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.