Insights

The Fallacy of Unilever’s Conscious Uncoupling from Ben & Jerry’s November 2021

Dan HarrisPartner Boycotts and Sanctions, ESG

The Fallacy of Unilever’s Conscious Uncoupling from Ben & Jerry’s

In July 2021, Ben & Jerry’s Homemade, Inc (BJH) announced its intention not to renew the license agreement of its Israeli franchisee. This played right into the hands of BDS activists, who had been lobbying BJH. Unilever immediately sought to distance itself from its subsidiary (or, in legal terms, to downplay proximity), saying in its media release, “We remain fully committed to our presence in Israel… [W]e have always recognised the right of the [Ben & Jerry’s] brand and its independent Board to take decisions about its social mission.”

As an exercise in damage limitation, there can be no doubt that this conscious uncoupling, to use a neologism, has failed. From Israel to Illinois, the consequences for Unilever are plain to see. More than this, it has raised serious and ongoing corporate governance issues for investors in Unilever.

Holding companies want to distance themselves from their subsidiaries, but only in certain respects. After all, investors in blue chips don’t bargain for risk and reward in equal measure; they bargain for effective governance from boards with the skills and judgement to minimise the former and maximise the latter. Effective governance requires continuing alertness to risk, not corporate communications after the event.

Income generated by a subsidiary? ‘We’ll take that,’ says the board of any holding company. Income is given free passage up the corporate structure. Liabilities? ‘You can keep those.’ Holding companies attempt to contain the associated liabilities at source, fencing them off behind the corporate veil of the subsidiary. If income works its way up the corporate structure like spawning salmon swimming upstream, the liabilities are ring-fenced like their unfortunate farmed cousins.

To try to head risk off before it crystallises, boards of holding companies usually place great reliance on the use of a series of subsidiaries, each acting as a corporate blocker to contain local risk. The objective of such a corporate structure is to militate against the requisite proximity for liability to attach to the parent company.

A stark example is when employees and former employees of Unilever Tea Kenya Limited, operator of a tea plantation in Kenya, brought mass tort proceedings in the English courts. They contended that they were the victims of inter-tribal violence carried out by machete-wielding criminals after the Presidential election in 2007.

They brought a claim against the ultimate holding company, Unilever PLC. They claimed that the risk of such violence was foreseeable by Unilever, that it owed a duty of care to protect them from the risks of such violence, and that it breached that duty.

A group of NGOs, concerned about issues relating to corporate accountability, wrote to Unilever in connection with the claim, writing, “we understand that Unilever has been arguing throughout that it has no real involvement with or legal responsibility for its foreign subsidiaries. For us, this is a surprising and disappointing position for Unilever to be adopting, not least because… Unilever’s enthusiasm for human rights standards does not sit easily with an apparent attempt in this case to hide behind its corporate structure in order to avoid legal responsibility to these victims of serious human rights abuses”.

Any expectation that Unilever might forego the corporate structure protecting it may have been a little naïve, but it did serve to highlight the management’s reliance on it. On the specific facts, the English courts refused jurisdiction on the basis the requisite degree of proximity had not been established.

In governance terms, if the role of a board in managing group risk is simply to put in place a corporate structure before risk is crystallised, then the board need consist only of lawyers. In the case of Unilever, there is also an intermediate holding company sandwiched between BJH and Unilever and, according to Unilever, the parent company is further distanced from BJH by the terms of the acquisition.

Unilever has also been at pains to emphasise that BJH was “acquired” by Unilever and that, by the terms of the deal, its independent Board takes decisions about its social mission. If this is to imply that BJH is not a home-grown company made in the Unilever mould, but an adopted child with a free spirit or troubled background, then this is an artificial distinction of the first order. BJH does not exist in a vacuum. It is no less a part of the Unilever group than any other subsidiary.

At the same time, Unilever has stated that it remains “fully committed” to Israel. This is desperate stuff. The mixed corporate messaging is undoubtedly a trial for corporate communications executives, usually striving for consistency. They might well fear that such corporate niceties might be interpreted along the lines of Oscar Wilde’s caution that “A good friend will always stab you in the front.”

Yet, despite the distancing strategy, the fallout for Unilever has been significant and widespread. And it is continuing. This suggests that if the strategy at parent level is to once again to hide, it is misconceived.

Risk management is at the heart of effective corporate governance. What is expected of any board with regards group risk management? The answer first requires a definition of risk. Alexander Ineichen has defined risk as “exposure to change”. Not all change is uncertain or unknown of course. Risk can often be predicted with a high degree of confidence.

In this case, negative risk (not all risk is bad) was predictable before the BJH decision, assuming Unilever knew or had reason to believe it was coming. Taking a position at odds with the stated purposes of U.S. state anti-boycott legislation was always going to risk a negative impact for BJH and, ultimately, Unilever. Legal, financial and reputational damage have not been confined to BJH; they have followed the money upstream, without regard for separate legal personalities.

There are two possibilities. Either the Unilever board was in a position where it could have proactively managed the risk on an ex-ante basis, but was content to place dogmatic reliance on a playbook that worked in the past; or it was advised that it did not have the corporate authority to manage group risk.

Either case is surely of concern to shareholders. In the first, it was entirely foreseeable that distancing would not work as a strategy. In the second, if the board of Unilever lacked the power to override the decision on risk-management or other grounds, this only serves to highlight to shareholders the existence of a structural problem. Where a company operates through subsidiaries it is not enough for directors to simply distance the parent company from the subsidiary on the basis that they may not be directly responsible for the management of those subsidiaries. Shareholders demand effective governance: control from the top down, not from the bottom up.

