The practice adopted by some banks in EU member states to structure financial collateral pledges as floating charges may result in invalidation of the pledges.

A major requirement for establishing valid collateral under the EU Financial Collateral Directive 2002/47/EC (the Directive) is to transfer "possession or control" over the collateral to the collateral taker. This requirement is often overlooked in practice, partly because the Directive provides no express guidance on the meaning of "possession or control".

In Bulgaria in particular, until recently, this requirement was entirely omitted from the local act transposing the Directive, and introduced for the first time in August 2013. Meanwhile in a large number of local banking transactions the financial collateral regime was extensively used without any measure being taken to secure that the collateral taker is always in a position to assess the financial obligations (secured by the pledge) against the value of the available collateral and exercise effective control prior to any disposal with collateral by the pledgor.

On the contrary, under many financial collateral pledge agreements, pending an event of default, pledgors were entitled to withdraw without restrictions money from the "pledged" bank account. Following the same practice, after the statutory amendment that makes clear that possession or control must be effectively ensured, poses risks for the validity of financial collateral arrangements.

What are the risks?

While there is no Bulgarian case law or guidance from the European Court of Justice on the matter, two important English judgments throw light on the "possession or control" requirement.1 In both cases pledge agreements were at stake, containing provisions whereby, before an event of default, the collateral taker could withdraw money from the pledged bank account, or dispose with the pledged securities. These loose arrangements resulted in invalidation of the pledge as failing to ensure the effective control of the pledgee, as the latter had no means to object to a withdrawal of the pledged collateral. It is worth noting that in both cases the pledgee was actually holding the pledged collateral as a trustee/custodian and thus had (what the court called) "administrative control" over the collateral. Nevertheless, it was held that the existence of contractual arrangements allowing the pledgor to withdraw financial collateral before an event of default was fatal for the validity of the pledges, since such arrangements meant that the pledgee had no effective "legal control" over the pledged financial collateral.

Are the English courts' arguments relevant for other EU jurisdictions?

The English courts stressed that it was not to the national laws of the EU member states to define "possession or control" and assumed that the phrase has an autonomous meaning in the EU law - in other words, must depend on the interpretation of the Directive and the general EU legal principles. To clarify the phrase, the English courts relied on two arguments, based entirely on the Directive.

First, Recital 10 to the Directive states the Directive should cover "only those financial collateral arrangements which provide for some form of dispossession". It was held that "dispossession" suggests that, for the collateral to be in the possession or control of the collateral taker, the collateral provider must be legally prevented from dealing with the collateral.

Secondly, substantial reliance was placed on the second sentence of art.2, par.2 of the Directive, providing that, "any right ... to withdraw excess financial collateral in favour of the collateral provider shall not prejudice the financial collateral having been provided to the collateral taker as mentioned in this Directive". It was held that this rule would be meaningless if the parties could agree that the collateral provider could withdraw collateral without having to demonstrate that the amount subject to the withdrawal request is not more than the excess over the pre-agreed secured amount.

Practical steps to ensure that possession or control has been transferred to the collateral taker

The particular steps depend on how the collateral is being held. If it is held by the same person that is a collateral taker (eg, when a bank account is pledged in favour of the same bank where the account is held), a contractual prohibition on the pledgor to withdraw collateral may be enough because the pledgee would be in a position to effectively control it. If the parties have agreed that excess collateral may be withdrawn, this should be coupled with a mechanism to calculate the mutual parties' exposures, thus placing the pledgee in a position to assess at any time whether excess collateral exists that may be withdrawn.

When the collateral is held by a third person (eg, a bank account held with a third bank, different from the collateral taker), a mere contractual prohibition in the pledge agreement may not be enough. In this scenario, the third party where the collateral is held must also undertake to observe the prohibition, for example by a separate agreement or by another type of arrangement that is binding on the third party.


The Directive was primarily intended to protect collateral arrangements with respect to derivatives transactions where the systemic risk poses disastrous threats to financial markets. For derivatives transactions, the market practice for collateral arrangements is to block the collateral, thereby creating in practice a fixed charge. It is this standard market practice that seems to underlie the requirements for transferring of possession or control under the Directive, thus drastically restricting the possibilities to structure a pledge agreement as a floating charge.

So using the security instruments under the Directive to secure payments under ordinary credit transactions by floating charge types of arrangements may pose serious risks.

QUOTE: "The existence of contractual arrangements allowing the pledgor to withdraw financial collateral before an event of default is fatal for the validity of the pledges."


[1] Gray v G-T-P Group Ltd, Re F2G Realisations Ltd (in liq.), High Court of Justice Chancery Division, 7 May 2010; and In the Matter of Lehman Brothers International (Europe) (in administration), Chancery Division, 2 November 2012.

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