Smilena Hrusanova of Penkov Markov & Partners in Sofia looks at the issues surrounding participants rights in repo transactions

Both theory and practice attest undisputedly to the fact that repo transactions with financial instruments represent a "technique to obtain short-term financing and additional income" and are concluded as a form of collateral, hence do "not aim at acquiring or selling securities."

Unfortunately, the Financial Supervision Commission’s (FSC) practice shows inconsistency in the treatment of repo transactions’ legal effects related to the acquisition of or share participation increase in the issuer of respective securities by supervised entities.

In reality, repo transactions with financial instruments represent an unnamed contract that combines the characteristics of a financing and a collateral transaction, dressed in the form of a contract for the sale of securities, including a repurchase provision. Under a repo transaction, one party (the grantor/ borrower/ person providing the collateral) transfers the securities to the other party (purchaser/ lender/ secured creditor) for a predetermined period of time and for a certain price (amount of funding), however with a clear commitment to repurchase those securities at a specific future date and at a fixed price (the difference between the prices of the first and second transaction is the cost of funding). In this case, the fulfillment of a transferor/borrower’s obligation to repay the granted funding, including a fee for using it during the agreed period, is guaranteed by transferring ownership of the securities to the purchaser/lender.

In this type of transaction we are talking about the transfer of quasi-ownership, since the purchaser is placed in the position of a secured creditor (the securities themselves serve as collateral) rather than legal owner with title to the securities and respective rights arising from them.

For example, when shares are the subject of a repo transaction, the transferee does not acquire the fundamental rights of a shareholder in a joint stock company, namely the right to a dividend, the right to participate in management and the right of liquidation proceeds. These features/limitations to the ownership of shares acquired under a repo transaction are stipulated through explicit contractual clauses. Very often, repurchase agreements explicitly foresee that the right to vote at the general meeting of the issuer of the respective shares, subject to the repo transaction, is not transferred, and that for the duration of the contract the purchaser of the shares does not exercise any rights arising from them (such as the right to register shares in connection with an issuer’s capital increase resolution). Should the issuer make any dividend payments while the repurchase agreement is in force, the holder of the shares is obliged to transfer the amount paid by the issuer to the transferor. Furthermore, the shares in question are not freely available on the market and thus, cannot be acquired by third parties at any given time, as the transferee under the repo transaction is entitled to do so only upon the occurrence of specific circumstances. In essence, such circumstances are typical forms of default on a credit agreement, which provide the grounds for a lender's right to lay claim and make use of the collateral procured by the borrower. It is also important to note that the repurchase price of securities under the reverse repo does not necessarily represent the shares’ fair value at that given time. This price is fixed in advance, already at the time of the initial transfer of shares, and all risks and rewards arising from the securities’ ownership, including those with respect to fluctuations in fair value, remain with the transferor. Moreover, securities are usually transferred to the transferee for a relatively short period of time (six months to one year), which is being agreed in advance. This is a further indication that a repo transaction’s purpose is not to actually invest in securities.

The above described features of repo transactions are also reflected in their accounting, clearly defined in the International Financial Reporting Standards (IAS 39), which provide for and distinguish two cases depending on whether the transferor company loses actual control over the respective financial asset (securities). In one of these, IAS 39 regulates the hypothesis whereby the transferring company does not lose control over a financial asset (securities). It states explicitly that the transferring company (borrower) does not write the securities off their balance sheet, respectively the receiving party (lender) does not reflected it as an asset in its own balance sheet. Consequently, the transferee of securities must record a receivable in their balance, concerning the financing provided under the repo transaction, while the transferor must record a pledge in relation to said funding. In terms of accounting, such a repo transaction shall not be treated as a final purchase and sale of securities.

In light of the above, the FSC Insurance Supervision Department’s practice, according to which the acquisition of shares under a repo transaction with abovementioned characteristics leads to a real change in a trensferee’s share participation in the capital of the issuer of shares, is not only incomprehensible, but also creates unjustifiable uncertainty in sales figures.

The correct application of the law inevitably goes through a thorough analysis of the contractual terms of each repo transaction with securities. It is imperative to clarify the question of whether it is a case of actual acquisition of dematerialized securities (and all rights "incorporated” therein) or not. Should it be determined that the repo transaction is concluded as a form of relaxed lending for a relatively short period of time, whereby the creditor has no long-term investment plans for the acquisition of securities and does not intend to take control over the issuer, quite to the contrary - there is a clear intent to restore the status quo, which existed before the signing of the repurchase agreement, namely through the commitment to repurchase the securities, then the enforcing body’s only legally justifiable conclusion can and should be that there is no acquisition or share participation change of the securities’ purchaser in relation to their issuer’s capital.


Smilena Hrusanova

Attorney at Law

Penkov Markov & Partners