the context of such proceedings, the insolvency or bankruptcy court will, pursuant to its domestic insolvency regime, apply general conflict of law rules to determine whether the collateral taker has a valid and perfected interest (or ownership) in the pledged collateral, free from the claims of other creditors.
Conflict of law rules generally dictate that in order to effect an enforceable transfer or pledge of securities, one must apply the 'lex rei sitae' or 'lex situs', the law of the place where the subject matter of the transfer or pledge is situated. In the simple, traditional paradigm described above, the lex rei sitae of a pledge of physical securities is the law of the jurisdiction where the pledgee takes actual possession of the securities certificates. The 'lex rei sitae' of a pledge of dematerialised or registered securities is either the law of the issuer's place of organisation or the law of the jurisdiction where the issuer's securities' records are maintained. Unfortunately, one cannot apply this general rule in the context of the modern, multi-tiered securities holding system where the investor does not take physical possession of the securities and where his name, as owner of the security, is not maintained on the issuer's records.
The linchpin of the legal quagmire faced by collateral takers is that at present, conflict of law rules do not address what constitutes the lex rei sitae for book-entry pledges of physical or dematerialised securities held through financial intermediaries in cross border, multi-tiered securities holding systems. Therefore, it is frequently difficult to ascertain which law to apply to pledge effectively such interests. This legal uncertainty may compromise the enforceability of the pledge and therefore its value to a secured creditor.
How a particular jurisdiction defines the nature of the book-entry interest created will affect the 'lex rei sitae'. For example, a jurisdiction which defines such interests as personal rather than proprietary to the investor will find the location of the intermediary (or more specifically, the location of the intermediary's records on which such right is evidenced) relevant in determining the lex rei sitae. An investor or pledgee in such interests would only have a contractual right against the intermediary to call for securities of the same type and value, rather than a proprietary right in any individual securities. Since the investor's contractual right against the intermediary is evidenced by the account on which the interest is recorded, the 'lex rei sitae' of such book entry interest will be the law of the jurisdiction where the intermediary maintains the accounts on which the interest is recorded. In order therefore to pledge effectively such securities as collateral, the collateral taker need only apply the pledging procedures of one jurisdiction - namely the jurisdiction where the financial intermediary is located, without regard to the laws where the securities or the issuers themselves are located.
The requirement to apply but one law simplifies significantly the pledging procedures. However, defining the nature of the interest created as contractual against the intermediary, rather than proprietary to the investor, generates significant financial intermediary risk for the collateral taker. If the collateral provider as investor only has a contractual right against the intermediary to call for securities of the same type and value, rather than a proprietary right in any individual securities, the securities pledged by the collateral provider to the collateral taker would be part of the estate of the intermediary in the event of its insolvency, available for the general claims of the intermediary's creditors. Therefore, the collateral taker would become simply an unsecured general creditor sharing pro rata with other creditors in the pool of securities held by the intermediary. No collateral taker would likely assume such financial intermediary insolvency risk.
On the other hand, a jurisdiction that has redefined such book-entry interests on the records maintained by financial intermediaries not as mere contractual rights against the financial intermediary but representing collective property rights legally traceable to actual pools of individual fungible securities, would determine that the 'lex rei sitae' of a book-entry pledge of an interest in certificated securities to be the law of the jurisdiction where actual custody of the physical certificates is maintained. In the event of dematerialised or registered securities, the 'lex rei sitae' would either be the law of the issuer's place of organisation or the law where the securities' records of the issuer are kept. These conclusions are premised on the assumption that, where the investor or pledgee's interest is deemed traceable to actual pools of individual securities, the intermediary is irrelevant for purposes of applying the 'lex rei sitae' rule. One should therefore look-through the intermediaries and determine that even though an investor has neither actual possession nor is his interest actually recorded on the issuer's books, for legal purposes, he is deemed, in the case of bearer securities, to have constructive possession, and in the case of registered securities, to be the actual owner of record, on the issuer’s books, of a part of the pool of securities.
Although such re-characterisation of the interest as a collective property right that is traceable to an actual pool of individual securities mitigates financial intermediary risk, it may generate significant counterparty risk. Applying in practice the 'lex rei sitae', to a transfer or pledge of an interest defined as a collective property right that is traceable to an actual pool of individual fungible securities, is costly and cumbersome, particularly when some or all the securities in the pool are held in certificated form in multiple jurisdictions. Perfection of a pledge of securities held in different countries would require that the pledge be effected according to the laws of each jurisdiction. If a single pool of fungible securities is located in more than one jurisdiction, a portion of the actual pool to which the right attaches could be located in any jurisdiction over which the pool is spread. To ensure that a creditor has an enforceable pledge over a particular portion of the pool, the pledgor would have to follow the pledging and perfection procedures in each jurisdiction over which the pool is spread. If the pool of securities changes, the original pledge could be compromised; the collateral taker would need to apply constant vigilance to assure that it has followed the pledging procedures of the jurisdiction where the new securities added to the pool are located. Adding further complications, if there are conflicts in the pledging procedures of different jurisdictions, such a pledge may not be enforceable. Seeking multiple perfection's in local jurisdictions is time consuming, expensive and from a practical perspective, may be near impossible, thereby further undermining the collateral taker's confidence in his pledge of collateral.
