Part 5	
Financial collateral
Introduction
5.1	This Part of the report deals with security (charges and pledges) over ‘financial collateral’. We use the phrase ‘financial collateral’ in, broadly speaking, the way it is used in the European Directive on Financial Collateral Arrangements (‘the Financial Collateral Directive’ or ‘FCD’) and the Financial Collateral Arrangements (No 2) Regulations 2003 (‘FCAR’) which implement the Directive. 
5.2	The FCD provides that when financial collateral subject to a ‘security financial collateral arrangement’ (that is, a mortgage, charge or pledge) has been ‘provided’ in such a way as to be in the ‘possession or control’ of the ‘collateral-taker’, formalities such as registration cannot be required in order to render the arrangement enforceable.
5.3	The FCD also requires, in outline, that certain remedies must be available (unless otherwise agreed) and remain so notwithstanding winding-up or re-organisation of either party; that agreed rights of use must be available; and the arrangements must be exempted from certain effects of insolvency law. These aspects of the FCD are not affected by the draft Company Security Regulations. 
5.4	The FCD and the FCAR apply to various forms of investment securities (termed ‘financial instruments’) and to ‘cash’. It is helpful to explain at the outset what is meant by these terms, as our scheme’s provisions on financial collateral apply only to security over these assets and certain other forms of what we call ‘investment property’.
Investment securities
5.5	Investment securities such as shares or debt securities fall into three types:
(1)	certificated bearer securities (such as bearer shares or bearer bonds). These are a form of negotiable instrument, transferable simply by delivery;
(2)	certificated, registered securities (for example shares for which the company has issued paper certificates). These are not negotiable. Transfer of the legal title requires that the person acquiring the security is entered as the owner on the issuer’s books; and
(3)	uncertificated securities, for which no paper certificate is issued. Trades of uncertificated securities issued in the British Isles are settled electronically through the CREST system. The name of the direct holder of the securities is entered on both the CREST (‘operator’s’) and the issuer’s registers. For UK companies it is the entry in the operator’s register that confers legal title.
5.6	If the investor has possession of a bearer security, or if the investor is shown on the issuer’s or on the CREST register as being entitled to the securities, it holds ‘directly’. Alternatively, any of the securities may be held by the investor ‘indirectly’, for instance where a stockbroker or other intermediary holds shares for an investor whose entitlement is recorded on the books of the intermediary. (The FCD refers to indirect holdings as ‘book entry securities’.) There will be an indirect holding where, for example, 
(1)	the physical certificates for shares are ‘immobilised’ by being deposited with a custodian, and the intermediary with which the investor has its account holds the shares through the custodian, or through the intermediary directly above it in the chain; or 
(2)	the intermediary is registered as the holder of an uncertificated security but holds for the person (the investor or a lower-tier intermediary) shown in its books as the account holder. 
5.7	Each kind of directly-held investment securities, and indirectly-held investment securities, are dealt with in the draft regulations in Appendix A to this report. Different provisions apply to each type, because the practical methods by which a chargee may obtain ‘control’ over each type differ. We will see below that in our scheme directly-held securities are termed ‘financial instruments’, whereas indirectly-held securities come within the phrase ‘financial assets held with an intermediary’. 
‘Cash’
5.8	In this context cash does not have its everyday meaning of hard currency. It is defined as ‘money in any currency, credited to an account, or a similar claim for repayment of money and includes money market deposits’. Thus a typical form of cash is a bank account.
Other forms of investment property
5.9	The scheme also applies to other forms of ‘financial asset’ that are held through an intermediary. An example is rights under a commodity futures contract, a commodity futures option or other similar contract. Financial assets held with an intermediary and financial instruments are termed collectively ‘investment property’.
General objectives
5.10	As we said in the CR: 
Shares and other forms of investment property are of enormous importance as collateral. Convenient and legally robust financial collateral arrangements are crucial to the effective functioning of the wholesale financial system. Companies have very large holdings of various kinds of investment property and need to be able to use them as security, and to do so with confidence that the legal position will reflect accurately proper commercial practices and reasonable commercial expectations. In particular the law must accommodate the fact that much investment property is now held in dematerialised form. The law should make it clear how lenders may take security and, where there is a contest between different SIs [security interests] or other interests over the same assets, what the rules of priority are. At the same time the law must not hinder trading in investment securities. Thus there must be ready mechanisms that suit the needs of the various parties:
(1)	secured parties should be able to take effective security without the need to file; 
(2)	both potential secured parties and potential buyers should be able to take security over/buy the collateral without the need to search, confident that they will not be subject to SIs of which they are not aware; and
(3)	debtors (so far as compatible with the relevant settlement systems) should be able to continue to deal with the investment securities.
5.11	Consultees supported these general objectives strongly.
Our proposals on consultation
The proposals
5.12	In CP 164 we explained that Revised Article 9 of the UCC provides a special method of perfecting charges over securities and bank accounts. This is particularly to deal with charges over securities and other investment property held indirectly. The secured party may perfect by taking ‘control’ of the debtor’s securities entitlement. A similar approach is applied to security over bank accounts. We pointed out that the (then) proposed directive on financial collateral was likely to prevent national laws from requiring registration of charges over such ‘financial collateral’ that is ‘in the possession or under the control of’ the secured party. We provisionally proposed that we should apply the same rules to charges over bank accounts and shares, but asked whether control should be the only method of perfection in both cases.
5.13	The responses to CP 164 and subsequent discussion suggested that there was quite wide support for bringing charges over investment property and bank accounts within our scheme but permitting ‘perfection’ by control or by registration as alternatives. Therefore in the CR we developed a scheme based on Articles 8 and 9 of the UCC and proposals for similar reform in Canada. The scheme was intended to be compatible with the Financial Collateral Directive, which by then had been adopted and implemented by the FCAR. It sought to define what amounts to ‘control’ for the purposes of the FCAR (which gives only a partial definition); and to provide clear rules on the priority of charges between themselves and as against innocent purchasers of the property in question. 
Responses to the CR scheme
5.14	Of those who commented on the issue, a large number (including the Financial Law Committee of the City of London Law Society and thus, by implication, those who adopted the Committee’s paper) supported our attempt to define ‘control’ for the purposes of the FCAR. 
