- Non-intermediated securities — Transfer of securities — Geneva Securities Convention — Hague Securities Convention — Bank resolution and insolvency — Money and the conflict of laws
1.01 Securities were formerly held in the form of certificates issued directly to the investor. Over time, the holding of securities through intermediaries became a general practice, at least for securities intended to be sold and traded on capital markets. In a simple case, the intermediary is registered in the books of the issuer as security holder and maintains for the investor an account into which the securities are credited; a certificate may, or may not, have been issued by the issuer to the intermediary but the investor itself holds no certificate.
1.02 Yet, a large number of securities continue to be held by investors otherwise than with intermediaries, in particular where the issuer is a ‘private’ entity. Moreover, there are still investors in publicly traded securities which continue for various reasons1 to (p. 2) prefer to be registered in the books of the issuers. The investor then has a direct relationship with the issuer and its interest is recorded in the books of the issuer. Even for these securities, the paper form has often been abandoned and in some cases the issuance of certificates is prohibited by corporate law.
1.03 This chapter deals with non-intermediated securities, that is to say, securities not held with intermediaries. As stated, non-intermediated securities may, or may not, be represented by certificates.
1.04 In its early development, at least in some States, the legal framework on intermediated securities consisted of a transposition or adaptation of the rules governing certificated securities directly-held by the investor. Many States have now implemented laws on intermediated securities which are no longer a mere transposition of their old rules on certificated securities. At the international level, this is illustrated by the Geneva Securities Convention (GSC) with respect to substantive law matters and the Hague Securities Convention (HSC) with respect to conflict of laws matters.
1.05 Ironically, the existence of a new legal regime for intermediated securities has raised the question of whether new rules also need to be in place for non-intermediated securities. In other words, should the law on non-intermediated securities borrow from the law on intermediated securities, in particular where non-intermediated securities are dematerialized? In principle, there should be a level playing field for all holders of securities, whether or not intermediated. This approach has already been retained in some States.
1.06 This chapter attempts to set out, in a harmonization context, the legal framework applicable (or which should be applicable) to non-intermediated securities, with a comparison to the rules established by the GSC. Section B deals with terminology and concepts. Section C examines how non-intermediated securities are created or established. Sections D, E, and F address various issues relating to the transfer of non-intermediated securities: the requirements for a transfer to be effective between the parties (section D), against the issuer (section E), and against third parties (section F). Sections G and H consider priority issues. Finally, section I discusses the conflict of laws rules to apply to non-intermediated securities.
1.07 The GSC defines intermediated securities as ‘securities credited to a securities account’; the term ‘securities account’ is defined as ‘an account maintained by the intermediary to which securities are credited’. A person who holds intermediated securities is described as an account holder.2
(p. 3) 1.08 It follows from these definitions that non-intermediated securities are securities not held through a securities account. This statement is not, however, sufficient to describe the principal feature of non-intermediated securities, namely that the holder thereof has a direct relationship with the issuer. Moreover, the holder of non-intermediated securities needs to be registered in the books of the issuer in order to be entitled to exercise the rights attached to the securities, except for bearer securities. This chapter will sometimes use the term ‘security holder’ to refer to the holder of non-intermediated securities and the term ‘registered holder’ to refer to a security which is registered in the books of the issuer. Indeed, the word ‘holder’ does not necessarily entail that the person so designated has physical possession of the securities (or, more accurately, of a certificate representing same); clearly, dematerialized non-intermediated securities are not capable of physical appropriation.
1.09 It is worth noting that a fact pattern involving intermediated securities generally involves non-intermediated securities. If issuer A issues and registers in its books securities in favour of intermediary B, which in turn credits the securities (or a portion of them) to a securities account of C, then B will hold non-intermediated securities whereas C will hold intermediated securities. This example shows that securities may be viewed as being at the same time non-intermediated (at the A-B level) and intermediated (at the B-C level), to the extent that under the applicable law account holder C is considered as enjoying a property right in the underlying securities issued by A. On the other hand, in legal systems where intermediated securities are characterized essentially as a contractual right against the intermediary (as opposed to a sui generis property or real right in the underlying securities), then in the example the intermediated securities credited to the account of C are not the same securities as the non-intermediated securities held by intermediary B.
1.10 The term ‘securities entitlement’ is used in some legal systems as the term corresponding to intermediated securities. The term ‘securities entitlement’ carries in some way the implication that the account holder is not an indirect holder of the underlying securities.
1.11 The GSC seeks to take a neutral approach on the legal nature of intermediated securities and avoids characterizing them as a property right or a contractual right, or a combination of both. For this reason, the GSC does not describe intermediated securities as indirectly held securities. In addition, the HSC does not take a stand on the characterization of intermediated securities (referred to in the HSC as ‘securities held with an intermediary’).3
(p. 4) 1.12 It is also implicit from the neutral approach taken by the GSC and the HSC that the term ‘directly-held securities’ is not a substitute for non-intermediated securities. Nonetheless, the legal relationship between the issuer and the registered holder of non-intermediated securities is still a direct relationship; therefore, this chapter on occasion will refer to non-intermediated securities as ‘directly-held’.
1.14 Certificated securities are securities represented by a certificate issued by the issuer. In such cases, possession of the certificate is normally required to permit the security holder to fully exercise the rights conferred by the related securities. Certificated securities may be in registered or bearer form. They are in a registered form where the certificate specifies the name of the person entitled thereto. They are in a bearer form where the certificate states that the bearer thereof is the security holder.4
1.15 Uncertificated securities are securities which are issued in favour of a person registered in the books of the issuer as the holder of the securities but which are not represented by a certificate. This term is preferred to the term ‘dematerialized securities’, as in common parlance the latter is at times used also to encompass intermediated securities.
1.16 The term ‘transfer’ will be used to include not only an outright (or absolute) disposition but also a transaction whereby a security interest or other limited interest is granted in non-intermediated securities.5 Whenever appropriate, the discussion will make distinctions between outright transfers or security interests.
1.17 The term ‘competing claimant’ will be used in the context of priority disputes between a transferee of securities and another person claiming rights in the securities superior to those of the transferee. The other person may be another transferee, a judgment creditor of the transferor, or an insolvency administrator in insolvency proceedings relating to the transferor. Priority disputes often arise in the area of secured transactions; as noted, the term ‘transfer’ will be used in this chapter as a generic term which includes the grant of a security interest. Therefore, the discussion on priority issues will also cover disputes involving a creditor to which a security interest in securities has been granted.
