учебный год 2023 / Goode, Legal Problems of Credit and Security

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VI SECURITY INTERESTS IN ffiRPORATE INVESTMENT SECURITIES

into by the company in the ordinary course of its business. 112 In this context,

..charge~~ would seem to bear its_ technical meaning of an incumbrance, as opposed to a mortgage, the grant of which would offend against the rule that

a company cannot acquire its own shares. The charge may be enforced by sale of the shares. 113

(2) Priorities

The normal priority rules apply. While the security interest is merely equitable it is subordinate to a prior equitable interest under the first-in-time rule, ll 4 although the holder of the subsequent interest could obtain priority if he has procured the deposit of the share certificate and a blank transfer form and registers himself as holder. us This is the case even if he knows of the prior equitable interest atl the time of the registered transfer116 A subsequent equitable securit;Y 'interest is also liable to be displaced by a subsequent mortgage or sale .to a third party who acquires the securities in good faith, for value and witJtout notice and becomes registere<,l as the holder. This could occur where the debtor fraudulently procures a fresh share certificate by misrepresenting that he has lost the original. A mortgagee with notice of prior equitable interests takes subject to them. However, if in the latter case the mortgagee grants a sub-mortgage and the sub-mortgagee is registered as transferee and takes without notice of the equitable interests he will have priority even though the mortgagee himself was subordinated.

Bearer securities

Bearer securities may be pledged or mortgaged by delivery. The pledgee or mortgagee acquires in the case of pledge a limited legal interest and in the case of mortgage legal title by way of security. 117 Alternatively bearer securities may be charged by an agreement for charge, wilh or without delivery, though delivery is necessary if the charge is to be converted into a pledge or legal mortgage. It is also possible to assign bearer securities without delivery, but such an assignment takes effect only in equity and is displaced by a subsequent legal mortgage'c~eated by delivery. 118

112 Co~panics Act 2006 s.670(3). It is necessary in addition for the charge to be authorised by the articles, -

u In theory they may also be forfeited and cancelled, but this involves a reduction of capital ~:and requires confirmation by the court.

ns"lhe rule in Dearle v Hall does n9t apply. See para.5--08.

SECURITY INTERESTS IN DIRECTLY HELD SECURITIES

-------- --------

Bearer debt securities 119 may be pledged or mortgaged back to the issuer by delivery. On default they may be sold to a third party.

Uncertificated securities

( 1) Creation of securil}' interest

Again, an equitable security interest in uncertificated securities directly held 6-26 by the debtor may be created by an off-register mortgage or an equitable charge. An equitable mortgage is converted into a legal mortgage by transfer

from the mortgagor's stock account with CREST to the mortgagee's stock account or, if the mortgagee is not a CREST member or sponsored member, to the stock account of his nominee. 120 An equitable charge can be converted into a legal mortgage in the same way; alternatively it may retain its status as an equitable charge. This means, however, that there is no public notice of the charge, and the chargee could lose priority to a subsequent purchaser or incumbrancer taking a legal mortgage. Since charges over securities are not required to be registered in the Company Charges registerll.! there are only two possible methods for the chargee to give public notice and to prevent effectively any other purchaser or incumbrancer obtaining legal title. The first is by obtaining transfer of the charged securities to a sub-account as an escrow balance, the sub-account being in the name of the chargor but under the control of another member of CREST who is the chargee's escrow agent. '22 CREST itself has no involvement in the eserow balance. On default the escrow agent can transfer the shares into the creditor's name if he is a CREST member. If the debt is discharged without recourse to the eserow balance this is transferred back to the chargor's main account An alternative is for the chargee to be appointed sponsor of a chargor who is a member of CREST. 123 It is likely that either method also gives the chargee contol of the securities, which means that any registration requirements and some

lH Bearer shareS are rarely issued in the UK because of their exposure to stamp duty. and in any

event a purported mortgage of them to the issuer would be ":C:id under s.658 of the Companies Act 2006, The prohibition does not apply to debt secuntre~ , ,

12J Security agreements may provide for collateral transferred to the creditor or xts nonl;tnee to be held jn a segregated account, separate from the credhor's beneficially owned h~ldmgs, to avoid problems arising from commingling of the creditor's assets and the assets subject to the

debtor;s equitv of redemption in the event of the creditor's insolvency.

121 See above p;ra.2-18 and below para.~39. Even if the charge includes a charge over dividends, which might be registrable as. charge over book debts under s.860(7)(0, a charge over financial collateral which is a security financial collateral arrangement under the Financial Collateral Arrangements (No. 2) Regulations 2003 reg3, in that the security holdet' has control over the collateral, is exempt from registration. ·

'" This can be seen as the electronic equivalent of the creation of an equitable mortgage by deposit of certificates (see para.6..-23 above an? To/fey's f:!ompany Lmv Serv~ce, C4013) 1be effect of control is to give limited public nottce of the mtcrest, and also ts to enable the chargee to enforce the charge without recourse to the mortgagor. . .