5.15	There were, however, a number of criticisms directed to particular issues. Some were directed at the proposed statement of rights and remedies. Another concern was that ‘title transfer financial collateral arrangements’ such as ‘repos’ might be caught by the scheme. As we are no longer recommending that a statement of rights and remedies be included in the companies-only scheme, the issue becomes at least temporarily moot. Similarly, as we are no longer recommending that the companies-only scheme should contain a broad definition of a security interest that would include title-retention quasi-securities, there is no reason to bring title transfer financial collateral arrangements within the scheme.
5.16	Other points made by respondents remain very relevant; for example, that we had not covered every aspect of the CREST system for settlement of uncertificated securities; that the test we were proposing for ‘control’ over bank accounts was unnecessarily demanding; that we had dealt only with bank accounts and not other forms of ‘cash’; and that commodity contracts were not treated adequately. We accept these criticisms. Below we set out our detailed recommendations, and we explain how we have revised the draft regulations to meet the points made.
Further analysis
5.17	Other aspects of our scheme received very positive support, in particular our aim of providing a definition of ‘control’ for the purposes of the FCAR and our recommendations for control over investment property. However, our own further work has led to some changes in these recommendations. The scheme we now recommend is less ambitious than that envisaged by the CR. Nonetheless we have managed to keep its essential features, so that the draft regulations and our report will provide those taking financial collateral with clearer guidance on what steps should be taken if a charge is to be effective in the debtor’s insolvency. They will also provide clearer rules on the priority of a charge as against another charge or the interests of a person who has bought the financial collateral.
5.18	We have also aligned the terminology of the draft regulations with the terminology of the FCAR and the Hague Convention on the Law Applicable to Certain Rights in respect of Securities held with an Intermediary. For example, the regulations now refer to ‘financial instruments’ rather than ‘securities’ and to ‘assets held with an intermediary’ rather than ‘securities entitlements’. This will make the regulations easier to understand by those familiar with the other instruments.
summary of our recommendations on security over financial collateral
5.19	The special provisions we recommend for financial collateral have three principal aims: 
(1)	to clarify, so far as possible, when a charge over financial collateral does not need to be registered in order to be effective in the debtor company’s insolvency (broadly speaking, this will be when the chargee has ‘control’ of the collateral); 
(2)	to establish clear rules of priority for competing charges over financial collateral (which depend largely on whether, and at what date, the chargee obtained ‘control’); and 
(3)	to provide clear rules on when a purchaser of investment property who did not know of a charge over it, or that the disposition was in breach of that charge, will take free of it. 
5.20	The scheme may be summarised as follows: 
(1)	A charge over a company’s financial collateral will be effective in the company’s insolvency if the chargee has obtained control (as defined in our draft regulations) or has ‘possession or control’ of it within the meaning of the FCAR; or if the charge has been registered.
(2)	The regulations set out the methods by which the chargee may obtain ‘control’ over different types of financial collateral, and also provide a general test of ‘control’ to cover situations not currently envisaged. The basic principle, which is reflected in the general test, is that the chargee will have control if the debtor company is no longer able to dispose of the collateral free of the chargee’s interest or so as to give a purchaser an interest ranking in priority to that of the chargee. In addition, and in each case set out below, the arrangement must be evidenced in writing (as required by the FCAR).
(3)	A chargee may obtain ‘control’ within the meaning of the regulations in the following ways:
(a)	with certificated financial instruments in registered form, 
(i)	by taking possession of the certificate, or 
(ii)	by being registered as the holder;
(b)	with directly-held uncertificated financial instruments, if
(i)	the operator of the system, on the instructions of the registered holder, has credited the financial instrument to a sub-account in the holder’s own name but the holder has given the chargee a power of attorney over the financial instrument,
(ii)	the operator of the system is only permitted to effect a transfer of title to the financial instrument on the instructions of the chargee or a person acting on the chargee’s behalf and attributable to the debtor, or
(iii)	if the chargee is entered in the relevant register as the holder;
(c)	if the debtor’s interest is in financial assets held with an intermediary: 
(i)	if the assets are transferred to an account held by the chargee,
(ii)	if the intermediary has been given notice of the assignment by way of mortgage or of a fixed charge, or, where necessary, has agreed that the debtor will no longer be able to deal with the collateral without the agreement of the chargee; or 
(iii)	if the chargee is itself the debtor’s intermediary.
(4)	With certificated financial instruments in bearer form, a secured party (who in this case will be a pledgee) will have control if it has obtained possession of the certificate.
(5)	With a bank account or other forms of ‘cash’ within the meaning of the regulations, a chargee will have control:
(a)	where the chargee is the bank or other ‘cash debtor’ itself, without more; or
(b)	where the chargee is a third party, 
(i)	if the bank or other cash debtor has been given notice of the assignment by way of mortgage or of a fixed charge, or, where necessary, has agreed that the debtor will no longer be able to deal with the collateral without the agreement of the chargee; or
(ii)	if with the agreement of the parties the ‘cash’ is transferred into the chargee’s name.
(6)	As between competing charges over the same financial collateral, a chargee who has obtained control will take priority over a chargee who does not have control, whether or not it had given value and whether or not it knew of the prior interest. If both chargees have obtained control, priority will (unless agreed otherwise) be in the order that they obtained control. This would be without prejudice to the rights of purchasers of investment property, below. 
(7)	A purchaser (including a mortgagee) who gives value for investment property and who does not know that the disposition to it is in breach of the terms of a charge will take free of the charge if:
(a)	in the case of a certificated financial instrument in registered form or an uncertificated financial instrument, the purchaser is registered as the holder, or 
(b)	in the case of a financial asset held with an intermediary, the financial asset is transferred into an account in its name. 
Scope of the provisions on financial collateral
5.21	The provisions on financial collateral apply to ‘financial instruments’, ‘cash’ and other forms of ‘investment property’ held with an intermediary. 
‘Financial instruments’
5.22	In our scheme, ‘financial instruments’ refer to directly-held securities. The draft regulations use the term ‘financial instruments’, rather than ‘securities’, to align the terminology of the scheme with the FCAR. 