1.18 This chapter does not attempt to define the various categories of rights or interests to be considered as ‘securities’ for the purposes of harmonized rules on non-intermediated securities. Paraphrasing Article 1(a) GSC, the term should (p. 5) generally include shares, bonds, or other similar equity interests or debt instruments the transfer of which may be registered in the books of the issuer.
1.19 As the goal of this chapter is to propose harmonized rules for non-intermediated securities in comparison to the GSC rules, specific references will not be made to national laws, with the exception of the Uniform Commercial Code (UCC) of the United States. The UCC in effect has been a source of inspiration for some other States which have modernized their laws on intermediated and non-intermediated securities. At the international level, in addition to the GSC, reference will be made to the HSC and the recommendations of the UNCITRAL Legislative Guide on Secured Transactions6 (LGST). The Guide does not deal with securities (whether or not intermediated). Harmonized rules on non-intermediated securities, in particular for security interests in such securities, must nevertheless take into account the UNCITRAL recommendations on other classes of property.
1.20 Non-intermediated securities are created or established where the issuer agrees to issue securities in favour of another person in conformity with the law (for example, the corporate law) and the terms and conditions governing their issuance. Nothing else than an agreement between the issuer and that person should in principle be required to create non-intermediated securities. The issuer usually maintains a securities register in which the issue is recorded. The person to whom the securities have been issued will then become a security holder (and a registered holder unless the securities are in a certificated bearer form). A frequent corporate law requirement is that securities cannot be issued unless they are fully paid.
1.21 The delivery of a certificate should not be a condition to the validity of the creation of non-intermediated securities. Thus, for those jurisdictions which permit the issuance of certificates, such issuance should be an option, and not a requirement. Indeed, where a certificate is issued, the possession of the certificate may become necessary to the full enjoyment of the rights attached to the securities.
1.22 It is beyond the scope of this chapter to discuss whether an issuer may challenge the validity of securities which have not been issued in compliance with the applicable law or the terms and conditions governing their issue, where the security holder is unaware of the non-compliance. Different approaches exist on this difficult question, and distinctions can be made between shares and debt obligations or between non-compliance with applicable law and non-compliance with the terms and conditions of the securities. Suffice it to say that in similar circumstances, (p. 6) the holder of intermediated securities might have a greater protection than the holder of non-intermediated securities. In its relationship with the account holder, an intermediary will normally be precluded from contending that the underlying securities have not been validly issued. This is so regardless of the legal characterization of intermediated securities, because by crediting the securities account the intermediary incurs the obligation to procure to an account holder the rights purporting to result from the credit.7
1.23 A transfer of securities, whether or not intermediated, may occur in a variety of circumstances, as for any other type of property. The term ‘validity’ is used here to refer to the effectiveness of a transfer between the parties thereto (and not third parties). The validity of a transfer as between the transferor and the transferee should be outside the scope of laws intended to establish rules on the right of transferees against third parties or the issuer; Article 8 UCC is an example of such laws and does not in general address validity issues.
1.24 Therefore, the law of obligations (including contract law) and property law will determine whether a transfer is valid. If a transfer is made by way of a sale and if, under the applicable law, nothing else than an agreement is required for a sale to take place, the transfer will be effective upon the parties reaching that agreement. If the transfer results from a contract the validity of which is subject to the fulfilment of formalities, then the transfer will occur only when these formalities are fulfilled. This may be the case in those States which subject the validity of a gift or a security interest to form requirements.
1.25 A transfer may also occur by operation of law; for example, the bankruptcy of a security holder will result in the assets of the bankrupt being vested in an insolvency administrator (eg, a trustee in bankruptcy). In addition, a transfer may be made through a judicial process further to a seizure by a creditor of the security holder. Special rules exist in some States on the enforcement of creditors’ rights with respect to securities.
1.26 The above remarks may also apply to the validity of a transfer of intermediated securities. The GSC does not deal explicitly with the issue of the validity of a transfer between the parties thereto; the matter is left to the non-Convention law, that is, the law in force in a Contracting State other than the provisions of the GSC.8
(p. 7) 1.27 It is, however, possible to construe Article 11 GSC as implying that nothing more than an agreement (even oral) is needed for the validity of a consensual transfer giving rise to a credit to a securities account; under that interpretation, the validity of the transfer could not be challenged on the basis of non-compliance with form requirements that would otherwise apply to an agreement of the same type (eg, a requirement that the agreement be notarized).9
1.28 At first glance, a defective or invalid transfer of non-intermediated securities should have no effect against third parties. For example, if the transferor has been induced by fraud to consent to the transfer, the transfer is subject to annulment and then the transferee would have no property right to enforce against a subsequent transferee of the transferor. The same analysis applies to an invalid security interest: the security interest, being invalid, would not rank ahead of the claims of the other creditors of the transferor.
1.29 However, as will be discussed in section H, this analysis does not necessarily hold true in a scenario where the transferee under an invalid transfer has retransferred the non-intermediated securities to a third party. A third party in good faith which acquires non-intermediated securities from the transferee under the invalid transfer should be protected in the same manner as an innocent acquirer under Article 18 GSC.
1.30 The law under which non-intermediated securities are issued generally states that an issuer may treat the registered holder as the person entitled to exercise the rights attached to the securities.10 It follows from that rule that a transfer will not be effective against the issuer until the transfer is registered in its books.
1.31 Indeed, the rule cannot apply to bearer securities, that is to say, securities represented by a certificate in a bearer form (eg, bonds payable to the bearer thereof). In that case, the only condition for the effectiveness of the transfer will be the delivery of the certificate to the transferee, and the possession of the certificate will be sufficient for the transferee to be recognized by the issuer as the security holder.
1.32 Securities which must be registered in the books of the issuer for its holder to be empowered to exercise its rights against the issuer are often designated as registered (p. 8) securities. For these securities, a discussion of the effectiveness of a transfer against the issuer requires the examination of whether the issuer is bound to give effect to any request for a transfer or may impose conditions to the registration of the transfer. Common sense dictates that the issuer may prescribe conditions to be fulfilled by the transferee, and most existing laws on this matter are to that effect. What are (or should be) these conditions? Distinctions must first be made between certificated securities and uncertificated securities.
