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More Lessons from Lehman: Avoiding Bear Traps When Taking Security

Introduction

On 2 November 2011, the High Court provided important guidance with respect to aspects of standard form documentation used by banking groups, in particular the creation and enforcement of liens over client assets.[1]

The court was asked to consider some 49 questions, the majority of which related to a Master Custody Agreement (the “MCA”) between Lehman Brothers International (Europe) (“LBIE”) and its affiliate, Lehman Brothers Finance SA (“LBF”) pursuant to which LBIE provided custody services to LBF.  Clause 13 of the MCA created a security interest, described as a “general lien”, over all property held by LBIE and belonging to LBF for the benefit not only of LBIE, but also its affiliated entities (described as “any Lehman Brothers entity”), drafted in the following terms:

“The Client agrees that the Custodian shall have a general lien on all other Property held by it under this Agreement until the satisfaction of all liabilities and obligations of the Client (whether actual or contingent) owed to the Custodian or any Lehman Brothers entity under any other arrangement entered into with any Person in the Lehman Brothers organisation. In the event of failure by the Client to discharge any of such liabilities and obligations when due…the Custodian shall be entitled to sell…or otherwise realise any such Property and to apply any moneys from time to time deposited with it under this Agreement and the proceeds of such sale or realisation in the satisfaction of such liabilities and obligations…”

In addition, clause 9 of the MCA provided that LBIE was under no obligation to deliver property where it believed that there may insufficient in the custody account to cover any exposure that it had to LBF.

The court was asked, inter alia, to consider the following questions:

What was the true nature of the security interest created under the MCA and described as a “general lien”?

The court held that the MCA did not create a “general lien” in the strict sense.  A general lien is incapable of applying to intangible property, such as that which formed the overwhelming majority of the property likely to be held by LBIE as custodian under the MCA.  As such, the court found it “highly improbable” that the parties would have had intended to create such a security interest.  Rather, the court considered the powers of appropriation and sale conferred by the MCA as being consistent with the rights attributable to a floating charge, both in relation to debts owed to LBIE and its affiliates.  The charge was categorised as floating, rather than fixed, on account of the fact that the MCA clearly gave LBF the right, prior to crystallisation, to substitute or withdraw excess property[2].  The court rejected the argument that a charge to secure debts owed to someone other than the chargee (i.e. LBIE’s affiliates) was a conceptual impossibility in the absence of a trust relationship, holding that it was not necessary for the chargee (i.e. LBIE) to be either a creditor itself or a trustee or fiduciary for a creditor, provided that it had a specifically enforceable right to have the relevant property appropriated to the payment of the relevant debt.

Did clause 13 of the MCA give rise to a trust or fiduciary relationship between LBIE and its affiliates?

The court held that this was not the case, on account of the fact that it was not necessary to imply a trust/fiduciary relationship in order to construe the contract.  There was no expression in the MCA of the terms of a trust or fiduciary relationship such as an order of priorities as between LBIE and its affiliates with respect to security rights.  Moreover, Briggs J found it “absurd” that, in the context of the management of the Lehman group’s affairs while a going concern, such a trust or fiduciary duty could arise as it would be nothing more than “an impediment to the sensible and practical making of business decisions”.

Whether the reference to “any Lehman Brothers entity” clause 13 was sufficiently certain to be enforceable

The court held that the reference to “any Lehman Brothers entity” in clause 13 of the MCA was sufficiently certain to be enforceable.  It noted the “well established reluctance” of courts to strike down contractual arrangements on grounds of supposed uncertainty[3].  For this to occur, it must be legally or practically impossible (and not just “difficult” as was presently the case) to give the parties’ agreement any sensible construction.  It was wrong to conclude that a question of ‘uncertainty’ arose merely because of the existence of a number of regulatory or company law definitions (such as “group”, “subsidiary” or “associated or connected company”) which provided possible meanings for the phrase “Lehman Brothers entity”.  Furthermore, had a trust relationship existed between LBIE and LBF, the court considered that it would have still been possible to tell with certainty whether any given person was or was not a member of the class “any Lehman Brothers entity” and therefore a beneficiary of the trust.

Did the arrangement constitute a “Financial Collateral Arrangement” for the purposes of the Financial Collateral Arrangements (No 2) Regulations 2003 (the “FCAR”)?

Directive 2002/47/EC on financial collateral arrangements, on which the FCARs are based, was designed to create a new EU-wide regime for “financial collateral arrangements” necessitating minimum formalities and free from Member States’ differing insolvency regimes.

The court considered that the MCA created security over LBF’s relevant property and to that extent it qualified as a security financial collateral arrangement.  However, ultimately, it held that the charges created by the MCA did not constitute a security financial collateral arrangement for the purposes of the FCARs.  Primarily, this was on account of the fact, when looking at the arrangement as a whole, LBIE did not have the requisite “possession” of, or “control” over, the underlying collateral so as to satisfy the test contained within the definition of “security financial collateral arrangement” in Regulation 3 of the FCARs.