123This method is used by settlement banks to take a floating charge overt~ secunttes held by a CREST member. For derails, see Beale, Bridge, Gullifer and Lomrncka, The Law of

Personal Properly Security 10.37,

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VI SECURITY INTERESTS IN CORPORATE INVESTMENT SECURITIES

insolvency provisions are disapplied. 124 CREST does not accept notices of assignment, so although the debtor can effect a mortgage by assignment rather than by transfer to the account of the creditor or his nominee there is no way of giving notice of the assignment, and so the priority of successive assignments is governed not by the rule in Dearle v Hall but by the first-in- time rule.

The rules governing a charge-back of certificated securities to the issuer125 apply equally to a charge-back of uncertificated securities.

(2) Priority rules

6-27 The priority rules are the same as for certificated securities.

5. SECURITY INTEREStS IN INDIRECTLY HELD SECURITIES

Certificated securities

6-28 Where securities are held indirectly by credit to a securities account they may be mortgaged by transfer to the mortgagee,I 26 who thereby acquires a mortgage by novation, 127 or charged by agreement, the chargee gaining control, if desired, by the agreement of the intermediary to allow the account to be operated only on the instructions of the chargee128 or alternatively by transfer of part of the securities to a separate account in the name of the chargor but under the chargee's control. There are a number of advantages for the chargee in taking such control, which would appear in most cases to amount to both positive and negative control. 129 One advantage is equivalent to publicity, in that the intermediary would not permit any dealings with the asset without the chargee's consent (this probably also has the effect that the charge is a fixed one) and so notice of the chargee's interest is given to the outside world. Another advantage is that any provisions on registration and avoidance on insolvency are disapplied. 130 The securities could also be mortgaged by an assignment of;_the account, and notice of assignment to the interme(iiary, if given, would obtain for the mortgagee the advantages set out in Ch.J above in relation to giving notice of asssignment to an account

below

126An in-house transfer if the mortgagee. has an account with the same intermediary, or if not, a transfer to the mortgagee's intermedi,ary through a common higher-tier intermediary. See above, para.6--02, fn. 7.

127The mortgage will be equitable as it entails a transfer of an equitable interest.

128i.e. an attornment. See above, para.3-33.

129See below para.6--38.

130This is because the transaction would be a security financial collateral arrangement, see below paras 6-39, 6-44.

SECURITY INTERESTS IN INDIRECTLY HELD SECURITIES

debtor, 131 although if the account holder was still permitted to give instructions to the intermediary, there would probably not be sufficient control on the part of the security holder for the transaction to be a security financial collateral arrangement. 132 This may not matter, however, as it is unlikely that such a security interest will be considered registrable under s.860 of the Companies Act 2006. 133 A mortgage by assignment has the disadvantage that the mortgagee takes subject to equities, including any rights of set-off the intermediary may have for cross-claims in respect of dealings prior to receipt of the noli<;!' of assignment.

Under the draft UNIDROIT Convention, a.security interest can be created by transfer by credit to the mortgagee's securities account, 134 but also by a combination of a security agreement and one of the following: either that the mortgagee is the intermediary of the account in which the securities are held or that a designating entry in favour of the mortgagee has been made in the account or or a control agreement in favour of the mortgagee applies. 135 Both a designating entry and a control agreement are defined as methods whereby the mortgagee can obtain positive or negative control. 136

Priorities are governed by the normal rules. So a mortgagee by novation has priority over an earlier equitable interest of which he has no notice, while priority as between successive assignees is governed by the rule in Dear/e v Hall.

Uncertificated securities

If the debtor holds uncertificated secunt1es in CREST through an 6-29 intermediary and the creditor is a CREST member he may obtain a legal mortgage by having the securities transferred to his CREST stock account.

All other modes of security-for example, transfer to the creditor's CREST nominee, transfer to a sub-account of the debtor as an escrow balance under the control of the creditor's escrow agent, or assignment of the debtor's security entitlement, perfected by notice of assignment to the debtor's intermediary-take effect in equity only, the first and third of these operating as an equitable mortgage, the second as an equitable charge. The priority rules are the same as for indirectly held certificates securities.

131Above para.3-31.

132See below para.6--38.

133Even assuming that a securities entitlement was held to be an interest in the underlying securities, charges on securities are not registrable as such. A security interest in the form of .a floating charge is registrable but the documentation is usually effective to ensure that what ts created is a fixed security. The only other possible category of registrable interest is a charge on book debts, but while security entitlements are assignable both at law and in equity they are .not book debts, since they are entitlements to an interest in securities, not to money, except poss1bly as to dividends, interest and the like received as cash into the securities account.

134Art.9.

135Art.lO. These methods are only effective if the Contracting State has made a declaration to that effect (art.10(4).

136Arts l(k) and (1). Which are applicable depends on the substance of the declaration of the relevant Contracting State, art.10(4)-(6). For a discussion of positive and negative control see para.6--38, below.

