Memorandum of UCC-8 and Book Entry PDF
Memorandum of UCC-8 and Book Entry PDF
Memorandum of UCC-8 and Book Entry PDF
April 2007
The prior version of Article 8 had assumed the evolution of a system in which issu-
ers would no longer issue certificates. n2 Hence, parallel provisions dealing with un-
certificated securities were established. Both the certificated and uncertificated provi-
sions of the 1978 amendments contemplated that the beneficial owners of securities
would often have a direct relationship with the issuer of the securities, either by being
the holder of a bearer instrument and thus having a direct claim against the issuer or
by, in the case of registered securities, being recorded as the owner on the records
maintained by the issuer or its transfer agent. n3 Other than in the case of mutual
fund shares, however, a system of uncertificated securities did not develop. An exten-
sive pattern of indirect holding developed instead. Certificates are still issued but tend
not to be in the hands of the ultimate beneficial owners. The securities are registered
in the name of, and immobilized with, clearing corporations and other depositories.
The depository's books in turn show the identity of the banks or brokers that are its
members, and the records of those intermediaries identify their customers. (See Dia-
gram 1)
The prior version also included outdated choice of law rules, based in large part on
where a physical security certificate was located, which often resulted in the applica-
tion of the law of a jurisdiction that most market participants considered irrelevant.
The UCC now provides choice-of-law rules in both the sale and security interest con-
texts that are keyed to the way in which the interest in the security is maintained.
The version of Article 8 now in effect was thus the result of the effort to overhaul
current commercial law rules for investment securities to reflect the realities of mod-
ern securities holding practices. The revisions have also expanded the types of assets
covered and deal directly with the nature of the property interest obtained by a pur-
chaser of securities and other financial assets in the indirect holding system.
The UCC has therefore moved from an approach based on an attribute of the secu-
rity itself (certificated vs. uncertificated), and reflects instead a distinction based on
how the security is held. Under Article 8, the most significant distinction is whether
one has a "direct" relationship with the issuer, as when one is a "record owner," or an
"indirect" relationship, as when the investment is held through one or more interme-
diaries. Because the differences between the systems of direct and indirect holding are
significant, the drafters determined that it would be better to treat them as separate
systems requiring different legal concepts. n4 Article 8 classifies the system in which
the owner has a direct relationship with the issuer as the "direct holding system;" the
rules for this system (set out in Part 3 of the statute) apply only to securities, not a
broader category of financial assets. The system in which interests in financial assets,
including securities, are held through one or more intermediaries is classified as the
"indirect holding system." Of course, the indirect system is not entirely independent of
the direct system - in the case of securities, the entity at the top of the indirect chain
will have a "direct" relationship with the issuer itself. n5
n5 For various securities issued by the United States Treasury and other agen-
cies and government sponsored organizations which are maintained in the form
of entries in the records of Federal Reserve Banks, a system of federal regulation
(commonly referred to as the "TRADES Regulations") intersects with the UCC.
This memorandum will not deal directly with these regulations except to note
that the issuer's obligations are governed by federal law and specific choice of
law rules paralleling those in the UCC ensure that in other respects the UCC as in
effect in the relevant state applies to these securities as well. See, e.g., 31
C.F.R. pt. 357 (later publications confirm that the limited, transitional preemptive
effect of these regulations is not longer in effect). Information regarding these
regulations may be found on the website of the United States Treasury's Bureau
of Public Debt (www.publicdebt.treas.gov/cc/cctrades.htm).
The recently adopted (and enacted) revisions to Article 9 brought along few sub-
stantive revisions to the treatment of investment property as collateral, and for the
most part simply integrated the investment property provisions (that had been con-
tained in a single section) into the revamped structure of the Article. n6
n6 The revisions did make some substantive changes, however, including re-
finements of the priority and choice of law rules, which are reflected in the sum-
mary provided below.
The term "Control" means that a purchaser (which term includes secured
parties as well as buyers) has taken whatever steps are necessary, given
the manner in which assets are held, to place itself in a position where it
can have the assets sold, without further action by the original owner. Offi-
cial Comment 1, Section 8-106.
The statute makes clear that control can be obtained directly by a pur-
chaser or through another person acting on behalf of the purchaser.
The term "Adverse claim" is defined in Section 8-102(a)(1) as "a claim that
the claimant has a property interest in a financial asset and that it is a vio-
lation of the rights of the claimant for another person to hold, transfer, or
deal with the financial asset." The term refers only to property interests
and requires that the claimant's property interest be violated by another
person's holding or transferring of the security (or other financial asset).
The term clarifies an ambiguity in Section 8-302 of the prior version of Arti-
cle 8 that suggested that any wrongful action concerning a security, includ-
ing a simple breach of contract, gave rise to an adverse claim. See Fallon v.
Wall Street Clearing Corp., 586 N.Y.S.2d 953, 182 A.D.2d 245 (1992) and
Pentech Intl. v Wall St. Clearing Co., 983 F.2d 441 (2d Cir. 1993) (which
decisions were based on this broader view and are rejected by the new
definition). The term is not limited to ownership rights but also covers se-
curity interests and other property interests established by law.
The term "Collusion" is not defined in the statute but is stated to be "in-
tended to adopt a standard akin to the tort rules that determine whether a
person is liable as an aider or abettor for the tortious conduct of a third
party." Official Comment, Section 8-115 (citing Restatement (Second) of
Torts 876).
The term "Securities intermediary" is the term used for those who hold se-
curities for others in the indirect holding system. It is defined in Section 8-
103(a)(14) as a clearing corporation or a person, including a bank or bro-
ker, that in the ordinary course of its business maintains securities ac-
counts for others and is acting in that capacity. n10
The term "Entitlement holder" refers to the one who holds financial assets
through a securities intermediary and is defined in Section 8-103(a)(7) as
"the person identified in the records of a securities intermediary as the per-
son having a securities entitlement against the securities intermediary."
The definition of security in the UCC does not restrict the scope of Article 8.
The direct holding system rules in Parts 2, 3 and 4 are limited to securities,
but the indirect holding system rules of Part 5 apply to the broader cate-
gory of "financial assets."
n7 Article 1 of the UCC has been revised, but very few states have enacted it to
date and therefore references in this memorandum to sections of Article 1 and to
the version currently in effect in the State of New York.
n8 Specifically, Section 8-105 provides that "the person is aware of facts suffi-
cient to indicate that there is a significant probability that the adverse claim ex-
ists and deliberately avoids information that would establish the existence of the
adverse claim."
(i) a security;
(iii) any property that is held by a securities intermediary for another per-
son in a securities account if the securities intermediary has expressly
agreed with the other person that the property is to be treated as a finan-
cial asset under Article 8.
A. Part 2 Rules.
These rules deal principally with certain aspects of the obligations of issuers. The
primary purpose of these rules is to apply to investment securities the principles of
negotiable instruments law that preclude issuers of negotiable instruments from as-
serting certain defenses against subsequent purchasers. These rules are largely un-
changed from the prior version of Article 8.
B. Part 3 Rules.
These rules addresses the transfer of securities held directly. One of the primary
purposes of the Part 3 Rules is to apply to investment securities the principles of ne-
gotiable instruments law protecting purchasers of negotiable instruments against ad-
verse claims. As a result of the addition of Part 5 to deal with the indirect holding sys-
tem, the elaborate transfer provisions in the prior version of Article 8 became unnec-
essary.
Part 3 also combines, where appropriate, the rules for certificated and uncertifi-
cated securities so that differences are not overemphasized and to emphasize that the
key attribute of ownership of a security was not its certificated/uncertificated status
but the difference in method by which ownership is evidenced. n11
n11 Consistent with this approach, Section 8-102(a)(15) adopts a unitary defini-
tion of security which refers to the underlying intangible interest or obligation.
With respect to uncertificated securities, Part 3 eliminates the need for transaction
statements and registered pledges. n12 The deletion of the provisions relating to reg-
istered pledges does not mean that issuers cannot offer such a service. The control
rules of Section 8-106 of the UCC and the related priority provisions in Article 9 estab-
lish a structure that permits issuers to develop systems akin to the registered pledge
device without mandating that it be done or providing the details.
n12 The prior version of Article 8 required that issuers of uncertificated securities
send out transaction statements to various persons upon registration of transfer
and at other specified times. This was considered an unnecessary intrusion of
commercial law into market practice and therefore deleted.
One of the key changes to Part 3 is the revision of the concept of "bona fide pur-
chaser." The revised UCC term for "bona fide purchaser" in Article 8 is "protected pur-
chaser." Section 8-303 of the UCC defines a protected purchaser as a purchaser of a
certificated or uncertificated security who gives value, does not have notice of any ad-
verse claims to the security and obtains control of the certificated or uncertificated
security. n13 To qualify as a protected purchaser, "there must be a time at which all
of the requirements are satisfied." n14 Section 8-105 eliminates any separate require-
ment of "good faith" that was formerly an element of "bona fide purchaser" status.
n13 This is parallel to Section 8-502 for the indirect holding system, as discussed
below.
Section 8-303 goes on to describe the benefits of being a protected purchaser: "In
addition to acquiring the rights of a purchaser, a protected purchaser also acquires its
interest in the security free of any adverse claims." Because of the breadth of the
definition of "purchaser" in Section 1-201, a secured party in addition to an outright
buyer can qualify as a protected purchaser.
C. Part 4 Rules.
Part 4 addresses the process of registration of transfer by the issuer or transfer
agent. The key change from the prior version of Article 8 is that the issuer is not liable
for wrongful registration of transfer if it acts on an effective indorsement or instruc-
tion, even though the issuer may have notice of adverse claims so long as the issuer
has not been served with legal process and is not acting in collusion with the wrong-
doer in registering the transfer. See Section 8-404 and Official Comment thereto. The
provisions of the prior version of Article 8 specifying that issuers had a duty to investi-
gate adverse claims of which they had notice were deleted. This provision parallels
that applicable to the indirect system in Section 8-115, discussed below. The policy
behind both provisions is to protect the right of investors to have their securities
transfers processed without the disruption or delay that might result if the record-
keepers risked liability to third parties.
n15 As noted in Part II, the instrument could also qualify as a financial asset if it
is an obligation, share, participation or other interest which is, or is of a type,
dealt in or traded on financial markets, or which is recognized in any area in
which it is issued as a medium for investment.
When such assets are credited to a securities account, security entitlements are
created. (A security entitlement can, in certain circumstances, also be acquired before
the financial asset is actually credited to the securities account. n16) Part 5 sets out
the package of rights and property interests that comprise the security entitlement
acquired by the purchaser.
n16 See UCC Section 8-501(b). This would occur, for instance, if the securities
intermediary receives a financial asset from, or acquires the financial asset for, a
person and, in either case, accepts it for credit to the person's securities ac-
count. Also, if the securities intermediary becomes obligated under other law,
regulation or rule to credit a financial asset to the person's securities account,
the person would be treated as having a securities entitlement.
The extent and nature of the entitlement holder's interest in the assets held
through a securities intermediary is set forth in a straight forward manner in Section
8-503:
The statute thus makes clear that entitlement holders are much more than unsecured
claimants: ". . . [a] security entitlement is itself a form of property interest not merely
an in personam claim against the intermediary. The concept of a security entitlement
does, however, include a package of in personam rights against the intermediary.
Other Part 5 rules identify the core of this package of rights, subject to specification
by agreement and regulatory law." n17 See Sections 8-505 through 8-509, discussed
below.
The interest of the ultimate beneficial owner does not, however, constitute a spe-
cific property interest in a specific asset. Insofar as the relationship among all entitle-
ment holders of a single intermediary (i.e., "owners" who hold through (have a secu-
rity entitlement with) the same intermediary) is concerned, Section 8-503 provides
that an entitlement holder's property interest with respect to a particular financial as-
set "is a pro rata property interest in all interests in that financial asset held by the
securities intermediary." To the extent there are not enough financial assets held by
the securities intermediary, the entitlement holder would simply have a claim for any
shortfall. If the intermediary is insolvent, special rules will apply and, to a certain ex-
tent, insurance will be available to satisfy customer claims. See, e.g., the Securities
Investor Protection Act of 1970, as amended, 15 U.S.C. 78aaa et seq. n18
n18 This particular aspect of the indirect holding system rules was consistent
with the situation under the prior version of the UCC for the vast majority of in-
vestors. (See, e.g., prior Section 8-313(2), which provided that where securities
were held as part of a fungible bulk, the purchaser was the owner of a propor-
tionate property interest in the fungible bulk.)
