Chapter Legal Risk in the Securities 9 Settlement System

JAMES STEVEN ROGERS

Around the globe, participants in the securities markets, secunttes market regulators, and central bank authorities are becoming increasingly aware of the need fo r modernization of commercial law to take account of the development of the system of securities holding through multiple tiers of intermediaries. In the United States, this concern led to a complete revi­ sion of the portion of the U.S. Commercial Code (Article 8 of the Uniform Commercial Code) that governs transfer and pledge securities.

I had the honor of serving as the reporter fo r that project and would like to share with you today some of the lessons that we learned in that project. I hope that my remarks may be of value to you as you contem­ plate the need fo r similar commercial law revision in your own countries.

In recent years, a major topic of concern within the international finan­ cial community has been the control of systemic risk in the payment and securities systems. A part of that concern is directed toward assuring that the settlement system fo r securities trading operates in a safe and efficient fa shion. The best-known part of securities settlement reform is modern­ ization of the operational systems fo r securities settlement. Within the past 10 or 20 years, most securities markets have made major changes to increase the speed, capacity, and efficiency of the settlement system. The time lag between trade and settlement has been reduced, and in the set­ tlement process itself efforts have been made to come as close as possible to simultaneous settlement of the money and securities sides of the trans­ action, a goal commonly known as "delivery versus payment" or "DVP."

This paper fo cuses on another stage in the modernization of the securi­ ties settlement system-the modernization of the commercial law fo unda­ tion upon which the operational system is built. We might speak of this concern as an effort to reduce legal risk in the securities settlement system.

Aspects of Legal Risk in the Securities Settlement System

We can identifY several aspects of legal risk in the securities settlement system. First, an antiquated system of commercial law rules may make it impossible, or at least much more difficult, to achieve needed operational modernization. This is particularly likely with respect to commercial law

263 264 • Legal Risk in the Securities Settlement System rules concerning the use of investment securities as collateral. Re gulators have become very aware of the need to reduce risk by identifYing the extent to which financial institutions are exposed to each other's credit risk and by requiring that unavoidable credit exposures be collateralized. Investment securities, especially government debt securities, are the most commonly used collateral in such risk reduction efforts. Yet if the basic commercial la\v of a country requires elaborate, cumbersome, or time­ consuming procedures to establish a valid lien on securities, it may not be fe asible to accomplish the policy objectives of reduction of credit risk by collateralization.

Second, an antiquated system of commercial law rules may create what I would call legal uncertainty risk. Suppose that you are involved in crisis management efforts in the midst of what used to be called-accurately but perhaps a bit too honestly-panics in the financial system. Suppose that you as a central banker are working, either on behalf of your own central bank or with private banks in your system, to provide liquidity to your securities markets by an emergency loan to a troubled, but funda­ mentally sound, firm that is a major player in your securities market. As a matter of financial policy and prudent banking policy you have conclud­ ed that the troubled firm should be rescued, so long as the extension of credit is fully collateralized by a lien on securities that the troubled firm holds fo r its own proprietary account. You turn to the lawyers and ask, "If this loan (of perhaps billions of dollars) is provided but the firm unfor­ tunately still does fa il, will we be absolutely sure that our loan is support­ ed by a valid lien?" I am sorry to say that in many legal systems, the lawyers' response is likely to be, "My goodness, that is a very interesting question." They will then begin to mumble about such things as how one obtains "constructive possession" of a securities certificate that is in fa ct in someone else's vaults, or does not exist at all but is "deemed" to exist by the law or regulation that permitted dematerialization or immobiliza­ tion. A central bank lawyer in the United States, who lived through the October 1987 crisis, once said that when you are on the brink of the col­ lapse of the financial system, "that's a very interesting question" is just not good enough as an answer to something that should be a simple legal question.

