учебный год 2023 / Haentjens, Harmonisation Of Securities Law. Custody and Transfer of Securities in European Private Law

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8.5 CREATION AND ENFORCEMENT OF SECURITY RIGHTS

8.5.1 Introduction

Under the laws of most US states, parties are free to define the form of the security interest they want to create. A wide range of arrangements can therefore be found, under which security interests are vested in securities or other financial instruments. Under some constructions, the debtor remains the legal owner and has control of the collateralised securities, which are only operationally marked as pledged securities. But under other constructions, the secured creditor obtains legal ownership as a purchaser, and the debtor is left with a mere equitable right. The former construction is usually known as an ‘agreement to pledge’, and the latter as a ‘hard pledge’.181

From a dogmatic point of view, US law treats an agreement to pledge and a hard pledge equally, i.e. it considers both constructions as different practical appearances of the same, viz. a security interest. It will be shown, however, that under the UCC, the (legal) consequences of non-possessory and possessory security interests are quite different, especially with respect to the creditors’ priority position in relation to other claimants. In that regard, the position of a taker of a ‘hard pledge’ is indistinguishable from the position of a taker of an outright transfer.182

UCC Article 9 governs security interests in general, and, more specifically, the creation and enforcement of security interests vested in securities. Its provisions on security rights in securities form part of Article 9’s specific rules on ‘investment property’, which includes securities, securities accounts, commodity contracts and commodity accounts.183 As a matter of interest, from a coherence point of view Article 9 explicitly distinguishes

application of UCC § 8-503; UCC § 8-503 official cmt. 3 and UCC § 8-511 official cmt. 1.

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] provides an example of such a case. QUINN (2001), [Rev] § 8-504[A][2]: ‘Drage did have a potential remedy. But, its successful exercise involved juggling complex sections of Article 8, marshalling the necessary factual information, and following required procedural consequences. Fortunately for the plaintiff in this case it was a law firm, “Nathan W. Drage, P.C.” The rest of us, alas, are not likely to be so felicitously situated.’

181UCC § 9-310 official cmt. 6. Cf. ROCKS & BJERRE (2004), 54 and ROGERS (1996), 1525.

182For instance, both the acquirer of a security interest by control and an outright transferee are termed ‘purchaser’ under the UCC; §§ 1-201(29), 8-303. In this way, the UCC avoids (re)characterisation issues that arise when considering repurchase agreements; MOONEY (1990), n.122 and ROGERS (1996), 1527.

183UCC § 9-102(49). On the inclusion of commodity contracts and accounts, see UCC § 9-

102 official cmt. 6.

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‘investment property’ from ‘goods’, ‘general intangibles’ and ‘instruments’, and provides specific rules for that distinct category of property.184

8.5.2 Pledge and attachment

Under UCC Article 9, a security interest is created or, in its own terminology, has ‘attached’, when the interest has been made enforceable amongst parties.185 Typically, attachment and enforceability occur at the same time, but parties may agree differently.186 Once a security interest has attached, it follows the collateral, even after the disposition thereof.187 A security interest is considered ‘perfected’ if the interest can be asserted against third parties. Security interests may be vested in a particular amount of securities of a certain issue, or in an entire securities account.188 In principle, a security taker is not entitled to the monetary proceeds of collateralised securities as additional security, but he may appropriate those proceeds so as to reduce the secured obligation.189

Creation

Under UCC Article 9, a security interest is created by agreement. Such an agreement becomes effective when the debtor has valid rights in the collateral, the secured party has given value, and the debtor has authenticated a (written) security agreement that contains a description of the collateral.190 This description need not be specific.191

Perfection

A security interest that has been created by agreement can be perfected, i.e. made opposable against third parties, either by filing or by conferring control over the collateralised securities to the security taker, which applies both to indirectly held securities and directly held uncertificated securities.192 The filing of a security interest must be effectuated in the UCC register that has been created for that purpose.193 When a security interest is to be perfected

184UCC § 9-102(a)(42), (44) and (47), respectively.