Related provisions do alter from former law the entitlement holder's relationship
with other market participants, however. Perhaps most significant, the statute makes
clear that, with limited exceptions, an entitlement holder's interest with respect to a
particular financial asset may be enforced only against its securities intermediary, and
not third parties. See Section 8-503(c) and (d).
In this respect, the UCC gives legal recognition to the realities of the modern secu-
rities holding system. First, each intermediary (generally) knows only the identity of
its own customer and the extent of its position. Second, the indirect holding system is
not based upon possession of a specific thing. "The idea that discrete objects might be
traced through the hands of different persons has no place in the revised Article 8
rules for the indirect holding system. Rather, the fundamental principles of the indirect
holding system rules are that an entitlement holder's own intermediary has the obliga-
tion to see to it that the entitlement holder receives all of the economic and corporate
rights that comprise the security, and therefore that an entitlement holder can look
only to that intermediary for performance of the obligations." n19
n19 James Steven Rogers, Policy Perspectives on Revised UCC Article 8, 43 UCLA
L. Rev. 1431, 1436 (1996).
- the securities intermediary must not be able to satisfy the securities enti-
tlements of all of its entitlement holders to the financial asset; and
n20 This is not the case under Section 8-303, the rule regarding protected pur-
chasers in the direct holding system. A purchaser is not a protected purchaser if
it has notice of any adverse claim to the security.
Section 8-510(a) specifies a similar rule with respect to the rights of persons who
purchase interests in security entitlements from entitlement holders (i.e., persons
whose rights are derivative from the rights of another person who continues to be the
entitlement holder).
While Sections 8-502 and 8-510 may seem to overlap with Section 8-503, the offi-
cial commentary following Section 8-503 makes clear that Section 8-503 takes prece-
dence over the more general adverse claim cut-off rules. Accordingly, the issue of
whether an entitlement holder's property interest can be asserted as an adverse claim
against a transferee from the securities intermediary is covered by the collusion stan-
dard and not by the lower "notice" standard.
Thus, there is no concept of owning or having an interest in a particular security,
or even a particular fungible bulk of securities, which can be traced and recaptured
from all but a limited class of "bona fide purchasers" - as was the case under former
Article 8. As a policy matter, with certain limited exceptions noted above, finality and
certainty have been given more weight. These provisions represent a change in the
statute's words more than a change in practice, since the usefulness of any legal right
to recapture an interest in securities depends upon the ability to trace the securities in
the first place, an unlikely proposition in the context of indirect holding patterns and
large volume trading.
Another category of relationships, that of the relative rights of entitlement holders
and creditors of the intermediary, is also addressed.
- Section 8-511 provides that, in the event an intermediary's assets are in-
sufficient, entitlement holders other than creditors (sometimes loosely re-
ferred to as "customers") have priority over the claim of the creditor having
a security interest in the subject financial assets.
- Section 8-511 proceeds to state, however, that if the creditor has "con-
trol" over the financial asset, the creditor will have priority. For clearing
corporations, which are typically in a "direct" relationship with an issuer,
making the obtaining of "control" by a secured party impractical, the rule is
that the creditor always has priority over entitlement holders. n21
- Consistent with Article 9's "upper tier priority" rule, under Section 8-
511(d), the securities intermediary (through which the financial assets are
held) as purchaser has priority over a conflicting purchaser having control.
n21 This was considered acceptable as a policy matter in light of the highly regu-
lated nature of clearing corporations.
What constitutes "control" depends upon the way in which the subject asset is held
at the time in question, as described in Part II above. The concept of control plays a
key role in both Article 8, in terms of establishing the rights and priorities among
players and participants in both the direct and the indirect holding systems, and Arti-
cle 9, in terms of what steps will suffice to perfect a security interest and what priority
that interest will have. The role played by control in the context of competing secured
parties is described below.
Significantly, control by a purchaser does not require that the original entitlement
holder be divested of all access to the assets. Section 8-106(f) provides that:
A purchaser who has satisfied [the relevant control requirements] has con-
trol even if. . . the entitlement holder. . . retains the right to make substitu-
tions for the . . . security entitlement, to originate . . . entitlement orders to
the . . . securities intermediary, or otherwise to deal with the . . . security
entitlement.
C. Intermediary Duties.
The duties imposed by the UCC relate to the manner in which the intermediaries
must deal with the assets to which their entitlement holders have entitlements. These
provisions have no prior statutory counterpart in the UCC.
- Section 8-507 establishes the duty to comply with orders given by enti-
tlement holders with respect to financial assets; and
- Section 8-508 establishes the duty to change the entitlement holder's po-
sition into another available form of holding the financial asset, e.g. obtain
and deliver a certificate.
- If the above does not apply, and an agreement between the securities in-
termediary and its entitlement holder governing the securities account ex-
pressly provides that it is governed by the law of a particular jurisdiction,
that jurisdiction is the securities intermediary's jurisdiction.
n22 This "last stop" in the choice of law cascade was not amended to track Arti-
cle 9's new rules for determining a debtor's location, which treats "registered or-
ganizations" differently -- by referring to jurisdiction of organization rather than
chief executive office. See Section 9-307 (discussed below).
VI. Miscellaneous
Summarized below are several other significant aspects of Article 8.
n23 The same rule also applies in the case of the direct holding system, to a
broker, agent or bailee that is dealing with a financial asset at the direction of its
customer or principal. See Section 8-115.
The standards in Section 8-115 follow from the premise that it is essential to the
securities settlement system that brokers and securities intermediaries be able to act
promptly on the directions of their customers. Thus, even though a firm may have no-
tice that someone has asserted a claim to a customer's securities or security entitle-
ments, the firm should not have to make a legal judgment about the validity of the
claim at the risk of liability either to its customer or to the third party for guessing
wrong. On the other hand, the intermediary or broker should not be shielded in egre-
gious cases where the action rises to the level of "affirmative misconduct in assisting
the customer in the commission of a wrong." Official Comment 5, Section 8-115.
C. Warranties.
The warranties for transfers in the direct system are set out in Section 8-108. With
respect to transferors, these warranties include, inter alia, that a certificate is genuine
and has not been materially altered, that the transferor or indorser does not know of
any fact that might impair the validity of the security and that the transfer is other-
wise effective and rightful.
In addition, Section 8-108 makes clear that warranties made by an indorser are for
the benefit not only of its immediate transferee but of subsequent purchasers. Fur-
ther, Section 8-108 contains new warranties from parties transferring certificated se-
curities or originating instructions for registration of transfer of uncertificated securi-
ties to the effect that (i) there is no adverse claim to the securities and (ii) the trans-
fer does not violate any restriction on transfer.
A broker that delivers a security certificate to a customer, or causes the customer
to be registered as the owner of an uncertificated security, makes the same warran-
ties as specified above.
With respect to the separate rules for warranties in the indirect system set out in
Section 8-109, a person who originates an entitlement order to a securities intermedi-
ary warrants as to its authority to give the entitlement order and as to the absence of
adverse claims.
Section 8-109 also specifies the warranties given when a person who holds securi-
ties directly seeks to have the holding converted into indirect form by delivering the
security, or originating, in the case of an uncertificated security, an instruction direct-
ing that the uncertificated security be credited, to a securities account. Such a person
makes the transfer warranties under Section 8-108, as described above.
In turn, if a securities intermediary delivers a security certificate, or causes, in the
case of an uncertificated security, the security to be registered in the name of the en-
titlement holder, the securities intermediary also makes the transfer warranties under
Section 8-108. Thus, securities intermediaries make the same warranties as those
that brokers make with respect to securities that they sell to and buy on a customer's
behalf. Official Comment, Section 8-109.
The warranty provisions in Sections 8-108 and 8-109 may be adjusted by agree-
ment. See Section 1-102(3).
n24 New York enacted special rules dealing with shares in cooperative apart-
ments, but such non-uniform provisions are not relevant for purposes of this
memorandum.
n25 Article 9 also covers certain sale transactions not relevant for purposes of
this memorandum.
A. Coverage.
Article 9's scope covers "investment property," defined to include not only Article 8
securities and security entitlements, but also commodity contracts and commodity ac-
counts. In addition to covering assets that are treated by the market like securities
(i.e., credited to securities accounts) but that might not otherwise fall within Article
9's reach, such as certain insurance products, special provisions exist for commodity
contracts and commodity accounts in order to clarify how security interests in these
important products are created and perfected. n26
n26 The discussion of investment property in this memorandum will generally fo-
cus only on securities, securities accounts and security entitlements, and not on
commodity contracts and commodity accounts.
n28 See UCC 9-203(h). A security interest in a securities account would also in-
clude all of the other rights of the debtor against the securities intermediary aris-
ing out of the securities account. For instance, credit balances due to the debtor
from the securities intermediary, whether or not they are proceeds of a security
entitlement, would be covered by the security interest.
Article 9 has a variety of rules for perfecting security interests in investment prop-
erty depending in part upon the type of asset and the way it is held and in part upon
the identity of the debtor. Of perhaps greatest significance for most market partici-
pants is the concept of "control" over investment property. This is defined in the case
of securities and security entitlements simply by cross reference to Section 8-106 of
Article 8, described above.
- Perfection by control is available for all types of pledgors and all types of
investment property. As noted above, the concept of control has been de-
signed to accommodate a variety of arrangements, including those that do
not deny a pledgor's or another secured party's access to the asset. See
Sections 9-106 and 9-314. (See Diagrams 2 through 7)
n30 Section 9-313(f) specifies that a third party in possession of collateral is not
required to acknowledge that it holds possession for a secured party's benefit.
Section 9-313(g) provides that such an acknowledgment, once obtained by a se-
cured party, is effective even if it violates the debtor's rights.
C. Priority.
Section 9-328 of the UCC sets forth specific rules for determining priority of secu-
rity interests in investment property.
- The basic rule is that "control" means priority: the security interest of a
secured party who has control has priority over a security interest of a se-
cured party who does not. See Section 9-328(1).
- In other cases, the basic Article 9 "first in time" rules apply. See Section
9-322(a).
n31 The law governing creation is that provided for in the security agreement,
provided it satisfies otherwise applicable rules such as the "reasonable relation"
test in Section 1-105. Some states do not require any particular relation test to
be met.
n32 The basic rule, in the case of most debtors, requires a determination where
the debtor has its place of business or, if the debtor has more than one place of
business, at its chief executive office. For individuals the proper location is that
of one's "principal residence." The need to make a factual investigation is elimi-
nated in the case of debtors constituting domestic "registered organizations" (as
defined in Section 9-102(a)(76)), which are considered located in the State in
which they are organized. Debtors located in jurisdictions that do not have filing
registries for nonpossessory security interests are deemed to be located in the
District of Columbia.
It is significant to note in this regard that the foregoing rules allow the possibility
for the local law of different jurisdictions to govern perfection and priority. For exam-
ple, although perfection of a security interest in security entitlements and securities
accounts by filing will be governed by the local law of the jurisdiction in which the
debtor is located, the priority of that security interest will nevertheless be governed by
the local law of the securities intermediary's jurisdiction. This split treatment has little
practical significance when both jurisdictions have adopted the same version of the
UCC, but can matter if there are non-uniformities in the United States and will need to
be carefully analyzed in cross-border holding patterns.
n33 If the collateral is not "of a type customarily sold on a recognized market"
the highly technical search and notification rules specified in Section 9-611 will
apply.
Diagram 1
Direct Holding System
[See Diagram 1 in original]
Indirect Holding System
Diagram 2
Control Via Delivery Certificated Securities
[See Diagram 2 in original]
Priority and freedom from adverse claims determined pursuant to 8-303 and 9-
328.
Diagram 3
Control Via Delivery Uncertificated Securities
[See Diagram 3 in original]
Priority and freedom from adverse claims determined pursuant to 9-328 and 9-
331 and 8-303.
Diagram 4
Control Via Issuer Control Agreement
[See Diagram 4 in original]
Diagram 5
Control Via Becoming the Entitlement Holder
[See Diagram 5 in original]
Priority and freedom from adverse claims determined pursuant to 9-328 and 9-
331 and 8-502.
