The exercise of a right of use shall not render invalid or unenforceable any right of the collateral taker under the relevant security collateral

agreement.

Commentary

I. Introduction

34-1. In order to enhance market liquidity and promote secured finance, Article 34 envisages a general right of disposal for the collateral taker under a security collateral agreement. Such a “right of use” must, however, be authorised in the collateral agreement. This is because the exercise of such right has an impact on the position of the collateral provider in the sense that, under non-Conventional law, it may loose its (proprietary) interest in respect of the collateral securities and be left with a contractual claim until equivalent collateral is given by the collateral taker.

34-2. Article 34(2) sets out the collateral taker’s obligation to transfer equivalent collateral to the collateral provider. The obligation arises at the moment when the right of use is exercised and should be fulfilled no later than the moment when the relevant obligations are discharged.

“Equivalent collateral” is defined in Article 31(3)(i) as securities of the same description as the original collateral securities. Under certain circumstances, the collateral agreement may specify an obligation for the collateral taker to transfer other assets, e.g., in the event where, following a merger or take-over concerning the issuing company, securities of the same description are no longer available.

34-3. If the collateral taker fulfils its obligation under paragraph 2 by transferring the collateral securities before the relevant obligations have been fully discharged, its rights in respect of such securities are upheld. More specifically, paragraph 3 states that the collateral securities transferred are subject to the security interest under the relevant security collateral agreement, in the same manner as the original collateral securities and with retroactive force. Moreover, the securities are also in all other respects subject to the terms of the relevant collateral agreement. This means, for example, that the collateral taker may exercise its right of use in respect of the collateral securities transferred under paragraph 2.

34-4. Article 34(4) makes it clear that the rights of the collateral taker under the security collateral arrangement is not rendered invalid or unenforceable as a result of the exercise of the right of use.

II. History

34-5. Like the issue of enforcement, the “right of use” has been within the scope of the project as of its very start (see Study LXXVIII – Doc. 1, sections 10 and 11), and features in the first preliminary drafts produced by the Study Group (see Study LXXVIII – Doc. 13, p. 13 and Study LXXVIII – Doc. 18, p. 12-13). For the Study Group’s explanatory notes to the initial right of use provision, see Study LXXVIII – Doc. 19, p. 35-36.

34-6. At its first session, the CGE specified the kind of securities or other assets that a collateral taker is obliged to transfer to the collateral provider upon exercise of the right of use (see Study LXXVIII – Doc. 24, Appendix 1, p. 17).

34-7. During its second session, the CGE envisaged a right of use which would arise automatically upon credit of securities to the account of a collateral taker. Moreover, the paragraph on the right of use and enforcement was moved to the article on enforcement. See Study LXXVIII – Doc. 42, Appendix 1, p. 18 and Study LXXVIII – Doc. 43, sections 149-154.

34-8. During the third session of the CGE, the automatic right of use inserted during the third session was deleted. Moreover, it was emphasised that the provision relates to security interest collateral agreements only. In addition, a new definition of “equivalent collateral” made it possible to simplify the right of use provision. See Study LXXVIII – Doc. 57, Appendix 1, p. 19 and Study LXXVIII – Doc. 58, sections 118-120 and 187.

34-9. During the fourth session of the CGE no substantive changes were made to the provision.

See Study LXXVIII – Doc. 94, Appendix 1, p. 17.

34-10. During the first session of the diplomatic Conference, the only substantive change made was the deletion of the square brackets in paragraph 2.

III. Analysis

34-11. Certain laws already authorise, to a certain extent, the use by a collateral taker of assets given as collateral under the terms of a security collateral agreement. According to these laws, the parties may agree to derogate from the prohibition against the collateral taker disposing of the assets given as collateral, that is, specifically, against disposing of collateralised assets. The purpose of Article 34 is to offer a more precise framework and protection for reusing securities given as collateral, in order to avoid any possible negative impact on market liquidity and thereby promote a sound “rehypothecation” market, where securities given as collateral remain available in the market place. In addition, permitting the use of securities which are subject to a security interest may lead to the reduction of the cost of secured finance for the debtor. Thus, the right of use is recognised in all situations where securities are given as collateral, for instance, in traditional collateral transactions or in prime brokerage arrangements.

