Lehman Extended Liens Case - consideration of a security interest characterisation and application of the Financial Collateral Arrangement (No. 2) Regulations 2003 (the "FCAR")Technical Bulletin No: 453

Case: Re Lehman Brothers International (Europe) (in administration) and others [2012] EWHC 2997 (Ch); Briggs J (2 November 2012)

Synopsis: A security interest in a master custody agreement relating to mainly intangible property and described as a 'general lien' was unlikely to have been intended by the draftsman to be strictly interpreted as a species of lien and the court concluded that it amounted to a charge. Whilst the extension of the security interest to custodial services provided by LBIE (the collateral taker) to its affiliates did not prevent it from being characterised as a charge, the interest did not qualify as collateral for the purposes of the FCAR as LBF (the collateral-provider) retained uncontrolled rights of recall and disposal of the charged property which went further than rights of substitution or withdrawal of excess permitted under the FCAR.

Topics covered: Legal characterisation of security interests: general liens; and floating and fixed charges. Application of FCAR: interpretation of possession and control.

The Facts

The administrators of Lehman Brothers International (Europe) (LBIE) sought directions from the court in relation to the interpretation, characterisation, validity and effect of security interests granted by Lehman Brothers Finance SA (LBF) to LBIE pursuant to two master custody agreements (MCAs). The first MCA was based on documentation which LBIE had originally used in its capacity as custodian to its customers outside the Lehman group and the MCA provided that LBIE would have a 'general lien' over all the 'Property' held by it under the agreement. The Property mainly consisted of intangibles comprising largely dematerialised securities and money. The MCA also provided that LBF (the collateral provider) would have a right to withdraw or substitute Property, but only if LBIE (the collateral taker) was satisfied that there was sufficient Property to cover any exposure. The second MCA contained similar terms, but did not contain the provision enabling LBIE to object to LBF withdrawing the Property should the available pool be insufficient to meet any exposure.

The Court was asked to consider more than 20 issues based on an agreed set of facts. In this bulletin we focus upon key issues likely to be of more general application, including in particular issues regarding the meaning and interpretation of the FCAR. Key issues 1 and 2 concerned the meaning and effect of Clause 13 of the MCA and account for the case becoming known as the ‘extended lien’ claim. Clause 13 provided:

“The Client [LBF] agrees that the Custodian [LBIE] 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….”

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The key issues which the court considered were: 1. Did the description of the security interest as a 'general lien' in the MCA mean that the security interest was a general lien or was it something else?

2. Could such a security interest be created in favour of LBIE over the Property in respect of obligations owed by LBF to LBIE and also obligations owed by LBF to any Lehman Brothers entity? No other Lehman entity was a party to the MCA.

3. Did the security interest comprise a security financial collateral arrangement under the FCAR?

4. Whether the security rights in relation to the affiliates’ debts fell foul of the British Eagle principle or insolvency set-off?

By way of reminder, the FCAR apply where, pursuant to reg 3, a collateral taker obtains a "security interest" in financial collateral (very broadly equating to cash and to shares) that is

"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…’’

Where security constitutes security financial collateral within the FCAR it is exempted from any requirement to be registered under the Companies Acts, and certain other restrictions which are advantageous to the collateral taker and which would otherwise apply under IA 86 are disapplied. For example the means of enforcement are not hindered by an administration moratorium (paras 43 and 44 of Sched B1 IA 1986) and an administrator's power to deal with the charged property does not apply (paras 70 and 71 of Sched B1 IA 1986). Equally the prescribed part pursuant to s176A of IA 1986 or avoidance of floating charge provisions pursuant to s245 of IA 1986 will not apply.

The Decision

1. 'General lien'?

It was common ground between the parties that under English law a general lien could not apply to intangible property and counsel chose not to seek to challenge the established case law, (although Briggs J had invited counsel to consider whether the time had come for the court’s analysis in this area to be reviewed). Briggs J went on to conclude that the draftsman could not have intended to create a general lien in the strict legal sense stating at para 38:

‘It seems to me highly improbable and therefore most unreasonable to attribute to commercial parties an intention to create security rights of a type incapable of applying to the overwhelming bulk of the property likely to be held as custodian by LBIE under its

2 standard form MCA.’

Instead, Briggs J considered that the security interest amounted to a charge and, having so found, it was common ground between counsel that the charge was a floating charge. This meant it was unnecessary for the judge to consider whether the security interest fell into a residual category of security right which might be termed a flawed asset (not being a lien, pledge, mortgage or charge).

2. Obligations owed to 'any Lehman Brothers entity' – would this create an effective charge?

Briggs J considered but rejected the argument that the rights as between LBF and LBIE’s affiliates were conceptually incapable of creating a charge. He agreed that no trust or fiduciary relationship was created between LBIE in relation to the security rights conferred upon LBIE under the MCA, but he held that this was not a conceptual impediment to the existence of a charge. Briggs J’s comment on this point was as follows:

‘All that is necessary is that the charge has a specifically enforceable right to have the relevant property appropriated to the payment or discharge of the relevant debt or other obligation. It is that right of specific enforcement which transforms what might have otherwise been a purely personal right into a species of proprietary interest in the charged property…’[para 43]

‘...I can see no good reason why A should not confer a specifically enforceable right on B to have A's property appropriated towards the discharge of a debt which A (or someone else) owes C, without any requirement that B be C's trustee or fiduciary…In truth, it seems to me that the relationship between B and C is irrelevant to the enforceability of A’s promise to B, if it derives from a specifically enforceable contract between them.’ [para 44]

3. Financial Collateral Arrangement under the FCAR

Briggs J then considered in detail a number of aspects of interpretation of the FCAR in order to determine whether the security interests created under the MCA qualified as financial collateral under the regulation.