1.33 For certificated securities, it goes without saying that the transferee must surrender the certificate to the issuer in order to be registered as the new security holder and to obtain a new certificate in its name. In addition, the issuer should not be compelled to register the transfer unless the transferee provides reasonable proof that the transferee has become the security holder. An endorsement of the certificate by the transferor constitutes such proof, but the laws of many legal systems often provide that the endorsement may be replaced by a separate document signed by the transferor evidencing the transfer. In each case, the issuer should also be allowed to satisfy itself that the signature of the transferor or its representative is genuine; in the case of a signature affixed by a representative of the transferor, an evidence of the power of the representative may also be required by the issuer.
1.34 For uncertificated securities, the basic requirements prescribed by the issuer to register the transfer should in substance be the same as for certificated securities, except for the surrender of a certificate. Thus, the issuer should be permitted to require a proof that the existing registered holder has authorized the transfer and that the authorization is genuine.
1.35 In addition to an evidence of the occurrence of the transfer, other conditions might have to be met by the transferee in order for the issuer to be obligated to register the transfer. These other conditions do not depend on whether the securities are certificated or uncertificated. They rather relate to restrictions on transfers that may be found in the applicable law or the terms under which the securities have been issued. For example, the applicable law or the constitutive documents of the issuer may require that a transfer be authorized by the governing body of the issuer (eg, its board of directors) or that the transferee belong to a specified class of persons. In such case, the issuer will subject the registration of the transfer to the fulfilment of the relevant requirements.
1.36 The registration by an issuer of an unauthorized transfer should not deprive the previous registered holder from its rights in the related securities. For instance, if a purported transferee of non-intermediated securities causes the issuer to register the transfer and if the endorsement or the authorization of the purported transferor has been forged, the issuer will remain liable to provide the true owner of the securities with equivalent securities. This general rule may, however, be subject to exceptions in certain circumstances: for example, if the issuer has taken steps to satisfy itself of the genuineness of an endorsement on a certificate surrendered for (p. 9) transfer purposes and if the true owner of the securities failed to notify the issuer of the loss within a reasonable time, the issuer should be relieved from liability to the true owner.
1.37 A related question is whether a transferee in good faith further to an unauthorized transfer registered in the books of the issuer should still be able to enforce rights against the issuer after discovery by the issuer that the transfer had been unauthorized. This may happen where the transferee has dealt with a person believed in good faith to be a representative of the true owner. Applying by analogy the provisions of Article 18 GSC on innocent acquisition would result in the transferee in good faith being empowered to exercise against the issuer the rights attached to the securities, except if the transfer was ‘made by way of gift or gratuitously’.
1.38 Another analogy may, however, be made with the law of negotiable instruments. Under the laws of some States, a forged endorsement on a promissory note in a non-bearer form will preclude the purported endorsee, even in good faith and for value, from being entitled to claim payment from the maker of the note. In order to achieve in the area of non-intermediated securities results similar to those contemplated by the GSC, the rule of Article 18 GSC should prevail over a solution based on an analogy with the law of negotiable instruments.
1.39 Indeed, the consequence of the GSC approach, as applied to non-intermediated securities, is that the number of outstanding securities of the issuer may exceed those initially issued. To the extent that this over-issue would not be permitted under applicable law or the terms of the securities, the law should provide means to compensate the previous registered owner.11
1.40 A transfer that is effective against an issuer will normally also be effective against third parties. However, consistent with the LGST, 12 the law should permit a transferee to achieve third-party effectiveness by means other than registration in the books of the issuer. For sake of concision, the term ‘perfection’ (or any correlative term) will be used hereafter on occasion as an equivalent to effectiveness against third parties.
1.41 This section examines the requirements, if any, to be met for a valid transfer to be effective against third parties which are competing claimants. Competing (p. 10) claimants include another transferee of the transferor, a judgment creditor of the transferor, or an insolvency administrator in insolvency proceedings relating to the transferor.13 Should steps be taken in order for the transferee to be able to set up its transfer against these persons?
1.42 Under the traditional nemo dat rule, third parties cannot acquire or claim better rights than those of the transferor. Under that rule, a transfer that is effective between the parties to the transfer should be effective against third parties. For example, if a person sells goods to a buyer, that person is no longer the owner of the goods and a judgment creditor of the seller cannot seize the goods after the sale. The nemo dat rule yields in principle to the same result if the seller subsequently resells the goods to a second buyer, as the second buyer has nothing to acquire.14 Likewise, goods sold by a person who subsequently becomes bankrupt are not vested in the trustee in the bankruptcy of that person. In most legal systems, the nemo dat rule is, however, subject to many exceptions. Real property law is an example: the purchaser of a land whose title is registered in the land registry will normally prevail over a previous purchaser with an unregistered title; a registered mortgage will rank ahead of a prior mortgage not yet registered.
1.43 The LGST and the laws of many States on security interests in movable property also contain numerous examples of exceptions to the nemo dat rule: certain steps must usually be taken in order for a security interest to be effective against third parties, with the result that security interests do not necessarily rank according to the time they have been granted. In the same vein, many legal systems subject the third-party effectiveness of an outright assignment of receivables to the fulfilment of certain formalities.
1.44 The GSC provisions on the effectiveness against third parties of an acquisition of intermediated securities also disregard the nemo dat rule in many respects.15 The underlying policy reason for such provisions applies to non-intermediated securities as it is intended to ensure certainty where third-party effectiveness is achieved by the acquirer.16 This is also dictated by the need for a level playing field for intermediated and non-intermediated securities. For securities represented by certificates, it is worth noting that the nemo dat rule has been displaced for a long time: a sale or other transfer of the securities will be ineffective against a subsequent purchaser in good faith to which the certificate has been endorsed and delivered.
(p. 11) 1.45 Therefore, what should be the best rules for the perfection of a transfer of non-intermediated securities? Should or how should they parallel the GSC rules? To what extent should they be comparable to those of the LGST or, in the case of certificated securities, to the rules governing negotiable instruments?
