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Chapter 4. The Intermediated System in the United States

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Abstract

In the preceding Subsection, it was discussed that in the U.S. intermediated system, there exists no object of transfer; disposition of security entitlements involves mere extinguishment of relationship with the transferor’s intermediary, by debiting the amount of the security entitlements to her account, and creation of a new relationship with the transferee’s intermediary, by crediting the corresponding amount of the same type of security entitlements to her account; therefore, disposition of security entitlements are not transfer, as usually understood in a transaction of securities or other property. Accordingly, from the theoretical perspective itself, it may be impossible to trace the same object of the transaction, because there is no object of transfer. As drafters of UCC Article 8 justify, even because of the netting practice in a clearing and settlement process, presumably, it is almost impossible to trace the transferee of the same securities. Notwithstanding, in order to cut off adverse claims, and to protect acquirers including collateral takers, UCC Article 8 provides several mechanisms for fulfilling strong innocent acquisition.

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Notes

  1. 1.

    Article 8 of UCC deals with issues of investment securities. Part 1 of Article 8 covers several important definitions and concepts, such as adverse claim, control, choice of law, clearing corporation, and securities intermediary. Other Parts of Article 8 specifies issuance of securities and issuer (Part 2), transfer of certificated and uncertificated securities (Part 3), and registration of transfer (Part 4). Part 5 provides innovative rules on the intermediated system of the U.S.

  2. 2.

    Article 9 of UCC addresses secured transactions, and was substantially revised in 1998. For the revised Article 9, see Terry M. Anderson, Marianne B. Culhane & Catherine Lee Wilson, “Attachment and Perfection of Security Interests under Revised Article 9: a “Nuts and Bolts” Primer” (2001) 9 Am. Bankr. Inst. L. Rev. 179; Jean Wegman Burns, “New Article 9 of the UCC: the Good, the Bad, and the Ugly” (2002) 1 U. Ill. L. Rev. 29; Harry C. Sigman & Eva-Maria Kieninger, “Introduction” in Harry C. Sigman & Eva-Maria Kieninger eds., Cross-Border Security over Tangibles (München: Sellier, 2007) at 36~53 (especially, for the filing scheme under Article 9).

  3. 3.

    For adoption status, see the following website of the National Conference of Commissioners on Uniform State Laws: http://www.nccusl.org/Update/uniformact_factsheets/uniformacts-fs-ucca8.asp and http://www.nccusl.org/Update/uniformact_factsheets/uniformacts-fs-ucca9.asp.

  4. 4.

    Treasury bonds are issued for a term of thirty years, and at fixed rates of interest every six months. Treasury bills are issued in terms of 4, 13, 26 and 52weeks, and are usually sold at a discount from the face value. Finally, treasury notes are issued in terms of 2, 3, 5, 7 and 10years, and like treasury bonds, earn a fixed rate of interest every six months until maturity. Besides these federal debt securities, there are TIPS (treasury inflation-protected securities), STRIPS, BECCS and BUBES, I savings bonds, and EE/E savings bonds. For a brief introduction to federal debt securities, visit the website of TreasuryDirect: http://www.treasurydirect.gov.

  5. 5.

    31 CFR Part 357 (Regulations Governing Book-Entry Treasury Bonds, Notes and Bills (Department of the Treasury Circular, Public Debt Series No. 2-86)). Most government-sponsored entities that are privately owned, publicly chartered entities created by Congress also adopted regulations essentially identical to the TRADES Regulations (U.S. Department of Treasury, “Commercial Book-Entry Regulations (TRADES)” available at http://www.treasurydirect.gov/instit/statreg/trades/trades.htm). For details of the TRADES Regulations and system, see Sandra M. Rocks, Penelope L. Christophorou & Gottlieb Cleary, “Memorandum Regarding the 1994 Uniform Version of Article 8 of the Uniform Commercial Code and the Federal Book-Entry Regulations (with Addendum Regarding Investment Property Changes under Article 9)” (2002) SG085 ALI-ABA 143 at 166~170.

    Since the rules in Articles 8 and 9 and TRADES Regulations are substantially similar in essence, although the meaning of security entitlements differs somewhat between the UCC rules and TRADES Regulations, this Chapter mainly explores the U.S. intermediated system based on the rules specified in Part 5 of Article 8, and relevant provisions of Article 9 of UCC.

  6. 6.

    Martin J. Aronstein, “The New/Old Law of Securities Transfer: Calling a “Spade” a “Heart, Diamond, Club or the Like”” (1990) 12 Cardozo L. Rev. 429 at 430; Russell A. Hakes, “UCC Article 8: Will the Indirect Holding of Securities Survive the Light of Day?” (2002) 35 Loy. L.A. L. Rev. 661 at 667.

  7. 7.

    Prefatory Note of Article 8 at Part I. A. (hereinafter, “Prefatory Note”). As discussed in the General Introduction, presumably this is because of the influence of the materialisation theory permeating the U.S. in the late 19th century. For the basic conceptualisation of the materialisation theory in the U.S., see Grant Gilmore, “The Commercial Doctrine of Good Faith Purchase” (1954) 63 Yale L.J. 1057; Egon Guttman & Thomas P. Lemke, “The Transfer of Securities in Organized Markets: A Comparative Study of Clearing Agencies in the United States of America, Britain and Canada” (1981) 19 Osgoode Hall L. J. 400 at 401~407.

  8. 8.

    See e.g. Ss. 8-320 & 8-313(1). For prior versions of Section 8-313 and drafting history, see Charles W. Mooney, Jr., “Beyond Negotiability: A New Model for Transfer and Pledge of Interests in Securities Controlled by Intermediaries” (1990) 12 Cardozo L. Rev. 306 at 415~427.

  9. 9.

    Russell A Hakes, supra note 6, at 668. In the U.S., the terms direct holding system and indirect holding system are common; the official comment to UCC Article 8 also employs these terms. According to Prefatory Note I. D., the distinction is made depending on investors’ relationship with issuers. If investors have a direct relationship with the issuers, it is classified as a direct holding system, and if not it is an indirect holding system. For consistency, this Chapter uses the term intermediated system, if it is not necessary to employ the term indirect holding system.

  10. 10.

    In 1977 the amendments to Article 8 were approved, and incorporated in the 1978 official text of UCC. In this Chapter, the terms 1977 amendments or 1977 version are employed interchangeably. See Martin J. Aronstein, Robert Haydock, Jr. & Donald A. Scott, “Article 8 is Ready” (1980) 93 Harv. L. Rev. 889 (for an overview of the 1977 amendments, supporting the revisions); James Steven Rogers, “Policy Perspectives on Revised U.C.C. Article 8” (1996) 43 UCLA L. Rev. 1431 at 1441~1448; Dorothee Einsele, Wertpapierrecht als Schuldrecht: Funktionsverlust von Effektenurkunden im internationalen Rechtsverkehr (Tübingen: Mohr Siebeck, 1995) at 302~390.

  11. 11.

    In the 1960s, settlements were performed by physical delivery of securities certificates, and workloads for preparing relevant transfer documents were tremendous. For the detailed situation of the securities industry and the paper-crunch in the late 1960s, see Joel Seligman, The Transformation of Wall Street: A History of the Securities and Exchange Commission and Modern Corporate Finance, 3d ed. (New York: Aspen, 2003) at 450~466 (diagnosing that the primary cause of the crisis resulted from sales-oriented, incompetent broker-dealer firm management during the 1964~1968 securities volume upsurge). See also David C. Donald, “The Rise and Effects of the Indirect Holding System: How Corporate America Ceded Its Shareholders to Intermediaries” (2007) at 10~23 for the paper crunch and related measures taken, available at http://ssrn.com/abstract=1017206.

  12. 12.

    Prefatory Note at Part I. A. The introduction of uncertificated securities was not successful, because issuers, investors and the securities industry had no incentive to adopt the uncertificated securities scheme over the certificated securities regime, and the 1977 amendments actually increased workloads of documentation with respect to the transfer of uncertificated securities (Jeanne L. Schroeder, “Is Article 8 Finally Ready This Time?: The Radical Reform of Secured Lending on Wall Street” (1994) 3 Colum. Bus. L. Rev. 291 at 333~334).

  13. 13.

    Prefatory Note at Part I. B; Martin J. Aronstein, Robert Haydock, Jr. & Donald A. Scott, supra note 10 at 893~895 (describing that parallelism was the initial premise of the 1977 amendments, and the 1977 version of UCC Article 8 was thought as an interim version towards full dematerialization).

  14. 14.

    Prefatory Note at Part I. B.

  15. 15.