As David Chivers QC, a leading company law barrister, has written, “Directors of holding companies must have regard to the same matters in relation to the exercise of control over a subsidiary (even a foreign incorporated subsidiary) as in relation to any other aspect of the holding company’s operations… Directors cannot avoid their responsibilities under the [Companies] Act by placing intermediate holding companies between themselves and the operational companies in a group.”

The board has had its say; shareholders will now want theirs.

 

If you wish to discuss this topic in more detail, please contact your relationship partner or Dan Harris at daniel.harris@chanceryadvisors.com.

NoticeThis publication, which we believe may be of interest to our clients and friends of the firm, is for general information only. It is not a full analysis of the matters presented and should not be relied upon as legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon the content of this publication without seeking advice from professional advisers. © 2019 Chancery Advisors Limited. All Rights Reserved.

Cryptocurrencies – Location, Location, Location October 2021

Damian MorrisManaging Partner Crypoassets

This note considers two basic questions surrounding cryptocurrencies (and other digital assets), namely:

  • what type of asset is a cryptocurrency; and
  • where is that asset located?

These questions arose in the recent judgement of Fetch.AI Ltd & Anor v Persons Unknown Category A & Ors1, an ongoing fraud case in which, in short, it is alleged that persons unknown accessed the claimants’ accounts at Binance Holdings Limited/Binance UK Limited2 and traded cryptocurrencies at an undervalue, resulting in losses to the value standing to the claimants’ accounts of £2.6 million.

What is a cryptocurrency?

While Jesse J noted that “It’s all about the money”, and one could be forgiven for thinking that the clue was in the name, the fact is that with cryptocurrencies it’s not. The various cryptocurrencies such as Bitcoin, Ethereum, Dogecoin and Tether etc, currently making their volatile way through the market landscape, are not money. Cryptocurrency assets credited to an account are regarded as property for the purposes of English law. As Pelling J, succinctly put it:

“They are, to put it no higher for present purposes, a chose in action, and a chose in action, as a matter of English law, is generally regarded as property.”

Where is a cryptoasset located?

Following on from the determination that cryptocurrency was property, Pelling J had to consider whether – again in short – the claim was maintainable under English law and that England would be the proper place to litigate such claim as being the law of the country in which the damage occurred.

To answer this question, Pelling J first had to consider the lex situs of the cryptocurrency. The claimants submitted that it was property located in England, because that was the country where the owners of the assets concerned were located. In agreeing to this reasoning, Pelling J adopted the conclusions reached by Butcher J in Ion Science v Persons Unknown3 at paragraph 13:

“…lex situs of a cryptoasset is the place where the person or company who owns it is domiciled. That is an analysis which is supported by Professor Andrew Dickinson in his book Cryptocurrencies in Public and Private Law at para.5.108. There is apparently no decided case in relation to the lex situs for a cryptoasset. Nevertheless, I am satisfied that there is at least a serious issue to be tried that that is the correct analysis.”

The relevant paragraph of the textbook to which Butcher J referred says the following:

“That analogy with goodwill supports the submission that the benefits accruing to a person who is a participant in a cryptocurrency system such as Bitcoin or Ripple (i) are a species of intangible property in the English conflict of laws, which (ii) arises from the participation of an individual or entity in the cryptocurrency system, and (iii) is appropriately governed by the law of the place of residence or business of the participant with which that participation is most closely connected. Rather than deciding a fictional situs, the choice of law rule can be more straightforwardly, and appropriately, expressed in the terms that the proprietary effects outside the cryptocurrency system of a transaction relating to cryptocurrency shall in general be governed by the law of the country where the participant resides or carries on business at the relevant time or, if the participant resides or carries on business in more than one place at that time, by the law of the place of residence or business of the participant with which the participation that is the object of the transaction is most closely connected.”

Of course, establishing where a legal person “resides or carries on business” is easier said than done in our cross-frontier trading world. In determining that English courts were appropriate in this instance, Pelling J looked to the principles identified and summarised in Adams v Cape Industries4.

However, we wish to look at the wider implications for the trading of this asset class if the lex situs is determined by where the relevant legal owner is domiciled.

Notwithstanding the ongoing disapproval of cryptoassets by global regulators, the genie is very much out of the lamp (and not going back in) with regards to investment and trading interest in this class of asset. As a result, market participants (in growing numbers) are looking at how to incorporate cryptoassets into their investment strategies.

The lex situs of property/assets being bought, sold, transferred, pledged and/or secured has always been a key component in any risk assessment of a transaction. In addition, it is a fundamental component of contractual performance to comply with the jurisdictional requirements by which the relevant property/asset that is the object of any such transaction is governed – whether that is being able to deliver all right, title and interest in and to the asset in question free of any liens, restrictions or other encumbrances or being able to perfect secured rights over the asset in accordance with the local legal requirements in the jurisdiction in which the asset is located.

Older readers may remember the debate as to the proper lex situs of securities when dematerialisation first occurred in the markets. This discussion surrounding cryptoassets is more nebulous: at least with dematerialisedsecurities, there were clear and logical options for the lex situs – e.g. the Issuer’s registered office, the Registrar’s office or the Central Securities Depository’s location. With cryptoassets, however, where do you start? They only exist as lines of digital code and can be accessed from any node anywhere in the world. And besides, the underlying distributed ledger technology is by design not dependent on being in any one central place, jurisdiction or location.

In Ion Science Butcher J commented that there are as yet no decided cases in relation to the lex situs of cryptoassets. However, there is perhaps more than a hint of the beginning of a body of opinion in this area, and this body is looking at where the legal person who owns the cryptoasset is located: at, again as Butcher J noted, “there is at least a serious issue to be tried that this is the correct analysis.” This seems logical, but also seems to be a significant departure from the orthodoxy.

