The Financial Services Action Plan and Financial Markets Legislation on Collateral

1. The Financial Services Action Plan and Financial Markets Legislation on Collateral A presentation by Olaf Christmann Legal Counsel Deutsche Bundesbank Delivered on the occasion of the Annual Meeting of the Deutsch-Nordische Juristenvereinigung on 13 September 2002 on the premises of the ECB

2. The Financial Services Action Plan and Financial Markets Legislation on Collateral Overview A. The Financial Services Action Plan B. Financial Markets Legislation on Collateral I. Settlement Finality Directive II. Collateral Directive III. Comparison C. Outlook D. Excursus - The Hague Convention

3. The Financial Services Action Plan and Financial Markets Legislation on Collateral • A. Adoption of Financial Services Action Plan in 1999 (COM (1999) 232); based on the findings of the FSPG (www.europa.eu.int/comm/internal_market/en/finances/general/actionen.pdf); last progress report dated 22 July 2002 • I. 5 main goals: • 1. conceive a legislative apparatus capable of dealing with new legislative challenges (comitology procedure) • 2. eliminate remaining capital market fragmentation • 3. exploit the commercial opportunities offered by a single financial market • 4. encourage closer co-operation of supervisory authorities • 5. develop integrated EU infrastructure to underpin retail and wholesale financial transactions • Overall goal: minimise cost for capital and intermediation

4. The Financial Services Action Plan and Financial Markets Legislation on Collateral • II. The Action Plan contained new priorities for a single financial market: • 1. Wholesale Market • Common rules for an integrated securities and derivatives market (ISD) • Raising capital on a EU wide basis (Prospectus Directive) • Harmonise Financial Reporting • A single market framework for supplementary pensions funds • Collateral - our topic - SFD/CD • Secure and transparent environment for cross-border restructuring (failed Take Over Directive)

5. The Financial Services Action Plan and Financial Markets Legislation on Collateral • 2. Retail Markets: • Provide Information and transparency (e.g. in Directive on cross border credit transfers) • Redress procedures in extrajudicial bodies (Schlichtungsstelle) • A balanced application of consumer protection rules • Paving the way for e-commerce based retail financial business (e.g. the Directive on e-money institutions, Directive on e-commerce 2000/31) • Regulation of Insurance Intermediaries • Cross-border retail payments (Reg. on cross border payments; now implemented in Sweden as well) • 3. Sound supervisory structures: Corporate Governance and Tax

6. The Financial Services Action Plan and Financial Markets Legislation on Collateral • III. Legal means to achieve a single financial market • 1. By means of Regulations - directly applicable in all Member States • pros: faster entry into force, no transposition - “full harmonisation” • cons: centralist in nature, no amalgamation with national laws • 2. By means of Directive - transposition necessary • pros: respects the principle of subsidiarity, Art. 5 Treaty, involvement of the national legislator, incorporation/adaption into national law • cons: frictional loss due to transposition (in time and content)

7. The Financial Services Action Plan and Financial Markets Legislation on Collateral • IV. Important Legal Acts in the field • 1. EU Regulation on Insolvency proceedings (1346/2000/EC) • 2. EU Directive on the reorganisation and winding up of credit institutions (24/2001/EC) - mutual recognition only! • 3. EU Directive on cross border credit transfer in Euro (5/1997/EC) • 4. EU Regulation on cross border payments in Euro (2560/2001/EC) • 5. EU Directive on settlement finality in payment and securities settlement systems (1998/26/EC) - predecessor of the CD • 6. EU Directive on financial collateral arrangements (2002/47/EC)

8. The Financial Services Action Plan and Financial Markets Legislation on Collateral • B. Financial Markets Legislation on Collateral • Mutual interest of the ECB and Deutsche Bundesbank • as a counterparty in monetary policy operations and secured intra-day credit operations in payments systems • and due to their statutory objective (Art. 105 Treaty) to promote the smooth functioning of payment systems

9. The Financial Services Action Plan and Financial Markets Legislation on Collateral • I. Directive of the European Parliament and of the Council on settlement finality in payment and securities settlement systems (98/26/EC; “SFD”) • 1. Aims • Reduction of systemic risk linked to payment and securities settlement systems • Protection against the effects of insolvency proceedings opened against a system participant • Certainty as to the applicable law for dispositions of securities as collateral in connection with systems or central banks

10. The Financial Services Action Plan and Financial Markets Legislation on Collateral 2. Content • Transfer orders and netting arrangements shall be binding and legally enforceable, Art. 3 (3) • Introduces concept “irrevocability” of a payment order for systems, Art. 5, 3 (3) • Abolition of the “zero hour” rule • Determination of applicable law in case of insolvency of a system participant, Art. 8 • Enforceability of collateral agreements with a system or a central bank in case of an insolvency of a participant, Art. 7 • rights of the collateral taker in respect of the securities are determined by the law of the State in which the account is maintained to which securities are legally recorded, Art. 9(2)

