An ancient legal tool, the sale with right of redemption has surprising and sophisticated applications in today's financial world. Originally designed for real estate transactions, it has been rediscovered by the capital markets for its flexibility. This mechanism enables the temporary transfer of ownership of securities, offering solutions for financing, investment or asset management. However, its ambiguous nature, halfway between a definitive sale and a secured loan, exposes the parties to significant legal risks. For an in-depth understanding of sale with right of redemption, consult our complete guide covering all aspects of the operation.
The various uses of sale with right of repurchase in financial practice
Although its use has declined in favour of more standardised instruments such as repurchase agreements, repurchase agreements remain relevant for specific transactions where their unique structure provides a suitable solution.
Sale with right of repurchase as an investment or financing instrument
One of the most common applications of repurchase agreements is cash management. The transaction enables a seller, often a bank or institutional investor, to obtain liquidity by temporarily selling part of its securities portfolio. The seller obtains financing at a generally advantageous rate, as the transaction is secured by the securities transferred.
For the buyer, which may be a collective investment scheme (UCITS) or a company managing its surplus cash, the transaction is similar to a short-term investment. The buyer acquires full ownership of the shares while receiving a return in the form of the difference between the purchase price and the redemption price. This structure was particularly popular with money-market funds, known as "réméré" funds, which were able to hold securities in compliance with regulations while offering a stable return to their subscribers.
Sale with right of repurchase in securities lending transactions
Sale with right of repurchase can also be used as an alternative to securities lending. In this case, the main objective is not cash but the temporary availability of the securities themselves. The buyer needs to hold the securities for a short period, for example to cover a short sale or to carry out an arbitrage transaction on the financial markets.
Rather than a formal securities loan, the seller "buys" the securities under a repurchase agreement. It uses them for its transaction and then, at maturity, the seller exercises its repurchase option to recover its assets. The price of the securities then acts as collateral, and the remuneration for the transaction is included in the difference between the sale price and the repurchase price.
The application of repurchase agreements for tax management
A more technical use of repurchase agreements concerns so-called "coupon" transactions. Certain securities, particularly bonds, give entitlement to a tax credit when the interest is paid. A holder who is unable to claim this tax credit (for example, an organisation with a tax deficit) has an interest in temporarily transferring ownership of the securities to another entity that can benefit from it.
The sale with right of repurchase is then concluded just before the coupon detachment date. The buyer receives the coupon and the associated tax credit, then the seller exercises his right to repurchase. The tax gain is shared between the two parties through the agreed repurchase price, which is adjusted to reflect this optimisation.
Carrying shares and hedging stock options
A repurchase agreement can also be used to carry securities. A person (the principal) wants a third party (the holder) to hold securities on his behalf for a certain period, before selling them back to him or to a designated beneficiary. Sale with right of repurchase enables this commitment to be structured, by offering the originator an option to repurchase the securities.
Similarly, a company that has issued stock options to its employees must be able to deliver the corresponding shares to them if they exercise their options. To cover this risk, it can sell shares to a financial institution under a repurchase agreement. This ensures that the company can buy back the shares it needs when the time comes, within the five-year limit set by law.
The major legal problems associated with the practice of repurchase agreements
The main advantage of réméré, its flexibility, is also the source of its greatest risks. The fundamental ambiguity lies in the nature of the 'option' to repurchase. Legally, it is simply an option left to the seller. Economically, in most financial transactions, both parties regard it as an obligation. This difference opens the door to disputes and reclassifications. To understand the strict conditions and complex effects of the Find out more about the legal status of repurchase agreements here.
Counterparty risk: when the redemption option is not exercised
The most direct danger for the buyer is that the seller chooses not to exercise his right of repurchase. If, during the term of the transaction, the value of the securities collapses, the seller has no economic interest in buying them back at the agreed price. He will prefer to abandon the securities and keep the proceeds of the initial sale. The buyer then finds himself the definitive owner of heavily depreciated assets, suffering a dead loss.
This risk is particularly acute if the seller is the subject of insolvency proceedings. The insolvency administrator, acting in the interests of the creditors, will only exercise the repurchase option if it is profitable for the company. The DG Bank affair in the early 1990s cruelly illustrated this danger, when a bank refused to buy back impaired bonds, causing its counterparties to suffer substantial losses.