1.46 A preliminary question is whether the same methods should be available to perfect both an outright transfer and a security interest. In principle, a positive answer must be given to this question. First, it is not always easy to characterize a transfer as absolute or only made for security purposes; allowing for the use of different methods for outright transfers and security interests would not determine the applicable perfection method with certainty. Second, complications would ensue in the resolution of a priority dispute between an outright transferee and a second creditor, if the outright transferee could achieve third-party effectiveness under a perfection mechanism not available to a secured creditor. It must be noted that the methods of perfection provided by Articles 11 and 12 GSC are available for any kind of transfer.
(1) Certificated securities
1.48 It is generally recognized that the transfer of a certificated security may be made effective against third parties by the delivery of the certificate to the transferee (or another person acting on behalf of the transferee). This long-standing rule comes from negotiable instruments law. After delivery of the certificate to the transferee, the transferor cannot usually transfer real benefits to another person.
1.49 In the case of a certificate in a registered form, should it be required that the certificate also be endorsed by the transferor? A certificate in a registered form is a certificate which is issued in favour of a person named on the certificate as the holder thereof (as opposed to a bearer certificate). Without the endorsement of the transferor, the transferee will be unable to compel the issuer to record the transfer in its books. On the other hand, after delivery to the transferee of an unendorsed certificate in a registered form, it is impossible for the transferor to deliver and endorse the certificate in favour of another person. Therefore, it appears that the delivery of the certificate should be sufficient to make the transfer effective against third parties.17 Requiring an endorsement could imply that third parties may disregard the transfer even if the certificate is no longer in the hands of the transferor.
(p. 12) 1.50 Consistent with the law of negotiable instruments, a transfer with delivery of a certificate in registered form should oblige the transferor to provide any missing endorsement.18 In the event of the failure of the transferor to do so, the courts should be empowered to issue an order allowing for the transfer to be registered in the books of the issuer.
1.51 In the area of secured transactions, the LGST and many legal systems provide that registration in a security interest registry is a method of achieving third-party effectiveness, including for assets capable of being the subject of a possessory security interest. There is no reason not to permit such method for a security interest in certificated securities as well. As will be discussed in section G, a possessory security interest in certificated securities should nonetheless prevail over a non-possessory security interest previously registered in a security interest registry.
(2) Uncertificated securities
1.52 Uncertificated securities cannot be the subject of physical appropriation; therefore, possession cannot be a means of perfecting a transfer of uncertificated securities. In many ways, uncertificated securities resemble intermediated securities, except that the former are held directly with the issuer. But for that distinction, they are conceptually similar. Therefore, the legal framework of the GSC for the effectiveness against third parties of an acquisition of intermediated securities appears to be an appropriate template to model the rules on the effectiveness against third parties of a transfer of uncertificated securities.
1.53 Under that approach, a transferee of uncertificated securities may render its transfer effective against third parties, either by causing the issuer to register the transfer in the issuer’s books or by obtaining control of the securities through a control agreement.19 These two methods should be available not only to an outright transferee but also to a transferee which is a secured creditor. Both methods play the same role as the delivery to a transferee of certificated securities of the related certificate. In the case of a security interest in uncertificated securities, a control agreement is a functional equivalent to the possession of a certificate representing the securities.
1.54 A control agreement, in the context of uncertificated securities, is an agreement between the transferee, the registered holder, and the issuer whereby the transferee becomes empowered either to prevent a disposition of the securities by the registered holder or to dispose of them without any further consent by the registered holder. Article 12 GSC also provides that a control agreement perfects an acquisition of intermediated securities.
1.56 This section deals with the rules that should resolve a priority dispute between a transferee of non-intermediated securities and another person claiming a right or interest in the securities as a result of dealings with the transferor or other action taken against the transferor. A dispute of this kind may be described as a horizontal priority dispute: each of the transferee and the competing claimant invokes a right or interest deriving from that of the transferor.20
1.57 At first glance, a priority dispute between a transferee and a competing claimant may be resolved using one single rule: a transfer, once made effective against third parties, would necessarily have priority over another right or interest not yet so effective. For policy and efficiency reasons, the GSC, the LGST, and many legal systems have not adopted this straightforward approach, in particular where there is more than one method to achieve third-party effectiveness under the applicable regime.
1.58 Another issue is whether any third party may assume that the securities still belong to the transferor where no perfection requirement has been fulfilled. In other words, should a non-perfected transfer still have some effects? The question arises notably in the case of a dispute between an outright transferee and a judgment creditor or an administrator of the insolvency of the transferor.
(1) Horizontal general priority rules
(a) Certificated securities
1.60 Consistent with the expectations of the parties that possession of a certificate normally entitles the holder thereof to exercise the rights attached to the related securities, two basic priorities rules should apply for certificated securities.
1.61 First, a transferee whose transfer is effective against third parties by the delivery of the certificate should have priority against any competing claimant. Second, a transferee whose transfer is effective against third parties by registration in a (p. 14) public registry should have priority against any competing claimant other than a transferee in possession of the certificate. The combined effect of these two rules is that perfection achieved by possession of the certificate will trump perfection by registration in a public registry, even if the registration occurred prior to the delivery of the certificate.
1.62 For the sake of simplicity, the super-priority resulting from the delivery of a certificate to a transferee should not be conditioned upon the certificate being endorsed in favour of the transferee. This is a matter relevant to the ability of a transferee to compel the issuer to give effect to the transfer, but not to the priority against competing claimants of a transferee in possession of the certificate. Providing for two levels of priority by possession depending on whether the certificate has or has not been endorsed by the transferor would lead to unwarranted complexity and would necessitate the elaboration of sub-rules dealing with a scenario where two competing transferees would be treated as having possession (actual or constructive) of the same certificate.21
1.63 Registration in a public registry as a method of achieving third-party effectiveness is usually reserved to a transfer made for security purposes, namely a security interest. However, nothing should prevent a legal system from providing that the party-effectiveness of an outright transfer may also be achieved by registration in a public registry (eg, in a bulk transfer of the securities portfolio of a business).
(b) Uncertificated securities
(i) an acquirer whose securities account is credited with the securities prevails over any competing claimant;22
(p. 15) (ii) a transferee which has obtained control of securities credited to and remaining in the securities account of the transferor prevails over another person claiming an interest in the securities credited to that account;23
(iii) a transferee which has achieved third-party effectiveness under a method of perfection not established by the GSC will have such priority as is afforded by the law outside the GSC, but cannot prevail over a transferee which has priority under the GSC.24
(i) First, a transferee of uncertificated securities which perfects its transfer by becoming the registered holder in the books of the issuer will prevail over any competing claimant (the ‘first level priority rule’).
