COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT pursuant to the second subparagraph of Article 251 (2) of the EC Treaty concerning the Common Position of the Council on the adoption of a Directive of the European Parliament and of the Council on financial collateral arrangements

2001/0086 (COD)

COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT pursuant to the second subparagraph of Article 251 (2) of the EC Treaty concerning the Common Position of the Council on the adoption of a Directive of the European Parliament and of the Council on financial collateral arrangements

1. BACKGROUND

Date of transmission of the Proposal to the EP and the Council (document COM(2001)168 final - 2001/0086 (COD)): // 27.3.2001

Date of the opinion of the Economic and Social Committee: [1] // 28.11.2001

[1] OJ C ..., ..., p. ...

Date of the opinion of the European Parliament, first reading: [2] // 13.12.2001

[2] OJ C ..., ..., p. ... Rapporteur: Fernández Perez Royo.

Date of adoption of the Common Position: [3] // 5.3.2002

[3] OJ C ..., ..., p. ...

2. OBJECTIVE OF THE COMMISSION PROPOSAL

The proposed Directive seeks to resolve the main problems affecting cross-border use of collateral in wholesale financial markets. It therefore promotes integration of the European financial market and secures the full benefits of the single currency. The Proposal abolishes existing administrative burdens and complexities, creates a clear framework of legal certainty in the field of collateral by:

- providing an effective and simple Community regime for the creation of collateral;

- providing limited protection of collateral arrangements from some rules of insolvency law, particularly those that would inhibit the effective liquidation of collateral or cast doubt on the validity of techniques currently used;

- creating legal certainty with regard to cross-border provision of collateral, in the form of book-entry securities, by extending the principles already applied under the Settlement Finality Directive 98/26/EC [4] to determine where such securities are located;

[4] OJ L 166, 11.6.1998, p. 45.

- restricting the imposition of onerous formalities on either the creation or the enforcement of collateral arrangements;

- ensuring effective agreements permitting the collateral taker to re-use the collateral for their own purposes under pledge structures, the classic way of providing collateral.

3. COMMENTS ON THE COMMON POSITION

3.1. General comments

Even though significant parts of the original text of the Proposal have been re-drafted, the Common Position preserves the essence of the Commission's initial Proposal. As such the Commission supported the text of the unanimous political agreement at the ECOFIN meeting of 13 December 2001, orally amending its initial Proposal (instead of making a written amended Proposal). The few material changes in the Common Position regard:

- the scope of application;

- the requirements, which have to be fulfilled by the parties establishing a collateral arrangements in order to be safeguarded by the Directive, as for instance how the arrangement must be evidenced and signed by the parties;

- appropriation by the collateral taker of collateral on the occurrence of an enforcement event;

- Article 9 (10 in the original Proposal) on conflict of laws, which determines the location of book-entry securities and thereby the applicable law governing proprietary aspects of such securities, as in Article 9(2) in Directive 98/26/EC.

These changes in the Common Position to the Commission's initial Proposal, which reflect the same overall concern as in the Parliament's Amendments, are commented in detail below. In addition, the other changes in the Common Position compared with the initial Proposal are also described.

3.2. The substance of Parliament's Amendments reproduced in the Common Position

3.2.1. Recitals

3.2.1.1. General comments

The Commission during the vote at the first reading accepted the Parliament's Amendments to the preamble. Other changes in the text of the Common Position reflect the changes made to the Articles, or specify the interpretation of the existing Articles, in line with the original Proposal.

3.2.1.2. Recitals changed to take account of Parliament's Amendments

Parliament's Amendment 1 has been accepted in the Common Position. Hence, the second sentence of Recital 11, which emphasised that the Directive does not protect so-called "credit risk top-up" collateral (collateral required upon deterioration of the credit rating of the collateral provider), has been deleted, so as to leave the protection of such a kind of collateral to national law.

Amendment 2 recommending the deletion of Recital 14 on comitology has also been adopted in line with the deletion of Articles 10 and 11 on the same issue.