5.23	The CR used ‘security’ (in the singular) and included a definition derived from the UCC. There were concerns that it might not cover the same range of investment property as is within the definition of ‘financial instrument’ in FCAR. In particular, there were doubts whether it would cover uncertificated ‘eligible debt securities’ and warrants entitling the holder to acquire shares. It was also said that units in collective investment schemes and depository interests were not necessarily ‘interests in the property … of an issuer’, because of pooling. The scope of our provisions should match that of the FCAR and therefore the definition should be the same. 
5.24	We think that if we are to follow the FCAR model, there would be an advantage in following it as closely as possible. This is why in the draft regulations we have replaced the word ‘securities’ with ‘financial instruments’. Although it may at first seem a little odd to refer to ‘certificated’ and ‘uncertificated financial instruments’, ‘certificated financial instruments in bearer form’ and so on, those we consulted told us that they would have no objection and favoured the resulting consistency with the FCAR.
5.25	The definition of ‘financial instruments’ in the regulations that we recommend in this report differs from the FCAR’s definition of ‘financial instruments’ in two respects. First, it excludes indirectly-held securities. This is because under our scheme these, together with other forms of investment property that is held on the books of an intermediary, have to be distinguished from directly-held financial instruments because the tests for control over the various types of asset differ. Indirectly-held securities are covered by the more widely defined ‘financial assets.’ Secondly, it has a provision to include depository instruments and the like held in CREST. 
5.26	‘International’ securities may be held through CREST, if the relevant securities can be held in a settlement system with which CREST has a link. A CREST subsidiary (through a CREST nominee in the other settlement system) holds the underlying security. A CREST Depository Instrument (CDI) is issued. It was pointed out that this is constituted under English law as an uncertificated security. There may be other assets besides CDIs that should be treated similarly. Words have therefore been added to the draft regulations to ensure that any securities held in CREST are treated as directly-held securities.
5.27	We recommend that the regulations refer to ‘financial instruments’, reflecting the definition of ‘financial instruments’ in the FCAR with the qualifications that:
(1)	the definition should apply only to directly-held financial instruments, since indirect holdings are treated differently and are covered by other definitions, and
(2)	the definition should include CREST Depository Instruments and similar assets that are constituted as uncertificated securities.
Indirectly-held securities and other forms of investment property
5.28	The provisions on financial collateral apply to indirectly-held securities, and also to any other financial assets that are held with an intermediary.
5.29	Examples of financial assets that may not fall within the FCAR definitions of financial instruments or ‘cash’, but are within our scheme if they are held through an intermediary, are rights under commodity contracts (a commodity futures contract, a commodity futures option or a similar contract). These may be held in an account by a commodities broker or other intermediary and may be used as collateral in much the same way as other financial assets. In practice such rights normally represent a right to payment of differences and are thus roughly equivalent to ‘cash’ held in an account, though they may not fall within the FCD. 
5.30	The draft regulations in the CR dealt with commodity rights in separate provisions, but this was merely because doing so made it easier to compare the draft regulations on financial collateral with the provisions of the UCC, which deals with commodity contracts separately. We reported that the UCC does so only because in the United States commodities and securities are subject to a different regulatory scheme. We suggested that in our scheme the two types of collateral could be covered by the same provisions. Consultees agreed and commodity contracts now come within the definition of financial asset. Thus a charge over rights represented by an entry in the accounts of an intermediary may be perfected by taking control, and the same priority rules will apply as with cash. 
5.31	It is conceivable that an intermediary might carry on its books not just rights under commodities futures contracts but rights to a commodity itself, for example bullion that is held by the intermediary in its own name. The definition of financial assets is wide enough to cover this possibility. 
5.32	We recommend that rights under commodity contracts and to commodities held with an intermediary should be treated in the same way as other financial collateral.
‘Cash’
5.33	The regulations refer to ‘cash’, which includes money in a bank account, whereas the draft regulations in the CR applied only to bank accounts. It was pointed out that the FCAR apply not only to money that is ‘credited to an account’ but also to any ‘similar claim for money and includes money market deposits and sums due or payable to, or received between [the parties] in connection with the operation of a financial collateral arrangement or a close-out netting provision.’ Apparently such sums will not necessarily be credited to an account. We agree that they should be included within the scheme for financial collateral, and we recommend that the relevant provisions of our scheme should apply to ‘cash’ as defined in the FCAR. It is true that the FCAR definition is somewhat counter-intuitive, as the things that most uninitiated readers will think of as quintessential cash – currency and (possibly) cheques – are not within it. However we think that almost all readers of the relevant parts of our regulations are likely to be familiar with the technical meaning under the FCAR. 
5.34	Therefore the special provisions for financial collateral in our scheme will, like the FCAR, apply to ‘financial instruments’ and ‘cash’. The bank or other person who owes the cash is referred to as the ‘cash debtor’.
5.35	We recommend that the rules on control over financial collateral should apply to bank accounts and all other forms of ‘cash’ within the meaning of the FCAR.
Terminology and definitions 
5.36	We have already referred to many of the definitions of different types of financial collateral in explaining the scope of the provisions on financial collateral: ‘cash’, ‘cash debtor’, ‘certificated’ and ‘uncertificated financial instruments’, ‘financial asset’ and ‘investment property’. 
5.37	The terminology of the draft regulations relating to indirectly-held investment property has been altered to reflect the FCAR and the Hague Convention on the Law Applicable to Certain Rights in respect of Securities held with an Intermediary. By contrast, the terms used in the CR derived from revised Article 9 of the UCC. It was put to us that, since we are departing from the North American model in any event, it would be better to adopt the terminology that is more widely accepted in Europe. The terminology and the definitions used in the Hague Convention are particularly apt. We agree, subject to necessary adjustments being made to take account of the wider scope of our scheme.
5.38	Thus the new draft regulations refer to: 
(1)	an ‘intermediary’ in place of a ‘securities intermediary’;
(2)	‘financial assets held with an intermediary’ in place of the former ‘securities entitlement’; and
(3)	‘account holder’ in place of ‘entitlement holder’.
‘Securities account’ is retained but is now defined in terms that mirror those of the Hague Convention. 
5.39	It was also pointed out that some of the provisions of the CR draft regulations referred to a ‘securities account’ as if it were an asset in its own right, rather than a record of the account holder’s entitlement. On the other hand it is convenient to speak of a securities account as a way of designating the financial assets in the account. The new draft regulations do not list ‘securities accounts’ as a separate item of property but a control agreement in respect of financial assets held with an intermediary may refer to the particular assets or to the account in which they are held.
