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Citation |
- Permanent Link:
- http://ufdc.ufl.edu/AA00055680/00007
Material Information
- Title:
- North America. Volume II, Part 2 Maintenance of Market Strategies in Future Broker Insolvencies: Future Position Transfers from Troubled Firms
- Series Title:
- Study of international clearing and settlement
- Creator:
- United States. Congress. Office of Technology Assessment
- Publisher:
- U.S. Congress. Office of Technology Assessment
- Publication Date:
- 1987
- Language:
- English
- Physical Description:
- 426 pages.
Subjects
- Subjects / Keywords:
- Clearinghouses (Banking) ( LCSH )
Bank deposits ( LCSH ) Financial institutions ( LCSH )
- Genre:
- federal government publication ( marcgt )
Notes
- General Note:
- This report discusses clearing agencies with the Securities and Exchange Commission that are an integral part of clearing and settlement for the national clearing and settlement market system. This is the part 2 of volume 1.
Record Information
- Source Institution:
- University of North Texas
- Holding Location:
- University of North Texas
- Rights Management:
- This item is a work of the U.S. federal government and not subject to copyright pursuant to 17 U.S.C. §105.
- Classification:
- Y3.T 22/2:2 EL 2/11/v.2/PT.2/A/NORTH ( sudocs )
Aggregation Information
- IUF:
- University of Florida
- OTA:
- Office of Technology Assessment
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PAGE 1
Collection of expert pnper.s on cleoring ~d3.2~:/~_;)l~ll~j ~~--~-Al~-~~ papei:s are part of Stud~f l'!l!.!U-:nntion:-.t_Clearin.g_~nd Settl~ment, Vo1 Bankers Trust Company, 259 pp., October 1939. This collection is orv,~!. follows: North America, Part!; 1 c.nd ~; Eurore; North~ast Asia/Austc11.l_ t:< Supra Regional Topics. VOLUME II, Part 2: NORTil AMERICA 13. t1rsintenance of H:irket Str:itctles in Futures Bl."oker lnsolvend.r .: Futures P~sition tr.ansfers from Troubled Firm~, Andrea H. Co.:-coran and Suu:r. C. Erv.i.n, Commodities Futures T1adini; Commission, 1987, \.lashin6ton snd Le~ Law l!avicw, Vol. 44: 8::'1. 11. vievpoint: Ferception and Opinions of a Non-United States P:i.rcnted Firm Doing Bli::iness in the United State:; and Uorld Securit~s Ma~kets," Dai~a Securitica Am~ricn, Ir.c., Sumr~er, 1989. 15. "'rhe Fede'C'al Reserve \Jire Tr,.nsfer Netvork, 11 1989, and "Secu::iti Lending, >.ugust, 1989, the Federal Reserve Bank of New 'York. 16. "The Securitle~ Investor Proteccinn Act: An Overviev, Theodore H. Focht, Securities Investor Protection Corp., May, 1989. 17. Issues, Risks and Opportunities in Ciearing and Settlemer.t, Philip Hubbard, Peter Reed, and Beth Shapiro Kopln, C~ic.ir,o Research and Trading Group, Ltd., 1989. 18. "Clearance and Settlement in the Municipal Bontl Market in the U.S.: An O\eniew of NSCC's Uational System for Municipal Bci,~i Processing, 11 H.irgaret L. Koont~, National Securities Cle.0rirg Corp., Aug. 1989. 19. "Automated Clearance and Settlement in the Huriicipal SE-curities Ma:-kP.c: A Report t'l the Securities and Exch:mge Coir.1Jissio:1," Municipal Securities Rulemaking Board, Har. 31, 1988. 20. "Beyond N~gotiability: A New Model for Transfer and Pledge of Interests in Securities Controlled by Intermediaries," Char.lEs W. Mooney, Unlv. of Pennsylvania, July 17, 1989. 21. "Custoner Account Protection Study, National Futures Assoc., Nov. 20, 1986. 22. securities Transfer," Raymond J. Riley and Michael J. Foley, The Securities Transfer Assoc., Inc., July, 1989. 23. "Clearance and Settlement in the U.S. Securities Markets: An Overviev of the Role of the Nation4l Securities Clearing Corporation in Equities Tradinc," and "Clearance and Settlement in the Markets for Govern11ent Securities; An Overview of the Role of the Government Securities Clearing Corporation," Robert \.1, Yoldow, National Securities Clearing Corp., Feb., 1989, revised July, 1990. 24. "A Strategic Plan for H4naging Risk in tho Payments System, Report of the L.1rge-Dollar Paywents System Advisory Group, Board of Covernors of the Federal Reserve System, August 1988. This document was prepared for the OTA Background Paper, Ixl..sUn.Uround __ ;:1~ Clock; Global Securities Ma;:}cets and Information Technology, July 1990 ~~1d report Electronic Bulls and Bears; o,s, Securities Markets and Informat.: l Technology, ~eptemi>er 1990. This document does not necessarily reflect ::~-:; analytical findings of OTA, its Advisory Panel, or its Technology Asses-;;._ Board.
PAGE 2
KAINTINARCI or JIAUIT STkATICIIS IN POTOU BlOIER INSOLVENCIES: FOTtJIE POSITION TRANsrns nox TROUBLED FIRHS BY ANDUA H. CORCORAN AND SUSAN C. ERVIN COIOIODITIIS FUTURE TRADING COMMISSION 1987 VASHINGTON AND LEE LAV R.!VIEV VOLUME 44: 849 This contractor document was prepared for the OTA Background Paper, Trading Around the Clock: Global Securities Markets and Information Technology. July 1990. and OTA Report, Electronic Bulls and Bears: U.S. Securities Markets and Information Techno ~. Sept. 1990. This docment does not necessarily reflect the analytical findings of OTA, its Advisory Panel, or 1ts Technology Assessment Board.
PAGE 3
MAINTl:NANCI! 01-' MAMKl:T STMATl!Cill:S IN FUTURES UROKl!R INSOLVENC:U:S: fUTUMl:S POSITION TRANSfl!RS 1:MoM TROUIII.ED FIMMS AN1.>a1A M. <"ua&:oaAN and SUSAN C. fav1N INHODUCJION lnaasillal,, blab, pnnioll rune, Nd a11wr llrac 11111il .. ional illvaaor, IClilll a _,_, ......-, ror lhc uviftp fJI IINII public antOIIICfl arr rn1nl111 1hc llillion'1 r111111a ..,cu. A a ,null, COIIIIIIOdll, lwolcra, or ru1ura commiwon incrchanla CFCMa),' arr brcomint aubllaaual r---.-..1 l111rnncdiarica. On 1hr awrra,r, an lCM 1oda, holdl ..,, lhu 1.16 lllillicNI i11 cuuomrr Ju.la, owrr ruur 1ima 1hc ,_, fiprr.1 Allhoup FCM railura and rcwlliftl banrut111.ia rrmain unuaual rvrn11 and lhc ra1cra1 rq,ilalnr, and indu11,, artr-rqulalor, prC11111.1iuftl lll'nll IUdl rwa111 hlvr inciralrll aulN1111ia11, In 1hc pua dccadr, rvn 1hc pn1rn1ial ru, cllllomrr luu and mah1 diuupuon llcmnaifta r,om an FCM ruurr un,lcncora 1hc need rfff rrrcaiwc rClpl)IIICI 10 a lwokn inlolvn-=,. In lhcir ablrra, 1hc raullina loua : "C li.dy 10 br warwcd M lhc dilUlrOUI P,1 or Ufti11rormcd pmll(IIICl'I lil1lc able 10 bcu 1hml ra1hcr 1hln I foracalllc COMCqumcc or poor crcdil Ma tor, .... .. birKI. _. Ma. t,,,. ii ,i. lllwf t-i. of ,i. Diof ,,..._ _. ...,, .. ,. c_,.,, n ., .... ,--. w....._.., u l" llw ,.,_,.., n ,, .... -lllnna .,, 11111t, lllow.,, ,i. NIM.,,. _,...,,., ,,,.,,_, ... of ... ........ ........ ,, ... ,-.... u.-of ,, ........ ........ I. Ti.,._,., 1:'adlMet A, 7 U.S C I I IIWZI r, 11-, 1i. lldtlal ,,..,...., f,_. ft# ,--,,., 1 uedt .. 18 llw U1111H Sllln, *ftan "ln ,_,.,. _,,111111" IO ...................... -IMMI, ,,.,._....,.,
PAGE 4
uo WASHING1VN AND LEE LAW REt'IEW I Vol. 44:149 da1M0111 bJ aophilalcaled, illfOlmcd 1n11i1111ioM penidpalill1 ill comple1 11111 htl.1 c_., llrolcn cwrt1111J subject 10 direcl ,.., .. rqul1d011 under 1ht c ........ EldlMer Ac1 (0:A Acer 111d rcpliliml promulpled lhffNllda,' .. wdl .......... .,, llldullry .. ,., ... .., ...,.. ... C510.t 1h11 wb;..t 10 federal owtrlipl. la 1974, eo.a,na tlllblWled lht CmNIIOdll, f .. 11111 Trlllirll Caaua 1116ole (CFl'C or Colnmiuiorl) 11 lht IIKXfllOf 10 1111 c_., E1ct111111 A11111ori1, INlder 1ht Dlplnmn1 of Apialllwt _. \llll9d ii Will IICMhe jlndictiole owtr COIIIIIIDdlly flllwn 111d op1iolel .,_..1a 1111 Uflllld si... TIie CFl'C ..._..en 111d .. rorca 1ht prowiliaa of 1111 CEA 111d rtlllal nplaliorll, wllidl indudt ....,....., for lole of FC'Ma' 11111 a111tr camadilr profcuiofllb, caaplilncit br FCMa 111d OIiier enc npar wllo IIMdlt cwaa.r funda will11 lllinirnum rlllWill ,.qui s r n a:r:tfia..., a,, 11111 CFTC, wioa of 111d ..., .. arwuairla for cwaoraa ... a,, FCMa, .. fflllllCit of lllequalc boob and near," ........ riak dilclmwa 10 Cllll_..,11 ud auptmUOII of cuaewr ~ _. pcnad ......_ IIICIII 8CICIDIIMl,11 I lddil.,.101ht ctTC'a 1111horilr 10 1 fa' 7"1 and cnfON:11 IMlt ud olla rcplllory 11-quir,_., direcdr, 1111 CEA can1tapllla llllc ncrdlc of 1Uba11n1ill MlfrtplllOfj ra,oMIWilin br _. daipaled co11uact ..,kcl Cnchlrltt) ud ...-aed flllwn auodll ... N Eadl S10 la fflllllred 10 IIIIUIII. M .m,. IIIIIIM act .. prap 10 ..... lht ialqrilJ of lht IUfkCII ii aupcmaa, lht fillMdll Yilbililr of iu ...._,, ud 1ht aalttr of eu11omcr ,_._., J. OIi ONlla II, 1. 1111 Dew ,_ ......... A,.111 fd -,..., II ,,, __ .................. ill .... ........... ... ., J ...... ,., ..-.... ......... .. _, ..... .......,.. ........... ill ......... ........ ... ....-., ...... ., ,. ............ darllle nr.. _.... ..... of ............................... -........... ...., ... _, .. ....... ,,_ ........ _,.., .... ill ... ... "_, ... 4. 1111 c:_., ACI, 7 U.S.C:. I I ., -. t1J1 t. 11 C.f.l. 11., flW. ua. c_., -,, ... Ad ., ,,, M. L. Ha ... ,. Si .,., u,,.,. 7. s.a.. ... II el !ill CEA, l U.SC. I Wilt C1J1 I. _.._ 6, 41. _. 4a el .. Cl'A, 7 U.S.C. II a. 61 CIIUJ. ,. Sec"4'1JI el ... cu. l u.s.c. I "CJI uJ1. cnl" ..... ,. 11 C.f . I ... 11-71. ....,._ 1111 a,llal ...... 1e ...... llr fCMa _. ,_... ...,..,. ......... FCM'.........., ..,...,_ Eadl .. .. -: .... 11, enc ................. ....... ..,_, ......................... .... ... ..._. ...... 1...,_1 ........... llr ... C'f'TC' ,..,... __ ll C.t.l. I UJ .... ,,. II ..._ ... JI et .. CEA, l u.1.c. I WIJt CIIIJJ. II. 11 C.F.I. H 1.11-1.H Cltll). IJ. 11 C.f.l. I 1.H e1. n. n c.,.1. I IM.J CltllJ, -c-......... fllCllaln ..... ......., .. .,..,cnc,-.111 ., .... el .... flll-- l U.S.C. II J, l CIIIJJ. 'ht .... .._.,__ A d Ike INFAI II cw..., ... ..i, ....... '"n ........ U. U.., Ill CEA ...i l"-., ..... .._, ROa -..... _,, .., "affil-M MINIII ...... -IOH .. ii......., Cl!A ......... C--...... ........ ...i _,..,.. -' ~-,.._ ,.,...._, u.1.c. H 1ac11.
PAGE 5
19171 MANA:tT Sl'llATt.G/l;'S ISi In 1he nme 1h11 dnpitc 1uch rqulIOfJ and wff-rr1ul11otr fl'oaram1 an t'CM failufc noncihelnl 111.1:un, another i:1>111111u1h1r-rdalnl IIIIUIOfJ frame work, Subchapcrr IV of (.'l\lpccr 7 of lhe llankrUfllCJ Code,'" fflklcd 1n 1971 10 addrcu problnn1 unique 10 commod11r broln" failurn, mar bear, .able. Allhouah lhclc bankruptcy pro"iilHII arr dnl1ncd 10 minim11c LUIIOIMf loun and markCI d11kk:1110N caulcil bJ btukcr 1nlOl"crkin, 11w, lw"i: bttn 1n fllkc fo, on1, 1m ,can and. li"cn 1hc rucurn ind1111rr'1 record of rrl111"cl' infrcqurn1 illlol"cnclCI, "'"' wldum bcm called into ll(ICrllion. In lhc ab_, or 1Ubll1111ial hi11orical rapawncr 1r11in, 1hc cff11:1Cr ur rr1ula1or, and IClf -rqulalory rnponlft 10 comrnodMr brolirr iruol"mca, 1he conscqucncn of commodilr brokrr failurn rfflllln uni:main. Rci:cnc dr"clopmmu, ho"""". indudina the March 19U failure or Vulumr ln"n1ot1 Corrcw1111>r1 (Yolumrt, a rr1111rrcd Fl"M ilnd a ctcar1111 mnnbrr or 1he ComnlOll!tr hLhanar, lnL. CCOME)O, increuin1 pa,1icipa1ion in the r111urri marh11 by profnwonallr manaacd fullll1, 1ueh u pmliun and mutual fund,, and public coni:rrn ow-a marliCI volllibly and lhe rffrcll of "info,m,iiMln1" lecllnical lrad1n1 pro1ra,u, havr lhalpnwd public inrnnt in 1hc 11111rn11al cusromrr and n111kct irnp11.11 of co,nmodilr brolirr inlol\'ffll:a. Slk'.11 1.XM11:rrns, ill the con1u1 ur innasinalr incrrlkpmdmt mare11, Wllftl the importance of dilpcll1111 un i:rrcainrr cuni:rr111n1 the con~urncn ur brokm 111111,n and lhe cffkkJ or the rqulalorr nd ldf-rqulaao,y rftpOIUft 10 1111.il nrnr1, unccnainer wh11:h maJ advrncfJ lffrcl lhe OlhaWilC P,OYCn rqulalory 1,Wffll fo, (UIUlft and ru1urn oplionl. Thil 111iclc raaminn one brokrr'1 failure, 1h11 ur Volumr lnvnco,1 Corpor11ion, u an iUu111a1ion or crnain cu11omrr ind 11111e1 protecuon problcml which can br Clllffldrrod bJ a commodlly brolirr'1 f11lurr, Ulftlft currcn1 rqulalory protectiont apinll IUCh problnn1, and IUllflll potmli&I improvcrnr1111 10 lhe .,.. . This anal,ail IUUCSII 1h11 llhouah a foolproof rqulllorr shield qainsa the effects of a commodity brolirr'1 fallurr ma, br impouiblc 10 con11rue1, a 1y11cma1ic appra.'11 toward achinina 1he 1wo princi,-1 10111 or any mcanin1ful rqulalory rnpomr, cullornrr protrction and marlirt in1r1rilJ, may br both pcK1iblc and prltlicablc. A1 pr01rc11un ur 1he cuaomrn or 1he failed rum and protcaion or 1he overall niarlirt q1in11 7llftl, Jllpl, 111111 Jllf Clcmfllll Of.... 181111 811 ......... Ill ,-1111\lkNI ....... -1.SI. IH" . SICINll .w ..,u,.,_, .. ,, .... .., ..... w., ..... t; .. ........ Ht, J," I('-t111 L. acp. ll'UII 1 MJO 1Ma, II. 1'11,a 111all 111o1a--ur N11ulo1""' I.SI ,......,,_,. !talll a1111 al,o.....,,. .... ,.,,.., 111lt1 p,ncullo"I 1111111 hnonual .... rclale,1 ,.,._,,.. l"IINI,__,, for lhcN -lwn llo Ml 11111111'11 tCM1 INI ln1 11un11M ,.,.. 111aw ..,.i,ca1111 ...., enc ,.,....,_, .,.. ,..,., ...,_.,., .. rorer - '""' 111 fmlll .....,_I U, 11 Cf I. 11.U $pK1II( trq1N1.-11U r .. 510 f1u11Cial """lhl .,..,_ .,, __ ,fNI ill 1111 u,.,_ of 1,...,..., Ma,,n, t'-"'..i allll ~111111-ln,-11111N -1. I c-. FIii. L ..... ca:H11 llltA ., ... Jt. 19111. II u.sc .. ... ,.., INClld" "''Ill .......... Pl<, atloe ,\(1., ltll, Plllt L. No .,.,,., ,1 s.11 ua 11t111. 11. TIii .... ,,..,.er Ca* - ",--...her "'"'"" 10 _...., fCM, 1 .. ,,.., fCM. clra,ifta .. ,_,.. __ lrwaae .,..,..._,_ -,,11a111 11111 c-..lilr ..,._ *Ir ull ,..,.. IO llicll lllnl II a c1111-. a1 dcl_,, Ill SKI-1611'11. II USC 1101111119111
PAGE 6
H2 W UIIINGTON AND LEE LAW un1:w IYol. t4:14t 1hr "doaiao" Of "ripple" tfflCII of I fira f..,_ .. IIOI _...,ilJ Ill ....................... 11111 ....... Clllloaer praleClloa ...... ......... ..... ..... ....... nplo,ed. PIii I of lllil .. id, rnlrwl 1111 fKIIIIII CIINIIII..,.. of Yoluar'a ., ... Md ...... ..........,, ........ of .......... lhl illdiridull CUIICIIMfl of Ille r .. Md IM ....... I wllole, 111d llpifil:MI r,aulllorJ .... rlllld., llloll Mal. I PIii II, lhil .. idc lddrnaa pu-wilioM of Ille ._.,..., Codr Md C'fTC ,......_ 1h11 rClpOlld 10 1111 INliqilC prolllcal ,,__. br C101Faar!tl)I ..._ ~-'lllil .... fucutn upoa Ille IWO ....... ,..,... of Ille ........... niplCJ Code P,OYililllla, P,Clllial of Ille a.-. of ..... FCM Md ..... llt't of lilt ..... of ... "" ........... fa of -fCM flilure, end lhc IIIIIIIOfJ 111d rq11ll1ot, .. ...,a llllndld 10 NWIIICC lllolc ,..,. po1e1. Tllil -,iorl allo ....,_. 1111 lilct, lflkac, of Ille Cude'11ra1ara1 of lilt lrMlfa of ClpCII flll-paeilloM of M ......,_ 1-cM IO IGlCIII l'CMa 1 wlllctc f IICIIII aaa_. .... pr....._ br ,,_... lhc Nllllill ......... rill ndlll:sloa f ...... of ... ___., flllwa - 11111 .................. ,._. .. fna FCM failure. Pan Ill COlllidcrl di, Yohat tpllodr a llpl of,_, .... fllPICJ Code pollda, C0111.iudilla IMt wllill Ille Codt'a ,., ..... pwpOIII were ....._ .. adlifted, 1111 pl of .,...,.,.._ poa11.,.. .. aCII, 1 111111 rcflciaa 1h11 ill Ille Cllffcal ldf-tcplllor, CINICII IM recowry of ..... .,.., OCr INIIC 11 far IIIOIC radilJ achanlblc lllala ........ IM COIIIRuilJ of opn COIi UIICIUII pmilloal. Pan IY diK.1111 pCllcalill prldial bcncf"III of pmilioll 1rwfer1 for ca11 tDdilJ CllaOlllffl Nd acllcr ..,. .. P111il:ipllll1 111d 1hc difficullla la ldlicWla 1i.. Nd .....-, -111111 could Ill IUCII 10 incf-Ille lillllillood 111111 lfwfcn of:poailloal fraa IMahal 10 aolval FCM, will omir ill IM f111 ... TllclC IIIIIClllml reflld Ille view 111111 If lbc COIH Md 111Mf111 of I prop .. IO cffa1 palllioll ., .. ,en N I 1J91ca11ic Nlil __, card.., ...... 1111 flllwa ..... ,, CiOUld wcl CORdlidc 11111 I ....., f ..... P,CIIJ WOIIIII IIOI -, 111111 I flilld rirra'a CUlloatn bul Ibo would ,-1 alpUicul ...ic bcncf"III for IM cachanac -plli.:c U I whale, ., ...... dcarina rill Md prCICfflrll 1111rl llrllqicl of imponlllCI 10 flllwa ...... plflicipMII, llowl\flr aophilliclled. I. THI DuAULT AND llcamu,ap Of YCII.UIII INYUTOU COUOUTIOH A. T EYllffl o, .-,,111., AND ~noN On Mardi JO, ,, Yolwnr lrMllorl Corpu,11loa, I dcarirll fflCfflbn of 111C COMEX Md of 1CWCJII oahcr dcuina orpniulioru, dcflllllcd on 1 ""'"" call f,a lhc C'OMEX C'larinl AIIOl.illion CCOMEX Clcariftat rt ported II In acm of founeca lillion dullln.11 Al 111C lime of Ila dcfaull, II. Sw 0. Sula, "How ll>MEX f11 F...._, 11 Slillilla U, TIit ..... ,,." Fun1a11, ,_ '"' .....
PAGE 7
IW71 MAlt#.1:."T !UNA rt;(ill:'S HJ YolulM hid .. 1hu one huadred cut1omn a,wnu." n. flffll'I drraull lpplfCIIIIJ OIC rrOIII 1111 COln&:idmce or Ille a,,...._ilJn br line rrl.lled YoltNM C1111N1n1, who were aho '1our 1radrf1 1111 lhr COMI::>(, of e,uaor, dmlrilr e.11 ud, ...._,, allracdlr iNtpl, uni:1MJN a1M>r1 call ,okl opeloll poliliona _, an unprecedrnlcd fflOWCIIICftl ill lhc price or ICJld. Anvrd1111 10 Ill ldnlinillfaliwt fflfOfL'Cfflffll (Ulllpiunl filed br lhc Ct"JC rollowt111 Yolulnc'a drlaull, 1hc 1111cc fkXM ullln-aneomrra, JIIMI Plrucll, Gerald Wal.__ Nd Yllcric Wnahamcr, lrldcd lhnr Yolul 8"0UIMI llndn COffllllN COlllrol Md/or purauanl IO u caprna o, -,lied llfCCfflffll o, llllllrflllllllina.'' Aa rnull, 1hcir poaioo111 -re lllqcdlr rrquNed 10 be ..., .... ed ror purpcllll of compliaticc ilh '"""'-pullllUII limM111 ..... lhc (.1:A.11 Al 1h11 COMEX hid adopted I ipKUlaliwt pullllOII ""'" or 4,000 op1IOIII '' lhorl al aold opeiorl poliuona.11 a, Mud! II, 1915, 1hc WCllllnillcrl Ind Puudl rqioncdlr held lftlOlll lhrm IOIII of ...,,o,imaldJ IJ,000 11111.vwcred lhort al opllOfll 1111 1'1111 f111111n 1:1>111racu, 1hrtc 11mn the pamu11blc COftl.fflfallOII of poliliona ir lhoac 11:COUflll WflC Ill flCI under cammon COlllrol." -....1 .., ._ 1 u '""" 141. ,.,., nn v ... ._,.. c.,. ,.. IS C" UII C3i l> N Y 1-,1 011 ....... II ... It, 1s. __ __. aoW _,111 t1,n1t11 r .... l--lfllllllAI otf Ille ........ ... ol ,....,., .......... 111d 11 .... ll'tlin tdll ... lot l>uwMII 81 I ,1111111 ... NI l11hAI In 1111111 Ille w, .. .._. ........... c- ... ...,. ........ ,, ... .,,,. ..... lUMt.X ...,..,_ .......
PAGE 8
:!f.i!il!!!ll11'lijiill!-=l~i~,: .,1~:,111~1 ,~;r1lf!;Ji::1 :.l"IJJ!ji!f:pf,f~ Jl!Jl"I; t !11"1?,1!~r,~t1iJJt1 ''l'1i1c!l -~; I ... 11 1!"' fl 1 ... 1 ., I I =l,,,.., ~. rti~ t ~1 I,( It~~ ~1, ii ; l~l;J;!(;ft11tl111l~:1ilJ1}i11, f li11J~rflfttl1J~tl. ..~,., ; 1.1i~l!ififtf1,Ji111i~,1 1~~1111 ,1~11s,I ~iillal~ac J-. I (I ..J.IJlf s 11.1-l"I ~=1~11J!lr~ ~Jf~:~:1 :E,r !2,1.~1 ~f l111~~1si1,,1fl .,.r =lf!ff~11~,,~ ... I. ..l I 11. 11 ,. .. rl .. I :. C I I... -= c:!:I ~~~~~l!li~1'rl1t,l,:t~ .. !ill1a~:~il -if r.. = I a. 1 .. ,, l :-1~ er iJ flfliJ1l1fr!!~::: iif!1itf(~il~~ =~ tl~i;l:t! 1.rafll 11~1 it .. Jfi: 1 !II ,-r 1 r ~1 ' ::I ... I = i 1i1. :I I ... 1"1-'"'= !,. tlr!fiillt. ~::Ii. r~; 11Jt~r!r -lfi i.flliiE i I 1 (Ii I If! f r1 i I f ,.tr 11f ,11,a. s.Jll _1..f ~t-I I -1 ;a: - I. f .... ... 0 .,,,111 ~l J r f I i j I 1J1cJsi!il~i Ii!-UH11!rt l1 I !lta.i t j.-f I t I--:.1 ... l If t'I 'Ii 11 i ... 1: .a I [li 1:!" i -11-1: ( .... fl r1 r -1,.-, .. {. 1~1 li~l1-J1! ... ,. r t--I J. .. .. < 'JI' :t::f' 1-J;; I.. t I f-r 1-='-....... !" !-I' I '-!-o t I S
PAGE 9
,.,.,, ,.IAIIU T HltA 11:Gll-..'i IU lawed bJ COMEX ('lufllll 11id 111rblr 1hr 111CMN111 uf Ma,,h 10. 11,u V.,_ ~Ir dtf1ullnl 10 COMl:X Clt111111" 1hr dt111111 111111111 ...... wlllCII Yolulnr f111td IIIC'rt wa, p,11111111, bawd un lnun 1111 voiu.r, -~ IIC1 .., powllCMI NI .... llf"NIIII, ..... "'IUlft rwwlfld, rdllcled 1llw Wnihnmn and P11udl pollllOM "0111hr followlnt ar, Minh JI, ltlS, COMfX C1nr111111wcd 1wo llfW .. ,,,n c.ih 10 Ylllunw, onr '"' or ..... _..,. will! rapffl 10 oplionl polllioM and one fo, w11111iorl IIIIIPI OIi iii .. wn pauliorll.11 Volume uublc 10 IMft cilhrr c111. Al 1hr Grllftlbln adlutt COUIIICfplr'IJ, 1hr CUlftl OfptllUII0II IUI' ..... 111111hr pa,tia Oii lhr profillblr aldr of I UIMICtlOft wtll rme lhrir profil Md 1h111hr panla on 1lw aldr WIii par 11w loun." Tllut, In lllw of a clar-. n.a *flUII, 1hr dean,. orpilUIIICMI fflU1I llllwtr for 1111 rw' 1111rpr1 ollliplionl 10 111t ctrar1111r111111 011 lhr oppo111r aldr of Ille -rt. {'Olllecllnllr, followinl Volulllr'i f.iwr 10 111ilfr COMEX Clarilla'1 11111aill call, COME>< C'lcanrlt ilactf, 111w "'*,a 10 rwr, adln" Md 11w "Idler 10 '"'' bu,a," becaar ilnaedillrlr 1iblltMrd 10 111ilfr Voll!Rw'a oblipliorll 10 lllw cou111rrper1ia 10 Y...,_., IIMlll.110ft1. Tu rar Ille oalltr aillr of 111w aatkrt fo, 1hr 11111ft t1r1 Yohlaw'11.'Utlunwr flOMlll>III 1111 COMEX, COMEX Clrlftl drew llflUII: Cit 1hr full lnlUUIII of lllw onplll ctranna ffllfPI drpolil1 of Volume NI rrlf'C\1 of Oflffl cuseomrr polllioaa (1,IOO,ooot; (Jt Volume', prCJIWir'larr IUOUM II COMf.)( Clr111111 (1661,fflt; and (Jt Volumc'1 conuibuliorl 10 1hr COMEX Ora11111 IUMtt fund (129,717.)St. Volumc'I oriainal ffllfPII IU"UUIII II (.'()Ml:)( (lrnna rrprncnlrd drpolill bJ II Volume CUIIOfflCfl, illcludiftt IIOI "'' 1hr lhrff JI ... ...,_ ..... Sew. u n "' ., ...... ,._ c.,,.,.,_ ..,,,. . M 11..w. 110, s.w n .,,.._ ,._. c..,..,_ ..,. -. H t, I-C,-,-. -,, -. . U JI M a1 JUt JJ. Al ...... n ,_, .......... ~, ...... n ...... IH ............ c1,.,_ di ....... ,.-11111 -11,n 1111 pw,llaw _. '* "*' of r fMl-,n 11-1-,..., '" _,,.._ 1111 ,,..., ,.,. dr-r .,.,._ .. ... a--11,q,11 a .... -c11 .. -,. '-'-.............. .. ,,_.., ,..,, 10 ........ vf llw ----"'lhr .,., 10 '"'' "''" Md ..... ,, ... ,.,., "'"" ,., 1hr ,_,..,,..,., 1 .. .-rrJ IM1111r, ....... ,-. llw c1,.,, ........ ., .. ""'""'"' 1lw ,..,,.,._,"' u,h u...ir kAflM I du, ... .!i,,r I I'. "*-. C,-1111 a11,ut 11 tllllMII I"'"''"' lo -U-n 11111 __ ,. .,,i11110 ,.., Ml,....._..,,.,.,,.._.,...,,_ 111r ,ltenn __... ,_ ... rn PAr llrt'"' ,11u.-11 11lhr11,.. ,.,.,._, T a,,, .. ,. a1011u ... 11ft t, .... ... fu1u111 ..... 0.1_, MAHI ft,''" ...... .. ,., ...... .... ,._ -Plrr ,_. ., .. of 1 ,.,.,, .. _..,, 111 11 IIMNt 111 ,emit ..... ,_ ..... ,_ --1rprr1r .. ........... ............. I. ,,_. 11, 1hr ,., ..... ----......... -_., ... ,,....,... ...... ,.,_..110 '"""" ....., fir ....... .,vfilaltlr oprt1 ..,..._, I 111< caw. 1lw di .. 111'1 oltlault ...................... ctra,1111 l11a1oa 1lw .......... ol 1 ......... ..,. _,1e11 lll,;1u1r llw ,1r ..... PUI-,...,alllrr .. ... n 1hr 11 .. 111n111p1M po,-111 111 .,.., __ ,,.ID,., cir ... l11a1 o-,,i ... ,..,11111111 Sn T llluPo, 111,,,.,u,_ ,,. 1'111 ('-1111 turuau D ci.1- Muun U'Nll II J 01-1 Ot. I P '''""" c-- lllwiI J.,o ll"J1. JI. t'a l-"'1 ,,,,~_,-, a,p, IIDlr JO II J1
PAGE 10
, iI!ttt fl;ltf 1r1= ;etl!J'lceff:ff{ '11'~ i:tt I' rr J ,~, ti fiJf!)lf(I :!flif:1,f 1 JJsf&tl llff I Jt ,~, 1'i'I; !1r1 I ls1rr1irf 1~ . Jf! !~l;l~tilJ 111:J r,Jr fr!JJ .... JJ.;J Jlrl I f f f ,..,-1 I jlll1l1!!t lr'1t lj! 111 -I Pl ft, 1''1~f., 1 ;)Is! .lf1 !J .J1111 ~~1;P. I'll 1-. rtr1 J!'r~ LI I ). ff flfs --t I fr [t1ji & IJ ( WI ~lc'I I f&il.f I II I, r~. It, I. 1r .. i 1t .. 1,,lp 1~11 if-~ ((] f ~ltfl ii,..llj-4 I lc ri t -'I~ 1 ~ 't t I iu,,1 111.1-hiu!lriH;h --t,lt 1Jhf If ~,,lhf I Ji' I li-!1-11&11,. 11ii&1.,~ I ,1, a. 1 r,., a I c It ,.1.e1=(t'i1 tl1i, 5 i&p11!~ifd;Hh~l1H=fi la, l1lf111hu~noh, 1f ii IJ,f lllHrl !l '11H c (}f' r I &1thl lllf lctlhlu : l. ,f l&f}ff lr l .f( ....... I
PAGE 11
... ,, MAIIAtr S TIIA n,<;/U H7 .... s... ,_ "'*' ,..._., ......, _"...., c1ra11111 .,_, ........ ,..... ....... ..... v...., eel.... ... ... ----........ .,,...,. _, cfr..1....., ,..,. ,. , ...... .. <.-.-rc-1 ...... ..,. ca,.,..,.. 111 ,._ .,__, ,..,,.,..,. ....... ~-1111 ..... ., Maldl . ,., ......... ., v ....... "' ,,l)jffl ........ mt-. v ... cw.-n ............... ,..._ ....... .. .... ,,.. ... ., AG.a .... IO ... Cff(."1 u-,, .... Ma,... of 11111 W ,._ wr::::a" v.._ ,1 1. .,..., ... _, tffft11111 ................ ,,..... ., .........., "' .... '"y__, .... TIit enc-, I ,rn 72 ..,. .... MIi ......... W elf .. el V ... ~, ..... .. -' ........ 10 U_,tl poy1 ... ,_. .... Sea of 1e. CEA. wlllCti "''*'*" ,, ..... w:a .. .. tti n::o,a ... a cm11ect1 If acirwMt,...., ..................... ~-.., ....... fa 1111 .... of MIi tfr..1 of M f I IPJWp ..... WI Wfft fro,a ............................................... 11ra .,,.... .,_,a, .. ,.,......, t rW ,e. paal of _., ....._ for ... ...... 011 W.dl JI, 1s. 1e. OTC .. 1 ,,,..._ t1I 1e. .,_... S.... Dillrid C... ,_ 111t S.. O..rict of Nlw Yl .... M y__, .. .,._ .. _.c....,_..,._" -,.....,. fl.,.,.,,.,,, v ..... ..._. c.,. enc D11111 ... 11-1, 11 I, .. ., ., ., ., .. 'U.IC I 111111 ... ,.....,., ....... v ......... c ... n-.cDld ... 11-1111.,11a .............. ..._. ....... .. ......, __ ...., ...... ., v ..... -. ,_ .... ..... ~ ,._ d .. AIIII. c-.. ... --...... ..... .... ........... ... .., ...... ......... __ .......... ......... COMt ...... _.,,._ _,_. ....... It ft U. fie AIII ,_._ ...... .._. c.,..-. ... II c.. 1111 Ii D 'Ill 1"11 ft9AIII, .................. V.._ . _, ____ ,_ .. _,. __ ...,_.. .......................... __ ......... ... ... C I It .................... --..,_ ............... .,_,_ ... ., v ................ di ........... u ... c. ........... ....... JI 1,1 1111 A ........... ..... ,-. ................. _ .. ..,, '" ....................... ,..._ ... ... ctr.,.. ................. ...__ .................... -.... M ... ,, .,.,..,_ .., ... -., ..,,_ ..... ,_ .... ( ............... ... ...... ... 'l f(" ...,, ...... -... ...... ._. .-. ................ __ ................... ""-"'-....... ~_ ..,.... __ ........ ,_., _, ....... Klllt ...., .... .............................. ..._. ... .. diet ...... .._ ................. K'MI ........................ .... ......... _, .... ... ----.... ....................... .. "'481 ........ ..._ .. .............. ............. ............... .. ......,. _,......,.. ....... ..... .... ... ..., ,._, c.,,....., 4 ..,.,. . u n. enc .,, ... .._._ .._ ..,_ ,,_,_ ._ .. .., ..... ...,....,,_ ........................ ........... ..... llf V..,_ 1,1 II .... ,...-.c...,_ ..,.-.n
PAGE 12
HI ......_ el zct II - a,1111 _, Wi58llllaa el ,_. 1 1 .... CEA me,,..,,_. n.useh .... .... _., ....... k. ,,,..,_ .. ............ ...... ............ v ......... .... ,1,1111111 el -~--,, .1111 .. z, .. "I ........... .... ... 1. ----_,..., .. ,.,. ............. ... ... _. ................ ,.,, ... .,v .......... ....... .... ,..........,, ...... .....,..,v.....-,~..-, ................... f('II. ..... II, COMIX aJMIX C'lllltll ......... .._,v..._ .,.. .....,v.....-.cialt!IJ e ....,_., All ............ ., .............. COMIX .... el O...wtW ....... I I wlldl ............ 111t & arr ..._.............. I ................ ...,,_ ---.w I.___,_..., ........ .... .._;11 Ir ,, .. -...-. ..... .,._we ................. el ...... Mardi 11...., ..,_. . .._. 11. C'OMU .....,_Alla...,_ ,,,,,...cmax ..... v ... w ._ LJ 11 C"" ... Ml .11 CGIIEX C'lllltll .... el ...... ....... ...... .... - _, 11:., ..... a, .......... 111 ., ....... COMU.._ ....... ..._W._ .. C cc-............................. ,:a1rt,,,C'OMU C'llarila, ... _,._.,, .. I luf .... m.-...v.,._ .... 11 -N ..... Wt II I I ...,_ r 2llf ., C'lrarillJ -. 71 ................ ., ............ ..... ,._ .. ..._ .... _,, ....... II ........... 11:U a.a. .. ...... ............. ,,. __ Aaw ... COMIXC'lalrills,ir 9--- ...... ,:a I efV..._., ........ ..._11.._,._ .... ti C ....... C"PK..,_.._.c.-,,, ..... ,-..1111.DNY .... N II .,..._..,,. ,._....,....., ...... enc ........ ..._ca, 1 ..._ ea. 11t1on ._ ,. n.nwn .. ....,_ ....... .._.. ... caaacaaaa... .............. _.._ ........ ., ............ ., .. RA. ,use ...... ...., ~_......, ......... taaaaa..a.-..._. .... ..__._ ......... ., .... ._ ................. ............... ___ ......_ __ ............................ c...,...11 ..... ,.., .... a.-.c...cnc ........ -.., ... .. H .,.._,..._,C; ..,.waM. ............ cnaa-"..._.._.,,_. r ,..-..._.,........_.._,__.......,_......., ___ ... caaax ........ ,, ............................ ., ..... Mia .. .......... ,...a.-.,.__,, ........ ...._,.,enc, ., ............ ....... ltC" .. UUdDNW flllt ., .. ...., ...... ..... .,.. ... ., ..
PAGE 13
""' MAIIAI r .\IIIAfll,11 \ .,., - ., ..... ....., COIIN uk-1lllllt lllf lw ,,..... ...... COMExa.... .......... ..,., .... ,._. .. _, ...... ,apra ... f ,. ... ...._.._ of y--, ........ illlltftt IO ...._, of __ ,_ ....._ ,.., en .. ,. ,.., ,_, ol ,.., COMI.X a... ... -........... ..... ,....., .. l'OMIX ............ v ..... ...... ,,,..IC'll ,lwl ...... ,._. .._.., ,,._. 1111 -... of Maktl JI. IIIS. llf Ir 1lwl COMIX a., .. W y__, dta, .. __... _, "llal ......... -, C ,-ofv ........................ u,nnl ., V ..... ,_ft,---, ... COMUC -(llMfll llanat *"' ............... ., .... ,,..... .. .. ,_ ...... ........ .. ,,....,. ................. ,__, ,... .. ,,_ v ....... ... FCMt --v ..... ...,._ ..................... .... ,.....Aaa ....... cnc..,,,..,. .. v.._ ..... ,.., ........ ., ....... JI l'WaX u., ............ -, '' ... r : :c IN ., vuew, ...... ,..,.._. ..., .. kolm II .. -.~ ..ul W.,11 ll. IIIS ,.._ CUMEX C'lnt .. a,.., Ca ... llft1 l/ofV ......... ,_. .. _..,, .......... ,111 ,. dler-ellCf ... di JI. 111, ........ cfla1IIII -... ellCf MIICII U .............. ,.._ '911 .. ., V..._ ,._ QUIIIHl._. ................. v ............. ~-Mem ............ II.,.. .... O'Tt., ...,, ,..,. edl lllpl I I ., rm.a V ... .......... lllfalct la CMII' of 11 It I..._ ,...._ .. -... of 111f .. .,. of _.,,,11 cw,.....~,,,,.....,w.___, .. .,......, ... v ............... ---_, ,.,. ...... .....,._ ....... ..... .,_ COMEX a.., '*' ....._, -to ,wr ,r,u ,11111 11 .,..,_l_,_n ... ........ n,, .. ,..__, __ ,., .......................... ,........,UrCNII ... __ .......... 1111 .. ulloa, '-C."UMl.a a-., c_ ... I ,. ...... .__. c.....-,..,. .......... ,, -....... -,_..,_..,...._,,enc,,,..,_...._,, ...... 11, .. uu .DNY,_. ... .,__.__.Cape ,... ,. .... o.. .. .,,_ ................................................. _, .. KIi. ..... ....-.. ..._ .............. --., ...... _____ .......................... II ......, .__. Cepe ,,,.,. -a It .. ,, .... ._., --.. '*' .................... DIPS 11.0ll.' W ..... ...._., .... Ne IIC,o HllrlDNY 1 ., ........... ... a..., ............. u.. ... -tlH.CffC ..._. ...... C... Ne ltl'IO UIICIPNY ltltl .... ....., ....__ C.pe-..... ...... .._., --.. .,..., ............ ...,...._enc, w ........... .. 110. UUCIPNY ltltt ...... _-.... I._, ._ ... _. CffC .,._..._ ....... Ne II(''" llllrlUNY 1ta. Al ............ ................................. ,.,.., ...........
PAGE 14
NII WASHINGTON AND LEE LAW IIO'IEN' 1vo1. 44:149 1hr clnrial ....... ,_ ..w ...... 1hr ctra,illt r ... rnpaMillililr 10 llquidllc pcllil lldlllf of illiliwedull ~. m lalll 10 ..,.... liquidaliloa prim 11111 ttfla1ed iadiNWI poailiw wilh, ror CUllll!k, aqia, lfHI-re. ..... poail ... Amlldillt IO ma b)' IZftlill Voluar cm,~ 1111 ..... of rlilllll 10 r--illc rlllllr Olhcr COlllf)ka powliw a 1111 ti:,dt':Dil ............ ill 1W ....... 1hr W ol tiquidalillt poailiw ii .. CNMd &..__, .......... 1hr lcp or COIIWff lionl, 1na11 cm,n1ioN ... Cllhrr ,..,.iallJ rill.fr pcllil wac lequidalell .,,._ ............ flPNI 10 1111 COIIIPCllil or 1hr Offl. pcllilm. 11w ,.rit:W "tf y._ pOlilklM W81 coaqilHell N Mardi 11, 1s, ... dliall of~ wcrt c*ulllell ._.. '"""' .. aa ncmoed ro, ,...,.11, 11 nd Duriat ,....,.. 111t ..._..,_ of v .... -ec poailkNls, ,.._......, 111d clllriltt 8IIOciadoll orncw., IOllllllr willl Yolult'I rlceiwcr, aoua111 10 ...... 1 plae ror nmprP1116oa of y....._,, CldlOIMfa. Al or Mardi ll, .... Ille .... of Y....._'1 ........ 111d ._. ..... rd, il ..,...,_. 11111 .,.. ___ .., 111.._ owed voi-, IIOlldtr,1111-. c ... -. ...-. wllicll voi-w ,,,...., ..., ....... .., 11u ailioa i wpep1ell ,_. ... IJ alliOII la n.. apilal, laYilll ..,., .. or lf'IIIO......., IJ.S .... Al 11111 I-1111 tlCriwcnllip lllo 111d daa .,. ... voi..c alllOIMfl ..._ 1CC0111111 wan la tltfidl 1allaa approiallclJ 116 ailioa, 114 .... or_..... rilNllllllr 10111c Waallciacr 111d P1111d1 1CC01a11." I addilioa 10 Y....._., aaa-,,, 111t adia prillcipal dliaMI ...-y.._,, _.. COMEX <.larilla, w11ic11 111d lillll _, ..... c:.-.. rm .,..._ ....... ......... 1u: ... UIICI.D.N ,. ,.,. .... ,_ IC,_. n..n.. ...... ,...._ ...._.,..-....-.ii.__ ._ .................... ..... ...., ........... .. .,__, ,._ C.....-, ..... . U; fONEIC a. .. .,.l .. 1.1111 ., w a>Ml:l'Clllrila ,-.,.,,. -11, .,,Cl ..... ....,_._ .......................... _,KM_,._ ......,_ .. _., ......... -................. -..... ,._._., ._.,...,, or: 1 11. s.. ~., ,...,. ..,_. ....._., o,, a www _, :11 ,...,_, me Y..._ .._ C ... Ne II Cw. UPI Cl DN.Y. 1t .. .,..., ,._. ~.,... a, ; ,_ ..... .__I t; ......... A,, ,-.a.. llllarillae ,_.,_. ...... .,..,.__II It, (fTl'w. v ..... ---.c ........ llCh tllldD.N.Y. 1-,1.c.,_ y.,.__, "-..... -.. ---........ ........ pf ... ---.... ...... ..,._ ....... CDell C'lllriae ........ ...,....., ......... ,tr ......... .. llnM_ .... _.,...,.61,'911wDwllL.SWtea-,~.,._ ,_ '* DIii! a -t:-c.-.. ,....._ ,nC' ... v...., ..__. c.,. Ne. 11 c ... UIJ d D.N.f. ,_,,_ ... '"" ..... .,..._I en<" ... v ..... .._, c., .. Na. 11 a.. nu CS.P N.Y. 1-k .,__, ,._ r_,,,,,__..,. -. U-M. ,. s.. .... .,.., ,._ ,.,.,..,.,_ .... ... JI ", .. ....,. .. ._I 11. n It' v.,._ ..__, l,.,. Ne. 11 C'..,. u11 cs I) NY. st c ............. WN.._, ... ., ... Ule cs.P.N.Y. ,.,.; ............ t""' P--., ._ l''" ..., CS D NY IWII
PAGE 15
19171 UAlln:r STRA Tl:."GIF.S N61 inruMd i cucu of St 111illion 10 n1akc w111a111N1 marain pa,mcn11 nn behalf of Volume.'' Tll11 St million paid b, lhc .:lcari ur11n1lalmn in warla1ioll .. ,Ilia on ope polilion1 carried b, Volume, incluJina 1huw of CUIIOIIICII who haJ IIOl dcfaullcd. lncere111111lr, 11 1lw ... ,h1 rewerwd illdf, 1hc loun oa Ille We1111cinwr and Paru.:h po111ion1 woulJ have been moderated 10 1hc HICIII 1llolc polilionl llad 1101 been hcd1cd aaaiue fuaure loun." In OClobcr, 1915, pcadi111 apamnl upon I final w11lcmm1 ilh rapccl lo Volume' CUIIOIIICH, Volualc'1 rudwcr llladc a COUrlIPP,OWed pariill dillribuuoa 10 Ille fi1111'1 aonc1cr1ul1i111 cu11omn1 of ar,roaima1dr 17 illion frOIII VollllllC'I aca,qalcd rund1, aboul one-hair or Ille rund1 lllcn aw1ilablc 10 par cullorMr daunt." A fiul dl11rlbulio 10 Volume' cullOIII er wu aadc In Fdlfuarr, 1916, pufllllllll 10 1 Klllannl aareetnn11 a111CN11 Yoluac'1 ra'Ciwcr, COMEX, COMEX Clcariaa aad Yolu111e prillciftal Charla fedfthu.a.." W111t 111i1 dillribulioa, Volurac'1 eu11ornc11 received 1hc ful b1laacc of 1lwlr Ml cqui1r d1i1111. 1c hr fe1111re of llw w11lc.1en1 .. ..... a 14.1 lllilliofl bridle lou br COMEX lfld fcdftbulll 10 Ille remwcrlllip wllidl ....... lhc llloflfd MWffll fllllda rcmaiai .. ia Vohrac'I Kpqaled 8CCOIIIII aad Ille ...... recd ponioll of Yoluac'1 IICMI dcfalillilll Clllloaer dlial. This bridp lou wu COlldiuoaed upoa courl approval ol a Klllnlnl of Ille 1ccdftf.a.ip'1 dai aaaiue lhc We111wimcn aad Parudl for IIOI Ina lllu S, iNioll ill call aad of Ille receiwcr'1 -~ 10 rcpar COMEX 1hc fuadl adwaaced upoa ...,oval or 1hc Wadlciacr Klllnlnl aad before ........ Olha dillribulioM, HCCpl ia pa,_.. ol 1.w1aill recciwcrlllip HpnllCI ludl u accoualiaa lfld !call fen. u ..- ., a.."' t ... enc . .,..._ - c., . No c.:.. un ISDN Y 1 U. ,._ ..-. ----'111..,.... el,...,._.,, kll rutld 1111 <"- ...... ... .... -......... .... l'nce ..... -... .., ........... ., cuaaoo111, .... ......... ,., ........... ,....,.,1111 H. A ,rn-1 lltl.,_ ..,_ ,__ 1U .... II V..._ .,_ ... I llarltt .......... .... .._,_, 111M ......... It I ..... II nr,_ ... llrn irIIHI,. A .... 1. T --......... at lllr -of lfNnlloolll ...a W..morr ol ...... ,_., ........ ................. ,_,_ dllal ....... of .., .,...., .,_. - ...._. ,._ el ...., .... ,.. ewe_, uf ,11r ,.,. ................. .., ... ................ ,,_ ... ..,_ .......... ,.., flilan el\' ..... ',, .. _, le--WlflC-trlNtn, N lfNnlloolll lffrrd IO,_ .. _,, Ila ..... .... ffl-, ..... Sw ... _., """"-t Aa '*' A .... ,.., ... ... .. ... -I err,_ A ................ .. A .... c-"' ...., ., 1111 _. .. ..u __. .,...,._ __ ,:nc .,..._ c ... No II Cl. UU CS.D NW. .. H .-..... ... ._ ... Alt_. ......... .,..._,_., c ... -. el A .... I. 1 ...... C'llarlll I ........... ,.__.., lilldlflll, lar., C.TIMI II (. ........ A--. I ... ,.._ f Ill ........ ... ,,.., f .,...,_ 1- C'p, l1 .... I 11 (II A-111111 IM ---W Ii-a.o A t,n.,. A-Mnl ... lntllftl Aa,-. c.:nc: .,,._ I- c .. ,.. .. _, No II c. .. JIii 1S D NY 1 "'
PAGE 16
1162 WASIIINGTON AND L1:.-. I.A..Rl:'VIEW IVol. 44:14 II. CunoMH PaoncTIION lssuu lwsED BY THI VULUIII l>EPAULT The Volume lnva1or1 dcr1ull mar be lffll u I c11e In which lhc i111ere111 or Ille nrm'1 cu1tumers and or lhc marblplacc u whole were, In lhc larlfll ICIIIC, errcaivclJ procmcd. Indeed, hom lhc pmpeclivc or 1hc marlie1place, 1hc IIIUII ulicnl rac1 1bou1 Volume's dcr1ull mar well hive bcn 111 lal!li ur impact. The dearlna orpni111ion 1uaran1ec opcr11cd cfrce1ivclJ, IUCh 11111 lhc couatcrparlin 10 Volume's open ru1urn Ind oplion poai1ionl, Ille dafl nrms oa 1he oppoaile lklc or 1hc m1rlie1, were URIHCClcd .,, 1h11 nrm'I c1cr1u11. The cpilOdc 1hu1 confirmed lhc abililJ ur lhc clcarina 1,slCIII 10 11111181111 an unimpeded flow or vialion m1r1i11 and lhcrcbJ prncnc Ille finucill i111qrilJ of I contract m1rlie1" despite 1hc insolvnc, and coucqucn1 lnabilitr or a linalc clcuin1 firm 10 C\Jlllinuc 10 mec1 111 coa11111 .... ,. The .....,.ion br Ille clcarlna orpni111ion or couaicrpanr rilli ii CIIClllial auribuec or 1hc eachlnae mulie11 for commodilJ flllura ad oplioM lradi in 11111 cauair,.11 From 1hc pcnpcctivc of Ille nondcf1ulliq ~omcr or lhc c1cr111l1in1 rirm, however, Ille voau. eapcricnce did IIOI atablisll, and i rac1 raised qUCllionl COIICCnliq, Ille efrac, of cunCIII lqal pr0Ceclio111. 11 Allhoulh Volume' c1111C1111a1 were cwcn111111, compn .. 1cd ror &heir loan, 1hi1 compn111ioa occurred Olllr af1cr a lcnalhr period durina which their fulld1 were rro,n ad dcpaided 11p011 I 1111 .... UrlftlCIIIIIII ncplilled IIIOlllhl 1f1cr 1lle railurc 11111 neallcd vohullarr acticNI a,, 1lle COMEX and I Volume principal 10 1upplr ialcria aourcc or ruada. Tllil ou11."0111C lllo followed e11cnlive Voluac-rclalcd liliplicNI wllicll lllrCIICIIIII W rur1hlr clcla,a and ruc1cc1 preu npon1 or "finpr poinlina" and dilavowall of rftPOlllibilllr ror lhc r.,... ...... ; .. The clclaJ alld ulll:erlaiMJ 11111 preceded Ille CN!pcnulloll or Vol11111e'1 nondcraulllna coacr ecner11cd widaprad public coaca over 1lle 1eopc or lhc prOIICINNII afforded bJ cwrnl law lo CIIII_,. of ddaullilll clurina firms, IUCfl voa-c, and or iMalveM FCM1 ill aeac,al. Dapile 1he 11rinpa1 1111111-, ,...._.. 11111 rulldl dcpoaied will! FCMI be mli 1aincd I ICIQllled 11CCOU1111 for 1hc adulivc bncfil or 111e clcpoailina CIIIICIIIIU, hlllocenl CUlloacrl llad appun11, 11111 IIIODCJ, IIOII 1hrou1h 1hcf1 br 111cir 11<."M or 111 elllplo,cn, blll rrum lhc lacli or credllwonhinns n,,-,....,,,_._,..,.. ..... 71. S.. ,.,., 41 ....... .,., llt76t ,.,.., -el ,., II al I fa1wn _, .. _., i.-, el ... _, .. - 11.W, ii ... dNriaa .,__... .. allicll -n ... .... 4, 111-. ,._ w IJ; 11113 I 1, _,,. w .. D14; O'DIII. 11, a-.. n., .,_,. Jllrw, 111-1n, ...,, s ,.., -. . E.1., Klrwla, ..,_ -.. JI ...... Nrw ,_. fa1- .__,., *"'if! al "1 .... ctrcll el ........... -' ...... 11111 COMEX ... COMl!X C'lrlr .. _... .._ -. ..... ,.... dldr f-* ,_ V..._; V..,., rfflha IOIIIIII ,_,fr-, .. w ....... _. ,._., ... .. W111 .... _, ,_ ..... COMEX _.v._,_,,_ II. CEA t 41NII, 7 U.S.C. I MJl-l!tlJI.
PAGE 17
1"1111 MARKl:."T STIU 1'1:.Cill.' ... 116) of 01hcr cu11omen a1HI 1CCmin1IY lawful 11:1ion1 of lhe dcarin1 or1aniia1ion. Even if 1uic1ly honored, 1he rcquircmcm or ~1rep1iun of ru,Hls appare11lly was nol a foolproof 1afc1uard." lhi1 1nul1 c:111111a11cd wi1h Ille prcv1ou,ly widespread a11ump1ion 1ha1 wi1h 1hc bc,icfil 01 ..:omplc1e ..:umpli11nce w11h 1hc CEA' sc1re1a1ion rcquircnicn11, ..:u11onic11 of II b;111bup1 rirm "should receive 100 ccn1s un 1hc dollar for cKh dollar dai1ncd, 11U1wi1handin1 lhc b1nkrup1cy or 1hc firn, which holds 1heir 11.-counu. "11 Had Ibis a11ump1ion proved a..:cura1e, Volume's c:ullomcrs need IIOI have 1ufrcrcd si1nifil:an1 harm a1 a re,ull or 1hc ddaull bcc:ausc uansren or 1hcir posi1ions could have occurred and "lblu1incu, albcil 1hrou1h anOlhcr broker, c:ould proceed as usual." .. c.onscquc111ly, dcspile 1he cven1ual compcnsa1ion or Volume's cu11omen, 1hc case revived previous con1en1ions 1ha1 ,11c ru1urcs indu1uy could no1 provide 1uffi..:icn1 .cc:uri1y 10 ill cu11oincn; i11 llac ab.cncc or a 1ovcr11-mcn1-1pontfcd insurance fund or Olhcr indu11ry-widc compcnsaaion mcchaniwn similar 10 11111 afforded sccurilin c:u11omcn by lhc Sci:urilin lnvesior Pruia.1ion Corpo,11ion CSll"Ct.11 Al1huu1h 1hc ru1urcs indusuy bu rcc:ord or (ewer broker insolve1ic:ic1 and rar smaller 1:u11onacr lu11es 1h111 lhc sccuri1in induwry, .. cu11omer loHCI have been rorcwallcd and public con fidence in 1he ru1urn markeu mai1111incd, in 1i1ni(ican1 mc11ure, by 1hc volun1ary conuibu1ion1 or ru1urcs cach1n1n 10 1hc compcn1a1ion or cu11omcn or railed dearin1 membcra. Such crror11 may no1 only have par1ially IJ. ..... ,,,,,,. JO )J, II. IIMAftlll#I o/ C'___,, _, SnW# .,___. ,,,__,, Jan ,_ .._. __ ,.,. ... 1 n MIi C'--' L o/ lltr ,,_ ,.__ rltr "'*. t1t c-. .. hi linl. SI. taftllllllte of C-.lilr F111n t, .... c--IO <"n-w,., .. Q,,nl-s.1Nai111d llr 11111 s.ei.- Mt ol ... c-~..i Lew ol 11111 ..,_. l.__. .. ,._ Jllllicrt 111nnu1111, ... ..,... ol 11111 enc 1tt c-w,., .. Oun 1io11,"t. 14. IIMA"'1*1 o/ c----,,,, _, sw11"' ... sn.-,,_,_,, "'" 11tr s.a. "" ........ ,.,. MIi ,.___, t.w o/ lltr ,,__ C'-. N lltr .,,.._,, ,,,. c,,..., IM Sn&. IU IIWlt111 .. ,_ of for-l"t'TC l'l1air-.... F. l._tllllft1Mfln "Julllil11tMHl"I a,. SIN', !Nufll w1111111-1111111"1111 Sc.w. uol 1:,, .... t.-.. ,...,. .... (' .... 1n....a .......... ---lfl ,11;i1fll1CI flfM ....... ,, IKftffflllipo 8N .... ,11p1,111 aRII __. .. -...-, ,..., II"' IN ,11....,, __ ol ,1111_, iu.111 of up 111 IMIU,CUI 91C1 c1111-. -- 111M IIOU.111111 of lwll _, 1cprcwM ... ,., .. ,_ of ~Ll11111 llald ,_ ca.. !lill'l"1 ........ lq1lll1-. Ille lifl;llflllll lwnrur Pr0111:I-ACI ISll'AI, ",._,,Ille flllllllic ........ f111 IM ia1uralkt 111111111hr **' -1," ,,..,.,.u, lu...,.. llr 81-MI of !lill'C.: ....... 111111 auw priac .. lr IUpllOfld IIJ IMflCII fllttfll "" -- 1on-111.wilin. S. l'llllloa, ,,..,..,., f'rol-U"*' ,,., ill'A A -NII_....,_ Jo, Ft11wr c~. 11 l"OIUII ,. l A Soc ... __ ... 1111st. II. S., Na111..a l'Uln A-llliall, _,,. 1, 81 11 11. NFA'1 .... ,u, rdll\11 1llal tt:M 11uu1-, lul~ (r.-11111,.,1111111 1 ,,. ... IN 111M IIO _. __ 1, .,..,.,., ...., .. -fNII ,_,_ re of Sll't:'1 l&lllffll:C, "" ............. ii .... ,_. .. er of app,oaiaMclr 110 '"""' per ,cu. or ,,.., ol ..,..., .... ,c1, IUJ .....,., 10 111,u111w. CUii-fi
PAGE 18
WASHINGTON ANO I.EE LAW REVIEW IYol. 44:149 dispelled 1hc impad or p,rviou, inll>lvcncia" bu1 also prcvcnlcd acncral awarcncsa or lhc limi11 or lhc clcarina house 1uaran1cc. Durina 1hc period roUowina Volume' default and prior 10 lhc final di1uibu1ion 10 1he firm', cu11ome11, ii bcl:1mc clear 1h11 reliance upon a record or volun111y indllllry crror11 10 a1:hicvc c1111omer compcnu1ion had 1hc dcfcc1 of 111 Ml /tot 1pp,~1. Such an approach did no1 auurc recovery in Y aivcn cue nor did II climlnaie Ille pouihili1y 1ha1 fu1urn cu11orncrs would be required 10 fend fof 1hcm1elvn followina clcarina firm default or panicipalc i p,olonaed rcccivcrahip or bankruptcy p,o cccdinp 10 obtain lhcir aharc or whatever runda could be marshllled from an insolvcnl FCM'1 IIICII. In addi1iun, lhc absence of a pre-a1abli1hcd sclf-rc1ula10,y rapolllC 10 coapenaalic>II of dcraullina clcarina firm cuilom en deprived 1hc relevant sclf-rcaulalo,y orpnlllliona of 1hc accurily of a clear courac of IClion, pcr111i11ill& individual cachanac member firms 10 cavil over 1hc calCnl 10 which 1hc cachanac should voluntarily recompenac Vol ume's cu11omcr, and over pocaiill approadMI lo follow ahould ii clccl 10 11. NfA - .. "lalll'-111 lfnl ........ Uff _. lllllllilllld I fo,11111 rnp11111111rMCt llh SIP<" NII I,.._ caaail-1oc....-e1111-1 fo, ...._, ........ ldllaen llilloriclllJ ........................................ ---.... f-.1." Nllilwil f A--,-...,.,. -J, .. 114. NFA'I rtpOfl .... llill f11111r11 ....,,, .......... ......... ccapmaiilia lO ... ol 11CUr11t acallct fwm I ..... _, lllllil. to, ........ ill 1111 IM illlal-, ol "Q" C--'ilin ('u., 1111 ..... ill wllicll ... fir 111W .......... .... .., 11, _,ill, . ltlJ, Ille COMIEX a..ilc "-illlol ........ .... ol ndil 111111 11 wilr IO prawilk -u---.. -,. ...... ol .... -,o1111 datilla ...,., Sollllln1 Sc-Trl4lila c..,..,, Ille. NfA', ,...,. .lia ,_..... 11111 llalll 1111 C'11ic1eo Mcteulilr E ......... lllllllillClliclao ... 4o1T, ..... lillm1111wlllil.-ll NJ .......... ICl .. ioutJ ... 111 IO niaNrw CIIII-...... NllioMI f111 A-..iol, _,,,. -J, U, M, 114; 1111,._ . N. Al 4rfiild !tr ................... 1111 dlltiae cwplli,11m 1uar11111t 11.1 .... p,11111.11 ....-..._, lira ., .... _., 10 llill cu ol -MIi pa,-uf varilliuol --IO dntille ...._ f ,rilll Ill .... llleit ...... N "don IOI ,,_.. II ml ol .,_.. .._ 1111 clatilla 111.w ... au1 a--1111 nllliplioM ol 11tol111,. irden wllll ac IOI intilla --""" T. -. - lllli C'c-na tun11u "" o. .... MHtn I J. 11. 1111 ca.e of voi-, ... ...,.,, ,11e cte .. i111 or ..... iol ........ 4i4 1111 .. -Voa-'1 ........... ~-...... Ille -W II"""" of ., .... liJ orlllf call-I of 1111 lira TIie ieerilla or...,llm 1-Ullt 111111 .. ........ ,,, .......... ..... .,..,. .. N ... 1,, ....,ii, Ollr "--_,., ....... C-,,.,r SECIOTr:' .,.,,_.,.,_, ,,_ ,,_.,.,.._,_, I: 1,-.,,,, .,. II It. Jff7, II I. JJIJ-' ff.I .,,. .,_, 1w .SO.-. oa ,..,.__. .,_, C'-l'ru,,rrerw ,~-' lllr s.i-. 0-..111 ,._,,.,.,,. fl/,., Hour c- ... 1.-,, -' C-. '71111 c-.., M Sna. IN, JU UJt C"lill au-oi.-.:111 1111 Ille --........ ...... ii -Ille ......... of, ......... 10 ,lo IO" Hol "ir. for MJ -. Ille lllruln -l'IJ llluM ... ,. ........... (1111 ... 11U11M _,. wilfJ llwa"t l('f'TC .......... MeJ .. 1J1; .UCtt'ITC" Jw ... 1__, ,_ -' 0-111111-,,_, I: ,,__,, H.I. Uf7, H.1. JJIJ -' H.I. 61M _,,,,,. 1lw s.,,-_, f,,,truwwui~lliu1, c-""'*''e,w I~. 1lw .11,11,i-. ,...,..,., -' ,,._,..,_ f tlw II,-c-. 1.-,,, 11W ,-. '11111 l"OIII., M Seu. )2', MS ...... 10 ... datilla -----........ "IIID -UI Ille ..... -ct Mn! _,, lbolll Ill (rcdllortlllilal ul MJ Ollln perl~\"I IO'TC ......._, J11M It, 1'1121,
PAGE 19
19871 MANI.ET STIUTl:."GIES IM do ''" The re1ul1in1 delay and conuoveny unnr~a,ily d1mi11i1hrd both 1he e1:onomic: and public conridencc value or any compc:11ialion ul1im11cly provided. In addition, 1hc Volume case enaendered conuovcny bl:cauK or lhe apparcn1ly un1.'l1ual uca1men1 or 1h11 firm', cu11oi11rrs n111wi1l"1111di111 lhe c1ali1arian principles of required banlrupccy di!ip111i11on1. A1 di\l"UHcd above, followina Volumc'1 ddaull, alle1a1ions .urfaced 1h11 some cu11on1ers were warned of 1hc impcndina defaull and pamilled 10 lranlfrr equi1y from 1hc firm, while: others were 001. Such claim, 1u11r~1 unfaiJ11e11 and, if 1ubS1an1ia1ed, illc11li1y in 1ha1 "insiders" or other cu.iomen wilh special 11a1u1 or acccs1 10 information may have secured advan1111rou1 1rca1men1 10 lhe potential dc1rimen1, in lhc event of a delayed or par1ial recovery, of lhe firm' other cu51omcn. To lhc e11Cnt that 1~h wlf-hclp and collu1ive u1n1fers were allowed 10 occur unremarked and unrcmcdicd, they could encouraae dfor11 to obtain unfair advan111e in future insol"encin and call into qunlion the aencral ability of individual public cu11omcrs to achieve fair treatment in such c11e1. Moreover, even if unfounded, charan of collusion and unequal trcatmcnl may impair public: pcrcepcio11 of the bo"" /idn of any aclf-rcaulatory rnponac 10 an inlolvency and undermine con fidence in Ille in1qri1y of the marketplace aencrally. finally, the Volume episode cre11cd conuoveny because ii illu1tra1cft thal ac9rqa1ed customer fund, were not .:on1plr1ely ucrOIIIICI and could be dimini1hcd followina a clcarina firm default by vir1uc of 1he ckarina o,.aniu1ion'1 11:cn1 10 prcviou1ly dcpo1i1ed clearina marain." In 1hc Voln. S... ,., . O'Dt1, -,,,. _, 'It 81 .W-4S; Sall, ,.,,,,. _, II M ... 61 111- .. ,_ duri .. lir oflio:ial'1 -11111 .oiulllllldrl111llq ,_n rrrt1'1 "-r icli" irl lhrr rrcriIII the lbrrirlit of "
PAGE 20
166 WASHINGTON AND LEE LAW REVIEW 1vo1. 44:149 ume cue, II became apparCIII 1hal followina a clurina firm dcfaull on marain obliplions 1h11 cacecd 1he available capi1al of 1he firm, lhe clurina orpniution, as lhe rcprnen1alivc of lhe marllCI, and lhe firm's Cllllomcrs apparcnlly held connie1in1 in1crn11 and, indeed, potcn1ially adverse claim, 10 ofiainal 11111rai dcposi11 rciaincd by 1hc clcari111 oraanizalion on behalf of 1hc rirm' cu11omcr1 collcclivcly. Had such funds and properly been required 10 be used or llllli111aincd by the clcarin1 oraanization solely on behalf of Ille cu11omer for which &her had been dcposilcd ralhcr than the firm's cllllomcn acncrally, each Cllllomcr should have recovered his full aa:ount equity from scarcp&cd fulld1. However, the clcarina or1aniza1ion used such funds as security for the payment of Volume's collective customer marlin oblip1ions and hence dfa-&ivdr employed funds auributablc 10 nondcfaul1ia1 1."UllC11DCr1 10 sa1i.rr obli1a1ion1 of Ille defaulters. This aciion was comcndcd by some 10 be inconai11cn1 wilh lhc in1cn1ion of the sc1rc-111ion rcquircmcnll of the CEA. Under lhclC rcquircrncn1s, FCM1 arc oblipacd 10 raainlain for 1hc c1du1ivc bencfil of each cullomcr all funds deposi1cd 10 rnarain, 1111ran1cc, or secure 1h11 cu11omcr'1 fu1ura contracis."' To 1he catcn1.1hal such scarca11cd funds were dcpo1ilcd al COMEX Clcarin1 as oripnal rnar1in dcposi11, however, 1hey ceased 10 be held exclusively for 1he spcciric benefit or 1he dcposilina cu11omcr and also served u 1CCUri1y 10 lhe clc1rin1 orpniza1ion for 1hc open 1.-on1ract1 of Volume cu11omcrs conliclcrcd collectively, a major factor in cldrayin1 coun1crpanr rial! and in rnaincairiiq market inlcpi1y. The clcarina or1aniza1ion'1 au1horilr to use such fuacls u sccurilr for a clarin1 firm' collective cullomcr oblipaions rcfllcl1 Ille face thll the dcari orpniution 11 not merely a dcpolitorr for CIIClllia!ly fua,iblc ..,Pl bu1 ha a special 11a1 u a clcarin1 or...,.IOlt. II also refla11 lhal acn,taly die dcarirlt lira alone, Md not 111 CUIIOIIICfl, ii In COlllractul privily with the dcarln1 orpni1a1ioll. The lcpl concllllioll, bucd on the CEA and Conulliuiolt rqulalions, that the v.._ a.-. ea. .. enc .... ,.._ a,.a, 11s1 ...... COMEX a.-. .. 11..,. _, ............ "' ........ 411121 of* CEA_, enc ......... t.lQal, UIIICI ..t I.U lllr ....... _, ...... a -.-..,._ -V..._ w11i1r .. ,_, o1 flCtl 11111 ._..._.a.,11 ............. ...,, ... ,.,_,v__,_....,.. .. _, .... .. -, ...... ,rap111, al ..... .. "-.. ---.. ...... _,_.,_. ...... ~_,_ ......... ...... I. ti. A.., ..., __.. ill la -Gf 1111 ....... Gf ieilllllril FCM 10 ...... .............. -----ew1--c---.t ., __ Gf .. -,_. _,earn., I IC\1IIN t"l'M la Ille -of lllt laillllile FCM llllff IIIM ill ......... -If Ille ---..... -W 1101 .. IMilf ... ltr 1111 orlaiNllril FCM, 1111 carr,lae FCM clllllll dlia Illa! 111t ........ CVII--1111111 -illllH I ..... "CIIII-" ... 11111 .. ---ftllNh ....... ill fflllKI ol 11111 -cOIIW 1llrrlf_ ... ...... 101Milfrloa-....... 111illllllllk1odll-111 ..... S.W l"'fTC ...,,.._,. siNo. IU. U. -, ,_. ., a..., ~-u,_. Dr/et1111111,......, F ... ,.,,,,. IIOlr II, Ill, 10111 JO, ~11. tJ. 1., .. .,,,. . 11 .,.,. 1.-cMNII -of I v .... --.... 1111 darillt ...,.. .. "nllJ looNII Ille Cllll-1' ICl'eplllll -"I, N. Stclloa 411121 ol 1111 CEA, 1 U.S,C. I 6dlJI t1.
PAGE 21
19171 MANI.ET Sl"NA n::c;u;:s 1167 ,sc1re111ion rcquiremenll applicable 10 clcarin1 or1ani,a1ions difrer rrom thole 1h11 appl, 10 FCMs remains, however, un1e11cd."' a, drawi111 on ori1inal mar1in dcro1i1s 10 s11isr, Volume's obli1a1ions 10 the opposite side or the mariiel, C:OMEX l'lc11in1 auured 1h11 other dcarin1 firms and their cu11on1crs would not be advcrld, arrr1:1cd b, Volume's railure 10 the ca1en1 1h11 slk:h llcposils served 11 1e1:uri1, for the rirm's u1n111:1ions. The nccessar, errcc:1 or this markct-orie111cd 11:1io11, 1ssumin1 ii were proper upon I rinal findin1 or 1he r1i:11 11 1he disposal or the clc11in1 or1aniza1ion, was 10 dilldv1n1qe, 11 lc111 lemporaril,, Volume's "innoi:enl" customers because or the 1pp1ren11, irresponsible 111din1 or the firm's three dcrau1tin1 cus16mers. Dccausc or COMEX tS. TIW IW'"''""" uf Cl:A !it<'I-._JI lf'C'iho:llr l'fllio;lllk 10 fCM1 11a1t1 1u1 tlwr 1hal ~, tlw f11nd1 nd PfCJIWIIJ of c1111_, ''brlon11r,1 10 -h .:u11_,,. ht ""'"'. llw ,_.,.,_ of KClioNI 411111 t11Nrulr ............ to ,1ta1lr,1 or1ni1tN1111, ,ltpoli, HUIII Mid al Ullwr '"""""'in uf CUIIINMr futllh p,c,.iuiln IM UIC of -Ml UI pr11fWIIJ pu1111111 oa llchalf of cull-n "a1 bdoa"I 10 Ille dcplllil1A1 lfl"MI .,., pcn,111 orhn thaa llir c1111-u Ill - IFCMI." Se<1icul 411111 Ill Ille Cl:A, 1 U.S l'. I 611111 tlVIJI. TIie lattn p,o,,i-lla1 brCII .-..,11111 10 ... 1ha1 .:lcu"I ...... ,.._, 11N orhn pn_, 1hal llawc CUii-fu ..... f,_ fCM _, .. ......... lido ...... collMtdr Ill the c1111-1 oa .....,.. llcllalf 11ir, - olcpolilcd, without rrprd 111 tlw iNiidual iatnnu of panlcular CUii-i ill ....... 11111111. CtT(" IMCIPfll s. .. ,_ No. IJ.l, 1/111 of s.,,,,.,.., .. t, c......, o.a---II,-l'lil/-" ., .,,,,_ ,,,,,._ ..,.,. -91, 1 ll. 'Ill) 11 1. TIie Cl'Jl""1 ,,..;.. COMillM witll llln <.1-TC" .,.._ Ulllbl, 11 0t':F.I. 11.JIDIIIII ON11, for cua,lc, rlljlllfn dur .. or1a1111a110 .,,.,11dr accot1t11 fo, MIi ..., .... -,_. rcctiffll ,,_......,of llir dc11i111 plliulioll lO purcllaM, -. .--. ICCWI MIiie 1radn, ,_,ac1, or OjNiou Md al-, accNirla OI Ille ,,.... of aII uldn, COMr0<11 or oi-icut, " ......... 10 aII ~, oi-icul .,.11_, .. 111111 .,.._-mn 11111 drarirle oraaua1-tllall or 11.,.. of ..ei et111-flNNh "taapl u loclortet .. toc___.., Of -CWl-1." Ir coapar-. ( .. TC 1, ..... ioll I.JJ, 11 C.F.I. 11.JJ 119171, llodl p,cdudn FCM1 Ir-111i111 or ..,_ .,.. tllc 1111 of "Ille CIIII-flllldl of ....... ...,/or opl-CIIII10 .......... -.-, 11111c 1tir uadn, c_, .. ,., c-.oolilr lll'lilllll of, 111 .. ,., or cllaNI tlle crtdtl of, r .,,_ orlirr ,..,. 1111:II ,1111_ or op1icul ,1111-." rdn1 Olllr IO f("M1.., 111111, accor,.. o Ille CFTl", 11aff opiaioll, "don aOI .-,a clca,illl or...,.._, or other dtpotilorin of cu11-fUIIIII." ctrc IMnp,naii" !ila1rac111 No. IJ.J, II of s,,,,,.,,., Fi,""' t, C,,_,,,, o., .. ,r-,_ 11,..,,, U,J_,,, ., ,,,_lw 1.,...,, 111p, aOlc 91, U. JUJ II )O,,U Tlut coa11n1ctioa of Stiorl 4dCJI nd CFT<" 111111-rr1ulllloa1 ha, lln11 uNI 10 rtflect Ille r .. 1 hat "clcu.., "'- duect _,, .,,, 11-111,. clta1ill1 1111111, -.... ultiallc 'a,11_,. wllo CMtrrd NIIO the .. ..,,. ,_,ac,1 .... ...... -. acccp1CIII f clrar_., 11, 1111 dcu1n1 Uli*-" Id .w ,..,,or ... 11ua.,4.,...,.,..., s,,.,,a,n Jo, t.a, AtA,, ,,., . .,,..,,,., It In .,. S., AND (0-IIIIINNI Ibo. 111, 114, JS, .,. IA111. n. l'INl61 lht .. or limila, ,,.-.... _., .. .... IKUlltll _11,bu1 ace- II carrrill fl"M1 could i. dMrlcd 10 coa11il .. tinalt c-ace-lllllt 10 be .. 10 UltlfJ .. UIIUliditd -11th ill rnpccl of llllal IICCOIIIII I 1h ............. -,. carrrifll FCM, UC hdr 10 .... ,_,act .... "'"'' ilh Ille ult,_,_ c1111_,, "-pu111icul1 lier m,,. Stt...,,,. -n tl-t1 Nd an-...,..,.., 1111. Of c-ic, 10 Ille 1111111 lllow dcpoail1 n ......--c11 11, cltarirla -an, clcarlaa ......,,. llbl1p1iorl110 wpporl Ille -IMN f1111C1-.... IIPflll. tl. Jllc cffC\11 of 11111radi., 0Lt1itw1 of 1111 Wculw- ar,d Parucll etc.,...,.,..,, cumllalcd 111J ., _, ... ill 11tr fiaa11cial 1111ocillucc IWOIof COMEX ... C"OMl'X Ocarilla, .,..,_ l11wn1orr Corpu,to, "'P' - JD, at JU.SJ; Lctltr f10ta A .... ca M.
PAGE 22
1161 WASHINGTON AND LI:." I.AW Nl:Tll:."W 1vo1. 44:1149 <.'lcarin1'1 uae of m.1r1in dcpolitcd 10 1u1,pGfl 1hc clcarin1 ruiM:lion, open (IO'ilions or Vulumc'11MMklcrauhin1 i:u11omcr1 were alJPllrenlly umupporlcd by mar1in 1urriden1 10 pcrmil their lranslcr 10 IOlvtnl fCM1 and "'OnllC qucnlly wr,e tiquidaicd. The lnabilily to uanafr, po1i1iona mcanl 11ta1 Volume's 11onddauhin1 CUSIOIIICfl could be eapec1cd 10 be deprived or 1hc ui.c or 1hdr ru1Nl1 pcndin1 a ballkrup1cy or rccclvcrahip dis1ribu1ion or 1hcir pro ,.,. porlion 01 available customer properly and 11111 some cuslomcrs i:ould 1utrr, addi1ional loua because ol lhc 111Uncr In which 1hcir po1ilion were liquidalcd or aui&ncd lquldatio values. These and oihcr aspei.11 or 1hc Volume lnwes1ors ddaull resul1cd In Cllminalions of c0ntmodily CUllomcr aocollRI prOICClion by bolh lhc ei:TC and, al lhc CFTe's ffllUCII, Ille Nalional FUlurn Auuci11ion (NFAt. In a repor1 10 eonarcu mandated by 1hc Commodity Fucura Tr1din1 Commission Act or 1974, 1hc C:tTC prcvloualy had dclennincd lhal i:ondilions in 1hc comlllOdilia tDUbls did IIOI warranl lhc es1abli1hmcn1 or an lnsuraft'-'C fund and lhal a CUIIOlllcr illlurHcc propam similar 10 lhal adminislffcd by SIPC far lhc bcncr11 of MCUrilia i11Yes1or1 would nOI be i:oll crrcc1ive.'"' followiq V11lumc'1 failure, Ille eFTC'1 Division or Tradin1 and Marke11 took a broader view or CUllomcr 1CCOUnl in1ur1ni:c and idcnlirlcd I number or possible con1pcnaa1MM1 MCChlni5111s lhal iiKludcd, bu1 were not limi1cd 10, 1 rcdcrally-spotllOfed iasurancc corporalion 1uch u SIPC .., Allhoup lhil enc 11arr 11udy did nOI rei:omnicnd cstablishmcnl or an inaurMCe proaraa, ii found 1h11, despile widespread rc1ula1ory improwcmcat1 in 1hc decade liACC lhc CFTC'1 previous i11111rancc lludy, some risks 10 cu11omcr funds 111d 1hc ;,artiH auppor1cd 1hffcby remained. II also round 1h11 as lhc result or chanan in the char111.1cr or 1hc commodi1il.'I markels duriaa 11181 period, lhc poiCllfial CONCqucnca or such 10IICI i:oukl well have lncrellCd. The CFTC 11arr rcpon recommended tha1 NfA be rcque11cd 10 u11dfftakc I rur1hcr 11udy or 1hc c011-clr"'1ivcnc11 or various <'om l>il..-. Ulriliolt fll ,,..._ ...i Mern,. nTc 1a Alu J. llrudr alld ,...._., O'llc f,\pril I, ,.,,. .,_ 1111 fll la:1-' -=tiN llrl-1k--.. ill lclf.,c .... _, .,.., _, dta,lae fir .,.,., 11,c drlae 11rpal,11iolo'1 "p,111111r" kt 11riliul ---.-*'-" _, .... ......,11;..a 111, in role aclf-,c1illa11.,, bod, M ... .. of MllirMM ...... ol IIIIWCI ltillln _..,..,. f,ir dca, ... -e. TIii! i1, IIIC dcilre ...,. __ ,MW NI ... palllll .. r -n.., .. f-'Nllh irlwilu u II lla1 111C a,edlr 1a....., ,riorilr ritlll te jliul -.-.._., IV ,....,-e lolan ror wllicll 11 .. ,.,.. .. .........,_ .. .,,._.,_ . .s,,, .... - UI; ., .... .__ c......., .... .. Jt. It .S,,, _,.. ICII ISf.60. 1111. M. L. No. 4'1, SC. Ult f1'1. IOI .S,,, C:__.,1 A-,,,_,_,,, _,.. _., 2, 11 Appllldia A. IU. C'_,_,.,, A,.,..., ,,,_,.,,, ... J, 6J. Altn-c coar-ina rnilwN lilr 111C tt,t.:'1 lllwiliN fll T, .... alld Mffln1 111o:hoJcd -r ......_, flddilr ...._., Nd IIIC -of dta,ilre llrlllM,_ioll puallllC f-'t IU CfCMC I CIIII-~-... 10). ..
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191171 M,INU'T STNA Tl::G/1:.'S 1611 alternative form, or commodity customer cotnpcn~atiun or in,uraru:c. NFA' "Cu110111cr Account 1'1u1cc1iu11 S1udy," ii.i.ucd in Nunmbc:r, 1916, in rnponr : 10 the CFlC'1 n:qunl, add1ftsc1 po1en1:al "cps "to reduce the rii;k ur or 10 remedy an inwlency loss" a:J "thr direct and indirect c:1>111 and bc:ndits or each." Th111 11:;,iy rocus.n heavily on current rc1ula1ory requiremcnll of a preventive nature, sui:h as ~1re1a1ion or customer funci. and FCM internal controls. While ,i,a:ifiully dcdinin1 10 make policy chuicn or rccommcnd11io111, NFA found 1ha1 an insurance proaram would not be co1t-cffcc1ive and stressed the si1niric1111:c or the "substantial 111d wide-ra111in1 customer a1:cou111 protections" currently in pl11.-c.,. With relflC\.1 10 in1uram:e, the NFA report commentrd 1ha1 the substanaial public commitment to insurance pro1rams in the banltin1 and sccuritin industries wu "born out or the importance or the retail customer in those scctors" and threats to investor c:onfiderice posed by "w1dc1pre1d 1'1ilurcs ... ,., Nt'A observed, however, tluat in the futures indu11ry "inwlvency loss is rare occurrenu," that futures cu,tomcrs "derive their conl'ideni:e" rrum "the protections arrordcd by the indu11ry as a whole and the rir111 with whom they d1uusc to deal," and that the retail i:utumcr, "althou1h important 10 the futures industry, is not its lirebloud."11 Si1nific1n1ly, the NFA study, lie the Ct"YC staff's e11mina1ion of commodity account protection, idcntiricd alternative approaches 10 remc-' ICM. ......... 10 1lli1 ,11:-lldallOII, lhc c.t, C.: ....,Mltlc1111 ul """' irua o1t11 .. ,MI un .. tl'M lhotUW 11111 ........... ., br,:auw. ,, ....... Uf, WIIC'.illt1HI H''IUIHIIIC'llh ., 1.111111,hrJ nh, lu1t1h 111fho:inN to IINblJ c,i11"-, "'"-' da1m1 _.., al all 11mc1 be aatlablc caupt, ho,..,. aim ~1111-oltlault cccdo 11oc .. .,,..,., uf 1hc r;,,. 11, ,,.,.,,, 1hc Jtl1
PAGE 24
110 ftASIIINGTON AND Lf.'I: LAW Rl:"VIEW IYol. 44:149 drin1 Ille cffcels or I eo111aodi1r brolrr insolvcncr 1h11 arc no1 pa11cr11Cd after 1lle 1CCuri1ics lndusur's Sire imuraM:C proar1m. In p1r1iculu, ahc NFA reparl 11,cucd Ille pa1cn11111, substantial bcaclill 11111 could accrue from an apprOICh 10 cullomcr ICCOIIIII insurance dni1ncd IIOl lo compmulc cullOIIICl's fur loll lunda bul "lo lacili111c 1r1mlcr1 or pou1ion1 ,,.,.. 111 in'iOlvcm rirm 10 1 solvcaa OM." Accordiq 10 NFA, such an 1pprDkh could lipirlcaa11, 11ewcr11 alle c11110111crs or u insolvnt firm i addilioll 10 the rnarlr1pllce 11 1 whole, 1llowina llrdarrs 10 rn1in11in their polilion1 withoul c1pc1111R 10 adverse price aovtlMIIII ia lhc cuh NrCls ind facili111ina "the COllliaucd ordcrlr opcr11ioa or 1hc lu1ura - br cli1ninalilll Ille speclcr ol forced liquidalioa ol po1ilion1. "1 NonClllcla1, II NFA 1.'0lllmcnled, Ille ... ,, 10 1n, such praplrn would be Ille llftfflitllf w,ilbili11 ol 1Ulrlclcal funds 10 accomplilll ordcrlr 1rau1cr,. "111 While idcn1ilyin1 p05ilioll tramlcrs II a paulblc ob,ICClive or I CUIIOIIICf pra1a1ion proar1n1, NFA'1 rcporl doa ao1 apecHicallr .... lhc rclalivc COIis ind bcncfi11 or a prap dnipcd solely 10 ,... IIICII 1rU1lcr1.111 Sui:h poccn1ial bc11Cfi11 could lndlldc reduced dc1n111 orpnizalioll lilllbilily lor Vlrillion maraill plJIIICIIIS, lhc climiUlioll OI iacrcnccl bllil rial for hcdacr1 forced 10 rc-a11bli1II lledps lollowi111 a liquldalioll ol 1llclr poa1. 1ion1, and 111e nllumncnl or overall 1111rle1 inlcpilr achined br pro1ectina CUIIOIMf P111ilioM apilll forced liquidalioll.111 TIie cvcn11 or Vohlac laVC11or1' dclaull ud rccdvcrshlp, well 11 lhc pall-Volume 1 ... ucc lludia by Ille CFTC and NFA, railc qualiou concmliaa Ille applicalion or cuncnl law 10 prOICCI CIIIIOIDCI' lllcrCIII lollowinl II FCM IMolvnc,, lncludi lhc lollowina: -To .... CJIICIII do currCIII ban'fuplCJ .... ud rqulaliou .. ,, a lair and crrldcnl recover, br cu11omcr1 and facililllc Ille 1r111rcr of eu11oacr poliliou in 1hc cvc:11 or u FCM inlolffacJ? -To ftll c11ca1 would 1pplic11ion or currcnl bubup1cr proviliolls ill rei.-eivcrlflipl sudl 11 1h11 employed 10 dillribulc Volume lnvr11or1' .... cnhucc Ille prUlecticMls available 10 CUIIGaCH or dclaullill dcarint rirm and lo CUllomcH in Ille 1111rlC1pllcc 1cncrrt IOI ....._. f .... A_..i..,-,,. lllllf J, I. 111.11 . 11. 111. II. a ...... IIIMII-TIit NfA ,._ Mdiliaa .. ....._, well ........................ 111 .......... .... ---.. ... ,,,. ,.. .......... ---el IM CfTC'I .... IIIIIICJ .......... II. S.. llf/ra-1 J0e _, ll""Mf 'NII ICII ltlilai ................ _,1, IIJ. NFA'I ..-W ... _.. N ...... el 1111 -.1 ""' el MIi I ,, ... el ..,, .. ....., IU ..... II. 111; ..,,. -JU. IIJ. TIii ..._.,,,, ,_.. ....... 1!t -(iuadll 1llfll'lll*'II, r ......,_in 111111111 I ........ -ft IU lacilillff plllilila 11-(nl ....... ef ill -;-tioa .... ,, ....... ..... _____ ................ ,,...,,,._ .,_,....... -n ID facilil ll-(n1 Ill dilcll~ ill 1111 1111 el !Ilia lllide M f11111 IJ,
PAGE 25
1~1171 MANU:.'f l TIU Tl:.Cill:S -Whit mc11urn could be 1akcn 10 i1k:rca1e the hldihood 1h11 pt11i1i,H11 will be uandtrrcd ra1ner than hquida1cd w11hm11 d1 min1hin1 current prolL'\:lio111 or 1hc e:ltarin1 YICm and 1hc: overall marhl in lhc tvc111 or i11M1lvcne:y '" ma1e1illy bu1de111111 1hc indu"ry wi1h un11c:1ry e:0111 Of rt11ila111ry rcquinmrnu? These issues arc di1eu11cd below. II. IANllllUPTCW' CODE raoVIIIONS G()VHNINO TIit LIQUIDAINlN llf Co1omn1n llaoaus 1171 In 1he Bankruptcy Reform Acl or 1971,"' Con1rc11 e1MK1ed the r,111 bankruptcy law 1pce:irically addrnwd lo "lhc unique problems ra11ed llr commodity broker llankruplcin. ""' U1c1C new provi,ioos, codiricd a, Suh, chapicr IV "' Chaplcr 7 or 1hr Bankrup10 todc !Code), 11 rdlcc1 1w11 paramouna lt1ill11ivc objcc1ivn: 10 protect monin or cu11omcn dcJ11,11i1ed with inlOlvml commodi1y brokera and 10 prcvcnl 1he po1en1ial chain reaclion Of "donliao" tUKIS or I commodily broker r1il11rc.'" To racihlalC CU\IIHlltf proteclioll, thc,.e Colle provisions accord cu11omcr claims the h11hcll priori1y a11ins1 the blnkrup1'1 Cllllc, subject unly 10 claims "111rib1111blc 10 the adminillra1ion or cu11omcr propcrly."111 Conarns dcKribccl 1h11 policy as one which "main11in1 consis1c11cy with the Commodity E1ch1111c Act, which c111bli1ha customer procrc1ion 11 a primary objective" and is caprc1ed 10 "promote cu"omcr conridcncc in commodity marhu lffltlllly. "11 In -~C,diliOII, lhc Code WU dcsi1ned IO impose Upoll lhe bankruptcy lrUIICC lhc duly 10 ndc1vor 10 uansrcr 10 another commodity broker or brolicrs opc11 cullorncr commodity contracts and suppor1in, mar1in In order ''10 insure 1h11 producers who hive hed1cd their production in lhc commodilin market arc allowed the oppor1uni1:, 10 prncrvc their polilion,. "1 Con1rn1'1 HCond principal objcctivc in C111C1in1 lhc commodity broker liquidllion provilions or lhc Code WII 10 prOltcl lhc 111bilily or lhc ru1urn markets. The Code provilion1 rormul11cd 10 ldv1nt:c this 1oal rcRce:1 11 lh .. P'J Ntl&NM Act ul 1'1111, r .. 11 I Hot I'll, tJ !oo.o1 2'4'11 IIS. 5. lltP. No '111'11, tSIII l"CIIII JJ Sn, 1 Cl'flll 11,. II U S.C. II 161-16' CIW21. TIit t'tTC llaJ 1n11,aNJ l"UlkllH _,_,.. ur r,., .................... ,, Codr ...... ... ID l"UNlt ........ ,.,.,_ .. .. H."M.. ""'"" IC M,. ............ ..... .,., .... .,.,._,_ ................... ....... ,, ............ ., ... .. ll'fflldJ. II.I. It, No. stS, tSIII CCIIII-, JJ Sru. J1J 11'111 <"Ollllnl ,..,,a,1 ta.1tll ..,.., ,__., INolin llqllidalioll ullo:hapln. Tllr 1tt1.i..,,. "'"'' al 1llr .. "."'"''' ldara Act't ,--,,,, ltfolrt llqllNIII-p,u-1 11 11 -mtd WIIMt, Tlw ,....,,..-.4 l'ro- u/ 1lw ...._,.,,,,r1 Ac, of 1'11, ) lrcard of clle Auof lllr a. of Ille CilJ of Nr Yar Jtl Cl'IIJtl. 111. 5. It, No _,, tSIII C11111, Jd Sru 1-1119111 Ill II u.s.c. t 1'61111 111121 A ril11 p,,or11, far ..i -u111i .. dallll llrlotrd _.,.,.., 10 a\\ult 1llr au"""r of ..,u, .. ...,..., """ 10 ...._,.,,. .. e11a1r IM
PAGE 26
i~~1,~~!l.ii !f !H!~i IHI !~U rP1 l ilf Jt"iUHJHt1 ii, lit' 1~11 'i &~!rl? .. I 11 .. ri-_1;1{ ~!ti 'Is r-1~1 > Iara J 1 J '---:!i;uf: 11ib~u,, u1!!Hi1t!Hhi~H~iu~n 1 -!I ~D f 1J1 iJll 1111 ~i11'.t11( J'I t t 1.. .. Ir t 1-.. 11 ... e :1 -... ;!~i;ffi I i!ii~1ii -~!il1iiJ1~i H~H!!J::~HH~ I I 1~ia1 :h:111 'l1h~I.! : !111 tf 1ft 1:Hf. 1 ''"'fl 1 ... :-1I 1 1ff1li[ I 1-I 1 .. --. J Jti t .. !t~r!. ,toel. !l. 1-, I l lr.-.. l .-1! i. 1
PAGE 27
,.,, a,11ur sr.11 ru;,u .,, .... ---.......... .... .. ,act, - ,., .. .. a ., r ,,,.._ ,C,MNI otlllf ,.._ ._.., ...._ ,._ ..., ........ "'" ... ,. .... ............. ...,,... ... .. ,..._, _..,......., ,......a--.,~ .. ,., --saa.......... drar ... ICII .... .,, ,....,..., .... ....... ,._.,of F<."M -, ,-,...IO .... ..., lllfl _. ,.,orcc ._ .....-, ,...__,,..,...,of ......... ~. .................. ..., .. .,.._ ..... _, el w n11wr ._. IO --- niln el- w-lllna ...... Qlll-,.,... .......... FCM-,.,....._ Mial ,,_ ... a,llal IO w r11 ,.,..., IO w cara1r ... .............. -n11........ -,., ........... of ....... fllfkr ..... Ad ., lffl, .... nM1m11 ,rOlft.1.._ el Ill CEA W ~ic Wlllfl -..... r-,.c, .... _.Ill,,_ .... 11111 vs uf'11 caa .... ,...., ,....,. ....... ., H.'M .... ,-,ac, ........ ., ........... ..... ........................................................... I I n" el a fillwW C1i111 ttlial .. w1., el,_._ ... aalldlaa of ......... -.-lllNIII 1..il>lll ...... "ra ...... lalllf ...,_..,u,aaHc.., ... ,_.,apac,,. .. ,,_ c t ,ana,aua. ... CFTC _.ill,_...._ ...-,. tlw C 1 11411 E ...... Aat ..... ,, Mlf .... IM .... ,llfkr CNIII ............ fC'MI OI ...... tlw ,_. ....... "r ,._ nm1m111 10 -.. u 1Ci r ....... 6a ,CIOM ... hc ..... u.ln tllil ........ IM fCM ...., ..... 8a1111 ...... ......... .............................. .. ._.""" ..,_. a- ....... lllce ...., ........ .............. ca,,;.-. ,... ., .. ., -.... ,..., CONII." t.nlwr, .... tllil .... IO tlw .... tllal ..ti, ... aNIN Ill ........ ....,...,, ..., ............ ..., .,, .......... cw, ...... All.._.. ._.,.er.,_..., ._...,_, comut .... .., a.ad,.,.... ... IM daal .. CD f ll Wllwn lO ... ill ........ -. wdl*'--Wlac..,actur,11iGalk..,car ulr~ ........................................ _.,, .... n. s.-..,..,., CIA., use ..,. ... u.. ct.A ..-., .. ...., ... ..__,, __ Lt: ..... ._...,,_ .. ..... ..-.... --............... -............. .... ... ... .,&IA, IUll" 1 ... l'IA"1..-11 .......... __ .._11._._. --~ ....... -................ .. ,.,H. ..... ___ .. ...., ...,_., a,..._ __ ...._. ...._,, .... c . ,,m ... ,, ........ "- ._ ,n111 I trnl". "'" ..,.,eta 1u11w,.,-H.,..., ____ .,,... .. -... ... ----..-........ -L ....... ltltt .. 11 ., .....,,._,_.,.. ___ ,.,. .. ,, .... ... ..