The third, and perhaps most worrisome, aspect of legal risk is what I would call the risk of a lack of post-settlement finality. The ideal toward which securities settlement modernization projects aspire would be a sys­ tem in which all temporal lags between trade and settlement were elimi­ nated. Not only would the cash and securities sides of settlement be simultaneous, but settlement and trade would be simultaneous. No sys­ tem approaches that today, though it is the type of things that Internet visionaries like to contemplate. But I want to warn you of a little known Ja mes Steven Rogers • 265 but troublesome fa ct. Without an adequate commercial law fo undation, even a completely instantaneous, simultaneous system would not elimi­ nate systemic risk in the securities settlement system. We tend to assume that once settlement has occurred, all our worries are over. That is not necessarily the case. Suppose that a firmthat is delivering securities in set­ tlement of an ordinary market trade is in fa ct acting wrongfully against someone in delivering those securities. For example, the firm might be using securities that it should be holding fo r its custodial customers or securities that it obtained fraudulently from another firm. Different legal systems have different rules on the general question whether, or under what circumstances, the true owner of stolen or otherwise misused prop­ erty can recover the property from a person to whom it has been trans­ fe rred by the wrongdoer. Those rules may diffe r depending on the type of property. For example, in most common law systems, the answer is very different fo r "negotiable instruments" than fo r ordinary personal property. If you ask enough hard questions of your commercial law experts, you may well find that there is no clear answer to this basic com­ mercia! law question with respect to securities held indirectly through a depository or other intermediary.

Fundamental Cause of Legal Risk in the Securities Settlement System

Fundamentally, I think that the cause of legal risk in the securities set­ tlement system is that it is not true that you can always pour new wine into old bottles. In most legal systems, the basic commercial law rules on transfer and pledge of investment securities are based on the assumption that changes in ownership of securities are effected in either or both of two ways: delivery of physical certificates or registration of transfer on the books of the issuer. Yet in the system by which the vast majority of secu­ rities trades are actually settled today, neither of those events ever occurs. Today, most actively traded securities positions are held though the indi­ rect holding system. In the traditional direct holding system, the ultimate beneficial owner of the security either had physical possession of a security certificate or was recorded as the owner on the official registry of the issuer. In the indirect holding system, the only entity that either has physical pos­ session of certificates or is directly recorded on the official registry is the central securities depository. The central securities depository's records do not typically show the identity of the ultimate investors. Rather, the central securities depository's records show only the aggregate positions held by the banks and brokers who are its direct participants. Only at the next level, or perhaps several layers further down in the pyramid of intermediaries, will we find the actual evidence of the identity of the ultimate investors. 266 • Legal Risk in the Securities Settlement System

In many systems, physical certificates representing the central securities depository's total position do exist. These "jumbo certificates," however, are never delivered from person to person. Just as nothing ever happens to these certificates, virtually nothing happens to the official registry of stockholders maintained by the issuers or their transfer agents to reflect the great bulk of the changes in ownership of shares that occur each day. Thus, the principal mechanism through which securities trades are settled today is not delivery of certificates or registration of transfers on the issuer's books, but accounting entries on the books of a multitiered pyra­ mid of securities intermediaries through which investment securities are held.

This is the basic problem that gives rise to legal risk in the securities set­ tlement system. Virtually all the rules of traditional commercial law spec­ ifying how change in ownership of securities are effected, and what happens if something goes awry in the process, are based on the concepts of a transfer of physical certificates or registration of transfers on the books of the issuers, yet that is not how changes in ownership are actual­ ly reflected in the modern securities trading system.

Until the recent revision of Article 8 of our Commercial Code, we in the United States handled this problem in a fa irly common fa shion fo r lawyers. Basically the law said that if securities are held through a depos­ itory system, a transfer can be made by making appropriate accounting entries. The law then said that the making of those entries "has the effect of delivery of a security in bearer fo rm." We had a commercial law about delivery of certificates, but a commercial world in which securities were transferred by accounting entries rather than delivery of certificates. What to do? Simple. We "deem" that accounting entries are the same as phys­ ical deliveries.

But, there is a problem with that approach. Abraham Lincoln told the story of the old fa rmer who was asked, "How many legs does a horse have if you call its tail a leg." The fa rmer's answer was "Four, ...because calling it a leg doesn't make it a leg."

In the United States we tried fo r several decades the approach of pour­ ing the new wine of the indirect holding system into the old bottle of physical certificates. But we fo und, particularly in times of stress in the financial markets, that the legal uncertainty inevitably produced by that approach was a risk that we should be unwilling to accept.

