UCC Article 8, Investment Securities (1994) Summary

In 1994, the Uniform Law Commission promulgated a revised Article 8 of the Uniform Commercial Code. Article 8 governs transfers of investment securities. Stocks and bonds are the most well-known kinds of investment securities, but mutual fund shares, limited partnership shares, and just about any medium which permits investment in an enterprise or financial participation in a business may fall within the scope of the rules in Article 8. One of the results of the 1994 revision is expansion and clarification of those investment medium that are "securities" under Article 8, as shall be discussed further on in this summary.

Article 8 has a long and honored lineage. Before the Uniform Commercial Code there was the Uniform Stock Transfer Act of 1909. This Act became Article 8 when the Uniform Commercial Code was promulgated in 1951. Article 8 was also extensively amended in 1977.

Investment securities are intangible property. A share of stock in a corporation is a share in an abstraction that primarily gives the owner a right to share in the income of the corporation. There is nothing that the owner can see, feel, or otherwise experience that constitutes the corpus of his or her interest. The corporation's tangible property is the corporation's, not the property of any shareholder. The shareholder's rights have no corporeal existence. The intangibility of investment securities has meant historically that their transfers from one person to another require some special rules.

The time-honored way to transfer shares of stock is to transfer a certificate that represents the intangible shares. The transfer takes place when the owner delivers the certificate with the appropriate endorsements to another. If John Doe wants to transfer 10 shares of AJAX Company stock to Mary Roe, the classic transfer takes place when John physically delivers the certificate representing the ten shares to Mary, with any necessary endorsement on that certificate. The original Stock Transfer Act and Article 8 after it, provide rules for transfer that contemplate exactly this kind of transaction.

In 1977, an additional concept was added to the time-honored rules respecting the transfer of a certificate from one person to another. That concept is the "uncertificated security." In the 1960s the volume of securities transfers in securities markets in the United States grew to such an extent that corporations, their transfer agents, the exchanges, and brokerages could no longer process the paper. The number of certificates were defeating the ability of the marketplace to administer transfers in a timely way, not a tolerable condition in markets that rise and fall literally by the minute. The securities industry and investors were choking on paper.

At the same time, it was becoming very apparent that the markets were amenable to automation and electronic systems of transfer. So in 1977, the concept of the "uncertificated security" was added to Article 8. This concept allows issuers of securities the option of issuing securities without certificates. Transfers of uncertificated securities are registered on the books of the issuer of those securities.

The concept of the uncertificated security has not proved to be entirely satisfactory, however, and the best way to look at the 1977 Amendments is to consider them a kind of prelude to the 1994 revision. First, the states were slow to adopt the 1977 Amendments, although the great bulk of them had done so by the mid-1980s. But the slow progress did not encourage very many corporate issuers of stock, traditionally represented by certificates, to issue uncertificated stock.

But a second development even more profoundly hindered the move to uncertificated securities among corporations. As a response to the paper crisis of the 1960s, the securities industry responded by creating a system of transfers, though dependent upon the transfer of certificates, that overcame the paper crisis. The principal component of that system is the depository institutions that were developed for holding stock certificates. The chief of these institutions is the Depository Trust Corporation in New York.

The Depository Trust Corporation holds most of the certificates representing shares in major corporations in the United States within its vaults. Brokerages hold ownership positions in the stocks held in the Depository Trust Corporation, but do not ever withdraw certificates. Their holdings are registered on the books of the DTC, which assigns interests from among the fungible bundles of stock certificates it holds in its vaults. In other words, each of the brokerages has a "securities account" with the DTC.

In turn, the brokerages set up "securities accounts" for their customers, in which the customers hold ownership interests in the securities held in the brokerages' or their nominees' names on the books of the DTC. Certificates seldom are issued to customers. The advantage of this two-tiered system is that investors are served in a timely fashion. Accurate, fast electronic systems actually transfer interests in securities between investors and brokers and between brokers and the DTC. On the date this summary is being written, the New York Stock Exchange enjoyed a volume of nearly 280,000,000 shares. In 1954, the volume would have been lucky to have reached 28,000,000 shares. The importance of the DTC and of "securities accounts" is strongly suggested by these numbers.

Therefore, few corporations have opted for uncertificated stock issues. They have depended upon the system rooted in the depository institutions to overcome the paper problem. The bulk of uncertificated securities issued to date are government securities and mutual fund shares. The federal government long ago instituted a certificateless system for its debt issues. Mutual fund companies have never issued security certificates for the most part, and have avoided the paper crisis as a result.

