USE OF CUSTOMER SECURITIES BY UK PRIME BROKERS: THE ROAD AHEAD

USE OF CUSTOMER SECURITIES BY UK PRIME BROKERS: THE ROAD AHEAD DERIVATIVES AND TRADING A. INTRODUCTION The subject of the right of use of customer securities under English law has been greatly in focus since the collapse in 2008 of Lehman Brothers International (Europe) (LBIE), the London-based arm of the failed US investment bank. LBIE, like its UK competitors, was an habitual user of customer assets and its prime brokerage customers were therefore exposed to its balance sheet as a result of such activity. The Legal Certainty Group, mandated by the European Commission to examine the dismantling of the barriers having legal issues at their source, advised in 2008 that EU legislation is needed in this area providing for a more harmonised legal framework for intermediated securities and a better protection of investors rights enshrined in their securities. The European Council invited the Commission to present its response to the Legal Certainty Group Advice as a matter of urgency, including an outline of proposed legislative measures, accompanied by precise timelines for their effective submission to the European legislator, bearing in mind the benefits of maintaining global compatibility with other jurisdictions. 1 Since then, the European Commission issued a wide-ranging consultation paper in 2010, with the title Legislation on Legal Certainty of Securities Holding and Dispositions. 2 The European Commission Services are currently preparing a draft Directive on legal certainty of securities holding and transactions. The Directive is expected to address three issues: (i) the legal framework of holding and disposition of securities held in securities accounts, covering aspects belonging to the sphere of substantive law as well as conflict-of-laws; (ii) the legal framework governing the exercise of investor s rights flowing from securities through a chain of intermediaries, in particular in crossborder situations; and (iii) the submission of any activity of safekeeping and administration of securities under an appropriate supervisory regime. 3 At a Member States Technical Working Group in November 2012, the Commission signalled its intention to possibly change the scope of its proposals to include, inter alia, client asset regimes and rehypothecation as regards arrangements for making it easier to identify who owns what securities. 1 http://ec.europa.eu/internal_market/financial-markets/securities-law/index_en.htm 2 http://ec.europa.eu/internal_market/consultations/docs/2010/securities/consultation_paper_en.pdf 3 This is according to the Commission s website: http://ec.europa.eu/internal_market/financial-markets/ securities-law/index_en.htm There has also been discussion amongst some participants in the financial markets as to whether any new European securities legislation should seek to provide increased protection to customers of financial services firms and more specifically whether such protections should include a limitation on the extent to which a financial services firm (such as a prime broker) is permitted to use customer securities. 4 The focus on the practice has therefore never been so sharp. It is hoped the views in this paper will contribute to the surrounding discussion. B. TERMINOLOGY SEMANTIC OR CONCEPTUAL CONFUSION? The term rehypothecation is employed widely in the global prime brokerage market. Its modern usage has its origins in the United States, within broker-dealer regulation applicable to prime brokerage business. The expression has since taken root in the City of London. Despite its wide use within the market as shorthand for the accepted practice of a financial services firm accessing and using a customer s securities, it is nevertheless a conceptually confusing label for English lawyers, as it does not necessarily describe what typically happens in practice. Hypothecation in English law, and by derivation rehypothecation, did not historically always involve a transfer of ownership. In modern practice it typically does. The International Swaps and Derivatives Association has been even more definitive: [T]he term rehypothecation is best avoided as its commercial meaning differs from its legal meaning, which can give rise to confusion Commercially, the term rehypothecation is generally used to signify any use of collateral by a collateral holder (including sale and repo) whereas its strict meaning is merely to repledge. 5 In the London prime brokerage market, the use of assets typically involves a prime broker removing securities from the customer s segregated custody account (where they had been subject to a mortgage or charge) and taking ownership or exercising a right of use as owner. 6 Arguments from some quarters that such a practice was contrary to certain equitable rules, e.g. the rule against a clog on the equity of redemption and the maxim once a mortgage always a mortgage, have been overcome as a result of the certainty afforded such arrangements under the Directive 2002/47/ 4 See, for example, the article published on the COOConnect website, a peer group network of COOs working in fund management: http://cooconnect.com/archives/4299 5 User s Guide to the ISDA Credit Support Documents under English Law, page 53 6 Either under a title transfer financial collateral arrangement or a security financial collateral arrangement with an accompanying a right of use - see the Financial Collateral Arrangements (No 2) Regulations 2003. For discussion of such arrangements in practice, see Re Lehman Brothers International (Europe) (No 2) [2009] EWCA Civ 1161

