Although it has been over a decade since the EU Financial Collateral Directive (Directive 2002 / 47 / EC of the European Parliament and of the Council of 6 June 2002 on financial collateral arrangements) came into force, there has been very little case law, either in the UK or Germany, on the meaning and effect of the Directive.

On 2 November 2012, the High Court in England handed down an important decision in “Re Lehman Brothers International (Europe) (in administration)” considering a number of key provisions of the Directive. In Re Lehman Brothers, the Court was specifically concerned with a number of provisions of the Financial Collateral Arrangements (No 2) Regulations 2003 (UK) which transposed the EU Directive into UK domestic law; however, for reasons set out below, the decision is of wider importance.

The driving policy behind the Directive was to create an EU-wide regime harmonising the various national regimes for the provision of securities and cash as collateral in financial and capital market transactions. In particular, the Directive was designed to provide a common regime of minimal formalities for the creation of qualifying financial collateral arrangements and to enable the rapid and non-formalistic enforcement of such arrangements free from restrictive provisions of national insolvency legislation throughout the European Union. The recitals to the Directive make it clear that in order to limit the administrative burden on parties using financial collateral, the only perfection requirement which a national law is permitted to impose is that 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”. It is this crucial element of “possession or control” which the court was required to examine at length in Re Lehman Brothers.

A “financial collateral arrangement” is defined in Article 2 of the Directive as a “title transfer financial collateral arrangement” (i.e. where title to the financial collateral is transferred to the collateral taker) or a “security financial collateral arrangement” (i.e. where the financial collateral is provided to the collateral taker by way of security). Article 2 (2) of the Directive provides as follows:

“Reference in this Directive to financial collateral being “provided” or to the “provision” of financial collateral, are to the financial collateral being delivered, transferred, held, registered or otherwise designated so as to be in the possession or under the control of the collateral taker or of a person acting on the collateral taker’s behalf. Any right of substitution or to withdraw excess financial collateral in favour of the collateral provider shall not prejudice the financial collateral having been provided to the collateral taker as mentioned in this Directive.”

The Court noted that it was clear from the drafting of the Directive that it was only forms of financial collateral where such collateral was in the possession or under the control of the collateral taker which should come within the Directive.

The first question which the Court was required to examine was the meaning of the words “so as to be in the possession or under the control of the collateral taker” in Article 2 (2) of the Directive.

The Court held that Article 2 (2) of the Directive effectively imposed a two limb test: The first limb being that the collateral must be delivered, transferred, held, registered or otherwise designated to the collateral taker, and the second limb being that it was only those forms of delivery, transfer, holding, registration or designation which actually resulted in the collateral being in the possession or under the control of the collateral taker which would qualify for inclusion within the Directive.

The Court then went on to consider the meaning of the concept “possession or control” in the context of the Directive. In the only previous decision on this aspect, the High Court in Gray v G-T-P Group Limited had held that the concept of “possession” had no application to intangible property. In Re Lehman Brothers, the Court espoused the view that as the vast majority of financial collateral used in the markets is intangible property (i.e. dematerialised securities or cash), it would be wrong to assume that the Directive had chosen to refer to “possession” of financial collateral if it were to have no application to intangibles. The Court held that “possession” meant more than mere transfer to or holding by the collateral taker such that he had “dominion” over the financial collateral but rather the principal question to be asked is whether the collateral provider has been “dispossessed” of the financial collateral.

Concerning “control”, it was accepted on the basis of Gray that one must distinguish between administrative control, in the sense of the collateral taker having ability to deal with the intangible property as the account holder, or legal control, in the sense of having the legal right to prevent the removal of charged property from the pool of collateral held.

In Re Lehman Brothers, the Court affirmed the view that legal rather than administrative control was the appropriate criterion. The Court stated that in order for a collateral arrangement to be within the Directive, the transfer or delivery etc. of the financial collateral must be to such an extent that sufficient possession or control is said to be in the hands of the collateral taker such that the collateral provider has been dispossessed of the financial collateral. Where, for example, financial collateral is in the possession of the collateral taker but the collateral provider has an uncontrolled right to call for the money etc. it cannot be said that the collateral provider has been dispossessed.

In Re Lehman Brothers, one of the entities in the Lehman Brothers group, Lehman Brothers Finance SA (LBF), had provided security over financial collateral to Lehman Brothers International (Europe) (LBIE) as security for debts owing by LBF to LBIE and debts owing by LBF to certain of LBIE’s affiliates.

The terms of the arrangement were such that pending crystallisation of the security (in the nature of an English law charge), LBF had the right to demand immediate withdrawal of all or any part of its property in the relevant account at any time and LBIE merely had a limited right of retainer to cover any exposure that LBIE had to LBF.

In respect of the arrangement providing security for LBF’s debts to LBIE, the Court stated that LBIE’s limited right of retainer was sufficient to give it the requisite “possession” or “control” over the collateral and that LBF’s rights were tantamount to being mere rights of substitution or withdrawal of excess (such rights in favour of the collateral provider being specifically referred to in Article 2(2) as not inconsistent with the collateral taker having “possession or control” of the financial collateral). However, the Court said it was more appropriate to regard the security interest, which was security for debts owing by LBF to LBIE and to certain of LBIE’s affiliates, as one security created over a single class of collateral security (being all property held by LBIE for LBF), and that in these circumstances the totality of LBIE’s rights were such that LBF had not been “dispossessed” of the financial collateral, therefore the security rights did not constitute a “security financial collateral arrangement” under the Directive. The Court noted:

“This is because LBF retained, pending crystallisation, uncontrolled rights of recall and disposal of the property held in custody to a substantially greater extent than rights of substitution or withdrawal of excess, treating “excess” as referable to the whole of its liabilities for satisfaction of which the security existed. In short, leaving aside its debts to LBIE, LBF could do what it liked with the property, regardless of its liabilities to LBIE’s affiliates.”

While questions still remain unanswered following the decision in Re Lehman Brothers, for example, what is the meaning of “excess” financial collateral and at what point do a collateral provider’s rights become more than mere rights of substitution and withdrawal, the High Court decision in Re Lehman Brothers has provided welcome clarification on the meaning of one of the central elements of the Directive, that is, when financial collateral can be said to be “in the possession or under the control of” the collateral taker.