3.2.1.3. Changes made in the Recitals of the Common Position independently of the Parliament's Amendments concerning recitals

The following Recitals in the text of the Common Position are almost identical with the text of the original Proposal: 1-3, 5 (4 in the original Proposal), 7 (5), 12 (7), 14 (10), 21 (15) and 22 (16). They basically detail the fundamental rationale and objectives of the Proposal.

The following new Recitals further support the interpretation of the original Commission Proposal: 4, 6, 10 (half of the text originates in Article 4(2) in the initial Proposal), 13, 15, 16 (first sentence is from the former 11), 17, 19 and 20. In particular, their wording upholds the balanced approach adopted in the Proposal: promote non formalistic enforcement procedures validating some of the existing financial techniques (such as the provision of top-up financial collateral or the right of use in case of "pledged" assets) against certain automatic avoidance rules, without prejudice to existing ex-post judiciary safeguards, which remain necessary in the case of ill-faith and commercially unreasonable transactions.

The following Recitals are new or changed in accordance with changes in the Articles: 8 (corresponds to 8 in the initial Proposal), 9 (6), 11 and 18 (13). The changes to Recital 8-9 are in line with the Parliament's Amendments 3 and 17 to the Articles, i.e. they regard the Article on conflict of laws and the requirement that the collateral must be provided in order to fall under the scope of the Directive (Recital 11 further specifies how the collateral transaction must be evidenced for that purpose). Recital 18 clarifies the use of cash collateral.

Recital 9 of the original Proposal (on third-country counterparties) has been deleted.

3.2.2. Substantive provisions

3.2.2.1. General comments

Parliament's Amendments to the Articles were accepted by the Commission during the vote on first reading, subject to some rewording with the aim to find a final agreement towards the text in the Common Position.

3.2.2.2. Articles changed to take account of the Parliament's Amendments at first reading

- Amendments Nos. 3, 4, 10, 11 and 12 - Articles 1 and 2 (2 and 3 in the original Proposal)

The requirements, which have to be fulfilled by the parties establishing a collateral arrangement in conformity with the Directive, have been eventually fine-tuned after long and complex negotiations. Article 2 of the original Commission Proposal required a straightforward written contract (including in electronic form) outlining the terms of the collateral arrangement. Moreover, the arrangement itself had to be signed by the collateral provider (including by electronic signature with authentication). However, these requirements have been adapted in order to provide market participants with an even more flexible framework, as reflected in the Parliament's Amendments 3 and 10, as well as Article 1(5) in the Common Position, which requires that the provision of collateral be evidenced in writing. Moreover, Article 1(5) of the Common Position further specifies that the arrangement has to be evidenced in writing or "in a legally equivalent manner", which is both prudentially workable/sound and flexible enough to be consistent with the Parliament's views and satisfy the Commission.

The definition of "writing" has been revised accordingly: thus, Article 2(3) of the Common Position broadly reflects the Parliament's Amendment 12. Another key precondition for financial collateral to fall within the scope of the Directive is dispossession, i.e. transfer of possession or control to the collateral taker or a person acting on its behalf. This is as stressed in the definition of the collateral "being provided" incorporated in Article 2(2) of the Common Position much in the same line as the Parliament's Amendment 11. Last, provisions in the Common Position refer to "financial" collateral arrangement, as specified in Amendment 4.

- Amendments Nos. 5 to 9, 18 and 19 - Article 1(2) (2(4) in the original Proposal)

The personal scope of the Directive Proposal has been adapted, too, in order to reflect the strong views taken by both the European Parliament and the Council. The original Commission Proposal covered public authorities, financial institutions under prudential supervision and large companies defined through certain thresholds, which could be updated through a comitology procedure. However, this latter approach has not been upheld by the Parliament, whose Amendments 5 and 9 widen the scope by including all kind of companies provided that their counterparties are, broadly speaking, either a financial institution or a public authority. Article 1(2) of the Common Position reflects both the same prudential rationale and a political compromise, by incorporating an opt-out clause allowing Member States to exclude non-financial companies from the scope: certain Member States found that the inclusion of all kind of non-financial companies might lead to difficulties in case of bankruptcy concerning the ranking of creditors.

