“The transnational nature of collateral goes beyond the mere (but important) fact that the parties to a swap are often incorporated in different jurisdictions. Collateral may be posted in different currencies, or in the form of government bonds issued by different governments. The collateral is held with intermediaries often incorporated in yet other jurisdictions, with places of business in still other locales. These intermediaries book the collateral in computerized ledgers maintained on servers that may be located elsewhere in the world. And if, as is permitted under the law of some countries, the pledgee (the party that receives the collateral) “repledges” the collateral to yet another party to satisfy its own obligations, which then repledges it again, then lawyers are left to make sense of a constant global movement of collateral in and out of accounts in many jurisdictions in terms of legal rules created to address a far more stationary and localized conception of property and contract rights.”

Annelise Riles, Collateral Knowledge: Legal Reasoning in the Global Financial Markets, p. 43 (University of Chicago Press, 2011)

By Thomas Werlen / Matthias Wühler / Jonas Hertner (Reference: CapLaw-2018-02)

 

On 1 April 2017, the Hague Convention on the Law Applicable to Certain Rights in Respect of Securities held with an Intermediary (Hague Securities Convention) entered into force. The entry into force of the Convention coincides with renewed efforts by the European Commission at modernising the conflicts rules for the third-party effects of transactions in book-entry securities and financial claims in the overall context of the Capital Markets Union action plan.

Nearly eight years have passed since the promulgation of the Swiss Federal Act on Intermediated Securities (FISA). This year’s entry into force of the Hague Securities Convention again puts a spotlight on the Swiss legislation in this domain which compares favorably with the set of rules prevailing in the EU and its Member States. We wish to take this opportunity to place the Swiss legal framework for intermediated securities in the broader context.

In the first of our two-part contribution, we outlined the prevailing indirect and/or intransparent systems of securities intermediation and reviewed key aspects of the UCC approach to intermediated securities. We begin this brief and final part with an introductory comment on FISA (1). We then turn to the private international law challenges arising in cross-border holdings and transactions (2) as well as the solutions offered by the Hague Securities Convention for a subset of these issues (3). The flexible approach of the Hague Securities Convention contrasts with the rigid nature of Union law in this domain, and we discuss the European Commission’s ongoing attempt at reforming it (4). A brief outlook concludes this article (5).

1) FISA, The Swiss Federal Act on Intermediated Securities

In an effort to adjust Swiss law to the new realities of securities trading, the Swiss lawmakers adopted the Federal Act on Intermediated Securities (FISA). The preparation of FISA occurred in parallel to extensive debates in international fora. In the course of the political debate in Switzerland, a consensus emerged that legal certainty must be improved in light of the new challenges brought by the modernization of securities trading, but that at the same time any new law would need to be flexible enough to sensibly apply to still evolving, new market practices.

FISA introduced a new category of rights – “intermediated securities” – into Swiss law. Before the implementation of FISA, transactions in intermediated securities were governed by the rules governing the transfer of movable property (transfer of ownership in chattel and assignment of choses in action). Article 3(1) FISA defines “intermediated securities” as (1) personal or corporate rights against an issuer which (2) are of a fungible nature, (3) have been credited to a securities account, and (4) may be disposed of by the account holder in accordance with the provisions of FISA. Article 3(2) complements this definition by clarifying that intermediated securities are effective against the intermediary and any third party (erga omnes). While this definition is more restrictive than the definitions in the Geneva Securities Convention, which defines securities as “any shares, bonds or other financial instruments or financial assets (other than cash) which are capable of being credited to a securities account and of being acquired and disposed of in accordance with the provisions of the Convention”, FISA is understood to be fully in line with the Geneva Securities Convention in terms of policy and practical effect.

2) Cross-Border Holdings and Transactions in Intermediated Securities: The Conflict of Laws

Numerous intermediaries stand between the ultimate investor and the central securities depository, and their number is larger still in a cross-border setting (for an empirical analysis of a dataset on subcustodian structures in the safekeeping of foreign financial assets collected by a National Competent Authority, see BuBa Discussion Paper No 31/2015). When a custody chain extends across jurisdictions, it is the body of law variously referred to as private international law or conflict of laws that coordinates these jurisdictions.

a) Characterization/Qualification

The custody of and transactions in intermediated securities touch upon several bodies of law, the following of which are of particular importance (and to each of which corresponds a set of conflicts rules):

• The rules governing custody agreements (contract law);
• Insolvency law;
• The rules governing the rights embedded in/underlying the intermediated securities (corporate law, contract law); and
• The rules governing the legal nature and effects against an intermediary and third parties of the rights resulting from a credit of securities to a securities account or of a disposition of intermediated securities (hereinforth referred to as the “Law of Intermediated Securities”).

