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interest in favour of the US has priority over all other interests.44 But because of the limited scope of the federal rules and their overall similarity to UCC Articles 8 and 9, the following sections will primarily focus on the UCC.45

8.3.2 Indirect holding under the UCC

As noted above, the revised Article 8 takes a neutral position in that it caters for different holding practices. The underlying idea was that the development of these practices should be solely determined by market and regulatory forces, and that the UCC should not influence such development.46 The most important goal of the 1994 revision therefore, was to provide sound legal underpinnings for the indirect holding system based on securities accounts. To that end, a new conceptual framework was created in which ‘security entitlement’ is the central notion. A security entitlement must be understood as the package of rights an accountholder can assert against his immediate intermediary.47 Thus, the security itself and the rights an accountholder enjoys as to this security via an intermediary are sharply distinguished.

Generally, investors can assert direct rights to their securities only in a situation of direct holding, and an issuer has ‘primary’ obligations towards the beneficial owners only in such a situation.48 When securities are indirectly held on the other hand, the rights of beneficial owners relate to their intermediary’s obligation to pass on the issuer’s primary obligations.49 UCC Article 8 considers only the first tier in the indirect holding system, i.e. the relationship between the issuer and legal owner/first intermediary, as a direct holding relationship to which the rules connected therewith apply.50 In other words, beneficial owners in the indirect holding system are always holders of a security entitlement, but only the first-tier intermediaries hold securities themselves.51

4431 CFR § 357.12(b) and (c).

45For a highly detailed treatise with many references to regulatory law as well as case law, see GUTTMAN (2005).

46QUINN (2001), [Rev] § 8-101[A][2].

47See further infra, s. 8.3.3 and 8.3.4.

48In the in the language of UCC Article 8: the issue of a security does not constitute the establishment of a security entitlement; UCC § 8-501(e). Consequently, the issue of ADRs also does not result directly in the creation of a securities entitlement; UCC § 8-501 official cmt. 5.

49UCC § 8-501 official cmt. 5.

50It is to the security itself, and thus to the relationship between issuer and first intermediary, that the definition of ‘security’ (see the next section) should be tested, and not to other relationships, such as the one between the beneficial owner and its account provider; In re County of Orange, 219 B.R. 543, 36 UCC Rep. Serv. 2d 181, 552 (Bankr. C.D. Cal 1997).

51Cf. In re County of Orange, 219 B.R. 543, 36 UCC Rep. Serv. 2d 181 (Bankr. C.D. Cal 1997).

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Since a security entitlement does not represent a claim to securities themselves, but a package of claims against a specific account provider, the concept excludes tracing, and an accountholder has no direct legal relationship with his securities through the chain of intermediaries.52 Consequently, a security entitlement is not transferable, as it is created by a credit-entry in a securities account and is extinguished by a debit-entry.53 This approach corresponds perfectly with the modern practice of securities custody, where every intermediary has a securities account in its own name with the next intermediary, CSD or issuer, and where the underlying assets are not only fungible, but also located at different tiers. Moreover, because the drafters of the Revised UCC Article 8 abandoned the concept of tracing, the number of intermediaries that are interposed between issuer and ultimate investor does not influence the substance of the latter’s rights.

Securities eligible

For the purpose of Article 8, UCC § 8-102(a)(15) provides a definition of ‘security’ which is very broad and covers practically all types of financial instruments.54 Thus, to all kinds of debt instruments and interests in the issuer or its property, the provisions of Article 8 apply. As to form, the definition distinguishes between bearer, registered and uncertificated securities. ‘Bearer securities’ relate to physical certificates that represent the security and jumbo and global certificates are therefore also considered to fall within this category.55 Registered securities are characterised by the fact that it is the issuer’s register that ultimately determines the investors’ ownership and transfers thereof, even though certificates are often issued as a means of evidence.56 ‘Uncertificated securities’ relate to dematerialised securities that exist only because of a credit-entry in the issuer’s books.

