| The European parliament approved first reading | ||||||
The approval of a pan-European legal framework for the use of collateral will provide easier access to funding for corporates and reduce credit risk for banks. Despite French opposition, the Ecofin Council has endorsed the EU collateral directive.
This directive has been a priority for the European Commission’s financial services action plan over the past year. It will assist in the development of the European capital markets by making cross-border activity legally secure and less complicated. Once approved by the European Parliament, member states will have 18 months to put the directive into national legislation.
Currently, the legal intricacies of the individual countries within the EU make cross-border collateral use difficult. “Such laws are 200-year-old legal techniques being applied to 21st-century finance,” says Robert McWilliam, co-chair of the ISDA collateral committee and head of collateral management at ABN Amro. The aim of the EU directive for collateral is to create an environment that allows bonds and equity to be used as security in the same way that physical assets have been used in the past. Wider use of collateral will also decrease systemic risk in the financial markets, as well as reduce losses for the collateral taker in the event of default.
France has been opposed to the directive since its scope was expanded to include non-financial institutions. Many feel that the reasoning is unclear. France felt, before compromises made during the Ecofin meeting, that the directive would have compromised its national bankruptcy law. A French delegate says the problems with the directive were twofold. “First, in the case of insolvency, the collateral taker would come before the employees in the distribution of assets. Secondly, when a company is undertaking reorganization measures in order to find a solution either to continue the activity, or sell the company, or liquidate it, the person responsible for this needs to be able to freeze the debts of the company,” he says.
Many say that France’s negative view of the directive is based on an inaccurate analysis of the effects of the legislation. An EU affairs advisor at a European bank says: “They say it will change the ranking of creditors. They’re worried about changing their bankruptcy law because they don’t want the French public to think the employees of companies that go bankrupt will lose out because the big, nasty banks will grab all the cash through collateral arrangements.” She says that this would not be the case because collateralized creditors in all EU countries already have secured creditor status and employees do not. The EU collateral directive would not change this. A French representative says, however, that: “The general principle in French law is that you have ‘super privileged creditors’ which are mainly the employees, as well as tax administration and social security administration.”
However, some feel that France was opposed to the directive on more of a political level. There are both presidential and general elections in France next year. The government has also been under pressure about the bankruptcy of kitchen appliances maker Moulinex. It appears that the present government does not wish to be perceived as changing the law in the favour of the banks and to the detriment of employees.
It is understood that the French sent out letters to the member states in an attempt to convince others that this directive would negatively affect bankruptcy law. In order to reach agreement on the directive at council level, it was amended to include an option for member states to opt out of the directive for collateral contracts in which one party is a non-financial institution. However, some say it will be difficult to use the provision because of pressure from the market.
The inclusion of an opt-out from the directive for non-financial institutions could prove to be detrimental for collateral arrangements as the new requirement introduced under Basle II is legal certainty. So, if collateral is not 100% legally enforceable, it will not be recognized under Basle II as a credit risk mitigator. A French delegate says of the opt-out: “It only applies to a very limited part of the scope of the directive. The collateral technique is used to an extremely dominant proportion for operation on the financial markets and not for the financing of the local bakery.”
The permanent ambassadors of Austria, Finland, Greece and Portugal also opposed the directive. It is understood that Portugal agreed with France. Greece was concerned about the inability of a collateral taker to be able to appropriate the collateral, as opposed to selling it. Without this compromise, Greece would have been obliged to change its civil law. Other countries that do not agree with this option will be able to exclude it from their legislation.
Austria and Finland agreed with France that the courts should have the power to impose a cooling-off period after bankruptcy, during which the collateral taker would be unable to realize the capital. They were concerned that rapid liquidation of collateral would hamper a troubled company’s attempts to reorganize. However, this suggestion was not included in the directive, which will provide protection for collateral arrangements against local insolvency laws that make it difficult to liquidate the collateral.
One of the main issues that the legislation aims to address is the clarity of rules regarding creditors in the event of bankruptcy. If it is deemed that a creditor has arranged a collateral agreement within a certain period before the debtor goes bankrupt, the transaction is usually declared invalid. However, some countries rely purely on a decision about whether the collateral was accepted with or without knowing the company was about to go bankrupt. Such differences in legislation can lead to concern about the validity of a cross-border collateral agreement.
Another of the main difficulties of cross-border collateral regards perfection requirements in the event of bankruptcy. This refers to the procedures that must be followed by creditors in order to secure their right to collateral, which aims to prevent the illegal use of this collateral by either the creditor or the debtor. These requirements can be difficult and time-consuming but failure to follow the procedures can invalidate the collateral agreement.
Which country’s legislation should apply to collateral can also be difficult to determine. The lex rei sitae rule states that the applicable law is that of the jurisdiction in which the collateral is located. However, this rule dates back to Roman law and has not been altered with the development of the market. It does not encompass the fact that securities are easily moved around in the modern market.
The collateral legislation will not only benefit large financial institutions. There are also advantages for corporates. Companies that may not usually be able to source funding easily will have more access and cheaper financing. Matthew Brooke of the Union of Industrial and Employers’ Confederations of Europe (UNICE) says: “It removes the legal uncertainty of dealing with foreign companies because it provides a European framework.” The directive will also decrease the credit risk for banks lending to SMEs and reduce the banks’ credit and capital costs, which can then be passed on to clients by way of lowered collateral requirements.
Although the EU collateral legislation will address many issues currently faced by cross-border market participants, further difficulties remain. Many member states have different taxation and settlement rules for collateral.
For example, if collateral is provided, some tax authorities consider it a transfer of title, which, strictly legally speaking, it is. However, from an economic perspective, collateral is often only transferred in order to secure an exposure. That is, it is not the collateral provider’s intention to achieve transfer of title. Olivier De Ryckere, credit risk mitigation manager at KBC in Belgium, says: “Most countries do not apply tax rules to the collateral on a repurchase agreement, which is transfer of title. This tax neutrality should also apply for other collateral movements.”
The EU collateral directive will increase the efficiency of the EU capital markets by increasing the legal certainty of cross-border collateral arrangements and making the negotiation of arrangements less onerous. The European Parliament has approved the directive on its first reading. The Council of Ministers, which met on the same day, has agreed to the directive with a few amendments.
First, to allow the opt-out for collateral arrangements involving a non-financial institution and, secondly, to allow the opt-out for appropriation of collateral. The parliament has four months to agree to the amended directive, after which the national governments will have 18 months to implement it into national legislation.
