Loan with Collateral Repo Deal

Loan with collateral repo deal

Loanwithcollateralrepodeal[1]

The proposed as collateral financial instruments, however, must be issued by a company with a good reputation

Ivana Bliznakova,Attorney at law at Tocheva and Mandazhieva Law office

In times of crisis and low liquidity of most standard assets, which could serve as collateral of the financial institutions, except the most liquid bond, namely the blocking of a certain amount of money, the funding institutions could use the so-called repo transactions with financial instruments as collateral. Of course, this could happen, on the condition that the offered for collateral financial instruments are issued by a company with a good reputation and are fairly liquid.

Bulgarian law recognizes several almost identical legal definitions for repurchase agreement, under which a repo transaction is any agreement when a transfer of securities/financial instruments occurs, andundertaking to re-buy themat a specific price at a specified future date or on the date which will be stipulated by the assignor. At the same time the repo transaction is explicitly indicated as a type of contract for financial collateral arrangement under the Financial Collateral Arrangements Act(FCAA).

The issues that arise in connection to repos, are related to, on the one hand, with the nature of the transactions themselves, and on the other hand – with the subjects, who may be parties on these transactions.

In its legal traits the repo transaction is an agreement for the sale of an asset with a stipulation to repurchase it. In addition, theFCAA states that this type of transactions shall ensure the execution of a financial obligation. In their economic traits and on the basis of the accepted accounting system of reporting the repos constitute a loan, as the seller of the financial tools is the borrower, and the buyer is the lender.

Problems that may arise and arguments directed at their solution

In relation to the type of person – natural/legal persons a seller in a repurchase transaction:

Natural persons

When the seller of the financial instruments and a borrower in a repo transaction is a natural person, there is a risk that the repo transaction will be appealed against before Court by this natural person with a claim for its announcement as void. If the Court proclaims the repo transaction as void, this means that the parties to a repo transaction should return everything, which they gave to one another in this deal, as if it has never occured. However, since the trades of the Exchange are irrevocable that will mean that the natural person will be able to seek via legal channels from the finance institutiona monetary compensation for damages (it cannot be completely excluded that the Court will decide on areturn of the same financial instruments instead of a monetary compensation for damage, since these are generic and not individually defined possessions).

This risk of a void declaration of the transaction is unlikely to happen (it may not be completely excluded), but should it happen, it would have significant consequences.

The risk is justified by the hypotheses provided in the Obligations and Contracts Act(OCA), which, on the one hand: a) prohibit the sale of belongings (including financial instruments) with an arrangement for repurchase, and on the other hand, (b)) agreements which pre-arrange in advance a way for the satisfaction of the creditor (in this case, the financing institution through a sale of the financial instruments) and in case of a loan default, whose way of fulfillment is not stipulated in the law. In case law decisions specifically related to financial instruments cannot be found, however, there is plenty of those which declared thetransactions as null and void, when the subject of repurchase is real estate, as well as a decision regarding the movable property (in this case the financial instruments are also movable property). However, since OCA does not differentiatein the application regime of these norms regarding immovable or movable property, in this case,for applicable should be consideredthe entire stipulated case law.

Arguments against the aforementioned interpretation

When we analyze the stated imperative rules of OCA, we should consider the fact that one of the partieson the loan with the repo transaction, is a merchant (namely - the financing institution) and the deal may be treated as "a commercial one" within the meaning of the Commerce act (CA). In commercial transactions the application of the rules of the CA takespriority, and theOCA is applied in a subsidiary manner, if it does not contradict the explicit norm of the CA. Unlike the OCA, the CA does not prohibit the sale with an agreement to repurchase as a type of a deal.

Therefore, the sale of an asset with an agreement to repurchase is valid according to CA. In so far as this agreement is used as a collateral on a loan,the risk of the borrower trying to ask for a judgment, declaring such a contract as nulled by court order due tofactitiousness or discrepancy in accordancewith art.152of the OCA, could not be ruled out.

Arguments for refuting this thesis could be adduced as follows: the repo transactions are strictly recognized by the Bulgarian legislation as transactions defined in legal terms as mentioned above. Although, according to their factual structure, they resemble the sale with an agreement to repurchase, it may beconsidered that they are rather sui generis agreementswhich by their economic nature and accounting adjustmentrepresent their own unique type of loans with collateral from financial instruments.

Whenthe sellerofthe financial instruments,and aborrower in arepotransaction, isa naturalperson, there is ariskthat the naturalperson willfile a claim against it to make it null.

The possible application of the Consumer credit act (CCA)

Apart from the validity of the repo transaction,when a seller and a borrower on it, is a natural person, and its contract term, respectively itsrepurchase, is longer than3months from the signing of the Contract, it may be considered that for this loan CCA is applied. CCA places the natural person – a party to this Contract, in a more favourable position, by giving him a right to withdraw from the contract within 14 days of its signing, and by doing this it writes a mandatory option for pre-term repayment and gives an upper limit for compensation of the creditor during a pre-term repayment and others similar to this one.

We reckon that the possibility of rolling of the contract, i.e. on every trimester through intradaytrading the position is closed and then open, then again we cannot completely exclude the risk of the application of theCCA. In the event that it is considered that CCA is applicable it is possible to impose a property sanction to the financing institution, as the most unfavourable consequence is for the loan agreement to be declared invalid.

In this case, the consumerreturns only the net value of the loan, but does not owe an interest or any other costs on the loan, andrespectively the financing institution accordingly should return the given as collateral financial instruments or compensation.

Legal persons

Concerning a legal person – a seller in a repo transaction, the risks mentioned above, can be completely excluded when the repo transaction is strictly settled by theFCAA. This law expressly allows the execution of repo transactions by registered financial institutions, however, a counterparty to the transaction (seller of financial instruments) must be a legal person. In this case the repo transaction is signed in the form of financial tools transferagreement.

The tools transfer proceduretakes place before the"Central Depository" AD pursuant to the rules of its statutes.

The article does not constitute a legal opinion or advice related to concrete situation or entity. Due to its limited scope the same does not seek to be theme exhaustive. For more information on the touched upon questions you can contact the author via the followinge-mail:

Tocheva and Mandazhieva Law Office, 26, Stoyan Mihaylovski Str., fl. 5Page1

[1] The article is available in Bulgarian language here -