Security Financial Collateral Arrangements: Key Questions for Lenders

In a typical finance transaction, a lender will generally seek to take security over a number of different types of assets. Where the assets in question include financial collateral, such as shares or cash, lenders will usually want to ensure that their security qualifies as a “security financial collateral arrangement”, so they can avail of the related benefits, including the alternative remedy of appropriation.

However, although the law relating to financial collateral arrangements came into force over 20 years ago, there are still quite a few areas of uncertainty.

In this article, we will take a look at some of the key points for lenders to consider when taking and enforcing this type of security arrangement, as well as what the future may hold.

What is a security financial collateral arrangement?

A security financial collateral arrangement is a form of security governed by the Financial Collateral Arrangements (No.2) Regulations 2003 (the “Regulations”), which provide lenders with an alternative mechanism to take and enforce security over financial collateral, including cash, credit claims, shares and certain types of bonds and securities.

What are the criteria?

In order to fall within the scope of the Regulations, a security arrangement (such as a debenture or a share charge) must meet certain criteria, including that it must be evidenced in writing, its purpose must be to secure the financial obligations of the security provider to the security taker and both parties must be non-natural persons i.e. not individuals.

The assets in question must also be delivered, transferred, held, registered or otherwise designated so as to be in the possession or control of the security taker.

What are the advantages?

As long as it meets the relevant criteria, a security financial collateral arrangement will be exempt from some of the statutory formalities which apply to other forms of security and will benefit from the modification of certain aspects of insolvency law.

Depending on the terms of the security document, the security taker may also be able to avail of the right to appropriate the financial collateral on enforcement.

What is appropriation?

Appropriation is a self-help remedy, which offers a less formal means of enforcement than the more traditional route of appointing a receiver.

As long as the security document gives the security taker the power to appropriate the financial collateral, the security taker may exercise that power when the security becomes enforceable, allowing it to take ownership of the assets without obtaining a court order. If the security document does not contain that power, a court order would have to be sought.

How should the appropriated collateral be valued?

If the power of appropriation is exercised, the security taker must value the appropriated collateral in accordance with the terms of the security document and, in any event, in a “commercially reasonable manner” (as required by the Regulations).

Until relatively recently, there had been little to no guidance in relation to the method of valuation or the interpretation of this requirement.

However, in the case of ABT Auto Investments Ltd v AAPICO Investment Pte Ltd [2022] EWHC 2839 (Comm), the English High Court considered the appropriation of charged shares and made the following points in relation to the valuation:

• The parties must agree a method of valuation in the security document that is “capable of being carried out in a commercially reasonable manner”. The agreed method does not itself need to be commercially reasonable and can be such method as the security taker chooses.
• It is the way in which a valuation is made, not the result of it, that needs to be commercially reasonable, and this must be assessed objectively.
• If the security taker arranges for someone else to carry out the valuation, that other person must carry it out in a commercially reasonable manner.
• In carrying out a valuation, there is no implied requirement for a security taker to act in good faith, and the equitable duties applicable to security takers when enforcing security do not apply.
• If a valuation is not made in a commercially reasonable manner, the appropriation will be unaffected, but the court can replace the valuation or award damages.

What does the future hold for the Regulations?

As the Regulations are derived from EU law, they are due to be repealed and replaced with new rules in due course under the Financial Services and Markets Act 2023.

The replacement rules are likely to be similar to the Regulations, but in October 2023 the Financial Markets Law Committee published a letter to HM Treasury which highlighted several long-standing areas of uncertainty (for example, the meaning of “possession” and “control”) and suggested that this would be a good opportunity to provide greater clarity. The letter also contained draft wording to effect the proposed changes.

As such, although it remains to be seen when the repeal process will take place and what form the replacement rules will take, it is possible that some of the uncertainties will be mitigated as a result.

However, in the meantime, careful consideration must continue to be given when drafting security documents to ensure that they are brought within the regime of the Regulations and that they contain the requisite provisions in relation to appropriation.

If you would like any further information or advice, please contact Rachel Lewis from our Banking team.

*This information is for guidance purposes only and does not constitute, nor should be regarded, as a substitute for taking legal advice.