5.40	There was concern that the definition of ‘securities intermediary’ in the CR draft regulations was too wide and might catch not just intermediaries but also CREST. This is not the intention since there will be separate rules for control in the CREST system (which involves only directly-held securities) and for indirectly-held securities. The new draft regulations therefore adopt the FCAR’s definition of ‘intermediary’, which we were told was drafted by Treasury Counsel in the light of article 5 of the Hague Convention. This allows Contracting States to declare that operators such as CREST are not intermediaries for the purpose of the Convention.
5.41	We recommend that the regulations should use terminology that reflects that of the Hague Convention on the Law Applicable to Certain Rights in respect of Securities held with an Intermediary and the FCAR. They should refer to ‘financial assets held with an intermediary’ and ‘account holder’ and should define ‘securities account’ and ‘intermediary’ in ways that fit with the Convention and the FCAR.
‘Control’ of financial collateral and exemption from registration
5.42	A charge under which the chargee has ‘possession or control’ under the FCAR is exempted from any registration requirement under section 395 of the Companies Act 1985. Neither the FCD not the FCAR provide a precise definition of what amounts to ‘possession and control’ of financial collateral. Our aim in the CR was to provide a definition of what should amount to ‘control’ within the meaning of the FCAR, and clear rules to govern the priority of competing interests over financial collateral. The scheme that we provisionally recommended was based on the North American models. It applied a similar test of ‘control’ to both investments and bank accounts. On the one hand the secured party was treated as having sufficient ‘control’ to perfect its security interest if it had taken all the steps that it reasonably could to give itself the right to realise the collateral, or to appropriate it in order to satisfy the secured obligation, without any further act on the part of the debtor or any court order. On the other hand, in the cases of investments held with an intermediary and with bank accounts, the secured party who had obtained the right to realise the collateral would have control even though the debtor retained the right to deal with the collateral. 
5.43	Thus for investment property the draft regulations in the CR provided: 
an… intermediary enters into a control agreement with a purchaser if, with the consent of the entitlement holder, it agrees with the purchaser to comply with the purchaser’s instructions directing the transfer or redemption of the property in question without further consent from the entitlement holder, whether or not the entitlement holder retains the right to deal with the entitlement.
5.44	For reasons we will explain, comments from consultees combined with our own further analysis have convinced us, first, that the test of ‘control’ suggested in the CR is not compatible with the FCD and, secondly, that it is not possible to provide a definition of ‘possession or control’ for the purposes of the FCAR. We are able, however, to provide clear guidance on when a charge does not need to be registered. It will not need to be registered if the chargee has obtained ‘control’ within the meaning set out in the regulations. 
5.45	The issues are complex and require explanation in some detail. We begin by considering the possible meanings of ‘control’.
Forms of ‘control’
Positive control versus negative control
5.46	A chargee who has secured the agreement of the intermediary to comply with the chargee’s instructions without further consent from the entitlement holder has what we call ‘positive’ control. It enables the secured party to realise the collateral forthwith. This may be contrasted with having only the right to prevent the debtor from disposing of the collateral, which may be called ‘negative’ control. An example of negative control is when a chargee or other purchaser of a debt notifies the account debtor of the assignment or fixed charge. Provided that the agreement creating the debt does not contain a prohibition on assignment, the account debtor is now bound to pay the assignee/chargee, and will not be discharged if it pays the assignor or follows the assignor’s instructions in paying some other party. This has the effect that the debtor is deprived of the power to deal with the debt. 
5.47	The CR’s draft regulations provided a number of ways in which control could be obtained over investment property and bank accounts. All of them involved the secured party obtaining positive control. 
5.48	Among those who responded on the question, there was broad agreement that for bank accounts (and other forms of ‘cash’, which the draft regulations did not deal with) positive control should not be needed. In other words it should not be necessary, as the CR draft regulations provided, that the secured party either become the account holder or reach an agreement with the bank that it would comply with the secured party’s instructions without further consent from the debtor. It should suffice that the secured party had taken negative control by notifying the bank of its assignment or fixed charge. 
5.49	For investment property, however, there was general agreement that it was correct to require positive control. It was said that this was important in order to maintain the ready transferability of investment property.
Positive control without negative control
5.50	There was relatively little comment on the second aspect of the test of control on the CR’s draft regulations, namely that both for investment property and bank accounts the draft regulations, like the UCC, allowed for what we may call ‘positive control without negative control.’ In other words, provided the bank or intermediary had agreed to comply with the secured party’s instructions to transfer the funds or property without reference to the debtor, it did not matter that the debtor remained free to deal with the collateral. However, further work on our part has suggested that this may not be appropriate in the light of the FCD.
‘Possession or control’ under the Financial Collateral Directive
The requirements of the Directive
5.51	The FCD and the FCAR which implement it confer advantages, for example in insolvency, to financial collateral arrangements, provided that (among other things) the ‘financial collateral’ is:
delivered, transferred, held, registered or otherwise designated so as to be in the possession or under the control of the collateral-taker or a person acting on its behalf.
5.52	‘Possession or control’ is not defined in the FCD or the FCAR. In the case of indirectly-held investments (‘book entry securities collateral’), the matter is governed by ‘the law of the country in which the relevant account is maintained’ – in other words, by national law. There is no provision for that in the case of directly-held investment property, presumably because it was assumed that the traditional lex situs rule was adequate. Our initial analysis was that it was simply up to national law or the lex situs to define ‘control’, but we no longer think that is the case. We have to assume that the phrase has an ‘autonomous’ meaning in European law – in other words, its meaning must depend on interpretation of the Directive and general principles accepted in Community law - and that national law must comply with that meaning. We believe that the terms of the Directive itself, when read in the light of the recitals, show what is meant; and that this is ‘negative control’. 
5.53	Recital 10 states
This Directive must… provide a balance between market efficiency and the safety of the parties to the arrangement and third parties, thereby avoiding inter alia the risk of fraud. This balance should be achieved through the scope of this Directive covering only those financial collateral arrangements which provide for some form of dispossession, i.e. the provision of the financial collateral…
5.54	‘Dispossession’ suggests that, for the collateral to be in the ‘possession or control’ of the collateral taker, at least the collateral provider must be prevented (whether legally or practically) from dealing with the collateral. This is ‘negative’ control.