Practical implications

For parties interested in entering into commercial contracts involving the transfer (by sale or as collateral or as security etc) of cryptoassets, there are a few useful steps that could be taken to bring more certainty into your contractual arrangements:

  • agree and establish the domicile of all the parties involved and the capacity in which each is acting5;
  • agree/confirm the jurisdiction(s) for performance of the contractual obligations6; and
  • ensure the effective (and timely) completion of all the necessary formalities (if any) for THE delivery or perfection of security etc in the jurisdiction in which the party who owns the cryptoasset being transferred or secured is domiciled.

Accordingly, if Party A, who is domiciled in London, England and acting as principal, is using Bitcoin to secure a cash loan from Party B, who is based in Guernsey and also acting as principal, Party B should make sure it completes the necessary formalities for perfecting and prioritising its security against third parties in accordance with English legal requirements (to the extent there are any). If, on the other hand, Party A (while still in London) is acting as agent for a New York based principal, then Party B should consider what (if any) legal requirements there are to establish and perfect its security in accordance with New York law.

If you wish to discuss this topic in more detail, please contact your relationship partner or Damian Morrris at damian.morris@chanceryadvisors.com.

Notice: This publication, which we believe may be of interest to our clients and friends of the firm, is for general information only. It is not a full analysis of the matters presented and should not be relied upon as legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon the content of this publication without seeking advice from professional advisers. © 2021 Chancery Advisors Limited. All rights reserved.

1 [2021] EWHC 2254 (Comm)
2 The eagle-eyed of you will no doubt have spotted that Binance UK Limited is the same entity that was issued with a Supervisory Order on 25 June 2021 by the FCA, who at the time also noted that it “was not capable of being effectively supervised.” Last week, however, the FCA updated its position and noted that the firm had complied with all aspects of the FCA’s requirements, broadly giving it the green light for operations in the UK.
3 (unreported) (21 December 2020)
4 [1990] Ch 433
5 Perhaps this seems obvious, but with Group structures and multiple associated and affiliated entities often operating off the same systems, this is often not clear, as the Fetch.AI Ltd case demonstrates.
6 This need not be the same as the governing law of the underlying contract.

LIBOR Alert: IBA and UK FCA Announcements on LIBOR Consultations November 2020

James HaddadPartner Markets Regulation

ICE Benchmark Administration (IBA), the entity responsible for LIBOR administration, has today announced it will consult on its intention to cease publication of euro, sterling, Swiss franc and yen LIBOR at the end of 2021. Discussions on the future of USD LIBOR will continue between the IBA, the FCA, official sector bodies and panel banks.

The FCA has also released a statement regarding the potential use of new benchmark powers conferred by the Financial Services Bill which was introduced into the UK Parliament on 21 October, 2020. The FCA is planning to consult with market participants on its potential approach to the exercise of the new powers to ensure an orderly wind down of LIBOR.

Following this, ISDA released a statement confirming that neither of these announcements will constitute an index cessation event under the IBOR Fallbacks Supplement or the ISDA 2020 IBOR Fallbacks Protocol. As such, no fallbacks under the supplement or protocol will be triggered and there will be no effect on the calculation of the spread.

Separately, Refinitiv, the benchmark administrator for Canadian interest rates, has announced that the calculation and publication of the 6-month and 12-month tenors of the Canadian Dollar Offered Rate (CDOR) benchmark will cease from Monday May 17, 2021 onwards. The last day of publication of these CDOR tenors will therefore be Friday 14 May, 2021. As a consequence, the announcement is expected to mean that the “Spread Adjustment Fixing Date” for the purposes of the ISDA fallback mechanism will be November 12, 2020.

If you wish to discuss this topic in more detail, please contact your relationship partner or James Haddad at james.haddad@chanceryadvisors.com.

Notice: This publication, which we believe may be of interest to our clients and friends of the firm, is for general information only. It is not a full analysis of the matters presented and should not be relied upon as legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon the content of this publication without seeking advice from professional advisers. © 2021 Chancery Advisors Limited. All rights reserved.

ESG Derivatives – a Silver Bullet? November 2020

Dan HumblePartner ESG

As an industry, we have reached the point of near saturation in terms of the ‘noise’ surrounding ESG. What remains to be seen, however, is how the vast majority of buy-side firms will put the theory into practice. Many market participants will be wondering if the emerging pipeline of ESG derivatives could present the answer they have been waiting for.

October saw the introduction of futures and options on ESG indices by Eurex, while Nasdaq aims to offer ESG contracts based on customizable baskets of stocks in 2021. Whilst the use of these products can serve as worthy additions to an ESG strategy, it will be rare that it can be a strategy in and of itself. Complex ESG swaps have also been mooted, under which exposure to the ‘good’ parts of a company or group can be separated from the ‘bad’. Leaving aside the potential conflict with principles of stewardship and engagement (a large part of the ‘G’ in ‘ESG’), these also appear only to be a partial solution.

For an existing fund seeking to add an ESG overlay to an established portfolio and investment strategy, the emergence of ESG derivatives as tools is welcome, but it is not a silver bullet.

A bespoke and detailed ESG policy, including tolerances, which allows fund managers to keep all the tools currently at their disposal requires consideration beyond simply selecting from the plug-and-play products on offer today.

We have seen a great deal more engagement from the buy-side in terms of how firms are approaching ESG investing. The real test is whether firms are able to practice what they preach and deliver investment returns as part of a comprehensive, coherent and credible ESG policy.