Diagram 6
Control Via Securities Account Control Agreement
[See Diagram 6 in original]
Diagram 7
Control Via Being the Securities Intermediary
[See Diagram 7 in original]
Diagram 8
[See Diagram 8 in original]
Diagram 9
[See Diagram 9 in original]
The regulations (the "TRADES Regulations") issued by the United States Treasury (the
"Treasury") parallel and, in certain cases, incorporate the revisions to Article 8 of the
UCC. Subject to narrowly defined exceptions, the rights and obligations of the United
States and the Federal Reserve Banks with respect to Treasury Book-Entry Securities
maintained in the TRADES system are stated to be governed solely and exclusively by
the TRADES Regulations, the offering circulars pursuant to which Treasury Book-Entry
Securities are sold, the offering announcements and Federal Reserve Bank Operating
Circulars. See Section 357.10.
n35 See 24 C.F.R. pt. 81 (April 1, 1998) (FNMA and FHLMC securities); 12 C.F.R.
pt. 912 (January 1, 1998) (FHLBank securities); 12 C.F.R. pt. 1511 (January 1,
1998) (RFC securities); 12 C.F.R. pt. 615 (FFCBFC, FCSFAC and FAMC securi-
ties); 31 C.F.R. pt. 354 (July 1, 1998) (SLMA securities); 18 C.F.R. pt. 1314
(April 1, 1998) (TVA securities); 24 C.F.R. pt. 350 (April 1, 2002) (GNMA securi-
ties).
Information regarding these regulations and the Book-Entry Regulations may
be found on the website of the United States Treasury's Bureau of Public Debt
(www.publicdebt.treas.gov/cc/cctrades.htm).
At the time that the TRADES Regulations were issued in August 1996, Treasury
noted in the commentary (the "Commentary") thereto that it had taken steps to
facilitate simultaneous adoption by U.S. government-sponsored entities of simi-
lar book-entry rules. In fact, according to the Commentary, the delay until Janu-
ary 1, 1997 in the effectiveness of the TRADES Regulations was intended to
"permit sufficient time for rules similar to TRADES to be in place for GSEs." As a
result of this process, the regulations issued by the GSEs in the first week of
January 1997 were modeled after TRADES Regulations, with minimal alterations.
As a result of the similarity between the TRADES Regulations and the book-entry
system applicable to U.S. Treasury obligations and the regulations issued by the
GSEs and their book-entry systems, the remainder of this section will concen-
trate on the TRADES Regulations, and it should be assumed that the regulations
of the GSEs are comparable, except as noted below.
The TRADES Regulations provide clear choice of law rules for determining
the law governing rights and obligations with respect to Security Entitle-
ments to the extent not specifically preempted by federal law.
The choice of law rules in the TRADES Regulations (Section 357.11(a)) state that,
where not specifically preempted by federal law, the law (not including the conflict-of-
law rules) of a securities intermediary's jurisdiction governs:
n36 On February 15, 2002, the Bureau issued an interim rule making certain
technical and conforming changes to the TRADES Regulations in order to make
them consistent with the latest revisions to Section 8-110(e) made in connection
with the most recent revisions to Article 9. These changes include: (a) the addi-
tion of a new Section 357.11(b)(1) permitting a securities intermediary and its
entitlement holder expressly to specify a jurisdiction exclusively for purposes of
Article 8, the addition of a new Section 357.11(d) to make clear that the location
of the debtor, relevant to determining whether and how a security interest may
be perfected automatically or by the filing of a financing statement, is deter-
mined by state law, including Revised Article 9. The TRADES Regulations were
also restated in plain language, as required by presidential Executive Order. The
Bureau stated that it would coordinate with the other Government Sponsored
Enterprises and agencies having rules modeled on TRADES, "in an effort to
maintain consistency among all these rules." 67 Fed. Reg. at 7079. No further
regulations have been issued by the Bureau or other government sponsored en-
terprises, however.
A provision to the effect that if the jurisdiction selected pursuant to these choice of
law rules is a state that has not adopted the "Revised UCC" (referring to the 1994 re-
visions to UCC Article 8), the governing law "shall be the law of that State as though
the Revised UCC had been adopted by that State" has become inoperable. See Section
357.11(d) and the Bureau's publications at 63 Fed. Reg. 69191 (December 16, 1998)
and 66 Fed. Reg. 33832 (June 26, 2001).
Not all issues of perfection are governed by the law of the securities intermediary's
jurisdiction. The law of the jurisdiction in which the person creating a security interest
is located, regardless of whether that jurisdiction has adopted the Revised UCC, gov-
erns whether and how the security interest may be perfected automatically or by filing
a financing statement. See Section 357.11(c). Uniformity in these methods of perfec-
tion was not considered essential. Priority of all security interests remains, however,
governed by the law of the jurisdiction of the securities intermediary as determined
above.
The TRADES Regulations clarify the procedure for serving notice of attach-
ment in respect of Treasury Book-Entry Securities.
Section 357.44 provides that the interest of a debtor in a security entitlement may
be reached by a creditor only by legal process upon either (i) the securities intermedi-
ary with whom the debtor's securities account is maintained or (ii) where the security
entitlement is maintained in the name of a secured party, by legal process upon the
secured party. This portion of Section 357.44 is very similar to that set forth in Sec-
tion 8-112. Section 357.44 goes on to provide, however, that "these regulations do
not purport to establish whether a Federal Reserve Bank is required to honor an order
or other notice of attachment in any particular case or class of cases. Thus, while the
possibility of service on a Federal Reserve Bank is, by virtue of the fact that a Federal
Reserve Bank is a securities intermediary, provided for, it is not a foregone conclusion
that a Federal Reserve Bank would have to comply with the notice.
n39 Professor Curtis R. Reitz, Biddle Professor of Law at the University of Penn-
sylvania Law School, represented the United States on the Study Group and
Sandra M. Rocks participated as a co-coordinator for the private financial sector.
n40 The November 2006 session resulted in a revised Preliminary Draft conven-
tion on Harmonised Substantive Rules Regarding Securities Held with an Inter-
mediary (November 2006) UNIDROIT Study LXXVIII, Doc. 57 available at
http://www.unidroit.org/english/publications/proceedings/2006/study/78/s-78-
57-e.pdf (last visited March 20, 2007). Many additional reports and other mate-
rials are available on UNIDROIT's website http://www.unidroit.org/.
This opinion is uncorrected and subject to revision before publication in the New York
Reports.
USCOA2 No. 38
Highland Capital Management LP, Appellant-Respondent, v. Leonard Schneider, Leslie
Schneider, Scott Schneider and Susan Schneider, Respondents-Appellants,
Jenkens & Gilchrist Parker Chapin LLP, Respondent, RBC Dominion Securities Corp.,
Third-Party Respondent.
Paul B. Lackey, for appellant-respondent.
Katherine Ash, for respondents-appellants.
READ, J.:
The United States Court of Appeals for the Second Circuit has asked us whether
the eight promissory notes at issue in this case are "securities" within the meaning of
section 8-102(a)(15) of the Uniform Commercial Code. For the reasons that follow, we
conclude that they are.
I.
In April 1998, Norton McNaughton, Inc. (subsequently, McNaughton Apparel
Group, Inc.) acquired two women's apparel companies -- Jeri-Jo Knitwear Inc. (owned
by Leonard Schneider), and Jamie Scott, Inc. (owned by his three children, Leslie, Su-
san and Scott Schneider). These two businesses were combined to form a division of
McNaughton called Jeri-Jo Knitwear, Inc. (Jeri-Jo). Under the terms of the Agreement
of Purchase and Sale, McNaughton paid the Schneiders $ 55 million in cash, assumed
$ 10.9 million in debt, and agreed to a future earn-out payment based on Jeri-Jo's
performance over the two-year period ending in June 2000, during which the Schnei-
der children managed this business for McNaughton. n1
n1 Earn-out provisions in merger-and-acquisition agreements are intended to
accommodate the seller's desire for compensation for the anticipated future
value of the transferred assets and the buyer's reciprocal desire to avoid over-
paying for potential, but as yet unrealized, value. In this case, the earn-out was
based on Jeri-Jo's profitability, not its sales.
The earn-out payment was fixed at $ 190 million, which the Agreement called for
McNaughton to pay to the Schneiders in cash or, at McNaughton's option, up to 50%
in common stock. In light of available cash flow, however, McNaughton was only able
to make the minimum cash payment, and wished to avoid the significant dilutive ef-
fect on earnings of paying the balance in stock. As an alternative, McNaughton pro-
posed issuing the Schneiders a three-year note secured solely by the face value of the
stock to which they were entitled. Ultimately, McNaughton and the Schneiders com-
promised, agreeing to retire the earn-out obligation as of August 29, 2000 for $ 161
million, consisting of $ 125 million in cash ($ 95 million to be paid immediately and $
30 million to be paid on or before November 30, 2000, subject to financing); two mil-
lion shares of common stock at $ 13 per share ($ 26 million); and four three-year
subordinated promissory notes with a combined face value of $ 10 million. They also
agreed that if financing could not be arranged for the $ 30 million cash payment,
McNaughton would pay the Schneiders $ 59 million in a combination of cash, unse-
cured subordinated notes and/or shares of common stock at McNaughton's option.
In October 2000, McNaughton's chief executive officer informed the Schneiders
that, given McNaughton's stock price, the company was unlikely to raise the additional
equity needed to fund the $ 30 million payment fast coming due. He asked the
Schneiders to extend the November 30th deadline to April 30, 2001. In the end, the
Schneiders declined this request and, on December 10, 2000, four three-year subor-
dinated promissory notes with an overall face value of $ 59 million were issued to
them in lieu of the $ 30 million cash payment.
The eight notes with an aggregate face value of $ 69 million (the four issued in
August 2000 plus the four issued the following December), running 12 pages apiece,
were each payable to one or another of the four Schneiders. n2 The notes required
McNaughton to make quarterly principal and monthly interest payments to the named
payee. McNaughton was designated the maker of the notes, each of which bore the
following restrictive legend:
"THIS NOTE HAS NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF
1933, AS AMENDED. IT MAY NOT BE TRANSFERRED IN THE ABSENCE OF
AN EFFECTIVE REGISTRATION STATEMENT UNDER SUCH ACT OR AN OPIN-
ION OF COUNSEL TO THE MAKER THAT SUCH REGISTRATION IS NOT RE-
QUIRED."
Each note was marked "SUBORDINATED PROMISSORY NOTE" on its face because
these notes were subordinate to McNaughton's existing bank and bond debt amount-
ing to roughly $ 350 million. Upon McNaughton's default, the payee had the right to
declare the entire amount under the note due and owing, and to elect either to receive
payment in stock or to accelerate payment. The notes stated that they were "gov-
erned by and construed in accordance with" New York law.
n2 Specifically, the subordinated promissory notes issued and dated August
29, 2000 were payable to Leonard Schneider in the amount of $ 4 million; Leslie
Schneider in the amount of $ 2.4 million; Scott Schneider in the amount of $ 1.2
million; and Susan Schneider in the amount of $ 2.4 million. The subordinated
promissory notes issued December 10, 2000 and dated December 1, 2000 were
payable to Leonard Schneider in the amount of $ 23.6 million; Leslie Schneider
in the amount of $ 14.16 million; Scott Schneider in the amount of $ 7.08 mil-
lion; and Susan Schneider in the amount of $ 14.16 million.
The securities industry professionals who subsequently dealt with the notes con-
sidered them to be high-risk debt akin to junk bonds. Consequently, it was anticipated
that any potential purchaser would expect a high yield or internal rate of return. Con-
comitantly, the notes carried a substantial, variable interest rate (initially, 9.34% on
the December notes).
As it turned out, McNaughton was acquired in June 2001 by Jones Apparel Group,
Inc. As a result of the merger (an "Event of Default" under the terms of the notes),
Jones redeemed the notes at par value, paying the Schneiders $ 69 million plus inter-
est through June 19, 2001. The parties to this litigation dispute whether the Schnei-
ders reneged on an oral agreement to sell seven of the eight notes when they learned
of the planned acquisition before it was announced to the public. In particular, High-
land Capital Management LP alleges that the Schneiders, through their agent and bro-
ker, Glen Rauch of Glen Rauch Securities, Inc., retained RBC Dominion Securities Cor-
poration (now RBC Capital Markets Corporation) to market the notes on their behalf,
and that on March 14, 2001, RBC purchased the notes from the Schneiders for 51
cents on the dollar, and then immediately resold seven of the eight notes to Highland
for 52.5 cents on the dollar. n3
n3 Highland alleges that RBC resold the remaining note to Fidelity Manage-
ment and Research Company, also on March 14, 2001 and for 52.5 cents on the
dollar.