The Commission has accepted this opt-out clause based on an expectation that the use of this possibility will be very limited or if used have a limited impact. In the Commission's view, it would be very difficult or strongly detrimental for a Member State to exclude permanently companies from the benefits of the Directive, all the more since some large companies already use collateral techniques in the wholesale market.

Further to changes in the overall structure of the personal scope, Article 1(2) of the Common Position also incorporates further precision in the definitions of involved institutions, almost using the same wording as Parliament's Amendments 6 to 8.

In accordance with the Parliament's Amendment 9, the thresholds defining the kind of companies falling under the scope of the Directive are deleted. Accordingly, the former Articles 11 and 12 on comitology, now redundant, have also been deleted, as set out in the Parliament's Amendments 18 and 19.

- Amendments Nos. 13 and 14 - Article 4 (5 in the original Proposal)

On the occurrence of an "enforcement event", by which the collateral taker is entitled to liquidate the collateral arrangement, the Commission's initial Proposal already allowed the collateral taker to sell the collateral consisting of financial instruments. As an alternative to sale, the Common Position also allows appropriation by the collateral taker, subject to an agreement of the parties, including on the valuation of the collateral, as set out in the Parliament's Amendments 13 and 14. However, it is a key principle in certain Member States to require that collateral being realised on an arm's-length in order to secure an independently fair valuation of the collateral. Thus, it was found necessary in the Common Position to permit Member States, which do not allow appropriation at the date the Directive enters into force, not to recognise this technique.

- Amendment No 15 - Article 5 (6 in the initial Proposal)

The text of the Common Position clarifies that the collateral taker only has a right of use on pledged collateral, where this has been agreed between the parties in the financial collateral arrangement, in accordance with the Parliament's Amendment 15.

- Amendment No 17 - Article 9 (10 in the initial Proposal)

The Article on conflict of laws has been significantly modified: in particular, the former paragraph 2 has been deleted from the Common Position, in accordance with the Parliament's Amendment 17, in order not to impact on the ongoing discussions in The Hague Conference on International Private Law. These cover the same conflict of laws issues as this Article. Moreover, the remaining provisions have been fine-tuned in order to account for developments in the draft Hague Convention.

- Amendment No 20 - Article 11 (12 in the original Proposal)

In Amendment 20, the Parliament has taken the view that the Directive should be implemented one year earlier (end 2003) than was originally scheduled in the Commission's initial Proposal (end 2004). Due to the complex impact of the Directive on proprietary rights, bankruptcy legislation and conflict of laws rules, the Common Position simply requests the Member States to implement the Directive within 18 months from entry into force. However, it is clear that pursuant to the conclusions of the Stockholm European Council (2001), the Member States share the view that every effort should be made to take key steps for achieving an integrated securities market by the end of 2003. This shared commitment calls for swift adoption and, accordingly, implementation of the Directive.

3.2.2.3. New provisions introduced by the Council

- Article 1 (1 and 2 in the initial Proposal)

Article 1(4)(b) of the Common Position makes it possible for the Member States to exclude from the scope of the Directive financial instruments, which are directly linked to the means of production of the collateral provider. The aim is to avoid jeopardising the possibilities of reorganisation measures for collateral providers. This is fully in line with the original proposal, i.e. it has never been the intention to cover, e.g. real estate or movables under the scope of the Directive.

Article 1(6) in the original Proposal, defining the "relevant financial obligations" to be covered by the Directive, has been moved to the definitions in Article 2(1)(f).

- Article 2 (3 in the initial Proposal)

The following definitions have been deleted as superfluous: "sale and repurchase agreement", "collateral provider", "collateral taker", "financial collateral", "relevant intermediary" and "securities collateral account". However, a definition of "financial collateral" is included in Article 1(4)(a) in the Common Position. The Common Position has also introduced a new definition of "cash" in Article 2(1)(d), in order to exclude physical banknotes from the scope of the Directive.