PAGE 28
N'ASIIINGTON ANO I.U: LAN' llD'IEW IYol. '4:149 IOfflMIII 1111 .._.,.cin uf ailin hrolcr/dalen ptlor 10 ltJl.111 111 1111 t:n<."1 wn 1111 1ial ,, rdor wu 11ti111 ca111eaplaled i lhe ltllll, 1111 _. aer-. drficicM:J ill Iliac et# It appraedla WU 1h11 1iw, ._,._. *'iailiw lcall 11wa1, alld Md IIOI 1Nr11 clllloned a., r .,.....come.'" n. ,,.._. accadcd caaoacr dMI 10 fuch ., .. ,,.., divcncd froa ....... m Olilllrwile rlqllircd 10 Ill, 11111 IIOI aclulllJ ill, .. ,cp1ccl amtN11 ... nea ._ facaor,. Sllcll clairal were llhlJ 10 IIIC rejcelccl 0111rielll, ...... ~--wtlllolll priorilr lalcrna irl IUCII l11adl Md, lhefcfore, ilW Nlr IO 11111111 of ..-rel crcdil ... TIii CnC lcporlcd IMI "I IW la 1111 Mlll'lllllda of flll .. coaloll -CMIIII a...e .,_.., ...,.. ~, caa-. prefcrCIICll 10 ,_. irl ..,,...._, 1111r llaw ..-, ped MIi e1111oacr1 prefmace 10 .....,,_.. ,_., nea wllcre well,_..,, radilr 1racalllr a., 1u cal--."'" DedliDM ......... irl ,,, ,,,, ,,,.,_, ., ..... s,n,,;,,n, I. 11115-ltn T,_,., ... IC-. F. L. lep. t JD.Im (S.D.N.Y. 111St caallracd .. (TI<. .. ..... Tllal CM1 addralld, "*' ... 1111 daial of cammlr4illr ca1wr1 to caawr ,_. 111111 br dclllor, Wci1 5larida. lac., ...................... IO SIPA. necmn .... 1ao1111-11111c.--,_..._..,,,..,._. ... ,. ti. ...,......., 1111 ........ ccamaili1s ~.,.. 111111w IO.,. 111111ir dlim paid ,n, ,_ Ina MIi ........ ... ,. Al 10 -, ....-t, UMtJIMJ ...... ilownlr, Midi ~I CWlilcd..., ..... acd ilonof ....... n. cnt: caa11,,m11, cdwocaled ........ of or, pr1or11, la C1G adIJ calwrS lllal ....W,lllnd IO al---,, --ilia, prop-enr, _. .,. ., ... 1racallll 10 ,Iii FCM'I cmewr, callCliwlr, illl ... 11or11, ....... ,111cnceo .. crailll,llrnaleorr ...... lN, wllicll ._., ....W Ill.._...,_... 10 mamatilr cmaoaer,. eo.a,111 adoplcd 111m1-.llal lilaplcr ..,_ of 1111 CFTC'1 for ..... iN of 1111111-, llriorilr lor commNilr c1111wr1."' A1 IMClcd, .. Code' flail of "Cllllwr prClplllJ" prowlda balil fm ..., .. 111M coaNlilr cu11oaa1 rc,'Ciwe priorilJ daiaa lhlll arc cuna..,. willl 1111ir owmrlllip irller1111 ill ,_. ud prOlllflJ lltld bJ 1hc ..... ,. FC'M deflrled 11J Sfflioa 4d(Zt of lhc CEA. Uflder lhe Code, "clllloaa prOlllflr" laclllOa "cull, NCWilr, or oahef propc,1,. ur IJI. II. ,u." Ill." .. IN ... ,,, ............ ,.. . m. ... .....,,-,_..,. ____ __ m. Al.....,,.,....."' 1111 ,n,, 1111 -- .,._ ... ......, .. KIii ... .......... ~, .......... ...._ .... ,_ ,_...,.....,, ... C .. N ._. ....... .,_.,. _.., ...... ,la I ............. II ..... I ._.,_,. ,,._ 11u.9-~.H-l,N6IIIUI ... _..-, ..
PAGE 29
IWJI MAlll.l" STllATl:till:'.'i IU procnd1 of 1uch ca1h, ICCUUIJ, or prupcrly, ,n:c,val, kquiml, n, held by o, for 1hc 11:.:oun1 or 1hc ddNo, huen ur ru, 11ic 11..:1111111 111 a .:11,10t111,. " I add11ion, 1hc Code idcftulic, number uf lf'C\"IIIC .:a1c1ur1e1 uf .:u1 umcr prope,1y, includ1111 "prnpcfly 1ha1 wa1 u11lawfullr .:1N1wc11rd and II al i1 p,oprrlJ of lhc n111c"1 incl "Olhef p,Uf'CIIJ of 1hc dcblur lhl', any allfll..:ablc law, rule, ur rc1ul11ion ,rquirn In he r.ct "illc o, hctJ ,ur 1hc bcncfil of cu111HMr, unlc11 i1icludin1 w.:h prClflCIIJ 1, .:u11unt. properly would ROI ,i1llific1nr1, incrca.c CUIIOIIICf P,Uf'Crlf ... ,. Thnc proviuun, e11abli,h 1h11 an l'l"M'1 improper commilin1 uf cummodily cu11umcr fu" hclllcr ilh ill own 1radin1 aounll ur Olhef lunch, don no1 ckprlwc cu11omcr1 of priurilr daim, 111 11Kh furNh wherever 1hcJ ca be found, cffcaivcl, ovn1urlli111 lhc ,null i N"tis Sft,,n,in. I addilion, lhc l"odc'I CUIICNIICr propcnJ ddiniliun prowidCI I ba1i1 for rrachi .. Olhcr a1W11 of lhc FCM 10 fCIIOfC ai .. CIHICf fulldl Mi1li111 from an n111c 1hrouah diw,lioll or oihcr abulc. In lhil rcprd, 1hc ("udc n11ln dcu 11111 cullOIIICf proprrlJ lndudn 11.c11 of lhc balrup1 FCM 10 Ille Cllnl ..... 1waillblc 1qrcp1cd .... lfC inadcqu11c 10 lllilfJ Ille CWIIII of public CU .. OIIICfl ilhoul rqud 10 hclhcr well IIICII were in 111.1 diftllcd from lhc CUIIOIIICf 111rq;Mcd aa:1111111. Si111.-e f("M1 lfC obliplcd ulNlcr Ille CEA and CnC rqulllion1 10 cower lhor1fall1 i cullomcr lfpqllcd 111."COUIIII illl lhcir ow fund,, m 1ft FCM'1 a11C11 con11ilu1c propc,1, required 10 lie "held fur lhc llendll uf lhc CU\IOfflCf" 10 lhc Hlcnl 1h11 awaillblc w1rcp1cd fu11d1 arc in1uffi(ic111 10 111 .. 1, cullClfflCf IICI cqu11r ,daim1. Thl1 rnuk i1 .:onfinncd by rr1ula1ioM prot11ulp1rd br 1hc Ct"JC pursualll 10 iii 11a1u1or, au1hur11r 10 prowidc bJ rule u, rqull1icNI "1ha1 ccfllill call!, ICCUfilin, Olhcr proper,,, Of commod11, COIIUKII arc 10 lie inducled I or cacludcd from CUIIOIIICf P,OIJCIIJ u, IIICfllbcr proprrlJ ... ,., Scclioll 190.0ICaNINiiNJI of Ille Comai11ion'1 rqullliolll ll*ifin lllal culloracr properly indudn "1:1~. accurilin or Olhcr propcrlJ of Ille dcblor'1 CIIIIC, iacludina IIIC dcblur'I uadina or o,cr11in1 ICCOUIIII and comlllOdilin of Ille dcblo, hcld i i11wcn1orr" 10 1hc ca1cr11 1h11 Olher nu111C111cd c11c1orin of cu11orncr properly arc "iasuffi&:inl 10 1111,r, in full all cllilll1 of public CUIIOIIICII. "111 TIIClc rqullllOIII a,wrc 1h11 difficulun i Uacina cu11omcr fund1 will IIOI unfairlr diwidwa111qc cu .. umc" 10 1hc bcncfil of Ille firm'1 1cricral cr&'di1011, n11bl11h1n1 br rule warillNNI un 1hc fNC 1ump1ioll drawn from En1li1h 11u11 law 1h11 "where a wrunaduc c:omnunalcl llil OWII fund, in I ban KCOUnl Wllh lholC of IIIOlhcr IICIWR d 1hercaf1n rnaln wri1hd11w1l1 r,om 1h11 anoun1, 1hc wronackJcr w11hd,cw lli1 o funds firll. "111 Ill. II u.u. I i.1111111 Ill. II U S.c. I i.llllllAI 11 1 11 U S l" I i.111Aia1 llJt ltl. S. ..,_ .. IU. ,.,. us, , .... u11, 141. 11 C t I. I NINIII 11t ... tH ... nm. mu 11t ,.., oTc, ,........, a1 ..._ --.,
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176 WASHINGTON AND LEI LAN' RE."VIEW IVol. 44:1411 In addilicNI Jo 11111rilta 1hlll cu11omc11' priority dai1111 rtflccl 1lleir 111.uaal propeny inlaali ilftdir Ille CEA, lhc Code' priorily provi1iona n11bli1h 111 cquileble 11udard for alloc:atill1 cu11CllflCf property 1mon1 lhe fCM'a (UIIOIIICfl. Sectioll 766(11) of Ille Code rcquirn lhc banbuplcy 1ru11ec 10 dillribulc CIIIIOlllff properly "flflbly 10 CUIIOfflffl OIi Ille bui1 Ind 10 lhc HICIII of such ct111omcn' allowed DCI cq11ily claims" ind "In priori1y 10 Ill Olher daial" caccpt claim allribulablc 10 Ille aclmini11ra1ion of cu11omcr propeny.01 nil p,o ,.,. di11ribuli011 rcquirnlffll e11abli11hcs a principle or equal 1rca1an1 for all CIIIIOIIICrl and effect a proponionalc alloc11ion of any sllor1fall I CIIIIOlllcr properly available for di11rihu1ion, a llandard 1h11 aicaNd1 will! a1abllahed law unda 1hc CEA, common law 01111 "'-,..,.., ._ .._ ailicial ---' --11111 uh-ialiln 1111 __.,. of ... ,....,., ...... .._nlflCJ C"MI ltr _ial, wllifflille al prClllfflJ al 1111 ...... 111 ... to tlll priarllJ dliaa el,...__, ......... ,..,.,, Cook ........ lllal -io ,......,.... 11111 -daoal ...WIN, ....,... .. .,.,11 n ,.._, 10 1111 -of ._.,. ,_ prOllfflJ. SIi' T. luun. 1..-.,- 1111 CW1111 n Funina Orn,-. Maaun II II 11-1J 11. " c ... ,n1 ,'UllllcapH -..i, .,, ._ ,nc _..., ......... 10 *' 1111 .. ..., of ,,,.._ .,.,...,1,, iii _._ al __ pro,,itioa lllal .....-i, _,..,...n 111a1 ,,..._ P,llflll'IJ c1IIIIII fall lO....,... 1111 ..... catlrt Nllf .....,. IO lllr illtelldef to pntwick ,,.... ,._. ,_ _, 11111111r,.... 111111 ,111 enc .. 10 caadlt 11, .., ... ,.. 11111Nl1i1J to r cwt-P,IIP'IIJ 141 '-' lnl 111M II awlilllolf _,_ la_.._ Codr pro"'liMI io .-a tlll ..._....,. ol _....., lll. t...,n1 n,-ftltd 1111 illtttlll Olllr to prowi* 'f1wl' f lllul N111 rta1icw 'Wllidl '"lcllllt lot 1111r 111...i IIMt of ........ al llllr ~-...,,, . don -pr...W, *taiW .... 10 -C,,tlJ mM..-r" _. ...w IN ...,.._.., ..,, ,...-.... 111r pr--,..., .., 1111 cnt ,.._ ........... ., ...................... ,. s ..... "" .,, ,,. .. c-. .. Jell s.... 1 llfflt. To-. .._,_,.__.._.. ,111 .... a11111 .,, .. ., 111t tn, Plflllia al lllt defm al -pr ..... IO._, ... OIMr f'IIIMl..i, pro,tiltJ -efFCM_.,~_.._,...,._,adil..Wka81Cfill,affc.'HII. Sff r,.._. A llrle. 1-* ,._,_,,,: A aiw-e/ .,_, n.,,,,, WM! C__.,, ,,,,._ .,_ .......... 1 ..... A& llf FUIIIUI Mu11n tJ, II tWillttr ,,., .. TIii ..... fOI 11111 ....... ii ............. ,..._ IUI MKM __ .,.ldll 1rilll ill ... ... s.,.,,. _lat ......... ,.., .... 1. II U.U:. I 'NIIIII OIIJI. A,,..._.,,-Nt al,,....., cwt-.. Ol'CflJ ii calclilll .. la ....... Fir. 1111 Cllll-'1 -Cljlli!J daia ... ID -"lllt .... dlia al I -.......... -of 1111 oldilcw Nltd N 1111 aaaaili!J h*rMII 111W IIJ 1111 ..... ,_ OI ..... ef .... CIIIIlnl NJ ....... ol 1111 CIIII-IO 1111 ...._, .. ii ....... 17 C.F.I. I lt0.a11111 11. llll ,inl-'1 .. ...,_ell ... .... ... _.., ..... 10 ... ,,,. -..... ol 1111 .....,lot ...... 1111 Mt .... daia, ii ......... ..,,...,_ .. ,.., .. .............. c,f --...... .... A CIIII-' ....... fOI .... ., fiw dllltl ol _,II, ....... II, ....... ,NII lllf Ille of Ille ,_'I ...... deia, .... ml. llljcnl-1, ID 1111 llllal Mt "IINI, c'-,. -.., ............. ....... ,_ ........ u -........ 10 ,.., -ef tillll cllll. Jlle ..... Ml .... ii ..................... "' .. ........... ., ... ...... ,cw-fo, .... "'-cllll .,., .... .., cntaill .. ,..._, .......... ill Ct"TC' ....... lto.011dl, 11 t.t.1. I II0.01tcll 119111. TIii CFTC'1 .............. f ,.._._ 1111 _., ,_, llr 11w elllt of,_.._ ........... lldllll ........... IAIIJ ........ proper,, rn, .. ,.. IU, 1111 ... IO .... well prc4ill1iloollialo 11..rt11 .. IIOI 1twll I pn IIIM ,-,_. rilNlioll lot ..-.:1fio: (1111-1,
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191171 MARn:r STRATl:."G/1:.'S prcccpu, and lhc bankrup11:y principle 1ha1 "equality is cqui1y."1 8. TIANSFH PaOVISIONI Of THE. BANI.IUPTl'Y COO 177 As noied above, lhe k1isl11ive hisiory or 1hc Bankrup1c:y Code ren c:on1rasion1I roani1ion 1ha1 bo1h rundamcnlal purposes or 1hr c:omn1Udi1y broker liquid11ion provisions, cuslomcr protcclion and marN rroirc1ion, would be advanced by 1r1nsrer1 or lhc open posi1ions or an inmlvc111 FCM 10 IOlvcnl lirms. The Smale Rcpon clac:ribes 1hc 1rus1cc'1 duly 10 a11cmp1 10 1r1nsrcr cus1omcr posilionl and 1uppor1in1 mar1in 10 Olhcr brocrs as an lnilial and primary duly, based upon 1hc overridin1 impor1anc:c or pracrvina 1hc hcd1ina func:lion or 1hc ru1urcs m11ke1s: ni1 rcquircnicnl is plac:cd upon lhc 1ru11cc 10 Insure 1h11 producers who have hcd1ed 1hcir produc:1ion in lhc c:ommodilica markci arc allowed 1hc opponunily 10 preserve 1hcir posi1ions.11 Similarly, in advoca1in1 1hr enac:lmcnt or provisions 10 rac:ili111c 1randcr1, lhe CnC had Slrascd lhal "in order for lhe hed1in1 mechanism lo work, 1he in1c1ri1y or ru1ura con1rac:11 mull he beyond quaiion, and hcd1cr1 mull be able 10 keep lhcir ru1urcs po1i1ions open as Iona as 1heir cash posilions arc open and 10 close ou1 &heir ru1urcs posilions u soon as 1hcy close oul 1heir cash posi1ion1 ... .. The enc also sunscd 1he impor111M:c 10 lhe hcd1in1 mechanism or "1ran1in1 s111u1ory rccoani1ion 10 1hc 11bili1y -9r, lhe various c:on1rac:1 m1rke1s lo lake prompl ac:1ion 10 prOlccl lhc commodi1y cusiomcrs or 1hcir member rirms by 1r1nsrcrrin1 cus1omer1' open lradn and mar1i11 rund1 10 oihcr ru1urn commiuion mcrch1n1s. "'"' Tt.c Code'1 rramers also viewed posi1ion uanders as I key 10 markCI s11bili1y in lhc evcn1 of a broker banliruplcy because uansfcr1, by reduc:in1 posi1ion1 under 1hr coauol or 1rus1cc, would minimize 1hc poien1ial ror decisions by lhe uusice 10 ,cruse to mah daily mar1in payments or delivery, cven11 thal could have disrup1ive crreca on the en1irc markciplac:e. ''" The House Report commmted, ror c11mplc, thal bec:aui.e 1he suri1ies marlLCI ii "well mablishcd, nuid and 1cncrally 'lhic:IL,' 1he uustcc or a ba11krup1 11oc:IL broker "could rejccl conuaciual c:ommi1mcn11 wi1h linlc impal."I on lhe m1rke1. "111 Dy c:ut1UISI, in 1he compa,11ivcly "lhin" tommodily ma,ke11, "1 simila, power in the uusiec ur an inwlvcnl c:ommuch1y broker could rnul1 in a ripple errcct di1ruplin1 1he cniirc markcl. ""' -Soullocnina Eaptftl Co. w. lalllr,_, Z.. Us HI 119141 HJ S. l1r. Nu. '" 9'1 l:OIII . Jd Sn,. 101119111 Tlw URIC CUONIII would l'l'lr ,,. llaltct of r-ial 1a11,_, ..._.._ IIDM clfectowc ,.,, of ,ct.,. ... _... .,. aulllCIII-of IIIN llcdtc ....... 141 Te11-,, -,,. _, JI, 11 JG. ... "' .. .a ... UO. S. No tit, s. COiii Jd Sn1. I C19111 ISi. H.I. a1r. No. ffj, ts. <.., Jd Seu JJI.Jl C19111 UJ. Id
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171 WASHINGTON AND LEE LAW Rl:."f'/EW 1vo1. 44:114'1 I. /Jult Tr~m Uflll,r 1/w S.11truptc,1 COM NI CFTC Rq11"11io111 The Code ind Commiuion rqul11ion1 conscqucnlly con1cmpla1e cssen-1i1lly immcdille drorts by lhc lrUIICC ID drce1 lrlnden or Ill or a porlion or lhc Oi>CI'. poailioal or lhe dcblor'I CUIIOfflCrl. The principal Code pro' l(ision, Scclioll 764(b), insulaln r,om 1hc 1r1111cc'1 avoidance power 1r1nders or commodilJ CDftlrlCII Ind runds or properly marainin9 or 1CCUrin1 l~h con1r1C11 made wi1hin five da,a ar1er 1he order ror relier, H 1hc lransrer is approved br 1hc Commiuion br rule or order, ci1hcr bdore or 1r1cr 1hc 1r1ndcr. m Br rule, Ille Commis5ion hu required 1h11 ii be notirlcd no l11er 1han 1he 1hird bulincu day ar1er lhe order ror rclid11 u 10 whclhcr a 1randcr under Seclioa 764(b) or 1he Code will be made and hu provided 1ha1, H such 1,1111rcr 11 no1 disapproved by 1hc Commiuion, It may no1 be avoided by lhe 1ru11cc.111 The Code doa not eprculr require 1he lrUllcc o 111cmpc 10 crrcc1 1ransrcr1 eaccp1, u diacuacd below, ill 1he me or 1pecirically idcacirlablc con1ract1 10 1hc n1ca1 1h11 1hc value or such co111r1e1, doa noe ecccd 1he cu11omcr'1 pro,.,. lharc or Cllllorncr property. The Comllliuioll'1 bankrupcc, rqulalio111, lllowcvcr, inandlle linmcdialc, 1mrma1ivc crror11 by 1hc 1rU11cc 10 crrcct such ua .. rcn. Rqul11iOII 190.0J(e) requires 1hal 1hc UUllcc "immcdillcly UIC ill baa crron1 10 cUCCI I lran1rcr" or open CUIIOfflCf coarac11 and cquilr ao la1cr 1hu 1he rounll bulincu day ro11owina 1he order ror relier. u, la pacral, aH CUIIOfflCf ICCOUllll wilh open posilionl qualiry ro, a bulk lraMfcr, Hccpl ror ICCOUIIII which lrC la dcfici. The rc1ulalic1111 ,-crallr preclude he uan.rcr or ruada or propcr1r In rapKI of aar accoua1 cliaiblc ro, uamfcr ill ecna or a cu11orncr'1 caeim11cd plo ,.,. lllarc, ,.,., "Ir 1hc value or inonc,, 1CC11ricia o, property would ncecd fuaded balallce or auch accoun1" calcula1cd u or 1hc cloac or he buaillCu day prcccdi., 1he 1r1111rcr. la compu1in1 a eu11omcr'1 rundcd balance, wllicli ii 1hc -,c of equilr 1h11 1111, be uamrcrrcd, 1hc value of any propcrlJ prcvioudJ lrandcrrcd Is reflcclcd 10 usurc cqulvalcn 1rca11ncn1 10 eu11omcr1 u a whole.,. Al1houah not con11raincd br he Code 10 apply a llriclt, pro ,.,. appr01Ch 10 bulk 1r1ndcr1, lhc Commi11ion'1 ruin COlllanplalc lhal "la Ille in1cre111 of cquily, an, bulk 1r1n.rcr should IU. II U.S.C. I fMCllt Ufflt. H. ''Or f ,..,., II .,ille4 -"11111 filllle el Ille ,ctiliN la IINlr-,ic, ill ....., -_. 1 a : ., ._..., 1r1 ......, __ .. 11 c.F.a . ......... ,.,,, US. 11 C.f.l. H 1.IICNJt, Gllat Cllllt. U6. II U.S.C. I 1MM llfflt. UJ. 11 C.f.l. I 1.U1e1111t CINJt. TIie CffC'1 r111t1e11oM ,. .... 1M1 durille ......................... .., ........................... lillal wll 111t .......... ..,ilcellll 1e ,aliliaa ,,-,.,. U C.f.l. I 1.-.t UNlt. ISi. 11 C.f.l. 11-t 11t. Ut. 11 C.F.I. I Jt 11t. ..,. .., 141. leo. 11 C.f.l. I "t 111171; ..:, fN. 111. 51,-.~ e1: fN, 111. IJJJ Cl"Jt.
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19171 MARKl::T STHA 1'1:.'ult:S 11, 1ppro1im11e, 10 lhe ulcnl possible, lhc dis1ribu1ion which would be made in bankruplcy."111 A-slricll)' pro rota dis1ribu1iun is nol, however, 111a1u1ory or re1ul11ory prcrcquisile 10 in1ul11ion or such 1r1n~rers rrom 1void1nce..1 Thia rlHibili1y is imp0r1an1 ba:1usc ii pcrmi11 capcdilious aclion 10 be 1akcn based on n1im11e1, u1in1 lhe shor1f1II in sc1rep1ion as a rderence poinl for a11nsmen11 or 1hc 1ssc1s available for Iran fer on a pro rota b11is, before more complica1ed calcul11ions or individual nc1 cq11i1ics can be madc.11.1 CFTC re1ul11lo Clpre11lr con1empl11e par1ill uansrcrs ir 1U cus1omcr conlrkll cannol be 1r1ndcrrcd. .. Re1ula1ion 190.06(0()) s1a1n tha1 lhe Commission wiU not disapprove such I uander for "lhc IOle reason thal It was a panill lransler if ii would prder 1he uandcr or accoun11, 1he liquidalion or which could adversely 1rrcc1 1he market or lhc bankrup1 ac11e ...... Commission re1ula1ion1 also uprcui, JWOvidc ror lhc possibilily of lhc uanslcr or a porlion or a sinalc customer's open commodily con1ract1 if 111 such conlracu cannot be uansfcrrcd .... Such a uanslcr "may be crrcc1cd by liquida1in1 1ha1 ponion or 1hc open cU111111Udi1r conua.:11 held by I custonicr which repre1en1s 1ufficicn1 cqui1y 10 pcrmil the lranslcr or lhc remainder ..... l. Tn,,qf,r of Hnl1, Positiott1 Undn tlw Cod, Reflcctin1 lhe spuial impor1ancc 1111ibu1cd 10 hcdac positions by 1he Code's framers, 1he Commission's banup1cy re1ul11ions cs1ablilh I method for 1ranslerrln1 1uch' positions even ii a bulk 1r111slcr or 1hc clcblor'1 customer accounts cannot be achieved. Al1hou1h 1hc l'odc docs aoc e1prnsly 1ddrcu 1hc uansrcr or hcdae posi1ions, it makes special provision ror the 161. 46 Fed. liq. S1S4S UIIII, 16l. 46 Frei. l,a. S1S46 CINI). 1n TIii lllililr 10 cfftc1 11M1f 11N .._ of CMialln willlOIII 11N -..ilr f -,ilclitla p,Cl:ile akllllliDIII of .. .. ""'f.adnl llaleKf _, .. ,,. .. ,., p,Kti.:al -I --.,, Illa .. .,_., lliailld lial tu lilllc .. .,, Illa! ct., ............... lildr 10 lllow IUCII PlllilioM 10 .... .,.. kf _,illlll CNlract...t aucllMlrMJ 10 liqllidllc 1111a. s ........ l,a. 1716 (INJI; tlf/,9 1111 ll,_.1111; II U.S.C. I '" 11 .... 1 164. la ICIIIMIII 1111 Coile _,uw1MN11 fu, lrHlfn, 1111 s.-1 lcpcw1 "'''"'"" 1._. "talk...._.. II ii ,..,.,..,._ f alt MIi - lo IN lfMlfn,..i, ca.-,:on _, d1<1a1c ....... 1...t . s .. No, "' tkll c ...... Jd S.11. 107 tlt711, .. ,. 11 C.F.a. I ltO,'IOtJNI 11'1171. '" n c.F.a. t 1t006IOUNiil ""'' n. 11111 lpldfla 1.,.. 1, .. o11111 .. u.1110 k 11 ...... N U ,..1 of a ,-1ial IIHlfff aN 1*11 uf 8 ...... llrldcll, ''.llotll lldtl ol llldl .,._, 111,_.. k uaalfnrld arillla aidl _, k ar_,.,,.,._ .. lplcanlloua of lllil ,..., ... __,....., 10 ,.,.... 1111 ---of..,..,........,_ 11o, 1111 ddllor FCM ill ..._ifJIIII 111,..._ IPlad ,outioM. 161. 11 C".F.a. t lt0.0610tlMiil 11. All llccliclll 10 liqllidal1 ,-1icNI ot c1111CN1rac11 10 faci1Ma11 IIMlflf of 1111 ,....., .. ...,._..,, crn11 1111 po111bilo&J for Cllll-daiaa (OlllnlNII 1111 111111n'1 dloa of poailioM f liquidalicNI or &ruafn. Ald1oup 11N CFTC'a rqulal-WOllld .....,., 10 lea _.., olltlib ill 1111 111111N'1 ac,r1;.,., u1111tt1 k ........ IO 1apoae 111nudv1110 1111 ... ol (OIIIIUVftllCI -1111 procedurn _plo,... ir, 1ff1e1 ... pa,1ill 11-fn1.
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IIO WASHINGTON AND LEE LAW REVIEW IYol. 44:149 disposilioll of cen "apcdfically idcn1ifiablc" properly, lncllldina com modily coa1rac11, by affordia1 cu11omcr1 a dearer or control over 1he disposilion of IIICII properly, while propmy Illa! ii IIOI IO ca1e1orizcd ra11 In 1hc udusive coacrol or Ille bakrup1cy 1,1111ec aubject 10 judicial review. Ml The Code provlda lhal Ille 1r1111er "lliall rciw promp1ly" 10 a cultomcr any q,ccificai, idctllllieblc IICllfily, propmy, or "commodily COlllrllCI" or "111111 uamrcr," oa IUdl eu11onicr'1 behalf, IIICh 1CC11ri1y, propcny, or commodily COlllract 10 a COIUIOdlly llrollcr lhll ii IIOI a dcblor under Tille I subject 10 CfTC rules X rqllleaiolll ud lo the Cllffll thal the value or such aecuritr, properly, or CCNDIIIOClily matrecc docs not exceed tlr.c customer's p,o ,.,. lharc or Ille dcblor'1 ac11e If auch 11CCUrity, property or commodily contrut were IIOI oahcrwilc rea11rned or trenlfcrrcd. Ml The Code provida that In the ffCIII ahal the value or a cU1tomcr'1 apecifically identifiable propcray eacccdl bis p,o ,.,. Clllillemall, the Cllllomcr may dcpoua l:Uh with the 1r1111er equal 10 lhe diffcrcace between the value or such 1pccif~ally idcllliflable aecurkia, property, or commodity co111rac11 and bis p,o ,.,. share or the 11urupacy atete . ,. The trustee shall then either rciurn auch propcny 10 the cusaomcr or effect ill transfer to another commodity br~cr, aubject 10 rules or rquletlom prescribed by the Corn million. "1 Althouah the Code doa not dcfi11e either "specifically idcnlifiablc property" la acncral or "1pcciflc:ally idcallfilble commodily contracts" in particular, p11l'IIIMI 10 saaaorilJ ddcplcd definitional au1hority1 the enc ... Clllldcd rcaulatiolll llmicln1 the caaqory or 1pccifically idcatin able conuaodilr C0111ract1 10 properly ldntlflcd bcdac positions."' nil approach rtflecal Ille .... ruplCJ Code' lqlsletlve history, which IUUCIII "thll apcdal 1ratr.in1 of llcd,c accounts wu paniculerly intadcd ...... The C.'0111mwioll'1 dcflnilioa of the COIII,.,,., thal ... Y be treated u apcdfically idcntifl8blc alao rcata upoa the practical UICIIIIIClll thll while "in 1cncral, commodity conuact1 hive 110 value or uileelll.'C illdcprndcttt of 1he equity auribuleble to thca," C0111ract1 mered lato for hcdaina p11rposa "have 811 intupble VN ICPlflCC ud apart froa any equity deposited with rnprct to them wliidl rault1 rroa their llcd1in1 function."1 The apccial value illlplrlcd to hcclac politioM by their ,11 reduction fulldioa in respect or cull pCllitiOIII in ocher -Cl ii the buil ror lhe apccial burdens .. t. f.1., II U.U:. ff llS, 'N6 (lt71t. lff. II U.S.C. I -.CCt CINJ a .... tllJt. 111. tt u.s.c. ... um a ..,_ 111n. m.11. m. 1 U.s.c. I J .. 1NJt. ,__ to 111it ._...... ,...., ,., C't'T<.' prowlde, "willt ,..,_. le I ~, ..... .. ii I ...._ -*r Clllpl 1 of Tille II 111, l1llt 111 .... ioa IJt ,._ -CIIII, -illn, lllf prClfffl,, ~, Clllllra.1111110 Ill ................ IO I Plllinllr --ill I .-,if"IC Clfldl,." m. 11 C.t a. I 1.tc .. NJNlit Cllllt. 11. 41 F. 17t111Jt. m. 41 F .... 11ll CIIIJt.
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111171 MARKl:.'T STIU Tl:.'Gll:."S 1111 imposed upon 1he banlirup1cy 11u11cc in disposi111 or suc:h conuatu. Ac cordin1ly, Commission re1ula1ion1 provide 1h111 lhe only oprn con111ds cli1iblc ror Uellmenl U 1pcciric1lly idcnlifilblc CDnlrlC1S lie bon /ilk hed1e posilions u defined in Ke1ula1ion 1.)(1)" or commodi1y oplion 1r1n111.1iona "dclermincd by lhc conuac1 markce 10 be economically flpplO pri11e 10 lhe rcduc1ion or risks in 1he conduc:1 and mana1emen1 or a commercial cn1erprisc. "'" To qualiry ror 11ca1men1 as spcciric1lly idcnliri able properly, su.:h ru1ures and op1ion posi1ions mus1 be "idcn1iricd on 1he boob and ra:ords or 1~ dcblor as held ror 1he accoun1 or I par1icul11 cullomcr" and be held in 1n aa:ounl dcsi1n11cd u a hcd1e account in the deblor'1 records.,,. Under 1he CFtC's re1ulations, 1uch po1i1ion1 are eli1ible for di1posi1ion by 1he 111111cc in accordance wi1h customer ins1r111:tions, provk:cd 1h11 lhe cu11omcr firsl dcposils t11h wi1h lhe 11u11cc "in an 1moun1 equal 10 lhc amount by which lhe cquily lo be uansrerrcd lo mar1in such conuac:1 ... plus I reasonable racrve in lhe 1ru11cc'1 sole discrceion," c.cccd1 lhe cuseomer's cs1ima1cd pro rt share or lhc b1nbup1 at11e, less lhe value or any previously rceurn~d properly.',. The CtTC's re1ul11ion1 1l10 con di1ion such 111nderi on provision by lhe cu,1omcr or "adcqu11c sccurily ror lhe nonrccoverr or 1nr overpaymenu by 1hc 1ru11cc," 1 1 requirement thal may be lllisricd by lhe IJUIICC'I rClcnlion or I portion or Olherwisc 1r1nsrcrablc cquily or by I le1ally enrorce1blc 11rccmcn1 10 rceurn I per ccn1qe or the di11ribu1ion 10 1he dcblor'1 e1111e in the cvcnl or 1n over .ptyment.111 Within two buainns days followin1 muy or 1hc order ror relier, the 1rus1cc mu11 request cu1tomcr ins1ruc1ions concernin1 the 111nsrcr or liqui d11ion or spccirically idcntiriablc open commodily contrlCIS Ind 1rford notice th11 con1racu ror which 111nder inllr1M.1ion1 are no1 received prior 10 1he close or business. on the rirth bu1incs1 day rollowin1 cnuy or 1hc 116. 11 C.f.l. I I .1411 IIN11. m. 11 cf.a. 1 1to.011 .. ,m 1111111 111. 1,1. Mtnl lar,c 111Mi1111-i 111en of lhc lu1urr 11111h11. '"'" ,,.,....,. fun.Ji ,. liet, 10 looW po111_, IMI wOllhl .,_.,, IM.i, ...,.. ...,,. under lie ctl CI ,c1ula1t1Nn I a ,_ .......... of IIIC dcfillllMNI of "'IM.i,1111'" in l"ll l: ........ . Jell, ll CI II I I.JOI (11111, 1111 c-illioa danhrd 1hc ...... ..:allol11, uf 1hc drliflll-n ,rna,11 ,., . rnloonloll 11ra1qin -1111, uMII la pc111folio ,,.....,_ hJ 1111111111--i 111r11on U Fed. ca-m" u1111. 11t. n C'.F.a. t 1.0ICdNJ) 111111. nr ...... 1ft1u11ed 111 11r .,_..,. ill 11w 1ru111'C'1 ._, ... IIIIY llr 11tliMd 10 -.._illial,auwc carce1e1. 46 t'ed ..... SJSH IINIJ. IIO. 1,1. Ill. I w t-. lac.; No. I-IIJ11 llull1. Cl., 5.0.N.Y. 1. wloic wu '81111 .. ed .. lor lo Ille i11--. of Ille CFr<."1 hul111p1,, 111-. Hc,11a,r C'-.odll, C011111111a11 1111:. tHrrilaarl wu prnaillCd IO rice! llrt-11u1ft1 o, lici11Nlllioe of il1 poailicNII. II dlld lrH1f.. NII iii polllOII were IHlf .. ,811 will! Hn11a,r'1 Ill-rd dillriNllw IUre of Ille r...i. alllablr fo, clil11ihlllioe. ar, .. 1r1e1ill fo, ..... 111,auwc ... IIIIMI -" ftptllltl, lourd upo>II ftcrilqt'I ..,,,__, IO rn111 a pollof 1 flllldl NI 111c.-o1 .. _,.,__.
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,112 WASHINGTON AND LEE LAW REVIEW IVol. 44:149 order fo, relief will be liquidalcd. 111 The CFTC'1 rcaulalionl also affo,d lhc holden of hedac aca,uD11 the opporlunily 10 specify al lhe lime lhcir hcd,c accou uc opened 1hal 1hcy dairc such accoun11 10 be liquidated by 1he bulliruplcy u1111ce i lhc evenc of banlruplcy, obvialina Ille lransfcr 1101icc Md UlllrtlCINNI procedure ocllcrwilc required al the la of banlrup1cy. 111 C0111racl1 for whicla iuuucdou have been received bul which have IIOI ben uandcrrcd MUii be liquidalcd within 1en bualneu days followilla Clllry of the order for relief .... Tlaac provisiolu lllpply a fr...,._l for procccllna lhc conlinuily of open hedae posillonl 11181 lllould lipificully lncrcue lhc likelihood 1hal such posiliolll will IIOI be liqllidalcd ualaa 1hc owner so dlrc1:11. TIiey may enable Ille lloldcr1 of hedac poliliclM 10 lranafcr 1hcA1 even If 1hc 1r1111cc canno1 accoaplilb a bull uamfcr of all or a 111bslan1ial porlion of lhc FCM'I CUllomcr accouMI. Moreover, .. rcquirina lhal Ille ... cc rcquctl in11rucliOD from Ilic owner, or daipa1cd llcdte posillona CNCcrlliAI lhcir dispolilioll ud Ilic opponuuy 10 aupply rcquililc runcb 10 aecurc 1ramfcr of 111ell posillou, lllae pro"'8ioM pcrall 1he Md,cr 10 .. ,e hil owa 111C11mn1 of Ille value or Ille heclac apiua Ille COIi of abandollina or rcaaablilllifta II. Thia abililr of llcdprl ulldcr Ille CFTC'1 bulnap1cy rqula1iolll 10 illllrue1 apiRII 1hc liquidalloll of 111cir opca polillona and 10 1upplr addiliollal fuada u aeceauy 10 rclldcr aucll 1rm praclicablc 11anda i. aipinc... c011lrU1 10 Ille ancralr pnduaivc crrec:1 of a aepeplioa lllonfall 11po11 1hc abili1r 10 1ra111fcr opn posi1iolll, affordina u individual cu11oacr lhc oppor1un11, 10 advance fund, 10 facililalc lranafcr of a pusilioa 1llal would Olllcrwilc be undcrmaralacd. C. Pu-BANf8UPTCY TUNSIUI TIMI Coamluioll'1 rcaulaliolll also con1emplalc 1hal lrwfcn of cu,.,.. posiliclM .. Y occur prio, 10 a banbup1cy fillna, on a prcvcnclve 111. 17 C.f.l. I 1.Q1tNJ1 C1. 111. -11 t:.F.I. I - 11. enc ._..... .. n 1U11 1 _..,.,..., .. .,.. ,. ..... ..,.. ... ,., ndl_ ,o IPldfr .._...,.,, ... 111 lirll .....__,.. ....... la.__ al ._.,llfk-,, well-,rcfa1 IMII 011111 ~.-............... ............. .,, ........ ....._ ...... -........... n C.F.I. I IIO.N(. TIIIII,,..... ..i, aa1n 11 .,... .... ...... ,_.,...._.ioll.To111t..-1M1a ...... _Win10 ,,_ .............. _......_ ........... .,~. _._..,.. .,.. ..... ., .. ,...._.,.._., ...... .._.,enc ........................ u..r. ........ .................... ... _,........, ........... I thla..._.Tolllt_._....,_, ...,, ................... .., ........ ., _. ,.._ ..... -., .......... .., .............. ill ...... ., ................... ., .... ............. ...... ................. .............. poiilioaldlr ..... lr_,a, 10 I ..._ ........... "_,.ii ........ "' IM. 17 C.F.I. I 1.QtllZI 11 la liMlloa, ..., 11111 CFTC'1 r11oM. 1111 .,... .............. ___ a11 ..... ........... ~, ........ ........ _, wtlcll ...... ........ -INI Inda. 17 C.F.a. I 1.0l(aNZI (INJJ. Ace_, wllicli .,-ICII -Ill liqlllllalal. Id. 11,. S,,, ..,,_ 1111 -ll'..a7,
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19171 MARKl:."T URA Tl:."Gll:."S Ill basis, when an FCM'a capi1al has become lianirlcanlly impaired. The C:0tnmi11ion'1 minimum rinancial ruin require 1ha1 each FCM 1ha1 knows or should know 1ha1 i11.adju1ted nCI capi1al is lcu than 150 perce111 or lhc minimum fiaed bJ CommiHion re1ula1ion or applic:abk cacha111e rule n1ablilhin1 a hiaher level notir, 1hc Commission and lhe rclcvan1 e1ch1111e or 1h11 rlk.1 wi1hin 1wen1,-four hours. fur1her dedillft in an l'CM'1 capi1al require 1ha1 1he FCM take action 10 uansrer all customer accllllnts. Under Rqulation l.17CaM4t, an FCM that cannot demonstraie compliance with applicable minimum financial requirements "mull uansrcr all cu11omer accou1111 and immedia1ely cease doin1 business as a rutura commission merchanl until such lime 11 lhe firm ii able to clcmon11ra1e suc:h compliance.""' These p,ovilipns are dcsiancd 10 r11:ili1ate uanders "before a rirm bccollla serious!, underseare111ed" and 1hu1 "1o;permi1 1mcliora1ive mcas ura lo be 11ken before cuseomcr los5Ca occur." Al previously discuued,1 the 1u1hority vnted in 1he ('!'TC bJ Sec1ion 764(bMI) or the Banltruplcy Code to in1ula1c rrom the tru"ce'1 avoidance powm "bJ rule or order" u111srer1 or commodi1y contrac11 and supportin1 muain made "bc(orc five days arter 1hc order rw relier' permits prulection of such p,c-banltrup1cy 1r1nsrcrs apinst 111ack in an en111in1 bank rup1c, proceedina. Pur'Suant to this authoritJ, the CFTC has provided by rule thll p,c-banltrup1cy 1r1nsrers made in compliance wilh Rc1ul11ion 1.17(1)(4) of lhe CFTC's minimum financial re1ul1tions uc not avoidable by 1hr. trUSlee unless disapproved by the Commission."' In 1frordin1 1encr1I :protccdon for such prc-banltruplcy transfers, the CFTC suCHCd 1h11 lhe absence of such I safquard could diminish the willinancu of transferee 116. 11 C.t'.a. I I.IJ CIM1). Ill. 11 C.F.a. I 1.nc1N41 11"111, TIie ,qullliull 1111n ...._, 11111 ii lllr FCM .. .,......., *-11r11n kl 1hc MllflCliofl of tllr C.-- lllr c1ca1t1111td Mlf. rqlllllr W11iofl lllr 1bilitr 111 acllwwe ,-..-,., IM c-uil 111 llw olnltllllcd tdf-rqlllllorr or.-i,11iorl - ill 111 oliw:rniofl ...,_ - rqillrMI 10 1 -11111u ol 10 NIMII 111,. ill llicll 10 aclllinc c-pliae llwt ...... to ,, ... rn ac,_, 11111 L'flW doiflt INoliMu required 111ote." Id. 1r ac,llllliurl l.llf1N41 ,.,.uir_ of -CIIIINIII ol ........ ii IIIUI qualified llr IM f("M'1 ""'"lu .. 10 *-rate "Ille 1b .... J 10 i1
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U4 WASHING1VN AND LEE LAW REVIEW IVol. 44:149 firms 10 ecccp1 1r1111ra1 and 1hercbr undermine a lier proacclion or cus tomers or railina FCM1 ud or SRO. ill addrcuin1 s111:h railurcs. As lhe "proper ruric1ioniq or Ille Commiuioll' minimum financial rules depends 10 a lffal e11n11 OIi lhe coopcrllioll of rqulaled firms," if Ille Commission could IICII luula11 such pre-bankruptcy uansfm rrom avoidance u prdaencn, Ille)' could be recalled al a lala dale, "po1ea1iallr jeopardiiiq Ille financial 111bililr of Ille 1, ... raee and iAlaferlna wilh the willin1acss of finu 10 ICClpl acCOIIIII lrusra, ..... la proposiftl paaal proaeclioa for trulfen made In compliucc wllh llqulaliun l.17(,JC4t, 1he Corallliuioll oblcrved 1h11 "lildeaUr, any pre bankruplc)' ua,.sl,cr of aue11 uadcr Ille IDU!imurn financial rula would 1pproalrna1e ii. 11011-bankrup1cy dialribuliOII scheme, while 1voldin1 Ille li1i1a1ion ud oillha adminialraalvc apaua coainonlr usocl11cd wilh bukrup1cr procadinp. "'" 111 addilioll, UM1fa1 uader Re1ulalioa I .17(aN4t mar afford 1ublla111ial prllClical advUla,a Over thole cffeclcd ia 1he con1e11 or a bulrupacy or reccivcnllip prOl."Cldial. Al IICllcd above, Rqula1ioll I .17(aN4) lrartsfera "allould occur before a firm bccomea Hriouslr undcracpr.pled" .. ud, lherefore, allould avoid lhe chief obslade 10 1ran1ra, 1he 1N1williapcu or uusrme Rrau 10 acccp1 ullder-pncd accoua11.'" Moreowr, such 1r .. rer1 1118)' be effe&:1ed wi1houl compliance wi1h lhe specmc 1iae liak11iona ud Olher requiremen11 applicable la bankruplcy. Abo, Ille auialucr: of perlOMd of lhe failina rirm lo facililall 1ud1 uuarm r be IIIOl't readily available ouisicle or a baakrup1cr con1a1, ud lhe CFTC'1 rqulaliona "provide more floibllil)' ill cffCClina prOIICled 1ra111fm prior 10 bukrUplcy 1han 1hercar1er bcca1111 1he COIII missicNI claira 10 pve i11 curr1111 fcauarda ample opportunilr 10 work ..... Consequallr, while lhe enc -'ed iii view 1h11 pre-bankrup1cy uansfaa lhould "appro1illla1e""' po11-bankrup1cr diauibulions, ii also IIClled 1h11 Rqulalic111 I. 17 "doa DOI require 1raurm 10 be made pro ,., ,.,. D. MAHIT PaotlCTIONI AH08DID H THI IAN1taunc, CODI Al discuued above, lhe Baakrup11:r Code's commodi1r broka liqui clalioll provilioal reflecl Conpess'1 in11111 10 mili111c 1he daqers 10 Ille IIJ. 46F ........ '7kt on. la.._.,. ,o I,..._.,.,., .. ,,. c: .................. 11 of -' 11...rm alllW _.. fllilwt 10 ~....., will! <'tTt" a,.....,.,. 1.111 ill 111M ,,_ ,.._ n11oar --, .,_,.,, ... s.. 46 Ftd. a11. ,no un; ..... lq. llJJUJt. IU 4' !W ..... JlMS Cl.II, ........,.._, ....,_, ,.._ 10 l"fTC" ...... l.l,...4tllaM ............... fa dlf K'M ... fa ii,~..._ II. ___ ........, ............ _ii_ ... _., ....... .... lllf l"odt,."' ........ ~, ..... ...... ............ ..... I,....,..._ .... a..-II. S. II U.S.C". I IOIUJ; ,..._ 11. IM. 46 IW ..... SJMS 11. lfl. llaaltr TCII .... ,. ,.,,,,. lllllt JI. M JG. I ... 461' ... att, SlkSCl.11. 1'1. 1. "" -'.!' s.. ..,. ...... llJ. .\.
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IHll MAIIKl:."T STIIATl:."Gll:."S us 11abili1r or 1hc mariiccplacc posed br i:c,mmodi1, brulier banlirup1i:in. The uanara of ru1urn positions, pu11uan1 10 1hc provi1ions disi:uucd above, cOlllliluled a lier objccliwe or 1he Code no1 on1, because such uanders would pracrwe 1he hcd1in1 and consequcnl risk uansler or insura1K.-c runc1ionl or 1hc ru1urn marllcc1 bu1 alao because 1ui:h 1ransre11 should support the in1e1ri1r or 1hc mark11placc and or prcwiouslr under1alica 1rauac1ions apin11 lhe impacl or an individual rirm failure br rcdui:in1 lhe po1enlial for rcl11ed ddaul11 in 1Ukin1 mar1in parn11 and liwcr,. Addllionalli,, posilion transfers arc conaialcnl with lhc concepl of an ca chanae market, where 11ic obll111ions ahd crcdil risli of lhe coun1crpar1i, arc auuad br a clcuina or1aniution ralher lhan individual market par-1icipa111s, and asaa,...._.s of 1hc crcdi1wonhincu or individual conuac1ual cou111erpu1ia should 1herdorc be un111CC111rr,": A second i:ri1ical inarka Afquard cnac1cd br lhc Code wu a rcvcrlal of prcwious decilion1 illclicalina 1h11 marpn parnll made 10 a clcaria1 orpni111ion or other i:ommodi1r bruler prior 10 a banllrupac, filin1 miahl h avoided br a banlirup1i:, 1ru11ec. Pr0111.1ion apinll recover, of such asar1in par111C1111 wu .icwcd u illlperaiivc br the CFTC because if such pa,mcn1s could w rl&:lplurcd bi, the 1ru11ec, the failure of an FCM 1.-auld undermine the 11abililr of other brokers and 1hc dcariftl orpnialilHI i1sclf. Indeed, Ille llllllini11ra1iwc burden alone of rcuadq and rcd1in11n1 maraia prnlouslr passed 1hrouah the 1.icuina lfllcm 10 cou111crp1r1, dear Ina firm and their eu110a1Crs could 1hrcaacn 1he ordcrlr operation of the : clarina 1,11cm. 1 Lilbili1r on the pan of a clcuia1 orpniz11ion for p111 marain parmcnll, which would IIOI neccuarilr be recoverable from ilr lramferec clcarlna firms, would i1Dp111C financial demand upo11 the clcariq orpniu1ion u odd1 witll the cucntial 1.u11C1cr or the clcarin1 1i,11c111 a1 hillor icalli, con11i1u1cd and ppcr11cd. The chid Ju111.1ion uf the dcarin1 1,11m1 is 10 cuurc the in1cari1r of futura con1rac1s acccpled for clearance, u obja:1ivc accomplished primarilr lhrouah the dailr marli-1u-mulle1 1i,11m1 br which the c:lcarin1 orpnizalion, u the omnibu1 cach1n1c coun1crpar1r, 1uaru1cn 1h11 the pan~ on the profitable side of a 1ran11e1ion will rci:civc their profi11 and 1ha1 the parties on 1he loai111 side will pai, 1hcir loa!lft. Dallandl for wariaaion naarpn parmc1111 arc iuued on a dailr and, 11 1im.:1, D. .1., S. 11. Nit .... tslll Co-.., U Seu. J, 101 09111; 1/ H.1. IIP. ND. 1111, ... IIC-,.,MSna.6-7CI ... .. S...,. 17 JUI, ....., ...... ,, .... -II, 11 Ja ..... ,..., ., ....... _, kw .... ,n: ,,__, .,.,.,., s.r--. -,,.u, _,, C:--' Le.,,., ,,,,,.., c-.... ,., .... ,. "' .. ....... hi Snl. 167 t1t llftlilaaar of SI .... F. Sllill l"lf 1111 J,uiw of la _,.. Iii 1u W ""....,_, IIN ID ID -illlo Ills-ID 1a,;u"' _, ... -.-. llln ... .... ,,. __...._ .... .. _......., ..... ............... .. .......... ... ...... T!lll--r, .... JI, 11 J171-IJ; -111,,a 1111 11 IH.
PAGE 40
... WASIIINGTON AND LEE LAW Et'IEW IYol .,.:Mt .... ...., ....... ..... caa11 ........ ,,_ ....... .............. ---a.r., ............. prladpalJ" cmMI ,_ ... .,..,.of ...... --, ......... --..,..... ..................... ,. ......... ...,_ ........ .. ,....Oriplll_ .................... lload ....... 11 .. ........ a... ................... ...... .. ........ ..., .... ,..... .......... ,, tau rm. All ................ .., .. ,....., ..... ..... .., .. ...... .... -.... of., ....... lira ... "' e1111-., --.... .,_.. .. ull1 Pd,..._ ...... ._ WNW.....,. to ,non ct.rial ..................... ,.. ........ ,, ...... -Ille dlartat ................ 11N bed NCCI Ill ,...,. .. rapid IO Ila ....... .._ of ,_. 111111 ......, cca11rp1Mt lipificaal ct.rial flra ...... t'om.. e,, If _..,__ of ,,_ ce.r., ......... IO dlarills ---,.._. prior IO ina1>wp Wlft ..-caaf.a,-ccaa ... ..,_. ...- COIIM ,_,. ,....., ,....,, ........... -.... ................ of ... ..... .. prior IO I .... flllllCJ. TIii flnlladnl ...... of 1n. dlartat ...... .. 11111, 111cnf, of Ille adte JI ........ I _., COIIM ,,._ lie .......... "' Tllaecwamwcrt ... ., ..... ._,.... .. ,..,._ . ,._ rort,,,..,. ... _... .............. fllf'CJ .,, 1t111p1 . ....., ,......,, .... UJNa ... ..._ ....
PAGE 41
,.,, IIAlll.f."I" UIIA11:Cill."S ., A Co . FCM, ...... 10 ICI -* "' wdYc ...._...,,ill w11illioll ---,.,... ..... N ....... ol ... wa'1 CIIII_, -~ 10 lw New Yl Pfodace Eadl-., Otar-. Auonllioll ..... ...... pr,iod ......., ............ ... c, ..... All ............. ol ... drerilll ............. lilllilllr w aa1 .., raahed ill ... II' a r11 f e, lw ,... ........... ., .... CIOllfl ill..,... ... du, ............. -- _,; .. .......... __. llilllililr nNIW n111 lw ..... ... ... c1rer-. ................. ol I .......... ,._..._ .. f...W ........... la ......... ..., prOIIC'IIN ..... f.OWCSJ ol -.-,.,_., ........... ,,.... .. 1a J,ts,N .... enc., ..... ... dlar ....... .., 111 .., ........ .._.,. ..,. lar'I fa ol ... ........... ill dariae ............ <; ................ ..... ... ... lNrl fa -.... M I f 111 .... drer ........ 'I .... ..... .. ...... ---........... dlelilll .......... .., .. .............................. ...,of-,will .. ---,.,.... 111 durilll ...... aipl -IO .......... ... .............. dolillaolMlf,-il .... -...... ,. ._ lllo of -, ,.,.... MJ .... ..., a _. ....... _. ol iae. ,...... ........... _.__ ..... nr enc lwldorc .......... of ...., ...... IO ........ 11111 .... Ill .... ,-,.CJ o1 illlN ......... ---,.,... ...... ., ..... ..., ..... CGa .... ............... ,-,.c, ......... ill mlllllioll .... ... drerf ;HII ....... a Cl P0IEW willl ........ ol .,, ...... Olllllfmdllenol .. ._.,.,. ... .,..,a iN~ ..... nu, aa1t111 10 Ill cn<."1 ewer. lw c.., ......... ,olicr ............. of ...... ... ..,..., ............... ill
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Ill WASHINGTON AND LEl' LAW ltnEW IYol. 44:149 hi11orr rdlen1 u speciricallr o ovcrrlllt SrliflOlf ,. N,111 r Prodl,tt E.ll'-,.,111 ud lliercbr o "prGIICI 1U _,,in pa,-cMI la he cu11oaer-llrol1r-dar.,....._ chaia" ud "111IIIIHiaUr rcduclcl Ille likelihood Ille ._.,.,.,, of OM CUlloacr or broker will lead o he bul.n1111cr of .... ..., brolcr or rlrarilttllou. "'" A cwn111lr ill effeci, SeclicNI MACe) of he Code"' prowlda bal a rUllee r aCN aWONI Md recower aarai ,.,_.., alld llanl ,.,_.., eacep1 ,. ..... o Seclm MICNU,"' wllicll prowidel for reco"" of ccr11ia pre-padl ,, ...... ,,-,era. u .. Ille ..... provision, 1111 lrUIICC .. avoid a lrUlfa ... willMII OM JW prior lo Ille fdi .. of Ille pllilioll 1hal aade ltr Ille delllor " .. ..a....,, dclar, or rralld ur niilr wllicll IIIC dllllor -or ..._, or afer IIIC dale Ila& IUCII u..rer wu ...... ...._., ... "111 Fura, Seel S41CdNZNI) ...... dar ...... ClllllaDIIIIJ ............ dearllla orplliaalm, Ila& ,..... a -.-pa,-or ---,.,_.. "al.a for .,.._ lie CIINI of IIICII pa,-," ..... la fawor of Ille darial orplliulm a I.er ._, .. ill IIIC s.,;,.. caae Md prowidilll a auurace ...... ,.....,, of ,.,.... ,, ...... ., .. ...... n., ---,.,_., ...,.., an wa6dallllle u prefernca. Tll6I rllllll followl froa 1111 111 'N ltr Sia Ml(e) of recowerr of - or ... .__ pa,-. aa,e .., ..... Ille,,....._. uaufer prowilioa of Seel ,. ,, ........... ,.,.... ...... CGMlilllll COllleapo-,_ CICMIIIII for ..-t-1lr11 .,.._ .... Seam S4l(cN2).111 A 1 .. d ........ -' prGIICI ..... 10 Ille .. l.naplc, Code ill 111210 ..... illla ..... wilCGlllractul rfpl1ofdarllliorpai-U1ioM _. oelller camadllJ .,ola1 IO....._.. a baal.nipl fir' opea coa1ract1 ... n. enc w adwotillll ...... of a prowWoa 11111 ..w prGIICI rflllU IO ........ .. COllraCII Mii o recdft auPII ,.,..... Ill. S ..... NI..,.. c ..... M .... U"8t. 111. s., c-. 1a. m.JJ ,..., ...., ... o.. .,,.. ,_...,...., ....._......, c....: ._.wwn t .,.._...,. - 1111 ... "" IJI. II ll.l.l'. I,_. Ill~ a S.... 11 st. 1111ia11 MllI, ..... .. ...... .......... ...__ ......_ ...., m .. ...,. .. _..., ....... .. ........... .. llflCW ..... Ml, llaiall 'JMlct. A ...._. L. 1-, llua1wn. ,-tc ... ..._.. ....._ "' m. u . 11 u.1.c. I ....... IINI a ... HI ..... JU.ti. u, . ,.. ..... ..,... ....................... _... ... .................... _...,, ... ..,...._.,., ......... ......................... .................. l'CMI,,_ ... .... .._. el .. CIA ., -el "fl .. ..,.. ---._.. doc er-, .................. ..--........ _" ........ _._. ....... ... 114. II u.1.c. I MlkNlt IINI I ... HI . S.. ,._.. c- .... -, H ..... M-1112'. 'JM.11111 1111 d 't-n,. II U.S.C. I 116 Clmt. 1'1111 ....... -.._,_ ... IMe 1M ......... ... ill 1111., ,--Law NI. IJ.UJ, "T..-llllial ........... l ........ ia ._.,__, ..... ........ _, c__..,., .. ,._ ... ,unn I,,. .. u11 ..... .
PAGE 43
1 MAIIKE:T STIIATEG/1::S .. no1wi1h11andin1 lhc Code' JN011i1ion for an 1u1om11ic 111, or c:rcdi1on' rrmcdia111 and i11 JNohibi1ion 111in11 ue11mcn1 or 1hc banluup1,, or 1 CUIIOfflCf U In CVCIII or ddauh.11' In upporlilll lhc Cn.lClfflffll or IUCh pr01cc1ionl, 1hc CtTC obacrvcd 1hal ii 111ndard bu1ina1 Pfklk:c for cornmadi1r cu111H11er 11rccmcn11 10 pcnnil lhc liquicl11ion or a cu11omcr'1 po,i11U111 "whru: 1hc ru1urn con1mi11ion mcrc:hl11t mai11111nin1 a cu11omcr account bclicvn 1hat i cu11omcr mar not be able 10 fflftl ill obli111ion1 wi1hout an 1c:1u1I dcr1ul1. " Additionallr, clcarin1 or11niution ruin com monlr provide for 1u1pcnlion or tcrmina1ion or the clcarin1 privilc1cs or 1 clcuin1 member, ir other remedial mca1urn arc not crrce1ivc, upor1 apecirlcd cwmts lncludin1 iruolvcncr or lhc filina or I bankruptcy pc1i1ion, and ror lhc liquiclalion or U1n1rcr or IM rirnt'I posilionl II rapidly II possible followina auc:h 1mpcnlion or 1crmina1iun.uo Ac:c01di111 10 1hc c:nc. "ii i1 111ndard prac1k-c" ror 1uch c:lcarina or11nit11ion' ruin 10 be incorporarcd in every con11ac1 purchucd or lold OIi or 1ubjcc1 10 &be ruin or lhc c1ch1nac: con.cqum11, "ii would ... be corrt1.'I 10 11, 1laa1 1hc ri1hl or 1hc 111plicablc clcarin1 or11ni111101110 liquiclllc a conulCI upon i11 mcmbcr'1 inwlvnM:J bccomn a pir1 or rac:h commodi1y conuac:1 ii clcara. "1 llt. II U.$.C. I Jil'IIIIJ A S..,, Ill llltl. u,. II U.S(". I J6stcr(lt121; ...... s. .. -.,,,,,,. ... M J4. JJI. t....., of 1111 <.TIC 10 l"a.._ W1i111n Qwti_,, ..,,. II, M 61 . JJt. M 67. s.r. r., ...... of,, .. t.lu, .. c.-.,..,_ 1,-u .. ,.,. *fNII <."lc11 .. c.,_.,_ - .,.. ., ...... 1a11...., .. 111 ,._.. 11111 .. .. O; <.l>Ml:X l,_,.. IJla Ulf) I ..... Mr- of dllrille ............... _, .. 1110llledlld_ .... .....,.., ............... _____ .. dllll., .......... b,....., .... ..._.., ......................... _llll a,c ll-nre41; 1f llllc clarille ...... 11 M fl,., C'OMtX 0..ille llilal ..... 10 ..-,., IIIClll opn --............... ,. uo a......-o1 ,111e enc ao l'cn WriHn Q,ondNI, .,,. -11. .,_.. n11 c---1111 ............. -----......... _,., ... ...,_ ...... --M -111181 .. .., Ille .. nad ........ wtllilllla !lilt CN-ef Ille"'"... lildl -11 _,..,,., ..... ...,_. .. .. W., 11 .., -11 l'f a. I 1JtNII 11 I ...., lllu ,_ .. , n . 111111 - ,..,... no11,_ -1-=tiNI -Cl .... !lilt IIOI ..,....._ of lfKl.io;ally ...... C-1 .. 11 -,...,.14110 Ill liq,alalc41..., -l'IUOJ40ll1, 11 Ct a I l'lllelllllll 1111,1 T l.__,_ IIMI 111111d, ...._, 111M .. ,,..,.., 111 -no,_11_n ... ""II 111c ........ daulte.,,_, .. ,__.. .. ,.....,. .... .................. ., ... dr11i111 ------wlldl .............. _, IK .... U llilol ... 1 ......... of lllr l'nt IO('-Wrillla c,,.na-,..,. IJ, II M T11 .. -.... Ille...,.. __ .....,., llf dcaoilll ..., .. ,~ ....... 10 Ill .. ,_, .. 11111 .. N4I ., ... M ., s..,-,,., .......... ...................... ..,-Ill ............ ""'"' .. 111C1111 ..... ....,. 1oc _...., .. 1111 a:w,.wc ,, ....... ,...,,.. r .... ,..., ,1111_,1 Al ... 1111 dear .. .,...,.,_ MIi 1111 du, ....... i,,-11 a,c i,, Ille- of ... dcao ... ----...... c1oeo,.. ............... -..... ..... ...... lioa. Will. ..... lo ..... ,1111-.1, ....... .,___._ ..... ... ,ow .. ........ ...... .......... ......... .., "<1111_, .......... de .............. I. (UMl:X a... .. lrL ,1110 .,.,. .. 11-,lc, 111181 "ill ao .... llillll !Ille ctu, .. ooa-1a1-1 ... ...... (lcll ........... uo .. .. ICIOI, o1r""" .......... oo .,... ot ... c ... ,._ .. .. ..., c.1r .. ,.. Mnilllt .. 111t 1ea111c ,o *''"""" to. 111 ,.,,11_,1
PAGE 44
WASHINGTON AND LEE LAW REnEW IYol. 44:149 EMct111e111 of Seelioll 556 or 1hc Code refleclcd specific concerns 1ha1 Sc\.1ioll J65Ce), which prollibi11 1hc 1crmilllliOII or inodiricalioa or caccu1orr C0111ract1 br rCUOII or 1hc COffllllCIICCII or a bubup1c, cue, could be COllllrued lo preclude carorCCIIICIII or "dolc-oul" provilioM (or lhc liquldalion of opca mare1 posiliolll Car1uablr Olhcrwisc e1cc111or, conuac:1s subjccl 10 am, .. ncc) or bln,rupt FCM1 br clc1rin1 orpai111ion1 or or opcri .. ,11ie1 posiliom or a banbllfll CUllomcr br an FCM un1II an aciual ddaull OIi well C0111rac11 occuncd. 111 The Conimiuion observed lhal "1hc volalililr or the coafflCNlllla ,..,,e1 ii ordlnullr 1uch 1ha1 10 require rirm 10 await dcraull hcrore liquldall111 opc11 posilion1 could be parlicularlr dafflalHII. "HI Nol OIIIJ lfliahl milliolll Of dollars be NVcd b, lhc abililJ or a 1ru11cc, dcarilll actnbcr, or clcarlq orpniu1iorl "10 ckNe ou1 posi; Ions rapidlr la a cllllomcr ba11,rup1c," bul prompl liquldalion could be in1pcra1ive 1110 11abiU 1hc 111a,,e1."111 Sla1utorr protection or conuac1ual liqui d11ion ripl1 allo IOUlhl "lo allar coaccr111 lhal lhc commodi1r brocr carrrt 1hc posiliolll or I bubupt cullOlflCf or rum would have 10 pc1i1ion a courl 10 vaca1e or aodlfr 1bc a111oma1ic 111, 10 111.>w lhc broler 10 close OUI posilioM," rcquircacnl 1ha1 would aposc lhc bro,er 10 "1hc ri or 11111aini111 IUbllanlial Iowa" berore a cou,1 order could be ob-11incd.l .. The ctr< 11,Cllcd "1hc special ncccuilr for not rCllrkllq 1hc aormal wor,iap or 111C coainodilia ru111ra clcariq splem which will liquidale OflCtl posilioa if Olhcr ucrnaliva do IICII appear sound. "1 1 In lhc Com miuioll'I view, "N WOlllcl be VCJJ dirficuk for lhc jud1111C111 of a COUJI 10 be belier lllu lllal of 1hc dcuiflt orpniulion in clctcrminina when conuac11 should flOI be liqllidaled and . 111, courl procccdinp would incvi1ablr e liaic durillt whldi 1hcre cobld be 1 111bllanllal lou 10 Ille baabupl e11a1e 1hc rflllll or price d11qcs. "1 Conscquen1lr, evn 1110 pcrmil 1hc approprialcncu of a co11uac1'1 liquidalion 10 be dcba1cd before courl ii 10 riu IIOI Olllr Ille rapid 1R001i111 or lhc qua1ion in 1hc aaa,,e1p1acc, bu1 ., ... ,._ .._ ..... c-M-_, .. _, ... 14." ., .... "'of ...... of,, .. Clnr ... c.,. .......... ... ,., .... of,., Clnrirla c.,.. ..... .... .. ...... .. .... 11 ... ,.... ,._ ............... ....... c.,. ....... _, ... -ce..i, .......... .... ,., llnrirle c .......... Ill llllolt ;,,,,, ............... .., drlrirla ........ ,. lllldillori, ., ........... dtlr-.,..,.,..;. .. ., ... _,.,,_. ,rlwilr willldnrirla ir--c..w., ...., ........ 1111 .,_.., a'"""" Nl'-irr of Lirllrirla orplliul.IO ........ ... ...., ____ ... flC'II ...... ....... ..... ..... ... ,., ca81aiw ---......... of II aotl-1 of lilt ....... fw ....... rrprtl 10 IN ..,......, ,-illal ft irilff1111 of spedflc aotr- ,;,. ,,,,.. n fl.fl.., a-coaparilll 1111;-,,. ........... JJI. ,,.._ !II .. -. _,,. _, 14, J4-II JU. lfl H. UJ. 1#1. H-. JN. W. JU. a,.,,._ ..... c-.Tc To c .. .. WrillCII Qunriou, ,,,,.. _, IJ, lJ, JJ6. "' .. 1J, 1J.
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19171 MARKET STRA 11::cm::s .,, alw ... 1i1nifican1 ipjury to other marbt partil:ipanu."11' Moreover, a court-ordered 11ay would creale the danaer 1ha1 in the event of a prke movcme111 qain11opcn posltioni prottcted a1ain11 liquidation, the clearina orpniutlon or FCt.t would be ror"-ed 10 use iii ow11 rund1 10 sa1isly den1and1 ror variation_ inar1i11 on those posi1ion1.1 In eaireme cases where the rrozen positions were larae and the advent market movemenl sevtre, the financial 11abili1y or the clearina orpniza1ion itself could be jeopardi,ed, crea1in1 a "potenlial 1hrea1 10 the 11abili1y or the en1ire market."'" A1 enKled, Sec1ion 556 provides, in parl, 1ha1 "lllhe c:oniractual ri1b1 or a commodity broker . 10 cause the liquid11ion or a con1modi1y coniract" because or conditions of the kilMI 1pecified in Sfftion J6SleNI), u well u the ri1ii1 10 varia1ion or maintenance marain payments from a 1ru11ec with respec:1 to open con1rac11 "shall be stayed, avoided, or otherwise limiled by operation or any provisiltn 11r this Tille or b:, lhe urlkr or a courl in any pr~in1 under this Title. "1 Sel:tion 5'6 alw 11a1cs 1ha1 the term "cuniractual ri1h1" includes "a riaht sel forth in a rule or bylaw or lal c:1earin1or11ni111ion or con1ra"1 market or in a resolution or the 1owernin1 board th_ereor. um JJJ. "' 81 11-11. JJI . ....... of Ille Ct"TC la c,n_ w,., .. Quell-. .,,,,,. ... IJ, .. ~,. JJt. "' ...... ,. J40. II U.S.l". I SS6"U!IIJJ. J41. ltl. Jlle Calle'1 ..... ifil: p,ullillilioln ill S.1ia11 ,,. api,11111ar1 11111a illlt1f11ca,;c illl _, ..... 1i11111 lot........,, c___.,,, CN11 ........ caapa,N la Ille ...... Calle ,ro,,iliaa willl ffll*1 1G _, .. 1ul 1ipl1 lot........,, MCWilicl NNlilCII, S.1-HS of Ille Cadr, 11 U.S.l'.. L 1H lltlJ _. 51,pp. IV 1. TIie 111111 p,-p,11. ...... Ille lier, ---1M IIIIICI Nllllfcrca,;c wiall Ille tUl..-ilc al_, ..... .... al ll11<.lwal111, f--.ill ialllllll-ar -wilin de ... ..,_..IO.......,, IIClllilicl ..-rlCII llc,;uw 1,t ca.liliaM .. Ille ... apccifid .. _,_ IISCtlllt .. ., ....... al-Tille .... .... al_, .....__,,.,,,,..-,ill r .,...._ _.., ,._ TIiie .....,u ..,.. "'"" """fflll ...... Ille P,UWllflllll af Ille !iccwilin --P111111:1iaa Act al ltJI tU U.S.C. I .... ff lffl,I GI .. ..................... Ilic ste1 ... l:K ... c~." 11:apulil llddctlJ. TIit lllililr af Sll'C la- a MIJ al Ille c111ciw af ~--- !Ni11Nlal.,. rielll ill 1apa1 af ilicl _, .. 11, in_,.., 1a Ille .. ,--tlle.....,., p,1ei.-of - 118p la nlfilCI el fllln ..-111C11, ICIIKII f,....._al lfcr- Ilic illlol._, f, __ .. lllflicllllc aa -in"''"' uol 10 --"' "''"' Tllnc illcltNlc Ille fa.:11, ,..., SIPC ...... -ii .... 81:COUIIII; 11111, lor Pll'PDICI al SIi'('. IICotn ... Ml 11111t1, II ........ of Ille .......... ,, Iii ....... .... '"'"'" .... _,., Mt ftltlllr nuc,_CI ii II .... pllliliaM ...._ lcfl Ille dcllllm'1 111811; uol 11181 SIPC llu lfMIII power 10 11...rn ..., -ilte1 ,....,_, 111r1111111o111 er .,....., w11trca1 "Ille llllllfnlllilll, af ~, fllllllMIM -ia,r .. 1ocMlc 81 I _,_ af II OIi Ille follll ... ........... la ...... .... er, ...... CICcpl ill Ille ...... cir, __ .. llii:h .,....,_, _, 11111111111,..i ,..._,. aa an1-irlll 1..,.... at ,11e enc ,a ca,_ w,111111 QwllioM, ,.,. _,, IJ, al JI.JJ. 111 ,. ........ illlcrt,, ... willl ,..,,ac,1181 ........,_ 1ielll1, Ille Cadr afflh _..., _....,_... diK1nN1111a clear-, 0111Mi181.,.1 au........,, apca 111111111 _,ac:11, cffK1awclr ,..., ...... 8 .......... af 8 .......... IN' c1111_, GI af Ille illlllf ...... Ille flNcllar-al Ilic clear-, .m.-181-fr-............. IIIICII ,OU,- ortkr 10 81111fC 111 .,._..,.., 10 11_,.lltr .... f111111n pau1-. 111 p,-t1laa1t111 ill ...... ..... ,, 11111111-,
PAGE 46
192 WASHINGTON AND LEE LAW REVIEW IYol. 44:149 Ill. Cu110111a PaotKTION hlPUCATIONI Of IHI VOi.Viii DIPAULI Allllauah Voluae 1 wu placed in receivership rllher than in bankrup1c,,1 .. 1111 IMl,.,.c, Code provilion1 rorn1ula1ed 10 prOIICI cu1 1oniers or illlOlfflll coamodilr broker IIOMlhclcSI 1hould serve u an approprialc tubllaivc .......,, or &he c11cn1 to which 1hc in1cra11 or 1hc rum, e1111oaer1 were cffec1ivt1, proteaed."1 A1 lhcic provisions were ... cnc .............. ,....._.111, ....... ...., ..,.._ ....... .... _..__...._., ........ ................... ....... ~, ...._ .._ ........ ...... ,.. .. ,_... -,ridnl __ ................. ,.. ...... .,_ ...... .. ......... ... . ...... .. ..... ..... ..... .. ........... .... .... ... ....... _,_ .. ........ ......., .. dllllat .............................. ,..1c ... .. .. ..... .. .................... llalfllril, .................... ...... ............... c111 ........................ ..... ...... .............. ........ .. JQ. ................. ef v ................. ef 1111 fir ....... .. -, .......... -, ve .......... r .. ......_, ,.. .... ,. ,., ..... ,,.... II ., ......., .... ,,. ,. a. ........... Ne ., .L., .... ,. ... ,. _,Ill,. Vlllrir ......... Ne. IS ... .,. NNm IINSJ. y__, _... ...... ,.. ........ _. ,_ ................. ,,_ ........ ..., c- ..._..,.. u.u:. I '" .... ,..._ f ......... ..r IIIIIIIIIIIICr ,......_ "if - .................................. __. .... ., ... ............ .. .................................... .,,... .... _" .. ----.................. lllflCr ..... ..W .._.. Cllllll*l11iaa .. l'EA, 1'lls ,.. .......... r. ..._..of ... ._....-, ,niliaM ,_ ..... 11 11.S.C. I IIIZ.111 ..... M .., -......, fW la W fall ID ._ --.. ............................ _.. .......................... v ................................................... ........ .. .. Dilaillll .................... ..., c-. ................... f ...... SJ cs.o.N.Y. 1. TIii _..., _. ..... .,. ,.,.. .,... . enc v. ,._ .._ c-, ...... ., Cw. uu ,s.u.N.Y. A .. il ..... ...... MJ. C'__., ........ wllicll ...._ ..... MIi N .,,._, ........... ..... ... ........... ... lllfiler .............. ...... of ....... altjlal-of c ... _, .... nflffl ................ _...._ ....... .. ....... .. .. .... ........ ....... .. . ... ... ~, .. __.., ....... ........., .. ....... .,_ ..................... .............. ~, llm ._.lllflCr ,...111111 r ..... ... dlaa Df la ....... la ..... ..... ,_....,....,_.,1'111 .. 1 I ,_~,...,....,._._., ... q ......... il ................ __..., ....... .., ...................... ..._.., ..... __ .111111, 1M 1111 .... C'Ff(." ililillc ............... le ,.....,......_~, ................. drarillaflrllntu ....... ..... .. ........... -., Jira ........... ii-..._.., ..... ....... CFTc11...,., ............ ,._,.,r ,--,. la..__, '8111r le lallil a._....., ........ CFTC' -cff1e1iw _.,,._... .............. __ .,., ... ... ,. ........ i.,.o.lililr ........ .. ....., ..................... ................... .... ..-, ...................... fir ......... _. ...... _. ....... ... ............ will!"' ....... ,,_ ................. ., ..... ill... ,._ ... ,.,. ._ ........... L .... _, 5lldl &1ioa .... -...... a ..... llllkr ...... ,, .......... ....... .. -........... ... daial _, .............. a .... ... q fllilll ...W ..................... 111-
PAGE 47
19171 MAHKf:'T STRATEGl/:'S formulated 1pccifically 10 addrcu 1hc unique problems poled by commodi1y broker IMOlvcncin, Ille Code' commodily broker liquidation proviUORI would appear 10 supply lhc mosl rclcvanl lc1al 11andard1 for rcccivcnhipi 1ha1 operate 10 liquidate an FCM'1 buunns, 11 lc111 u 10 dislribulional iasucs such u 1hc priority or customer claims .... Since ra:civcrshi111 arc remedial mechanisms 1C11Cr11lly ,overncd by fle1ihlc cqui11blc priRl:ipla,"' lhcir use should noi rna1crillly dimini1II prc-c1i11in1 protcelions or cn1illc mcn11 or cotnmodily cu11omcr1 and other in1ern1ed parlin conferred by ahc CEA or other applicable law. A conuary result would be lncqui11blc and could undermine ihc very procedural economics IOll&hl 10 be advanced by receiverships. If Bankruptcy Code cus1oincr proecc1ion1 arc noc observed al lcall In principle when a receivership procccdina is used 10 distribute lhe uscll or an insolvent commodity broker, customers &hereby di11dv1n111cd, if fully lnrormcd, would presumably ICCk lhc prOICClion or lhc bankruptcy laws ... Moreover, a 1i1nific1n1 departure rrom the 1cnct1 or lhc Bankruptcy Code in 1hi1 conical ,would enable lhc rOt'm or lhc procccdin1 10 m11crillly al1er subllantivc riah11, a result di1ravorcd in 1hc law and evidence or unrairncn in praclkc. A rurahcr reason why 1hc receivership rorm or 1hc procccdin1 should not raull in dcparturn rrom lhc 1ubllan1ivc protections arrorded by the Bankruptcy Code ii 1h11 &hose protections csscn1i1lly derive rrom and parallel lhc. trca1mm1 or propcny and cu11omcn under the Commodity E1ch1n1c Act. ConK4ucnlly, lo lhc CIICRI 1h11 the Bankruplcy Code ii ROI ,honored in receivership procccdinp, 1hclC CEA prcecpls noncthclcu should secure an 1ppro1imatcly cquivalcnl rault for an insolvrnl firm's cu11om cr1. 11' For caamplc, lite Bankruptcy Code cu11omcr priorily provides 1pcciric 1111u1ory rccoinilior\ in bankruptcy or cullomcr i111crcs11 defined by Section 4d(2) or the CEA.~ w .. _, Md Clllla ncdililn I adclilicln, llw pa1a ,. .....,., flcaillolllr of ,..,ci_.,.._, hicll UII __ ,....., .1-1icNl1 ,...... ,,_ "''"'"' cu11odr of CUii-flllld1 10 liquNIMioa Md ............. of ,,,..... 11>110 ..... prPCcdurn 111lorcJ 10 '"' (IM 11111 ...,..,...., 10 ........, cvc-11111Cn. _, rttNlrt ,_,.,nllipo pu11o:11i.1, 111cful rrtlltdtn la CN,iuiwtilla WMh CtT(' tfur-pr ... rcJt .. 1 IIIIIIM fifMI la al'l'llffll il,la1ine l>I llw <:nC'1 1.-:ial rqulalil;NII "' Dllwr lqll rcquil-1. Stt ,_,,,11, rc1111n1 a i.,,... """"' hOlf A ,,_,,,. -, W.., 11,,,,,,.ru 11-. ,:---,.,, .,,..,, ..,_ lruolw. J J. a. Funiau Ma,un 11 9'-101 1Wia1cr. ltlll, :144 .,, -JohrllM SIIIAolrlw, 611 t'. Slrfp. IJ41, IJ41-4t ID ColD ltlll lCINla11
PAGE 48
IIM WASIIINGTON AND Ll:E LAW REV/1::W IVol. 44:149 Noncthclcu, Ille Volume rcceiwcrlllip dcmon"raled the e11t111 10 which HCminslJ clear balllrup1c, principla llliahl be diq,uled or even, po1en1iallJ, di1rqardcd ill receivcnhi111. For eaamplc, In 1he Volume recciwcrlhlp lhe view wu advanced 1ha1 1hc prlorilJ claim, of 1he firm' IIOlldcfaukina cu110111Cr1 did IIOl calcnd be,-aearepled funds, an allllChronillic view recaUina 1he dcciaioll in l11 1/w ,,,.,,. of Wm swi1in, which wu caplk:illJ reversed bJ Ille Code.'"" To lhe Clltlll lhal 1uch basic cu11omcr pr01eclion1 relllaia open 10 dilpule ill ra"CiverlhiP', lhe prOlcctioa or commodilJ cUIIOIIICfl affa1ed bJ comaodilJ broler lalolvcncia raaiu lhc uncer1ain1, lhal impelled nacllllllll of lhc CIP,ftl llalUlor, prOICClionl or COfflmodilJ CUIIOfflCrl provided bJ Ille Bulruplc, Rdor Act. In le, rftl*l1, however, 1hc Vohune rcccivcnhlp evt11111111, achieved lhc lllli111a1e objecllva of Ille Baalrupec, Code's provlsioaa for lhc prOlcc lion of cc11111nodilJ cU11omer1. For 1he IIICIII parl, lhne raull1 were oblailled bJ comprorniae and wllhoul proclucin, clear judicial pra"Cdenl 10 aulcle future cun. Howewcr, clapife 1he faca lhal Volume' cllllomen ra-cived rull compensation bJ inau of coucasual arra111emcn11 ralller lhan judil.-ial e11forc:cmen1 of priofkJ claims, ii is reasonable 10 infer lhal UICUIIICtlll of lhc respective lcpl rl1h11 of 1he parliea shaped 1he cornpromlan even1ua11, achieved and 1hal u the 1ovcrnina leaal princlpln are rur1her defined and clarified, similar conuoveraiea can be resolved more capedilioualJ in 1he future. illln .. ill., .... .......... FCM, ... Cl:A ...... lulrllllkJ C9* lllollN prowidl _..., CGalf-.. --hpp I lftll IIUUr . TIit Hlnl o ......... la Pl 11 I z I HI of.._ .... _, wllicti CEA or .... ,..-:, t:9* ........ -..... ,.,,_ in. dra,. s.. ....... ............. ,,,,,,. J4J ... ICJI.CII 1-illa ,-dlJ of MIIIIINIIJ per .. .. propa .... or .... receillf'I ,._, ill ... _.. of KM ...... IN 111M ""llal1Ct1 f11r1lllr coa,liuld.., 1-craialJ ......... -............... ,... 11c,a ............ 9tlidlil1arart, .......... 24'. ,_ ,. Wlil S.Wilia. 1- lltlS-1917 r,-,. liMnl c-. F ... L. acp. CCCHI 1 JO,I. CS.D.N. Y. ltlSt. :S,., .... 1n1 .. 114-116. TIii tllCIIII lo wllicll ... V,._ ,_. ........................ _, __ ,, ... .................... ,11111<, c .. ii ,.., ill,. ____ ,._, / .......... ,._, c: .. ,_.,_ V../-". Eialil A....i ALlAIA c-rc of SIINIJ cr-Dnlrr ........... .. 11-IJ. 1:11. s...,. 1111 a,J.J4. .. - .. ,--. 1111 ........ or .... ... c, C9* ,....._ ... ,.._lo..._,.., llfolcr ,_ ... ...,. IWll II V..._., rrn...11. u ~,_y..._,,...._.,...illf'lliapwll._,..,"'...._-. ._ ... v.._ .,...., llrll ''aoior ,..,.,.. of 1 a ca rl11iall lrllfdllrll 11111 ....., et -,,., ....., .,,.... ..... ._ ... <.-nc-, az#h-lo '"' ic ,, 1'1 .... .. .,__. -"'81 ,._ ,. wMdl dNn ii ........ N ...................................................... _,., ... c-a.llJ bdlloal Acll ... CtTC la ,-, .. correct ....-1oo of.,...._ of .. IIIIIMllflC, C9*, _, ... -<.'FTC ...................... cor,_....., _. .,.ilcallDa of IC(JMl!X Clartoa'II...., ... .,., ... f ...,..., --lljtlilin la lC911 .......... of deofilla ....... _, .. Pllorilla ..... Mfn CIIIIDfin ol cllilolol1." .,., ol ,..._., A11or..,..10 ("CA o;.jffllool f Afilllic .. lDM, ('FTC v. Voi-t I-Coi, . ND. IS~-DU 1S.D.N. Y. ....
PAGE 49
111171 . MAllKl;"l' STIU n::cm-:s .,, Priorit1 of Custom,, Claims. To lhc een1 th11 Volume's cu11omcr1 reivcd compcn111io1t for the liquida1ion value 01 1hcir positions, lhat {e,ull can be Hen 11 1 reOtction or lhe special st11u1 or commudi1, til'-lomer1 under boch lhc CEA and 1he Bankruptci, C:ode. As discu,~d above, the "bridp" loan that facilitalccl a full di .. ribulion to Volume's c~stomcrs rcpre1en1cd an utension or crcdil cunditioncd upc,11 the availabili!y 10 recompense Ille COh,JEX or cer1ain funds owed b, lhe firm's ddaullln1 customers in sculcnicni of 1hcir liabilili, 10 1he receivership. The Code's customer priori,, provisions apparcnllr made clear or reinforced basic cqui1ablc uaasmcn11 Oia1 1uch funds should be subject 10 lhe first claim or Volume's aondcfaullina customers and 1ha1 cu11omcr claims prcdcd claims or lhe clearinall_oulc for lhc rCCOYCrJ or mar1in funds advanced 10 1he other side or the market or or acncral crcdi-.,1.111 H 111n1mcn1s or ivailable recoverable &.'Ullon.,er propcrllf were made promplli, and su,ch aa1kipa1cd recoveries emploi,ccl 11 the basis for bridae loans such 11 even1uaJ1, occurred in Vulumr, di1tribu1ion1 10 a dcfaul1ina firm's customers could be 1rca11, expedited in mani, cases. 111 The Bankrup1ci, Code cuscorncr priorili, provisions 111d pcrti1icn1 C:l:A provi1io111 thus should racili111e sctllements such as thal in Volumr that ra'Olni1e 1he primarr entl1lemen1 or cu11omeis in a brokeraac insolvencr to Ill fullds 1h11 11:1uallr were or should have been in sc1rep1ion. Pro Rota Distributi..on of CustomB Pro11Bt1. In addition to the priorili, or customer cl1lm1, 1he Bankruptcr Code pner1Hr is intended 10 assure :customers or cquali1r in 1he disiribu1ion or custuner propcrli, and 10 prevent a race amon1 crccli1ors recover 1heir funds. l'he events followin1 Volume's default raised qucslioni conccrnin1 cqualitr or di11ribu1ion or the firm's assets which, in the absence or a sculcment affordin1 full customer com pcnsa1ion, could have' been resolved br reference 10 the Bankruptcr Code's pro rota disiribulion iaandard.111 To the utcnt 1h11 collusive 1r1nsfers alleaedlr were made br Volume or Volume repraen111ivn in an1icipa1ion of or immcdi11ely followin& the firm'I dc,ault br which &.-Crtlin customers JH. c-1111 ..... Illar ..... INI-UINJII ...... for ................ U ... ,_ ... .. -- OIi Val-'1 --..,..._ -11il.t - .. c.1 1k .,..._ w -lililalNI. 110 ... n, 1111 111,.._. cw1111ualr acllitwM rllr.:11dr ....,.._. _. dual .._ or va1ai11-1. s,,, ,,,,.. 1111 II0-11, a,.,., ,., Kti'1 AIIOllltJI 10 l.t:A C>ltilo,111N11 10 hr A1'1*Mioll1, l:t'Jl" w. V....._ IHtlllNI c., .. No. II Ci. mJ cs.D.N.Y .... 81 7, J7,JI. HJ. C-1 llr I. Krwia T. Duffr, lllo l'lnilW -lir I'..,_, IKliwnllllp, ... ilal1ac11 .. ill dlil ........ Al o ... .......... ... -, ....... ioll, ...... o.rr, ,..... 11111 v..,_,, r.11 ,. Pclolo, w ....,.... ..... --o1 ,., ,,....._ ..... pn .... 1li, llillll ..... IJOllld .. 1 fM11Kli ... ill ....... IOil ll"OMEX Cltllllle ---"'"' ........... ..... puMic .................. ., ... .. .. v..,_...,..,. ... ,-..-1111, ........... .......,...,..,. Pr1uto10 .,_ 1a c1111.,. Y 1f1n of 1111i1 .... .,.. llalil:dr i1 IOllllioll." enc . v..._ lawt11or1 c., .. No. H c.: UIJ (!i.P.N.Y. t Cll8111C1ipl of., .... llrld oa ... Jt, ... ,. .. HJ. S. _,,,. aa 116-n.
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196 WASHINGTON AND l.EE LAW REVIEW IVol. 44:14'1 111emp1ed to olltlill property caccedin, 1hcir pro '"'" lharc or 11se11 available ror dislribulion, IU(h 1ran1rcr1 may have COllllillllcd rraudulcnl 1rullm odds wilh 1hc r1111C1amc111.U, c,llilarlan purposa or 1hc Code 111d voidable by I ba111kruplcy lrllllft, The CFfC'I adminillrlliVC charp 1h11 IUdl lramrm violaled Seaioa 4b or the CEA, which proscribes rraud la c:ouectioll with Ille .. llliq or ruaura COlllrlCII, ii rurther evidence lhal, I aaabliahlna the rcvcnlbililr of well 1r111.rcr1, 1hc Bulllrupecy Code advuca oihcrwisc applicable polida or lhc CEA.1w Comcqucnlly, had Volume's CUlloam IICII bcea 1rrorded ruU c:ompc1111lo11 ror lhdr Iossa, recovery or 111ell UU1lcr1 would hive bcn 1ppropri11c 10 protect lhc in1crna1 or VolURW CUIIOIIICfl whole pro ,.,. dillribu1ion1 were dimlnilhcd by such 1,111.rm. To racililaac sucll recover,, lhc rccclvcrlhip court would lilicfJ have ndowed Ille receiver will! avoideDCC power, p111crncd 1f1cr lhose or I balllllruptcy lfllllcc.111 Cwri111 ar,.iu11M l'rlorlly. A 1hlrd 11pcc1 of lhc Volume cpilodc wilh irmacdillc ilnplicalioM ror Ille flna' CIIIICllllffl, lhc ICliolls or COMEX Clcarint, also lllould be UICIICd apiua Ille rclcvanl provilionl ud pulicia of lhc Banlirupecy Code. MOIi controversially, Volume illllllrlled lhal, In prlClice, 111c ia1cra11 or the ckarina orpniu1ioa u 1hc principal qcncy for pracrviq Ille illlcpily or r111ura COlllrlCII and lhc lllbilily or lhc marlllctplace"' poaca1illly mar co11nict will! lhc ia1crnH or an inrolvenl firm' i11t10CC111 Cllllomcn duri11 1hc lli&hlr comprcucd lime r,ama within JM. S. ..,_ NII 11 117. HS. la A'- ~. "'I"' U., 1111 COWi ...._. dlla .... .,.. ............. ............... .....,c.. ........ ., ........ _ffll ................................................. _., _.._, .. ......,....._ .... nll*J ................ Sl ..... ,iltF. s.,,. ,,.,, IMf co. c. 1 TIit - alla ...._. dlial lor -,.,.., ...,. .. ... _., .... ,.,_, ................... ,., .. _~.--1111 ...... ._ II ...W ... Ill ........ f Ill ncipinl1 lllirl Midi '6alrilillllou. lllirr .... I ... h ... :+Me!t of ..... 11111 law -of NIII IO Ill ICliMtlllip. II IHI. la Hjeaile 1111 ........ ...... IO ,...., ........ ,, Code ,.efcrnicc .. oriliDu, .,,._ ...W -..... kl_.,.. ...-lllilll, of, ..... -el Ktillll ill rftli, ....... f ......,, .. __.._ ..... IO ....... daial _., Scclioa 411 uf IN 01,\ foo ,_,.,, .......................................... ,.,., .. ._. of llir ..... llfllCJ c .. -....,....IO rffa1 ..,. .. .,.of....,., a...r1 ............ ..._ ........................... ,_., ............. ,.., ... ...... ...,_, ... lllirle.,. IIMlni,ic, ....... TIie --.................. .... S.. Ml of ....... fllfkf C .. "a llriCI lilllilllr prowllioo ,-ail1 a lf111111 ...................................... willlirl "" .......... ... of ._.....,, .. OaMl e ,._ IO Ill "Clllrirld ..., .. ., ,N aldilor1 of_. ..... ,, 111111 ..... dlial f,W ... alowd .. ._ ... 10 OIMI lllllllurr ---" 11 IMt. n.-_.._.. .... ,.., .............. ,_ ....... """' "' ... ...., .. f111 lllf ....... el .. .,._ o wlNa llillillloriN allilNlelr .. DldtH. ill 1 .............................. of ....... u ..... iNkill lqjllllioll..,... .... Nllllfilr of -" ltl. a, ,,_,111, lfflllllllioll of f ... 11 ,_of .... I .. Pill ,...._ ..., ... ..,._. .,.o:,c,.wou111.,.... ..... _,, ............... ,., rt\'li.., ... -llilll ,._. irl ..,._, of ~lilllle f ... 11 1111 .. or polic,. u, .s.w..,,. ...... .....