The result of this history is a transfer system that is served only partially by Article 8. The 1994 revision remedies this omission.

Securities Accounts and the Indirect Holding System

Although Article 8 has validated transfers made by financial intermediaries before the 1994 revisions, it does not sufficiently clarify property rights for investors, brokers and other financial intermediaries in the indirect holding system. The system that depends upon securities accounts for investors with brokerages and for brokerages with depository institutions is called the indirect holding system, because investors ultimately have no identifiable relationship with the corporate issuers of investment securities.

An investor holding certificates registers ownership directly with the issuing corporation, and an uncertificated transfer occurs upon registration with the issuing company. An investor with a security account at a brokerage has rights in shares held in the brokerage's name (or nominee's name) with the depository institution. There is no relationship between investor and corporate issuer.

Therefore, without some further recognition of the indirect system in Article 8, rights are uncertain. It is of particular importance to have rights and priorities clarified for the purposes of obtaining credit. The revisions to Article 8, along with accompanying amendments to Article 9 of the UCC, assure that investment securities can be safely used as collateral for obtaining credit.

The credit issue is important to individual investors, but has enormous significance for securities markets. Part of the genesis for the revisions to Article 8 and amendments to Article 9 was the stock market crash of October 17, 1987. The Securities and Exchange Commission in its subsequent findings indicates that one plausible reason for the precipitousness of the crash on that particular day was the inability of the market makers and specialists in the New York Stock Exchange to obtain rapid credit from the banks in their efforts to support the market. It is a fair conclusion that the improvements in attaching and perfecting security interests under revised Article 8 and the amendments to Article 9 will help inhibit future market crashes.

The Security Entitlement

The primary innovation in revised Article 8 and the answer to the problem of rights in securities accounts is the concept of the "security entitlement." A "security entitlement" is a property right that a person obtains in the contents of a security account with a "securities intermediary." That term encompasses investor accounts with brokers and brokerage accounts with depository institutions. In general, a "security entitlement" guarantees an entitlement holder a priority in the financial assets held in that account over the securities intermediary or the security intermediary's creditors. The securities intermediary must follow the entitlement holder's directions with respect to the contents of the account. In particular, the securities intermediary must honor an "entitlement order" which is a communication from the entitlement holder directing transfer or redemption of a financial asset in the account.

Most significantly, the "security entitlement" may be used as collateral in obtaining credit. A creditor may take a security interest in the entitlement under the amendments to Article 9 that accompany the revised Article 8. That security interest is unambiguously perfectible and enforceable.

The "security entitlement" and all the rights that flow from its creation are the major innovations in revised Article 8. They solve the problem of the security account and the deficiencies of law respecting the indirect holding system. There are some other things to note about revised Article 8, however.

Securities and Financial Assets

The advantage of being subject to Article 8 is the free transferability of interests in investment securities—free from adverse claims that are not known. The classic transfer of stock by physical delivery of a certificate with any required endorsement suggests treatment of that certificate as if it is a negotiable instrument. Although securities certificates are not negotiable instruments under Article 3 of the Uniform Commercial Code, the transfer rules parallel with much the same effect.

Some investment mediums have not been regarded as subject to Article 8. To some degree the choice of the issuer has always ruled. If the issuer wants to issue securities that obtain the advantage of free transferability, the issuer uses the established certificate form or issues uncertificated securities. If not, the issuer provides a different form for representing the particular investment security and Article 8 does not apply. Some investment contracts, such as commodities contracts, have never been subject to Article 8. The only way to trade such contracts is through the open outcry system of the commodities exchanges.

Ordinary stocks and bonds have been subject to Article 8 without question. There has been some question about stock shares in closely-held corporations. Other mediums about which there is some ambiguity include mutual fund shares and limited partnership shares.

The revisions remove the ambiguities. The principal determination of what is a security or not remains the form in which the investment medium is issued. If certificates are issued or registration of uncertificated securities is instituted, and if the medium is divisible into a class or series of shares, participations, interests, or obligations, it will be a security under Article 8 provided that the shares or participations are traded in a recognized market or the medium of investment by its terms declares it subject to Article 8.

But beyond the general definition, Article 8 more specifically addresses some investment mediums. Shares of stock are explicitly securities. Shares in investment companies (mutual fund shares) are securities. Limited partnership and limited liability company shares are not securities unless dealt or traded in securities exchanges or markets, and unless the terms of the medium expressly declare them to be so or they are investment company securities.