Furthermore, § 8-102(a)(15)(ii) requires that a ‘security’ be one of a class or series, or be divisible into a class or series, so as to distinguish it from negotiable instruments (drafts, checks, certificates of deposit, notes57). In addition, ‘securities’ are required to be tradable on a securities market. But should an instrument not be tradable, issuers can opt in for the application of Article 8, provided the instrument is a medium for investment.58

52E.g. UCC § 8-102 official cmt. 17 and UCC § 8-104 official cmt. 2. Cf. ROGERS (1996), 1456.

53UCC § 8-501 official cmt. 5. See also ROCKS & BJERRE (2004) 35-36.

54This definition differs substantially from the definition of ‘security’ as developed for purposes of federal securities laws; ROCKS & BJERRE (2004) 6-7.

55UCC § 8-102 official cmt. 15. But see GUTTMAN (2005), 1-25 et seq. and GUTTMAN (1990), 447-449.

56UCC § 8-102(a)(13).

57UCC § 3-104.

58UCC § 8-102(a)(15)(iii)(B).

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The definition of ‘security’ as just discussed is particularly important in the context of directly held securities. The rules of UCC Article 8 on securities accounts, however, are applicable to an even broader category of financial instruments, as UCC Article 8, Part 5, applies to all assets that are held in an indirect holding system by means of a securities account.59 Thus, UCC Article 8 considers a security as a type of financial asset, but the Article also caters for the (indirect) custody of other types of financial assets, such as options; § 8-102(a)(9).60 But financial assets must be tradable in order to fall within the scope of Article 8, although its application can also be opted for, just as non-tradable securities.61

Since a security entitlement, i.e. the means by which ownership of a financial asset is evidenced, is also referred to as ‘financial asset’, both a security entitlement and the underlying asset are referred to as a ‘financial asset’, which thus represents an exception to the distinction that is generally made between entitlement and underlying asset.

Securities accounts62

A securities account is defined very broadly in UCC § 8-501(a) so as to include different types of relationships that have securities or other financial assets as an object. UCC § 8-501(a) intends to include, for instance, both the relationship between a clearing corporation and its participants, and between a securities firm or bank and its customers. To accommodate these different relationships and changing market practices, a relationship classifies as a ‘securities account’ under the UCC if the subsequent application of the rules of Article 8 would be ‘consistent with the expectations of the parties to the relationship.’63

A securities account and a corresponding securities entitlement can be created by a credit-entry in the books of a securities account provider,64 or by an intermediary’s acceptance of a security certificate or other financial asset when that asset is to be credited to a securities account; UCC § 8-501(b). An entitlement may thus be created before a securities account is credited. It must be noted, however, that the acceptance of a security certificate by an intermediary alone is not sufficient to result in the creation of a securities entitlement, as the accepting intermediary must also intend to credit an accountholder’s account accordingly. But if the intermediary fails to make the appropriate and corresponding entry in a securities account, any

59UCC § 8-102 official cmt. 9.

60Cf. also UCC § 8-103(e).

61UCC § 8-102(a)(9)(iii).

62See GUTTMAN (2005), 1-31 et seq., extensively on operational aspects of securities accounts.

63UCC § 8-501 official cmt. 1.

64Cf. 31 CFR § 357.12(a) on the creation of a securities entitlement on the books of a Federal Reserve Bank.

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obligation under non-UCC law to do so results in a de iure creation of a security entitlement.65 In these particular instances, a security entitlement is therefore created without a credit entry in a securities account.

Conversely, when an account provider has credited one of its customers’ securities accounts, a securities entitlement is created, even if the account provider does not hold all corresponding assets; UCC § 8-501(c).66 Thus, ‘maintenance of financial assets is a consequence of, not a cause of, the establishment of a security entitlement’.67 This rule may be thought of as an encroachment on entitlement holders’ rights, as it sanctions uncovered credit entries, i.e. credit entries that do not correspond with identical entries in the account provider’s omnibus account with the higher tier, which thus reduces the estate against which accountholders can enforce their claims. But good reasons have been advanced to support the provision.