185UCC § 9-203 (a) and (b).

186QUINN (2001), [Rev] § 9-203[A][2].

187QUINN (2001) [Rev] § 9-315[A][3], has aptly called this principle, known to the civil law tradition as the principle of droit de suite, ‘the pitbull principle’.

188UCC § 9-203 (h).

189UCC § 9-207 (c).

190UCC § 9-203 (a) and (b).

191UCC § 9-108 (d).

192UCC §§ 9-312(a) and 9-134(a), respectively, and UCC § 8-106(c) and (d). For a discussion

of the pros and cons of either way of perfection, see ROCKS & BJERRE (2004), 71. 193 UCC § 9-312(a).

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by control, a creditor must obtain control over the secured assets pursuant to the security agreement, and provide value for his interest.194

A creditor can obtain control in several ways. First, he may become the entitlement holder and the collateralised securities then have to be credited to an account in his name. When the debtor is an intermediary, that intermediary can execute this transaction on its own books, which was impossible under UCC law before the 1994 revision.195 A creditor can also obtain control through a control agreement, or when a third party has or obtains control over the collateralised securities on behalf of the creditor. In addition, control can be obtained automatically, viz. when the creditor is also the debtor’s account provider.196

As noted above, the debtor remains entitled to the secured assets’ proceeds, even when the secured party has gained control over the collateral. Furthermore, the debtor retains his power of disposal absent an agreement that declares otherwise, and he thus remains entitled to transfer and vest other security interests in the assets. But if the debtor sells the secured assets without the creditor’s authorisation to do so, a security interest is attached to the proceeds of the sale in favour of the creditor.197

The concept of control had been introduced by the 1994 revision of UCC Article 8 so as to avoid the ‘uncertainty and confusion that results from attempting to apply common law possession concepts to modern securities holding practices.’198 Although the concept may be new, ROGERS has shown that it is ‘fully consistent with basic principles of secured transactions; indeed the control concept can usefully be regarded as merely a generalization from several specific rules that have long been part of the law of securities and secured transactions.’199

Creation and perfection for intermediaries

In addition to the methods of creation and perfection just discussed, a security interest can be created and perfected automatically, i.e. de iure, when the creditor is an intermediary. UCC § 9-206(a) and (b) determine that a security interest is de iure created in favour of the debtor’s account provider, if that account provider has credited its accountholder’s securities

194UCC § 9-203 (a) in conjunction with UCC § 9-106. Cf. ROGERS (1995), 697.

195Cf. MOONEY (1990), 342: ‘A property law construct that denies the effectiveness and perfection of such a security interest, while giving effect to similar transfers of ownership interests, could only be grounded on an historical anomaly or a failure to appreciate the sui generis characteristics of the intermediary control phenomenon within the securities markets.’

196UCC § 8-106(e). See infra.

197UCC § 9-315(a)(2).

198UCC § 8-106 official cmt. 7.

199ROGERS (1996), 1481-1482, with reference to the law of negotiable instruments and documents of title.

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account but not received payment for those assets. Furthermore, UCC § 9- 309(10) provides that a security interest is perfected de iure also if the creditor/intermediary does not already have control over the secured assets as the debtor’s account provider. These provisions are a codification of the common law concept of a ‘broker’s lien’, and its underlying policy is that intermediaries would otherwise be reluctant to credit their customers’ accounts on margin.200

With their clients’ consent, intermediaries may rehypothecate clients’ assets, as is common practice for securities firms, to obtain the funds needed to provide their clients with margin, i.e. unpaid, securities.201 If an intermediary’s creditor has perfected his security interest by control, or if the intermediary is a clearing corporation, the intermediary’s clients cannot assert their accountholder rights against this creditor, even if they did not authorise the rehypothecation.202 It has been argued that without such a rule, the availability of funds to securities intermediaries would be severely restricted. In addition, it has been stated that the rule does not encourage rehypothecation without customer consent, for federal regulations prohibit such illegal rehypothecation.203