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(2) Substitution

6-33 For reasons similar to those relating to withdrawal of securities tile debtor is commonly pruvided with the right to substitute new securities for those subject to tile security interest and to dispose of the latter as his own. A general advance authorisation to do this should be avoided as it risks converting the security interest into a floating charge. It is therefore very desirable to stipulate that the release of any securities by the creditor is dependent on the debtor having first furnished the substitute securities. 15! This not only gives the creditor a unit-by-unit control which preserves the fixed nature of the security, it also avoids exposure to the risk that the debtor, having disposed of tbe original securities, fails to provide substitutes. In the light of Spectrum even this may not be enough to avoid characterisation as a floating charge, but so long as. the right is limited to the substitution of 'equivalent financial collater<>l', the effect of the Financial Collateral Arrangements (No. 2) ReguYations is that this right does not prevent the charge falling within their sco~152

't

7. THE EC DIRECTIVES ON FLVANCJAL COLLATERAL

6-34 The European Community has long been concerned to limit systemic riskm to ensure both the efficiency and the stability of dealings among participants in recognised clearing and settlement systems. To that end two Directives have been issued, the 1998 Settlement Finality Directive154 and the 2002 Directive on Financial Collateral Arrangements. 155 The latter in particular is designed to override rules of national law that impair the legal efficacy of financial collateral arrangements and provision within or outside insolvency.

Tbe Settlement FinaHty Directive

6-35 The effect of the Directive and implementing regulations is largely to remove from attack under general insolyency law the rules of a designated settlement system,. and transactions (including the realisation of collateral security) effected in connection with participation in such a system. Thus system rules governing default arrangements, in particular, arrangements fot netting

provided some other form offprotection.

152 See below para.6-38.

LH 'I11erisk that the failure of oile major participant wiU have a domino effect on the system as awhnJe.

;:14 Directive on Settlement Finality in Payment a11d Securities Systems (98/26 dated May l9, 1998), implemented in the UK by the Financial Markets and Insolvency (Settlement Finality} Regulations !999. SI 199912979.

155 2002i47. The Directive has been implemented by the Financial Collateral Arrangements (No. 2) Regulations 2003, Sl 2003/3226.

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THE BC DIRECTIVES ON FINANCIAL COLlATERAL

······-···---~

and the closing out of open positions, 1' 6 and the application or transfer of c<Jllateral security,"' are to be respected notwithstanding any rules of insolvency law which might otherwise invalidate them.156 Thus the restrictions imposed by paras 43(2), 70, 71 and 72 of Sch.Bl of the Insolvency Act 1986 on the enforcement of security while a petition for an administration order is pending or the order is in force do not apply in relation to a collateral security charge,159 and s.l27 of the Act (which invalidates dispositions made after the commencement of a winding up unless approved by the court) does not apply to a disposition of property as the xesult of which it becomes subject to a collateral security charge. 160 Of some importance also is the conflict of laws rule embodied in art.9(2) of the Directive161 which provides that where securities are provided as collateral to a (system) participant and/or central bank of a Member State and their right ,.,;th respect to the securities is legally rec<Jrded in a register, account or centralised deposit system located in a Member State the rights of holders of the collateral are to be determined by the law of that Member State. One effect of this is that concerning rights in relation to securities held through an account with a securities intermediary in a Member State, it is the PRIMA law162 that applies.

The Settlement Finality Directive will require some revision in the light of art.4 of the 2002 Hague Convention on indirectly held securities. 163

The Directive on Financial Collateral Arrangements

The 2002 Directive on financial collateral arrangements is altogether broader 6-36 and more ambitious in scope. Its purpose is to facilitate the provision of fmancial collateral under bilateral transactions, and thereby promote not

only the stability of the market hut also its efficiency, by requiring Member States to disapply rules of law and statutory provisions that would otherwise invalidate financial collateral arrangements and provision, whether before insolvency (as by rendering void transactions not carried out or perfected in conformity with prescribed formalities) or on insolvency.164 The Directive

156 See below, Ch.7.

m Including security provided under a charge or repurchase or similar agreement for the putpose of securing rights and obligations potentially arising in conn~ction w!th the s;,:ste~.

1ss Note too that Pt V1I of the Companies Act disapplies the moratonum regune apphed m administration in paraA3 Sch.Bl Insolvency Ac-t 1986, to market charges and system charges, see Financial Markets and Insolvency (Money Market) Regulations 1995 (Sl1995f2049) and

Financial Markets and Insolvency Regulations 1996 (SI 199611469),

159 Flnancial Markets and Insolvency (Settlement Finality) Regulations 1999, SI 1999/2979, reg.l9(!).

160 Financial Markets antl Insolvency (Settlement Finality) Regulations 1999, reg, 19(3).

VI SECURITY INTERESTS IN CORPORATE INVESTMENT SECURITIES

covers both directly held and indirectly held securities. The Directive has now been implemented in the UK by !he Financial Collateral Arrangements (No. 2) Regulations 2003 165 and it is these regulations which will be considered below. The UNIDROIT Draft Convention on Substantive Rules regarding Intermediated Securities also has a number of provisions relating to collateral transactions, which to a large extent replicate the provisions of the Financial Collateral Directive. 166

(I) Scope of the Regulations

6-37 The Regulations cover financial collateral in the form of cash or financial instruments. 167 The Regulations apply to 'financial collateral arrangements,' which includes both title tran~fer financial collateral arrangements and security financial collateral aprimgements, whether or not these are covered by a master agreement. Bot,h sorts of arrangements are required to be evidenced in writing. The d~tinction made in the Directive between arrangements for the provision of financial collateral and its actual provision does not appear in the Regulations.