First, it has been argued that it corresponds with current market practice, in which operational gaps exist between the moment that a credit-entry is made in a transferee’s securities account, and the moment that the account provider has received the corresponding assets.68 Second, UCC § 8-501(c) does not imply that an intermediary is free to create securities entitlements without corresponding assets, since both UCC § 8-504 and regulatory law restrict the ‘uncovered’ crediting of securities accounts by intermediaries to a minimum.69

Third, it gives conditional transfers proprietary effect, so that accountholders/putative transferees are protected should their account provider become insolvent, even if that account provider does not hold all corresponding assets. This is generally regarded as a considerable improvement compared to the traditional property law construct employed in the prior version of UCC Article 8. Under that construct, accountholders obtained the status of co-owners only if they were entitled to specific, identifiable assets, and putative transferees were therefore not proprietarily protected.70 Fourth, UCC § 8-501(c) generally facilitates the extension of credit in the form of securities. More in particular, it facilitates the extension of securities credited to a so-called margin account, i.e. an account to which securities are credited that have not (yet) been fully paid for by the

65UCC § 8-501(b)(3) and see UCC § 8-501 official cmt. 2.

66When an account provider receives the financial assets that correspond to its customers’ entitlements, he is considered a ‘purchaser for value’, and consequently enjoys the protection connected with that status. Thus, such an account provider takes free of third party claims regarding the financial assets it holds for its clients; UCC §§ 8-303 and 8-502. See also infra, s. 8.4.2.

67ROCKS & BJERRE (2004), 40.

68UCC § 8-501 official cmt. 3. Cf. SEC rule 15c3-3, 17 CFR § 240.15c3-3(b)(2).

69See infra, s. 8.3.3.

70MOONEY (1990), 335-337 and GUTTMAN (1990), 463.

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accountholder.71 In sum, it is submitted that UCC § 8-501(c) represents an important improvement compared to the older version of Article 8 that was based on the traditional property law construct.

8.3.3 Accountholder – intermediary relationship

UCC Article 8 governs the accountholder – intermediary relationship, but by no means exclusively. First, an intermediary may perform many services that do not fall within the scope of Article 8, such as investment advice and the like. These aspects of the accountholder – intermediary relationship are left to other laws, such as the law of contract and agency on the one hand, and state and federal regulation on the other. Second, in their capacity as custodians, intermediaries are subject to state and federal regulatory law, and UCC Article 8 only applies when these regulations do not.72 Finally, the common law of contract and agency may supplement UCC law.73

At an early stage in the revision project of UCC Article 8, it was decided not to describe the accountholder – custodian relationship in ‘old’ legal concepts of the common law.74 Instead, UCC Article 8 now describes and regulates in a functional way the intermediary’s duties towards its customers/securities accountholders.75 The UCC defines minimum standards that an account provider should comply with, and provides supplementary rules.

Because of the functional approach, the characterisation of the accountholder

– intermediary relationship in common law terms has become unnecessary and, as such, characterisation proved to be impossible, so that the new approach better corresponds with the sui generis character of the accountholder – intermediary relationship. Yet the common law may supplement UCC law when the latter does not apply, and the following section therefore discusses the common law concepts by which the accountholder – intermediary relationship was traditionally characterised.

Common law concepts

Bailment is defined as the ‘rightful possession of a chattel by one who is not the holder of the title to it’.76 While few would object to such a minimal

71See GUTTMAN (1990), 464-468, on the segregation of these categories of accounts.

72Yet it is reminded that banks and broker/dealers are regulated by different regulators with different policy goals.

73Cf. UCC § 8-509 official cmt. and Legislative Intent at UCC § 8-101, by the New York legislature; Laws 1997, Ch. 566, § 5.

74ROGERS (1996), 1496. Cf. MOONEY (1990), 310 et seq.

75Cf. UCC § 8-102 official cmt. 17.

76BURKE (2003), 182.