(ii) Second, a transferee which has obtained control of the securities by a control agreement will prevail over any competing claimant other than a transferee which becomes the registered holder of the securities (the ‘second level priority rule’). As between two transferees with which the issuer may have concluded a control agreement, priority would be accorded to the transferee whose control agreement is concluded first in time.
(iii) Third, a transferee which achieves third-party effectiveness only by registration in a public registry will prevail over a competing claimant other than a transferee which has already perfected or subsequently perfects its interest by control or by becoming the registered holder of the securities (the ‘third level priority rule’). As between two transferees relying only on registration in a public registry, the first in time to register will have priority over the other.
1.68 Under the first level priority rule, a transferee which becomes the registered holder of the securities will have priority even against another transferee with which the issuer may previously have concluded a control agreement.
1.69 The following example illustrates the application of the first level priority rule. Suppose that A is the registered holder of uncertificated securities issued by issuer X and transfers the securities to B; instead of causing the transfer to be registered in X’s books, A and B enter into a control agreement with X, whereby X is only permitted to follow transfer instructions from B. Subsequently, A transfers the securities to C, and the issuer X despite the control agreement registers in its books the transfer in favour of C. The result of the first level priority rule will be that the transfer by A to C will have priority over the transfer by A to B.
(p. 16) 1.70 However, this result would not relieve the issuer from liability if, as in the example, the control agreement did not permit the issuer to accept transfer instructions from the person who was the registered holder at the time the control agreement was made. As a practical matter, in most cases, the previous transferee (B, in the example) is unlikely to suffer a loss as a result of its transfer being subject to the first level priority rule. Either the issuer is solvent, in which case the previous transferee will have recourse against the issuer for the loss arising from the breach by the issuer of its obligations under the control agreement, or the issuer is insolvent, in which case the previous transferee would not have been better off in absence of the breach (at least if the securities are shares in the equity of the issuer). It is worth mentioning that the use of control agreements to achieve third-party effectiveness of a transfer will be more frequent in the area of secured transactions. An outright transferee will generally prefer to rely on the greater protection afforded by a registration of its transfer in the books of the issuer.
1.71 An example of the operation of the second level priority rule is where A, the holder of securities registered in its name in the books of the issuer, grants a security interest in the securities in favour of B and subsequently grants another security interest in favour of C. In each case, a control agreement is entered into between A, the secured creditor concerned, and the issuer. The respective priorities of B and C will depend on the order in time of their respective control agreements, and not on the order in time of their respective security interests. Indeed, a prudent issuer which has concluded a control agreement with a transferee will not become party to another control agreement with another transferee without appropriate safeguards; in particular, the issuer will insist on the provisions of the second control agreement to be subject to the first control agreement. Allowing for the possibility of more than one control agreement is a useful tool in lending transactions where all parties contemplate that the same uncertificated securities will serve as collateral for loans made by two lenders. By achieving perfection through a control agreement, each of the first and second lenders will ensure that they rank ahead of another secured creditor perfecting its security interest by registration only.
1.72 The following example illustrates the purpose and application of the third level priority rule. The assets of company A include a manufacturing business and investments in uncertificated securities. Company A has granted a security interest to a lender in all its present and future assets. For practical reasons, company A is unwilling to spend the time and incur the costs associated with convincing each issuer of the uncertificated securities to conclude a control agreement with the lender. The lender is prepared to abstain from obtaining a control agreement and to rely on the honesty of company A and on the ‘negative pledge’25 provisions of the loan agreement. Nonetheless, the lender still wants protection in the event of the (p. 17) insolvency of company A. Achieving third-party effectiveness by registration in a public registry will then ensure that the lender’s security interest in the uncertificated securities will be enforceable against the administrator of the insolvency of company A if the latter becomes subject to insolvency proceedings.
(2) Qualifications or exceptions
1.73 The above priority rules apply to any transferee and to both an outright transfer and a transfer by way of a security interest. The question arises whether qualifications or distinctions would be appropriate for a transfer which is not made for value or where an outright transferee competes with a judgment creditor or an insolvency administrator.
1.74 Should a transfer be for value in order for the transferee to benefit from the priority rules stated above? An outright transfer may be made gratuitously (for example, as a result of a gift). A security interest is typically granted for value, but even in such a case the issue is not entirely moot.26
1.75 A review of the GSC indicates that the provisions of Articles 11 and 12 on the methods of achieving third-party effectiveness apply to any acquisition of intermediated securities, regardless of the nature of the agreement under which the securities have been acquired; there is no requirement that the acquisition be for value. In the same vein, the provisions of Article 19 GSC on priority between interests in the same intermediated securities do not distinguish between an acquisition for value or one not for value. It is only in Article 18 GSC, which deals with the protection of an innocent acquirer, that such a distinction appears, albeit in a limited way. Article 18(3) and (4) provide that the rule protecting an innocent acquirer ‘does not apply to an acquisition of intermediated securities, other than the grant of a security interest, made by gift or otherwise gratuitously’; in such a case, ‘the applicable law determines the rights...of the acquirer’.
1.76 The issue may arise in the following scenario. A, the holder of uncertificated securities, donates the securities to B, and B makes its transfer effective against third parties by becoming the registered holder. Suppose that A subsequently transfers the same securities to C under a transfer for value. Would C be entitled to defeat the transfer in favour of B and obtain a court order compelling the issuer to cancel B’s title?
1.77 There is no policy reason specific to the law on intermediated or non-intermediated securities which mandates that C be given priority merely because B has acquired (p. 18) the securities under a gift (namely, not for value). The better view is to leave the matter to the law on donations: to the extent that the donation is valid and effective under that law, transferee B should be entitled to benefit from the priority rules governing non-intermediated securities.
1.78 The same analysis may be made to determine the priority of a donee against a judgment creditor or insolvency administrator. A transfer not for value may be subject to avoidance under creditors’ rights or insolvency laws, but, again, this is not a matter falling under the rules on intermediated or non-intermediated securities. If the transferee is insolvent, the gift could be set aside by a judgment creditor or an insolvency administrator of the donor as a result of the prejudice caused to the creditors of the donor. However, this is not a ground for imposing a requirement that the third-party effectiveness of a transfer be conditional upon the transfer being for value.
