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David C. Donald the Rise and Effects of the Indirect Holding System

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David C. Donald the Rise and Effects of the Indirect Holding System DAVID C. DONALD THE RISE AND EFFECTS OF THE INDIRECT HOLDING SYSTEM: HOW CORPORATE AMERICA CEDED ITS SHAREHOLDERS TO INTERMEDIARIES WORKING PAPER SERIES NO. 68 PROF. DR. THEODOR BAUMS PROF. DR. ANDREAS CAHN INSTITUTE FOR LAW AND FINANCE JOHANN WOLFGANG GOETHE-UNIVERSITÄT SENCKENBERGANLAGE 31 D-60054 FRANKFURT AM MAIN TEL: +49 (0)69 / 798-28941 FAX: +49 (0)69 / 798-29018 (INTERNET: HTTP://WWW.ILF-FRANKFURT.DE) David C. Donald The Rise and Effects of the Indirect Holding System: How Corporate America Ceded Its Shareholders To Intermediaries Institute for Law and Finance WORKING PAPER SERIES NO. 68 09/ 2007 THE RISE AND EFFECTS OF THE INDIRECT HOLDING SYSTEM: HOW CORPORATE AMERICA CEDED ITS SHAREHOLDERS TO INTERMEDIARIES David C. Donald Abstract This paper explains how the choice of the indirect holding system for securities settlement forced U.S. issuers to cede their shareholder data to intermediaries. Part I describes the law applicable to the transfer of certificated securities. Part II describes how the paper-intensive process of transferring certificated securities led to a market failure in the 1960's. It further shows how the indirect holding system was seen as a temporary, second-best solution pending the dematerialization of shares and improvements in communications technology. In the mean time, the effects of separating beneficial and record ownership led to an expensive and inefficient process of shareholder communication and voting. Part III examines this process, whose inefficiency offered service providers the profitable niche industry of assisting issuers to distribute proxy materials through and around extensive chains of intermediaries. Part IV explains how, when law and technology had developed sufficiently to allow a return to a system of direct issuer-shareholder relationships via a direct registration system, intermediaries acted rationally to absorb DRS into the DTTC system, and continue to enjoy their central role between issuers and shareholders. This Part also demonstrates how a truly effective direct registration system could provide the transparency necessary to address problems such as "empty" voting and could arguably spread the costs of securities settlement more equitably through broader- based netting, rather than pushing them downstream. Part V argues that although the indirect holding system and its negative effects are no longer necessary, a combination of unawareness and interest serves to perpetuate a perceived need for issuers and shareholders to cede their ownership/governance relationship to a custodian utility, which then offers to put them back into contact, for a fee. INTRODUCTION ................................................................................................................................................... 2 I. THE TRANSFER OF REGISTERED SECURITIES UNDER ARTICLE 8 UCC ...................................... 5 1. TRANSFER OF CERTIFICATED, REGISTERED SHARES ....................................................................................... 5 (a) Direct Transaction between Seller and Buyer ......................................................................................... 5 (b) Transaction on a Securities Exchange ..................................................................................................... 8 2. TRANSFER OF UNCERTIFICATED, REGISTERED SHARES .................................................................................. 9 II. THE CREATION OF THE "INDIRECT HOLDING SYSTEM" ............................................................. 10 1. THE "PAPER CRUNCH" .................................................................................................................................... 10 2. IMPOSING "IMMOBILIZATION" AS THE FOUNDATION FOR SECURITIES SETTLEMENT ..................................... 14 (a) The SEC's Investigation ........................................................................................................................ 14 (b) Immobilization is Imposed by Law ........................................................................................................ 18 (c) The SEC's 1976 Street Name Study ...................................................................................................... 21 III. COMMUNICATING THROUGH INTERMEDIARIES .......................................................................... 