The Banking Bill recasts key aspects of bank supervision and insolvency. With such wide-ranging changes to digest, financial institutions and other companies could be forgiven for ignoring the seemingly obscure clauses relating to financial collateral. But these provisions could remove legal uncertainty for those taking collateral particularly in traded markets (like energy trading) where banks are not always the main players.

The Financial Collateral Arrangements (No.2) Regulations 2003 (the Regulations) were meant to address any legal uncertainty in taking financial collateral. The Regulations implement the Directive on financial collateral arrangements 2002/47/EC (the Directive). There has, however, been some debate about whether the Regulations were validly made under the European Communities Act 1972. If the Regulations were under threat, this could leave some financial collateral arrangements entered in reliance on the Regulations dead in the water. This article examines how the Banking Bill would deal with the mess.

What do the Regulations do?

The Directive and the Regulations aim to reduce legal uncertainties for those taking cash or securities as collateral. They seek to do this by removing formalities governing the creation and perfection of these arrangements and restricting insolvency provisions that may limit their enforcement or effectiveness.

In very broad terms, the Regulations apply where these forms of collateral are taken by way of title transfer (this is known as a title transfer financial collateral arrangement). The Regulations also apply where the collateral taker takes a security interest in the collateral, although the Directive and the Regulations require the collateral taker has "control" of the collateral (this is known as a security financial collateral arrangement). The Regulations provide that security financial collateral arrangements do not need to be registered under section 395 of the Companies Act 1985 (and the equivalent section of the Companies Act 2006 when it comes into force). They also prevent a moratorium on enforcement of security in an administration applying to security financial collateral arrangements.

What is the problem?

The Regulations were made under section 2(2) of the European Communities Act 1972, which authorises the Government to make legislation implementing the UK's obligations under EU law. The Directive only contemplated implementation where at least one party falls within a limited class of financial institutions and public bodies. The Regulations went further and implemented the Directive for any collateral arrangements where neither party is an individual human being.

Market participants raised concerns about the extended scope of UK implementation following the decision at first instance in Oakley v. Animal. The case turned on whether certain UK regulations implementing EU obligations relating to registered design rights were validly made. At first instance the court interpreted section 2(2) of the European Communities Act 1972 very narrowly and this raised doubts about the Regulations. The Court of Appeal allowed the appeal against the first instance decision. In particular, the judges held that section 2(2) of the Act left room for the Government to make policy decisions when implementing European Directives which would potentially allow them to go beyond the strict terms of the relevant Directive. Arrangements made in reliance of the Regulations were safe.

Nevertheless, the case of Alfa Telecom v. Cukurova in the British Virgin Islands raised this issue once again. The BVI courts had to consider the Regulations as two of the security interests granted by the defendants (one of which was a BVI company) were governed by English law. Although the court did not decide on whether the Regulations were valid, this point was raised in Professor Cranston's expert evidence on English law. This caused some doubt in the financial markets about whether the Regulations had the necessary authority and led the Financial Markets Law Commission to investigate the issue. Its report (issue 132) concluded that the extension to the Directive introduced by the Regulations naturally arose from or was closely related to the purpose of the Directive, and so the Regulations were validly made under section 2(2)(b) of the European Communities Act 1972.

Cukorova also asked the English court for permission to challenge the validity of the Regulations by way of judicial review. Cukorova applied for permission outside the normal time limit for judicial review but in considering whether to grant an extension the judge had to consider the merits of Cukorova's claim that the Regulations are not valid. The judge refused to extend the time limit and permission to appeal against his ruling. In the process he cast doubt on the arguments supporting the Cukorova's claim but did not have to decide the substantive issue of validity to reach his decision.

Even before this latest twist, the saga had caused great concern among market participants. As financial collateral is absolutely central to the credit risk of counterparties, it is understandable many market participants wanted to exclude all doubt.

What does the Banking Bill do?

The Banking Bill seeks to remove any lingering uncertainty. Section 232(1) of the Banking Bill allows the Treasury to make rules about financial collateral arrangements. For this purpose, the Banking Bill defines financial collateral arrangements much more broadly than the Directive. Section 232(5) states that these rules may provide for the Regulations, or for anything done in reliance on them, to be treated as having had effect despite any lack of authority on the part of the Regulations. In addition, the Treasury may make any provision it considers necessary to restore certainty about any matters concerning the Regulations.

In effect, section 232(5) takes the unusual step of allowing the Treasury to retrospectively "correct" a statutory instrument that may not have had the right authority under an Act of Parliament. When the Banking Bill comes into force in February 2009, it will therefore allow the Treasury to make regulations putting right any lack of authority for the Regulations and assisting market participants to rely on financial collateral arrangements entered under the Regulations.

It is unfortunate this situation has been reached since in all likelihood the Regulations were validly made. But the fact the Government felt it necessary to include these provisions in itself might be read as casting doubt on the Regulations. As a result, some doubt will continue until the Banking Bill comes into force and the Treasury has made regulations under it dealing with this point.

Conclusion

The Banking Bill was intended to provide certainty in the market in response to the current banking crisis. It would seem that the Government has also taken the opportunity to remove the existing uncertainty over whether the Regulations were validly made under the European Communities Act 1972. Although this is perhaps not the most important provision in the Banking Bill, it is a further example of the Government taking unusual steps to provide certainty to the market in these challenging economic times.