EC of the European Parliament and of the Council of 6 June 2002 on financial collateral arrangements, as implemented in the UK through the Financial Collateral Arrangements (No 2) Regulations 2003 and various subsequent amending and supplementing regulations. Focus on the vocabulary is not mere semantics. In the United States, an investor knows that despite rehypothecation of his assets, he has statutory protections through the customer asset protection rules whereby the rehypothecated assets are treated as part of his net equity claim upon the failure of the prime broker. Prime brokers regulated in the United States by the Securities and Exchange Commission have a right of rehypothecation which is capped at 140 per cent of the customer s debt. In relation to rehypothecated assets, the protection comes in the distribution priority afforded to customers with net equity claims. The amount of a customer s net equity claim in liquidation is the value of its customer long positions minus the value of its obligations. Under that particular regime, customers whose securities have been rehypothecated have the same priority as customers whose securities have not been. Therefore the customer of the SEC-regulated prime broker associates the expression with a certain level of protection. 7 To the non-lawyer, it is easy to equate use of exactly the same expression in the London market as attracting a similar customer asset protection regime as is present in the United States. But that assumption would be misplaced. In Englishlaw governed arrangements, with the transfer of ownership 8 on use of customer securities by a prime broker, the customer ceases to have a proprietary interest; the securities cease to be customer securities benefiting from regulatory protections. The use converts the status of the customer s claim. From having an interest in rem, the customer has a contractual right, in personam, to equivalent securities, thereby making the customer a potential creditor of the financial institution because the property becomes an asset of the financial institution s estate. Of course the customer would typically have the benefit of insolvency or contractual set-off so as to reduce that risk to a net risk. Rightly, on several recent occasions, English judges, regulators and legislators have steered away from the temptation to adopt the expression rehypothecation when the subject-matter has involved the right of use, as understood by the commercial community. 9 The discussion on vocabulary does not end there. Interestingly, in the context of a contractual right of use governed by English law, several prime brokers use the terms use and appropriate interchangeably, despite the fact that the first is really a tool and the second a remedy. When customer securities are used by a prime broker the customer has a corresponding receivable a claim for equivalent securities. In contrast, appropriation is a self-help remedy 10. In both cases, the collateral-taker acquires an indefeasible interest in the collateral. However, in the case of appropriation, the customer no longer has a contractual claim for equivalent securities because his claim is effectively notionally monetised and the value applied against his debt (the customer has a right to be paid the amount by which the value of the collateral exceeds the amount of the debt). The distinction is commercially important because, in the absence of a default, in the ordinary course of business a customer might expect some of its assets to be used, but would not expect its long securities positions to be subject to appropriation if the effect is that its profit and loss in those positions is crystallised and the value applied to eliminate its portfolio leverage. 11 C. THE COMMERCIAL AND LEGAL BASIS FOR USING CUSTOMER SECURITIES There is surely a commercial and legal basis for use of customer securities in certain circumstances, such as where the customer is receiving long- or short-side financing from the prime broker. Equally, there is surely a case in the context of English law-governed rights of use for exercising such a right in a proportionate manner. However, it does not necessarily follow from this that legislation, over and above bilateral contractual agreement, is required. To suggest otherwise implies that legislation is the saving supplement of contract, which doesn t say much for the law of contract. These views are examined below. 7 The US regime has its own challenges. For example, the account is valued at the close of business on the filing date of the liquidation proceeding. Obviously the market can move against the customer before distribution 8 In English property law the expression absolute ownership has no single, precise meaning, but it is in general used to refer to the quantum of an owner s interest, rather than to its character as legal or equitable ownership, per Lord Walker in Cukarova Finance International Ltd. v. Alfa Telecom Turkey Ltd. [2012] UKPC 20, at paragraph 33. Note that the transfer of legal and beneficial ownership may be technically unworkable in situations involving an intermediated chain holding of book-entry securities because the customer may be at the bottom of the chain see Pearson v Lehman Brothers Finance [2010] EWHC 2914. In such cases it is transferring its full ownership, consisting of equitable title 2 9 In the courts, the principal judgments relating to the collapse of Lehman Brothers International (Europe) where a right of use was part of the fact-pattern before the court, the court declined to adopt the term rehypothecation : Lomas & Ors v RAB Market Cycles (Master) Fund Ltd & Ors [2009] EWHC 2545; Re Lehman Brothers