Tuesday, November 22, 2011

Cross-Border Collateral Complexities

by PF2 consultant Rick Michalek

It's 11:59pm. Do you know where your collateral is?

The question of how to locate and ensure the realization of security is often asked, but rarely definitively answered, particularly in international complex derivative transactions. In an ever increasing number of cases, lenders - and counterparties and their insurers - have been forced to ask exactly this question.

The question is becoming increasingly relevant. Consider the following from a recent Press Release from the Office of the Trustee for the Liquidation of MF Global Inc. (published 11/21/2011)

"Further complicating matters, assets located in foreign depositories for customers that traded in foreign futures are now under the control of foreign bankruptcy trustees, and while the Trustee will pursue them vigorously, it has been his experience that recovery of these foreign assets may take more time. The Trustee's counsel has also stated in open court that the Trustee has only relatively nominal proprietary - that is non-customer - assets in his immediate control."

The "recovery of foreign assets may take more time...." is the key issue, and one that remains despite the wholehearted attempts by the regulatory bodies both in the US, the UK and elsewhere, to address the long standing challenge of rationalizing international and inter- jurisdictional processes for the realization of posted and pledged collateral.

Those experienced with derivative structured finance transactions will recall the litany of "assumptions" contained in the typical security interest opinion delivered by deal counsel and relied upon by the transacting parties. The utility and reliability of that legal opinion was conditioned on every single one of those assumptions being true at the time of delivery. The diligence required in verifying those assumptions was often "delegated down", and whether that diligence was fully and accurately performed - often under the pressure of a closing deadline - is critical to the ultimate outcome when pursuing collateral.

Mirroring those assumptions, the deal's legal opinions will also include critical "qualifications", including those related to the location of the collateral. Exceptions would inevitably be made to cover the possibility of collateral being moved out of relevant jurisdictions after the date of closing (particularly relevant to those secured by physical notes or other forms of indebtedness).

In multi-jurisdictional transactions, involving collateral originated in legal jurisdictions lacking well-developed protocols for settling competing interests of creditors residing in different jurisdictions, a trustee may be faced deciding which of the mutually inconsistent judgments it will recognize and honor. Creditors thinking of suing might want to delve deeply into the documentation - a decision that may make the difference between covering the costs of litigation or suffering the sting of a pyrrhic victory of having paid to prevail.

To get in touch with the author of this piece, email Rick at rm@pf2se.com

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