PAGE 51
1 MAHU::T STRA Tl:."GIES 197 which lhc di1p05i1ion of a ddaullin1 firm's niar1in funds and open con1ract1 i1 clclCfmincd. Spccini;ally, 1he Vol11m, case raifl lhc pouibilily 1ha1 a 1hor1fall in ac1re1a1at funds could be crealcd in lhi, conical wi1hou1 1hcf1 or OlhCf arrirma1ive nialfeaunce by 1hc Fl'M bul 1hrou1h a1111armlly lawful action of lhc clcarin1 or11niu1ion followin1 a cu11umer default. Thia could occur, for c.amplc, if followin1 a clcuin1 lirm, ddaul1 on a varia1iun marain call of Im million dollUI lhal principally rcprctcnll louc1 on lhc p05i1ions or one cu11omcr who hu defaulted on a mar1in demand issued by 1hc firm, lhc clcarina or1a11iu1ion u1iafin 1hc 1en million dollar mar1in demand by u,ina 1hc.. firm' 1oial oriainal mar1in dcpoai11 of 1en millioa dollara, consiin1 of. five million dollars auribu1ablc 10 1hc defaul1in1 cullomcr and five m~lion dollara a11ribu1ablc 10 lhc firm's nondefaul1in1 cu110fflCf1. In 1ha1 event, lhc se1rcaa1ed funds or nondefauhina cu11omcr1 are depicted by lhe dearina or1aniza1ion 10 errcci 1hc payment or varia1ion maraln pur1uan1 10 ic1 function as 1uaran1or or 1hc ddaul1in1 firn1'1 open ru1urn posi1ion1. As ~n1ioncd previously, such an evcn1 occurred followina Volume lnve1tor'1 dchull when COMEX Ocarina applied ori1inal n11rain dcposi11 of app,oaim.-cly St.I million held in se,rcpled accoun11 on behalf or Volume's cu11omcri collcclivcly 1oward u1idac1ion or 1nar1in oblipliona pritnarily aurlt,vlible 10 lhe firm' 1hrcc dcfaullin1 cu11omcr1. In ao cmployln, Volume' oriilnal cu11omer marain dcp05i1s, COME>( Clearina acted in a manner 1ha1 ippcara 10 be con1illcn1 wi1h, al1hou1h DOI compelled by, ill by-laws"' and, ii 1hc absence of knowlcd1c of or panicipa1ion In 2'1 .S.. <.'OMl:X Cltarilte rL t.J Ill cull lkpalil1 ... CDllalnll .,..... llr dr11ille _..,. 11 NCilr for lllr perf-of ur ollliplioll 10 Ill l"mpor11ioll _, llr "applild , ,.., Corporilm o ur -*"'IIIMu ollllpl of Ilic illt au, ... Mralln o lit tr,o,lliolll"I. 0r11,.. orp!liulioll ,IIIH ,..i rII ., .. -liotin 11w of oriatMI - olcpc,ut 10 111111, lllllip of okllllll1na
PAGE 52
191 tl'ASIIINGTON AND LEE LAW REVIEW IYul. 44:Mt Olhcrwilc Olllf .. l conduct, 1ppacn1lr pcrmillcd br lhc CEA and Cl-TC qullliofts,IN TIie appaCIII priorilr of cleaina orpniulionl 10 oriaiMI maai funds a1 1hc clariaa leYcl is j1111irlcd princip111, on Ille poler pound 1h11 such dcpolil1 CNllillllr 1CC11rilr for 1hc cleariD1 orpai1111on rapo111ibili1r 10 111ilfr dcllllllds for v1ri11ion Mlrain owed on lhc Ml poailioa1 of iii CUIIOIIICf lhc def1 .. lliR1 fim, 111d lhlll ID CIIIIOIIICfl OIi 11111 oppoule side of Ille dcflllllilll R'1 COlllflCII, Al Ille rill of IIOllperforllllllCC on ill 111C111ber'1 palilioal ii nuu, IN>r br the cleariD1 orplliuaioa, 1hc clearint orpniralioa c:ou1i1111a 1lle "ulliallt beuer. "111 TIit priorilr of Ille clarilta orpnilalioa 10 11eur11, for 1hc discharp or 111 olllip1ionl u "1uuaMor or 1111 raora" 1haelor1 scrva 10 11111re the inlqrilr or r111 ... a arllllldioal, pr01tc11 darl111 fi and the Cllllaaen of IIICh firms on Ille opposite side or Ille ..... Cl, and fOlltrl mutl lllllililr. In this apea. tlle Rn& dlim 1pi oriaiul -al dcposil1 ca be uid 10 be 11111 of overall ...... 111bililr. prllldpal objective of &lie .. pie, Code. while Ille Olhcr pr1 ... Code objective, Ille prOltclion or Cllllomtrl, ii lddrmcd to e1111omcr1 of the mup1ace ...,111, ad the prOlccaioa of CIIIIOIIICl'I of specirlc r1111nci1Ur illlplircd fim II corrapondinal, 111bordi1111cd .... ----.... ....,,; C'lariae ,._ ................ ,,,,,, ... ...... i.. .. -., .......... J; ,_ ..... a. .. c.,,.. ..... .. llillillilJ ., ... C...,illl .. ..,_, ... o laNn ltllllliaa -.. -.nf-.. _, .. 11 dllrtll., ii .. ....,ii:.., ......... ..._._of a. .......... _._ .. _._a-.. ......,let, Sr,_,,. -tl,fl ai:n....,.. 1111, Jtl. ('FTC ........ SlllcW NI. IJ.J, U. fl!/ S..,._. .... DI/all t, ......, ............. ; .... 1111 ..,,.,_ DI. 1 .._. c-nu -1 a.uaa. MM, Mt. 1111 ............... iDrllr _, .... ._. dllrMI la ... II -n ... ""' ............... ill .......... ,,,_ ........ ................. fir ., ....... lllo ............ ICI Ill clNrill ............. -, ..... ,_ -8ili11M ..................................... ,...., .., ................ ................. ..., ... ....... ......................... ...................... ,... _._ .......... ,., ... ..... ... ,,. ............................. _,.,.,NN:1~-wllicll-1 ,..... ______ _.,. ................... .. .r. ..,._.,enc~ w.t1 Qmi--..,,,. ,,. ,.._ n. ._....,,;;1 a.,..,_ .. ....,.,, .. ,.,.__.....,.,.._._...., ................................... ,.,_, ... __ .. .. ..... Ill _. lllice _, ..... r.-. nr=iNtilill wMdl 1111 CFTC'1 ff _..... -....,.._., ... ..., ... la 1111 c-.. V..._ l1-ur1 ., .... ,._, c.,.. .. .., .,,,. w . ,o.,i; ..,.... .. Ill enc c .... w,111 .. QaniiuM _,,. IJ SI-SJ. Sr, l'iludll _. Slp ... ioll ,_,, __ NI, CAIi,,.., 1-,r Mlaa Sdf ....... C)lplliullaa Suru-0,,., ....._.. C-,liwe llilll ........ -....... ..,... ............... .._ .,.......,_, oMliul fll T ........ Mar. Ct'TC. 11.i, at. 1st. t c-. hi, L ..... tC:CHI I llltA. TM cnc11.r,...,. 111v._., .... _n,1111 ... _...., .... .__ .. .,,111c .......... _, ....... aalll ................. ......... a-
PAGE 53
191171 MANl.t:T STRATl:'GIES 1'9 The consequence or a 1hor1ra11 in an t'l'M'1 w:1rr1au:d cu11omcr runc11, IUCh U WOUid (ollow UK bl/ a clearin1 uraanizalion or ori1inal mar1in cleposill comprised or ae1rc1a1cd runds, coupled wilh a cu11omcr marpn c1eraul1 raukina in,an unsecured clcbil balance, i1 10 place an immediate obli111ion upon 1hc firm 10 re11ore 1hc rund 10 ill required balance, 1h11 i1, 10 cover ill oblip1ion110 ill cullomcra.111 H lhe amount or 1he 1hor1ra11 cacccdl lhe FCM's available capital, however, 11 w11 Ulac in 1he .:asc or Volume lnve11or1, 1he ahor1ra11 in sc1rqa1cd runc11 ii errcccivcll/ allocated pro rt11 amon1 lhe rirm's cu11omcra with 1hc Ii.ell! result lhal cullomcr positions will. be UllfUpporlcd bl! adequate mar1in. As poli1ion 1rander1 then nlll! be a prac1ic'al impo11ibilill!, a dira.1 c:onaequcnce or such a shortfall i1 lilidl! 10 be 1he,lmmcdia1e liquidation of the open positions or the c1eraul1i111 firm. In the cue of Yolumc, liquidaaion of 1hc firm's posi1ion1, while not immcdiale, followed 0dircc11, once 1hc full ca1en1 or 1hc 1hor1rau in 1e1rc-111cd funds crcalcd bl! a .:um,mcr c1craul1 ucccdins 1hc firm's capi1al and Mafd1 11 uol M.ld1,lt "wu WCNIICMll l!r WCM-lft ill llllr riufto.-.al -nlucc l'flll'or COMl:JC N't'OMl:J( Clnlillt." llio.,. "were.....,_,, 1101 -c or 1111r rrni. v._ -ii,-... or 111e..,.. w allcld, llffll .__ ... .,...,_ ,.__, ,.,.,~. ,,,,.. -llP. so. lh rnull or ii, 1cwic or v._ lYfllcw, CWM1, ... ,.-re, .... ,,.___._,._, ill (OMl:JC ... CUMl:JC ac ..... __ 1111 ...... pr .. ,_, lkffllllNIICIII of 1,11,_ IO IHWC 111111 .. ,,ICM-of u-... _,,... lliall ,. pillilm, ,., .. ,o 111Cir i.-c Ill ---r ,_ ................ or powlioa ... --.......................... ,.__, c.,,,.,,., __ ,,,,,,. -- .. ,o.n. Siaildr, -,_. r. ..._,..!Ml_..... .. ca.rill llllir ....... IO .. .... ..... --~-1 ................................. ... ------.. .,., ...... _, ..... "Illa, ..... wolllll -ill ;,.,., .. "'c ,.., .. tct "!Mlilll a lewd ., .. rricint to -- ,.a. st:c-,cnr .,,,,...,..,,. /w,n .w 0-.,.111_,._, /: ,,_,_,, N II .. JU7, H .. JJ/J .w ff .,,. _,,,_ rlw .w--.. T"'1c l'llf-. c-,,,_,_...,, ,._. .w ,,., .~-... rhw,;,11 .w I-.--., llw H-c-. E,wru-' c-. tltll COIII., M Sn1. I., :NO (<.TIC ,._,tiN, Mar ltlJI I 111 rcwww ef 111c Y...,_ I- *', tllC ("tT<"'1 Uiffliaa ef ,, .... ...i Marc" nprnld -n 1i. "we - ,alio;y 111C nd Ind _, llawe 111rilf1<-lr cumlMllcll ro tllC Voluac rat111." t'""'-/a _, C,._.,_, 1111" -C 10, M ....... T11 Ille CIICIN Illa! lkfi,;Wll(lft dn, ... ..,.., .. fiu.ial -cill .. u ud oeha -,1f.rc1111a!nr, "'" .. r_,..,.c 10 a drarifla rira dcfollllt or lail 10 ..,cwo111 ai11111c kK,n 111M .....,... llawr hn11 oodrd. 1he drarilla or.-,-P'"'!N,, alllltt111II canWil 1n bdw11 of 111c ,, .,,. aDIIII. .,.,_ "tdf-lldp"., .. illlncwcll, lrNI ar1uably par1ia11, rnpor1>1111t, pa,11npa111 1lle fonalkial t1i111. J6J. S,,,,,,,.. ICU at IJJ. Ml. S,,,, ... Ir; ,c11iacNI, ...,,, ..,.c JI. 11 UOO t1ra111fn1 "arc ac- __. 11111, WIIII rnpat ID rllll-11alk1 wlNtll arc adcq1111dy aralllNI wt1II lllotll 1lllr de,.. ........... .. I ...... ..... ft ,o, .... __ ,. ........ ,; IICIJICIIIIC of lllr CtTC Ill ("n1a w,111 Quell-,. ,.,,, -u. a1 10.11 1tt re, 11112 a,w.-or ...,..,..,. .. ,..c l"*' dflCtiwr dale illokn Illa! hell fllfllh lllrld v1rcptfor c1111-1 aro ......... liall, lnl Illa Ille <11111_, Ill IU.11 rllflll1, Ille lthltlluuol of tllfi"I ...... Halcrtt, fut -11 _, 1111r,..ic 11-..i .,_ awadablc 111 clfc.t .,_,er, 1llal 11c rcnlllllc 11, a lrllllff ii _.,,
PAGE 54
tCIO WA$HINUTON AND I.Et' LAW aEnEW 1vo1. 44:Nt <.'OMEX Cleariaa' .. of oriplal -pa dcpolil1 ..._.ed rCll*I of 1.Wloaert of 11111 fir aNIIP'cllnlded,.-COMl!X <.'lnriat bJlaWI prowidt 1llal .... 1111 1craiulioll ol darilla prl ..... of a __.. r ........ ......,. i. 1111 na1 o1 rahre 10 .... ,, ---...._.. ... 10 1111 darillt orplliuliOII, opea eoa1ract1 carried lldlalf of Midi c1ar-. __.. _. lie 1, ldmd a., 1111 dole or uadillt lw c11, followial Midi .......... aap1 10 1111 a llal Midi coaracu art 1r...rtm1110 ................ Howncr, Ir ... ,,, ..... cd drarillt ...., II FCM, "Ille corporalioll 11111 tadawor 10 u..ra 10 OM or Ollllr dtarill ............. _, ... of CWIWrl ol ... ..... mo llabe -..rce.. la ._ of dDllaa oa 1111 w ...... .. All ..... Ille al-of a darilll ........ ... IO alllllpl 10 tffea ., .. .. of .................... 10 Midi prorilioM 1111 IIOI lifla ad;.licaMd, Ille -,rollalllil, a 11..r Jira clOIIIII IIJt localed IO acapl .... --IIIUH"n. ....... ---, .. 8 Jira coa ail-lO ....... Midi, ... or .. 11, for lldr ....... WOIIW radlr ... ,.., llrad, ....,ronaalllt la caaa Midi V..._, If polillw ,_,. Ill ,,..,arad, ,..,_to.._....., Illa aa Ill rill of...,. IDuel ror 1111 dnrNII orpeluliOII. wllkll ..w Ill..._.._. ............. ,.,_ ., ..,.., price --T1lis ,...... II nm _., ..,_... 10 _._. m.a, ill:0111111, .......... of opa ,_._ 1111 ., ....... r ..... UII......,. 1111 ., ...... fir' wu-. ,.... a1 rill II ... ,........, polillw arc ..... _. price dllaea, 1111 llilecliDII of wtlicll lie ldpalad, CM * Ille ..-, ,......, ......., ror tlllrilNlliDII. Proapt ac1ioa 10 ....... .,. can 1111, c0111ract1 c...oc lie 1rudmed ii llrnfore waur, to ,,.._. cwao..r ... - 1a11n111. ......... -. .,, .,_ cNU a...., ....,. ucn ... "' MJ. n,......._,.., I I .,_,....... ...... ..,,-.. 111 ... -1 ...... ........................................................... .. ....... danat '-...., ....... ...................... ., ..... ............................................... ...... ............................................ ,...... .._. ._ .,.....,.._ .. ,. 1-...,. -n.1 ue J.lt . n, 4.'ff("1 .............. ., ................................ .. .. ._.. .... 1111a ...... ill.._. ....... 11t CllMU _. CCN:X l ...... ................ ..._. ...................... .... ...... .,_ CC*EJl a...,_.._,,._ ... _,..._ l"WIEX -............ Madi D _, Mardi U .,..._ ,._ c...-. ... -... ,,............. ............................... .... .. .... ..... .... .. .. .,. ......... _......, ---., ..... ... bdlap ....... .._ ........... ........... ........ _....., .................. Ian' ."MWIIJ ...................................................... ......... ..., ...... _.._ .. .,...., ...... ...,._.,,. ...... _, ....... TIii enc.:,..,,,...,_ t c ., ... 'llta -._ COMEX <."OMl:X
PAGE 55
INJI MAIIU:T STltATUUES ... I rapllJfwt ai.ewr -.-drpoMl1 10 .. ,.f, YIIIINM'1 .. ,. olllplioa. ii did IIOI, uwe --lcdar of, ,-1icipelc la or lid .... fal CIDadact, <1*EX Clrilll ,.._ -.1cd a __, coaillni .. 11 .. Olm._ of .. Ol'i,al - a.1111 tor ._.,..., Codt ol,jlclM .... ., illla' of fUla catloaGI .,_...,, ......... lail ........ IIIIOlli ca11. n11-.. ... IMOhnl r ,,,_.IO...,, ... -,._. ....... ...., urrJilll firm'1 .,_.., ,..._.. ,_. ........, for_,.._ ..... rffectMIJ dict...a ... ....,. .. of lllir oplll poeilioal. hi 1ffec1, Ma acaioll ....... upo11 Yot-'1 ,._. .......................... ................ .. f 1dlMct, ........ fr-Ill r .. , ...... ,__,. ...... arilf, ,,_ ... .,__... nr . To .... IUI ....... COMEX CINrilll ........... IO_ ........ ....,or.Wllllllla10lllr-CI .... ....... diat ..... ,, .. 0111J 111 ctnr1111 fir N ... oppoeil.., of v..-., .... caa1,acu. ._ a11o. ,......,, ... neaoa-111 of ..ai fir. .. TIii v--. ,111111, ......,, .. lllllftl .._, .. ,Ill cup1l1t ill ...., aee. 11 Ill;.. of .,. COllllict ......... ...,,., of Ill .. ...., ....... ofnea-sofadcf_.illlr .. alliller of ... _, ........ ................ ......... coaproaill of Ill..,,., of ,,. ii fawor of ....... of ... --,. Tllil don ... ...,..._, --IUI a.a .. Ill ipored ..,._n lllon of ... ., 11, ....... ,of- ...... .......... ...... of dearilll r .. -IIIIH M ... M .... of Ill darille Of ..... ioe ... Ill -place .... .., tu11 ..... o darilla fir def ... ........ ..,.,.i ......... ......, of ... ----acllirwd .. vae-II ............ of Ill INlrlll*J Cale, II ii mdnl cneral C-,-,, ,Iii.,_,., of.,.. ..,..._, .. aclllcwcd. Tllil .......... .......................... .,...,,. ..... ffl .... .. illdi"6dul caeoar..,.... _.Ill .._., of ... -place ... ..,.. Ill fact 11181. ,, Ira ... of ialcnneicNI, ... eu11 of Midi 1,...ra1 could "'" ... rdaliIIJ .... Ill Yotcut. IV. MatllOOI o,_.FACanaTING THNUIU o, Cutr01111 Pmmo f,-a CUii_, .. OlecliN palPICliwe, a ....... 1n1N of ... Y ... cpilodt .. 1111 I .... P,GpOIIIIOII ua ill lht cc of a du, ... f11 ,,.,... .............. v .......... .., -..... -...... -...... ... ....... ......... ,. .. ..,_ ........ ...., ___ ............ ... .................... "IIC'OMtXO..,._._ _.. __ ......... ,... ...._.aa..._ ., ._..,. ..... ,.._.v.._., .................... ........... dal ........ .... U 73 C 1, ..... -.,._.., ..... 111., ,_. ._," C'OlaX ..... c-..... -...... nJME.a...,-11111 .... .---..---. ....... ..... ..._,...__ ............... ,.._,.... .................. ...,.__ .. .. ..,._.,,._ ......... -......
PAGE 56
902 WASIIINGTON AND LEI:." LAW REt'IEW IYol. 44:149 c1rr1u11, procectiorl or the 1111n, i1 more rudilr 1ehio1blc 1h1n procccclon or Ille few. Th, ro, CIIIIOIIICJI II the 1Ueclcd firm, compcnlllion Offf IIN bued llflOll liq4aidlliorl wllue1 b rar ruin 10 achicff thin continuilJ or opc11 - poaicNJU. Tu clle calcrll 11111 1 dtarl., orpnl111ioa'1 nadcd 11te of oriplll dcpolic1 10 aecc 611 oblip1ion1 10 cou111crpar1ia ,rrec1iwd, prfdllda poail6orl 1r1rcr1, 1hi1 rnull rcflccu the coani&.1 llclwen .. ,re 111bllicr, wllidl acna broadblacd cuacomcr p,occcciun objecdwa, 1rNI C11Moacr UMcrau -,liulcd II the lrnaed6alclr 1rrec1cd rir111.'" Howner, 1he rahrc 10 crrcct poaiciorl u .. rm also 111a, reflect the .. ,ow ciac r,.,. wkhi whkh u .. .rcr1 1rpklllr be crrecccd, 11 liulc one u, i "'" c1aa,"' Md 1he 1blcncc or prc-a11bllahcd p,nccdllra 10 or.-ic ind 1rltc1U111 tr1rcr1 wllhi auch tlac c01111r1i1111. Al -ii of Ille ...... --of lhe ... UI ,..., or open pCKilion, r1ilurc 10 lllwc a prcdclcralMd COW1C of IClion 10 11111taue 1111 poccndal ror u-rm is tad, 10 dktllc ..... the opponuail, 10 err.a lhca will be loll. Morcowa, tlle cwlllUN 11111 well uwrm c1noc bc acllicwcd hcrl 1 acpcplicNI lllorl fll 111111 bcc1 .. no uuafcrec would be lidr 10 ICUpl ...,__,...,.. ICCOINICI lllaJ be adf-pcrpclUIII .. IAamuch II IIO acuilllflll lllcapl Ml ,cl becri aadc 10 p,owldc I IJIICtlllllc approach 1ow1rd .... UNII 1111 poccdll 10 ICll6nc well 1ruafcr1. '" CllirM tllal pllliam 1, .. .rcr1 caMOt be IICMcwcd IHI r rcflecl the flCI 11111, lllhaorlclllr. litllr 111cap1 llu ._. aadc 10 ICllicwc tllnl rather ..... Ille ICI ... iaposaibtltlr of ... IO. If Ille pOICIICIII few poaicm ., .. .. ..,, to lie ... inliad, adwucc ,....... would be necaurr 10 prCMdc npedililNII actllod of IIIClliaa awllllblc ..,,..._. fUIICb 10 aarp1 open cwaoaa p01ido, 10 ldntlfr po1ndll trusfcrca, 111d 10 aecwc Midi addiciorllll fllad1 or' Iller ... MCUrilr u .. be ncca11r, 10 illdKe Ille .apt ... of Midi politicNla .,, I lflMftrlC firm. Such furMII-, could bc olllaiaed a,, lllirla, ro, 11-,lc, caclblilhcd crcdil flCillela of the clcariaa orpllUllioa,'" clcari .. orpiulioa 1,1111 flllldaa" or dcarlr11 CM pllillliorl pararllec fllllda,''" on 11caporar, bul1. Aa di1a1111cd below, 10 n,.s...,._ .., ...... ,. 17J. le ..... 111 ._.,IIIIICJ nplll'-. 1111 <"tTC 1111M II ....... lll'ffl .................... _.,.__......_ ....... daalaa_ ... ...,.. ,..... el ....,_ - .,,,.n" "*" 1111 ._.,llllkf u- c,111_, .................... .,, ........................ -.. ,.,_, ....... _. ... ...... ., .... ). JU. Al_.. ..... ...._, ,...._ ,,_,n, .... __ ,_. la ...._. ca111 .S.. .,,._,., .. ,... JM. f ....... 1111 \I..,_ I- ....... CUMl:ll Cit ... ,......., ..... .,_ c.-..... ......... ........................ ... ,._ a1.,.. 11, .,. ...... s,,, ou. . .,.. .... C.OM1:ll t11erirle'1 ,__ .... .. ... .... ... ........ ...... -........... "' ................. ... .... "''"'., """' of ..... n ......... ..._ ,._. c .. ,.,._ ..,.,. . n. 11:n-. -,,. - JO ,,,_..,. __ ,,. .. .,...,._.,
PAGE 57
19111 MA Nii ET STNA 11:"Gll::S ,OJ 1hr ca1cn1 1ha1 such llclwancc plannina may "l"iricanllr incrraw 1hr hkcli IM'IOd or po1i1ion 1r1ndc11, 1uhn1i1I ccunoniic1 10 1hr dc11ina or1ani111ion and oihcr mar~cl p111ic1p1n11 11 well 11 1i1n1rican1 bencri11 10 con1modi1J CUIIOfflCfl ffllJ ~rl,K: A. Cun~1.-. AND MAHIT BENlinrs Of PosmoN TIANlflH The Bankrupic, Code' commodilJ broker provi1ion1 rcfk.:1 1hr &:on clu1ion 1h11 1hr prc1Crv11ion or open pGIIIKllll ro11owin1 1 clarina rinn dd1ul1 ffllJ, In man; c1111, provide superior bcndi11 10 individual com modilJ cu11omcn ,_. 10 1hr overall m11ke1 1han lhc liquidllion or 1uch po1i1icNl1.1 Thi IIICllnlCIII II 111pponcd by lhc N11ional f111urc1 AIIO&:il 1ion'1 reccnl 11uc1, or cu11omcr accoun1 proiccuon which 111c1Hd 1h11, in addilicNI 10 cu.iOIIICI' compcn .. 1icNI, "l1ln01hcr ',,oicn1iall1 lmpor11n1 1oal or an acc:oun1 proieqion proaram would be 10 provide lhc 1bili1y 10 illlrncdia1cl, errcauaie 111c o,c1cr1, 1r1111rcr or cu11omc11' open po1i1ion1 rrom 1R inaolv~ FC~ 10 I rinancilllJ Mable FCM."1 Bcndill lO CUlhJftl cr1 accrue from polillon 111ndc11 because c1111orncr in~ne111 in open poailionl .. nOI be fulr recouped bJ recover, of Ille lt111ida1ion value of 1hole posi1ion1. TIie ~uidalion of open markCI polihon , di11up1 an oi.aoina hcd,c or oclia ri1k-rcduction ICrllca,, IIIN cllClllial value of which lin in Ille conlinualioll of 1hr opca flllura or aplion poailion.1 NFA'1 rcporl ablcrva 1ur N 1bili1J of hcd,c11 10 M1i1111i11 1hcir f111urn or opiioll polilio111, and 1hcrcb1 inlurc apinll capoeure 10 price mowancn11 : idver11 10 lhcir calll lillrlCI poai1ionl dnpi1c I broker's illlolVCIICJ, would C01111il111e " wblluijal bcncrN" and 1ui small hcdacr u well 11 111111, coamcrdal and iud1111ioul cuscomcr1 111i1hl prefer 10 re1ai1 1hcir po1i1iou rllhcr 1h11 receive m 1 complete rciurn or .. rain fundl. Moreover, 10 1hc 111111 1h11 1hc .capcdi1iou1 uaufcr or poailion1 from inlOlvc111 10 1 IOIVCIII firrn cnabla buli11C11 10 "proceed u 1111111" 1hrou1h 1n01hcr broln, 111N danaer of po1i1ion1 bccomina dfcaivelr "rrozcn" pcndina liquidalioo or 111n1fcr, wi1h 1hr prOlpCCI of 1ublC1n1ial inlcrim lo11e1, i1 diminilhcd.1 '" ..,,,. ... M 171.111-11 JJI. Netioaal t A,_.., __ 111p, ..,., I. ti "'-"' --...... iw,ip ........... ...,._ ................ .., .................. .. f,_ r ..,.., .,....., 111pa1 10 llw k 1nul11 .,_ 111111 """'"' '""''""'" .. fd. lq. IJJI llflll. I#.,,,,,. IHI el 1111-11 IN. NII-' n ,._.., __ -I, II. I Ndllitla 10 *11rtKtof 1 .. .-..i el ...... ,....\GM If lfMI 1111-r.-1ioll 11,.,..., fo,cftl ..._..iolll, - aho ........ ._ .. ....... I .. .... of c-,ke. I .... IIIHr 1111 acrel pGIN-1 tf0 11 .. ..., -Ill fal!-tal'IIII V._ *IHII ....,..._ < ..,.._ lhin e1 ..... II el fflllM ..... IIIIIINI ..... 10 tllf 0,11 .. c..,..._ ol IM polit-.W .,,,,.......... HI.,.._ SI,-.,,,,, ..,., M, 111-IO, A_.,1 a ln*r. OJ/.,._, S-, .... _. W_,, II II L,..., iA, a-11~. IIIIIIIVl-& l111UICII, IJ- IWI. 11 U ltf a lluli'1 .,.. f111n polil-II fro,o. ""ltr 1"' ,_ could IN ...,...., o, 11-f111N, 1111 ...-MIi ,1111 tllt Illa ...., ... of tllouulldt of dollen"t
PAGE 58
WASHINGTON AND LEE LAW RU'/1:.'W IVol. 44:141J I addilioll, 11 the rramcn or the Bankrupecr Code recoanized, prncrv11ioa or opn poliliou enhances the likelihood or con1inui1r or marai parmnll IM thereby iKrHICI Ille lllbililr or Ille markCI II I wbolc.m The NFA' 11uc1, ii in aa:urd, oblcrvina 1h11 poli1ion 1r1n1rer1 rrORI inlOIVffll rirm1 "IIWOUld 1lao racili111e the conlinucd ordcrlr opcr11ion ur 1hc r111ura 1111rke11 br climin11ina the 1pcr or rorccd liquid11ion of poailiont." Moreover, br incrcuina the problbili1r 1h11 c1&11omcr1 wiU continue 10 111idr mar&itl dnnudl OIi their open po1i1lom, 1r1nder1 1hould diminilh the likelihood 1h11 the dwiq orpaiulion will be required 10 do ao, po1a11illly ainc lianiflCIIII ICOIIOMI ror the clcarina orpaizalion ill iii role II auar ... The cvcn11 followina Volume' default i111&11r11e 1hc po1ai1i1I economic bcncfi11 10 C1111omcr1, the clcuina orpnilllioa, and other market par1k:lpan1s from prnav11ioll of the open posi1ioll1 or I dcf1ul1i111 clc11in1 firm. As rCC011cd above, ccr11in Volume cu11omcrs claimed 10 have suffered subll1111ial loaa because the liquidlllon of the firm' posilionl or 1hc IIWIRIIICII or liquidllioa valucl did IIOI reflecl lbc compoailiOII of complca, pu111ivclr rilk-llClllrll poliliona. I addition, hid po1ilio111 bcn uamferrcd rllller lbu liquidlled, the clcariq orpnilllion's lilbiU1y ror vuia lion ..,.. pa,-cn11 would likely bavc been 1i1nirlca111lr reduced by cnabliq the r ... 1NN1ddaulli111 cUIIOlllal 10 continue 10 rund marain pa,-1111 OIi lhcir ow poliliont. S.blequc.a recclvcrlhip procccdlqa Ind rclllcd liliplicNI allo Cllllilcd COIII ror Ille dnrina oraallizalioa, the H chlnac, and Vohunc'a Cllllotncrs. Further, the ullimale price or illlpairmcnl of public coafNlcncc ill 1bc ru1ura marke11, particularly aivn lhe 1row1h or COlllpdia rilk-rcduclioa and apcculalive produc11 aold Ollllide of ea cbanac awlie11, 1111y be lipiflcaill. Thc fact 1h11 conccru over Cllllomer protection uoulcd br lbc Volume dcfauh have persisted for months Ind, Indeed, ,CIII ar1er Ille f11m's r1ilur.- IIIUall the r111ilily or public confidence I ... 1ice1 111al lack a 1y11ema1ic method for minimizina the IIJ. S....,.. 1n1 111, 177-11. JIJ. Nllioal F A ..... illll, _,,,. -J, ti ... s.r ................ --..... ,,_ ..... _.., .... _, .. coa,,,.iliaa of.,.,.... ......... ........ _..... .. -...,, .............. ... ~la..,,-_,111. N ...... .... Ille 0.1ullcl 1111 ... 11 lornl, Ille ....... ._ of ,-ii ill lilllcr IM,-ilin - cOllld ...._ illcrlUIIII r11llcr ..... ,....., ................ JIS. Al__...,.....,,, el COMEX a.an. Ndcrllllll ....._ _, y..._,, ,-ii, II ... 1111al _,_It aillioll la leliN-ala ,-,-n11 111C fira'1 opt11 ............... -.... 1. 116. S. SJ ,-. lq. JIU UIIJI ....... ._ of CenM H,tirW _. lclel lllr -"IICFTC _. __ ktof ...... ,..._...__ .. pr ..... ........ ,,, __ fGf ...... ~,., .... prodactl .... lllllcr I .... N ........ CNlrllCI -, Jl7. t:.1. Hilllia, A ,.,,,, u/ (1111/*-P, l'1N. W011D IJa, 11111 l"Voi-'1 collaplc ..... .................. ,,., ....... 'wpcplNIII' ruin ... ..,. iaaolcqulc ID prlllffl aiu_, ,,_ _..., .. .. "lllal, la lian uf ~rilil, 11, ...... u,1 dnr1111llou11 olficill1 ... C..W lie rclial .. ,o ICI nc1u11,c1, ill 1llc illlcraa of 111c -p1Kc"1.
PAGE 59
1'1171 : MAllliET STHATl:.'Gll:.'S '' dislocalion1 or a ddiull or Insolvency, no1wi1h11andin1 the rela1ivcly low lncidcn or cu11omet io.s. Had Volume carried aa:oun11 rOf pcuion plans or mutual rund1, ra111tr than 11oor traders and a rcla1ivcly small 1roup or public cu11omcr1, ii ii rair 10 a11umc 1h11 public conridcncc would hive been 1rrec1ed even more proroundly . 8. IIIPEDIIIENTI TO POSITION TUNSPHS Dapite Ille cvideld advan1a111 10 1rrtc1cd cullomen and 10 lhc ffllr licaplacc 1h11 may accrue r,om lhc 1ranlfcr or open cu11omcr poli1ion1, lhc evcn11 followini. Yoluioc's ddaull rcl1cclcd lhc absence or any n11bli1hed procedure or in11i1u1ional mcch1ni1m, Olhrr 1h1n 1hc Banlirupccy Code and CtTC b1nlirupJc1 rqiila1ion1, 10 errec1u11c 1ransrcra. A a rc1ul1, cu11om cra, even Ir willina 10 1upply 1ddi1ion1I mar1in runds, apparcnlly were nOI arrordcd an oppoJ1uai1y 10 cHccl lrandcrs. The clcarin1 or11ni111ion and c1c:han1c were equally. unable 10 brin1 aboua 1h11 r11ul1, dnpiic lhc fac:1 1h11 1hc c1cha111c eventually advan.:cd rund1 in an 1moun1 1h11 would have enabled 1ran1fcr1 10 01.uar had such rund1 been provided al lhe lime of 1hc dd1ul1.111 These rnul11 rcflcc1 lhc rcalily 1h11 1randcrs of po1i1ion1 ror which surricicn1 .marJiri ii lac:liin1 arc imprac1ic1blc unlcu a more formal procedure i1 implcmetplcd 10 compcnute temporarily for a lhonap or 1ran1rcrablc mar1in ru.ncls. PrlClically spealiin1, a 1randcrcc firm s11nd1 immediately liable lo :supply any difference J,ctwccn required marlin rund1 and 1hc rund1 1ran1fcrred rrom 1he.ddaulin1 firm, in addilion 10 111ilfyin1 varialion marai demands u 1hcyaccruc, by drawin1 upon ill own c1pi1al. Such rWldl may ullim11dy be rccovcrablc, u occurred in lhc Volume receivership, 1hrou1h proscculion of claims: qai1111 ddaul1in1 cu11omcrs or 01hcr1 1n1wcrablc ror 1hc derici1. However, lhc traufcrcc, which may hive no in1cra1 i11 KCepciq lransrcrrcd poaiiiom oiw than allruillic 'loyally 10 lhc c1chan1c, may be unwillin110 a11umchc risk 1h11 rcc:ovcry of 1hc 1honfall will noc occur, commil rc1011rct1 l11ip1ion nccn11ry 10 efftcl such ra:ovcry, or be deprived of the use or ks own funcl1 pcndin1 such rft.-ovcry. Conscqucn1ly, in c1sc1 such 11 Yol11nic where 111rc111ed runc11 arc 1i1nificanlly dcplcled, lhe clcarln1 or1anizalifn or, in lhc c:asc or a non-member firm, 1no1hcr SRO, may delcrminc ihlt no likelihood or loc11in1 a uansrcree cai111 and 211. Slw..,,,. Mal M61, 219. AMilioul llllllln ID 11-frn el opn polilNNU .. Ille ,,_ ... 1 1r1111fnn fir' -illirlpnl 1Ct;f111 - el c1111_, ii -w NI a1llnwill ict 1ad 111r ......., el llllllllt rl'CGil el 1111 Hlllllftll fCM. If 1111 fCM'1 NI 1,i.u ID Ill cua,lne .. ,rllllllii, .,_,,. ... ..... ,1_ .. cD1N:n1 111111 ill 1 .. .._,._ .... ..... ,, Plcucdiltl Ille lilaMr-,icr Ullllff llf Ille C-iuiol .. Ille ....... IU .....,,,.. 1r1111frr1 el 111r n1iaalcd .,,;. ,., .._, el c1111-, "'""' fllft:11111 of 1llr poa1111i1at, 111111 Ille ra.'Ollb .. ... 111ppo,1 .. ,111111 c1k11l11of ,,.a di11rllluloona 111 _i, -CUii-,11 .. Nlll~I~. !ff C11111111tot1111 AmNHII l'rolftf-, .,,,,,_ IIOle J, 11 SI.
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lf'ASIIINGTON ANO LEI:.. LAW RO'll::W IYol. 44:149 1ha1 liquidalion 1hcrdo,e mull occur.,. As 1hc CFTC reported In 1971 in advoca1in1 bankrup1cy prOlcction or accoun1 1r1nsren, "where lhc 1moun1 or undcrsepqalion hu 1moun1cd 10 only I few 1hou11nd dollars, some of lhc lar,cr hllura commission mcrch1n11 hive caccasionally aa:Cplcd I f1ilin1 fu1ura commission mcrch1111'1 cu11omcr1 Irides and absorbed any mullina lou 1hclnllClva fo, lhc 'aood of lhc inclu51ry.' .. ,., However, no provisions for milip1ina losses usoci11cd willl lhc accep11nce of 1uch Irides e1is1cd and, u I praccical maucr, k could be "usumcd 1h11 no fu1ura commission merchant would be wlllina 10 aa:epc such cullomcra' uada where 1hc 1moun1 or unclcraqrcp1lon ii lens or hundreds of 1hou11nds of dollars ... ,., Conscqucndy, 1l1hou1h transfers of adcqualely maraincd open po1i1ion1 punu1n1 10 1hc Ct'TC's provilions for 1hc 1r1nlfer of cu11omcr accounls or fCMs 1uffcri111 impaired 1:1pi11I have occurred wilh IOfflC frequency,"' 1r1ndcr1 from iA!i0lvcn1 FCM1 or where I lianificanl aqrcp1ion ahor1f1II eai111 have liulc precedcnl ... To 1hc limilcd HICnl 1h11 1r1nafcra of accoun11 JIG. Sr,..,. -141; llalr, Tni'-r, _,,,. -JI, 11 UGD. TIii .... Dlllllllil, of ................... ,11e.._a1._.....,o,111illlfwiteaillpM ,11e c1, .. o1 .......... ,, .. ,,n.,n1 ill ,11e enc-, lnilw ill of ,11e .... ... rift of ""'" -lllftlMI K."M1 IMI 1111,1 oca.1ftl ,....,.,.. .. -1of Ille .... ,...., ,: ... TIie c ...... ,.,.. .. 111111 II, '"' ,_ of '"' ......... ,..,,c, filillp, ... ..,,...... .. 1111111 for ncll --....... Ina 1111111 .... --rllial - ,_., w1111111111,r ,-... ,,_ J io u aillia. r.. enc""" 11111 "ltlllllooip _... ..... -, , _.II, lllt 111111 i ,., INMfll of c1111_, ........... In 1111 .... ... ,-, fillae, ii ii UIJ 10 wllr 1lla1 ao illilte lr-faen ....... ... ,. 11-r., ....... 111111 ........ II, "-cCIIIW ............ .. TIie ctTC _,_.,lie.,...._ cre11t11 .. ,._., catn llr ..,1qrrp1ioll wllll 1111 "SilCrilil" ,_, of lffl. .. win Ille .._,of <.'OMEX Clnr ........ wu jeapudilcd llul, ..._ 111 ..,,....,. ,_. were 111111 i..,.,cd, " 1ru1fcr of ap111 --polilioa1 ..,.. ..,. 111n ...-. lftllllllM of 1111 enc io C111aia Wril1n Qwlliolla, ,,,,,,. _, IJ, 11 IIUI. Jtl ....., Tlaoar, ..,. -JI, 11 JSCID-01, Z,J. "' Z,J. A....._....,., 1111 (t"fC'1 rcplllN1111 ,....,, 111t 1ruafcr of CUii-ace_, Clfrild II, M fl'M ill ialllioll of IN ----"lflilal ,,.,.__, of enc lqulllioa 1.17fal. Sr,..,. lell .J.a,. s.:11 11-flfl .... __ ,ftl ill _..., of CUii. la Ille c-of two fir, ...._,, a S-... Finl La.Wit, lac., a.It 1rafcr1 - dflCIIIII, ... ...._. Milllcr r .....,.., ill wiolllilla of ....... ,......, ,...,_,, ....... upoll Millnl ._..._ rncW IIJ 1111 ra ... Ille rclrw .. _....,_ la Ille all of 1illlrd rira, C111111iC'.....-r Snwicn, lac.,, ... flr'1 a,pilal lapail,_... II, u laf111ioa of ... frill ,_,_, COIIIIN1111111 t1rlla, wllicll nallW .. flra 10 --ill opnioa. Ari ac11a.., ...., .. ,, .. .rn of __ -llelnl ..,,.. ..-... dflctnl. I ,...., __ ... __ ...., ........ .... -......... .......... ,0_ .. Ofllll --,-llloal. c-.,,, A-~-... -J, 11 IJ.IJ, H. ,,.. la ...._.., I., -IINdrlll CIIII-_,, ,..,_ ... _., U ..._ ill Clflllllr ...... opni poailiolll, II P11il S...vilia Corparllioa l"P11il"t, New var Ma~E ...... INYMl:JO dtarila .,..., .............. ffnllll ,,_ ... pairof capilll llclow Ille ,,.._Id ----U wtll II a lllorllfl of Npqlllill fllllllM, 11-farftl ..... I .. lllfllfWilillll of Ille llt ...... All"'"'-PIiia' .............. 10 ...... Ille fllllda 10 1111 Ille *fldncr ill Nprpltd CIIII-, ... ,rlor 10 IM u...ra, Ille .,.., .... feo:illlllnl "' NYMEX ...... ro ..... irulfnN fir, (ieldcr-lacor,0,11111, apirlll 1!i9 1M1 of lflllNII 1111 1ra11fcrrllll _,, illcludillt
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19171 MANl(l:.'T STNATl:'Glts IJ07 un1uppor1cd by. 1urricicn1 se1rcaa1cd runds have occurred, they have depended, in lhe ab1tnc:e or an ins1i1u1ional lrameworli or procedure, upon od /toe, ne1ocia1ed aria111emen1swith in1tru1rd parties 10 11ure addi1io11al rund1 10 permit 1r1n.reu. Such measurn, while available 10 lhe ini1ia1cd, do nOI afford either ci,mmodily cu11orners or lhe n11rlit1placc 1cnerally a realistic option for (lfCicrvin1 1he con1inui1y Pr fl(Kilion~. Moreover, in the absence or dearly dcrined procedures, even in 1hc rare ins11m:n in which 1randcr1 arc crrcc1cd, the po1en1ial for unrair resul11 and cosily con1rovcrsic1 conccrnin1 the mcc~nics and valuation of uandcrs may be crcalcd.", Flcaiblc procedures nliblishcd in advance which would provide immediate accc11 to a source or-runds 10 cover shortfalls in a failed firm's sc1rc1a1cd cu,1omer accou111 arc apparen1ly ncccuary ir lhc 11a1u1ory cpeclalion 1ha1 open positions can be uandcrablc in such casts is 10 be rneanin1rully rulrillcd. C. POTENTIAL METHODS Of fACILITATINO TaANSfHS ... In conllruc1in1 Pf.OCcdurcs 10 racili111c IMllh individual and bulk pusi1ion uansfas, the CfTC's .l,anllrup1cy rc1ula1ions, while not dircc1ly applicable NYMEX .,.,d of Oirn:.1t1
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90I WASIIINGTON AND LEE LAW REVIEW IYol. 44:149 ouuiclc or banrupccr procccdi1111, suun1 1h11 1hc po1cnli1I ror crrcc1in1 1,1a1rer1 ... ,cl 10 be rully eaplored in other con1ea11. For caamplc, 1hesc rc1ulaliolll 1uact1 1h11 procedures 10 perRSil inrusions or lddilionll runcb by individual CUllomers u nc-:naar, 10 uaure 1h11 such 1ransrcr1 do no1 rnuk i11 1 pnlcr 1llu pro ,.,. dillribu1ion can be crca1cd 10 rac:ili111e posi1ion 111nsrcrs OIi I sp1ema1ic bub.'" Al1hou1h lhc CFTC'1 bankruptcy re1ulalionl do nol ac,vcr11 when blnbup1cy pctilion hu nol bcca riled, &hey NJ scrw II a rrioclel on whid, other approaches, lncludina voluntary mcuures by sclr-reaulllorr or11ni111ion1 10 provide relier 10 cu11omers dirccily arrec1ed by a ddaull, miahl be r11hioncd. Such meuurn could parallel or eapend upor1 1he CFTC'1 rqul11ions wilh rapccl 10 hecl1e accoun11,"' lftlllloYiDI Cllllomer account qrccnacn11 1h11 would aimpliry 1r1nsrcr iuun by allowina accounl holden 10 spcciry when openln1 their acc:oun11 wbelhcr lhcy wished 10 have their ac:coun11 liquidated in lhc evenl or Ille sulpeftlioa from 1radin1 of a c1rryin1 rirm, inaolvcncr, or I bankrupecy filin,. Similarly, also drawin, upon Ille CFTC'1 blnbup1cy rqul1-IMN11, irl such CIICI cun1in1ency plans could be mldc ror no1ifyin1 cu11omen 1h11 liquidalion of open posilinnl would ensue ir 1n election 1u 1r1nsrer ind 1 11a1emen1 of willinancu 1u supply addilionll runcls u nccdcd lu make up any ahonrlll between lhe cu11orncr'1 pro'"'" share or cu11oe11er properly and ruac11 surricic111 10 permit 111nder were no1 received within a specified period. Al a minimum, 1uch procedures coukl be e~11bli1hed ror hcd1c P01ilion1, or ror parlicullr lypn of cu11omen, achievin1 parity oulside or brinkrupacr procadinp with 1he uu.rcr oppor1uni1y ,rrordcd by 1hc CFTC's blnkrupecr rqulalions. Akhou1h 11tc crea1ion or procedures 10 racili111e pracrv11ion or hecl1c P01iliolas Y 111ilfy lhe cleareM need ror position 1r1nd1.'fs, procedures 1h11 ftllail cu11orricr-by-cu"unicr nOlice, ela.1ion 10 1ran1rcr or liquida1e, and cllculltiora of pro rt di11ribu1ive lhlra may impose upon I clcarin1 o,1aniu1iOII or other i111ermediary imprac1ic1ble 1dmini11r11ive burdens. Moreover, while helprul 111 avoidin1 1he lidy disorpniulion 111endan1 m. la Ille .... of ... "-, ...... _...,,, twn .1111_, ... .....,., ,_,, wlllilll _....,le...,., lllloliliollel -.-,_. " rMlfn of ..,, l'QlilkNII ......................................... ,,_ ......... '"'"'" ...,.1w1M1 ............... ..,. Ille .. ,.,. ltt Ill ii'' ._.11 hu,rllfllq la mlclllkd le .. -. S.W, ,.,., It U.S.C . MllllN_. lllt, .,..,. u1111n'1 .... 10 ....... .,.,.,_ ...... ,_,., ... Mllirl ".,,,nor IO llw hurlll'ICJ' fiMa I, If ... IO ...... Nllla ,-,.1or 10 llw filllll) f Of of M Mia..._ ... Md ............ .................... c, .......... ,, .... pn-.., llit dlia ...................... c, .... illlllia.#4. IN. n. ...._.., ,...., .. _.. .._ ,. ...... ..., 1111 enc, ...... c, ......... le ............. 11111 ..... .... ,IO,,_ .. 1111'11 pollillNl o facilllak -ft11 Olllt'* of .... nlflCJ. c ..... ill ,oailioll prOIICIKIII ..... o Ill -....... ............... _,_ .... lilclilluoll .... -- illl ........ posiliou ..... -wee of failiat fir' fl-ial clllldiliurl .....W dffl pla(r llr fir la .,...lfPlcr IO,rut"'1riruprapoeil ..... 1'9. 11 C.F.I. I IW.06(dNlt,IJI IIMl); -,,,,, ra1 M UO.IJ.
PAGE 63
19171 MARKl:."T STRATEGll:."!t 909 upon I rin111cl1I ~~aency a11d 1he co11scq1icn1 prderem:e ror lhe swill and lhe easy, such pra-cdure1 would fall shorl uf u1urin1 lhe rou1inc con1inui1y or opn posi1ien1 !Id marain paymen11 1h11 a mechanism ror the uan1rer or 111 cu11omcr po1ilion1 would 1rrord. A pre-cai11in1 or even merely pre iden1iricd aourcc or rund1 10 replenish 1hor1f11ll1 in sc1re1a1cd funds, 101e1hcr wi1h 1a ln11i1111ional procedure of acncral 1pplic11iun 10 effcctuale 1r1n1rcu, could t1pcdile. tranirJra and thereby mi11imize lhc marllCI risb of open po1i1ion1, rcd111:e 1~.li1bili1y of 1hc clcarina or11niu1ion 10 make vari11ion marain pa,ments, and limit the po1en1ill for inequitable self-help measures. Indeed, an cs1abli1!1cil auurce or fu1ids 10 facili1a1e uan1fcr1 and a s,s1ema1ic procedure for df~ua1in1 1hcm could si1mfi&:an11, enhance the abilillf of banllrupccy 1ru11cc, io fulfill e1i1liq Bankrupcc:, Code and CFTC bank ruptcy 1ransfer policies by affordina acc:urillf, 10 1hc dearina or1aniza1ion lhal uanafcr1 can ~-hicved and lhll lhc e1erci1C of conuac111al liquida1ion au1hori1y i1 1hcrcf~1 neither inevitable nor desirable, 1Kllwi1h11andin1 the exercise of 1he clcarina priority. The br 10 1111:h 11 transfer proaram, 111he NFA'111udy messed, would be the imn1cdi11e availabilillf of funds suUicic111 10 marain po1i1ion1 10 be uansfcrrcd. NF.\'1,s1udy e11in111cd 1ha1 appro1ima1elr 12.4 million would be required on 111 annual basis 10 provide for lhe transfer or po1i1iona from failed rirms ., Nt"A!is. review of 1he hi11orical record of FCM insolvencies also rcflcc1ed:howncr, lhal IS m11ch IS one-half or lhe avcraac shorlfall in sc1rep1cd runds is eventually ra.-overed and lhus 1ha1 "the annual drain on lhe raourca or 1rander mechanism" would lillcllf be "IOIIICWhll lc11" 1han the cs1i..._1cc1 i.-4 million dollars. Even based upoe.NFA's cak:ula1ions, which address the ntimatcd rund required 10 r~s1ore ic1rep1cd runds 10 the amounl nccaury 10 u1isfy cuslomer cquily -clalms in full, ii appears 1h11 a modc11 fund would be surricicn1 10 ptrmil irandeu or po1i1ions in mos1 cases. NFA apparently calcula1cd an amounl sufficienl 10 ra1ore funds sufficicnl 10 111i1r, c:u11omcr claims in full.:Howinr, a rundina mechanism dcsiancd 10 suppl, lem porar, extension .or crcdi1 10 facili111e 1r1nlfers ra1hcr than providina permanent c:om1icnialion 10 deari111 firm c:u11omers could be s1ruc:1urcd. Usina 1hi1 approach, lhe IOlal funds required 10 replenish 1he lhoufall i11 a. s., 11 u.s.c.' 1-,s. un: ,.,,,, .,., 1111-. JOI. s., _,,,. teal al _, .. ,. JIii. Tllil r11111e ii llllftll ..... Nh\"1 ...... ol ....... _, .. __ ,, ... f"IUIIC _, f FCM,_- ef s.,italln JO. 1111, ef ..,,11,iaaldr It.I..__ NFA01 11-1,f r.w fCMI 11lllcl., 1 _. r11 1,peca1, llaw 111W COMidctllllr 1a1 --IIIINh ... 1111 awt1aae t"CM ....... .,._ a -11nlwc ...i,111 of 1111 ...... ical n,;ord ,., F<"M IMolwncitl, NFA ....... f 1111 .-,paaa ef ill calclllaliorll 111111 1111 - lailcd f11 Ilea a ---,..,._.. d -llalf of 1111 It., ,ailliorl OWfl81t ... lllal 1111 IIIOl'1fal ill IC ........ .... NUWID Ina I ... '81111 of llir fllfllll ,....,. .. ID lit ill IClfqll-. ..... .,_ llwN --llift Ul-pliclM, NFA a1111111col IMI apprD1iaal.., II 4 lllllliafl IIDIJIII lit ,....a1 ID lit 11111lilr aw1dablc u -ual ha111 111 lullol 1hc .,_,., of ...,..._, fr-lailld FCM1. Na,iullll f .. 11,a AIIOCial-. 1up,I _, J. It J-4'. JOJ "' ....
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910 H'ASHINGTON AND LEE LAW REVIEW IVul. 44:149 1e1rcp1cd runcb would be mc11urcd by 1hc prcvailina ralc or in1crcs1 mul1iplied by 1hc pniud required 10 rccu~cr collcc:liblc obliplions lo lhe dcblor's a1a1c, an amoun1 which could be sianiricanlly Ina 1han 1h11 es1im11cd by NFA u ncccuary 10 n11blish and 10 secure I uansrcr proaram. Such I mechanism would rcco1nizc 1h11, while open posillons can be maintained only Ir supponcd by immcdi11cly available runds, subscqucn1 rft.'CIVUY or runds rrom dcraullin& CUSIOfflffl, the rirm ilsclr, Gr others rcspomiblc ror the aqrcplion c1cr"i1 may 1ub111nli1lly ra1orc 1he lnilial shortfall In 1qrcp1cd runds. Such a proaran, would dcparl rrom previous conccplionl or cullomcr accounl Insurance by 11ressin1 shorMcrm availability or runda 10 rlCili111c 1randcn ralhcr 1ban cornmodily accoun1 insur ance or a C0111peualion rund 10 shirl Iossa pcrmancn1ly r,om a c1cr1ullin1 firm's cU11omcr1 10 Olhcr market partlcip1n11 or lhc lndUllrJ u a whole. Ir a mochaniaa bucd 11pon an ca1ensioa or crcdil 10 brldp lhc pp bclwccn cvcnlual recovery or cquilJ In I rueivcr1hip or bankruptcy pro cccdi111 and luncb immcdialclJ 11CCC11UJ 10 supply 1randcrablc marain were C111bliahed, 1hc deulna orpniralion and/or c1chan1c could draw upon 1 number of 1kerU1ive sources. For example, lhc clcariaa or11niu1ion or exchanae could draw r,.,.. 1uara111ee runds, lrUSI runds, surplus oper11in1 runds, or crcdil lina 10 supply lhc dlrrercnc:c bnween available sc1rqa1cd runda and lhe IOIII marlin immcdillely required 10 lrander posi1ions 10 aolvea1 r., .... To 1hc e11en1 runds advanced 10 crrec1 1ransfera con11i1u1cd borruwlnp, lhc dearina or11niza1lon and/or e1ch1n1c supplyina auch runcla should be subrop1cd 10 1he ri1h11 or lhc c1craul1in1 firm and ill cu11omer1 10 dillribUliona in a subsequclll rcc:civership or b1nkrup1cJ di11ribu1ion. la cues in whlda auch recoveries did ROI equal lhc amounl or crcdil ex1cnclcd 10 racilila1c 1ransra1 plus in1ercsai" cus1omcn reccivina 1hc bendi11 of 1he 1r1n1fer could be called upon 10 pay 1hcir pro '"'" share or lhc shor1ra11. In crrca, lhe exchllnae or clcuina or1ani111ion would assume 1he di11ribu1ivc aad recoupmcn1 au1horily or a bankruptcy 1ru11ee, 1 runction 1ha1 could be clarirlcd by 1he adoption or 1ppropri11e clcarina or1aniza1ion and c1-chanae rules and implcmen1cd by specific provisions in cu11omer 11reemcn11. Such I procedure would raul1 in shinin, lhe inilial impact or 1 1qrcp1ion 1hor1r111, by conscnl or lhc parlin, 10 1hc clcarina or1aniza1ion or e1chan1c ra1hcr lhlln lhc cu11omcr1 or the c1cr1ul1in1 firm, wi1h potc111i1I bcncfill c11cndin1 rar beyond 1hosc cus1omcr1' ability 10 maintain their poai1iona and accrui111 lo lhc mukel u I whole. However, a procedure ... Tllil ....... -W ellO __,..., .... ID'"', .......... llloliln1 of lrMlfcrrld ......... ,.. ..... "'" of !Mir,,,.,.,. .. of,..,_,_ ... ...... I .i.trilllllloll, ,..., WNW lllt ,....,_. ID rdlNNl 11tr tK'tll dillrhiclrl. T1lil DMld ~, Ille - ,.,. .... irl NFA"1 rcport 11111 laflllioa of flldt 10 per 1r...r1n ....W 11C11 raull la,,,., .. .,_,er,. NMiaul l'MIMln A1-ia1ioa, ..,,,,. IICllt I, u 91. Motcu,er, rllt CNI ,,. .... lfulfn, lllklll do IICII H11111 la llriCI /lfD ,.,.,,. If acc-,li.W prior ID fi .. u,s after Ille .... ... er*' of relief ud appro,ed 11, llllc CFTC. II U.S.C. I 7641111 111141. Srr ,,,,,. lnl M 111. Trudn1 ould .. ,. lllt 11pee1d 10 occw lfllnt 1111c FCM'1 rfflN Mt so -1a11, deficlnl 11111 ,,n lipprcmu1 ..ia.lulou of ,,,. ,.,. dillrillMlioM __ _._
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19171 MARKliT STRA Tl:."CilE:S 911 1h11 en11ils lhe use of e1ch1n1e or clcari,1 or11niza1ion funds 10 supply 1 soun:e of marain wou1.i'con1empl11e 1h11 1he relevanl dearina or1111iza1ion uscu i11 1bili1J 10 ll!lrlnlcc markCI in1e1ri1y wi1huu1 1hc use of resources earmarked 11 a 1em~ary source of fundin1 for uansfen. This would assure 1h11 such uinsfti1 .:ould 1encr11e lhc cus1umer and m1rke1 bcndill discussed previously wi11tou1 impairin1 lhc dcari111 or1111i1111io11's 1bili11 lo assure marllcl 11ibili1,r. Had 1hc cleari111 orpniza1ion facili1a1ed 1r1nsfers of Volume cus1u'nicr ppsi1ion1 by forbcarina 1hc use of ori1in1l marain dcposill 11 sccurilJ fOr. lhe firm's vari11ion mar1in obli1a1ions in favor of even1ual recovery in lhe'rc.:eivenhip disuibu1ion, ii volun1arily would have achieved lhc eff~II oullincd above. A crilical prcmilc or any such 1r11111fcr proaram would be lhc availabililJ of suff1eien1 rnour1.u 10 assure Ille dearin1 orpniulion's abilily 10 conlinuc 10 1uaran1ec payrncnl 1>{ varia1ion marlin 10 1hc opposi1e side of 1hc market on open posilions of 1hc dcfaul1in1 firm prior 10 a lransfer. However, since clcarina orpniz11iuft ; 1uaran1ce funds In fatl e1i11 for lhc purpose of sccurin1 1hc paymcal of varialion mar1in, lhc e11e111 10 which such funds also could facili111e fu!ldina of a modCII pre-1pproved uansfer pro1ram wi1hou1 jeopardizina the inlqrily of lhc markCI should be caplored. II is possible 1ba1 if such .1uaran1ec funds were employed diret1IJ 10 fund uansfera, or indireclly 10 facili1a1e lransfers by 1uppor1in1 an e11ension of credil, Ibey could subsran1ially advance 1hc purposes for which they Hill by reducina lhc c1posu,e of dearin1 or11niza1ions 10 demands for vari11ion ,.,,in 1ha1 could be cape.:1ed 10 be 111isfied by cu11omer1 if 1hcir posilions were transferred lo ~enl firms. ConscquenllJ, 1hc bencfils of such a pro1r1in for clearina or1ani111ions could e1cecd ill co111, even wi1hou1 reaard 10 lhe 11l111ar,"-crrcc11 or uansfcu upon affcc1cd cus1omcr1 and 1hc overall inarke1place. ; A transfer proarain .of 1hc na1ure proposed here would, of RCCCllilJ, en1ail discrciionary ai;iipn bJ I clcarina or1aniza1ion or euhanae. If 1he 1hor1fall in available sc1re1a1ed funds Htcedcd or even approached 1hc resources dcsi1naied 10 fund 1r1nsfcrs, lhc clearina or11nia1ion or cxchanae could reasonably be e1pcc1cd 10 fureao uansrcrs ra1hcr 1llan incur 1he risk of nonrccoverJ of ovcrpayincn1s due 10 poor or incomplcle records or di1pu1es over atcounl valuaeions. Moreover, even if resources sufrii:ic111 10 fund uansfen were a~ailable bur the failed FCM's rctords wrre ddicien1, courl approval mi1h1 bi considered necessary 10 1Hord prOlctlion a1ains1 subscqucnl rccalcula1ioi11 and 111e1Mla111 cus1u111er claims. In addi1ion 10 allo1JVin1 lhc caercisc of discrciion on the pan of the cach1n1e or clearina 0(1aniz11ion 10 dclerminc 1hc fe1sibili1y of transfers on a case-br-c1sc basis, 1 pro1ram for lhe uansra of positions could cn11il li1nifican1 adminis1r11lve burdens lhal sub111n1i1lly replic11e lhosc assumed by I bankruptcy uu11ce or nun-bankruptcy reiver. for eHmple, a melhod 10 11fe1uud 1he firm's sell a11in11 dissipalion pcndin1 lhc u1nsrer uf i11 funds and posi1ion1 c~uld be impor1an1 ... In addi1ion, compu1a1iun or JOS. TIii -alluli" llaNl111 allqcd 10 llat o.:nfll on Ma1d1 JO, 1S whc11 the llolu111e
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912 WASHINGTON AND LEE LAW REVIEW 1vo1. 44:149 available wpqaacd fllllCla and of the balucc neccuary to be covered to perlllit tranlfer1 would IICICClli1a1c acce11 10 IM failed Dnn'a boola and rC1."0fds and, potc11lially, 11tc alliltance of firm cmplotcn and ac:1,'CII 10 111 computer 1,a1cau. Thac 1a1b would r,quirc the prompt availability or eachac or dearin1 personnel, the cooperalioll or the firm ltaclf or recourse to the couna, and an advance or npenaca by the clcarin1 or1anization or cuhac that cvcllllly would hive to be tucd apinat any eaiatina c:ompcaaatloa (11nd. _, For thclC practical and lepl reuo111, cailtin1 proccdurca under the CFTC's bankruptcy rqulationl or c:oun-appoin1cd rccciver1hipa such u that employed in t'ohlN may provide the fflOSl practk:al framework in which to admlllilter a pre-atablilhcd uchanac or clcarina or1aniu1ion uamfer fund if the ua111fer occurs after an actual default and there ia a shortfall in aqrcptcd funds. Such an approach would provide the procection1 or the coun, retain the adminiatrativc auiltancc or tllc SRO, and tap the raourm of a receiver or trtlllcc, while aubltan1iallr incrcuina lhe likelihood or traufcn by arrordlq a bull for dcfcnal by ,ic.ina orauizaliou or their c:omrac:tual authority to liquidate opn poaitioal and an, atablilhcd, althouah ll111i1cd, fund to permit transfers. Ullinlalcly, of course, 1hc bell protecticNI apinll the dialocaliom of an FCM'1 insolvency is prevention or the lnaolvcncy and lhc IIIOll capedicn1 and CCOIIOll'lical method of cffa:tlna tranafas of open positions dcapile an insolvency ii 10 prevent lhortfall1 in ac1rqa1cd funds, throu,h Insufficient capi1al or otherwise, lhat crcalc 1he neccuitr for ealraordinary cfforu to accure addilional 1111r1in fund1 10 facilitale transfers. An in111lu1ional framework 10 fac:ililate positicNI tranlfer1 such u lhat oullincd above would c:anstltutc a aublaantial aclf-re1ufa1orr raponac to cullomcr and market prota:tlon problem that cnauc when mcuurca 10 prevent impairmc11t of FCM capital and dcplctioa or aqrcptcd funds have failed. Suell a remedial mechuiam should be advanced, however, witt; a rcco1ni1ioll that a formal tranara proaram ii ncce111ry GIiiy 10 the catcnt lhat c1istin1 rqul11ory and aclf-rcaula1orr ufcauarda have noc fully achieved their objcc1ive. Indeed, Volu111e's default and concornilant diaruptloa1 have been a1trib111cd al least In pan to wcakncasa in relevant 5110 financial survci11111(c and other sclfrcaula1orr propam1. la 1h11 rcaard, the prc-bankrup1c)' aa:ounl uandcn ..... -....... Of MIi oWr~d Md prior IO..,__ uf I rtaiwff fo, llw flra N Mltcll II, ltlt, 111U111 llw -..ilr f,w -11 PfOIICII"' -141fn. Sllr ,.,,,,. 1111 11 ISJ. Elldllaan IN dnrilll ll'lilll-....,.. "'"' 1CCn1 10 delrlaa _..,,, llooll1 ... ,_,. ill 1111 .,._., ,_., ol ...,_. ill ordn 10 flllfill 111tir rt.,...iilill 10 nfa ----,.__Ill,...,_, 11111 UIIMr rllln.,..... ,o lllcir ...... .S.W ll C.f.l. II UlH (ltlJt. Pcw ... illr, !MIi ... ,lln wOllld -..1ID~1111ri 1lw ,_ ol o 11-rn. JOJ. n. "'" 11 ..... ,, . ,., w11.,q,e1a1,., rli,11icNI .w.11 dlrdllran irlr of IINlil ... _.,... fu.lioM IN -IUII I lllff of qlllltficd llldilort, could palt .. illr prow;,, 1 -" of illlcria 111ff ..... _. 10 dilo.'lluac 1lw Nftlilli11111iwc ... 1lldrl fMMtiou __ 10 .. ......... ,, .. ,. JOI. Sff..,,,. _, Ml.
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19171 MARKET STRATEGIES 91) that have been crrce1id punuan1 to enc Rc1ulalion I .17(a)(4,can be viewed u illlluca in which banbupccr disloca1ions and Volumc-lilic controvcrsicl over c:umpc1in1 dcarin1 system and cu11ontcr demands were avoided by sclf-rc1ulaiory a1td rc1ula1orr klio111 10 ac:hicvc conscnaual uansrcr, based \lpon ,crrcc1ivc financial 111rvcillancc prior to an accual insolvcncr or dcpletioa or sqrqalcd rund1. Consequently, an,: concerted crron to improve the indusur' scUre1ul1torr mpunsc 1e.FCM insolvmcin should firll auure lhe dftcaey or nis1ina scH-re1ula1ory ~01rams or a preventive nature. In thia connection, 1he relative cconomr pc1 aimplidty or 1randera pursuant 10 Re1ula1ion 1.17(1)(4) su11cst.thal 1uch uandrra 1hould be prderrcd 10 later intervention and 1hould be viewed ai a liey adjunct to ~lf-re1ul11ory rinancial surveil lance propams to idcltliry FCM1 that may be In jeopardy or 1i1nirican1 capi1al impairmcnl. (.anploycd II prophylactic mcasurn before any Iii nific:ant capi11I impairlDJflt actually occurs and, thua, prior to any depiction or sc1re1a1cd runds, such pre-banliruptc:y uansrers ,nay hcqucnlly obviate crisis situations in which the inte1ritr or the ruturcs positions or a railin1 firm's customers or o(the firm's obli1a1ion1 lo the clcarin1 system and the marketplace II a whollt. arc direclly 1hrca1cncd. ,,. CONCLUSION The fu1urcs ipdllJt~y ha1 a record or remarliably rew insolvencies and :low cus1omcr loisa." -~ a consequence, establishment of 1 1ovcrnment sponsored insurance rulld has been round unwarranted for the fu1ura markets, whereas the ai1ni11cantly 1rca1cr frequency of scc:urilicl broker/ dealer insolvcncict and .hi,hcr 1C11:uritia customer loucs have been addrClled by lc1isla1ion crcalin1 a customer in1urancc system subject to rcdcral ovcr si1h1. Nonc1heleu, u di1CuHed above, lhe potential caists ror subl11n1ial dislocation, or at least a temporary nature, in the event of I fu1ura firm failure. Nearly three yeara after the event and despite full reimbursement of lhe firm's c:us1omer1, lhe Volume epi~odt lives on in 1he publie; mind as a lesson in the po1en1i1ll cq,15cq:cs of a ru1ures brohr railurc. Thal ~uc rclk~u:d that even run c:omplianc:e with lhe Con1modi1y E1d1an1e A~1s suin1rn1 sc1re111ion rrqujremcnll could not assure the firm' cu11omers apinst loss and 1ha1 once such ioiica had <11:currcd, no formal 1overnmcn1al or aclf rc11ulatorr proaram wu in place to restore s11&:h losses. Moreover, 1hc posilions of lhe rirm's cilslomen were liquidated wi1hou1 any serious auempt 10 transfer 1hcni, rcfltin1 lhe c:urrenl a~ncc or any mechanism to replenish availahlc sc1re11tcd fund, to provide mar1in sufficient 10 permit transfera. M1 imponan1ly, however, the 11abili1y or 1he market remained undisrupted 1hr~u1h~t. the clcarin1 or11nia1ion sicppcd forward 10 pay JOt -.,,,,. J91: JIO. Sff ... IHI M IIJ-N.
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914 WASHINGTON AND LEE LAW RErlEW IYol. 44:149 Ille COllalerpartia oppolilc Voluac for Ille lolaa accrued Ila polilioM, ud _., oac ,a, af1cr 1hc fir' dcfallll, Volume' IIOlldcfaullill1 CUI ,_,. naived f ,...,.,.,.., n., wllilc FCM failllfca arc rare, ma MIi V._ ..., .. ...-W ... ..._ 11111 cOllld lie 101 lllell llll'Olllh a _. QllaMbl: approadl 10 pmilm Ir-fen dlaa la afforded bJ currCIII replalorr Md alf-nplaeory prap-. Eullilla nplllory and 1111-rcplalory f,-... u, wllkll prcwidc a balil for ...,.. Cllllwr recovery ol equilr Mllliea IO l"D ,_ alocalioa ol lllaca Md for ..rqua,clillt CMI' .-kll allililJ .... Ille ...., ol a flra failure. The lalkr11t11cr Code' commodilr brohr liquidllioa prcmsicNla advance 1wo pualllCNIIII oltjcctiva, c1111eer prDlcctioa ud ..,.,. 11abilllr. Thac olljccllwa arc reflected i apedfic MIIIOIJ prowiaiolu Illa! IIIDuld auurc ct111omcra flldanNal fllirMU ia 1111c MIii of a coamodilr broker' inaolwac, ud prCfflll "donliao" cffccta Illa! could jcopardile 1111c aolwac, of Olllcr inarlka panlciplMa. TIiie Code' lcpalaliwc llialory Ibo rcflccta C0111raa' illlClllkla 10 fOller a 11tird olljlclwc, 1111c u1111fcr of opn cominodilr poeilioal from iaaolYCllt 10 MYnl c:oamodilr brolkc,1, wtuch could prowidc a .,.. for adwuci .. and llarlllOllilina lhc 11M111e'1 owcrricli CUIIOIMJ ud markll P,Olcctioll pu,poan. Ulllilic 111t prOlcctioa or eu11omer and 111ark11 i111eraa1, llowncr, 1111c in1n1 ol Ilic 8Mknap1c, Code's framen 10 (Oller pcllilioll lr1Mfcr1 COllld IIOI be cffectUled lllroup naclllltlll of IIMIIIOIJ prowiaiolu, aucll u llllc CIIIIOlller prlorilJ, proKripliolll apNUI lhc rnaul of prc-bukn,plc, IUJ ai ,.,_,.,, or preduaioll ...-.. a1erfcr11K1 willl COlllractllll liquidalioll ripla, 11111 IChiew 111cir 1111111orr purpoaa a,, audalilla penlclllu actiolll or precllNliaa Olllm. R11llcr, 1hc Code' framer recopircd, polilloll lr1Mf colllll lie prOlmed ...-. awoidaace br a bulkfllPlcr u1111ec ud ncNJaecd a _,er ol policy, blll colllcl IIDI lie reqtdred la al cua. Indeed, IIO replllorr fraacworlk Illa! don DOI aupplr IOIIICC of .... lo mlort f .. ---IO poaieiDM Illa! UYI become lllldermarpaed could 1uar 111M 111Cll 1, ... rm would ocaar. Howew, 10 clllllle holder, of propcrlJ ldClllirled _.., Pl)liliolll 10 prescnc 1hcir poailiDM dapile a brolker'a iMolwtllcr, llllc cnC'a balkrup1c, rqlllallou prowidc. delailed procedllrc 111a1 pcrail1 lndMdul poailm llolder1 10 ....,, IIICII addilional fllllda r be MCC1UJJ 10 praat Illar po1ilio111 ud u adlni11i11r11iwc framcworlk for orlllliluia 1,1111fc, cffor11. Allllollah 1hc loablical bllfdelll n1ailed ill cffectilla nn Ibis limited carqorr of 1raufcr1 .. appear OMrNI, Ille CffC'1 lllcdp Uuafer proccdurca COllllilUIC Ille oa1, llltlhod ,et awllioaed, allCll lca acabliahed, 10 rftl'Cllld 10 Ille oillenriae .,..an, predllahit effect ol IClfqllioll allonfalla 11po11 posiliDII 1raiufer1. Allhoup poailloa lrlMfen llawe occurred i laollled cua ewea when a IINK1ap of acpqlled f...ca. uia&ed, aucll ewn11 hawe bcn u1retndr rue and ha"' depeded 11po11 -' It, AQOlialed ana1tp111C11C1 11111 afford ao ICM'al 11111,ucc lhal U1Mfcn of nea hcda, posi1iou ill occur. Moreowc,, 10 lhc HICIII IIIM Ille CFTC'I bMbuplc, rqulaliou prowidc hcdan ilh 111111u or .. 1Mailli111 1hclr poailiou i 1hc ne of a IIIIDIYC11Cr, 1hcr canaoi uaurc 11111 raull nn for hcdlCfl eacep1 I 1hc limiled caccaorr of CIICI ill wllich inaolwen1 \i'olller i1 placed in bankrup1cr.
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19111 llAltU::T STIU r1::m1::s "' Hitloricd,; ~IU ..... lhc r111u,n Uklu11r, f 10 1Ho,d 111Hicinl ICCllfilJ 10 il1 cuu,~n. in 1hc ablncc of ac:C011n1 iluufuce or Olhcr CUIIOIMf coapnulioa IIICdUIINUM, IUiwc IICC1I MIWCfcd bJ rdnncc 10 Ille iadullrJ record ol rdaliwdJ iafrequn1 ilnohcllcin ud low c1111oacr losan, .. lapraaiwc -.o,d inaprowcd i 11111mca111 --.urc a., 111r pue wilhrlpal or cOIIIINdilJ CIICIUifllCI 10 afrord (IIIIOftlCU ContpCIUllioll OIi 8 wohllllar, bui,. Pulllic drbalc OIi IUCII iuun, howncr, ha1 failed IHMil rcr111, 10 addicu Ille iapor1U1Cc of pracnina opn r111urn Md opeiolll political, u opposed ff) fulldtnt CIIIIOIMI' rcimburletMIII, or 10 nplorc 1llc rdaliwc COIII and batrfil1 of a CIIIIOIMr prOlfflNMI ,..,., .. ckliped raduliffly 10 prncrwe Ille COlllilluitJ or opn poliUOIII. POlfflliallJ lfllliR ca bncr111 10 1lw lclf-rquluon u well u 10 cCNIIIIIOdllJ cu11oarr1 froa 8 IJllftlllic procedllrC ror Crfectilla polMNMI lf~fllrn1 lhcrdorc !lave bcca !pored. aecc111 llllllin wgn1, llowcwcr, u 1llr Code's rraacn ropiffd, lllal aai111a.ai111 opal poMINMII .. afrord 111bllancial bcrlcr111 lo i:oa moililJ CUIIOINfl 81 well U 10 Ille -Cl II 8 wllulc ud IU p&KMNM uan,fcn arc uimpor1M1 prOlcctkJII of 1lle hcd1illt fllflClkJII or lllr flllurn .... a,. Viewed ...... 1llc0.JIOICn1ial bcncfill of prncrYiat opn posilicNl1 of u ialolwtlll llron. Ille .;.11111,, llilloricalJ low 1.'Ulluacr loua .. be aorc prONliwe ef 1~prac1icabilil, or proar 10 racilil11c UM1fn1 ,.._ or Ille acaplabilllr of'Jlle 11,u 'lflO. CCNUCqUCIIIIJ, allllcJuall ao 111flcailllc procedure or 11lllillllftd IOll,CC of r11ndl ,.... ill CIUUH Ille 111111rn of : poailiou ill ncr, catc: cu rcU01111blJ be cOlllnaplalcd, we Mlllftl 1"81 iaodic or adwuce plauina and iaodcll crcdil facililJ oellcr aourcc or fudl could iacfcaac lipirlcancl, 111e hlchhood or cffec1illt u111dn1 ia ... illlolwncia. s.cll prCJII .. could prowc 10 be wllllaMiallJ ldf ...... Off ia ..... rowerin ia Ille ce111rsc of rcccivcrlhilt or NM rup1e, procndillp .ia; lipificMCIJ rcarorc iailial ouai.,. 10 cfrcct u1111rcu and npalilicMl1 U1Mfcr1 pocen1ia11, cOIIW IICUfC lipiflCIIII rcdUCIMNII ill clcariaa orpni111icMI uaraa1cc ollliplioM. 111 addieicMI, well PIOI' .. would arrord 1hr ldf-rquluou ud CCNNIOdllJ c11110111cn i11acascd ccr-11i111J and accuritJ, ral11ec 1hc JIOIClllial ror COIIIJ Md diarup1iwc lil1111ioll, c11lwa 1hc hcdaina ruac1icMI of 1hr fuaurn 111are11, alld pro"1dc I fir fouadMIOfl ror public conrldcncc 111 11w r111urn indu11,, abthtJ 10 rnpond 10 INocr iatolvcnc:, i raanncr 1ha1 cwcnhandcdlr adw1111:c1 the intcrnu or conalllOClitJ c,111-.1 and of 1hc n111lcIpla.c 1 hulc
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VIEW POINT: PERCEPTION AND OPINIONS OF A NON-UNITED STATES PARENTED FIRM DOING BUSINESS IN THE UNITED STATES AND WORLD SECURITIES MARKETS. Prepared by: DAIWA SECURITIES AMERICA INC. for OTA Study is contractor document was prepared for he OTA Background Paper, Trading Around ~--'lier 1989 he Clock: Global Securities Markets and nformation Teclmolo July 1990, and OTA port, Electronic Bulls and Bears: U.S. ecurities Markets and Information Techno o Sept. 1990. This document does not ecessarily reflect the analytical findings f OTA, its Advisory Panel, or its echnology Assessment Board. I' I I
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INTRODUCTION ................................................. 1 DAIWA ......... 1 TECIDfICAL DIFFERDICES ...... 2 MARKETS 2 REGULATORY ISSUES .......... 2 SETTLEMENT 3 ACCOUNTING PRACTICE 5 NUMBERING SYSTEM 6 CUL'l'URAL IHl'LUENCES ....... 6 BUSINESS PHILOSOPHY p 6 INVESTOR PROTECTION 7 FAILS ......................... 7 RECOMMENDATIONS AND CONCLUSIONS .... 8 RECOMMENDATIONS . . . . . . . . . . . . . .a -~-: : . -.~-~ i. . . . . .a Accounting and Auditing. . . . . . . 9 Market Automation .... 9 Security Derivatives 9 Adoption of Global Securities Numbering System ..... 9 _u_n_i_f-o_rm __ s-e-c-u_r_i_t_y_I_n_f_o_rm_a_t_io~n_ . . . . . . 10 Trade Matching ................. 10 _s_e_t_t_l_e_m_e_n_t __ Cy __ c_l_e ___ .... 10 Book Entry Depositories and Clearing System ... 10 Delivery versus Payment ...... 11 Standardization of Payment System .... 11 Netting . 11 Development of Linkage ........ 11 Cross-Border Information Flow ............... 12 Reduction of Global Credit Risk ............... 12 Equal Treatment and Access ...................... 12 CONCLUSIONS. . . . . . . . . . . . . "IIIW ......... 13
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-1-INTRODUCTION Indirect international investment has increased dramatically over the past five years. As investment managers and investors look for different avenues to pursue, products are created and derived and new markets emerge. Results are not only calculated by returns on investment in local currencies, but against a real rate of return in the investor's home market or any other. Global investment strategies have become more sophisticated and diverse. While the prospect for increased efficient global trading looks bright, its future may be sullied by inconsistencies, confusion and problem in settlement, regulation and information. . . While new and derivative products have been developed with standardization and global trading in mind, the practice with the underlying securities and more mature markets differ greatly from country to country. The lack of a consistent, cohesive, understandable global framework for the securities industry presents a potential for pro~lems. I o o l',"o , o .: ' ,:... , , .. Daiwa Securities America Inc. (DSA), with$ 11,522,405,501 in assets, is a wholly owned subsidiary of Daiwa Securities Co. Ltd.(Tokyo). Daiwa Securities Co. Ltd. is the world's second largest securities firm. It has 17 subsidiaries in 12 countries, 9 representative offices and 125 domestic offices. Not only is Daiwa involved in the standard broker/dealer services, but through subsidiaries, it is also represented in the banking, trust and custody business. The Daiwa Group is also involved with research, asset management, unit trusts, venture capital, information services and real estate. DSA, the 2nd largest of Daiwa Tokyo's subsidiaries, acts as an investment conduit between Japan and the United States. Not only does DSA provide the Japanese with a vehicle to invest in the United States treasury market through its primary dealership, and in the blue-chip equity and the futures markets with its various exchange memberships, it also provides a way for the United States institutional clients to invest in the Japanese securities markets, as well as providing other securities services. While the United States and Japanese are among the most developed and sophisticated in the world, many differences abound. These differences in practice, regulation, procedure and information, can create a misconstrued system for each investor out~ide of their home market. This confusion and differing perceptions between two of the most liquid and possibly efficient markets, demonstrates the need for harmonization worldwide of standards, practices and procedures.
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-2-This paper is not meant to be an authoritative bible with specific solutions, but will highlight some problems and discuss a framework under which more universal solutions may be found. TECHNICAL DIFFERENCES MARKETS Japan and the United States are two of the most diverse, liquid and active markets. Among the instruments traded, there are major active markets in corporate and government bonds, equities, commodities and futures. The futures and commod:lty ~arJce't;s qaay_ not.be a, -~ve~se.: in -~~P~a~ th,y are i~ the United.States but they are currently developing and expanding. The Tokyo Stock Exchange on average has a higherdaily share volume than the New York Stock Exchange. This is partly due to the fact that minimum round lots for most Japanese issues are 1000 shares, versus 100 shares round lots commonly traded in the United States (there is no minimum share order in the United States). Like the United States it is a continuous trading market rather than a call or single-pri~e auction market. Derivative markets in Japan are generally associated ,~;I;~---~ xctaang.~ -dealing .in-~ ~Jceta,; of -the : .. underlying security ... l.n .. tha -t1ni.ted .States.,. -the .derivative and underlying securities markets are on separate exchanges. While the basics of each country's markets are similar, the practices relating to the operational and regulatory end of the markets can be quite different. REGULATORY ISSUES Japanese firms find a great deal of the United States regulatory system confusing and inconsistent. In Japan, although each exchange has their own rules and regulations, all is coordinated and approved by the Ministry of Finance. In the United States there are different regulatory bodies for different instruments and exchanges, and while the rules may be coordinated and focused in the same direction, different interpretations by different bodies can cause confusion to a non-American dealing in these markets. As stated previously, in Japan, ultimately, all rules and regulations are deferred to and coordinated by one body, the Ministry of Finance. In the United States, this is not quite the same. The futures organizations defer ultimately to the Commodity Futures Trading Commission; the stock exchanges defer to the Securities and Exchange Commission. Even the Depository Trust Company is regulated by more than one agency. The Securities and Exchange regulates it; as well as the Federal Reserve.{This is due to its status as a non-bank bank.) Taxation, another issue, is handled by the Internal Revenue
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-3-Service. This differentiation, by itself, while possibly confusing for a non-American firm, is not the only problem. Among the various industry organizations reporting to the regulatory agencies, there is disparity and inconsistencies. This further complicates and confuses an already complex and sophisticated environment. One example is the assessment of fees as applied to members by the various futures organizations. The National Futures Association fee assessment do not apply on proprietary trades and those "carried by an exchange member FCM on proprietary trades of affiliate which, directly or indirectly owns lOOt of, is owned lOOt by or is subject to lOOt common ownership with the exchange member firm." This means the affiliate of the non-Uni tad States parnted firm, a~e. not asseased. fees for trades dona through. the United states subsidiary~ The Chicago Board of ~rade consid~rs only a.vertical ownership structure. They consider as members the United States company, its direct subsidiaries, and its parent, but not the other subsidiaries of the parent. The Chicago Mercantile Exchange has another set of rules which, although similar to the National Futures Association's, states that member rates are "entitled to each account OW!led. by the member, its subsidiary and related party in a chain of related parties, provided that the officer of the ~.,.~,-,;~.~-,P~.~, .---~~t..}~ii;:~c:t-lY .. :C?"---i~'ectly :Owns. --allthe. related partis ~n :th .,.c~ain_, .. h.q.ld. a .. ~titmbers~iP~ .... .. . i... . .. 'I, ... , .... These differences in rules for different industry organizations, although they service similar instruments, can only create confusion for a firm accustomed to a more consistent and cohesive regulatory environment. SETTLEMENT Although settlement for the derivative products and futures may be more uniform and consistent, the underlying bond and equity markets differ greatly. Japan settles Government Bonds every five business days. The United States Treasury market settles book-entry the next day. Japanese equities and most convertible bonds are settled on a T + 3 cycle with other corporate bonds being due within five business days. The United States equity and bond settlement cycle has become mostly book entry through the use of the Depository Trust Company and operates on a T + 5 basis. Trade comparison and matching are also very different While the United States has a vary automated process with the Continuous Net Settlement system through the National Securities Clearing Corporation and the Institutional Delivery system through the Depository Trust Company, the Japanese market is still manually oriented. Trade data is received from the stock exchange through the Japan Securities Clearing Corporation (JSCC) and must then be compared against each brokers own data. Any correction are made the following day. Many brokers and custodians contact each other
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-4the day before settlement to ensure that one another has corresponding instructions. It is not an automated system except for broker to broker information received from the stock exchange computer (JSCC). The process is in direct opposition with the United States system; most broker to broker comparison and that with the custody banks are done through an automated system. Providing a client affirms or a broker matches a trade, most trades (which settle through Institutional Delivery system or Continuous Net Settlement system) will be processed smoothly. Most settlement problems are found on physical delivery trades due to unavailable securities or incorrect instructions. Japan's enviz:onm~t BJ\. ext;remely. paper~~nte~se physi_cal system~. -~le thia liiay.not.' $Hin~ efficient to: United States firms, for the .'7apanese it works. ,. Alt~ough steps are being taken to complete a book entry deposi tory, the Japan Securities Depository Center (JASDEC), and many broker to broker trades are now bookentry, physical delivery is still prevalent. Physical shares are currently delivered with a much lower fail rate than most automated markets and in a shorter time period This is aided by two major. fac~ors: one is that transactions between the exchanges.and the broker are netted; the other is .t~'---~--~ J~( -~~-. ;!l.it,1;\.o~ .. gu.,arao~.--:; . :;' . l,: .,. .... ,.,: ,., -, . ~:.-:-. ".,. .--, ... ... . : .. . . . ... . . ..... . . \. :. . . ~.. : .. . . .. . . . . . ~f. shares ire. not available for delivery in Tokyo, a broker issues a letter of guaranty, essentially a promise to deliver later, to its clients. The client then pays the broker, with the knowledge that they own the stock and it will be delivered shortly. A safekeeping receipt is delivered on trade date, with the shares following when available. The Japanese allow the use of letters of guaranty with domestic counterparties, but acceptance for foreign participants varies from one custodian to the next. This practice, along with daily netting, allows the Japanese to deliver shares from one client to another with only the cash differences transferred. Actual physical delivery decreases extensively. While JASDEC will usher the Japanese into a book entry environment, the payment system is not included in the plan. Many payments will still be made by physical check, as Japanese banks control this portion of the cycle. Although this seems inefficient to outsiders, the Japanese system works and will continue to do so. As previously stated, once compared and affirmed most trades in the United States settle through an automated book entry environment. Positions are netted through the Continuous Net Settlement system, but in a way different from Japanese method. In Japan the netting is done on a daily basis only; in the United States it is a continuous system. This continuous system combined with the use of a book entry depository allows for a very efficient system for equity and corporate bond settlement.
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-s-Treasury securities in the United States are processed book entry by the Federal Reserve Bank. Settlement is T+l with same day funds. Japan settles government securities through the Bank of Japan. While handling the central banking function similar to the Federal Reserve, it has no direct regulatory function or policy, only control by influence and relationships. Settlement of government securities takes place every five days. A letter of consent (for a change of ownership) must be delivered two days prior. Payments are same day funds to each participants account with the Bank of Japan. This book entry settlement and electronic payment system were recently implemented. ~11 transactions ar final ~d daylight overdraft .4t: the ... B.ank.:ofJaparl"ls .-not; alioweif~ : Iriterest payments. are subjeqt to a w~thholding ta~.unless registered to an exempt domestically incorporated financial institution, Japanese governmental bodies or foreign, national governmental bodies. Japan and the United States still rely mostly on next day funds. In Japan, with the exception of Government Bonds, net money settlement is made through checks which do not clear until.thenaxt day. The United States environment for the ,~i ~. ;~~: 1~~'?~~:t:~ .... .,~-~~--t--,~~ .. atj.ll, .. ,a ,JQO.tly next day funds environment, -;with JDQnies moving_ electronically. as well as checks/:,, Mora :progress has been made in the United States than in Japan towards a practice of same day funds and electronic payment systems. ACCOUNTING PRACTICE American and Japanese companies follow generally similar accounting principles. There are, however, basic differences. Equity accounting is not required for associated companies and the periodic income statement does not include unrealized foreign exchange losses. Insurance companies in Japan also expense on a cost basis while the premium actually is accrued over time. Assets are not frequently adjusted for value, making many appeared undervalued. Depreciation can also be treated quite differently, adjustingincome in the p~ocess. An even more basic difference is the reporting time. This can cause difficulties when analyzing and comparing corporate information. Disclosure, in general, is not as extensively required by the Japanese and segmented reporting is not required. Although the basic principles are similar, especially when compared to the British model or the French-Italian-Spanish modal (based on Napoleonic code), the differences can create confusion and make comparative analysis difficult.
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-6-NUMBERING SYSTEM Throughout the world there is no consistent numbering system. Not only does each country have their own, but soma systems which try to create multi-country codas are not widely enough accepted. Many investment managers use the SEDOL number to ide~tify a security in their intemational trades. Although widely accepted by United States global custodians, Japan, similar to most countries, uses their own local numbering system. Cross referencing from one numbering system to the other is not only time consuming, but allows for errors. A slight difference in a security(naw or old issue, or share class) can cause mistakes. ~his _led to .f,.i~s o.r_.~ven -~~tar. risk. and. 'exposu:t"e. ," >-: . .": .... .. . .. :. . . . . With Japanese investors going to the United States, there is not as great a problem. The Japanese investors use the United States CUSIP system readily. Also, the extra two day in the settlement cycle allow for any problems to be sorted out before they become fails. Thia c:raataa lass fails for not having or having incorrect .i~~f\l~tiQ~i:-.tor. ... .:ra~:.in,eatora in the umted States than ,~~iJ/~'9~. s.~.at,8! _i.,.y.e~tc;,rs ~Qing. ,_bue~nesa inJapan . CULTURAL INl'LUENCES BUSINESS PHILOSOPHY A major difference between the United States and Japan lies with attitude towards investment strategy. Historically, the Japanese brokerage firms have relied on fixed commission income, similar to the United States prior to deregulation, for a large proportion of their profits. This along with investment banking activities, mainly underwriting and investment management, creates the bulk of their profits. Trading profit (or loss) and mergers/acquisition departments were not of great consequence to the income statement. Many individual investors in Japan invest in life insurance firms and buy stocks for long term gain. These insurance companies along with major corporations are the major investors in the equities markets. Corporations develop cross holdings in their suppliers or clients forbatter business relationships. It is a market where stable growth and cooperation is expected, and volatility and risk are unwelcome. To emphasize this, price change limits (market circuit-breakers) have been in place for quite some time. Fulfilling one's obligation is expected and honor is an important part of the culture.
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-7-This, in many ways, is directly in opposition to United States attitude, where trading profits are expected and more of a gambler's attitude prevails. Two areas where cultural differences become clearly apparent are investor protection and fails of securities deliveries. INVESTOR PROTECTION The United States investor is protected against possible abuse in the securities market by the Securities Investor Protection Corporation (SIPC). This organization provides investors with a form of group insurance which is funded by member securities firms. The extent of its obligation and rules are clear and enforceable. It/. .. .: . .. . . . ~.. :, .. :~-. : ... !" .. '... . .. _.. . :. The.-Japanese, al though .required to set aside some reserves, are more bo~d by 1'\onor., than t,y forma agreement or obligation. "Their.business community through its moral influence, and that of the Ministry of Finance, would not allow for unfair treatment of an investor. Transgressions would be dealt with harshly, although no set rules or penalties apply. An obligation or commitment of a firm employee, is that of the firm. Respect and. reputation of.the firm is al~o passed to the employee. cuiture and attitude make itdifficult to justify --~:;~v~or_.-.:pr;o.t~t;Lc,n;;-WOUld:be neceaaary~ ,: __ .-_ .. _. I -. ; : .. -: .. ,\ ... ...... FAILS With securities deliver/receipt fails, the same attitudes still apply. Although using a letter of guaranty gains extra time before actually delivery of physical securities, failures in Japan are not considered as part of. the business. It is considered that by failing to deliver p:omptly, one has not kept with their obligation. Not only are fails frowned upon by the Ministry of Finance, but a firm with a continuing problem will soon find itself out of business. Other firms will no longer do business with them. This makes it very difficult at times for the Japanese in American markets. Although fails are not welcomed in the United .States environment, it is accepted that they will occur. The use of the Depository Trust Company, Continuous Net Settlement system, and Institutional Delivery system, as well on other bookentry and clearing system reduces fails; but as no system is perfect, they do occur (more commonly when a physical delivery must be m&de). Accepting that they do occur and are part of the system is contrary to the Japanese cultural background and attitudes.
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-aRECOMMENDATIONS AND CONCLUSIONS Although the United States and Japan are very similar in many aspects of their markets, technical and cultural differences do abound. The differences can cause confusion for one operating in another's markets. Trying to work in an environment that may be even more unique, such as many of the smaller or emerging markets, presents even more difficulties. By developing a more standardized and uniform framework for all markets, confusion and misconcep,t:ion can be reduced creating a more efficient market and alleviating some systemic risk. RECOMMENDATIONS Basic steps that should be taken are: :: . . .. .. .. .. :, : .. :. . .. .. . . .. . . ..... .. . ~.. \ .. p Uniform regulation . o Coordinated accounting.and auditing principles o Automation of markets where applicable and possible o Coordination of markets between securities and their derivatives o Development of a global securities numbering system o Uniform and accessible security information o Trade matc~ing .. .... q_ '~-~4~~-~.-a -~~~1;.l-!111~1;.-cyc~~ :-,. ': ., .. .-,'_'-: ....... .. ,.. .:, .. -... _., o cr,ti~n."_c;,.t. --~~~--~~:t;9. dap(?sitories and. clearing systems o Delivery versus payment o Standardization of payment system o Use of netting o Development of linkages o Better and more efficient flow of cross border information o World-wide credit information o Equal treatment and access to markets Uniform Regulation While the issue of national sovereignty regarding rules and regulation of securities ma~kets make this a difficult topic, certain areas needed to be ~dressed and cooperation extended. Capital adequacy and reporting standards should be uniform and enforced. Not only does this protect participates but allows for batter credit determination on a global basis. Ona regulatory body in each country should oversee a securities market and that for its derivative products. Paperwork required for firms should be consistent throughout. Tax treaties should be enforced evenly and repatriation where necessary. By developing a consistent direction and focus for all regulation; participants can not by-pass one country's laws, directly or indirectly, by operating in another market. Regulation is one of the most complex issues affecting the globalization of securit~es. It is the important task that must be dealt with quickly and with cooperation.
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-9-Accounting and Auditing Minimum standardized accounting principles will allows for accurate, fair analysis and evaluation. By providing standardized data, increased capital markets will be available to more companies. As cross-border investment and merger/acquisition increases, audited financial information is necessary to provide a truthful and fair assessment Only if there is a standardized format, can comparative analysis be true andaccurate. Auditing principles must protect the investor from misstatements and deceit. Minimum standards and principles, taking into account the differences and similarities of each country's practices, should be formed and adopted. : .,.Market Automation... . . : ... ,oat trade market 'function should be automated to the extent each market may bear. While technical requirements and available expertise vary greatly in each market, comparison, delivery and payment system are primary choices for increased use of computerized technology. Standards for information must be developed, although each sytem must meet each.markets individual needs. Efficiency created by automation will help support increased. trading and. aJ.1.eviate .. potential. stress~Autom~-tion; ~ifiivai.; -~~houf~.-,b . .-~~~p~ed. :w.~ ~h. iong term goals, notin_responsa"toshort"teJ:111 problem or wants. It should also be able to handle stress caused by rapid and extreme market fluctuation, or it will only aggravate a potential problem. Automation can also help to provide real time accurate market information and conditions. Security Derivatives Coordination must be established between securities and their derivative products especially as the use of these derivatives increase. Settlement cycles should be made consistent not only for different type of derivatives, bu~ also with the underlying securities themselves. Regulation of both should be controlled by one body and consistently applied. This will only improve coordination between a security and its derivative in the market place. Adoption of Global Securities Numbering System Even though the SEDOL numbering system has been used, especially by US investment managers and custodian banks, no true global numbering system exists. Adoption world-wide of a system such as the International Security Identification Numbers (ISIN) will certainly help alleviate these problems. While ISIN's use seem certain, whole-hearted cooperation and support must follow. Local differences and preferences must be set aside for the adoption of a uniform standard.