International (Europe) (No 2) [2009] EWHC 2141; Re Lehman Brothers International (Europe) (No 2) [2009] EWCA Civ 1161; Lehman Brothers International (Europe) v CRC Credit Fund Limited & Ors [2009] EWHC 3228; Lehman Brothers International (Europe) v CRC Credit Fund Limited & Ors [2010] EWCA Civ 917; Lehman Brothers International (Europe) v CRC Credit Fund Limited & Ors [2012] UKSC 6. Similarly, the Financial Services Authority has also declined to adopt the term, preferring the expressions right to use or right of use (e.g. see CASS rules 7.2, 9.2 and 9.3). Legislators too: the expression right of use is used in the Financial Collateral Arrangements (No. 2) Regulations 2003 10 Introduced by the Financial Collateral Arrangements (No 2) Regulations 2003 (which implemented Directive 2002/47/EC) 11 For a full analysis of appropriation see Cukarova Finance International Ltd. v. Alfa Telecom Turkey Ltd. [2012] UKPC 20; and Lord Millett, The Remedy of Appropriation Under a Share Mortgage (2008) 2 Law and Financial Markets Review 333

To the casual observer it is incongruous that, in the absence of a customer s default, a prime broker can on the one hand maintain a safekeeping account for the customer s securities and, on the other hand, access those securities for its own purposes. Once armed with securities and free of custodial obligations, the prime broker can use those securities as a funding tool to raise cash via the overnight repo market and other funding sources. In such circumstances, he would say: What is going on here? But there are in fact various justifications for the use of customer assets. A prime broker will wish to use customer securities to collateralise funding it obtains to support the customer s borrowings. More than that, a prime broker will want to use customer securities with a value in excess of the value of the loans extended to the customer (the precise ratio may be subject to negotiation), on the basis that to raise one pound or dollar in the money markets the prime broker will inevitably be required to post more than one pound s or one dollar s worth of assets to the payer of the cash leg of the repurchase agreement. When explained in these terms to the customer enquiring as to the justification for the value of securities used exceeding the amount of the debt, such explanation is routinely accepted. A customer whose securities have been used to fund his borrowings recognises there is a direct nexus between benefit and risk and accepts credit risk of the prime broker as the quid pro quo. The second justification is that use of customer securities enables the financial institution to fund its own proprietary business (rather than just customer accounts). When it comes to the institution s own business, the ability to improve access to cash enhances the institution s liquidity. There are counter-arguments to this as a business model but that is not for this paper. The third justification is that use of customer securities may in theory enhance cash and securities liquidity in the market. The fourth justification is that use of the securities of customer A, can allow a prime broker to cover the short sale of that security by customer B which assists liquidity for customer B and reduces the risk of naked short sales (and the prime broker makes a profit in the form of a lending fee under such an arrangement). Clearly some of the reasons for exercising a right of use listed above are necessary for the customer to implement its strategy, some may not be necessary but produce a commercial benefit to the customer and some have a less direct benefit to the customer but are justifiable as producing indirect benefits or benefits to the other clients of the prime broker, to the prime broker itself and/or to the market as a whole. For example, the more assets that can be used by a prime broker, the cheaper it can make borrowing costs for customers generally. D. LIMITING THE EXTENT OF USE But, in the context of English-law arrangements, should there be some limit on a prime broker s right to use customer assets? And how should any uniform limit be established? The answer to the first question is surely yes ; the answer to the second, it is suggested, is only with very careful consideration and, in any event, with great difficulty. If justification over and above common-sense is needed to arrive at the affirmative answer for the first question, it is perhaps illustrative to test the proposition by way of examples. Take the master of a ship transporting cargo in the eighteenth century. Mid-voyage the ship requires certain necessary equipment to enable completion of the voyage. The master does not have sufficient funds available and no other source of credit to fund the necessaries. In the absence of the owner of the cargo on the voyage and faced with the extreme difficulty of communication with the owner, can the master hypothecate (or indeed sell) the cargo, in order to obtain credit to fund the replacement equipment? There is an extensive specialist body of law in this area, mainly consisting of cases from the 1700s and 1800s, well-beyond the experience of the writer. At the risk of over-simplifying works in that specialist area, it appears that the courts kept the master on a tight rein and vested him with only a limited implied authority to hypothecate part of the cargo to the extent necessary to fund the necessary equipment to enable the vessel to complete the voyage. 12 The concept of proportionality is apparent. This is not easily translated into the modern context, other than to observe the starting point for the courts of the time: that the master was first and foremost a carrier of cargo, rather than a hypothecator. In the old shipping cases involving hypothecation there was typically no transfer of possession or ownership. The need for proportionality, in the writer s view, applies, a fortiori, where there is a transfer of ownership. 12 See, generally, the well-regarded treatise by the American lawyer, William Story: A Treatise on the Law of Contracts (5th Ed, 1874). With contracts of bottomry, the master of the ship could borrow money on the security of the ship s keel to finance completion of the voyage. Contracts of respondentia were the cargo equivalent 3

