A New Legal Structure for Credit Support

Robert M. McLaughlin, a partner with the law firm of Eaton & Van Winkle, explains why revisions of New York State law could help derivatives innovation.

New York State will soon join the growing number of jurisdictions that have enacted ambitious legislation designed to modernize the laws governing securities transfer and pledging practices, which are important elements in derivatives transactions. Bills introduced in the assembly and senate in March would incorporate so-called "1994 Revisions" into Article 8 of New York's Uniform Commercial Code (UCC). The revisions will clarify and simplify the legal effects of common market practices largely unforeseen in 1978, the time of the last major Article 8 revision. These new changes, which should be enacted once the legislature frees itself from an unwieldy budget debate, should also eventually reduce transaction costs and render the UCC more responsive to future market innovation.

This is good news for all derivatives market players, because the legal uncertainty surrounding the use of securities as credit support in derivatives markets has held back the development of these markets. The revisions are long overdue, yet many players have questioned the need for the changes because they believe that securities pledges are commonplace transactions that give creditors well-defined legal rights. In actuality, this is seldom true. Thus it is no surprise that academics, government officials and domestic and international bar associations have voiced loud disapproval of the existing legislation.

Are pledges worth the paper they're printed on?

As the derivatives business has developed, it has become common for institutions seeking access to derivatives markets and improved pricing to pledge investment securities and furnish counterparties with assurances that the pledges work. Secured parties need to know they can immediately apply pledged securities toward net amounts owed to them if a default occurs. But under New York's current Article 8, such assurances can be problematic.

Consider the following example. First, say an end-user holds 50,000 shares of publicly traded AT&T Corp. common stock in an account at a regional broker. The broker holds no AT&T stock certificates, nor are any AT&T shares registered on AT&T's books in the end-user's or the broker's name. The broker, instead, maintains all its customers' AT&T shares in a single account with a national securities firm. Similarly, the national firm holds no certificates and is not a registered owner on AT&T's books; rather, it maintains a single AT&T account with the Depository Trust Company. DTC, the only owner registered on AT&T's books, holds one jumbo (or global) certificate representing all outstanding AT&T shares. Hence, the end-user's ownership of its AT&T shares is, for all practical purposes, shown only by a series of book entries.

Second, the end-user enters into an ISDA master agreement, supplemented by a 1994 ISDA credit support annex, with a swaps dealer. The end-user agrees to post AT&T shares as collateral whenever its net swap obligations exceed a specified threshold amount. The annex includes standard end-user representations as to, for example, its ownership of the collateral and the first priority status of the pledge, free and clear of all other encumbrances. The violation of any representation is a default under the ISDA master agreement.

The end-user and dealer likely expect the pledge to convey to the dealer clear rights in identifiable securities and, upon foreclosure, equity interests in AT&T. Nevertheless, that may not be the result under New York law.

Layers of intermediaries

Most non-cash derivatives collateral consists of securities held indirectly through financial intermediaries, including banks, brokers, clearing corporations and other entities that ordinarily maintain customer security accounts. The volume, size and speed of derivatives transactions would preclude timely processing of pledges if not for sophisticated clearance and netting functions performed by intermediaries. Those functions depend on highly automated electronic processing which, in practice, obviates the need to shuffle certificates around and register transfers on issuers' books.

Analytically, it helps to think of the indirect holding system as a multitiered hierarchy, with issuers, such as AT&T, at the top. Just beneath them are depositories-like the DTC-which often hold jumbo certificates representing all shares of each particular issuance. The certificates are immobilized at the depositories, meaning they will never be physically transferred. Participants maintain omnibus accounts at the depositories in which are recorded their interests in specified quantities of shares covered by the certificates. Below the depositories may be multiple tiers of intermediaries, which act as custodians for their customers, including other intermediaries. Retail customers occupy the bottom tier.

The indirect holding system enables market participants, such as the end-user in the example above, routinely to execute electronic transfers and pledges of securities held in "fungible bulks," or pools of indistinguishable units. Furthermore, at each tier in the hierarchy, the ability to net transfers reduces dramatically the number of entries to be made to accounts maintained at higher tiers, because many same-tier transfers are offsetting.

Intermediary credit risk

An important consequence of New York's Article 8 is that a right to securities held through an intermediary as part of a fungible bulk is usually only a "proportionate property interest in the fungible bulk." Essentially, a customer, and its secured counterparty, has merely "a claim against [the intermediary] for the value of that security and the reasonable hope and expectation that [the intermediary] holds or otherwise controls sufficient securities to satisfy that and all other similar claims," according to Martin J. Aronstein, professor of law emeritus at the University of Pennsylvania Law School. Regulatory oversight and other investor protections (for instance, Securities Investor Protection Corp. insurance) may mitigate, though not eliminate, the risk of securities shortfalls upon the intermediary's insolvency.