If you wish to discuss this topic in more detail, please contact your relationship partner or Dan Humble at daniel.humble@chanceryadvisors.com

NoticeThis publication, which we believe may be of interest to our clients and friends of the firm, is for general information only. It is not a full analysis of the matters presented and should not be relied upon as legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon the content of this publication without seeking advice from professional advisers. © 2019 Chancery Advisors Limited. All Rights Reserved.

Where does the UK / EU trade agreement leave financial services, and what is next? May 2020

Damian MorrisManaging Partner Markets Regulation

The EU–UK Trade and Cooperation Agreement (‘TCA’) contains very little to facilitate access to the EU’s single market for UK financial services firms. However, it is accompanied by a Joint Declaration, which, inter alia, obliges the parties to agree a Memorandum of Understanding on this issue. This note considers how these have affected the provision of financial services, and what may yet happen.

What does the TCA contain regarding financial services?

Excluding the scope and definitions sections, the financial services provisions take up slightly more than one page, in an agreement comprising over 1,200. This is because, as regards services, the TCA is merely intended to establish a favourable climate for the development of trade and investment between the UK and the EU. To this end, it provides a baseline for the treatment of services suppliers from the other side, imposing high-level non-discrimination and market access standards, although there are derogations even from these.

What does the TCA not contain regarding financial services?

The TCA does not retain passporting rights, nor does it address equivalence decisions. UK financial services firms accessing the EU’s single market therefore lost their passporting rights upon the expiry of the transition period.

This is not a surprise, and many firms have been planning for this eventuality since 2016 (the TCA arguably offers little more than would have been available had the UK defaulted to WTO rules). For example, some have set up separate group companies in the EU to continue servicing their EU clients, whilst others are relying on the concept of ‘reverse solicitation’ – i.e. if a customer “initiates at its own exclusive initiative the provision of an investment service”, no passport is required. However, firms using this latter approach should be aware that ESMA published a statement on 13January 2021 noting that “some questionable practices by firms around reverse solicitation have emerged”, and that “including general clauses in their Terms of Business or through the use of online pop-up “I agree” boxes whereby clients state that any transaction is executed on the exclusive initiative of the client” are unlikely to suffice.

Equivalence decisions

If the EU were to make equivalence determinations in favour of the UK, its financial services firms would be able to enjoy many (although not all) of the benefits they had under the passporting regime. However, despite the 2019 Political Declaration stating that both sides would endeavour to conclude their equivalence determinations by mid-2020, this has not happened, and the EU has thus far granted very few.

The Joint Declaration

Instead, the TCA is supplemented by a Joint Declaration on Financial Services Regulatory Cooperation, under which the parties have agreed to establish structured regulatory co- operation on financial services, with the aim of “establishing a durable and stable relationship between autonomous jurisdictions”. The framework for this should be codified in a Memorandum of Understanding, to be agreed by March 2021, and the parties shall discuss “how to move forward on both sides with equivalence determinations”.

However, a non-binding declaration to draw up a framework for future cooperation will be, of course, scant consolation to UK financial services firms for the loss of access to the EU’s single market.

Consequences for UK financial services firms

The almost complete lack of substantive provisions regarding financial services means that there is much uncertainty as to what will eventually be agreed. It is, for example, possible that the EU will grant equivalence decisions across a breadth of areas, and agree to additional measures making it more difficult for such decisions to be revoked. However, this may be highly optimistic, especially if the recent reports that Boris Johnson is holding talks with industry leaders to transform the UK into a lightly regulated ‘Singapore of Europe’ are true. Firms should therefore scrutinise any Memorandum of Understanding and follow updates regarding equivalence decisions, but should also ensure that their business models are ones which will allow them to continue to prosper if no further agreements are reached. Any financial services firms which have thus far postponed taking any action, hoping for equivalence decisions, or that ESMA would take a generous approach to the requirements of reverse solicitation, would be well- advised to plan on the basis that neither of these may occur. For those which have already expended significant effort on Brexit contingency planning, it is unlikely that this will be in vain.

If you wish to discuss this topic in more detail, please contact your relationship partner or Damian Morris at damian.morris@chanceryadvisors.com.

NoticeThis publication, which we believe may be of interest to our clients and friends of the firm, is for general information only. It is not a full analysis of the matters presented and should not be relied upon as legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon the content of this publication without seeking advice from professional advisers. © 2019 Chancery Advisors Limited. All Rights Reserved.

Intermediated Securities – Who owns your shares? February 2020

Damian MorrisManaging Partner Markets Regulation

On 11 November, the Law Commission published its response to the UK Government’s Department for Business, Energy and Industrial Strategy’s request for it to undertake a “scoping study” into investor rights in a system of intermediated securities (the “Paper”)1.

As a scoping exercise, it was not the purpose of the Paper to draw definitive conclusions, merely highlight particular problems and possible solutions. Accordingly, for those of you interested only in the punchline, “watch this space” and/or “back to the UK Government to determine next steps (if any)” just about sums it up.

On the other hand, in accumulating a thorough overview of the benefits and problems associated with intermediated securities and their associated custody chains, the Paper puts down the ground- work for (what we can hope may be) thoughtful and proportionate developments in respect of a complex set of issues.

The Benefits

There is no need to revisit here the legal workings of the chain of trusts, sub trusts and tangential contractual nexuses between the Company, each intermediary in the custodial chain and, finally, the ultimate investor. Nor to spend time considering the nature of the “beneficial” (not “legal”) interest that the ultimate investor holds. It is though useful to consider the numerous and significant benefits that intermediated securities holding patterns have brought to the market, including:

  • increased efficiencies and economies of scale (particularly in using omnibus accounts);
  • lower costs (because of efficiencies ) passed on to ultimate investors;
  • convenience for ultimate investors, particularly where they hold a diverse and large portfolio (which can be multi-jurisdictional) through a single intermediary; and
  • speed of execution, together with lower trading costs and administrative

The Problems

On the debit side of the ledger however, the intermediated securities structure receives significant criticism for (i) corporate governance and transparency issues, and (ii) lack of certainty as to legal rights and remedies.