So to another example. Take the prime brokerage customer with no debt to his prime broker who permits the prime broker to use all of his securities held in custody. No collateral moves from the prime broker and no fee is paid for the privilege of use. That customer will struggle to identify the risk/reward if the prime broker becomes insolvent at a time when the prime broker has used 100,000,000-worth of securities, leaving the customer as an unsecured creditor of the prime broker (unless of course he had no real choice in the circumstances other than to use that prime broker on those terms). 13 On the question of how to arrive at a limit, there are two distinct options: contractual agreement or legislative prescription. 14 In reality, the vast majority of customers (typically hedge funds) accept the prime broker s contractual right of use, not only because of the commercial justifications but also because that is the way the prime brokerage world works. The business structures and investment strategies of certain hedge funds mean that the use of a prime broker is, for those types of funds, important, and the prime brokerage market generally operates on terms that require a right of use. Lord Justice Patten recently observed: Hedge funds do not have substantial back office functions of their own. They therefore require a third party to deal with the trades themselves and thereafter to provide custodial and reporting services. As part of these transactional arrangements, prime brokers such as LBIE lent cash and securities to the hedge funds and provided foreign exchange services. Any finance was usually secured against the assets of the hedge fund held by or through the prime broker. 15 However, it does not mean to say that limits on a right of use cannot be agreed contractually. Indeed they are commonly agreed. Hedge funds are generally alive to the existence of a right of use and the risks associated with such a right. If they are not, they are made aware of the risks. A prime broker acts in several capacities. Two of these capacities are of particular note. It is a custodian of customer securities. But it is also a lender of cash and securities to the customer (the typical 13 Total transfer of title arrangements have existed see the observations of Briggs J at first instance In the Matter of Lehman Brothers International (Europe), Lomas and others v. RAB Market Cycles (Master) Fund Limited and others [2009] EWHC 2545 para 8 14 Some jurisdictions impose limits on rights of use on certain types of funds established in those jurisdictions, e.g. Ireland, which prime brokers need to adhere to as a condition of the fund doing business with the prime broker. These jurisdictions do not include the Cayman Islands, where a large proportion of hedge funds are established 15 Re Lehman Brothers International (Europe) (No 2) [2009] EWCA Civ 1161 para 2 customer is a hedge fund either wishing to lever its long investments through borrowing money and/or to borrow securities to cover its short sales). It is in its capacity as a lender that the prime broker has a second relationship to the securities: that of user. There is an inherent but recognised potential conflict of duty and interest here. On the one hand, the prime broker, as a custodian and nominee shareholder of securities beneficially owned by the customer, is obliged to act in the interests of the customer with respect to those securities, subject to its rights as a secured lender. On the other hand, the prime broker has an interest in removing the securities from custody and using them to raise finance, as a potentially deeper and cheaper alternative pool of funding to its own treasury reserves. This is not entirely self-serving as the customer receives the commercial benefit of cheaper financing. It follows that if it is to use the securities for its own account (and make profit from such use), the prime broker is obliged to obtain the informed consent of the customer. This is typically achieved by disclosure to the customer 16, who consents by signing the prime brokerage contract. With knowledge of the risks arising when a right of use is exercised, hedge funds may wish to limit, by contract, the extent of the right of use and often seek to do so. As with any commercial negotiation, any cap is entirely a matter for the two parties and many factors will come into play in arriving at an agreement. F. USE OF CUSTOMER SECURITIES: BEYOND CREDIT RISK Does the exercise of a right of use bring with it risks to the customer other than counterparty credit risk? Indeed it does. On the prime broker s insolvency, the customer may not have upto-date information as to which securities were used and which were not. This creates uncertainty when it comes to valuing the customer s portfolio (which it needs to do for investors) and managing its investments (e.g. the hedge fund may not know whether its bond, which was being held as part of an arbitrage against a short swap, still exists in its portfolio or not, and therefore whether the arbitrage exists or whether the fund is now directional). New FSA Rules impose on prime brokers an obligation to provide transparency reports, incorporating the value of collateral where the firm has exercised a right of use. 17 However, this is provided on a next-day basis and does not reveal the specific securities used (only their value). 16 Usually a term of the contract but now supplemented by a regulatory obligation to make disclosure, including detailing the key risks: see FSA CASS rule 9.3 17 FSA CASS rule 9.2(3)(c) 4