A key issue to be determined was whether LBIE had the requisite 'possession' or 'control' over the secured assets pursuant to Regulation 3. Briggs J approached his analysis here on the footing that the English regulation should be interpreted as far as possible so as to be consistent with the purpose of the EU Directive.

When considering the meaning of 'possession' and 'control' Briggs J held these to be separate requirements (i.e. you could have possession – but not control and vice versa). Briggs J concluded that the FCAR draftsman would not have intended the definition of possession and control to exclude intangibles as they were the 'very stuff of modern financial collateral'. Possession and control should, however, mean:

‘something more than mere custody of financial collateral by the collateral taker under an agreement giving the custodian no more dominion over it than that of a pure nominee.’ (para 131)

Without providing a prescriptive analysis of what this might comprise, Briggs J held that

3 the collateral-taker must be able to show some kind of possession or control and dispossession by the collateral giver. (See in particular comments at paras 134-137.) On an analysis of the terms of the MCA Briggs J considered that, as between LBIE and LBF, the requirements to be considered a financial collateral arrangement under the FCAR were met as LBIE had ‘a sufficient right to retain the security pending crystallisation to render LBF’s right as provider not significantly greater than rights of substitution or the withdrawal of the excess’ [para 144]. However, the terms of the MCA did not provide LBIE with similar rights of retainer in relation to LBIE’s affiliates. Briggs J concluded that the security should be treated as creating a single security which therefore failed to satisfy the ‘possession’ and ‘control’ requirements of the FCAR.

Briggs J also made a number of further findings concerning the FCAR which, in view of his analysis of the application of the possession and control test under reg 3 are strictly obiter. The points are likely nevertheless to carry weight in any future case as they were fully argued before the court. Briggs J’s further findings here were as follows:

• The FCAR were not limited in their scope to bilateral agreements because no such restriction as to their scope is imposed by the Directive (but Briggs J added that if he was wrong as to this point any bilaterality condition was in any event on the facts satisfied here as only the two parties to the agreement had direct rights to enforce proprietary interests) (see paras 86-90).

• The FCAR do not apply to security interests created by agreements entered into before the FCAR came into force on 26 December 2003 (see parags 153-160).

4. The application of the principles in British Eagle and insolvency set-off

LBF was in Swiss insolvency proceedings which had been recognised as foreign main proceedings under the Cross Border Insolvency Regulations 2006 and, in that context, arguments relating to the application of the principle in British Eagle and insolvency set off had been put to the court as part of counsels’ submissions. As Briggs J concluded that a charge had been created (rather than a contractual provision or flawed asset) he did not need to decide issues arising from these submissions, but he did express considerable doubt regarding the proposition that the British Eagle principle applied automatically to all contracts governed by English law, irrespective of whether the assets or parties were subject to an English insolvency process. Briggs J’s view here contrasts with the obiter comments of the Chancellor at first instance in the Perpetual case [2009] EWCH 1912 (Ch) (see our ILA Bulletins 233 and 243 for the CA and SC decisions).

Comment It is important to be able to determine when collateral will be considered as a financial collateral arrangement under the FCAR in order to benefit from the exemptions as to registration and the freedom from certain limitations in the context of enforcement and other limitations that normally apply in insolvency situations. In this case, whilst the extension of the secured obligations to debts owed to LBIE's affiliates did not prevent there being an effective charge, it did prevent that charge from qualifying as collateral for the purposes of the FCAR.

This is the second case to consider the meaning of possession and control under the

4 FCAR (see our Bulletin 286 Re Gray: floating charges and financial collateral by operation of law). Interestingly this latest case follows the conservative approach to security, where legal rather than administrative control was needed to fall within the FCAR, as set out in Re Gray.

Whilst the case has provided some clarity in this area, Briggs J’s judgment has highlighted a number of issues of uncertainty regarding the application of the FCAR which are of real practical significance. Recently, the Financial Markets Law Committee issued a paper highlighting the areas of uncertainty remaining with the application of the FCAR, including those identified in this case, and recommending amendments to the FCAR to make them clearer. As the FMLC points out, at present, it is unclear what rights the collateral provider can retain (in addition to a right to substitute security) and it is unclear whether, in particular, it can take income accruing on the security and/or receive notice or exercise voting rights in respect of the security without this having the effect that the collateral taker no longer has the requisite possession and control under the FCA. The FMLC paper can be accessed via its website at http://www.fmlc.org/Pages/home.aspx.

It should also be noted that the rules in the Client Assets Sourcebook (CASS) have been amended so that general liens over client assets which are held under custodian agreements are generally prohibited, except in a defined set of circumstances listed in CASS 6.3.6.

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