Who does this affect?

Participants in the securities lending, derivatives, repo and securitisation markets.

What do you need to do?

Consider the decision in the context of absolute transfers which take place in your business.

Author
Scott Farrell  
Partner

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Scott Farrell  
Partner
T +61 2 9296 2142

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Sydney
Scott Farrell  
Martin James  
Rowan Russell  

Melbourne
Ian Paterson  

Perth
Nicholas Creed  

Brisbane
Berkeley Cox  

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The Federal Court of Australia has confirmed the validity of the absolute transfer provisions in security lending documents. Today, Justice Finkelstein of the Federal Court of Australia handed down his decision on a preliminary, but critical, question arising from the failure of Opes Prime Stockbroking Ltd.

The Question and the Answer

The question asked of the court was whether Beconwood, a client of Opes Prime, retained any kind of equitable interest in the securities it lent to Opes Prime, or the securities Opes Prime needed to return to it, under a securities lending agreement entered into between them.

The court answered “no”. The court found that under the terms of the securities lending agreement there was an absolute transfer of the securities from Beconwood to Opes Prime and Beconwood had no retained equitable interest in any securities.

How the decision was reached

The terms of the securities lending agreement provided that the securities provided by Beconwood passed absolutely to Opes Prime and that Beconwood did not retain any interest in or right to them. Instead, the agreement provided that Beconwood had a right to the transfer of “equivalent securities” from Opes Prime at the end of the loan.

Beconwood argued that, despite the terms of the agreement, the shares which it provided to Opes Prime were not transferred completely to Opes Prime and Opes Prime did not become the absolute owner of the shares. Instead, it argued, the “true character” of the agreement was a mortgage under which it borrowed money from Opes Prime and Beconwood provided shares as security for that loan. Alternatively, Beconwood argued that it had an equitable charge over the “equivalent securities” held by Opes Prime which were to be returned to it by Opes Prime.

The judge did note that the legal provisions were not consistent with the description of “lending”:

“The term “securities lending” under these agreements is factually incorrect. The transaction that is referred to as “lending” is in terms an outright disposal of the securities lent, linked to a subsequent acquisition of equivalent securities. In other words the agreements provide that title to the securities on loan, as well as to any collateral that is received by the lender, passes from one party to the other. On the other hand, the economic benefits of ownership are “manufactured” back to the lender by the terms of the securities loan agreements.”

However, the court found that the character of the transaction is to be determined by reference to its legal nature, not to its economic effect or the subjective motivations of the parties. It was the legal terms which prevailed. The judge said:

“The character of the SLA [the securities lending document] must be determined from its language, particularly of its operative parts. If those provisions are clear, they must be given effect, unless there are provisions which alter that effect.”

After considering the wording of the agreement, the court found that its terms could not be characterised as a mortgage. This was because, under the agreement, Opes Prime had no obligation to hand back the actual securities which were lent to it, and instead its obligation was to return equivalent securities. This was not consistent with Beconwood having retained any proprietary interest in the securities. Also, the netting provisions which operated on default of a party would not have been effective if the client retained any type of proprietary interest in the securities. If the agreement did not give Beconwood a proprietary interest in the securities then the argument that the agreement created a mortgage was “simply unsustainable”.

The court also dismissed Beconwood’s argument for an equitable charge over the equivalent securities to be delivered to it. The court found that such a charge could not be created unless Opes Prime “appropriated” those securities to the agreement (effectively setting them aside for that purpose). As the agreement did not require this, and instead gave Opes Prime the freedom to decide how and from whom it would obtain the equivalent securities, no charge was created by it.

Why this is important

Setting aside any issues or matters related to Opes Prime (this Alert does not comment on any of these), the decision itself is legally very significant. The securities lending documentation used by Opes Prime is very similar to the market standard documentation used in the securities lending industry in Australia (the Australian Master Securities Lending Agreement) and in other countries (the Overseas Lending Agreement and the Global Master Securities Lending Agreement). Also, the concept of an absolute transfer is used more widely, in reciprocal purchase (repo) transactions, in collateralisation arrangements relating to derivatives (for example, the transfer-method ISDA credit support annex) and in securitisation and debt factoring transactions. In all of these contexts it is critical that the absolute transfer mechanism works in the manner set out in the document agreed between the parties. The decision, and the reasoning for it, will provide further confidence to market participants that under Australian law these arrangements will not be recharcterised as mortgages or charges.