On October 18, 2001, Highland brought this suit against the Schneiders in Texas
state court. The action was removed to federal court in Texas on diversity grounds,
and then transferred to the United States District Court for the Southern District of
New York. As relevant here, the complaint alleges that the Schneiders breached an
oral agreement to sell the notes to Highland or, alternatively, breached a binding pre-
liminary agreement to do so, or breached an agreement to sell the notes to RBC, of
which Highland was a third-party beneficiary. n4 The Schneiders answered, denying
they had ever agreed to sell the notes to anyone on March 14, 2001 at any price, and
asserting that any such oral agreement would have been unenforceable anyway since
it fell within the statute of frauds. After the close of discovery, the Schneiders moved
for summary judgment to dismiss the complaint.
n4 RBC intended to act as a "riskless principal." That is, RBC sought to elimi-
nate its risk for variable market conditions by obtaining commitments to a speci-
fied price from both the seller (here, 51 cents on the dollar) and the ultimate
buyer (here, 52.5 cents on the dollar from two buyers) before executing a trade
with the seller. RBC's compensation on the transaction would have been the
spread between these two prices.
"(iii) which:
Thus, the promissory notes must fulfill the requirements of subparagraphs (i) (the
transferability test), (ii) (the divisibility test) and (iii) (the functional test) of section 8-
102(a)(15) in order to qualify as a security for purposes of article 8 (see generally
UCC 8-102, Comment 15; Hawkland & Rogers, UCC Series 8-102:01 [Rev Art 8];
see also, NY Bill Jacket, 1997 A.B. 6619, ch 566 at 68 [Report on Proposed Revisions
to Article 8 to the Association of the Bar of the City of New York prepared by The
Committee on Uniform State Laws and The Banking Law Committee of the Associa-
tion] ["'Security' as defined in Revised Section 8-102[a][15] . . . includes . . . any
other obligation of the issuer . . . that is transferable, divisible, and is dealt in or
traded on securities exchanges"]).
First, we must consider whether the notes are obligations "represented by a secu-
rity certificate in bearer or registered form." Section 8-102(a)(4) defines a
"[c]ertificated security" as "a security that is represented by a certificate," and section
8-102(a)(16) defines a "security certificate" as "a certificate representing a security."
These definitions are, as the Second Circuit observed, somewhat circular, and might
refer either to a specialized document like a traditional stock certificate or, more gen-
erally, to a paper embodying the underlying intangible interest. Of course, the defini-
tions in section 8-102 were deliberately worded by the drafters "in general terms, be-
cause they must be sufficiently comprehensive and flexible to cover the wide variety
of investment products that now exist or may develop" (UCC 8-103, Comment 1 [em-
phasis added]). We see no reason to accept the Schneiders' invitation to read "certifi-
cated security" and "security certificate" more narrowly than their plain words sug-
gest. Thus, we interpret these terms to encompass the eight subordinated promissory
notes, which are papers that definitively embody and evidence the underlying intangi-
ble obligation of McNaughton to the Schneiders.
The notes are obviously not in bearer form; therefore, our next inquiry is whether
they are in "registered form." In this regard, section 8-102(13) states that
"'[r]egistered form,' as applied to a certificated security, means a form in
which:
No. 38
SMITH, J. (dissenting):
The question of when a promissory note is a "security" is a familiar one in federal
securities law, and has proved very difficult (see e.g. Reves v Ernst & Young, 494 U.S.
56 [1990]; Chemical Bank v Arthur Andersen & Co., 726 F2d 930 [2d Cir 1984]; Ex-
change Nat. Bank of Chicago v Touche Ross & Co., 544 F2d 1126 [2d Cir 1976]). The
authors of the Uniform Commercial Code made the question of what is a "security" for
UCC purposes easier, by including in the definition of "security" an element not pre-
sent in federal securities law: with some exceptions, an obligation is not a security for
UCC purposes unless it "may be registered upon books maintained for that purpose by
or on behalf of the issuer." Today, the majority effectively undoes the work of the
UCC's authors, by reading this registrability requirement in so broad a way as to make
it meaningless.
Though it is not apparent from the majority opinion, registrability is the only sig-
nificant issue in this case. No one disputes that what the majority calls the "divisibility
test" and the "functional test" in the UCC definition of "security" (UCC 8-102 [a] [15]
[ii] and [iii]) are met here. The majority holds that the notes at issue are "represented
by securities certificates" within the meaning of UCC 8-102 (a) (15) (i), but it does not
matter whether the majority is right or wrong about this, because registrability is nec-
essary to make either an uncertificated obligation or a non-bearer certificated obliga-
tion into a security. If the obligation is certificated, the certificate must be in either
"bearer or registered form," and the definition of "registered form" requires that "a
transfer of the security may be registered upon books maintained for that purpose by
or on behalf of the issuer, or the security certificate so states" (UCC 8-102 [a] [13]
[ii]). If the obligation is not certificated, it is still a security if it meets the other tests
and its "transfer . . . may be registered upon books maintained for that purpose by or
on behalf of the issuer" (UCC 8-102 [a] [15] [i]). Registrability is therefore critical,
whether there is a certificate or not.
Before considering the meaning of the registrability requirement, it is useful to
consider why the UCC's authors made it part of their definition of "security" -- a defi-
nition that is completely independent of the federal securities law definition of the
same term (see UCC 8-102, Comment 3 [1977 Amendments] reprinted in, 8 Law-
rence's Anderson on the UCC 8:102:1, at 29-30 [3d ed rev 2001]). The apparent
reason for the requirement is to facilitate line-drawing -- to provide a relatively simple
test to distinguish between obligations and interests that are securities and those that
are not. As the Official Comment says: "The definition of registered form . . . .
[s]erves primarily to distinguish Article 8 from instruments governed by other law,
such as Article 3" (UCC 8-102, Comment 13).
These distinctions matter. For example, the rights and obligations of an issuer and
holder of an Article 3 negotiable instrument are substantially different from those of
an issuer and holder of an Article 8 security. The issuer of a security in registered form
may treat the registered owner as the owner for all purposes, until the security is pre-
sented for registration of transfer (see UCC 8-207 [a]). The issuer of an unregistered
negotiable instrument does not have that option. The indorser of a negotiable instru-
ment may also be liable to subsequent holders in the event that the issuer defaults
(see UCC 3-413). The indorser of an article 8 security, in contrast, makes no warran-
ties with respect to the issuer's ability to satisfy the underlying obligation (see UCC 8-
108).
The need for clear distinctions led the authors of the UCC to adopt the formalistic
requirement of registrability. Such formalism would be out of place in the federal se-
curities laws, which have the prevention of fraud and other abuses in securities mar-
kets among their primary purposes. Congress wanted to make evasion of the federal
securities laws difficult, and accordingly:
"[i]n defining the scope of the market that it wished to regulate, Congress
painted with a broad brush. It recognized the virtually limitless scope of
human ingenuity, especially in the creation of 'countless and variable
schemes devised by those who seek the use of the money of others on the
promise of profits,' SEC v W. J. Howey Co., 328 U.S. 293, 299, 66 S. Ct.
1100, 1103, 90 L. Ed. 1244 (1946), and determined that the best way to
achieve its goal of protecting investors was 'to define "the term 'security' in
sufficiently broad and general terms so as to include within that definition
the many types of instruments that in our commercial world fall within the
ordinary concept of a security."' [United Housing Foundation, Inc. v For-
man, 421 U.S. 837, 847-848 (1975)] (quoting H. R. Rep. No. 85, 73d
Cong., 1st Sess., 11 (1933)). Congress therefore did not attempt precisely
to cabin the scope of the Securities Acts. Rather, it enacted a definition of
'security' sufficiently broad to encompass virtually any instrument that
might be sold as an investment"
"[the taxpayer] cannot succeed unless [the bond] was 'in registered form,'
a phrase whose meaning in this context is entirely plain. It refers to the
common practice in the issuance of corporate bonds which allows the
holder of one or more coupon bonds of a series the option to surrender
them and have one bond 'registered' upon the books of the obligor or of a
transfer agent; or the holder may subscribe for such a bond in the first
place. The purpose is to protect the holder by making invalid unregistered
transfers, and the bond always so provides upon its face. The mere fact
that the debtor keeps books of account upon which the debt appears is al-
together immaterial; to construe the statute as the taxpayer asks would in
effect make the payment of any corporate debt - evidence of indebtedness'
-- a 'retirement' of 'capital assets,' for almost all corporations keep books.
It is scarcely necessary to labor the answer to so plain a misinterpretation"
Following certification of a question by the United States Court of Appeals for the Sec-
ond Circuit and acceptance of the question by this Court pursuant to section 500.27 of
the Rules of Practice of the New York State Court of Appeals, and after hearing argu-
ment by counsel for the parties and consideration of the briefs and the record submit-
ted, certified question answered in the affirmative. Opinion by Judge Read. Chief
Judge Kaye and Judges Ciparick, Graffeo and Jones concur. Judge Smith dissents and
votes to answer the certified question in the negative in an opinion in which Judge
Pigott concurs.
PREAMBLE:
1. Broker has established a securities account, number , in the name of (the
"Account"). n2
n3 The security agreement in this case need not be "written", although such
agreements are recommended. See 9-203(b)(3)(D). Under 9-203(b)(3)(A)
the "written" agreement requirement has been replaced by the requirement that
the debtor "authenticate" a security agreement. The securities intermediary need
not, and normally will not, be a party to the security agreement. If less than all
the assets held or to be held in the account are to be subject to the secured
party's security interest, a schedule should be provided to identify the relevant
collateral. As a practical matter, however, the parties may prefer to move such
assets to a separate account or sub-account. This is likely to be easier opera-
tionally for the intermediary and will make it easier for Debtor and Creditor to
add or subtract collateral from time to time.
3. Creditor, Debtor and Broker are entering into this Agreement to perfect the se-
curity interest of Creditor in the Account.
TERMS:
Section 1. The Account. Broker hereby represents and warrants to Creditor and
Debtor that (a) the Account has been established in the name of Debtor as recited
above, n4 and (b) except for the claims and interest of Creditor and Debtor in the Ac-
count (subject to any claim in favor of Broker permitted under Section 2), Broker does
not know of any claim to or interest in the Account. All parties agree that the Account
is a "securities account" within the meaning of Article 8 of the Uniform Commercial
Code as in effect from time to time in the State of [] (the "UCC") and that all property
n5 held by Broker in the Account will be treated as financial assets under the UCC.
However, Creditor and Debtor acknowledge and agree that [specify relevant assets or
types of assets] [to the extent so indicated on Account statements, certain assets] are
shown on Account statements for informational purposes only. Such assets are neither
credited to or carried in the Account nor covered by this Agreement. n6 Broker agrees
not to change the name or number of the Account without notifying Creditor and exe-
cuting any amendments hereto requested by Creditor in connection therewith.
n8 This is not a necessary element for perfecting the Creditor's security interest.
Rather, it goes to the business issue of the extent to which the Creditor will allow
the intermediary to have its own liens against the Account. To the extent that
there may be future trading in the Account, it is highly likely that the intermedi-
ary will want to retain its lien.
n9 Without this waiver Broker will have priority over Creditor, irrespective of
when Broker's interest arises. See 9-328(3). Note that adjustment of priorities
should be included even if extensions of credit by the Broker are contractually
prohibited. Moreover, 9-206 gives a securities intermediary a purchase money
security interest as a matter of law, which would be perfected via 9-306's op-
erative cross reference to 8-106(e).