11. The Financial Services Action Plan and Financial Markets Legislation on Collateral • II. Directive of the European Parliament and the Council on financial collateral arrangements (2002/47/EC; “CD”) • 1. Timeframe • Initiation of the FSAP in May 1999 • Preparation of the Forum Group on Collateral (October 1999 - May 2000) • Preparation of the Commission Proposal (June 2000 - March 2001) • Publication of the Commission proposal for a Directive on 27 March 2001 • Establishment of a Council Working Group and start of the Parliamentary debates in May 2001 • Finalisation of the Common Position in March 2002 • Adoption of the Directive on 6 June 2002

12. The Financial Services Action Plan and Financial Markets Legislation on Collateral • 2. Preparatory work • Installation of a Forum Group composed of experts from the banking sector and from securities settlement systems under the lead of the Commission • Analytical Reports • ISDA Report “Collateral Arrangements in the European Financial Markets” of 2000 (www.isda.org/press/pdf/eur_coll_law_reform.pdf) • EFMLG report “Proposal for an EU Directive on Collateralisation” of 2000 • Final report of the Forum Group of June 2000, recommending a Directive on collateral • Proposal by the Commission of the EU of 27 March 2001, including an Explanatory memorandum (www.europa.eu.int/comm/internal_market/de/finances/banks/collateral.htm)

13. The Financial Services Action Plan and Financial Markets Legislation on Collateral • 3. The Collateral Directive Itself • Problems of the current legal environment within the EU • Different collateral techniques (e.g. pledges, repurchase transactions, title transfer transactions) • Variety of formalities and administrative requirements for the creation, validity, enforcement etc. of collateral • Problems with the legal recognition of top-up collateral, the substitution of assets and close-out netting • Harmful effects of insolvency proceedings

14. The Financial Services Action Plan and Financial Markets Legislation on Collateral • Goals • Removal of the major obstacles for the cross-border use of collateral • Limitation of administrative burdens, formal acts and cumbersome procedures • Creation of a clear legal framework and thereby promoting legal certainty • Content • Substantive collateral law (Art. 3 - 6) • Substantive insolvency rules (Art. 7 and 8) • Conflict of laws rule (Art. 9)

15. The Financial Services Action Plan and Financial Markets Legislation on Collateral • 4. Content of the CD • a. Material scope of application • “financial collateral” • cash (if credited to an account) • financial instruments - bonds, shares, other negotiable debt instruments, units in collective investment undertakings, money market instruments etc. (Art. 2. para. 1 (d) and (e)) • the provision of which has to be evidenced in writing or legally equivalent manner, whereby it is sufficient that a book entry security has been credited to an account (Art. 1(5))

16. The Financial Services Action Plan and Financial Markets Legislation on Collateral • Collateralisation techniques • security financial collateral arrangements - ie provision of collateral by way of security w/o the full transfer of ownership, e.g. pledges, charges, liens (Art. 2. para. 1 (c)) • title transfer financial collateral arrangements, e.g. repurchase transactions or transfer of title (Art. 2. para. 1 (b)) • to the extent that the collateral taker (or someone acting on his behalf) acquires possession of the financial collateral (Art. 2 para. 2)

17. The Financial Services Action Plan and Financial Markets Legislation on Collateral • b. Personal scope of application (Art. 1 para. 2 (c)) • Public sector bodies and central banks • Supervised financial institutions (credit institutions, investment firms, insurance undertakings etc.) • central counterparties, settlement agents, clearing houses • a person other than a natural person, including unincorporated firms and partnerships, provided that the other party of the collateral arrangement is an entity defined above • Last bp. was controversial until the end; therefore: opt-out possibility; other considerations have been to look at the base capital of the entity (but that can change) or use the zebra approach (mandatory, but only partial application)

18. The Financial Services Action Plan and Financial Markets Legislation on Collateral • c. Material securities law • abolishment of further formalities (Art. 3), such as • notary deed • registration • notification • public announcement • in case of an enforcement event (irrespective of insolvency proceedings, as agreed between the parties, Art. 4), realisation is possible • by sale or appropriation (if so agreed), w/o • prior notice • court authorisation • public auction • waiting period