On the first of these, the most obvious example is the inability of the ultimate investor to exercise voting rights owing to the fact that, not being a direct member and shareholder of the company in question, the ultimate investor is therefore not known by the company. Of course, voting is not the only issue: under English law members of companies have a number of other rights including being able to challenge resolutions to re-register a public company as private2, participate in schemes of arrangement3 and bring contractual claims against the company (the “no look through principle)4. Further, while the recent Tesco5 case clarifies that a person who has acquired “an interest” in securities is able to bring an action against a company for issuing misleading information6, commentators and market participants argue that the relevant legislation should be amended to make this explicit.

Turning to problems with legal certainty, further clarity is considered useful in respect of remedies for wrongly sold securities, the formalities required for transfers of securities7, asset distributions to investors (and share of shortfalls) following an intermediary’s failure and what “possession” and “control” actually mean in the context of giving or taking a security interest and complying with the Financial Collateral Arrangement (No 2) Regulations 2003.

The Proposals

Accepting the need for a proper cost/benefit analysis, the Paper splits its proposals into two. For investor rights, corporate governance and legal certainty, the Paper suggests a range of targeted solutions. These include extending existing regulation (e.g. the Shareholders Rights Directive II) to cover off perceived gaps, making certain focused amendments to existing legislation (e.g. the Act or FSMA) so as to fix or clarify recognised uncertainties, together with supporting the implementation of previous recommendations from, and further ongoing work by, the Law Commission itself. With regards the question of holding securities, the Paper makes three proposals8:

  • remove intermediation altogether, so that all investors are direct shareholders and named on the register of members;
  • retain the current model of intermediation, but also introduce a genuine alternative to allow investors to hold shares directly if they so wish; and
  • look to Distributed Ledger Technology (“DLT”).

These proposals assume that the move towards “dematerialisation” is unstoppable. This is surely true, and while the consensus is that dematerialisation is net positive (and inexorable anyway), that result may not be quite as obvious as it first seems. To start with, in excess of 10 million investors currently hold shares in paper certificated form. In addition, the dematerialisation process was formalised in EU Legislation by the Central Securities Depositories Regulation (“CSDR”)9, and the UK is, of course, leaving the EU prior to the specified implementation deadlines of 202310 and 202511, which means the CSDR requirements no longer apply.

Nonetheless, assuming dematerialisation is here to stay, perhaps the most interesting of these three solutions is DLT. It is becoming more widely accepted that DLT could have many benefits with the data of shareholders not maintained by a central administrator but rather maintained collectively by a network of computers (“nodes”). Such a ledger can demonstrate a direct relationship between the investor and the company – good for voting rights and claims against the company etc. – but, inevitably, is not without its own structural difficulties. To take just two examples: (i) if the ledger is spread across a number of nodes, which in turn are located in a number of jurisdictions, where is the “lex situs” of the asset, and what does that mean vis a vis legal certainty for contracts, transfers, charges, liens, disputes and conflicts of laws questions; and (ii) what exactly is, legally speaking, a DLT record that is accessible through numerous nodes – is it a property right itself or evidence of a property right?

As for the other two proposals, while the direct name of the investor on a company’s register should promote better governance and transparency, together with settling a number of legal certainty complexities, it throws out many if not all of the benefits of intermediated securities. Consequently, and absent profound changes in the market, this would presumably lead to increased costs, less efficiencies and a significant additional administrative burden for each investor. On the other hand, retaining the current model of intermediated securities maintains the established benefits without requiring material changes in the market. The Paper acknowledges that this second solution is the more proportionate response, which nonetheless leaves scope for the development of a realistic, cost effective option of direct ownership for investors who want it, whether for their whole portfolio or in respect of certain securities holdings only.

Next steps

The Law Commissions’ work is done, at least for the time being. It is now for the UK Government to decide whether there should be further work undertaken on this topic. So, watch this space (or did I say that already?).

If you wish to discuss this topic in more detail, please contact your relationship partner or Damian Morris at damian.morris@chanceryadvisors.com.

Notice: This publication, which we believe may be of interest to our clients and friends of the firm, is for general information only. It is not a full analysis of the matters presented and should not be relied upon as legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon the content of this publication without seeking advice from professional advisers. © 2021 Chancery Advisors Limited. All Rights Reserved.

1 The Paper considers solely investments in UK Plc’s and, as a result, holdings via CREST and does not include within its scope pooled funds, such as unit trusts and open-ended investment companies.
2 Section 98 Companies Act 2006 (the “Act”)
3 Section 899 ibid
4 For completeness, it should be noted that this limitation doesn’t affect the ultimate investor’s ability to bring a claim in tort against the company
5 SL Claimants v Tesco plc [2019] EWHC 2858 (Ch)
6 Pursuant to section 90A Financial Services and Markets Act 2000 (“FSMA”)
7 Section 53(1)(c) Law of Property Act 1925
8 Presumably to be implemented alongside the targeted solutions
9 Regulation No 909/2014 of the European Parliament and of the Council of 23 July 2014 on improving securities settlement in the European Union and on central securities depositories and amending Directives 98/26/EC and 2014/65/EU and Regulation (EU) No 236/2012, Official Journal L 257 of 28.8.2014 p 1
10 Ceasing to issue paper certificates for most new publicly traded securities
11 Dematerialisation of existing paper certificates for publicly traded securities