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-10-Uniform Security Information While adoption of a global numbering system will help solve the problem of identification, consistent and uniform information concerning securities must be available. Information concerning dividends, interest, rights and other corporate actiona must be consistently maintained and accessible. eaaic underlying descriptive information should be sat up in a standardized format and understandable to all concerned. Without this information, problems with interest, dividends and pricing will occur to stress the markets. Trade Matching Whi~a it may not.~-P.O~s~bla ~r warr~ted.tQ da~a~op un'i.f01'111~tr-ac,J.ng practic.es ln'. all ,'cowit~ies, ,poat-t=3de . functions'. should be consistent. ~~-at-.rts with comparison or matching.While many markets through their clearing system and depositories, have highly automated efficient systems that provide their members with detailed information, many have no trade matching at all. Soma, such as Japan, have a very labor intensive, manual process. Without quick and accurate matching, markets ar~ doomed for inefficiencies . Trade day or Trade+1 compariaon.ahould.eziat in all markets, and should be .,~~C?.:~~.t.f!.~: .f.9f .. ,~t~e..~.,~@:~,~----~,~:-~~~9-~~ .... < ... ">>: ...... ., . .... -.~ttiament.: Cycle .'. ; ', ... : .... ; .. . The Group of Thirty have proposed a settlement cycle of T+3 aa a worldwide standard. However, the previous suggestion of automated matching must first occur. Without it, failures will bathe norm rather than the exception. Developing a rolling uniform settlement cycle benefits the globalization of securities markets. As many securities truly become global, the investor faces aggravation and risks exposure if he buys on a market with one settlement cycle and sells on one with a different cycle. A standard of T+3 will alleviate this potential inequity and confusion in the market place. In many countries it will reduce the cycle, which reduces the exposure of a unsettled trade from trade or countarparty default risk. In markets such as Hong Kong and Belgium, it will provide extra time for non-domestic participates to affectively settle the trade on time. For soma countries where settlement is less frequent (fortnightly or monthly) an interim step of a rolling T+5 may be necessary. Creation of Book Entry Depositories and Clearing System Use of book-entry depositories, and the immobilization of securities therein, is essential for improving efficiency and reducing fails in most markets. By lessening the actual number of securities to be moved, one not only quickens the settlement process, but reduces cost involved. Less physical transfer and movement of securities, also reduces the volume of claims for
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-11interest or dividends. While the merit of a system that records the ultimate beneficial ownership (such as the proposed JASDEC) versus those which show only member firm ownership (such as DTC) may be debated, the efficiencies provided by bookentry can not. Reduction of paper flow, lessening of risk (due to fails, or loss) and ability to quickly redeliver positions create a more efficient market for all involved. Delivery versus Payment All markets should have a delivery versus payment system for securities. Thia should also be coordinated with the use of a clearing house. The risk (while considered acceptable by some countries currently) of not having a true delivery versus payment system ia not ne_cessary. ~r .. a~ceptable in an efficient global trading. emrironment. Simul.taneoua ezchange of payment value and securities abouldbeaccomplished through the applicable c1earanc and depository system. The payment should be final (baaed on delivery of securities in good and negotiable form) and guarantees developed through the clearing, depository, or banking system. Standardization of Payment System ...... -~~-~k!9;a_ahoul~. edopt. ... a. ayt-. of simultaneous delivery and payaaen.1:, th tboda of. payment should be conaiaten-t. Many markets use same day funds, while others use nezt day funds. In some cases the type of funcla used is differentiated by the type of instrument, even within the same market. Electronic methods of money transfer should be used and linked to the clearing process. Elimination of checks will create efficiency and reduce risk. Check also tend to be next day funds. Netting Both securities and money should be netted on a daily basis. Securities should also be considered for a continuous net settlement system, as is used in the United States. By reducing the actual number of money and securities movements, efficiency is maintained or increased, even as trade volume increases. The type of netting dona should be determined by the volume and number of participants in the market. With the decreased number of daily movements, coats should also be decreaaed. Efficiency ia again promoted and risk reduced. Development of Linkage In order to improve global efficiency and competition, linkage between each country's depositories and clearing houses should be established. As it is generally agreed that a global clearing system is not currently viable (realistic), reciprocal linkage should be established providing there is expected a sufficient level of use.
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-12Allowing members of the country's system to link to another country's will increase competition and reduce costs. Although some linkages have been established, increasgd expansion can only benefit the market places and improve the goal of a global market place. Standardization for instruction hould be developed and reliable communications established. The linkage should include each country's comparison, delivery, payment and safekeeping system, whether it is handled through a depoaitory, clearinghouse or separate entity. Cross-Border Information Flow While the adoption of uniform and ~on~istent standards for aec~:l ty,. &CC?ilntirtg. .. and market iriform~tion iii necessary, without quick. and effil.cie~t flow of. thi _information across nationai borders, it is of little use. Accurate and timely news and company information should be available to all markets, not just domestic ones. Information, which can ultimately affect prices, if not available to some participants, creates unfair markets. Globalization should allow for fair and competitive markets for all, world wide. All information hould be available and flow efficiently across .. ~f~~.~.-~ ;.:.-=-;:, : ::::.\. .o; : . '; ., ,::, ..... r.'. ... : . . . .... . . : I . .. .,_', . ,. ., .. lteduction of Global Credit Risk By developing better flows of financial information between countries, counter party credit risk will be reduced. Though confidentiality is important, protection of participant and reduction of risks must also be weighted heavily. Providing account information across several markets, in a consistent form for easily analization, will only benefit all in the long term. Thia prudent practice and adequate capital standards protect participants by reducing default risk and deception. Equal Treatment and Acces~ Rules and privileges regarding a domestic company should be applied and afforded equally to a foreign company: regulation should not hinder competition from within or outide. Thi openness, however, will not happen overnight. National sovereignty, historical background, and cultural differences make this a slow and difficult process. Although support for domestic firma, especially in smaller or emerging markets must be provided, unfair practices will only make a market inefficient and less attractive. Gradual reduction of barriers for foreign firms will show a willingness to change and a spirit of cooperation. As markets become more uniform and global in nature, the markets by normal forces and competition will help remove any further hindrances.
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-13-CONCLUSIONS Diversity and differences created by the independent development of each country's markets, form an environment that may be confusing and inconsistent to non-domestic participants. While each participant's home markets have their own local customs and pratices, working in another market can cause misconceptions and problems thereby being perceived to be unfair. Steps currently being taken, to bring more uniform pratices to all markets, will have the highly desirable effect of reducing confusion, systemic risk and creating a more efficient global marketplace. Many of these recommendations have bean developed by diverse industry groups, but a coordinated effort in implementation by all participants in securities markets must follow. I : ;.. . .. National 80V~raigrity, ~ocal issues and practices are important concerns, but an efficient, liquid global market needs the cooperation and assistance of all. These new global standards and changes are not, however, the end to creating a truly global market place. They are only the first steps of many. In a truly automated and efficient global environment, rapid accurate exchange of information will ~e _nace_ssar.y ~--. Settl:'9Qlent sho.u~d_not. ~ave to take three days, 1'ut coinputeriztioq should al.low it to occur on T + 1 Funds should have same day value,be guaranteed and freely transferable worldwide. Greater reduction in risk will occur and an electronic efficient market will then exist. While nothing will happen overnight, adopting consistent standards and pratices, uniform regulation and the free flow of information worldwide will point the markets toward the future.
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THE FEDERAL RESERVE WIRE TRANSFER NElWORK This contractor document was prepared for the OTA Backgro\llld Paper, Trading Arotmd the Clock: Global Securities Markets and Information Technology, July 1990, and OTA Report, Electronic Bulls and Bears: U.S. Securities Markets and Information Technology, Sept. 1990. This document does not necessarily reflect the analytical findings of OTA, its Advisory Panel, or its Technology Assessment Board. August 1989
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Table of Contents Introduction Evolution of Fedwire in Brief The Fedwire Funds Transfer System The ~ook-Entry .Securitie$ S.yst~~ : Federal Reserve Risk ori Fedwire Funds Transfers. Fedwire Securities and Reserve Bank Risk 1989-Proposals for Modifying Payment System Risk Reduc~ion Policy Page 1 2 9 10 17 21 24 ,. ....................... :~_,,: ,' .,,.;; . ~. /~t,,-t-11. :"'~'.''~.~-.,~::;.-r-,: .. ,;.-,::,.;.-,_-~., .,.:', ;.~',;''':,, }.,._., --~.:. I I .,-1. Interim Policy.... ... .... 25
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The Federal Reserve Wire Transfer Network Under the Federal Reserve Act of 1913, the Federal Reserve Banks play several major roles in the operation of the nation's payments mechanism. These roles include such familiar activities as the clearing and collection of checks and supplying the economy with currency and coin. A less widely familiar service of the Federal Reserve, but one that dwarfs all the others in the dollar magnitudes involved, is the operation of Fedwire--an electronic funds and securities transfer networi<"which links the twelve Federal Reserve Banks arid their branch offices . with almost 10,000 commercial banks and other depository institutions nationwide, and which handles daily average transfers of funds and securities now exceeding one trillion dollars in value. Fedwire is a "wholesale. wire transfer system, used principally for the transfer of ,i:; .. ~,,--'""..,,' ...... ~.,-.::,.,: .::a;,\:,,,,, .. ,.,._,.,_;,." .. 1,,.,;,,;--- 0 .,.,,_-~ \,'r, . ;-,-.,;.".~I:, 0'~.-,1.::i- , .. ,. funds and secLJrities in large-doHar Jmounts betw~n-depository institutions and their major corporate customers. 1 For instance, in 1988 the average funds transfer on Fedwire was over $2.9 million in size, and the average securities transfer was about $9 million. To put these numbers in perspective, the average check size is about $900. Fedwire is one of two large-dollar electronic payment systems that serve the nation's domestic and international financial business. Fedwire is principally domestic in orientation, while foreign-related dollar payments primarily flow through the Clearing House Interbank Payments System (CHIPS). CHIPS is an electronic system for transferring dollar balances only. It is privately owned and operated by the New York Clearing House Association, and closely rivals Fedwire in terms of dollar volume and importance to the nation's financial 1 There are, however, no restrictions on the minimum dollar size of money transfers over Fedwlre, and Individuals and small business can and do use Fedwire for transferring funds when the need for Immediate and assured transfers of funds justifies the cost.
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Federal Reserve Wire Transfer Network 2 business. In recent months CHIPS has been handling over $650 billion per day in funds transfers, with an average payment size of about $5 million that is even larger than the average for Fedwire. However, because CHIPS and Fedwire serve essentially two different payments functions, there is little overlap between them, and that fact, as well as other differences, makes it appropriate to discuss them separately. Accordingly, this paper focuses only on Fedwire, though the reader should keep in mind that many of the larger depository institutions have the ~p~~iiity. to ~end ~e~~ive .. fund~o~er b~th-.F~d~i~e --~~d .CHIPS, and that they can and do I o shift between the two systems as need or circumstances warrant. The following discusses the evolution of Fedwire and the current capabilities of its two principal operational features--the electronic transfer of funds only and the electronic tJWlf~r ~f ~~-ritl-~ag~r,~ p~y~ent._ the ~ajar policy concerns that have arisen' iri recent yeats as 'the growihg number "and dollar volume of funds and securities transactions have raised the risks to both the Federal Reserve and the users of the Fedwire system. The Evolution of fedwire in Brief The evolution of Fedwire began over 70 years ago, with the initial opening of the Federal Reserve Banks on Monday, November 16, 1914. At that point in the nation's history, adjustments to bank balances and the movement of funds from a member commercial bank's reserve account with its Reserve Bank on the east coast of the United States to a reserve account of a member bank on the west coast, or any point in between, often required the Reserve Banks physically to ship currency or gold. This procedure was costly, required considerable time and involved heavy risk. The only available alternative was to use the public telegraph facilities of Western Union Telegraph Co. or Postal Telegraph Co. to instruct the
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Federal Renerve Wire Transfer Network 3 Reserve Banks to make accounting transfers of funds bemeen banks. However, because these transmission facilities were not under the control of the Federal Reserve, such alternatives also had their risks and operational drawbacks, and were used only occasionally. In 1918, taking advantage of the latest technology then available, the Federal Reserve introduced its first dedicated funds transfer network in the form of a Morse Code system using leased wires for greater security. That first network connected only the 12 Reserve Banks, the Board -~f Govern~rs and the Treas~ry. The_ Federal Re~erve Bank of Chicago served as the switching center, relaying messages between points in the East and the West. From the beginning, use of the system grew rapidly; at the New York Reserve Bank activity ranged from 75 to 100 messages daily in the first year of operation and averaged more than 600 messages daily ten years later. ,. .. .. .' "' \ . ... .. .. ; _, .. -: '1. . .. --. . :. As technology continued to advance, the Federal Reserve decided in 1937 to convert the Morse Code network into one using more modern equipment, such as teletype machines, which eliminated many manual operations in switching messages. Then, in 1940, further advances were made when the Federal Reserve installed a Western Union semi-automatic message switching system, with Washington D.C. and the Chicago Reserve Bank serving as the main switching center sites for the country. By 1950, with the prosperous economy pushing funds transfer activity to ever higher levels, the Federal Reserve considered itself vulnerable in two areas: (1) given the possibilities of war, Washington, D.C. was no longer considered a preferred site for a switching center, and (2) the existing network--a mixture of American Telephone and Telegraph and Western Union equipment--lacked integration. Recognizing these flaws, in 1953 the Federal Reserve replaced the existing teletype network with a virtually automatic message system using AT&T equipment exclusively. It also eliminated the Chicago switching center and moved the Washington, D.C. switch to the Richmond Federal Reserve Bank.
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Federal Reserve Wire Transfer Network 4 The advancing nuclear and computer ages together led to the next phase in Fedwire's evolution. In 1967 development began on a new message switching center in Culpeper, Virginia, whose out-of-the-way location and structural design (built into the side of a mountain) acknowledged the nuclear threat. At the same time, the existing Fedwire communications and transactions processing systems were replaced with state-of-the-art, QOmPL!t~rlzed. high-speed electronic telecommunications and processing systems. The . : : , : '. : : : =. . . : . . Culpeper:-based .rietwork was pl.lJ into operaiion In 1970. 1n ~at year, Fedwire js'rocessed 4.3 million funds transfers totalling $7 .2 trillion in value. Also in 1967, the Treasury and the Federal Reserve Banks, as fiscal agents of the Treasury, jointly initiated a system for issuing and maintaining marketable Treasury securities .-In boolHntry.fQml .. The.tp>k..,,ir,y.sys~rn.~~le~ .. 9.wn~~-s!!iP re~r~s for eligible securities to o I "', ,o ' I '." ,'o: o ''... o be maintained and transferred as accounting entries on computerflles at Federal Reserve Banks, thereby eliminating physical securities, which are susceptible to theft or loss, from existence. The design and development work on the book-entry securities system had actually begun in 1963, but several years were required to solve the formidable operational complexities and legal problems involved in the implementation of such an innovative and far-reaching change in the Government securities market. Although the book-entry system evolved primarily during the late sixties and early seventies, its genesis can be traced to 1921, when the Treasury first permitted telegraphic transfers of its securities. These telegraphic transfers, which eliminated the exposure, expense and delay of mailing securities long distances, came to be known as cpo Transfers because, Initially, the Commissioner of the Public Debt had to approve each one. However, this procedure proved to be awkward and Inefficient. A seller had to deliver a definitive bearer security to one of the 12 Federal Reserve Banks (or one of the 25 branches), which would thti n retire the seller's physical certificate and wire an order to the buyer's Reserve Bank to issue an
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Federal Reserve Wire Transfer Network 5 Identical physical security to the buyer. Thus, each CPD transfer still required movements of paper securities to and from Federal Reserve offices, as well as significant printing and engraving costs. In 1965, in an interim step to improve the efficiency and reduce the risk of the physical securities transfer process while the book-entry system was still in the developmental stage, the Treasu_ry and th~ FederafReserve Bank of Ne_w Yori<" implemented the Government . . . . . Securities Crearing Arrangement to cle~r-trades-among banks and securities deaiers in New York City with minimum movement of physical securities. The arrangement permitted telegraphic transfers of securities to take place among participants during the day, with each participant then settnng Its net city-wide position at the end of the day through one delivery of physical securities . . 6r from' ttie Feoi~al.-Reserie' saii1c' of N~v/Vork -- > . .. .. I ',, ._ From its inception in 1967, the book-entry system grew rapidly in coverage and scope. Over the ensuing ten years, Treasury regulations were amended from time to time to make an increasing percentage of outstanding Treasury securities eligible for book-entry, and several Federal agencies as well began issuing their securities in book-entry form. By 1977, the successful conversion to book-entry of the bulk of outstanding physical Government securities, and their eligibility for electronic transfer by wire, had largely eliminated the need for settling transactions in physical securities. Accordingly, the end-of-day physical settlement through the Government Securities Clearing Arrangement became unnecessary and was eliminated that year. As funds and book-entry securities volume increased steadily throughout the 1970s, the need for an alternative to the centralized message switching concept became apparent. As a result, In 1982 the Federal Reserve began Implementation of an Improved electronic communications network called the Federal Reserve Communications System for the 80's (FRCS-80). Unlike the previous system, where all messages between Federal Reserve
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Federal Reserve Wire Transfer Network 6 Banks had to go first through Culpeper as a switching center. messages on the new system are sent by the most direct route, using multiple lines within the network. Consequently, messages arrive faster and, since multiple paths are available, a breakdown in one part of FRCS-80 is less disruptive than was a breakdown In the centralized Culpeper system. 2 While Fectwire in its current configuration is a highly sophisticated computer-based ystem designed for the rapid and _secure electronic movement of enormous amounts of money ... _:-_ .. -~ .; :.i."' ... :. :.. :: ... : .... : '/ .. , .~ .. . ,. .. . '. _ar)d sec~r~es fro~ and ,o accounts o~ tlie books of' Reserve Ba~ks, stripped to its essentials -.. ' Fedwire is quite simple in concept. Fedwire consists of three basic components: 1. A high-speed communications network (FRCS-80) electronically linking all Federal Reserve Banks and their branches; ,.-~.-.,~.~-; __ .. ~-~~P,ut.eri:Zed_p~~_cessi11g __ and .r~~rdkeeping capal>ility at each Reserve Bank tp procest anct account for individual funds and securities transfers as they occur, and 3. Local Federal Reserve District electronic networks linking depository institutions in each District to their respective Federal Reserve Banks. The local networks which link depository institutions to their respective Federal Reserve Banks reflect the high level of automation that also exists at most depository institutions using Fedwire. Nearly 99 percent of all securities and funds transfers processed over Fedwire are entered by depository Institutions on-line. That is, transactions are entered directly irito the Fedwire system by the Institutions sending funds or securities, without the necessity for any intermediate processing by the Reserve Banks. These on-line transactions are entered via one of three types of connections: dial-up terminals using ordinary telephone line connections; leased line terminals, or computer-to-computer interfaces. Instructions for funds or securities 1 As discussed later, the Culpeper site Is now being used as a contingency Fedwire operations center to serve as a back-up should a Reserve Bank suffer an extended outage of Its own Fedwlre facilities.
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Federal Reserve Wire Transfer Network 7 transfers thus go directly from the sender's terminal or computer interface to the Reserve Bank's computer for processing, and then are sent automatically to the receiver's terminal or computer. Off-line transactions, by contrast, require manual processing by Reserve Bank personnel. Off-line access by a depository institution is typically accomplished by means of a telephone request, done under special arrangements with the requester's Reserve Bank, that must be authenticated at the time the request is made by codes or other procedures established . . ..: .' : .;., .. : : ... ..... ... "': . : -: .-. . . ... . by the Reserve Bank. All such telephone requests are tape recorded. Following receipt of an . . . . . authenticated off-line transfer request, the transaction is entered into the Reserve Bank's computer by Reserve Bank personnel. As the foregoing discussion suggests, Fedwire is a payments mechanism that has ~en evoMng rapidly over the years in response to the nation's growing needs and technological ' t I .. \ ,: 0 ' 1, 0 p 0 ,,. ~, f ' ', ,. 0 capabflitlea. And that continues to be the case not just for Fedwire but also for the Federal Reserve's book-entry securities system. While both current capabilities have been in place for close to seven years, the Federal Reserve is already actively planning changes to enhance the quality and reliability of these services and to better serve the expanding needs of its users in the decade of the 90's. With respect to the existing Fedwire system, the prime focus of the Federal Reserve at the present time is on improving the security and operational reliability of the network. While Fedwire is already a secure operation by most standards, the Federal Reserve is nonetheless undertaking two major additional steps to guard against fraudulent or unauthorized use. The first, involving encryption of all communications flowing through on-line connections with Fedwire, began in 1984 and was completed by the end of 1987. The second step, is a proposed message authentication procedure to ensure that messages originated by any participant on Fedwire are valid and are received at their ultimate destination without error or alteration.
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Federal Reserve Wire Transfer Network 8 The second current concern--the operational reliability of the Fedwire network--is being addressed on several fronts. While Fedwire presently incorporates much in the way of protection against service outages, through such means as redundant computer and telecommunications hardware and software at the indMdual Reserve Banks, and multiple communications paths between Reserve Banks, temporary outages in the availability of local parts of the Fedwire -~ystem have remained a chronic and unacceptable problem. Given the :. -~ . . .. : .. :. : : .. .. . . . . : . ~.. .._ . -.. . . enor~ous doller val~e ,andthe_ time-critical ~ature of ~' funds and securities transfers that go .. . . .-. . . . . . through Fedwire daily, even such temporary outages in local segments of the system pose significant economic and financial risks to all concerned, and a prolonged outage would be entirely unacceptable. Accordingly I the Federal Reserve has begun to evaluate and implement meaoa _of .. impro~ Fe4wir,e;a.,p~~Q~4de ~pe~~ting .r~~i~~illty, ~d has developed contingency . .. : ..... plans to handle a prolong~d local outage, shourd one occur. A Contingency Processing Center, established at Culpeper, Virginia, has been equipped to serve as a back-up Fedwire operating center for Reserve Banks, other than New York, Chicago and San Francisco, to relocate their Fedwire operations in a day or so in the event of a prolonged outage of any of those Reserve Banks' Fedwire facilities. The Federal Reserve Bank of New York, because of its location in the nation's central money market, and its role as the operating arm of the Federal Reserve in the conduct of domestic monetary policy and international financial operations, has established its own contingency operating site within the Second Federal Reserve District, which is designed to permit a resumption of Fedwire operations within a few hours following any loss of the Bank's on-site capabilities. The seventh and twelfth reserve districts banks are following New York's example by establishing contingency sites within their own respective districts to support demands for rapid recovery. In addition to these efforts to Improve the safety I soundness and operational reliability of their Fedwlre services, the Reserve Banks are also working closely with the
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Federal Reserve Wire Transfer Network 9 depository institutions that are the major users of Fedwire services to encourage and assist them in improving the reliability of their own operations. The outage of a major money center bank, leading to its inability to either send or receive traffic over Fedwire can, of course, also be enormously disruptive to the efficient operations of the nation's economic and financial system, as well as posing risk and operational burdens to all other participants in Fedwire :-: :. ,' . ; .' . .r : . .:. : ,_; The Fedwire funds Icansfer System . . . ... I As suggested earlier, the Fedwire network has two distinguishable applications--one for the electronic transfer of funds alone and one for the electronic transfer of book-entry securities either free .. or against specified payment. This section describes the .funds-only transfer system .. -. .,. .. ,. ,., >-:..... ... .-_~ ' ....... .. The Fedwire funds transfer system is a credit transfer system. That is, funds are sent through Fedwire only upon the request of the depository institution that is the sender of funds. The sender in making the request irrevocably authorizes its Reserve Bank to debit (charge) its account for the amount of the funds to be transferred and further authorizes the receiving depository institution's Reserve Bank to credit (pay) the same amount to the receiving institution. The receiving institution, by maintaining an account with a Reserve Bank, authorizes the Reserve Bank to credit the amount to its account, and further agrees that if the funds are designated as payable to a third party beneficiary, the beneficiary's account at the receiving depository institution will be credited promptly or the funds otherwise made immediately available to the beneficiary. With a few exceptions, any institution that maintains a funds account on the books of a Federal Reserve Bank may routinely use Fedwire to make and receive funds payments, subject to terms and conditions established by the Federal Reserve. At present, there are now
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Federal Reserve Wire Transfer Network 10 alm-)st 12,000 depository institutions with funds accounts at Reserve Banks, more than double the number a decade ago, and about 10,000 actively use those accounts to make funds transfers. This recent expansion of accounts largely reflects passage of the International Banking Act of 1978 and the Monetary Control Act of 1980. Prior to those two Acts, eligibility to maintain funds accounts at Reserve Banks was largely limited to member banks of the Federal Reserve .. . .. . . . . . .. .. \ ~-, :. . : : "' . . . System, Agreement and Edge corpor_ati~ns established under Sections 25 and 25(a) of the . . Federal Reserve Act, the U.S. Treasury, Federal agencies and Government-sponsored enterprises, official international financial organizations such as the International Monetary Fund, and a number of foreign central banks and governments. The International Banking Act of 1978 _add~, U.S. branches and agencies of for~ign banks to the _list of eligible account holders, and \ '. ,,., . o ' I ,I.. I '. ,' o ,. ., 0 e : ".I the Monetary Control Act of 1980 added most nonmember commercial banks, savings and loan associations, savings banks and credit unions. At the same time, all of these added institutions were given access to the full array of Federal Reserve payment services, including those provided by Fedwire. A transfer of funds over Fedwire is deemed finally and irrevocably paid by the Federal Reserve when the receiving depository institution receives the payment message or is given or sent an advice of credit to its account by its Reserve Bank, whichever occurs first. For most transfers Involving on-line depository institutions the elapsed time from the sending of a funds transfer to the receipt of finally paid and available funds by the receiving instiiiJtions is a matter of seconds, or minutes at most. What this means in practical terms is that a funds transfer over Fedwire, once completed, Is backed by the full credit of the Federal Reserve System and Is thus the functional equivalent of th" Immediate payment and receipt of cash. The legal framework for Fedwire funds transfers is set forth in Subpart B of Regulation J reonection of Checks and other Items and Wire Transfers of Funds), Issued by the Board of Governors of the Federal Reserve System. The regulation governs the handling
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Federal Reserve Wire Transfer Network 11 by Reserve Banks of funds transfer requests and provides rules for funds transfers over Fedwire. Additionally, each Reserve Bank Issues an operating circular that la In the "ature of an agreement govemlng the details of Its funds transfer operations and other matters the Reserve Bank deems appropriate. Regulation J further provides that both Subpart B of the Regulation and the Reserve Bank's operating circulars lasued pursuant thereto are binding on transferor and transferee ~ory lnatlttl~ and.~r interested parties. . . . . . . .... . . : . .. : The nstant flnallty' feature of Fectww, funds transfers-immediate and Irrevocable settlement of payments on a transaction-by-transaction basis-sets Fedwire apart from attemative means of making and receiving large-dollar payments. As noted, the only close equivalent in terma of certainty la payment In legal tender currency and coin, but even that anemative .. . ... . thousands or millions of dollars. Payments by conventional check are, of course, an efficient attematlve means of making and receiving large-dollar payments, but a payment by check is provisional and the holder of a check payment faces the risk that the payment will be rescinded If the check Is returned because of Insufficient funds In the drawer's checking account, payment on the check 11 stopped, or failure of the payor's bank. Payments over private-sector wire transfer networks are also efficient but similarly provisional. Unlike Fedwire, which uses participants' cash balances on the books of Reserve Banks to Immediately and Irrevocably debit and credit funds transfers, prlvatsector wire 1yatem1, which do not have access to their participants' funds accounts, operate on a net aettlement baaJa. While Individual payments messages are exchanged between participating banks throughout the business day, the actual transfers of funds between banks do not take place until the private wire syatem aett1e1, with thole participants owing fund1 paying their net due to amounts into the system and thole with net due from positions receiving those amounts. Thua, In the absence of 10me form of settlement guarantee, the Inability of any
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Federal Reserve Wire Transfer Network 12 participant Institution In a private-sector wire transfer system to settle Its due-to position can have broad ramifications, Including, in the extreme, an Inability of the system as a whole to achieve a settlement and the resulting necessity for revocation of many or all of the payments that had been provlaionaly made and recetvect.1 Private-sector wire systems thus function on the basis of their participants' oonflde~. in the credltworthineu of one another, whereas participants on Fedwire need rely . : . . . .. : . . -. . . : . . : .... :-.. . . .. . . : . . : . . . only on the Federal Reserve' ability to pay, since a Reserve Bank effecti_vely substitutes lta credit . . . . . . ,, . for that of senders of payment messages. The Book-Enby Securities System ,. --~-, Th6Fetlnl A....---booka,y-NCUritill sysl8ffl ii a "8tional system for the. . . --. .. ..... issuance, maintenance, servicing and transfer of ownership of U.S. Govemment and certain Federal agency debt solely in the form of accounting entries on computer files at the twelve Federal Reserve Banks. At present, more than 98 percent of all marketable U.S. Treasury debt la in book-entry form, as well as a similarly high proportion of the debt of several Federally-sponsored agencies. The latter agencies include, among others, the Federal National Mortgage Association, Farm Credit System, Federal Horne Loan Mortgage Corporation, Federal Home Loan Banks and Student Loan Marketing Association. And, more recently, some International organizations-the World Bank, the African Development Bank and the Inter-American Development Bank-have begun to issue their securities in Federal Reserve book-entry form. 1 For a dlactlon d this aapect d prlvatNCtor wire trlnlflr aystama. w the New York a.ring Houle' Aprl 28. 1989 memo to al CHIPS partlclparu and Appllcaru regarding ,ncreaect Au&nnce d Slalemlrt Finally on CHIPS.
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Federal Reserve Wire Transfer Network 13 Currently more than 150,000 separate securities issues are in book-entry form, and about 2,000 are being added to the inventory each month. In terms of dollar value, the $1.8 trillion of marketable U.S. Treasury debt constitutes the bulk of the total value of securities held In book-entry form. However, in terms of number of issues, those of the Federally-sponsored agencies predominate. Indeed, almost 95 percent of the issues on Fedwire are residential .~gag~~ u,cuntt,s iss~ by .. the Federal Mortgage Association and the : . . . ; . '. Federal Homeloan Mortgage. Corpora11on_; ancfthose Issues currently account for an even higher percentage of the number of new issues being added to the book-entry system. On a typical day, Fedwire processes about 42,000 securities transfers, aggregating more than approximately $350 billion In par value. .. ...... ; .. Wharf the 'Treasury and the' Federal -R8'8M first implemented the book-entry .. . .. system In the late 1960's, the system was restricted to those Treasury issues owned outright by institutions that were then eligible to maintain securities accounts at a Reserve Bank--principally member commercial banks of the Federal Reserve System. In the early 1970's that restriction was relaxed to permit those institutions with book-entry accounts at Reserve Banks to also establish accounts for holding their customers' securities in book-entry form as well. Moreover, with the passage of the lntemational Banking Act of 1978 and the Monetary Control Act of 1980, access to the Federal Reserve book-entry system was also made available to foreign banks with branches or agencies and to all domestic commercial banks, trust companies, savings banks, savings and loan associations, and credit unions that are eligible for Federal deposit insurance. Thus, any depository Institution is now eligible to maintain a direct book-entry securities account at Its Reserve Bank, provided It also maintains a funds account with its Reserve Bank. At present. about 5,300 depository Institutions have book-entry securities accounts at Federal Reserve Banks.
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Federal Reserve Wire Transfer Network 14 Additionally, each of the fifty states is allowed to have up to two book-entry accounts with the Federal Reserve Banks for the segregation and safekeeping of book-entry Treasury securities Investments held by state and local govemments. Also, when the Treasury In August of 1986 ceased to make Treasury notes and bonds available to individual investors In engraved paper certificate form, it initiated a new arrangement, called TREASURY DIRECT, which allows individuals to have their own electronic book-entry accounts with the Treasury on .... .: ._: ... :. :."; .. .... :_-,:.,..: ... ~_-".:: .. .'-. :~ : .. _,; .. ._. .......... -,, ....... . .. the ccwnputer 8'es of the federal R-.r:ve Bank of. Philadelphia as fiscal agent for the Treasury. . . . . . .. . .. . . . .. These accounts for individuals are also only for the holding of Investments in safekeeping however, and may not be used for other transactions purposes. Finally, many foreign central banks and official international organizations also have book-entry securities accounts in their .own-aamea..at ltll .. .. qf ~ew -Y~, _in which they may transact off-line . . ... ...... "' .. ........ ..... -~:-. !'\ l .... . .. . th~h Instructions io the. Forelgn Relations Oepirtment of 1he 'Bank .. All of these latter book-entry accounts are for the account-holders own use, however, and are not intended to be used to hold or transfer securities other than those of the account-holders. Depository institutions with book-entry accounts at Reserve Banks, on the other hand, are under no restrictions as to the individuals and organizations who may maintain and transact in book-entry securities accounts with them. And, in practice, depository institutions maintain records on their own books to Identify securities that they hold in their Federal Reserve book-entry account on behaH of their customers, including securities held for correspondent banks, other financial institutions, govemmental bodies, corporations, Institutional investors, and individuals. Thus, ownership interests in book-entry securities are recorded in a tiered system of accounts, beginning with the Federal Reserve Bank that records the securities In the name of a depository Institution, and ending with the entity, which can be several stages removed from the depository Institution, In whose records the interests of the beneficial owners of the securities are recorded. Maintenance of records of holdings of book-entry securities at
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Federal Reserve Wire Transfer Network 15 the aggregate level, however, remains the responsibility of the Reserve Banks In their capacity aa ftscal agents of the United States and the other Issuers of book-entry secuntiea. A diagrammatic example of the kind of tiered relationships that exist in book-entry recordl of ownership II shown on the next page. In this example, only the depository lnatltutions (Dis) labeled (A) and (B) are assumed to have securities and funds accounts directly with the Federal Reserve Bank of New York (FRBNY). All other entities below that level have securttfes acc0ldl clf'ectly, :or lhdnc:tlyttvough o'*' wilh Dis (A) or. (B). For instance, a -. of broke~~ (B) will tiave b interest 1n~:.entry securtilei ;9corded on the books of broker-dealer (B), and the latter will have a corresponding interest In those securities recorded on the books of DI (C). DI (C) in tum will have an ownership interest in the securities recorded on the books of DI (A), and DI (A) will have corresponding ownership recorded electronically on . . ,_. ---~; : ~--....... ~ . ....... ._.-,i :.,, ... _..,, !"'' . :. -.. the comput records .of FFIBNY. : . : . . . DI (A) (C) eu,tame,. of 01 (A) DI Examples of Relationships of Institutions Maintaining Book-Entry Accounts FRBNY I Broker-Dealer (A) of DI (B) / / "' o.,tom.,. Brok-of DI (C) Dealer (B) Cu,tome,. of Broker-Dealer (A) Broker-0.ater (C) I 0.1tamer1 of Brok-Deater (B) 67 "Of" tt1onifies Oeoositorv Institution / Brokar-0.aler (0) I 0.1tornerl of Brokar-0.ater (D) Cu1tomer. of InkerDealer (C) DI (B) 01 (8)11 Tru1t Operationa DI (D)
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Federal Reserve Wire Transfer Network 16 Assume that a customer of broker-dealer (8) Instructs that broker-dealer to sell the customer's book-entry securitiea, and that broker-dealer (8) arranges to sell the securities to DI (D). In the normar cowse, such a trade wta call for delivery of the securities the day after the trade la agreed--1.e., next-day delivery-though Irides may also be arranged on a same-day or cash delWrybasli; Onlhe _.._ uaurllJes ... to. be delivered, DI. (A).wll, acting on the lni~ of brok~~-(8)' ..... hough. 01 (C):. ~trud FRBNY to transfer the securities from Its account at FRBNY to the account of DI (8). In the great majority of cases this Instruction to FRBNY will be received on-line and will be utomatically processed and executed by FABNY'a computers without any handHng by FF BNY personnel. FRBNY's ._. !I. . ~v.ti-ihitihi~1ot>etrani~ecfnpresinl1n01fA>securtt1esaccoun1. . and will then automatically debit that account In the amount of the securities to be transferred and simultaneously apply a corresponding credit to the securities account of DI (B). A unique feature of the Fedwlre book-entry system is that securities may be, and almost always are, sent against Immediate and final payment. That is, In the example presented, DI (A) 's !nstruction to FRBNY to transfer securities to DI (B) most likely will also specify the price to be paid by DI (B), and that payment Instruction wiU be processed by FRBNY simultaneously with the securities transfer. Thus, at the same time FRBNY debits the securities account of DI (A), It will simultaneously credit DI (A)'s funds account on FRBNY's books for the sale price of the securities. Correspondingly, at the same time that FRBNY credits the securities to the account of DI (8), It will simultaneously debit the funds account of DI (8) on FRBNY's books for the amount to be paid for the securities, as specified In DI (A)'s Instructions to FRBNY. Nole that this requnmn that l8Cldles to be sen1 fflUII be presen1 In the aencWa aecurlles acccxn precludes an overc:traft"occurrlng In a sander's securities aCCOll1t wlh b R818Mt Bank,-.TJ\11 conlrUtl wlh funds accouru In which. as discussed later, overdrafts are pennlltad on the books oMllerve Banks.
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Federal Reserve Wire Transfer Network 17 To complete the transaction described above, the meuage sent by 01 (A) to FRBNY must unambiguously specify the particular securities issue to be transferred, the face amount to be transferred, the payment amount, and the party to whom the securities are to be transferred, which must be a party that has both a securities and a funds account with a Reserve Bank. In addition, the message sent to the Reserve Bank may also contain additional .Jn~ .lower tier parties to the transaction. For instance, in the example, the .. to ~by ~i. (~). ~~~~~-also ~ttfy 01 (A)'s sending customer, Di . . . -(C), and contain instructions to 01 (B) to credit the securities received to Its customer, DI (D). The message sent by DI (A) is, after processing by FRBNY, forwarded to DI (B) as confirmation of the transaction, and this additional information assists 01 (B) in relating the transaction to . lnltruclic,ns It wil have naived be~ fr~ Dl. _(D) to accept dellvery and pay for the . .. . ... . \ .... "' . . securities on Its behalf. Normally securities systems begin their processing cycle by matching trade instructions, clearing the transaction and then delivering securities against payment. The Fedwire book-entry system differs from most of the world's securities systems in that matching of Instructions takes place after the securities movement and payment are final during the reversal period just prior to closing. This approach has provided for a fast and efficient system that supports the implementation of monetary policy and fulfillment of the U.S. Treasury's debt requirements on a same day basis. Federal Reserya Risk on Fedwlre Funds Transfers The Federal Reserve Banks are at risk on Fedwire funds transfers if a depository Institution's transfers of funds result In an overdraft (negative balance) in Its account with Its Reserve Bank. Since the receiving Reserve Bank will, as discussed earlier, have given final and
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Federal Reserve \Vire Transfer Network 18 Irrevocable credit to the recipients of funds sent over Fedwire by the transferring depository Institution, the Reserve Bank serving that sending Institution cannot recover the account shortage from the recipients, and would hive to absorb whatever lou tlowl from Its reaunant creditor position. The magnitude of the theoretical Fedwlre exposure faced by the Reserve Banks II not_ trtvill,. lince overdr . ~,red qo the :-of the RIMM _,.. by_ depository 1n1t1tut1onaii a NtSUft.of"f&nil ansferactlvity on Fedwire now run In ... neighborhood of S70 billion daily. However, Reserve Bank risk of financlal loss Is tar smaller than such a number would imply. A Reserve Bank will experience a loss from such intra-day extensions of credit on Fedwlre only If a depository Institution faHa In an unsecured overdrawn position without wirnlng. ti6:ii-~use Aeselw'Bank \ii ltlakl evtr/ etrort to pnMnt a ffnandally troubled Ill, I' I Institution from sending funds transfers over Fedwire unless the institution has sufficient funds available In Its Reserve Bank account to cover the charge to the account.' The argunient that Reserve Bank risk Is manageable tends to be supported by the tact that the Reserve Banks to date have never suffered a single loss from the operation of the Fedwire funds transfer network as a resun of the closing of an Institution. The caUNS d dayllgte CMl'drafta on the books d RIMM Banlca .,. varied and complex. but gll1ll'lly ralate to cash nw,aganm pradlces of depository lnstlutlona and their corporata customers that n dNlgned to mkllmlze the CMrnlght holding d non-ireerelt bearing money balances. For lnltance, I fflllor ICUCe d daylight CMrdraftl on Fldwtrl Is the Federal bids market. In which depository lnstlutlona wllh axrm non-lrurelt belrtng blfancee at their RN81'V8 Banks Ill (lend) lhoee balances, typlcaly on an OVlffllgtC bull. to other depository lnstlutlona In nnc:t of such Ill* Aa lhoee funds are thin paid back by the borrowlr In the morning over Fedwlre, the borrower may temporarly overdraft b acco1n with b Reserve Bank. tu tt..l restore the balance lat In the day wlh new borrowings d Federal bids or wllh odllr funds crldlad to b ICCOIR. N. the ..,.,. time, -rhe Federal Reserve also stands ready to provide payment mechanism services to troubled depository lnltl.ilona that Olher proYldn of paymn l8MC8I may no1 NM because of the rtlkl lrwolvld. Thia helpa to.,... 1h11 the lnabllty of a depoelory ..... to make or proceea paymen11 wl no1 trigger b lnlolvency and that the lnllMlon'1 problema can be '8IOlv9d In an orderly fashion wlh a "**num of dlsrupllve effecla. See Board of Governors of the Federll Reeerve System. -rhe Federal Aerve In the Paymeru System. zg FadlQII Aasarya 114111n (September, 1984) p. 708.
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Federal Reserve Wire Transfer Network 19 In any event, It became lncreuJngly dear In recent years that the credit risk exposure of Reserve Banks arising from daylight overdrafts was Increasing, the Federal Reserve began to take steps to limit that exposure. In 1982, the Board of Governors directed the Reserve Banks to apply moral suasion to reduce overdrafts on their books by counseling those institutions that regularly Incurred Fedwire overdrafts In excess of 50 percent of their capital. At the aame time. the Federal Reserve ~an an extensive review of the risks associated with dayllg~--rafti genlra1y-nof ju11" ~:.F~e -~ ~onic payments systems as well-and of the methods available for con-trolling and reducing those risks without harming the efficiency of the payments system. Following that study, the Board of Governors In March of 1984 requested public comment on the possible components of an overdraft risk policy~ Incl~~ t)oih N-~-that such a policy should seek to.attain and several I o possible methods for controlling and reducfng that risk. After receiving and evaluating the public's comments, the Board in May of 1985 Issued its policy statement regarding risks on larg dollar electronic funds transfer systems. The policy adopted by the Board of Governors relies heavily on voluntary efforts of depository Institutions to reduce the aggregate amount of risk they each present to payments systems. Speciflcally, the Board asked each depository Institution that incurs daylight overdrafts on Fedwire or participates on private-sector largMollar wire networks voluntarily to adopt a cap or limit on the total amount of overdrafts it Incurs at any time of the day across all large-dollar funds transfer networks, Including Fedwire, with the cap set according to seH-assessment guidelines established by the Board.' Those guidelines require a depository Institution to address and rate Its creditworthiness, its operational controls, policies and procedures, and Its Whle this la referred to u the Board's dayllghl overdraft reduction program, the payments exposure created In CHIPS by a participant la noc, atrtctly speaking, an overdraft In an _.cc;QUnJ. ,:J. .the, CHIPS. participant. tu rather the net debtor (due to) position of the participant relatlN ld all alher CHIPS partlclpanla at any point of time during the day.
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Federal Reserve Wire Transfer Network 20 credit pollclea and procedures. The self-evaluation performed In each of these three areas ta then combined by the depository Institution Into an overall aelf-aueument which serves aa the bail for the lnatltutlon'a determination of Ila overdraft llmlt as a multiple of Ill capital. ConaJatent with the voluntary, flexible approach adopted, a depository Institution's compllance with Its sell-determined overdraft cap la monitored by Its Reserve Bank on an ex-post bala. That_ la, an lnltltutlon Incurring a crosa-aystem (Fedwlre and CHIPS) funds transfer .,.. : .. .: : : f Jn -. it, cap:ia d~ the fad by lta. Aeaerve eank with a view : , I to d-alng ~ya to. ell~lnat~ the lnafflution~. excess use000of i~ ln~a-d~y ~it .. If~ lnltitutlon were to persist In exceeding Its cap, the i=ederal Reserve could be expected to deal with the lltuatlon more formally :' .. : ... _.Whtie~-riak_l~-~~ -~ Board of Govemors was designed \ . . .. . ... .. -:: ~ ... . .. ... to apply ma a1 1arge' dollat' fundatranafer systems, and not Just to Fedwtre, It has components that apply strictly to Fedwlre. First, the cross-system daylight overdraft cap a depository Institution sets for Itself through the self-evaluation process Is also the maximum perrnlsalble overdraft on Fedwire. That Is, net credits on privatsector wire systems cannot be used by a depository Institution to Increase the amount of overdrafts Incurred on the books of Reserve Banks. Moreover, the allowable overdraft on Fedwire is reduced to the full extent that an Institution also Incurs overdrafts on other networks. Also, a Reserve Bank may continuously monitor an Institution's account when It believes the Institution Is exposing the ReseNe Bank to an undesirable level of risk. In more severe cases, the Reserve Banks may also unilaterally reduce the Institution's Fedwire cap, Impose collateral or special balance requirements, hold or reject outgoing Fedwlre transfers during the day until the Institution has sufficient covering balances In Its ReaeNe Bank account, and-In the moat extreme case-terminate the Institution's access to Fedwire.
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Federal ReselV8 Wire Transfer Network 21 Fedwlra Securities Transfers and Reserve Bank Risk Fedwtre securities transfers, like funds transfers, expose Reserve Banks to risk of lou when a deposttory Institution, at any point In the day, has received over Fedwire a greater dollar value of aecuritiel than It has sent. Since, In such a sltuatkin, the corresponding debits to the Institution's Reserve Bank funds account for the value of securities received will exceed the credits to III account tor the value qt securities sent, Fedwite securtllel tranafera can and do . . create dayllght overdr~i,; funds-~ on Rese~ Ban~~. IM>olcs ,n much the same fashion as funds transfers. And, the magnitude of those overdrafts la about S60 billion a day. Overdrafts caused by book-entry securities transfers, however, have at least two characteristica that dlatlngulsh from funds transfer overdrafts. First, book-entry overdrafts .. :. ~: .... . .. .. ., ... .:~, ...................... .,. -.. much. more concentrated among a few depository Institutions. Indeed, about three-fourths of all book-entry overdrafts on Reserve Banks' books are accounted for by four New York City banks that clear (receive In and transfer out) book-entry securities on behalf of their securities dealer customers. This high degrH of concentration, while increasing the Reserve Bank's risk exposure to particular institutions, makes It possible to focus the monitoring of that risk more sharply. Second, since the book-entry system largely involves value-for-value transfers--i.e., securities for money-a book-entry overdraft on a Reserve Bank's books has Its close counterpart In equivalent-value holdings by the over-drafting depository Institution of securities received In for the account of, but not yet paid for or resoldby, the depository institution or its customers. This latter characteristic of book-entry related overdrafts has always offered the possibility of a Reserve Bank establishing a claim against the securities underlying the daylight overdraft credit txtended by the Reserve Bank for their purchase. In adopting the daylight overdraft controls for the funds transfer overdrafts described In the preceding section, the Board of Governors exempted from quantitative
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Federal Reser.-e Wire Transfer Network 22 llmltatlonl overdrafts on Relerve Banks' books ca 118d apecfflcally by book-entry MCurtUea transferl. Thia wa done out of concem that inclulion of such book-entry overdrafts within 1 quantJtatlve cap or limit might have advrirse effecll on the Government securities market 8/ld/o, on the conduct In that market of open market operations In Government MCUritlel through which Ill Federal Reun,e lmplementl monetary policy. When Ill Board adopted Ill funds transfer overdraft risk reduction polcy, It did, however, begin to explore other means of controlling and 0 I ,' 0 : 0 o ; 0 Io 0 "I 0 1 o, 0 Ndudng book-entry:~ riik to ANerve a.,,kl ........ ': .. ,i, p . To 1h11 end, the Board of Goveniora ha on two separate occas1ons published b comment propoaala to provide for the collaterallzation by depolitory Institutions of their book-entry related overdrlftl on Reserve Banks' books. The first set of proposals was published In.~ 1985. -~ .ttle -~ :~ 1~.. .-. . . . the Board has, however,~ adOpted aome alternative llepl aimed at reducing book-entry overdrafta. First. and most Importantly, the Board Imposed a maximum transaction size lmlt on book-entry securltlel transfers of SSO rnJHlon, which took effect In January 1988. Thia tranaacllon llze llmitatlon wa Imposed to reduce a current practice In the Government securities market. called position building, that II considered to be a major source of book-entry overdrafts. Under that practice, a dealer with a large order from an Investor for, say, S200 million of securitlel, win accumulate, perhaps In several purchases during the day, the entire amount of the order before wiring the aecurltlel to the Investor. As a result. the dealer's clelrlng bank wl recet1e In during the day the entire S200 mlllon of securities for the dealer, Incurring a S200 million charge that can contribute to an overdraft with Ila Reserve Bank, before receiving an Instruction from the dealer to wire the aecurltlea to the lnveltor against covering payment to the clearing bank. The $SO million tranuctlon llmlt Imposed by the Board II dellgned to change this practice by requiring the dealer to wire the securltlea to the Investor In mulllple deliveries a they come In to the dealer's clearing bank account during the day. In the
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Federal Reaarv8 Yt1re Transfer Network 23 above example, the polentill maxJmum clelnng blnk overdraft created by the tranuction will ltu be reduced from 1200 million to little SS> milion, depending on how quickly partial dlUveriel are made MCUritiel are accumulated. And, to auure that deliveries are made qulckly, the Board hat stated that n w1 be d11med an UMCCIPllble UM of Fedwlre to avoid the Intent of the trwacllon size llmltatlon by continuing to buld ucurtllll politlonl and Mndlng deltl8riel of S!K> mlllon or leu In rapid IUCCllllon to the purchaser. : . . . . . : ... ; . : . . . Addltlonlly, the asked the .Federal Aelerve Bank of New York to continue .. :. s ,. . : to monitor the trading practicel and polidel of aemtllel dealers with view to Identifying and seeking to modify market practicel that contribute wlduly to book-entry overdrafts. When ._. atepa were dedded by the Board of Govemorl In July of 1987, the allo ..-n lmmedlately Wldlrtake a tul review of Its long-Nn strategy . . .. .. ..... .. .. . ,. .. .. .. --. -.. . .. and golll foi COl,trollng and 'reducing P8Jmenll lyallm rllk. A talk force establiahed by the Board of Governors worked with an advilory group tom the private sector In addreulng these llw. In August 1988 they recommended the UM of market forces to provide lntraday credit. In combination with regulatory overalghr to addr-payments ayatem rlak. They also made four apecfflc auggeatlonl: 1. A level of free overdrafts should be establllhed to reflect the operational delays of a complicated network. 2. Pricing lhould be Introduced tor Fedwlre overdrafts above the free level and below the crou ayatem cap. 3. Ctoa ayatem net debit caps 8ltlbllhed through a Nlf evaluation procea and Federal Aelerve guldellnel lhould continue and perhaps be reduced IUblequent to pricing introducllon. 4. An announcement of a apecllc Introductory date lhould be made after Implementation lllun have been addreued.
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Federal Reserve Wire Trarx1er Network 24 Suba1anllal Implementation luues were also raJsed by the Large Dollar Payments System Advflory Group'1 recommendations which Federal Reserve staff analyzed and weighed over a period of nine fflOlllha. 1989 Prcpye'I for Modifying Iha Payment System Risk Reduction Policy In May 1988 the Board of Governors proposed modlflcationa ~ncorporatlng of the-~ GrOUl)) system risk reduction policies which . ~-I " o , 'II ', ' : I ,,' '; ',, : Include the ll*adUcllon of.pricing~~~ ~al, the Inclusion of book entry Items . . . . .. In the detlnttlon of overdrafts and a redefinition of net debit cap use and overdraft measurement 11 well II guldellnea private networks and systems. All modifications, except private networtca Ind lyataml guldellnel, are presently avalable for public comment through 'lllovillTlber 17 . 1189 ... --~~.\..... ~,: .. .. ;4. ..: . . . -"" ,. ,,\ Fldwlre _,. iubject io pricing n expected to be based upon the average daily lntraday total funds and book-entry overdraft In excess of 10 percent of a Di's risk-based capital rthe deducllble1, Pricing II expected to be phased In over a three year period beginning In 1981, cukNnallng In a 25 ball point (annual rate) charge. Overdraft measurement is expected to be modified through changes In the sequence of posting of non-wire transactions to a or, account. In regard to net debit caps the crou 1ystem cap will be abolished when CHIPS lmplementa l8tlllment ftnllty, only the Fedwire cap wiU remain. Small Dis may be exempt from tlllng a Fedwn net debit cap if their dally overdrafts are lell than $10 million and 20 percent of rtlk baaed capltll. The cap multlplea for Dis flllng wil be related to risk-based capital (Tier I & II) deflntllonl not the prevtoualy employed adjusted primary capital. If a Di's total Fedwire overdraft uc11dl the net debit cap frequently or routinely by material amounts solely because of book entry overdraftl, the total F,dwlre overdraft wll have to be collaterallzed. It Is further
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Federal Reserve Wire Transfer Network 25 expected that foreign bank branches and agencies will collaterallze all Fedwlre overdrafts which exceed their cap multiple times U.S. capital equlvalency. {Total overdrafts must remain less than cap multiples times world-wide capital.) In addition, regardless of cap standing, a DI must file a board-of-directors resolution H (a) It authorizes another entity to make Fedwlre payments or receive book entry transfers for Ila account or (b) makes transfers to an affiliated DI to fund the afflliatel reserve : _. :: _.,. ~ :: ~-.. : I' ,:i::."' ,: ,,1~! ,-., , .~ :, : ... .-.' :~.-,I .accotJnt lntraday. . . . ; .. ". ' : . pl ." ' : .--: , . : ' I : .. Interim policy Immediately Effectiye The Board of Govemors also Instituted an Immediately effective Interim policy in the areas of private networkl/ayatems and Fed Funds and Repurchase Lending agreements. . I- .. Eklok-entry dellvery~-payrnent aystema _..,_ wish to net letlle on the books . . . . . of the Federal Reserve must --is a .,_,;, ufeguards for liquidity ind credit, prohibit settlement unwinds, and provide open settlement Information to participants. Offshore dollar clearing networks that wish to settle on a net basis directly through Fedwire or Indirectly on CHIPS should be supervised by a relevant central bank or authority. The offshore system should make participants risk responsible, develop a means for 818Urlng settlement finally and have a Nt!lement agent In the U.S. through which aatilfaclory aettlement can be acertalned. Finally, the Board has expressed Ila support of modlflcation to federal funds and repurchale lending arrangementa 10 to ellmlnate or reduce repayment each morning followed by re-lending to the same bonower each afternoon (causing daylight overdrafts for the borrower). Lenderl lhould be awn of the f8IUltanl lllghtly reduced liquidity and should l8liafy themselves that the terma and condltlonl of IUCh arrangernenta maintain their flexibility. For men---. co.,1n1g1 and dllclllllor ol lhlN prcpaul1 and lrurtm pallclll -= ?ropoal1 for Modlylng the Paymn Syatem Rlllc R1ducllon Polley. snpared by the Staff ol lhl F9dlrll RIIIM Syatem. May 11118.
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TBI SECURITIES IBVESTOR PB.OTICTION ACT: AR OVD.VIEV KAY 1989 BY TBEODOU B. FOCHT SECURITIES INVESTOR PB.OTECTIOR COB.POliTION This contractor document was prepared for the OTA Background Paper, Trading Aromd the Clock: Global Securities Markets and Information Tectmology, July 1990, and OTA Report, Electronic Bulls and Bears: U.S. Securities Markets and Information Techno M!BI, Sept. 1990. This document does not necessarily reflect the analytical findings of _0TA, its Advisory Panel, or its Technf?logy Assessment Board.
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TIIB SECURITIES INVEBl'OR PROTECTION A<:r ANOYBRVIEW Sfockbmke: Liqgidatim Ba&u 1938 Prior to 1938 customers of a bankrupt stockbroker were treated 88 general creditors if they could not reclaim cash and securities which they could trace into the st.ockbroker's possession. S., e.,.., IbJ.cl v. HolJiu11 241 U.S. 523 (1916); Gorrneu y. Littlefield, 229 U.S. 19 (1913); Sgton L Arnerican Trust Co., 45 F.2d 372 (8th Cir. 1930); an alao, In re McMilJu, ., & Co., 123 F.2d 428, 431 (3d Cir. 1941); 3. Collier on Beukrnpt&y f60. 2 (14th ed. 1977). s.-t;,,,, 6Qe altbe Benls:m&t&Y Ad In 1938 Congress enact.eel section 60e of the Bankruptcy Act (11 U.S.C. f96e) (repealed 1979). This section carefully defined "customers" and "cash customers". Cash customers were permitted to reclaim cash or securities which could be specifically identified as their property. Otherwise, it provided that cash or securities which were held for the accounts of customers (but not s~cally identifiable to particular cash customers) would constitute a single and separate fund" to be appli~ rata iil satisfaeti~ of customera' claims 88 a "single end~:llflpVate:cl-----~-;-m ority :t.c,,:.:ctaims of general creditors~ A customer's. share of the ain.gf:1and Nparate fund was based on the "net equity" of his securities account. Aa for the unpaid balances of their net equities, customers shared with general crectitors in the J91!eral ~te. more detailed diacuaaion of section 60e may be fOW1d ID 3 Col)J,r, Qll. Qt, sgpra, 73-. 76. Sa;wm Ipygztz Pmtection 1ct al 1970 Because of the usually inadequate single and separate fund, section 60e did not prevent cuat.omer loaaes. Cuatomer mounted when the rate of at.ockbroker failures accelerated in 1969 and 1970. The Congreae responded to the crisis by enacting the Securities Investor Protection Act ("SIPA"), 15 U.S.C. aaa et IIIQ., whose purpoees were stated thusly in the Senate Report: ". . to protect individual investors from financial hardship, to insulate the economy from the disruption which can follow the failure of major financial inatitutiona; and to achieve a general upgrading of financial responsibility requirement.a of tirokers and dealers to flJirnioJtte, to the rnaxirnmi ext.ent poasible, the riaka which lead to customer losa." S.R. No. 91-1218, 91st Cong., 2d Seas. 4 (1970) ("Senate Report"); BB alao H.R. No. 91-1613, 91st Cong., 2d Sess. 1 (1970) ("House Report"); SIPC Y, Barbour, 421 U.S. 412 (1975).
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-2-SIP A created SIPC and, among other things, established procedures for liq_~dating financially troubled broker-dealers who are members of SIPC. Under SIPA section 78eee(a)(3), a SIPA liquidation is commenced by the &ling by SIPC of an application for a customer protective decree in the apJ>rOpriate federal district court. Upon the filing of the application, the district court acquires ezclusive jurisdiction over the debtor and its property and over any suit against the trust.ee with respect to the liquidation. Sections 78eee(b)(2)(A)(i)and(ii). Additionally, t.o the utent consist.ant with SIP A, the court assumes the powers, jurisdiction, and duties of a court in an ordinary bankrupt.cy case. Section 78eee(b )(2)(A)(iii). If a district court grants the application by SIPC and appoints a trustee, it orders the removal of the liquidation proceeding to the bankruptcy court for the same district under section 78eee(b )( 4). Upon the removal, the bankruptcy court has the jurisdiction, powers, and duties of the district court. Id. SIPC and Ite Fan+ SIPC is a non-~fit membership corporation whose members mcliide-, 'Dlalit-~, iJltatatate :,rrour41ea1en~ Miinl>enhi in SIPC is automatic u~Nliatration as a broker or dealer wi'tl the Securities and Excbnp 'rnrnission under section 15b of the Securities Ezchange Act of 1934. Section 78ccc(a). SIPA requires SIPC to establish a fund via aal888ments up,n its members. Section 78ddd. If SIPC's funds should become inaaequate, SIPA authorizes a borro~ against the U.S. Treasury of up to one billion dollars. Sections 78ddd(t),(g), and (h). Theae reaources are available for the satisfaction of the claims of customers and broker-dealers within limits mentioned below. Nature alSIPA Pnr e:tinr A proceeding under SIPA ia a bankruptcy proceeding for all practical ~-S., 1., SIPC Y, Amhuaador Church Financea>m,ITrnent am,. me,, 788 F.2d 1208, 1210 (6th Cir.>, cert.denied., 47U.S. 850(186); Ev;banp National Bank Y, wr. 617 F.2d 463 (2d Cir. 1975); SIPC y. Cberierne Securities Qorp,. 06 F.2d 1191, 1193 (2d Cir. 1974); SEC y. Aherd,een Sec;uritiea COQI,, 480 F.2d 1121, 1128 (3d Cir.), can. denied, 414 U.S. 1111 (1973). Section 78tfflb) reqwrt!II that, to the extent conaistent with SIPA, "a liquidation proceeding [under SIPA] shall be conducted in accordance witli, and as th~h it were beiq conduct.eel under, Chapters 1, 3, and 5 and subchaptera I and D of Chapter 7 of title 11" of the United States Code. The SIPA proceeding looks not only to the disposition of claims of cuat.omers, but also t.o the elairn '>f broker-dealers and general credit.ors. In the Mattar of Lewellyn. 26 B.R. 246, 253 (Bankr. S.D. Iowa 1982); Goldy. Hymen. 1974-75 Transfer Binder Fed. Sec. L. Rep. (CCH) para. 96,043 at pp. 97,657-58 (S.D.N.Y. 1975). The trustee must not
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-3-only perform his special duties toward customers, but he must "liquidate the 6usineu of the debtor." Section 78fffla)(4). Broker-dealers and general creditors are subject to the same outer time limits as customers for &ling claims against the estate. Section 78ffl'-2(aX3). And, estate property is distributed in the order Jrovided in section 726 of the Bankruptcy Code. Section 78ftlte). The SIPA trustee has "the same Powers and title with respect to the debtor" and its property as a trustee m bankruptcy, as well as powers that enable him to perform the special functions of a SIPA liquidation. Section 78ftf-l(a). S. S~y. Chriatian-Peiot & Co., 755 F.2d 359, 361 (3d Cir. 1985). A SIPA liquidation has some elements that differ from those of a bankruptcy cue. For eumple, in the SIPA liquidation, the trustees and their counsel are selected hT SIPC. SIPA eee(bX3). The trustee is responsible for .mailing notices to customers and other creditors. Section 78flf-2(aX1). Customers "need not file a formal proof of claim" but must file a "written statement of claim" which is submitted to the trustee instead of the court. Section 78flf-2(a)(2). The time period for filinJ claims also differs under SIPA. The outer limit is six months from rublication of the liquidation notice. Section 78ftf-2(a)(3). Because customer" status is a ~=ed status giving the customer priority over other creditors in the ution of aaaeta IIUll'8halled by the trustee, ~~~i.!l:"e~~&~1: :-~ -Ct . Dec.-1083; ... -103' ( 8.D~ Ala. 19'17).. SIPA requires that a debtor's obliptiou to ita customers be "ascertainable from the books and records of the debtor" or "otherwise eetabliahed to the satisfaction of the trustee." Section 78flf-2(b). Furthermore, the satisfaction of a claim "may be conditioned upon the trustee requiring claimants to execute, in a form to be determined by the trustee, appropriate receipts, supporting affidavits, releuea and assignments." Id. Cuetemer CJmme Ve+r SJPA Ae Qriplly Bnedel The "customer" definition and other operative provisions of SIP-t,were derived, in some instances nearly word-for-word, from section 60e. SIPA has been characterized as an ... en,rraftment of insurance provisions upon the preaisting section 60(e) 6ankru.Jtcy provisions applicable to stockbrokers, lf U.S.C. (e)." SE y. Aberdeen Sec;m:itiffl 0,,, IIIID, at 1123. Like section 60e, SIPA established a "single and separate fund" in which all customers in the "single and separate claae of creditors" shared pro rata and to the ezclusion of general creditors. To the extent customers' claims could not be satisfied from the siqle and separate fund, they then shared pro rata with general creditors in tlie general estate. Thus, those who fit the l/ See Senate BeJK)rt at 11; House Be~ at 10, SEC y. F. 0. Bvaff Co,. Inc,, 497 F.2d 280 (2d Cir. 1974) SE~deen Sec;urities Co,, Inc,, 480 F.2d 1121 (3d Cir. ad.. denied, 414 U.S. 1111 (1973); SEC Y, Albert & Maqgire Co,. Inc,, 378 F. Supp. 906 906,911 (E.D. Pa. 1974).
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definition of "customer" under section 60e or SIPA were accorded ereferential treatment in the form of a priority over general creditors. Report of Special Stu1f. of Securities Markets of fheSecurities and Exs:beop Cernrnjyinn, H.. Doc No. 95. Pt. 1, 88th Cong., 1st Sess. 411-412 (1963); SEC y. Keooeth Bove & Co., Inc., 378 F.Supp. 697, 700 (S.D.N.Y. 1974). Ow+mm CJiw Ve1'er: SIPA Ae Amended. In 1978 SIPA was amended21 to provide greater Oezibilit:r__to SIPC in satisfying customer claims in an expeditious fashion. The essential elements of a SIPA p_roceecling were unchanged. The concept of a "single and separate fund" was alt.ered to a fund of "customer property," section--78111(4); the fund of "customer l)rGperty" encompasses somewhat broader t~ge of asse~ than the :~gle ~d separa~ fund." Customer property 18 set aside for distnbution ezclumvely to "customers." Uaa Of SIPC Pmda To SatjefJ Caatemer CJeiw Under section 78flf-3, SIPC is authorized to advance to the trustee, in order to satisfy net equity claims of customers, not more than $600,000 per customer, and in no event more than $100,000 for that ,portion-of a clim .which--ia foraab;, -Thus, n,prdleesof the uaeta of the .l'aiW. tkm; each .customer with -.a -valid claim ia. aaaured of satisfaction within" the limits indicated. Significant protection is thus afforded to persona whoae claims qualify aa claims of "customers" within the statutory definition. However, the availability of SIPC'a funds does not lessen the burden of customers' claims on the ~eral estate or its general creditors. To the extent of its advances, SIPC is subrogated to the claims of such customers. Section 78flf-3(a). As the foreaEoinf demonstrates, SIPC'a funds do not insure customers against all f088 m their securities accounts. Its funds merely augment the fund of "customer property" within the statutory limits. Bmkr-DeeJe: Qliw PMS SJPA Aa Qripn1br Boedei SIPA as ori~ally enacted in 1970 contained a section entitled "Completion of Open Contractual Commitments." S. former aeetion 6(d), 15 U.S.C. fffldX1970). That section provided for completion of interbroker or interdealer transactions only when the interest of a customer on either side was involved. SEC y. Aberdeen Securities Co., lpc., supra at 1125, 1126. 'JI SIPA was amended by Pub. L. No. 95-283, 92 Stat. 249 (1978), Pub. L. No. 95-598, 92 Stat. 2549 (1978), and Pub. L. No. 96-433, 94 Stat. 1855 (1980); and Pub. L. No. 97-303, 96 Stat. 1409 (1982).
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-5-In 1973, the Securities and Exchange Commission enacted Rule S6d-1, 17 C.F.R. .206d-1 which "codified ezisting procedure." SEC v. Security P!auum:s, Ltd .. Inc., 416 F.Sup~. 762, 766 (D. Mass. 1976). The rule simply required brokers with open contractual commitments with a debtor in a SIPA case to "close out" transactions, not by actually completing them with the debtor, but rather by purchasing the securities elsewhere and submitting a claim for any loss m the SIPA p~eeding. If the purchasing broker was acting for its own customers, SIPC funds could be used to cover any loss. If the purchasing broker was actinf for its own account, the loss was simply a claim against the debtors general estate. Bmker:!leeler Claiw Under SJPA Aa ADWPdwl . Th 197_8 ~ndments to. SIPA .changed the treatment of broker-dealer claims from compl~tion or open contractual commitments to closeout of those transactions. The present SIPA section which deals with open contractual commitments --section 78&r-2(e) -is entitled "Closeouts. Aa under prior law, closeout losses incurred by brokers dealing with the debtor should be protected by advances from SIPC --if and only if the broker was a~ for one of its customers and the tranaaction was "wholly ezecutory' on the &ling dat.e. No SIPC funds can be uaed where the brokers were purchasing or Ding the securities :fertllmown-bene&I..~._ ........ fl.,;. ... _-.:-:':.:... ' ...... .: ,,., ... : :"' ,. ', .. '~ '.. : .. 1 ~. .. ... ...... : SIPC has adopt-ad, pursuant to section 78ftf-2(a)(l), the Series 300 Rules regardina the closeout of open contractual commitments. Rule 302 requires the claiming broker to close out the contract within 30 calendar dar of the settlement to mitigate an__y ~ble damages. M.S, Wien Co., Ius-~ No. 81-0889 (Bankr. D.N.J., February 1, 1985). This "covering" ~ase or sale liquidates the amount of the broker's claim against the debtor. Under section 78ftT-2(e)(3), ezcept as SIPC may otherwise provide by rule, a registered clearing agency which has an established procedure for cloeeout of open contract.a and the agency's participants, to the extent such participants' claims may be proceaaec:l within the clearing agency, cannot receive SIPC funds in payment of any loaaes on such contracts. StQa m SJPA Pmcae lior The &ling of the application operates, pursuant to section 362(a) of the Bankruptcy Code, as an automatic stay with respect to actions enumerated in that section. In addition, SIPA section 78eee{b){2)(B)(i) provides that the Court "shall stay any pending b~!7 mortgap foreclosure, equity receivership or other proc to reorgamze, conserve, or liquidate the debtor or its property and any suit acainst any receiver' comervator' or trustee of the debtor or its property .... Such actions are also stayed by operation of section 362(a) of the Bankruptcy Code.
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-6-Moreover, in accordance with the ~uthority set forth in SIPA sections 78eee(b)(2)(B)(ii) and (iii) and notwithstanding the provisions of sections 565 and 669 of the Bankrupt.cy Code, SIPC typically obtains an order from the Court which stays all creditors of the financially troubled broker-dealer for a period of 21 days from enforcing liens or pledges against the property of the broker-dealer; from exercising any right of setoff; and from causing the liquidation of a repurchllSfl agreement as defined in section 101 of the Bankruptcy Code, without. first receiving the written consent of SIPC and the trustee. In addition, pursuant to SIPA section 78eee(b)(2)(B)(ii) and (iii) and notwithstanding the provisions of section 556 of the Bankruptcy Code, SIPC usually obtains a Court order staying all stockbrolters, financial institutiona, and securities clearing agencies, as defined in section 101 of the .. J3ankruptcy Code, .for ~od of 21 days from exercising a contractual riJlit to cause the li,;iuidation of a contract for the loan of a security within the meanintJ of section 741(7) of the Bankruptcy Code, without first receiving tb.e written consent of SIPC and the trustee. While the typical stay order does not s~ what factors SIPC ~d the trustee should consider in deci4ing whether to consent to a liquidation of the re~aae qreemeDt or ~e security loan contract, it :ii-likelttbatSIPC'aiid ~traateeoaldC:Onaent upon the receipt of an affidavit (and such additional docamentation-as may seem appropnate in particular circumstances) from the repurchase participantllender of securities or one of its officers attesting that (i) the aftiant has no knowledge of any fraud involved in the transactions and (ii) the repurchase participantllender has a ~ect.ed security interest in the underlying collateral securities. This assumes that SIPC and the trustee have no information to the contrary. If the above procedures are followed, SIPC and the trustee would make every effort to determine promptly whether the securities involved in repurchase transactions or pledged as collateral in the securities lending transactions were necessary for the satisfaction of the claims of cuatomen. While this det.ermination will depend upon the circumstances of each liquidation and the number of transactions involved, it is hop,d that the determination could be made in no more than four or five days after the initiation of a liquidation ~' though this cannot be ~anteed. Any liquidation would be without prejudice to the trustee s right to take action against the counterparty if, upon closer analysis, it appeared that the counterparty's rights were not as clear as initially thought.
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ISSUES, llISXS AND OPPOB.TUNITIES IN CLIWlING AND SETTLEMENT 1989 BY PHILIP HUBJWU> PETEB. llEED AND BETH SBAPIB.O KOPIN CHICAGO IESEAB.CH AND TRADING GB.OUP, LTD.
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ISSUES RISKS AND OPPQRTUNITIES IN CLEARING AND smLENENT Prepared by Chicago Research & Trading Group, Ltd. as part of a market study coordinated by the Office of Technology Assessment. This paper covers several of the current issues we see in the financial markets from the perspective of an industry participant. Given our role as a market-maker specializing in options, we have focused our conments on the futures and options markets. This vantage point may give CRT a somewhat different perspective on the issues being addressed in the OTA study, and we hope our views will be constructive as well as applicable to other areas of the financial markets. 1. Margin svstems As a starting point, we must differentiate between margin as used in the stock market and margin as used in the futures and options markets. Stock margins are a form of credit extension -a buyer is permitted to put up in cash SOS of the value of the equities .. _.being_ purchas~, with_ ... the balance. financecl' by_ the buyer's _broker. :--:--.-~1n~ttn!" der-t~at-1:ve: productiai"fcets~-=margin ls a perfonaance guar antee. which.sta-nds behtnd ap.art1ctpant's obligations under futures and options contracts. We believe that this is the~ approrriate use of margins in the futures and options markets. Artificial manipulation of margin requirements is not an effective tool for regulating financial leverage of participants. If controlling leverage is the goal, more appropriate regulatory measures could be designed to accomplish that objective more directly, effectively, and at a lower cost. In addition, margin systems should not be viewed as a homogeneous arrangement which can be applied equally to all exchanges and all products. Margin systems are customized for the risks associated with products being traded and the characteristics of each market. To be effective, margin systems must require the participant to put up sufficient cash to cover the impact of a significant move in the market, without imposing artificially high cash require nts that would negatively impact aarket liquidity. It is there fore essential to take into account the settlement period for each market instrument as well as the volatility of the underlying c011110dity or security (please refer to Towards a Theory of Harmonized Margins attached). Once this information is known, appropriate margin guidelines can be established which are tailored to the instrument being traded. CRT also favors flexible margin systems which adjust margin levels up or down depending on the underlying volatility in the market.
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The level of sophistication in margin systems has grown signifi cantly in recent years. Many derivative products have moved away from systems using fixed initial margin combined with variation margin based on actual market fluctuations to more advanced (and more precise) risk-based systems. As a market maker with rela tively large but generally market neutral positions, CRT has been supportive of the development of delta-based options margining. The development process has been aided by the advances in clearing technology at the exchanges and clearinghouses involved in options, and the increased understanding of options risk among key decision makers has played a positive role. We are encouraged by the developaent by exchanges of more advanced risk measurement systems such as DAR at the Chicago Mercantile Exchange and SAFE at the Chicago Board of Trade, whic~ take advantage of the available COllll)uter technology and are able to give a more accurate represen-... tatJon. of true -risk ~nd :eX,posure of giv.en 111arket parti_cipant's portfolio. . . ;., . The process of setting trading and margin guidelines currently is controlled by each clearinghouse, and can therefore be customized for the instruments they clear. We believe this is the most appropriate place for margins to be set, as the clearinghouse understands its products and has as its primary goal controlling risk exposure, because its embers' own funds are at risk if aargins are set too low. I-n the interests of protecting all .. _,.-.:.-.:,d11rkets,: owev.r.,, tt.-uy: be~1ppropr1~t1.-for -the, CFTC ora similar ..... regulatory-bodyto estabH-sh aini1111argin lave.ls which must be t by all clearinghouses. Minimum levels should be risk-based, that is, specified in standard deviation tenns rather than dollar amounts or percentage terms. This might allow for greater uni foraity of risk control while avoiding the problems inherent in a unified clearing system. II. Risks in the Margin Area In a,alyzing the risks in the margin area, we have focused on some of the regulatory risks as opposed to the financial risks. One of our primary concerns as a market participant is that well inten tioned decision makers will make broad changes to the margin systeas which will result in artificially high margins on deriva tive products. Such a move was widely discussed following the October 1987 market crash, and was apparently based on the misconception about margins on different financial instruments dis cussed above. Artificially high margins would clearly restrict market liquidity, which in turn could potentially result in great er price volatility.due to the inevitable reduction tn the number of aarket participants. As regulators and lawmakers have become increasingly informed, the risk of such action has diminished. -2 -
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A second tssue, which was covered tn the Brady C0111tsston report, ts that the creation of a centralized or untfted clearinghouse would lessen the rtsks inherent tn the ftnanctal urkets. Vhtle a untfted clearing chants tntttally sounds ltke a staple solu tion, the realtttes of adapting and cOllbtntng systs at a nuaber of exchanges aake thts concept unworkable. Ve feel that aany of the concerns that led to the call for a untfted clearing system can be addressed through a greater level of cooperation and infor aation sharing U10ng the principal exchanges and clearinghouses. The sharing of inforaatton has been growing steadily for the past ten years, and has accelerated following the aarket crash in October 1987. A recently published suary of tnterexchange cooperation coapiled by CRT ts attached, and provides addittonal details. By uktng available to other exchanges trading posttions of clearing aeabers (or custoaers who are clearing aeabers at other exchange~), a fira's t~tal.aarket exposure.could be aore eastly ~nitored by any .. ~ne of t~e clearinghouses. J I I : o 1, In addttton to the operational difficulttes tn creating a untfted clearing systea, the tssue of tnnovation aust be considered as well. If gtven a choice, parttctpants tend towards those exchanges that offer the aost flexible and cash flow efftcient aargin systeas. Innovation tn the securtttes aarket has come predoainately fro the saaller exchanges, and would be stgntft-.. cantly iapatr,d under a unifild syst. Monopolies generally lead .. .;'.: .. tt: cOlipl aeem:y\ i11d the c:teirhr, :anct" settl-nt irer would be no exception. ... ~-:-: -= In suary, we are satisfied that the futures and options exchanges are aoving in a positive way to develop and tapleaent accurate and appropriate risk sur1111nt and urgtn systs. Any effort to iapose arbitrary iUtdeltnes on these exchanges or to standardize or centralize the clearing and settleaent process would cost auch aore, but accoapltsh no aore, than would effective tnfor111tton sharing. III. cross Marqtntnq/Jotnt sattJ111ot Issuas As a urket-uker with hedges on a variety of exchanges, CRT fully supports the concept of cross-aargining, due to the beneftcial effects on liquidity in the aarket as a whole. Ve have participated tn, and benefited froa, the jotnt settl-nt arrang-nts whtch have been available in the aarket to date, such as the SINEX/CME and CBOT/CBOE 250, and would welcoa the develoP111nt of siailar arrang-nts. There are, however, a nUllber of signtficant obstacles to cooperation at this level which wtll tend to ltait further progress: 1. Coapetittve pressures between exchanges will uke tt difficult to agrN to new joint arrang-nts. -3 -
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2. Operational issues such as which clearinghouse will hold the position and the margin funds, and which one will reduce its aargin requireaents in the case of offsetting positions. 3. COlll)atibility of margin systems. 4. Perfection of a security interest on positions may be a prob lea, especially when dealing with international exchanges where siaple filing procedures like the UCC don't exist. There are also definite risks in cross-aargining on a half-way basis, where aargin credit ts given for offsetting positions on other exchanges, without actually having control over those post ttons tn the case of default. Whtle tnterexchange information flow can vertfy that the offsetting postttons actually exist, there aust also.be 1. 1,gal_ly erJforceable-.lten on a participant's tradi~ _pos_i_t1o~s io ~aake cross-aarg~nJng effe_c.ttv_e. . ,. . . 1v. Issues 10 the Oyer-the-counter opt1oos Market In addition to our extensive exchange trading operations, the CRT Group is acttve in a wide variety of OTC options markets. These 111rkets have grown signtficantly during the past 2-3 years, and tnc1ude options on lt.S~ eovernaent securities, petroleua, metals, :.: ,\net t'tirte\'lttis.;.-~ CRTtasbeen :an ct1ve proponent .. of aarg1n1ng tn al 1" these aarkts for both credit r1 sk and cash fl ow reasons, although the 111rket participants have not been overly receptive to thfs idea. Froa a credit perspective, aost partfcfpants are large coapanfes and financial tnstttuttons whose credit standing ts not generally an issue. Given the extensive resources of these par ticipants, they are not usually concerned about potential cash flow inefffcfencfes, i.e. paying out aargfn on an exchange posi tion and not receiving urgfn for an offsetting OTC trade. Final ly, 111ny OTC players have not developed the operational capabtltttes, such as coaputerized back offtce systems, to manage margin flows, and are therefore reluctant to enter into such arrangents. One exception to the general trend is the OTC opttons market for U.S. Governaent securities. The dealers in OTC treasury options, prfncfpally the Prtaary Dealers, have successfully developed standard doc ... ntatton (recently endorsed by the PSA), and widely accepted aargfnfng teras. These developnts have taken place desptte the lack of an exchange chants, and are a good example of how an unregulated, non-exchange arket can devise a workable syst. At the other end of the spectrum, the OTC currency options market, which 1, believed to be larger than the exchange market for cur rency o~~fons, has not developed any sfgniffcant margin guide lines. As this aarket is doafnated by aJor international banks, 4 -
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aargin systeas aay have to be reexaained in light of the new capital guidelines being phased in over the next several years. v. sua,cr In general, we are satisfied with the current state of clearing and settl-nt within the futures and options markets where CRT trades. While there are clearly areas where improvements can be aade, the exchanges and clearinghouses are taking the initiative in developing new and" advanced systs. Most iaportantly, we feel these systs are utilizing advanced coaputer and trading technology to aore accurately analyze trading risk, which will lead to" appropriate risk-based aargin guidelines. Given the prog"ss aade by the individual exchanges and the increased level ; of .1.nforaa.tton .shar-t.-g ._aaong c.le1rtnghouses and exchanges, a ~ntfiect" cle..-ing and set.tlitlln~ _syste is not c~nsidered to be .. .-appropr_1ate-:. w.-'Ito .not. expect' -tnterexchange cooperation to extend to significant Joint settleNnt arrangents in the near future, due aainly to coapetitive pressures, although we would favor such cooperative efforts. Finally, CRT sees good potential in the over-the-counter options aarkets, which we believe are a viable alternative to the aore structured exchange markets. These markets, however, wtll face continued pressures to iaplement margining or other risk control systs. .... -,-~ .. _. ..... ~-.......... .,.... _; .. :., -~\ .: .. -..;.,~' .. ::~~-~r..-:::~ :-. .. .. ~: .: -_ ... - ... .I'' ,, I January 1989 -5 -
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I l~l r JJlf lJl! I J E I ,~ r fr !I I !ii i ~-f .. 1[~ .. ,18 -it(IIS f f ~~'-,~ llitE 8 !I~ If 111;11 111:~-;1 '~ -'I ir~lt 11 Ii 1,~ili ,1;~;i11 t1~all II I 1 ~11! u "Iii I :.-Ir Jilt~.{ R~f.flf _;.1, 11 I 1\1,1 --u 1rr 11 t I\ !'It r' 11 II n-w g _.a 1::-il~ r ~[ff:> 111 a i~ 11. a1 t, CD CD B 51 fin i E ~= E I II i" i l .; :: ;r;, ~, li ;:: 5 ; ;:-: ; = ; :=f F~ -~$ l !~ .J'I .I ;
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CRT Ifflltb of Stttlee& ild,Qd Inf r Margin cam atcdm aattJ.e in fiw b.1lliJw dayll, lihidl can navar be 1-tban NVan calAmar daya. '1'o be e,;paJ Jy lllrgimd ovar an axt:amd pa:ricxl of tDIII babl9111 b:cdi data an:i aattlwat data, a cl~ lUlt b0ld a bigbar IIIDmt of mar.gin. lflltlwetica] ]y, CIW mst b0ld IIIZ'gin eqaJ to tha aia~ z:,x,t of than.,_,. of daya bebnlan b:acla data and attlllllnt data. Since atodal raquire m lea than N'Jm calAndar daya to aettle, atocJc 1111Zgina ebruld be at l...t ./'f t1-larqer than tuturu margina in ordar to afford equal protection agaimt risk. '1hat ia, stcc1c llll'9im mad 2. 7 t1we IUCb mar.gin -tutuna just bra-9t.ocJca. taJca -~ to Nttle. . . : ... . .. : . .... -. . \ . . .. . . . . . . : .. . . . . . .. ... . ' I t,~ ' ,_ ... , .-:., . , ',.,_ . : . = .. .. ;._ ..... . .: . . .. ,: ". .. : . : : ~--! .. . . Jtwt is '2baJ "1 In tum of risk, th-two tactora (graater volatility and lcnJE timl to ..ttlwat) are mltiplicatiw. 'lhantara, to haw "CC1111istant" ar "blml:l1ic:Jua" in:112:2, to bllva atfactiwly mal JIIIW1tanlmca IIIIZgina mtw11111 a atccJc of awaga wlatility am at:cck imaxfubaa, tm nsB-ebruld mld--m tblln tba -m rginilb1m:tblly.~cmnnt1Y nq,fmllbUett SIP wtack,-m!llli:t&ztma raqukea., cmly--7.451.Jll.intllaa. mrgin fer ,eqwJ pa:
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l 111g1sr111 r:rn1 : 1! .I I[ I I n ll I 111111 I ~-' f.-< l i~rl --ft tr ..__.. t!P&=;. Id ,d_R H D lia II 1i a M !! Ai 2r Ai ii : -~ . . . Ill 0 -... -: -: "'II I! 1t1ti:(!;f_ }l!j~~;; :C f If 11 ~:1 Jlil. ~Ill ti~&gf~ r fil ,-.
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! l 1S _g C 8 0 0 I B. 0 0 C ea 0 E 8 C 0 C .! C 0 :I 80,C 50,C 40,C 30,C 20,C 10X 95 ox 0 CHART A .. . Constant Standard. Deviation Margin 7 .0 standard deviations Microsoft Corp. : 41.8X Typical Stock : 29. 7,C IBM : 25.4X Sc!cP 500 : 20.5X 2 4 ,. \ . .... --. ::, '.j. .. t ... : ,. 6 Calendar days to 1ettlement . 10 Sc!cP 500 Average Maintenance Margin : 7.45X Average Daily Volatility 1/4/88 -9/30/88
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CHART B CONSTANT STANDARD DEVIATION MARGIN CD :, .... ., > ..., u f 601 ..., C 0 u 501 CD en ca ..., C 401 CD u L CD a. ca 301 CD ca C "S, 201 L ca e CD u 101 C ca C CD ..., .S 01 I o _) -. ., r n r.,. I 9G 4.3 Standard Deviations -~ Microsoft Corp. 77~{ Typical Stock 501 IBM 441 ._;. . S&P 500 391 :: .. : ., .. 2 3 4 ; ,. .. . I 5. 6 7, Calendar days to settlement --8 9 10 Computations baaed on avg. doily volatility for period 10/1/87-5/5/88
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In~cbange cooperation I.alt winter the Bradv Cnrnmipinn called for broad cooperation and cammuruc:aoon across all financial mar kets as one meaus of protecting markets apinst another catutrophe like the October stock market crash. tion is not what is needed that a great deal can be accomplished through cooperation among current regulaton and self-regulatory organi zations without creating new lqisla tion or new regulatory meci\aniuns. Over the last year, cries have come from several quarters or new lqislation to b,:e the futures and securities indumies to bepD c:ooperaliq and evbnpn1 the kind of information that would help prevent any repeti tion of the crash. In the meantime, the presidents Workin1 Group recommended.last spriDI .that new lqilla. ' .... -. .. .. .: A careful look a1 developments in the futures and options industry shows tm' cammuiticatioa and coaperu:ion have been evolviDS and expndin1 OWi' the lut several yean and that cooperadaa bu accelerued mark edly since the c:rash. The industry has been establilbmg the framework for sharin1 financial information for a ... :. : .. _: ... . -: : . : -' ,. : -1m .C;1l111twlrl& .. J11IIIIIIC!W ----, ................... ~.-... no.111 ..... ,.. .... C80t CME lhn aay-ana-callKt a.a 011 ctally Dais far Vlll8DOl'I nwgin. malt CIMIS 72.7% of 101a1 1978 fullns ...... \ .. :_-. .---:_ .... : :~.. . .. .:~ ,_ : .. .. : "' .:_ ...... : .. _. : .. ~-........ .. '..r.."' ..... .. , .. : ,.,. ,_ ,_ ,_ ... ,_ ,_ .: .. .. :.. "': ... . .. ... .... -.. CME. KCBt C8ot NYFE blcameafflclll WDaammillN .,,.,,.. d Ille SIMSG. wt11Ct1 CD1111r1 1CJOIW. al U.S. --Inda t&analllllClllliarllanlllCillndarlulnl. CUI. NVMl!X dllcla CMD JIii lua I J aplallmaginlyallllfarflaar ..... 11111 clllnnl www.-. .. NVMl!X --dl!IH111J apllall .,.. llllifaraudealClllllarll-CMEdln .. GDlialllFllllcAnalylil- ,RAP) amadllfartndua) ldML CF'1C ...... Cll'IIDlalCI 111d ....... .... 1111 ICI ~: CME, C80r ag.N ID --CGmDullnad 1tlde AlcanlllUallan (CTR). PIIMdlllg II one-,,.IM ...... an...., .uae-itt,111 .till:ti:llg tiala' &bf I IIIJ: CME.NVSE.C80E(S&PDSPX)caa,. ............... .-... -----.., COil .... decade and cooperating to help con trol position risk since 1986. This table, compiled by Mary Jo Mildasz. a 10-vear 1ndustrv veteran with Chicago Research and Trading Group, shows how the industry has been workin1 toward complete shar iq of 6ancial uid risk-analysis in formation and toward developmg a common JDU'IUWII system that is risk-bued to protect markets against excessive risk concentrated in any one market participants position. (For abbreviations not noted in table, see box in "Trade Winds'' section.) . .. ._. Aullla aid ......... ,., .... CFTC allocmft camDliance ana regulaary ,NPQlllibilily IDJN:. a a~ laary argalilllian (SAO) ID fflOllil0r and ...Clanng ffllllDS f'CMI' .-am 111d --P11 tc. CDl,ifflOdlty fUMa. CUII_I Wf .... 111d C8ltl COiliil a Jilll JACCDW ..... NYSEID ad~ dlllllattwnFCMa. NVPIJl*IIJAC. cmt KC8't MGE jain JN;. NMbegiril lldllng nc,,lclNlwig manDlr FCMI 11111 iDin8 JN;. JN; tneauragN IIIDMliGft at lmar-Mar-l111oii11illi#I Syam (pay ana c:atlectl amang al ctNrinO COtDCll"lliala JAC.-SAOl ...... 1DCF'1Cre-QU111tar ......... farlfMl9llacyflnal-ci11 U"ri ,111 ....... .,.,.. in lilJlfil d -....11P.111c 1dlfa,lC01EX. PlllaJllpla Bae'd al 1tlda (PST) jainl JAC. CME. caor baClln jaint wane an a .-. bllld__,IUlelD,__UIIIIICFTC C8llilll rule bald on W(ll'lgMU funal. 97 Ocealm 1911 Futura 6J
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,_ Cocnpllawwww .. ,...._._ ,_...,... July Compliance and market sur 'CICTA1yt11mapermai ... BOTCC begins providing nsk-analySis ..w:etor fourfulufN-=nanges 1n New '1brtc. la Mulwl lnfmnlillNM Syatlffl calll fllMt ...... parfamtaice July Agreement rHched among all CUfflilmty m:hlngN to share dally s,ayand-colled da far all common cseanng memDer firms. Lawyers draft agreemem which CCMr1 100% rA fulu.-and futures oc,liorll'GITle. 0dDber All par1iN Sign ag'"'"9ffl to ... CINling manaetS daily pay-andcollec:l da. 0.:.aDW-AI ..... ID indud9 OCC and~ i,bn.-., sharing by IIXl'lll,gQlllallsn,niUl'll...,..,Y.DilCUlaalllblgirllDindudtieponliig o,.., ; ; . ; plLw/dllcl In ... Inter Marut In, a111111011~ : . . .. . : : -: . .. my 01en: ...... blgirll wiltl -... CINnng Corp.. Nlllol,al Secldla February -CBOT otf9ra NYSE and Owing CGrv,. PliladllDtia Slack caw, AME( I 1tia In ~IC1Di'9 CTR ing CorD. ID Plr'liCiDlla J'l lnW-Martcat lnadtrlilsyaffl. NYSE. CBOT .... iig fomllllOn Syalal'l'I. Audlta and flnanc:tm IUl'Wlllance July -CBOT Illes a prol)Osea nsk-baS80 caona1 rule With CFTC. Seotemeer BOTCC begins providing dally risk analysis of cleanng memoers open posillOnl for four New 'ft>rk futures m:tlangel: CSC CINring Corp.. COMEX Clanng .AIIOCil1i0", Commodity Clearing Corp., NYMEX. o...,t,er -CME lilel PIOPOlld risk based capital rule with CFTC. March tnter-Market Financial Sur V8111ance Group (IFSG) forms to ennance coormnaliOn and snanng of financial infor-.w,..-ayamaaagn. Acri -tntlf-Martal Information sys11m ma?iOn among commodity ana secunty on-line.~-al original 1971 CME SROI and ragu&aan. Prnenay inctuaes and CIOT par and alJlllct, i:nniUffl and AMEX. AME)( CommodiUN Coro,, CBOT. _mqil .......-CII dlilJ da?a-lnnag CBOE. CME. CACE. CSCE. COMEX, .... ~: -~, .. : :: .. :.~~..,.:.:~ ,'.~. --.-.=~~'!.~ :-=--~~::.:::.~ CMa.,COIIECCINrillg.Auoaallon. SeclnlNDllllra.N~NalianalSecuti. .. ... .. : ,/'; . .. June CUI. NYS! announce jOillt an "cnuil tn~ llffllllng .. 111181 w tlnllng d a ..... du&IIWCI 111CM In the ltaclC ,...... ..._ a P1aD191af IOi'I pra llnilllnd .......... 1'hll "~ ie c:unenlly ....... app;NI, C:0,111IOdlyQ11n,gCarll.,CSCC111ritJ tie Clearing Corp., NYCE, NYFE, Corp.. lCCl't MGE. NVMEX. NYMEX. NYSE. Plclftc S!Dck Exchange, Shamg-, par 111d cl>IIC:t da&a only: PBt PHLX..SEC. ICC. AMEC Cana J r1W11 -:a,p.. NYFE. PBt --. --__.. .............. olOCC1DiOiL CINrtng Orpntzadan/Clearing Bank Aludlllllg1D11111onnldlD .,._ICI~ ...... .... al fflliar CDllfflCl*iEE and...,..dllnnQcagar..-.aw. Sealemant banka: Chicago Marris lhlll& SMlp Banc. Comil-,ra, Illinois Nllloraa a.-. Fill Nlllllna Bir* d Qi. cago:NIW'ttltl-11wO...Ma,;.,.., 1111* NA. Qwui&al 8lnlc. Cllicorp Narlti AI.Wtaa Inc., Manufaclurarl Hanover lhlllCo.. ..... GuanyltultCo. PI I fagllUl&CFTC.SEC.r:... Allllwlll*dOllalgD. C11au11 .... .__occ, Nallonal Saurllln c,,.,.. Coria,. D-.iociliwy Truat. Co., Mldweea Cleartng Corp., IOICC,;CMI. . _.,;. : --Cl'TC ...... MIi .., ICC. a ... - ...,, al occ. tar a pilalp;ag11111 mame lllll'gln_.. .. ~----flllnellulurN tlalll CGll&ll cllel9dtlllaugtl 119 0CC ..... ice. July-IFSG lnpn:aa d drafting a for. mal wrlDln ag.wwt ragaralng sftamg ol fllICilll lnbnillllan Augull-lFSG annaan=-piogram for stwtng flnaiCilll 1ntam.-o .. about mutual clNrtnQ ,., .. among al.,..... ing llloregulllDry agaleill in group. Odiiber 1911 Futures 65
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Clearance ud Settlement la the Municipal Bond Market la the U.S. An OYemew of NSCCs National System for Municipal Bond Processing A Submission to the Office of Technology Assessment United States Congress for its study Qc;ariq1 111d Settlement of Financial iustnnneuts Worldwide August 1989 Margaret L Koontz Margaret L Koontz is Director of Corporate Communications at National Securities Cearing Corporation, SS Water Street, New York, New York 10041. rr 99 This con tractor document was prepared for the OTA Background Paper, Trading Around the Clock: Global Securities Markets and Information Technology, July 1990, and OTA Report, Electronic Bulls and Bears: U.S. Securities Markets and Information Techno.!!!ll, Sept. 1990. This document ctoes not necessarily reflect the analytical findings of OTA, its Advisory Panel, or its Teclmology Assessment Board.
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The information presented is factually correct to the author's best ability; however, as a matter of policy, the opinions expressed by Ms. Koontz are her own, and should not be presumed to be representative of National Securities Clearing Corporation or its user Board of Directors. For ease of reading, footnotes have been omitted. However, specific citations can be provided upon request.
