Avoiding Collateral Damage: Whose Pledged Assets are They Anyways?

The 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. 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.

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