 

Intermediated Securities (as not sold by Tesco) December 2019

Damian MorrisManaging Partner Markets Regulation

The recent case of SL Claimants v Tesco plc [1] is the latest authority concerning the nature of interests held by end investors through an intermediated securities custody chain. It is welcomed as a well-reasoned contribution to the ongoing narrative surrounding what rights ultimate investors have in respect of their securities positions, but is perhaps more confirmatory than revolutionary in nature. Nonetheless it will take its rightful place as part of the ongoing debate both generally and, more specifically, as a result of the UK Government’s direction to the Law Commission to conduct a “scoping study of investor rights in a system of intermediated securities.”[2]

The case concerned a strike-out application in relation to the availability of remedies to ultimate investors for untrue or misleading statements relied on for investment decisions.  Simply put, Tesco argued that ultimate investors holding through an intermediated securities custody chain did not have standing to sue for compensation under section 90A and Schedule 10A of the Financial Services and Markets Act 2000 (“section 90A”, Schedule 10A” and “FSMA” respectively).  Tesco’s argument was based on its narrow construction of the statutory provisions of paragraph 8(3) of Schedule 10A and rested on two limbs:

  1. none of the Claimants had an “interest in securities” within the meaning of paragraph 8(3) in Schedule 10A because none had ever acquired an equitable interest in Tesco shares; and
  2. in any event, and even if they did have such an interest, none of the Claimants had “acquired” or “disposed” of an interest in securities or “contracted to acquire or dispose of securities or of any interest in securities” pursuant to the transfer of legal ownership in the CREST register.

The Court rejected both limbs of argument and dismissed the strike out application. In doing so Hildyard J followed the principles laid out by Briggs J (as he then was):

  • in Lehman Brothers International (Europe) (In Administration),[3] (often cited as the Rascals case) at paragraph 226:  

“it is common ground that a trust may exist not merely between legal owner and ultimate beneficial owner, but at each stage of a chain between them, so that, for example, A may hold on trust for X, X on trust for Y and Y on trust for B. The only true trust of the property itself (i.e. of the legal rights) is that of A for X. At each lower stage in the chain, the intermediate trustee holds on trust only his interest in the property held on trust for him. That is how the holding of intermediated securities works under English law, wherever a proprietary interest is to be conferred on the ultimate investor.”[4]

  • In the matter of Lehman Brothers International (Europe)[5]at [163] where he stated that:

“It is an essential part of the English law analysis of the ownership of dematerialised securities that the interests of the ultimate beneficial owner is an equitable interest, held under a series of trusts and sub-trusts between it, any intermediaries and the depository in which the legal title is vested: see paragraph [226] of my judgment in the RASCALS case.”

  • Together with several further references to the ultimate investor as the “ultimate beneficial owner” in each of the cited cases.

Accordingly, it remains settled law that the issuer cannot see the ultimate investor does not mean that the ultimate investor does not have an interest in the securities.   But the question of the nature of that interest continues to give rise to significant debate, with dichotomies between legislation, practical realities and academic assumptions and arguments. 

At this point, it is perhaps useful to pause to clarify what the confusion is not concerned with.  To start with, it is not about the risks of the intermediated securities custodial chain in respect of failure or insolvency of the links in the chain.  Although jurisdictional risk exists, as a matter of English law the contractual arrangements seek to ensure that their clients’ holdings are held and kept separate from all their own proprietary assets, and therefore remote from creditors of that intermediary should it fail and/or go insolvent. Nor is the flow of the economic benefit to the ultimate investor generally in question; gains and losses in the value of the shares together with dividends etc. will, in the ordinary course, clearly flow through to the ultimate investor. 

The issue is rather that of how the ultimate investor may enforce the rights attaching to the securities and the potential hardship the ultimate investor may face when the issuer does not recognise that ultimate investor as a registered member.  However, this fact pattern occurs as a result of the split of the legal and beneficial ownership of an asset, which is a centuries-old and accepted ownership pattern much loved by equity and trust lawyers, and not because of the intermediated securities holding pattern, which is a more recent development.

The exercise of rights attaching to securities are exercisable only by registered members, the legal owners, of the shares.  When talking about dematerialised securities, the legal owner will be the member on the issuer’s register, and for UK Companies the register of members is held as part of the CREST system.  By and large, the members on the CREST registers will be custodians or nominees of major banking corporations.  Those legal owners may be obliged to exercise those rights in accordance with the instructions of their immediate beneficiary in the chain, assuming they receive valid instructions, but the fact that ultimate beneficial owners can only exercises their rights through the agency of the legal owner is hardly new: the chain created by intermediated securities custodian holding structures merely stretches the distance between the ultimate beneficial owner and the legal holder, it did not create it.

Of course, that can generate practical difficulties. Intermediaries generally only accept an obligation which is something short of an absolute commitment, such as “best efforts” or “reasonable endeavours” in respect of (i) notifying their clients down the chain that certain rights and options have become exercisable and conversely (ii) in acting in accordance with the instructions received, either directly – if the intermediary is the relevant member – or by passing instructions up through the intermediary chain. 

The jeopardy in this state of affairs is open to debate. Unless you really have not been paying attention over the last 25 years or so, this holding pattern is well understood.  The majority of end investors do not have a primary expectation of exercising voting rights in respect of the securities for which they are the ultimate beneficiaries whether they be held via pension funds, unit trusts, trusts, hedge funds or other investment vehicles, at least not without engaging with the structure in which they hold the asset. Consequently, if you are not expecting to exercise voting and other rights and are not concerned either way, the fact that it can be difficult to do so is scarcely a matter of import. 

