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securities account relationship has been created, i.e. when a credit-entry has been made in an accountholder’s securities account.116 A security entitlement consists of an accountholder’s rights in rem as well as in personam against the intermediary that maintains the securities account, i.e. the account provider.117 The contractual rights of an accountholder mainly consist of the intermediary’s obligation to hold the accountholder’s financial assets in good faith, a rather general obligation which is substantiated by the more specific duties discussed above.118

An accountholder’s rights in rem are thus evidenced solely by a credit balance in the books of a financial intermediary, while Article 8 does not impose a statutory obligation on that intermediary to separate its own assets from those of its customers. But although an account provider registers all credit balances in an omnibus account in its own name with a higher-tier intermediary, client assets do not form part of the intermediary’s property, and customers’ claims have priority over their account provider’s claims in the case of the latter’s insolvency.119

Although, in principle, rights in rem or proprietary rights are enforceable against all third parties, under UCC Article 8, an accountholder’s rights may only be asserted against third parties, i.e. persons other than their account provider, in very specific situations. First, since the Article 8 system is not based on traceable property rights, accountholders’ interests in the financial assets held by their intermediary are calculated pro rata, and the traditional property law maxim prior tempore, potior iure therefore does not apply.120 In other words, all accountholders are treated equally as to the moment in time of the acquisition of their interests and, as a consequence, an accountholder cannot assert his rights against his fellow accountholders.121

Second, it is only in insolvency situations, that an accountholder can assert his rights against the intermediary‘s trustee in bankruptcy, the intermediary’s creditors and other third parties. Under certain circumstances however, the account provider’s secured creditors take free of the accountholders’ claims.122 Moreover, an accountholder can successfully assert his interests against third parties only in extraordinary circumstances, viz. if the insolvent intermediary’s estate appears to show a deficit because the intermediary had violated its obligation to obtain sufficient assets, if the trustee in bankruptcy

116Cf. UCC § 8-102 official cmt. 7 and UCC § 8-501(b).

117See, e.g., MOONEY (1990), 413, GUYNN & ROGERS (2002), 607 and ROCKS & BJERRE (2004), 50. Some have, on the other hand, considered the intermediary-investor relationship to be ‘basically contractual’, albeit supplemented by ‘some measure of protection which normally comes from a property interest’; OOI (2003), 216. Cf. SCHIM (2006), 22.

118UCC § 8-504 et seq. See also UCC §§ 8-102(a)(17) and 8-505 and supra, s. 8.3.3.

119UCC § 8-503(a).

120CODEX IUST. VIII, xviii, 3.

121UCC § 8-503(b) and cf. UCC § 8-502 official cmt. 4.

122See infra, s. 8.4.2.

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does not enforce the accountholder’s claim, and if the third party concerned is not protected under the rule that protects bona fide transferees against competing claims.123

As a corollary of this limited enforceability of an accountholder’s rights, both other accountholders and other financial intermediaries are almost always protected against competing claims.124 Thus, while an accountholder’s rights are protected against competing claims, these rights can usually only be enforced against his own intermediary, and the UCC regime provides accountholders with solid legal certainty as to their security entitlement.

8.3.5 Intermediary insolvency and the treatment of shortfalls

Federal law

Federal insolvency law pre-empts the rules of UCC Article 8, which therefore deal with the property position of accountholders, rather than with the distribution of assets of a bankrupt estate.125 While the allocation of losses in the insolvencies of banking institutions is made under state law, securities firms’ bankruptcies are principally governed by federal law.126

Under the Securities Investor Protection Act (‘SIPA’) of 1970, the Securities Investor Protection Corporation (‘SIPC’) was founded.127 Membership of that corporation is mandatory for securities firms that are registered with the SEC, and the SIPC is authorised to initiate liquidation proceedings in the case of a securities firm’s insolvency. In such instance, the SIPC distributes all securities present in the insolvent estate pro rata between those clients that have ‘customer’ status, while it makes no separate distribution per category of securities.128 Should the estate appear to be insufficient to satisfy all customers’ claims, the SIPC makes contributions to all customers up to an amount of $500,000 per customer to satisfy the deficit.129

123UCC § 8-503(d). All these conditions were met in Nathan W. Drage, P.C. v. First Concord Securities, Ltd., 184 Misc. 2d 92, 707 N.Y.S. 2d 782, 41 UCC Rep. 2d 673 (2000) [34 UCCLL 10 (Dec. 2000)]. On the protection of third parties, see infra, s. 8.4.2.