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'l1ae Nadoul s, .. ror Malclpal Boad Procellina NSCC's National System for Municipal Bond Processing. which proeeued 2.6 million transactions last year, is the reaJiation of a loq-$tlndina 8(Mll which many in the tax exempt state and local securities ~k~rs, dealen, dealer-banks, regulatory : .. age~de$ industry_a.,i_ati~ ;--have~ with NSCC.since the late 1970s. Its .: . . . . .:.. . . . . . . . . .. . . .. development as an intep-ated pan of the national clearance and settlement system envisioned by Congress in 1975 bas been the result of the industry's own collaborative efforts and foresight. Today, ~,200 municipal dealen, dealer-banks and broker's brokers panici pate in~ ~tional tem ~ectly_ and indirectly._ . .~_ :, ,,-..,"',"',: ,:,.----~~.-.... --.:,," .._,:f', ..... .-~..:.}I_.,; .,,, " .. ,,o ~-:'',;.:.:,,_,,ii I .... ':,~ ..... &., o _;." .,, ', ........ ... -~ .. : :.,. . ... :' .. ~-..... ; ' .. As early as 1977, the Municipal Securities Rulemakina l3oanl (MSRB) began to call for the development of automated systems for the industry, noting that rising expense levels highlighted a need for an efficient automated trade comparison and clearance system. The MSRB conttasted the municipal bond prncessina environment of 1977 with the substantial cost-savinp and other benefits which the equity and corporate bond markets were already achieving through servicina provided by NSCC. Only months earlier, NSCC had merged the dearina operations of the New York and American Stock F.xcbanaes and National Association of Securities Dealers and built industry-wide links with other regis tered clearina agencies in the U.S. In early 1978, NSCC filed a rule with the Securities and Excbnae Commission (SEC), proposina to add municipal bonds to its masterfile of securities eli11ble for processing 1
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within tbe national system. While the SEC agreed that the tu-exempt market could gain mucb from usina autt1mted clearance systems within the national system, other priorities delayed approval. Over the next two yean, working infonnally with tbe industry, NSCC continued to develop its system and enhance its procedures and services in line with the evolving needs of tbe munidpal market. NSCC's pvwiDg reputation for effident processing occasioned NSCCs first direct oppor lllDity in the munidpal market in the fall of 1979. Asked to assist in dearing a high... .... ,.. .. : .. ~ .... . ; ... -:. ....... .. ..... ......... _. ....... : . wlume trading cnincb involvfng'a New'Yort Staie bo~issue;where the"vaiue of out-: ,tanding f.ails exceeded tbe total issue, NSCC successfully processed municipal trades valued at more than $70 million, reducing ultimate receive and deliver obligations to less than 1591, of tbe previous fails. 1be experience reemphasized the market's increasing wlume c:oncerm and NSCC's reacffneu to process that wlume effidently and accurately. . -~~-; ... _. :,. -~,:.; ~--:-,., ..... .. .,,. .. :_. .-._.-~ ..... .. ...... -~.-... .. ~"' .. ~-~:-,;~-~--ta.:: .. -'::,.:--~-~ : .. Fifteen montbl later, tbe ao~rir.ed NSCCto implement its Municipa! Bond Comparison System, initially u a pilot program. The pilot approach continued until early 1984, when NSCC expandt.d the program to munidpal bond departments of other existing NSCC participants. Participation grew significantly within a sbon time. Recognizing the need for a system that would ensure efficient, controlled, cost-effective processing from trade execution through settlement, the MSRB amended its Uniform Practice Rule 0-12 to require most industry partidpant to conven to the automated comparison procedures of a reptered dealing agenc.,, such u NSCC, effective August 1, 1984. By year-end 1984, a total of 545 brokers. dealen and banks were usina tbe system induding 385 direct partici pants and 160 indirect participants using dealing agent sub-accounts. In addition, the direct NSCC participants were also dealing trades on behalf of 319 executing brokers. 2
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NSCC designed the National System for Municipal Bond Processing to muimiu the opponunities, and minimiR liabilities, of municipal bond brokers, dealers and dealer baaks The system strategically redefined comparison by replacing dealer-to-dealer mail ing of confinnations with a central, automated processing -ervice linking participants industry-wide. The M,nicipal Bond ~q,arison System uses a central processing approach. Each panic-.. . t' : ._, : . ... : \ ~. .. :: .. '. .. . . . ipant submits its own trade reports to the. system, which attempts to match related buy-side and sell-side records according to details established by the MSRB, such as quantity, price and issue. In daily repons, NSCC promptly notifies participants about the match results, with all matched transactions acknowledged as binding contracts. When the system dis-. ~-~~-J>e~p-~~~-~ ~~de ~e .~ ~e-~unicipal Boad Comparison 'system.effers'a variety of-.ys'for trade.data to'be added,' revised or deleted, as appropriate, with an emphasis on timeliness, accurac:y and control. By identifying any trade differences on the morning after participants repon their transactions, the system enables brokers, dealers and dealer-banks to focus on reconciling them early in the fiveday cycle. Panicipant can submit trade records and receive reports in almost any medium, including paper blotters, magnetic tapes, personal computer (PC) link and full computer-to-comput er commnnications, depending on their computer sophistication. Municipal bonds follow a five-day settleme.it convention, i.e., trades are due for settle ment oa the fifth business day after trade date. While the Municipal Bond Comparison System emphasizes the efficiencies to be pined through centralized comparison primarily 3
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over the first three days after the trade bas been executed, it provides benefits on the founb and fifth days as well. After establishing binding contracts, NSCC notifies each participant of its settlement obligations through receive and deliver instructions. The seller, for example, is instructed to deliver securities and receive money as payment; conversely, the buyer should receive securities and deliver money. 1bis is the typical flow; however, if a municipal bond transaction is reponed late or if a trade discrepancy delays comparison beyond the ihird day (after trade date), NSCC's system expedites the settle ment, sched~ the trade to settle two days after the comparison match is ~eved. ........ !:: ._:::.-::.~ ....... ~.,, ...... ... :., ... ~:.-: .. ~;.;, .... -~:--:. ._,,;.." :: ., ._.. : ... -~--In the clearance and settlement of participants' municipal bond transactions, two options are available. Participants can elect to settle each trade individually, on a Trade-for-Trade basis, or alternatively, for certain issues, through accumulated, net.accounting. known as ... ~~'!.~~ ~-o.~ ai . . . Trade;..for-Ttadebisis automaticallygetreceive and deliver instnicdons foreacb trade as . . . . the basis for the exchange of bonds and funds at settlement. Since most municipal bonds are eligible for book-entry processing at The Depository Trust Company (where S33,000 issues were eligible as of December 1988), participants typically arrange for book-entry deliveries. For the relatively few trades where physical delivery of securities is still needed, participants can use NSCCs centrali7.ed Envelope Settlement Service. While most regular-way municipal bonds settle Trade-for-Trade, CNS is available for OTC-eligible, regular-way bonds on a limited basis through a netting pilot which was initiated in 1989. CNS amrnulates compared transactions and establishes one net position per issue. For participants with CNS shon positions (net sellers), the appropriate bond 4
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amounts are deducted from participants' DTC accounts and are credited to NSCC at DTC. In tum, they are allocated to satisfy the CNS long positions of other participants (net buyers). Syadlcate Takedown Trades Initially available only for secondary-market trades settling in five business days, the Municipal Bond Comparison System was enhanced in 1986 to accommodate participants' ~~te, ~en-~~ exte~ded se~e~ent ~ons. of these types of ::: _.;_~.--:~ ~~--.-..:: .--,;. __ ... ....... :--:.-..... ~~.:.--~:~::::':~ ::;,:.,.,. _. ..... -=::~--.:-.. ~-::oc. .. ::;._.~ ... .. ,~__;-.-... :~;---~"'/" ... .:. transactions.through an.~automatecf system.btcari::te mandatory un~er the MSRB's Uniform . Practice Rule G-12 at the point that NSCC offered the enhanced system. A "syndicate takedown" transaction in the Municipal Bond Comparison System is defined .a be~n. th~-IN,d unde,wri.ter of the snidicate .an~. a ~ember of the syndi, ....... -~. \ ._ 0 , -~1 :''!1~,;I;:~-',:. :0.'r.,. '."' ~-:' :t. '",~''." '. "'" .,-. : . ,,,, . .. -.~-.. .i ." ., : . ta~ group forthe syn~cate aecotuif[Note: AU other ~es that: are exe~ted outside the . syndicate account six days or less before the first settlement date are considered whenissued transactions, as described later in this paper]. For all underwritings, both competitive bids and negotiated deals, the lead syndicate manager submits sell trade input on behalf of the participants even if there is as yet no announced settlement date for the new issue. The one-sided syndicate input automatically generates a compared purchase trade (NSCC creates the contra side) on each syndicate member's Syndicate Purchase Contracts the next morning. The trade also appears on the lead manag~r's Syndicate Sale Contracts as a compared sale. NSCC assumes respoDStbility for calculating accrued interest and notifying participants of all final monies related to syndicates. Syndicate members, or even the lead manager, may disagree with the compared "take own" ttade and have the ability to delete the item, although this does not release either 5
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counterparty from the original trade agreement. The lead manag~r further retains the ability to reverse all or pan of a previously compared trade. All syndicate takedown trades compared through NSCC settle individually on a Trade-for Trade basis, showing final monies. Receive and Deliver Order tickets are generated for every compared trade and have a "Syndicate notaf:ion. The syndicate Receive and Deliver Order tickets are distnbuted along with all of the participant's regular when-ismed and when-issued extended settlement Receive and Deliver Order tickets one day before the ~ui~~~~n;ie'(~~i): ---.: -: :-.. ~::. :w. -:.. : -~ ... .. .: "r ,-:: ;.: . .-. : When-Issued Trades All transactions in newly is.med ~cipal securities executed between brokers, dealers . . t :mJ/--dealer-blntsar-leut u blisiriess ctayspriorto. the new issue~ -first-regular-way _,.:... : ,._ .,. ... ,._-, :1'-:;-.,, u . .---~.-.-~ 4:.: ... _.~~--j;.: .-.:.. :-.,;;.:,."-.-._;_.., . \:._.::. -~-:.:.., ..:.~ .. settlement date are submittedas when-issued trades to the Municipal Bond Comparison System. These trades must be submitted for comparison even if no settlement date has been announced (as long as a CUSIP number has been assigned by Standard & Poor's). Again, NSCC calculates the appropriate accrued interest and final monies, but unlike the approach used in syndicate takedown transactions, two-sided input is required to compare when-issued trades. At the participant's option, NSCC compares when-mued trades on the basis of either dollar price, yield or a yield and concession amount. Other required elements for comparison indude CUSIP, quantity, market, trade date and major and minor executing and clearing brokers. When-issued trades are reponed to participants as compared, uncompared or advisory on Wben-Ismed Contract Sheets on the morning after submission. Correction capabilities I
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exist to enable participants to compare unresolved ttades. NSCC bolds all compared when-issued trac'es in a pending status prior to settlement. Trade and quantity total are aamnnulated by issue and settlement date, and are listed in one section of the WhenIssued Con~ Sheets. NSCC receives daily notification of settlement dates as they are announced. Participants may settle their when-issued tranw:tions on a Trade-for-Trade basis or through Continuous Net Settlement (CNS). Receive and Deliver Order tickets for transactions settling on a rracle~for".'~~ da~ th~. ~~ed ~tt.le:IJleDt date . . . . . . . . (SD-2) and are available to participants one day before settlement (SD-1). These tickets reflect dollar price, principal amount, accrued interest and final monies. Extended ~ement for When-Issued ud'Jl~plar-Way Tra~ /.:. ........ .:---~'..:\ .... .-.......... 1,;, ......... : .... :.,:,.~-.--,~--~--... ,.. .. ~:. -:.--~--, .-.:-....... In:~ M~c:ip~i&od-~.SJ*-. partidpulS.~ also arrange to settle both . . their when-issued and regular-way transactions on an extended settlement basis. NSCC allows up to 15 additional business days beyond the announced settlement date for whenissued trades or conventional T + S settlement date for regular-way trades for items requir ing additional time for physical settlement. The number of days identified as "extending" the settlement is part of the match criteria and is required input by both sides at the time of submission. Conditional Trades In response to a request by the MSRB, NSCC has also expanded the Municipal Bond Comparison System to indude the processing of special conditional trades. Formerly, these trades had to be exduded from processing in the automated system because they 7
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could not be dearly identified. A conditional trade is defined as any transaction between two parties which requires, along with normal comparison criteria, that special terms be fulfilled. Special conditions indude: Subject to triple-A (AAA) rating Ez-lepl &-interest Called Settles in same-day funds __ a.:..-.-:..... ... -._ :.-. .. ._ .. . _-_... .. _.... .. :_-.. . . . .. .. -,. -~--.. -. . -. < - ~'-I~, . :. -~ . ... . . ... : ... Registered only Other 1brougb the use of the Special Trade-indicator on municipal bond comparison input, . . i~t;ifi~IJS,.~~ ~~-~ee~.-~.f~~e is . . . . . milabte'towben~isiiiec1 incl-~lilirymaf\'ei :~na 'otteplat-way ind extended settlement transactions, although it is not yet available for syndicate takedown transac tions. Nettlq With the comparison system widely implemented, NSCC since 1987 has emphasized the net book-entry capabilities of the CNS system. NSCC began netting when-issued municipal seauities in September 1987 on a pilot basis with 31 participants netting one issue. The pilot was expanded over the next year so that by the end of 1988, all when-issues trades in OTC-eligible is.mes could by proceued in CNS. More than 140 participants, representing 709& of the municipal volume, are now settling their when-issued transactions 8
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in CNS. Continuous recycling and netting in CNS have significantly reduced the number of book~ntry movements by approdrna~ly 50%. In 1989, netting of regular-way issues began on a pilot basis. In the regular-way netting pilot, NSCC bas selected a series of new DTC~ligable municipal issues, one at a time, and allows them to remain in CNS for the first 10 days that they are traded regular-way. Any trades compared in those issues after the particular 10-day period revert to a Trade-for Trade settlement. NSCC selected the 10-day netting period to allow participants to closely momtortheiftrades_Jii.CNS:andt0,ensute -..a ~nable ..,._t of Jietting occurs while also m~niiorlni the l~~i ot~al d~liveries. Nst<:,.expects tbai .by further coordination with participants and regulators, even greater efficiencies will be gained through netting in the future . ~, -;;;. .. ... . .. : ... -. . .. -.. ........... :-.--.... ., ...... ,_--.~-. -... ., . . ... . . . .... . .. .--. .. :_ : ; ... .. ." , : , .r ',~''" ;, :, .. ,.'. ',.-::', ,;,_ -~~ :' -~ :~ .:,0'". ,-'0-f: --~'." ,: --~, 0"-':.> ., ,-. .-!',: ... : ., I- 9
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I I T+ r I I f l ................................................................. T+ 1 .J .... ... ,. .=: -l ,I! I ...... .. ;, ....... ,_._,._.. ::.~ i. _. .... \-~,. ... -=~.;., ...... # .. . . .. \ f .=: l J 0 Fitsr Senlemenr Olre T+2. T+3 T+4 ,,,., ... ...... a.-I .. MAlmlilrI I lilll Dlttattl I ........ Glae .. Alalilr I ,.,a... I I ..,.., .......
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AUTOMATED CLEARANCE AND SE'I*I'LEMENT INfflE MUNICIPAL SECURITIES MARKET A Report to the Securities and Exchange Commission Marc1131, 19D This contractor document was prepared for the OTA Background Paper, Trading Around the Clock: Global Securities Markets and Information Teclm.ology, July 1990, and OTA Report, Electronic Bulls and Bears: U.S. Securities Markets and Information Teclm.o .!2.&I, Sept. 1990. This document does not necessarily reflect the analytical findings of OTA, its Advisory Panel, or its Technology Assessment Board. 11 Municipal Securities Rulem.aking Board
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Introduction The Municipal Securities Rulemaking Board is a self-regulatory organization created in 1975 by the enactment of section 15B of the Securities Exchange Act ("the Act").1 Section 15B of the Act delegates to the Board primary responsibility for adopting rules that govern the municipal securities activities of broken, dealen and municipal securities dealen ("dealenj and sets forth a number of areas appropri ate for Board rulemating.z One important task delegated to the Board is to write rules for dealen which foster CXM>pention and a>ordiDation with penons engaged in ... clearing, settling, proc:euing information with respect to, and facilitating transactions in, municipal securities.J The Board's role in facilitating clearance and settlement of municipal securities transactions is given additional direction by section 17 A of the Act, which mandates the creation of a national system of automated clearance and settlement of securities transactions and the elimination of the physical movement of securities certificates between dealers.4 Enacted in 1975, section 17 A expressly includes municipal securities. Although Congress delegated the central authority to facilitate the purposes of section 17 A to the Securities and Exchange Commission, it made clear that the Board, subject to Commission ovenight, was intended to be primarily responsible for addressing the special clearance and settlement problems of municipal securities within the national clearance system.s -.. .. ,~r. i~ ~.l?'~,. ~~--~-~l.~-!h~-P~ 9f~QP.~&.~~--\~ ~~darc;l~ industry operational practices and to facilitate the safe an~ efficient processing of mwutjpal seculjties. In April .1983~ the Board furnished the Conuiimion with i. comprehensJVe report OD these efforts entitled Prospects for Automation of Municipal Clearance and Settlement Procedures (the "1983 Report"). The 1983 Report descnbed the traditional physical processing and delivery of municipal securities used in the industly. The 1983 Report also discussed the existing impediments to integrating municipal securities into the automated clearance and settlement systems then available for corporate securities and the Board's efforts to lead the industly toward automation as envisioned under section 17 A of the Act. In July 1983, the Board adopted rules requiring dealen to use automated clearance and settlement systems for certain transactions. Since the adoption of those rules, industly members and registered securities clearing agencies, baveworted bard to implement automated systems for municipal securities. 1 Securities Acts Amendments of 1975, P.L 94-29, 89 StaL 155, 131-137 (1975), codifil at 15 U.S.C. -4. 2 'lbe Board is composed of 15 memben who serve staggered three year terms and who are divided equally into three categories-persons representing bankdealen, securities firms and the public. Of the five public represen tatives, at least one must represent investors and at least one must represent issuen. J Section 15B(b)(2)(C) of the Act, 15 U.S.C. o-4(b)(2)(C). 4 15 u.s.c. q-1. s Section 15(c)(6) of the Act, 15 U.S.C. o(c)(6), grants the Commission authority to adopt rules applicable to dealers to effect the purposes of section 17 A. but specifically eiempts municipal securities transactions from this grant of authority. The legislative history of this provision states that the Board is intended to be the primary medium for regulation of the municipal securities industry and should be furnished with ample opponunity to developresponsiblerulesfortbeindusuy. RqonofwSDl/lUCornmitueonBankinf,HousingandllrbanAJfain, Senate Repon No. 94-75, 94 Cong., 1st Sea. (April 14, 1975), at 48. 'lbe term 9registered securities dearing agencies refen to those clearing corpontions and depositories registered with the Commission under section 17 A of the Act. i
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The Board bas supported these efforts by providing its expertise to the clearing agencies and by using its resources to inform and educate municipal securities participants about the systems. In addition, when appropriate, the Board has adopted additional rules or interpretations to facilitate the use of the systems. As a result of these efforts, the Board believes that today a majority of inter-dealer and institutional customer transactions in municipal securities are being processed in automated clearance and settlement systems.7 Notwithstanding the considerable progress achieved since 1983, the transition to automated clearance and settlement of municipal securities is not complete. Many industry members have not obtained the efficiencies and cost savings that automation iscapable of providing. 1bis report summarizes the progress that bas been made in automating the clearance and settlement of municipal securities transactions since the 1983 Report. It also discusses the developments necessary to complete the industry's transition to automated systems. ..: .' ",. .: :,.:"-~ . , ~-. : ., .. -~~---:,;.: ::;---: : . .; .-;.,_: .. ,J ... "':':: ..... ,:. ,r ....... .. .a;~--. ~: .. \. -,.,.~--. -~ -...._,.-_ :,= ......... :, ..... : ;,-... : .... .-.. ; .. :~-; j. ',,. -~ .. :, ... : .. _,; ....... ~; .. ..... _:: -~-----: ... ' ,.,;,:_ ,. =~.. "'I ,:,. .. -:: . ')_ 1 Because there is no reliable estimate of the total number of municipal securities transactions, it is not pouible to provide eiract statistics on the percentage of total transactions that are cleared through automated systems. ii
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Table of Contents I Backpound . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . p. 1 .. . .. -.. D Adoption and Implementation of the Automated aearance Rules . . . . . . . . . . . . p. S m -~t-~-~-oR~~ .. -~_.l;Jc;ap.-af .. :,~ .-.:,::--.:1--,~: ... -,;,,.:..-., .,._ ~-.. P~ 13 .. .. ii, .. _. _.: .... Y. ..... : \ ... .,.. "".: . ~: : o .. :: o o ','-. I o " '," 0 o O ,,., o IV Rf!maining Issues to Be ,Addressed. . . . . . p. 17 Appendix Securities and Exchange Commission Order Approving the Board's Automated aearance Rules November 14, 1983 iii
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I Background Automated Clearance and Settlement Systems for Municipal Securides Today, automated clearance and settlement of municipal securities transactions is achieved through three automated systems offered by registered securities clearing agencies: comparison of inter-dealer transactions, confirmation/affirmation of institutional customer transactions, and book-entry settlement of inter-dealer and institutional customer transactions. Automated comparison of inter-dealer transactions replaces the expensive and cumbersome process of confirming transactions by mailing and physically matching paper confirmations. To use the automated comparison system, dealers submit transaction data to a ce~tral processing facility operated by National -Securities Clearing Corporation ("NSCC")'by the day after trade ~te. The transaction data is matched. (comparedj, indicating that the dealers agree OD the terms of their trades. Compared trades are reported back to dealers the next day on contract sheets, which are written memoranda of transactions containing the same information as paper confirmations. The contract sheets also list transactions that have not compared in the system, allowing the parties to utilil.e additional automated procedures to obtain a comparison or other resolution of each of the uncompared trades. Dealers obtain access to the automated comparison system through membership in NS~C, Midwest Cearing Corporation, Stock Clearing C.OrJ?Oration or through clearing agents that are members of these organizations. . . . :._ '. "I'b,;. confiriiiation!affimlatfoh~ ~~:,~deal~ .. to. a,1~m11i":"~iiswith institutional customeri widioutmaili~g confirmations:. fn t&fs syalem,"a dealer (of" iii clea~g agent) subinitS data on a customer transaction to a deposi~ory through a computer link. The next day, the depository electronically provides the customer and the customer's clearing agent with a confirmation of the transaction.z If the confirmation is correct, the customer ( or its clearing agent) acknowledges caff"mns) the transaction through the system and this affirmation is reported to the dealer. This system allows dealers to confirm transactions to customers by use of electronic media and thus avoid delays associated with mailing paper confirmations. In addition, the affirmation process greatly increases the probability that the customer's transaction will be settled by ensuring that the customer's clearing agent is aware of the transaction and is prepared to accept or make delivery. The affirmation process also allows depositories to set up book-entry deliveries automatically on affirmed transactions, saving dealers additional processing of the transactions. The Depository Trust Company ("DTC"), Midwest Securities Trust Company ("MSTC") and Phila delphia Depository Trust Company ("Philadepj offer automated confirmation/affirmation services to their members. These services are linked together in the National Institutional Delivery System ("NIDSj, for which DTC functions as _the central procasor. Dealers and institutional customers participate in automated confirmation/affirmation systems by joinin1 one of the dep01itories directly, or by using a clearing agent that is a depository member. 1Dea1entbatareNSCCmembenalsocanmakeamagementstosubmittramac:tionda1atllrougbneDepositoay Trust Company. z Tbe customer and/Or its agent can use printen to provide a "bard mpf of die mnftrmadon for their records. 1
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Book-cntrysettlementof inter-dealer and institutional customer transactions eliminates the need for cmtly and time~muming physical delivery and handling of securities certificates. In a book-entry delivery system, securities certificates of eligible iuues are deposited with OTC, MSTC or Philadep. Inter-dealer and institutional customer transactions then are delivered and transaction monies settled via bookkeeping entries at the depository. Instructions to the depository to make book-entry settlements normally are made through electronic communication links between the depositories and their members. Dealen and institutional customen participate in book-entry settlement systems by becoming direct memben of depositories or using clearing agents that are memben. The book-entry systems operated by DTC, MSTC and Philadep are 1inbd through interfaces, allowing deliveries to be made between memben of different depositories. Preparation or die Municipal Securities laclutry for Automation \~.~ .. ~-~.~~~~~rkfQ~~u~~D-~~~tbe-~.was~ in September 1975, -~p adopuo~o~ ~:~ ~.reponalized trading, clearance .and settlement practica that were prevalent in the industry. The adoption, in 1976, of Board rule 0-:12 on unifoon practice established, for the 6nt time, uniform national standards for confirming, delivering and settling inter-dealer municipal securities transactiom., The adoption of rule 0-15 in the same year established uniform procedures for confirming customer transactiom. The Board continuously bu refined these rules to require increalin1 uniformity in physical clearance and settlement practices. Obtaining uni!ormity'Wll an eaential fint step toward automatio~ which requires standardization of operational pridicel . -. ... .... -. .... ,.,.:._.,.' .. i.,~ .. .-. --r~_._.,,_.: __ . .. ,..;:: .. -: .... ... .. : .. ,,/." . -~... ": .. :.. -:----... ')"':. .... "DaeloarduomandltedtbattbeCUSIPmanbeiiqlJltelltbellledtoldtntifymunicipatsecurities.s In May 1977, the Board amended rule 0-12 to require that inter~rconfirmatiom include the CUSIP number of the security traded if one was miped to the issue. In 1981 and 1982, the Board adopted amendments to rule 0-12 to require that securities delivered on a transaction be identical to those identified by the CUSIP number, if any, on the confirmation of the transaction. The Board also adopted Approved September 8, 1977, Securidcs En:banae Ao. Release No. 13939. Rule 0-12 also standardized inter dealer m1wtions, dole-oall and cenaiD otber precdml reladn& to dearlllce and settlement of transactions. ID 1915, amendments were added to standrdlze IDacrest payment dalm procedures. MSRB Rqans, VoL 5, No. 5 (Aqat 1915), at 13-15; pproved October 15, 1915, Securities En:bnae Act Release No. 22534. AppnMdSeptembcr9, 1977,SecuridcsEaenaeActReleeseNo.13942. Rule0-15wesmendeclin 1984to setlllDdardlofddMl'yf'orrmtomertrellllCtlom. MSRBRlpora, VoL4,No.2(Marcb1984),at 17-20;approved Maf 29, 1984,Secaridea Esben,eAa. Relellc No. 2UXX>. ID 1986,naleO-Uwesamended to standardize interest payment claim procedara. MSRB Rqo,a, VoL 5, No. 5 (Aupst 1985), at 13-15; pproved October 15, 1985, Secarida Esbenae Al:t Rde i'1o. 22534. s Tbe CUSIP namberiD1 l)'ltem II an elpba-numeric securities klentlftcatlon l)'ltem developed ID 1967 by the American Banten Aaociatlon'I Committee on Unll'orm Security ldentUlc:atlon Procedures end is used to identify mrporate and munidpal secaritla. In aeneral, die l)'ltem provida for sa-dlpt number Identifying the 111_. of secarida and a three-dlpt suftll ldeatlf/lD1 tbe spedftc Issue, IDdudlDg, ID the case of munidpal secaridel, die spedlc hlrity, IDacrest rate and deted dete of die secarity. SR-MSRB-76-12 Ameadmcat No. 1; ppnwed September 8, 1977, Securida E.sblnge Act Release No. 13939 (dfecdveJanauy 1, 1979). Asimilar requirement wes adopted for customer mnftrmetlons in April 1983. MSRB Rqa,o, VoL 3, No. 2 (April 1983), at 13; ppnwed May 9, 1983, Securida En:bnae Act Release No. 19742. 2
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deliw:ry standards providing that different issues of securities are not interchangeable for purposes of deliw:ry unless identical with respect to the criteria used for CUSIP number assignmenL 7 The rules adopted in 1981 and 1982 concerning use of CUSIP numbers for clearance and settlement applied to all securities that were migned CUSIP numbers, but not all issues of municipal securities were being assigned CUSIP numbers at that time. In June 1982, the Board addressed this problem by adopting rule G-34, which requires dealers underwriting new issues of municipal securities eligible for CUSIP number assignment to apply for and obtain number assignments. The rule became effective on July 8, 1983, and ensures that virtually all municipal securities issued after that date can be identified by a CUSIP number. In September 1984, the Board amended rule G-34 to require dealers also to apply for new CUSIP numbers for an outstanding issue of municipal securities if the issue is advance refunded to different dates or prices, or made subject to certain other security enhancements in the secondary market which create differences within the issue. Ruic 0-34 arid the amendments to tule 0-12 effectively l'aluire-dealem to identify municipal securities by CUSIP numbers. This development was crucial to the implementation of automated systems, whi\':h use CUSIP numbers to identify specific issues of municipal securities. Another area of Board activity in preparation for automation related directly to automated clearance systems.1 Because the automated clearance systems in existence prior to 1983 were designed primarily for corporate securities, few transactions in municipal securities were submitted to the systerns.11 The Board sought to ensure that its rules did not prew:nt use of the automated systems then available when -~-~''-~q~-~-.ci.to.~~~ ~t4aY-~9T7 . ~~-~QdcdruleG-.12toexcmpt .inter .... ~Df co~pire(' ~d setdcd: ~ugh th~ facilities ot a registered clearing aiency from the applicable provisions OD confirmation and delivery.u Amendments adopted in April 1981 clarified that transactions compared through the facilities of a clearing agency were exempt only from the confirmation provisions of the rule and that transactions cleared and settled through a clearing agency were exempt only from the delivery provisions.u The amendments also stated that delivery 1 MSRBRq,ons, Vol. 2, No. 6 (August 1982), at 11-13; approved March 14, 1983, Securities Exchange Act Release No. 19599. Prior to these amendments. there were a variety of practices in the municipaa securities industry reprding the types of securities that were interchangeable for purposes of delivery. For example, securities with the same interest date and maturity date, but with different call provisions and dated dates were oonsidered interchangeable in some cases. 1be amendments adopted by the Board require, among other lhinp, that the securities delivered on a transaction be identical with respect to call prmisions and dated date. MSRB Reports, Vol 2, No. 6 (August 1982), at 7-10; approved May 9, 1983, Securities Exchange Act Release No. 19747. MSRBRq,ons, Vol 5, No.4(June 19&S),at9-1l;approved August 9, 1985,SecuritiesExchangeAct Release No. 22308. 111be Board, of a>urse, does not have rulemaking authority to mandate changes in automated systems, but may adopt rules for dealen to facilitate use of the systems. n Municipal securities transactions a>uld be submitted to oonfirmation/allirmation systems for customer transactions prior to 1983, but no significant numben of transactions were submitted. 1bere were, in addition, pilot programs for automated a>mparison of inter-dealer municipal securities transactions and eligibility of bearer municipal securities in depositories at that lime. It was not until the Board actually adopted its automated clearance rules in 1983 lhat implementation of full-scale automated systems specifically for municipal securities bepn. u SR-MSRB-76-12 Amendment No. 1; appRMCI September 8, 19TI, Securides Elcbange Ari. Release No. 13939. u MSRB Rqon,, Vol 1, No. 1 (July 1981), at 17-18; approved June 22, 1982, Securities &change Act Release No.18829. 3
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through the facilities of a registered clearing agencywas an acceptable alternative to the traditional "over the-window" physical delivery at the purchaser's premises, and exempted transactions involved in netting programs from the provisions in rule G-12 against partial deliveries.u The Board also began working with the registered securities clearing agencies in modifying existing automated clearance systems to accommodate municipal securities. In 1982. the Board concluded an agreement with NSCC concerning the standards for physical deliveries of municipal securities made by dealers through NSCC facilities ... In January 1983, the Board reviewed and supported a OTC proposal to revise its automated confirmation/affirmation system to allow the entire municipal securities descrip tion required on customer confirmations by rule G-15( a) to be included on confirmations generated by the system.7 The Board also provided its expertise on municipal securities to the registered clearing agencies to assist in the modification of the systems that were necc::ssary for municipal securities processing. : . ..... ;; :-:-.-. ;:-._\ .r ..... :.: .-~. :: : . :. . ,.":!.~- ;, .. ,, ... -."::~ ...... . ' :., ..:."' ... ... . . . .... .-.......... .. .-: _., .; "-. ,, ,. ---: :.,., : _, .,,. I' '! . .. -:.:,. : .. :.~-.,, . : : .. ... ; .. ... ~. -: . :_. ...... .......... f:. .. : . :"'-:_::-;;. -,'!:-.:.:_ . :,' .,,,. -: :-: .... .. :.: :_-;,..;_. .: ._.,_ 1bis pl'OYision was added to aa:ommodate physical deliveries of cenificates through such facilities as NSCCs envelope delivery services. tS Rule G-12(e)(iv) states that, m:ept for this eemption, partial deliveries on municipal securities transactions may be rejected. 'Ibis rule reftects a lonptanding pnctice in the municipal securities industry of not accepting partial delheries. 1'Febnuuy16,1982,letterfromJeanJ.Rousseau,CbairmaD,MSRB,toJackNelson,Praident,NSCC,andMarch 16, 1982, response from Mr. Nelson. 1, 1be Board also provided DTC other interpretive guidance on the requirements of Board rules relative to customermnflrmations. lnJuly 1983, the Board amended rule G-lS(a) to delete the requirement to indude the address and telephone number of the dealer on mnfirmations generated by automated systems. The Board noted that the automated systems were not capable of providing this information and that the types of institutional customers receiving such mnfirmations generally did not need this information on each mnfirmation they rec:eiwd. Sa MSRB Reports, VoL 3, No. 5 (September 198.1' at 25; approved September 30, 1983, Securities Exchange Act Release No. 20243. 4
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II Adoption and Implementation of the Automated Clearance Rules Adoption of the Automated Oeannce Rules In 1982 and 1983, two events occurred which accelerated the Board's actions on automated clearance and settlemenL FU'St, the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA") was enacted, requiring all municipal securities over one year in maturity issued after July 1, 1983, to be in registered form.w Practically all outstanding issues of municipal securities issued since that date have been issued in registered form. In considering this impending development in 1982, the Board observed that registered securities are more difficult and costly to settle physically than are bearer securities, in part _beca~ of vacying ~(Cl dates on issues and transfer delay problems ., _The lack of regulation of some m~pal securities t~fet'ligentsa_~d the 'uiexperience .of many "industry members with registered securities raised the likelihood of substantial cost increasesaod delays in tlie physical settlement of municipal securities transactions. The Board observed, however, that immobilization of certificates in a depository mini mitt.el the problems associated with registered securities. In addition, the Board noted that registered securities are less expensive to immobili7.e than are bearer securities.21 The Board also was influenced by the proposal and adoption in 1982 of rules by the New York Stock ~bange ("NYSEj1 ~e ~ational ~ti~n Qf ~ties Deal~rs, Inc. ("NASD") and other self.-.~~~-IJ mpnjz;atioas,wh:icli n;cJ~.Dl~~ ~~tiopil cust~me_r transactions in.depmitory-eligible P.;>~~te~.t.i~-to~ c;~-~d-.~~~-~gb au~ted syste-.~ :Jbese rules were aimed at reducing the number of transactions that faii to settle on settlement date ("DKs") by greater use of the automated confirmation/affirmation process and book-entry delivery. The adoption of the rules by the NYSE and NASD raised the issue whether similar rules might be used to reduce DKs in the municipal securities industry. The Commission, which found the direction being taken in the corporate securities industry to be consistent with the mandate of section 17 A of the Act. suggested that the Board consider 11 Pub. Law 97-248, section 310(b), 96 StaL 324, 595-600 (1982). 1, In October 1982, the Board sponsored a conference for interested persons to discuu the problems created by registered securities culminating in a Report of tM Confem,ce on Regi.stettd Mumdpal Securitia, which was published by the Board in 1983. Most tnnsfer agents providing corporate securities transfer services are required to be registered with the Commission under Section 17Aof the Act, 15 U.S.C. q-1, and are subject to the requirements of SEC rules 17Ad-1 through 17Ad-14. In general, these rules require most transfer agents to oomplete (turn around) 90 percent of all routine transfer requests within three busineu days of receipt These standards, however, apply to municipalsecuritiestnnsferagentsonlyiftheyarerequiredtoberegisteredbecauseofcorporatetransferactivity. In 1982, many municipal muen acted as their own transfer agents or utilized non-registered transfer agents. 21 This has been bome out by experience. In a comment letter on a recent Board proposal, OTC estimated that savings of approximately S1.00 per year would accrue for each bearer c:enific:ate that oould be changed into registered form. OTC currently immobilizes approximately 20 million bearer cenific:ates. Sa SR-MSRB-87-12, filed October 6, 1987. zz ~e, e.1-, amendments to NYSE rule 387 (9COD Orders") and amendments to the NASD's Uniform Practtc:e Code, section 64 r Acceptance and Settlement of COD Orders"). These rule changes were approved by the Securities and &change Commmion on Nm-ember 9, 1982, in Securities Exchange Act Release No. 19227. 5
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what steps would be required to bring the municipal securities industry into parity with the corporate securities industry.a I. JulJ 1982 Proposal. In contrast to the corporate securities industry, which at the time was largely automated, practically all municipal securities transactions in 1982 still were being confirmed and settled physically. Moreover, certain unique characteristics of the municipal securities market made the use of automation more difficult than for the corporate securities markets.24 The Board recognized, however, that a large number of securities firms handle both corporate and municipal securities and that the NYSE and NASO requirements for corporate securities transactions could have a positive effect in assisting the municipal securities industry toward automation if the Board adopted similar rules. In July 1982, the Board published an exposure draft of an amendment to rule G-1S on customer transactions which essentially was the same as the NYSE and NASO rules.is The draft amendment would ha~ app~ed to delfyery V$. paym~~t (".DyP") ~nd receip~ vs. paY,IJlent ("R VP~). ~tome~. ~ransactions in sec~tieseligibleat a cfepi,sJtory:. ltwouluraged the development of systems capable of proceuing all potential transactions. 1bevarietyof different issue types also neceuitates much longer securities descriptions than needed for mrporate securitie.,, presenting another technical difficulty that hinders incorporation of municipal securities into the automated systems developed for corporate securitia. :is MSRB Rqo,a, VoL 2, No. 6 (August 1982), at 3-S. 3'1bemrporatesecuritiesmarketsalreadywerecbaracterimlattbetimebywidespreaduseofautomatedsystems for inter-dealer transactions. The NYSE and NASD proposals therefore did not refer to inter-dealer transactions. 6
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confirmation/affirmation systems to all securities with CUSIP numbers.21 In addition, the Board published a new draft amendment to rule G-12 to require inter-dealer transactions to be compared in an automated comparison system if the transaction was between direct participants in a registered clearing agency offering comparison services and the securities were eligible for automated comparison.21 The draft amendment to rule G-12 also would have required book-entry settlement of such transactions if depository-eligible securities were involved and the parties to the transactions were direct depository participants. The Board received 27 comments on this proposal, 14 of which supported one or both draft amendments and only two of which opposed the draft amendments in concepl Some commentators continued to express concern that the automated clearance systems were not ready to incorporate municipal securities and that industry members did not have experience with the systems. The majority of commentators, however, again emphasized that the draft amendments were essential to bring clearance of municipal securities into parity with the corporate securities market and would provide the -industrywithsignificallt~~cs ~dcostsaviilp. Seve~cominentators stated that if any cc;onomies ~~t9.be reali~from~-~~o~ti~Di~~~oul(j bein~l~_~i,n-the ~em. 1_bq& urged the Board "to ~end}~e. inter;.deale~ ~equire~eJlts to "incl_ude indir;ect:as 't_VCII direct participants in registered securities clearing agencies. The comments received on the July 1982 and March 1983 proposals persuaded the Board that use of automated systems for municipal securities transactions was feasible and would (i) greatly reduce the costs of producing, mailing and proces.1ing physical confirmations; (ii) reduce the costs of delivering, pro,cc;uing,_ and safekeeping ~ties ce~~; ~d (il;i)_ red~ th~ n~t>r~ of "DK'ed" transactions. 'wint~ib~Bo&ra.~-#)in~ ~at'ttiednf(Biiieiimnen_fs~i.ilde~costs ~a-municipal securities dealers ..... ..- , ,1 I '"' . I ,I,-..-:' "" ..... : ; '' ,i I ' that were not using or were not faniiliai'with automated systems, 1t concluded that'the potential benefits to be derived from automation by municipal securities market participants outweighed the inevitable transition burdens. Accordingly, in July 1983, the Board adopted the draft amendments, with a revision in the draft amendment to rule G-12 to include indirect participants.2t The Board's automated clearance rules included provisions for delayed implementation in two phases, allowing sufficient time for the industry to prepare to use the automated systems. The first phase, which began on August 1, 1984, required use of automated comparison and confirmation/affirmation systems. The second phase, which began on February 1, 1985, required use of book-entry delivery systems. The SEC approved the amendments on November 14, 1983.JO After adopting the automated clearance rules in July 1983, the Board received a number of inquiries from dealers that were indirect participants in registered securities clearing agencies. It was brought to 21 MSRB Reports, Vol. 3, No. 2 (April 1983) at 3-S. The draft amendmentto rule 0-1S also included requirements tbat certain information be obtained from DVP/R VP customers, including information regarding the customer's clearing arrangements, that would be helpful in the use of automated clearance systems. These requirements were written to apply to all DVP/RVP transactions with customers, including transactions notsubject to the automated clearance requirements. The requirements ultimately were adopted as rule 0-1S(d)(i). MSRB Reports, VoL 3, No. 2 (April 1983), at 7-8. a MSRB Rq,o,a, VoL 3, No. 6 (November 1983), at 19-26. Securities Exrbange Act Release No. 20365, rq,rinUtJ in MSRB Reports, Vol. 3, No. 7 (December 1983), at 7-12. A cx,py of the C.Ommission's order approving the rules is attached. 7
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the Board's attention that many of these dealers self-cleared transactions for local delivery and used clearing agents only for transactions that were settled in money center cities such as New York. These dealers expressed concern that the rules might require them to use clearing agents on all transactions ,11 securities eligible for automated systems, which would be considerably more expensive than if they continued to self-clear their local transactions. The Board agreed that such transactions should not be required to be cleared through automated systems, at least during the transition to automation. Thus, in April 1984, prior to the first phase of implementation, the Board adopted amendments to clarify that the automated clearance rules would apply to a transaction by an indirect participant only if the indirect participant uses a direct participant clearing agent on the transaction.n 3. s,,,,...,, of A"'""*" MSRBRepom, Vol 4, No. 4 (June 1984), at 17-18; approved May 10, 1984, Securities &change Act Release No. 20')52. JZ The Board obtained and oontinues to obtain information on the operation of the automated clearance systems at various meetinp of municipal securities dealers sponsored by the Board and other industry associations such as the PSA, the Cashiers' As.1ociation of Wall Street, Inc. and the Bank Capilll Markets Auociation. The Board (C.ontinued on next page) 8
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of the Board's rules as well as the proper use of the systems. Once the rules became effective and the industrygainedexperiencewiththesystems,theBoardpublishednoticesinMSRBReportstoalertdealers to specific problems being encountered with the use of the systems and methods to avoid such problems. At. the industry gradually adjusted to the automated systems in 1985, the Board began discussing with the enforcement agencies the need to improve industry compliance with the automated clearance rules and the Board's view of appropriate enforcement priorities.,. 1. A""""'*" Compariso,I Sy,mnfor sontlary Marat Transat:tians. When the Board adopted the automated clearance rules, the NSCCsystem for municipalsecuritiescomparison was still in a pilot phase. Implementation of this system required a number of actions by the Board. During late 1983 and early 1984, prior to the August 1, 1984, effective date for use of the system, representatives of the Board had numerous meetings with NSCC to discuss system developments. One important topic of these discussions was the securities description appearing on the contract sheets that are produced by the ,in_ ~u qf_P.~~ c;o~ .. ti9~-~~--~~-s~n&lJ-!-'r&e,d NSC.C to include a complete_securities deicriptionas:required'under the Board's nile g9v~rn~ng physical inter-dealer co~ations, rule 12(~),ita_, .than a sJioru;t.~pti01t. .NSCC jncoq,orated the longer securities descriptions in the system in July 1984. ; The industry quickly gained experience with the automated comparison system after the August 1, 1984, effective date of the automated comparison requirements and certain problems in the use of the systembecame clear at that time. It became apparent, for example, that many dealers were not using the approp~te featuresof thccomparisonsystemto ~he~ons that did not compare in the original .c:qm~n ~-~i .... .~.~-~~co~ation procedur:es for.raolving.s~b transacqom. J;)ecember l9$4,.the ~~dedrule-.G~l~pecifically to require that dealers use the "post origmaicomparison procedures offered by a registered securities clearing agency to resolve uncompared transactions submitted to the automated system.JS In February 1985, the Board published an interpretive letter to resolve problems that some dealers had experienced in determining the appropriate settlement date of a transaction compared through post-original comparison procedures.36 In that interpretive letter, the Board also urged dealers to discontinue sending unnecessary physical confirmations of transactions submitted to the automated comparison system. A significant compliance problem has been the persistence of some dealers treating certain inter dealer trades (predominantly trades with small firms and bank dealers) as customer tran~actions.37 This also obtains information from comments on proposed rule changes and through telephone inquiries from industry members a>ncerning the requirements of Board rules. In addition, the Board's Opentions Advisory Committee, which is a>mposed of industry representatives actively engaged in municipal securities cleannce and settlement, bas provided technical eq,enise on use of automated systems since 1985. 1be notice on inter-dealer venus customer transactions and the interpretive letter on settlement dates on post original a>mparison transactions, discussed infra, are examples of such notices. J41be Board does not have inspection or enforcement authority with respect to its rules. This responsibility rests with the NASD, the Office of the Comptroller of the currency, the Fedenl Reserve Board, and the Federal Deposit Insurance Corpontion for each of their respective constituents. JS MSRBRtpo,a, Vol 5, No. 2 (Febnwy 1985),at 7-8; approved March 18, 1985, Securities Exchange Act Release No.218S9. 36MSRB Rq,ons, Vol 5, No. 2 (Febnwy 1985), at 17-18. fl 'Ibis problem apparently originated because of the compensation policies of some firms, which treat cenain inter-dealer transactions as customer transactions for purposes of sales a>llllllmions. 9
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practice prevents the timely comparison of the transaction in the automated comparison system. In February 1985, the Board published a notice warning dealers against erroneous submiuion of inter dealer transactions to the institutional customer confirmation/affirmation system and instructing dealers how to distinguish inter-dealer from customer transactions in the particular situations in which problems had been reported.JI The Board also later communicated with enforcement agencies concerning this problem. In some cases, industry experience with the automated comparison system revealed that additional system modifications were needed to accommodate the characteristics of the municipal securities markets. Municipal securities dealers, forexample, oftenem:ute trades with special conditions attached, t.g., that an expected AAA rating will be given to an issue. During 1985, the Board received complaints from dealen that the automated comparison system could not provide notation of special conditions on contract sheets provided by the system.,, This made it nr.ceuary for dealers to send duplicate physical ;q:>~llPQ~~f.di~.~-~~-~~ttca.~of~co~ In-September 1985, the Bqard isked---N~ to. develop allowing notation of spec:ia: con~tiom and_ to n:quii-e that traniactiorii"l>e submitted _to the.system with.the same special condition designated for a comparison to occur. NSCC implemented such a feature in January 1987. 2. A""""'*" Co,npari.ro,I S,-,n for ,,,,__.l.mMd 7'nuu-actia,u. As initially implemented, one problem-with the automated comparison system was that it did not accommodate when, as and if issued ("wben-iuuedj transactions. The inability of dealcn to submit primary market transactions, which are :a majf)r $Cgment of the municipal seeurities market, into the compamon system caused many dealers to ,.cWaJ ...-.the..-and.to-continueto-rcl)"on phJsical"ct>nfirmations.-,'.: : ... .. -,::. ..... : : ~ _._: ,.,.: :: ; ....... .-::;.:. ;_ --:: . ; ~--,'~-"""'' :-: ... ,="::-_.;,, .... ,, ~~--,.-.~-~-.-........ . When the automated comparison provisions of rule G-12 went into effect in August 1984, the Board urgedNSCCtodevelopwhen-issuedcapabilityquicklyanddiscussed the design of the system withNSCC. In July 1985, the Board insisted that the when-issued comparison system not exclude transactions between syndicate managen and syndicate members, as was originally proposed by NSCC. The Board noted that the efficiencies of automated comparison and the purposes of section 17 A required that all transactions in securities with CUSIP numbers be included in the system. The Board also adopted several amendments to its rules to accommodate automated when-issued trade comparison. In July 1985, the Board amended rule G-12(b) on inter-dealer settlement dates to ensure that NSCC or its agent is notified of the initial inter-dealer settlement date of a new issue at least six days prior to its occurrence. This provides NSCC with informationnecesw-yto compute transaction monies on when-issued trades and time to provide final contract sheets once a settlement date is established. In September 1985, the Board amended rule G-34 on CUSIP numbers to require that CUSIP numbers be assigned to a new issue by the date that the contract for sale is executed with the issuer or MSRB Rq,ora, Vol S, No. 2 (Febnwy 1985), at 9-10. ,,~e,e.g.,MSRBRqora, Vol S, No. 2 (Febnwy 1985),at 17-18. MSRBRq,ora, Vol S, No. S (August 1985),at 7-8; approved October 25, 1985, Securities F.xcbange Act Release No. 22559. 1be settlement date of a when-issued transaction often is not known by the panies to a tnnsaction at the time the tnnsaction is executed. 10
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the formal award is made by the iuuer.4 1 In December 1985, the Board added a provision to rule G-34 requiring managing underwriters to disseminate the CUSIP numbers and the initial trading date in a new iuue to all syndicate and selling group members. 42 These amendments ensure that dealers have information necmaryto submit transactions in newmues to tbewhen-iuued comparison system no later than the day following the day trading begins in an iuue. NSCCs when-iuued comparison system became operational on February 28, 1986, but, as discUSM:d below, is not providing a satisfactory means of comparing when-issued transactions. 3. Book-Entry Set&m.ent Systems. As the book-entry delivery requirements of the automated clearance rules were implemented in February 1985, the Board began receiving comments from dealers that they often did not receive adequate advance notice of the depository eligibility of a new issue from OTC and thus could not make appropriate arrangements to accept book-entry delivery. In February 1985, the Board requested that OTC publish a timetable for the submiuion of information by underwriters ~king to _~ew ~~~~tQcy, ~~ii~l~! ~~.I P'l'.G,tq pl'.(W.ide t~eindustry -~t'1 at least five 'days advance nolicc:"of ali issue's eligi"bility. DTC proposed such a timetable to its participants in ~uch 1985 and.adopted it iii'.October~fJhat~ . :.;_:. .::.-_;_. . : :. :_,' :._ _: .. <:. The Board also received complaints from a number of dealers in 1985 that the interfaces linking depositories presented a number of problems in making book-entry deliveries from members of one depository to another. These problems were caused by inefficient computer links between the depositories, a lack of uniform eligibility standards and differing lists of eligible securities at the various depositories. In 1~ and 1986,_~e ~ard asked each of~~ depositories to improve the interfaces and to. .es~b~ JJ;lQ~ ~of~t.~pbiJityJis~ .-.--~. ~ttnc,, tbe.Board llu-co._nued to pres.\ for -~P.~mc:n~ in. these_.~,-'.,,._. .-, ::, . -~. -.-.. -. ~ .,., ... . . . . . . . . .. . 41 MSRB Reports, Vol. S, No. 6 (November 1985), at 13-14; approved December 19, 1985, Securities Exchange Act Release No. 22730. 42 MSRB Rtpons, VoL 6, No. 1 (Januuy 1986), at 15-16; approved February 24, 1986, Securities Exchange Act Release No. 22938. The initial trade date for an issue is defined, fora>mpetitive issues, as either the date of !Y::mi or the first date allocations are made to syndicate or selling group memben, whichever date is later; and, for negotiated issues, as either the date on which the oontract to purchase the securities from the issuer is executed or the first date allocations are made to syndi'?lte or selling group members, whichever date is later. o E.g., November 5, 1985, Letter from MSRB Chairman Ralph Hom to William Denuer, Jr., Chairman, OTC; January 2, 1986, Letter from MSRB Chairman Ralph Hom to Andrew Anderson, President, MSTC 11
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m Recent Board Actions on Automated Clearance 1,86 Board Review of Automated Clearance and Settlement Rules During 1985 and early 1986, after the industry had gained some experience with the automated systems, the Board undertook an extensive evaluation of bow its rules and the automated clearance systems were working. The Board reviewed the use of automated systea through detailed interviews conducted by Board staff with a number of dealers using a variety of clearance and settlement procedures. Although some dealers reported that they were achieving substantial cost savings from use of the systems, others reported that they were noL Most of the savings from the systems were reported to be derived from the.use of book-entry deliveries. A small num~rof dealers act~y reported increased costs from ilseof automated compara>n ofinte~-:deale'r ~ck:s"ti~camephysu;alconfiimitions continued to 6esent : and P~.by .-ny d_eal~~-~cing all deale~!._JC~ QO automa~ comparison." In additio~. _many d_ealers were not submitting tnctfonsto th~ day after trade date and were relying on the more costly post-original comparison procedures. The Board's review also revealed that the benefits of automated confirmation/affirmation of customer trades in municipal securities were substan tiallv lower than for corporate securities because of the low percentage of affirmed transactions. In asence, inefficiencies were being caused in two ways. Fust, a number of dealers reported system ~e-~~~tf9f"~e!JS.~~~-~~e:~.~ ~.o( .. ~tio_~,e-&,.w~e~~~'-ed -~,~-~*~_tio~-~~~p~~~-~:~~~~~~i~lj'm~rfa~.l~c~of_~9~deposi~ocy tlipoility standards, and delays iJi oJ;iaimJii pbysicid witfickawal o( securities froin depositories. These inadequacies resulted in increased costs for dealers attempting to use the systems. Second, it was clear that a number of dealers, institutional customers and their clearing agents had not made the "in-house" equipment and technical changes and other preparations necessary to use the automated systems efficiently. In considering this information, the Board was concerned that it might have attempted to bring about the industry's transition to automation too rapidly. The Board debated whether it would be advisable to establish certain priorities for the completion of the industry's transition to automation. In December 1985, the Board published draft amendments to the automated clearance rules designed to allow dealers first to concentrate their efforts on completing their conversion to automated comparison, then to focus on book-entry settlement of inter-dealer transactions and finally to devote their full efforts to automated confirmation/affirmation and book-entry settlement of institutional customer transactions.45 The draft amendments would have permitted physical delivery of inter-dealer transactions when agreed to by both parties and would have required use of automated confirmation/affirmation and book-entry delivery for customer transactions only if requested or agreed to by the customer. The Board stated that, if the proposed amendments were adopted, the full requirements of the automated clearance rules would be reinstated in the future, once the industry was better able to focus on the book-entry and confirmation/ affirmation systems. The Board asked for comments on whether this plan would facilitate the transition to automated systems. .. 1be review was conducted prior to NSCCs implementation of the automated wben-iuued comparison system. e MSRB Rqora, Vol. 6, No. 1 (January 1986), at 7-10. 13
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Eighty-five commentators opposed the amendments, while 24 commentators supported them. The commentators supporting the amendments cited higher costs, settlement delays or other inefficiencies that they were experiencing with the automated systems. Most of the commentators, however, indicated that many municipal securities market participants already were deriving cost savings from using the automated systems and resisted what was perceived as a step back from the Board's commitment to automated clearance. The majority of commentators argued that the draft amendments would act as a disincentive for dealers to convert to automation, would sanction physical settlements and would increase clearing costs for dealers already using the automated systems. The Board was persuaded by the comments that the entire industry would experience cost savings offered by automation once the necessary "in-house" preparations were accomplished by dealers and that it was appropriate to continue to press for automation of the municipal securities markeL The Board, therefore, reaffirmed its commitment to the automated clearance rules as drafted and withdrew the draft amendments in April 1986. In its notice of withdrawal of the amendments, the Board urged dealers to -~~te~nal~~-andoth~ ~sary.cominitnien,ts to0btainefficie~t and cost~ffective au~~ted,c,~ _The Board also si.ted that ~dditional action would.be needed by-registered clearing agencies to fatjlitate the transition to automation and urged industry members with suggestions for improvement of the systems to contact the clearing agencies directly. During the 1985-86 evaluation, it became apparent that some indirect participants were experiencing great difficulty with the automated systems. In many cases, the policies, practices, procedures and fees of the registered clearing agencies were not being adeq~tely communicated to indirect participants. 'Ibis resulted in unnecessary delays in processing or settling transactions and other time-consuming prdbleins: tor tndiri,ct--paitici~ as'~-u 4isimi~actioiiwatli autb~-~ cleanm~ systems. 1n some cascs,: the mis bf semc:es: providectby"depoiitories rs combined witli'otiiersetvices so iliat indirect participants cannot determine the actual costs charged by the registered securities ciearing agencies.47 The Board requested from each registered clearing agency offering municipal securities services a list of personnel and telephone numbers that could be used by indirect participants to obtain information on the automated systems. The Board published this list along with its notice on the withdrawal of the draft amendments in MSRB Reports. Recent Board Actions on Automated Oearance Issues Since the Board's 1985-86 evaluation of the automated clearance rules, the Board bas taken a number of additional actions designed to promote further progress in the automated clearance of municipal securities transactions. 1. Omnua and Sdtlltunt Fea. The Board bas been very sensitive to the costs of the transition to automation by the industry, particularly for dealers that bad not participated in automated systems prior to the adoption of the automated clearance rules in 1983. The Board has carefully scrutinized fee MSRB Report,, VoL 6, No. 3 (June 1986), at 3-5. ff There are no regulatory standards applicable to the performance of those clearing agents not required to be registered with the Commmion as dealers or u registered clearing agencies. 1be Board believes that the vital role of such clearing agents in the national cleannce system should be acknowledged and that the Commission should a>nsider whether cenain minimum standards are needed for all clearing agents. The list was first published in June 1986. The Board a>ntinues to publish the list periodically. 14
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proposals by registered clearing agencies and, on several occasions, has commented on proposed fee changes. Although the Board understands that clearing agencies have the authority to set fees based on participants' needs and an evaluation of the costs and benefits of various services, it believes that consideration also should be given to the effect of the fees upon the municipal securities industry's transition to automated clearance systems. The Board believes that proposed fees should be examined carefully by clearing agencies and by the Commission to ensure that they do not impede use of the systems by municipal securities market participants. 2. Alnmdmenl la RM G-34 on CUSIP Number,. In July 1987, the Board adopted an amendment to its rule G-34 on CUSIP numbers which effectively requires that new CUSIP numbers be assigned whenever necessary to reflect distinctions created within municipal iuues in the secondary market. 4' This ensures that securities that obtain credit enhancements in the secondary market or which are remarketed with various put features can be identified accurately by their CUSIP numbers . . .. : -~; .,._J~J986/Dtc .. tm)~ c~anic.-thc maiuiet m winch it provides. seamties. descriptions on. c:oafirmations generated. by .its automated confirmation/ affirmation system. Atthat time, the securities description appearing on a confirmation had to be entered by the dealer submitting the transaction to the system. DTC proposed a system which would print automatically on confirmations securities descriptions provided by a private vendor, but also would allow dealers to add a limitedamountof~ormation to augment the securities description provided. The Board commented ~at, even under the proposed revision, dealers :ultimately would be responsible for ensuring that tbesc:curities description provide4,to.the customer ii accurate and in compliance with the customer confirmation disck;Jsure_Jeq~ents Q( _(i-J-~(a), ~-Bom,d .l;lsc> poin~ out several disclosure ~uue~~~ of~ -~-l$(aj :~o~ge~en~if ~et'by~mu.,~~Uf ~ab~ ~~dud.securities descriptioilL "D'l'Cimpldiientedtlie reviilmi iii'Jwy'1987,for both itsbwn conlirmation/afliriliationsystem and NIDS. The Board also has monitored a DTC program for proceuing when-mued customer transactions in its automated confirmation/affirmation system. The program allows whcn-iuued confirmations to be generated by the system at the time of trade, based on available information about the iuue. This confirmation is informational only and cannot be affirmed. Oncethesetdementdate and other necessary information about the iuue are available, the dealer submits it to the system in the form of a final confirmation, which can be affirmed by the customer. This allows DTC to deliver OTC-eligible securities automatically for such affirmed trades on the setdement date of the new iuue. Although DTC made the program available to all participants in 1987, it has received, thus far, limited use by dealers. 4. Bool-E""1 s,,._. The Board recently adopted certain amendments on the delivery of securities that may be issued in either bearer or registered form (interchangeable securities") which will offer great benefits to automation. In March 1987, the PSA requested that the Board consider amending its rules on delivery of interchangeable securities to allow such securities to be delivered in bearer or registered form, ending the former requirement tbatsuchsecurities be delivered in bearer form. The Board published draft amendments to rules G-12 and G-15 incorporating this suggestion in June 1987 and received 18 comments, the majority of which were positive. MSRB Rq,o,a, Vol 7, No. 4 (September 1987), at 7-9; approved October 14, 1987, Securities Exchange Act Release No. 25020. ,. MSRB Rq,oru, Vol. 7, No. 3 (June 1987), at 9-10. 15
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The comments on the draft amendments penuaded the Board that revision of the Board's rules on delivery of interchangeable securities would allow depositories to convert much of their inventory of bearer certificates into registered form, which may be safelcept at substantially lower costs. lbe lower costs for safekeeping these securities should allow depositories to lower the costs of depository services for municipal securities and to increase municipal securities issues that are eligible fordeposiL The Board also was convinced that the amendments would reduce the number of failed transactions because dealen obtaining registered certificates of an interchangeable issue will not be required to convert them to bearer form prior to delivery. For these reasons, the Board adopted the draft amendments in September 1987.st lbe amendments will become effective on September 18, 1988. Aa noted by some commentators, the effect of the amendments may make it more difficult to obtain bearer securities for physical delivery to customen. The Board, therefore, has stressed the need for dealen to educate customen on the benefits of registered ownenbip and safekeeping of securities in depositories.SJ lbe Board also bas taken actions to facilitate the operation of a OTC pilot program offering .depositoiy -~ f~.:~. -settlini: in federal ("Wne-&yi fundL A: number .of short-tcmi muQi~ipal securities 'pay interest redemption proceeds in same-day fundi." -Because transactions in these ~ties also generally are settled in same-day funds, depositories historically have not made these municipal securities eligible for deposiL In April 1987, at the request of OTC, the Board adopted amendments providing an exemption from the automated clearance rules until June 30, 1988, for book entry delivery of securities that settle in same-day funds.s. 1bis exemption permits dealers to participate in the OTC pilot program and become familiar with its procedures on a transaction-by-transaction basis. The Board is reviewing opention of the system to.determine whether it would be appropriate to c:xtend-the sunset date of the amendments. . ... .. .. .: ..... . --.. .. .. .. '. ._: .. ,.:. . -:-.... .. .-.. ... . ,--.\I.,:---."-,:~-, . -,"'='----.:---~.' .-.:-... ... s/Miiiit,~ Nettiii1~~ ge~requuedeaie,i to ~pi.pariial deliveries that occur in the netting process. The historical practice in the municipal securities industry, however, is not to accept partial deliveries and this is refected in rule G-12( e )(iv)." AJ a result, netting programs have been slow to develop as a means of clearing and settling municipal securities transactions. The Board, however, currently is monitoring a voluntary pilot program begun by NSCC in September 1987, for the netting of certain municipal securities issues. AJ of year-end 1987, approximately 38 dealen were participating in the pilot program and transactions in two new issues bad been netted.,. To reduce the possibility of short positions and partial deliveries, NSCC has limited the pilot program to when-issued transactions in boolcentry-only securities. The pilot program appean to have worked succes.1fully for the issues chosen. The Board plans to continue to monitor the pilot program andeuminewbether a wider application of netting municipal securities transactions will be feasible in the industry. s1 MSRB Rtpo,a, Vol 7, No. 4 (November 1987), at 3-6; approved on Mardi 18, 1988, Securities Exchange Act Release No. 25489. SJ/ti. at 4. SJ Most transactions are not settled In federal funds, but rather by cbeck In nat~y' funds. s. MSRB Rtpo,a, Vol 7, No. 3 (June 1987), at 7-8; approved June 30, 1987, Securidcs f.lcbange Act Release No. 24661. ss This practice arose because of the general inabWty of dealen to obtain securities In the market to fill shon positions created by partial deliYerics. ID 1983, the Board proposed amendments to rule 0-12(e) that would have allowed partial deliveries In certain cues. 1be comments on the draft amendments were predominantly neptive and the Board decided not to adopt these amendments. Sa MSRB Rq,orr,, Vol 3, No. 6 (November 1983), at 15. ,. These two issues bad a total of 43 various maturities that are distinct ror purposes of trading. deliYery and setdement. 16
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IV Remaining Issues to Be Addressed In the last four years, the municipal securities industry bu made tremendous strides in its transition to automated systems of clearance and settlemenL However, to achieve further progress, a number of problems must be addressed. AJ discussed below, some problems fall outside of the Board's regulatory authority. The Board, neverthelas, is committed to supporting improvements in automated clearance and settlement and will mist efforts by the Commission and other groups to overcome impediments to the goals of section 17 A of the Act. -~"'-:1ri11.-~:&iudA~-Md a~- ~:-:._ ..... ~-. :: ::-:..... . . 1naaiera1, 'ibe Board. ~~that the majority of munici~~~deal~n bavesouiht to comply with the Board's automated clearance rules. However, as revealed in the Board's 1985-86 evaluation, manydealen, including a number of dealen that arestrongsupporten of automated clearance, still have not made the internal technical changes, training and supervisory coniL1itments neceuary to use automated systems efficiently and to comply with the automated clearance rules. I . 1'1ar-DI* S.:11 ,_,,. Marllf o.,.,a... The percentage of secondmy market inter-dealer -tra1mmmpaittil in-the illitialeom,-dlonc,de ir a pxtiilcbt1>rof .--industry compliance with tbeautoill~tedeom~tsofruleG-12.:s-t~mitiilc:ompuilonratebarisenslowly,from approximately 60 percent 'wlien the rule 6nt became etfectiw: in August 1984, to only 75 percent as of February 1988. Obtainingfurtberefliciencies from the comparison system requires that this percentage be much closer to 100 percenL 1beprimaryreasonthatsecondarymarkettramactionsdonotsucc:essfullycompareintbeinitialcycle is the failure of dealen to submit tramaction data to the system correctly by the day following trade date. 'Ibis may result from inadequate internal procedures for transmitting transaction data from trading penonnel to operations penonnel, delays in obtaining transaction data from regional offices, or clerical erron in coding or submitting data to the system. Some dealen, however, consistently submit almost 100 percent of their transactions correctly and in a timely manner. 'Ibis demonstntes tbaL if sufficient raourcea were dedicated by other dealen, the automated comparison system could be used with great efficiency. The Board bas discuaed compliance with its automated comparison requirements with the various enforcement agencies responsible for enforcing Board rules. In 1986, at the Board's request, NSCC assisted the enforcement agenciea in their complianc:e activities by supplying information on the S1Tramactioucomparedintbeinidalcompariloncyde(ontbeevenin1ofthedayfollowin1tradcdate)repraent compullom ICbicved with tbe least amount of manual proceuin1 and iDdicate tbat both parties submitted their trallllCtiom in a timely manner (DO later tban tbe day after trade date), as required by rule G-12. HOMVCr, if postortpnal compartsoa procedures mut be med tocompue a trade, mucb of tbeeftldeacyoffcred by the automated -,.tem ts loll. la mntnst, the comparison rate for corporate securidel transactions in the initial comparison C)'de is close to 100perczDL 17
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performance of individual dealers in the automated comparison system. The enforcement agencies used this information to conduct special programs to address noncompliance, which sparked an improvement in comparison rates from approximately 63 percent in mid-1986 to approximately 74 percent by April 1987." Since then, comparison rates for secondary market transactions have remained relatively stagnant. The Board believes that additional vigorous enforcement efforts are necessary to improve compliance with the automated comparison provisions of rule G-12. 2. 11*r-D,aJ.,. Whffl-1.s.r,_, C',omparison. The initial comparison rate for inter-dealer when-issued transactions in February 1988 was only 43 percent. This low comparison rate seems to indicate that the system, as currently operating, does not provide an efficient means of comparing when-issued transac tions. Moreover, there does not appear to be any trend of steady improvement in the when-issued comparison rate' and the low number of transactions submitted to the system suggests that a substantial percentage of when-issued transactions are not being compared in an automated manner.'2 Thc .poo"r"wh~n-~~ ~mparison tat~ma~ ~O~t-~:t~~d~ri~ ~f tradi~g-~rsofliiet t~ ~thh~I~ when-issued trade data from operations personnel and thus delay proceuing~ It also may reflect the complexity of the when-issued comparison system, which requires one procedure for inputting a trade in which a syndicate manager allocates securities to a syndicate member and a different procedure for other when-issued trades. In addition, the when-issued comparison system is a separate system from the secondary market comparison system. As a result, operations personnel may erroneously submit whenissued and secondary market transactions into the wrong systems, causing uncompared trades. The relativelycompa procedures for when-issued comparison also increases the pouibility of clerical errors in the coding and submission of'..t;radedatL .. .. ;~--.,~ ... .;,: ... .,:., ... :. : ... -.,:..;<-. \--:. . :.: ~. :-. .. ...... .. -~--....... :, .-.: -. -~ : .: '. :_-. :,' tit_ ....... : .-. :; .... --~: . ... -. : '= ,:.. :-, : .. ... I The Board believes that the continued problems in the when-issued comparison system are unacceptable if the industry is to move forward with automation. It is concerned over an apparent lack of attention to the operation and usage of the when-issued comparison system. Accordingly, the Board is undertaking an extensive evaluation of automated when-issued comparison. The review will focus on the design of the when-issued comparison system, dealer compliance with the automated comparison requirements of rule G-12 and enforcement efforts. The Board will share the results of the evaluation with the Commission and other interested parties. 3. butiludDnal '8lolnff' <:onjinnalion/AJJin,,alion SJslflm. The rate of customer affirmation of DTC-eligi"ble municipal securities transactions submitted in the NIDS confinnation/affinnation system was only 64 percent for the month of February 1988.e Many dealers report that they now submit "The NASO also conducted a similar program to addreu a>mpliance with rule G-12(b)(ii)(C), which requires syndicate managen to notify NSCC of the initial settlement date of a new mue to facilitate when-mued a>mpamon. This percentage excludes transactions in which syndicate managers allocate new mue securities to syndicate members, which are submitted only by the syndicate manager and recorded automatically as compared trades on the day following submission. "Foremnple,theJune1987initialwhen-iuueda>mparisonratewas45percent-highertbanthe43percentrate experienced eight months later in Febnwy 1988. In the interim, the rate fell to 31 percent in July 1987, and then to 29 percent in December 1987. a In ~ber 1987, for example, the total number of when-issued transactions submitted to the system averaged less than 600 transactions per day. In light of the tolal $5.61 billion volume of new issues which came to market in that month, this figure seems to be low. e 1be rate for non-OTC eligible municipal securities was much lower-approximately 2S percenL 18 ,, 1 r, 1
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substantially all of their municipal securities transactions with institutional customers for automated confirmation/affirmation, but that such confirmations routinely are not affirmed by their customers. There may be a number of reasons for the failure of customers to affirm trades. The clearing agent for a municipal securities institutional customer often is responsible for affirming transactions for the customer and must receive instructions from the customer prior to affirming the transaction. Affirmation of the transaction thus depends in part upon the communication links established between the customer ( or the customer's investment advisor), the customer's clearing agent and the depository. Dealers cannot control these factors and generally are reluctant to jeopardize busin~ relationships with customers by insisting that improvements be made ... The Board has asked OTC to work with all of its participants, including those selVing as clearing agents for customers, to improve the affirmation rate. In 1986, OTC initiated an ongoing program of visiting its participants to discuss ways to improve performance; however, the affirmation rate for m.~~P~ ~ic;,_.-~~~~: 19. t.1 ~~~-J~t. forq1r.ppntc; ,~~es-~: AIUi~ugh th~ recopiii~s'the"difficul_es tbaf dealers fa~ in~improvmg their cusiorpen' affirmation perforinan~, these efforts. tiltiriiately must: be made if' the automaied sysiems for clearance and settlement of customer transactions are to be used efficiently. Improving affirmation rates will require industry-wide efforts, involving dealers, customers and clearing agents and, to be effective, also must be coordinated with enforcement activities. Investor Edu~tion on Beneftts of lDUQ.obilmtioil -:.~: 'Sipilieairt nuiil~ bf numaj,al '~"'ties::mw:sto~--uicfudbig. some "initiiutional customers, .continue to tt:quire br p,refer-pbystat-pmsessioftef seairi~i~'certifica~~Somedeaiersencourage this preference and promote delivery of physical securities certificates to theircustome~. To provide physical securities to customers, however, dealers must utilize the expensive and time-consuming procedure of withdrawing securities certificates from a depository. The preference for physical certificates by customers thus far has limited the potential cost savings of automation and has discouraged the transition of the municipal securities industry to immobilization of certificates. The decreased risksoflcm, theft and missed call notices offered by depository immobilization provide strong incentives for investor acceptance. Continued progress in the immobilization of municipal securities will depend, in part, on educating dealers and customers about these benefits. A number of dealers have advised the Board that customers who previously preferred physical securities generally have responded positively to such educational efforts. As part of its 1985-86 review of automation and its adoption of amendments on interchangeable securities, the Board urged dealers to educate their .. Automated confirmation/affirmation systems may provide some advantages over physical confirmations, even when transactions are not affirmed. For exampl~ in the automated system, both the customer and the customer's clearing agent usually receive electronically a confirmation giving advance notice of the settlement of a transaction, eliminating the risk of postal delays in paper confirmations. "'lb-, affirmation rate for corporate transactions in the month of January 1988 was 90 percent compared to the 64 percent rate for municipal securities. When the Board adopted the automated clearance rules in 1983, several states also had requirements that securities purchased for cenain purpcses, e.g., insurance reser."C requirements, be safekept physically within the state. Most of these requirements have been altered to allow immobili7.ation of securities cenificates in out-0f state depositories. The Board understands that the state of Wyo111ing, however, continues to have insurance requirements that limit the ability of insurance companies to safekeep securities in an out-0f-state depository. 19
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customers on the benefits of securities immobilization.'7 A successful educational campaign will require coordination of efforts by dealers, depositories and industry organizations. The number of book-entry-only municipal securities issued in recent years also has highlighted general investor concerns about immobilization." Many customers are reluctant to purchase book-entryonly securities because of fear that it would be difficult to trade and recover securities in the event of a dealer insolvency. The increase in book-entry-only issues bas led some investors to express conr.em that the protection offered by Securities Investor Protection Corporation ("SIPC") may not be adequate to cover their municipal securities accounts. Therefore, the Commmion may wish to determine whether SIPC coverage continues to be adequate given the increased immobilization of municipal securities. Issuers undoubtedly will increasingly prefer book-entry-only issuance since this allows them to reduce the costs associated with printing certificates, recording and transferring registered ownership, processing interest checks and redemptions of principal. 'fhe costs of reco~ng ownership and interest andte4e~pttoii-paynients, boweYer, oftenate shifted ~(>' dea(entbat safekeep such securities for investors. Municipal. securi~ies dealers that have not previously offered safekeeping services niay face additional recordkeeping and financial responsibility requirements under Commission rules if they offer such services. It would be appropriate for the industry and the Commission to discuss in more detail the implications of these new responsibilities in light of the anticipated growth of bookentry-only municipal securities. Issuer's ~stees, Pa~a and ~s~e.-Agents '.': :.Jssue~.Qf-ni~pal_securitiea .~'CO~~ witb:separate, nongovemmentalentities to fulfill various ongoing_ admini1tra~ functions with respect to ~e.~es they issue. In a.typical callable issue, a trustee is selected that must conduct any lotteries necessary to allocate partial calls among securities holders, notify the securities owners affected by a call and generally supervise the redemption of called securities.11 The issuer also selects a paying agent responsible for paying interest and principal to securities owners and, in issues of registered securities, a transfer agent responsible for recording record ownership. 11 Because depositories have become such large holders of municipal securities, TZ problems in trustee, paying agent and transfer agent performance have become major depository problems. Depository participants who receive late credit for redemption payments because of inadequate call notices or who are delayed in receiving securities because of transfer problems first look to the depository to address such matters. The problems, however, are industry-wide and affect all holders of municipal securities. '7 MSRB Reports, VoL 6, No. 3 (June 1986), at 4; MSRB Rtpons, Vol. 7, No. 4 (November 1987), at 6. "Securities c:enificates are not available to investors in book-entry-only iuues. In most book-entry-only iuues, securities owners must hold the securities through a depository, either directly as a depository member or through a safekeeping arrangement with a securities firm, bank or dearing agent that is a depository member. Newbook-entry-onlyissuesgrewby250percentin 1987andcomprisedapproximately28percentoftheparvalue of new issues. See "Depositories Report Book-Entry-Only Municipal Sales Rose by250% in 'frl, CreditMarkea, January 25, 1988, section 2, page 1 .,. Not all issues of municipal securities have trustees and it is possible for an agent of the issuer other than a trustee to have responsibilities concerning call processing. In most cases, however, it is the trustee that is responsible for these functions. n In many issues, the paying agent and the trustee are the same entity. n OTC, for example, bad over $500 billion in par value of municipal securities on deposit in 1987. MSTC bad over S200 billion in par value of municipal securities on deposiL 20
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1. umaand PllJinfApnlr. The Board routinely receives complaints from investors concerning the duties performed by trustees and paying agents. The complaints often concern the manner in which call notices are written or transmitted to securities owners, inadequate identification of securities on call notices, improper performance of call lotteries and late payment of interest by paying agents. Since no governmental entity regulates these functions, there is little that the Board can do to assist such investors. In November 1986, representatives from industry organizations, regulatory agencies, depositories, the Commission and the Board met to discuss these problems and recommended that trustees and paying agents observe certain voluntary standards when providing call notification. The depositories have advised the Board that, after the December 1986 publication of the standards by the Commission74 and subsequent re-publication by the Board and other industry organizations, call notification improved during the first three quarters of 1987. Voluntary observance of the standards, however, began to decline in the fourth quarter of 1987 and compliance with some of the standards continues to be low. -~... Th,~-.1%>~--~~~-~t, -~ -~~ ~t~p.in.~~g-~ !Uld _jQte~t_pa~~i;t.t problems, issuers sboukhj~cify within aii is.,~e's ofaciaf doauiien~ sucli" as the truit" ~denture or paying agent agreemerii c"lear~taildards that m~t be'fuet by the panics perfonnmgthese functions, including the 1986 recommended standards for call processing. In addition, the Board believes that issuers should monitor the performance of their agents to ensure that the standards are being met. Since the entities performing these functions are almost exclusively banks, it may be appropriate for banking regulatory agencies to include oversight of these activities in bank examinations. If these .suggestions are not practicable, it may be necessary, as the Board noted in a 1986 letter to the Commission, to seek legislation providing regulatiqn o( mun(cipal secutjties call noti6cation.1S lb~ Board strongly supports the statements of CAQ1dssioa.Q~-~~-ih&_logi~J~-9f,~ ~atic;,n in~ area should be on tcmtces .anc(payinaagents BD4.tbatadirecrt grant of.authority-to ~Q>mmislion,would-be appropriate to provide such regulatio~ The Board urges the Commission to act quickly upon Chairman Ruder's statements iO that these problems, which continue to affect clearance and settlement of municipal securities and present serious investor protection concerns, may be addressed. 2. Transfer Agats. The Board received a considerable number of complaints concerning transfer delays in the years immediately following the adoption ofTEFRA in 1982 In May 1983, the Board, the Commission, and the Government Fmance Officers ~ation published a joint statement recommending that municipal securities issuers choose transfer agents which meet the same three-day turnaround standards applicable to most corporate transfer agents.11 Today, the problem of transfer beCommissionalsoai,parentlyredeves similar complaints. Commmion Chairman Ruder recently noted that, in fisc:a1 year 1987, questions about lack of notice on called bonds were raised in over 200 investor complaints to the Commission. Text of Remarks of David Ruder, Chairman, Securities and Exchange Commission, Before the Public Securities Association, October 23, 1987. 74 Securities Exchange Act Release No. 23856 (December 3, 1986). 1be Board endorsed these standards in December 1986. MSRB Reports, Vol 7, No. 1 (January 1987), at 11-15. 1be Board also urged the Government F'mance Offlcen Association (9GFOA ") to incorporate the standards as a pan of its rea>mmended procedures for munidpal muen. 1be GFOA included the standards in its 1988 Di.rclosutt Guitklina for State and Local Govemmmt surilia as Procedural Statement No. 7 .,, November 14, 1986, Letter from MSRB Chairman Keith Brunnemer to Richard Ketchum, Director, Division of Market Regulation. See Text of Remarks of David Ruder, Chairman, Securities and &change Commmion, Before the Public Securities As.1ociation, October 23, 1987 .,, MSRB Reporu, Vol 3, No. 3 (May 1983), at 3-4. 21
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delays does not appear to be as serious as it once was, due in part to the increasing immobilization of municipal securities." The Board, however, continues to receive occasional complaints about extraor dinary transfer delays and it is apparent that a number of transfer agents, including those subject to the standards set forth in Commission rules 17Ad-1 through 17Ad-14, do not complete routine transfers within three business days, as generally required by those rules. The Board believes that all parties conducting transfers for publicly held securities, either municipal or corporate, should be subject to the same standards. The Board strongly agrees with the recent statements by Commission Chairman Ruder that the Commission should be given statutory authority to regulate transfer agents for municipal securites, even when such agents do not provide corporate transfer services." The Board also believes that it would be appropriate to emphasize increased enforcement of the existing standards for transfer agents already registered with the Commission. :inierracei ~~d: Eii&ibiiiti/s~~~t;: : .-_. .-: .. _, : . .. . : : -~ .. : .. Although the Board understands that improvements have been made in the interfaces linking the various securities depositories, it is concerned that interface problems continue to limit use of the automated clearance systems by municipal securities dealers. These problems have led dealers that are members of several depositories to withdraw fro~ certain depositories or otherwise limit their partici pation rather than accept deliveries through the interfaces.11 This, in tum, discourages participation in the automated systems by dealers that are m~mbers of those de~itories through which_ deliveries will not be accepted. The Board-believes that, for the transition to automation QJ. the municipal $CCurities mdusuf~ ~~tiii~~,~ th'e o,;IDIDiai~ ~-~(~ufrf_cre~tto~~; ~--~ii~~~~--n( irii~?a~. policies_ and 'piocedurei winch" proinot~-tither' tlian'discouiage, use of the_ interfaces. . . The Board reali7.es that the large number of mues and complex features of municipal securities currently make depository eligibility for all municipal securities impractical. However, if municipal securities are to reach a parity with corporate securities in automated clearance and settlement, it is critical that eligibility in the various depositories be as broad and uniform as possible. This will allow a steady reduction in the number of transactions that must be processed physically, outside of automated systems. In this regard, it is incumbent upon depositories to maintain a certain degree of flexibility in their eligibility policies concerning municipal securities, even, for example, if immobilizing a particular issue may be more costly or difficult than normal for the depository. Progress has been made in this area in recent years; DTCs pilot program to make eligible securities that settle in same-day funds is one example. The Board, however, believes that additional efforts are necessary, especially in the area of securities that By allowing changes in the ownership of securities to be accomplished through depositories, rather than by changes in record ownenhip, immobilization reduces burdens on transfer agents. This promotes better performance by transfer agents when transfers are requested. Sa Text of Remarks of David Ruder, Chairman, Securities and &change Commission, Before the Public Securities Auociation, October 23, 1987. The Board also notes that the need for such regulation has been endorsed by the Stock Transfer AsM>ciation, a 500-member association of transfer agents. The Board notes that the recently adopted legislation bringing associated persons of transfer agents under Commmion regulation may mist the Commmion in its enforcement activities. Securities and Exchange Commmion Authomation Act of 1987, Pub. Law 100-181, 101 Stat 1249 (1987). 11 ~e, e.g., "Phlx Hits Merrill Lynch Action as Anti-Competitive, The National Suritia Processing Repon, Vol. 1, No. 3 (December 1, 1987), at 2. 22
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are advance refunded by certificate number, for the full benefits of the automated systems to be realized by municipal securities participants.az Exemption for Indirect Participants in the Board's Automated Cleannce Rules When the Board adopted amendments to the automated clearance rules allowing indirect partici pants to self-clear transactions physically, it stated its intention that indirect participants ultimately should participate fully in the automated systems. Experience has verified that the benefits of automated systems increase as a greater percentage of total industry transaction volume is processed through the systems. In light of the problems discussed in this Report, however, the Board does not believe that it is appropriate at this time to require all municipal securities transactions by indirect participants to be included within automated systems.a Because of a.variety of factors, indirect participants are paying more for the use of automated systems than are direct participants ... For many dealers, indirect participation in a registered 'secuntfes~g_a __ cy. ~:tfrt:o.~ ~le gieam of us~:aatotcd_'dearancefacilities.. '. ; .. ... , .... .: .: .. The Board-will continue to monitor the participation of indirect participants with a view to bringing them fully into automation when this can be done without substantial adverse effects on this group of dealers. The Board will support efforts to resolve the remaining impediments to full participation in automated clearance systems by municipal securities _dealers so that the goals of Section 17 A of the Securities Exchange Act can be achieved for municipal securities. ,...._..: --~--~ :, .. .. ....... .: .... : .. -_ ... ,.., .. ;..._ .. --:-_,.:: .".,: .-:--:-~ .. . :. /':-.-~~:.\: ... : --~-.. .-~-.. .. '_ .. /: ,. . I,'. ., __ .. ... -.~. .. -.-. . . . .. . -. : a The Board understands that OTC, for aample, does not allow securities to remain eligible in tbe depository if an issue is pre-refunded to different maturity dates or prices by c::enificate number. a The Board is aware that self-regulatoryorgani1.ations fora>rporate securities markets recently have taken steps to ina>rporate substantially all OVP/R VP transactions by indirect participants into automated systems. Amend ments to NYSE Rule 387 and NASO Uniform Practice Code Section 64; approved by the Commission on November 13, 1987, Securities Exchange Act Release No. 25120. 14 The bigberc:osts, in part, can be attributed to the c:ostsadded by clearing agents. In addition, indirect panicipants tend to bave lower transaction volumes than direct participants and do not share in tbe same economies of scale. The customers for indirect participants also appear to be more likely to be retail customers who prefer physical c::enificates. 23
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Appendix Securities and Exchange Commission Order Approving the Board's Automated Clearance Rules November 14, 198-1
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UNITED STATES OF AMERICA before the SECU~ITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT of 1934 Release No. 20365,INova!ber 14, 1983 ORDER APPROVING PROPOSED RULE CHANGE OF THE MUNICIPAL SECURITIES RULEMAKING BOARD (File No. SR-MSRB-83-13) I. INTRODUCTION The Municipal Securities Rulemaking Board (the MSRB) filed a proposed rule change on September 7, 1983, 1/ under the Securities Exchange Act of 1934 (the Act), 2/-concerning c;J.-~~~r~---~~:..!:tt.l.~~~~---:Q~. ip.a-1 ,ec-~r-i ties. _.t.t~act ions. : ,.Cenerally_, the .p~opoi,~ed .r\i~e. change: w~uld requi're use of c1~aring a_ger:icy facilities to ~c_c;:C?lftpli_sh. vari.ous tasks, including comparison of inter-dealer trades: confirmation and acknowledgement of customer trades: and settlement of related delivery and payment obligations by book-entry. The proposed rule change would apply to municipal securities brokers, dealers and their clea~ing agents, as ~ell as municipal securities investors. and their.,e.curities custodians. 3/ . . ,_ . . . . . . .. : ,. : .. : :,\Th-=propos~ 'rui: cbn~. ,,ouI1t-'bece:eff.-~tfve in wo. :Stages..:Af~ri'.A-agU'9~-1~_~-19&4~-for .. trad.es -.._ubject to the Rules, comparison of inter-dealer trades and confirmation and affirmation of customer trades through clearing agency facilities would be mandatory. After February 1, 1985, those trades would be required to be settled through the hook-entry facilities of registered securities depositories. The proposed rule change was developed through extensive public discussion of appropriate clearance and settlement procedures for municipal securities transactions. The specific dialogue concerning mandatory clearing agency use began when the MSRB published a draft of the proposed rule change in July 1982. That draft concerned only the settlement of !/ 1/ 11 See Securities Exchange Act Release No. 20189 (September IT; 1983), 48 FR 43470 (September 23, 1983). 15 U.S.C. J78s(b)(l): 17 CFR 240.19b-4 (1983). The rule change, however, would apply to those entities only if they participate directly or indirectly in clearing agencies registered under the Act.
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-2 -dealer-customer obligations, but drew 24 comment letters.!/ In March 1983, the MSRB solicited further comment on that proposal and on a proposal concerning use of clearing agency facilities for comparison and settlement of intP-r dealer trades. The MSRB received 27 comment letters on the March 1983 draft, as well as three comment letters after Se~tember 7, 1983. Those comments generally discussed the need to implement the proposed rule change in stages and the need for uniform clearing agency systems specifically tailored to municipal securities. All comments addressed to the MSRB were filed with and reviewed by the Commission. The Commission solicited written comment on the proposed rule change as filed on September 7, 1983, but received none. As discussed below, the Commission has determined to approve the proposed rule change. ..... ,: .. :', ....... ,. ,# .. . . .. . . . .. ... Currently, the majority of the 15,000 -20,000 transactions in municipal securities that occur daily are processed in much the same way the securities industry processed trades in corporate debt and equity securities issues during the 195O's and 6O's. 5/ Dealer trade reports, customer confirmations and instit~tional settlement instructions are produced manually on paper and. re sent by mail to the appropriate .parties.: .... :rhe_r.-tter~ .-t~le~ent ---octurs i0n. manydi f'ferent 10.ca-t:i.0~-s-.daily-, tbrou;h the physic-al-.-exchange of -securities certificates versus money. Securities industry reliance on paper and manual processing techniques for corporate securities transactions led to paperwork crises in the late 196O's, which in turn caused the failure of many securities firms and significant investor Commenters, while supporting the MSRB's proposal, emphasized three areas of concern: 1) the limited number of municipal securities issues currently eligible for clearing agency services: 2) the difficulty of identifying customers as depository participants: and 3) the need to bring settlement of inter-dealer trades within the same time-frame as customer-side settlement. See Securities and Exchange Commission, Study of unsafe ind Unsound Practices of Brokers and Dealers, H.R. Doc. No. 231, 92nd Cong., 1st Sess. 28 (1971).
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-3 -losses. 6/ Proolems for the municipal securities industry at that time, however, were much less apparent --for two reasons. First, significantly lower secondary market trading volume in municipal securities meant less pressure on the industry's municipal firms' back-offices. Second, historically, municipal securities certificates have been issued primarily in bearer-form, rather than registered-form. Thus, delivery of certificates to settle secondary market trades has been possible without the need to transfer record ownership, and efficient interest collection has not depended on transferring record ownership by record date. The recent increase in the ~umber of municipal securities }If':'~-~.-~~-.E'fQ~_~,~-'f'~-~f~~ :2(,.an~ .. -~n .. ~e~on~a-~.y :_11\~r-~_e_~-, ~?tiv_i ~Y-. for all secui-ittes issues, necessarily i'ncreases the risk of back-off ice de.lays _in processing m~nic1pai" securities transactions. The municipal securities industry is unaccustomed, generally, to the use of registered instruments and to the recordkeeping and other functions of transfer agents and registrars. Increased secondary market activity, th~refore, will likely aggravate the delays and inefficiencies inherent in the industry's physical securities processing systems for registered-form municipal. bonds. The MS.Ra and many industry members recognize th-at-,-the. proposed::-ru-1. chan.oe,-.bypromot'ing.eff.icient. processing ~nd-t-ialy. --ttlem_e.pt ~c_,.ce:r~-ain. munic.ipal ~ec'1rities .-tr~nsactions through a,.itomated facilitieP, !/ should help preclude crises. !/ 11 !/ Id. The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) requires that security issues with maturity dates of more than one year be in registered-form to retain federal income tax-exempt status. Thus, after July 1, 1983, virtually all long-term municipal securi-ties issues are likely to be in registered-form. Recently, the National Association of Securities Dealers, Inc. (the NASD) and various national stock exchanges adopted rules si!llilar to that proposed by the MSRB requiring use of registered securities depositories for the processing and book-entry settlement of certain customer side trades in corporate securities. Adoption of these rules was rec0111111ended by a Joint Committee of the Operations Committee of the Securities Industry Association (the sxA) and the New York Stock Exchange. Inc. (the NYSE) to insure efficient procesing of securities transactions, particularly during periods of high volume trading. !!! Securities Exchange Act Release No. 19227 (November 9, 1982) 47 FR 51658 (November 16, 1982).
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-4 -III. DESCRIPTION OF THE PROPOSED RULE CHANGE The proposed rule change would a~end MSRB Rule G-12 concerning comparison, 9/ clearance and settlement of interdealer trades: and MSRB-Rule G-15 concerning confirmation, affirmation 10/ and settlement of customer delivery and payment obligations. As explained below, ~he two rules together would require clearing agency participants to use clearing agency facilities for tasks associated with both street-side and customer-side settlement. The rules define participation broadly to encompass both direct and indirect clearing agency participation. Neither rule mandates direct particip~tio~. in. a _re_gist_er,d ,cle.aririg. agen.cy nor.-do ,thef-requir1{:p"attlc"ipation.-n any .. particular deposl tory or: clearing corporat.ion. However, a non-participant dealer. or institution whose clearing agent or securities custodian participates in a registered clearing agency generally would be subject to these rules. Phase I: Comparison, Confirmaticn and Affirmation of Participant Trades As. of August 1984, .munic.ipal. ecur.ities. dealers, 'bt0Jurrsand.~uii"tomer1i" .. t::.hat!par~ic ipa"te in. 'reg'istered clearing ageft'eies will be re:qu"tred'/ ln"'''effe~'t/"to use 'the facll'ities of a registered clearing agency to compare, confirm and affirm their municipal securities transactions. Trades covered by !/ !.Q/ comparison is the process by which brokers and dealers match trades executed in the marketplace. Daily, each broker and dealer compares information about executed purchases and sales. If the relevant terms of the trade match, the two parties have a contract. If the parties report different information respecting a trade, the parties must resolve those differences before the trade can be settled. The confi-:mation and affirmation process is similar to the comparison process. In a typical institutional trade, an investment manager instructs a bro~er to execute a trade. After executing the trade, the broker sends the terms of the trade to the institutional customer or its investment manager. If the confirmation matches the customer' instructions to the broker, the custaner will issue an affirmation to the custodian bank authorizing it to receive or deliver securities against payment to or by the executing broker.
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s the rules include all transactions in municipal securities issues that are assigned CUSIP numbers. 11/ MSRB Rule G-12 would require municipal securities brokers ar.d dealers to use the automated facilities of a clearing agency fer the com~arison of their inter-dealer trades if they, or tr.eir agents, participate in a registered clearing agency that provides comparison services. The parties to such an interdea:er trade would be required to submit trade data and other ir.for:naticn to the clearing agency for comparison in accordance with the clearing agency's rules. Parties to an inter-dealer trade th&t participate in different clearing agencies would not ~e exe~pt from the rule if the clearing agencies are interfaced or linked with one another for comparison purposes. Similarly, parties to an inter-dealer trade that participate in a securities ~d_t:,.,9 .. i ~9~---~h~~--~:~: l.i.r:tk~d irt,~fa;c,t ~j.1;p .. ~-_c;.~~a.f'..~"g ~o~pora-1 tr_on that: pr~-i-aes="'Iinke~. c~par;i-son se~vic,s-~ou-id be subject to the Rule. . . MSRB Rule G-15 would prohibit participating municipal securities brokers or dealers from settling trades against payment ccoo/ovp) 12/ with th3ir customers, whenever the customers or their agents participate in a registered securities depository, unless certain co~ditions are met. First, the dealer must obtain from th.e customer prior to or at the time .o.f -:aacepti:i1'g:."aCOD/DYP :t-~ad order.-. cer--tain information:. necessary ~a--.ideA~-Jy .tti-AAt'1ffller ,.;. .. ,i~.tJ ,set-t-lemen.t, ag~nt .or. custodian, and the customer account with the agent. Second, the dealer, customer, and settlement agent, as appropriate, must use the facilities of a securities depository to confirm and affirm .ill ill The CUSIP Service Bureau automatically assigns CUSIP numbers to municipal securities issues with greater than one year to maturity and a total principal amount greater than $500,000. (A COSIP number may be assigned to an issue with a total principal amount less than SS00,000 upon request.) Currently, over one million long-term municipal securities issues have been assigned CUSIP numbers. This represents more than 20 times the number of corporate issues assigned CUSIP numbers. See Pros,ects for Automation of Municipal Clearance and Sett ement Procedures, MSRB Reports (April 29, 1983), at 11, n.l. Federal credit regulations require customers to settle securities transactions with their brokers no later than seven business days following execution. Federal credit regulations extend this time limit to thirty-five days for those custaners who establish special cash accounts and who agree to settle purchases against the delivery of securities (cash-on-delivery --coo) or to settle sales upon payment (delivery-versus-payment -ovp). See 12 CPR 220.4(c) (1982).
