iThe practice of repledging (sometimes referred to as “rehypothecation”) is utilized in, among others, loan, swap, and brokerage transactions. In connection with troubled financing institutions, it may be a classic example of borrowing from Peter to pay Paul and was a focus during the 2008 financial crisis with the bankruptcy of Lehman Brothers. Following the recent collapses of FDIC-insured Silicon Valley Bank, Signature Bank, First Republic Bank, Heartland Tri-State Bank, and Credit Suisse, an in-depth analysis of this common practice deserves renewed attention.
Repledging
In a typical secured transaction, a borrower pledges an asset (in most cases this involves securities, although it is possible that the pledged asset can be trade receivables or other collateral) to a lender as collateral to secure a loan.[1] The borrower retains ownership rights to the asset unless there is a default, in which event the lender is entitled to sell or retain the collateral.
What many borrowers fail to appreciate, however, is that despite the borrower’s pre-default retention of ownership rights to the collateral, many standard loan documents permit the lender to further pledge the borrower’s collateral, to (1) secure the lender’s own obligations to a third-party lender, and (2) facilitate the lender in making a new loan to a third-party borrower. This repledging could occur at any time, even prior to a default. Moreover, if a lender repledges the borrower’s collateral, and the lender thereafter becomes insolvent, then the borrower’s only rights could be as an unsecured creditor vis-à-vis its own collateral in the lender’s bankruptcy or receivership proceeding.
This client alert constitutes the first in a four-part series that will discuss repledging generally, how standard agreements and current law treat repledging, the potential pitfalls that borrowers should be aware of, and how borrowers can protect themselves going forward.
A Word About Nomenclature
Throughout this series of client alerts, we will refer to the borrower as “Borrower,” the lender 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 third-party beneficiary of lender’s repledge of the borrower’s collateral as “Bank Lender.”
Repledging Impact
While the original example of repledging that we provided above was of a lender using property pledged as collateral by a borrower to secure the lender’s obligations to a third-party, repledging can occur in a variety of different contexts (e.g., (1) a broker, as Original Lender, utilizing securities posted as collateral by the broker’s client, as Borrower, (2) a swap provider, as Original Co-Lender, typically securing its obligations to a third-party with the same assets pledged to Original Lender). This will become of greater importance in later iterations of this series, where we will discuss how applicable law treats repledging, and how that treatment can differ depending on the type of lender at issue.
Regardless of the types of parties involved, however, repledging is a practice that is completely legal, minimally regulated, and one to which Borrowers routinely consent through execution of standard documentation. However, this likely will only surface as an issue for a borrower when its lending institution is having liquidity issues as potentially occurred this past spring with certain troubled banks.
While we will reserve our discussion on how repledging is currently regulated until the next installment of this series, an overview of how repledging is typically treated under standard documentation is further described below.
Standard Documentation Regarding Repledging
Many standard documents (e.g., customer agreements with brokers, loan agreements with lenders, swap agreements with swap bank counterparties) permit repledging without restriction.
For example, the standard documentation for over-the-counter derivative transactions permits Original Co-Lender to repledge without Borrower’s consent, and to repledge the pledged collateral before Borrower’s default. The standard documentation also provides that if Borrower’s pledged collateral is repledged, Original Co-Lender may retain the proceeds for its own use (as opposed to applying them to Borrower’s obligations to Original Lender and Original Co-Lender). In addition, standard documentation sometimes permits (or does not prohibit) the repledge of Borrower’s collateral in an amount greater than the amounts due to Original Lender.
Why Should Borrowers Care?
In a repledging scenario where Original Lender or Original Co-Lender becomes insolvent, Borrower would become an unsecured creditor, and may receive pennies on the dollar, on its own collateral, in any related bankruptcy proceeding of such lender.[2]
While being unaware of the potential pitfalls of repledging is, at least practically, of little consequence while financial institutions remain stable, the recent bank failures bring repledging into renewed focus.
Upcoming Series
Enumerated below are the themes of each installment:
Part 1 – Repledging Generally
Part 2 – Treatment of Repledging under Current Law
Part 3 – Repledging in Light of the Collapse of Lehman Brothers
Part 4 – How Borrowers can Protect Themselves Against the Dangers of Repledging
Since writers and actors have been on strike, we hope that this series somewhat fills the gap in the fall TV season.
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] Although these principles apply to real estate transactions, use of real estate as collateral is less likely to trigger repledging concerns. However, this caveat is inapplicable to receivables, securities and general intangibles, which are often pledged alongside real estate in the same transaction.
[2] A similar analysis would be applied to the bankruptcy of not just Original Lender, but also any subsequent Bank Lender.