124See Cotton v. Private Bank and Trust Co., 49 UCC Rep. Serv. 2d 1281 (N.D. Ill. 2003), where the court held that pursuant to UCC § 8-115, the intermediary in question could not be held liable, because it did not act in collusion with a wrongdoer. Cf. infra, s. 8.4.2.

125UCC § 8-503 official cmt. 1 and 2.

126Cf. MOONEY (1990), 361. Deficits arising in a banking institution’s insolvency, however, are initially covered by the Federal Deposit Insurance Act; 12 USC §§ 1811-1832.

12715 USC §§ 78aaa et seq.

128As an over-simplification, ‘customers’ are understood as all entitlement holders who are not broker/dealers; 15 USC § 78fff-2(4). See MOONEY (1990), n.74. Cf. also ib. at 364.

129USC § 78fff-3(a). The money is funded by mandatory membership fees; 15 USC § 78ddd(c).

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Securities firms bankruptcies that are not covered by SIPA, are governed by Subchapter III of chapter 7 of the Bankruptcy Code. Under the provisions of that code, a similar procedure is applied as the one just described, but, as a difference, distributions are made by the trustee in bankruptcy, rather than the SIPC.130 Furthermore, the trustee does not distribute all securities present in the insolvent estate pro rata amongst the account provider’s clients, but

first reduces the securities to money and then distributes the proceeds pro rata.131

UCC

As stated previously, the proprietary rights that UCC Article 8 confers upon a securities accountholder become almost exclusively apparent in the insolvency of that accountholder’s intermediary. Accountholders’ interests are then calculated pro rata per category of securities, and these pools of securities are distributed accordingly. A possible deficit in any of these pools is also allocated pro rata per pool.132

The pro rata sharing mechanism implies that accountholders are treated equally in the event of a winding up of the securities pools, with no distinction being made as to the moment of their acquisition of interest. As stated before, this forms a departure from the traditional property law maxim prior tempore, potior iure and is in accordance with a risk allocation approach.133 It is, on the other hand, analogous to the common law treatment of the commingling or confusion of chattels.134

Accountholders’ securities entitlements do not form part of the insolvent intermediary’s estate and therefore take free of the intermediary’s general creditors’ claims as if they were identifiable assets that belong to the

130Clients of non-SIPA covered account providers are therefore not automatically insured against their losses like the SIPA insures investors; see, e.g., www.fdic.gov/consumers/consumer/information/fdiciorn.html.

131See MOONEY (1990), 352 et seq. and GUTTMAN (1990), 460.

132§ 8-503 official cmt. 1. Thus, the distribution is made differently under UCC than under SIPA. However, the present author believes that it must be agreed with MOONEY (1990), n.191 and MOONEY (1998), 91-93, that there is no good reason why customers holding entitlements to a certain category of securities should bear the costs of a deficit in this pool of securities (as would be the case under UCC Article 8), while other customers of the same insolvent intermediary who hold entitlements to another category of interests do not, when neither customer was in a position to assess the likelihood of a deficit in one or another pool of securities held. Moreover, MOONEY (1998), 92, also shows that the allocation model he proposes results in a lower risk of large losses and a higher risk of small losses and is therefore also more economically justifiable.

133Cf. MOONEY (1990), 329.

134See, e.g., BURKE (2003), 369.

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intermediary’s customers.135 Yet this rule is subject to two important exceptions. First, secured creditors of the intermediary have priority over entitlement holders rights if they have control of the secured assets.136 Second, all secured creditors of clearing corporations take free of the claims of the clearing corporation’s clients, regardless of whether these creditors have obtained control of the secured assets.137 These two exceptions will now be briefly discussed, but first, the concept of control will be explained.138