As to the rules designating the proper law of custody agreements, they are the rules of international contract law which follows the primacy of party autonomy and poses little problems in terms of internationally harmonized conflicts rules.

The conflicts rules designating the law governing the bundle of rights embedded in/underlying the intermediated securities depend on the type of security at issue. The rights embedded in bonds are contractual in nature, so the conflicts rules are those in the international law of contracts. The rights embedded in equity securities are membership/corporate rights. The law governing these membership rights is the personal law of the company (lex societatis), the corresponding conflicts rules are the rules of international company law.

In a cross-border setting, the lex societatis and the Law of Intermediated Securities must be clearly distinguished. The intensity at which securities are traded on secondary markets and the prevalence of securities finance and wholesale collateral management inside current systems of securities intermediation imply that the Law of Intermediated Securities will change frequently. Where the applicable Law of Intermediated Securities is determined separately at each layer of a given chain of intermediation, this further compounds the issue. Whether an investor must be recognized as the shareholder of an issuer corporation, corporate actions, all issues that involve the relationship between the issuer of the security and the ultimate investor cannot be subject to constantly changing laws.

b) Connecting Factors

In coordinating national laws, one may depart from either of two questions:

• To which territory is an “intermediated security” most closely connected?
• What conflicts rule best serves the interests of the parties involved?

Both perspectives resonate in discussions over appropriate connecting factors along with the usual concerns accompanying legal policy discussions (practicability, cost etc.).

Once a multi-tiered system of securities intermediation is established, it is arguably the interests of intermediaries that should inform the formulation of appropriate conflicts rules. To simplify, let us establish three categories of parties involved: issuers, securities intermediaries (with intermediaries also filling in for central banks) and investors. Further, let us assume that the interests of issuers are fully served by a clear delineation of the Law of Intermediated Securities and its associated conflicts rules from the lex societatis, the law applicable to the terms of its bonds, notes and other issuances, and the conflicts rules corresponding to the latter bodies of law. That is to say that predictable and clear characterization suffices to serve the interests of issuers.

These assumptions leave us with two types of Parties concerned, intermediaries and investors. The interests of investors arguably do not extend to the inner layers of the securities intermediation system. As discussed in Part 1,  indirect/intransparent systems of securities intermediation provide that an investor may only exercise his or her rights to an intermediated security throught the custodian. An investor’s creditors cannot effect so-called upper-tier attachments.

The interests of intermediaries are a product of their activities at the inner layers of the system, in particular securities finance and wholesale collateral management. Intermediaries want a legal framework permitting the use of diverse pools of securities as collateral at low cost. On a general level (brushing over the refinement of alternative solutions such as the lex creationis approach developed by Ooi), there is a tradeoff. What is a multitude of laws from the perspective of a bystander observing the chain of intermediation for a given security in full, becomes a single law applicable to all securities in the portfolio from the perspective of an intermediary within that chain. Conversely, if a single law were to govern each level of chain of intermediation for a given security (by operation of a connecting factor situated at the top of the chain), an intermediary within said chain would be faced with laws as diverse as the pool of securities it is working with.

The needs of securities intermediaries are seen to require what has come to be known as PRIMA (Place of the Relevant Intermediary Approach). Under PRIMA, the law applicable to the (third-party) effects of transactions in intermediated securities must be determined separately at each layer of the system, at the level of the relevant intermediary. PRIMA implies that different Laws of Intermediated Securities apply at different levels of a given chain of intermediation.

PRIMA as adopted by the Hague Securities Convention differs from PRIMA as adopted by the Union law instruments addressing the needs of securities intermediaries. This eventual divergence of approaches was not foreseen by the European Union at the start of the negotiations over the Hague Convention, which were conducted in parallel with negotiations in Brussels over the Financial Collateral Directive. It was expected that the Hague Convention would harmonize internationally the localization of the relevant intermediary. The Explanatory Report on the Hague Securities Convention (Int-43 et seq.) provides background:

The reference to the place of the relevant intermediary suggested that a single situs of the relevant intermediary or the securities account it maintains for the account older had to be determined. The history of the negotiations leading to the Convention clearly revealed, however, that there is no criterion – generally acceptable on a global basis for the vast majority of transactions – to precisely and unequivocally determine the location of a securities account or the office of an intermediary that maintains a specific securities account. (…)

In such a situation, if the criterion for determining the applicable law were the location of the securities account (…), no certainty could be achieved and such a test would invite litigation in which courts would be required to make fact-intensive inquiries. The risks and burdens presented to a potential collateral taker are readily apparent.

