This constitutes the third in a four-part series that discusses the practice of repledging (sometimes referred to as “rehypothecation”), how standard agreements allow for repledging, the treatment of repledging under current law, the potential pitfalls of which borrowers should be aware, and how borrowers can protect themselves going forward.

In Part I , we explained what repledging is — namely, the repledge by a lender of a borrower’s collateral to (i) secure the lender’s own obligations to the lender’s lender, or (ii) facilitate the lender in making a new loan to a different borrower. We also highlighted how standard documentation often permits repledging without the initial borrower’s further consent and even before the initial borrower’s default.

In Part II , we outlined how repledging generally was unfavorable to borrowers as addressed by the Bankruptcy Court in connection with the demise of Lehman Brothers.

In this Part III, we will further discuss how repledging may burden borrowers under current UCC provisions and other law.

A Reminder About Nomenclature

Throughout this client alert series, we refer to the borrower as “Borrower,” the lender (or, for the purposes of this discussion, the broker or broker-dealer) as “Original Lender,” the bank swap counterparty as “Original Co-Lender” (who is most often the same as, or an affiliated entity of, Original Lender), and the beneficiary of Original Lender’s or Original Co-Lender’s repledge of Borrower’s collateral as “Bank Lender.”

Evolution of Legal Treatment of Repledging

Contractual Authorization

Before the advent of the Uniform Commercial Code (the UCC) in 1952, under most case law, repledging generally was permitted (i) by express contractual agreement, or (ii) in the absence of express contractual agreement, so long as the repledged amount was no greater than the amount of the loan from Original Lender to Borrower.

Relevant UCC Provisions

All 50 US states, the District of Columbia, Puerto Rico, and the US Virgin Islands have since adopted, in whole or in part, the UCC.

Although the official comments to the UCC are not statutes, but merely commentary from the panel of lawyers who drafted the UCC for the Uniform Law Commission, courts often consider them in interpretating UCC provisions.

Pre-2000

In the versions of the UCC enacted before the overhaul of Article 9 in 2000, UCC §9-207 provided that a secured party could repledge a Borrower’s collateral in a manner that did not impair Borrower’s right to recover its collateral upon its repayment of its secured obligation. As a practical matter, this meant that if Borrower only owed Original Lender $1,000 and had the right to recover its collateral upon payment of the $1,000 debt, Original Lender could only repledge Borrower’s collateral if Original Lender also had the right to recover the repledged collateral upon payment of not more than $1,000. The provisions of the pre-2000 version of the UCC basically mirrored pre-UCC case law.

Current Repledging

General

UCC §9-207(c)(3) specifically permits a secured party (i.e., Original Lender) having physical possession[1] or control[2] of a Borrower’s collateral to create a security interest in a Borrower’s collateral so Original Lender can repledge it.

In Excess of the Loan Amount

UCC §9-207 no longer contains the pre-2000 provision that protected Borrower’s right to recover its collateral upon its repayment of its secured obligation. Under the current version, Original Lender is permitted to repledge Borrower’s collateral to secure any obligation. It is therefore possible that, even though Borrower has repaid its secured obligation in full to Original Lender, Original Lender might not have adequate resources to redeem the repledged collateral from Bank Lender.

The comments to UCC §9-207 indicate that the agreement between Borrower and Original Lender will determine whether Original Lender’s power to repledge Borrower’s collateral is limited to a repledge that secures an obligation not greater than Borrower’s obligation to Original Lender. Those comments indicate that, in the view of the UCC drafters, it is entirely common for the agreement between Borrower and Original Lender to address this issue, and there is no reason for the UCC to limit an Original Lender’s power to repledge. As a result, at least under UCC §9-207, an Original Lender in possession or control of a Borrower’s collateral may freely repledge Borrower’s collateral to secure any obligation of the Original Lender. Nothing in the UCC limits the ability of Borrower and Original Lender to expressly agree that Original Lender can repledge any collateral — whether or not in the possession or under the control of Original Lender — and whether or not to secure an obligation greater than the obligation of Borrower to Original Lender.

In practice, in transactions in which a Borrower pledges investment securities and instruments (e.g., promissory notes), loan documentation provisions commonly expressly permit Original Lender to repledge Borrower’s collateral and do not address (i) whether Original Lender’s obligation secured by the repledged collateral is or is not greater than Borrower’s obligation to Original Lender or (ii) any requirement for return of Borrower collateral upon Borrower’s repayment of the loan from Original Lender.

Limited Recourse of Borrowers

Under UCC §9-623, Borrower always has the right to redeem its collateral from Original Lender by repaying the secured obligation. But having the right is not equivalent to having the power.

Assume that the obligation for which Original Lender has repledged Borrower’s collateral to Bank Lender exceeds the amount of Borrower’s obligation to Original Lender. In that instance, even if Borrower repays its loan in full, Original Lender would be unable to redeem the repledged collateral from Bank Lender unless Original Lender uses other funds to do so; that is, funds other than the funds paid to it by Borrower. Consequently, Borrower’s power — as distinct from its right under §9-623 — to redeem its collateral depends not only upon its repayment of its loan to Original Lender, but also upon repayment by Original Lender of its loan from Bank Lender.

If, despite having repaid its loan to Original Lender in full, Borrower cannot recover its collateral because it has been repledged by Original Lender to Bank Lender[3] and Original Lender cannot or will not redeem it from Bank Lender, Borrower will have a claim for damages against Original Lender for failure to return Borrower’s collateral.