Section 3. Control. Broker will comply with entitlement orders (within the mean-
ing of Article 8 of the Uniform Commercial Code of the State of [] (the "UCC") n10
originated by Creditor concerning the Account without further consent by Debtor. n11
Except as otherwise provided in Section 4 below, Broker shall also comply with enti-
tlement orders and other instructions concerning the Account originated by Debtor,
n12 or Debtor's authorized representatives, until such time as Creditor delivers a writ-
ten notice to Broker that Creditor is thereby exercising exclusive control over the Ac-
count. n13 Such notice is referred to herein as the "Notice of Exclusive Control." Until
Broker receives a Notice of Exclusive Control, Broker may distribute to Debtor all in-
terest and regular cash dividends on property in the Account. n14 After Broker re-
ceives a Notice of Exclusive Control and has had a reasonable opportunity to comply,
it will cease complying with entitlement orders or other instructions concerning the
Account originated by Debtor or its representatives and cease distributing interest and
dividends on property in the Account to Debtor. n15 Broker shall be entitled to rely
upon any entitlement order or Notice of Exclusive Control that it reasonably believes
to be from Creditor. Until it receives a Notice of Exclusive Control, Broker shall be en-
titled to continue to act on such instructions from Debtor as are delivered in form sat-
isfactory to Broker. n16 Broker has not agreed and will not agree with any third party
that Broker will comply with entitlement orders concerning the Account originated by
such third party without the prior written consent of Creditor and Debtor. n17
n10 "Entitlement order" is defined in 8-102(a)(8) to mean "a notification com-
municated to a securities intermediary directing transfer or redemption of a fi-
nancial asset to which the entitlement holder has a security entitlement." This
can be defined in the agreement, or the requirements for an effective communi-
cation can be spelled out.
n11 This language tracks 8-106(d)(2). There is some concern that conditioning
the Creditor's ability to originate entitlement orders upon the occurrence (or the
allegation) of an event of default under the underlying security agreement could
be viewed as delaying the Creditor's acquisition of control, thus delaying the
time of perfection of its security interest. Note, however, that the revised version
of Article 9 of the Uniform Commercial Code, which was enacted in all 50 States
by July 1, 2001, contained new commentary to 8-106 which indicated that a
Creditor will have control notwithstanding that the Creditor's right to originate
entitlement orders is conditioned upon the Debtor's default. See 8-106, Exam-
ple 11. The existence of this changed commentary may be considered a "clarifi-
cation" and as such have current legal significance.
n12 Allowing the Debtor to exercise trading rights does not affect perfection or
priority (see 8-106(f) and comments; 9-314 and 9-328), but may affect
credit decisions. The Creditor might wish to limit the nature of the trading or in-
vestment permitted by the Debtor, but requiring the Broker to police the
Debtor's activity is likely to be perceived by the Broker as unduly burdensome
from an operational or monitoring perspective. Accordingly, any such limitations
are probably best left to the underlying security agreement -- which has the dis-
advantage for the Creditor of constituting only a covenant by the Debtor rather
than an independently applied limitation.
n13 Obviously, the Creditor will want the right to terminate the Debtor's access
to the Account at some point. The Debtor and Creditor should provide in the
relevant security agreement for the circumstances under which the Creditor is
entitled to send such a notice, which may be before or after default.
n14 This is a business point. The Creditor may wish to require that all such dis-
tributions be retained in the Account, but that may present operational concerns
for the Broker.
n15 See, in this regard, 8-115, which affords a securities intermediary a rea-
sonable opportunity to act on an injunction, restraining order or other legal proc-
ess before incurring liability to adverse claimants. The reference to "other in-
structions" is intended to terminate all access to the Account by the Debtor--
including, for example, issuing instructions to purchase financial assets, which
might not fall within the definition of entitlement order (an instruction to "trans-
fer" or "redeem"). Technically, it is not necessary to state that the debtor can
continue issuing entitlement orders; provisions are necessary, however, to ter-
minate this right.
n16 Operational and customer relationship concerns may dictate that, so long as
the Debtor is free to trade in the Account, Broker will want to leave its manner of
communicating with its customer unaffected. On the other hand, acting on in-
structions from the Creditor may be perceived as an operational change warrant-
ing the requirement of a writing. The "Notices" provision contained in Section 14
would impose that requirement.
n17 This provision is essential in order to ensure that the securities intermediary
does not comply with a later request by the entitlement holder that it enter into
a control agreement with another creditor. If the intermediary did enter into an-
other control agreement, priority would be determined based upon the time that
the secured parties take the steps necessary to obtain control. See 9-328(2).
Even though such a secured party would be junior, secured parties generally
prefer not to permit the existence of other secured parties without prior consent
and the negotiation of appropriate intercreditor provisions.
n18 The use of the term "withdrawal" appears to be understood in the market to
refer to "free deliveries" or other instructions by a customer to deliver securities
to a named recipient, as opposed to "trading" in an account, which is accom-
plished by the Broker executing a trade with a third party. Prohibiting "withdraw-
als" by Debtor is a business issue. It is not necessary in order for the Creditor to
achieve control (and thereby perfection) as a legal matter. If the subject Account
were being maintained solely for the purpose of containing collateral, provision
might also be required for permitting "substitutions" but this might once again
introduce operational issues if the relative values of the financial assets arriving
and leaving needed to be compared.
n21 Consideration should be given to the appropriate standard for Broker's loss
of indemnification--ordinary negligence, gross negligence, etc.
n22 It normally is necessary to provide the Broker with some ability to cease
acting in connection with the Account. On the other hand, simply permitting the
Broker to terminate the control arrangement while the security interest remains
in effect would pose too great a practical risk to the Creditor, unless the Creditor
is free (under its agreement with the Debtor) to either move all the financial as-
sets to its own account or to move the financial assets to another securities in-
termediary with which it has entered into a satisfactory control arrangement.
The terms and conditions of any Broker-initiated termination will need to be ne-
gotiated.
Section 10. Complete Agreement. This Agreement and the instructions and no-
tices required or permitted to be executed and delivered hereunder set forth the en-
tire agreement of the parties with respect to the subject matter hereof, and, subject
to Section 8 above supersede any prior agreement and contemporaneous oral agree-
ments of the parties concerning its subject matter.
Section 11. Amendments. No amendment, modification or (except as otherwise
specified in Section 9 above) termination of this Agreement, nor any assignment of
any rights hereunder (except to the extent contemplated under Section 13 below),
shall be binding on any party hereto unless it is in writing and is signed by each of the
parties hereto, and any attempt to so amend, modify, terminate or assign except pur-
suant to such a writing shall be null and void. No waiver of any rights hereunder shall
be binding on any party hereto unless such waiver is in writing and signed by the
party against whom enforcement is sought.
Section 12. Severability. If any term or provision set forth in this Agreement
shall be invalid or unenforceable, the remainder of this Agreement, other than those
provisions held invalid or unenforceable, shall be construed in all respects as if such
invalid or unenforceable term or provision were omitted.
Section 13. Successors. The terms of this Agreement shall be binding upon, and
shall inure to the benefit of, the parties hereto and their respective corporate succes-
sors or heirs and personal representatives. This Agreement may be assigned by Credi-
tor to any successor of Creditor under its security agreement with Debtor, provided
that written notice thereof is given by Creditor to Broker.
Section 14. Notices. Except as otherwise expressly provided herein, any notice,
order, instruction, request or other communication required or permitted to be given
under this Agreement shall be in writing and deemed to have been properly given
when delivered in person, or when sent by telecopy or other electronic means and
electronic confirmation of error-free receipt is received or upon receipt of notice sent
by certified or registered United States mail, return receipt requested, postage pre-
paid, addressed to the party at the address set forth next to such party's name at the
heading of this Agreement. Any party may change its address for notices in the man-
ner set forth above.
Section 15. Counterparts. This Agreement may be executed in any number of
counterparts, all of which shall constitute one and the same instrument, and any party
hereto may execute this Agreement by signing and delivering one or more counter-
parts.
Section 16. Choice of Law. Regardless of any provision in any other agreement
relating to the Account, the parties hereto agree that, subject to Section 8 of this
Agreement, the establishment and maintenance of the Account, and all interests, du-
ties and obligations with respect to the Account, shall be governed by the law of the
State of [ ]. n23 The "securities intermediary's jurisdiction" within the meaning of
Article 8 of the UCC shall be the State of [ ]. n24 The parties hereto agree that the
law applicable to all issues in Article 2(1) of the Hague Convention on the Law Appli-
cable to Certain Rights in respect of Securities Held with an Intermediary is the law in
force in the State of []. n25
n24 This specification is often included even if the chosen law is the same as the
governing law.
n25 Since the Hague Securities Convention has been signed and appears headed
for ratification in the U.S. (although it does not by its terms become effective un-
til adopted by three signatory countries) it is useful to include this explicit selec-
tion of law so that the transitional rules applicable to pre-existing account
agreements will apply and give effect to the parties' choice. The law chosen for
Hague purposes should be the same as that selected for "securities intermedi-
ary's jurisdiction" purposes but (as with the latter) need not be the same as the
law governing the agreement. Note that the selection for Hague purposes will
only be given effect if the Broker has an office in the jurisdiction selected -- but if
the jurisdiction selected is a state of the United States, the office can be any-
where in the United States. The text of the Hague Securities Convention is avail-
able at http://www.hcch.net/index_en.php?act=conventions.text&cid=72 (last
visited , 2007).
n26 Whether this agreement needs to be written is determined by law other than
Article 9.
CREDITOR
By:
Name:
Title:
CUSTOMER
BROKER
By:
Name:
Title:
Aware of the urgent practical need in a large and growing global financial market to
provide legal certainty and predictability as to the law applicable to securities that are
now commonly held through clearing and settlement systems or other intermediaries,
Conscious of the importance of reducing legal risk, systemic risk and associated costs
in relation to cross-border transactions involving securities held with an intermediary
so as to facilitate the international flow of capital and access to capital markets,
Desiring to establish common provisions on the law applicable to securities held with
an intermediary beneficial to States at all levels of economic development, Recognis-
ing that the "Place of the Relevant Intermediary Approach" (or PRIMA) as determined
by account agreements with intermediaries provides the necessary legal certainty and
predictability,
Have resolved to conclude a Convention to this effect, and have agreed upon the fol-
lowing provisions -
1. In this Convention -
a) "securities" means any shares, bonds or other financial instruments or financial as-
sets (other than cash), or any interest therein;
c) "intermediary" means a person that in the course of a business or other regular ac-
tivity maintains securities accounts for others or both for others and for its own ac-
count and is acting in that capacity;
f) "securities held with an intermediary" means the rights of an account holder result-
ing from a credit of securities to a securities account;
g) "relevant intermediary" means the intermediary that maintains the securities ac-
count for the account holder;
h) "disposition" means any transfer of title whether outright or by way of security and
any grant of a security interest, whether possessory or non-possessory;
m) "Multi-unit State" means a State within which two or more territorial units of that
State, or both the State and one or more of its territorial units, have their own rules of
law in respect of any of the issues specified in Article 2(1);
b) it records in its own books details of securities credited to securities accounts main-
tained by an intermediary in the names of other persons for whom it acts as manager
or agent or otherwise in a purely administrative capacity.
1. This Convention determines the law applicable to the following issues in respect of
securities held with an intermediary -
a) the legal nature and effects against the intermediary and third parties of the rights
resulting from a credit of securities to a securities account;
b) the legal nature and effects against the intermediary and third parties of a disposi-
tion of securities held with an intermediary;
e) the duties, if any, of an intermediary to a person other than the account holder who
asserts in competition with the account holder or another person an interest in securi-
ties held with that intermediary;
f) the requirements, if any, for the realisation of an interest in securities held with an
intermediary;
g) whether a disposition of securities held with an intermediary extends to entitle-
ments to dividends, income, or other distributions, or to redemption, sale or other
proceeds.
2. This Convention determines the law applicable to the issues specified in paragraph
(1) in relation to a disposition of or an interest in securities held with an intermediary
even if the rights resulting from the credit of those securities to a securities account
are determined in accordance with paragraph (1)(a) to be contractual in nature.
3. Subject to paragraph (2), this Convention does not determine the law applicable to
-
a) the rights and duties arising from the credit of securities to a securities account to
the extent that such rights or duties are purely contractual or otherwise purely per-
sonal;
b) the contractual or other personal rights and duties of parties to a disposition of se-
curities held with an intermediary; or
Article 3 Internationality
This Convention applies in all cases involving a choice between the laws of different
States.