Other jurisdictions, namely Luxembourg and Belgium, have redefined the nature of the book-entry interests as embodying a combination of personal rights and proprietary rights. Since all deposited securities of a given issue are fungible, the investor transfers ownership of his securities to the intermediary and acquires a personal or contractual right against the intermediary to the re-delivery of fungible securities. In addition, the investor acquires a proprietary interest as co-owner of a notional pool of fungible securities held at any time by the intermediary acting as custodian. Since the rights to the securities are proprietary in nature, the pool of securities is not available to the general creditors of the intermediary, thereby eliminating intermediary insolvency risk.
If one were to apply the 'lex rei sitae' rule to a jurisdiction like Luxembourg or Belgium which recognises investors' interests, not as collective owners in a legally traceable pool of individual fungible securities, but rather as collective owners in a notional pool of fungible securities as evidenced by the book-entry annotations on the records of various intermediaries, the location of the records whereby such interests are located becomes the seminal focus, not where the securities themselves are found. This is because the account recording the investor's entitlement, not the certificates representing them, constitutes the source of an investor's rights. Therefore, a collateral taker accepting as collateral a pool of securities originating from multiple issuers in numerous jurisdictions need only apply the law of the place of the intermediary in order to enforce its collateral. It need not worry about the practical problems of satisfying the laws of the jurisdictions in which the issuers of the securities or the securities themselves are located.
This modern approach corresponds with the Belgian decree governing Euroclear transactions. All interests in securities held by Euroclear are deemed located in Belgium (and therefore Belgian law applies to their transfer and pledge), regardless of where the certificates representing the securities are located. In the same vein, Luxembourg law recognises that the 'lex situs' of securities deposited with Cedelbank is Luxembourg, even when such securities are deposited outside Luxembourg. To provide further certainty with respect to pledging securities held through Euroclear and Cedelbank, both Belgian and Luxembourg law provide for the creation of a book-entry pledge without the need to comply with the formalities prescribed by the general law governing pledges of securities. Similarly, Article 8 of the U.C.C. explicitly creates a new interest in securities as constituting a bundle of rights which arise in relation to a participants account with its intermediary in a multi-tier holding system. These reforms enable a collateral provider to look to only one jurisdiction, namely the place where the intermediary is located, in order to perfect and enforce its interest in securities provided as collateral. This modern approach for dealing and settling of international securities enables investors and their creditors to determine in advance, with predictability and confidence, the law that will govern their rights and obligations in their book-entry interests.
Likewise, the EU Finality Directive aims to impose a greater degree of legal certainty when parties provide securities as collateral held in custody accounts, depositories or settlement systems within the EU. The relevant provision of the Finality Directive, Article 9(2), states that when securities are provided as collateral to participants, central banks of the Member States of the EU or the European Central Bank and their rights with respect to the securities are legally recorded on a register, account or centralised deposit system located in a Member State, the determination of the rights of such entities as holders of collateral security in relation to those securities shall be governed by the law of that Member State. The collateral taker would look to the law of the place of the intermediary (the 'place of the relevant intermediary approach' or 'PRIMA') to assess the validity and priority of the collateral taker's entitlement to the securities against third parties. Under PRIMA, a collateral taker accepting a pool of securities held in different locations and comprised of issuers in multiple jurisdictions would need only to satisfy the requirements of the law of the financial intermediary in order to ensure it has an effective and perfected interest in the collateral, free from the claims of other parties.
There has been considerable debate amongst Member States as to the scope of Article 9(2) of the Finality Directive. Under the narrow view, a few Member States have argued that the Finality Directive should only eliminate legal risk for certain collateral takers, namely the central banks of the Member States, the European Central Bank and those participants that provide liquidity to an EU payment or securities settlement system. An alternative view which is gaining support amongst most Member States and the European Central Bank is that Article 9(2) should eliminate legal risks for all participants, including indirect participants, of an EU payment or securities settlement system. Some proponents have advocated a further extension of the Finality Directive to apply to all participants, direct and indirect, of all, not merely EU, payment and securities systems. The Finality Directive is currently in the process of being implemented into national legislation throughout the EU. Austria, Belgium, Finland, Ireland, the Netherlands, Portugal and Spain have all codified the Finality Directive into national legislation and the other Member States of the EU are on target to adopt legislation shortly. As of the publication of this article, the necessary Statutory Instrument has been put before the British Parliament and will eventually form part of the Financial Markets and Insolvency (Settlement Security) Regulations 1999, adopted late last year.
The rapidly changing way in which securities are held, traded, cleared and settled has mandated that the law change to accommodate this ever-evolving and expanding securities market. Luxembourg, Belgium and those states in the U.S. which have adopted the revised Articles 8 and 9 of the U.C.C. are jurisdictions which have modernised their laws to accommodate the commercial realities associated with holding, transferring and pledging book-entry interests through financial intermediaries in cross-border securities holding systems. Their legal reforms have mitigated intermediary and counterparty risks and reduced uncertainty and thereby costs associated with cross border collateral transactions. However, national reforms, in the context of a global system, have limited value. Since the system operates across national borders, it requires an international solution. Only after all jurisdictions modernise, and ideally standardise their laws, will we mitigate further the risks, legal uncertainties and additional costs associated with cross-border collateral transactions. We therefore urge all nations in the EU, but most importantly England with London as an international financial centre, to adopt expeditiously into national legislation the Finality Directive (ideally embracing the broad view of the Directive) in order to minimise further these risks, uncertainties and costs.
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