Ramifications of Bankruptcy or Receivership of Original Lender

Borrower’s claim for damages against Original Lender may be far higher than the value of any collateral that Borrower is able to recover. In addition, as we illustrated in the Lessons of Lehman episode in this client alert series, if Original Lender files for bankruptcy or is in receivership[4], Borrower’s damages claim against Original Lender becomes an unsecured claim, likely worth pennies on the dollar.

Current Limited Restrictions on Repledging

As discussed above and in the Whose Pledged Assets Are They Anyways? episode, applicable law permits an Original Lender to repledge a Borrower’s collateral and much standard documentation (e.g., customer agreements with brokers, International Swaps and Derivatives Association (ISDA) documents with bank counterparties) expressly authorizes Original Lender to repledge Borrower’s collateral without further consent of Borrower.

Applicable law does, however, impose some limits on the behavior of Original Lender, Original Co-Lender, and Bank Lender.

Current Regulatory Limits on Repledging

SEC

The US Securities and Exchange Commission (the SEC) partly governs Original Lender’s ability to repledge Borrower’s collateral when Original Lender is a broker-dealer in a securities transaction. Under the SEC’s Customer Protection Rule,[5] repledging by a broker-dealer Original Lender is limited to 140% of the original loan amount (e.g., if collateral of $5,000 secures a $1,000 loan, only $1,400 may be repledged).

Article 8

Article 8 of the UCC governs the contractual relationship between customers, and brokers, broker-dealers, and the brokerage arms of commercial banks (collectively, “securities intermediaries”). Without delving into the details of Article 8, it is important to note that §8-504(b) provides that a securities intermediary that maintains a securities account for a customer cannot repledge the securities in that account.

Documentation Concern Summary

The concerns outlined above are best summarized in the following Information Statement pursuant to Article 15 of the Securities Financing Transactions Regulation, published on June 8, 2016, by the Securities Industry and Financial Markets Association (SIFMA®):[6]

Where you provide financial instruments to us under a title transfer collateral arrangement or we exercise a right of use [e.g. repledging] in relation to any financial instruments that you have provided to us by way of collateral under a security collateral arrangement containing a right of use, we draw your attention to the following Re-use Risks and Consequences:

1. your rights, including any proprietary rights that you may have had, in those financial instruments will be replaced by an unsecured contractual claim for delivery of equivalent financial instruments subject to the terms of the relevant Collateral Arrangement;

11. those financial instruments will not be held by us in accordance with client asset rules, and, if they had benefited from any client asset protection rights, those protection rights will not apply (for example, the financial instruments will not be segregated from our assets and will not be held subject to a trust);

111. in the event of our insolvency or default under the relevant agreement your claim against us for delivery of equivalent financial instruments will not be secured…

vi. subject to any express agreement between you and us, we will have no obligation to inform you of any corporate events or actions in relation to those financial instruments…

Real World Impact

While the effects of repledging may not be of immediate concern, a renewed focus on the potential pitfalls of repledging is warranted for Borrower, Original Lender, Original Co-Lender, and Bank Lender alike in light of the recent collapses of FDIC-insured banking institutions, such as Signature Bank, Silicon Valley Bank, First Republic, Heartland Tri-State Bank (Kansas), and Citizens Bank (Iowa), especially if financial concerns in connection with a Borrower’s financial institution begin to surface.

In the final part of this series, we will provide general suggestions on how to counter the potential loss of the Borrower’s pledged collateral, absent a default, when entering into transactions with troubled financial institutions.

Additional research and writing from Denny Peixoto, a 2023 summer associate in ArentFox Schiff's Washington, DC, office and a law student at Pennsylvania State University, and Alexis Mozeleski, a 2023 summer associate in ArentFox Schiff's Washington, DC, office and a law student at American University.

[1] Under the UCC, a secured party may perfect its security interest in tangible collateral by physical possession, including through a custodian or other agent. Although goods are tangible collateral, the situations we are discussing in this paper are unlikely to involve goods. Rather, the likely situations would involve instruments (e.g., promissory notes) and certificated investment securities.

[2] Under the UCC, a secured party may perfect its security interest in certain collateral by control. The situations we are discussing in this paper are likely to involve investment securities in securities accounts held by brokers. If Original Lender is the broker that maintains the investment securities pledged by Borrower, control would exist automatically. If the pledged investment securities were held by a separate broker, Original Lender would establish control by entering into a control agreement with Borrower and that broker.

[3] Of course, Bank Lender also could have re-repledged Borrower’s collateral to still another bank lender.

[4] It should be noted that insolvent banks do not file for bankruptcy; instead they enter receivership administered by the FDIC.

[5] SEC Rule 15c3-3 [17 CFR §240.15c3-3].

[6] Copyright © by the International Swaps and Derivatives Association, Inc. (ISDA) [global derivatives], the Association of Financial Markets in Europe (AFME) [European wholesale financial markets], the Futures Industry Association, Inc. (FIA) [global futures, options and centrally cleared derivatives], the International Capital Market Association (ICMA) [global capital markets, repos, collateral markets, commercial paper, CDs, asset management, FinTech and digitization], the International Securities Lending Association (ISLA®) [European, Middle Eastern and African lending] and SIFMA® [U.S. securities]. ISDA, AFME, FIA, ICMA, ISLA® and SIFMA® are all trade associations comprised primarily of financial institutions.

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