1. The law applicable to all the issues specified in Article 2(1) is the law in force in the
State expressly agreed in the account agreement as the State whose law governs the
account agreement or, if the account agreement expressly provides that another law
is applicable to all such issues, that other law. The law designated in accordance with
this provision applies only if the relevant intermediary has, at the time of the agree-
ment, an office in that State, which -
a) alone or together with other offices of the relevant intermediary or with other per-
sons acting for the relevant intermediary in that or another State -
b) merely because it is a place where call centres for communication with account
holders are located or operated;
c) merely because it is a place where the mailing relating to securities accounts is or-
ganised or files or archives are located; or
b) the account agreement between the account holder and that intermediary is the
relevant account agreement;
c) the securities account for the purposes of Article 5(2) and (3) is the securities ac-
count to which the securities are credited immediately before the disposition.
1. If the applicable law is not determined under Article 4, but it is expressly and un-
ambiguously stated in a written account agreement that the relevant intermediary en-
tered into the account agreement through a particular office, the law applicable to all
the issues specified in Article 2(1) is the law in force in the State, or the territorial unit
of a Multi-unit State, in which that office was then located, provided that such office
then satisfied the condition specified in the second sentence of Article 4(1). In deter-
mining whether an account agreement expressly and unambiguously states that the
relevant intermediary entered into the account agreement through a particular office,
none of the following shall be considered -
a) a provision that notices or other documents shall or may be served on the relevant
intermediary at that office;
b) a provision that legal proceedings shall or may be instituted against the relevant
intermediary in a particular State or in a particular territorial unit of a Multi-unit State;
c) a provision that any statement or other document shall or may be provided by the
relevant intermediary from that office;
d) a provision that any service shall or may be provided by the relevant intermediary
from that office;
2. If the applicable law is not determined under paragraph (1), that law is the law in
force in the State, or the territorial unit of a Multi-unit State, under whose law the
relevant intermediary is incorporated or otherwise organised at the time the written
account agreement is entered into or, if there is no such agreement, at the time the
securities account was opened; if, however, the relevant intermediary is incorporated
or otherwise organised under the law of a Multi-unit State and not that of one of its
territorial units, the applicable law is the law in force in the territorial unit of that
Multi-unit State in which the relevant intermediary has its place of business, or, if the
relevant intermediary has more than one place of business, its principal place of busi-
ness, at the time the written account agreement is entered into or, if there is no such
agreement, at the time the securities account was opened.
3. If the applicable law is not determined under either paragraph (1) or paragraph (2),
that law is the law in force in the State, or the territorial unit of a Multi-unit State, in
which the relevant intermediary has its place of business, or, if the relevant interme-
diary has more than one place of business, its principal place of business, at the time
the written account agreement is entered into or, if there is no such agreement, at the
time the securities account was opened.
In determining the applicable law in accordance with this Convention, no account shall
be taken of the following factors -
a) the place where the issuer of the securities is incorporated or otherwise organised
or has its statutory seat or registered office, central administration or place or princi-
pal place of business;
2. In this Article -
a) "the new law" means the law applicable under this Convention after the change;
b) "the old law" means the law applicable under this Convention before the change.
3. Subject to paragraph (4), the new law governs all the issues specified in Article
2(1).
4. Except with respect to a person who has consented to a change of law, the old law
continues to govern -
b) with respect to an interest in securities held with an intermediary arising before the
change of law -
i) the legal nature and effects of such an interest against the relevant in-
termediary and any party to a disposition of those securities made before
the change of law;
ii) the legal nature and effects of such an interest against a person who af-
ter the change of law attaches the securities;
iii) the determination of all the issues specified in Article 2(1) with respect
to an insolvency administrator in an insolvency proceeding opened after the
change of law;
c) priority as between parties whose interests arose before the change of law.
5. Paragraph (4)(c) does not preclude the application of the new law to the priority of
an interest that arose under the old law but is perfected under the new law.
Article 8 Insolvency
1. Notwithstanding the opening of an insolvency proceeding, the law applicable under
this Convention governs all the issues specified in Article 2(1) with respect to any
event that has occurred before the opening of that insolvency proceeding.
This Convention applies whether or not the applicable law is that of a Contracting
State.
In this Convention, the term "law" means the law in force in a State other than its
choice of law rules.
1. The application of the law determined under this Convention may be refused only if
the effects of its application would be manifestly contrary to the public policy of the
forum.
2. This Convention does not prevent the application of those provisions of the law of
the forum which, irrespective of rules of conflict of laws, must be applied even to in-
ternational situations.
3. This Article does not permit the application of provisions of the law of the forum
imposing requirements with respect to perfection or relating to priorities between
competing interests, unless the law of the forum is the applicable law under this Con-
vention.
1. If the account holder and the relevant intermediary have agreed on the law of a
specified territorial unit of a Multi-unit State -
a) the references to "State" in the first sentence of Article 4(1) are to that territorial
unit;
b) the references to "that State" in the second sentence of Article 4(1) are to the
Multi-unit State itself.
a) the law in force in a territorial unit of a Multi-unit State includes both the law of
that unit and, to the extent applicable in that unit, the law of the Multi-unit State it-
self;
b) if the law in force in a territorial unit of a Multi-unit State designates the law of an-
other territorial unit of that State to govern perfection by public filing, recording or
registration, the law of that other territorial unit governs that issue.
4. A Multi-unit State may, at any time, make a declaration that if, under Article 4, the
applicable law is that of one of its territorial units, the law of that territorial unit ap-
plies only if the relevant intermediary has an office within that territorial unit which
satisfies the condition specified in the second sentence of Article 4(1). Such a declara-
tion shall have no effect on dispositions made before that declaration becomes effec-
tive.
In the interpretation of this Convention, regard shall be had to its international char-
acter and to the need to promote uniformity in its application.
The Secretary General of the Hague Conference on Private International Law shall at
regular intervals convene a Special Commission to review the practical operation of
this Convention and to consider whether any amendments to this Convention are de-
sirable.
In a Contracting State, the law applicable under this Convention determines whether a
person's interest in securities held with an intermediary acquired after this Convention
entered into force for that State extinguishes or has priority over another person's in-
terest acquired before this Convention entered into force for that State.
3. Any express terms of an account agreement which would have the effect, under the
rules of the State whose law governs that agreement, that the law in force in a par-
ticular State, or a territorial unit of a particular Multi-unit State, applies to any of the
issues specified in Article 2(1), shall have the effect that such law governs all the is-
sues specified in Article 2(1), provided that the relevant intermediary had, at the time
the agreement was entered into, an office in that State which satisfied the condition
specified in the second sentence of Article 4(1). A Contracting State may, at the time
of signature, ratification, acceptance, approval or accession, make a declaration that
its courts shall not apply this paragraph with respect to an account agreement de-
scribed in this paragraph in which the parties have expressly agreed that the securi-
ties account is maintained in a different State. If the Contracting State is a Multi-unit
State, it may make such a declaration with respect to any of its territorial units.
3. Any State which does not sign this Convention may accede to it at any time.
2. The Regional Economic Integration Organisation shall, at the time of signature, ac-
ceptance, approval or accession, notify the Depositary in writing specifying the mat-
ters governed by this Convention in respect of which competence has been transferred
to that Organisation by its Member States. The Regional Economic Integration Organi-
sation shall promptly notify the Depositary in writing of any changes to the distribu-
tion of competence specified in the notice in accordance with this paragraph and any
new transfer of competence.
1. This Convention shall enter into force on the first day of the month following the
expiration of three months after the deposit of the third instrument of ratification, ac-
ceptance, approval or accession referred to in Article 17.
2. Any such declaration shall state expressly the territorial units to which this Conven-
tion applies.
3. If a State makes no declaration under paragraph (1), this Convention extends to all
territorial units of that State.
Article 21 Reservations
Article 22 Declarations
For the purposes of Articles 1(5), 12(3) and (4), 16(2) and (3) and 20 -
e) a withdrawal of a declaration shall take effect on the first day of the month follow-
ing the expiration of six months after the date on which the Depositary made the noti-
fication in accordance with Article 24.
Article 23 Denunciation
1. A Contracting State may denounce this Convention by a notification in writing to
the Depositary. The denunciation may be limited to certain territorial units of a Multi-
unit State to which this Convention applies.
2. The denunciation shall take effect on the first day of the month following the expi-
ration of twelve months after the date on which the notification is received by the De-
positary. Where a longer period for the denunciation to take effect is specified in the
notification, the denunciation shall take effect upon the expiration of such longer pe-
riod after the date on which the notification is received by the Depositary.
The Depositary shall notify the Members of the Hague Conference on Private Interna-
tional Law, and other States and Regional Economic Integration Organisations which
have signed, ratified, accepted, approved or acceded in accordance with Articles 17
and 18, of the following -
b) the date on which this Convention enters into force in accordance with Article 19;
In witness whereof the undersigned, being duly authorised thereto, have signed this
Convention.
Done at The Hague, on the ... day of ... 20..., in the English and French languages,
both texts being equally authentic, in a single copy which shall be deposited in the ar-
chives of the Government of the Kingdom of the Netherlands, and of which a certified
copy shall be sent, through diplomatic channels, to each of the Member States of the
Hague Conference on Private International Law as of the date of its Nineteenth Ses-
sion and to each State which participated in that Session.
Having regard to the deliberations of the First Commission during its meetings of 21-
22 June 2001 and 22-24 April 2002 -
1. a) Decides that the Special Commission on General Affairs and Policy of the Confer-
ence shall be convened with greater frequency than to date, in principle at least every
two years;
b) Decides that the implementation of the Strategic Plan shall be reviewed on a regu-
lar basis and that, depending on the outcome of such reviews, the Strategic Plan as a
whole be reviewed on a four year basis.
Having regard to the deliberations of the First Commission at its meetings of 21-22
June 2001 and 22-24 April 2002,
1. a) Decides to include in the Agenda for the Twentieth Session the preparation of a
new comprehensive convention on maintenance obligations, which would build on the
best features of the existing Hague Conventions on this matter and include rules on
judicial and administrative co-operation, and requests the Secretary General to con-
tinue the preliminary work and to convene a Special Commission for this purpose;
b) Notes that, following the decisions of the First Commission at its meeting of 22-24
April 2002, the Permanent Bureau, assisted by an informal working group, is facilitat-
ing an informal working process with a view to preparing a text to be submitted to a
Special Commission followed by a Diplomatic Conference to be held, if possible at the
end of 2003, and requests the Secretary General to report on the progress made at
the next meeting of the Special Commission on General Affairs and Policy.
b) the conflict of jurisdictions, applicable law and international judicial and administra-
tive co-operation in respect of civil liability for environmental damage,
a) Invites the Secretary General to convene a Special Commission to study the practi-
cal operation of the Hague Convention of 15 November 1965 on the Service Abroad of
Judicial and Extrajudicial Documents in Civil or Commercial Matters and the Hague
Convention of 18 March 1970 on the Taking of Evidence Abroad in Civil or Commercial
Matters, in the light inter alia of the impact of electronic means on these Conventions;
b) Invites the Permanent Bureau to study the practical operation of the Hague Con-
vention of 5 October 1961 Abolishing the Requirement of Legalisation for Foreign Pub-
lic Documents, in the light inter alia of the impact of electronic means, and, in particu-
lar with a view to assessing the need and possibility of developing the legal framework
for an electronic apostille and an electronic register;
c) Invites the Permanent Bureau to continue its activities in support of the effective
operation of the Hague Convention of 25 October 1980 on the Civil Aspects of Interna-
tional Child Abduction, including the development of a Guide to Good Practice and
measures to improve the operation of the Convention with regard to transfrontier
rights of access.
Unidroit Committee of Governmental Experts for the Preparation of a
Draft Convention on Substantive Rules Regarding Intermediated Securities
Third Session
Rome, 6/15 November 2006
UNIDROIT 2006
Study LXXVIII -- Doc. 57
Original: English/French
November 2006
3. - The Drafting Committee held its first meeting on 7 November 2006 and its last
meeting on 14 November 2006. On 15 November the text of the preliminary draft
Convention n3, including amendments proposed by the Drafting Committee, was laid
before the CGE meeting in plenary.