19. The Financial Services Action Plan and Financial Markets Legislation on Collateral • or set off (close out netting), Art. 4 para. 1 and 2 Opt-out clause for member states for appropriation (para. 3) • right of use (Art. 5) if agreed bestows on the collateral taker to use financial collateral provided under a security financial collateral agreement as if he were the full owner (French against, since it blurs nature of rights) • if exercised, the collateral taker is obliged to transfer back equivalent collateral, which will be treated (e.g. for avoidance periods) as the original collateral • the obligation may be subject to a close-out netting provision • Recognition of title transfer arrangement - no re-characterisation (Art. 6)

20. The Financial Services Action Plan and Financial Markets Legislation on Collateral d. Insolvency provisions (Art. 8) • protection of close-out netting provisions (also against judicial attachments et al.) • no retroactive effect of winding-up or reorganisation proceedings on financial collateral (= abolishment of the “zero hour” rule) • no invalidation, avoidance or reversal of collateral provided • due to an obligation to provide additional financial collateral (“top-up collateral”) in order to take account of changes in value of the original collateral • to exchange financial collateral against financial collateral of the same value (“substitution”)

21. The Financial Services Action Plan and Financial Markets Legislation on Collateral e. Conflict of Laws Art. 9 CD expands the applicability of Art. 9 (2) of the SFD: certain matters regarding book-entry securities will be governed by the law of the country where the account is maintained, like • the legal nature of the right and the proprietary effects of the credit to the account • questions of priority • perfection requirements (if any) • realisation

22. The Financial Services Action Plan and Financial Markets Legislation on Collateral • III. Comparison between the SFD and the CD • SFD: limited in personal scope - only where collateral security is provided in connection with the participation in a system or operations of the central banks of the Member States • but: broad scope of collateral and collateral techniques were covered • CD: broad personal scope (with opt out for transactions between financial and non-financial institutions), most kinds of securities transactions covered • but: limited scope of financial assets covered: only cash and securities; transfer of possession necessary

23. The Financial Services Action Plan and Financial Markets Legislation on Collateral C. Outlook • new projects are becoming tangible • draft Hague Convention on the law applicable to certain rights in respect of securities held with an intermediary • UNIDROIT is considering a Convention that mirrors the CD on a world wide basis • given the strong interest of commercial players, so. will sooner or later tackle the issue of a uniform securities code

24. The Financial Services Action Plan and Financial Markets Legislation on Collateral • What will it look like - what are the chances • so far, most legal acts in the field concerned themselves only with choice of law questions and mutual recognition aspects • the SFD and CD could be seen as a first step towards a (partial or full) material harmonisation of European securities law • it will be difficult to achieve: although wanted by practitioners, securities law in its civil law aspect forms part of the whole body of law of a country - they interact with each other and creating something new might cause that interaction to cease; result: loss of a homogeneous body of law, creation of many special fields • law also forms part of the culture of a country - it’s not like throwing away an old tie and wearing a nicer one • lastly, operating in a accustomed legal environment presents an asset, that has economic value

25. The Financial Services Action Plan and Financial Markets Legislation on Collateral • Proposal of the Lamfalussy Report of February 2002 (europa.eu.int/comm/internal_market/en/finances/general/lamfalussyen.pdf) - 4 level approach for legislation related to financial markets • framework principles according to normal EU procedure, preferably by means of Regulations • implementation by Commission assisted by two new Committees (Committee of European Securities Regulators CESR and European Securities Committee, ESC) • enhanced co-operation between securities regulators to achieve EU-consistent transposition and/or application • strengthened enforcement of the Commission • criticism in this weeks paper

26. The Financial Services Action Plan and Financial Markets Legislation on Collateral D. Excursus: The Hague Convention on the Law applicable to certain rights in respect of securities held with an intermediary • purely a choice of law Convention • follows the so-called “PRIMA”-principle = Place of the Relevant Intermediary • while the principle is easy, the concrete content is not: who is the relevant intermediary?? • basically PRIMA as a principle is an empty shell to be filled with sense and meaning - depending on how it is filled out, it will lead to different results • European approach: relevant intermediary is the one that maintains the account to which the securities in question are credited • Anglo-American approach: relevant intermediary is the one that the parties have agreed upon, whether he actually maintains the account to which the securities in question are credited or not

27. The Financial Services Action Plan and Financial Markets Legislation on Collateral • Status quo: The last draft will form the basis for the Diplomatic Session this December (www. hcch.net) • Problems that still need to be solved: • very broad definition of securities - “other financial assets” • therefore “lex specialis” for more traditional means of determining the applicable law (e.g. Art. 12 of the Rome Convention)? • a single economic transaction is broken down into numerous single elements, emphasising a certain legal concept of entitlement towards securities • determination of applicable law w/o objective factors - incompatibility with EU legislation • “reality test” is concerned with the general business of maintaining securities accounts - not necessarily the one where the securities are maintained