5.55	There are several situations in which there is simply no mechanism by which a secured party can ‘dispossess’ the debtor without at the same time acquiring positive control. The most obvious examples are the arrangements that are possible under the CREST system of settlement for uncertificated directly-held securities. There are three methods by which a secured party can effectively prevent the debtor from dealing with its holding in CREST: by taking the securities into its own name; by having them placed in an escrow account; or, in the case of a CREST settlement bank, by being appointed as the member’s ‘sponsor’. Each of these not only prevents the debtor from dealing with the securities but also gives the secured party the power to transfer or dispose of the securities without further reference to the debtor. There is no suggestion that in these situations the CREST arrangements are in any way inconsistent with the Directive, which was drafted with CREST in mind. But there is nothing in the FCD to suggest that ‘positive control’ is necessary in order for the chargee to have ‘possession or control’ within the meaning of the Directive.
5.56	In cases in which the two forms of control do not necessarily co-exist (leaving aside for the moment any restrictions imposed by the FCD) it would be possible to require either form of control. Take the case of indirectly-held investments. One possibility would be to say that a purchaser would not obtain control merely because it had blocked the debtor from dealing with the collateral by giving notice to the intermediary. The draft regulations in the CR took this approach. They stated that a purchaser (including a secured party) would have control only if it became the entitlement holder or if the intermediary had agreed to transfer the collateral on the purchaser’s order without further consent from the entitlement holder. This amounts to a requirement of positive control. An alternative approach would be to require that the chargee obtain negative control by blocking the securities account.
5.57	As consultees pointed out, in practice the secured party will want to obtain positive control if it can, so that it is in a position to realise the collateral without any delay. However, good practice is not necessarily the same as the requirements of the Directive. In the light of our further analysis we now believe that the Directive requires that a secured party who has blocked the debtor from dealing, but who has not obtained ‘positive control’, is treated as having ‘possession and control’ for the purposes of the FCAR. The secured party will thus qualify for the advantages conferred by the FCAR.
Control for purposes of perfection distinguished from control for other purposes
5.58	Consultees who argued for a test of positive control said this would preserve and enhance the ready transferability of investment property, and its easy use as collateral. We entirely agree with these general aims. However, we think that ready transferability involves different issues from whether a charge should be registrable, or should have the advantages offered by the FCAR in, for example, insolvency. Ready transferability affects questions of when someone who buys financial collateral that is subject to a security interest should take free of it, and of the priority of competing security interests over the same collateral. We will deal with these issues later.
Should ‘possession and control’ be defined at all?
5.59	In the light of the analysis we have just made, we were initially inclined to persevere in providing a definition of ‘possession or control’ for the purposes of the FCAR but to employ a negative control test for both financial instruments and cash. However, there are decisive arguments against attempting to do so. The meaning of the FCD is far from clear. There must be a risk that the European Court of Justice may one day determine that our interpretation was incorrect. If it happened that too narrow an interpretation by us had led to the advantages of the FCD being denied to secured parties who the Court decided were entitled to them, the consequences would be serious. 
5.60	We are loath to give up our aim of providing a definition for the purposes of the FCAR. We think it is in general very important that domestic measures implementing European legislation should give the parties clear guidance as to what is required. However, the correct interpretation of the FCD is particularly unclear. We have argued that a party who has not prevented the debtor from dealing with the securities does not have ‘possession or control’ within the meaning of the Directive, but we reached this conclusion only by interpreting the relevant articles of the Directive in the light of the recitals. 
5.61	We have therefore decided that we have to give up our original aim. The question whether collateral is ‘in the possession or under the control of’ the secured party for the purposes of the FCAR should be left to be determined in accordance with the FCD and FCAR. However, we hope that the analysis of the requirements of the FCD and the FCAR in the preceding paragraphs will be useful to those who want to know what is required.
5.62	What we are able to do is to provide a secured party who wishes to know whether or not it needs to register its charge over financial collateral with a ‘safe harbour’. The Directive does not require Member States to impose any requirements of registration or form on financial collateral arrangements under which the secured party does not have ‘possession or control’. What it does is to prevent Member States from imposing requirements when the secured party does have control. Therefore there is nothing to prevent our scheme from providing that, whatever the meaning of possession or control for the purposes of the FCAR, a party who has control as we define it does not have to file a financing statement in order for its charge to be effective in the debtor’s insolvency. 
5.63	For this purpose, we think that ‘control’ should be defined in the ‘negative’ sense. This is for two reasons. First, this is the sense of control that we believe to be required by the FCD. Secondly, we consider that this is the most appropriate test for questions of perfection, for the reasons set out in the next paragraph.
5.64	The reason for denying effect to a charge that has not been perfected by either filing or control is to make sure that unsecured creditors and other parties (including potential second secured parties) dealing with the company have a chance to discover the charge. We do not see that the existence of the charge will be more readily discoverable because it is the subject of an agreement between the chargee and the intermediary than it will be when the chargee has simply served notice on the intermediary. 
5.65	Thus we conclude that for the purpose of deciding whether a charge over financial collateral should have to be registered, the test required by the FCAR is one of negative control only. Positive control as well as negative control is not required and positive control without negative control is not sufficient. Our regulations should take the same approach. 
5.66	We would add that in practice whether ‘positive plus negative’ control or merely negative control is required may make little difference. With uncertificated securities, as we explained earlier, there is no way of obtaining negative control without at the same time obtaining positive control. With indirectly-held securities, the secured party will normally have to obtain the agreement of the intermediary in order to be sure that it has even negative control. This is because a mere notice of assignment or fixed charge will not be effective if the agreement between the intermediary and the account holder contains a prohibition against assignment or charge without the intermediary’s consent. In addition, the secured party will want if possible to obtain positive control, so that it is in a position to realise the collateral without delay. 
5.67	It is of course possible that a party who has merely taken steps that do not meet the tests set out in the draft regulations may also be held to have satisfied the requirements of the FCD. For example, the European Court of Justice might decide that a secured party who has obtained positive control without negative control is within the FCD. The secured party would then be entitled to the same advantages, including its charge being effective in the debtors’ insolvency though not registered. Whether a chargee wishes to take the chance that a more liberal interpretation of the FCD is correct is a matter for its legal and commercial judgement.