    For instance, Schroeder makes trenchant criticism of the 1977 version of Article 8, evaluating it as a “disaster” (Jeanne L. Schroeder, supra note 12 at 303 (interestingly, Schroeder criticises the materialisation concept as “philosophically and jurisprudentially naive” at 306)); Rogers explains it as “too difficult to use”(James Steven Rogers, supra note 10 at 1447); Mooney indicates that “a property law construct is a fundamentally flawed approach,” “principally Article 8 is grounded on a distorted perception,” and “the property law construct of [the 1997 version of Article 8] is inadequate and unworkable” (Charles W. Mooney, Jr., supra note 8 at 310~311 & 313).

  16. 16.

    Prefatory Note at Part I. B.

  17. 17.

    Curtis R. Reitz, “Reflections on the Drafting of the 1994 Revision of Article 8 of the US Uniform Commercial Code” (2005) 10 Unif. L. Rev. 357 at 359~360.

  18. 18.

    Section 8-313(2)(s.2) of the 1977 version provided that “[i]f a security so held is part of a fungible bulk, as in the circumstances specified in paragraphs (d)(ii) and (d)(iii) of subsection (1), the purchaser is the owner of a proportionate property interest in the fungible bulk.” Official Comment 4 to Section 8-313, however, stated that “unless specific securities are separately identified as belonging to the purchaser, he cannot become a bona fide purchaser…If bona fide purchaser status were given to those whose securities are held as part of a fungible bulk, there would be a possibility of inconsistent claims between two or more bona fide purchasers, since if the bulk should prove to be smaller than was expected, the claim of one or both must be compromised.” The same comment made an exception to this. In the case of intermediated securities held by a clearing corporation, innocent acquisition was acknowledged due to the reason that clearing corporations hold only for others’ accounts, and thus the possibility of inconsistent claims are small. Despite the official comment, however, courts frequently recognised investors’ innocent acquisition. For more discussion of innocent acquisition in the 1977 version of Article 8, see Prefatory Note at Part IV. B; James Steven Rogers, supra note 10 at 1467~1968; Jeanne L. Schroeder, supra note 12 at 334~349 (for the interpretations of courts as to Section 8-313(2) of the 1977 version) & 451~461.

  19. 19.

    See e.g. Charles W. Mooney, Jr., supra note 8 at 330~342, 349~351 & 365~379.

  20. 20.

    As to the October 1987 market break, see generally Andrew M. Klein, “the October 1987 Market Crash” (1988) 619 PLI/Corp 79. See also Joel Seligman, supra note 11 at 589~593 (on 19 October 1987, the Dow Jones Industrial Average fell 508 points or 22.6 percent on the record volume of 604 million shares per day); Eve L. Hill, ed., Symposium on the Regulation of Secondary Trading Markets: Program Trading, Volatility, Portfolio Insurance, and the Role of Specialists and Market Makers (1989) 74:5 Cornell. L. Rev.

  21. 21.

    Mooney, however, explains that the very beginning of the amendments to Article 8 was with several failures of government securities dealers in the early 1980s, causing losses by investors including secured lenders and investors advancing funds in repo transactions, although direct or indirect influence came from the October 1987 market failure. (Charles W. Mooney, Jr., “The Roles of Individuals in UCC Reform: Is the Uniform Law Process a Potted Plant? The Case of Revised UCC Article 8” (2002) 27 Okla. City U. L. Rev. 553 at 559 & 562).

  22. 22.

    Curtis R. Reitz, supra note 17 at 360.

  23. 23.

    See James Steven Rogers, supra note 10 at 1445~1447; Charles W. Mooney, Jr., Sandra M. Rocks & Robert S. Schwartz, “An Introduction to the Revised U.C.C. Article 8 and Review of Other Recent Developments with Investment Securities” (1994) 49 Bus. Law. 1891 at 1892.

  24. 24.

    James Steven Rogers, ibid. at 1446~1447; Financial Markets Law Committee, Issue3-Property Interests in Investment Securities: Report on Research into the 1994 Revision to Article 8 of Uniform Commercial Code (London, 2005) at 5~6. See also generally Charles W. Mooney, Jr., supra note 21 at 559~576; William D. Hawkland, James S. Rogers & Carl S. Bjerre,7A Hawkland’s Uniform Commercial Code Series (Database updated in Oct. 2010) (hereinafter, “7A Hawkland”) at S. 8-101:04 for detailed drafting history and process of the 1994 amendments to Article 8.

  25. 25.

    James Steven Rogers, supra note 10 at 1432; Charles W. Mooney, Jr., Sandra M. Rocks & Robert S. Schwartz, supra note 23 at 1891.

  26. 26.

    Charles W. Mooney, Jr., supra note 8 at 403~405; Charles W. Mooney, Jr. & Atsushi Kinami, “Transfer, Pledge, Clearance and Settlement in the Japanese and United States Government Securities Markets” (1991) 12:4 U. Pa. J. Int’l Bus. L. 517 at 518~519. See also Jeanne L. Schroeder, supra note 12 at 371~375 for difference between the intermediated system and payment system.

  27. 27.

    See Prefatory Note at Part II. B; Russell A Hakes, supra note 6 at 671~677 for amendments to direct holding systems.

  28. 28.

    As discussed below, in UCC Article 8, the concepts of entitlement holders and investors are not equivalent. Since there exist security entitlements in each tier of the intermediated system, intermediaries in the tiers of the intermediated system are also entitlement holders, though they are not investors.

  29. 29.

    Securities mean “obligations of an issuer or shares, participations, or other interests in an issuer or in property or an enterprise of an issuer: i) which are represented by securities certificates in bearer or registered form, or the transfer of which can be registered upon books maintained for that purpose by or on behalf of the issuer; ii) is one of a class or series or by its terms is divisible into a class or series of shares, participations, interests, or obligations; and iii) which: A) are, or are of types, dealt in or traded on securities exchanges or securities markets; or B) are mediums for investment and by their terms expressly provide that they are securities governed by Article 8” (S. 8-102(a)(14)). As for further explanation of securities under Article 8, see Egon Guttman, 28 Modern Securities Transfers, 3d ed. (Database updated in Oct. 2010) at Ss. 1:16~1:19.

  30. 30.

    As regards the legal nature of CDs under U.S. law, see ibid. at S. 1:4.

  31. 31.

    S. 8-102(a)(9)(s.2). In this regard, as mentioned in Chapter 1, the definition of a financial asset in UCC Article 8 is different from that in the Geneva Securities Convention. For further understanding as to a financial asset, see UCC S. 8-102 cmt. 9; 7A Hawkland at S. 8-102:04.

  32. 32.

    S. 8-103. An option or similar obligation issued by a clearing corporation to its participants is a financial asset, though not a security (S. 8-103(e)).

  33. 33.

    UCC S. 8-501 cmt. 1. For a similar reason, deposit accounts and mutual fund accounts are not covered in the intermediated system (7A Hawkland at Ss. 8-501:03 & 05).

  34. 34.

    Ibid. For more detailed accounts as to the definition of a securities account, see 7A Hawkland at Ss. 8-501:02~06.

  35. 35.

    UCC S. 8-501 cmt. 1; Russell A Hakes, supra note 6 at 680.

  36. 36.

    See Art. 1(e) of the Geneva Securities Convention and Art. 1(1)(d) of the Hague Securities Convention.

  37. 37.

    Section 8-102(a)(8) defines an entitlement holder as “a person identified in the records of a securities intermediary as the person having a security entitlement against the securities intermediary. If a person acquires a security entitlement by virtue of Section 8-501(b)(2) or (3), that person is the entitlement holder.”

  38. 38.

    S. 8-112(c). If a security entitlement is maintained in the name of a secured party, the creditor’s claim should be made upon the secured party by legal process (S. 8-112(d)).

  39. 39.

    As discussed below, where extremely strict requirements are met, a creditor or third party (e.g. an entitlement holder’s insolvency administrator, i.e. liquidator) may claim financial assets vis-à-vis an upper-tier intermediary.

  40. 40.

    A broker means “a person defined as a broker or dealer under the federal securities laws, but without excluding a bank acting in that capacity” (S. 8-102(a)(3)). Sections 3(a)(5) and 5 of the Securities Exchange Act of 1934 (“SEA”) define the definitions of a broker and dealer, respectively.

  41. 41.

    This definition of an intermediary is also similar to that under the Geneva Securities Convention and the Hague Securities Conventions.

  42. 42.

    See Art. 1(d) of the Geneva Securities Convention and Art. 1(1)(c) of the Hague Securities Convention.

  43. 43.

    A clearing agency is defined in Section 3(a)(23) of the SEA.

  44. 44.

    With respect to a comparison of the definition of a clearing corporation under the 1977 version and that of the current UCC Article 8, see 7A Hawkland at S. 8-102:05. As discussed below, with respect to a clearing corporation, unlike normal intermediaries, UCC Article 8 provides two preferential clauses for clearing corporations. First, the clearing corporation’s rules are effective, even if those rules contradict UCC and affect other parties who do not agree with the rules (S. 8-111). Second, a creditor of a clearing corporation that has no sufficient financial assets has a super-priority over the claims of entitlement holders, according to Section 8-511.