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definition, the character of bailment is not uncontroversial. It has been analysed both as a property law relationship and as a contractual one, with different legal consequences.77 The disagreements with regard to bailment are long-standing, and bailment does not seem to be applicable to intangibles. For instance, under both the property and contractual approach, bailment requires the ‘possession’, i.e. the actual physical control, of a ‘chattel’, i.e. tangible goods.78 These concepts clearly do not match the holding of interests in fungible financial assets.79

Another element of bailment is the bailor’s relinquishment of control over the chattel. The relinquishment of control is a central element of trust also, where the trustee has a high degree of control over the affairs of the beneficiary. But unlike bailment, the trust property can be intangible.80 Further, the fact that the settlor, i.e. the initiator of the trust, loses legal title to the trust property and retains only equitable rights, whilst the bailor remains the legal owner, represents a major difference between bailment and trust.81 Moreover, if a settlor wants to assert his rights to the trust property (e.g. in the trustee’s insolvency), a settlor must show that he can follow the property into the trustee’s estate.82 Since the tracing of fungible intangibles that are located at different tiers of a custody chain is impossible, the trust generally does not apply to the custody of indirectly held securities.83

A bailee who has been given the authority to deal with the bailment goods classifies as an agent.84 Agency is distinguished from trust because an ‘agent is ordinarily not the owner of property for the benefit of his principal, while a trustee always holds title (…).’85 The pre-1994 versions of UCC Article 8 incorporated agency law into the accountholder – intermediary relationship, but restricted its applicability to situations in which the ultimate investor was registered as the owner in the issuer’s books.86 Because, as a matter of principle, ultimate investors are not registered as owners in modern indirect holding structures, and because an intermediary is – in its capacity as custodian – not empowered to deal with its customers’ assets, an agency can generally not be said to apply to the accountholder – intermediary relationship.87 In conclusion, none of the pertinent common law concepts

77BROWN (1975), 209.

78BROWN (1975), 223.

79The custody of a fungible chattel is also considered bailment under the common law, although older case law had characterised the bailment of fungibles as a sale; BROWN (1975), 237-238. Cf. BURKE (2003), 208.

80Restatement Third, Trusts § 40. See also BOGERT (1987), 2.

81BOGERT (1987), 28.

82SCOTT & FRATCHER (1987), § 523.

83Cf. MOONEY (1990), 377.

84See HYNES & LOEWENSTEIN (2005), 29.

85BOGERT (1987), 35.

86Cf. MOONEY (1990), 419, Appendix II.

87Cf. MOONEY (1990), ns.220 and 257.

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proves to be fully applicable to the sui generis accountholder – intermediary relationship, and the functional approach of the revised UCC Article 8 therefore correctly takes a functional approach.

Flexible duties

As stated previously, the current version of UCC Article 8 describes an intermediary’s duties towards its customers in a functional way. Interestingly, Article 8 not only defines these statutory duties, but also describes the methods by which they can be satisfied, and it will show that the description of these methods allows for greater flexibility in their satisfaction. Generally, an account provider’s duties are satisfied either when their performance is specifically defined in an (account) agreement, when the account provider exercises due care as required by reasonable commercial standards, or when the account provider complies with requirements of other law.88

The underlying policy consideration for the reference to party autonomy was to protect accountholders’ expectations in the best way possible, and to provide for sufficient flexibility at the same time.89 Such flexibility, it has been argued, could be needed in extraordinary custody situations or when irregular securities were held by the intermediary. The custody of foreign securities over which the intermediary can exercise little control as to their actual safekeeping, for instance, could require a lenient approach towards the performance of the intermediary’s duties.90 Moreover, a variable standard of care is consistent with the common law concept of bailment, in which freedom of contract is only limited to violations of public policies.91

However, party autonomy as referred to in, e.g. UCC § 8-504(c)(1), is not entirely unrestricted, for intermediaries are bound by both a practical incentive to preserve their reputations and by the legal obligations required by general contract law. Thus, an intermediary must refrain from fraud and generally act in good faith.92 Under the UCC, the performance and enforcement of contracts and duties in good faith is understood as an observation of ‘honesty in fact’ and the ‘reasonable commercial standards of fair dealing.’93 General principles of private law on the other hand, understand ‘good faith’ as ‘faithfulness to an agreed common purpose and

88As a matter of legislative technique, the first two ways in which an intermediary’s duty may be complied with are repeated in each of the provisions that list these duties; UCC §§ 8-504 up to 8-508. The third way is codified in a separate provision; UCC § 8-509.