5.68	We recommend that a charge over financial collateral should be effective in the insolvency of the debtor although not registered before the onset of insolvency provided that either:
(1)	the collateral has been ‘delivered, transferred, held, registered or otherwise designated so as to be in the possession or under the control of the collateral-taker or a person acting on its behalf’ within the meaning of the FCAR; or 
(2)	the secured party has taken control as defined in our regulations, namely, if the debtor is no longer able to deal with the collateral without the agreement of the chargee or pledgee.
A general test of control
5.69	The draft regulations in the CR set out a number of ways in which the secured party could obtain control over the different forms of financial collateral. It was suggested to us that it would be sensible to add a more general test, which could be applied to any new arrangements that might be devised in the future. The various methods of taking control listed should be retained to make it clear how control may be obtained over different types of collateral and under the various arrangements commonly used at present. We agree that this would be a good idea to have both a general test and specific examples. We think the general test should be whether the secured party has negative control, so that the debtor cannot deal with the collateral without the secured party’s consent.
5.70	We recommend that:
(1)	The draft regulations should set out the methods by which control may be taken over different forms of investment property and cash. 
(2)	There should also be a general provision that the secured party should be regarded as having control over financial collateral for the purposes of our regulations if it has taken steps to ensure that the debtor cannot deal with the collateral without the secured party’s consent.
The listed methods of taking control
5.71	Draft regulation 40 sets out the ways in which a chargee may obtain control over various types of investment property and over cash. The rules were outlined in the summary at the beginning of this Part. There are some changes from the draft regulation in the CR. First, the listed methods will now apply only to secured parties and not to other purchasers, who will be treated separately. Other changes follow from the switch from positive control to negative control, or in the case of uncertificated securities within CREST, cover an omission. There are three main changes.
 (1) control over certificated securities in registered form
5.72	A secured party will have control over certificated securities in registered form if it is registered as the holder, or if it has obtained possession of the certificates, whether or not it also has obtained a signed transfer form.
(2) Control over securities in CREST: sponsorship arrangements
5.73	The methods of taking control over uncertificated securities include, in addition to having the holding transferred into the chargee’s own name or into an escrow account, the process by which the secured party can secure its appointment as the sponsor of the debtor. Consultees correctly pointed out that the CR did not deal with this method, which has been developed between CREST and the CREST settlement banks that provide short-term financing to cover any gap between settlement of a deal (payment) and receipt of funds from the buying CREST member. It relies on the rule that a CREST member can surrender its right to give instructions to CREST to a ‘sponsor’ and, when that has been done, CREST will accept instructions only from the sponsor. (Only certain persons may act as sponsor.) The bank will take a ‘system-charge’, which will be floating charge over the monies receivable from the member and the member’s securities and other entitlements under CREST. The securities remain registered in the member’s name and in its ‘available balance’, so that the member can continue to trade in the securities. However, under the security deed the bank obtains an irrevocable power of attorney to act in the member’s name to appoint itself as sponsor. The bank ‘pre-lodges’ the deed (with the power of attorney) with CREST. The bank does not exercise the power immediately, but if it becomes concerned about the amount owing to it in relation to the securities subject to the charge (each CREST member has a ‘debit cap’), the bank can then notify CREST of a ‘change of user’ (relying on the power of attorney). It will be appointed as sponsor from that moment. Exercise of the power places the securities under effective control of the bank and enables the bank to order that the securities be transferred or sold without delay. This is now covered in the draft regulations as an illustration of how control may be taken over uncertificated securities. 
(3) Control over indirectly-held financial assets and cash
5.74	A secured party will have control of financial assets held with an intermediary or over ‘cash’ in three circumstances: if the assets are transferred to its account; if it has given a notice of its assignment or fixed charge to the intermediary or cash debtor; or, where the latter is entitled to disregard a notice of assignment or charge, the chargee has secured its agreement not to permit the debtor to deal with or dispose of the assets. 
Charges in favour of an intermediary or cash debtor
5.75	If an account holder grants the intermediary a charge over financial assets held in the account with the intermediary, the intermediary should be treated as having control without more. This was provided in the CR and was not criticised. The same rule applies to charges in favour of ‘cash debtors’. 
‘Writing’
5.76	The FCAR, reflecting the FCD, provide that a charge or pledge will amount to a ‘security financial collateral arrangement’ that falls within the FCAR only if the ‘agreement or arrangement’ is ‘evidenced in writing’. In the CR we included the same requirement of writing as part of the definition of ‘control’. Consultees agreed but pointed out that the Statement of Council’s Reasons that preceded the FCD makes it clear that the Directive’s definition of writing as ‘including recording by electronic means and any other durable medium’ could include a recording of a telephone conversation. It is said that whereas the FCAR would be interpreted consistently with this, our regulations might not be. The new draft regulations provide expressly that, for the purposes of control over financial collateral, an electronic recording of a conversation will suffice for ‘writing’.
5.77	We recommend that a chargee or pledgee should not have control of financial collateral unless the charge or pledge and the provision of the collateral are evidenced in writing. For the purposes of defining ‘control’, writing should include an electronic recording of a conversation.
Priority and control 
5.78	As we said earlier, one of the main purposes of the provisions on financial collateral is to set out clear rules on the priority of competing security interests over financial collateral. The principal rules are: 
(1)	As between competing charges over the same financial collateral, a chargee who has obtained control will take priority over a chargee who does not have control, whether or not it had given value and whether or not it knew of the prior interest. 
(2)	If both chargees have obtained control, priority will (unless agreed otherwise) be in the order that they obtained control. 
5.79	The rule that a security interest perfected by control has priority over one perfected by other means (such as filing) is a cardinal principle of Revised Article 9 of the UCC. It reverses the normal approach of the scheme for collateral in general that priority depends on date of perfection. The policy underlying this rule is to enable financial collateral to be taken without the need to search or make enquiries about other possible security interests. In the CR, we included the rule, together with the rule that as between two security interests perfected by control, priority depends on who first obtained control. 
5.80	These two rules were supported by consultees. The question that must be asked, however, is whether ‘control’ for this purpose should be the same as for determining whether a charge over financial collateral needs to be registered. Should it be ‘positive’ control or ‘negative’ control? 