1.79 Such a requirement would also create uncertainty and add an unnecessary layer of complexity to the area of priority rules. The concept of value or consideration is not the same in all legal systems and significant differences exist between the common law and the civil law.27 In the case of a security interest, different approaches are possible on whether the security interest has been granted for value. One position is that the grantor itself must have received value; under another position, it is sufficient that value be given either to the grantor or a third party.28 This difficulty has not gone unnoticed by the drafters of the GSC: Article 18 on the protection of an innocent acquirer does not apply to an acquisition effectuated gratuitously except for an acquisition by way of a security interest.29 Other difficulties include the treatment of nominal value and of a transfer made in satisfaction of an antecedent debt.30
1.80 In addition, requiring that value be given in order for a transfer to be effective as against third parties would discord with the rules on the effectiveness of a transfer against the issuer. An issuer is under an obligation to register a transfer (whether or not for value) in its books, if the transferee provides reasonable evidence that the transfer has been authorized. If the title of a registered transferee which obtained the securities through a gift could be defeated by a subsequent transfer for value, the rule that an issuer may treat a registered holder as ‘true owner’ would need to be relaxed to take into account such possibility: an exception to the rule would have (p. 19) to be provided to deal with the rights and duties of an issuer receiving a request for registration by a subsequent transferee for value claiming that the previous transfer was not for value. This would increase the risk of the issuer becoming involved in litigation resulting from circumstances out of its control.
1.81 Should the above analysis also apply to a competition between B and C, in a variant of the example in paragraph 1.76 where C, instead of being a subsequent transferee, is a previous transferee? In other words, if the gift in favour of B is subsequent to the transfer for value in favour of C, should B prevail over C in a situation where B (the donee) is the first in time to perfect its transfer (eg, by becoming the registered holder of the securities)?
1.82 To the extent that giving value is not a factor relevant to the determination of the priority of a transferee, B should prevail in the second scenario as well. It is true that, in this second scenario, the application of the priority rule would trump the nemo dat rule: transferor A has donated to B securities previously transferred for value to C. However, priority rules are intended to provide certainty and it is generally recognized that they may have the effect of displacing the nemo dat rule. Again, the consequence of a transfer not being made for value should be a matter left to the legal principles governing gratuitous transfers of property or fraudulent conveyances.
1.83 As a practical matter, the scenario where a gift subsequent to a transfer for value would have priority does not necessarily yield an unfair result. First, a prudent buyer of securities would normally subject the payment of the purchase price to its transfer having been made effective against third parties; if this cannot be done, the purchaser will not pay the seller. Second, the transferor would still be liable against the transferee for value, on the basis of a legal or contractual warranty; if the transferor is unable to honour the warranty because of its insolvency, the transferee would likely be able to attack the gift as being a fraudulent conveyance.
1.84 Secured transactions laws generally provide that an unperfected security interest does not have priority over a judgment creditor or an insolvency administrator of the grantor of the security interest. The policy underlying the rule is that creditors may assume that the assets of their debtor are free from security interests unless the latter have been perfected.
1.85 Should the same rule apply to an outright transferee? For example, if the buyer of securities has not perfected its transfer and if the transferor subsequently becomes bankrupt, would the buyer be entitled to invoke the transfer against the trustee in the bankruptcy of the transferor?
1.86 In general, the buyer of goods does not need to take steps to ensure that the transaction will be effective against the creditors of the seller; if the goods have not been (p. 20) delivered at the time of the bankruptcy of the seller, the buyer will be entitled to claim the goods from the trustee. In the area of immovable property, some legal systems take the same approach: an immovable which has been sold prior to the bankruptcy of the seller is not vested in the trustee even if the sale has not been registered in the appropriate land registry. In such case, the trustee is treated as a successor (and not as a third party) and cannot have greater rights in the immovable than those held by the bankrupt.
1.87 On the other hand, the LGST and many legal systems apply to an outright assignment of receivables31 the same regime as to a security interest: an outright assignment is not effective against an insolvency administrator of the assignor if perfection steps are not taken. This facilitates the resolution of priority disputes between an outright assignee and the holder of a security interest in the receivable. It is noteworthy, however, that other forms of intangible property (eg, intellectual property) are not subject to such a uniform regime. Moreover, even for receivables, the LGST and the legal systems which contain perfection requirements for an assignment of receivables contemplate exceptions to such requirements for certain types of receivables (eg, certain financial receivables).32
1.88 In relation to intermediated securities, the GSC does not take a position on whether steps must be taken to render an acquisition (including a security interest) effective against an insolvency administrator. The GSC provides that an interest made effective against third parties by credit or by control is also effective against an insolvency administrator.33 It does not state, however, that failure to do so results in the interest being unenforceable in insolvency proceedings. The matter is left to law outside the GSC.34
1.89 Therefore, the principle that assets not belonging to an insolvent debtor are not vested in its insolvency administrator should apply to an unperfected transfer of non-intermediated securities. There is no compelling reason to treat non-intermediated securities differently. The LGST and some legal systems assimilate, to a certain extent, an outright assignment of receivables to a security assignment. This is not however the case for an outright transfer of other types of assets.
1.90 A vertical priority dispute is triggered where the interest of a transferee is challenged by a person whose claim is not derived from dealings with the transferor of such transferee. The typical scenario is as follows: A delivers and endorses to B certificated securities in a pledge transaction; B is not authorized under the transaction to transfer the securities to another person. In spite of the foregoing, B grants to C a security interest in the securities and delivers the certificate to C. After discharging its obligations to B, would A be entitled to require from C the restitution of the certificates (assuming the obligations of B to C have not been satisfied)?
1.91 The GSC addresses a similar question in Article 18 (‘Acquisition by an innocent acquirer’). Essentially, the GSC provides that an acquirer in good faith of intermediated securities is immune from a claim by another person asserting an interest in the securities. The protection afforded by Article 18 is confined to vertical priority disputes; horizontal priority disputes35 are dealt with by Article 19 (priority to the transferee which is the first in time to obtain control).
1.92 Applied to the above example, Article 18 would protect C: its security interest in the securities would be effective against A even if B did not have the right to transfer these securities to C. It is worth noting that the provisions of Article 18 are not new in this regard; they transpose to intermediated securities an already existing rule in the area of certificated securities. The origin of the rule is found in the law of negotiable instruments: a ‘holder in due course’ obtains good title to the instrument even if the previous holder had a defective title or acted fraudulently in negotiating the instrument.