  45. 45.

    DTC was established in 1973 as a successor to the business of the NYSE’s Central Certificate Service created to cope with the paper crunch in the late 1960s, and is a limited purpose trust company established under New York law. In 2009, DTC settled transactions worth almost $299.4 trillion, and about 3.6 million securities issues (worth about $33.9 trillion) are in custody of DTC. Together with NSCC, DTC became a subsidiary of DTCC in 1999. For details and services of DTC, see its website, http://www.dtcc.com/products/index.php?id=dtc; DTC, “Assessment of Compliance with the CPSS/IOSCO Recommendations for Securities Settlement Systems” (13 August 2009), available at http://www.dtcc.com/legal/compliance/DTC_Self-Assessment.pdf.

  46. 46.

    NSCC was formed in 1976, and provides clearing, settlement, risk management, CCP services, and a guarantee of completion for transactions for almost all broker-to-broker trades. For details and services of NSCC, see its website, http://www.dtcc.com/products/index.php?id=nscc; NSCC, “Assessment of Compliance with the CPSS/IOSCO Recommendations for Central Counterparties” (13 August 2009), available at http://www.dtcc.com/legal/compliance/NSCC_Self-Assessment.pdf.

  47. 47.

    For treasury securities, FRBs play a CSD role, similar to the Bank of Japan, which functions as the CSD for Japanese government bonds.

  48. 48.

    DTCC is a holding company of 10 subsidiaries. DTCC’s principal subsidiaries are DTC, NSCC, Fixed Income Clearing Corporation (FICC), DTCC Deriv/SERV LLC, DTCC Solutions LLC, and European Central Counterparty Limited (EuroCCP). In 2009, DTCC settled nearly $1.48 quadrillion (1.48 x 1015) in securities transactions, and processed $209.7 trillion value of NSCC equity, bond and ETF transactions and $121.8 trillion value of electronic book-entry deliveries. For details of DTCC, see DTCC, An Introduction to DTCC: Services and Capabilities (2010), available at http://www.dtcccom/downloads/about/Introduction_to_DTCC.pdf.

  49. 49.

    A global certificate is a concept similar to the German Globalurkunde, contributing to immobilisation of securities. In the U.S., however, the term jumbo certificate is also used as a similar concept to a global certificate. A jumbo certificate is a certificate representing 10000 or more shares and breakable into individual certificates, thereby being registered in the name of beneficial owners. As in Germany, there is a controversy over global certificates’ nature as securities under UCC. For more debates regarding this issue, see Egon Guttman, supra note 29 at S. 1:9; Egon Guttman, “Transfer of Securities: State and Federal Interaction” (1990) 12 Cardozo L. Rev. 437 at 448~451.

  50. 50.

    Cede & Co. symbolises ‘Certificate Depository and Company’ (David C. Donald, “Regulatory Failures in the Design of Securities Settlement Infrastructure” (2010) at 28, available at http://ssrn.com/abstract=1669208). The legal form of Cede & Co. is a partnership between DTC and employees of DTC. This form was taken to facilitate the verification of signatures to the issuer, because it was understood that a signature for a partnership is less onerous to verify than a signature for a corporation (Jeanne L. Schroeder & David Gray Carlson, “Security Interests under Article 8 of the Uniform Commercial Code” (1990) 12 Cardozo L. Rev. 557 at 561, n. 9). The sole function of Cede & Co. is to maintain registered ownership of securities deposited with DTC (Charles W. Mooney, Jr., supra note 8 at 319, n. 34).

  51. 51.

    DTC, supra note 45 at 15. Unlike in Germany, almost all securities are issued in the registered form. The reason can be, first of all, found in the strong influence of English law in the early period. With respect to debt securities, however, from the economic point of view, this phenomenon can be understood from higher taxation on bear securities in the U.S. tax regulation (Jeanne L. Schroeder, supra note 12 at 307, n. 31).

  52. 52.

    DTC, supra note 45 at 15.

  53. 53.

    See SEC, Depository Trust Co. (28 April 1976) 41 Fed. Reg. 17823, Release No. 34-12353; Egon Guttman, supra note 29 at S. 2:8, n. 17; ibid.

  54. 54.

    More description of the DRS program is provided in the following Subsection III. B. 3 of this Chapter.

  55. 55.

    Cf. 7A Hawkland at S. 8-504:01.

  56. 56.

    An entitlement order refers to a notification sent to an intermediary instructing transfer or redemption of a financial asset to which the entitlement holder has a security entitlement (S. 8-102(a)(8)).

  57. 57.

    Under Article 8, control means “the steps necessary for a transfer that will qualify the transferee for protection against adverse claims” (7A Hawkland at S. 8-106:01). In the intermediated system, a transferee obtains control by 1) becoming an entitlement holder, 2) a control agreement with an intermediary, 3) another person’s obtaining of control on behalf of the transferee, or the acknowledgement that another person, who previous acquired control, has control on behalf of the purchaser (Art. 8-106(d)). The third method to obtain control was added in the 1999 amendment.

  58. 58.

    It is said that the U.S. intermediated system was constructed targeting middle and upper class individual investors (Charles W. Mooney, Jr., supra note 21 at 580, explaining that “the individual members of the drafting committee epitomized the middle- to upper-income individuals who maintain a substantial portion of their wealth in securities accounts”).

  59. 59.

    Mooney states that in the drafting process of UCC Article 8, “investor group representatives believed and continue to believe that the framework of SEC regulation and SIPA protection, not “property” rules under Article 8, are the appropriate areas of concern of investors” (Charles W. Mooney, Jr., ibid. at 579).

  60. 60.

    Rule 15c3-3, 17 CFR S. 240.15c-3 provides for the segregation rule. See Egon Guttman, supra note 29 at Ss. 6:6 & 11A:6 for further explanation regarding the segregation rule and practice in the U.S. See also Francis J. Facciolo, “Father Knows Best: Revised Article 8 and the Individual Investor” (2000) 27 Fla. St. U.L. Rev. 615 at 685~688 for discussion regarding the SEC segregation rule and its subordination to hypothecation rules (i.e. Rules 8c-1 and 15c2-1).

  61. 61.

    Schwarcz mentions that without comprehensive regulatory protection by federal and state laws, it is doubtful of the UCC Article 8 rules in favour of collateral providers (Steven L. Schwarcz, “Intermediary risk in a Global Economy” (2001) 50:6 Duke L.J. 1541 at 1596).

  62. 62.

    See 7A Hawkland at Ss. 8-501:01 & 8-503:01 (emphasising that the new concepts and rules under UCC Article 8 are only a legal recognition of the market practices, as commercial law has done for centuries); Jeanne L. Schroeder, supra note 12 at 351~352 & 357 (stating that “[t]he drafters took the legal realist approach which implicitly recognizes the dialectical nature of legal theory and practice: Commercial law is supposed to reflect market practice and expectations, but market practice and expectations are in large part conditioned by legal rules”).

  63. 63.

    Russell A Hakes, supra note 6 at 687. According to Schroeder’s account, security entitlements are quasi-property interests in the underlying financial assets less than ownership (Jeanne L. Schroeder, supra note at 12 at 371).

  64. 64.

    Russell A Hakes, ibid. at 692, n. 162.

  65. 65.

    It is understood that the purpose of Section 8-104 is to set forth provisions operating as “translation or explanatory rules intended to foreclose possible misunderstanding of the new terminology and concepts used in Article 8 [Rev]” (7A Hawkland at S. 8-104:01).

  66. 66.

    The concept of security entitlements is said to be analogous to the concept of securities certificates in the traditional law (ibid. at S. 8-501:01).

  67. 67.

    See especially S. 8-104(d). Official Comment 3 to Section 8-104(d) explains that Subsection (d) is designed as a “translation rule to eliminate problems of co-ordination of terminology, and facilitate the continued use of systems.” Although not related to this issue, Donald mentions that the UCC Article 8 regime is constructed without “any real concern for logical consistency” (David C. Donald, supra note 11 at 43; David C. Donald, supra note 50 at 23).

  68. 68.

    See further Prefatory Note at Part II. A. for the neutral drafting approach.

  69. 69.

    Treasury bills have been issued in a dematerialised form only since 1978, and all marketable Treasury securities have been issued in a dematerialised (book-entry) form only since 1986, when the Treasury began the Treasury Direct System (Egon Guttman, supra note 29 at S. 1:13). On August 23 1996, in line with the 1994 amendment to Article 8, Treasury made a final rule governing securities held in the commercial book-entry transfer system, which is usually called the Treasury/Reserve Automated Debt Entry System (TRADES). See Egon Guttman, supra note 29 at Ss. 4:8~4:9 for some discussion of the commercial U.S. government securities market and regulation of brokers and dealers.