Under the UCC, a creditor can acquire control over directly held, uncertificated securities either by becoming registered as the owner in the issuer’s books, or by instructing the issuer to comply with entitlement orders from the security taker.139 A creditor can acquire control over indirectly held securities in a number of ways. First, he can obtain legal ownership of the collateralised securities, and the debtor is then left with a mere equitable right. Alternatively, the creditor, debtor and the debtor’s account provider can enter into a control agreement under which the securities remain registered in the debtor’s name, but the account provider agrees that it will comply with entitlement orders from the pledgee without further consent by the pledgor. Such a control agreement may also be concluded between the creditor and the debtor’s account provider with the debtor’s consent, or so as to confer a third party with the authority to give entitlement orders.140 Thirdly, a third party may obtain control of the collateralised securities on behalf of the creditor, and finally, the creditor automatically obtains control over the debtor’s assets if the creditor is the debtor’s account provider.141

The rule that an intermediary’s secured creditors take free of the claims of that intermediary’s clients contrasts with the traditional property law principle of nemo dat quod non habet, as those creditors can thus assert rights that were not the intermediary’s to convey. Yet the intermediary’s creditors are protected and can enjoy their rights as if the intermediary’s accountholders do not have better claims. On the other hand, this rule is in accordance with another principle of property law, viz. the negotiability principle, under which bona fide transferees are protected against competing claims.142 However, secured creditors are granted priority over entitlement holders’ claims, while these creditors are not subject to all requirements that

135UCC § 8-503(a). In the instance of a shortfall, see UCC § 8-511(a). Cf. MOONEY (1990), n.200.

136UCC § 8-511(b).

137UCC § 8-511(c).

138The concept of control will also appear to play a crucial role in the rules that concern the protection of bona fide transferees and the perfection of security interests. See infra, s. 8.4.2. and 8.5.2.

139UCC § 8-106(c).

140UCC § 8-106(d)(2) and (3), respectively.

141UCC § 8-106(d) and UCC § 8-106(e), respectively.

142Cf. ROGERS (1996), 1522. On the negotiability principle, see infra, s. 8.4.2.

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normally apply for purchasers to be protected; secured creditors are not

required to have had no notice of the adverse claim in order to be protected against it.143

The priority of secured creditors over accountholders has also been justified by other arguments. First, reference has been made to the benefits that the (securities) market as a whole enjoys, when lenders are willing to extend credit to intermediaries, and it has been argued that the extension of credit is more attractive if lenders can obtain collateral that has a low possibility of being challenged by competing claims.144

Second, since creditors who acquire control over secured assets by obtaining ownership of those assets do not differ in appearance from other accountholders, there appear to be no good reasons to prioritise one accountholder over another. Consumer protection would also not require a different approach, as it has been pointed out that the difference between secured creditors and accountholders does not translate ‘neatly into any lines of class, wealth, power, or the like’.145 Moreover, the alternative, viz. a first- in-time rule under which claimants with older rights trump younger claimants, would lead to fortuitous results, for it is impossible to establish a connection between the time a right is created and a particular financial asset, when these assets are by definition fungible and untraceable.146 Finally, the rule cannot be argued to encourage intermediaries to enter into agreements while using investors’ assets as collateral, since the UCC as well as state law and federal regulations expressly forbid such conduct.147

The rule that all secured creditors of clearing corporations take free of the claims of the clearing corporation’s clients, regardless of whether these creditors have obtained control of the secured assets, has been justified by the fact that a clearing corporation’s creditors are not in a position to take control of the secured assets.148 A clearing corporation is the highest tier in the custody chain, and securities transfers by book-entry to another intermediary (other than on the clearing corporation’s own books) are therefore impossible. Moreover, because of a clearing corporation’s pivotal role in the clearing and settlement process, it has been argued that it should be in a better position to provide collateral and obtain credit than someone else.149 Second, clearing corporations are highly regulated entities and are

143See infra, s. 8.4.2.

144Cf. ROCKS & BJERRE (2004), 58.

145Accountholders may be institutional investors, while creditors (e.g. pension funds) may represent retail consumers; ROGERS (1996), 1529.

146ROGERS (1996), 1513 et seq. In priority contests between some classes of security takers however, a first-in-time rule applies; see infra, s. 8.5.2.

147UCC § 8-504(b). See UCC § 8-511 official cmt. 2, ROGERS (1996), 1519 and supra, s.

8.3.3.

148UCC § 8-511 official cmt. 3 and UCC § 9-310 official cmt. 6.

149REITZ (2005), 364-365.