Appendix 1
Preliminary Draft Convention on Substantive Rules
Regarding Intermediated Securities
[O> provided that a declaration referred to in this sub paragraph must be made on
the grounds of the reduction of risk to the stability of the financial system; <O]
(o) "securities clearing system" means a system which -
(i) clears, but does not settle, securities transactions through a central counter-
party or otherwise;
(ii) is operated by a central bank or central banks or is subject to regulation, su-
pervision or oversight by a governmental or public authority in respect of its rules;
and
(iii) has been notified, on the ground of the reduction of risk to the stability of the
financial system, as a securities clearing system in a declaration by the Contracting
State the law of which governs the rules of the system;
(p) "uniform rules" means, in relation to a securities settlement system or securi-
ties clearing system, rules of that system which are common to the participants or to
a class of participants and are publicly accessible.
[O> (r) "collateral taker" means a person to whom a security interest in intermedi-
ated securities is granted; <O]
[O> (s) "collateral provider" means an account holder by whom a security interest
in intermediated securities is granted; <O]
[O> (t) "collateral agreement" means an agreement between a collateral provider
and a collateral taker providing (in whatever terms) for the grant of a security interest
in intermediated securities. <O]
n1 [O> This definition remains under consideration. Questions have been raised,
for example, as to the appropriateness of the particular term "intermediated se-
curities", as to whether it should be replaced by "intermediated rights", and as to
whether the definition should be expanded so as to include terms that currently
form part of Article 4. <O]
Article 2
[[O> Scope <O] Sphere of application]
This Convention applies where --
(a) the conflict of laws rules [O> of private international law <O] of the forum
state designate the law in force in [O> of <O] a Contracting State as the applicable
law; or
(b) the circumstances do not involve a choice in favour of any law other than the
law in force in the forum state and the forum state is a Contracting State.
Article 3
[Central Securities Depositories]
This Convention does not apply to the activity of creation, recording or reconcilia-
tion of securities conducted by central securities depositories or other persons vis-a-
vis the issuer of those securities.
Article [O> 3 <O]4
[Principles of interpretation]
[O> 1. - <O] In the implementation, interpretation and application of this Conven-
tion, regard is to be had to its purposes, to the general principles on which it is based,
to its international character and to the need to promote uniformity and predictability
in its application.
[O> 2. - Questions concerning matters governed by this Convention which are not
expressly settled in the Convention are to be settled in conformity with the general
principles on which it is based or, in the absence of such principles, in conformity with
the domestic non-Convention law. <O]
Chapter III -- [O> Rights of the Account Holder <O] Transfer of Intermedi-
ated Securities
Article [O> 4 <O]7
[Acquisition and disposition [O> of intermediated securities <O] by debit and
credit]
1. - Subject to Article 11, [O> l <O]intermediated securities are acquired by an ac-
count holder by the credit of securities to that account holder's securities account.
2. - No further step is necessary, or may be required by the [O> domestic <O]
non-Convention law, to render the acquisition of intermediated securities effective
against third parties.
3. - Subject to Article 11, [O> l <O]intermediated securities are disposed of by an
account holder by the debit of securities to that account holder's securities account.
4. - A security interest, or a limited interest other than a security interest, in in-
termediated securities may be acquired and disposed of by debit and credit of securi-
ties to securities accounts under this Article.
[O> 4. - Without prejudice to any rule of the domestic non-Convention law requir-
ing that no credit or debit be made without a corresponding debit or credit, a debit or
credit of securities to a securities account is not ineffective because it is not possible
to identify a securities account to which a corresponding credit or debit has been
made. <O]
5[O> 5 <O]. - Debits and credits to securities accounts in respect of securities of
the same description may be effected on a net basis.
[O> 6. - This Article does not preclude any other method provided by the domestic
non-Convention law for the acquisition or disposition of intermediated securities. <O]
Article [O> 5 <O]8
[Grant of [O> Security <O] interests in intermediated securities by other methods]
1. - An account holder [O> may <O] grants an interest in intermediated securities,
including a security interest or a limited interest other than a security interest, to an-
other person [O> collateral taker a security interest in intermediated securities <O] so
as to be effective against third parties -if - [O> by: <O]
(a)- the account holder enters[O> ing <O] into an [O> collateral <O] agreement
with [O> the collateral taker <O] that person; and
(b) one of the conditions specified in paragraph 2 applies and the relevant Con-
tracting State has made a declaration in respect of that condition under paragraph 4;
and no further step is necessary, or may be required by the non-Convention law, to
render the interest effective against third parties.
2. - The conditions referred to in paragraph 1(b) are as follows -- [O> delivering
the intermediated securities to the collateral taker; and no further step is necessary,
or may be required by the domestic non-Convention law. <O]
[O> 2. - Intermediated securities shall be treated as delivered to a collateral taker
if they are credited to a securities account of the collateral taker. <O]
[O> 3. - Intermediated securities shall also be treated as delivered to a collateral
taker -- <O]
([O> a <O]a) that the person to whom the interest is granted is [O> if <O] the
relevant intermediary [O> is itself the collateral taker and the relevant Contracting
State has made a declaration under paragraph 4 in respect of this sub-paragraph;
<O]
(b[O> b <O]) that [O> if <O] a designating entry in favour of that person has
been made [O> and the relevant Contracting State has made a declaration under
paragraph 4 in respect of this sub-paragraph; or <O]
(c[O> c <O]) that [O> if <O] a control agreement in favour of that person applies.
[O> and the relevant Contracting State has made a declaration under paragraph 4 in
respect of this sub-paragraph <O]
3. - An interest in intermediated securities may be granted under this Article so as
to be effective against third parties --
(a) in respect of a securities account (and such an interest extends to all interme-
diated securities from time to time standing to the credit of the relevant securities ac-
count);
(b) in respect of a specified category, quantity, proportion or value of the interme-
diated securities from time to time standing to the credit of a securities account.
[O> 4. - <O] A Contracting State may declare that under its [O> domestic <O]
non-Convention law --
(a) the condition specified in any one or more of sub-paragraphs (a) to (c) of para-
graph 2[O> 3 <O] is sufficient[O> , <O] to render an interest effective against third
parties [O> to constitute delivery of intermediated securities to a collateral taker <O];
(b)[O> . <O]
[O> 5. - A Contracting State may declare that under its domestic non-Convention
law <O] this Article shall not apply in relation to [O> security <O] interests in inter-
mediated securities granted by or to parties falling within such categories as may be
specified in the declaration;
(c) paragraph 3, or either sub-paragraph of paragraph 3, does not apply;
(d) paragraph 3(b) applies with such modifications as may be specified in the dec-
laration.[O> . <O]
[O> 6. - If the domestic non-Convention law so permits, a security interest may be
granted -- <O]
[O> (a) in respect of a securities account (and such a security interest extends to
all intermediated securities from time to time standing to the credit of the relevant se-
curities account); or, <O]
[O> (b) in respect of a specified category, quantity, proportion or value of the in-
termediated securities from time to time standing to the credit of a securities account.
<O]
5[O> 7 <O]. - The [O> domestic <O] non-Convention law determines[O> : <O]
[O> (a) <O] in what circumstances a non-consensual security interest in interme-
diated securities may arise and become effective against third parties.[O> ; and <O]
[O> (b) the evidential requirements in respect of a collateral agreement and the
delivery of intermediated securities to a collateral taker. <O]
[O> 8. - This Article does not preclude any other method provided by the domestic
non-Convention law for the grant of a security interest in intermediated securities, but
the priority of a security interest granted by any such other method is subject to the
rules in Article 6. <O]
Article 9
[Other methods under non-Convention law]
This Convention does not preclude any method provided by the non-Convention
law --
(a) for the acquisition or disposition of intermediated securities or of an interest in
intermediated securities;
(b) for the creation of an interest in intermediated securities and for making such
an interest effective against third parties; other than the methods provided by Articles
7 and 8.
Article 10
[Evidential requirements]
The non-Convention law determines the evidential requirements in respect of the
matters referred to in Articles 7 and 8.
Article [O> 8 <O]11
[[O> Lack of authorisation, ineffectiveness <O] Invalidity and reversal]
1. - A debit of securities to a securities account or a designating entry is [O> not
effective <O] invalid if[O> unless <O] the relevant intermediary is not authorised to
make that debit or designating entry:
(a) by the account holder and, in the case of a debit or designating entry that re-
lates to intermediated securities which are subject to [O> a security <O] an interest
[O> arising <O] granted under Article 8[O> 5(3) <O], by the person to whom that
interest is granted[O> collateral taker <O]; or
(b) by the [O> domestic <O] non-Convention law.
2. - Subject to Article[s] 12 [and 13], [O> T <O]the [O> domestic <O] non-
Convention law and, to the extent permitted by the [O> domestic <O] non-
Convention law, an account agreement or the uniform rules [O> and agreements gov-
erning the operation <O] of a securities settlement [O> [or clearing] <O] system de-
termine -
(a) the validity of a debit, credit or designating entry;
(b) whether a debit, credit or designating entry is liable to be reversed;
(c) where a debit, credit or designating entry is liable to be reversed, its effect (if
any) against third parties and the consequences of reversal;
(d) whether and in what circumstances a debit, credit or designating entry may be
made subject to a condition; and
(e) where a debit, credit or designating entry is made subject to a condition, its ef-
fect (if any) against third parties before the condition is fulfilled and the consequences
of the fulfilment or non-fulfilment of the condition. [O> , may provide that a debit or
credit of securities or a designating entry is not effective or is liable to be reversed.
<O]
[O> 3. - Subject to Article 7, the domestic non-Convention law determines -- <O]
[O> (a) where a debit or designating entry is not authorised or a debit, credit or
designating entry is otherwise ineffective, the consequences of such ineffectiveness;
<O]
[O> (b) where a debit, credit or designating entry is liable to be reversed, its effect
(if any) against third parties and the consequences of reversal. <O]
Article [O> 7 <O]12
[Acquisition by an innocent person of intermediated securities]
[O> 1. - Where securities are credited to a securities account under Article 4 and
the account holder does not at the time of the credit have knowledge of an adverse
claim with respect to the securities -- <O]
[O> (a) the account holder is not subject to the adverse claim; <O]
[O> (b) the account holder is not liable to the holder of the adverse claim; and
<O]
[O> (c) the credit is not ineffective or reversible on the ground that the adverse
claim n2 affects any previous debit or credit made to another securities account. <O]
[O> the fact that the initial credit or designating entry was made in circumstances
such that it is not effective or is liable to be reversed does not make the further credit
or designating entry ineffective, in favour of the acquirer, against the person making
the further disposition, the relevant intermediary or third parties unless: <O]
[O> (i) the further credit or designating entry is made conditionally and the condi-
tion has not been satisfied; <O]
[O> (ii) the acquirer has knowledge, at the time when the further credit or desig-
nating entry is made, that it is made as a result of the further disposition and that the
further disposition is made in the circumstances referred to in this paragraph; or <O]
[O> (iii) the further disposition is made by way of gift or otherwise gratuitously.]
n3 <O]
n3 [O> Further consideration to be given to whether there should be a more
general protection against reversal based on reversal etc. of earlier transactions;
paragraphs 4 and 5 reproduce Article 7(6) and (7) of Doc. 24. <O]
[O> [6. - For the purposes of paragraph 5 the acquirer has knowledge that the fur-
ther credit or designating entry is made as a result of a purported disposition made in
the circumstances referred to in that paragraph if the acquirer has actual knowledge
that it is so made, or has knowledge of facts sufficient to indicate that there is a sig-
nificant probability that it is so made and deliberately avoids information that would
establish that that is the case.] <O]
Article [O> 6 <O]13
[Priority among competing [O> security <O] interests]
1. - This Article determines priority between [O> security <O] interests in the
same intermediated securities which become effective against third parties under Arti-
cle 8.
2. - [O> Security <O] Subject to paragraph 5 and Article 14, interests that become
effective against third parties under Article 8[O> 5(3): <O]
[O> (a) <O] have priority over any [O> security <O] interest that becomes effec-
tive against third parties by any other method permitted by the [O> domestic <O]
non-Convention law [O> other than those provided by Article 5(2) or (3); and <O].
[O> (b) <O]3. - Interests that become effective against third parties under Article
8 rank among themselves according to the time of occurrence of the following events-
[O> : <O]
(a[O> i <O]) if the relevant intermediary is itself the holder of the interest, when
the [O> collateral <O] agreement granting the interest is entered into[O> , if the
relevant intermediary is itself the collateral taker; <O]
(b[O> ii <O]) when a designating entry is made;
(c[O> iii <O]) when a control agreement is entered into, or, if applicable, a notice
is given to the relevant intermediary.