  70. 70.

    The SEC recommended for debt securities the use of global securities certificates, which are a corresponding concept to permanent global certificates in Depogesetz (ibid. at S. 1:9, n. 4).

  71. 71.

    See David C. Donald, supra note 11; David C. Donald, supra note 50 for critical reviews of immobilisation in the U.S. intermediated system in relation to shareholders’ rights vis-à-vis issuers.

  72. 72.

    Prefatory Note at Part II. C.

  73. 73.

    Ibid.

  74. 74.

    Even though the fundamental nature of a security entitlement is a package of personal rights, and some characteristics of property rights are added to those personal rights, the sequence of the following discussion begins with the aspect of property rights, because specific descriptions in relation to a security entitlement begin to be specified in Section 8-503, which provides property aspects of a security entitlement.

  75. 75.

    There exist, however, differences between both concepts. Among other things, the Germanic concept is based on the securities certificates held by the CSD, but the U.S. concept of proportional interests, in principle, has nothing to do with physical certificates held by the CSD, and is related to the financial asset held by the relevant intermediary.

  76. 76.

    As discussed below, Section 8-511 specifies priority rules, and the property aspects of security entitlements are restricted by those rules. For further discussion of the relationship between Sections 8-503(a) and 8-511, see 7A Hawkland at S. 8-511:04; Russell A Hakes, supra note 6 at 775~779.

  77. 77.

    Under the term of the second sentence of Section 8-503(d), an insolvency administrator is a trustee or liquidator. In this Chapter, the term of the two international Conventions, insolvency administrator, is used.

  78. 78.

    7A Hawkland at S. 8-503:12.

  79. 79.

    UCC S. 8-503 cmt. 1; ibid. More discussion regarding shortfalls and loss sharing rules in insolvency is made below. For the current purpose, the SIPA distribution rule is that all securities are proportionally divided in accordance with dollar amount as if they are sold, and distributed to all the account holders, without regard to types of securities.

  80. 80.

    See further 7A Hawkland at Ss. 8-503:07~8-503:09 for illustrations of the difficulty of meeting all these requirements.

  81. 81.

    See Egon Guttman, supra note 29 at S. 11A:4 and accompanying footnote 29, which introduces the case of Nathan W. Drage, P.C. v. First Concord Securities, Ltd., et al., 184 Misc.2d 92, 707N.Y.S.2d 782. The Drage court held that before initiating a suit against the transferee under Section 8-503(e), a suit against the intermediary violating a duty under Section 8-507(b) should be established. For a brief introduction to the Drage case, see Howard Darmstadter, “Three Article 8 Cases” (2002) 57 Bus. Law 1741 at 1746~1750.

  82. 82.

    7A Hawkland at S. 8-503:01.

  83. 83.

    Ibid. at 8-503:03; Jeanne L. Schroeder, supra note 12 at 469.

  84. 84.

    15 U.S.C. Ss. 78aaa et seq. Under SIPA, each customer of an insolvent broker or dealer is protected for securities claims up to the amount of $500,000 and for cash claims up to $250,000. The total maximum is, however, $500,000.

  85. 85.

    See UCC S. 8-503 cmt. 1 (explaining that “since securities intermediaries generally do not segregate securities in such fashion that one could identify particular securities as the ones held for customers, it would not be realistic for this section to state that customers' securities are not subject to creditors' claims.”). In the U.S., an intermediary opens an omnibus account with an upper-tier intermediary, and segregation of investors’ securities is made only at the level of the intermediary of investors (Egon Guttman, supra note 29 at S. 11A:6) As mentioned, brokers and dealers are obliged to segregate their investors’ securities under SEC rule 15c3-3. This segregation requirement, however, means that broker/dealer-intermediaries make book-entry segregation on the books of the broker/dealer-intermediaries, and does not mean upper-intermediaries make segregating accounting, as in Korea and Japan. It is worth noting that the segregation obligation under the SEC rule applies only to brokers and dealers, not to banks.

  86. 86.

    See Art. 4(1) of Depogesetz (the principle of the Fremdvermutung).

  87. 87.

    Of course, this does not mean that segregation itself prevents intermediary risk.

  88. 88.

    Hakes mentions that some limitations on rights against a third party are inherent in an indirect holding system, but the higher standards of transferee protection in Section 8-503(e) are not (Russell A Hakes, supra note 6 at 691).

  89. 89.

    Sections 8-503(d) and 8-503(e) employ the broader term purchaser. Under UCC, a purchaser refers to “a person that takes by purchase” (S. 1-201(b)(30)), and the term purchase means “taking by sale, lease, discount, negotiation, mortgage, pledge, lien, security interest, issue or reissue, gift, or any other voluntary transaction creating an interest in property” (S. 1-201(b)(29)).

  90. 90.

    For instance, Section 7.40(2) of the Model Business Corporation Act includes a beneficial owner whose share are held by a nominee in the beneficial owner’s behalf (i.e. entitlement holder under UCC Article 8) in the definition of shareholder.

  91. 91.

    See S. 8-506 and further discussion below with respect to relationship with an issuer.

  92. 92.

    Official Comment 2 to Section 8-506 seems to presuppose this method. In an issuer’s insolvency case in California, the County of Orange Bankruptcy Court rejected entitlement holders’ assertion that they are holders of certificated securities. The Bankruptcy Court held that the holder of certificated securities is limited, in application to recovery thereon, to direct holders of such certificated securities, not to mere entitlement holders. Since the entitlement holders in this case primarily asserted their claim on the basis that they are holders of certificated securities under the Californian Commercial Code Article 8-114(c) (i.e. UCC Art. 8-114(3)), the Bankruptcy Court’s judgment is correct in the rejection of the entitlement holders’ assertion. For the case, see In re County of Orange, [1997] 219 B.R. 543; Robert A. Wittie, “Recent Case Law Developments in U.C.C. Article 8 and Investment Securities” (1999) 54 Bus. Law. 1921 at 1921~1928. For reference, in Germany and Korean, in principle, it is not possible to procedurally assign a right to litigation to others, except that civil procedure law explicitly provides so or some strict requirements of case law are met, because a right to litigation is a public right in its nature.

  93. 93.

    Through this provision, the U.S. intermediated system recognises a multi-tiered holding pattern.

  94. 94.

    However, the federal securities regulations require brokers to obtain the explicit consent of customers prior to encumbering customers’ securities (UCC S. 8-504 cmt. 2). An intermediary’s encumbrance of a security interest without its customers’ prior written authrisation is, therefore, transgression of federal securities law. In addition, pledges of investors’ securities are allowed only to fund loans to the investors under SEC Rules 8c-1 and 15c2-1 (UCC S. 8-511 cmt. 2).

  95. 95.

    Cf. Article 12(1) of Depogesetz and the discussion in Chapter 3.

  96. 96.

    7A Hawkland at S. 8-505:02.

  97. 97.

    UCC S. 8-505 cmt. 3.

  98. 98.

    7A Hawkland at S. 8-506:01.

  99. 99.

    Guttman, however, demonstrates that an intermediary is obliged to distribute informational disclosure made by the issuer (Egon Guttman, supra note 29 at S. 2:4).

  100. 100.

    Provided, however, that Article 10(2)(e) is applicable only if provided by the non-Convention law, the account agreement, or the uniform rules of a securities settlement system. Therefore, individual investors governed by UCC Article 8 of any U.S. state should be dependent on account agreements.

  101. 101.

    Although the term instruction is a defined term for uncertificated securities (S. 8-102(a)(12)) in parallel with an entitlement order, here it is used according to its usual meaning as direction.

  102. 102.

    See UCC S. 8-507 cmt. 5; 7A Hawkland at S. 8-507:04; Russell A Hakes, supra note 6 at 694.

  103. 103.

    Under UCC, a representative refers to a person empowered to act for another, such as an agent, an officer of a corporation, and a trustee, executor, or administrator of an estate (S. 1-201(b)(33)).

  104. 104.

    UCC S. 8-507 cmts. 3~4.

  105. 105.

    UCC S. 8-507 cmt. 4.

  106. 106.

    UCC S. 8-507 cmt. 3

  107. 107.

    The same provision specifies that an entitlement order may be effective, if the appropriate person is precluded from refusing the effectiveness of the instruction.

  108. 108.

    The second sentence of S. 8-507(b).

  109. 109.

    Consider that the circumstance of an intermediary not recrediting a security entitlement is mostly a matter of time imminent to insolvency of the intermediary.

  110. 110.

    This author could not find out any explanation of this formulation.

  111. 111.

    For an overview of intermediary’s duties under federal securities law, such as record keeping rules, segregation rules, collateral transaction rules, margin rules, net capital rules, and reporting rule, see Egon Guttman, supra note 29 at S. 4:11.

  112. 112.