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therefore arguably even less enticed than other intermediaries to enter into security agreements with creditors while using their clients’ assets as collateral.150 Third, the rule corresponds with the previous version of UCC Article 8 that treated all transferees recorded on the books of a clearing corporation as bona fide purchasers, and consequently took free of competing claims.151

Both rules just discussed result in the priority of upper-tier claimants over lower-tier claimants. Apart from legal considerations, such a result is justifiable on economic grounds. The analysis made by MOONEY, for instance, shows that the priority of upper-tier claimants is more efficient, since it allocates loss (viz. not honoured claims in intermediary insolvencies) to the class of claimants that could avoid or reduce the losses at the lower cost, viz. by choosing another intermediary.152 In addition, he argues that this class also places a lower value on their priority. Yet the present version of UCC Article 8 takes the position that normative considerations should sometimes be preferred, as upper-tier creditors with unsecured claims, upper-tier creditors who have not obtained control and upper-tier creditors subject to the exception of UCC § 8-503(d) remain subject to entitlement holders’ claims.

8.4 SECURITIES TRANSFERS

8.4.1 Introduction

Prior to the enactment of the Uniform Commercial Code, securities transfers were governed by the Uniform Stock Transfer Act – in the states that had adopted that statute. One of its most important features was the ‘negotiability principle’, i.e. a protection of transferees against competing third party claims. That principle continues to play an important role in the provisions of UCC Article 8.153 In the following section, the negotiability principle and its implementation in UCC Article 8 will be discussed, but first, some general remarks will be made on the transfer of securities.

All categories of securities can be transferred without any formal requirement. For instance, general rules of private law determine that the contract that initiated a securities transfer need not be in writing for the transfer to be effective.154 But a transfer of securities can only be asserted

150ROCKS & BJERRE (2004), 58-59.

151See MOONEY (1990), 400 et seq. and cf. infra, s. 8.4.2.

152MOONEY (1990), 384 et seq.

153Cf. GUTTMAN (1990), 443 and ROCKS & BJERRE (2004), 1

154See ROCKS & BJERRE (2004), 21 and 22.

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against third parties if certain requirements have been met, and different categories of securities require the fulfilment of different technicalities.

A transfer of directly held bearer securities can be asserted against third parties (including the issuer) only when the transferee has obtained possession of the certificates. A transfer of directly held registered securities on the other hand, is made effective against third parties through the registration of the transferee’s name in the issuer’s books, or the endorsement of the certificate in the transferee’s name and the transferee’s possession of that certificate. Transfers of directly held, uncertificated securities can only have proprietary effect through the registration of the transfer in the issuer’s books.155

In the case of indirectly held securities, a transfer has proprietary effect, i.e. it can be asserted against third parties, when the transferee acquires a security entitlement, resulting in a credit-entry in his securities account.156 Thus, a securities transfer is ‘implemented’ when the securities entitlement of the transferor has been extinguished, and the transferee has acquired a corresponding entitlement through a credit-entry in his securities account.157 Consequently, transfers can only be initiated by an entitlement order from the entitlement holder to his account provider.158

8.4.2 Negotiability

As a general principle of Anglo-American property law, a transferee can only acquire the rights which his transferor has to transfer (nemo dat quod non habet).159 UCC Articles 8 and 9 derogate from this principle in most instances, to protect innocent purchasers of securities against the adverse claims of third parties that might have been involuntarily dispossessed of their assets. As a related general principle, a transferee acquires all the rights his transferor has to transfer. For example, if a transferee acquires from a bona fide transferor, he will be treated as a bona fide purchaser, even though his transferor acquired his interest from a mala fide transferor. The present UCC Article 8 codifies that principle, which is also known as the shelter

155UCC § 8-301.

156UCC § 8-301 official cmt. 1 and UCC § 8- 501(b). The intention of one of the parties not

to transfer a part of the securities credited to the transferee’s account is therefore not relevant as to the result, viz. the transferee’s (full) ownership of these securities; Ennis v. Phillips, 890 So.2d 313, 55 UCC Rep. Serv. 2d 407 (Fla. Dist. Ct. App. 4th Dist. 2004). On the concept of ‘security entitlement’ see supra, s. 8.3.4.

157UCC § 8-501 official cmt. 5. See also ROCKS & BJERRE (2004) 35-36.

158UCC § 8-102 official cmt. 8.