34-12. Paragraph 1 of Article 34 confirms that if and to the extent that the parties to a security collateral agreement so agree, the collateral taker has the right to use the collateral securities as if it were the owner of them. In other words, the collateral taker may sell those securities, lend them, use them as collateral or perform other similar legal actions (namely, any act of “disposal”), on the condition explained below. The right of use may be granted in the context of, for example, securities lending, repurchase and derivatives transactions, or prime brokerage arrangements.

34-13. Paragraph 2 imposes on the collateral taker the obligation to return equivalent collateral or other assets if so provided in the agreement, by the time of the discharge of the secured obligation. Specifically, where the collateral taker exercises its right of use, paragraph 2 obliges the collateral taker to replace the collateral securities originally delivered (the "original collateral securities") by delivering equivalent collateral to the collateral provider, not later than the discharge of the relevant obligations. Alternatively, where the security collateral agreement provides for the delivery of other assets following the occurrence of any event relating to or affecting any securities delivered as collateral, the collateral taker is obliged to deliver those other assets. An example of such an event is the extinguishment of shares as a result of a merger of the issuer company.

34-14. If an enforcement event occurs while any obligation of the collateral taker to deliver equivalent collateral (equivalent securities or “other assets”) under a collateral agreement remains outstanding, Article 33(2) applies. In such situation, the collateral taker's obligation to deliver

UNIDROIT 2009 – CONF. 11/2 – Doc. 5 – Article 35 153.

equivalent collateral and the relevant obligations may be subject to a close-out netting provision. If the value of the equivalent collateral which should have been delivered is higher than that of the relevant obligations, the collateral provider may suffer a loss.

EXAMPLE 34-1: A credit line was granted by bank X to company Y, and Y received an advance of amount 100, repayment of which is due on D+90. As collateral for the sums advanced in this line of credit, X was granted a pledge of securities credited to Y's securities account maintained by intermediary Z. The portfolio of pledged securities consists of bonds issued by company M and of shares issued by companies P, Q and R in equal proportion and for the total value of 120. The collateral agreement stipulates that the creditor/pledgee may use the pledged securities and lays down the manner in which equivalent securities are to be returned.

On D+25, X uses, of the securities pledged, securities consisting of shares for the value of 90, and lends them out to one of its customers. At the latest on D+90, X must, in accordance with the collateral agreement, return equivalent securities, to Y. Once equivalent securities are back in Y's securities account, they will serve as collateral as if there had been no interruption relating to the pledged securities. Should X fail to return equivalent securities to Y's securities account by D+90, the value of the collateral, calculated according to the close-out netting provision set out in the collateral agreement, will be applied to the advance of 100 (i.e., the amount of credit extended by bank X).

If all the 120 securities have been disposed of by X on D+25 and X fails to return equivalent securities, Y is left with a contractual net claim of 20 (after 100 is netted out).

34-15. Paragraph 3 sets out the principle that collateral securities delivered under paragraph 2 follow the same legal regime as the securities initially given as collateral. By explicitly stipulating this subrogation, the provision prevents, among other things, the possibility of a challenge based on the assertion that this is new collateral and a security interest in it has become effective at the time of the delivery of it, for instance, for determining the priority of such interest.

34-16. Paragraph 4 explicitly provides that the use of collateral securities shall not render invalid any right of the collateral taker. The latter thus retains its rights, even if it temporarily no longer holds the securities that were initially given to him as collateral. The Convention thus neutralises the provisions of national legislation that often require that collateralised assets must remain in the possession of the collateral taker or of a person designated by the parties for this purpose (designated third party).

34-17. Finally, under Article 35, courts may be empowered, under the non-Convention law, to exercise a posteriori control of the conditions for valuing the collateral and the secured obligations.