The court held that, in order to bring a particular collateral arrangement within the protection of the FCARs, it was necessary to show that sufficient “possession” or “control” (but not necessarily both) lay in the hands of the collateral taker for the collateral provider to be rightly regarded as having been “dispossessed” of the collateral.  It was noted that the existence of rights of substitution or withdrawal do not undermine the existence of an FCAR, provided that legal (and not just administrative) control of the charged assets remains with the collateral taker.  The court considered that, viewed in isolation, the MCA did confer sufficient possession and control on LBIE in respect of the security for its own claims to constitute an FCAR.  This was on account of LBIE’s pre-crystallisation right to retain property held by it.  However, this was not the case with respect to the security arrangements for LBF’s debts to LBIE’s affiliates.  Rather than view the arrangements in isolation, the court held that the question as to whether there has been a sufficient dispossession by the collateral provider should be addressed by reference to the parties’ legal rights viewed as a whole.  On the facts, pending crystallisation, LBF retained unfettered rights to recall and dispose of the charged property regardless of its liabilities to LBIE’s affiliates.  These rights extended beyond a simple right of substitution or withdrawal of excess collateral.  On this basis, the court held that the possession/control requirement was not satisfied and the security rights conferred by the MCA fell short of a qualifying security financial collateral arrangement under the FCARs.

Would the mere extension of the security interest to affiliates of LBIE mean that the arrangement ceased to constitute a “security financial collateral arrangement?

It had been argued before the court that the security created by the MCA failed to qualify as a security financial collateral arrangement because it was multi-lateral in the sense that it created a security for the debts of LBIE’s affiliates, rather than for LBIE alone.  The court held that this argument was wrong on account of the fact that neither Directive 2002/47/EC nor the FCARs required arrangements to be bilateral only.  Moreover, even if this were the case, any ‘bi-laterality test’ was satisfied by virtue of the fact that the MCA was itself a bi-lateral arrangement conferring no proprietary interest upon, or rights directly enforceable by, anyone other than its two parties.

Does non-exercise of legal rights disqualify a security under the FCARs?

The court considered existing authority[4] regarding the question of whether the habitual non-use of apparent rights of control over secured property could lead to what looked like a fixed charge being identified, in substance, as a floating charge.  Although the arrangement between LBIE and LBF was not sham, it was also noted that, on the facts, prior to the collapse of the Lehman group, LBIE did not exercise any legal rights of control or retainer it may have had under the MCA.  Nonetheless, the court held that the mere non-use of LBIE’s rights was insufficient to change the conclusion that the arrangement satisfied the criteria of an FCAR.  In doing so, it distinguished cases where agreements are silent (and therefore conduct is relevant in determining the parties’ apparent rights) from the present case where the agreement conferred an express right of control by retainer.

Do the FCARs apply to Security interests created by agreements entered into before 26 December 2003?

This issue arose because the MCA was entered into on 22 August 2003, a little over four months before the FCARs came into force on 26 December 2003.  However, the court held that the FCARs did not have any kind of retrospective effect.

Lessons to be Learnt

From a sell-side perspective, the good news is that multi-lateral security arrangements covering group affiliates can qualify for protection as FCARs.  Moreover, provided that clauses are drafted correctly, the non-exercise of rights should not jeopardise ongoing FCAR protection.  Nonetheless, there are a number of lessons which can be drawn from the relationship between LBIE and LBF which may merit a review of existing documentation portfolios as well as standard templates:

  • Be sure of your security: liens and charges are very different creatures, the latter creating a proprietary interest falling outside of an insolvent’s estates.
  • Be sure of your drafting: security arrangements purporting to be for the benefit of other group companies will be viewed in their entirety and must be capable of passing the “possession and control” test on this basis in order to benefit from FCAR protection.  Despite the helpful guidance of the courts in the instant case it is also advisable to avoid any unnecessary ambiguity in defining the beneficiaries of security arrangements.
  • Be sure of your rights: in order to benefit from FCAR protection it is necessary to ensure that a sufficient degree of rights are reserved such that the collateral provider can be regarded as having “disposed” of the underlying collateral.  Custodial rights analogous to those of a mere nominee will not be sufficient.
  • Be sure of your position: consider whether a trust relationship between group companies benefitting from a security arrangement is appropriate.  Trust relationships imply obligations on the trustee which may constrain an ability to take the most appropriate commercial business decision in the circumstances.

[2] National Westminster Bank plc v Spectrum Plus Ltd [2005] 2 AC 680

[3] Durham Tees Valley Airport Ltd v BMI Baby Ltd and anr [2010] EWCA Civ 485

[4] Spectrum Plus

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