159Cf. ROGERS (1996), 1461.

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principle, so as to apply to the transfer of directly and indirectly held securities also.160

Indeed, one of the main reasons for the 1994 revision of UCC Article 8 was to establish firmly the application of the negotiability principle to all securities transfers, as transferee protection was considered to enhance the transferability of assets, and a requirement for any economy to function properly.161 More in particular, it was argued that, should a purchaser have to investigate the proprietary position of his transferor in every instance of a securities transfer so as to assure himself of the absence of competing challenges, ‘the system’s rapidity, inexpensiveness, certainty and finality’ would be severely impaired.162 Moreover, it was thought that a substantial systemic risk would be created if a defect in the transferor’s proprietary position would affect the legal position of the transferee.163 Thus, while the nemo dat principle gives priority to first-in-time claimants, Articles 8 and 9 now generally prioritise last-in-time claimants.164

However, originally, only a transferee of movable tangibles could be protected against challenges by third parties, because only possessors of those assets could obtain the status of bona fide purchasers. Under the previous version of UCC Article 8, a transferee who received certificated securities was therefore protected against third party challenges when he obtained the status of bona fide purchaser, i.e. when he acquired possession of the certificate in good faith, against value, and had no notice of adverse claims. Thus, transferee protection was a direct result of the ‘reification’ of the rights which a certificate represented in that certificate.165

Consequently, investors entitled to indirectly held securities could not achieve the status of bona fide purchasers, as accountholders are entitled to intangible assets. In addition, under the old Article 8, accountholder interests classified as co-ownership rights in a bulk of fungible assets, and an accountholder could therefore not be considered to be unaware of possible adverse claims, since he would be certain that he would have to compete with his fellow co-owners when their account provider would hold insufficient assets to satisfy all accountholders’ claims.166 Moreover, much uncertainty existed as to the precise relationship between the concepts of

160UCC §§ 8-302(a) and (b) and 8-510(b), respectively.

161ROGERS (1996), 1462-1464.

162ROCKS & BJERRE (2004), 30. Cf. BURKE (2003), 238 and 240.

163ROGERS (1996), 1461. Cf. MOONEY (1990), 315 and UCC § 8-503 official cmt. 3.

164Cf. MOONEY (1990), 379-380.

165E.g. MOONEY (1990), n.332 and GUTTMAN (1990), 443. On the development of reification and its legal consequences, see also supra, s. 3.2.1, and extensively ROGERS (2004).

166See MOONEY (1990), n.92, for a critical account of this line of argument.

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‘good faith’, ‘without notice’ and ‘bona fide purchaser’, and, for all these reasons, the revisors of UCC Article 8 took a different approach.167

Although in its present form, UCC Article 8 does not use the concepts ‘good faith’ and ‘bona fide purchaser’, it is identical in effect, i.e. it extends the protection previously granted to a bona fide purchaser to all transferees of securities. UCC §§ 8-303, 8-502, and 8-510(a) now provide that a transferee of directly held certificated or uncertificated securities, an ‘acquirer’ of indirectly held assets, and a ‘purchaser’ of indirectly held assets or a taker of a security interest therein are protected against competing third party claims.168

However, in order to be fully protected against a competing third party claim, a transferee must have had no notice of the third party’s adverse claim, must have control over the assets transferred, and must have given value for the transfer.169 The first requirement is a codification of well established criteria developed in case law, according to which a transferee is required not to be ‘wilfully blind to the existence of an adverse claim.’170 Yet a transferee is not under the obligation to make inquiries as to these claims.171 More specifically, the ‘wilful blindness’ criterion turns on whether the transferee is ‘aware of a significant probability that the adverse claim exists’ and whether the transferee ‘deliberately avoids information’ that would establish the existence of the adverse claim.172

In the case of typical transfers that follow a securities sale, the requirements just discussed are easily met, but the finality of a transfer of indirectly held securities is even more secured than the finality of a directly held securities transfer. Purchasers of indirectly held securities are protected unless they had notice of the specific claim with which they are challenged, whereas

167ROGERS (1996), 1470.

168Similarly, a transferee is protected against an issuer that asserts the invalidity of the transfer; UCC § 8-202(d).

