General liens and financial collateral
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The recent case of Re Lehman Brothers International (Europe) (in administration)  EWHC 2997 (Ch), in which we acted for Lehman Brothers Finance ("LBF"), has much to interest those involved in taking security over financial collateral. The court was asked to consider no less than 27 issues relating to an English law governed master custody agreement ("MCA") between different Lehman's entities, but this note only addresses those likely to be of most interest to lenders.
The key issues were the nature of the security created by the MCA made in August 2003 between Lehman Brothers International (Europe) ("LBIE") as custodian and LBF, being one of LBIE's group companies, and the application of the Financial Collateral Arrangements (No 2) Regulations 2003 (the "Regulations") to that security.
Nature of the security
The MCA described LBIE as having a "general lien" over assets held by it as custodian, coupled with rights of retention, sale, and application of proceeds. Most of the assets consisted of de-materialised securities and cash, and the first question was what kind of security interest, if any, LBIE had. English law has, traditionally, only recognised a general lien in relation to tangibles and old-fashioned certificated securities, and the court invited the parties to argue that the time had come to take a broader and more commercial view of what a general lien might apply to, but the parties declined to do so. Given that, the court held that the MCA created a charge in favour of LBIE, and counsel for LBIE conceded that this was a floating charge, because LBF had a contractual right to substitute or withdraw excess collateral. As a result it was unnecessary for the court to decide whether the charge was fixed or floating, which would have entailed a close examination of the extent to which the parties had legal and administrative control over the relevant assets.
A feature of the MCA was that the charge secured not only obligations to LBIE, but also to other Lehman group companies, namely to persons other than the chargee. Despite a lack of authority on the point, the court held that such a charge is conceptually possible. In other words, on this analysis, it is possible for A to create security in favour of B which also secures obligations owed by A to C (or other associates of B), without the need for B to be C's trustee or fiduciary. Such arrangements are sometimes found in banks' standard terms and conditions, but there has already been some debate about this part of the judgment.
Had the arrangement not constituted a charge, the court left open whether or not it would have been invalidated under the British Eagle principle, being the principle that a provision for the disposal of an insolvent's property in a liquidation otherwise than in accordance with the insolvency code is void.
Financial Collateral Regulations
During the course of proceedings, the issue attracting most argument became whether or not the charge was a financial collateral arrangement within the Regulations, so as to save it from various grounds of invalidity or challenge that are disapplied by the Regulations. In considering this issue, the court held as an intial point that the Regulations could apply to an agreement such as the MCA, made between more than two parties, and to security for debts owed to a party's affiliates, even though they were not themselves parties to it.
Given that the MCA created a charge, it was necessary to decide whether it met the requirement that, in order to fall within the Regulations as being a "security financial collateral arrangement", the charged collateral must have been "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". For this purpose the Regulations add that "any right of the collateral-provider to substitute equivalent financial collateral or withdraw excess financial collateral shall not prevent the financial collateral being in the possession or under the control of the collateral-taker". The same requirement also applies in order for a floating charge to fall within the Regulations but, given the nature of floating security, is always likely to be more difficult to satisfy.
The court held that what was required to meet the "possession or control" test was "that there is shown to be sufficient possession or control in the hands of the collateral taker for it to be proper to describe the collateral provider as having been 'dispossessed'." It did not disagree with the much criticised decision in Re F2G Realisations Ltd: Gray v GTP Group Limited  1 BCLC 313 – other than in that it had been wrong to hold that it was conceptually impossible to possess an intangible asset – but considered that there will be cases where the collateral is sufficiently clearly in the possession of the collateral taker that no further investigation of its rights of control is necessary. In this case, however, although the MCA gave LBIE the right to retain assets sufficient to cover its future and contingent liabilities, on the particular terms used in the MCA, it did not enable LBIE to do so in relation to LBF's liabilities to LBIE's affiliates. The court applied an "all or nothing" analysis: only one security interest was created, and that did not contain a meaningful right to retain assets in relation to LBF's debts to LBIE's affiliates. As a result, the charge did not satisfy the possession or control test, and fell outside the Regulations.
That made it unnecessary to consider the parties' conduct, and in particular the factual question whether or not sufficient control had actually been exercised over the relevant securities and cash accounts. The court indicated, however, that mere non-use of LBIE's right of retainer would not in itself have taken the MCA outside the Regulations.
Although it was strictly unnecessary for it to do so, the court also addressed the question of whether the Regulations came into force too late to be capable of applying to the MCA, which pre-dated them. It concluded that they did, since the relevant date was that on which the security interest was created, rather than that on which collateral was provided under it. The Regulations did not, moreover, have retrospective effect.
The case was decided on the terms of the Regulations as enacted, prior to their amendment from April 2011. The court recognised, however, that this amendment has disappointed those hoping for greater clarity, by purporting to recognise that possession may be by means of financial collateral being credited to an account, while at the same time requiring that the rights of the collateral provider must be limited to a right of substitution and the withdrawal of excess collateral. The court commented that the issues in Gray had been addressed by the amended Regulations "only to an immaterial and largely theoretical extent".
Given that the generally accepted English law analysis of dematerialised securities is that the interest of the ultimate beneficial owner is an equitable one, the issue also arose whether or not section 53(1)(c) of the Law of Property Act 1925 applied. If it did, the security interest in the MCA would have been ineffective because it was not in writing and signed by the person granting the security or their agent. The court held that the section did not apply. As between LBIE and LBF, the MCA was signed on LBF's behalf. As between LBIE and an affiliate, LBIE acquired title to the relevant dematerialised security from a vendor to the chargor, such that the charge arose simultaneously with the transfer of title. There was no moment of time in which the beneficial interest in the dematerialised securities subsisted in LBF, and the section is simply not aimed at a situation such as this one, where the vendor of securities was directed to transfer them directly to LBIE.
As mentioned above, the MCA purported to create security for liabilities and obligations owed to LBIE and to "any Lehman Brothers entity". Although this imprecise expression was not a particularly happy one, the court indicated that, had it been necessary to do so, it would have been unlikely to have had much difficulty in determing whether or not a particular company was a "Lehman Brothers entity". The MCA was not, however, drafted in such a way as to confer rights on LBIE's affiliates that could have been enforced by them under the Contracts (Rights of Third Parties) Act 1999, nor did it create a trust or fiduciary obligation by LBIE in favour of such entities.
A further question was whether the MCA had been superseded by revised terms and conditions (referred to by the court as the "STB") which were agreed to apply from November 2007, meaning that the security interest created by the original MCA was no longer enforceable. Such an issue will always turn on the particular documents and facts, but is of particular interest to lenders operating on the basis of a set of terms and conditions that are periodically updated, and which contain or reference a security interest. In this instance, however, the court held that the STB had not discharged and replaced the existing floating charge created by the MCA, which remained in force.
This further detailed analysis of the Regulations by the court is to be welcomed, but it is unlikely to be the last word on them, and in particular on the "possession and control" issue. Indeed, since the decision, the Financial Markets Law Committee has renewed its call for the Regulations to be amended to clarify what amounts to "possession or control", including what rights may be left with the collateral-provider without this preventing the collateral-taker from being in possession of the collateral, and how this requirement operates when the collateral is held in a third party account. Also of interest in the case is the classification of a "general lien" as constituting a charge. A broader analysis of what a "general lien" could constitute in relation to a custody agreement and financial collateral might have been of interest, but the decision is also a reminder that although in commercial usage the terms "lien" and "pledge" have become ubiquitous, the courts will tend to analyse such arrangements in traditional English law terms of mortgage, charge, pledge and contractual lien.