The Act of 2 April 2004 on Certain Financial Collateral Arrangements (the “Act”) implements the European Directive on Financial Collateral (Directive 2002/47/EC, the “Directive”) in Poland. In force since 1 May 2004, the Act is intended to improve the certainty of financial collateral arrangements, remove the formalities for the creation and enforcement of collateral, sanction netting provisions designed to facilitate settlements, and limit the financial risk of a solvent party in the event of insolvency of the counterparty.
Scope of the Act
Assets
The Act applies to collateral on cash (money in a bank account or claims for the repayment of such money; cash in the form of banknotes or coins may not be provided as financial collateral) and financial instruments. “Financial instruments” are defined in the Act as:
- Securities, which are listed in Article 3 of the Polish Act of 21 August 1997, the Law on public trading in securities (the “Securities Act”), regardless of whether they are admitted to public trading unless it concerns property rights that may become securities only if they are admitted to public trading.
- Certificates of deposit issued by banks.
- Shares in limited liability companies.
- Investment fund participation certificates.
As a result, the Act does not apply to security over fixed assets, intellectual property rights or liabilities under commercial contracts. Moreover, it seems that the Act does not apply to security created over securities such as cheques, promissory notes or bills of exchange. This may be significant in practice, as many debt securities issuance programmes in Poland (in particular, prior to the liberalisation of the regulation of bonds) were based on promissory notes (e.g. in commercial paper programmes). Interestingly, the definition of “financial instruments” in the Act differs from that used in the Securities Act. By way of example, the definition in the Act does not include money market instruments not being securities or commodity derivatives or other derivatives (such as futures contracts) that are not securities.
Secured Obligations
Another requirement for the Act to apply is that the financial collateral arrangement secures cash obligations (or obligations under which a debtor is obliged to pay a specific sum of money), or obligations under which a debtor has to deliver “financial instruments” (as defined in the Act). These obligations are described in the Act as “financial obligations” and may arise out of credit facilities, loans (provided they are loans of cash or of financial instruments), issuance of securities, financial futures settled in cash or in financial instruments, and securities sale and repurchase transactions. In particular, following the intent of the Directive, the Act envisages that financial collateral arrangements should be created in connection with framework agreements concerning over-the-counter (OTC) derivatives, such as the 1992 and 2002 International Swaps and Derivatives Association (ISDA) Master Agreements and the Framework Agreement concerning certain transactions in the Polish inter-bank market, recommended by the Polish Bank Association.
The Parties
A financial collateral arrangement may only be entered into if a collateral provider or taker is a financial institution or public sector body. “Financial institution” includes a bank, brokerage house, pension society, insurance firm, settlement or clearing institution or an international financial institution named in the Act, for example, the European Central Bank, the European Investment Bank and the International Monetary Fund. The Act may also apply if the collateral provider or taker is a Polish public authority acting on behalf of the State Treasury (i.e. not on behalf of local government units) and in some other limited circumstances. On the other hand, the Act does not apply if any party to an agreement creating financial collateral is a natural person.
The Agreement
The parties should specify the financial obligations secured by such collateral and select one of the types of financial collateral arrangements available under the Act (as to which, see below). An agreement creating financial collateral should specify a date until which the collateral is created, the basis for enforcement of collateral (e.g. breach of the terms of an agreement to which the collateral applies), rules for settlement between the parties and the manner for valuation of an asset provided as collateral.
No special form is required for the creation of financial collateral. The Act explicitly abolishes requirements as to the form of a pledge as it provides that entering into a financial pledge agreement does not require a certified date (as is the case with a traditional pledge of rights) or signatures certified by a notary public (as is the case with a pledge of shares in a limited liability company). Furthermore, it is not necessary to enter such collateral in any public register (including, in particular, a pledge register). The Act requires only that collateral on cash is evidenced in a collateralised cash account and collateral on financial instruments is evidenced in a deposit account, securities account or in another register of securities held by appropriate entities.
The making of an appropriate entry in the account will suffice to infer the creation of collateral where book entry securities are concerned. In the case of securities in paper form and shares in limited liability companies, appropriate provisions of the Polish civil law and the Code of Commercial Companies will apply (including the signing of a collateral agreement where shares in a limited liability company are concerned). With respect to the parties, collateral is thus created by the signing of a financial collateral agreement and delivering the document to a pledgee or an agreed third party.
Types of financial collateral
The Act provides for three types of financial collateral arrangement.