3) The Hague Securities Convention Approach

a) Substantive Scope of the Convention

The Hague Securities Convention applies (only) when securities are credited to a securities account, article 2(1), article 1(1) lit. f). Once a security is credited to a securities account, the Convention applies, regardless of whether the law it designates qualifies rights resulting from a credit of securities to a securities account as a matter of contract or property, or qualifies them yet differently.

Article 2(1) lists the issues to which the Convention applies, i.e. the issues which the law the Convention designates is called to regulate. These issues include:

• The legal nature of the rights in intermediated securities;
• The legal nature and effects of transfer and hypothecation;
• Perfection requirements;
• Priority of interest; and
• The admissibility or not of an upper-tier attachment.

None of the issues listed in article 2 (1) are issues adressed by the lex societatis, the law governing terms and conditions of bonds, or any other law that may govern the rights embedded in/underlying the intermediated security. The Convention does not address any of the rights and duties of an issuer, as reiterated in article 2(3) lit. c).

Article 8 delineates the boundary between the Convention law and the applicable insolvency law. An interest perfected under the law designated by Convention prior to the opening of an insolvency proceeding cannot be disregarded, article 8(1). After the opening of an insolvency proceeding, the consequences of an interest perfected before the opening (how an interest can be exercised and whether it enjoys priority over other creditors) fall to be determined exclusively by the applicable insolvency law, for which the Convention containts no conflicts rules.

b) Connecting Factors

The novelty of the Hague Securities Convention (from a continental perspective) is in its primary connecting factor, a choice of law between the parties to the relevant account agreement. According to article 4(1):

The law applicable to all the issues specificied in Article 2(1) is the law in force in the State expressly agreed in the account agreement as the State whose law governs the account agreement or, if the account agreement expressly provides that another law is applicable to all such issues, that other law.

The third-party effects of transactions in intermediated securities may therefore, as long as there is no credit to the counterparty’s securities account at its relevant intermediary, be subject to a law over which a third party has no control. The freedom to choose the governing law is tempered by the Qualifying Office requirement or “reality test” in article 4(1), second sentence and article 4(2).

In the absence of a choice of law meeting the requirements in article 4, the fallback rules in article 5 determine the applicable Law of Intermediated Securities with the help of objective connecting factors. Article 5(1) connects to a Qualifying Office expressly and unambiguously identified in an account agreement as the office through which the intermediary entered into the account agreement. Article 5(2) looks to the laws of the relevant intermediary’s jurisdiction of incorporation. If both objective tests fail, article 5(3) designates the laws in force at the relevant intermediary’s place of business.

4) EU Law and EU Reform Discussion

The EU is not a party to the Hague Securities Convention. The comprehensive coverage and flexible approach of the Convention contrasts with the fragmented state of Union law and its more rigid approach to finding the proper Law of Intermediated Securities.

a) Settlement Finality and Financial Collateral Directives

There is no comprehensive body of harmonized private international on intermediated securities within the EU. Catering to the needs of the Eurosystem and securities intermediaries, the EU legislated for harmonized conflicts rules in specific domains. Leaving aside the sector-specific provisions in Articles 24 and 31 Directive 2001/24/EC (Winding-up of credit institutions) and article 291 Directive 2009/138/EC (Solvency II), the harmonized EU conflicts rules for intermediated securities are found in the

• Settlement Finality Directive (Directive 98/26/EC) and the
• Financial Collateral Directive (Directive 2002/47/EC).

The Settlement Finality Directive is concerned with legal risk in payment and securities settlement systems. In order to reduce systemic risk, the Settlement Finality Directive protects qualifying settlement systems from the consequences of insolvency of participants, and creates certainty as to the law governing collateral used in qualifying systems.

Depending on the national implementing legislation, the Settlement Finality Directive governs the highest/higher layers of the securities intermediation pyramid. Article 9(2) introduced the PRIMA approach into Union law. It provides (emphasis added):

Where securities (including rights in securities) are provided as collateral security to participants and/or central banks of the Members States or the future European central bank as described in paragraph 1, and their right (or that of any nominee, agent or third party acting on their behalf) with respect to the securities is legally recorded on a register, account or centralised deposit system located in a Member State, the determination of the rights of such entities as holders of collateral security in relation to those securities shall be governed by the law of that Member State. 