(2) Categories offinancial collateral arrangement

6-38 Financial collateral arrangements are divided into two categories, title transfer financial collateral arrangements and security financial collateral arrangements. The former are arrangements, including repurchase agreements, under which full ownership is transferred to the collateral taker. 16' This reflects the securities industry's usage in treating title transfer as a form

collateralisation of central bank credit operations, which are defined as 'pecuniary claims arisiing out of an agreement whereby a credit institution...grants credit in the form of a loan' .. For detailed comment, see ~the response to HM Treasury by the Financial Law

Comt11ittee of the City of London LaW Society, dated July 22, 2008.

1652003/P226. The Defendants in the Alfa V Cukurova case (see below fn.167) have applied to the Administrative Court for judicial review of the Regulations on the grounds that they are ultra vires the European Communities Act 1972, in.. that they apply to collateral arrangements

between any non-natural persons while the Difective is limited to arrangements between

1financial institutions defined in art.1(2)(a) to (d). For discussion of the relevant issues, see the

~report by the FMLC (issue 132) (July 2008).

166·Law Commission Updated Advice (May 2008) para.4.206.

167Reg.3. "Financial instruments" are·. defined in Reg.3 and cover virtually all forms of instrument issued on a market. It also:;appears that shares in private companies are included: this point appears to have been agreed between the learned experts who gave evidence to the British Virgin Islands Court of Appeal in Alfa Telecom Turkey Ltd l' Cukurova Finance

International Limited HCVAP2007/027.

168Some countries do not recognise the grant of security by title transfer. Art.6 of the Financial Collateral Directive requires Member States to ensure that a title transfer financial collateral arrangement can -take effect in accordance with its terms.

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THE EC DIRECTIVES ON FINANCIAL COLLATERAL

of collateral even !hough in English law an outright transfer does not constitute a security interest. 169 In !he case of direct holdings, outright title transfer is by entry on the share register; in the case of indirect, or book-entry, holdings title transfer presumably includes not only transferby novation, that is, transfer to the collateral taker's account, but also assignment. Title transfer arrangements do not include mortgages, which transfer only security ownership, not full ownership, but do include outright sale and repurchase agreements which are intended to fulfil a security function even if not, under English law, constituting security agreements.I70

Security financial collateral arrangement& are defined as arrangements 'where the collateral-provider creates or there arises a security interest in financial collateral to secure those obligations' .171 A security interest is defined as 'any legal or equitable interest or any right in security, other than a title transfer financial collateral arrangement, created or otherwise arising by way of security' and expressly includes all four types of security interest: pledge, lien, mortgage172 and charge. However, security financial collateral arrangements only include arrangements whereby "the financial 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". 173 Possession174 or control is not defined in the regulations or the Directive, and its meaning is open to some debate.l'5 The concept was analysed by the Law Commission in its report on Company Security Interests, although no definitive definition was recommended. 176

Control can be either negative (prevention of dealings with the collateral by !he collateral-provider) or positive (where the collateral-taker can take or dispose of the collateral without any further involvement of the collateralprovider). The Law Commission concluded that, though a collateral-taker would often want to obtain positive control, negative control alone was probably enough to satisfy the test of 'possession or control' under the

169See above, paras 1-37, 6---21. Title transfer collateral arrangements are also recognised by the draft UNIDROIT Convention at art.29.

170See above, para.l-37.

171Financial Collateral Arrangements (No. 2) Regulations 2003 reg.3.

172On the.wording of the Directive there was an argument that a mortgage, which involves transfer of ownership to the mortgagee, was not included but this problem has been expressly rectified by the drafting of the Regulations.

173Financial Collateral Arrangements (No. 2) Regulations 2003 reg.3. The requirement of possession or control appears in the Preamble to the Directive (para.9) as the only possible perfection requirement which a Member State can impose.

174The orthodox position is that possession of an intangible is impossible. However, the word has sometimes been. used in this context, see D. Turing, "New Growth in the Financial Collateral Garden" (2005) 1 J.LB.F.L. 4; L.C. Ho, 'Possessing 'possession': Re Oval 1742

(2008) 1 C.R.I. 19.

175Replies of a working group of the City of London Law Society Financial Law Committee to the Questionnaire of February 2006 to the Private Sector from the European Commission for the Drafting of the Evaluation Report in relation to the Financial Collateral Directive [2006] 6.J.I.B.F.L 263; M. Hughes, "The Financial Collateral Regulations" [2006] 2 J.I.B.F.L. 64; D. Turing, "New Growth in the Financial Collateral Garden" (2005) 1 J.I.B.F.L. 4.

176Report 296 (2005), Ch.5.