23 Research Associate, Institute for Law and Finance, University of Frankfurt. This paper is an adaptation of part of the author's doctoral dissertation for the Faculty of Law of the University of Frankfurt, which will appear in October 2007 from the Peter Lang Publishing Group under the title: DER EINFLUSS DER WERTPAPIERABWICKLUNG AUF DIE AUSÜBUNG VON AKTIONÄRSRECHTEN: EINE UNTERSUCHUNG DER ENTSTEHUNGSGESCHICHTE UND AUSWIRKUNGEN DES AMERIKANISCHEN "INDIRECT HOLDING SYSTEM". The author would like to thank Professors Theodor Baums and Andreas Cahn for their advice and comments on the doctoral dissertation. Draft of September 26, 2007. © David C. Donald INTRODUCTION 2 1. THE CONTENTS OF TODAY'S STOCKHOLDER LIST ......................................................................................... 23 2. THE SHAREHOLDER COMMUNICATION RULES ............................................................................................... 25 3. DISTRIBUTING PROXIES AND VOTING THROUGH INTERMEDIARIES ................................................................ 30 (a) Distribution of the Proxy Materials ........................................................................................................ 30 (b) Casting Votes ......................................................................................................................................... 32 4. THE RISKS AND COST OF COMMUNICATING THROUGH INTERMEDIARIES ...................................................... 34 5. IS THE SEC GRAVITATING TOWARDS A CONTINENTAL EUROPEAN COMMUNICATION MODEL? ................... 37 IV. SETTLEMENT OF TRANSACTIONS IN IMMOBILIZED SECURITIES .......................................... 39 1. THE DTCC SECURITIES SETTLEMENT SYSTEM ............................................................................................. 39 2. SECURITY ENTITLEMENTS TO FINANCIAL ASSETS HELD IN SECURITIES ACCOUNTS ..................................... 41 (a) Adapting the UCC to Immobilization ................................................................................................... 41 3. TRANSFERRING SECURITY ENTITLEMENTS WITHIN THE DTCC SYSTEM ....................................................... 43 4. THE DIRECT REGISTRATION SYSTEM ............................................................................................................. 48 (a) Creation of the Direct Registration System ............................................................................................ 48 (b)Transferring Shares of Stock within DRS ............................................................................................... 51 (c) How DRS Could Be Streamlined ........................................................................................................... 55 V. POSSIBLE REASONS FOR THE INDIRECT HOLDING SYSTEM'S CURIOUS ENDURANCE ..... 59 1. UNAWARENESS ............................................................................................................................................... 60 2. INTEREST ....................................................................................................................................................... 62 CONCLUSION ...................................................................................................................................................... 65 INTRODUCTION Communication between shareholders and corporations is necessary for everything from distributing dividends to casting votes at the annual meeting. Beginning in the 1970's, such communication became increasingly more complicated as more and more shares came to be held through intermediaries such as brokers, banks and central depositories. Today, with a mouse click, we can send each other data directly from any location to another at any time, so the difficulty of efficient communication between shareholders and companies is an anomaly. How did shareholders and the companies they own come to be isolated from each other? The answer is simple: a company's "shareholders" as they appear on the stockholders list are not really "shareholders", but only intermediaries. One might think that shareholders instructed the intermediaries to take their place as registered shareholders for the sake of privacy, but in almost all cases they did not. Rather, Congress intentionally created the indirect relationship in 1975 1 to facilitate the settlement of trades in securities.2 Since the transfer of a certificated, registered share is very paper intensive, when trading 1 Securities Acts Amendments of 1975, Pub. L. 94-29, June 4, 1975, 89 Stat. 97 (1975). 2 "Settlement of a securities trade involves the final transfer of the securities from the seller to the buyer and the final transfer of funds from the buyer to the seller." COMMITTEE ON PAYMENT AND SETTLEMENT SYSTEMS (CPSS) & TECHNICAL COMMITTEE OF THE INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS (IOSCO), RECOMMENDATIONS FOR SECURITIES SETTLEMENT SYSTEMS 38 (Nov. 2001); MICHAEL SIMMONS, SECURITIES OPERATIONS 261 et seq. (2002); HAL S. SCOTT, INTERNATIONAL FINANCE: LAW AND REGULATION 279 (2004); DAVID LOADER, CLEARING, SETTLEMENT
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