Enforcement, priorities

A creditor with a security interest can enforce this interest either by suing for the debt, by enforcing the interest through judicial process, or by executing certain so-called self-help measures. These self-help measures, which are the most important methods of enforcement in practice, are the following: collecting proceeds of the secured assets, taking possession of the secured assets, disposing of the secured assets by sale or otherwise, and appropriating the secured assets (strict foreclosure).204 Execution of the selfhelp measures is, however, restricted by the standard of commercial reasonableness.205 That standard is highly fact-specific, and it may depend on the situation, for instance, whether a private or public sale would be appropriate as a means of enforcement.206

Theoretically, a security interest that has attached, but has not been perfected, can be enforced. But all creditors with a perfected security interest

200Restatement, Security §12. Cf. ROCKS & BJERRE (2004), 78 and ROGERS (1996), 1487. On margin accounts, see supra, s. 8.3.2.

201Accountholders commonly authorise their securities firm to ‘commingle securities of all margin customers for rehypothecation to the lender who provides the financing’; UCC § 8-

504official cmt. 2.

202See supra, s. 8.3.5.

20317 CFR §§ 240.8c-1(a) and 240.15c2(a) and see ROCKS & BJERRE (2004), 59.

204UCC § 9-601, 9-607, 609, 610 and 620 and see ROCKS & BJERRE (2004), 85. For a concise

overview, see also QUINN (2001), [Rev] § 9-601[A].

205UCC § 9-610(b).

206ROCKS & BJERRE (2004), 87.

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trump imperfected security interest holders, both in and outside of bankruptcy situations, and most secured creditors therefore perfect their interest.207 Yet if multiple creditors have perfected their security interests, priority conflicts may arise when it comes to enforcement, and intricate rules have been drafted to determine the priority ranking between holders of perfected security interests.208

UCC § 9-328(a) codifies the basic rule: a security interest perfected by control has priority over a security interest that has not been perfected by control, while intermediaries that have obtained control rank even higher.209 This rule thus contrasts with the general property law principle prior tempore, potior iure, under which older in time claims trump claims that have been created later in time. But it could be argued that the rule accords with another general principle of property law, viz. the negotiability principle, under which bona fide acquirers take free of competing claims.210 The rationale for prioritising control, rather than seniority, thus seems to have been that secured parties that have bona fide put themselves in a position to liquidate, should be able to rely on that position. The stronger position of intermediaries, on the other hand, has been justified with reference to the safety of the banking and financial system.211 Whereas that argument might or might not be wholly persuasive, it has also been pointed out that the untraceability of fungible and indirectly held securities prevents an effective first-in-time rule.212

Yet in some instances, especially when it is an easy matter to determine the time of perfection, prior tempore is used as a default rule. First, secured creditors who have obtained control take free of claims by creditors who have subsequently obtained control over the same collateral.213 But, as stated previously, higher-tier claimants with control always take free of other

207UCC § 9-322(a)(2).

208Whether principles of equity displace these priority rules is a matter of debate. Although case law seems to support the application of principles of equity, UCC § 9-328 official cmt. 8 argues that this would render security interests in securities less certain and that it may thus contribute to systemic risk. See ROCKS & BJERRE (2004), 85, referring to General Insurance Co. v. Lowry, 412 F. Supp. 21 (S.D. Ohio 1976), aff’d, 570 F.2d 120 (6th Cir. 1978) and ROGERS (1996), 1491-1992.

209UCC § 9-328(c). UCC § 8-510(c) and (d) apply the same rules of priority to outright

transfers, rather than to security interests. These sections have been drafted so as to provide for the same rules as Article 9, but apply when Article 9 is not applicable, e.g. because a repurchase agreement is classified as an outright transfer, rather than a security interest; UCC § 8-510 official cmt. 4.

210The author is grateful to Professor J.S. Rogers for his explanation on this point. Professor Rogers further explained that the priority of control is primarily needed because filing would not have been introduced as a perfection method if perfection by control would not be prioritised. On the negotiability principle, see supra, s. 8.4.2.