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VI SECURITY INTERESTS IN CORPORATE INVESTMENT SECURITIES

Directive and the Regulations, 177 and that positive control alone was not enough. 178

If this is correct, then a floating charge would fall outside the regulations. There is, however, an express exception in that if the financial collateral arrangement includes the right to 'substitute equivalent financial collateral or withdraw excess financial collateral': the regulations provide that this does not prevent the collateral being under the possession or control of the collateral-taker. In the Regulations, the right to substitute is limited to 'equivalent financial collateral', which, in the absence of express agreement, means securities of the same issue or class as the financial collateral initially provided: such a limited power to substitute may not prevent a charge being a fixed charge, though the position is uncertain. The right to withdraw excess collateral also seems only consistent with a floating charge, although the requirement that the collateral ):le 'excess' limits the right considerably. 179 There are, moreover, indicationl' that the regulations were intended to apply to at least some floating ctiarges. The list of security interests covered includes "a charge created as a ,floating charge where the financial collateral charged 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". 18°Further, some of the disapplied provisions are those only applicable to floating charges. 181 Of course, these provisions could just apply if a chargee crystallised a floating charge by obtaining control, since the charge would still be a floating charge as created. Further evidence that the Directive covers some floating charges, 182 is that the right of substitution permitted in the Directive appears to be unlimited, 183 and an

177The main reason for this is that appropriation without a court order (art.4 of the Directive, reg.l7 of the Regulations) is only possible if such a power is given in the financial collateral agreement: the situation where the agreement provdes that there is no power or only a limited power to appropriate is therefore envisaged, but this would be inconsistent with positive control. It is however clear that negative control is required, since it is expressly provided that the existence of a right to substitute collateral does not prevent the collateral being under the possession or control of the collateral~taker: this would not be necessary if negative control was not required. Law Commission report 296 (2005) 5.54 (fn.66) and 5.55 (fn.71).

178Law Commission report 296 (2005) §~53-54. This is because of the wording of para.lO in the

Preamble to the Directive which makyS..it clear that the Directive covers only 'those financial collat~ral arrangements which provide·'fOr some form of dispossession.' If the debtor has the

182···D. Turing, "New Growth in the financial Collateral Garden" (2005) 1 J.I.B.F.L. 4. The EU's proposal for amendment of the Directive (see above, fn.l64) provides that, in the case of credit claims, a right on the part of the.ccollateral provider to collect the proceeds until further notice is not inconsistent with control by the collateral taker (proposed Directive Art.2(2)(i)). No mention is made of a requirement of negative control by the collateral provider over the proceeds, and the implication is that the collateral provider can be free to dispose of the proceeds. If this is the case, many floating charges over credit claims would fall within the proposed definition of security financial collateral arrangements.

183 Art.2(2).

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THE EC DIRECTIVES ON FINANCIAL COLLATERAL

unlimited right of substitution is clearly not consistent with a fixed charge. 184 The matter is still very uncertain, and parties would be well advised to register any charge which is not clearly a fixed charge.

Having said this, most of the methods of creating a mortgage or charge over securities described above would appear to give the creditor both positive and negative control. 185 One possible exception is where a security interest is taken over indirectly held securities, and the notice given to, or the agreement made with, the relevant intermediary only has the effect that the intermediary is obliged to comply \\jth the instructions of the security holder in respect of the indirectly held securities (positive control) and does not have the effect that the intermediary is not permitted to comply with the instructions of the account holder in respect of the securities (negative control). The possibility of such an agreement or notice, if the notice is entered in the securities account, 186 is acknowledged by the draft UNIDROIT Convention.l87 It is up to Contracting States to declare what kind of agreement or notice is required to make an interest in intermediated securities effective against third parties, and such a declaration must specify whether the agreement or notice has to include negative control, or positive control, or both. 188 Article 10 of the draft Convention provides that if such a declaration is made by a Contracting State, the non-Convention law cannot require any further step for the interest to be effective against third parties, and it would seem that if the EU were to ratify the Convention, a decision as to the meaning of 'control' in the Financial Collateral Directive would be necessary, since if only negative control is sufficient to comply with the Directive, it would not be enough for an agreement or notice merely to give positive control for the security interest to be effective against third parties. 189

Another situation when a collateral-taker will not have negative control is where a settlement bank takes a security interest over the securities held by a

CREST member, by taking a power to appoint itself as sponsor. 190 Until the time that the power is exercised the collateral-giver has the power to deal with the securities, however, on exercise of the power the collateral-taker obtains both negative and positive control. 191

(3) Reduction of formalities

One of the main purposes of the Directive is to reduce the requirements for 6-39 attachment and perfection of a security interest in financial collateral to a

184 Para.4--21 above.

185 Paras 6-23--6-29.

186 It is then called a "designating entry".

187Art.l(k) and I(l).

188Art.10(4).

189Law Commission, Updated Advice in relation to the Unidroit Convention on Substantive Rules regarding Intermediated Securities (May 2008) para.4.80.

190See above para.6--26.

191The moratorium on administration is in any event disapplied to such charges, see Financial Markets and Insolvency Regulations 1996 (SI 1996/1469).