Stewardship rules and the growing importance of Environmental, Social and Governance (“ESG”) investing criteria, on the other hand, may require more direct engagement with an issuer. Matters such as potential acquisitions, new product lines, board remuneration, withdrawal from sectors etc. may provoke the desire for the exercise of shareholder rights.  However, for a large proportion of asset and wealth management companies this is just not an issue; they have no difficulty in engaging with issuers, regardless of the fact that primarily these managers’ investment vehicles will hold as beneficiaries under an intermediated securities structure rather than as registered members.  But then, as we know, theory and practice often diverge.

This is just as well, because the implementation of  the EU Revised Shareholder Rights Directive,[1] as transposed into UK law,[2] requires managers to set out and adopt policies on this engagement, which should describe, amongst other things, how the firm integrates shareholder engagement in its investment strategy, conducts dialogues with issuer companies and exercises voting rights attached to shares.  Managers should not consider the intermediated securities structure as necessarily frustrating their obligations under this Directive, notwithstanding the practical flaws that may occur in having instructions passed through an intermediary chain on a “reasonable efforts” basis only.

So where does this leave us? There are, we think, several points of clarification and matters that investment managers may consider merit further action. 

The points of clarification are that: (i) ultimate investors have the protections offered by FSMA and so are a class of people that issuers should have in mind (although perhaps the starting point should be that companies should not make untrue or misleading statements in the first place); (ii) ultimate investors are to all intents and purposes “beneficial owners” and therefore have the right to pass instructions up the intermediary chain to the registered member in respect of voting and other rights – it does not matter if you are the beneficiary of the first trust, which is over the equitable interest in the shares, rather than a sub trust further down the holding chain, which only gives “a right over a right” (to the equitable interest in the shares held further up the chain) which is, legally, a different thing altogether; and (iii) the risk in the execution of actual engagement should not disturb compliance with obligations under the EU Revised Shareholder Rights Directive.

The matters for further thought are: (i) if a manager wishes to be truly activist, while being a direct shareholder guarantees skin in the game, it is by and large impractical to have an account at CREST. Absent that, being the beneficiary of the first trust of the registered member (rather than a subsequent sub-trust), is most likely to ensure your views are counted – as a matter of practice, and common sense, the less links in the chain, the less chance there is of something going wrong in the passing of instructions and, consequently, the more likely it will be that the instructions reach their destination and get actioned; and (ii) managers should ensure that their offering documents and periodic updates reflect the distinction between the protection afforded by recognition under FMSA and the risks involved as a result of the intermediated securities holding structure, which FSMA will not cure.

If you wish to discuss this topic in more detail, please contact your relationship partner or Damian Morris at damian.morris@chanceryadvisors.com.

NoticeThis publication, which we believe may be of interest to our clients and friends of the firm, is for general information only. It is not a full analysis of the matters presented and should not be relied upon as legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon the content of this publication without seeking advice from professional advisers.
© 2019 Chancery Advisors Limited. All Rights Reserved
.

[1] [2019] EWHC 2858 (Ch)
[2] Law Commission, ‘Intermediated Securities: Call for Evidence’ (August 2019), available at: https://www.lawcom.gov.uk/project/intermediated-securities/.
[3] [2010] EWHC 2914 (Ch), [2010] 11 WLUK 494.
[4] At para 226; see also decision in Tesco.
[5] [2012] EWHC 2997 (Ch)
[6] Directive 2017/828.

[7] FCA Rules COBS 2.2.3R.

 

Negative Interest on Swaps Collateral June 2019

Dan HarrisPartner Derivatives

On 2 May 2019, the English Court of Appeal ruled in the case of The State of The Netherlands v Deutsche Bank on whether negative interest accrued on cash collateral posted under an English law title transfer ISDA Credit Support Annex (the “CSA”). Paragraph 5(c)(ii) of the CSA provides for the transfer of positive interest from the Transferee to the Transferor. The question was whether, in circumstances where rates were negative, the Transferor had an obligation to account for negative interest. The trial judge held that it did not.

Arguments on appeal by the State. The State argued that although paragraph 5(c)(ii) did not create an obligation to transfer a negative amount, it did not mean it did not have to be accounted for. It argued that the definition of “Credit Support Balance” ensures that a running total is kept under the CSA and that positive and negative interest is taken account of on termination. In addition, the commercial purpose of the CSA is to provide credit protection, not to enable the collateral receiver to make money; that was why both positive interest and distributions had to be passed on.

Arguments on appeal by the Bank. The Bank argued that the absence of an express provision in the CSA or the ISDA User’s Guide demonstrated that it was not intended that negative interest would be accrued or paid. In response to the State’s arguments, the Bank pointed out that this would require a number of asymmetries between how positive and negative interest is accrued and paid under the mechanics of the CSA.

Decision of the Court of Appeal. For the Court of Appeal, an analysis of paragraph 5(c)(ii) was too narrow. Its approach was instead to consider the CSA as a whole. It did not believe that the CSA could be taken as providing for the payment of negative, as opposed to positive, interest. In addition to some fact-specific points, the reasoning of the judges included the following:

  1. The ISDA User’s Guide and various ISDA statements of best practice on negative interest did not show that ISDA thought that negative interest was intended to be payable under the standard form of
  2. Paragraph 5(c)(ii) covers positive, but not negative,
  3. The fact that Interest Amounts were excluded from both the Minimum Transfer Amount and the Rounding provisions created an “inexplicable disparity” between the way in which positive and negative interest would be accounted
  4. The court saw nothing in the CSA read as a whole that gives the impression that negative interest was contemplated or intended. Interest would, of course, be swept up on a default, but that did not mean that negative interest, which might (as turned out to be the case) be theoretically payable for years, would be likely, if intended to be payable at all, to be excluded from paragraph 5 that deals with Interest

Clients will be familiar with ISDA’s Negative Interest Protocol, which is incorporated by reference by some dealers in more recent CSAs. Clients may wish to check the position across their CSAs to ensure consistency.

