The primary expectation of secured creditors in insolvency proceedings is that their claims will be enforced through a sale of collateral. However, if restructuring proceedings are opened, even secured creditors may be obliged to accept certain limitations necessary to save viable businesses (e.g., the stay of individual enforcement action or the use of collateral by a debtor in its day-to-day operation). As an exception to this rule, financial collateral holders in the EU may still foreclose on their security notwithstanding the commencement of a debtor’s restructuring, as permitted under Article 4(5) of Directive 2002/47/EC on financial collateral arrangements (“FCD”). Financial collateral holders are neither affected by the stay of individual enforcement actions nor can their security be used as part of restructuring measures.
Such exclusivity is reminiscent of Orwell’s saying, paraphrased for the insolvency context as “all creditors are equal but some creditors are more equal than others,” raising the question of whether this approach is justified. Therefore, this post aims to analyse the following three points: (i) the rationale behind the right of secured creditors to foreclose on financial collateral and its compatibility with the pari passu principle, (ii) the exact conditions for the FCD’s invocation by secured creditors, and (iii) the compatibility of the FCD with the objective of effective restructuring proceedings.
Setting the scene: reasons for excluding financial collateral from restructuring proceedings
It is crucial to note that the FCD and the Restructuring Directive serve competing purposes: the FCD aims to enhance the legal certainty and effectiveness of financial collateral for creditors, while the Restructuring Directive purports to enable debtors in financial difficulties to continue their business operations. But what if a debtor seeks to retain financial collateral, deeming it necessary for the prospects of restructuring proceedings? The Restructuring Directive answers this question negatively: if there is a conflict between two acts, the FCD’s provisions shall prevail.
Not all financial collateral is enforceable under Article 4(5) of the FCD. To apply this provision, ratione personae and ratione materiae criteria must be met. Namely, a collateral taker shall be either a public authority, a financial institution, or a central counterparty. Financial collateral must consist of cash credited to a bank account or financial instruments.
The personal and material scope of application of the FCD is important for understanding the reasons for the privileged position of financial collateral takers. As explained by the CJEU in Swedbank (Case C-156/15), the pari passu principle is not absolute, and the divergence from it is justified by certain objective criteria, like the one envisaged in the FCD – the stability of the European Union’s financial system. It implies that the legislator’s primary intention was to protect financial institutions, due to the significance of their smooth operation for the economy. That said, why did financial collateral receive this protection and not other type of collateral pledged by the debtor, like real estate, with which financiers secure transactions as well? In my opinion, the rationale shall be attributable to the economic nature of financial collateral. The market value of financial instruments, such as shares, is highly volatile. As for cash and credit claims, concerns regarding inflation, rather than volatility, are applicable. Either stock market fluctuations or inflationary evolutions may render the financial collateral worthless, undermining a creditor’s secured status. In light of this, the prompt enforcement of this type of collateral is vital for the protection of secured creditors’ interests.
Invocation of the FCD by secured creditors: what does “collateral provided” mean?
Pursuant to the FCD, secured creditors may enforce only the financial collateral that has been provided. In this respect, Article 2(2) defines “provided” as being in the possession or under the control of the collateral taker. Since Article 2 does not define the terms “possession” and “control”, the question of what collateral actually “provided” means was examined by the CJEU in Swedbank in 2016. In para. 54, the CJEU established that to invoke the FCD, a collateral provider must be prevented from disposing of the financial collateral from the moment it is transferred to a collateral taker. Notably, in para. 39, the CJEU articulated that the “provision” concept shall be given an autonomous and uniform interpretation throughout the EU.
Given the requirement of an autonomous interpretation of the “possession”, it can be suggested that the FCD would determine it through defining “possession” and “control” concepts in its Article 2. Importantly, this would also contribute to legal predictability, as the counterparts would have a clearer understanding of what kind of financial collateral is enforceable in insolvency proceedings.
Compatibility of financial collateral takers’ rights with effective restructuring proceedings
Although the Restructuring Directive first and foremost serves the purpose of promoting the “rescue culture” in Europe, the doctrine notes that insolvency law should aim for a fair balance between the interests of the debtor and its creditors, even in the case of restructuring proceedings. Striving for such a balance, the UNCITRAL Legislative Guide on Insolvency Law suggests that a secured creditor should be allowed to enforce its security only if the encumbered asset is not needed for the restructuring.
Nonetheless, due to the monetary and non-tangible nature of financial collateral, if a debtor is permitted to use this asset, it may be completely extinguished as a result. To compare, when a debtor continues using collateralised machinery or premises during restructuring, these objects will still exist after such usage and can be sold off later to enforce a creditor’s claim. But if it is the case that financial collateral has been used and extinguished by a debtor, this tips the balance considerably against a creditor. As such, financial collateral should be excluded from restructuring proceedings.
*This research blog was written by Anhelina Andrieieva, junior associate at TEGOS and PhD candidate at Mykolas Romeris University
Conclusion
In my view, EU law adopts a reasoned approach to the enforceability of financial collateral, as such an asset may become completely worthless or even extinguished if not enforced promptly. However, to ensure legal predictability, it can be suggested that Article 2 of the FCD defines the concepts of possession and control. It would allow the parties to have a clear understanding of what kind of financial collateral may “lift the veil” of insolvency proceedings.
About BWILC and the PhD Workshop
This research was presented and discussed at the last PhD Workshop on European and International Insolvency law, organised by the Stichting Bob Wessels Insolvency Law Collection (BWILC). Since 2018, BWILC maintains the private insolvency law book collections of Prof. em. Bob Wessels, extended with the collections of the late Prof. Ian Fletcher and the late Gabriel Moss QC, in addition to books that have been kindly donated by scholars and practitioners from around the world. To browse or visit this unique collection, click here.
Since 2019, BWILC organises an annual PhD Workshop for PhD students from Europe and beyond. At this workshop, PhD candidates can present their ideas, but also the challenges and questions they are confronted with in a two-day workshop attended by their peers and senior academics. At the end of the workshop, organised alternately in Leiden and another city, prizes are awarded for the best presentations.