    It is explained due to the reason that passing over payments or other distributions to entitlements is “a simple monetary obligation, not a complex duty of performance,” therefore a performance standard is not necessary (7A Hawkland at S. 8-505:04).

  113. 113.

    See Ss. 8-504(c), 8-505(a), 8-506, 8-507(a), and 8-508.

  114. 114.

    For more detailed discussion, see UCC S. 8-504 cmt. 4; James Steven Rogers, supra note 10 at 1503~1511; 7A Hawkland at S. 8-504:07; Russell A Hakes, supra note 6 at 696.

  115. 115.

    UCC S. 8-504 cmt. 4 exemplifies the case of foreign securities, for which American intermediaries commonly disclaim responsibility for custodial risk. Cf. Art. 12(4) of the Special Conditions for Securities Dealings (Sonderbedingungen für Wertpapiergeschäft) in Germany (which provides a similar disclaimer).

  116. 116.

    Section 1-302(b) specifies that “[t]he obligations of good faith, diligence, reasonableness, and care prescribed by [the Uniform Commercial Code] may not be disclaimed by agreement. The parties, by agreement, may determine the standards by which the performance of those obligations is to be measured if those standards are not manifestly unreasonable. Whenever [the Uniform Commercial Code] requires an action to be taken within a reasonable time, a time that is not manifestly unreasonable may be fixed by agreement.”

  117. 117.

    Throughout UCC, except as otherwise specified in Article 5, the term good faith means “honesty in fact and the observance of reasonable commercial standards of fair dealing” (S. 1-201(b)(20)), and a good faith obligation is required for every contract or duty within UCC in its performance and enforcement (S. 1-304). The core element of the good faith performance provision is explained as "faithfulness to an agreed common purpose and consistency with the justified expectations of the other party” (Restatement of (Second) Contracts S. 205).

  118. 118.

    Cf. Art. 28 of the Geneva Securities Convention. See James Steven Rogers, supra note 10 at 1505; 7A Hawkland at S. 8-504:07 (demonstrating that “[t]he duty of good faith performance plays a key role in assuring that the agreement/due care formulation would not sanction abusive or unreasonable provisions in agreements between intermediaries and their customers, such as efforts by an intermediary to exonerate itself from the consequences of its own neglect or wrongdoing by including general exculpatory language in the fine print of boilerplate provisions of retail-level customer agreements.”).

  119. 119.

    7A Hawkland at S. 8-504:07.

  120. 120.

    Ibid.; James Steven Rogers, supra note 10 at 1503~1511.

  121. 121.

    Egon Guttman, supra note 45 at S. 11A:5.

  122. 122.

    For the reality of negotiations for an account agreement, see Russell A Hakes, supra note 6 at 749 & n. 499.

  123. 123.

    See ibid. 750~752 for more detailed accounts.

  124. 124.

    See UCC. S. 8-511(b). Hakes mentions that pledging customers’ securities is in violation of federal securities laws and regulations, unless the pledge is established for the purpose of advancing margin loans to the customers, but the pledging itself is not against any duty under Part 5 of Article 8. Besides, he further stresses that as the federal securities laws are applicable only to brokers and dealers subject to the SEC rules, and under the federal securities laws the scope of securities is narrower than UCC Article 8, which provides much wider types of financial instruments, intermediaries in financial need could completely be detrimental to investors, because the investors may later face unexpected, inmeasurable, and unacceptable risk in the event of their intermediary’s insolvency (ibid. at 751).

  125. 125.

    See Chapter 3. III. B. 3.

  126. 126.

    See Kurz v. Holbrook, 989 A.2d 140 (Del. Ch., 9 February 2010).

  127. 127.

    See Crown EMAK Partners, LLC v. Kurz, No. 64, 2010 (21 April 2010)

  128. 128.

    UCC S. 8-506 cmt 2 (mentioning that rights to bring derivative and other litigation are “far removed from the matters that intermediaries are expected to perform.”).

  129. 129.

    This statement, however, does not mean that there was no effort to link investors directly to issuers. On the federal law level, as discussed below, issuers may communicate directly with investors who did not object to their information being transmitted to the issuers.

  130. 130.

    Note, however, that except for shares of stock corporations, for other securities there is no statutory provision to recognise entitlement holders.

  131. 131.

    American Bar Association, Model Business Corporation Act Annotated: Model Business Corporation Act (2008) with Official Comments and Reporter’s Annotations, 4th ed. (Chicago: ABA, 2008) at 7-130.

  132. 132.

    The Model Business Corporation Act was first promulgated in 1950, and amended several times. The most recent revision was made in 2009. The substance of Section 7.22 was first introduced in Section 33 of the 1969 MBCA (ibid.).

  133. 133.

    Section 7.23 of the MBCA, which was introduced in 1973 after the experience of the paper crunch, further provides that a corporation may establish a recognition procedure for beneficial owners of shares that are registered in street name, whereby entitlement holders of shares are able to exercise their rights vis-à-vis the issuer. It should, however, be noted that the states of Delaware and New York did not incorporate Section 7.23 into their corporate law.

    For reference, the term beneficial owner is defined in Rule 13d-3 under the Securities Exchange Act of 1934 (for details, see http://taft.law.uc.edu/CCL/34ActRls/rule13d-3.html). The term street name is rooted in Wall Street, where most major securities firms are located, and the practice that securities were registered in street name was established in order to obviate burdensome and time-consuming registration in the early period. Although nowadays such practice no longer exists, the term is usually used together with the term nominee name. See 7A Hawkland at S. 8-504:05 for the history of the term.

  134. 134.

    Section 1.40(21) of the MBCA defines a shareholder as “the person in whose name shares are registered in the records of a corporation or the beneficial owner of shares to the extent of the rights granted by a nominee certificate on file with a corporation.” Therefore, entitlement holders in a nominee certificate are shareholders under the MBCA, but their rights are limited to those granted in the certificate. See American Bar Association, supra note 131 at 1-99.

  135. 135.

    Commonly, the term proxy means the “grant of authority to vote, the document granting the authority, or the person to whom the authority is granted.” In the MBCA, the term proxy always means the last meaning, i.e. the authorised person (American Bar Association, ibid. at 7-127).

  136. 136.

    15 U.S.C.A. S. 78n.

  137. 137.

    SEC Rules for solicitation of proxies are Rules 14a-1 through 14a-15. Section 14(a) of the Securities Exchange Act empowers the SEC to regulate the solicitation of proxies from shareholders of listed corporations. As to primary aspects of SEC proxy regulation, see Thomas Lee Hazen, Law of Securities Regulation, 6th ed. (Database updated in July 2010) at S. 10.01.

  138. 138.

    15 U.S.C.A. S. 78n(b). This Act took effect in December 1986.

  139. 139.

    For detailed procedure and critiques as to the shareholder communication scheme in the U.S., see David C. Donald, supra note 11 at 25~32; David C. Donald, supra note 50 at 29~37.

  140. 140.

    The SEC adopted the NOBO-OBO rules in the mid-1980s to facilitate communication of issuers and beneficial shareholders who did not object to forwarding their information to issuers. According to statistics of 2009, almost 15 percent of all listed shares are held by registered holders (meaning that 85 percent of shares are held through intermediaries), and about 73 percent of all beneficial owners are NOBOs (Frank G. Zarb, Jr., Report on the Shareholder Communications Process with Street Name Holders, and the NOBO-OBO Mechanism, A Report by the SIFMA Proxy Working Group (10 June 2010) at 15).

  141. 141.

    Ibid. at 11.

  142. 142.

    See SEC Rules 14a-13 & 14b-1.

  143. 143.

    Frank G. Zarb, Jr., supra note 140 at 11.

  144. 144.

    Proxy materials generally include a proxy statement, an annual report, and a proxy card (for registered shareholders) or voting instruction form (for beneficial shareholders). For a sample of proxy materials, see SEC, Spotlight on Proxy Matters, online: http://sec.gov/spotlight/proxymatters.shtml.

  145. 145.

    Section 14(b) of the SEA is applicable only to brokers and dealers, but SEC Rule 14b-2 extended the scope of application to banks and other entities holding securities in their names as fiduciaries on behalf of beneficial owners. The Shareholder Communication Act also applies to banks, thrift institutions and other entities holding securities in their names as fiduciaries for customers. See Thomas Lee Hazen, supra note 137 at S. 10.10.

  146. 146.

    See SEC, Internet Availability of Proxy Material (22 January 2007) 72 Fed. Reg. 4148, Release No. 34-51146; SEC, Shareholder Choice Regarding Proxy Materials (26 July 2007) 72 Fed. Reg. 42221, Release No. 34-56135. Note, however that for investors in the intermediated system, the notice should be sent through the investors’ intermediaries (Rule 14a-16(a)(2)).

  147. 147.

    SEC, supra note 144.

  148. 148.