211ROGERS (1996), 1479-1483.

212ROGERS (1996), 1513 et seq. Cf. supra, s. 8.3.5.

213UCC § 9-328(b).

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security takers with control, even if the latter have perfected their interest earlier in time.214 Second, the prior tempore rule also applies to determine the priority ranking between security takers who have perfected their security interest by filing.215 Because the exact time that a security interest is automatically created cannot be determined, no priority rule is given to solve a possible conflict between creditors who have obtained such a security interest, i.e. a security interest against an intermediary.216

Attachment

Under the UCC indirect holding system, no upper-tier attachment is possible, as creditors cannot trace their debtor’s assets to securities pools held by higher-tier intermediaries.217 Thus, attachment can only be effected upon the debtor’s account provider, and must be authorised with a court order. Uncertificated, directly held securities on the other hand, must be seized against the issuer.218

8.6 CONFLICT OF LAWS

8.6.1 Introduction

The UCC effectively harmonised state securities custody and transfer laws, but its drafters still thought that a uniform conflict of laws rule would be necessary, firstly because different states might implement the UCC differently, and secondly, because different state courts might interpret the UCC provisions differently. Moreover, cross-border securities transactions with non-US counterparties would continue to require a uniform conflict of laws rule.219

UCC § 8-106, the predecessor of the current private international law provision of UCC Article 8, provided that ‘general choice of law rules’ determine the law applicable to the transfer of certificated and some uncertificated securities. Regarding uncertificated securities, that ‘general choice of law rule’ was the lex incorporationis, and thus referred to the law of the place where the issuer was incorporated.220 Current UCC conflict of laws provisions, however, distinguish between directly and indirectly held securities, and more or less radically depart from the lex incorporationis

214Cf. UCC § 8-510(c) and (d).

215UCC § 9-328(g) in conjunction with UCC § 9-322(a)(1).

216UCC § 9-328(f). Cf. ROCKS & BJERRE (2004), 83.

217Cf. supra, s. 8.3.2.

218UCC § 8-112(c) and (d), respectively.

219See ROGERS (1996), 1460, ROCKS & BJERRE (2004), 89 and SIEGEL (1994), 216-217.

220See QUINN (2001), § 8-106[A][2].

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rule. For the purpose of a conflict of laws analysis, the UCC determines that securities are directly held only if they are either registered with the issuer or its registrar in the investor’s name, or specifically endorsed in favour of the investor.221

8.6.2 Accountholder interests

UCC § 8-110 contains the current, uniform conflict of laws rule that determines which law to apply to proprietary interests in securities. In short, it employs the lex rei sitae rule in the case of directly held, certificated securities, the lex societatis to determine the law applicable to proprietary interests in directly held, uncertificated securities, and a variation of the law of the place of the ‘relevant intermediary’ (‘PRIMA’) in the case of indirectly held securities.222

More accurately, lex rei sitae, as referred to in UCC § 8-110, governs the proprietary rights of an acquirer of certificated securities, and points to the law of the location of the securities at the time of delivery. UCC § 8-110(d) substantiates the lex societatis rule, and explains that it refers to the law of the jurisdiction under which the issuer is incorporated (lex incorporationis) or to the law designated by the issuer itself, provided the lex incorporationis permits such autonomy. The drafters of that rule considered that an issuer and others – including the investors, the protection of whose interests depends on their registration by the issuer – should be able to easily determine the applicable law. They therefore referred to the law chosen by the issuer as the one single applicable law, rather than a conflict of laws rule that would result in different laws to apply to the interests of different securities holders.223

The same policy consideration lies behind the PRIMA rule of UCC Article 8, which gives primacy to party autonomy, and leaves the parties to a securities account agreement free to choose the law applicable to the property law aspects of the securities entitlement resulting from that account agreement.224 It was thought that an account provider and others should look at a single law to determine the rights and duties of an accountholder against

221GUYNN & ROGERS (2002), 607.