Positive or negative?
5.81	The draft regulations in the CR applied the same test of control for purposes of perfection and to determine the priority of competing security interests over financial collateral. There were three relevant rules: 
(1)	A charge perfected by control has priority over one perfected by filing. 
(2)	As between charges perfected by control, priority is by order of control. 
(3)	A secured party who is a ‘protected purchaser’ (in other words, a purchaser who gives value and obtains control without knowing that the disposition is in breach of an earlier security agreement) will not be affected by the earlier security interest.
5.82	Priority between competing charges is not affected by the FCD. It is therefore open to us to provide that the priority question should depend on different criteria to those for registration. It would however make matters simpler to use the same criteria. 
5.83	We argue below that, for the purposes of the ‘protected purchaser’ rules, negative control is not the appropriate criterion. For rules (1) and (2), however, we consider that obtaining ‘negative’ control should be adequate for purposes of priority. In the following paragraphs we explain our reasoning.
5.84	The question needs to be considered from two viewpoints. The first is whether a chargee who has obtained merely negative control, without positive control, should have priority over a chargee who has done no more than register. The second is whether a party who has obtained positive control but who has not obtained negative control should retain priority against a subsequent chargee who gets negative control. 
Control trumps mere filing
5.85	The first question arises only in relation to situations in which it is possible to have negative control without positive control: in other words, in relation to financial assets held with an intermediary, certificated securities in registered form and ‘cash’. It seems to us that negative control should suffice to give priority over a charge that has merely been registered. Suppose SP1 has a floating charge over a securities account. SP2 takes a fixed charge over the same account and notifies the intermediary. The intermediary now knows that it should not allow either the debtor to deal with collateral or SP1 to enforce its charge without reference to SP2. There is no reason to require SP2 to obtain positive control.
Negative control trumps ‘positive without negative’ control
5.86	In the light of our further analysis and comments from consultees, we have realised that if the ‘control trumps filing’ rule were to be retained together with a requirement that, to have control, the secured party must have taken steps to prevent the debtor from dealing with the collateral, the effects would be different to either current law or those under the UCC. It may help to give a practical example.
5.87	Take the arrangements between a CREST member, CREST and the settlement banks described earlier. Until the bank has been appointed as sponsor, the debtor is still able to dispose of its holdings in CREST. Therefore the bank will not have control under FCAR and, for the purposes of exemption from registration, it will not have control under our regulations. But should it also be at risk of losing its priority? Or should the (unactivated) ‘lodgement’ arrangements it has made protect its priority?
5.88	Under current law the settlement bank is at risk of being trumped by a subsequent fixed charge. We understand that the bank will normally try to protect its priority by means of a negative pledge clause. This will protect the bank only if the fixed chargee has knowledge of the clause, but consultees suggest that subsequent potential secured parties will normally make enquiries. They are therefore likely to find the negative pledge clause and to be affected by it. The priority of the bank’s floating charge will be preserved.
5.89	If we were to require negative control for purposes of priority as well as for purposes of perfection, the bank would not have control until it exercised its right to ‘block’ the debtor’s securities account. Unless it had done so, its charge would be trumped by the subsequent fixed charge if that were perfected by control. It would lose the chance to protect its priority by means of a negative pledge clause. 
5.90	This is not the effect under UCC Article 8 and Revised Article 9. As we explained earlier, under the UCC a bank that has obtained the issuer’s agreement to transfer uncertificated securities without further reference to the debtor is regarded as having control, even though the debtor remains free to deal with the collateral. We suspect that on the facts of our example, the bank might be held to have control within the meaning of the UCC. It would not be at risk of its charge being trumped by a subsequent charge.
5.91	Were our scheme to copy the UCC, the same analysis might apply to a CREST settlement bank which has taken a floating charge and has used the pre-lodgement procedures described earlier. Even when it has not yet used its power of attorney to have itself appointed sponsor, it may do so at any moment. It does not have negative control because the debtor is still able to dispose of the ‘financial instruments’ but it might be held to have control within the relevant provisions of the UCC.
5.92	There is thus a question whether for the purposes of priority (but not for other purposes) we should treat a secured party that has ‘positive but not negative’ control as having done what is necessary to preserve its priority against a subsequent charge that is perfected by negative control. Similarly, should a secured party that has taken this form of control gain priority over a (floating) charge which is perfected by filing but where the charge-holder has not reached any agreement with the intermediary (or, in the case of a floating charge over securities held in CREST, if the chargee has not pre-lodged documents)?
5.93	Our view is that ‘positive but not negative’ control should not be a ‘priority point’. The reason is that in some cases this would be inconsistent with the general policy, strongly supported by consultees, that lenders should be able to take charges over financial collateral without the need to search. Take the example of the CREST settlement bank. Under current law the existence of the negative pledge clause presents a threat to subsequent lenders. As a consultee pointed out, they will feel they must conduct enquires. If they do not do so, and therefore they do not discover the negative pledge clause, they will in principle not be affected by it, but they might well find that they were embroiled in difficult issues of fact over whether they had actual or constructive notice. Similarly, if under the new scheme the bank were to be treated as having priority because of the pre-lodgement procedures, the subsequent lender would have to search to find out whether a floating charge had been registered and, if so, whether the charge-holder had obtained ‘positive control’. We understand that CREST would not reveal this information. To give the bank priority would therefore interfere with the ready use of financial instruments and cash as collateral.
5.94	We recommend that a security interest over financial collateral of which the secured party has negative control should have priority over one where the secured party does not have negative control, and that priority as between competing charges perfected by control should depend on the date on which negative control was obtained.
Purchasers
5.95	We agree with consultees that it is essential to preserve the ready transferability of financial instruments. A purchaser who acquires a financial instrument for value and without notice of a security over it should not be affected by a charge or other security over it. That was the aim of the ‘protected purchaser’ rules included in the draft regulations in the CR. These applies to all purchasers including subsequent secured parties.
5.96	The general aim was strongly supported by consultees. Therefore the draft regulations should provide rules protecting purchasers, including secured parties.
5.97	A remaining question, however, is what steps should the purchaser take if it is to be protected? A person who has merely agreed to buy the entitlement should not be protected. If, in contrast, the financial asset is transferred into the purchaser’s name or into a securities account in the purchaser’s name, and the conditions as to value and lack of knowledge are satisfied, the purchaser should be fully protected. This is necessary to ensure the ready transferability of the financial instruments. 
