Charges over Securities in Margin Accounts: Fixed or Floating?

Introduction

It is common for securities firms to create first fixed charge over securities and monies deposited into margin accounts opened by their clients with the securities firms by virtue of standard terms and conditions. Those standard terms and conditions are generally executed by their clients together with other account opening documents at the time of account opening, and are often carefully drafted to provide a high level of protection in respect of the rights and interests of the securities firms. The characterisation of such charge as fixed charge has never been challenged in front of the Hong Kong Courts. Such charge is therefore commonly regarded by the industry as ranking ahead of charging order and/or further fixed charges subsequently created over the same batch of shares deposited in those margin accounts because the former is a fixed charge created first in time.

In Bei Ni Ltd v Cornwell (Hong Kong) Ltd [2023] HKCFI 1799, the characterisation of such charge as fixed charge has for the first time been challenged in front of and determined by the Hong Kong Court of First Instance (CFI).

DLA Piper Hong Kong (led by Harris Chan, Partner and assisted by KC Tai, Of Counsel and Rita Chow, Senior Associate) represented Huatai Financial Holdings (Hong Kong) Limited (Huatai) in the Bei Ni case, in which the CFI agreed with Huatai and confirmed that the charge over securities and monies deposited in a margin account created in favour of Huatai by virtue of standard terms and conditions executed by its margin client was a fixed charge, notwithstanding challenges raised by a competing creditor who alleged that such charge was merely a floating charge.

 

Factual Background of the Bei Ni case

In the Bei Ni case, Cornwell (Hong Kong) Ltd (Cornwell) opened a margin account (Margin Account) with Huatai in July 2022, and was required to deposit collateral into the Margin Account. The collateral was subject to a fixed charge in favour of Huatai (Huatai Share Charge) as per the terms and conditions of the Margin Account (T&C):

“… the Client hereby charges in favor of Huatai, free of all encumbrances and adverse interests:

1. by way of a first fixed charge, its interests and rights in all present and future Securities, Collateral, receivable and monies (including any dividends, rights, monies or property accruing in respect thereof) delivered to, deposited with, transferred to, or held in the possession of, in the name of, or under the control or direction of Huatai, or any nominee of Huatai (including Securities, Collateral, receivable and monies held in any Account); and,
2. by way of a first floating charge its interests in all assets referred to in paragraph (a) above insofar as not already charged by way of fixed charge under these Terms and Conditions. …” (emphasis added)

The T&C specifically provided that Huatai may sell any of the collateral where an event of default is triggered, and further restricted Cornwell’s freedom to deal with any collateral deposited into the Margin Account.

Cornwell deposited shares of Shanghai Bio-heart Biological Technology Co Ltd (Listco No: 2185) (2185 shares) as collateral into the Margin Account in July 2022, and 3,459,700 2185 shares left in the Margin Account (Charged 2185 Shares) at the material time.

Bei Ni Ltd (Bei Ni), a creditor of Cornwell, obtained a charging order nisi over the Charged 2185 Shares on 14 October 2022, which was made absolute on 14 December 2022 (P Charging Order). By then, the share price of the Charged 2185 Shares had plummeted from HKD51 on 1 November 2022 to just HKD8.38 on 14 December 2022. In exercise of its rights as the chargee under the Huatai Share Charge, Huatai began to dispose of the Charged 2185 Shares on 15 December 2022, selling 1 million shares on that day.

In the evening of 15 December 2022, Bei Ni and Cornwell jointly applied for an ex parte injunction against Huatai, seeking to restrain Huatai from disposing of the rest of the Charged 2185 Shares. The injunction application was dismissed by the CFI on 16 December 2022 upon the undertaking by Huatai to pay the sale proceeds of the Charged 2185 Shares (Sum) into court, which was done by 29 December 2022.

Huatai took out a summons applying for payment out of the Sum to satisfy Cornwell’s margin debt in the Margin Account. The Summons was opposed by Bei Ni.

 

Issue in Dispute in the Bei Ni case – Was the Huatai Share Charge a fixed or floating charge?

The dispute between Huatai and Bei Ni turned on whether the Huatai Share Charge (created by virtue of the T&C) had priority over the P Charging Order over the Charged 2185 Shares – there was no dispute that the Huatai Share Charge was created first in time, but Bei Ni alleged that the Huatai Share Charge was merely a floating charge which crystallised after, and thus ranked behind, the P Charging Order.

As such, the only issue in dispute was whether the Huatai Share Charge a fixed or floating charge.

 

The CFI’s Decision in the Bei Ni case

The CFI held that the provisions in the T&C prima facie sought to create a fixed charge. The issue was whether there was any justification to depart from that characterisation.

Upon consideration of the T&C and the actual operation of the Margin Account, the CFI was of the view that there was no justification to depart from that characterisation (i.e. the Huatai Share Charge was a fixed charge):

First, the T&C provides that “… and the Client shall not (without the prior written consent of Huatai) be entitled to withdraw any Collateral in part or in whole from its Account”. There is therefore clearly positive legal control by Huatai over the shares in the Margin Account.