I will not trouble you with a detailed account of the problems that we fo und with the old approach. But it may be useful to give one illustration. Consider the problems of conflict of law posed by the indirect holding system. Suppose that your own country has developed an extremely Ja mes St&1Jen Rogers • 267 sophisticated securities holding and settlement system. Indeed, suppose that your system is so sophisticated that it is, in effect, one of your most valuable "export products." Investors around the globe choose to hold securities and settle trades through the institutions of your market, and issuers of securities around the globe choose to have their securities deposited in your institutions. Suppose too that your own domestic com­ mercial law is at least "semi-modern," that is, you have some special legal rules on the indirect holding system, but they fo llow the common approach of deeming that accounting entries have the same effect as a physical delivery of a certificate or a registration of transfer on the books of the issuer.

Now suppose that a firm or investor located in another country holds through your system a diverse portfolio of securities issued by issuers around the globe. The firm or investor wishes to use that portfolio as col­ lateral fo r a loan or other credit exposure. The lawyers in your country fe el fa irly confident that the transaction is valid under your own domes­ tic law. But, how can you be sure that a court, even in your own country, would apply your own domestic law? The traditional approach of conflict of laws is that questions concerning a transfer of property are governed by the lex situs, that is, the law of the jurisdiction where the property is located.

We may know that the accounting entries are being made on the books of the securities settlement system in your own country, and virtually all lawyers who have given much thought to this question have concluded that the right answer should be that the law of the institution where the securities account is maintained should govern the legal effect of a trans­ actionimplemented by book entries in that system. But our "solution" to the problem of adapting old law to new practice comes back to haunt us.

For conflict of law purposes, the situs of securities has traditionally been interpreted as either the location of physical certificates or the place of incorporation of the issuer. Re member, I am assuming that your own settlement system is so good that issuers around the globe want to use it. That means that the jumbo physical certificates representing the aggre­ gate positions held through your system may well be located with sub­ custodians located around the globe, and if the securities are truly dematerialized, the situs, in the sense of location of the issuer, may also be anywhere in the world.

So, consider what your lawyers will have to tell you. Well, they may say, we solved the legal problem of adapting our traditional commercial law to the realities of the modern indirect holding system by deeming that accounting entries in our system have the same effect of physical deliver­ ies or change of the shareholder registry. Unfortunately, one consequence 268 • Legal Risk in the Securities Settlement System of our solution to the problem of adaptation of our substantive law is that we have created a system in which our own courts may not be permitted to apply our own law. So, we have an intellectually intriguing solution that works just fine except fo r the fa ct that by its own terms it does not apply to the problems it was designed to solve.

Brief Overview of U.S. Revised Article 8

Revised Article 8, which has now been enacted in all but a handful of U.S. states and has been adopted by fe deral authority as the governing law fo r U.S. Treasury securities, drops the approach of trying to fit the indirect holding system into the legal concepts that evolved fo r the com­ mercial world of a previous era. Instead, Revised Article 8 establishes clear legal rules designed specificallyfo r modern securities holding practices. In effect, though, it does not so much change the law as recognize the changes that have already occurred as a result of developments in the marketplace.

Revised Article 8 uses a new concept-"securities entitlement"-to describe the property right of a person who holds a security through a securities intermediary and a new term- "entitlement holder"-to refer to a person who has a securities entitlement. A new Part 5 of Article 8 specifies the basic rights of those who hold securities entitlements, sub­ ject to any applicable regulatory law such as the fe deral securities laws. The term "securities entitlement" is defined as the package of rights that a person who holds securities through a securities intermediary has against that securities intermediary and the property held by that securi­ ties intermediary. Like many legal concepts, however, the meaning of "securities entitlement" is to be fo und less in any specific definition than in the matrix of rules that use the term.

Under Revised Article 8, a person acquires a securities entitlement when a securities intermediary indicates by book entry or otherwise that a security has been credited to a securities account maintained by the securities intermediary fo r the person. The rules provide that a securities intermediary must itself maintain a sufficient quantity of securities, how­ ever held, to satisfY all of its entitlement holders, and that the positions held by the intermediary fo r the entitlement holders are not subject to claims of the intermediary's creditors.

Thus, a securities entitlement is not merely a claim against the inter­ mediary, but a property interest consisting of a pro rata claim to the fun­ gible pool of underlying securities held by the intermediary. The concept of a securities entitlement does, however, include a package of rights against the intermediary. The rules cover such basic matters as the duty Ja mes Steven Rogers • 269 of the securities intermediary to pass through to the entitlement holder the economic and legal rights of ownership of the security, including the right to receive payments and distributions, and the right to exercise any voting rights. The rules also specify that the securities intermediary has a duty to comply with authorized orders from the entitlement holder and to convert the entitlement holder's securities position into any other available fo rm of securities holding that the customer requests, such as delivering a certificate or transferring the position to an account with another firm.