A customer of an insolvent prime broker would presumably therefore say that something more is needed. Customer accounts typically do not show a debit corresponding to use of the particular security by the prime broker. This is on the basis that in the absence of the prime broker s insolvency and even though the customer s risk changes, as a business matter the customer would regard its balance sheet as unaffected given that it has a receivable for equivalent securities. A customer needs to know, in one place, what its portfolio composition is, whether in the form of proprietary positions or contractual receivables so, commercially, consolidated reporting makes sense. Subject of course to what is operationally achievable, in the writer s view the customer accounts should continue to show the used positions, but with an annotation that they have been used. This would allow the prime broker to provide the customer with the information it needs as to its total assets and liabilities (with assets comprising proprietary positions and contractual receivables) but also enable the customer to identify what positions are at risk. G. CONCLUSIONS Some thoughts, by way of conclusion: 1. There is a sound legal and commercial basis for proportionality when it comes to the extent of the right of use of customer assets. This is often expressed by way of contractual limitation through an agreed cap. 2. When it comes to caps, one-size does not fit all. The precise ratios of customer debt to value of securities used may vary customer to customer for a variety of reasons, including the fundability of the particular customer portfolio. For example, a prime broker accessing a very liquid and easy-to-fund hedge fund portfolio, where the securities used for repurchase are not subject to significant haircuts, will not need as many assets by value to raise finance as the prime broker accessing a very illiquid portfolio. 3. Contract allows for the flexibility required to address these variables; a hard-coded regulatory cap would be inconsistent with the conclusion above. If there was such a cap, applied across the board, it would therefore need to err on the side of allowing more rather than less, and therefore away from the direction of customer protection, if the commercial justifications for use were to still be achievable. A one-cap-fits-all approach may therefore end up benefitting some sections of the hedge fund market and harming others, particularly those who may otherwise have negotiated lower caps. For that reason, any regulatory cap should be expressed as a maximum amount, so as to give the parties scope to negotiate a lower amount. 4. It would be clumsy to simply follow the 140 per cent cap in the United States because that is set against a specific framework that allows for rehypothecated securities to form part of a customer s net equity claim. A similar regime is not in existence in the UK. 5. If the market is capable of agreeing caps bilaterally, would the additional cost and time needed to implement a regulatory cap (which would include building logic into prime brokerage asset sweeping systems) achieve a great deal? 6. Operational challenges duly acknowledged, annotations on customer accounts against specific security lines, to indicate whether they have been used and, if so, in what proportion, would be a useful risk management tool for hedge funds. CONTACT DETAILS If you would like further information or specific advice please contact: DANIEL HARRIS 18 DD: +44 (0)20 7849 2408 daniel.harris@macfarlanes.com MARCH 2013 18 Solicitor-at-law. The views expressed are the writer s and do not necessarily represent the views of Macfarlanes LLP. Nothing in this paper shall constitute legal advice and it may not be relied upon as legal advice. The writer is grateful for the thoughts of Damian Morris, General Counsel EMEA, ICAP plc and Lord Millett, on an earlier draft. Any errors are entirely those of the writer This article was first published in the March issue of Law and Financial Markets Review. MACFARLANES LLP 20 CURSITOR STREET LONDON EC4A 1LT T: +44 (0)20 7831 9222 F: +44 (0)20 7831 9607 DX 138 Chancery Lane www.macfarlanes.com This note is intended to provide general information about some recent and anticipated developments which may be of interest. It is not intended to be comprehensive nor to provide any specific legal advice and should not be acted or relied upon as doing so. Professional advice appropriate to the specific situation should always be obtained. Macfarlanes LLP is a limited liability partnership registered in England with number OC334406. Its registered office and principal place of business are at 20 Cursitor Street, London EC4A 1LT. The firm is not authorised under the Financial Services and Markets Act 2000, but is able in certain circumstances to offer a limited range of investment services to clients because it is authorised and regulated by the Solicitors Regulation Authority. It can provide these investment services if they are an incidental part of the professional services it has been engaged to provide. Macfarlanes March 2013