If you wish to discuss this topic in more detail, please contact your relationship partner or Dan Harris at daniel.harris@chanceryadvisors.com.

Notice: This publication, which we believe may be of interest to our clients and friends of the firm, is for general information only. It is not a full analysis of the matters presented and should not be relied upon as legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon the content of this publication without seeking advice from professional advisers. © 2019 Chancery Advisors Limited. All Rights Reserved.

INR Interest Rate Derivatives Market April 2019

James HaddadPartner Markets Regulation

Background

On 27 March 2019, the Reserve Bank of India published the Non-resident Participation in Rupee Interest Rate Derivatives Markets (Reserve Bank) Directions, 2019 (the “Directions”), concerning Rupee interest rate derivative transactions in India, undertaken on recognised stock exchanges, electronic trading platforms (ETP) and over-the-counter (OTC) markets. The Directions give non-residents access to the interest rate derivatives market in India by allowing them to enter into Rupee interest rate derivative transactions either to hedge an exposure to Rupee interest rate risk or for purposes other than hedging.

Hedging transactions

A non-resident1 may enter into Rupee interest rate derivatives in India to hedge2 its interest rate risk using any permitted interest rate derivative product transacted on recognized stock exchanges, ETPs or OTC markets. The conditions include the following:

  • A non-resident must ensure that its interest rate derivative transactions conform to the provisions of Section 45(V) of the RBI Act, 1934, as well as applicable provisions of the Foreign Exchange Management Act, 1999 and the rules, regulations and directions issued thereunder.
  • Market-makers3 are required to ensure that transactions by a non-resident are being carried out for the purpose of hedging. As a result, market-makers have the right to request any relevant information from the non-resident, who, in turn, is obliged to provide such

Transactions for purposes other than hedging interest rate risk

Non-residents, other than individuals, may enter into Overnight Indexed Swap (OIS)4 transactions for purposes other than hedging interest rate risk. These transactions may be entered into directly with a market-maker in India, or by way of a ‘back-to-back’ arrangement through a foreign branch/parent/group entity (foreign counterpart) of the market-maker. A ‘back-to-back’ arrangement involves the non-resident entering into the transaction with a foreign counterpart of the market-maker at which point the foreign counterpart must immediately enter into an off-setting transaction with the market-maker in India.

OIS Transactions. OIS transactions by non-residents for purposes other than hedging interest rate risk are subject to certain limits: (i) the Price Value of a Basis Point (PVBP), as published by the Clearing Corporation of India Ltd (“CCIL”) on a daily basis, of all outstanding OIS positions transacted by all non-residents must not exceed INR 3.50 billion (PVBP cap); (ii) non-residents must not undertake any further OIS transactions for purposes other than hedging after the PVBP cap is reached; and (iii) the PVBP of all outstanding OIS positions for any non-resident (including related entities) must not exceed 10% of the PVBP cap.

Interest rate futures. Foreign Portfolio Investors (FPIs), collectively, may also transact in interest rate futures (IRF) up to a limit of net long position of INR 50 billion.

1 A person resident outside India as defined in section 2 (w) of Foreign Exchange Management Act, 1999 (42 of 1999).
2 Hedging is the activity of undertaking a derivative transaction to reduce an identifiable and measurable risk. For the purpose of these rules, the relevant risk is Rupee interest rate risk.
3 Entities regulated by the Reserve Bank of India that provide bid and offer prices to non-residents.
4 An interest rate swap based on the Overnight Mumbai Interbank Outright Rate (MIBOR) benchmark published by Financial Benchmarks India Pvt. Ltd(FBIL).

Pre- and post-trade matters

Accounts. All payments related to interest rate derivative transactions of a non-resident may be routed through a Rupee account of the non-resident or, where the non-resident doesn’t have a Rupee account in India, through a vostro account maintained with an authorised bank in India. The market-maker must maintain complete details of such transactions.

Compliance. The Market-maker must ensure that non-resident clients are from a Financial Action Task Force (FATF) compliant country. Market-makers must also ensure that non-resident clients comply with applicable KYC requirements.

Reporting. All OTC Rupee interest rate derivative transactions must be reported by market-makers and ETPs to the trade repository of CCIL, clearly indicating whether the trade is for hedging or other purposes. Market-makers must report trade details, including particulars of the non–resident client for OIS transactions under the ‘back-to-back’ arrangement, to the trade repository of CCIL. Cross-border remittances arising out of transactions in Rupee interest rate derivatives must be reported by banks to the Reserve Bank at monthly intervals in the prescribed format.

Concluding remarks

We suspect many of our clients will be interested in the trading opportunities presented by the opening up of the onshore Indian Rupee interest rate derivative market. We are aware that a number of sell-side entities are already facilitating onshore market access and contacting clients with the requisite documentation to paper these relationships.

If you require advice on draft trading documentation for these products, or if you wish to discuss these matters in more detail, please contact your relationship partner or James Haddad at james.haddad@chanceryadvisors.com or Dan Harris at daniel.harris@chanceryadvisors.com.

Notice: This publication, which we believe may be of interest to our clients and friends of the firm, is for general information only. It is not a full analysis of the matters presented and should not be relied upon as legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon the content of this publication without seeking advice from professional advisers.
© 2019 Chancery Advisors Limited. All Rights Reserved
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