The shift to the securities entitlement concept greatly fa cilitates the rationalization of the legal rules in two areas that have been problematic under old law: (i) security interests (pledges) in securities and (ii)choice of law. The rules on security interests in securities in the fo rmer law were based on the conceptual structure of the pledge by physical possession. These concepts could be applied to the modern system only by deeming a lender to have "possession" if the securities are held through an inter­ mediary who has agreed to act on the instructions of the lender. Revised Article 8 seeks to strip away the unnecessary confusion created by fo rcing these arrangements into the Procrustean bed of fictitious possession of securities held through the multitiered system.

Instead, the new legal rules are based on what the parties to such arrangements are actually doing. Under the rules of revised Articles 8 and 9, a pledge of a securities position held through an intermediu-y would be described as the creation of a security interest in a securitie.> entitle­ ment. If the arrangement is such that the lender has the ability to direct that the position be liquidated, the lender would be described as having "control," and the security interest would be fully enforceable and would have priority over other claims.

Another advantage of the securities entitlement concept is that it great­ ly fa cilitates the choice of law analysis of transactions involving interme­ diaries in different jurisdictions. The securities entitlement analysis of Revised Article 8 invites a choice of law analysis that distinguishes among the different levels in the holding system. The basic choice of law princi­ ple of Revised Article 8 is that the rights and duties of a securities inter­ mediary and entitlement holder with respect to a securities entitlement are governed by the law of the securities intermediary's jurisdiction. Suppose that a Mexican investor holds a position in German bonds through an account with a New York custodian bank. Under Revised Article 8, the investor would be described as the entitlement holder of a securities entitlement through its custodian bank. The law governing securities entitlements recorded on the books of the custodian would be the law of the custodian's jurisdiction, that is, New York. The custodian 270 • Legal Risk in the Securities Settlement System

bank might in turn be the entitlement holder of a securities entitlement through another higher-tier intermediary, such as Euroclear. Thus, the Article 8 choice of law rules would direct one to Belgian law to determine the rights and duties of Euroclear and the custodian as a Euroclear par­ ticipant. If Euroclear in turns holds through a German bank, then German law would apply at that level.

The use of new concepts and terminology cannot, of course, eliminate all legal problems or uncertainties. Indeed, it must be recognized that using new concepts may itself present some risk of unforeseen complexities. The judgment of those who worked on the Article 8 revision project-senior lawyers, government officials, and law professors-is that there is much more to be gained than lost by taking a new approach. Indeed, the main virtue of the new approach taken in Revised Article 8 may be that it fo rces lawyers and judges to confront the fa ct that the modern system of securi­ ties holding through intermediaries presents unique legal problems that need to be addressed directly rather than by trying to fit the new practices into a conceptual structure that evolved in a different era.

The Challenge of Modernization

Achieving the political will to undertake the process of study and revi­ sion of the commercial law of securities holding is not easy. The task is all the more challenging given the highly technical nature of the subject matter. Revising the commercial law of the securities transfer system is a bit like infrastructure repair. The commercial law rules of the securities holding and transfer system function somewhat like the utility systems of a building or the transportation systems of a nation. When they're work­ ing right, no one notices them. Asthey age, it takes more and more effort to keep them working, and the people who know how they work come to realize that they may break down altogether if conditions put them under a heavy load. At some point, prudence demands that they be replaced with systems that are designed fo r modern conditions and have the capacity to handle heavy loads, even though at the time they are replaced they are still "working."

Until a catastrophe has occurred, it is hard to persuade a building owner, a nation, or a legislator to devote the time and expense necessary to modernize such systems. Ye t, in assessing the political realities that effectively set the priorities of law reform, it is probably worthwhile to contemplate the alternatives in any situation of infrastructure moderniza­ tion. It is highly unlikely that one will gain great acclaim from the effort to push a project to modernize bridges. But fe w of us would like to find ourselves in the position of explaining, after the bridge has fa llen, why the risk of a collapse seemed, at the time, too small to warrant spending the effort to strengthen it in advance.