A year in finance

Nick Grandage and Daniel Franks of Norton Rose Fulbright discuss major developments over the last year in finance law.

Regulation

Daniel: In a word, regulation. While increased regulation has affected all financial markets (most notably, European Market Infrastructure Regulation and Dodd-Frank in the context of over-the-counter derivatives), the repo markets are finding themselves at the centre of a range of regulatory initiatives.

Some of the regulatory reform is aimed specifically at repos or, to be more precise, at the ‘shadow banking’ sector which regulators are concerned has the potential to be of systemic importance while previously having been subject to less regulation. For example, the Securities Financing Transactions Regulations require for the first time the mandatory reporting of repos (and other transactions), with a view to promoting transparency in the market. They also seek to impose certain limits on rights of reuse over collateral, which has caused much debate given how fundamental such a right is in the financial markets (thankfully, the final draft appears to adopt an approach that is somewhat more consistent with the way in which the markets operate).

Basel III and Capital Requirements Directive IV/Central Securities Depositories Regulation (CSDR) have also had an impact on the profitability (and feasibility) of repos, to such an extent that some market participants have been looking carefully at the way in which they use repos, and whether they can be profit centres in their own right or simply support other businesses of the institution.

Other types of regulatory reform appear to have caught repos inadvertently – there was some debate when the first draft of the CSDR was published as to whether the mandatory buy-in rules were intended to capture repos, rather than simply spot sales of securities. Again, this has required institutions to look at the way in which the repo model works, and to adapt accordingly. Some have also questioned whether pre- and post-trade transparency for repos under Markets in Financial Instruments Directive II/MiFIR is deliberate and appropriate.

Whether for better or worse, there is still more to come – we still await regulations for the mandatory imposition of minimum haircuts, which will again put repos in the spotlight.

Regulatory developments driving change to transactional documents

Nick: Building on Daniel’s point above, a number of regulatory developments have led to changes in transactional finance documents. Sanctions have been important again this year, and it is hard to see that changing. EU and US sanctions relating to Russia have been implemented, and there have been developments in relation to Iranian sanctions. The Bank Recovery and Resolution Directive will drive changes to contractual wording in relation to the bail-in provisions, in particular where contracts are governed by non-EU law.

‘The repo markets are finding themselves at the centre of a range of regulatory initiatives.’

Daniel Franks, NRF

Developments in law relating to contractual provisions of sale contracts

There has been a lot of discussion this year in relation to the manner in which commodity repurchase transactions are structured as well as related warehousing issues. Part of that has been analysis of the true sale nature of such transactions as well as whether delivery of goods can take place when a third-party holder of the goods confirms that it holds them for the new owner. In particular, is that a mandatory provision or can the parties contract out of it? We have also had important Supreme Court decisions relating to the determination of damages for breach and in relation to penalty clauses. The latter decision will bring greater certainty to commercial contracts and provide comfort to financiers in a number of areas such as project finance. English law has until now outlawed clauses providing for penalties on breach of contract, unless the amount was a genuine pre-estimate of loss. That test has changed, so that now the test is whether the provision is out of all proportion to the legitimate interest of the innocent party. I think that will make the law in a number of areas, such as take or pay contracts, clearer.

Supply Chain Finance

In relation to receivables, the government announced that it would go ahead and change the law so that contractual provisions prohibiting assignment of invoices would be ineffective. That’s good news for small-and-medium-sized enterprises and others looking to raise finance against invoices, but does raise questions as to whether the law should restrict parties’ freedom of contract. We await the detailed provisions, as we anticipate from the consultation that the proposed law will, like many, have some unintended consequences. What it does mean is that some structured financing transactions involving true sales of receivables will be more robust.

The interaction with accounting

We’ve noticed that there is an increasing tension between legal rules and accounting treatment in relation to the balance sheet treatment of certain structured financings, where there is tension between the legal analysis of a true sale transaction and whether the accounting is consistent with that.

Finally, as we have touched on the subject of true sales at a number of points in this article, and written a book about the law and practice of true sales, it would be useful to explain the concept in a nutshell.

It’s a concept primarily of importance in structured financings like securitisations and receivables purchases. It relates to the possibility that the courts will treat a purported outright sale as an attempted secured loan, and recharacterise the transaction. There is a body of case law in respect of a number of financing structures, but it is an area that is often treated with a level of wariness by commercial entities that perhaps it doesn’t deserve. Hopefully we have clarified the law that there is.