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f, -transactions in municipal securities issues assigned CUSIP numbers. 13/ The MSRB would exe~pt from this Rule, however, internal trades of a dealer-bank department .!!/ Phase II: Book-entry Settlement Effective February 1, 1985, the proposed rule change would require affected persons to settle by book-entry, through the facilities of a registered clearing agency, certain transactions in municipal securities issues that are depository-eligible. A depository-eligible security is an issue of securities that is eligible for safekeeping and book-entry transfer services in a registered securities depository. 15/ .Thus, MSRB Rule G-12 would require municipal securities "deal,ira. ari"d. !>rokers: "tc,."ae't-tie~_-'"by' book::e'n'try movement, all inter-dea-le-r tr:ansactions -in depository-eligible municipal securities issues if those transactions are successfully compared through the facilities of a registered clearing agency. Although settlement must occur by book-entry movement, participants will not be required to settle trades through any ll/ ... ,S--~--~ 11 ,~-,upra.,.--.~ .-._Un4r .. ,t.~i.-~.u.l~,. ~J:l ,m_unicipal .'. .... -,.-.. :!.ec;;~,;:.~.~;~-.~::o..k_,r;. ~r ~~-~-'' also -~~s.t: ( i.) ident_ify such transactions -as PVP or RVP transactions on the .!!/ ,ill trade ticket, (ii) send the confirmation to the customer not later than the first business day following trade dater and (iii) obtain a representation (writte~ or oral) from the customer that instructions regarding the transaction will be transmitted to the customer's settlement agent Thus, this Rule would not require a dealer-bank or its non-participant customer to use the automated facilities of a clearing agency for the confirmation, affirmation and book-entry settlement of any customer-dealer obligation when both parties use a department of the dealer-bank as their agent. See MSRB letter to Robert v. Slater, Second Vice Presidiiit, The Northern Trust Company (September 21, 1983) in Pile No. SR-MSRB-83-13. Currently, all registered securities depositories offer safekeeping and ancillary services for registered-form municipal securities. However, only some offer those services for bearer-form municipal securities. !!! note 36, infra.
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-7 -particular clearing agency accounting operation. 16/ Accordin~ly, participants may provide standing instructions to settle on a trade-for-trade basis. !1/ MSRB Rule G-15 would require certain municipal securities brokers or dealers and their customers to settle, by book-entry, through the facilities of a registered securities depository, 18/ 1!/ Seve~al types of accounting systems are used by clearing corporations. The most sophisticated accounting system i~ the Continuous Net Settlement (CNS") system, which generates a single, daily net buy or "sell" position for each securities issue in which a participant has ,;,._ --~ -~~f,-~P~f.~~--~~.,d.d~_, .. ~~-~ed~-~Jt~~--J~.-:,~~.s;-~:_.,oa'\-.~~et.l.'~~-f-~-~-:.~ay_ :". _,,_ :te~tr:aue ate--an ne s accWDu~a~e set ement obl:igat-iona in--that issue.-The.-ay.stem severs the link bet~een the original parties to the compared trades and interposes the system as the contra party. Accordingly, the clearing corporation's CNS system, rather than the original parties to the trade, becomes the entity obligated to deliver or receive securities and money. Unlike CNS systems, daily balance order (oao") systems traditionally h.ave not int.erposed cleJring corporations .,. .. ~----~.t~-tten. P-'.i;~ies .... I.n-st~d ,. -~ ti~ Yt.m generat~s a daily .... ., .. Otl~., -~-bw.y,~ _:.~~~-1 ~-. P..9,,~t,i.(?'1. ,f~~-.e,ic_h .. i1s~, .. of .. secur ~ties in which a partieipant has a compared trade due to settle, and allocates among, and issues to, participants net daily settlement orders to deliver or receive. As a result 111 .!!/ of the netting cycle, a participant may be required to deliver securities to, or receive securities from, a participant with which it had no direct trades. Many municipal securities dealers attempt to preserve confidentiality about their trading activities through the use of ~roker's brokers. In a traditional Balance Order System, however, broker's brokers can net to zero, leaving municipal securities dealers to deliver securities to and receive payments from securities dealers they, in effect, ultimately traded with through the brokers' broker. For that reason, among others, municipal securities dealers historically have settled trade-for-trade with their broker's broker wen circumstances required. Currently, NSCC does not plan to provide DBO services for the settlement of municipal securities transactions. !!! infra, note 32. The Depository Trust Company (oTc) operates an automated settlement system for institutional transactions (the system) in corporate securities issues. The ID (Footnote continued)
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8 C0::>/DVP transactions in depository-eligible municipal securities issues. The proposed rule change, however, would not require securities to remain on deposit after settlement. ll/ IV. DISCUSSION A. Why Auto~ate Processing And Immobilize Certificates? All parties to a municipal securities transaction subject to the Rules should realize significant cost savings by clearing transactions electronically, settling obligations by book-entry, and immobilizing municipal securities certificates in depositories. 20/ The savings inherent in automated trade processing shouldextend to bearer-form as well as registered fom instruments, although the benefits of immobilizing bearer _forin. cert.if ica.tes may .. be .. n.ar.rower_ . Moreover-, ~afek-eeping and processirig economies and_ efficiencies should be enjoyed by all parties subject to the Rules. Automated trade processing should assure timely settlement of securities transactions and reduce settlement financing costs by expediting the transmission of trade reports, confirill 19/ (Continued footnote) .. -~_,_. .. ... _.,,:-.:.-.~ .. .:-_! . :._ ... -:~-;._ _, . .:_.,-._.~:1,.-.; .-_-,: . -.:.. ;~--~ # system-coordinates ainong cert.a in brokers,. fn"vestinent managers and custodian banks participating in the system all the tasks that must be accomplished to effect customerside settlement of these corporate securities transactions. In cooperation with OTC, the Midwest Securities Trust Company ("MSTC), Pacific Securities Depository Trust Company (pscTc> and Philadelphia Depository Trust Company
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-9 -mations and affirmations. ,ll/ Moreover, by eliminating repetitive preparatory tasks, automated processing should enhance the accuracy of trade information and increase the number of trades settling in a timely and predictable manner. As a result, municipal securities industry ~embers should realize significant cost savings as labor and research expenses decline, as dependence on the mail is reduced, and as delayed or lost trade documents a::-e eliminated. Similarly, book-entry settlement should reduce aggregate costs for the municipal se~urities industry by reducing thP. number of physical deliver1~s. 22/ Since book-entry movements only require physical deliveries of securities in connection with deposits in and withdrawals from the depository, investors, brokers and dealers subject to the Rules should be able to avoid repetitious physical movements of securities. In -~cij.t_i.on,..--;cl.,~j..~g.: ~P"Jl~~ -PJ~~:i!=~~~._; -~~f'.a-. s:tiaz:~. _ecoo~ia _and f.fic1en~1es .t~a.t. result trom dep9~1tortes. bulk shipments and special arrangenien'ts' between _depos'itories and 'transfer agents for ~xpedited turnaro~nd of tr~nsfer requests. Savings in certificate-related expenses should be particularly significant for registered-form municipal securities issues. Moreover, reduced physical deliveries of registered and bearer-form municipal securities certificates should enhance certificate safety and reduce costs associated with certificate los-s. f ioally, book-entry settlement through t-h various .interf'acea should fecJ.-1-itate.tr.adi-n~r--a.n1Lsettlement --without .re9.-rdr to~-the ... part,~:' _:geogr;phic -. locat.ion. One ,-Accoun.t Settlement saves participants unnecessary fees for participation in and use of more than one depository and promotes timely and efficient clearance and settlement. 23/ ill ll/ Mailing paper confirmations, affirmations and comparisons can delay receipt of documents necessary for settlement. In turn, such delays can cause settlement agents to reject tendered securities or withhold payment for securities ("OK's), causing delayed settlement on the customer-side and unnecessary finance charges. The Joint Committee estimated that NYSE trades DK'd on the customer-side cost the corporate securities industry more than $100 million in finance charges, in 1980. To the extent municipal securities brokers and dealers use the CNS System, the netting process will reduce the number of actual deliveries necessary, thereby further reducing costs. one Account settlement -a basic feature of the National Clearance and Settlement System --permits a participant to settle all its trades through one clearing corporation or depository, regardless of the place of execution, recordation, and comparison of the trades.
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-10 -Increased use of book-entry settlement pursuant to the proposed rule change should encourage participants to immobilize municipal securities certificates in securities depositories. In the corporate area, depositories have provided cost-efficient vault fac:lities and ancillary services 24/ for registered-form certificates. Such certificates can be handled efficiently in a fungible bulk, through the safekeeping of "jumbo" certificates 25/ registered in nominee name. 26/ B. Why should the MSRB facilitate automation in clearance and settlemen~? The proposed rule change reflects an important step in the MSRB's continuing efforts to facilitate improvements in the indu$_tr.y' s. secz:-.itie~t~an~actio~: process-ing_;;. As. discussed in a recent MSRB Report, Prospects for Automation.of Municipal Income accounting (i.e., the collection and processing of interest and maturity payments) is an important ancillary service for depository-eligible issues. 25/_ For reasons of safety and economy, depositories generally con~oJi~a~~ the c~tif~cates _re~eive~ in.each issue by .I: . .: teq'ues't"ina.'froni' "tl\9 ,.transfer' agen:f sevifr"al.' large' denomi nl./ ; .-at ion ce-rtif icates-.-.: The particular denominations maintained on deposit depends, primarily, on participant demand for certificates. (Depositories often elect to put interchangeable issues into registered-form for this reason). The cost of immobilizing bearer-form certificates in securities depositories, of course, may be high relative to registered-form certificates and, at least initially, relative to other custodial alternatives. Higher depository fees result, in part, from the need to clip and present coupons to the paying agent prior to collecting interest payments and to provide more storage space for certificates with coupons attached. However, once the number of depository-eligible municipal securities issues in bearer-form grows, significant certificate immobilization by participants could help create certain economies at the depository that all participants can share. In any event, for municipal securities dealers with relatively small inventories and high transaction volume, depository immobilization would provide benefits and economies that likely exceed ex-clearing processing costs.
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-11 -Securities Clearance and Settlement Procedures, 27/ the MSRB curing the last two years has used its rulemakingauthority to advance the prospects for uniform national practices and procedures among cisparate rarkets. 28/ Furthermore, that Re~ort nctes that major progress hasbeen made in developing ap~ropriate systems and preparing the industry for the transition to automated clearance The rule changes [under consideration here] will result in the inclusion of large numbers of transactions in such systems. 29/ The Commission believes that the proposed rule change is a timely and appropriate exercise of the MSRB's rulemaking ~esponsibility. 30/ Promoting back-office efficiency is an appropr_iate goal ol Self-Regulatory Organ~zation ("SRO") rulen'l~Kif)g .. ,~-ut-hor.i t:y;~: pa~t.i-C:\.l~ai=-ly. i~~.l ight .-ot trad it-tonal -industry .emphasis on front-Officeexecutionactivities. The MSRB initiative in this area~~ in keeping with othe~ recent SRO initiatives that the Commission encouraged and approved, 31/ and should generate important economies in both trade andcertificate processing. As the MSRB noted in both its filing and its recent Report, the registered-form" requirement of TEFRA creates a special need for automated processing of these.securities. lll 30/ '.: :.. ... -~ ,I, ~-: See e.g., MSRB Rule G-12 (uniform practice respecting: dealer confirmations: comparison and verification of confirmations: delivery of securities: payment: rejection and reclamation: close-out: good faith deposits: and settlement of syndicate accounts), MSRB Manual (CCH) 1 3556 (April 1983): MSRB Rules G-12(c)(v)(F), G-15(a)(vii) (mandatory use of CUSIP numbers on dealer confirmations), MSRB Manual (CCH) t 3556,3571 (April 1983). MSRB Report, at 45. In its filing, the MSRB notes that the proposed rule change is consistent with Section 15B(b)(2)(C) of the Act, which directs the MSRB to propose and adopt "rules designed to foster cooperation and coordination with persons engaged in regulating, clearing, settling processing information with respect to, and facilitating transactions in municipal securities, to remove impediments to and perfect the mechanism of a free and open market in municipal securities, and, in general, to protect investors and the public interest. (Footnote continued)
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12 -In addition, the MSRB has provided ample time for industry education and preparation before the effective dates of the prc~osed rule change. Under the rules, for example, municipal SP.curities brokers and dealers will need to develop or modify their inte~r.al operations to accomodate automated processing and book-entry settlement through clearing agencies. More importantly, the registered clearing agencies will need to co~plete system and interface enhancements promptly, so that the objectives of the proposed rule changes can be met. As discussed below, the Commission expects the MSRB to continue to monitor closely industry and clearing agency efforts under these arnendments. c. Current and prospective clearing agency systems provide a foundation for safe and efficient clearance and se.ttlement.und_er the rule change. Currently, only NSCC provides comparison services for registered and bearer-form municipal securities. The Commission understands that NSCC, in the next several months, will establish a national system for the comparison of municipal securities transactions in issues that have been assigned CUSIP numbers (the National Trade Comparison System for Municipal ll/ . .. \ ... > '(Cor\ti"ri.ued footnc,ter' . The MSRB further suggests that its proposed rule change is consistent with Section 17A of the Actg and, in particular, with the Congressional finding set forth in Section 17A(a)(l) of the Act, which encourages the linking of all clearance and settlement facilities and the development of uniform standards and procedures for clearance and settlement [because it] will reduce unnecessary costs and increase the protection of investors behalf of investors. !!,!, e.g., Securities Exchange Act Release No. 19227 (November 9, 1982), 47 FR 51658 (November 16, 1982) (approval of Exchange and NASO rules requiring depository participants to use depository facilities for customer-side settlement of certain institutional trades). The SRO's have used their legislative authority to an even greater extent in other contexts. For example, the NASO has required certain NASOAO market-makers to use the clearance and settlement facilities of registered clearing agencies. See NASO Manual (CCH) ,1653A, Securities Exchange Act Releasetfci. 19689 (April 26, 1982), 47 FR 19500 (May S, 1982).
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-13 Bonds). 32/ Initially, MCC and OTC plan to establish inks to NSCC toaccess the comparison services of this national system for their respective participants. The Commission urges all other clearing agencies (directly or through NIDS, as appropriate) to establish effective links to NSCC for the national comparison system. Ideally, these arrangements should be concluded well in advance of the Phase I implementation date (August 1, 19~4). As noted above, all depositories currently offer contirmation and affirmation services through a National Institutional Delivery System ("NIDS"), for which OTC is the facilities manaer. NIOS provides these services for corporate debt, eguity, registered and bearer-form municipal securities issues. For those i$sues .which are eligible for depository )tHdil'"e'rnej;:f/ ~'.tli"e:;.d.~osftofle11 ~afs'o"'.provlde/ t:hrough interfaces, b~ok~entty~servi~es naticn-wid&. Althoogh: useof NIDS~ as it curre.ntly operates, would penni.t part ieipants to satisfy the MSRB Rules, the Commission understands that limited 32/ The National System will operate in a manner similar to .the National OTC Equity Co,:nparison Sy!iltem f(?r corporate :. ...... ... s,~.~~!,t.~,.~. -.~~-~~;~ .. :.,9t ... ~t"i.i.9~.,-~~c;:.c .J~ .~+~o .. the. ~en~ral 1 ., ,.-. R..r~~-~C?r.~ ..... .. ~'?-t...-.~t,. ~ti. pr,e~t t_ 1me to ofler its participantsaccess tothe NSCC balance order system because of the reluctance of municipal securities dealers to use netting systems. NSCC believes that municipal securities brokers and dealers would prefer to settle on a trade-for-trade basis to avoid (i) the netting of transactions, which can entail disclosing the parties actually trading, and (ii) partial deliveries of securities, which, under current MSRB Rules, is not mandated. see Participant Report, National Securities Clearing Corporation, No. 16 (October 30, 1983). NSCC, however, will offer a comparison Only mode for transactions in securities that are not depositoryeligible. For these inter-dealer transactions successfully compared at NSCC, however, the resulting delivery obligation may be settled physically, through NSCC's "Envelope services. (NSCC has a New York City envelope service that consists of a central location where participants can drop off envelopes containing securities and have those envelopes delivered to another participant: NSCC also provides an inter-city envelope service that ships envelopes, by courier, between New York City and several regional locations.)
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-14 -modifications are being contemplated to accomodate more ef!ectively the unique characteristics of municipal securities issues. 33/ The registered securities depositories also provide a broad range of depository services for most registered-form ~unicipal securities. Only OTC and MSTC, however, safekeep bearer-form municipal securities: 34/ OTC at its central facility in New York and MSTC at anetwork of regional custodians. The Commission understands that MSTC and OTC anticipate extending their current depository interfaces to accomodate book-entry movements of both bearer and registered fom municipal securities issues. The Commission believes that effective interfacing is cru~ial if participants are to realize the benefits inherent in one Account Settlement. 35/ Tnerefore, the Cominission .urges OTC and M_STC to complete their arr'angements promptly. .The success Of the. MSRB rule change depends critically on earnest cooperation among clearing agencies and between the clearing agencies and the MSRB. 36/ 33/ For example, OTC contemplates establishing a separate, more extensive field on the computer-generated confirmation and affirmation forms to capture impo-rtant descriptive = ~ -:i.~fo.rma~-ipn.:( 1.-e.-, .-~atu~i.ty date,-. is.tue -,.purpose). , . : :.): . :.-: ... = ;. -;: .... -.::,:. '"":'.,. .-.~-.-. ., ... ........ ... .... . i . .. OTC makes eligible for deposit over 40,000 municipal securities-issues, of which approximately 35,000 are in bearer-form. MSTC makes depository-eligible approximately 123,000 eligible municipal securities issues in bearer-form and approximately 35,000 in registered-form. PSOTC recently initiated a pilot link to MSTC's bearer bond program to offer PSOTC participants the full range of MSTC services. See File No. SR-PSDTC-83-3, Securities Exchange Act Releasi"'No. 19802 (May 23, 1983), 48 FR 24504 (June 1, 1983). supra, note 23. Many canmenters noted that the current depository-eligibility standards should be made uniform by the Phase II imple-mentation date (February 1, 1985). Currently, eligibility criteria vary substantially between MSTC and OTC: MSTC will accept for deposit, upon participant request, almost any municipal securities issue while OTC requires, among several other things, that the issue have a transfer agent whose performance is consistent with the Commission's 72 hour turnaround standard. (.!!,! 12 CFR 240.17Ad-2.) (Footnote Continued)
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15 -The Commission believes that current clearing agency systems provide a foundation for the proposed rule change and for safe, efficient clearance and settlement of municipal securities transactions. The Commission also believes that these systems, if modified and expanded by the clearing agencies and used by their participants, will remove the paper processing shackles that can constrict the municipal securities markets and will prepare active market participants for sustained high volume trading of the l980's and beyond. D. General Business Impact and Competitive Considerations In light of the flexibility afforded rnunicipal securities b~~~ei:-.s, c;}lst.qd-ia,:i .ban~s ,._,._ ~.l'}Y,es,~-.ot. innage_~lf-.and..--~a,t '.-~~n-icipal.. -eeeu~it;iee .a . a1e~s;: t',e t6.imn_iss1o_n .b'lieves tha~ the proposed rtile ~hang~ ~oes n6t i~pose ~riy_iri~ppropriate or ti~necessary (Continued footnote) The Commission understands that the rule wil 1 not regu ire sole participants of different depositories to settle, by boo.k-e.ntry.~ transactions in-securities issues that ....... -r.,.;~t:,e.lg-ibile.".-for ct.posit :at. bo;th--depositories ... ... .-.Nonet~el.e$$,-;.diff.t-ing .-ligib-i-lity _c-riter.ia,, .. could limit th~ value of th~ rule and the National Clearance and Settlement System by forcing settlement of such trades to occur outside clearing agencies. Differing eligibility criteria, coupled with the economic benefits of clearing agency participation, could pressure sole participants to join multiple depositories or to at least join the depository with the greatest number of eligible securities issues. The Commission is reluctant to require depositories at this time to adopt uniform eligibility criteria. The Commission recognizes that eligibility requirements are important decisions reached by the depositories after extensive consultation with their participants. These decisions reflect a balancing of available resources, participant demand, operational preferences and system safeguards. The Commission also recognizes that eligibility determinations reflect a dynamic process and that the universe of dually-eligible securities issues should grow dramatically by February 1985 as a result of depository and participant experience. The Commission and the MSRB, of course, will monitor developments and, if necessary, will consider appropriate action.
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-16 -costs on the parties to such trades. The Rules, as a general matter, do not require persons to join clearing agencies, but merely require existing clearing agency participants to use the most efficient industry means for clearance and settlement. The Com.~ission recognizes, however, that industry participants subject to the Rules may incur substantial start-up costs. For instance, municipal securities brokers and dealers will incur costs in connection with identifying accounts which are subject to Rule G-15 and devising procedures to capture and convey to the depository crucial data such as the identity of the customer and agent bank. Similarly, custodian banks and investment managers will incur new costs in connection with the distribution of confirmations. The Commission believes that the benefits derived from widespread, uniform and safe automated processing of institutional an~ inter-dealer trades far outweigh the compliance-related expenses. As indicated, the expenses are, for the most part, one time implementation or start-up costs. The benefits, however, should be realized continuously over time. For instance, brokers, dealers and custodian banks ultimately should experience reduced aggregate transaction processing expenses. 37/ Similarly, institutional customers or their _i~V-~~~l'.'-~m,,o~,ge;.! "J~.~.--~n~,o~. ,i!lC~~-ea,$~_d. p~~~i_ct~~ili t~ an~ e_ff~c1_~ncy __ i.n c;;~_a;a".'c,-.~.11~. s_e~;_l~men~~. ond they may_ experience reduced commission e:x:pensesas a result of broker and dealer cost savings. 38/ The Commission also believes th~ MSRB has provided appropriate and sufficient lead time for firms to make any needed systems and personnel changes. Indeed, prior to August 1, 1984, many industry members should be able to draw upon their experience with automated customer-side processing of corporate equity 11/ Ill As noted above, for customer-side processing of transactions in corporate securities issues alone, these savings aggregate annually to hundreds of millions of dollars. Moreover, with regard to municipal securities transactions, brokers and dealers face financing costs for fails on both the customer-side and the street-side. At the present time, depositories recover the costs of confirmation and affirmation processing from participating broker-dealers and custodian banks. The depositories do not charge institutional customers for ID processing. The Commission, therefore, recognizes that those processing costs may well be passed through to institutional customers. Such a pass-through would offset, in some measure, reduced commission fees.
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-17 -and debt securities transactions. 39/ Moreover, several compliance alternatives are availab!e to persons subject to the Rules. For instance, a municipal securities broker or dealer may choose to establish a correspondent relationship with another participating broker-dealer, in lieu of direct clearing agency participation. 40/ A participating broker or dealer, on the other hand, may avoid the expense of installing and operating an internal computer system by submitting hard copy trade data to a depository (i.e., paper) --assuming that is a cost-effective alternative in light of that participant's settlement volume. Similarly, custodian banks may obtain from institutional customers st~nding instructions to affirm trades on behalf of a non-depositor}' participant investment manager, thereby reducing such banks' ID expenses. :... ~. .. . ... . . ,.,, .. ....... '. .. ' ' . # '. : "' .: I o ", '; I 39/ -. See note 31", suyr,. E:icchange and NASO rules requiring depository part c1pants to use depository facilities for customer-side settlement took effect in January 1983. Many municipal securities brokers, dealers, and investment managers that effect transactions in both corporate and municipal securities issues are fully automated on the corporate side. These industry members may be able to r~ly Qn.that expetience during the transition to ,. :< -u~am~ted. pr~csslng ,for;-muD-ic::ipal.. seeuri-t.iestransactions r ... _.,,.~Qce .. so...o.ve~l~P,.-j,n_-.y_.tems. n.d .per.onnel. JDUSt. exist. Also~ municipal securities dealer-bank departments may .!QI be able to rely on the trust department, or other internal or bank subsidiary clearing operation for either the expertise in developing automated clearing and communication systems to interface with clearing agencies or the actual performancE of the clearance function. A non-participating dealer department in a bank that has a participating trust department, however, faces a special problem. In that instance, the trust department's participation is imputed to the dealer department under the Rules. If the trust department does not provide clearing services to the dealer department, the dealer department must use a participating clearing agent to be in compliance with the MSRB Rules. Canmenters suggested to the MSRB that, in this situation the dealer department may be forced to use clearing agency services. The Commission understands, however, that the vast majority of dealer-bank departments already employ participating broker or bank clearing agents. Nevertheless, should a dealer-bank department find that it must change its clearing arrangements under the Rule, it will face additional start-up costs. Over-time, however, as with all participating parties, the benefits should greatly exceed the costs.
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-lR Finally, the Commission has considered the potential cC::t~etitive burdens of the proposed rule change in light of the relevant benefits and costs, discussed above. In this regard, the Commission acknowledges that depositories compete to some extent with custodian banks and brokers for the sale of custocial services. For the reasons discussed in Securities Exchange Act Release No. 19227, however, the Commission believes the proposec rule change will not impose any inappropriate ~urden on competition in the sale of custodial services. 41/ The Commission also believes that, as the MSRB stated in Tts filing, the proposed rule change does not impose any burdens on competition not necessary or appropriate in furtherance of the purposes of the Act. CONCLUSION For the reasons stated above, the Commission finds that the proposed rule change is consistent with the Act. The Cc:nmission also finds that the proposed rule change will not i~pose a burden on competition that is not necessary or appropriate under the Act. IT IS THER~FORE ORDERED, pursuant to Section 19(b)(2) of the Act, that the proposed rule change be, and hereby is, approved. .. . ... ' . .. For the Commission, pursuant to delegated authority, by the Division of Market Regulation. ill -::,.( tt.(.,,c,?l.. ..~..., ~-; J George A. tzsimmons Secretary (November 9, 1982), 47 FR at 51662 (November 16, 1982). Those reasons included: the absence of a requirement that securities be maintained in a depository account after settlement: the ability of custodians that wish to perform a full service role for their non-participating institutional customers to operate independent, automated ccmmunications systems adequate to assure timely confirmation, affirmation and settlement through the institutional delivery systems; and the flexibility afforded participating custodian banks in choosing direct or indirect participation in a securities depository.
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Municipal Securities Rulemaking Board 1818 N Street, N. W. Suite 800 Washington, D.C. 20036-2491 Telephone: (202) 223-9347
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BEYOND NEGOTIABILITY: A NEV MODEL FOR TRANSFER AND PLEDGE OF INTERESTS IN SECURITIES CONTROLLED BY INTERMEDIARIES BY CHAllLES W. MOONEY UNIVERSITY OF PENNSYLVANIA JULY 17, 1989 This contractor document was prepared for the OTA Backgronnd Paper, Trading Around the Clock: Global Securities Markets and Informat~on Teclmology, July 1990, and OTA Report, Electronic Bulls and Bears: U.S. Securities Markets and Information Teclmo .!28.l., Sept. 1990. This document does not necessarily reflect the analytical findings of OTA, its Advisory Panel, or its Technology Assessment Board.
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BBmllD IIIIGO'l'DIIIL?ffl Am JIODBL ~-'l'Ull8~ UD ILBDGB 0~ 1ftBU8'18 DI 8BCUU'IIB8 COIIDOLLBD BY IftBltDD%D%B8 CJaarl . lloOaey, Jr. INTRODUCTION I. SECURITIES CON'l'ROLLED BY INTERMEDIARIES: lNTERMEDIARY ROLES AND RISKS 1 10 A. 'l'h Rol of Intaraediariu in Securiti-Marketa 10 a. 1. Clearing and Settlaent a. Th DTC-NSCC System. . b. Government Securiti--Fedwire and the clearing Bank syata 2. Th Selection of Intenaediari by Market Participant Risks Poaed by Securiti Intenaediari 1. 2. overview. Approach to Reducing Intermediary Risks a. Regulatory Approach b. Prophylactic Approach .. c. Insurance Approach d. Property Law Approach Risk Allocation Approach t. Observations DOC. SWP1101 July 17, 1989 11 12 18 25 28 28 29 29 30 34 34 35 36
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ii II. TRANSFER AND PLEDGE UNDER THE U.C.C. AND THE BOOK-ENTRY TREASURY REGULATIONS. . . . A. Articles a and 9 1. Tranafer and Delivery 2. Bona Fide Purchase . 3. Tranafer of Security Interests (Pledges) : .... ' .. .. -:_. ~-i.~Tbe-'.-~ft'(?pO~t.o:na--te Property. Interest. Rul 5. ~anaf~~--of. Nonexistent .-or-In~utficient Quantity of Securities ... . .a .... The Book Entry Treaaury Regulations .. ., . . . I ', 0 I:.. "' .. ... 1. Th eearer Definitive Fiction on the Top . . . ., . . Tler: :-rransfar and Pledge on the fed ., .... - .. .... .................. -:-:..,:. .... ~.. .. Booka 2. Th Bearer Definitive Fiction" on th Lower Tiers: Transfer and Pledge Under Applicable State Law 3. Th Propoaed TRADES Regulations III. CLAIMS AND DISTRIBO'l'IONS IN INTERMEDIARY INSOLVENCY PROCEEDINGS A. ownership Claia of cuatomers B. Claims of Secured creditors c. Obaervations IV. COMPETING CLAIMS AND PRIORITIES ON DIFFERENT TIERS: 38 38 38 42 45 51 53 5.7 59 63 78 86 87 107 110 BONA FIDE PURCHASE, FIRST-IN-TIME, LAST-IN-TIME 114 DOC. SWP1101 July 17, 1989
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v. iii A. Transfers to Upper Tier Claimant First-in-Time 117 B. Transfers to Lower Tier Claimant First-in-Time 129 c. Obaervations ....... 134 A NEW MODEL FOR RESOLVING DIFFERENT TIER COMPETING CLAIMS AND PRIORITIES 138 A. The Basic Principle: Priority for Opper Tier Claimants . 1. An Economic Analysis a. overview of Efficiency Implications of Behavior and Perceptions of Market 142 143 Participants . . 146 b. Lower cost of Reducing or Avoiding Loss. 150 c. Losa Spreading 162 d. Costs of Predicting and Imposing Loss Allocation Observations 2. Analogues and Comparisons under currant Law 165 169 and Doctrine 170 a. Negotiability and Bona Fida Purchase 170 b. Entrustment and the Like: Putting Goods and Securities In Play 178 c. Money and Bank Account 180 d. Observations . . 183 B. The First Corollary: Broad Intermediary DOC. SWP1101 July 17, 1989
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iv Warranties 185 c. Th Second Corollary: Seniority of Upper Tier Transfer Notwithstanding Notice or Knowledge of Lower Tier Adverse Claills. 194 CONCIDSION 200 ~:' ': .... _. ... ,. APPENDIX I u.c.c. Section 8-313 APPENDIX II . ., .. ll.-.C.l'.R .. -1~306 .118 -Tranafer-.or pledCJ . ... '! -._. ....... .-. ': ~:. :.-' .. -: ~-...... :.. : . "" .... APPENDIX III Drafting History of u.c.c. Section 8-313 DOC. SWPllOl July :&.7, 1989
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PRELIMINARY DRAFT --NOT FOR CITATION. ArJ'BIBQTION OR QUOTATION anon DGOTIUIL%ff I A -JIODBL ~-'l'DIIIDR UD PLBDGZ 01' Di'tBU8T8 DI 8BCUJlITIB8 COftm'LLJm B'r Dl'nltllBDIUIBI CJaarl 11oone7, Jr. Th obscure we see eventually, the apparent takes a little longer. Dl'nODUC'!IOB This article explores the transfer and pledge of interests in securities under Articles 8 and 9 of the Uniform Commercial Coda EO.c.c.)1 and the Federal ragulations applicable ... ,,... :. :....... . ~ ~:-. : ":t .. .,.:-..... -.-~-_ ::,.-~_._:. ~:-., --. B.A. 1969, University of Oklah0111a1 J.D. 1972, Harvard University. Associate Profeaaor of Law, University of Pennsylvania Law School. I would like to thank and the participants at a faculty workshop at the University of Pennsylvania Law School for their helpful comments on earlier drafts of this article. I also wish to thank the University of Pennsylvania Public Policy Initiatives Fund for generous research support, Chris Nakamura, J.D. 1989, University of Pennsylvania Law School, and Stephanie Abrutyn, University of Pennsylvania Law School, Class of 1991, for valuable research assistance. ** Edward R. Murrow, [cite]. 1. ALI, NAT' L CONF. OF COMM I RS ON UNIFORM STATE LAWS, UNIFORM COMMERCIAL CODE: 1987 OFFICIAL TEX'l' WITH COMMEN'l'S (10th ad. West 1987). Th Uniform Commercial Code hereinafter sometimes will be referred to as the Code or the o.c.c.: all citations to the Coda are to the 1987 Official Text with Comments unless otherwise noted, and all citations to the Coda are by section numbers only. DOC. SWPllOl July 17, 1989
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2 to book-entry United st~t Treasury securitiea.2 on the aurface, the iaau addrd are familiar on for acholar of c011111ercial and property law: Bow doe one bec011 a purchaar of a property interut in personal property? Bow can a purchaaer be aaaured that it property intrt i and will raain fr of conflicting claima? When do a good faith purchaaer cut off prior c:onfli~_::clilla ,,net thereby acquire a greater interest than its tranafaror had? un1ik~ earlier co-ntary, however, thi article provide a holistic consideration of the characteritica o~ pr~perty rights that are transferred in modern curitiea markets. The resulting viaion of the property i,.~.? .. t'that'purchaaera 'ofae'c:uriti typically receive under ,..', .... .: :.-,,. ..... ~"':\:.~. ' ... __ . current law ahowa the way for reforms to the legal regime that are proposed here. Th persistent tendency of securities market participants to uchew direct relationship with c:uriti isur and to rely on financial intermediaries, such aa stockbrokers and banks, is a dominant characteristic of the securities market's structure and operation. The principal focus here, therefore, is on transfers and pledges of interests in fungible bulks of securities that are controlled by such financial intermediaries. Under current law, the property 2. in 31 C.F.R. 11 306.115 306.122: 350.2 350.6 (1988). DOC. SWP1101 July 17, 1989
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3 interaat raceivad by a tranfr who clailla through th books of a curiti intermadiary bear little reamablanc to the interest obtained by a tranafaraa who racaiv a pbyaical delivery of a certificated aac:urity or bacoaa a registered owner of a curity on th books of tba iaauar. Th interest of an ownership claillant through an intermediary is bast characterized as a bundle of contractual and legal right against th intnadiary. Tb right antitl th clai.Jlant to tba indirect benefit of ownarsbip if tba intenaadiary remains financially viable. It the intarmediary fails, the claimant bas a priority claim, sbarad ratably with other siJDilarly situated claimants and -ured. by a; twlg-ill .lnllk acariti .. tbat -y or aay not be autf iciant to satisfy tboaa claims. J Claimants who are secured creditors of a failed intermediary may fare batter or worse, dapanding on tbe cirCUJUtancaa. Thi broadar vision of the intarat of a clailllant to securities controlld by an intanaediary suggests that under 3. Under th Securities Investor Protection Act (SIPA), non-financial institution customers of insolvent securities brokar-daalars ganarally are protected against lo up to $500,000, in th ca of aacuriti clailla, and $100,000, in the case of cash clailla, by th sacuriti Invaator Protection Corporation (SIPC). s11 q1n1rally Securiti Investor Protection Act of 1970, 15 o.s.c. II 78aaa 78lll (1982) [hereinafter SIPAJ; infra not and accompanying text. This articl ganerally addrs tba right and claiu of market participants who are not eligibl for, or wboaa claiu exceed, such protection, rather than amallar, possibly unsophisticated investors. DOC. SWP1101 July 17, 1989
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4 currant law auch a claimant ia a spacial kind of creditor of the intermediary. Viewing the claiaant aa th owner of diacrete property that ia in the poaauaion or control of a bailee-agent o1fen a poor, diatorted analOCJU' Yet in certain iaportant raapecta th uiating legal ragilla--principally o.c.c. Article a -invite and dauanda analyau baaed on that diatorted perception in deali119 vitbtrana'fer, s,ltidga, and 'prioritlea uong c0111pating claiaanta to intereata in aacuriti In particular, the property law conatruct of current law fail to come to grips with the role and aubatanca of diatributional rules applicable in inaolvency proceeding of intemadiariea. And it fails to ' ... . ". . ,. ... -~ ' .. -. . . .. ., ... coritapl1it tlie"crucial. fac:t tbat actual enforc-ant of property o o I '_, ' , o rights againat intarmediariaa 1111ntia11y does not occur outside of insglyency proceedings. Th diatorted conceptualization can lead to arbitrary and fortuitoua raaulta and baa reaultad in 4. For example, it baa long been recognized that commercial and financial transactions could not be made dependent on the physical exchange of currency or the like. Ultimately, moat money consists of unsecured clai(bank deposits) against financial institutions (banka). Most c01111arcial payments of money end with the creation of auch an unaecured claim rather than an exchange of currency. However, the wideapraad appreciation that curiti marketa could not function if they ware dependant upon either exchange of paper curitiea by the active participant or the uteliabJlant of direct relationahips between beneficial owner and aacuritiaa iaauera i a relatively recant phenomenon. It ia undarstandele, then, that the viaion of aecuritias tranafers praaentad her may be diacomforting to the uninitiated. see qanarally infra not 371-79 and accompanying text (discussing and comparing claims to securities controlled by intermediaries to bank dapoaita). DOC. SWPllOl July 17, 1989
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5 aiaconceptiona on th part of legal acholara, practitioner, and courta. Eratvbil and current law refom projecta have failed to abrac:e thia broader conceptualization of tranafera of aec:uriti controlled by intel'llediari Tb reviaiona to Article 8 that ruulted in th 1978 Official Text of th o.c.c. priaarily -rved to provide a atatutory. fr-evork tor the tranafer and pledge of uncertificated aecuriti' Although the effort vaa vortbvbile, in the larger context of aecurities market operation the potential for a certificateless society is merely a detail.' Market participant now recognize not only that ----------_, ..... . '1 : I ... I ,;_ I 5. U. c. c. app. 1, Reporter' Introductory Comment, at 812 [hereinafter Reporter' C01111ent] (What th revision is in~ended to accoapliah i to set forth a coherent group of rules for the issuers, buyers, llers and other persons dealing with uncertificated securitiea, to the same extent that preaant Article 8 d-1 with thua 11Btters with rupact to certificated securi ti.) For d .. criptiona of tba background and developaent of the 1977 aaendllenta to the u.c.c., which resulted in the 1978 Official Text, ... Aronatein, Haydock, Scott, Article 8 Ia Ready, 93 earv. L. Rev. 889, 890-93 (1980); Coogan, Security Interest in Investllant Securiti Under Revised Article 8 of tb Uniform Commercial Code, 92 Harv. L. Rev. 1013, 1017-22 (1979). Because the 1987 Official Text of tbe o.c.c., which added Article 2A, aade no change to Article 8, tbe veraion of Article 8 in both tb 1978 and 1987 Official Texts hereinafter will be rfrrd to aa tba 1978 Article 8. Tb identical varsiona of Article 8 in the 1962, 1966 and 1972 Official texts hereinafter will be referred to as the pre-1978 Article a. A version of tbe 1978 Article bas been enacted by [38] states as of [June], 1989. [State Correlation Tablea; State correlation current Materials] o.c.c. Rep. serv. cca11aghan). ,. Even before the 1978 Article 8 waa promulgated the paperwork crunch that inspired the revision of Article 8 was subatantially reaolved by tbe development and wideapread use of a central depository sytand enhanced method of clearing and DOC. SWP1101 July 17, 1989
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6 deliver! of paper reflecting each urket transaction are intolerable but also that transactions ut occur without changes on tbe boou of curiti iasuers. 7 Tb role of intermediaries i central to -rket atructure and operation. Yet the 1978 Article I offered no new conceptual fraaevork to take account of tbe broader vision ot vbat it -an to beccme a tranater ~QUCJ~ .tba booka of an:intazaediary~ Tb propoaed regulation that would cover transfer and pledge of book-entry Treasury .. . .-: .... r,,1. Ht:~inq aecaritiu trad-. In CONNIU 011 STOCK C!!R1'IFICATES, SECTION OF CORPORATION, BAlflaNG, BOSINESS LAW, AMERICAN BAR ASSOCIATION, REPORT OF THE COMMI'rl'EE ON STOCK CERTIFICATES at 3743 (1975) [hereinafter cited as A.BA REPORT]; Aronstein, Haydock & Scott, supra note 5, at 890-91; Aronstein, A Certificatalass Article 8? We can Have it Both Ways, 31 Bua. Law. 727, 728-30,732-35 (1976) [hereinafter Both Waya]. Th legendary paperwork c:zuncb in the sec::uriti -ruts durinq the late 1960' vaa the prillary impetus for the A.BA project that eventually reaulted in prmmlga~ion of the 1978 Article 8. Ima, 1,q,, Aronstein, Both Way, aupra, at 727. A considerable volume of c01111lentary was addressed to prospects for a certificateless society during the 1970' In, L.Sl&., Aronstein, Both Ways, supra; Aronstein, Tbe Decline and Fall of the Stock Certificate in America, 1 Comp. L., Sec. Reg. 273 (1978); Guttman, Toward the Oncertificated Security: A Congressional Lead tor States to Follow, 37 Wash., Le L. Rev. 717 (1980); MUlhern, First Steps Toward a Certificatel Society Under Existing Law: one Practitioner' Experience, 26 Bua. Law. 617 (1971); Smith, A Piece of Paper Revisited, 26 Bua. Law. 1769 (1971); Steadman, The Lender in the Certificatele Society, 26 Bua. Law. 623 (1971); Werner, Th Certificatl Society: Why and When?, 26 Bus. Law. 605 (1971). 7. s11 infra text at not 15-42 (discussing clearing and ttl-ent of securities trades). DOC. SWP1101 July 17, 1989
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7 Securiti are equally probleJ1atic;1 they would opt tor a baaelin rule of laat-in-tiae-first-in-right.' Part I of thi article introducu a011e illportant tranaactional patterna in the Ncuriti urketa, including clearing and Nttlmaent and th tunctiona of eecuriti interaediari It qenerally addr the risk.a inherent in a .. rket structure dependent on c~ntrol of securiti by intermediari and th various approach that th leqal regime baa taken to reduce or -naqe those risk.a. Part II introduce the basic statutory framework !or tranater and pledge of interests in securities. It explains and ~t~tae,.hav,_.=:rr~: l&1t daal vitb c:on~lictinlJ property clai. ot cuatoaen ancl crediton of a COD..,n intenaediary (which I call same tiar claims). Part III considers th treatment of claims to intrts in curiti when an intermediary become subject a. on llarcb 14, 1,1,, the Departaent of 'l'reaaury publiahed proposed new rule, called the Treasury/Reserve Automated Debt Entry System (TRADES), to deal with transfers and pledq of Treasury Securities within the co-rcial book-entry Yt-. 51 Fed. Req. 8846 (1986) (to be codified at 31 C.F.R. pt. 357) (proposed March 14, 1986) [hereinafter March Proposed TRADES Requlations]. After consideration of numerous co-ants, a subatantially revised version of proposed TRADES Raqulations was published on Novamber 28, 1986. 51 Ped. Req. 43,027 (1986) (to be codified at 31 C.P.R. pt. 357) (propoaed Novamber 25, 1986) [hereinafter Proposed TRADES Requlationa]. S sorally intra text at not 163-80. 9. Th propoaed TRADES Raqulationa provide that a good faith transferee will take tr ot prior advar claims. propoaed TRADES Regulations I 357.14. s11 infra notes 168-76 and acc0111panying text. DOC. SWP1101 July 17, 1989
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8 to inaolvency proceedinqa and, in particular, the important utter of ditributional rulaa. S01N u;nificant thaortical and practical prol:,l-are identified and ,.:artain cbanqu in law ar 8Ufteated. Part IV axploru coapetinq claiaa to aecuritiaa, that -y be included in tbe -funqibl bulk, by tranafarae vbo claia through different intaraadiari (which I call itf1r1nt tiar. c:laiaa) . ,:_ .. Part V, tben, propoe a new aodal for rolving different tier clailla. Entially, the nw model would provid that claimant againat a curiti intermediary could look only to tbat intanaediary tor utiafaction Cubjact, of course, to .. ~,, "\ . . . . . . . . .. 'abaring ra1u applicable aaUIOIIIJ .... t1arc1aiaanta). Ill : .. ... Claiaanta generally would have no nior claima to curiti or o~er righta aa againat uptream intermadiari or tranfrees fr011 auch intarmadiari" Th aarita of the new modal are aupported by an econoaic analyi and by various analoqoua priority rulu under the u.c.c. In addition to tbe detail of change in law that tbe new modal would create, it epitomizes the richer viion of (indeed, a nav way of tbinking u,out) what it meana to bacmae a transfer through an intermediary. Legal cholar of commercial and property law have paid relatively cant attention to tbe important aubjact of tranfr 10. ror a more detailed explanation of different tier priority conflict, see infra Part IV. DOC. SWP1101 July 17, 1989
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9 and pledq of c:uriti in th contxt of aodm c:uriti aarket activity. Siailarly, legal acholar vbo have foc:uaed tbir attantiona on tb aec:uriti urketa bav rarely dlvad into tb conc:aptual and tbaoretical undrpinninq of tranafr and pledcJ" Tlli articl i an initial effort to bridg tb c:haa. Noraovr, tba iau-addruaad in tbia paper &re not rely of acadaaic and tbeoratic:al intarut. Tbay ar nov tbe aubject of rioua atudy and conaidration by lavaaun.12 Perhapa thi article alao will provide guidanc to tho vbo are 11. ona axcaption i lgon Guttman. In 1. GU'1"1'MAN, mma nanaTaa naw. f3d .... 11n, c11are1natter GU'l'TIWfJ. Bat c:attaan treatiae, u vith any broad traa~t tbat i intandad to canva-the atata of th lav, could not alway acccmaodate axtanaiv theoretical exploration aor c011patible vitb articlu in ac:holarly journals. 12. Th propoaed TRADIS Ragulationa undr considration by tb Dapartaant of -rr .. aury bave bean aentionad. s11 aupra note 1. In addition, at tba requeat of David Jtuder, Cbainan of the Sec:uriti-and lxc:banCJ CO--iion (SBC), a apec:ial Adviaory CcmaittN (on vllic:h I NrYe) of tb AMrican Bar Aaaociation (A.I.A.) Sction of au.in tav currently ia atudyinq tb iaauu, uonq otbn. Chairman Ruder atated: Aa you -y know, aaveral rporta on tb ~kt brak concluded tbat uncertainty concminq pladg parfction Mc:hani-and diaparat banlcruptcy tr .. taant of futur and curitiu poaitiona impairad bronr-dalr and claring -be~ poaition financing durincJ th octobar 1987 urket break. I baliav tbat tb [A.I.A. au.in- Lav) Section is in a uniqu poaition to davelop reccmaandationa tor incr .. aing unifor11ity and lagal crtainty in tbia coaplicatad ar .. vllich i ao illportant to our nationa' payment ayat-. Lettr trma David Ruder to David Nelaon, Chairman, A.I.A. Section of Buain Lav (Oc:tolw~ 25, 1988). DOC. SWPllOl July 17, 1989
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10 poitioned to cbanq the law. %. ncvarna C:UlffaOLLSD 8T Dl'IBIDDIUIUI lft!#IDDIUT 110Ll:8 aam uau a. ne Pol of IJl~ari la aecsari~i 11arkau Tile aoat taailiar role ot a aec:uriti intenaediary i tbat of the brolcar vbo, throuqb a-ton an exchanq or a a ~icipant ,ln.an. ewer thac:ountar (OTC), -rket,buya and aec:u.riti on behalf ot ita clienta a well tor ita own account. In order to participate in the c:uriti -rkt inveators auat hire aucb market profional to execute trades. Yet a peniatent feature of curitiu -rketa i th propensity tor inveatora allow Ult*raadiarl, ncb HCUriti tirma 0 I O o .. I and banka, to -intain continued control over ecuriti that are beneficially owned by the invuton even after the curities are bouqht and paid for. Th convenience and enhanced liquidity tor active tradera vbo uintain accaunta vitb an inter.ediary wbo control tbe aec:uriti in atraet naae,11 for exuaple, are obvioua.14 But thi intermediary control phenomenon reflects 13. street naae generally raters to the practice ot aec:uriti interaediari vbo bold fungible bullca of curiti in their own na, or that of their noain-, even though th aecuriti .. y be beneficially owned by their cuatamers. In GD'l"l'IIAN, IJ1RA note 11, at 2-3 to 2-4, n. 1; N. STic:tJM, AFTER TD TRADE 154-55 (1988) (hereinafter, S'l'IQUN, TRADI]. 14. lec:auae the interllediary or i ta noain i the raqiatered owner in poion or control of the aecuritiea, the cuatoaer can aak tb interMdiary to aell tbe aec:urity without th need to deliver a certificate to intemediary, together wi~b a aiqnatur quaranty and otberwiin fem tor good delivery." DOC. IWP1101 July 17, 1989
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11 aor than r convenience for active inveatora1 it i an ntial -nt of tbeir participation in th market. conaideration of clearing and ttl-nt of curiti trades provide an example of vby thi i ao. 1. Cleariag ud ttlat Clearing and ttl-ent compri the operational proc .v~areby curitip tJ;:"a~(grnt to. ll and buy). . . . .. . .. : .. . ., . . . . . . . are conammatad by a dliver.y15 of tb curiti and payment of the agreed prica.16 Nore preciaaly, it is the proc whereby th actual parties to trades made on exchanges and in aver the counter (OTC) marketa deliver and pay to each othar.17 There two . . .-: .. . \. .. : ~~<.. ~ :,. .. :' ~,:::,"'"!.." --~.. . ..: -~:--_::~ ..... .,.,._.,_., --:. ....... I , '., ; . ,.' ..... , ,;-.":-,. ;, .... an AM REPORT, gpra note,, at 21-301 1111110 GU'l'TNAN, aupra note 11, at 8-31 to 8-34 (dia.:uaaing market practice concerning good delivery.). Th convenience alao i important to many l active invaaton, including individual. 15. In curiti induatry parlance (atrt-apeak"), delivery raters to tb ccmpletion of a tranatarora obligation with respect to delivery of aacuritiu, but dou not ncarily aean an actual pbyaical delivery. Por UU1Pl, in atreat-apaak tranfr of book-entry (uncertificated) aacuriti, transfers on the books of curiti depoaitori, and credit to accounts of curiti intermediary cuatomera are referred to a dalivari 1,. an STiatJN, TRADE, aupra not 13, at 121-22. 17. Broken usually act agenta for undiacloaed principal and thereby become obligated on trade to buy or , the ca may be. ID GtJT'l'NAH, aupra not 11, at 8-17, n.67 (citing RES'l'Ai'i!lUM' (SECOND) or AGENCY I 321 (1958). 'l'hua, clearing and ttlaent on the wholaaal level deal with delivery and payment aa among tba curiti intermadiari Moat larv, active inveaton have tb privilege of "delivery veraua payaant--tbat ia, they are not obliged to pay the interaediary vbo i to control the ~-uriti for thuntil the curiti have been delivered to tbe intermediary. DOC. SWPllOl July 17, 1989
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12 principal aystema of clearing and sattl-ent in the United States curitie J1&rkets today. One is a national clearing system that involvu The Depoitory Trust Company (D'l'C),11 a securities depoitory, and the National Securities Clearing Corporation (HSCC).19 The other yst-deal with book-entry United States government and agency curities. _;_ .. -..:-:-:,;,._ .. ,: :,'.;i:~.'.;:'.~---~-,&CC.-;~--1:aa: .::', :,:a. :r.-~'.., .... : 18. DTC, a Hew York limited purpose trust company, is the world's largest securities depository. THE DEPOSITORY TRUST COMPANY, 1988 ANNUAL REPORT 27, 29 (1989) [hereinafter OTC 1988 REPORT]. It was formed in 1973, as a successor to the business of the Kew York Stock Exchange' Central Certificate Service, which wa created_ to tbe :~perwor~ ... cruri~ o; the. late Ho-a. 14; ,_t 2f.: At yea~'i988, ~DTc u'intained ilecurities account. for ,osparticipanta '(413-"'broker~ealers/ 183 banks, and 9 clearing agencies). l5i., at 21. only its participants are el~gible to become shareholders of DTC, and shares are reallocated annually pursuant to a formula based of use of OTC during the prior year. Isl., at 29. "Indirect participants," securitie intermediari that are correspondents of (i.e., cuat011era of) D'l'C participants, totalled 110re than 3,000 during 1988. Jd., at 21. 19. HSCC wa formed in 1977 to provide post-trade clearance and settlement service tor trades on the Hew York Stock Exchange (NYSE) and the American Stock Exchange (AMEX) and National Association of Securities Dealers (HASD) OTC trades; HSCC is owned jointly by the NYSE, AMEX, and NASO. STIGtJM, TRADE, supra note 13, at 249. During 1988 there were more than 1800 direct and indirect participants in the HSCC clearing sytem. NATIONAL SECURITIES CLEARING CORPORATION, 1988 ANNUAL REPORT 5 (1989) [hereinafter HSCC 1988 REPORT]. 20. Unle otherwie noted, the following discussion of the proc of clearing and ttlaent in the DTC-NSCC system and for book-entry Treasury securitie is based on STIGtJM, TRADE, IYPA note 13, at 77-145, 245-57; R. TEWELES 'E. BRADLEY, THE STOCK MARICET 174-79 (1987). While the discussion is adequate for preent, entially contextual, purposes, it is quite general and overimplified in many repects and much detail is omitted. DOC. SWP1101 July 17, 1989
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13 Most of the (non government) securities trades made on the major United States securities exchanges and OTC markets are cleared and aettled, directly or indirectly, in the D'l'C-NSCC Yt-.11 A fundamental characteristic of the Yt-is that on each ttlement date all of the aecurities to be delivered will be controlled by D'l'C. Prior to the settlement date the trades _,8'1C?,~.CJ .. ~ll. o~ .-~e. P.~~;~~J)a.~t. ~rt! n~~t,~ ~i ~e~pect to each . ... . . . . . . . securities issue, with each D'l'C participant becoming obligated to transfer or entitled to receive only a net quantity of securities that takes into account all of that member's trades in that security issue.22 On_ the day before the settlement date, NSCC l ... .. ,; ,,. .... . .. . . .. :: :.:. .. .... :~. ;.: .. .... '_::. . .'-.~-:.-: .. :. ;. . ....... . ,,. ... . -~--. !:,,-. . ......... ., ,._ .... . 2.1 ... :-: In, 1987. .. IISCC ~larad-a .. daily -average of about 600, ooo trades and in 1988 about soo,ooo trades, including equities, municipal bonds, and mutual fund transactions. NSCC 1988 REPORT, supra note 19, at 1. About 901 of all equities trades in the NYSE, AMEX, and NASO markets are cleared and settled through Nscc. STIGtJM, TRADE, supra note 13, at 249. During 1988 67.2 million OTC book-entry transfers of securities with a total value of $7.9 trillion ware made. D'1'C 1988 REPORT, supra note 19, at 21. At year-and 1988 there were deposited with D'l'C securities valued at $3.28 trillion, consisting of 106.6 billion equity shares, corporate debt (principal amount) of $$844.8 billion, and municipal debt (principal amount) or $623.8 billion. lg. The following description is subject to two important exceptions. Institutional trades generally are settled in D'l'C's Institutional Delivery System. see infra notes 26-28 and accompanying text. Also, certain issues of securities for which payments settlement normally is made in same-day, rather than next-day, funds can be settled in D'l'C's Same Day Funds Settlement system. an D'l'C 1988 REPORT, supra, at 16-17. 22. This is the concept of multilateral netting." bA STIGtJM, TRADE, supra note 13, at 246-47. Prior to netting, the important process of "comparison takes place. Buyers' and sellers' trade confirmations are compared in order to detect and modify or eliminate transactions where a buyer's and seller's DOC. SWP1101 July 17, 1989
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14 becomes obligated to transfer and entitled to receive these netted amounts to or from each member. on the payments side, all amounts to be paid and received by each aUlber are also netted, with each aUlber becOlli.ng obligated to pay or ~titled to receive only a aingle aum on account of all trades for all issues to be settled on that date.25 NSCC also becomes obligated to pay and _.,ti t:led.-, 1:~ ... rci ve, payaent :to -~r:-:r~-ea~: . member., 'In ; sum," on . . . .. : . . . . . . each settlement date, each member.pays to or receives one sum of money fr011 NSCC and each member transfers to or receives from NSCC, by book entry on the books of OTC, a single quantity of each security issue involved.8 . .. .. ... .., .,, "'' .. '.:: .: .: .. . .. -:. ..., :, .. . . "': .. ,,,-:-' . :. .. ... .. 1:ecorda :do not agne~ ,;Thia';proceas'. ls "tilcjhly 'automated . 23. This is the concept of "multi-issue" netting. an STIGtJM, TRADE, supra note 13, at 247. 24. Because NSCC comes between all parties to trades for purposes of netted securities delivery and net~ed payment obligations, in effect there is a novation of all trade obligations. 25. This method of settlement involves obvious credit risks for the participants since NSCC's ability to deliver securities and make payments depends on its receipt of securities and payments from participants. Netting, however; reduces the aggregate amount of each participant's obligations. In the case of a payment default arising from a participant insolvency, OTC maintains a fund of participant deposits designed to ensure that settlement will take place even in the face of such a default. in STIGtJM, TRADE, supra note 13, at 253. In the event the fund were to be insufficient, participants share the risk as they are subject to additional pro rata assessments to make up any shortfall. 1d. : Rule 4, RULES OP THE DEPOSITORY TRUST COMPANY (198 ). In theory, however, the potential for "systemic risk" exists were a large default to result in dafaults by other participants. 1ml, e.g., BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, CONTROLLING RISK IN THE PAYMEN'l'S SYSTEM, Report DOC. SWPll0l July 17, 1989
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15 Trades invol v~.ng large institutional investors are now handled in a separate OTC syst(not involving NSCC), the Inatitutional Delivery (or ID) Systea. In the ID system, the invutora are directly involved in the automated c0J1111Unications process tor clearing and comparing trades. They receive and make .PX: ox, tasx totee 00-cantrolling-eavments system Risk to the .... Payments system Po11cy tQinmlttee at the r,4era1 Reserve system 9 ([August] 1988) [hereinafter Payments Task Force Report]: This risk that the inability or refusal of one participant to meet its settl-ent obligations will prevent other depository institutions from meeting their remaining obligations represents systemic risk in the payments system. Systemic risk in the financial system as a whole encompasses tll posaibi1ity t:th failure of one institution to meet -.. :.~.,.:any of ita:Yarioua.:cmli1Ja1:1-a :vill---eontribute to the .., ailli1ar.-.failure. of. its .creditor inatitutiona, to honor their . obligations. .. Recently, as a result of a single investor's failure to make settlement payments, the Brazilian Stock Market was temporarily closed and "brokers, banks and stock market officials spent hours in meetings, desperately trying to avoid the brokerage firms' financial collapse and a dmaino effect in the financial -rket as a whole. PD Man' Qabt woes sin Down Brazil's Markt. Wall St. J., June 13, 1989, at Cl, col. 3. In the case of routine failures to deliver securities, under the OTC-NSCC "continuous net settlement system" delivery obligations are continually deferred to the next settlement date (by netting with deliveries to be made on that settl-ent date) and marked to market" so as to adjust for price changes. an GtJ'l"l'MAN, supra note 11, at 8-19; STIGtJM, TRADE, supra note 13, at 252. 26. see generally 1988 OTC REPORT, supra note 18, at 18-20; STIGtJM, TRADE, supra note 13, at 254-55. Recent rules changes of the NYSE, AMEX, and NASD now require inatitutional investors to settle trades through an institutional delivery system (such as the ID System) through a registered securities depository (such as DTC). an AMEX Rule 423 (Rev. 1982): NASD Unit. Prac. Code, I 64 (Rev. 1988): NYSE Rule 387 (Rev. 1988). DOC. SWP1101 July 17, 1989
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16 deliveries through their custodian banks by book entries to or against the banks' securities accounts with OTC. It is aignificant that th aoat of these institutional investors tend to leave their curiti with D'l'C, although they could request their DTC Ulber-intenaediary to withdraw and hold them or request that certificates be issued in the investors' own ,nn.~;.'~: :.::~ .;_ *t_:--t~--~~-:~_-'-io~:. ~:t.or::rket: .pu:t:"1.cipanta. t;o .. . . 'liav~ nQ rel~tlonship. to the !~suer: of --~e=it.ies oi which they c1.aim to be the beneficial owner. 21 D'l'C participants expect 27. la STIGtJM, TRADE, supra note 13, at 255 ("When a cwatody bank take delivery of aecurities for a [sic] ~t~tu~ional c:ust~r, __ ~~-~o-~1-.p~ed~ ~d the on~ ~c -p~~en -"ia that --the custody *riJt. ;-l'eave tho ~itia in me s vault.-) ;/--Rot an1y=_wot1l:d routine wi'thdrawa1=,'0-t 'certif'icates result in additional costs, but it would make no sense for many active traders. Because the securities ultimately must be in DTC's control for purposes of clearing and settlement, continual withdrawals would result in an intolerable loss of liquidity. Even if these institutional investors were to obtain accounts with D'l'C as direct participants in the DTC-NSCC clearing and aettlaent procaa, it i likely that aoat wouid continue to prefer to use a custodian. [Interviews]. 28. In DTC 1988 REPORT, supra note 18, at 18-19: While bank Participants continued to deposit private pension fund assets into their D'l'C accounts in 1988, most had previously been placed in the depository 49 states and the District of Columbia now have all or a part of their pension fund assets in eligible securities on deposit at OTC through custodian banks currently several hundred insurance companies are known to have their securities on deposit at DTC through custodian banks Virtually 1001 of investment company D'l'C-eligible assets are on deposit. In addition, as aore securities become me-eligible, custodian banks can deposit eligible DOC. SWP1101 July 17, 1989
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17 D'l'C's nO?Ainee to becomA the registered owner of securities, and non-p, ,rticipant investors, in turn, look to the OTC members or other downstream intermediaries. It is apparent that the role of th depository system in clearing and settling securitiu transfers bas achieved much more than -rely reducing the aov81lent of securities certificates among the market p~,icipant .. El.iminating or reducing reliance -. ..... :_ : .. -. :.,. : -i_"= .. : ; .:.:-: .. _;:--~. ; .' . :-. :.: ~: .. .,. :. ~. ... on securities certificates and moving toward a world of uncertificated securities would be useful and could further increase efficiency by reducing transaction costs.29 But an ',! :.' .............. ..;.. .: .... :..-.-~ ... - ,"t,.".': . .. ..... ,. .;.,-.,:~ .. : ........ :. :_: ... "" =~-' -.-~rtior.ia =. :~t. ~t~J.. _"r __ ._debt: -~rtf oli~~ . Securities deposited with OTC normally are registered in the name of its nominee, Cede & Co. DTC collects and distributes to its participants amounts paid by issuers as dividends, principal and interest. OTC also provides information on participant beneficial ownership to issuers who can then cOD1111UDicate directly with the participant. concerning .. tters such voting rights. Th participants, in turn, COIIIIUDicate with their own customers. ,ld., at 8, 13. 29. The principal savings from eliminating certificates would sea to relate to D'l'C's costs of physical storage and retrieval. Although OTC also incurs substantial costs in connection with deposits of certificates and withdrawals of certificates for participants' customers, similar operations would be necessary with uncertificated securities in order to confer registered status on beneficial owners. see infra note 81 (registratJ.on of transfer of uncertificated securities under 1978 Article 8). Indeed, the successful development by D'l'C of the book entry only (BEO) system for securitie issuance and transfer bas resulted in even greater savings for securities issuers. BEO securities involve only one global" certificate par issue to be held by D'l'C, and BEO global certificates are not available to investors. ld-, at 17. About one-third of all JllUJlicipal debt issued during 1988 involved BEO securities. l,d. DOC. SWP1101 July 17, 1989
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18 uncertificated security world probably would have no fundamental impact on the most important characteristics of securities market operations. In an uncertificated world D'l'C' nominee would continu to bathe regiatered owner of the securities (although freed fraa the burden of aaintaining physical control of certificates), and the propansity of 11arket players to claim ~gij_ i~na.4iui .. _;VQi'tl"d:'ftot\be-j1bat.s~:-_ :<--.::-_'. :._.,:. ---.-:_. .. ..... ~-aove,-,,-ent aeouritiea--Fe4wire u4 tb clearing Bank" ayst-A glimpse at the world of United States Treasury securities, which are virtually all uncertificated (book-. . . entry) __ ~~. :ffidanc~-~-. -~-~ p~ity" -~C?i--1n~enaedla_ry .. ... : ' " . . . .. ... '": ;, . ............ ".",. . . . .... . . 30. Interview with Richard Nessen, General Counsel, The Depository Trust Company, in New York City (July 6, 1988). 31. A.a of December 31, 1985, 971 of the outstanding .. principal uaount of marketable United Stat-Treasury aecurities vera in book-entry fora. 1M Regulation Gqyarninq Bgpk-Entry Treasury BQnd, IQt, and 11111, S1D1Mry of Departaent of Treasury, 51 Ped. Reg. 8846 (1986) (proposed) [hereinafter March Trades Summary]. Since 1978 Treasury bills have been issued only in book-entry form, and since [June,] 1986 all Treasury securities have been issued only in book-entry form. 1,si.: [other cite]. Securities issued by various Federal agencies with full or partial guaranties by the United States government also are issued in book-entry form. bA intra note 111 (citing relevant regulations applicable to such agency securities). The following discussion generally applies to such agency book-entry securities as well as to book-entry Treasury securities. One important type of Federal agency aecurity, mortgage-backed pass-through" securities guaranteed by the Government National Mortgage Association (usually called GiMie Maes"), is not issued in book-entry form, and clearing and settlement for Ginnie Maes continues to involve physical deliveries and registration and reissuance in the name of beneficial owners. See generally STIGOM, TRADE, supra note 13, at 151-68, 263-78. A new system DOC. SWP1101 July 17, 1989
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19 control.32 Book-entry Treasury securities are subject to a tiered system of ownership and transfer estal:>lished by Treasury _-;. ." .. :, ... ~. .. . .. .. : ': ..... <. -~:. ~-.: ... .. ~-'"":= t 11!.,;,-...... : :_::._,,~_.: ... ,: ... ,. =. '!'.. ,::.', .... .-, .. --:_., ... ~..... -~-........ _! ... ........ -~ .... .. ... r :~.. :.. ,._, . ... . .. .. . :. '. . .... : ..:. '/' .. ,; .. . .. ; ..... : for Ginnie Mae clearing and settlement is on the horizon. The Fed has approved the application of Participants Trust Company (Pl'C), [a Hew York lillited purpoae truat cmapaliy], for membership in the Federal Reserve Systa and the SEC has approved P'l'C's proposed rules. [cit to Fed and SEC orders]. Under the proposed rules, clearing and settl-ent on the books of P'l'C would be illilar to the DTC-NSCC system in many respects. bA generally Rules of Participants Trust C01Dpany ( __ 1989) (copy on file with ). 32. For a d-cription of the market for United States Treasury securities, see GENERAL ACCOtJHTING OFFICE, o.s. TREASURY SEctJRITIES, '1'BE MARKET'S S~OC'l'DRE, RISKS, AND REGULATION ([August,] 1986) [hereinafter GAO REPORT]. see also ASSOCIATION OF RESERVE CITY BANKERS, REIORT OF THE WORKING GROUP OF THE ASSOCIATION OF RESERVE CITr'BAHDRS ON BOOK-ENTRY DAYLIGHT OVERDRAFTS ([June,] 1986) [hereinafter RESERVE CITY BANKERS REPORT]. The United States government securities market is unqueational:>ly the largest and most illportant securities market in the world. [current data re: daily average trades compared with DTC-NSCC settlements and or NYSE daily volW1e]. DOC. SWP1101 July 17, 1989
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20 Department regulations. Significantly, only a "depository institution (DI) can attain a status equivalent to that of a registered owner on the books of a Federal Reserve Bank.34 Thus, an active invutor in book-entry Treasury curities that is not itself a DI can gnly obtain an interest in securities through an account with an intermediary (either a DI or another downstream 33. in 31 C.F.R. 306.115 -306.122; 350.2 -350.6 (1988). The.Department of Treasury baa described the aystas follova: ., .. ;.,.-~ ~:t.ic:~ .;;~ :.~ =: :: -~:::.~-:. .,,. .,;,..:,.. .. -~ '.~-:-~.1 .. -. bme -that an lndivtdual"'---(Imividual Investor) has invutad in a Treasury 5-year note through a local government securities dealer ("Local Dealer"). Local Dealer will be maintaining one or more Treasury 5-year notes of the same issue through another book-entry custodian such as a larger government securities dealer ("National Dealer"). National Dealer would, most likely, be maintaining the 5-year notu through a bank ("Clearing Bank*). Clearing Bank would be -intaining the 5-year not directly in an account a1". a Federal Raerve Bank. Bach of the book entry custodians will record on its books securities maintained for the account of the book-entry custodian below it in the chain, and local dealer will record on its books the interest o~ Individual Investor. March TRADES swmu.ry, supra note 31, at 8846. 34. Treasury regulations applicable to book-entry Treasury securities, as written, contemplate that only a member bank" (defined as a member of a Federal Reserve Bank) can maintain a book-entry securities account with a Federal Reserve Bank. In 31 C.F.R. 306.115(g), 306.117(a). However, those privileges have been extended to all depository institutions. an 12 o.s.c. S 461(b)(l)(A) (defining "depository institution" esaentially as an entity eligible to apply for federal deposit insurance); [other cite]. DOC. SWP1101 July 17, 1989
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21 intermecliary).35 Just membership in DTC is limited to an elite group of members, only Dis have access to securities accounts on the !:>oolcll of the Ped. It follows that clearing and ttl-nt in the book entry Treaaury securities market36 llUst involve the participation of Dis. In aeveral r-pecta the proc- differs significantly .#:~ -tba~-.. o.t ,,~ -:-17!C.-lfS-CC.-ayata.'!: ~: are .. c;:learec:l. and Nttlad ... .. \ . . . . . . . .. . . for th' p~incipal' "govermien~ --~itiea deal~-. ~nd brokers by only four banks, known in this context as clearing banks.37 Rather than settling securities deliveries and payments en a netted basis at the end of the day, book-entry Treasury eaariti.. are.-traufi.ti.1ed acJainat-payllan~on a -real-time, .. : "':' . . :~ ... .. :\". ": ... : -:. : .. .. . .. ....... ;' '' -. . ..... .. ,,'.: 35. Transfer and pledge of interests in book-entry Treasury securities under the Book-Entry Treasury Regulations is discussed infra text at notes 109-62. Investors who do not require the flexibility of intermediary control, such as individuals that deaire to hold curitiu for.long periods, now have the option of establishing a book-entry security account directly with the Department of Treasury. a.A 31 C.P.R. II 357.20 .32 (July 1, 1988) (regulations dealing with the TREASURY DIRECT system) 36. The market for Treasury securities is an OTC market. see generally GAO REPORT, supra note 32, at 18-32. 3 7. The banks are Manufacturers Hanover Trust Company, The Bank of New York, Irving Trust Company, and Security Pacific National Bank. STIGtJM, TRADE, supra note 13, at 122-24. The recent acquisition of The Bank of Hew York by Irving Trust Company will reduce the number to three. bA L.A. Times, Dae. 31, 1988, at 2, col. 1 (holding companies merged and banking subsidiaries expected to be merged in 1989). Ona clearing banker estimated that the top 3 clearing banks clear securities trades of more than $300 billion per day on average. au STIGlJM, TRADE, supra note 13, at 124-25. DOC. SWP1101 July 17, 1989
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22 continual basia throughout each business day. Th practices are ude possible by the Fedwire syat-. A participating DI can transfer curitiu electronically on Fedwir to another DI and aillultaneoualy receive payment fr011 the transfer DI. The Pedwire Yt-of settling securities trades involv .. enormous extenaiona of intra-day credit, in the form of -~f~,:-b.y_:~~-:cl. .. ri111JibanJta_.to ~"brokr--and. d~alers. . . ,. ... . . . .. . . . . When a dealer' clear~ng bank receivu securities against payment, the dealer often does not have in its funds account with the clearing bank sufficient funds to pay the clearing bank, thus ..... 1 ...... -. :: ,._ J -.: . ..... ;' : ....... ... : .. ; . :.. I -~ . -.. : . " . -: _,.., . _.:: . >.,. . :. .. , t' , 'I"' ',' 0 .f _., ,"'": ,' I, 0 . ,.-_ :, .:,. ,;,,, ," 0 .,. 0 _. ' I '"':' ; ', ,;,I". _,. "'' ', 38. Fedwire is a c011puterized communications system operated by the Federal Reserve Syst-for the transfer of funds and book-entry Treasury and Federal agency securities among participating Dia. In Federal Reserve Syt-Regulation J, 12 c:.P.R. Part 210, Subpart B (wire tranafen of funds): Federal Reserve Bank of N~w York Operating Circulars Hoa. 21 (Book-Entry Securities) (Rev. 1977): No. 21A con-Lin Transactions in Book Entry Securities (Rev. 1988). Other Federal Reserve Banks have operating circulars that are substantially the same as Operating Circulars 21 and 21A. Pora description of the Pedwire system see STIGtJM, TRADE, supra note 13, at 105-20. 39. Fedwire permits a participating DI to transfer securities to another participating DI against payment. Federal Reserve Bank of New York Operating Circular 21A, para. 7. Although such tranafers are final, but it necessarily follows that the recipient could simply reverse the transaction by sending the securities back to the transferor, also against payment. Fedwire also accommodates so-called tr transfers," not made against payment, as well as funds only" transfers not involving securities. In STIGtJM, TRADE, supra note 13, at 105-08. DOC. SWP1101 July 17, 1989
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23 creating an overdraft in the dealer' account, and th Fed,' in turn, 11Uat extend overdraft credit to the clearing banlca duri1.g the day. 41 During the day, the clearing bank l00kll to curi ti 40. .Thi diac:uaaion retera to a Federal Reserve Bank or, a 'th context uy requlre; .. ali of' the Pederal Rrv Bank11, as the Ped. 41. Th dollar amounts involved are ataggering. In 1988 the average daily peak overdrafts (baaed on two week averages) with the Fed attributable to receipt ot book-entry securities against payment, tor all Dis, were almost $60 billion. BOARD OF GOVERNORS OF '1'BE FEDERAL RESERVE SYSTEM, UCOIIIIENDATIONS OF THE PADlll'l'S SYS'?DI POLICY COIDII.flU 11, 35 ( [llay 16, ] 1989) .. [llareinafter. POLiCI CCP"JrtU-DOCallllDAftOIIS J. Pruuaably, aoat of. th-~erdrafta van. incurred-by tile aoat active clearing banka. In mrm c:rn BABrm REPORT, &Rn not 32, at 20-21 (atimating that more than 751 of average daily book-entry overdrafts were attributable to the five largeat clearing banks). Official in the Pederal Rrv Syt-have expred much concern about the amount of tha (a well aa non-book entry curiti related) daylight overdratta. I uurally POLICY COJIIIIItu UCOIIIIIIIDU'IOIIS, &PD ( reccmaending pricing to be cbarged to DI' tor dayliqht overdratta, iapoaition of net debit cap, and requiring DI' to collateralia overdratta under certain cirC1.D1atanca): Paynnt; Tk Pprc Rapgrt, 1upra note 25: BOARD or GOVERNORS OP THE FEDERAL RESERVE SYSTEM, A STRATEGIC PLAN FOR MANAGING RISX Ilf '1'BE PAYMEH'l'S SYSTEM, BIPPG pf th LOrs1-pg11ar Payment; sx1tu A4YiPrx qrpup tP 1;h Paym1nt1 sv1:ta Pplicy c;ppggitt pf th ltdr11 Blrx sx1tu ([August,] 1988). In part becauae at the Ped' concerna u,out daylight overdrafts, the Government Securitiu Clearing Corporation (GSCC), a aubaidiary at NSCC, i developing a Yt-to introduce the benefits of multilateral netting aaong principal government curiti -rket participants. I.ea STIGCII, TRADE, 1upra note 13, at 257-62. Such a netting ch- could aubatantially reduce tranafr of book-entry curiti over Pedwir and, conaequently, reduce overdratta. In 1988 GSCC began operation of automated c0mparia0n ot government curiti trade and expects to male a netting ch- available in 1989. NSCC 1988 REPORT, 111Pr1 note 19, at 4. DOC. SWPllOl July 17, 1989
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24 rac:aived and allocated to the dealer' clearing account42 a collateral for the overdraft credit. Before the end of the day, tbe daalen expect to rac:aive funda in, aatly froa inatructing tbe clearing bank to tranafer aac:uritiu over Pedvire aqainat payment, o a to caver their overdraft. RepurcbaH aqremnta (rlPQI) are an important aeana for dealers to .. Clbbin _. 0Wuni9b~ "tinancinq. nacuaary to cover dayliqbt overdraft.. a In. a repo, a aaller of a curity (funds borrower) tranafen the aacurity to a buyer (fund lander) under an arrang-nt whereby th ller (funds borrower) agr to repurcbue the ~ity on a apecitied date (often the next day) at a ~:[f i.S .. ,~ice and_ .the _. fmlda 1eild~) aCJZ'899 to . .. .. . '. . . . . re.ell the aac:urity back to the Hllar (funda borrower). From the penpectiva ot the buyer (funds lender), the transaction is a reverse repurcba aF-ent (rlY9n rep). Obvioualy, repo an the functional equivalent of HCllr8d borrovinqa and loan, 42. Clearing banJca normally obtain a curity intrt in all aecuriti in a cuatoaan clearing account--that i, curiti not allocated to an account maintained with the clearing bank for fully paid c:uatoaer curiti la STIGtJM, TRADE, IJ1Pr note 13, at 177-79. 43. la STIGO>.. TD IU!:PO AND REVERSE MARKETS 25-26, 57 (1989) [hereinafter, STIGtJN, IU!:POJ. DOC. SWP1101 July 17, 1989
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25 although they are denominated a aal and reaales." 2. ft aeleatioa of IatezaecU.ari lf llarket artiaiputa Tb propensity of invutora to allow interaediari to control their curitiu i apparent froa the volma to D'l'C cuatody and HSCC clearing activity and the necity of DI ~-~IJ~J: --~---~-.-~~~~--~~~i~. -~bt,_:-=. --~~in.-_ ~~ptiona . . . . .. -. . . the behavior alid' attl tudea. of -rket participant 'in their lctiona of intermediari are central to th thesis of this article: Participants generally exerciae extr-e care in the lction of the interaediariu vbo ~ to control their . . . ,~i1'i .. Gi~-tbe. -potentially -dJ.~,.-COIINqllenc of f ',I,;,,, o I I .... r';'" o ' ...... ::.'' ',, '.' o ~.ecuri 1:-intanaadi&ry inaoivency and iaiabehavior, to be addrd abortly, market participants tend to cboo aafe interaediariu where the rik of inaolvency and aiabebavior is perceived to be uaentially nil. Available evidence of aarket behavior and anecdotal perception of profional in the curiti industry em to confirm th aaaU11ptiona. Th largeat institutional inveators, including inaurance companiu, penaion funds, and invetme ... t ccmpani (aucb a mutual fund) normally lct large, "blue 44. 'l'h economics of the tranaaction are auch that when the ller (funds borrower) pay the repurcba price ti,, repay the loan), the buyer (funds lender) receive a profit (a return on the aoney loaned). ld, at 5-6. Th legal characterization of repo i not clear. 3 intra note 95. DOC. SWP1101 July 17, 1989
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26 chip" c01111ercial banks as their custodians."" Other active 45. an STIGOII, TRADE, aupra note 13, at 232: What if, due to aoae terrible mimnag-ent, fraud, or whatever, a cuatody bank failed and a011ehow took its trust area down with it? _The answer is tht most major portfolio ~~.:-:.:. ~'. ... ~9~rs-.~ue:'-::--b-ig~;fto1F~,-) ,::baftic;--aa~aicustody .-banJt~~--and.the :. gene~~l vi.~,, .. ~t ~e .. Fed. .is. the de facto. guarantor of any-auch bank. Slla.ller inatitutional investors often use naller custodians, ho~aver, in order to obtain better service. lg. at 220-21. The use of custodian banks by institutional investors in not a recent pbenoaenon. .iU ABA REPORT, supra note 6, at 32: In _order to pr;r:v~. [inat.~~~ti~na.l. inv~ai1;0_"' J .. . .. .. < :,,.rreiidoil"~to:du1vitli' linyw'bra1c:t~~=t:an belit: serve. their ~rtadiate requiraena~,: placingAcuri:t!e ln the hands of a particular broker would be impractical. Furthermore, inatitutions may not prudently, or, in many cases, legally, entrust their subatantial portfolios to even the largest or moat stable of brokers, even for the relatively short duration of th settl-ent process. For auch investors, the brokerage account i not a viable option, and the choice is aolely between the bank cutodian and theuae of their own peraonnel and facilitiu. The Nlf aaintenance of an inatitutional portfolio, even vben permitted by law, however, is not a mere inconvenience, but a substantial and meaaurabl cost. In addition, the use of a bank custodian in a financial center enables an institution to effectuate direct aettl-ent of securities transactions regardless of it own location. Thus, for primarily economic reasons, the role of bank custodians is presently a significant one for institutional investors. Legal reatrictiona on investment c011p&ni registered under the InveatJaent Company Act of 1940 easentially make maintenance of their aecurities through an independent bank custodian the only practical altemative. In 15 o.s.c. 180a-17(f) (1988): 17 C.P.R. II 270.17f-1.-.17f-4 (1988). Moreover, because inatitutional inveatora now must use the DTC ID System, the use of bank custodians that control securities through DTC has been largely formalized. s11 aupra note 26. DOC. SWPll0l July 17, 1989
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27 investors allow securities firms to control their securities." It also seems that active investors tend to select only one custodian bank or securities fina as a principal securities intanaediary. 47 The high level of care with which large invutora have selected securities intermediaries is demonstrated by the minimal losses experienced by investors not protected by StP<: .. wben, securities inte;a.ediari .-hav.,_.failed~'8 .. The. -~=-. ~. :.-:.~-, .. ,:. ~---.-~ -.. ... -~:-.. i . ~-: : . : . . ~-. : .... .. 'CO~Cltulio~J.si~es~pable that: int~rmediarias:selected by important securities market participants generally have not 46. [Inte~iews/data] !. :i.. ._:~_47...'... ;"_;:c.~9"~~} .... -::'l'tae/naaon for--1:lti~-~: behavior doubtless ariaaa: troa .tha, tac:t.. tbat. an :-active. invutor securities trades are/ in" "effect, cleared and sett.led by its intermediary. au STIGtJM, TRADE, supra note 13, at 219. 48. During 1988, 305 (lass than .21) of the more than 240,000 claims satisfied by SIPC exceeded the protection provided by SIPA. SECURITIES INVESTOR PROTECTION CORPORATION, ANNUAL REPORT 1988 6 [hereinafter SIPC 1988 REPORT]. The aggregate unsatisfied portion of thue claims tor 1988 was $31.7 aillion. l4. The corresponding data tor 1987 reflects 320 unsatisfied claims (.21) out of 222,000 total claims, with unsatisfied claims of $50.8 million. SECURITIES INVESTOR PROTECTION CORPORATION, ANNUAL REPORT 1987 7. Por 1986, the data were 323 unsatisfied claims (.21) out of 200,000 total claims, with unsatisfied claims of $70.9 million. SECURITIES INVESTOR PROTECTION CORPORATION, ANNUAL REPORT 1986 6. Thus, the mean of unsatisfied portions of claims for 1988, 1987, and 1986 was approximately $104,000, $159,000, and $247,000, respectively. [Describe aggregate data for unsatisfied claims during 1971-88]. When compared to the size and volume of the securities markets, the relatively small mean lo indicates clearly that the large, active investors generally have selected securities intermediaries that have not failed. Experience with failed commercial banks has been even more striking. Substantial shortfalls of customer securities controlled by failed banks have been virtually nonexistent. [Interviews with PDIC personnel]. DOC. SWP1101 July 17, 1989
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28 failed or misbehaved to the investors' detriment. However, significant losses incurred by repo participants with several failed government securities dealers in recent years provide triking exceptions to thi pattem.49 lliau Jtoaed bf aenriti Iatemediari 1. o.eni r-~~ .. ;:._..::-::: ~~rt:~-~~~~~~~-.:.~~?t!t~ _;_~,-~~:v,~~-.. a~d -~~- ,. I securities ~at _it.con:tro~s ar~_insu~ficiant ~o satisfy all of . . the claims of its customers and creditors, priority disputes among claimants to a finite pool of securities.may ensue.50 In ~e .fashion, the pplic~le legal regime_muataort out these .. -c:adlicting claiu.-and -'ditrilmte--1:he ab of tile il'.'llo~vent ,".'.,1 .,. .. :-.-~~,, -" ."' ...... :-. .,.-. ---~-.. ::: ... -~-t-,., .. ,_ : ....... _. _.,... ,. .. ,; ... 'f ina ( or the asaet value) to 80118 or all of the competing claimants. Bow the law deals with these claims also is important in contexts other than that of an actual intermediary insolvency. Invtora who claia through an intenaediary expect to receive the benefits of ownership-a property interut. Even if the likelihood of an intermediary insolvency is deemed to be 49. see intra note 59. 50. The reasons why an intermediary might bec011e insolvent, and the reasons why the aecurities available to an insolvent intermediary might be insufficient to satisfy the claims of its customers who have paid for the securities, are important areas of inquiry, but an exploration of those matters is beyond the scope of this article. Part III, intra, considers the approach and substance of the legal regime's treatment of how to divide an inadequate pie when such events occur. DOC. SWPllOl July 17, 1989
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29 extremely remote, unless that possibility is discounted altogether the treatment of priorities may affect investor and creditor behavior and the efficiency of the market. 51 It i a characteristic of securities intermediary arrangaenta that the aecurities involved tend to be controllac:l by the intermediaries in a fungible bulk.52 The intermediary ~Y-, ~d .. pJly~cal: ... ~it.j.q,,:~ .. -~~~ _or-,it ~Yitself be ~: .... _. ........ : "'""'(... . ,. .. ..... : .......... ,.. ...... . .. : : .... . . .. . 'a cust'Oller of an upstream~ ihteriediary '(s_uch. as another securities firm or bank or a securities depository). These arran~aments complicate the process of sorting out claims under a.~sting law -~d e'V'.~~uat~n9_su9gastion .f".'r change. : : ... ':. _,. .......... . .appnaeiae. --~.::tatuaetiU'!' tiabsecurities intermediaries are addressed by a variety of approaches under both federal and state law. a. llaplatozy &pproaaJa .. The regulatgry apprpach serves to ensure, or Jllake it unlikely, that intermediaries will become insolvent. Financial 51. Saa generally infra Part v.A.1 (economic analysis of proposed new model for resolving conflicting different tier claims). 52. ware the securities not a part of a fungible bulk, much of the benefit of the intermediary control phenomenon would evaporate. For example, the benefits of netting in the D'l'C-NSCC clearing and settlement process depends on the inherent fungibility of securities on deposit with DTC. Sae supra notes 22-25. DOC. SWPllOl July 17, 1989
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30 institutions-that serve as securities intermediaries, whether banJcll or securities firms, are subject to broad regulation and auperviaion.51 Clearly the regulatory approach does not provide a perfect solution, as both banks and securities firms sometimes fail. b. ~pbylaatia &pproacb 53. Capital requirements, restrictions on powers, requirements of prudency, audits and financial reporting, and supervisory examinations are examples. see generally,. e,q,, GtJ'l"l'MAN, supra note 1~,at 19-11 to -20 (reporting and net capital requir-anta for broker-dealers): A. POLLARD, J. PASSAIC, K. ELLIS -, J. DALY, IWOCDG. IAW Dr .THE UH_ITBJ) ST~'l'ES. 57-104 (1988)' (l,ank'~~atora entorcqent _poven)' ~111~2,, .. (national baftk . power.: and :1 .. mg ;~iwts; retrietiona on. bank transactions with affiliates, reserves and capital requirements). 54. Since 1971, when SIPC was formed under SIPA, through 1988, 206 proceedings involving broker dealers have been c011111enced under SIPA. SIPC 1988 REPORT, supra note 48, at 6. Prior to SIPA, however, stockbroker insolvencies had been cmmonplace during some periods. In, ,q,, J.4., at 32 (During the difficult years of 1968-70 [h]undreda of broker dealers were merged, acquired or simply want out of business. Some were unable to meet their obligations to customers and went bankrupt. Public confidence in our securities markets was in jeopardy."). In 1988, 200 banks insured by the FDIC failed. GDERAL ACCOUH'l'ING OFFICE, FINANCIAL AUDIT, FEDERAL DEPOSIT INSURANCE CORPORATION'S 1988 AND 1987 FIN~lCIAL STATEMENTS 6 ([April,] 1989). In 1987, 184 failed: in 1986, 138 failed: in 1985, 116 failed: in 1984, 78 failed: and in 1983, 48 failed. FEDERAL DEPOSIT INSURANCE CORPORATION, 1987 AHHUAL REPORT 12 (1988). This article does not examine whether "improved" methods of regulation and supervision in the United States would result in substantially fewer insolvencies of financial institutions or whether any regulatory process having that result would be wise. Certainly that matter is receiving much attention, however. au, LJL., B.R. REP. NO. 101-54, 101st Cong., lat Sass. (1989) (Report on Financial Institutions Reform, Recovery, and Enforcement Act of 1989--H.R. 1278). DOC. SWPll0l July 17, 1989
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31 'l'he prgphylact;ic approach seeks to ensure that an intermediary will always control sufficient securities so as to cover clailla of its cuatomars that have paid for them. Then, even if the intermediary were to become insolvent, customers claiM to e=ritiu would be aatisfied.55 'l'he segregation and other cuatoaer protection rules applicable to registered .. .. ... ;~t., .. ~: ir.Q~ylac:tie-. appr~---56 Aa a ~::" e: ... .,t~---~ ... --.-~:: .-'<,'-,:.-,:,:: ;.~ .,_~-.: .-_.:I .. .: . _~-----~------.. ... ... : .... . .... .-:~.. .. ...... 55. The statement in the text assumes that applicable law would entitle the customers to receive the benefit of the securities controlled by the intermediary rather than awarding the securities to other claimants, such as general creditors. Sae infra Part III (discussing insolvency proceedings of securi tJ.,as intermediaries). ~. l",--~~54.~-,-:!,.-;. &a. .. a~-~;'.',iairt-tar;,-brobr-dealer-
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32 general aatter banks also are required to maintain possession or control of their customers securities.57 posaeaaion or control): -3(d) (1988) (determination of poion or control of aecuriti 11ade at clo of business day for next preceding business day and tiJle periods specified tor aaving securities frma certain non-control locations to qualifying control locations). cuat011ers retain the "absolute right to receive in the courae of normal business ::~"'~~9~;,t~lli~i.t\9 .4~-.,. ::~ .. _~--~J,.bY.i~l--~eli:very c,t: .. : .-,. certifi~tes~:-" :szc .. ltflle 15c3-3(b) (ll, -17 c.r.R.'I i40.1sc;J-3-(l) ( 1.9.88) Broker-deal~ also .are. r~qited to aaintain a special ruerve account with a bank for the exclusive benefit of customers. SEC Rule 15c3-3(e), 17 C.F.R. I 240.15c3-3(e) (1988). saa also 15 u.s.c. s 8(b) (198 ): SEC Rule 8c-1, 11 c.F.R. s 240.8c-l (198 ) (broker-dealers prohibited from hypotbecating .. customer sec;urities so as to (i) c0J11111ingle securities with other customer securities (in absence of customer's consent), (ii) cmni119le customer securities vi-th non-cua~om~r. ~ities ,. and -f iii) .aecur.;aaounta : i,i.: :of-: 6'ft:Z:ilgt: -~debtadnesil o"f all -caatc::1111an~-aa:to .. ,c:ustaaer' aec:aritiu)". _. ~. -, .. :-.-~. 57. Par exuaple, national banks holding assets while acting in a fiduciary capacity in the exercise of trust powers must segregate those assets from the general assets of the bank. 12 U.s.c. I 92a (1982): .Dil 12 C.F.R. 11 9.1 9.22 (1988). When conduc:ted by a national bank's trust departllent, bank safekeeping and custody aervicea are aubject to the-rule that apply to fiduciary activiti .. even though no investaent discretion is involved. -OPPICE OP THE COMPTROLLER OP THE CODEHCY, DRDBOOK POR HATXOHAL TRUST EXAIIIHERS, Pr1ced1nts and Opinions. 1 9.2020 (198 ). [Although national banks that do not have trust powers uy undertake safekeeping and custody arrangements that do not involve discretion, those activities are subject to the same restrictions on control and segregation that apply in the case of trust departments. Jin~-, at __ 1 9.2600.]. Rational banks that fail to exercise proper control over customer securities are subject to enforcement proceedings by the Comptroller of the currency. bA 12 o.s.c. II 92a(k) (1982) (proceeding to revoke trust powers on account of unlawful or unsound exercise of powers): 1818(b) (1982) (proceeding for cease and desist order against national bank engaging in unsafe or unsound banki.ng practices) s11 also Comptroller of the CUrrency, Hews Release Ho. 84-75 (November 21, 1984) (announcing consent order against First Rational bank of Maryland relating to lending of custcmr securities kept in safekeeping). DOC. SWPll0l July 17, 1989