Article 35

Requirements of non-Convention law relating to enforcement

Articles 32, 33 and 34 do not affect any requirement of the non-Convention law to the effect that the realisation or valuation of collateral securities or the calculation of any obligations must be conducted in a commercially reasonable manner.

Commentary

I. Introduction

35-1. The non-Convention law may contain a standard of commercial reasonableness where a right in respect of collateral securities is enforced or where the obligations between the parties are calculated. Such a standard is upheld under Article 35 in the event of enforcement under Article 33 and the calculation of obligations under Article 34.¹⁰

II. History

35-2. The requirement to act in a commercially reasonable manner has been in the Convention since its first preliminary draft was presented by the Study Group (see Study LXXVIII – Doc. 13, p. 13 and Study LXXVIII – Doc. 18, p. 12), but originally it was part of the provision on enforcement.

35-3. At the first session of the CGE, the draft provision was refined. In particular, it was made clear that the requirement to act in a commercially reasonable manner is optional to Contracting States (see Study LXXVIII – Doc. 23 rev., section 174 and Study LXXVIII – Doc. 24, Appendix 1, p. 17).

35-4. During the second session of CGE, no substantive change to the provision were made.

35-5. At its third session, the CGE decided that the provision relating to commercial reasonability should no longer be part of the enforcement provision, but should be a separate article. As such, the provision could not only be applied to the enforcement provision (then: Article 28), but also to the enforcement section of the new article relating to the recognition of title transfer arrangements (then: Article 27) and to the calculation of obligations in the event of a right of use (then:

Article 29). See Study LXXVIII – Doc. 57, Appendix 1, p. 20.

35-6. The CGE made no substantive changes to the provision at its fourth session. During the first session of diplomatic Conference, no substantive changes were made either.

III. Analysis

35-7. Articles 33 and 34 contain rules on enforcement and right of use, and the rights of a collateral taker under these articles apply despite any contrary rule in the non-Convention law. In order words, the non-Convention law cannot change Articles 33 and 34. However, Article 35 contains a restriction to this principle. Article 35 upholds requirements in the non-Convention law that the realisation or valuation of collateral securities or the calculation of any obligations must be conducted in a commercially reasonable manner even if it may result in some limitation of the collateral taker’s rights under Articles 33 and 34.

35-8. Article 35 itself does not provide what exactly the requirements are for acting in a

“commercially reasonable manner”. Such requirements are expected to be provided by the non-Convention law.

10 Note of the Editors: the reference to Article 32 is no longer correct since the reference to close-out netting provisions and their operation has been moved to Article 33 during the first session of the diplomatic Conference. The Editors have therefore suggested a revision of the Convention text. See CONF. 11/2 – Doc. 6, section 7.

UNIDROIT 2009 – CONF. 11/2 – Doc. 5 – Article 36 155.

35-9. Other requirements in the non-Convention law are not within the scope of Article 35. For instance, a requirement in the non-Convention law that obliges the collateral taker to give notice to the collateral taker prior to enforcement is not covered by Article 35 as such rule is not a requirement to ensure that realisation of collateral is conducted in a commercially reasonable manner. The same is the case with respect to, for instance, a requirement under the non-Convention law that a collateral taker is not permitted to realise collateral by appropriation. On the other hand, a requirement in non-Convention law that in case of appropriation the valuation of the securities may not differ from the current market price of the securities is a requirement covered by Article 35. Consequently, such requirement in the non-Convention law would apply even if the parties to the collateral agreement have explicitly agreed that the collateral taker can value the securities by the lowest market price within two weeks prior to the appropriation.

35-10. Finally, although this does not follow from Article 35, it should be noted that Articles 33 and 34 (and any other part of Chapter V) are subject to the rules of the non-Convention law on the rights with respect to restitutions, errors or lack of capacity. In other words, enforcement under Article 33 or an exercise of right of use under Article 34 does not preclude any claim based on the non-Convention law regarding restitutions, errors or lack of capacity.

Article 36

Top-up or substitution of collateral