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minimum. The regulations therefore provide that various statutory formalities do not apply to any financial collateral arrangements, as defmed above. Thus, the requirements of writing and signature for a guarantee,"' for the disposition of an equitable interest,19l and for a statutory assignment of a chose in action194 are disapplied. 195 The registration requirements under s.874 Companies Act 2006 196 are also disapplied. The effect of this is not dramatic, however, as there were no formal requirements under English law for the attachment of a security interest in registered securities, and formal perfection requirements in the shape of registration in the Companies Registry apply only to floating charges, charges on book debts and charges to secure any issue of debentures. The risk of recharacterisation of a sale and repurchase as a registrable security transaction has been eliminated, but the need to register floating charges still remains because of the uncertainty as to the scope of 'possession or control' .197 Various insolvency provisions are also disapplied. 198 Some of these only apply to floating charges, as created, and so are probably of limited effect, which is just as well as some are rather unexpected. For example, s. 154 Companies Act 2006, which provides that where a debenture holder taki!s possession of assets subject to a• floating charge, preferential debts should be paid out of those assets, is disapplied, while the parallel provisions in the Insolvency Act which apply on windingup199 and on the appointment of a receiver"'" are not disapplied. 201 Further, it is not entirely clear why (sometimes) the provisions about priority of preferential creditors and the ring-fenced fund are disapplied, and yet the provision in para.99 of Sch.Bl Insolvency Act 1986, which provides for the priority of administrator's expenses, is not disapplied202 nor does there seem to be any plans to disapply s.l282 Companies Act 2006, which is a similar provision applicable on winding-up.

(4) Enforcement

THE EC DIRECTIVES OK FINANCIAL COLLATERAL

. ------------------

collateral taker has available to a range of enforcement measures, subject to the parties' agreement. These measures have been implemented by the regulations as follows:

(a) Financial instruments Enforcement can be by sale or appropriation, the 6-41 value204 being set-off in discharge of the relevant financial obligation. Restrictions on sale that would otherwise apply during an administration, or pending the appoinonent of an administrator, or during a moratorium under

a company voluntary arrangement have been disapplied. 205 Regulations 17 and !8206 permit the remedy of appropriation,''" which means taking the collateral in satisfaction of the underlying obligation, while accounting to the collateral-giver for any surplus value,""' but only where the security financial collateral includes a power of appropriation209 Rather strangely, reg.l7 limits the right of appropriation to where a legal or equitable mortgage is created (despite the fact that reg.3 includes charges in the definition of security interest covered by the regulations). There is no obvious reason for this limit, although the remedy of appropriation could be said to be rather like that of foreclosure, which is only available to a mortgagee. Tbis does seem to be one of the very few situations where the difference between a charge and a mortgage makes any difference, and it would be wise to provide expressly that the security interest created is a mortgage rather than a charge if it is desired to exercise a power of appropriation. In the case of an equitable mortgage, appropriation can be effected by the collateral-taker becoming absolute beneficial owner of the securities: there is no need to obtain legal title. 210 Where the collateral consists of securities, the~e need to be valued by the collateral-taker in order to calculate any surplus: the valuation must be done according to the terms of the arrangement, hut in any event in a

1~¥ Reg.8 covers provisions restdcting the enforcement of security on insolvency, and reg.lO

·,·covers provisions avoiding cont;;acts and floating charges.

199Insolvency Act t986 s.l75 (this -Sectiqn aJso applies if an administrator makes a distribution, see para.65(2) Schedule B1 Insolvenej.: Act 1986.

m! D. Turing and K. Lester, 'Implementation of the EU Directive on Financial Collateral Arrangements in the United Klngdom' (2005] J.I.B.LR. 65, 68,

:Wl D, Turing, "New Growth Jn the Financial Collateral Garden" (2005) llLREL 4.

203Defined by art.2(1)(1), and also reg.3 of the regulations, as: an event of default or any similar event agreed between the parties on the occurrence of which, under the terms of a collateral

financial arrangement or by operation of law, the collateral taker is entitled to realise or appropriate financial c-ollateral or a close~out netting comes into force. Again, the drafting is a little strange, for read literally it does nol cover a right of realisation given by law unless the relevant event is one agreed between the parties! This comes from the misplacing of the phrase "or by operation of law'', which should have been inserted after "parties." It is thought that art.2(l){!) and the regulations are to be interpreted as if drafted in this way,

zw The reference to "value" rather than "proceeds" as regards the remedy of sale :is no doubt designed to protect the collateral provider against the risk of a sale at undervalue.

2(15 Reg.S.

2~ Implementing artA of the directive, and consistent with article 30 of the draft UNlDROIT

Convention.

mEnglish law did not previously recognise appropriation, which is in effecl a sale by the mortgagee to himself and therefore not permitted even if at full value, Hodsan v Deans [1903] 2 Ch. 647; Farrar v Farrars Ltd (1888) 40 Ch. D 395.

2Cll! Regs 17 and 18.

21)9 This is now bein12 done in standard documentation~ see R. McCormick, "EU Directive On Financial CoUateral Arrangements: Replies Of A Working Group Of The City Of London Law Society FinancJal Law Committee To The Questionnaire Of February 2006 To The Private Sector From The European Commission For The Drafting Of The Evaluation

Report" (2006) 6 J.LB.F.L. 263 para.l.9.