[O> 3 <O]4. - Where an intermediary has an interest that has become effective
against third parties under Article 8 and makes a designation or enters into a control
agreement with the consequence that an interest of another person becomes effective
against third parties, the interest of that other person has priority over the interest of
the intermediary unless that other person and the intermediary expressly agree oth-
erwise.[O> enters into a control agreement with a collateral taker or makes a desig-
nating entry in favour of a collateral taker, the security interest of the collateral taker
has priority over any security interest of the intermediary that is effective against
third parties under Article 5(3). <O]
5[O> 4 <O]. - A non-consensual security interest in intermediated securities aris-
ing or recognised under any rule of the [O> domestic <O] non-Convention law has
such priority as is afforded to it by that law.
[O> 5. - Subject to paragraph 2, the priority of any competing security interests in
the same intermediated securities is determined by the domestic non-Convention law.
<O]
6[O> 6 <O]. - As between persons entitled to any [O> security <O] interests re-
ferred to in paragraphs 2, [O> paragraph <O] 3 and 4 and, to the extent permitted by
the [O> domestic <O] non-Convention law, paragraph 5[O> 4 <O], the priorities pro-
vided by this Article[O> he preceding paragraphs <O] may be varied by agreement
between those persons, but any such agreement does not affect third parties.
Article 14
[Priority of interests granted by an intermediary]
This Convention does not determine the priority or the relative rights and interests
between the rights of account holders of an intermediary and interests granted by that
intermediary that have become effective under Article 8.
n4 The square brackets in paragraph 1 reflect the need to ensure that the Con-
vention does not relax more stringent requirements under a domestic non-
Convention law that might, for example, require the intermediary to maintain
with another intermediary securities sufficient to reflect securities that the inter-
mediary carries on its books for its own account. Consideration may be given to
addressing this issue more generally in the convention.
2. - If at any time an intermediary does not hold sufficient securities and interme-
diated securities of any description in accordance with paragraph 1, it must within the
time required by the non-Convention law [O> [immediately] [promptly] <O] take
such action as is [O> required <O] necessary to ensure that it holds sufficient securi-
ties and intermediated securities of that description.
3. - The preceding paragraphs do not affect any provision of the [O> domestic <O]
non-Convention law, or, to the extent permitted by [O> subject to <O] the [O> do-
mestic <O] non-Convention law, any provision of the uniform rules of a securities set-
tlement [O> [or clearing] <O] system or of an account agreement, relating to the
method of complying with the requirements of those paragraphs or the allocation of
the cost of ensuring compliance with those [O> the <O] requirements [O> of those
paragraphs <O] or otherwise relating to the consequences of failure to comply with
those requirements.
Article [O> 18 <O]20
[Limitations on obligations and liabilities of intermediaries] [O> Application of do-
mestic non-Convention law and account agreement to obligations of intermediary]
<O]
1. - The obligations [O> and duties <O] of an intermediary_-under this Convention
and the extent of the liability of an intermediary in respect of those obligations [O>
and the extent of the liability of an intermediary <O] are subject to any applicable
provision of the [O> domestic <O] non-Convention law and, to the extent permitted
by [O> that <O] the non-Convention law, the account agreement or the uniform rules
of a securities settlement system.
2. - [An intermediary, including the] [The] operator of a securities settlement sys-
tem, who makes a debit, credit, or designating entry (an "entry") to a securities ac-
count maintained by the [intermediary] [operator] for an account holder is not liable
to a third party who has an interest in intermediated securities and whose rights are
violated by the entry unless --
(a) the [intermediary] [operator] makes the entry after the [intermediary] [opera-
tor] has been served with legal process restraining it from doing so, issued by a court
of competent jurisdiction, and has had a reasonable opportunity to act on that legal
process; or
(b) the [intermediary] [operator] acts wrongfully and in concert with another per-
son to violate the rights of that third party.
3. - Paragraph 2 does not affect any liability of the [intermediary] [operator] -
(a) to the account holder or a person to whom the account holder has granted an
interest that has become effective against third parties under Article 8; or
(b) that arises from an entry which the [intermediary] [operator] is not entitled to
make under Article 18.
4. - The operator of a securities settlement system or securities clearing system to
whose securities account securities are credited and who authorises a matching debit
of those securities to its securities account is not liable to a third party who has an in-
terest in intermediated securities and whose rights are violated by that credit or debit
unless --
(a) the operator receives the credit or authorises the debit after the operator has
been served with legal process restraining it from doing so, issued by a court of com-
petent jurisdiction, and has had a reasonable opportunity to act on that legal process;
or
(b) the operator acts wrongfully and in concert with another person to violate the
rights of that third party.
Article [O> 19 <O]21
[Allocation of securities to account holders' rights[O> : securities so allocated not
property of the intermediary] <O]
1. - Securities of each description held by an intermediary or credited to securities
accounts held by an intermediary with another intermediary shall be allocated to the
rights of the account holders of [O> that <O] the former intermediary to the extent
necessary to ensure that the aggregate number or amount of the securities of that
description so allocated is equal to the aggregate number or amount of such securities
credited to securities accounts maintained by the intermediary for account holders
other than itself.
2. - Subject to Article 14, s[O> Se <O]curities allocated under paragraph 1 shall
not form part of the property of the intermediary available for distribution among or
realisation for the benefit of [O> its unsecured <O] creditors [O> in the event of an
insolvency proceeding in respect of the intermediary or be otherwise subject to claims
of unsecured creditors <O] of the intermediary.
3. - [O> Subject to paragraph 4, t <O]The allocation required by paragraph 1 shall
be effected by the [O> domestic <O] non-Convention law and, [O> subject to the
domestic <O] to the extent required or permitted by the non-Convention law, by ar-
rangements made by the relevant intermediary.
4. - The arrangements referred to in paragraph 3 may include arrangements under
which an intermediary holds securities in segregated form --
(a) for the benefit of its account holders generally; or
(b) for the benefit of particular account holders or groups of account holders; in
such manner as to ensure that such securities are allocated in accordance with para-
graph 1.
[O> 4 <O] 5. - A Contracting State may declare that under its [O> domestic <O]
non-Convention law the allocation required by paragraph 1 applies only to securities--
that are held by the relevant intermediary in segregated form under arrangements
such as are referred to in paragraph 4[O> with another intermediary under an ar-
rangement for the segregation of securities held by the relevant intermediary for the
benefit of its account holders <O] and does not apply to securities held [O> with an-
other intermediary <O] by the relevant intermediary for its [O> for the relevant in-
termediary's <O] own account.
Article [O> 20 <O]22
[Loss sharing in case of insolvency of the intermediary]
[O> 1. - In any insolvency proceeding in respect of an intermediary, if the aggre-
gate number or amount of securities and intermediated securities of any description
held by an intermediary is less than the aggregate number or amount of securities of
that description credited to securities accounts, the shortfall shall be allocated: <O]
[O> (a) subject to sub-paragraph (b), among the account holders to whose securi-
ties accounts securities of the relevant description are credited, in proportion to the
respective numbers or amounts of securities so credited; or <O]
[O> (b) where the intermediary is [the operator of] a securities settlement [or
clearing] system and the rules or agreements governing the operation of the system
make provision for the allocation of the shortfall, in the manner so provided. <O]
[O> 2. - [Unless otherwise provided by the domestic non-Convention law,] [I]n
any allocation required under paragraph 1(a) no account shall be taken of: <O]
[O> (a) the origin of, or any past dealings in, any securities held by the intermedi-
ary or credited to securities accounts held by the intermediary with another interme-
diary; or <O]
[O> (b) the order in which or time at which any securities are credited or debited
to the respective securities accounts of account holders. <O]
[O> 3. - The preceding paragraphs are subject to any conflicting rule applicable in
the insolvency proceeding of the intermediary. <O]
1. - This article applies in any insolvency proceeding in respect of an intermediary
unless otherwise provided by any conflicting rule applicable in that proceeding.
2. - If the aggregate number or amount of securities of any description allocated
under Article 21 to an account holder, a group of account holders or the intermedi-
ary's account holders generally is less than the aggregate number or amount of secu-
rities of that description credited to the securities accounts of that account holder, that
group of account holders or the intermediary's account holders generally (as the case
may be), the shortfall shall be borne --
(a) where securities have been allocated to a single account holder, by that ac-
count holder;
(b) in any other case, by the account holders to whom the relevant securities have
been allocated, in proportion to the respective number or amount of securities of that
description credited to their securities accounts.
3. - To the extent permitted by the non-Convention law, where the intermediary is
the operator of a securities settlement system and the uniform rules of the system
make provision in case of a shortfall, the shortfall shall be borne in the manner so
provided.
[O> Article 21 <O]
[O> [Overriding effect of certain rules of securities settlement [or clearing] sys-
tems] <O]
[O> Any provision of the rules or agreements governing the operation of a securi-
ties settlement [or clearing] system [which is directed to the stability of the system or
the finality of transactions effected through the system] shall, to the extent of any in-
consistency, prevail over any provision of [Articles 8,X,Y, ...] [this Convention]. <O]
Article [O> 22 <O]23
[Effect[O> tiveness <O] of debits, credits etc. and instructions on insolvency of
operator or participant in securities settlement [O> [or clearing] <O] system]
1. - To the extent permitted by the non-Convention law, the following provisions
[O> Any provision of the rules or agreements governing the operation of a securities
settlement [or clearing] system [which is directed to the stability of the system or the
finality of transactions] <O] shall have effect notwithstanding the commencement of
an insolvency proceeding in respect of [O> [<O]the operator of[O> ] <O] the relevant
system or any participant in the relevant system [O> in so far as that provision- : <O]
[O> (a) precludes the invalidation or reversal of a debit or credit of securities to, or
a designating entry in, a securities account which forms part of the system after the
time at which that debit, credit or designating entry is treated as final under the rules
of the system; <O]
(a[O> b <O]) any provision of the uniform rules of a securities settlement system
or of a securities clearing system in so far as that provision precludes the revocation
of any instruction given by a participant in the system for making a disposition of se-
curities, or for making a payment relating to an acquisition or disposition of securities,
after the time at which that instruction is treated under the rules of the system as
having been entered irrevocably into the system;[O> . <O]
(b) any provision of the uniform rules of a securities settlement system in so far as
that provision precludes the invalidation or reversal of a debit or credit of securities to,
or a designating entry in, a securities account which forms part of the system after the
time at which that debit, credit or designating entry is treated as irrevocable under the
rules of the system.
2. - Paragraph 1 applies notwithstanding that any invalidation, reversal or revoca-
tion referred to in that paragraph would otherwise occur [O> by <O] under any rule
applicable in an insolvency proceeding[O> mandatory operation of the insolvency law
of a Contracting State <O].
n5 Further consideration will be given to the terminology of this Chapter and its
consistency with that of the remainder of the preliminary draft Convention.
the provision of securities or other assets as described in paragraph (a) and paragraph
(b) shall not be treated as invalid, reversed or declared void solely on the basis that
they are provided during a prescribed period before, or on the day of but before, the
commencement of an insolvency proceeding in respect of the collateral provider, or
after the [O> secured <O]relevant -obligations have been incurred.
2. - A contracting State may declare that paragraph 1(a)(ii) does not apply.
Article [O> 27 <O]32
[Declarations in respect of Chapter [O> V <O] VI]
1. - A Contracting State may declare that this Chapter shall not apply under its
[O> domestic <O] non-Convention law.
2. - A Contracting State may declare that under its [O> domestic <O] non-
Convention law this Chapter shall not apply --
(a) in relation to collateral agreements entered into by natural persons or persons
falling within such other categories as may be specified in the declaration;
(b) in relation to intermediated securities which are not permitted to be traded on
an exchange or regulated market;
(c) in relation to collateral agreements which provide for [O> secured <O] relevant
obligations falling within such categories as may be specified in the declaration.
(a) realise the collateral securities provided under a security collateral agreement:
(i) by selling them and applying the net proceeds of sale in or towards the dis-
charge of the relevant obligations; or
(ii) by appropriating the collateral securities as the collateral taker's own property
and setting off their value against, or applying their value in or towards the discharge
of, the relevant obligations, provided that the collateral agreement provides for reali-
sation in this manner and specifies the basis on which collateral securities are to be
valued for this purpose; or
Appendix 3