222UCC §§ 8-110(b), 8-110(a), and 8-110(c), respectively.

223UCC § 8-110 official cmt. 2.

224UCC § 8-110(e)(1). This variation of PRIMA is the result of an effort to bring into conformity UCC § 8-110(e)(1) with UCC § 9-304(b)(1), a provision which determines that the parties to a deposit account agreement are free to choose the law applicable to the perfection and priority of security interests in the deposit account; UCC § 9-304 official cmt.

2.Cf. also UCC § 4A-507(2) (1990); the underlying policy consideration there was also the idea that party autonomy “provides a greater degree of certainty with respect to rights of various parties.”; UCC § 4A-507 official cmt. 3. Cf. SCOLES ET AL. (2000), 984.

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his account provider and vice versa, rather than having to look to the laws of the locations of the underlying securities or their issuers.225 The law designated by the parties may either have been chosen to govern the account agreement itself, or to govern specific proprietary issues. But if no choice of law has thus been made, the law of the place where the securities account is maintained applies, a place which may also have been designated by the parties.226 It is only as a last resort that the location of the account provider is used as the connecting factor. More specifically, either the law of the location of the office that serves the securities account (which may be designated by the parties), or the law of the location of the account provider’s chief executive office applies.

Thus, in order to establish ex ante certainty, parties are granted a very large degree of autonomy, as the UCC variation of PRIMA not only extends the effects of a choice of law in the account agreement to proprietary issues and thus to third parties, but neither limits this choice of law in any way.227 Whereas under general US private international law, a ‘reasonable relation’ is required with the jurisdiction chosen, and the application of the law of the chosen state must not be contrary to a ‘fundamental policy of a state which has a materially greater interest than the chosen state in the determination of the particular issue’, the more specific rules of UCC Article 8 do not require such conditions to be met. 228

8.6.3 Security interests

The conflict of laws rules just described apply to accountholder interests, but also to securities transfers, and proprietary issues arising from a transfer of securities by book-entry are governed by the law that applies to the securities account (agreement) of the transferee.229 But a classification of a securities

225UCC § 8-110 official cmt. 3.

226This reference to the place where the securities account is maintained has been considered by the Reporter to the Drafting Committee to Revise UCC Article 8 (1994) to ‘specify the jurisdiction that is most appropriately associated with the package of rights’; ROGERS (1996), 1460.

227UCC § 8-110 official cmt. 3 and cf. Rome Convention Article 3. When the current version of UCC Article 8 was adopted in 1994, its reference to party autonomy went further than the autonomy granted to parties to a common commercial agreement, which was limited to laws that had a ‘reasonable relation to the State or country designated’. But in the present version of UCC § 1-301(c) (2001), that requirement has been abolished, and choice of law is currently limited only when one of the parties qualifies as a ‘consumer’; UCC § 1-301(c) and (e) (2001).

228Restatement (Second) of Conflict of Laws s 187(2)(a) and (b) (1971). But note that private international law, even in international cases, is a matter of state law; Klaxon Company v. Stentor Electric Manufacturing Co., 313 U.S. 487 (1941).

229Cf. GUYNN & ROGERS (2002), 612. On the transfer of funds, cf. UCC § 4A-507(c) (1990). Whether payment has been made ‘is governed by the law of the jurisdiction in which the

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transfer is made under the substantive law of the forum, and it is that law that determines, for instance, whether a securities transfer classifies as a transfer of title or as a security interest.230

UCC Article 9 provides a specific conflict of laws rule for issues arising out of the creation and enforcement of security interests in investment securities, but this rule is similar to the rules as discussed in the previous section.231 Thus, the lex rei sitae applies to issues concerning security interests in directly held, certificated securities, lex societatis to issues concerning directly held, uncertificated securities, and a variation of PRIMA determines the law that governs security interests in indirectly held securities.232 These rules point to substantive law only and consequently prohibit renvoi.233