169The fulfilment of these conditions must coincide; a transferee who obtains notice of an adverse claim, before he has given value or obtained control, cannot be protected; UCC § 8-

303official cmt. 2. UCC § 8-106 defines ‘control’ (see supra, s. 8.3.5), while UCC § 1-204 defines ‘value’ very broadly.

170Goodman v. Simonds, 61 U.S. (20 How.) 343 (1857) and Graham v. White-Phillips Co.,

296U.S. 27, 31-32 (1935). See also First Nat’l Bank v. Lewco Sec. Corp., 860 F.2d 1407 (7th Cir. 1988). A recent case in which notice of an adverse claim was established is SEC v. Credit Bancorp, Ltd., 386 F. 3d 438, 55 UCC Rep. Serv. 2d 74 (2d Cir. 2004). In this case, the court held that some securities were subject to a claim of revendication, because notice of the adverse claim was established. Although they were credited to the same account, other securities, however, were not subject to that claim, because they were credited before the entitlement holder had taken notice of the adverse claim.

171UCC § 8-105(a)(2) and official cmt. 2 and 4.

172UCC §§ 8-102(a)(1) and 8-105 define the concept of ‘adverse claim’ and make clear that an adverse claim must relate to a violation of property interests, including principles of equitable remedies that give rise to property claims.

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purchasers of directly held securities are (only) protected if they had no notice of any adverse claim.173 Moreover, UCC § 8-502 explicitly cuts off all possible constructions under which revendication claims could be made regarding indirectly held securities.174 In addition, for any revendication claim, a previous entitlement holder (verus dominus) must be able to identify the transferee that has received the assets he was deprived of, which is difficult to imagine in the instance of indirectly held securities that are traded

on anonymised markets by intermediaries that sell and buy securities in their own name.175

Furthermore, UCC § 8-503(e) determines that a previous entitlement holder can only successfully challenge a transferee’s rights if the latter acted ‘in collusion’ with the entitlement holder’s account provider that violated its obligations to honour the entitlement holder’s rights.176 This ‘collusion standard’ seems to be met in all instances that a transferee has been ‘wilfully blind’ to the adverse claim, yet these standards should be distinguished.177 The New York legislature, for instance, considered that ‘collusion’ only occurs if the wrongdoing purchaser acted ‘in concert’, ‘by conspiratorial arrangement’, by ‘agreement for the purpose of violating the entitlement holder’s rights’ or ‘with actual knowledge that the securities intermediary is violating those rights.’178 Such ‘knowledge’ will be determined on a subjective rather than on an objective basis, but, again, the purchaser is under not under a duty of inquiry.179

If, however, a transferee has indeed acted ‘in collusion’, the main rule of nemo dat applies and the previous entitlement holder can successfully claim restitution of his assets. UCC § 8-503(d) provides a specific example of such a situation, and determines that a restitution claim can be successfully made when the previous entitlement holder’s account provider is insolvent, when that account provider’s assets cannot satisfy all of its customers’ claims, and when the challenged transfer of assets constituted a violation of the intermediary’s duty as codified in § 8-504(a). Obviously, the satisfaction of all these conditions will rarely occur and even more rarely be proven.180

173Cf. UCC §§ 8-303 and 8-502.

174UCC § 8-502 official cmt. 2 and 3, refer to, e.g., a constructive trust.

175Cf. GUTTMAN (1990), 456 and UCC § 8-502 official cmt. 2.

176On UCC § 8-503, see supra, s. 8.3.4.

177ROGERS (1996), 1536.

178Legislative Intent at UCC § 8-101 by the New York legislature; Laws 1997, Ch. 566, § 5. The Canadian harmonisation instrument for securities custody and transfer law, which is similar to UCC Article 8 to a large extent, differs in that it contains a definition of ‘collusion’; SPINK & PARÉ (2004), 382.

179In Cotton v. Private Bank and Trust Co., 49 UCC Rep. Serv. 2d 1281 (N.D. Ill. 2003), for instance, no collusion (as a necessary element for a claim under UCC § 8-115(2) to be honoured) was found, since ‘actual knowledge’ was not proven.

180Cf. ROCKS & BJERRE (2004), 62. Yet it is the only instance in which dispossessed entitlement holders can successfully assert their rights against secured creditors of the intermediary who have obtained control; UCC § 8-511(b). This provision is considered an

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