Clarifications on the issues around granting security over bonds and other securities, with a particular focus on the Euroclear system
In brief... Taking security over bonds (and other securities) held in a clearing system raises a number of legal issues. Understanding these legal issues is a pre-requisite to structuring an appropriate security package. This article addresses some of the key questions to consider before taking security over bonds and other such securities.
Clearing is the process of managing a range of actions, including transmitting, reconciling and confirming the obligations of the buyer and seller, between the time of execution and settlement of a trade. Clearing enables each party to understand the obligations of the other and to anticipate the amount which they can expect to receive upon settlement of the trade. Clearing plays a central role in the over-the-counter (OTC) derivatives market where the period of time between execution and settlement can be substantial, and during which the obligations of either party may vary. Clearing is less significant in relation to the issuance of securities, where there is greater certainty as to the assets to be transferred between the parties.
Settlement is the process flow whereby the buyer receives purchased securities and the seller receives the corresponding cash proceeds for those securities.
Question 1: In which clearing system are the securities being held?
Most debt securities (securities) are held by central securities depositaries, whose role is to facilitate the transfer of securities (and related cash proceeds) between participants. Securities depositaries are commonly referred to in the market as “clearing systems” due to their role in both the clearing and settlement process (see the ‘Jargon Buster’ box). Securities depositaries are either operated on a national scale (by central securities depositories (CSDs)) or on an international scale (by international central securities depositories (ICSDs)).
Internationally traded securities will be held by (or on behalf of) one of the ICSDs, Euroclear or Clearstream, which provide a range of clearing, settlement and other services. By contrast, domestically-traded securities will be held by (or on behalf of) a CSD, such as Euroclear UK & Ireland, which operates the CREST system in the UK. In each member state of the EU, only one CSD will normally exist.
ICSDs were borne out of the traditional CSD in response to the changing nature of the international securities market. There remains a connection though, as the operators of Euroclear and Clearstream own a number of CSDs: the Euroclear group owns CSDs in Belgium, Finland, France, Ireland, Sweden and the UK, and Clearstream owns CSDs in Germany and Luxembourg. Given the international nature of most debt issued in today’s market, this article focuses primarily on issues concerning the ICSDs - and in particular Euroclear, which is of greater relevance to UK market participants.
Click here to view table.
The majority of ICSD participants are financial institutions, broker-dealers and other professional institutions who specialise in new issuances, market-making and secondary trading. Each participant will maintain and operate a securities account within the relevant ICSD for the purposes of recording their interests and book-entry transfers. By contrast, CSD participants may also include individuals, companies, government treasuries and central banks. Of these participants, each financial institution and most large corporations will maintain and operate their own securities account with individual participants acting through a "sponsor" (such as a financial institution). Such sponsor financial institutions in this instance will be acting as a custodian on behalf of its individual customers (see below).
Click here to view table.
Question 2: Which party holds legal and beneficial title to the securities?
Most securities held through an ICSD system are in global form, meaning that one note represents the entire issue of securities. The custody of the global note is entrusted to a common depository or common safekeeper (or in the case of registered securities, in the name of its nominee company) on behalf of Euroclear or Clearstream. The global note is effectively immobilised within the clearing system. Interests in the securities represented by the global note are traded within the relevant clearing system and pass by way of book-entry transfers. While securities are held in clearing systems, legal title to the securities rests with the common depository/safekeeper (or its nominee, as applicable) and beneficial title rests with the participant (and/or the ultimate client of the participant, as applicable). The nature of the interest held affects the type of security that can be granted, as will be explored further when considering question 3.
Question 3: What are the usual steps for taking security over securities held in a clearing system?
Unlike securities held in the CREST system, which may be secured by an account charge governed by English law, granting security over Euroclear assets will require a Belgian law pledge over the relevant assets. We have considered only the Euroclear system here as this will be the most common ICSD for UK corporates and financial institutions; Clearstream has a comparative system in accordance with Luxembourg law.
Pledges of securities that are held by Euroclear are dealt with expressly under Belgian legislation. Two discrete steps are required under statute in order to create a valid and enforceable pledge against third parties:
- the conclusion of a Belgian law-governed pledge agreement to which Euroclear will not be a party, and in respect of which the parties are free to agree their own form between themselves; and
- transfer of the pledged securities to a specially designated ‘pledged account’ opened with Euroclear in the name of the pledgee, or, where the collateral-taker or secured party is not a participant of Euroclear, in the name of another participant (commonly known as the pledgee’s representative).
The security will be perfected at the point of transfer of the securities into the pledged account. Upon any event of default by the pledgor, assuming that the value of the pledged securities is readily ascertainable, the pledgee (or the pledgee representative) may immediately realise its rights over the pledged securities without the need to obtain prior authorisation of a Belgian court or, depending on the provisions of the pledge agreement, notifying the pledgor.
The pledgee or secured party should also consider:
- whether registration or filing of particulars of the pledge/other security interest may be necessary in its own jurisdiction; and
- whether a local-law charge or pledge should be taken alongside any Belgian law-governed pledge.
In the case of a UK pledgor, it would always be prudent in the circumstances to register such security interest at Companies House, regardless of the governing law of the instrument.
Question 4: What rights (if any) do the ICSDs have to the securities?
As a matter of Belgian law, a statutory lien is granted in favour of Euroclear which applies to both securities and cash held in the relevant participant's account, and permits the recovery of all debts to Euroclear related to securities clearance and settlement activity. However, Euroclear has agreed in its Operating Procedures to waive this lien in relation to any securities and/or cash identified in writing by participants as being held in an account solely on behalf of a participant's customers. Euroclear also waives its right of set-off in relation to any pledged account, save for any fees or expenses incurred in relation to the sale or realisation of pledged assets. Before exercising such set-off rights, Euroclear will obtain the consent of the pledgee or secured party.
Clearstream also benefits from a similar statutory lien under Luxembourg law. Additionally, the Clearstream general terms and conditions create a pledge in favour of Clearstream over all of a participant's assets held in the Clearstream system. Unlike Euroclear participants, Clearstream participants do not benefit from any waiver with regards to their customer securities accounts. However, Clearstream would normally agree to waive set-off rights upon request by a pledgee who has been granted security over assets held within Clearstream.
Question 5: If an ICSD becomes insolvent, what rights does a secured party in the securities?
The rights of ICSD participants over assets held in Euroclear and Clearstream are governed by similar concepts under the laws of Belgium and Luxembourg respectively.
Taking Euroclear as an example, participants of the Euroclear system agree that all securities held in its account are fungible with all other securities deposited with Euroclear of the same type and with the same common code. This is in accordance with the Royal Decree No. 62 on the Deposit of Fungible Financial Instruments and the Settlement of Transactions involving such Instruments and other applicable Belgian legislation.
When a participant deposits securities in the Euroclear system it receives a co-ownership right in a pool of fungible book entry securities of each category. In practical terms, this means that an ICSD participant will not have a sole right over its own assets, but over all of the assets of the same type within the ICSD, collectively with all other participants owning securities of that type. In the event of an ICSD insolvency or analogous process, each ICSD participant will have the right to enforce against the ICSD for return of an amount of such assets held in their account with the ICSD. Should there be insufficient assets or cash proceeds to satisfy the claims of each participant in relation to one type of asset, each participant will share equally in the losses incurred in relation to that asset. However before such losses are calculated, any securities of the same type which are held directly by the ICSD will be made available in the pool of assets to be shared between participants.