1.93 Therefore, in a law reform context, a transferee of non-intermediated securities should benefit (or continue to benefit) from the same protection as that contemplated by Article 18 GSC for intermediated securities. For the transferee to be protected, its interest must have become effective against third parties. However, in addition to being in good faith, must the transferee have given value? Article 18 excludes ‘an acquisition of intermediated securities, other than the grant of a security interest, made by way of gift or otherwise gratuitously’.36 The security interest exception makes irrelevant the question of whether a security interest granted by a person other than the debtor of the obligation secured is accorded gratuitously. But for that exception, a secured creditor would not qualify as a protected acquirer in circumstances where the security interest is treated under the applicable law as a gratuitous transaction.
(p. 22) 1.94 Thus, should a transferee of non-intermediated securities have given value in order to be protected in the event of a vertical priority dispute (assuming that a secured creditor is treated as giving value to the extent of the obligation secured)? In line with the UCC37 and other existing laws on the issue, as well as the GSC38 and the law of negotiable instruments, 39 this requirement appears appropriate.40 Between a donee and an owner of securities which is the victim of an unlawful action, the law should accord precedence to the victim. The donee would not suffer a real loss as a result of the gift being declared ineffective; the value of its assets (prior to the gift) would remain the same. Giving priority to the donee would be an unjustified windfall for the donee in a situation where B, a thief, steals bearer certificates belonging to A and donates the certificates to C.
1.95 It is true that in horizontal priority disputes, giving value is not a prerequisite to the priority of a transferee which meets the relevant priority requirements. However, the policy reasons for not requiring such condition in the case of a horizontal priority dispute are different. Among other things, a transferee for value whose transfer might be defeated by a subsequent transfer made gratuitously is in a position to protect itself against the occurrence of such event; for instance, a lender which lends in reliance of a security interest in securities may postpone the disbursement of the loan until its security interest has been perfected by a method ensuring that the security interest will be first-ranking.
1.96 This section examines the conflict of laws rules that should apply to the effectiveness against the issuer and third parties and to the priority of a transfer of non-intermediated securities.41 The factors that determine the law applicable (the connecting factors) to an outright transfer and a security interest must be the same. Otherwise, in the event of a priority dispute between an outright transferee and a secured creditor, it might be impossible for a court to resolve the dispute: this would be the case, for example, if the priority of the outright transfer is subject to the law of State X (under which the outright transfer prevails over the security (p. 23) interest) and the priority of the security interest is subject to the law of State Y (under which the security interest prevails over the outright transfer).
1.97 Certificated securities are in many respects assimilated to tangible property: the rights attached to these securities are embodied in certificates. Uncertificated securities are entirely dematerialized. Therefore, even if the relevant conflict rule is the same for an outright transfer and a security interest, the factor most closely connected to the perfection and priority of a transfer of certificated securities appears to be different from that connected to the perfection and priority of a transfer of uncertificated securities.
1.98 The traditional lex rei sitae or lex situs rule is applied in many States to certificated securities, as is the case for negotiable instruments or negotiable documents of title. Because of the similarities between certificated securities and negotiable instruments, there seems to be no compelling reason to take a different approach in uniform conflict of laws rules that attempt to deal comprehensively with non-intermediated securities. These similarities should dictate that the law applicable to the third-party effectiveness and priority of a transfer of certificated securities be the law of the State in which the certificate is located. Thus, if a transferee obtains delivery of a certificate in State X, the law of State X will determine the priority of the transferee for as long as the certificate remains in State X.
1.99 The effectiveness of the transfer against the issuer cannot, however, be governed by the law of the place where the certificate is physically held. An issuer has no means of knowing where a certificate is held and needs to be able to rely on one single law to ascertain its duties and obligations to security holders. In addition, many of these duties and obligations may come under the corporate law governing the issuer. The situs of a certificate cannot be an appropriate connecting factor to determine the law applicable to the effectiveness of a transfer against the issuer.
1.100 The factor best connected to the situation appears to be law under which the issuer has been formed or constituted (the ‘issuer’s constitutive law’).42 Therefore, the relationship between the transferee and the issuer should be governed by the issuer’s constitutive law, including the conditions to be met for the registration of the transfer and the obligations of the issuer to a previous security holder in the event of a wrongful registration.
(p. 24) 1.101 A different approach may, however, be envisioned. In the area of receivables, many legal systems provide that the law applicable to the effectiveness of an assignment of a receivable against the debtor of the receivable is the law governing the receivable; in the case of a receivable arising out of a contract, the applicable law is then the law governing the contract.43 Debt securities are receivables in a broad sense and it is arguable that the applicable law should be the law governing the terms and conditions of the securities. In line with that approach, some legal systems provide that the law applicable to the relationship of the issuer with a security holder (including a holder of equity securities) is the issuer’s constitutive law unless the issuer selects another applicable law in the terms and conditions of the securities.44
1.102 The difficulty with the possibility of the issuer selecting the applicable law is that certain matters relating to the effectiveness of a transfer against the issuer may fall under corporate law, especially where the securities are equity securities. At first glance, a solution reconciling the receivables approach and the issuer’s constitutive law approach might be to allow the issuer to determine the applicable law only for debt securities. However, this would not provide certainty as the distinction between equity securities and debt securities may be blurred (eg, debentures convertible in equity). Moreover, debt securities may still be subject to the issuer’s constitutive law for certain matters relevant to the relationship between the issuer and the holders of these securities.
1.104 With respect to uncertificated securities, the conflict rule should point to the issuer’s constitutive law for the effectiveness of the transfer against the issuer and for perfection and priority. As to the effectiveness against the issuer, the reasons discussed above for selecting the issuer’s constitutive law in relation to certificated securities lead to the same conclusion with respect to uncertificated securities. Matters concerning the relationship between a security holder and the issuer are essentially the same whether the securities are certificated or uncertificated. It follows that the law applicable to such relationship should be the same for each type of non-intermediated securities.