5.98	Should an ‘innocent purchaser’ take free only if it has had the collateral transferred into its own name, or into an account in its own name? Or should it suffice that it has obtained ‘control’ in one or other of its forms? For example, should it suffice that the purchaser has reached a control agreement with the intermediary, not knowing of a charge under which the chargee has also made a control agreement with the intermediary? It appears that under the UCC it suffices that the ‘innocent’ purchaser has obtained control.  
5.99	An outright buyer of the collateral will normally have it transferred into its own name. In practice, therefore, this question will affect only competing secured parties. We have said that a secured party who takes the collateral into its own name – thus, a mortgagee – without knowledge that this is a breach of an earlier charge agreement should be protected. That will ensure that a party wanting to take financial assets and cash as collateral has a safe method of doing so without having to make enquiries. We do not think it is necessary to provide further protection. If the first secured party has allowed the debtor to continue to deal with the collateral, then for reasons explained earlier, the second secured party will in any event gain priority by taking control. If the earlier secured party had obtained control by notifying the intermediary of its assignment or fixed charge, the second chargee who also obtains control by notifying the intermediary will find its charge is subject to the earlier one, but the remedy is in its own hands. It should make enquiries of the intermediary – or demand that the assets are transferred into its own name. 
5.100	This solution is, we think, close to the current law. A purchaser who has left the securities in the debtor’s own name will have at best an equitable interest. That will be subject to any existing equitable interest. Only if it acquires a legal interest in good faith, for value and without notice of the prior equitable interest will it take free of that interest. However, the innocent purchaser of an indirectly-held security may not qualify as the purchaser of a legal estate, as the interest it is buying may be only equitable. Legal title to the securities lies with the custodian or intermediary registered as the owner. 
5.101	We were asked what should happen where a purchaser advances money on the strength of investment property and then learns of a prior charge over it that has been perfected by a control agreement. Should the purchaser gain priority by subsequently becoming the entitlement holder? This was correctly likened to the current doctrine of tabula in naufragio, which permits a party who has advanced money without notice of a previous equitable interest, which subsequently he discovers, to secure priority by ‘getting in’ the legal estate. We think that all the conditions should be fulfilled at the time the purchaser takes control. In relation to the priority of security interests generally the scheme is that priority should be by date of registration, whether the competing interests are legal or equitable, and the tabula in naufragio doctrine will no longer apply. It would be incongruous for it to apply in relation to the rule for protected purchasers.
5.102	We recommend that a purchaser for value (including a secured party) who takes financial collateral into its own name without knowledge that the disposition is in breach of a previous charge agreement should take free of the earlier charge. 
An automatic charge in favour of an intermediary
5.103	A broker has a general lien over share certificates until the client pays up. In the CR we asked whether our scheme should follow the UCC in creating a new and more powerful device for intermediaries and others who deliver financial instruments before they have been paid for them when there was no agreement for credit. This gives them a charge over the securities for payment of the price. Such an interest would arise automatically and would not require registration. However the intermediary would not be treated as having control, so that its priority would not be protected against subsequent charges under which the chargee did obtain control. 
5.104	Few consultees commented on this question but those who did supported the proposal. We therefore include it in our recommendations, but with the adjustment that where the charge is over financial assets held with an intermediary, the charge should be a fixed charge, as the intermediary will effectively be able to control their disposition. In other cases the charge will be a floating charge, since the buyer will have the certificates and will in effect be able to dispose of the assets.
5.105	We recommend that: 
(1)	An intermediary who credits assets to a buyer’s account before being paid for the assets should have a fixed charge over the assets. 
(2)	A person who delivers certificated financial instruments or assets to a buyer before being paid for them should have a floating charge over the assets.
In neither case will the charge need to be registered; but nor will the chargee be treated as having control.
Provisions that have been removed
5.106	Consultees objected to a number of provisions in the CR draft regulations (in addition to those in the statement of rights and remedies in Part 5). 
The obligation to disclose a ‘control agreement’ 
5.107	The draft regulations in the CR imposed an obligation on an intermediary or a bank to disclose a ‘control agreement’ if so requested by the debtor. The core scheme no longer obliges the secured party to give information at the debtor’s request; there is no such obligation under current law and there is no evidence that one is needed. We think the same of the obligation on an intermediary or a bank. 
Rights of use
5.108	Consultees also objected to the provisions on the right of use of financial collateral. We have concluded that this is not necessary. The right of use was effectively part of the statement of rights and remedies and, like that statement, should be left for consideration at a later date. 
‘Super-priority’ of intermediaries and banks
5.109	The draft regulations in the CR followed the model of the UCC in providing that an intermediary which takes a security interest over a securities entitlement maintained with it should have priority over a security interest in favour of any other party. Similarly, they provided that a charge taken by a bank over an account with itself would have priority over a security interest in favour of any other party unless the other secured party had ‘become the account holder’. Consultees thought both to be inappropriate. 
5.110	Another respondent commented that such priority should remain subject to arrangements between the various parties. We would like to emphasise that there is no question but that the parties could reach a contractual priority agreement. The only question is what the position should be in default of such an arrangement.
Intermediaries
5.111	In the CR we argued that giving the intermediary priority could be justified when it had provided the finance for the purchase of the investments concerned (that is. the security interest was a purchase-money security interest (PMSI)). However, we questioned whether a wider priority, as provided in the draft regulations, was justified – for example by the convenience of borrowing from the intermediary. 
5.112	We consider that there is no particular reason to give the intermediary priority in respect of anything that is not a PMSI. The respondent that criticised this rule also argued, however, that it was quite correct that the PMSI rule should not apply to investment securities. This is more difficult, but after some reflection and helpful discussion with other consultees we have concluded that PMSI rules are unnecessary for investment securities. 
5.113	The intermediary can protect its interests by taking a charge over the securities account as soon as it is opened. It will have control without more, and thus will have priority over any subsequent chargee. 
Bank accounts
5.114	Similar comments were made about the rule giving super-priority to a bank that takes a charge over an account held with itself. Similar arguments have led us to conclude that the bank (or any other cash debtor) can in practice protect the priority of its own charge over the account without the need for a special priority rule.