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33 Again, experience has demonstrated that the prophylactic approach is not foolproof. Shortfalls in customer aecuritiea are the nora in securities fira insolvencies.51 Nevertheless, the most serious shortfalls have occurred in cases in Which than-unregulated government securities dealers, not subject to regulations directac:l to custody and control of ,-~~~-i,~~1:-.. ~'{,_-.f~l;_ed.'.'.:~ ... :._;::: .. : __ :::".::. ~:._. ... _, -~--~ "" : . . . . ... . . .. . ..... . . ., . . . . . In the 206 proceedings commenced under SIPA through year-and 1988, all but_ required advances by SIPC to cover customer securities shortfalls. [cite]. Banlt insolvencies, however, have resulted in a low incidence of shortfalls in customer property held in custody or trust. see supra note 48. It is pos~ible that the differing experiences result, in part, fraa the.fact that set:11ritia fi:i:118-are J110re likely-to be .J.n,rolVed in--,ac:ti~ -~.b9',:tor:1tak-ift:ac:cdmrta~ -'.or, bemuse banJc .. castodiw-._~orwa-lly.,are--lectad to-control cariti for reaaona of safety, it Y be that banJca with substantial custody ac~ounts simply have not often failed. 59. &u GAO REPORT, supra note app. VIII, at 143-51 (SUJ1111111rizing pertinent facts conceming failures of Drysdale Government Securities, Inc. (1982), Comark (1982), Lollbard-Wall, Inc. ( 1982) Lion capital Group ( 1984) B. s .11. Government Securities, Inc. (1985), Bevill, Bressler, and Schulman Asset llanag-ant Corp. (1985)). The SEC eatimated that frOJll 1982 to 1986 investors lost about $900 million before recoveries frOJll reduced income taxes, insurance claims, and civil suits, if any," resulting from these failures and that more than $300 million of th losses resulted from the failure of E.S.M. Government Securities, Inc. alone. ,ld., at 13-14, n.6. Largely as a result of these losses, the Government Securities Act of 1986 was passed. Pub. L. Ho. 99-571, 100 Stat. 3208 (1986). Th Act requires the Secretary of the Treasury to adopt rules for cuatomer protection, "including but not limited to, capital adequacy standards" and "the acceptance of custody and use of customers securities. 15 u.s.c. I 78d-5(b)(l)(a) (1987). The Treasury regulations adopted under the Act require government securities brokers and dealers (including DI' not qualifying for exemption) that are not registered under the Securities and Exchange Act of 1934, as amended, to comply with SEC Rule 1Sc3-3, with certain exceptions. 17 c.r.R. I 403.1 (1988)1 sea supra DOC. SWP1101 July 17, 1989
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34 a. lnauruae &pproaaa Another approach to customer protection is exemplified by the SIPA. This approach provides prote~ion to investors who Jlight lack the aophiatication and resource necessary to evaluate any particular interaediary.61 Sllaller investors, then, -Y take advantage of the convenience of an intermediary account 'vit:hout any' liubilt~iali" rik ., , e ,.~.-.,V .... : ,' :., .",-. .,,,,' 00 ":".; ,,'.r''-" ,:,A;., .. _::: : 0 :._ ,: :. .. . > : ... :_ , ', .. .. : .... f: .-_. .. :. ;. _, _::. _: 'i ... ,:.. .--:-:; .. _.: .. : .. :~ .:_-,, . '.: ::: : .. '. ... . 4. ft"Openy Law appr.oaala The application of property law rules may provide another approach to investor and cr~ditor protection. For example,. a bona fide purchaser of a security will.take the .-~iti._ -.. -~-,ot j~or:-~~-~.~/c1aiJi.: ~l----~~:. paities .a ..... such : J:.;' --;.":.1 ..-'li,..r,:.:.-J;.': .... ,,:.,r: .. ~ .. ,.,, ~.-,-:,.:. :~:." ;,":.,.-;':_,l:':t,,', ,: ,: . .,,' .,,~ ..... ,' -~-:, rulu can provide aecurity and comfort toa transferee of a property interest. But reliance on traditional property law concepts for investor and secured creditor protection in the event of an intermediary inaol vency i problaatic. 'l'he property note (discussing SEC Rule 15c3-3). Requirements similar to SEC Rule 15c3-1, dealing with net capital, also ware adopted for such govermaent securities brokers and dealers. bA 17 C.F.R. 402.2 404.2d (1988); SEC Rule 15c3-1, 17 C.F.R. I 240.15c3-1 (1988). 60. supra note 3. 61. Smae securities firms have obtained private insurance affording additional protection to customers in amounts up to $2,500,000. ba R. '1'EWELES Is B BRADLEY, '1'BE STOCK MARKET, supra note 20, at 319. 62. text. Saa qenarally infra notes 82-85 and accompanying DOC. SWP1101 July 17, 1989
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35 law rules either are nct easily adaptable to the intermediary control context or result in little or no protection,1hen appliad.61 'l'he intermediary insolvency risk considered bare involves customer and secured creditor claito secrities included in a fungible bulk that is controlled by an intermediary and, significantly, that is insufficient to satisfy all of the :. 9-},~~'!>. ,-:~P~Y:.. ,~~lt ,.~.!8: ~~~),~., . p~J.ia4.-: -~n.-1:b~ ::c;:-~ntext of .. ~e ...... 1! -~:-: ......... ....... ,. -~ ..... :: ,: ... .... . . . distributional rul:es applic:abietnan"insoivncy proceeding, . where they may or may not be honored." Finally, experience suggests that reliance on prope~y law concepts and terminology is an awkward and unsatisfactory approach to codifying rules . . .. -. -applic:ule.,~ olai11a aqa.-t inteZ'Jilediari -'that control fungible ..,.. : ... __ :,.:.\'., .. ,-....... ..... .. .. , .::, .. _.,.: .. .... ,. ...... ........ ... '. .. bulks of securities. Jlisk Allocation Approach The risk allocation approach to property-related claims against an inaolvant interaediary contaplateslegal rules that distribute assets to claimants based on objective classifications of the claimants status and relationship to the failed firm. In contrast to the property law approach, the risk allocation approach would not be based on determinations of discrete property interests in particular assets. An example of this 63. see generally infra Parts II, III, IV. 64. see generally infra Part III. 65. see. 1,q,, infra notes 283-85 and accompanying text. DOC. SWP1101 July 17, 1989
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36 approach ia the distril>utional rule applicable to securities firm inaolvencies under SIPA." But the line between the property law and risk allocation approach i not clear. In the SIPA contaxt, the assertion of or entitlaent to a ~roperty claim may be necuaary in order to determine that a claimant has customer" status.67 Moreover, the application of property law rules to any priori.1:y.:cont-.,1t -'nec: ... ari=ly .. 11ali. -'Ua. :t9iji1t; _of: a1i'ocatincj loaiaes'.'' . . . : .. . . . . . (and risk) tQ the j~ior parties. The ~f~erences. lie, perhaps, only in the degree to which property law rules play a role in the risk allocation process and the dratting techniques employed in codilying_applicable law. . .. . ..... ... .. .-.... :. ' ,~----;".,,~... _:_. -.-:;;_ ................... ....... : ... ..... ~-.. -: ..... .:..: ... ~= ... -~ .. = .. :-.-~ .. --~ :-_- ... ... .. . .... ~-f ... Oli . . . . -~-~ OU ...... ,; ....... : ... . .: .. ,._., ._: -~-:-.!... ... -. : .. ., .. ~ ~.... -~ .. : . .. . _.. . . The approachoutlined above are related. The prophylactic approach can be viewed as a subset of the regulatory approach. And if the regulatory and prophylactic approaches were abandoned, th insurance approach might be prohibitively costly in a world with more intermediary insolvencies and greater 66. Under SIPA, claimants wbo are determined to have cust011er status share pro-rata in cust011er property" regardless of whether none, s0111e, or all of tbe securities they claim are actually included in cust011er property". sea infra notes 189-91 and accmnpanying text. 67. 14. DOC. SWP1101 July 17, 1989
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37 shortfall in customer aacurities. Although th following diacussion of intermediary insolvency risks i largely devoted to tha property law and risk allocation approachu, tho who would explore changu in law should view tha subject fraa a broader, lus coapartaantaliaad panpactiva .. . ......... ;: :-~ ,. <_: .. ~ .. ".::. .::~-~.4: .... _. .. ::. :.:-~. -~--,. .: :: .. . : ., ::., ~. .~: .,.-:. .... ~-.. : _; ~-~.. -.. -... 18. Although SIPC bas confirmed lin of credit, maintananca of tha SIPC fund primarily dapanda on annts of SIPC's mambers. SIPA I 4(d), 15 U.S.C. I 78ddd (1982); SIPC 1988 REPORT, supra nota 48, at 32. DOC. SWP1101 July 17, 1989
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38 %%. nD8DT Ucam.&UOll8 a. artialu ... 1 1. 'lraaafar ... DeliTUJ ft principal operative rule in th 1978 Article 8 that deal.a vitb the purcbaaa of aecuritiu i found in action a-_ 30,i._f.l): .. "Upon:.-~~er--af ;NC:IIZ-i~ 1:0 .a'.. purcbaaer (Section a-. . 313), the purcbaaer acquiruth riqbta in the aec:urity which bis tranafaror bad or bad actual authority to convey 111 Section 8-313(1)," then, apecifia the exclusive mew by which an interut in a aecurity can be ~ferrad t~ a_purcbaaer and ~ ~1tut;_~. ~far oc:crars~~-:.'ftli.1--~ --.~C)idti?ft~ ,. I I . . :' ; : ..... .. : ,: .. ~. -. ... V -~... ;, .... 19. II 1-201(32) (defining purcbaae to include takincJ by Ale, diacount, negotiation, aartqaqa, pledqa, lien, iaaue or re-iaaue, qift or any other voluntary tranaaction craating an interut in property); 1-201(33) (defininq parcbaaer u a penon who tab by purcbaae~). 70. 1178 I 1-301(1). Thia praviaion atatu the faailiar uaJ.ter principle, and by illplication ita obverae, the C01111on lav uxi ngp dat; qyqd nqn b.aba1;--ona cannot qive what one does not have. 1978 I 8-301(2) pravida iwportant qloaa: A tranafer of a liaited interaat acquira riqbta only to the extent of the interut tranaferred. Th creation or relea of a c:urity intereat in a c:urity i the tranafer of a liaited interat. 71. 1978 I 8-313, urked to reflect additiona and deletions fraa the pre-1978 varaion, 1 quoted in full in Appendix I to thi article. 72. 1178 I 8-313(1). 'l'b vord only' in the firat aentence i intended to provide that the -tboda of tranafer liated are excluaiva and that ccmpliance vith one of th-i uaential to a valid tranafer. 14., cc:nmant 1. 'l'be explication of excluaive -thoda of tranafer in 1978 I 1-313(1) baa been DOC. SWP1101A July 17, 1189
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39 departure trma the pra-1978 Article 8. Pra-1978 section 8-301(1) stated tbe effect of a daliyary75 of a security rather tban the effect of a tranfr.71 Sillilarly, the pra-1978 section 8-313(1) specified the necuaary -nta, and till of effectivn, of a delivary.15 Tb various Mana of delivery under th pra-1978 section 8-313(1) are, however, largely preserved aa ans of :-~ -~tba _.l,.9.;7,J ~v.niQD .... ---~-, .... : ... _:-.-._ :.; ._ .( .--, .. :-....... -~--:._:-,J .. :..,, : <',. ,; -~ ,. r t ': . I '.I ,., t, . \ : : 't :, ' ', -~ , ''"; : : : : o ,. : . ' I ... The. aove frim' . c:tai~very.:baad to a tranafar..:baiiid . operative rule tor purchasers i important in the context of transfer who are customers or secured creditors of a financial intanaediary and who claim an interaat in aacuriti controlled . . . . ... . . . n:. .,int;anecli~ :,-in hligilal~ .bu,J;Jt. 'l'Jl .paradipatie-ca .. --~--.-.,.. ... .... -_: . _.-.;" .. >,. ' ;,;.,,..... :-,.. ~ .... involvu a purchaaar through a broker who nd th purchaser a confirmation of the purcha and marks ita boolca to reflect the purchaser' intereat in a fungible bulk of aecuriti controlled by the broker, either in atreat nue or for tba account of the broker on the boolca of another intenaediary. Such transfers, criticized. la, ,q,, atJ'1"1'11AN, aupra note 11, at 5-8 (exclusivity requirement will inhibit constructive delivery" in the context of a gift and "introduce uncertainty). 73. "'Delivery with reapect to certificated aecuriti uana voluntary transfer of poion. 1978 I 1-201(14). The pre-1978 version did not include the word certificated." Pra-1978 I 1(14). 74. Pra-1978 I 8-301(1). 75. Pra-1978 I a-313(1). DOC. SWP1101A July 17, 1989
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40 -intaya of the toclcbrokerage business for many years, do not constitute deliveries under pre-1978 section 8-313(1), although it i clear that an ownership intarut i transferred nonathal-11 Stated otherwi, under the pre-1978 section 8-301(1) a transfer of an intaret in a curity to a purchaser nacu-rily ruults from a delivery, but a delivery is not a --~~-..? -c.oncll:t+~:.fo~1 -~;~d~. '~---~ pz:c,party-.:_intarut ta occur.71 -_~c~~ ~-i978 ~-crt:~~n.,.;13(~)sp-~ci~iu th~ exclusive an of transfer, provisions were added which .. ,",,_ .... . ... ;,.._'":..;:,:.,:,:I:.,,,:.-.'.,, .. :,:,, . _. .-, .. ,i::~-.. .-~'.r,,:,,.,.-,~ .. ', .,,.-' :'~,,:.,~ ,, .. ; ""' _.,,,"..,. .: .. : I . . ..... : ....... :.-.: ... :-:~ .!.::. :: = -~~. : .. :. .:'< . "-;: ,._ ..... ~,: ... -~~-: ,; : : .. 76. an infra notes 96-99 and acc01Dpanying text (discussing oparation of proportionate property interest" rule of I 8-313(2) (second sentence)); Appendix III, infra notes 13-15. 77. l,d. Thi point has not always bean understood. btl, ,q,, Caban v. Army Koral support Fund (In n Bevill, Bresler Schulaan Allsat llanag-ant Corp.), 67 Bankr. 557, 603, 615 (D.N.J. 1986) cundar [pra-1978] Article 8 the transfer of owner.hip of securities to a purchaser is govamad by the concept of 'delivery. If the three requirements for achieving delivery/transfer under [pra-1978 I 8-313(1)(c) or 1978 I B-313(i)(d) (i)] are not satisfied, than a purchaser acquires no interest in the securities.); Memorandum of Law of the Federal Rrv Bank of New York as Amicus curiae, county of Dauphin v. Bradford Trust co., No. 85 Civ. 2220 (S.D.N.Y. [1985]) [hereinafter Bradford Truat Mpg], :reprintl4 in RingS1Duth, Federal Reserve Book-Entry Systa, and the Rola of the Federal Rarv, in REPURCHASE AND REVERSE REPURCHASE AGREEMENTS 1985 (PLI) (A. Levin, R. Novikoff, co-chairman) 110-11 ("If the delivery did not meat the raquirmaanta of N.Y. [pra-1978] o.c.c. I 8-313(1) (c), it appears that the purchaser did not acquire any rights in the security. Thus, if the broker became insolvent, the purchaser could not enforce a claim to the ecuritias against the broker estate.). DOC. SWP1101A July 17, 1989
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41 accommodate expressly these non-delivery transfers affected by confirmation and book entry.11. Hoving from a delivery-based to a transfer-based structure also facilitated another illportant feature of the 1978 Article a--the treataant of uncer1.ificatad sacurities19 in a 78. iU S 8-313(1)(d) (ii), (d)(iii). In addition, f~~m.\~,~-.i . (~~.E,i~----~:ll-,.~~ -~-f~~;~ Qf ..... :8~~-0~J :.in -i,n.~"1~'78 ra-l13 -~ .tiean" gnanged to the:broadar category of financialintarmediary" (defined in 1978 S 8-313(4) to include banks, clearing corporations, and other appropriate entities in addition to brokers). Section a-313(l)(d) provides that a transfer occurs at the time a financial intermediary sends a confirmation" to the purchaser "and also by book entry or otherwise identifies" the securities "as belonging to the purchaser. S 8-313(1) (emphasis supplied). Thus, the affac:::tivenass of -nch a transfer is conditioned. upon an objective ~~i-on.-,by.,:.tbe ~-.intena11diar.,,:t:o.;anotbar person concerning -~--~fer ... .. &~~~:. boolt~ antriu a-lone, without confirmations or other cOllllliunicationa, are sufficient to consti tuta a transfer when the intermediary is a clearing corporation. 8-313(1)(g), -~20(1). Similarly, the Proposed Trades Regulations provide that an intermediary's book entries alone would be sufficient to affect a transfer, without the necessity of a confirmation. bSl Prgpgsacl TRADES Regulations 357.12(a)(3). Heither 1978 S 8-313(1) nor the Proposed 'l'RADBS Regulations 1l&ke provision for an intermediary to affect a transfer by an acknowladg-ent. an 1978 I 8-313(1)1 Proposed TRADES Regulations I 357.12(a). 79. 1978 S 8-102(1)(b) provides: An uncertificated security is a share, participation, or other interest in property or an enterprise of the issuer or an obligation of the issuer which is (i) not represented by an instrument and the transfer of which is registered upon books maintained for that purpose by or on behalf of the issuer, (ii) of a type commonly dealt in on securities exchanges or markets, and (iii) either one of a class or series or by its terms divisible into a class or series of shares, DOC. SWP1101A July 17, 1989
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42 fashion that is, insofar it is feasible, parallel to the treatlllant afforcled certificated securities. Uncertificated securitiu, however, Y be transferred by registration of the transfer on the boolca of the issuer.11 a. Bou lde l'llrallue Both versions of Article 8 contain the familiar .exc;:eptj.an_ :to.--~~-~baelJ.n-ru-i'O"f DIJPP dat;: :.-_--.-~A .. b.ona -fi:de .. : -, .addi~ion to .. a~qui~~~~. ~ights ~f a -p~ch~ser . -. (Section 8-301) also acquires his interest in the security tree of any a~verse claim.12 Only certain transferees can achieve partic.ipatio~; _.int~~~, _or.~o~~~gat;o~~ .... .... -_:: .:, ./, ,::_., .. :.'".':.: ---:--:---: :---~-.!;:,_-;, "'.'-''.~.-:: ..... ,~ ... ._. .. _.,: .. : .' _.,.. ~-........ .. 'l'Jle',.defini~ion:.of_:ce~i!'icatect=-ec:urity'.la'"!ii!"lrucept'that in subparagraph (i) reads represented by an instrument issued in bearer or registered form and subparagraph (ii) includes the additional language or commonly recognized in any ar~a in which it is issued or dealt in as a medium for investlllent. 1978 8-102(1)(a). 'l'he definition of security in pre-1978 I 8-102(1)(a) is .. aentially the same u the definition of certificated security in the 1978 version. 80. _, ,q,, Reporter' C0111N11t, aupra notes, at 813: Aronstein, Haydock, Scott, aupra note 5, at 893-94. 81. 1978 I 8-313(1)(b). Pledges and releases of pledges also can be registered. ld: w infra note 89. Registration of transfer is initiated by the sending of an instruction" by an appropriate person (the current registered owner i.f the security is not subject to a registered pledge) to the issuer. 1978 I 8-308. For a descriptions of the process of registration of transfer, see Reporter's COllllllent, supra notes, at 814: GtJ'l"l'MAH, supn note 11, at 5-9 to 5-14. 82. 1978 I 8-302(3): In, ,q,, Matthysse v. Sec. Processing Serva., Inc., 444 P.Supp. 1009, 1020-23 (S.D.N.Y. 1977): Satterfield v. Raymond, No. c-a4-0646W (D. Utah Oct. 31, 198S) (LEXIS, Genfed library, Dist file). Pre-1978 I 8-301(2) is identical axcept that it omits the cross reference to I 8-301 and DOC. SWPll0lA July 17, 1989
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43 bona fide purchaaer status. In particular, a transferee of an interest in a fungible bulk of securities through an intermediary :,-.-.~--. ; ... ... __ .. . ,_..~ .. >+\. '.'": :-::.; __ ,,:::=:.-:.~--;--~-{'._:: .. : _-:..._::.-:,._'.._:._.-. .,,:,_..-:~-;: :,-:.. ._ .. '; ,.;~ ':'. the. VO~ the ae~ity11 .are used rathe~ th~ the WOrcbi "his interest." "Adverse claim" is defined identically in 1978 I 8-302(2) and pre-1978 I 8-301(1) to include "a claim that a transfer was or would be wrongful or that a particular adverse person is the owner of or bas an interest in the security." As to what constitutes notice of an adverse claim, JIU 1978 I 8-304: 111i1.hx111, 444 ~.supp. at 1020-23, sa:t;t;arfiald. saa alsg infra text at.n~t .. 350-66 (diac:uaslng consiatency between the new IIGdal --~o,c,aect :for: di'ffarent-uw: conflic:tinJ' claims -anc:1-the ,doc:1:r_~ of bona< fide .pa'Chasa ..-.-applied, to -negotiable inatrmaents). 83. 1978 I 8-302(1) provides: (1) A bona fide purchaser is a purchaser for value in good faith anc:l without notice of any a~verse claim: (a) who takes delivery of a certificated security in bearer fora or in registered fora, issued or indoned to hill or in blank: (b) to wh011 the transfer, pledge or release of an uncertificated security is registered on the books of the issuer, or (c) to wh011 a security ia transferred under the provisions of paragraph (c), (d)(i), or (g) of section 8-313(1). Pre-1978 I 8-302(1) is subatantially the same as 1978 I 8-302(1)(a). 1978 subparagraph (l)(b) was added to accommodate uncertificated securities and subparagraph (l)(c) was added for clarity only, the same result following from both versions of 8-313(2) (first sentence). iCA u.c.c., app. 1, I 8-302, Reasons for 1977 Change, at 841-42. DOC. SWP1101A July 17, 1989
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44 (other than a clearing corporation) cannot become a bona fide purcbaaer. 84. A transfer effected on the books of a clearing corporation can confer bona fide purchaser status on a tranaferae. 1978 II 8-302(1) (quoted IPPD note 83), -313(1)(g), (2) (first aentence), -320; pre-1978 I 8-313(2) (first sentence), -320; m Satterfield v. Bayaond, No. c-84-0646W (D. Utah Oct. 31, 1985) (LEXIS, Genfed library, Dist file). Both DTC and NSCC are clearing corporations. I supra not. 21-~8 and . a~ing. t~ :(4ic:lisil'.ICJ,-ro1e'of, me:anc1 -xscci.; intra:--notas. 359.;.55 and accoapanyingtaxt (diacus~ingrationalefor bona fide purcbaaer. atatua. of clearing corporati,on transferees). 1978 I 8313 (1) (g) refers to entries t;p ;the accpunt Pt ;the purchaser pr a perspn d1siqnat1d by him (the italicized wo~s having been added to th pre-1978 paragraph (l)(e)). Read literally, the "designated by him" language would seem to-say that a purchaser who is.a customer of an intermediary can receive a transfer under paragraph (l)(g) and, thereby, becoae a bo;na fide purcbaaer. The ~i---~~-_by:~1-~--~-.f~r?. ~~1:lY.-. ~-:.d~~v~ _.f;raa.: .. ,. ~gnp1i ,c1J Jr -:c~ :1-t. ~----~ _: .. ~9'~p4 p~e-:;J.97:a. -venicma ..-r-1y to Incorporate a 9enera1 agency principle) perhap in the (1ii.aguided) interest of conaistency. Such a literal reading of paragraph (l)(g) would mean that most routine transferees of interests in fungible bullcs in the securities market become bona fide purchasers--certainly not the intended ruult under paragraph (1) (g). IU Katzman, Security Interests in Federal Agency Book-Entry Securities: Doing It With Mirrors, 42 au.. Law. 157, 176 (1986) (tranaferee on boob of clearing corporation can becOll8 bona fide purcbaaer, but transferee's cuatoaer cannot; the duignated by hill" language was not diacuaaed); infra note 85. Fortunately, not even the most fervent advocates of bona fide purchase have had the temerity to suggest that literal reading. Guttman has argued that a customer of an intermediary participant in a clearing corporation can become a bona fide purchaser, but ha acknowledges that such a customer can receive a delivery under 1978 I 8-313(l)(d)(i) or pre-1978 I 8-313(1)(c) only if the specific certificate to be delivered is identified. GtJ'l'TMAN, supra note 11, at 8-4, n.14, 8-29 to 8-30; m infra note 85. Because clearing corporations normally maintain securities in fungible bulk, Guttman' explanation has little practical significance. 85. bA 1978 11 8-302(1) (c), -313(1) (d)(ii), (1) (d)(iii), (2) (first ntence); pre-1978 II 8-313(2); infra notes 242-54 and accompanying text (rebutting arguments and authorities to the contrary and discussing requisites of identification of a DOC. SWP1101A July 17, 1989
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45 J. ~r ... fer of aeaurity Iatrta (Pledg> The exclusive methods of transfer specified in 1978 action 8-313(1) apply to th [t]r,nafer of a security or a lillited interest (including a aecurity interest) therein, and a aecurity interest in a curity ia enforceable only if it bas been transferred to the aecured party (or ita designee) pursuant . ..... pacific curitywithin the -aning of 1978 I 8-313 (1) (d) (i) and pre-1978 I 8-313(1)(c)). The Official C01111ent to I 8-313 explains: If bona fide purchaser status were given to those whose curiti _are bald a a part of a fungible bulk, there .. woald be a po~aibility.ot inconaiatent clailla betwHn two or -: :,:.-"~ bolia.'~14 -~; inceif tile: balk: aliOUld prove to :. ~-.= ~. N;:-mll.r .. than ~--expect-S";~the-c:laia -of one or both 1111st be coaprcmdaed. 1978 I 8-313, c01111ent 4 . Saa also Haydock, When is a Broker a Bail or i an Interest in Securities a General Intangible?, 35 Ark. L. Rev. 10, 18 (1981) (I 8-313(2) makes sense, since it avoids giving one bona fide purchaser priority over another"). The r .. aoning of the t"OIPleU aism the 11ark. certainly there is nothing odd about the transfer of curiti to a aeriu of bona fide purchasers; the last-in-time would always cut off the rights of prior purchasers. bA GtJ'1"1'MAlf, supra note 11, at 8-4 n. 17. What the c01111ent and Haydock probably intended to recognize is that such transfers of interuta in fungible bulks do not fit the paradigm of delivery of a diacrate negotiable instrmaent and the corresponding general policy that transferees who share a common intermediary ought to share according to the proportionate property intr-t" rule. s11 intra text accompanying notes 9699. If the intermediary is itself a bona fide purchaser, of course, the I 8-313 (1) (d) (ii). or (iii) transferee is benefited by the shelter principle. In I 8-301(1); supra note 70; see also 8-313(3) (notice of adverse claim received by intermediary or purchaser aubsequent to delivery of certificated security to intermediary is ineffective as to intermediary and purchaser). 86. 1978 I 8-313(1); m 1978 8-301(2) (quoted supra note 70). DOC. SWP1101A July 17, 1989
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46 to 1978 aection 8-313(1).11 If the transfer is made pursuant to agreement by a transferor who has rights in the security to a tranaferee mo has given value, it i a perfected aecurity interut. Although a aecurity interest can be transferred purauant to any aubparagraph of 1978 8-313(1), certain aubparagraphs of ction 8-313(1) apply pnly to the transfer of a --~~c;Qrit~ _. /:. ::~_:. :'.. :, ~: ....... ,. .. ::: :.: .':: = -~ .: :.~ .. ,, '. '. ;;: .: .. ,' ., -: >. ;. : ; ...... .. 87. 1978 s 8-321(1): P.D.I.c. v. w. Bugh Meyer Assocs., Inc., 864 F.2d 371, 374 (5th Cir. 1989): Xn re Domestic Fuel Corp., 70 Banlcr. 455, 460 (Bankr. S.D.N.Y. 1987). Consistent with COIIIDlonly used securities industry terminology, "security interest ancJ pledge" are used interchangeably in this article, whether or not the aecurity intereat i a non-poaseaaory one. IM 1'978 .1 :-1-101 (regi~~ion ~( pl~~:~~. ~ce,~if,i.ca~~d-....... a:uri:ty)"i''V-.C'~'C;', "&pp;:1;: 1a-1a1'~ :lteiaom ~-f'or' 19.7'7 -~, at a,1\:.-c:,~p1--,..-~----.: ,~ -wn~~ 'calblmf ~no1ogy. r., .... ,. "! 88. 1978 I 8-321(2). The filing of an Article 9 financing stat-ant is not required. 1978 I 8-321(3)(a): In re Domestic Fuel Corp, 70 Banlcr. at 464. 89. 1978 I a-313(1)(h) (till of written notice by secured party, after debtor ha aigned a curity agreuaent ducribing collateral, given to debtor' financial intermediary or third party in poaaession of, or who ia registered owner or pladgee of, security), (l)(i) (if debtor ha signed a written security agre-nt describing the collateral, time that new value is given by secured party), (l)(j) (if secured party is financial intermediary to whoa security bas already been transferred, time debtor signs security agreement describing collateral and secured party gives value). Transfer pursuant to 1978 section 8-313 (l) (i) provides only temporary perfection that is essentially equivalent to pre-1978 I 9-304(4). 1978 I 8-321(2) ("security interest transferred solely under paragraph (i) of Section 8-313(1) becomes unperfectad after 21 days unless, within that time, the requirements for transfer under any other provision of section 8-313(1) are satisfied.") see also 1978 II 8-108, -313(l)(b), -321 (perfection of security interest in uncertificated security by registration of pledge). For a descriptions of the process of registration of pledge, see Reporter's comment, supra note 5, at 814-15: GtJ'l"l'MAN, supra note DOC. SWP1101A July 17, 1989
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47 The treatment of all aspects of creation and perfection of security interests in the 1978 Article 8 and the corresponding rmaoval of those -tten froa Article 9 bave been strongly criticized. But, c:lrafting and style considerations aaide, tbe aubatance of tbe rallUlting unification within 1978 Article 8 has produced acme distinct illprov-enta. confusion aa to whether .-P~;a.~,;-.ot, ,~~'--='' ~;:--~~l_.:.:t-. ~t:rol..::-~~-parf.ection of 0 ' ,.. ''" t ... 4 ... ....... .,\. , ,II,,. .a .. I . , ." : _.~~~i~; i~t~.~~---in.-.~~~i~i~--~~-~en --~oved~" Moreover, . . -:. . . 11, at 5-56 to 5-60. 90. In Coogan, supra note, at 1052-69; Rasor, A critical Look at Secured Transactions Under Revised Article 8, 14 Fla. st. L. Rev. 859,.861-72 (1987). Both autbon appear to have been .. ...-tantially, -inf1u.~-J~y: ~9ic-. concerna-about abandoning .,ld.;i~: .-9 .' .-. g4111er_ally-~tul .approacb.: of -deaJ.inq vith ciirity interests in personal property in one place. In co99an, supra, at 1052-53; Rasor, supra~ at 868-69. Aronstein, Haydock and Scott responded to Coogans article by persuasively explaining that many of Coogans problems with the 1978 Article 8 also exist under the pre-1978 versions of Articles 8 and 9 and that otbera are not serious. In Aronstein, Haydock Scott, gpra note 5, passipl. Pora diacuaaiona and ccmp&riaona of aecurecl tranaactiona covering aacuritiu under the pre-1978 Article 8 and 9 and tb 1978 Article 8, Aronstein, security Interests in securities: Bow Code Revision Reflects Modern Security-Bolding Practices, 10 u.c.c. L.J. 289 (1978) [hereinafter Security Interests]; Haydock, supra note 85. 91. For example, when a third party bailee is in possession of securities collateral, under pre-1978 I 9-305 a secured party can achieve perfection "fr011 th till the bail receives notification of the secured party's interest. Pre-1978 I 9-305 (second sentence). But pre-1978 I 8-313(1)(d) can be construed to mandate that the perfection requires an acknowledgement by the third party bailee. an Aronstein, Security Interests, supra note 90, at 296 ("It i aurely not a trained construction to conclude that the creation of a security interest in a security i the purchase of a limited interest' therein, and, therefore, governed by the provisions of [pre-1978] Part 3 of Article 8."); Haydock, supra note 85, at 15-16; WiMett v. Inverness counsel, DOC. SWP1101A July 17, 1989
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48 1978 ction 8-313(1)(d), claus(ii) and (iii), provides a ans for a secured creditor to become perfected even when the intenaediary that effects the transfer by book entry and confirllation is, itself, th debtor. Concerns about misleading Inc., Ho. 76-3810 (S.D.H.Y. Aug. 14, 1979) (holding that third party bailH 111W1t agree to hold for notifying secured party and aar notice ia insufficient for perfection, but not ci~ing pre_.~97..8 .. 1-,:-.313(.1.)-.(~)-_) .: aft.'d,~.61 . ,F;-._-i24 .. 1~.9.3-: .. (-2d.Cir . -.19-79.) ... _. _,. ... Cmaaentators.-generlilly t:~e-the view; however, tht pre-1978 9305_ ought to control over: any contrary provision of pn-1978 Article 8 unless an Article 8 transferee i a subsequent bona fide purchaser. an 1978, pre-1978 s 9-309; GtJT'l'MAN, supra note 11, at 5-55: Haydock, supra, at 16-17: see also Hale v. Kontaratoa lin re Kontaratos), 10 Banlcr. 956, 970 (Bankr. o. Me. 1981) (when third person in possession ia senior secured party, notice under pre-1978 I 9-305 111USt caae frma the debtor): Hot, Ratice Prabl-in the -Double-PledgeSituation, 55 Fordham L ......... ,09. >8~37'(} '"fdiaae)nein;fvt& .nilulte' and" ~-lysls in IArtan-iA).,-WMn--=u:riti' -an~ coiltrolled i,y~:1ntermediaries in fungible bulk, 1978 I 8-313(1)(h) makes it clear that transfer (and perfection) can be achieved by notice to the debtor's intermediary. 1978 S 8-313(1)(h). 92. It ia a longstanding tenet of the common law that a debtor cannot serve aa an agent or bail of a secured party for purpo-of clelivery and po-ion of collateral o a to create and perfect a pledge. In 1 G. GIUIOD, SBCDRrl'Y INTERBS'l'S IH PDSOHAL PROPERTY I 14.2, at 440 (1965). 'l'his principal has been left intact by the U.c.c. In I 9-305, Comment 2 ([I]t is of course clear, however, that the debtor or a person controlled by hill cannot qualify as an agent for the secured party."): Starr v. Bruce Farley Corp. lin re Bruce Farley corp.), 612 F.2d 1197, 1200 (9th Cir. 1980) ('l'he debtor cannot qualify as an agent for the secured party for the purpose of perfection.~): Huffman v. Wikle lin re staff Mortgage, Inv. Corp.), 550 F.2d 1228, 1230 (9th cir. 1977) cu.c.c. drafters did not intend that debtor could be agent for purpo-of perfection and possession). With certain exceptions, a security interest in a security rmina subject to the provisions of Article g under the Revised Article 8. I 8-321(3). But the unambiguous language of I 8-321(1) and (2) makes it clear enough that (subject to the requireaents of an agreement, debtor's rights in the collateral and value) transfer of a security interest in a security under section 8-313(1) is sufficient for the attachment and perfection DOC. SWP1101A July 17, 1989
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49 appearanca, even if justified in other contexts, appear to have little relevance when the debtor that remains in control of the collateral i a prof-ional aecuritiea intermediary. Just as auch interaediariea are generally known to be in possession or control of cuatcmera aecaritiea, in a world where auch pledges are given effect, intermediaries are known to be in possession or c~n~rul ot .P.~edged securities"~ ... Juc;h t;a~~~J:' .. p~~id .... .. _. . :t: .. ~.-,;";' .. : 1 '. ,-:.,.,.. ' I_:., ... ~: ... . i,..,,,,.,.'.-1111'.. -!' -;_.1. .: ;;" .-. ". ~ ": .. ;, "'. / .. ,_. ._: ..... .. .. .. ... ... .. to .-.e~~-credit~~ o~ ~nateree of securities pursuant to a repo transaction, because the transfer will be of a security interest. see supra notes 86-88 and accompanying text. Por_ example, under I 8-313 (1) (d), properly construed, the f~i~ interaediary . can be, anc1 nonally .will. be in retail .. ~e,:,.~~,: -~,--..feroz-.... .Sec:t-ion,&-ll3(1) (d} .Jee.-. .diatinc:tiqn bebfeen.. transfers.of. entire .. interests . (ownerilhip). and 'i'illited''intaresta (such as aecilrity interests). A financial intermediary that is a tranaferor acts in two capacities--aa transferor and as the transferee's financial intermediary. a.AS 8-313(3) (defining financial intermediary" as a ... person who maintains security accounts for its custoaera anc:1 is acting in that capacity) (~hasi added). 93. Givan the difficult!-of anyone aacertaininCJ the current statu of aec:urities controlled by an intermediary in a fungible bulk of aecurities and the various claima that exist with respect to such securities, it is hard to see how anyone could be mialed by appearances. Saa infra note 107. Risks of fraud or debtor-creditor collusion may be mere real, however. ba Mooney, Th Mystery and Myth of ostensible ownership: A critique of Proposals to Extend Filing Requirements to Leases, 39 Ala. L.Rev. 683, 752-53 (1988) (prevention of fraud and collusion as to tilling and veracity of secured transactions is an important function of the Article 9 filing rules). I do not argue more generally here that a pledge should be effective when a pledgor raains in possession. 94. S supra notes 43-44 and accompanying text. Many landers to securities firms extend secured credit without taking delivery of the collateral--so-called "A-P" ("agreement to pledge) loans--while relying only on temporary perfection." DOC. SWP1101A July 17, 1989
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50 effective and perfected regardless of whether it is characterized as an outright sale or a secured transaction.95 a.a 1978 I 8-313(1)(i), -321(2) (21-day tuaporary perfection): pra-1978 I 9-304(4) <->~ [Interviews]. Unless specific Ncuritie in the debtor' poeion have beml identified within th aeaninCJ of 1978 I 8-313(1)(d)(i) or pre-1978 I 8-313(1)(c), such a secured lender cannot achieve bona fide purchaser status. sn supra note 85. such secured creditors as wall as transferees in hold in custody or d-ler safekeeping repo transactions, .. w-.-.. .-~e. ~itiu .:ore ... nae;. .:~oug~ :a .third.; p~rty ,. : necasaariiy bear the.rikll: that,l:he tr.ansferor-intermadiary.~illfail and that.there will be insufficient securities available to satisfy their claims. .an STIGtJM, REPO, 1upra note 43, at 191204 (discussing dealer safekeeping repos and less risky alternatives): intra notes 96-99 and accompanying text (discussing proportionate property interest rule): intra, Part III (discussing secured claims and ~tamer claims in insolvency prac..SinCJ> 'l'h tr111111feree. also i exposed to th risk that i~ intarut will not :~ntinue tn proc.-of the ~01iateral upon ; a cH.pmitm1 un1.a.-t11a proc..s. an etiden1::tt1a1:t1e~ 1 -. .. ::rosc.2) )''"Ba, .-.-t;q, -~ ~'Q11iv-..1. c~-r,~-r~~---c:rectitcorp.-v;-. Paraars Banlc of Portageville, 358 P. Supp. 317 (E.D. Mo. 1973) (application of "lowest intermediate balance rule in determination of whether cash proceeds commingled in a bank account were "identifiable"); qanarally B. CLARK; THE LAW OF SECDRED TRANSACTIONS tJNDER THE lJHIFORM COIINERCIAL CODE I 10.3, at 10-20 ta 10-24 (1980): R. BBHSON, SBCDRED TRANSACTIONS UNDER THE lJHIPORM COMMERCIAL CODE I 6, at 204-05 (1979): Note, Standarda and Sanctions for the Use of cau Collateral Under the Bankruptcy Cade, 63 Tex. L. Rev. 341, 347 n.41 (1981) c[T]he jor limitation with respect ta a security interest in proceeds is the ability of the secured party to trace the proceeds. ) Arguably, the standard for identification of proceeds should not ba more strict than that applicable to the original transfer. in I 8-313(1) (d)(ii), (l)(d) (iii). 95. The law is not clear as to whether a repo is an outright sale with an agreement to repurchase (as it is denominated) or a secured transaction. c;gmpara Cohen v. Army Moral Support Fund (ID rt Bevill, Bressler, Schulman Asset Manag-ent Corp.), 67 Bankr. 557, 596-98 (D.N.J. 1986) (repo and reverse repo agreement were contracts for the sale and resale back of securities) with Union Planters Nat'l Bank v. United States, 426 F.2d 115, 118 (6th Cir. 1970) (repo transactions were secured loans for Federal income tax purposes) AIJd Westchester County Sav., Loan Ass'n v. Legel, Braswell Gov't Sec. Corp. (lD DOC. SWP1101A July 17, 1989
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51 4. fte roportioaate itropeny latereat Jtllle Th transfer of an intrt in a fungible bulk of c:uritiu purawmt to 1978 ction 8-lll(l)(d)(ii) or (iii) "i the owner of a proportionate property interut in th fungible bulk. Thi 11eana that all auch transfereea clailling an a zaga1, sraawa11 c.ovt sac. corp.), 648 P.2d 321, 324 n.5 (5th -~ir:~-)t.~~l J.a ~~P.?:.-~-~---~.:~O;.t.;t? .. even, ... tl1ough 11: i i11 th fOJ:il ot a aale)" Ami Xn r1 Lombard-Wall, Inc., No. 82-B-11556, bench op~_ (~.D.N. Y. Sept .. 16, 1982) (repo i a c:urd loan for bankruptcy purpo> Ill al10 Focht, Harbeck, Repurcha Agre-ents in Stockbrokerag Bankruptci, 11 A.L.I.A.B.A. Course Mat'ls J. 7, 10-12 (Oct. 1986) (repo abould be characterized as secured tranaactions for bankruptcy purposes): Note, Th Heed for a Uniform Clasaification of Repurchase Agre..anta: Reconciling Xnv .. tor Protection with lconoaic Reality,. JS Aa. u. L. Rav. ,,,, 178-81 (1974) (characterization -of: .rap., :~-'the c:cmrta.-~lras--baa inconaiaunt) :-Kou,: Lirting the Cl.aud.-o:t-,1Jncertain1sy. Qver tlla Jlape 11ar~-= Cbuactarization of Repoa aa Separate Pllrcba .. and Sal .. of Sec:aritiu, 37 Vand. L. Rav. 401, 415 (1984) (neither courta nor federal regulatory bodi have given repos a clear legal characterization"). 96. 1978 I 8-313(2) (second aentenca). Pra-1978 I 8-313(2) (aacond aentanca) i to th -effect, although the pra-1978 veraion of Article 8 contained no axpreu praviaions otharvi dealing with auch tranafera. Tile 1978 veraion continu .. to refer to th ownership of a purcbaaer. 1978 I 8-313(2) (Hcond ntance). C:ivan the goal of unifying both curity interest and non-aac:urity interest tranafara in 1978 I 8-313(1), however, the cond ntanc of aubaection (2) alao ahould be read to apply to same tier security intereata and ownarahip intr-t alike C,q,. where the debtor is itaelf th intermediary affecting a tranafer, or where a cured party transfer giv a notice to an intenaadiaey, who cuat011er i th debtor, under 1978 I a-313 (1) (h)). Ill IJ1PA not 86-88. Arguably a aillilar reault could be achieved under pre-1978 II 8-313 and 9-305. Th debtor could introduce parol evidence, if neceaaary, to ahow that what appeared to be an outright transfer waa actually a cured tranaaction. ba I 9-203 comment 4 ("Under thi Article as under prior law a debtor may llhow by parol evidence that a tranafer purporting to be absolute was in fact for curity.")1 4 s. WILLISTON, COH'l'RAC'l'S, I 635, at 1032 (3d ad. 1961, Supp. 1988). A broker' confirmation to a cured pany ahould comply with th DOC. SWP1101A July 17, 1989
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52 interut in a fungible bulk of a articular iY of curitiu controlled by the interaediary bave a proportionate property interat abared ratably vith all other aucb tranaferw of t;hat i&- Bvery tranafer punuant to an intenlediary' confinlation and book entry, vben there i no identification of a apec:ific certificated aec:urity purauant to 1978 NCtion a-~-Cl-J.(d}li)., -~ .-tlie .~feree.to.thia proportional I <. .. ' . raqllinaant in pra-1971 1 9-3~5 ~t! a _third party ~ilM ~eceive Dftif'.tc:atiotl ot .. =z:i~~-~t ~c~~ broker ver. i.n il-ion-:crr:tu fimfilll :ba1:J:: iiwa1vedl. a. p~1978 1 9-305; IPPD note 91. IP1i IN Aronatein, Haydock Scott, IJ1PD note 5, at 902, n.14 ("Under [pra-1978] article B' provisiona, an interest in a curity, including a liaited interut auch curity intereat, could not be effectively transferred to a aecured party without delivery.) (citinq pr-1978 I 8-301(1)). An ac:JcnovledC)Mnt under pra-1978 I 8-313(1)(4) vauld not conatitute a delivery vith raapec:t to a fanlJibl bulk, however. la Appendix III, infra, note 12. 97. In I 1-201(17) (1Pm1qibl' vith raspec:t to aecuritiu aeana aecuritiu of vtlich any unit i, by nature or usage of trade, th equivalent of any other like unit.). Certainly a share of atock isaued by X Corporation i not equivalent" to a abare of tock iaaued by Y Corporation. iU alaq 1978 I 8-107(1) ([A] penon obligated to transfer curiti .. -Y transfer any certificated aacurity gf t;h 1pacifil4 in ... or an equivalent uncertificated aecurity ) (aapbasis ~dded). The NCOnd sentence of I a-313(2) bas rarely been conatrued by the courts. However, one court appeared to apply the abarinq principle u uong all custcmen with rupec:t to all typu of aec:uriti .. controlled by the interaadiary, althougb the tacts are not clearly reflected by the reported opinion. United Statu v. Doyle, 481 P.Supp. 1214 (D.Jlinn. 1980). As to wbat aec::uriti .. of the appropriate issue conatitute the tunqible bulk, ... infn note 102. DOC. SWP1101A July 17, 1989
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53 property intaraat rule. Th proportionate property intereat formulation, then, is the baseline rule provided by Article 8 concaming the prioriti among claimant to curities controlled by a comon intermediary, i,,, claimant on the aame tier." s. ftaufer of lloaaiatat or J:uuftiaiat QUmatity \~ 000 " ;.. :~ .... ,,., 9..( ... 1~~~ 0 ; .': I;';".,.;: .. ;,--;-... ._;. '~. : ."!,, . _-'. ,, .; 0 o .. : .--~. :. .": . -. "!'!;~,. . ; .......... ~. :;. ~. . I . . -: . ,_:,: . ,:: ~o: ." -~ r: , _, ....... :. .,"' ... . .. AaaUJDa :that an i:nt~adiaey takes all step~ necaasary to affect a tranafer of an interest in a fungible bulk of securities except that the in~eJ;"Jllediary ;tself does not control any curiti of the iaaua to be ~anaferrad. Under Article 8, . . '. . . .. .. ,it .. ia~ l~y,_-~~,.-:tb~ .Vffl.lld be .... no .~active .. transfer... That ...... -_ .. ... ... ' .. .. :. .:,:.-':".,. -: ._: ", ~. ..:. .. 98. Of the excluaiva method of transfer provided by 1978 8-313(1) only aubparagraph (d) provides tor transfer by a (non clearing corporation) intermediary's book entry and confirmation. Such transfers not within subparagraph (d)(i) necessarily take place, if at all, under aubparagrapha (d) (ii) or (d)(iii). 99. one comaantator ha augguted, incorrectly in my view, that the proportionate property intareat rule appli to claims among to curities among claiunt on different tiara. bA infra notes 265-68 (arguing that the proportionate property intereat rule is inapplicable except a among claimants that ahare a c011111on intermediary). Although it has bean suggested that the purpo of the proportional property interest rule is as a distributional rule to be applied in cases of intermediary inaolvancy, that auggestion is questionable. Sae infra notes 196-97 and accompanying text. To the extent otherwise applicable atate property law i controlling in an intermediary' insolvency proceeding, however, it i clear that the rule serves that function in fact. a.a infra notes 221-22 and acc011panying text. 100. 1978 II B-313(1)(d)(ii) and (d)(iii) refer to the tranafer of a quantity of aacuriti that constitute or are a part of a fungible bulk" of aacurities that are in the intermediary' posseaaion, or (if uncertificated) registered in DOC. SWP1101A July 17, 1989
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54 reault i not aurpriaing, given tbe traditional property law concept of QeJllP dat.111 How aasUJDe that th intermediary, at the tiaa of the putative transfer, controlled IQIII curities of the iu to be tranaferred (c011priaing a fungible bulk) but not a nfficient quantity to cover clailla of its existing customers and alao tho of the putative tranafer In that situation, it is poaib1e, ... t ~--tJ:~~~-:tici~ly ,..that\'af''trilwtr. would ... occur. 11Z 'l'lie _pu~ti~. f~a~f~r~e ~d-th. ~th~ c:uatome~ th~n ~~uld _.~wn "a proportionate property interest in the fungible bulk.1 Yet . its naae, or bown on its account with another J.nteraediary,.. :-1,,, .. :r.::s1,c1fcdft11r, (4) {fr1t/ ifhe:pz,o e4 ~zs. . . . . . . .. ... _pc,' . . ~Reg:Ulai:ionit aretct:tbe'a.-..ettect but:'aven ilore to the point. Propoaad TRADES Regulations I 357.12(c) (transfer by book entry on the books of an intermediary is effective only if the aecurities are all or a part of the same issue of securities that are in fact maintained in the intermediary's account with a Federal Reserve Bank or with another intermediary). 101. I aupra note. 102. To reach thi reault it would be necessary to find book entri or other actiona that would satisfy the identification requirement. ID 1978 I 8-313(1)(d) (ii), (d)(iii). Although theoretically possible, in the usual case it i unlikely that the intermediary would identify the putative transferee's interest to a fungible bulk that would be insufficient to cover the aggregate customer claims. on the other hand, 3-313(1)(d)(ii) and (d)(iii) should not be conatrued to require identification of a particular fungible bulk ta.q,, securities of the same issue that at any point in time may be controlled by the intermediary in street name, All5i in its account with a clearing corporation, .and in its accounts with other (non-clearing corporation) interv-1iariea). Intermediaries normally do not identify a particular fungible bulk with particular transferee-customers. [Interviews]. 103. 1978, pre-1978 I 8-313(2) (second sentence). DOC. SWP1101A July 17, 1989
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55 even in the latter situation the putative transferee might not receive a transfer of a property interest under Article 8. In tbe abaence of outright fraud, it might be argued convincingly that an honest intermediary bad no intention or desire to dilute tbe interuta of its existing customers. 1' While far from shocking under property theory, the .. .. .. P,P~~!:!~ ~~-f~'-': ~-.-.. uns~c:urecl _0.creditors :........ .~ ~.a. ':""-. -~:.,. -~ . :~ .... :':.; : .;_ . ..... ... ,. : . . ... : ; .,_; . -~.. .. . l,04. . 'l'b ahorttll. cou~d t fr01l a mistake or an pe,xpecte4.-~elopaen.t~ .. ,.'ftle. -intaraadiary.-.lliqht .. notnceive the ~itiu ... to.~; tranaf~ed-U. ~ulrt ofa. tailed. trade. or, tbe intermediary might bec01le insolvent attar the putative transferee's payment to it but before the securities had been transferred to it. or, a lender to the intermediary might tail to release the securities held as collateral or even dispose of tba. Even if the identification requirement were somehow met, a court might refuse to award the putative transferee with a property right in securitiu already on hand, to the detriment of existing cuat011ers, when that was not the intention of any of the parties involved. However, this analysis could yield bizarre results. The entire transfer could be nullified even though the securities on hand were only one dollar or one share short. A similar result could occur even if the intermediary subsequently acquired securities in order to cover the shortfall. Although 1978 I 8-313(d) does not expressly contamplate the intermediary transferor's acquisition of the securities after the other steps necessary for transfer have occurred, a reasonable reading should acco1111Dodate that result. ~Aronstein, Haydock & Scott, supra note 5, at 911 (arguing that the "at the time" language of 8-313(1) should not be read to preclude subsequent satisfaction of additional requirements of 1978 I 8-321 for attachment and perfection of a security interest). Moreover, the customer protection rules applicable to registered broker-dealers expressly contaplate that compliance in not inconsistent with the existence of temporary shortfalls in customer securities. see supra note 56. DOC. SWPllOlA July 17, 1989
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56 is of questionable wisdoa.115 The putative transferee has cast its lot with the intenaec:liary, as have the other, pre-existing cuatoaen. 'l'hey have cmmon interuta, have behaved ailailarly, the s- risks, and are victims of a c0J111on disaster: they ought to abare a c01111on fate. 'l'hat the putative tranaferN and the other customers might be victims of a :_~fal~.-1-.l.....,ly ... f~Ri~Oil~'::1=:-/.prac:tit:al attU, -none of: . . .. . ,' . . . . . . . :tli inteniediary'ii c::uat011ers.' wouicii-iiave any w~y to. as~.rt~in, either at the till of transfer or thereafter, that the intermediary owned a fungible bulk sufficient to satisfy their clailla.117 ~Y ~t-rely Qn the ultimate financial atrength and -: . . . .. .. . . .. . 1. ., --=_,;. :.4 .. ..... ~-: ~~--:. ..... _._, ... ,_:~-:-~~;_,~~~-~~-:-~ ~,-:. :, ........ ; ;,.~---~~ ..... _,,. -~: ~.-. .."' ,. . -.. .-.-.-.-: -1.u-. --~ 'otherv&a,<11rttt "'mnt:ot an nteniecilary insolvency, perhaps putative transferees who have paid cash to the intermediary should be treated the same as customers who have actually received transfers of securities. Presumably the putative transferee would have paid for the securities and would be entitled, at a minimm, to a claila for the money paid or a damage claim. If no payment had been made, then the no transfer ruult would not be ao harsh. In the case of an insolvency proceec:ling of th interaediary, a putative transferee that had paid for the aecuritiu llight receive additional protection notwithstanding the absence of a transfer under otherwise applicable state or Federal law. see infra notes 189-91 and accompanying text. 106. Thia point is developed in the discussion of risk sharing distributional rules among cust011ers in intermediary insolvency proceedings. s11 g1n1rally infra Part III. 107. If a transferee of an interest in a fungible bulk of securities looks to the books of its intermediary for evidence of a transfer, those books would undoubtedly show interests of many other transferees of interests in the same fungible bulk. Only a continuing "audit" of the books of the intermediary and either the aecurities in the intermediary's possession or credited to its account with other intermediaries would provide assuranca that the fungible bulk contains sufficient securities to cover DOC. SWP1101A July 17, 1989
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57 integrity of their intermediary and prophylactic controls designed to prevent such shortfalls.1 ne Book Bntrf 'freumy lleCJ11latiou The ov-ent toward increasing the efficiency of trading in govermaent securities, by eliminating the necessity of certificate deliveries, began aore than fifty years ago. 1 --~~~~~J:h,:-,~~t;:;~~~~--~~-~---~,t-4~---~rig~n -ii'.' ~-:in -~ tii.--1~t~. 1~60:, ~,. 'the tliii iaplaantation_.. o"t" .the boc~-entry systea the interests of all of the intermediary's custoaars. This would involve a deteraination of the aggregate claiu against the fungible bulk a~.well as the aggregate volmaeof securities 4,ncluded in.,"t:h, :f'lmgitil bUJ.k~-, "lllian,.-th f.mlg":lbl bulk includes iiaeqq:citi.in. -accoanta of th; .. traJiaferae intermediary with other intermediaries, the same analysis of the aggregate volume and aggregate claims would be required as to the other intermediaries. Obviously, such investigations are not feasible in connection with moat securities transactions. The status of the various accounts would be constantly changing in any event. an Aronstein, Haydock, Scott, supra note 5, at n.101: As a practical aatter, one who purchases through an intermediary does not investigate any further. Ba assumes that the intermediary bolds a valid and unencumbered interest and relies on the intermediary's integrity and financial strength. The kind of inquiry which goes behind the intermediary's confirmation, would rarely, if ever, be undertaken. 108. see supra notes 53-59 and accompanying text. 109. At first provision was made for the transfer of securities between Federal Reserve banks by telegraph. These transfers, called "CPD's, required the approval of the Treasury's C0111111issionar of the Public Debt and were called "CPD's. in STIGtJM, TRADE, supra note 13, at 83-84. They eliminated the necessity of transporting securities over long distances. For a brief description of the history of the Treasury security book-entry system, see i4. DOC. SWPll0lA July 17, 1989
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58 vaa accelerated in the early 19701a.111 Thia subpart takes a cloaer look at the transfer and pledge provisions of the Book'" ,:.j, .. ,. ; ... -!"."',.,.~;,:~ .. -.;.~,~;.-,,. 1"<1(1,","'.'! : --.'' ,..~ ... ~ :,',:,._-: ... ": . .':..~' :- :-=-.: .:_._.:,1,,:....:'. ,._ .. .'.,:.-.a, . ~.. . .. . ' .. .... .. .. . .. : .. ,. ... .... '-.~; .... :.-... -i .. _~:-.. -:. ,:t .--...... ~,:--=~~-:~~.-... .. :: .. ~ ....... _.:.~:.:.;:.J.a, : ... -~. :~:.;:;:----:._._. . .. .. . ~.. ~. .-.:'lo ..,_~.:.,' .. '\.,.._.--~-~::,'."',;,_:....-,~.:..,~-~ ;. .. ,('-'~-."_." .'\~ ... .:,: S, ,--:.:, . :-:. 110. The acceleration occurred because of a crisis created by the possible loss of theft insurance coverage by securities dealers (resulting from several large thefts of securities). ,bA STIGtJM, TRADE, supra note 13, at 86-88. Th portion of the current book-entry Treasury Regulations dealing with the transfer and pledge of book-entry securities were last amended in 1972. 37 Fed. Reg. 8671 (1972). The market structure and operation of the tiered system for book-entry government securities was described above. see supra notes 31-44 and accompanying text. DOC. SWP1101A July 17, 1989
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59 Entry Treasury Regulations.111 1. ft Bearer Defillitiven iatioa oath ~op ~ier: ~fer u4 e49e oa tile ed Boon Tranafera anc:l pledg-of interests in book-entry Truaury securities aaong DI' that -intain securities accounts at the Pad112 are subject to a Federal rule that does not, on its :>; :,_; .~: .: .> :: :!, . ::<:".."!, _:~. .. :., ... \~: ~: .,~,-:;~.:r;;r::I~::::(:: J~:.~-:~,._~>_: -~:: :J.: "-'.:~ -~<:: .. _";-":, :_._. .. :,.-:.: .. : :,~ >._<-~: :~, ., -... 111~ "31 e~p~--If~ 3,}1is-~306.122 (1988) [hereinaf'ter Book-Entry Treasury Regulations]. The Book-Entry Treasury Regulations cover book-entry Treasury bonds, notes, certificates of indebtedness, and bills issued under the Second Liberty Bond ~, as amend~. 31 c.F.R. I ~06.1is(d) (defini~g "Book-entry Treasury security) Substantially similar ( for present purposes) regulations dealing vi~ book-ant~ Treasury bills are found at 3~ C.P~R . 11 :3.50.2 350~6. (1988). 31 C.F.R. I ~~-50~-.,daf,ilwag. (-:~-.bill~l)-. :._vu-i.-.-F.C,eral agencies alQ:..~:ve .adqptad,.11ubatantially: aiJlilarregul.ations .. la 1 C.P.R. II 462.1 -462.8 (1988) (Federal Rome Loan.Mortgage Corporation): 1 C.F.R. I 1901.506 (1988) (Farmers Homa Administration): 12 c.r.R. II 406.1 -406.8 (1988) ('l'ha Export Import Bank): 12 C.F.R. II 506a.l -506a.9 (1988) (Federal Home Loan Bank 'Soard): 12 c.r.R. 11615.5450 615.5494 (1989) (Farm credit Adllinistration): 12 c.F~R. SI 111.1 -111.1 (1988) (Federal Pi.nancing Bank); 24 C.F.R. IS 81.41 -81.49 (1988) (Federal National Mortgage Association); 31 c.P.R. II 354.1 354.9 (1988) (Student Loan Marketing Association): 39 c.P.R. SI 761.1 -761.8) (1988) (United States Postal service). For simplicity, the following discussion focuses only on the Book Entry Treasury Regulations, but the discussion generally applies to transfer and pledge in the other book-entry systems. au qenarally G'O'l"l'MAN, supra note 11, at 5-65 to 5-75: Ringsmuth, supra note 77, in REPURCHASE AND REVERSE REPURCHASE AGREEMENTS 1985, supra note 77, at 51: crespi, Security Interests in Book Entry Govermnent Securities: The Unsettled Status of Clearing Agent Liens Under Article a, 20 u.c.c. L.J. 159 (1987): Katzman, supra note 84. In view of the size and importance of the government securities market, surprisingly little has been written dealing with the legal aspects of transfer and pledge of book-entry Treasury securities. 112. The following discussion refers to the various reserve banks as the Fed." DOC. SWP1101A July 17, 1989
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60 face, appear to involve state law.1u The concepts embodied in paragraph (a) of Book-Entry Treasury Regulations section 306.118 are ailllpl enough. Tranafera and pledges reflected by entries in the Ped' booka (auch as by Pedwire) are de-ed to have the affect of physical deliveries and receipt. in bearer form of definitive Treasury securities and the transferee or pledgee becOJDs _a:. ~l;\Qlcle~ 1:~ -In .the -:~se--.ot :-a pi.edge:, -the. pledgee -_ . . . . . . . . .. . . . . secur:lty. hlterest is ~rfected. "115 As among DI' s who have bookentry securities accounts at the Ped, this bearer definitive" fiction attempts to replicate the delivery of physical securities u.well as the effects of a delivery. -At the top (Ped) tier this . . . . : . -. . . . r1ctt1:od ha iwor ta!rlf v~1i~.: :--~~i-~~.tcl~t!ng:-&~s;.e~rs' ':4~ -. .. .... :. !~-.. ---:'-:-J, .. -. =..' .... --:: ,1-.: ..... -:-::------.-~.-.... ~_.,-. ._ ....... --_: .-~ :. . :-_--...... and transferees have accounts with the same intermed-iary (the Fed116). Every transfer involves simultaneous, identical, 113. 31 C.F.R. S 306.llB(a) (1988). Paragraph (a) also applies to transfers and pledges between DI's and either the Fed or the United States government. l,si. 31 C.F.R. S 306.118 is quoted in full in Appendix II to this article. 114. l,si. 115. l,si. 116. Although the entries actually are made on the books of various reserve banks, the book-entry system functions essentially as an integrated single intermediary. DOC. SWP1101A July 17, 1989
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61 corresponding entries in the accounts of the transferee and the transferor.117 Although paragraph (a) creates a Federal rule that preeapta state law,1 it leava much to resolution under applicable state law. Por example, the Regulations do not specify the effect of a delivery or of becoming a holder, and '-.'.,~ --~~ .. --~--~,~r!~:t.: :b~~~CJ .. .. -, ., __ ... -.-., _. _perfect~-~~tt9 Pres~ly; when the ~Ok-Entry Treasury . .... .. .. . . Regulations were drafted these concepts were thought to have fair~y strai~htfo~ar~ m~~ings ~nd.effects.1211 117. The. syata of tranafer IJVP. by Pedwire also .-a.iaal~ly_-~ua'.-1:he payaent.and :delivery functions .a-,nq __ .~ -Ped-'. .-book~try :~t .. -participantll. .,Sn supra notes 38-39 and accompanying text. 118. Transfers and pledgare "effected and perfected, notwithstanding any provision of law to the contrary." 31 c.F.R. I 306.118(a) (1988). 119. 111. 120. Delivery has long been a means of transfer and negotiation of negotiable instruments, including securities. ,bA 1978 SI 1-201(20) (defining bolder as one in possession of an instrument or certificated investment security issued to bearer ): 3-202(1) ("negotiation of an instrument occurs only when an instrument is transferred "in such form that the transferee becomes a holder); -302(1) ("holder" status is a requirement for obtaining "holder in due course" status;( -313(1)(a) (transfer of a security occurs at the time [a purchaser] acquires possession of a certificated security): -302(1)(a) (delivery of a certificated security is a requirement for obtaining bona fide purchaser status): pra-1978 II 8-301(1)(1972) (purchaser acquires rights upon delivery of a security"); -302 (1972) ("delivery of a security is a requirement for obtaining bona fide purchaser status). At the time the Treasury Regulations were first adopted o.c.c. Article 9 had bean widely enacted. As used in paragraph (a), "security DOC. SWPllOlA July 17, 1989
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62 Transfers on the books of a clearing corporation provide the best state law analogue for transfers and pledges on the boob of the Fed.121 Transfers and pledg-of certificated securitia in the c:watody of a clearing corporation (or uncertificatad sacuritia registered in tbe name of a clearing corporation) -y m affected by appropriate entries on the books :Of_-~ :q~~.J.~~-~:~-~io_n-.~-~-.,,~,. '.:=_-::'/\'.:? :.-, :: . '.: ... :. 7:'"':>/;,.:_: ".. ,-.. interests and the concept of' "petfecti~n" presumably were borrowed from Article 9. I.a I 1-201(37): 9-303. Problems associated with the choice of applicable state law are discussed in connection with lower tier transfers. see infra notes 129-42 and accmapanying text. 121. Transtere on the books o:r clearing corporat~ons, J.-.=:D1 Dnnareraes cm-:he:,:bookiil,:or. ttbe.-,p-s, -.i-ao-can achieve :baaa--ficla-~er .. status.:;. IHIJlPD.note a,,i ntnan, supra note 84, at 160, 178-79. Indeed, paragraph (a) was 'explicitly modeled after I 8-320. Katzman, supra, at 161 (citing Boey, Rassnick, Autoution of Government Securities Operations, 17 Jurilletrics J. 176, 181 (1976): Memorandum of Law for the United States Treasury Department and the Federal Reserve Bank of Hew York, Wichita Fed. Sav., Loan Ass'n v. Comark, 610 F. Supp. 406 (S.D.H.Y. 1985), mgdifitd,, 610 F. Supp. at 418 [hereinafter CQMrk IAPl), raprintfd in Ringauth, Federal Raerva Book-Entry Syst-, and the Rola of the Federal Reserve, in REPURCHASE Alfi> REVERSE RBPURCIIASB AGREEMENTS 1985 (PLI) 76 n. 9 (A. Levin, H. Novikoff, co-chairmen)). For present purposes, the role of the Fed, as the issuer's (Federal government's) fiscal agent, also is somewhat analogous to that of an issuer or transfer agent who maintains records of registered ownership of securities, except that only DI's may maintain accounts with the Fed in the book-entry system. In 31 C.F.R. I 306.116 (1988) ("Each Reserve Banlt is hereby authorized, in accordance with the provisions of this subpart, to: (a) Issue book-entry Treasury securities by means of entries on its records ). 122. 1978 I 8-320(1). However, the book-entry system for government securities and clearing corporation book-entry systems differ in an important respect: Members of a clearing corporation must devise external means to settle the payments side of securities trades whereas Fedwire allows simultaneous DOC. SWPllOlA July 17, 1989
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63 2. ft Bearer Definitive ~iatioa oa tb :Lower ~iera: ~rmfer and ~ldcJ Ullder applicable state Law Courts, counsel and commentators alike have been confounded in their attempts to interpret and apply the book entry Tr-ury Regulations. Moat of the difficultihave arisen .. ~~---~~~~<--~:-.P.Ji~e!':-:,.f.~~tf:;~~:-1_,-~t..!)~e: . .-.: ~1a!Jllari~ tbt:_. does .. :~~t:--.. ~~v~:. c~r is not' claU.mincf ~rough) .. a book. . . . . . . . . entry securities account with the Fed.125 Such "lower tier transactio~s., 11ot involving trans.fers. on the. books of the Fed, are governed -by paragraph (b) of ~ion 306.lll_of the Book;~:lllgal~~oraa.~~ .. -:::-: .-. -:, .': .,-.... :.~.-._,=.;,.:-:.:,:-;:, .. -.:.. :: ... _.,__ .... J_,. ...... I:-.,-:;,::., .. .. :.,: .... ..... o' -~.-,~,: .. : .. o ... ,,.. . ,,_,'.\.,: ,,.,:, ,.~,,,,,-:. :,,0 l,' o : o ,:_ Th scope of paragraph (b) is limited to book-entry Treasury securities maintained by a Reserve bank.125 Pursuant aecuriti-tranafara and payments. 123. For example, a non-DI d-ler normally finds it necessary to give a security interest to its clearing bank covering securities in" its cl-ring account on the books of its clearing bank in order to secure daylight overdrafts and overnight loans. l.n supra note 42. In that case the clearing bank is both the intermediary on who books the interest of its customer (the non-DI dealer) is reflected and a transferee of a security interest in the securities. or, a customer of a dealer (either a DI or a non-DI) may desire to sell or pledge to a third party securities "in its account on the dealer's books. 124. 31 C.F.R. I 306.llS(b) (1988). 125. lsi Presumably, maintained" means, at least, that the securities addressed by subparagraph (b) are limited to those that are s0111ehow attri~utable to securities accounts of DI's maintained on the books of the Fed. DOC. SWPllOlA July 17, 1989
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64 to the first sentence of paragraph (b), the effectiveness of transfers and pledges and the perfection of pledges turns on ccmpliance with what applicable law" would require "if the securitia were aaintained in bearer definitive form. 11126 The second aentence then instructs that the securities are to "be de-ad to be -intained in bearer definitive form. 127 The ----------. .. , .. --.:.-.,..ii&~-"n> ..>:::-.... ... --.. -= : = .-... .:-:= . . : : ...... 127. ~-"The "bearer definitive" fiction, when drafted, was necessary to allow transfer and pledge under the law applicable to transfer and pledge of securities--the pre-1978 Articles and 9. But the "bearer definitive" fiction in paragraph (b) does not provide, and does not mean, that each transfer is d-eci to-have an ~terat in a discrete, par1ticular, speci~ic piece. of pa~. To the co~trary, b(!ok-entry .ft,aumy.:sec::urit:J:~i111lenntly ... --~ at ..... tang11,1 w1Jt. ---BwN1t;iAM .c;anrninq iP0Jc:1n:t;ry -TnwlWY BODO, BPt;, and Bi11s, f:unanry of Department of Treasury, 51 Ped. Reg. 43027-41, 43035 (1986) [hereinafter Hovaabar Trades Summary]. A.delivery by identification of either a "specific security" in a broker' possession under pre-1978 I 8-313(1) (c) (or 1978 a-313(1)(d)(i)), or an identified security" in a third person's poasasion pursuant to pre-1978 a-313(1)(d), requires an identification of a specific aec:urity that i inccmpatil,le with the inclusion of the ecurity in a fungible bulk. IU infra notes 244-54 : Appendix III, infrl. note 6-9, 12. Thus, whether applicable law i the pre-1978 or the 1978 Article a, a delivery of book-entry Treasury securities cannot occur under 306.llS(b) because applicaole law makes no provision for a daliyery of securities included in a fungible bulk. A contrary conclusion-that a delivery can occur in the case of a fungible bulk--would mean that the Book-Entry Treasury Regulations made a drastic change in the result under applicable state law. see supra note 85 and acc0111panying text. Yet I 306.ll&(b) makes no provision for transfer or delivery except pursuant to "applicable law. sea infra note 121. And, where a different result was desired, as in the case of 306.lll(a), the regulations clearly provide that a delivery and holder status is attainable. supra note 114. Although 306.ll&(b) does refer to a "delivery" in the case of a third parson acknowledgement, it is plausible that the drafters of the Book-Entry Treasury Regulations simply did not understand the operation of applicable state law. Consideration DOC. SWPllOlA July 17, 1989
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65 reference to applicable law in subparagraph (b) an that 1t;at;1 law i to be conaul tad. 1 In ama, the fint two aantancu aandate that one fint pretend that the book-entry curiti are in bearer definitive fora (although they are not) and than look to applicable law of a tat to determine bow tranafen and pledge of bearer . ~~--,~~,~~~--,~:~~--Pl~CJ, _a~ -~ Bu~ th app~i~t~on. of ~. Boo~-Entry Treasury Regulations to lower tier transfers and pledges is problematic. Quest~ons lea~ to oth_ar questions_, and even the few clear answers pawn till -ore quutiona. Smaa examplu follow. . .>,.:,_..,..<'.:-~-Bet;: ISif.te' -in i. t;ll-1QR1tsebiw 1n1 ....... .. .... : ':. -~ ... .. ~'. .. : = :-. ... ': \ ..... -: ..... ..-.. ... :... u.c~c. Article a and 9 ccmpri the applicable atate law governing voluntary transfers and pledges of interests in sacuritias.129 Because state law is not uniform, however, in many cait will be nacuaary to identify the law of a particular of positions taken by the Federal Reserve Bank of New York and the Department of Treaaury in litigation and in connection with the Proposed TRADES Ragulationa have convinced that such a miaundarstanding almoat certainly existed. a.a infra note 175. 121. IIA, ,q,, Cohan v. Army Moral support Fund (In re Bevill, Breslr, Schulman Asset Manag-nt Corp.), 67 Bankr. 557, 616-17 (D.N.J. 1986); creapi, gpra note 111, at 170-71; Katzman, supra note 84, at 167; cgmark Mamg, supra note 121, at [8]. 129. s11 qanara11y supra Part II.A. DOC. SWPllOlA July 17, 198:>
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66 atata u the applicable law.111 The detenaination of applicable law under the choice of law rula of any given atat 11ay depend an tbe anmr given to yet another qu .. tion. Dlt: ltipd At PIRADl prsm,rty i an intnt in bqgkUnder tile pn-1978 U.C.C., intanata in book-entry ~'.':aK"i~i---,rauld.. .. .,.. ~pnual intangil>l~ .... Although . . . -. .. 130. Bach of the two veniona of Articla 8 and 9 is currently in effect in a substantial nUJlber of th stat. ID gpra not 5. To -k -tters worse, there are differences among the veniona of the 1978 Article 8 that have been enacted. Sipificantly, the illportant atata of lfev York has enacted a veraian at the a.vised Article 8 tbat. is different froa th unitana venion in a mmber of rupecta. [S~ta correlation 'l'ablea l u-.. c.c:.. 11ap.~ 'Sen~-:-"(C'allatbn) .:n-. Q n-zc 198&) , 1" ". : " 1,'" _.. '. ,,. i" ,,-. ,,,1,1,,', ,t:.,;. ,,,.-, 0 ,I l' " : ,,,, .. '.,"- 131. I t-10, (w,cbanged in the 1978 u.c.c., defining general intangible as any personal property (including things in action) other than floods, accounts, chattel paper, documents, instrmaents, and oney."): Heinicke Instruaants Co. v. Republic Corp., 543 P.2d 700, 702 (9th Cir. 197&) (purcbasars intarut in stock prior to issuance of stock certificate was a general intangible) Because paparlw aecariti .. ara not aecuritiu under pre-1978 I 8-102(1)(a), they ara not included in the Article 9 definition of instraaent. I 9-105(1)(1). an Coogan, &PD note 5, at 1020 I n.30. Cbaractarization of book entry Treasury aacuriti .. as general intangibl .. is precisely what the Department of Treasury sought to avoid by devising the bearer definitive" fiction, since security interats in general intangibl .. can be perfected only by filing. I 9-302(1) (unchanged in the 1978 o.c.c.): -Boey, Rassnick, Automation of Gavarmaant Securitia Oparationa, 17 Jurillatrics J. 176, 181 (1976): Katmn, supra not 84, at 167, 183. sn 1110 Coogan, upra note 5, at 1021-22, n.32 (sugguting that filing might be appropriate Mans of perfecting a security interat in uncertificated aecuriti .. in run of the mill transactions," but acknowledging that perfection by entries on the books of intermediaries would be desiraabla "[iJf uncertificated securities bec011a widely traded). Aronstein, Haydock, and Scott affectively countered Coogan' arguments favoring a filing rule for uncertificatad securities. Aronstein, Haydock, Scott, supra DOC. SWP1101A July 17, 1989
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67 the u.c.c. does not generally treat transfers of general intangibles, Article 9 does deal with security interests in ganeral intangibles.02 Under the 1978 Article 8, book-entry note, at 896-98 (arguing that a filing rule would impair eaaential attribute of negotiability). Although there are diaagreaenta at the margin, moat observers agree that Article -~ ... --~-~: .. g~p~~.a-~lY.:;;~PPiic~;i.~. fir~t:-to-file"."' o~prtect .rul are. uaefulbacauiN information ls provided to prospective purchasers about the possible existence of conflicting claims and because protection is. afforded to earlier in-time secured parties. bA o.c.c. 9-301 to -305, 312(5)(a): see generally, e.g., Baird, Notice Filing and the Prob.lam of Ostensible ownership, .12 J. Legal s.tud. 53 (1983) : Bairtl & Jackiaon, Intormation, Uncertainty, and the Transfer of Property, 13 J. Legal stud. 299 (1984): carlson, Rationality, ~ident and.Priority Under Article.9 of .the Uniform C011J11ercial -C9C:I~ .,7.1. Jlinn., L~:Rev -207. i-~Hl)",[bereinafter Rationality]: .-Oony. .. ,upra_ not :93:..--.P.billipa, :P.lawed Perfection: Proa Poaseaaion to Filing Under Article 9 (pts. 1 & 2), 59 s.u. L. Re~. 1, 209 (1979). An Article 9-type filing system for interests in fungible bulks of securities, however, would be wholly unworkable (wholly aside from negotiability concerns). First, to address fully the potential priority contests, it would be necessary that the filing systa be extended to ownership intereata, as well as aecurity intereats. Second, because the securities are fungible, it would be difficult to prepare collateral descriptions that would not be overbroad. By the same token, becauae securities intermediaries typically make transfers (as collateral and otherwise) to many, many transferees, broad filings te,q,, "all securities") would necessitate subordination agreements on a massive scale or exceptions to the first-to-file rule that would leave the conflicting priority issues largely unchanged. Finally, the high volume and velocity of transactions probably would overwhelm (or be overwhelmed by) any sort of filing regime heretofore seen by the world. 132. s11 supra note 131. For general intangibles, "[t]he law (including the conflict of laws rules) of the jurisdiction in which the debtor is located governs the perfection and the effect of perfection of non-perfection of the security interest." 9-103(3) (b). "A debtor shall be deemed located at his chief executive office if he has more than one place of business." 9-103(3)(d). DOC. SWP1101A July 17, 1989
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68 Treasury aecurities would seam, at first blush, to be uncertificated aecurities.m But the Fed does not undertake the role of an isauez, as contemplated by the 1978 Article 8, and traat111ent as uncertificatad securities would conflict with the bearer definitive fiction.' Thus, whatever version of Article 8 -y ba applicable, the bearer definitive fiction provides a -~ _anawer:: .. Book-entry.~aasury
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69 one mgre time; What state's law is the applicable law? Having concluded that book-entry Treasury securities are certificated securities for purposes of transfer and pledge under applicable state law, it does not necessarily follow that they will be treated as such for purposes of determining the applicable law.06 Even if they are so characterized for choice ~:-'.-~1!-' J~~~,,~,'>? W-~~;~.:~,~-. ~~
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70 in certificated securities, also can be problem&tic.140 Because section 9-103(1) makes the issue turn on the location of the collateral, 141 and the location alao may be an iJDportant factor in the application of section 1-105(1),142 yet ano~er question is presented. Whera is a bggk-entry Traasury sacurity located? ... : .':. ...... tangible, physical existence, only being deemed" to be in bearer definitive (certificated) form, determining the ~3_9.-~78 __ ~-~-:-~~71 ... 1 ~-~1-93.(11.(b) .. C~P~fec;:ti9n ... a.nd -~ effect; ot: pilrtec:tl:on .. or non-pe'r1e~lorl'. .. -~ 'governed by the law Of thejuriac::1:lc:tionWbere'.the Cbllai;aral is when the last event occurs on which is baaed the assertion that the security interest is perfected or unperfected.") 140. in, e.g., Coogan, The New OCC Article 9, 86 Harv. L. Rev. 477, 532-44, 555-58 (1973) (pointing out problems and pitfalls of aat event teat): Frisch, occ Filings: Changing CircuJ1Stances can Make a Rigbt Filing Wrong. But can-They Make a Wrong Filing Rigbt?, 56 s. ca1. L. Rev. 1247 (1983) (discussing Ulbiguities in aat event tut and problthat arise from strict interpretation): Petit, Choice of Law Under Article Nine of the occ, 7 Loy. u. Chi. L.J. 641, 666-76 (1976) (discussing ambiguities and problems with "last event" test). 141. see supra note 139. 142. ba, a,q,, In ra Longnecker, 7 o.c.c. Rep. serv. 264 (W.D. Mich. 1969) ("[T]he text for personal property generally is the location of the property on conflict of law questions"); J. BEALE, A TREATISE ON THE CONFLICT OF LAWS I 262.1, at 984-85 (1935) (the transfer of commercial paper, including bonds and certificates of stock, is governed by the law of the place where the paper is); Carnahan, Tangible Property and the Conflict of Laws, 2 o. Chi. L. Rev. 345 (1935) (in general, the law of the situs of the personal property governs transactions involving that property). DOC. SWPll0lA July 17, 1989
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71 corresponding "d-d" location presents patent problems. The Book-Entry Treasury Regulations do not expressly address the location of auch securities. The regulations do, however, address (albeit obliquely) another issue that may bear on the location of book-entry Treasury securities--possession. If the aecurities are da-ed to be in someone's possession, perhaps they ; ~;;_~?; ~~~~~-.:~r;_. ':~~:-: ,~ -~~,-: ~,~;. I II ... lO~ti~n -,~---, ~1111, another question becJcons. Who is in possession of book-entry Treasury securities? ~argraph (a) of ection 306.118 indicates that . . . . possea~ion is lodged with the DI to.whom book-entry Treasury e~iti~-are,;-.. ~f~:-,,~-pi-ed9ed on,.t!ie books of the Ped.144 11t1.~cie~~ -.~th~r;;this ~-ff~c:t -~f:. ~~ragr~~h(a) applies to lower tier transfers and pledges pursuant to paragraph (b). Paragraph (b) applies to securities "maintained by a reserve bank," thus arguably suggesting that it is the Fed which is in fictional possession of the deaed certificated securities.145 143. Once possession by an entity ware established, however, any formulation of the location of that entity, if it has a multi-state operation, would necessarily require additional gloss. 1ml, e.g., I 9-103(3)(d) (quoted in part supra note 132). 144. Such a transfer affects a "delivery" to the DI and constitutes the DI as a "bolder." 31 C.F.R. 306.ll8(a) (1988): see supra note 114. 145. a.A Katzman, supra note 84, at 168. DOC. SWPllOlA July 17, 1989
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72 on the other band, paragraph (b) provides that "[a] Reserve bank maintaining book-entry Treasury securities is not a bailee for purpo of notification of pledges or a third parson in poaaassion for purpose of aclcnowledgaent of .transfers thereof.* Thia indicates that, at least for purposes of paragraph (b), the Pad is not de-ed to be in possession of sacui-ities .. .. : :: .. .. '. I .. Paragraph (b.) goes on to provide: Where securities are recorded on the books of a depositary147 for account of the pledger or transferor thereof such depositary shall, tor purposes of perfecting a pledge of such securities or effecting delivery of such securities to a_purchasar ;,, -: ~:~:t::-:=t}~=!!o~f~~u:~ i:--!~t =-~:C:f!1:. ~:. . .. . .. . ...... -. P, .. 9 ... . . y "-be given or th third 'person' ln possession from which acknowledgement of the boldingMif the securities for the purchaser may be obtained. 146. 31 C.F.R. 306.118(b) (third sentence). The references to "bailee for purposes of notification" and "third person in possession for purposes of acknowledgement" are intended to embrace pledge and transfer pursuant to pre-1978 8-313(d) and 9-305, respectively. see supra note 91. 147. The following parenthetical appears after the word "depositary": "(a bank, banking institution, financial firm or similar party, which regularly accepts in the course of its business Treasury securities as a custodial service for customers, and maintains accounts in the names of such customers reflecting ownership of or interest in such securities)." 31 C.F.R. 306.118(b) (fourth sentence). 148. 31 C.F.R. 306.118(b) (fourth sentence). DOC. SWPllOlA July 17, 1989
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73 This language implies, then, that it is a depositary" (a term not limited to DI's149 ) that is in possession of the securities, at least for the specified purposes. When there are several tiers or layers of such depositaries, apparently each depositary in the chain would be in possession for purposes of transfer by acknowledg-ent and pledge perfection by notification.150 ... ..... .. :.: ....... .. i,oc:,t~En,~~ ,'1':r;~~-~ --~~~1:~o~.: .~o ... n0t..-3rie1d a :': ~-. ~::~ ~-~. :;.: --~~_-.............. -~.. __ :- . .-~' .. .. ~. -" .. -~. .', .... .. -'. ' . clear, generally applicable conclusiqn as to who is in possession . . . . of book-entry Treasury securities.91 At most we know for sure onfy th't depqsitaries,_rather than th fed, are to receive notificatio~ of pledges and give aclcnowledg-ents of transfers. . . . Ds concluaion,.rai- -another quution-..:' .... ~--i:. .. ft ..... : .... \ ... .. .. . .. . .... . .. -. ". .. : -; Jihot is th affect pf.the references in tbe Bgok-Entry Treasury Requlatigns tg the pre-197 prgvisigns for ackngwledgement transfers and bailee ngtificatign pledqa arfc:tign when th applicable law is th 191s Article a? The references in the Book-Entry Treasury Regulations to transfer by third person acknowledgement and perfection of 149. see supra note 147. 150. see infra note 243 ("constructive possession" doctrine). 151. Most certainly there is no crisp answer to the location puzzle as it relates to choice of applicable law .b supra notes 139-43 and accompanying text. DOC. SWP1101A July 17, 1989
PAGE 269
74 pledges by bailee notification clearly contemplate that applicable law will be the pre-1978 Articles 8 and 9.152 The affect of thaae references is uncertain when the 1978 Article 8 is the applicable law. Because 1978 section 8-313(l)(h)(i) is a clo analogue of pre-1978 section 9-305,155 the reference to bail notification could easily be read to embrace notification to a. financial --intermediary_ .under the .. version. The . .. . . . . . . references to transfer by third person acknowledgement are not compatible with the 1978 section 8-313, however. Acknowledgement by a financial intermediary is not one of the exclusive means of transfer provid~ by 197~ I 8-313 ( 1) _ 154 ~ Book-Entry Treasury ' ' ,: ... I . ' I-, .. . . .", .. -~ .. _. .. Ragulatio~ designat~ a dpoai~ a~ :. the prop~r person to give I::,: _.,, :.: ', ,_ ,,.',,: , , ,-" .';,, ~. ,_. ....... .' ' \. .... ,' an acknowledgement only for purposes of affecting delivery of such securities to a purchaser under applicable provisions of law.155 When applicable law makes no such provision the Book-152. s11 supra note 91. An argument that the acknowledgment and notification provisions in paragraph (b) are the exclusive means of transfer and pledge of book-entry Treasury securities has wisely been rejected. an Wichita Fed. Sav. & Loan Ass'n v. Comark, 610 F.Supp. 406, 413-14 (S.D.N.Y. 1985). 153. in 1978 8-313, comment 3 (fourth paragraph). 154. A "depositary" within the meaning of 31 C.F.R. 306.118(b) (fourth sente!lce) would be a "financial intermediary" as defined in 1978 8-313(4). 155. 31 C.F.R. 306.118(b) (fourth sentence). Although it is arguable that state law would be preempted in this connection, the batter view is that when the 1978 Article 8 applies it controls and financial intermediary transfer by acknowledgement is unavailable. DOC. SWPllOlA July 17, 1989
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75 Entry Treasury Regulations would not aeem to dictate a contrary result. Moreover, if pre-1978 a-313(1)(d) is properly int;erpreted, a delivery of book-entry fteasury aecurities by thi.rd person acknowledpent thereunder can never occur, 156 although there could be a transfer of a property interest by such an a1clcnowled911ent. 157 :::;.~ ;.;:;,-,; '.,;; = :;.,,:' :,5~~~ .. +~,f,.;:~~~;-; ~;. --~-"~~~-. -~,;,.~c:>k-Entry . .. . ...... . . . . Trusiiry_Regulations preempt s~te law raises still another, more . . .. . . . . general, question. What do the Book-Entry Treasury Regulations have to say @put priorities ARDS cgmpatinq 1gwer tier transferees . . .... .': ,.... ~9' -bggJc-9DRY. :rn,nn: sac;ur11;1 .. 1 : i . : __ :; .' . : : ,: .. ,. .. ;~ : . Happily, the answer to this question is simple: Paragraph (b) of the regulations does not address priorities. Applicable state law controls. Not so happily (and not so surprisingly), applicable state law (once identified) may not provide clear answers. Whether and under what circumstances a non-DI transferee of a book-entry Treasury security under 156. see supra note 121. 157. Pre-1978 8-313(2) expressly contemplates transfer of a proportionate property interest, even in the absence of a delivery under sw:,section (1). Presumably such a transfer of property interests could occur through e third person acknowledpent even though no delivery were effected. DOC. SWPllOlA July 17, 1989
PAGE 271
76 paragraph (b) can be a bona fide purchaser is a case in point.151 The absence of priority rules in paragraph (b) raises a final qution that alao concerna prioriti What ia tha ralatignship batwaan transfars and pledges PD tho books pf tb1 bd, under paragraph <1>, and transf1rs and pladczl under paragraph Cb) and : :applic@l stat law? Itsclear enough that a DI transferee under paragraph (a) who receives a delivery and becomes a holder can become a bona fide purchaser, thereby taking free of all then exiating adverse claims."' As to the intareats of subsequent . . . . ... i . ;., .-. ' .' . .,:, . : .... -=..-. .",:. -; -~-----~'I: .. -:::.":_: ... . .. ; ::-:-: -~ ..... :-:-:-._... ;' -~~---c1,1~.:~f~e~~ _h~ev,r, -~--~ffect of. the last ~-. . . .. . sentence of paragraph (a) is puzzling: "A transfer or pledge of book-entry Treasury securities effected under this paragraph shall have priority over any transfer, pledge, or other interest, tharatgfgra pr tharaaft1r affac;tad, pr parfactad under paragraph (b) of thi section or in any other manner. Read literally, that sentence seems to provide that even if the transferee DI is receiving the securities on behalf of its customer, or subsequently transfers securities to its customer under paragraph 158. sae infra note 246 (explaining that such a non-DI transfer of inherently f~ngible book-entry Treasury securities can never achieve bona fide purchaser status). 159. Saa supra notes 114, 120 and accompanying text. 160. 31 C.F.R. I 306.lll(a) (1988) (-phasis added). DOC. SWPll0lA July 17, 1989
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77 (b), the DI' interest is senior eyen as batween the QI and its custgmer. But that reading would be patently ridiculous. Properly interpreted, paragraph (a) transfers control over all paragraph (b) transfers as among the Fed. the transferor QI, and :tbl tranaterae QI. and as between the Fed and paragraph Cb) t;ranstereea.161 Again, the analogy of the Fed and DI s to a ~- .. : = _:,. i&iy. ; ?J: !'lti.-~~-~~ .. ;l:~~-~~--= ifi, ;tiita~i~tt:t~~~--~~~~nc~c1 by th~ Dapartmant of Treasury_and th Federal Reserve Bank of New Yark: I ,' ' '' ,. ' [Subsection (a) govems All. entries made on the books of a Reserve Bank or branch, while subsection (b) and "applicable law:" control the entries made .. on. the books of depository insti tutioris and other book-entry custodians. This does not alter the Courtsconclusion that subsection (b) applied to . the alleged c:uri ty interest . . [ granted to a DI by its ...... :. ~.J.cmat.aaarJ, .. ~uaaPedvira-~tnnsac:tian: .[aic.]-involvinq a. de~aito~:.-inati~utions. cuat;Oll8r securities require two entries --an entry of the transfer to the depository inatitution under subsection (a) and an entry of the customer's interest on the books of the depository institution under subsection (b). 'l'his interrelationship of the entries under subsections (a) and (b) serves two important purposes. Subsection (a) creates a uniform rule for all entries at the Reserve Bank level, thereby avoiding the complicated legal relationships that arise under state law in transfer and pledge of investment securities. Subsection (b) promotes certainty in the market by ensuring that a purchaser of book-entry securities receives the same rights under state law enjoyed by an owner of definitive Treasury securities. 'l'he uniform rule established by subsection (a) for all Reserve Banlt entries is of central importance to the Federal Reserve book-entry system 'l'he uncertainty surrounding "state law" entries on a Reserve Banlt's books would force significant changes in government securities processing DOC. SWP1101A July 17, 1989
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78 clearing corporation and its members under state law is compelling.162 3. 'Ille ropoaed ~-llecJlll~io11a Several of the foregoing interpretive puzzles were important factors that motivated issuance of the Proposed TRADES Regulations. Although a broad critique of th regulations is -myond Qe::. cope o-t: thi --_areicie; ce~in important features ot . . . . . the propoaal ahould be mentioned. 'l'h Proposed TRADES Regulations reject the approach to transfer and pledge of paragraph (b) of the existing Book-Entry Treaaury Ragulationa-relianc on applicable.atate. law. They . . . .. . .. .. ---~. ,.. ..... ~--. ~ ... ----~~ ; ., _.., .... \-.,. -...... -. ; .. 'II,.'.. . 'would" prcwida for. .: ~iv P~eral. regia~ .;:overi~g"all of : r 0 \ 0 ." : .;_ ' '.J, : . , l"I -,_: : , 0 I '." . I h I' I ' the baaic mechanical rulu needed for affectively transferring Treasury book-entry securities and tor perfecting security Banca, application of th uniform rule of subsection (a) to all Federal Reserve Bank entries clearly serves the national purpose and character of the Federal Reserve bookentry system. It permits Reserve Banks and depository institutions to rely on Reserve Bank entries as final and valid and allows Treasury to pay principal and interest according to Reserve Bank records. comark Memo, supra note 121, at [4-5, 8-9, 11] (footnotes omitted). 162. see supra note 121. 163. a.. March TRADES summary, supra note 31, at 8847 (discusaing defects and ambiguities in bearer definitive fiction relating to delivery and poion, and lack of uniformity reaulting from two versions of Article 8). DOC. SWPllOlA July 17, 1989
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79 intert therein.""' Patterned closely on 1978 ction 8-313(1), Propoaed TRADES Regulations section 357.12(a) pacifies tha u:cluaive aaana of tranaferring (and creating aacurity intrta in) book-entry Treasury securitiea.18 A security interut o tranafarred is perfected.* 'l'ha Proposed TR:J>ES Ragulationa also include prauaptiva Federal rule governing .. P~~-~f.ii;:i,~_ ~,c,_., c;:~~i;-~'1-~~-~-~-~ ~~--. b~9~".".n~ry .Tr~aury I ,It ' I I o , o "' , "" ' o curiti 164. li~ 165. Proposed TRADES Regulation I 357.12(a): also Propoaad .TRADES Regulat~ona I 357.11, which i to the same affect -1171. .I .1~301. .. : -~ : :. .., : .. ,._ .. , ... .... I I, . .. 166. Propoaad TRADES Regulations s 357.ll(b): also J.si. I 357.ll(a) (enforceability of security interest conditioned upon agraaent, transferor's rights in the securities collateral, and value given by secured party). Thia approach is similar to that of 1978 I 8-321. 3 supra note 88. 167. Thi i a ccmpleta turnabout from the approach taken in the March Propoaed TRADES Regulations. Th November TRADES Swmaary described the reasons for rejecting a bona fide purchase rule in tha March Proposed TRADES Regulations: In the March Rule, the Department expressed three concerns with adoption of such a rule. Tha first was a theoretical concern about structuring such a rule for the book-entry environment. Th second was a more practical concern that the concept of a BFP may be of limited use in a tiered book-entry system where transaction affecting a tranaferees righta in a security can occur at any time after the tranafaree acquires BPP status. The third concern expressed by the Department was that a BFP provision could affect tha efficiency and liquidity of the government acuriti market if it impaired the ability of clearing banks that Bxtend daily credit to government securities dealers to collataralize their dealer loans. DOC. SWPllOlA July 17, 1989
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80 Two of th- priority rules are of particular interest hara. The first deals with a "good faith transferee""' of a book-entry Tr-aury -curity. Subject to three axcaptiona, "a good faith tranafr acquiru ita interest in the security frof any advena claill which arose prior to the transfer of such intar-t to such transferee.",. Unlike the treataent of Havaber TRADES sumry, supra note 127, at 43035. The third concern was d-lt with by the "clearing lien priority" rule. b intra notes 177-79 and accompanying text. The November TRADES Sumry does not squarely address the other two concerns or the Treasury Department's reasoning far changing its mind. It appears ta have bean influenced by its receipt of eight c0111JDent letters urging it ta adopt a Federal priority rule, three of which propoNd a fora of bona fide purchaser priority rule. bA lfavaaber TRADBS--suaary.j IPPD, a1:;.,4)5.: : .. I . -.... -: 168. "Good faith transferee is defined as "a transfereP. that acquired a security or a limited interest in a security for value, in goad faith, and without notice of any adverse claim." Proposed TRADES Regulations 357.14(a). Thia definition is substantively ailllilar ta the definition of "bona fide purchaser" in 1978 8-302(1). Section 357.14(a) does not lillit good faith tranafar-status to th .... extant as does 1978 I 8-302(1), although only certain transfer-pursuant ta specified subsections of i357.12(a) can qualify for gonc:l faith transferee status. see intra note 171. Th definition at "adverse claim" in Proposed TRADES Regulations 357.14(c) is identical ta the definition of the same term in 1978 8-302(2). 169. Proposed TRADES Regulations 357.14(b). Thia provision, save for the exceptions, is essentially the same as that applicable ta a bona fide purchaser under 1978 8-302(3). Two of the exceptions are apec:iad in 357.14(b)--"clearing lien priority" and "priority at interests of the United States" pursuant ta Proposed TRADES Regulations 357.15 and 357.19, respectively. ld The other relates to sharing among same tier claimants against a c0111JD0n intermediary. Proposed TRADES Regulations 357.14(e): w infra note 172 and accompanying text. The Department of Treasury explained its selection of the term "goad faith transferee" as follows: DOC. SWPll0lA July 17, 1989