- Article 3 (4 in the initial Proposal)

In order to promote non-formalistic enforcement of collateral arrangements, the Commission's initial Proposal included a (non-exhaustive) list of unnecessary 'formal acts', insofar as they went beyond the formal requirements listed in the original Article 2 (see above, under 3.2.2.2). That list of examples initially set out in the former Article 4(2) has been moved to Recital 10. Article 3(1) also clarifies that formalities cannot be either imposed on the provision of collateral. Accordingly, the previous reference in the former Article 4(1) to the requirements set out in the original Article 2, making it clear that no other steps were necessary in order to make the collateral arrangement good against third parties, has been substituted with new Article 3(2).

- Article 4 (5 in the initial Proposal)

The original Article 5(1) specified the terms and conditions under which the collateral taker may realise the financial collateral on the occurrence of an "enforcement event" (see above on 'appropriation'). This paragraph has been divided into Articles 4(1) and 4(4) in the Common Position. Article 5(2) in the initial Proposal allowing close-out netting has been moved to Article 7(2) in the Common Position.

Article 4(6) in the Common Position, which correspond to the original Article 5(4), requiring that the valuation of collateral be conducted in a commercially reasonable manner, has been extended to cover also the calculation of the relevant financial obligations in connection with close-out netting in accordance with Articles 5 to 7 in the Common Position.

- Article 5 (6 in the original Proposal)

Article 5 of the Common Position lays down the framework for the collateral taker's right of use on 'pledged' securities. Article 5(2) clarifies that the collateral taker, if agreed with the collateral provider, can set-off the value of the equivalent collateral with the relevant financial obligations instead of transferring the collateral back to the collateral provider and require the redemption of the loan. Furthermore, the original paragraph 3 has been deleted as superfluous.

The new paragraph 4 in Article 5 in the Common Position makes it clear that the use of collateral does not invalidate the collateral arrangement vis-à-vis third parties for the reason that the collateral is not in the possession or under the control of the collateral provider as required in Articles 1(5) and 2(2).

- Article 6 (7 in the original Proposal)

Given the importance of close-out netting for title transfer and repo arrangements, the new paragraph 2 in Article 6 in the Common Position confirms that such arrangements can be terminated through close-out netting, if agreed between the parties to the arrangement.

- Article 7 (8 in the original Proposal)

Paragraphs 1 and 2 of Article 8 in the original Proposal, on the general protection of close-out netting, have been combined into paragraph 1 in Article 7. The new Article 7(2), which specifically exempts close-out netting from certain formal requirements, is moved from Article 5(2) in the initial Proposal.

- Article 8 (9 in the original Proposal)

The aim of the original Proposal found broad support in the Parliament and the Council, namely to protect some of the most important currently used techniques in the market (i.e. "top-up" collateral and "substitution" of collateral) against insolvency law, as well as against the "zero-hour rules" (these give retroactive effect to the commencement of insolvency events deeming them to have begun at midnight ("zero-hour")). However, following technical discussions in the Council, this Article has therefore been redrafted completely in the Common Position, but with no change to the substance.

Nevertheless, the Common Position incorporates a new paragraph 2 in Article 8 which is meant to protect collateral takers, who have received collateral after the opening of insolvency proceedings, provided that they can prove that they have acted in good faith. The Commission welcomed this rule, which correspond to a similar one in Article 3(1) in Directive 98/26/EC.

- Article 10

Article 10 in the Common Position introduces an obligation for the Commission to present a report to the European Parliament and the Council on the application of this Directive in particular on the opt-out clauses as described above and the introduction of a right of use of pledged collateral in Article 5, no later than 3 years from the implementation date.

4. CONCLUSION

The Commission considers that the Common Position preserves the key elements of its Proposal and of the Parliament's Amendments that were accepted and incorporated into the Common Position during the negotiations in the Council. The Commission supports the text of the Common Position on this eagerly awaited Directive, being essential for the participants in the wholesale market and for achieving an integrated securities market by the end of 2003.