    See SEC, Transfer Agents Operating Direct Registration System (8 December 1994) 59 Fed. Reg. 63652, Release No. 34-35038; David C. Donald, supra note 11 at 48~57 for fuller descriptions of the DRS.

  149. 149.

    SEC, Self-Regulatory Organizations; The Depository Trust Company; Order Granting Accelerated Approval of a Proposed Rule Change Relating to the Procedures to Establish a Direct Registration System (15 November 1996) 61 Fed. Reg. 58600, Release No. 34-37931 at 58601 (the DRS being implemented on 11 November 1996).

  150. 150.

    DTC, Direct Registration System, available at http://www.dtc.org/dtcpublic/html/lob2/prod6/drsdetail.htm. Even before 1994, in 1991 there was a similar initial proposal by a Subcommittee of the U.S. Working Committee of the Group of Thirty, the T+3 Direct Registration Subcommittee co-chaired by representatives of the Securities Transfer Association and the American Society of Corporate Secretaries, both of which maintain a close relationship with issuers (SEC, supra note 148 at 63653; David C. Donald, supra note 11 at 48~49).

  151. 151.

    The SEC originally urged implementation of the DRS program prior to 7 June 1995, preferring the program due to the reason that through the DRS program, issuers and securities holders are directly and continuously linked, and communicate without physical issuance of securities certificates (SEC, supra note 148 at 63654~63655; Egon Guttman, supra note 29 at S. 1:14).

  152. 152.

    The PMS was introduced in May 2000; prior to the introduction of the PMS, operations were performed by relaying papers between intermediaries and transfer agents.

  153. 153.

    DTC, supra note 150.

  154. 154.

    David C. Donald, supra note 11 at 54. After receiving a sale order, needless to say, the investor’s intermediary has to request a holding change through the PMS.

  155. 155.

    This default DRS book-entry position is called S position, and has become effective since 1 November 2001. See SEC, Self-Regulatory Organizations; The Depository Trust Company; Order Granting Approval of a Proposed Rule Change Relating to the Movement of All DRS Issues into Profile and the Establishment of the “S” Position as the Default Position (21 August 2001) 66 Fed. Reg. 43939, Release No. 34-44696 at 43940; David C. Donald, ibid. at 52.

  156. 156.

    David C. Donald, ibid. at 54. Specific provisions of the rules are: NYSE Listed Company Manual, S.501.00(B), and NASD Manual, S. 4350(L).

  157. 157.

    DTCC, Annual Report 2008, at 36.

  158. 158.

    DTC, supra note 150.

  159. 159.

    DTCC, An Introduction to DTCC’s Issuer Services at 9, available at http://www.dtcc.com/downloads/products/asset/issuer/Issuer_Serv_Brochure.pdf at 9.

  160. 160.

    DTC, supra note 150; SEC, supra note 149 at 58600.

  161. 161.

    UCC S. 8-501 cmt. 2; 7A Hawkland at S. 8-501:07.

  162. 162.

    Ibid.

  163. 163.

    Ibid.

  164. 164.

    UCC S. 8-501 cmt. 3.

  165. 165.

    In other words, the U.S. intermediated system does not require a strict matching booking. In the CNS (i.e. Continuous Net Settlement) practice of NSCC, an intermediary of an “open long position,” in which the intermediary (i.e. participant of NSCC) may receive insufficient securities from NSCC on the settlement date, credits relevant securities in spite of a shortfall. In this case, an excess book-entry may occur in the U.S. system. Except for this case, probably most other excess entries are made by a wrongful act of, or a mistake by, an intermediary. For more detailed explanation of excess book-entry practice in the NSCC’s CNS system, see Charles W. Mooney, Jr, “Law and Systems for Intermediated Securities and the Relationship of Private Property Law to Securities Clearance and Settlement: United States, Japan, and the UNIDROIT Draft Convention” (2008) IMES Discussion Paper Series 2008-E-7 at 111~116.

  166. 166.

    It seems to be a general understanding of industry practice that credit means a factual positive book-entry to a securities account.

  167. 167.

    UCC S. 8-501 cmt. 2.

  168. 168.

    7A Hawkland at S. 8-116:01.

  169. 169.

    Answer 18 of the U.S. to the Questionnaire of the LCG clearly states this point (“no object that is transferred”). Federal Reserve Bank of New York, US Law: Responses to the Legal Certainty Group Questionnaire from Federal Reserve Bank of New York (March 2006), available at http://ec.europa.eu/internal_market/financial-markets/docs/certainty/us_law_responses_en.pdf. See also UCC S. 8-501 cmt. 5; UCC S. 8-502 cmt. 2; 7A Hawkland at S. 8-106:01; Jeanne L. Schroeder, supra note 12 at 370.

  170. 170.

    See UCC S. 8-501 cmts. 3 & 5; 7A Hawkland at Ss. 8-501:09, 8-510:02 & 8-106:01; Russell A Hakes, supra note 6 at 717; Jeanne L. Schroeder, ibid. at 374; Kenneth C. Kettering, “Repledge Deconstructed” (1999) 61 U. Pitt. L. Rev. 45 at 116, 137 & 157.

  171. 171.

    UCC S. 8-501 cmt. 5.

  172. 172.

    Howard Darmstadter, “Article 8 - Investment Securities” (2004) 59 Bus. Law. 1637 at 1646.

  173. 173.

    UCC S. 8-501 cmt. 5 (maintaining that “[t]hat is not to say that an entitlement holder cannot transfer an interest in her security entitlement as such; granting a security interest in a security entitlement is such a transfer.”). Schroeder adds some other occasions in which a transfer may occur: these happen upon the death of an individual entitlement holder, and by operation of law upon a merger or other similar changes in organisation of a corporate entitlement holder (Jeanne L. Schroeder, supra note 12 at 375).

  174. 174.

    In the U.S. market, three types of repos are utilised: delivery repos (or called deliver-out repo), tri-party repos and HIC repos. Among them, it is said that HIC repos are popular in the market with investors due to the lower associated costs, and with intermediaries due to operational efficiencies (Francis J. Facciolo, supra note 60 at 664~665). For more detailed legal debates as to repos in the U.S., see Jeanne L. Schroeder, “Repo Madness: the Characterization of Repurchase Agreement under the Bankruptcy Code and the U.C.C.” (1996) 46 Syracuse L. Rev. 999 (arguing that repo transactions should be treated as sales rather than secured loans); Egon Guttman, supra note 29 at 6a:17 (mentioning that in an HIC repo, the intermediary may have control of the securities and earmark them to indicate that the securities are subject to a specific repo transaction. Guttman also recommends that a creditor of an HIC repo should file a financing statement, due to recharacterisation risk of the repo transaction as a mere sale).

  175. 175.

    As Sections 9-203(a) and (b) distinguish, attachment of a security interest is enforceable only between a secured party and the debtor, while perfection gives the secured party the status to enforce it even to other third parties, and to claim a priority over other creditors (Egon Guttman, ibid. at Ss. 6a:5~6a:6).

  176. 176.

    The term investment property corresponds to financial asset, although both are not identical in scope. According to S. 9-102(a)(49), an investment property refers to 1) a security, whether certificated or uncertificated; 2) a security entitlement; 3) a securities account; 4) a commodity contract; or 5) a commodity account. It should, therefore, be noted that a financial asset is not an investment property, unless it is a security or a security entitlement (Russell A Hakes, supra note 6 at 722, n. 331). See Egon Guttman, ibid. at S. 6a:4 for more explanation of the term investment property under UCC Article 9.

  177. 177.

    Section 9-106(a) refers to Section 8-106 for control of a security entitlement. See supra note 57; 7A Hawkland at S. 8-106:4; Egon Guttman, ibid. at S. 6a:1 for the concept of control and the three methods of obtaining control in the intermediated system.

  178. 178.

    Sections 9-206(c) and (d) also provides an exception that a security interest automatically attaches and is perfected where physical financial assets are delivered to a custodian in a DvP condition.

  179. 179.

    In practice, when an intermediary borrows funds from other financial institutions by way of a pledge agreement or HIC repo agreement, even if collateral securities are not transferred to lender’s account, the lender’s security interest is automatically perfected. In the U.S., where securities are pledged by an intermediary, those collateral securities are not moved to the collateral taker’s account on the book of the CSD; instead, a designating entry is made (7A Hawkland at S. 8-511:02).

  180. 180.

    See supra note 57. Besides Section 8-106, with respect to the intermediated system under UCC Article 8, the term control appears in Sections 8-503(3), 8-510, and 8-511.

  181. 181.

    Section 8-106(d) uses the term purchaser, which includes a secured person.

  182. 182.

    With respect to the introduction of the new concept of control, the Official Comment to Section 8-106 explains that the necessity comes from the need to eliminate uncertainty and confusion arising from similar concepts which come from other bodies of law like common law, because the revised UCC Article 8 severs deposited securities from what investors hold in reality (UCC S. 8-106 cmt. 7).