ZH See rhe decision of the British Virgin Islands Court of Appeal in A (fa Telecom Turkey Ltd v Cukurova Finance InterMtional Limited HCVAP2007/027. This point may be subject to an appeal to the Privy Coundt

VI SECURITY INTERESTS IN CORPORATE INVESTMENT SECURITIES

commercially reasonable manner2 ll This obviously raises the question of what would be seen as commercially reasonable by the courts, but it is likely that a valuation process agreed in advance by the parties would be seen as such unless it was unconscionable. Enforcement of title transfer collateral arrangements by close-out netting and set-off is very common, and these are given protection by the regulations from invalidation in the event of winding up proceedings or reorganisation measures in relation to either party. 212

6-42 (b) Cash Enforcement can be by set-off against, or application in discharge of, the relevant financial obligations. The remedy of appropriation also applies to cash, but there is no question of valuation since only enough cash to satisfy the underlying obligation need be appropriated.

(5) Right of use

!

6-43 Regulation 16213 provides that"a right of use, defined so as to include <)isposal as owner, is valid if the arrangtllnent confers it on the collateral taker. The collateral taker is required to replace the original collateral or its equivalent or, if the financial arrangement so provides, set off the value against the or apply it in discharge of the relevant financial obligation.

(6) Protection from insolvency avoidance

6-44 Regulations 12214 and 13215 are designed to protect the provision of financial collateral against avoidance for insolvency. Regulation 13 protects from avoidance by insolvency law a financial collateral arrangement coming into existence or the provision of top-up collateral on the day of commencement of winding-up proceedings or reorganisation measures.216 Section 127 of the Insolvency Act 1986 (avoidance of post-petition dispositions) is also disapplied in relation to any property or security interest arising under a

211Art.3i of the draft UNIDROIT ConVel).tion provides that the Convention does not affect any requir.ement of non-Convention law to 'the effect that the realisation or valuation of collateral securities must be conducted in a ·commercially reasonable manner.

212See reg.8(1) which disapplies s.127 of the InsolV~ncy Act 1986 (avoidance of post-petition dispositions) and reg.12. Reg.12 does not apply if at the time of entering into the agreement

\or of the relevant financial obligation coming into existence, one party was aware or should ~have been aware of the commencement of insolvency proceedings, widely defined (reg.l2(2)). ·These provisions implement art7 of the directive. and are consistent with art.30 of the UNIDROIT Convention, although in this provision there is no requirement for the absence

of notice of the commencement of insOlvency proceedings.

213Implementing art.5 of the directive and consistent with art. I of the draft UNIDROIT

Convention.

2J4 See para.6-41 above.

215Implementing arts 7 and 8 of the directive.

216So long as the collateral-taker was not aware of the commencement of the proceedings or measures.

268

THE EC DIRECTIVES ON FINANCIAL COLLATERAL

financial collateral arrangement or to any close-out netting provision taking effect in accordance with its terms. 217

8. CROSS-BORDER SECURITIES AND THE CONFLICT OF LAWS

Introduction

Where dealings in securities involve a foreign element, so that it is necessary 6-45 to make a choice between legal systems, the applicable law is to be determined

by the conflict of laws rules of the forum State. In England the applicable law depends on whether the securities are registered or bearer securities and, it is submitted for the reasons already given, on whether the securities are held directly or indirectly. 218

In all cases concerning certificated (as opposed to dematerialised) securities it is necessary to distinguish title to the certificate from title to the underlying securities. Where certificates relating to securities are transferred, it is for the lex situs of the certificates at the time of transfer to determine the effect of the transfer on title to the certificate, but it is for the law of the issuer's incorporation to determine the manner in which the underlying securities may be transferred and thus whether they are to be characterised as registered securities or bearer securities. 219 So if the holding of UK registered bonds is evidenced by a certificate which is later delivered to Creditor A by way of pledge in New York and the bonds are later mortgaged in London to Creditor B, who in good faith is told by the bondholder that the certificate has been lost, takes a transfer and registers it with the issuer of the bonds, then while the efficacy of the pledge will be determined by New York law, priority between A and B will be determined by English law and normally be accorded to B as bona fide holder for value of the legal title through registration, A's interest in the bonds (as opposed to the certificate as a piece of paper) being purely equitable. Again, if the bonds are issued as bearer bonds in London and the certificates are taken to New York and there pledged, an English court, having characterised the bonds under English law as bearer bonds transferable by delivery, will apply New York law as the lex situs to determine the efficacy of the pledge. Neither the two EC Directives referred to above nor the Hague Convention discussed below deal with conflict of laws issues in relation to directly held securities.

As regards indirectly held securities the EC Financial Collateral Directive and the Financial Collateral Arrangements (No. 2) Regulations,220 like the Settlement Finality Directive, applies PRIMA in determining the law

217Reg.IO(I).

218See generally Ooi, Shares and Other Securities in the Conflict of Laws.