The Financial Collateral Directive harmonizes the law of property, insolvency laws and private international law insofar as they have a bearing on financial collateral more generally. Recital 8 explains the motivation for mandating PRIMA:

The lex rei sitae rule, according to which the applicable law for determining whether a financial collateral arrangement is properly perfected and therefore good against third parties is the law of the country where the financial collateral is located, is currently recognized by all Member States. Without affecting the application of this Directive to directly-held securities, the location of book entry securities provided as financial collateral and held through one or more intermediaries should be determined. If the collateral taker has a valid and effective collateral arrangement according to the governing law of the country in which the relevant account is maintained, then the validity against any competing title or interest and the enforceability of the collateral should be governed solely by the law of that country, thus preventing legal uncertainty as a result of other unforeseen legislation. 

Article 9(1) Financial Collateral Directive provides that the legal nature and effects of collateral over intermediated securities, perfection requirements, priority and issues of realization of security interest in intermediated securities,

shall be governed by the law of the country in which the relevant account is maintained. (…)

b) Reform Discussions

In April 2017 the Commission launched a public consultation (Consultation on conflict of laws rules for third party effects of transactions in securities and claims) and established an Expert group (E03506) on conflict of laws regarding securities and claims.

The current consultation is part of a tradition of EU attempts to arrive at a harmonized set of conflict of law provisions for intermediated securities. On 15 December 2003, the Commission had submitted to the Council a proposal (COM(2003) 783 final) for a Council Decision concerning the signing of the Hague Convention. On 3 June 2006, the Commission published a Commission Staff Working Document on the Legal assessment of certain aspects of the Hague Securities Convention (SEC(2006) 910). The Executive Summary stated:

(…) On the basis of these findings, the Commission services remain convinced that adoption of the Convention would be in the best interest of the Community.

By notification in the Official Journal of 25 March 2009 (C 71/17), the proposal to sign the Hague Securities Convention was suddenly withdrawn. Having given up on its proposal to sign the Hague Securities Convention, the Commission started working on a comprehensive Securities Law Directive (SLD). The Commission’s latest consultation document suggests three ways forward:

• Leaving the status quo unchanged;
• Targeted amendments to the acquis to address specific shortcomings (clarifying which account or accounts constitute the relevant account; defining in more detail the criteria by which to locate such relevant account); and
• Establishing a comprehensive conflict of laws framework at Union level (joining the Hague Securities Convention or devising a comprehensive framework autonomously).

5) Outlook

Which of the approaches suggested by the Commission in its current consultation document the EU will pursue is as yet unclear. Reactions to the Commission’s 2017 consultation have been mixed. They range from renewed calls for the EU to sign the Hague Securities Convention to cautious assessments of the likelihood the EU would succeed in devising an appropriate comprehensive set of conflicts rules autonomously.

The discussion is highly politicized. There appear to be concerns that amending the acquis communautaire in the direction of the Hague Securities Convention or joining the Hague Securities Convention would entrench systems of securities intermediation perceived as inadequate and further disenfranchise investors from publicly listed companies.

The underlying concerns are forcefully expressed in the Consultation Response submitted by EuropeanIssuers on 30 June 2017 (http://www.europeanissuers.eu/positions/files/view/595a11785e3d4-en):

The European Union should never become a party to the Hague Securities Convention because such convention eventually would lead to the expropriation of European investors to the benefit of non-European custody banks. The Hague Convention is seriously and essentially flawed because:

• it does not acknowledge the importance of the laws under which securities are created;
• it does not acknowledge the interests of end investors but its application deprives them of their property rights to the benefit of international custody banks;
• it does not account for the imbalanced negotiation power of end investors on one side and large international banks on the other side; (…)

The Hague Securities Convention should not be supplemented, it should be completely disregarded.

This statement, although seriously flawed, illustrates a certain hostility towards the Hague Securities Convention prevailing in parts of the EU as well as the fundamental concerns driving this opposition.

The eminent expert Joanna Benjamin recently gave her assessment of the likelihood of convergence (LSE Legal Studies Working Paper No. 7/2017):

Three major law reform initiatives have sought to address (among other things) the rights of the investor in indirectly held securities. These are: on choice of law (internationally), the Hague Convention; on substantive law rules (internationally), the Geneva Securities Convention; and generally (in the EU), the proposal for Securities Law Legislation. At least in their original conception, each of these has favoured the collateral taker.

All these projects have stalled following the polarisation of opinion and the politicisation of the debate. In the past I have understood the failure of these projects to come to fruition as stemming from cultural differences between civilians and common lawyers. On reflection, the heart of the matter is more specific. If we are playing a zero sum game between investors and collateral takers, consensus will continue to elude us.

Thomas Werlen (thomaswerlen@quinnemanuel.swiss)
Matthias Wühler (mwuhler@cern.ch)
Jonas Hertner (jonashertner@quinnemanuel.com)