(p. 25) 1.106 The perfection and priority of a transfer of uncertificated securities will be achieved principally by registration of the transfer in the books of the issuer or by a control agreement with the issuer. Both the registration of a transfer and entering into a control agreement require the participation of the issuer. Both methods of perfection are dependent on the ability of the transferee to effect or block a disposition under the law governing the effectiveness of a transfer against the issuer. The logical consequence of the foregoing is that the issuer’s constitutive law should be the law applicable to the perfection and priority of a transfer of uncertificated securities.
1.107 The approach permitting the issuer to select the law applicable to effectiveness against the issuer was discussed in paragraph 1.102 but was not retained. Perfection and priority are matters that affect third parties and it is easier for third parties to ascertain the applicable law if the conflict rule points only to the issuer’s constitutive law.
1.108 The preparation and negotiation of the GSC has been a challenging exercise. From a superficial view, national laws on non-intermediated securities do not need to be substantially modified or revised, as they are based on a system that has been in effect for a long time and still applies to such securities. However, this chapter shows that modernization and harmonization are also desirable in the area of non-intermediated securities, in particular to ensure uniformity at the international level and consistency with the law on intermediated securities. As has been seen, there are several issues pertaining to non-intermediated securities where the law is not clear, with the result that different approaches may be taken. Providing for certainty on these issues would be a significant achievement.(p. 26)
1 For example, an investor may want to avoid the application of the rule whereby a security interest granted by an intermediary may impair the rights of an account holder of that intermediary. See Art 20(2) GSC and the discussion in Kanda et al., Official Commentary, 20–2. The same rule exists in some States which have laws conceptually similar to the GSC.
3 An elaboration of this neutral approach is found in Bernasconi and Keijser, ‘The Hague and Geneva Securities Conventions’, 549. See also discussions on the nature of intermediated securities in Kanda et al., Official Commentary, 9–3; Thévenoz, ‘Geneva Securities Convention’; Paech, ‘Market Needs’; Dupont, ‘Rights of the Account Holder’; Segna, ‘Impact on German Law’; and Garcimartín, ‘A Spanish Perspective’.
5 The term ‘security interest’ is used in a broad sense to denote ‘the grant of an interest other than full ownership in...securities for the purpose of securing the performance of...obligations’. The quoted language comes from the definition of ‘security collateral agreement’ in Art 31 GSC.
9 The above interpretation of Art 11 GSC is probably far too reaching given its scope. § 8–113 UCC and the laws of some other States specifically provide that no writing is required for ‘a contract for the sale or purchase of a security’ to be enforceable. This provision of the UCC is, however, subject to the form requirement that may apply to a security agreement under Art 9 UCC.
10 See, eg, § 8–207(a) UCC. Note that the UCC term is ‘registered owner’ and not ‘registered holder’; however, the person so registered is not always an owner and the term ‘holder’ as used in this chapter is more neutral.
11 See Ch 7.
12 The LGST does not deal with securities but provides that third-party effectiveness may be achieved by possession or by control for certain types of assets which, in some way, have features analogous to non-intermediated securities. Thus, under the LGST, possession is a mode of perfection for negotiable instruments or documents and control is a mode of perfection for letter of credit proceeds and bank deposits; see Recommendations 34 and 35 of the LGST.
13 This section does not consider whether a defect in a transfer may be raised against a subsequent transferee which has obtained in good faith the securities from the transferee under the defective transfer. This issue will be examined in section H.
15 For example, under Art 19 GSC, if A sells intermediated securities to B and thereafter sells the same intermediated securities to C and enters into a control agreement with the intermediary, then the sale to C will be effective against B despite the nemo dat rule.
17 This is consistent with Recommendation 37 of the LGST on the effectiveness against third parties of a security interest in a negotiable instrument. § 9–313 UCC is of the same effect for certificated securities.
19 Article 12(3) GSC also contemplates that an outright transferee or a secured creditor may perfect its interest through a designating entry. Under Art 1(l) GSC, a designating entry has the same effect as a control agreement.
20 By contrast, a ‘vertical priority dispute’ is where a competing claimant asserts against the transferee an interest not deriving from the transferor. If securities owned by A are stolen by B who subsequently sells them to C, a claim by A against C gives rise to a vertical priority dispute.
21 It should be noted that § 9–328 UCC provides in such cases for two levels of priority in the area of secured transactions: a transferee in possession of an endorsed registered certificate has priority over a transferee in possession of an unendorsed registered certificate. This is so because of the UCC priority rule providing that control of a certificated security (that is, possession of an endorsed certificate) prevails over mere possession. Indeed, such a hypothesis may materialize only in a situation where the law deems both transferees to be in possession of the same certificate. Still, in normal circumstances it would be rare that a certificate be considered as endorsed with respect to one party and unendorsed with respect to the other party. However, this may occur where a certificate is held by a third party on behalf of the two transferees and has been endorsed in favour of one of them; the latter would have control while the other transferee would have mere possession.
26 In the rare case where a security interest secures a promise to make a donation, the question of whether the promise constitutes value or consideration depends on the law of obligations of the relevant legal system.
27 Under the civil law, the concept of ‘consideration’ (as understood in the common law) as a requirement for the enforceability of a ‘simple contract’ (another common law term) is unknown. See McKendrick, Goode on Commercial Law, 73.
30 Under the traditional common law concept of consideration, a transfer in satisfaction of an antecedent debt is not made for a valuable consideration. This approach has been overridden by many statutes in common law States. See § 7–204 UCC.
32 See the definition of receivables in the LGST. See also § 9–309 UCC, which provides that filing is not required for the perfection of certain categories of receivables (for example, the sale of a loan is not subject to perfection formalities).
34 Article 14(4) GSC. In light of the limited scope of the GSC on insolvency matters, this article cannot be read as requiring that the law outside the GSC must also prescribe the fulfilment of perfection requirements in an insolvency context.
40 The concept of value should, however, be defined or understood in a way that avoids the difficulties alluded to in para 1.79.
41 The issue of the law applicable to the validity of the transfer as between the parties will not be discussed, although many legal systems apply the same connecting factor to validity issues as for perfection and priority issues (at least for security interests). Another approach is to apply to validity issues the law governing the agreement under which the transfer is made; this is to some extent the UCC approach.
42 It should be noted that in most cases third parties which have no direct dealings with the security holder cannot ascertain the physical location of a certificate. Therefore, it can be argued that the issuer’s constitutive law should also apply to the perfection and priority of a transfer of certificated securities.