Second, with reference to Agnew v Commissioner of Inland Revenue [2001] 2 AC 710 at §32, the CFI was of the view that the operation of the Margin Account was similar to a situation where a fixed charge is created over book debts. In this regard:

1. Cornwell had the ability to dispose of securities in its portfolio but only through Huatai as broker. This is important as such disposals could not be carried out without the knowledge of Huatai, and Huatai could refuse permission or grant permission on terms.
2. The question is not whether the company is free to collect the uncollected debts, but whether it is free to do so for its own benefit. Any arrangement will be inconsistent with the charge being a floating charge if the proceeds collected are not available to the company as a source of its cash flow. Cornwell had no control over the sale proceeds. Instead, the sale proceeds were automatically applied to reduce/ discharge Cornwell’s margin debt to Huatai, which can be demonstrated by the daily statements of the Margin Account. In other words, the proceeds never became available to Cornwell.

As such, the CFI held that the Huatai Share Charge was a fixed charge and had priority over the P Charging Order. The CFI ordered the Sum (i.e. the sale proceeds of the Charged 2185 Shares previously paid into Court by Huatai) be paid out to Huatai to satisfy Cornwell’s margin debt in the Margin Account due and owing to Huatai.

 

Key Takeaways for Securities Firms

Distressed borrowers and competing creditors can always come up with novel arguments (and even work together) trying to avoid being held liable for the borrowers’ repayment obligations and/or to obtain the benefits of security granted in favour of the securities firms first in time.

It is excellent news that the CFI confirmed in the Bei Ni case the (very common) creation of first fixed charge over securities and monies deposited into margin accounts by virtue of standard terms and conditions remains legally possible.

The classification of the charge in the Bei Ni case as fixed charge is highly fact-sensitive. In other words, it does not mean that all fixed charges created over securities and monies deposited into margin accounts by virtue of standard terms and conditions will be considered by the courts as fixed charges (as opposed to floating charges). That characterisation will depend on first, the provisions contained in the terms and conditions (noting that naming the charge concerned as “fixed charge” does not conclusively mean that it will be characterised as fixed charge) and second, the actual operation of the margin accounts concerned – the more control the securities firms have over the securities and monies deposited into the margin accounts (by virtue of terms and conditions and the actual operation of the margin accounts), the more likely the charges concerned will be considered as fixed instead of floating charges.

As such, in order to protect the interests of securities firms, it is important for the documents creating fixed charges in favour of securities firms (e.g. terms and conditions and security deeds) be very carefully drafted in order to make sure that the securities firms have as much control over the securities and monies (particularly, sale proceeds of the securities), both before and after margin calls (if any), as possible. It is also important for the actual operation of the margin accounts concerned to be consistent with the rights and powers granted to the securities firms under those documents such that distressed borrowers and competing creditors cannot later try to argue that, despite the express provisions in those documents, the securities firms actually do not have adequate control as a matter of fact to have the charges concerned to be characterised as fixed charges.

A non-exhaustive list of relevant matters which the courts will likely take into account in evaluating the level of control the securities firms have over the securities and monies in the margin accounts include:

1. Disposal of the securities in the margin accounts:


1. Do the clients have to first seek consent (written and/or oral) from the securities firms before they can dispose the securities?
2. Do the clients have no choice but to dispose the securities through the securities firms?
3. Do the securities firms have knowledge (before and after the relevant disposals) with regard to the disposal of the securities?
4. Do the securities firms have the rights and powers to prevent the clients from disposing the securities?
5. Do the securities firms have the rights and powers to control the timing, manner and price of the disposal of the securities?
6. Do the securities firms have the rights and powers to dispose the securities against the clients’ will?


2. Withdrawal of monies in the margin accounts:


1. Do the clients have to first seek consent (written and/or oral) from the securities firms before they can withdraw monies from the margin accounts?
2. Do the securities firms have knowledge (before and after the relevant withdrawals) with regard to the withdrawal of monies?
3. Do the securities firms have the rights and powers to prevent the clients from withdrawing the monies?
4. Do the securities firms have the rights and powers to control the timing and manner of the withdrawal of the monies?
5. Do the securities firms have the rights and powers to withdraw/ apply the monies against the clients’ will?


3. Application of sale proceeds of the securities:


1. Are the sale proceeds of the securities applied (automatically or otherwise) to satisfy the margin debt of the margin accounts?
2. Are the sale proceeds of the securities applied (automatically or otherwise) to satisfy any other outstanding indebtedness due and owing by the clients to the securities firms?
3. Are the sale proceeds of the securities available for the securities firms’ benefit or for the clients’ benefit?

Securities firms often use standard terms and conditions and/or standard security deeds to create its clients’ charges (i.e. all its clients will generally execute the same set of documents providing same level of control over the securities and monies in margin accounts to the securities firms). In this regard, it will likely be too late for a security firm to only find out after a dispute has arisen and been determined by the court that the level of control that security firm has over the securities and monies in a margin account is in fact too low such that the charge concerned is merely a floating charge, which will mean that all the other charges created by virtue of the same standard documents will have the same classification as floating charges, causing significant adverse impact on the security firm concerned and its ability to recover debts from all its clients with the charges concerned.

As such, securities firms are recommended to conduct thorough internal review of the documents creating fixed charges in favour of securities firms and the actual operation of its margin accounts forthwith. If it is now noted that there is any inadequacy or area of doubt in the documents concerned (e.g. there is no express provision stating that the securities firms can apply sale proceeds to satisfy margin debt automatically) and/or the actual operation of the margin accounts, improvements shall be made to the documents concerned (e.g. by virtue of amending the documents concerned for future clients and entering into supplemental agreements with existing clients) and/or the actual operation of the margin accounts as soon as possible to fill the gap.

Full text of the judgment of the Bei Ni case can be read here.