219See Macmillan Inc. v Bishopsgate Investment Trust (No. 3) [1996] I W.L.R. 387; Dicey, Morris

& Collins, The Conflict of Laws 14th edn (London: Sweet & Maxwell, 2008), paras 22-044

and 22--045. 220 Reg.19.

269

VI SECURITY INTERESTS IN CORPORATE INVESTMENT SECURITIES

applicable to dealings in securities involving a foreign element.221 However, under the Hague Convention this is adopted in modified form to give effect to party choice.

The Hague Convention on the law applicable to indirectly held securities222

6--46 The 2002 Hague Convention on the law applicable to certain rights in respect of securities held with an intermediary embodies PRIMA as the underlying concept except that the focus is now on the law selected by the parties to govern the account agreement,223 subject to satisfaction of a so-called "reality test" which in essence requires that the intermediary in question carries on the business of maintaining securities account (though not necessarily the particular account in question) )n the State whose law is selected.224 The Convention determines the law"applicable to the legal nature and effects against the intermediary and (bird parties of (a) the credit of securities to a securities account with an intermediary; and (b) a disposition of se~urities held with an intermediary, inclu'tling charge-backs to the intermediary and perfection requirements and priority rules, as well as requirements for realisation of an interest in securities and whether a disposition of securities held with an intermediary extends to entitlements to dividends, income and other distributions. It also preserves the application of the PRIMA law to these issues notwithstanding the opening of an insolvency proceeding.

The Convention is limited to securities held with an intermediary and has no application to securities held directly from the issuer. It is confined to proprietary rights and does not extend to contractual or other personal rights. However, the question whether the account holder's rights against its intermediary are proprietary or personal is determined by the PRIMA law. If under that law the rights are characterised as purely personal the Convention has no further application as regards relations between the account holder and the intermediary but it continues to govern the legal nature and effects of a disposition of those personal rights, since the disposition is a transfer of property.

The approach adopted in the Hague Convention, which was borrowed from art.8 of the Uniform Commercial Code, seems at first sight strange and counter-intuitive, since it is aXiomatic in most legal systems that parties to a cdntract cannot select a law to govern the rights of third parties.

22 '::Art.9. This is also thought to reflect the position at common law. See above, para.6--14.

222~See the Explanatory Report: R. Goode, H. Kanda and K. Kreuzer, assisted by C. Bernasconi,

Hague Securities Convention: • Explanatory Report (Hague Conference on· Private International Law 2005).

223Art.4(1).

224ibid. Art.5(1) provides an intermediate fallback rule if the parties fail to select a law or the selection is ineffective for want of compliance with the reality test, while art.5(2) provides the ultimate fallback rule (place of the intermediary's incorporation, etc.) if neither of the previous rules applies. It is recognised that this will in many cases have little or no connection with the parties or transaction; its one merit is certainty, and it is envisaged that it will be triggered only in a very small percentage of cases.

270

CROSS-BORDER SECURITIES AND THE CONFLICT OF LAWS

Nevertheless, the solution has a number of advantages. It subjects the 1--01 determination of all proprietary rights to the same law and by focusing on

the (deemed) place of the account it reflects the well-established lex situs principle in the conflict of laws. Third parties proposing to purchase a securities entitlement or to take such entitlement as collateral for a loan will certainly want to have sight of the account agreement and will thereby be able to see the full terms of the agreement, including designation of the deemed place of the account.

271

<'

"!

VII

Set-Off, Netting and Abatement

PARA.

I.Set-Off: Nature, Classification and Development.. ....................7-0l

6.The Effect of Assignment on Independent and Transaction

I.SET-OFF: NATURE, CLASSIFICATION AND DEVELOPMENT

(i)Nature of set-off and netting

Set-off

Set-off is the right of a debtor who is owed money by his creditor on another 7~1 account or dealing to secure payment for what is owed to him by setting this

off in reduction of his own liability. 1 For example, A sells raw materials to B to be made up into finished products which B then sells to A. If A owes B

1SeeP. Wood, English and International Set-Off(London: Sweet & Maxwell, 1989); and Law and Practice of International Finance: Set-off and netting, derivatives, clearing systems (London:

Sweet & Maxwell, 2008); R. Derham, Set-Off3rd edn (New York: Oxford University Press, 2003); S. McCracken, Banker's Remedy of Set-Off2nd edn (Haywards Heath: Tottel Publishing

Ltd, 1998). The leading early works are R. Babington, A Treatise on the Law of Set-Off

(London: H. Butterworth, 1827); B. Montagu, Summary of the Law of Set-Offlnd edn (1828); and two American publications, 0. Barbour, Treatise on the Law of Set-Off(W. & A. Gould, 1841); and T. W. Waterman, Treatise on the Law of Set-Off2nd edn (New York: Baker, Voorhis & Co, 1872). For historical and comparative surveys, see W. H. Loyd, "The Development of SetOff" 64 U.Pa.L.Rev. 541 (1916); and M. E. Tigar, "Automatic Extinction of Cross-Demands: Compensation from Rome to California" 53 Cal.L.R. 224 (1965).

273