Yet under the general rule of UCC Article 9, the creation, perfection and priority ranking of security interests is governed by the law of the debtor’s jurisdiction.234 Regarding investment property, this general rule only applies if the security interest is perfected by filing or if it is perfected automatically, and then overrides the conflict of laws rules just mentioned.235 In these instances, the location of a debtor is determined as follows. First, a distinction is made between companies and other debtors. When a company is incorporated, as the great majority of companies is, the state of registration applies.236 In the rare case of a company that is not incorporated, the main rule refers to its ‘place of business’, i.e. the place where its affairs are conducted.237 When a not-incorporated company has more than one place of business, the jurisdiction of the location of the chief executive office applies. To institutions organised under federal law (such as banks), and a branch or agency of a bank that is not organised under federal law, still other rules apply; these institutions are considered to be located in the state which is designated by federal law, or in the state designated by the bank, provided that federal law allows such a choice of law. If federal law does not

beneficiary’s bank is located’. The policy behind this rule is that payment to the beneficiary is made through the beneficiary’s bank; UCC § 4A-507 official cmt. 2 (1990). The law applicable to contractual issues is left to the autonomy of the parties to the agreement: UCC § 1-301(c). Public policy rules may, however, override party autonomy; UCC § 1-301(f) and cf. WHITE & SUMMERS (2000), 125.

230UCC § 9-109(a)(1).

231UCC § 9-305. As is the case with contractual aspects of a transfer of title, the contractual aspects of security interests in securities are governed by the law chosen by the parties: UCC § 1-301(c) and (e) (2001).

232UCC §§ 9-305(a)(1), 9-305(a)(2) and 9-305(a)(3), respectively.

233SCOLES ET AL. (2000), 984-985. Cf. Restatement (Second) of Conflict of Laws s 4 (1971).

234UCC § 9-301. Cf. QUINN (2001), at § 9-301[A][5] and [Rev] § 9-305[A][3].

235UCC § 9-305(c). See supra, s. 8.5.2.

236UCC § 9-307(e).

237UCC § 9-307(b)(2).

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designate a state and if the bank has not chosen a location, the District of Columbia is deemed to be the location of this debtor.238

In the most common situation, viz. when a security interest in indirectly held securities is perfected by control, the PRIMA variation determines the applicable law. Consequently, the applicable law changes with the way in which control is obtained, as PRIMA refers to the law of the creditor’s securities account when the collateralised securities are transferred to his account, but to the law of the debtor’s securities account when the securities pledged remain credited in the latter’s name.239 In short, the law of the account agreement with the intermediary that administers the securities account to which the collateralised securities are booked, applies to the security interests vested in those securities.240

8.7 CONCLUSIONS

8.7.1 Questions and answers

1. Which securities are admitted to the national systems of giro transfer and administration?

The legal infrastructure for the custody and transfer of securities by bookentry in the US is principally formed by the Uniform Commercial Code (‘UCC’), which harmonised the state laws in this field, and federal regulations. Custody and transfer of securities that are issued by the US government, i.e. the Treasury, or US government agencies, are held in the Treasury/Reserve Automated Debt Entry System (‘TRADES’) with its own (federal) rules, while securities issued by private companies are generally subject to the provisions of UCC Article 8. Yet the federal rules that apply to the government systems of book-entry custody are either similar to UCC Article 8 (with some minor differences), or refer to state law and thus to UCC Article 8, which has been implemented in all states.

As a matter of principle, UCC Article 8, in its current version, caters for different holding practices, and it facilitates the direct holding of certificated (both bearer and registered) and dematerialised securities, as well as the indirect holding of securities. The definition of securities that can be subject to the UCC’s provisions is very broad and covers practically all types of financial instruments. But the category of financial instruments to which the provisions of UCC Article 8 on the indirect holding system apply, is even

238For an overview of the different rules which apply to the different categories of debtors, see COOPER (2000), 49.

239UCC § 9-305(c)(2) in conjunction with UCC § 9-309(10). See also GUYNN & ROGERS (2002), 609 and 610.

240See GUYNN & ROGERS (2002), 608 and 613.

224