89ROGERS (1996), 1503-1504. Cf. MOONEY (1990), 409-410 and Legislative Intent at UCC § 8-101, by the New York legislature; Laws 1997, Ch. 566, § 5.

90UCC § 8-504 official cmt. 4.

91ROGERS (1996), 1505-1506.

92See, e.g., UCC § 1-304 (Obligation of Good Faith).

93UCC § 1-201(b)(20).

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consistency with the justified expectations of the other party’.94 Applied to the accountholder – intermediary relationship, the justified expectation of an accountholder would be that his account provider would allow the accountholder to enjoy the ‘benefits of the economic or other rights that comprise ownership of the security’.95

Absent an agreement, it is the standard of ‘due care’ that determines how an intermediary’s duties should be satisfied, and an intermediary must observe such due care both with regard to its own operations and its selection of other intermediaries through which it operates. The due care standard is meant to incorporate the principles of the common law under which all circumstances are taken into account to determine whether the standard is met.96 More specifically, professional securities custodians exercise due care if they ‘provide, for a fee, a level of expertise in securities processing that avoids or minimizes the risk of accidents.’97 Although this standard corresponds with the standard of good faith discussed immediately above, these standards are distinguished, and it is therefore possible to contract out of the exercise of due care, provided the intermediary remains within the limits set by the standard of good faith.

The intermediary’s duties are mainly aimed at passing through the ‘primary’ rights that are connected with the financial assets to which a securities account refers.98 More specifically, UCC §§ 8-504 – 8-508 set out the following duties:

1.To obtain, and thereafter maintain, the amount of financial assets

that corresponds to the aggregate amount of assets to which the intermediary’s clients are entitled.99 As a consequence, an intermediary is forbidden from disposing of the securities to which

its clients are entitled, either by transfer of title or by granting a security interest.100 But this prohibition applies only when provisions of federal law do not. SEC rule 15c3-3, for instance, imposes on

broker/dealers a duty to ‘promptly obtain’ and ‘thereafter maintain’101 the securities carried for their customers, while rules 8c-

1 and 15c2 forbid the hypothecation of customer securities.102 Under federal law, a violation of these rules constitutes a criminal

94Restatement Second, Contracts, § 205.

95ROGERS (1996), 1508. Cf. UCC § 8-501(a) official cmt. 1.

96UCC § 8-504 official cmt. 4.

97ROGERS (1996), 1507.

98Cf. UCC § 8-501(a).

99UCC § 8-504(a).

100UCC § 8-504(b).

10117 CFR § 240.15c3-3(b). This wording was directly included in UCC § 8-504(a); UCC § 8-504 official cmt. 1.

10217 CFR §§ 240.8c-1(a) and 240.15c2(a).

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offence.103 In addition, state law forbids these practices under the law of bailment or other laws of contract.104

2.To obtain and pass through the proceeds of the underlying securities.105

3.To comply with the accountholder’s directions regarding corporate actions and other rights connected to the accountholder’s assets.106 Since as a principle of the indirect holding system, a CSD, its nominee, or other intermediary is registered in the issuer’s books as the (legal) owner, UCC § 8-506(a) requires that an account provider

must comply with its customers’ directions, thus acting as a representative, and not at its own discretion.107

4.To comply with accountholders’ entitlement orders, provided that these orders are given by the appropriate person.108 For that purpose,

an intermediary should check the order’s genuineness, and the intermediary should reasonably comply.109 In the case where an intermediary transfers accountholders’ assets pursuant to an ineffective entitlement order and thereby wrongfully transfers the

assets, the intermediary can be held liable and must reimburse the deprived accountholder.110 An intermediary is not under an obligation to comply with a third party’s orders unless this is agreed upon with the entitlement holder, even if such a third party has been mandated under agency law to act on the entitlement holder’s behalf. However, if an intermediary does comply with a duly authorised

agent’s orders, he is not liable, even in the absence of an agreement to that effect with the entitlement holder.111

103Securities Exchange Act of 1934 § 32, 15 USC §78ff (1994).

104ROGERS (1996), 1519. But if customer securities have been (re)hypothecated by an intermediary without its customers’ consent, the security taker may take free of and gain priority over the customers’ claims; see infra, s. 8.4.2.