  183. 183.

    UCC S. 8-106 cmt. 7.

  184. 184.

    In the practice of margin lending arrangements, granting the intermediary control of securities accounts is commonly utilised in the U.S. (William D. Hawkland et al., 9 Hawkland’s Uniform Commercial Code Series (Database updated in Oct. 2010) at S. 9-115:10). Section 9-203(h) also provides that “the attachment of a security interest in a securities account is also attachment of a security interest in the securities entitlements carried in the securities account”.

  185. 185.

    Under Section 8-106(d)(2), a control agreement means an agreement that the intermediary will follow the purchaser’s entitlement orders without further consent by the entitlement holder. Even if this definition includes only positive control, it is explained that a negative control or cumulative, negative and positive control agreement is also possible (UCC S. 8-106 cmt. 4).

  186. 186.

    7A Hawkland at S. 8-106:04; Jeanne L. Schroeder, supra note 12 at 394. As discussed in Chapter 1. II. B. 1. c., under Article 1(k) of the Geneva Securities Convention, a control agreement between the collateral provider and the collateral taker is expressly recognised, provided that the collateral provider’s intermediary is notified of it. It seems that this method is also acceptable in the U.S.

  187. 187.

    See S. 8-106(f); 7A Hawkland at S. 8-106:04 (stressing that therefore, the concept of UCC Article 8 as to a collateral transaction parts with that of pledge under the common law which casts doubt as to the effectiveness of the case where the debtor has some dominion over the subject property).

  188. 188.

    Jeanne L. Schroeder, supra note 12 at 394.

  189. 189.

    Section 9-205(a) expressly permits debtor’s freedom to use or dispose of collateral, and provides that such debtor’s dominion over collateral is not treated an invalid or fraudulent.

  190. 190.

    As discussed in Chapter 2, unlike a designating entry, a control agreement bears no earmark or indication on the securities account of the collateral provider.

  191. 191.

    For the meaning and functions of filing under UCC 9, see Harry C. Sigman & Eva-Maria Kieninger, supra note 2 at 36~53

  192. 192.

    See Ss. 9-328(1) & 8-510(c).

  193. 193.

    The role of filing is explained as protecting a filing secured party from claims asserted by a debtor’s insolvency administrator, in the event of the debtor’s insolvency (Egon Guttman, supra note 29 at Ss. 6a:8 & 6a:13; Russell A Hakes, supra note 6 at 766). For another reason for the unpopularity of filing as a perfection method of a financial asset, Schroeder explains that a financing statement may not be specific enough as information, because it may state collateral securities only as all investment property (Jeanne L. Schroeder, supra note 12 at 398~399).

  194. 194.

    Egon Guttman, ibid. at S. 6a:13.

  195. 195.

    UCC S. 8-502 cmt. 2. Despite the netting system, the question of whether transferors may trace their financial assets may depend on the time of the clearing process. As in Germany, at the matching stage, tracing may not technically be impossible, but after the netting stage, it might be impossible. The drafters of UCC Article 8 always depend on their assertion at the stage after netting. In addition, as mentioned, in bilateral collateral transactions, identities of parties are always traceable. See Russell A Hakes, supra note 6 at 711 for a similar argument.

  196. 196.

    Section 8-502 exemplifies, as equitable rights, conversion, replevin, constructive trust, and equitable lien.

  197. 197.

    Section 8-105(a)(1) provides the phrase the person knows of the adverse claim. As Section 1-202(b) provides that knowledge means actual knowledge, Section 8-105(a)(1) means the person who has actual knowledge of the adverse claim.

  198. 198.

    Therefore, any obligation under common law is not covered (7A Hawkland at S. 8-105:03).

  199. 199.

    See UCC S. 8-105 cmt. 4, 7A Hawkland at S. 8-105:02; Egon Guttman, supra note 29 at Ss. 2:11, 7:14, 7:16, 11A:3 & 15:15 for detailed accounts and cases regarding the wilful blindness test.

  200. 200.

    Russell A Hakes, supra note 6 at 714.

  201. 201.

    Ibid. at 757 (evaluating that “[t]he focus is not on the innocence of the entitlement holder [(i.e. the transferee)], but on the diligence of the claimant.”).

  202. 202.

    See Kenneth C. Kettering, supra note 170 at 111~171 for more discussion related to the non-traceability principle in UCC Article 8.

  203. 203.

    UCC S. 8-502 cmt. 4; ibid. at 714 (pointing out that since the more specific provision of Section 8-503(e) takes precedence over the general provision of Section 8-502, the drafters’ suggestion is doubtful).

  204. 204.

    Russell A Hakes, ibid. at 715.

  205. 205.

    Ibid. at 717; UCC S. 8-510 cmt. 1 (mentioning that the primary purpose of the rule in Section 8-510 is to provide protection for a person who takes security interests and obtains control, but does not becoming an entitlement holder); 7A Hawkland at S. 8-510:03 (clarifying that the protected purchasers under S. 8-510 are acquirers of an interest in a security entitlement through a transaction in which the acquirers rights “derive directly from the interest of another person who is, and continues to be, the entitlement holder of the security entitlement in question.”).

  206. 206.

    The most common example of the secured persons here is the ones who entered into control agreements (UCC S. 8-510 cmt. 2; 7A Hawkland at S. 8-510:03).

  207. 207.

    UCC S. 8-503 cmt. 2 (the reason for the overriding application is explained that “Section 8-503 itself defines and sets limits on the assertion of the property interest of entitlement holders.”).

  208. 208.

    Besides these two clauses in Article 8, Sections 8-404(a) (Wrongful Registration) and 9-332 (Transfer of Money; Transfer of Funds From Deposit Account) employ the same collusion test.

  209. 209.

    UCC S. 8-503 cmt. 5; 7A Hawkland at S. 8-503: 10; Russell A Hakes, supra note 6 at 758.

  210. 210.

    7A Hawkland at S. 8-503: 10 (stating that it may not, therefore, be possible to say whether the collusion test is a higher or lower standard than the notice of an adverse claim standard), and S. 8-115:03 (similar to Official Comment 3 to Section 8-503, arguing that “a legal rule that made an intermediary’s protection against adverse claim liability depend upon any form of “notice” of adverse claims would be a legal rule that itself contributed to systemic risk in the securities settlement system.”). But see UCC S. 9-332 cmt. 4 (stating that the collusion test is the most protective standard among other standards in UCC); Russell A Hakes, ibid. at 758~759 (stating that upon the introduction of the collusion test, the drafters’ intention was to build up a higher standard, quoting Official Comment 2 to Section 8-503, and that the assertion in Official Comment 3 to Section 8-503 is inconsistent with other rules in Article 8); Francis J. Facciolo, supra note 60 at 624~640 (claiming that the assertion of drafters and supporters of UCC Article 8 in relation to systemic risk is exaggerated and not well examined).

  211. 211.

    Russell A Hakes, ibid. at 759~762.

  212. 212.

    Egon Guttman, supra note 29 at S. 7:16.

  213. 213.

    Russell A Hakes, supra note 6 at 761; Kenneth C. Kettering, supra note 170 at 163~165..

  214. 214.

    Nathan W. Drage, P.C. v. First Concord Securities, Ltd., et al., 184 Misc.2d 92; 707.Y.S.2d 782; 41 UCC Rep. Serv.2d 673. For introduction of this case, see Howard Darmstadter, supra note 81 at 1746~1750.

  215. 215.

    Howard Darmstadter, ibid. at 1748; Francis J. Facciolo, supra note 60 at 659 & n. 240 (the preamble states that “[t]he legislature intends that the purchaser’s knowledge will be judged on a subjective, not an objective basis.”).

  216. 216.

    Ibid. at 1750.

  217. 217.

    Russell A Hakes, ibid. at 762 (asserting that without regard to risk inherent in the intermediated system, collusion is much more favourable to secured parties than entitlement holders without persuasive justification).

  218. 218.

    UCC S. 8-502 cmt. 1; S. 8-503(a) (“…except as otherwise provided in Section 8-511.”); S. 8-510(a) (“[i]n a case not covered by the priority rules in Article 9 or the rules stated in subsection (c)…”); Charles W. Mooney, Jr, supra note 165 at 19~20.

  219. 219.

    The main reason for the duplicate rules in Section 8-510(c) is to address the issue with respect to the nature of repo transactions. Since UCC Article 9 governs the issue of security interests, if repo transactions are not characterised as secured transactions, there is a legal lacuna governing priorities of repos. For this reason, Section 8-510(c) was inserted to apply to repos irrespective of their nature. See UCC S. 8-510 cmt. 4; 7A Hawkland at S. 8-510:05.

  220. 220.