Because of intermediary risk, parties to pledges should, in structuring and pricing transactions, consider carefully the creditworthiness of the intermediaries that are involved. A secured counterparty's rights in the collateral may depend on the immediate intermediary's location in the securities hierarchy. In the earlier example the national firm might have been able to repledge or rehypothecate as collateral for its own overnight borrowings the AT&T shares it controls. Upon that firm's insolvency, the end-user's (and thus the dealer's) claim might be junior to that of the overnight lender; the end-user would not be a bona fide purchaser whose claim in the rehypothecated shares would defeat the overnight lender's, because the securities are held by an intermediary as part of a fungible bulk.

Defects are technical but serious

While Article 8's defects may be highly technical, they can be serious. Typically, securities pledges give rise to little doubt about secured parties' rights. But that may be due to the infrequency of intermediary insolvencies and the availability of non-UCC investor protections. Doubts do occasionally arise, especially when a market or firm experiences a liquidity crisis. Then creditors' comfort with collateral can decline precipitously. Indeed, perfection and priority concerns may have exacerbated the October 1987 market break and the collapse of Drexel Burnham Lambert. More recently, legal uncertainties may have contributed to the downfall of Askin Capital and to other infamous derivatives disasters.

According to the prefatory note to the 1994 Revisions, the difficulty with the 1978 Revisions is they "engrafted onto a structure designed for securities practices of earlier times" a tangled web of complex transfer and perfection rules. When Article 8 was first drafted securities were pledged by deliveries of certificates. The 1978 Revisions attempted to adapt Article 8 to the explosive growth in securities trading that was rendering physical delivery irrelevant. The revisions hoped to accommodate the anticipated dominance of uncertificated securities, thereby minimizing the emphasis on physical delivery. Unfortunately, few issuers abandoned certificates entirely. Today, virtually all publicly traded corporate securities used as derivatives collateral are covered by jumbo certificates, though they trade by book entry at and below the depository level. Government securities, which are uncertificated, are treated for transfer and pledge purposes as though issued in certificated form.

Consequently, in many ways New York's Article 8 bears only a passing resemblance to actual market practices, which still employ certificates. The resulting legal uncertainties may jeopardize the essential benefits of securities collateral held through intermediaries as parts of fungible bulks. As Professor Charles W. Mooney Jr., of the University of Pennsylvania Law School, observed, the 1978 version of Article 8 results in a "distorted characterization" of rights in securities that "promotes unnecessary costs, uncertainty, and arbitrary and fortuitous results."

Partial solution

The 1978 Revisions were a reasonable response to the paperwork crunch of the late 1960s. Unfortunately, they assumed that markets would soon become uncertificated, direct holding systems. Today, most securities markets rely on certificates and employ the indirect holding system, although that could change in the future.

To adopt to present practices without making any predictions as to future market evolutions, the 1994 Revisions are designed to accommodate both systems. Thus, they retain basic Article 8 rules for direct holding systems, but add a new Part 5 governing indirect holding systems. They also downplay distinctions between certificated and uncertificated securities.

Part 5 specifies the bundle of rights obtained by an institution receiving pledged collateral that is held through an intermediary. The bundle is named a security entitlement. It is defined, essentially, as a pro rata property interest in the underlying securities, which are in turn expressly excluded from the intermediary's property. Part 5 requires that each intermediary maintain sufficient financial assets to satisfy the claims of all entitlement holders.

The 1994 Revisions also amend Article 9 to simplify the procedures for creating and perfecting security interests in securities. Revised Section 9-115 permits a secured party to establish control over a security by taking steps to enable it to dispose of the collateral without the pledgor's further cooperation. This can be accomplished by registering the securities in the name of the secured party or by obtaining the intermediary's agreement to act at the instructions of the secured party. Perfection can also be effected by filing an ordinary Article 9 financing statement, but a secured party with control defeats one without it.

The modest objective of the 1994 Revisions is not to change the law but to clarify legal issues inherent in the existing Article 8 and make their resolution predictable and clear. The main difficulty is that the revisions introduce a new and unfamiliar vocabulary and new mechanical steps. It is difficult to see why that would be a heavy burden to bear, especially in light of the competitive advantages to New York derivatives participants in modernizing their commercial laws and, of course, the competitive disadvantages of failing to modernize.