105UCC § 8-505(a). Cf. SEC rule 14b1-1 that provides a similar rule concerning the forwarding of communications to the beneficial owners by securities firms; 17 CFR § 240.14b-1.

106UCC § 8-506(a).

107Yet an accountholder may, of course, confer discretionary authority upon his intermediary; UCC § 8-506 official cmt. 1 and 2. An intermediary may also put its client in a position to exercise its rights directly; UCC § 8-506.

108See UCC § 8-107(a)(3) (definition of ‘appropriate person’) in conjunction with § 8- 102(a)(7) (definition of ‘entitlement holder’).

109UCC §§ 8-507(a) and 8-102(a)(8).

110UCC § 8-107(b). See, e.g., Powers v. American Express Financial Advisors, Inc. 82 F. Supp 2d 448, 40 U.C.C. Rep. 2d 597 (D. Md. 2000) [43 UCCLL7 (Sept. 2000)], where the court held that the securities transfer concerned followed an ineffective entitlement order, as the order was made without appropriate authority. In addition, it was decided that ‘other law’ determined that the intermediary should bear the loss (consistent with UCC § 8-507 official cmt. 4), even though the intermediary had exercised due care in accordance with reasonable commercial standards. Cf. Watson v. Sears, 766 N.E. 2d 784, 47 UCC Rep. Serv. 2d 722 (Ind. Ct. App. 2002).

111ROCKS & BJERRE (2004), 47. See further UCC § 8-107(a)(4) and (a)(5) and UCC § 8-507

official cmt. 4.

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5.To comply with accountholders’ orders to change the form of holding. An accountholder may require that his account provider transfers his assets to another intermediary, delivers the assets out of the indirect holding system or otherwise provides the entitlement holder with direct ownership of the assets. But this duty is not unconditional, as the requested form of holding must be available

and the entitlement holder must be eligible for the requested form of holding.112

8.3.4Nature of accountholder interests

Prior to the 1994 revision of UCC Article 8, investors holding interests in indirectly held securities were considered to enjoy co-ownership rights in pools of securities on the basis of a trust construction. This ‘property law construct’ was based on the idea that investors are (co-)owners of discrete property in the possession or control of their intermediaries/account providers.113 However, upon proper analysis of the modern practice of securities custody, the revisors of UCC Article 8 concluded that the property law construct poorly matched that practice. Considering the fact that securities are by definition fungible and may be held at various tiers in various jurisdictions, scholars and practitioners alike argued that the proper approach would be to focus on the accountholder – intermediary relationship, rather than to trace ownership rights from investor to security.114

Consequently, the notion of ‘security entitlement’ was coined, a notion that refers to a sui generis package of rights that Article 8 confers upon securities accountholders.115 A security entitlement is acquired the moment when a

112UCC § 8-508.

113Cf. UCC § 8-503 official cmt. 2.

114Cf. UCC § 8-504 official cmt. 1 and UCC § 8-502 official cmt. 2, where reference is made

to the impossibility of tracing in a clearing system with net settlement. In such a system, all obligations to deliver to a seller’s intermediary are set off against its rights to receive, so that a seller’s intermediary may ultimately receive, rather than have to transfer assets. A particular fierce advocate of abandoning the property law construct was MOONEY (1990), 310: ‘(…) a property law construct for resolving priorities among claimants to fungible bulks of securities is a fundamentally flawed approach’, ib., 313: ‘(…) the property law construct is inadequate and unworkable’, and ib., 378: ‘As observed in the context of same-tier priorities, its [i.e. the property law construct’s, MH] application to different-tier priorities is confusing, awkward, and unprincipled.’ ROGERS (1995), 694 has likened tracing and its underlying technique, i.e. applying the traditional conceptual structure of property law to book-entry securities, to ‘the technique made famous by Procrustes’. Cf. also GUTTMAN (1990), 453, with reference to the fact that even federal law cannot require a registered owner to disclose the beneficial owners’ identity.

115 SPINK & PARÉ (2004), 358 have noted that the concept was known in Canada prior to its recognition in the US.

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