    Sections 8-510(c)(1) and 9-328(2)(B)(i) mention the method for obtaining control by an entitlement holder. In this case, the subject collateral securities should be transferred to the secured party’s account. Although from a logical point of view as to the nature of security entitlements, the collateral securities now maintained in the secured party’s account are not the identical property, from a pragmatic point of view, they seem to be deemed as the same collateral securities. However, the function of these provisions is not clear. Since the powerful innocent acquisition rules cut off all prior adverse claims, it seems that those provisions nearly has no role in practice. Notably, in the Geneva Securities Convention, priority rules always apply for the same intermediated securities in the same securities account, pursuant to Article 19(1).

  221. 221.

    Note that a security interest granted by an intermediary is automatically perfected upon attachment (S. 9-309(10)), but does not automatically give control to the creditor.

  222. 222.

    Even though Section 9-328(3) does not have the last conditional provision, Official Comment 4, Example 5 to Section 9-328 illustrates the possibility of a priority modification by agreement, and Section 9-339 recognises subordination by agreement by a person entitled to priority. See Frederick H. Miller & Neil B. Cohen, 9B Hawkland’s Uniform Commercial Code Series (Database updated in Oct. 2010) at S. 9-328:1.

  223. 223.

    With respect to the justification for this formulation, see Frederick H. Miller & Neil B. Cohen, ibid. But see Russell A Hakes, supra note 6 at 767~771 for a critical view of this approach (proposing that such unrestricted priority be limited to the case of intermediary’s lending related to settlement). Schroeder considers the super-priority rule favouring intermediary’s interest from the viewpoint of pragmatism, although her assertion does not seem that persuasive, compared to other countries’ regimes (Jeanne L. Schroeder, supra note 12 at 436).

  224. 224.

    Frederick H. Miller & Neil B. Cohen, ibid.

  225. 225.

    Cf. ibid.

  226. 226.

    See Subsection III. A. 1. a of this Chapter.

  227. 227.

    Although Section 8-511(b) does not specify the time at which the creditor obtain control, it seems that secured parties should obtain control at least before the debtor-intermediary’s insolvency. This might trigger the issue as to whether intermediary’s giving control to its creditors at that juncture are a preference or a fraudulent transfer.

  228. 228.

    As to the time when no collusion is required, there is a dispute. The drafters imply the time when securities are purchased, but due to the importance of control in determining priority under Section 8-511(2), the time should be at the moment of either purchasing the securities, or obtaining control over them, or at least at the moment of obtaining control (Russell A Hakes, supra note 6 at 720-721).

  229. 229.

    See 7A Hawkland at S. 8-511:04 for relationship between Sections 8-511 and 8-503(e). But see Russell A Hakes, ibid. 6 at 775~783 for a critical review of the relationship between Sections 8-511 and 8-503(e).

  230. 230.

    UCC S. 8-511 cmt. 2.

  231. 231.

    UCC S. 8-511 cmt. 3; 7A Hawkland at S. 8-511:05.

  232. 232.

    UCC S. 8-503 cmt. 1.

  233. 233.

    12 USC Ss. 1811 et seq.; Website: http://www.fdic.gov/regulations/laws/rules/1000-100.html.

  234. 234.

    Jeanne L. Schroeder, supra note 12 at 464~465.

  235. 235.

    Jeanne L. Schroeder, ibid. at 465; Charles W. Mooney, Jr, supra note 165 at 16.

  236. 236.

    Almost all brokers/dealers are required to be a member of the SIPC. See Egon Guttman, supra note 29 at Ss. 20:7~20:26; Michael E. Don & Josephine Wang, “Stockbroker Liquidations under the Securities Investor Protection Act and Their Impact on Securities Transfers” (1990) 12 Cardozo L. Rev. 509 for detailed relevant information on SIPA proceedings.

  237. 237.

    15 USC S. 78eee(a). However, if the SIPC refuses to act, then the SEC has the power to enforce the SIPC to act (15 USC S. 78ggg(b) (Michael E. Don & Josephine Wang, ibid. at 514; Russell A Hakes, supra note 6 at 735).

  238. 238.

    The scope of the notification recipients is the investors who appear to have been customers of the insolvent broker/dealer with an open account within the past twelve months (15 USC S. 78fff-2(a)(1)).

  239. 239.

    15 USC S. 78fff-2(a)(1).

  240. 240.

    15 USC Ss. 78fff-2(a)(2) & (3).

  241. 241.

    15 USC S. 78fff-2(b).

  242. 242.

    15 USC Ss. 78fff-3(a) & 78fff-3(a)(1). Previously, the maximum of the cash claim amount was $100,000. By the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (so-called “Dodd-Frank Act”) in July 2010, SIPA’s maximum cash advance amount was amended up to $250,000. The total amount of the SIPC protection is still $500,000 per customer, which includes the revised cash claim amount, $250,000. The increased amount applies only to SIPA proceedings filed on or after 22 July 2010.

  243. 243.

    The term net equity refers to the dollar amount of the account(s) of a customer, determined by calculating the sum which would have been owed by the insolvent broker/dealer to the customer, if the broker/dealer had liquidated, by sale or purchase on the filing date, all securities positions of the customer, minus any indebtedness of such customers to the broker/dealer on the filing date, plus any payment by the customer of such indebtedness to the broker/dealer which is made with the approval of the trustee and within such period as the trustee may determine (15 USC S. 78lll(11)).

  244. 244.

    The term customer property refers to “cash and securities (except customer name securities delivered to the customer) at any time received, acquired, or held by or for the account of a debtor from or for the securities accounts of a customer, and the proceeds of any such property transferred by the debtor, including property unlawfully converted” (15 USC S. 78lll(4)). For more details on the meaning of customer property, see Egon Guttman, supra note 29 at S. 20:22 (it is worth noting that even if the investor’s securities are pledged to her intermediary, and the intermediary uses them to repledge its obligation, those securities are viewed as customer property under SIPA; see Securities and Exchange Commission v. Investor Sec. Leasing Corp., 476F. Supp. 837 (W.D. Pa. 1979)). For the definition of customer under SIPA, see also Egon Guttman, supra note 29 at Ss. 20:13 & 20.

  245. 245.

    The following hypothetical is based on that in Michael E. Don & Josephine Wang, supra note 236 at 554~546.

  246. 246.

    In the SIPA scheme, the SIPC tries, to the possible extent, to return securities to investors, by buying securities on the market, while in the Bankruptcy Code scheme, investors are paid by cash resulting from sale of available securities, and for unsatisfied amounts, participate in the insolvency proceeding as general unsecured creditors (Jeanne L. Schroeder, supra note 12 at 464).

  247. 247.

    In order to avoid this kind of undesirable result, investors may open several accounts with other brokers/dealers, each of which carries up to the limit of 500,000 dollar worth of securities and cash.

  248. 248.

    In this regard, it can be said that if investors select a broker as their intermediary, from that moment, they become members of an association whose purpose is to proportionally share all property of the members in the event of their broker’s insolvency.

  249. 249.

    Financial Market Law Committee, Issue3-Property Interests in Investment Securities: Analysis of the Need for and Nature of Legislation Relating to Property Interests in Indirectly Held Investment Securities, with a Statement of Principles for an Investment Securities Statute (London, 2004) at 20.

  250. 250.

    See e.g. Securities Transfer Act, 2006, S.O. 2006, c 8 in Ontario and Securities Transfer Act, S.A. 2006, c. S-4.5 in Alberta, both of which took effect as of 1 January 2007, Securities Transfer Act, 2006, S.B.C. 2007, c 10 in British Columbia, which took effect as of 1 July 2007, and the Act respecting the Transfer of Securities and the Establishment of Security Entitlements, R.S.Q. c. T-11.002 in Québec, which took effect as of 1 February 2009. See Canadian Securities Administrators’ Uniform Securities Transfer Act Task Force, “Proposal for a Modernized Uniform Law in Canada Governing the Holding, Transfer and Pledging of Securities” (Consultation Paper, May 28 2004); Eric T. Spink & Maxime A. Paré, “The Uniform Securities Transfer Act: Globalized Commercial Law for Canada” (2004) 19 B.F.L.R. 321 for more information on the new Canadian law regarding transfer of intermediated securities.

  251. 251.

    Francis J. Facciolo, supra note 60 at 697~710; Russell A Hakes, supra note 6 at 670 & 742.

  252. 252.

    Charles W Mooney, Jr & Hideki Kanda, “Core Issues under UNIDROIT (Geneva) Convention on Intermediated Securities: Views from the United States and Japan” in Louise Gullifer and Jennifer Payne, ed., Intermediated Securities: Legal Problems and Practical Issues (Portland: Hart Publishing, 2010) at 110.

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  1. Korea Capital Market Institute, Seoul, Republic of Korea (South Korea)

    Dr. iur. Changmin Chun LL.M.

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Chun, C. (2012). Chapter 4. The Intermediated System in the United States. In: Cross-border Transactions of Intermediated Securities. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-27853-2_5

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