The risk of requalification: when the sale with right of repurchase becomes a contract of pignorance
If a judge considers that, in the common intention of the parties, the repurchase was not a simple option but an obligation, he may decide to re-characterise the contract. The sale with right of redemption is then no longer considered a genuine sale, but a loan of money secured by a transfer of ownership of the securities.
Historically, such a transaction was treated as a pacte commissoire, i.e. a clause enabling the creditor to appropriate the collateral in the event of non-payment. For a long time, however, the pacte commissoire was prohibited by the Civil Code, which meant that the agreement was null and void. The consequences for the buyer were disastrous: as the 'sale' was cancelled, he lost ownership of the securities that served as collateral, while having only a simple claim for repayment of the funds lent.
Analysis of case law and doctrine
The courts do not stop at the name of the contract. To determine the true nature of the transaction, they look for the real intention of the parties. There are a number of clues that can lead to a reclassification: the existence of a counter-letter providing for a repurchase obligation, a sale price that is clearly lower than the real value of the securities, or the habitual and repeated nature of these transactions for a trader. For a long time, case law penalised these arrangements by reclassifying them as void pignorative contracts, in order to protect the 'seller' (borrower) from being ripped off by the 'buyer' (lender).
Mitigating the risks: arguments in favour of legality and practical solutions
Despite these dangers, the risk of requalification should not be overestimated. Legislative changes and a pragmatic analysis of the situation mean that many repurchase agreements can be secured.
The limited scope of the requalification risk
It is essential to remember that not all sales with a right of redemption conceal a loan. In many cases, the intention of the parties is to effect a temporary transfer of ownership for reasons other than the creation of a security interest. This is the case for securities lending transactions or "coupon-based" tax management. The objective is to hold the securities, not to secure a debt. In these cases, the risk of reclassification as a pignorative contract is low, because the very purpose of the transaction is different.
The limited scope of risk: developments in legislation and case law
The strongest argument in favour of the validity of these arrangements is the development of security law. The prohibition on commissory agreements, which was the basis for the risk of nullity, has been considerably relaxed. Since the 2006 ordinance, article 2348 of the Civil Code expressly authorises a clause whereby a creditor may take possession of the pledged asset in the event of the debtor's default.
This legislative validation of the pacte commissoire makes the risk of a sale with right of repurchase being null and void, even if it is reclassified as a security transaction, virtually non-existent, especially when the transaction involves financial instruments. The legislator has gradually accepted the validity of transfers of ownership by way of security, as illustrated by the repurchase agreement and financial guarantee regimes. This fundamental trend indirectly secures sales with a repurchase option used as a guarantee instrument.
Réméré and double sale: implications in the event of requalification
If the court rejects the classification of the transaction as a sale with right of repurchase because of the compulsory nature of the repurchase, it will not necessarily declare the transaction null and void. Instead, he may reclassify the transaction as a double sale (a cash sale followed by a forward resale) or as a repurchase agreement, subject to the specific rules of the Monetary and Financial Code.
Such a reclassification is not neutral. It changes the legal effects of the transaction: instead of a retroactive resolution of the initial sale, there are two separate transfers of ownership. Reclassification as a repo or double sale has significant legal and tax implications. Find out about the tax optimisation strategies linked to sale with right of repurchase and how they are affected by its qualification..
Sale with right of redemption is a powerful instrument, but one that requires great caution. Its hybrid structure can be a source of litigation if it is not perfectly mastered. Precise contractual drafting and upstream analysis of the intention of the parties and the economic purpose of the transaction are essential to prevent the risk of recharacterisation. To secure your sale with right of repurchase transactions and anticipate legal risks, our expert lawyers will help you.
Sources
- Civil Code, in particular articles 1659 to 1673 (sale with right of redemption) and 2348 (validity of commissory agreement).
- Monetary and Financial Code, in particular articles L. 211-27 et seq. (repo system) and L. 211-36 et seq. (provisions on financial contracts).
- Commercial Code, in particular Article L. 225-126 (information on temporary transfers of shares).
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