1. Collateral involving establishment of a pledge in title to cash or of financial instruments (financial pledge)
The financial pledge created by the Act should be considered a new type of limited property right (alongside the ordinary and registered pledge). A creditor may enforce the pledged asset without the need for court execution proceedings and the pledge need not be entered on the central register of pledges. Application of Article 333 of the Polish Civil Code is excluded as regards financial pledges, so that only the pledgee is entitled to demand the benefit of the pledge. If an enforcement event occurs, a pledgee may enforce the pledge through:
- the sale of an asset provided as collateral;
- setting off or netting off its value against the secured financial obligation; or
- taking over the full title to the asset provided as collateral (if the financial pledge agreement so provides).
2. Outright transfer of title to cash or financial instruments
The outright transfer by a collateral provider to a collateral taker of title to cash or financial instruments (which is common in certain repurchase agreements) will constitute a financial collateral arrangement equivalent to security transfer of title and security assignment of rights. In this case, the collateral provider may demand re-transfer of the asset provided as collateral if the secured obligation expires or if the term for which the collateral agreement was entered into lapses. Upon an enforcement event, the collateral provider will lose the right to the return of cash or financial instruments under the transfer agreement.
3. Collateral involving a blockage in an account or securities deposit account
Blockage in a securities account or deposit account is established in accordance with the provisions of the Securities Act and secondary legislation to the Act. (These issues are beyond the scope of this article.)
Important Provisions
Right of use
A financial pledge agreement may give a pledgee the right to use an asset provided as collateral. The Act defines the “right of use” as the pledgee’s right to exercise rights from an asset provided as collateral including gaining benefits from it, e.g. collecting interest on a pledged bond, to exercise other equity interests or to dispose of such asset. The ability to dispose of pledged financial instruments, based on right of use, is broadly equivalent to the English law of rehypothecation and is considered a radical change to Polish law.
Right of Substitution
The Act explicitly allows for financial collateral agreements to include provisions enabling the replacement of cash or financial instruments with other cash or financial instruments. An agreement may, for example, give a collateral provider the option to provide for such replacement, which may be dependent on the occurrence of certain objective circumstances. While this option improves the liquidity of encumbered financial instruments and enables the collateral provider to react effectively to market trends, there is some uncertainty regarding whether substitution of a new asset results in establishment of new collateral and it will be interesting to see how the Act is interpreted in practice.
Top-up Collateral
There are also provisions authorising a collateral taker to demand (and requiring a collateral provider to satisfy the demand) that an asset provided as collateral be supplemented with additional collateral. The provision of such “top-up” collateral is typically required to coincide with the drop in market price of an asset provided as collateral or change in the amount of the secured obligation.
Netting Provisions
The Act provides that the parties may include netting provisions (klauzula kompensacyjna) in an agreement creating financial collateral (or in a master agreement related to such agreement or a detailed agreement entered into in the performance of a master agreement). The netting provisions should specify the manner for performing the netting and terms for settlement between the parties. Under Polish law, netting provisions are generally based on either contractual set-off or novation and are particularly significant if one of the parties announces bankruptcy as they allow the solvent party to limit the risk related to the counterparty’s insolvency to the net amount as calculated in accordance with the netting provisions. The netting provisions in the Act, however, have no interrelation with the provisions of the Polish Bankruptcy Law on netting and the resulting position appears inconsistent with both the effectiveness of the Act and the intent of the Directive.
The “Zero Hour” Rule
The “zero hour” rule allows the announcement of bankruptcy to be effective as regards a bankrupt entity, its creditors and third parties from midnight on the day the court issues its decision on the announcement of bankruptcy. Therefore, the Bankruptcy Law has a retroactive effect. This rule, however, does not apply to financial collateral arrangements as the Act amends the Bankruptcy Law regarding the effectiveness of financial collateral established on the date of announcement of bankruptcy. The financial collateral will be valid if the agreement was entered into or financial collateral established on the date of announcement of bankruptcy, provided the collateral taker proves it had no notice of the commencement of bankruptcy proceedings.
Bankruptcy
As the Act is silent as to the manner of realisation of a financial pledge if a pledgor’s bankruptcy is announced, the Bankruptcy Law assists as to the general regime to be applied. While the Bankruptcy Law does not make specific reference to a financial pledge, it is probable that the regime applicable to ordinary and registered pledges will apply (i.e. the pledgee may enforce its pledge from the price obtained from the sale of the pledged asset, the pledgee may take over the pledged asset in the case of a registered pledge and reorganisation does not affect the obligations secured by the pledge).
Book Entry Securities
The issue of governing law is a fundamental problem relating to the creation of financial collateral on book entry securities, as the lex rei sitae rule (i.e. the application of the law of the jurisdiction in which the securities are located) does not apply. The Act solves this problem by stating that, in the case of book entry securities, the governing law is the law of the state in which a deposit account, securities account or other register of such securities, in which collateral arrangements have been evidenced, is maintained.