Options and commodities contracts are specifically not securities. Commodities contracts are specifically not financial assets, either. "Financial asset" is another definition in revised Article 8. Securities accounts may include securities, but may also contain other assets that are not "securities." The term "financial asset" is defined broadly enough so that any asset in a security account is subject to the rules on securities entitlements. A "security" is a "financial asset," but so is a certificate of deposit or a negotiable instrument, which are not securities. The broader definition is necessary to govern all contingencies.

The definitions of "security" and "financial asset" iron out the questions about the various assets subject to Article 8. They make it fully possible to implement the concept of the "security entitlement." The result is a much more viable Article 8.

Simplification of Uncertificated Securities

When the concept of uncertificated security was included in Article 8 in 1977, it was a totally new idea. Time and experience indicate that the implementation of the concept could be simpler than originally envisioned. In addition, simplification may encourage more issuers of traditionally certificated securities to issue uncertificated securities.

The principal simplification concerns the documentation of an uncertificated transfer. The 1977 Amendments to Article 8 require the issuance of an "Initial Transaction Statement" by the issuer at any time a transaction is registered upon the issuer's books. The ITS must be sent to both transferor and transferee.

The 1977 Amendments also authorized the registration of a pledge as a means of attaching and perfecting a security interest in uncertificated securities. Taking a security interest in an uncertificated security could be accomplished by registering the pledge, or by registering the secured party as a transferee. Registering the pledge preserved, automatically, the equity ownership rights and income from the security to the debtor.

The fact is that these are matters that can be left to agreement between parties and other law. Specifying them in law merely limits the flexibility of issuers and investors. So the specific provisions for the ITS and registering the pledge have been removed from revised Article 8.

Attaching and Perfecting Security Interests in Securities and Security Entitlements

A primary objective of revised Article 8 and the amendments to Article 9 is to ease the taking of security interests in securities and securities entitlements. These revisions and amendments also incorporate commodities within Article 9 even though commodity contracts and commodity accounts are not securities or security accounts under revised Article 8.

The amendments bring all provisions relating to attachment and perfection of security interests into Article 9. Some provisions that were included in the 1977 amendments to Article 8 are therefore eliminated. The original method for attaching and perfecting security interests in investment securities remains the same, but is expanded upon.

A new concept of "investment property" is incorporated into Article 9. Investment property includes securities, security accounts, security entitlements, commodity contracts and commodity accounts. Remember that commodity contracts and accounts are not subject to Article 8 transfer rules, so that it is necessary to find an Article 9 concept that is broader than the Article 8 concepts. "Investment property" is that concept.

The traditional and exclusive way to perfect a security interest for a certificated security is for the creditor to take possession of the security. When uncertificated securities were introduced into Article 8 in 1977, perfection required registration of the pledge or of the ownership of the secured party on the books of the security's issuer. But these are inadequate methods for perfecting a security interest in the broader category of investment property. Therefore, the amendments to Article 9 provide for two ways to perfect. The first is by filing a security statement as is done for most personal property subject to Article 9. The second is by taking "control" of the investment property. These options are now available to secured creditors.

"Control" is the broader term that incorporates possession of a certificate for certificated securities, and registration on the books of the issuer for uncertificated securities. "Control" also can be taken over securities accounts and commodities accounts by agreement between account holders, intermediaries, and creditors that ensures the power of the creditor over such accounts to give instructions to the intermediary without the consent of the account holder.

Security interests taken in the accounts held by intermediaries are perfected automatically at attachment, and no further steps are necessary to perfect.

Perfection is a common term of Article 9. It is the event that determines a creditor's priority with respect to other creditors of a debtor in the property to which the security interest attaches. Having a security interest means that a creditor can take the subject property to satisfy the debt if the debtor defaults on payment, if that creditor has a security interest that has priority over any competing security interests. A creditor with priority over another gets to have his or her debt satisfied from the collateral before the other creditor.

Secured creditors have priority in the property that is collateral over unsecured creditors. Between secured creditors, generally, priority is a matter of first in time to obtain perfection. There are some special rules in the amendments to Article 9, however.

Any creditor who perfects by taking control over the investment property has priority over a creditor perfecting a security interest by filing. If more than one creditor has "control," they have equal priority. Any intermediary (brokerage, depository institution, etc.) with a perfected security interest in a security account or entitlement or commodity account or contract has priority over another kind of creditor's security interest. Security interests in favor of brokers or intermediaries that are not perfected by control have equal priority. Otherwise, the usual rules for priority pertain.

With the amendments to Article 9, taking security interests in investment property becomes easier and surer. The function of revised Article 8 and amended Article 9 become much greater. These revisions and amendments need to be adopted by the states as quickly as possible.