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81 bona fide purchaser status under Article 8, a transferee of an interest in a fungible bulk of book-entry Treasury securities, effected by book entry on the books of the transferee's "book entry custodian,111 can achieve good faith transferee status.171 In drafting its modified BFP rule the Department chose the phrase good faith transferee rather than "bona fide purchaser" to highlight the fact that under these .-..... P~~p~s~~--~~-'-~-~. -~~!Jp;a_ -9~ .. : .-,:. ~---; ,L.g_~ad-.tai~ transferee] ,. r. %'. somewhat 1-'ess : br~d than the_ rights of the traditional bona fide purchaser~ Although as a matter of semantics the phrases are virtually synonymous, the Department believes it appropriate to use a phrase that is somewhat less recognized as a legal term of art than is the phrase "bona fide purchaser." November TRADES Summary, supra note 127, at 43036. . . . .... :170 ..... -Th PropoaedflADES: Regulation use the term "book.entry custodian~--rather-.than_"financial intermediary." Proposed TRADES Regulations 357.3 ("'Book-entry custodian' is a person o~er than the Department [of Treasury] or a Federal Reserve Bank, that in the ordinary course of its business maintains bookentry securities accounts for other persons."); .au 1978 8-313(4) (defining "financial intermediary"). 171. Only transferees pursuant to Proposed TRADES Regulations 357.12(a)(l) (book entry to transferee's account with the Fed), (a)(3) (book entry to transferee's account with its book entry custodian), and (a)(S) (transfer of security interest to book-entry custodian by its customer) can become good faith transferees. Proposed TRADES Regulations 357.14(d) (2). Transfers pursuant to paragraph (a)(l) are analogous to those made by clearing corporation book entry under 1978 8-313(l)(g), where bona fide purchaser status can be achieved. Transfers pursuant to paragraph (a) (5) are analogous to those made under 1978 8-313(1) (j), where bona fide purchaser status will depend on the manner that the transferee-intermediary controls the securities (possession or on the books of another intermediary). See infra note 271. But transfers pursuant to paragraph (a)(3) are analogous to those made under 1978 8-313(1) (d) (ii) or (d)(iii), where bona fide purchaser status cannot be achieved under state law. Although Proposed TRADES Regulations 357.12(a)(3) does not mention a "fungible bulk," the Department of Treasury essentially acknowledged this characterization in the DOC. SWPll0lA July 17, 1989
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82 But the rights of a good faith transferee are diluted by a sharing rule, applicable amoJ.':' transferees of a co1111Don inter119diary, aillilar to th proportionate property interest rule of ction 8-313 (2) 172 Were the effect of the good faith tranaferee rule only to add some gloss to the manner of sharing among same tier claimants against the SIDie intermediary it would hardly J;>-. remarkabl.e . But it is not so limited: it also applies . (subject to the other exceptions175) so as to cut off claims of adverse claimants on different tiers who do not share a common November TRADES SUllllary: "[B]ook-entry aecurities of the same iu:~r _fungibl~. ~-.. .~. __ ~ES s~xy, supra note 121~ at---4303s. : ... :---. ::' ~-. .. - ... I . ' "':' IC ' ,' . ... 172. bA 1978 & pre-1978 S 8-313(2) (second sentence). Proposed TRADES Regulations S 357.14(e) provides: Among transferees whose interests in securities are reflected on the books of the same book-entry custodian, the interests of the good faith transfer shall have priority over th interests of those who do not qualify as good faith transfer In the event that the claims to aecurities of the aame issue of those who qualify good faith transferees exceed the aggregate amount of such securities available to satisfy their claims, the good faith transferees shall share ratably in the available securities of that issue. The seeming absurdity of such a sharing rule a~ong bona fide purchasers, reflected by the Official C01111Dents to 1978 8-313, apparently gave little or no pause to the drafters of the Proposed TRADES Regulations. see supra note 85. The regulations are silent as to how non-good faith transferees would share if the available securities were sufficient to satisfy claims of the good faith transferees but insufficient to satisfy claims of the non-good faith transferees. 173. see supra note 169. DOC. SWPllOlA July 17, 1989
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83 intermediary.174 The good faith transferee rule thus constitutes a striking departure from both the pre-1978 and 1978 Article 8 treatment of fungible bulk transferees on the books of intermediaries.115 Because it can be expected that most 174. sae generally infra Part IV (discussing competing claims on different tiers) . .-; -~--~7:~~ .. Saa I\Ul.a.~n~t:-:8~ ... >-., -~-~ld.:Jiave thought that the Treasury t)epartment would have acknowledged this departure. Amazingly, however, the November TRADES Summary indicates that the good faith transferee rule is in the mainstream. To qualify as a [good faith transferee], one must acquire a security under Section 357.12(a) (1), (3), or (5). This is to parallel somewhat the common law .requir-ent that to. qualify a BFP one must take delivery of the property. Aa with the traditional BFP .. .. . :,concept; a gooc:l: faitb transferee takes a aec:uri ty free .. ... ,, of all adverse-claims. November TRADES Summary, supra note 127, at 43035. This explanation is than followed by a puzzling non sequitur: In effect, the rule eliminates the possibility of tracing securities beyond what one's book-entry cuatodian itself -intains. The Department considers this to be an appropriate result given that book-entry securities of the same issue are fungible and generally not subject to tracing. lg. Were the Department of Treasury really satisfied that bookentry Treasury securities could not be traced, then there would be no need for the clearing lien priority rule. For example, lower tier claimants could never establish that a clearing bank's security interest covered "their" securities. I have a personal, wholly subjective, view of why the good faith transferee rule was proposed. The TRADES project followed a spate of government securities dealer insolvencies. see supra note 59. The clearing lien priority rule deals with one of the principal concerns arising out of these failures. The good faith transferee rule provides the illusion of dealing with another-substantial losses incurred by lower tier repo participants doing business with the failed firms. lg. This political expediency DOC. SWP1101A July 17, 1989
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84 transfer will be good faith transferees, the good faith transferee rule provides a baseline rule of last-in-time-first in-right. 1 'l'be cond illportant priority rule deals with priority of a clearing lien.177 Proposac::l TRADES Regulations section 357.115(a) stat th operative rule: A clearing lien in a security shall have priority over all other claims of third parties to that security including claims of a transferee that explanation may be related to the apparent reluctance by the Treasury Departllent and tho involvac::l in the Federal Reserve _sy_a~~ t~ _a~_QwJ~---~Y ,tJaat.~ ~dr-. ~ent. J,.a11, no on can becaae bona fide purchaser of Treasury securities that are controlled by anintenediary cucept for depository institutions that maintain an account with the Fed). ID supra note 127; intra not 246; see also comark Memo, supra note 121, at c21-22J (arguing that aubaccounts or segregation of book-entry customer securities may provide an effective identification of a specific security under pre-1978 I 8-313(1) (c) and, therefore, bona fide purchaser status); Bradford Trust Memo, supra note 77, at [110-13] (sue arqmaent as to 1978 I a-313(1)(d) (i). 176. Th good faith transfer rule would (where special exceptions are not made) apply equally on all tiers, including the top tier involving DI'a and the Fed. Unlike 306.llB(a) of the Book-Entry Treasury Regulations, transfers made among DI's on the books of the Fed no longer would be controlling over subsequent transfers on lower tiers. see supra notes 160-62 and accompanying text. 177. bA Proposed TRADES Regulations 357.3 (defining "clearing lien" as a security interest granted to a clearing bank or Federal Reserve Bank, pursuant to a written agreement, to cur credit extended in providing clearing services," "clearing services as "delivering and receiving securities and payments for securities on behalf of other persons, and "clearing bank" as a depository institution which has a securities account at a Federal Reserve Bank through which it provides clearing services."). DOC. SWP1101A July 17, 1989
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85 qualifies as a gooc:l faith transferee 1 The proposed priority for clearing liens is grounded on the crucial role played by clearing banks in the market for Treasury securities and the enormous intra-day credit exposure of the clearing banka.119 But the Proposec:l TRADES Regulations would leave those who supply financing to securities intermediaries secured by :~-~~-:--~~~;~~-: ~t--qu~lify tor.the. . .. . ..... clearing lien p~i~ri_ty, t~ the vagaries of the last-in-time good . : .. faith transferee rule.1 '. ..... . )_ -: ........ ' ... ., . : ... .-: .. ' .. -. ... 178. Proposed TRADES Regulations 357.15(a). Exceptions to this priority are made for security interests in favor of the United States pursuant to 357.19 le,g,, priority for security interests securing deposits of public money, deposits to the Department of Treasury for tax and loan accounts) and clearing liens in favor of a Federal Reserve Banlt. 14. Section 357.lS(b) further limits the clearing lien priority to tbe extent of credit actually extended in perfonaing clearing services and to liens that are perfected and acquired in good faith. Proposed TRADES Regulations 357.15(b). 179. I.U, L!l.L, November TRADES SWllllary, supra note 127, at ("[E]xtensions of credit [by clearing banks] must be fully collateralized to satisfy the safety and soundness requirements of the bank regulators."): STIGUM, TRADE, supra note lJ, at ("To anyone familiar with the mechanics of clearing and with the handling of dealer loans, the case made by clearing bankers (for a failsafe clearing lien] seems strong.): Crespi, supra note 111, at 186 ("It is essential tor the continued efficient functioning of the government securities market that clearing agent security interests be made secure against divestment by unilateral customer actions.). see generally supra notes 37-42 and accompanying text. 110. sea infra note 282. DOC. SWP1101A July 17, 1989
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86 IJ:J:. CLaIIIS UD DJ:8'1UBUTIOB8 DI IJl'l'BJUIBDJ:D% IB80LVDCT ROCBBDDIG8 In a v.,_-ry real ena, the characteriatic of the property interut obtained by a tranafer of an intereat in a fungible bulk of curitie controlled by an intermediary become relevant only if the intermediary becoaes subject to an insolvency proceeding. In many cases this ir ao whether or not the intermediary actually controls the securities and regardless of how the transferee's interest would be treated under otherwise applical:)le law. So long as the intermediary remains viable, the intermediary's warranty1 ~ and other obligations112 normally ensure that the 'transfer receives the benefits of the securities tranaferred. If the intermediary is or becomes unable to honor its obligations, actual enforcement of the transferee's property rights against the intermediary outside of an insolvency proceeding i extraely unlikely. Tb apecial nature of th 181. S generally GU'rl'MAN, supra note 11, ch. 6, at 6-s to 6-28: infra Part v.B. 182. [Cites to agreements with brokers and custodians, and interviews]: AU 1978 8-313(3) (purchaser's right to demand from financial intermediary security not subject to notice of adverse claims): S.E.C. Rule 15c3-3(l), 17 C.F.R. 240.15c3-3(l) (1988) (customer's "absolute right to receive physical delivery of certificates."). 183. It is a safe assumption, given the nature, supervision and regulation of securities intermediaries, that before a securities customer or secured creditor could judicially enforce its claims to securities that the intermediary could not honor (as opposed to enforcement when there is a dispute as to the claimant's rights), the intermediary would be subjected to DOC. SWP1101B July 17, 1989
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87 institutions that serve as securities intermediaries114 distinguishes the transferee's property rights from those of most other property owners and secured creclitora who do frequently assert and att-pt to enforce property rights outside of insolvency proceedings. If the intermediary can perform its obligations the transferee is protected. If the intermediary cannot parfo?, th~.such ~rnfrea normally will recover from ....... ._, .~'~ : .-~ ...... ''.: :_..,:.,:.,;-._ .... _., ~. .~".'\::_',., ~.,:'.""~:, I .._,. I ,,,. ,: : t,', P ' . the intermediary only what it is entitled to receive in the intermediary's insolvency proceeding.1 A. ~~r~hip Claims of ~stoaers If otherwise applicable state property law were to --~~ iii._ th .inte:r-cti-.z"Y' a ... ~~lvency, proceeding, the tnnster .. -~ould receiv~ .-the benefit ~f proportionate interest in the fungible bulk of securities of the same issue controlled insolvency proceedings or replaced with another intermediary. [interviews with SIPA, FDIC]; 11 generally GtJTTMAN, supra note 11, at 19-49 to -55 (monitoring of broker-dealers by SIPC and commencement of liquidation proceedings); A. POLLARD, J. PASSAIC, K. ELLIS, J. DALY, supra note 53, at 605-23 (failing and failed banks covered by FDIC). Obviously, non-judicial self help to recover securities would not be fedsible when the intermediary controls the securities as a part of a fungible bulk. 184. see supra notes 53-57 and accompanying text (discussing regulatory and prophylactic approaches toward intermediary risk). 185. In some cases the transferee also may have a conversion claim against a third party. See infra note 235. Part IV, infra, considers some troublesome different tier priority conflicts that are not resolved by distributional rules applicable in insolvency proceedings. DOC. SWP1101B July 17, 1989
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88 by the intermediary; the transferee's interest would be diluted by any ahortfall of such securities. SIPA and Chapter 7, Subc:bapter III, of the Bankruptcy Code iJlpo a very different result when the interaediary i a securities firm. Under both 186. sn supra not 96-99 and accompanying text ( discussing proportionac.a property interest rule) 187. ID 11 o.s.c. 11 101-1330 (1982 and supp. 1987) [hereinafter Bankruptcy Code]; 11 u.s.c. II 741-52 (1982 and Supp. 1987) [hereinafter Subchapter III]. 188. SIPA applies with respect to its members which consist of all registered brokers or dealers under the Securities and Exchange Act of 1934 (with certain exceptions not relevant here). SIPA I l(a)(2)(A). The stockbroker liquidation provisions of Subchapter III apply only to stockbrokers, and a stockbroker cannot be a debtor under any other chapter. Bankruptcy Code 101(48) (defining stockbroker); 103(c); 109. When a proceeding is c01111enced under SIPA all proceedings in a case under the Ba~ptcy Code are stayed. Bankruptcy Code 742. Thus, Subchapter III generally applies only to the limited class of stockbrokers that are not members of SIPC. For discussions of securities firm insolvency proceedings, see GtJTl'MAN, supra note 11, at 19-34 to 19-102; Brennan, The Role of SIPC in Brokerage railuru: A caStudy of the Delli of Bell and Beckwith, 13 sec. Reg. L. J. 18 (1985); Cheston, Invutor Protection Under the SIPA: A Reasaeamaent and Rec01111endationa for Future Change, 19 Colwa. J.L. Soc. Proba. 69 (1985); Harbeck, Stockbroker Bankruptcy: The Role of the District Court and the Bankruptcy Court Under the Securities Investor Protection Act, 56 Am. Bankr. L.J. 277 (1982). When SIPA applies, the investors with smaller claims generally are fully protected by the Securities Investor Protection Corporation (SIPC). customers are entitled to advances from the SIPC fund of up to $500.000, but advances on account of claims for cash are limited to $100,000. SIPA I 9(a); w GtJTl'MAN, supra, at 19-94 to -98. Although customers whose claims are within these limits are ultimately protected as to the value of their claims at the commencement of the proceeding, SIPA has bean criticized for the delays involved in satisfying customer claims and the limited coverage for cash claimants. Cheston, supra, at 87-93, 97-99. DOC. SWP1101B July 17, 1989
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89 SIPA and Subcbapter III, claims of investors (including the larger investors, of interest here, whose claims exceed SIPC coverage) are aubject to a risk sharing distributional formula that differs fr011 the proportionate property interest formula provided by Article 8. Inatead of aharing a proportionate interest in th fungible bulk of curiti of the isaue claimed, divided among al~ claimants with claims to that issue, claimants ~;.:. .. -~_ ... ,.-: .. _::,..=~.;-,,:;,:. .;,~,-_::.A.:_-_-.,.-:...:~.;:..~_:.--::~.;:-~:;
PAGE 285
90 their rapective net equi tiu, * in ~e entire pool ot cuat011U property. 191 'l'h SIPA/Subc:hapter III risk sharing distril>utional rule derivad tram -ction 60e ot the Bankruptcy Act, which was 190. A cuatcmer' net equity i entially the value of aec:uriti or cash claimed by the customer, as ot the date the proceeding c01111enced, less claillll ot the debtor intermediary againat th custoaer (auch as rmining outstanding obligations tor aec:uritia purchaaed on argin). SIPA 16(11); Bankruptcy Code I 741(6). Because cuat011er status in given to those who have advanced cash to the debtor for the purchase of securities, a cuatmaer may have a net equity claim, and thereby share in cust011er property, even though the customer bas no property intr-t at all under applicable state law. an SIPA 16(2), (11); Banlcruptcy Code I 741(2), (6). 191. SIPA I l(c) (1); Bankruptcy Code I 752(a). Under both SIPA and Sul::lchapter III, custcmer property includes virtually all securitia available to the estate of the type that are sw:,ject to (and to the extent ot) cust0111er claims. SIPA 16(4); Bankruptcy Code 741(4). The principal exception is for property that is a customer name security. 14. A customer naae -curity is a specific security bald by the intermediary that i registered, or i in the procua of regiatration, in the name ot a custcmer and that i not in negotiable fora. SIPA I 16(3); Bankruptcy Code I 741(3). Although the distributional formula tor custmaer property i usentially the same under SIPA and the Bankruptcy Code, the means of satisfying the claims differ substantially. Under SIPA, the trust distributes or purchases securities for distribution to customers. SIPA S(d). Under Subchapter III, the trustee reduces customer securities to money and then makes c&sh distributions to the customers. Bankruptcy Code 748, 750, 752. CUstomer name securities, however, are distributed in kind to customers under both SIPA and Subchapter III. SIPA I 8(C)(2); Bankruptcy Code 751. The SIPA/Subchapter III distributional formula also would override the distributional rule tor good faith transferees in the Proposed TRADES Regulations. ltm November TRADES Summary, supra note 127, at 43036 (good faith transferee provision is not intended to preempt other federal law, such as the Bankruptcy Code or [SIPA], on the distribution of assets in an insolvency. ) DOC. SWPllOlB July 17, 1989
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91 addad by th Chandler Act of 1938.111 Section 60a responded to widupraad dissatisfaction ith the essentially fortuitous and ar~itrary r .. ulta imposed on stockbroker customers under applicaJ:,la state law and th Bankruptcy Act. Section 60a 192. Bankruptcy Act of 1898, I 60a, Aaandmanta (Chandler Act), Pub. L. Bo. 75-696, 52 Stat. 840, 870 (1938), 11 O.S.C. I 96a (1970) (repealed). Section 60a as~lished three kinds of clailla for securities claimants in stockbroker bankruptcies. Pint, customers who could specifically identify their securities, or wboaa securities (or substitutes therefor or proceeds thereof) were, more than four months prior to bankruptcy and while the debtor was solvent, "allocated to or physically set aside for such customer, and remained so allocated or set aside at the data of bankruptcy," could reclaim the securities. 11 o.s.c. I 96e(2), (4) (1970) (repealed): COLLIER OB BAHDt1P'l'CY, 11 60.73, 60.74, at 1171-72, 1182-89 (14th ad. 1977). Arguably, even sacuritiu in a fungible bulk that was physically set aside for a customers could ba so reclaimed. JJI., 1 60.74, at 1187-89. Second, all other customers shared pro-rata, according to the value of their net equity" claims, in a:single and separate fund" comprised of all non-specifically identifiable customer securities of all issues. u.s.c. I 96e(l), (2) (1970) (repealed): COLLIER, supra, 1 60.73, at 1170-74. Third, to th extent customer claims remained unsatisfied, cust011ers received unsecured, general creditor status. 11 o.s.c. I 96e(l) (1970) (repealed). SIPA and I 60e coexisted from 1970, wban SIPA was enacted, until 1978 when SIPA was amended and Subchapter III, modeled on the amended SIPA, was anactad as a part of the Bankruptcy Code. Compare Securities Investor Protection Act of 1970, Pub. L. 91-598, 84 Stat. 1636 (1970) with Securities Investor ltrotection Act Amendments of 1978, Pub. L. 95-283, 92 Stat. 249 (1978) m5:l The Bankruptcy Reform Act of 1978, Pub. L. 95-598, 92 Stat. 2682 (1978). 193. Under prior law a distinction was drawn between cash customers and those who bought on margin, with the latter being treated lass favorably, and customers who could not trace their securities were given general creditor status .SU GtJ'l"l'MAN, supra note 11, at 19-38 to -40: Gilchrist, stockl:lrokers' Bankruptcies: Problems created by the Chandler Act, 24 Minn. L. Rev. 52, 53-57 (1939). Commenting on the (then-proposed but unenacted) Chandler Act, James McLaughlin noted: DOC. SWP1101B July 17, 1989
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92 differed in detail from SIPA and Subcbapter III, and it failed to reaolve aatisfactorily certain matters of its scope and application.* But th enc of the distributional rule of ction 60--that all cust011ers share ratably in all customer curiti---haa ben preserved by SIPA and Subcbapter III.195 If one approach the prcml-from the point of view of ,:_ ...... _\:: :---~Glllm'S-;;~:1-t"~:.J.az.: ~putabl tbat:tlle clifferant dacJn in which.different-cust011ers trust th broker run through such a wide -rantJ_that 11a11y possible dis~inctions might logically be taken. At the am time it is abundantly clear that the existing law turns upon refinements utterly unintelligible to the business man and involves elements of chance more appropri5te ta abeano party thn to the administration of justice. If the problem be approached from the point of view of- and econcmay of adllinistration, th solution of the Cllandler Bill warr,nts high ~:ting. . .. ... . .. .. .. . .. ~". .. . . .. .... . ... JrcLaughlin, As~cts of the Cbandler Bill to Amend the Bankruptcy Act, 4 o. Chi. L. Rev. 368, 397-98 (1937). As originally enacted, SIPA made a distinction between cash and margin cqatomers. 15 o.s.c. 78fff(c) (2) (A) (ii), (iii) (repea.,.ed). The 1978 amendments to SIPA, as well as Subchapter III, eliminated that distinction. SIPA 8(c) (l); 16(2), (ii) ; Bankruptcy Code 741(2). 194. In, ,q,, GO'l"l'Dlf, supra note 11, at 19-40 ta -47 (criticizing I 60 on the basis of ambiguity as to who is a stoclcbroker (an undefined term) and who is a "customer," and noting problems of tracing by cash customers); see also Note, Protection of the Accounts of Stockbrokerage customers, 77 Harv. L. Rav. 1290 (1964). 195. Surprisingly, I have found no case or commentary that explicitly acknowledges the radical difference between the pre-1978 and 1978 8-313(2) proportionate property interest formulation, on the one hand, and the risk sharing approach of Bankruptcy Act 60e, SIPA, and Subchapter III, on the other. Even more surprising, some commentary inexplicably appears either to miss the distinction entirely or to misinterpret one or the other scheme of allocation. For example: Until securities are delivered to the purchaser, they are held by the broker in fungible bulk. The customer is DOC. SWP1101B July 17, 1989
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93 Th drafters of what became o.c.c. Article 8 also subscribed ta the rationale of the section 60e risk sharing diatributional rule. Th second through sixth public drafts of the u.c.c. investment securities article included a section dealing with distributions of securities upon a broker's insolvency that generally incorporated the section 60e app~aach.~ Moreave~, the coexistence. of that section and the . . thus the owner of a proportionate property interest in the fungible bulk. In a bankruptcy of the broker, the customer would have his rights in the bulk determined by state law. GO'rl'MAN, supra note 11, at 8-27 (footnote omitted). If there be no specified security in the hands of the broker, the-creditor cust011era vi share ;rg rata in the fungible-bulk, whichwill notbe part of the bankrupt's assets; (Section 8-313(2) and Section 60(e) [sic] Bankruptcy Act) claiming any deficits as general creditors. Of course the rules as to sharing in fungibles would be equally applicable here [in bankruptcy], unless there has been a setting aside of the stock to the customer's order, i,1,, Section 8-313(l)(b) or (c) or (d) are found applicable. The most important aspect of Section 8-313 is thus seen ta be in the realm of bankruptcy law. STATE OF NEW JERSEY, COMMISSION TO STUDY AND REPORT UPON THE UHIFORM COMMERCIAL CODE FOR NEW JERSEY, SECOND REPORT TO THE GOVERNOR, THE SENATE AND THE ASSEMBLY OP THE STATE OF NEW JERSEY 642, 644, 8-313, New Jersey Study Comments (1960). 196. a.. commercial code. Tentative Draft No, 1--Article v, 33 (May 10, 1947), reprinted in 3 UNIFORM COMMERCIAL CODE DRAPTS 287-88 (E. Kelly ed. 1984); POJPJPorcial code. Tentative Draft No, 2--Article Y, s 33 (August 2s, 1947), reprinted in 3 tJHIFORM COMMERCIAL CODE DRAFTS, supra, at 533-34; commercial code. Proposed Final Draft No, 1--Article v, s 29 (April 2b, 1948), reprinted in 4 UNIFORM COMMERCIAL CODE DRAFTS, supra, at 342-43; congnercial code. Proposed Final Draft No, 2--Article v, DOC. SWP1101B July 17, 1989
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94 30 (Auguat 9, 1948), r1printl4 in 5 UNIFORM COMMERCIAL CODE DBAl'J'S, 1upra, at 205-06; u.c.c., May 1,,, Draft, Article 8Invutaent Securiti, I 8-316, r1printl4 in 8 UNIFORM COMMERCIAL CODE QRAPI'S, upra, at 243-44. Each of th draft contained a proviaion conteaplating that a broker' cuatoaer would obtain a proportionate property interut in a fungible bulk. In Appendix III, in(ra. The firat draft of th inveataent curitiu article va a partial draft and did not contain proviaion for diatributiona in broker inaolvency proceedin9a. cqparcial Cpd, Prliinary Tantatiy Qraft BP, 1--Ar:tic11 y (AuCJUt 2a, 1947), ;EIPE4-Dtl4 .-in ::3-: man;CDNNDCDL:'CODS::PBUTI~ aupra; at 1-44 .. Although there-were veral variation in the broker inaolvency diatribution.acbae aong the cited draft proviaiona, they differed fraa Bankruptcy Act I 60 priaarily in their propoaed re-introduction of the diatinction between caah customer and margin customers. IIA, ,q,, o.c.c., May 1949 Draft, Article aInvestment securities, s a-316(1), raprintod in a UNIFORM COMMERCIAL CODE DRAFTS, supra, at 243-44: ., .. c1, .. ---~. broker inaol"yent. and th . MC:Gri tfea 1n .. tii poNtiion iat '_ th tilie. of diacovery of the inaoivency are irinfficieilt 'for'due delivery to th person for wbo account they were bald (a) curiti regiatered in the name of specific claimants and not ao indorsed as to make th broker a bolder hall be duly delivered to aucb regiatered owners on proof of ovnerabip1 and (b) the r-inin9 Hcuritiu ahall be divided into tho held for aafekeeping and those bald a collateral for margin account and the proceed of each cl aball be diatributed pro rata aong the claimant of that cl but to the extent that auch curiti cannot be identified aa between auch claasu, both cl shall ahar pro rata. C01Dent 1 to I 8-316 explained: By adopting the baaic policy of Section 60 B [aic] of the Federal Bankruptcy Act which -k proviaion for a pro-rata diatribution uon9 a bankrupt broker' cuatomer a parate cl, the tiae conauain9 and coatly "tracing" technique nonaally -ployed when a c01Don fiduciary i DOC. SWP11018 July 17, 1989
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9!5 generally applicable proportionate property intereat rule indicate that the drafter did not view the latter rule to be directed to inaolvency diatributiona at all.191 Thi riak haring inaolvency diatribution rule eventually waa dropped from Article a on the grounda that aodifications to ction 60 would be a better approach than cbang in atate law, not on the baai that th approach waa flawed."' . . .. .: . .. ..,. . :: .~ : ..... .. . . . Notwithatanding the general aatiafaction with the risk haring approach, articulation of why thi approach of section guilty of miaappropr~ation and malfeasance is avoided. . . .14 CO+ ent. 1, .. at :-244 .-.--., .: .. ,., .. :,.. .. ,-. -r- I o " o '\ ', ,," 0 ,: 111. 14. 11 I 8-313 coaent 4 (auggeating that the proportionate property intereat formula of I 8-313(2) applies in insolvency proceedinga). 198. Th aeventh draft of the inveatment securities article deleted I a-316 of the Nay, 1949 drart. u.c.c., Txt only Printing IXS&t tpr t;b 1ic11 AD soi,, CAic11 a> and tb ar:t,icl PD l(tlSSiixl Pot and B1P11lr tArticl 11,, Article aInvutaent securiti (Karch 1, 1950), raprint,0 in tJNIPORM COMMERCIAL CODI DRAF'l'S, IYPD note 196, at 120-39. 199. Th reporter for Article 8, Soia Mentschikoff, explained that Bankruptcy Act I 60 would control over the draft I 8-316 and the chance of a broker' inaolvency coming up in a atate court rather than in bankruptcy are in my mind extremely r-ote. 26 A.L.I. PROC. 332 (1949) (unpubliabed). Unfortunately, ahe apparently failed to realize that aucb a rule could have potential benefit in the ca of failed curities interaediari auch a banks that were not aubject to the Bankruptcy Act. la 11 u.s.c. I 22 (1970) (repealed) (banking corporation not entitled to become a bankrupt); 111 also infra note 222. Sb alao obaerved that if the u.c.c. were enacted as a Federal law I 60 might be repealed by implication. 26 A.L.I. PROC., aupra at 332. Sb auggaatad that a recommendation be made to conform I 60 to the draft I 8-316. lsl DOC. SWP11018 July 17, 1989
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96 60, SIPA, and Subchapter III i auperior have not been refined. Juatification for treating the customer of a common insolvent interaediary in the auae way generally have been based on the eliaination of fortuitous and arbitrary result well as equitable principles. Application of the proportionate property intereat formulation, rather that the risk sharing .. ~P.~~,~! . p~~~~--~-.r~!~-~\ .,f.~~~J-~~.r~~--~"-~uf. ~~d. trary ... , ... .. of ... -i~o. .a.a, ,q,, Del>-CBUW, BANKRUPTCY 323(1956) (quoted in . GUT'l'IIAH,. upra note .11 -at. 19~4-1-} : ,, I, . 0 0 '.- I .. ", I ,llii, ,I Section 60e adopt the theory that all of the customers of a broker who permit him to have wide powers over their curitie are subjecting thamselves to the common risk of hi failure. Be should not be permitted to favor some over othera when be and they contemplate the imminence of bis failure. Furthermore, upon bankruptcy the available assets should be distributed by applying equitable principles upon a broader base than that recognized under pre-exiating bankruptcy law. cgp9rcia1 Code. Tentative pratt No, 2--Article Y, Note to s 33 (August 28, 1947), reprinted in 3 TJHIFORM COMMERCIAL CODE DRAFTS, supra note 196, at 561: The purposes of the section are, first, to reduce the expense, delay and uncertainty which derive from an effort to apply the uncertain and conflicting rules of bona fide purcha and of tracing to the unravelling of the manipul.ationa of a common fiduciary: and, second, to achieve real equity in the situation in whi':h several persona have put their trust, in common, in a defalcator. The reason is clear: once defalcation has set in, it is a matter of pure accident which securities become the particular objects of plunder, and the common risk should be shared, instead of being left to accident. DOC. SWP1101B July 17, 1989
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97 reaulta. Ona a011awhat ore praci conceptualization equated riak haring principle to the admiralty principle of common : ... : !. .... ~ ....... :. ~-. -~-.... :;_-.:~: :' ,_. .,_: :.-.. ........ ., : : .. _. _.,,.,. -~.... . :. ,. -.~. "' ... :' : ... ; .. .. ' ,.. : .. :. .. ;,'Ii ... . : ... 201. If an inaolvant intermediary controls a fungible bulk of X Corp. stock sufficient to cover all customer claims, but controls only a fraction of the Y Corp. stock claimed by cuatomers, application of the proportionate property interest fonaulation would allow the X Corp. claimants to be fully satisfied while the Y corp. claimants would not. Sae supra note 97 and accompanying text. DOC. SWP1101B July 17, 1989
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98 venture-c0J111on riat. In a recent article Thomas Jackson and Robert Scott auggted that a risk sharing analyi baed on th common diatr context of adlliralty law' general average contribution rule -Y provide a normatively justifiable ,. -~--=--:.-...._ .. : .. ..... ..... ~---~--_.;!--~.-~ .. ~--~: .. ...... ,,. .,_: ~._.; .. /.: . -..... .. ..... i -.r~':" .)::~, ... .:~ .... ": .. :-,---. :-= . ,. .-. ~-ccmmercfai 'Code~ Proposed Finai 'praft No. 1-~Article !, _Notet~ -I 29 (April .26, 1948), reprinted in 4 UNIFORM COMMERCIAL CODE DRAFTS, supra note 196, at 382. The quoted reference obviously refers to the admiralty law doctrine of "general average" contribution. see generally G. GILMORE & c. BLACK, THE LAW OF ADMIRALTY 244-71 (2d ed. 1975). When general average applies,-the interests of a ship' owners in the ship and their right to compensation for caniage ("freight") and the interasta of the ownan of the cargo share ratably any loss or dallacje t:o any ~f 'their 'ilitaruta--. .... ld~, . t_ .. '4;..45~-The doctrine i not.-applied to all such lo or d1111Bge; but only when three conditions are satisfied. First, there must be a danger or peril that i common to the "ship, cargo and crew" and that is "~inevitable,' except by voluntarily incurring the loss of a portion of the whole to save the remainder." Id-, at 245 tquotinq Barnard v. Adams, 51 u.s. (10 Bow.) 270, 303 (1850)). Second, a portion of the interests (such as the cargo or a ship's t) JIU8t be voluntarily jettion[ed] in order to avoid the peril. Jd. Third, the attempt to avoid the imlllinent common peril J1U8t be succesaful." Jd. (footnote omitted). Th I 60e/SIPA/Subchapter III risk sharing approach reaches a result similar to that of general average contribution--all customers share ratably whether or not a shortfall exists as to the issues of securities they claim. And the prospect of customer losses arising out of their intermediary' failure could be characterized as a common peril. But the metaphor seems to crumble at this point. Unlike the notion of a ship's captain voluntarily casting away cargo or daasting the ship in heavy seas, all for the common good and without self-interested concern for the particular sacrifice made, shortfall in customer curitie are likely to result from the misbehavior of the intermediary's management or, at best, imprudence. Nor does the risk sharing approach appear to bear any direct causal connection to efforts to save the common enterprise. 203. saa supra note 202. DOC. SWP1101B July 17, 1989
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99 explanation for varioua diatributional rule under th Bankruptcy Code. Their analyi i grounded on a paradigmatic hypothetical creditor' bargain and a nonativ claill that pr banlcruptcy entitlaenta ahould be ipaired in bankruptcy only when necry to aaxiaiz net at diatribution to the creditora a a group and never to accoapliab purely diatributipn~l goals.~~--. J.ac;Jca.on. JJ~ .. sc;ot~ -~l~ .~ aaaUJ1ptions . . ~,. ... . ,: --~. ,-. ." ..... -. .. :. . -~ ... .. . .. . .. 204. Jackson Scott, On the Nature of Bsnkruptcy: An Eaaay on Bankruptcy Sharing and the creditors' Bargain, 75 Va. L. Rev. 155 (1989). The common disaster analysis draws on Scott, A Relational Theory of Secured Financing, 86 Colum. L. Rev. 901, 967-68 (1986) [hereinafter Relational Theory], and Scott, Through Bankruptcy with the Creditor' Bargain.Beuriatic, 53 u. Chi. L. Rev. 690,. 100~01 .(1986) [brinafter ThrouCJh Bankruptcy]. For ,C?:itiqu .. of .t.be Jac:uo~ -and. Scottt u1:icle,-. BiNnberg, C0111Nnb.rY on. ~e>n th Hat~--ot, .BanJcruptcy: Bankruptcy and Bargaining, 75 Va. L. Rev. 205 (1989): Roe, commentary on "On the Nature of Bankruptcy": Bankruptcy, Priority, and Economics, 75 Va~ L. Rev. 219 (1989). 205. Jackaon, Scott, supra note at 155-56. For earlier expositions of this creditors' bargain paradigm see T. JACKSON, TBB LOGIC AND LIMITS or BANKRUPTCY LlW (1986): Jackaon, BanJcruptcy, Hon-Bankruptcy Entitl-enta, and the creditors Bargain, 91 Yale L.J. 857 (1982). Tb paradigm is grounded on the notion that creditors, each entitled to their ax ante legal rights and pricritias, would agree among themselves to vary those rights in a collective bankruptcy proceeding only when the result would be a collective aximization of wealth. It follows that if the bankruptcy process redistributes the assets of the firm in a way that not only varies froa the creditors' pre-bankruptcy entitlements, but also varies from the hypothetical creditors' bargain, it is normatively unsound. Differences between pre bankruptcy and bankruptcy entitl-enta alao create perverse incentive resulting in atrateqic behavior such a forum hopping. There probably i little diaaqreaent that collective maxilllization of wealth for the creditors i, or at least should be, one important goal of the bankruptcy process. Even critics of the normative component of the creditors' bargain paradigm aclcnowledge that collective wealth maximization is an appropriate goal. 1ml, La, Warren, Bankruptcy Policy, 54 u. Chi. L. Rav. DOC. SWP1101B July 17, 1989
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100 underlying the creditora bargain, aploying the c01111on diaaater riak aharin9 approach, in an effort to rationalize certain peraiatent diatributional effecta of the bankruptcy proc with the creditors bargain. In particular, they invoke the analogy to the adlliral ty law principle of 9eneral averaqe contribution a an illustration that riak aharinCJ in bankruptcy may be an .U~ve-. ~: to .conb'ol.: ~e of JanJc.ruptcy atrateqlc behavior . by a doainant Ncured creditor. Viewin9 the SIPA/Subchapter III riak haring diatributional rule for customer aecuritie in this light, does the rule have a collective wealth aaxiaization effect? Th peat. I .. ._, , . . ,' ! ,, bantruptc:y f~~ ot :ti- :ruJ.~ to-~ pur.iy'diatributional- o ,',Io , , it tak the value ot cuat011er curiti of aom iau away from cuat011ers claimin9 auch iaaues and diatributes that value to other cuatoaers claiming other iu. Th a9qreqate value ot cuatoaer aecaritiu and the aCJC)regate nount of cuatoaer claima 775, 812-13 (1987). Th principal disaqr-nt is whether it ou9ht to be the only goal. CQ1Par1 warren, supra, with Baird, Lo Diatribution, Forma Shopping, and Banlcruptcy: A Reply to warren, 54 u. Chi. L. Rev. 815 (1987). 201. Jackson, Scott, aupra note 204, passiJg. 201. a.a Jackaon, Scott, 1upra note 204, at 171-74. 201. I supra not 189-91 and accompanying text. DOC. SWP1101B July 17, 1989
PAGE 296
101 are tb -with or without the rule. However, an hypothetical 1x ant bargain aaong the cuatomer well might include a riak haring arrangaent iilar to th SIPA and Subchapter III diatributional foraula becau that fonaula turniab cuatcmers with a hiqbr liklihood of a lpytr pgt1ntial JJma.111 Yet thi would not to be a -nifeatation of tb .J)~.i~~I?~~-'.o,, .9~~~~'. .. ~~,.J.""9.!!, 9._~tz:~u~i~~--~\ .,lta~er, _auc:h a. . . hypothetical customera bargain would rely reflect the am 209. Arguably tb administrative coats of impl .. enting the SIPA and Subchapter III distributional rules are less than the coat of iapl-enting the atate law proportionate property intareat allocationa. Tb atate law foraula -would require 11&tc:llin9NC11ritiN of uc:b.-ime vitb claiunta-to that isu and C011pUtin9. a_ditte~t ratable 9hare.tor. each iaaue. However, even under SIPA and tbe Subchapter III, it is necessary to aacertain vbich isaues are subject to the claim of at least one customer and the extent of that claia in order to construct the pool of customer property. s11 aupra notes 189-91. 210. So long as the cuatoaers allow tbe intel'llediary to control the -curitiu they retain little control th-elv s11 gpra note 107. When the interaediary' inaol vency proceeding begins, the cuatcmer property aight contain few securitie (or none) of one iu and enough aecurities of another iasue to satisfy all cuatomer claima to that issue. Application of th proportionate property interest scheme in such largely fortuitous circwutances could result in highly disparate treatment of varioua customera. But, because of the regulation and supervision of securiti intel'llediaries, including the cuat011er protection rules, it is unlikely that tbe customer property in the aggregate would fall to a very low percentage of tbe cuatomera net equities. [SIPC data] Thu, the riak sharing approach aak it l likely that a customer would sustain a severe lo bl Jackaon, Scott, supra note 204, at 165-66, n. 22. A similar analyi may explain the deair of market participants to hare risks in the clearing and settlement proc S supra note 2s. 211. s1 supra note 202. DOC. SWP1101B July 17, 1989
PAGE 297
102 nomative principle that underli the baaic diatributional tomula tor unaecured creditor in banJcruptcy--pro rata haring aaon9 claiaanta that are aillilarly aituated.112 And the niority afforded to cuatoaera (a Maaured by cuatoaer property) over general creditoram retlec:ta, in turn, that only the debtor' property will be available tor diatribution to crediton.214 ., ~: :~ .. .-. ~-.:_ lo: ~theory;_., r.ialc. c .-.rirlcJ alo-could.-IIOdera1:e behavior by the interaediary~ or.a doainant customer, that would favor a particular cuatomer or group of customer to the detriment of other customers. such strategic behavior could undermine the collective wealth uxiaization of th group.215 But, that the . . ... . . . ... .. . . .. _,,,..,_ __________ ..... ' . '. I, .-. ._ 212.1M Bankraptcy coc1e~ .. &(a) (2), (b): Ii. also T. JACKSON, ypra note 205, at 31: [Pro rata distribution to unsecured creditors] seems to provide our basic apportioning rule, because it mimics the yaly ot our expected poaitions i-diately before bankruptcy Ho other aingle apportioning rule works a well aero a range of casu. It 1 also the apportioning rule that the Bankruptcy Code usu and that perhaps fuel the sbopvom phra that equality i equity. At bottom, it is perhaps beat ~o aee thi a aninq that those in a similarly situated group--aucb aa general creditors--should split the ast available to their group pro rata, and nothing more. 213. S supra not 189-91. 214. an BanJcruptcy Code I SI 541 (apecitying what constitute property ot the tate): 726(a) (distributions of property of tbe tate). 215. an Jackson, Scott, supra note 204, at 171-74. The SIPA and Subcbapter III risk haring approach do not diacriminat againat or in favor of any customer because the cuatomer' curities account i full, -pty, or in between. DOC. SWP1101B July 17, 1989
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103 SIPA/8\lbcbapter III risk aharinq diatributional foraula uy be nonativaly auparior and uy correapond to a hypothetical cuatoaan bargain doaa not naceaArily au99eat that the rule baa a aaterial iapact of th behavior of an intenaediary or it cuatoaera. It i plauaibl that tba choice of either the riak abarincJ or the proportionate property interut approach would not -~Y~-:;~ J~~e.,.~~~-~ .-'!'~1'.--~-~-~~~ ~io~ ~r. ~xpactationa of_aecuriti~ int~diary cuatoaera. cuatoar wbo clailla are excluded from or would exceed the limit of SIPC protection are predictably highly risk averse and likely to view th effect of an inaolven~ proceading_for their aacuriti intanaadiary as I 0 IO '' / o .. intol.-u.le, --~ tile fozmla-for distribationa of eaat011ar curitiu . Bothth~-ri~k .. iaba~i~~:app~~cb and 'th pro~rtionate property interest rule yield the potential for dilution of cuat011ers claima. Thus, it can be expected that they will aelect interaadiarias that they believe are virtually certain to r-in viabla.116 If that certainty tuma to doubt, th players will likely demand that their securities be delivered or Conceivably, the intermediary's managers (or a dominant customer), like a captain of a ship, could be discouraged from attempting to save one customer' property at the expense of other and would be encouraged to act so as to maximize the wealth of tba group. In JJI. 216. s11 supra not 45-47 and accompanying text. DOC. SWP1101B July 17, 1989
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104 otberviH tranafarred to tbu throu9b another intenediary.117 Altbou9h tbi potential for eve of bankruptcy atrategic behavior by cuatoaen of a failing intanadiary i obvioua, application of axiatincJ preference lav to aucb behavior i problmutic.211 217. I find it inconceivable that a cuatoaer with actual concama about tb financial condition of integrity of ita inter.adiary would fail to dmnd delivery or ov-nt of .vJl1.~.~~-:~ .tl;le.,c:.~rtinq .910.V _a~. a proapectiv .. Pi>?lcationof th SIPA/Subchapter III. riak abaring fonaula. 218: Preferences are govamed by Bankruptcy Coda aaction 547, vbicb alao ppli in SIPA proceeding. SIPA I 6(b): Bankruptcy Coda I 547: 111 also SIPA I 9(c)(3) (trustee may recover property transferred by debtor, that would have been cuat~r property except for transfer, if transfer is voidable or void under Bankruptcy Code)1 Bankruptcy Coda I 749(a) (to th -effect in. a SUbcbapterIII --ca> A tranafer i voidable -.Ser-9ection 547. only if, intseX:: lli, it 1a .. d within 90 days before eonencwat of the. proceec:ling and the tranafer enables the tranaferee to receive aor than it VC'Juld bave received in a proceeding under chapter 7 of the Bankruptcy Code. Bankruptcy Code I 547(b)(4), (b)(5). Tb time of transfer turns on non bankruptcy lav. Bankruptcy Code I 547(e). In th case of curiti bald in fungible bulk controlled by the debtor intermediary, the transfer would normally occur when th requireaenta of identification and confirmation occur purauant to section a-313(d)(ii) or (d)(iii) (to the extent tbat th fungible bulk ware sufficient to cover the interuta of all tho vbo share in it). A aubaequent physical delivery of curiti, or ovaent of curiti to another intermediary on behalf of a cuatomer, even if within tbe 90-day window, would nQt constitute a transfer for purpo of ction 547 because tbe tranafar had already occurred. Thia result would follow even though the curiti otherwise would have been customer securities and the delivery or ovemant allowed tbe customer to recover more than it would have recovered under SIPA or the Subchaptar III. But, if at the time of the original tranfr there had bean a shortfall in the fungible bulk, tben each aubaequent acquisition of aecuriti by th intermediary of th issue involved Ci,,, each aubaaquent increaae in the fungible bulk) would constitute a new tranafer to och cuatomer who interest was thereby increased. In the first case, overt eve of bankruptcy action by a customer that improves its position by taking physical delivery of curiti (or bavingtha oved to another intermediary) is DOC. SWP1101B July 17, 1989
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105 Becaua tb actual entorcaent of cuatoaer property intereata outaid of inaolven.:y proceeding ia unlikely, it ia only tbe entitleaent in tboa1 proceedinqa tbat ia trial.Zlf Tbua, tb SIPA/Subchapter III riak abaring fonulation IIN8t be avaluated on ita own rita, and the atat law proportionate property intereat fonulation baa no aeaninqful nonativ claill to tbe aqtu of.a_pre~bankruptcy entitlaent. J ,' , ... ; ~. " I .,. ~-: ,-:. .' -~: \ ._.,.. ... ': ~-= . ... ,; "I : .. . . . ,-.... not voidable. In tb aecond caae, poaail>ly fortuitoua action by tbe interaediary, probably unknown to th cuatomera, uy reault in voidability. Becauae tranafera of curities do not appear to be paymenta, auch tranafers will not be inaulated from preference voidability by the ordinary course of buainess" exception. Bankruptcy Code I 547(c)(2). A more rational preference rule vauld perait._avoi.s.nce of deliver! or ov-enta of_aecariti. tbat reacw-tll-.fZOII cuatoaar property (even if no tranateruild~.~~-lav occ:un-ad.~uaa _of tbe application of tbe proportionate property in~ereat rule). A coaplaentary rule would exempt such deliveries and aovaenta, as well a tranafera, ude in tbe ordinary cour of busin There is alao a broad exemption from voidability for settlaent payments" ude purauant to repo tranaactiona prior to tbe c011111enc-nt of a proceeding. Bankruptcy Code II 546(f)1 741(8) (defining aettlmaent payaent); -Bevill, Brulu Schul.an Aaaet Nanag-ent corp. v. Spencer sav., Loan Aaa'n (In ra Bevill, &ruler, Scbul.Jlan Aaaet Nana9aent corp.), No. 88-6020, 1989 u.s. App. LEXIS 9346 (3d Cir. June 30, 1989) (transfers of securiti by physical delivery to repo participants were aettlaent payment (und Bankruptcy Code I 741(8)) and, purauant to Bankruptcy Code I 546(f), were not avoidable). 219. s11 supra not 183. 220. Stated othervi, under the creditors bargain paradiga, cuatomers would not rely on th proportionate property interut formulation or expect it to be applied in the ca of a shortfall. Thu, at leaat aa a matter of bankruptcy theory, th riak abaring approach doe not require a reaolution of th Baird Warren debate about whether pre-bankruptcy entitlaenta ahould be favored over purely diatributional bankruptcy rules. au Baird, supra note 2051 warren, upra note 205. Voluntary pre-bankruptcy deliveri and movaenta of aecuriti that enable cuatomr to DOC. SWP1101B July 17, 1989
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106 If tbe SIPA and Subcbapter III riak aharin9 approach ia aound for aecuritiu fim inaolvency proceedinqa, perhapa it alao abould be Md applicable to inaolvenci .. of other interaediari .. ncb u banlca.111 But cuatoaer property in tb cuatody by inaolvent banu 9enerally i allocated accordiftCJ to tbe otbervi-applicable atate property lav. Tbua, in the ca 'bi,~. th~1~~1~altf~~ :~~~~::~~ii\;i"ti -~ ~~dj~ta~nb i~ prefarence law. IM IYRD note 211. BecaUH the doainant e1eaent of the cuatoaen' bazivain vi th tbe interaediary i that thera are to be aufficient aecuriti on hand to aatiaty All cuataaer claiaa, the proportionate property intereat rule can be explained aa ~ly a conventional property law conceptualization that linu the cuatoaera interuta to a tun9ibl bulk expected to Ntiafy tho claim. IndHd, tb proportionate property intereat approacb i conaiatent vltb the general C011Mn lav -approacb ta 0~ il:ngled property. a., ,a;,~ a. BROlllf, TD UW OF Pa80DL PIIOPZRl'I 11 e.1-&.9, 6.13 (Jd ed. 1975) (diac:uaainq caaon law doctrine of contuaion)1 Friacb, o.c.c. Section 9-315: A Biatorical and Nodem Perspective, 70 Ninn. L. Rav. 1, 14-21, 41 (1985) (diacuaift9 c:cmaon law doctrine of confuaion and treataent of interuta in cOIIIWICJled property). 221. It i not nacuaary for preaent purpou to dwell on tbe 1-,al fraaavorJt applicable to inaolvent banb under United statu federal and atate lava. In MDnJly A. Pt'I,J:UtD, J. PASSAIC, K. ELLIS I J. DALY, IPPD note 53, at 105-23 (failiftCJ and failed banu covered by PDIC). Tile riak abari119 analyi would be entially the .... for curitiu finaa. 222. Itto be well accepted that property in the handa of a failed bank that i identifiable aa belon9in9 to cuatmaen or othen doe not becaae a part of a failed bank' utate available for diatribution to credi ton. ba, , q, P.D.I.c. v. Nadaoiaell of calif., 379 P.2d 610, 614-65 (1967) (owner of participation intarut in bank loan i entitled to identifiable collactiona ude by P.D.I.c. aa receiver for failed bank)I accprd .. SaViftCJ BanJc of Rockland County v. P.D.I.C., 118 P. Supp. 799, 804 (S.D.N.Y. 1987)1 Cba llanbattan Bank, M.A. v. P.D.I.C., 554 P. Supp. 251, 254 (W.D. Okla. 1913). In practice, tbe P.D.I.C. routinely turna over ta beld in truat, cuatody or aafekaeping to claillanta vho interuta can be adequately identified. [P.D.I.C. Intervieva]. NotbiftCJ in tb lav DOC. SWP1101B July 17, 1919
PAGE 302
107 of cmatoaar HCNritiu beld by an inaolvent bank in a fungible bulk, tbe proportionate property intereat tomula would apply. Claiaa ot leaand cretiun Aa a 9eneral -tter, crediton that cl.aia a aecurity 1nterMt 1n aecurltiu of a aec:uritiu tlm are not cuatoaen" and an 9iven no apecial tnatMnt under SIPA or Chapter 7, ~~~"',W. ~~--= ~. ~-.COd-~ .. IVen._it a ~ad creditor of tbe inaolvent in~iary baa allowed tbat interllediary to control tbe aecuritie that compri th collateral, it i unlikely that the cured creditor will ... .. - .. .. -applicable to tailed federally inaured banka baa been found that would upaet a atate lav diatributional acb-(aucb a the proportionate property interut tomula) for allocating auch property aao119 ric,bttul claiaanta. Tbua, vere atate law changed to provide tor a IIPC/lubc:bapter III-type riak abarinq fol'IIUla, tllat tomula would be applicable 1n tbe cue of a tailed bank controllin9 cuatoaer aec:ariti. IM gpra notu 111-11 and accoapanyincJ text (diac:uuin9 aucb a diatributional rule applicable to tailed broura in -rly u.c.c. dratta). However, tbe virtual abaence of cuatoaer lo on account of property beld in cuatody by banka au99uta tbat prntly tbere 1 lacking a autticient concem ao u to inapire cban9 in law. I aupra note 48. 223. A aec:ured party tbat receive pbyaical delivery of collateral or to vboa tbe collateral i tranaferred through anotber, tbird party, intU'Mdiary, ia not a cuatoaer becau it baa no claia on account of aecuritiu received, acquired, or beld by tbe debtor. IIPA I 11(2)1 Bankruptcy Code I 741(2); -IJlPA note 111. 224. I IYPA note. 12-13 and accoapanyin9 text (diacuaainq tranafer of aecurity interut under 1178 I a-313(1)(d)(ii) and (iii)). DOC. IWP11018 July 17, 1189
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108 receive cuatoaer treatllent.m Aaauaing aucb a cured creditor would not be a cuatoaer, th proper treatllent of the cured 225. Sucb a cured party appeara to fit th plain aning of the definition of caatcmer under both &IPA and the Subcbapter III. Ill IJ1PD note 189. Both definitiona expreaaly include a cuatcmera peraona claiaing aecuriti-that are received, acquired, or bald in the ordinary coura of :-~-~~~'8..,: ,; __ ;:i,~-~i-~l~l~~--:,,;,.:a~PA',1.-11,2).1 -.~tcy _code I 7 ll ( 2) Howe.vr, 'both SIPA -and the Bankruptcy Code contain proviaiona allocaUn9 rmininq liquidation proceeda of collateral (where tb debtor inter.ediary i the debtor in th aecured transaction) between cuatoaer property and the debtor's general eatate. SIPA I 6(d); Bankruptcy Code I 7!52(c). Tho proviaiona clearly are at odd with tbe notion that a debtor intermediary' cured creditor would be a cuatomer and the collateral would be cuatoaer property, unl- tbey could be conatruedto apply only-when tbe collteral iii not controlled by tbe debtor; Autaoritiaa al.Ct liupport the. propoaition that a debtor, intenadiary-a ncurad. creditors are not .. cuatcmera. au In r Stalvey, Aaaoca., Inc., 7!50 r.2d 464, 468 (reference to collateral curity in SIPA I 16(2) includu only curiti of a purcbaaer curing aargin obligation to the debtor); In ti Hanover Square Sec., !5!5 Bankr. 23!5, 239-40 (BanJcr. S.D.N.Y. 1985) (lendera are not cuatcmera)1 s;f. GU'l"l'KAlf, aupra note 11, at 19-72 n.340 (approving of reault in In n Stalvey Aaaoca., Inc., and illplyin9 that if repoa are cbaracterized u aecand tranaactiona tbe aacured creditor would not be a cuatcmer under tile Subcbapter III). IM 1119 s.z.c. v. r.o. Baroff co., 497 P.2d 280 (2d cir. 1974) (lender of Hcuritiu to aecuritiu fin not a cuatomer); s.I.P.C. v. Executive Sec. Corp., !5!56 r.2d 98 (2d Cir. 1977) (lender of curiti to c:uriti firm, cured by caab collateral, not a cuat011er). In the lfYill. lnlr ca the court did not reach thi iu becau it determined that th rpo there involved were purcha and aalu, not cured tranaactiona, and that repo participant. were cuatoaera. Cohen v. Arlly Moral Support Pund tin n Bevill, Brlr, Schulman Aaaet llanagaent Corp.), 67 Bankr. !5!57, !516-602 (BanJcr. D.N.J. 1986). Accordin9ly, repo claillanta were given cuat011er atatua under SIPA. 14., at 102. However, SIPC' papen filed in that ca took tbe poaition that the repoa were cured tranaactiona and, conaequently, that tbe lenders were not cuatoaera under SIPA. 14., at 564-651 IU Focht, Harbeck, upra note 9!5, at 1214 (arvuin9 that repo participanta are not cuat011r under SIPA and Subchapter III). DOC. SWP1101B July 17, 1989
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109 claill under SIPA and Subchapter III is not clear. Certainly the curd creditor would not share in the pool of customer property. But awarding the cured creditor with the benefit of curitiu that otherwi would be included in the customer property -y give ita security interest that would not be achieved outside of an inaolvency proceeding.ZZ7 Subordinating --~.,~,~~::~~~~ ~~.: ~:~:-& .. ~~.:.:~~--~~~-~:-~~-.. -~~~7 -~:t;C?,~ers .. alao could . . 226. In the absence of contrary authority, however, it is assumed that the secured claims would be prior to customer claims. sae supra note 2~s. 227. Under the proportionate property.interest formula, the ~-CZ'.editor.a~claia to an -interut in a fungible bulk of .aenriti -conro1i.s;,.1,y the .. 4ebl:.or ,ifttanecliuy interat would axtend only to.it.a. p~nionat-ahan.of the. fungible bullca. of isecurltiu ot the isu claimed. saa supra not 96-97 and acc011panying text. Because cured creditors are not customers, the SIPA/Subchapter III risk haring formula would not upset the otherwise applicable proportionate property interest formulation. The secured creditor' interest in collateral would ba enlarged beyond ita proportionate property interest by pr011oting its claim ahead of tba cuatcman claiaing the -Ncuriti iasu (Thi asamaea, of couraa, that the security interest is perfected. Otherwi, th trust could avoid th security intarut. Bankruptcy Code I 544 (a).) Assuming that such perfected security interests are, a class, prior to customers' clailla, th priorities as gong the secured creditors should be determined according to the proportionate property interest formula. s11 supra note 96. It could be argued, however, that such priorities should be determined according to the time of perfection. ba II 9-312(5)(a) (priority for first to perfect wben perfection is not by filing); 8-321(3) ("security interest in a security is subject to Article 9"). That approach could involve difficult tracing probland would be wholly at odds with the proportionate property interest concept. sea supra not 96-99 and acc0111panying text. Arguably, the best method of ruolving priorities (assuming such secured creditors claims are senior to tho of customers) would ba to adopt the principles of the risk sharing formula for the entire cl of cured creditors. DOC. SWP1101B July 17, 1989
PAGE 305
110 have a distributional effect equally inconsistent with otherwise applicable law. If the risk sharing distributional formula is normatively superior, arguably treatllent of such secured creditors as cust011era might produce the aoat desireable reault. c. Obaezvatiou :-;;,:~~ .. \:_:~~-:~i?,\._~:-..;~~'.: -~(~1;.,.~~-~,.~~-~-.:P.J::-~~~~-,.~ -~~~:, .. ~~~-::a~_ampt_ .. a ~.solutio~.o~ the various p~ii~ and interpretiv:e _puzzles arising . . .. .. . in securities intermediary insolvency proceedings.229 But the . . . . 228. This approach, however, could undermine the whole purpoae and utility _of secured credit. s11 91narally authorities cited :intra; note--229J-inm-not And, by enlarging the aggzegate armnto~ cl:aiu to .:~.-.r-proparty; increased -'nds wolJld be: placac:1-; :0n. the SIPC : fund. in -cases where securities of the issues claimed by secured creditors were scarce. s11 supra note 188. Suffice it to note that the subject of same tier priority conflicts and distributional considerations as. among securities customers and secured creditors warrants further practical and theoretical exploration. 229. In recent years several bankruptcy scholars have explored the theoretical base for bankruptcy law. la, L.Sl, T. JACKSON, IYPD note 20!5; Baird, supra note 20!5; Baird, Jackson, Corporate Reorganizations and the Treatment of Diverse ownership Interests: A Comment on Adequate Protection of Secured Creditors in Banlcruptcy, 51 u. Chi. L. Rev. 97 (1984); Eisenberg, supra note 204; Eisenberg, Bankruptcy Law in Perspective, 28 UCLA L.Rev. 953 (1981); Carlson, Postpetition Interest Under the Bankruptcy Code, 43 u. Miami L. Rav. !577 (1989); Harris, A Reply to Theodore Eisenberg' Bankruptcy Law in Perspective, 30 UCLA L. Rev. 327 (1982); Jackaon, Scott, supra note 204; LoPucki, A General Theory of the Dynamics of the State Remedies/Bankruptcy Syst-, 1982 Wis. L. Rev. 311; Mccoid, Bankruptcy, Preference, and Efficiency: An Expression of Doubt, 67 Va. L. Rev. 249 (1981); Roe, supra note 204; Roe, Bankruptcy and Debt: A New Model for Corporate Reorganization, 83 Colma. L. Rev. !527 (1983); Scott, Through Bankruptcy, IJlRB note 204: Shanker, The Use and Abuse of Federal Bankruptcy Power, 26 Case Western L.Rev. 3 (1976); Warran, supra note 205; Carlson, Book Review, 85 Mich. L. DOC. SWP1101B July 17, 1989
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111 Rev. 1341 (1987) (reviewing T. JACKSON, supra note 205): Eiaenbarg, Book Review, 39 Stan. L. Rav. 1519 (1987) (reviewing T. JACKSON, supra note 205). A related and somewhat overlapping body of cOJ1111entary baa aerged that considers, and sometimes queationa, the role of and need for aecured credit and its priority over claima of general creditors, both in and out of inaolvenc,y proceeding. Ila, ,q., Ayer, on the Vacuity of the Sale/Leaae Diatinction, 68 Iowa L. Rev. 667 (1983): Baird, supra note 131; Baird, Jackaon, supra note 131: Buckley, The Bankruptcy Priority Puzzle, 72 Va. L. Rev. 1393 (1986): Carlson, aat.ionalitY..,. 1~ra note: .1a1_;. -J.ep~n._.,_,,; ~onun SQUrd.Financing eci""hlorl1fle~hong~er.dltori; .. ia.yafe 't,;'J ~-, ;ii43' "f1979f ; Jackson Schwart~., Vacuum ~f Fact of :vacuous Thao_ry:. A Reply_ to irofesaor Kripke, 133 u~ pa~ 'L. Rav. 987 (1985); Kripka, Law and EconOJli.cs: Measuring the Economic Efficiency of COlllJllarcial Law in a Vacuum of Fact, 133 u. Pa. L. Rev. 929 (1985): Phillips, supra note 131:.Phillip, '.,l'ha CQmmarcial .culpability $cale, 92 Yale L. J. 228 (1982): Schwartz, The Continuing Puzzle of secured Debt, 37 Vand. L. Rev. 1051 (1984); Schwartz, Security Interests .. 8114 aankruptcy .Pr1oritiea.: '. A Review. of. Cllrrent Theories, 10 J. ~-Lepl_ Stud.--1:.(1~1):J:seatt,, -IWItional 'l'beory-, supra: note s~upac:tf ., Solving -~-PuJl-.of, :.S.c:urad. Tranaactiona. 41. Rutgers L. Rav . i067 (1989") "[herainafter'pgzzle]: Shupack, Defending Article 9 of the ucc from Professor Buckley, 22 Ind. L. Rev. (forthcoming 1989); White, Efficiency Justifications for Personal Property Security, 37 Vand. L. Rev. 473 (1984). The bankruptcy and cured credit discourse essentially has ignored insolvency proceeding of financial intermediaries, auchas aecuritiaa firms and banb, including SIPA and Subchapter III. For example, recent dicuaiona of the riJt aharing general average contribution doctrine aa it relatu to bankruptcy theory never mention Bankruptcy Act 60, SIPA, or Subchaptar III. a.a Jackson, Scott, supra note 204; Eisenberg, supra note 204: Roe, supra note 204. Indeed, each of these authors suggests or hints that the risk sharing general average metaphor may be a new and original approach to bankruptcy theory. Jackson, Scott, supra note 2C4, at 157 ("This c011D11on disaster conceptualization was tirst suggested in" Scott, Through Bankruptcy, supra note 204) (emphaais added): Eisenberg, supra note 204, at 205 ("Jackson and Scott' discussion is valuable because it provides a fresh outlook on difficult questions of bankruptcy theory); Roa, supra note 204, at 219 (Jackaon and Scott's article will change [the] view that deviations from "absolute priority are "diatributional rules or mistakes"). But aea supra notes 192-202 (application of coJ11111on disaster sharing scheme in Bankruptcy Act I 60e and early drafts of u.c.c.). Recant co1DJ1entary on SIPA, imilarly, has failed to engage this ongoing discourse. la, DOC. SWP1101B July 17, 1989
PAGE 307
112 foregoing discussion does offer a clearer vision, from both the positive and th normative perspective, of the nature and diaenaions of cla~ to securities controlled by an intermediary in a fungible bulk. If the intermediary performs as expected, the claimants receive the desired benefits of ownership (or collateral security). If the intermediary fails, their claims -~~,,~ .-:.~~~~;-~ ..... r~~~~:-.-:~1}'~~:4.:_.,:~-~~q~CJ~:.:,-.~: .. ~e~on of:.-.. distributional ru1~: .. produce 110~8 or less deaireable effects, .. . .. . .. ...""'... . . . . .. the moat powerful force at work in the market is the discipline .and cau~ion .that must _be exercised-in. se_lecting an intermediary. . Thi ducription underacoru the obvious similarities between _.: -~., .-_ _."". .. . .. : .... ., --: .:,.:_ .. .= .;: .' '._ ... ., .. ., ., . ..... aecariti. claillairts .-a.plot intenaecli"ariu; "and. clam .. of general , .; .... ,, ., ', , ,,, 0 -. :. ,,. ._. . r., ; ,, , ,: _' -. f.', I ',.' , "' 0 ' creditors. Once a pool of property available for distribution to certain claimants is determined, and th~ distributional rule is specified, there i little that property law can do to increase the size of the pool. But property law rule can be uaed to increase the recoveries of claimants to securities that are also claimed by owners and creditors who do DZ claim an interest in a fungible bulk through the insolvent intermediary--claimants on ,q., GU'l'TJIAH, supra note 11, at 19-34 to 19-102: Brennan, supra note 188: Cheston, supra note 188: Harbeck, supra note 111. Perhaps tbe discourse concerning bankruptcy theory and secured credit and that conceming securities intermediary failures each could be advanced by a connection between the two. I intend to attempt such a connection, but that effort must wait for another day. DOC. SWP1101B July 17, 1989
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113 different tiers. In that context, addressed next, property law can interfere with the interests ot market participants who did not intend or desire to cast their c01111on lot with the insolvent intermediary. .:. ....... .. .: ...... ... .. .. ";' ..... .... .. -.. ':,' 90 ,~-1, I '. :,. 1 ., 0 ., .. ,' 0 ''i ' : 0 .,- ' ,,''~ . ~-. 1. :. o a ; I.' ,:, , ." . I : , ... : . : .. : . .. : ._ . . .. :. ..-:: . ....... .. DOC. SWP1101B July 17, 1989
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114 ff. CODftDG CLaDQI DD ft%0U'ID8 OB D%1TBJtBlft' 'l:CBU: BOD 1'%DB PDCDSB, l':CU'f-Dl-'IIJIB, L2Ul'!-:CR-TDIB Consideration of conflicting claims and priorities aaong claimants on different tiers will be aided-by an example. IXMPirE 1 Insolvent Intermediary, I-1, maintains a .;.;~::;./<":: .. ~~~-;_.;~--~.-_.~-~~~~:,~~~ti~i~-:an:=_:upatrelbi: --_;._,.':-:;,_f~:-,-,._:-~;_:..--.;:~;:~.-.i_ntermediary,. I.-a,: nd I-2,: -inturn, .-maintains a securities account with another upstream: intermediary,; I-J . x-1 .obtains a ~~ad .loan ~rom a ~~~d~r,. L, .a~~-pledges . , .. .. ... . : ...... ..... , .. .. ,. . . .. ... ,. . .. :' .. :, : :: .. c;nttitiea to--)~. by c-uiiinq j::..~ io:'ciat)_it .x~i'i~-- .... ;\ '; ;, ':, ..... ,' , .... ,. "': ' 0 ._ : .. \ ':, > .,, ,, , ."!' ,. t '"" : , I,. l securities account and credit the account of L, who also maintains a securities account with I-2. I-1 then obtains another secured loan, this time from I-2, and pledges different securities to I-2 by instructing I-2 to debit I-l's securities account and credit a spacial pledge account in I-l's name on the books of I-2. Whan I-1 becomes insolvent, one of I-l's customers, c, (whose claims to aecuritias would not otherwise be satisfied in full) claims the securities pledged to Land the securities pledged to I-DOC. SWP1102 July 17, 1989
PAGE 310
115 2 on the boob of I-2. Land I-2, of course, alao claim these securities as secured crec:li tors. The aecuri ties involved may be (i) certificated securities in the physical poasession of I-3, (ii) uncertificated securities registered in the nue of I-3, or ~,,., ....... J).~ J~!-J.>, v~~,~.: .. -.~ilM, .... -~it~~-(:,.-~.-->.: ... .... :~ .... _. .... :. _:,,. o : :--'I 't o :. I -. . ' ,. I .. '1 .: : 'I I: I .. '. I o I .credited to -the~ account -o~ .I-3 with a Federal . . . . ;~ .: : ... .. : . . . Reaerve Banlt. In_Exnple 1, c, Land I-2 ea~ have claiJIIS to securities as a result of .. tranaactiorui with th .. sue party., I-1. But their . : .. . ': \ . .. ... .. . .. : .. ,, .. .... ':,. . . ,., cl~-:are .. Naecl.-on.,enviea.:on.,-tbe:booa':of tvo-.. dif~erent . .'. . . .. . ; .. :., _:J.:._: ,.r, : . .,; . \.~ .: .. _-. ,: : ; ... _;_: .. .' 'inttinaediarie-.~-I-1 and I-2. %'~3 knows I-2, but does not know I-1 or L. I-2 knows I-1 and L, but does not know c (or I-l's other custamers). There are several possible approaches to solving this puzzle under current law.m Recall that in a proceeding under SIPA or the Bankruptcy Coda the risk sharing distribut~i,.,nal rule would pool C's claiJII to customer property with claims of all other customers.Zit However, the securities in Exupla 1 would not be 230. If things worJc as they are supposed to work such shortfalls in available securities should not occur. However, the shortfall -y have resulted from error, fraud, or intentional or inadvertent non-camplianca with applicable customer protection rulea. I 1J1Pr1 notes 56-57, 104. 231. I supra notes 189-91 and accompanying text. DOC. SWP1102 July 17, 1989
PAGE 311
116 cuat011er property to the extent they are subject to the perfected security interests of Land I-2.m It follows that ~s claim to priority over the interests of Land I-2 would not ba subject to the riak sharing formula.m Nor would the risk sharing rule apply if I-1 were a bank or other intermediary not subject to SIPA or the Bankruptcy Code stockbroker liquidation provisions.234 ;.~~-~~.1~+:,:,~~~M-,~-,,~~~~~:~~,+i~;~~1:\~r'~.:-\~n!~.l.!:~'':-~-_.,:: '.::--:'=.:~-~ PJ;"OC~eding would ~Q~. ra,c:.!v.e the pr:i.Qrity .conflict. Resort t~ - Ito. ... applicable state property law would be necessary.as 232. L and I_-2 are not ~-customers" of I-1 under either the -~pt~ Code o~ _SIP~ .. Ila supra no~ 189. ... .. .. .. ..... ... ~--.-.~ .. _.: .. .... _: ....... ,... .,,: .. .. -: ... ~---23.3. .. a,-. ~---;,Ii:,an4 .. -.1-z:a~ -ndt custOJilers,of.-z-1-, lf =~-.Mc:uri-ti .. cl&illed _,y :L and-I-.2.verti -a-eatad as customer property and C' claim were to achieve priority over those of L and I-2, a circular priority could result in the insolvency proceeding of I-1. C would be prior to Land I-2: the perfected security interests of Land I-2 would be prior to, and not avoidable by, I-l's trustee: the interest of c, a customer, in the securities would be subjected to the risk sharing formula under the Bankruptcy Coda or SIPA. 234. s11 supra notes 96-99 and accompanying text: infra notes 265-68 and acc011panying text. 235. The insolvency proceeding distributional rules also would not resolve the conflict in a situation where the securiti had been transferred by I-2 or L to a bona fide purchaser fr of the claims of c. In that case, c could seek to recover against L and I-2 on a conversion theory. ba Morgan Guar. Trust co. v. Third Nat'l Bank, 400 P. Supp. 383, 388-89 (D. Maas. 1975) (Article 8 envisions co-on law conversion suits, citing II 1-103, 8-318), 1tto., 529 P.2d 1141 (lat cir. 1976): Hartford Accident, Ind-. co. v. Walaton, co., 21 N.Y.2d 219, 287 R.Y.S.2d 58 (1967) (conversion action against stockbroker peraittad (under pre-u.c.c. law) where stoclcbroker failed to obarv reaaonabl c01111lercial atandarda). C's ability to recover on a conversion theory would not be defeated by I-2's or L's good faith or abaence of notice of C's claia. In Nickl, Enforcing DOC. SWP1102 July 17, 1989
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117 a. ~rmfera to Upper ~ier Claiwut rirat-in-~iae AasUlle further that the security interests claimed by L and I-2 were created and perfected before C's purchase of the aecuritiu. As to the securities claimed by both Land c, it is likely that C did not receive an effective transfer of those aecurities because, at the time of the putative transfer, the ':,,~+~+.~,~~~~-.,J~1~:~-,;-.~~, ... .... ~;:~~, .... ~'?~~~--~, .. :--~"".~,: . :_ e,~n--tb~ ~ks ~t~. I-2.~~: -Bo~;er; .beca~se the s~curities claimed I .... by both I-2 and-C remain~d in an account of I-1 on the books of I-2 (albeit subject to I-2's security interest), the transfer to C of those securities would be effective.Zff Thus, the vagaries . . . ... .. :" . .. ...... .. :. . .. '" .. . -of .. bow ._the. cur.itiu. aCCOU:Qta. are structured:_and denominatec:l may . . .. . .. : .:: . . ": ,,. .... ,. -~ t :~ .;: -; ... - :"':! : . : ,. -~-.. t. . ". .. . ... . Article 9 Security Interests Against Subordinate Buyers of Collateral, so Geo. Wash. L. Rev. 511, 524-25 (1982) ("A buyer's status as a good faith purchaser for value without knowledge of the security interest does not absolve him of liability. If the secured party ia entitled to priority and possession under Article 9's rules, the converter's pure heart and clear conscience are irrelevant.). However, if I-2 had acted "in good faith (including observance of reasonable commercial standards)," it would be have a defense to a conversion claim by c. 1978 and pre-1978 I 8-318. 236. I 8-lll(l)(d)(iii): 11 supra note 100. Rad L perfected its security interest by notification to I-2, however, pruUIUlbly the aecuritiu would have continued to be shown on I l's account. la I 8-313(l)(h)(i) (perfection by notification to financial intermediary). 237. In I 8-313(1)(d)(iii). DOC. SWP1102 July 17, 1989
PAGE 313
118 determine whether c receives an affective transfer of securities at all.m Asauaing that effective transfers to c occurred, C's intereat would be junior to the interests of Land I-2 unless c var a bona fide purchaser.a c, as a transferee pursuant to section 8-313(1)(d)(iii), could not be a bona fide purchaser. :.~~~~,>t. .. ~~t;;.~-~-i-1~:~~~~ ~"-&: :-~---.,~~. -mi~er:: _11e~on, -i~3iJci> c~>-,.~,_-tha~. ~~~t-holi1~ raii.--,irst~ :i-1.is not_ '. . . in possession of the securities within the meaning of section : ... .. _:..... .:. ........ ..... . .. _., ' _. ... : ... : .... ----""',.-. -----.-.-.--. ~; .-: ... ~_. .. _;._"'. \ ... -t.' ._.--,., ... ..,. .. .. .. .: ... .' -~ .. 231, . Bad.--'the ecuri-tia-claillladby --2 and' C btaen transferred to a proprietary account of I-2, rather than an account in I-l's nue, I-2 also might successfully argue that there was no effective transfer to c. on the other hand, it is arguable that there was an effective transfer to c of the securities claimed by Land I-2, regardless of the account n011anclature, because the books and records of Land I-2 presumably reflected I-l's beneficial ownership and that the transfers to Land I-2 were merely secured transactions. 239. II 8-301(1): -302(3): see supra notes 70, 82-85 and accompanying text. 'l'he sue result would obtain if c were a secured party rather than an outright buyer because I-2 and L would have bean the first to perfect. I 9-312(5)(a). 240. I 8-313(2) (first sentence). 241. Transfer pursuant to section a-313(d) (i) can confer bona fide purchaser status. l51. Such a transfer would require that I-1, in addition to sanding ca confirmation of the purchase, by book entry or otherwise identif[y] as belonging to [C] a specific certificated security in [I-l's] possession. I 8-313(l)(d)(i). Pre-1978 section 8-313(1)(c) was essentially identical to 1978 I a-313(1)(d)(i), except that the pre-1978 version dealt with what constitutes a "delivery rather that what constitutes a transfer. DOC. SWP1102 July 17, 1989
PAGE 314
119 8-313(1)(d)(i),212 although there is authority suggesting otherwise. Second, because the securities are a part of a 242. Although Example 1 states that I-3 is in physical poasusion of the securities (aaaUJ1ing they are certificated), c could be expected to argue that I-1 is in constructive possession as a result of its agency relationship with I-2 and I-2' agency relationship with I-3. a.. intra note 243. But the more reasonable construction of paragraph (d)(i) is that when securities are a part of a fungible bulk shown on the account of a_ tr~_f.;re,'-~--i.Jite~ed_i~ <~~-.,~. l~~~t, __ ~. ~~--JiC?~-,of i;t;~ ... ., ... -'upiitraaii' iri~ehedJ:ary ..: tauclf: . r..:2r/~ "1:he triristaree a= .. '.. ; .. : ., in~ar11adiary is DQt. .. in ~ion-ot -the securities. Paragraphs (d) Ci)_ -and (d) (ii) eac:;h cover.--certificated securities "in. the financial intermediary's possession," and there is no reason to believe that "possession" bas different meanings in paragraph (d)(i) from that in paragraph (d)(ii). If that language were construed to embrace the concept of constructive possession through upstream intenaediaries; then paragraph (d)(iii) would be -~~ar_.-t us~tially aupe~luoua u to certificated securities: -~;-..:, of. -~~ii'.S.catc-. ~iti-. tba't-, otberviae would be covered _by paragraph -.(d-) ( iii) would_. -alwaya be c;overad by paragraph '(d)(ii). Biitsae Aronstein, Investment Securities, 39 Bull. Law. 1375, 1385-86 (1984) (delivery can be effective under pre-1978 I 8-313(1)(c) even if neither the transferor not the transferee is in poaauaion of securities). Evan if this interpretation is not accepted, I-1 might be deprived of constructive possession by virtue of the pre-existing security interests in favor of L and I-2. .IA In re Paragon sec. co., 599 P.2d 551, 556-57 (3d Cir. 1979) (suggesting that lien on securities granted by intermediary to upstream intermediary would deprive intermediary of control necessary for constructive possession pursuant to pre-1978 I 8-313(1)(c)); Cohen v. Army Moral support Fund tiara Bevill, Brealer, Schulman Asset Managaent Corp.), 67 Bankr. 557, 609-12 (D.N.J. 1986) (security interest in favor of intermediary's upstream intenaediary together with contractual restriction deprived intermediary of control necessary for constructive poasession pursuant to pre-1978 I 8-Jll(l)(c) and 1978 I 8-313(1)(d)(i)). 243. a.A Louisiana state School LUncb Employees Retirement Sya. v. Legel, Braswell Gov't Sac. Corp., 699 F.2d 512, 515 (11th Cir. 1983) (intermediary' constructive possession through upstream intermediary pursuant to pre-1978 18-Jll(l)(c)); Levy v. Ch-ical Bank tin ra Scott, Gorman Municipals, Inc., 36 u.c.c. Rep. Serv. (C&llaghan) 283, 286 (S.D.N.Y. 1983) (sue); Matthysse v. Securities Processing Serva., Inc., 444 F. supp. 1009, 1017-18 DOC. SWP1102 July 17, 1989
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120 tunqibl bulk, identification of a pacific aacurity would ba iapoaaible ... Prior to 1985 ca that deteninad an identification ot a apecitic curity bad occurred all involved a phyaical identification of pacific certificated aacuritiu (i,1,, apecitic piecu of paper). TbrH recent deciaiona, bowevar, (S.D.H.Y. 1977). (a~).~. ,lfe. .. :1ZAt:-the:acur1tiH._. Irivolvad_ .. in. ( I .. .wel;;~---n:Il:;-:--sc;att~ GQrian, and -1att;hy111 ware not a part of a-. fiUICJibl bulk~ sn alsp Cohen v . Army Moral -support Fund (ln '9 Bevill,. Brealar Schulman Aaaat Nanagaent Corp. ) 67 Bankr. at-15 (intermediary in conatructive poion, through upatraaa intermediary, of curiti (in which uptrinteraediary did not have a aacurity interaat) purauant to pr-1978 I 8-313(1) (c) and 1978 I 8-313(1)(d)(i)). Aronatein believ tb reaulta in tb Lenl, 1ram11 ~d scptt, CiAAID caa-are ~anaaa.lo,w, .but.. correc:t:. Aro~tein, upra n~ 242, at:1385; . '.' . : .... ... ., / .... .. -:-, .... .. . .:-.. : -.-~-. :. ~--.= --~: .. .-: .. ... : .-.~, .. .... ;:.-,..-~~....... ..... :24,1~ 4n Aronatain, mpra note 90, at 297, 304 (identification of a apecitic curity under pra-1978 I 8-313(1)(c) i not poaaibl when a broker hold a fungible bulk, aucb a a 1jU11bo certificate repruenting tbe interuta of a nUllber of cuataaen in tba -iaaue, and 1978 I 8-313(1)(d)(i) embrace pre-1978 I 8-313(1)(c)). There can be no doubt that th aecuriti involved in Bxupla 1 are a part of a fungible bulk poed by or regiatarad to I-3 and allocated pursuant to book entri on tb books of I-3, I-2 and I-1. Certainly book entries and buain records of a curitiu intermediary that allocate to different cuatoaera or craditon certain quantiti of curiti controlled by tbe intermediary do not cbanga th nature of a fungible bulk. Tba tungibility would be affected only by action that identified a particular, diatinguiahabla, portion of th bulk that waa owned by a particular cuatoaer. With certificated curitiu that would be poaaibl only by identifying a part;icular c1rt;ificat1. la san1ra,11y infra notu 250-54 and accoapanyinq text, Appendix III, intra, notu e-9. 245. Louiaiana state School Iauncb bploy Ratir .. ant sya. v. Legel, Braavell Gov't Sac. Corp., 699 P.2d at 513-14 (apecitic certificated curiti prepared tor Miling by upatreu interaediary at downatraaa intaraadiarya inatruction)1 DOC. SWP1102 July 17, 1989
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121 indicate that, for purpoau of 1978 ction 8-313(1)(d)(i) or pn-1978 Nction 8-313(1)(c), a non-DI can identify a apecific -=rity in tbe caN of inbenntly fungible book-entry treasury aec:aritiu.116 Tb opinions in tbue ca ... tbe arguaenta of the llattbyaN v. Sec:uritiu Procuai119 Serva., Inc., 449 F. Supp. at 1014 (apecific certificated aecuritiu prepared for aailing and identified by uptr-interMdiary, on delivery foraa, by A~r .. ~'"-1'!,.~ ... .. ~~~-t11t~iary1a ... ~, i a41g _,r. Chai.cal &anA (In i' Scott, Gorman NUnicipala,: inc.; 36 u .. c.c. a.;. serv. -at 287 (r-nded for deteraination of vbetber client tag nmlbera on intenaediarys buy tic:Jceta coverinC) certificated curiti in pbyaical poa ... aion of ups~ interaediary constituted identification of apec:ific curitiu). Tb Laqal, Bragall, scgt;t, Gorman, and llrtt;mr ca ... acb involved the pre-1978 I 8-313(1)(c). : 241. -llicbita Ped . Sav . ,. Loan Aaa'n v. Coaark, 610 P .aa,p. "' . (S.D.N.-Y, -H85) (quu1:ionof fact raised as to identification mxtar pn-1971.1 8-313(1)(c)) WQdifiad, 610 F. Bupp. at 411, COilen v. Any lloral support Pund (In ra Bevill, ar.-1er, SdtulMn Aaaet Nanagwnt Corp.), 67 Banla'. at 605-09 (identification under 1978 I 8-313(1)(d)(i) and pre-1978 I 8313(1)(c))I XD ra Lion capital, 49 Bankr. 163, 187-88 (Banlcr. s.D.N.Y. 1985) (poeaibility of identification under 1978 I 8-313(1)(d)(i)). Pora diac:uaaion of tbue caau and tbo cited in note 14, IJ1PA, ... er.pi, IPPD note 111, at 171-85: m tllA Katmn, IJ1PD note 84, at 118, 173-75. Opon reargwaent and consideration of tb C:RWIU IDP, IJ1PA note 121, tb C:RJDork court atated that in order to aitigate any poaaibl hara to th governaent aecuritiu market caused by [tb court' opinion on tbia point], ve conclude that tbe opinion should not be treated a an autboritative interpretation of tb federal and state lav provisions then construed. Wichita Fed. Sav., Loan Aaa'n v. Caaark, 110 P. Supp. at 419. Neanvbil, bovever, the Lipn c;apit;al opinion bad been iaaued relying aubatantially on tbe CAHO opinion. Inn Lion capital, 49 Banla'. at 186-88. AltbouJb tbe pre-1978 Article 8 applied only to aec:uritiu evidenced by certificatu and tb 1978 I 8-313(1)(d)(i) applies only to certificated aec:uritiea, tbe barer definitive fiction iap. 1ed by tbe book-entry Treasury Regulations require book-entry treasury aecariti to be trated a if tbey are certificated. Treasury Regulations I 301.118(b)1 1978 I 8-lll(l)(d)(i)1 pre-1978 I 8-102(1)(a) (defining aecurity aa an instruaent), n sorally ypra not and accoapanying text. DOC. SWP1102 July 17, 1989
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122 partiu and picu curia, and the aubaaquent comentary 9enerally focuaed on wbetbar an identification could raault from tbe actions of a claiaant' intaziaediary alpn or wbatbar, when tbe aecuritiu were aubject to a ecurity intrt in favor of tbat inteziaediary' upatna intanaediary, action of tba upatraam intenaediary would be necaaaary for an identification to occur.7 .-:1.-.:t;J-..i-~'l;~:--~J;,t.i.; --~>1~.--.stat,s;-_~1-.rly..-tJlat. . . . . . : . . . : . : . .. .it i a 1:ranllf~e'-int~ary alone .tha~ can.effect .a . . . . ..... .. .. transfer or delivery by ita confirmation and identification. Becauae a tranafarH of an intert in a funqible bulk of .curit.t.u cannot be a bona fide purcb.aer under either veraion :!:..~!~!!~~~: .. ,! --~P.P111~~; :Ot~9!~~--'l'ri_d_ea~ --,...:a~v--,~~ .. o. ova n qn can, a uuna.~ e .. parc:11av or bOok-en~ -rra.ury NCU'it1-. except a depoaitory institution that baa an account with a Federal Reaerve BanJc. b.tl &PD note 1271 31 C.P.R. I 306.118(a) (depoitory institution tbat racaiva transfer of curitiu in its account with a Federal Ruerve Bank can be a bolder.). Tb CRN,rk, 19yill, 1n111r and Lian c;api;tal caau, of couraa, did not follow thi reaonin9. 'l'he Bayill. lnlr court recognized that 1978 I 8-313(1)(d)(iii). could be applied to tbe book-entry Treaury curitiu involved, but ita coMection of that tbou9bt with its focua on transfer under paragraph (1) (d) (i) was not clear. a.A Cohan v. Army Moral support Fund tin r Bevill, Brlr, Scbulun Aaet Mana9-nt Corp.), 67 Bankr. at 615-16. It may have viewed tbe only difference to be the requir-nt of pouaion in 1978 I 8-313(1)(d)(i). lsl 247. In, ,q,, Wichita Ped. Sav. Loan Aas'n comark, 610 r. supp. at 416-181 Cohen v. Army Moral support Fund tin r1 Bevill, &ruler, Schulun Aaet 11ana9-nt Corp.), 67 Bankr. at ,o,-o,, SANTIS IPA, aupra note 121, at [17-20, 23]1 creapi, 1J1PD note 111, at 175-84. 248. Identification i a condition precedent to transfer, aet forth in the chapeau to 1978 I 8-313(1)(d), vbicb applie to transfer undr paragraphs (l)(d)(i), (ii), and (iii) alike. Tb lanqua9e clurly contmaplatu that the identifying intermediary i to bathe -interaediary that aenda a confiraation DOC. SWP1102 July 17, 1189
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123 Thr are, u well, ccmpelling practical and policy justifications for this interpretation. Th solution to this puzzle li not in how or by whom an identification i to ba ude but in what is to be idntified- ...... . ~-........ ~. . 1 ;.' ....... .~.-......... :" ...... ::.,. .... ~. .;..,:, .. ,.. ('ftOriaatif,~tfr"lt~~iai,,tnt~rijed:iairy'c diiia~.-:'the :_Upiitre-. .' ,. -~. . intaraediaey. does lio as an agent). Paragraph (1) (d) (iii) also unaiilbiguoualy.-indicats. that -it iii a. transferee's immediate intermediary, and not that intermediary's upstream intermediary, that i to aatiafy the -identification requirement. There is no auggeation in the statutory_ language that identification under paragraph (l)(d) has a different meanings for purposes of paragraphs (1) (d) (i), (ii), and ("iii). :simila_rly, pre-1978 I s :313 (.1.)-(c) pn,vida-.-1;hat .. de.J.ivary to-a-purcbaNr _occurs vban .. ,..~.Jua.-~Ul'-~-bia -ccmf.i-raation~----= .. and . .. '., idanti.fi~ .. aec:ur~ty :(~a~ supplied) ConHntoraction by anupatrua intarmedlary that cla!Jlla a aecurity intrt in the aecuriti may bear on the issue of the downatrm intermediary' possession, however. see supra note 242. 249. Raquiring participation or consent by upstream intermediaria in the process of identifying aecuritias would undenain the very efficiencies sought to be achieved by facilitating transfer on the books of intermediaries. It would mean that an intermediary could not transfer a security to a transfer purauant to 1978 I 8-313(1)(d) unless the intermediary' uptr-intermediary (and, pruumably, all other intermadiari further upatr-> were also to 111ake book entries or a011ehov identify th interest of all downatrm claimants. Pora penuaaiv explanation of how aucb a requir-ent would be unduly burdanaoaa to the curities markets, Cohen v. Army Moral support Pund (Inn Bevill, Bresler, Schulman Asset Nanagwnt corp.),,, Bankr. at ,01-01. 'l'h Bayill. nr:a111r court' explanation i sound, aa is it conclusion that idantification can be achieved by the action of the downatream intermediary alone. 14., at 608-09. But it ais a turn when it appears to ua that unls book entry tranfr by interaediari can be 11ade pursuant to 1978 section 8-313(1)(d)(i) or pra-1978 I a-313(1)(c) they cannot be -d at all. DOC. SWP1102 July 17, 1989
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124 aspacific security.250 Identification of a specific" security, in this context, can mean only the identification of a particular, dicrete certificate evidencing a certificated ecurity251 that is tbe subject of the transfer. It cannot plausibly be conatraed to -an an allocation to a transferee of an interest in a quantity of securities included in a fungible ).~,~~-.. :~:: ... ~-~'7.8::,~vr~ :,(~l}j(it}.~.t:if.t=.-.trjl~ .ot;buvi_N:: :i,t: .. w~ld: . , . ..... . . ~il.ow ~ragrapha .(i) _(d)..(.i.i). _and. (1~~):.,_ .. If--thepossesion .and identification requirements are met in_ Example 1, it would be hard to imagine a transfer under paragraph (l)(d) (ii) or (iii) that would not also aatiafy paragraph ( l) (d) (i). It is cl.ear '" .... :.: fo ': .: o ~ o" ,_ I : -~ o -:~o :. ,;.' o ., f ,,: ,', :, ';."' , 0. 'o : ,''. ." ,), '; 'o -~ .. o , :,-,: I , o '," o ~-.. .-::-250~, -~--ria -~:~~-;;;._:,;; .. ; ;;..; .. -~i~~1!h~\1 _::-~:-3,;i/1 cc,;--~-. Although Katzman never squarely takes a position on whether a non-DI transferee of an interest in book-entry Treasury securitiu can bec011e a bona fide purchaser, and he fails to answer the question of whether such securities can ever be a specific ecurity with in the meaning of pre-1978 I B-313(1) (c) or 1978 I 8-313(1)(d)(i), at least he posed the right question. au Katz1ian, supra note 84, at 169. 251. United States v. Doyle, 486 F. supp. 1214, 1220-21 (D. Minn. 1980) (delivery under 1978 I 8-313(1)(d)(i) requires identification of a certificated security by certificate number and in abence of uch identification securities are a part of a fungible bulk)1 1978 I 8-313(l)(d)(i) is lillited by its terms to a specific cartificatad security. 1978 I 8-313(1) (d)(i) (aphasia added). All used in pre-1978 I 8-313(1)(c), specific security has the same meaning because pre-1978 Article a applies only to ecurities evidenced by inatruments. Pre-1978 II 8-102(1)(a) (defining security), -313(1)(c). 252. The reference to identification by book entry or otherwise in the chapaau to paragraph (l)(d) does not weaken the arguaent that paragraph (l)(d)(i) applies only to the identification of a particular piece of paper. 1978 I 8-313(l)(d). For example, a book entry could identify a specific certificated security by its certificate number. In United DOC. SWP1102 July 17, 1989
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125 fraa th drafting hiatory of pre-1978 paragraph (1) (c) that the interpretation of specific urged above ia the correct one. The antwhil drafters contuaplatad that deliveries pursuant to pre-1978 paragraph (l)(c) would be highly unusual ~nd normally would occur only during th procesa of preparing certificates tor actual physical delivery to a broker' cuat011er.m Moreover, .. ~F-~9-. .:~-. ..:~~~;.~~/:,~$-I-P~~~~~F9!-~J?,~.-,~~~~-::P~.~~,~-::..~~~~-:~.:;:-.-, ., :-: .,.. .. ~-.. -:. :~ . -t. . .. ,: : ... . , ,'_ . . . : . .. . certainly_ is not ~b!)cki~g i .a ~ansfr o,t an ,interest. in a. ,. . . ; . . . : .. .; .. ~. .. .. . . . -. fungible bulk of securities on th~ books on an intermediary bears little resemblan~e to.transte~ by physical delivery of a . .. certificated curity.254 Nevertheless, apparently ignoring the ;' . .. ,. ... : ...... ., .. '- : . .. ,:. .. :._ :-. :. .... ;. _."'\','"': ,. '1 ~--:-.,.--~: .,, .... :_.,.: ::" -.. ; .. __ ... ._, ..:-.,: .. -~-~ :.. .--:.-:. ':.;-:,.1:-. .. -..,.;_-._., ':. :: .... .:-.. .. . . -. .. ., '. .. Stat v.;. oy1~~ 486 p. Supp~ at 12i9. Nor i~ the argument weakened by paragraph (l)(f), which provides tor a transfer of a specific uncertificated security" by a non-financial intermediary registered owner's acknowledgement, although the draftan left to our imagination the rationale for the curious use of specific. 1978 I 8-313(1)(f). Note also that paragraph (l)(f)' analogue tor certificated securities, paragraph (l)(e) (which is aubstantially the same as pre-1978 S 8-313(1)(d)), refers to an "identified certificated security" but does not use the word specific." 1978 I 8-313(1)(e). I suspect that the inconsistent language is a reaul t ot inadvertence. an Appendix III, intra, notes 49-54. 253. I.la Appendix III, intra, notes 9-17. Katzman observed that if a DI held its entire position in a particular issue tor the account of any one customer, the entire bulk arguably could be specifically identified as belonging to that cust011er. Katzaan, IJlPA note 84, at 169. That argument should not succeed, however. Al though those facts ight make tracing an eaaiar taak, tr011 both the intenaediary' and the transfer' perspective such tacts would be wholly fortuitous and would not tit the original vision of the identification of a specific security. Ila Appendix III, intra, not 6-a. 254. s11 q1nora11y intra note 360. DOC. SWP1102 July 17, 1989
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126 drafting hiatory, the Departllent of Treasury and the Federal Reaerv Bank of New York have expressed a different view.255 Th Propoaed TRADES Regulations would provide a different reault for Treaaury securities: Unleas I-2's security intereat were to qualify for priority as a clearing lien,256 I-2 ' interest would be subordinated to C's claim. Assuming c :~~-~~;'..'.:~,~~-f'-~~-::~~;:~~JJr/P,Qd=-'ta:Lth~-:.:and:without-> no~i~~ .-_Qf. -~Y. ~l~ba,". c ;,~~~--~.a ~90~ -~aitb transfarae257 and would acquire an interest in the securities tree of any adverse claim which arose prior to the transfer of auch intereat to~ c.a .Why the 'ft'.easury Departaent opted for .. : .... -.. .. : ." ..... .' ..... :_ -.~,:. ,'." .... :-~-.. ,.... : ... 1:l1iaat:-~tm;iule 'ia--;-syiatery~a ilecawi tb good faith' _"~1"001\..'1 0 L 0 _._;_, ; .. . ,.,,_.::-,. 00,, ,':.,.~:, ....... , 0,.",f_-,,~."._ := ....... _,,,, ~=. ,, .-.. :.,,. ''!,: _ ,, ::' .. transferee rule allowa a lower tier tranafer of an intereat in a.fungible bulk of securities to cut off adverse claims, the rule repruenta a fundamental rejection of the result under Article 255. see supra note 175. one possible explanation for this disagre-ent may be the New York Pad's miaconception that delivery was a necesaary condition for an effective transfer of property rights under th pre-1978 Article a. s11 supra note 77. 256. an Proposed TRADES Regulations I 357.15: supra notes 177-79 and accompanying text (discussing clearing lien priority). 257. Propoaad 'l'RADBS Regulation I 357.14(a); 11 gpra not 168-76 and accompanying text (discuaain9 90od faith transfer rule and exceptions). 258. Proposed 'l'RADBS Regulations I 357.14(b). 259. s111upra not 167, 175. DOC. SWP11O2 July 17, 19 . 9.
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127 a. In an insolvency proceeding of I-1 under SIPA or the Bankruptcy Code, however, the applicable custoaar distribution ru1-would override the result of the 9ood faith transferee rule of tba Propoaed TRADES ReCJUl,ationa.211 The cured claims of I-2 and L probably would achieve priority over the claill of c in such a proceeding. But I-2 and L could remain vulnerable to a suit -J?Y:. C ~~~,;:-n~!~~9-ft~~~:-~: ~-.. ,: ~.; .... ;iii-~ ,,._::;.-, ;.~.'\-~-~;;'_.;:..,J~.::.,a:,~;. ~;.:t~--.-.. ~-.: .-.;:..-:i~~ ,.:. . ;.~. !'.---"'I..~: ''!II.~-:.~:.,._ ... -----~. : .. .. .. .. :.. .' .. ..... ; ... . . Bven ittb g~Qd faith transferee rule ware to give C's .. .. .. .. . . .:. . . -. claill priority over that of I-2, it is probable that L's claim would not be cut off because .no affective transfer to c would . . occur as to the aacuritiaa clailled by L.214 Thus, in one case c ~:p~i~~iti~;_ff~.; -~~--:~:~;ti~--: ae~~::. credi~or. ~d in ............. . . :_ .. .... ... ._.: : ... .: .. 1111othuca c ncaivea no e'ffective tnnaf~. There is another possible solution to this priority contest. Because C is claillin9 an interest in the- fungible bulk claimed by Land I-2, arguably the proportionate property 260. s11 IYPD note 175. 261. s11 supra note 191. 262. s11 supn not223-27 and accoapanying text (diacuaaing non-cuat011er atatus of secured creditors under SIPA and the Bankruptcy Code and seniority of secured claims to cuatoaer claias). 263. s11 supra note 235. 264. St IYPD notes 100, 236 .. DOC. SWP1102 July 17, 1989
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128 intereat rule of ction 8-313(2) would apply. Such an application would ruult in ratable abaring between c and Land c and I-2 u to the raapective two isau of aecuritiu. one ccmaentator ha indicated that thi i the appropriate approach. However, that interpretation of ection 8-313(2) . ;:,.~~-~-:~I:,,";~-~-::~/.-;_:~,-;:,..,~i; ;;.{r.: =~' ~->.~~;J.-~;;_~~:=;.-~-'.:~<:-r-~::,_-:::fc~--:~-\-: ;.: .,._./.;,:~..::: -::-';:"l-~:-._ ~~:-.:_:.::; -:;." -~: :_:~7::i t _. -.:: :_. l, .,... 265. Sae generally supra notes 96-99 and accompanying text. 266. au Mendelson, Investment securities Review, 43 Bus. Law. 1407, 1411, n.27 (1988) (suggesting that a lower tier trana~~e pursuant to 1978-I 8-313 (.-1) (d) (iii), ~ch as c, and an _,.~~:ti;~. .~~~~i~:-:-~.-~tig ::: :~e~~~y:: tn_t~r~~ ~:n _th~ --~~ --~ ___ 1I~~,_. -~~d.: ~-. in~~rest. in the ..... !\uigible bulk unaer-1978 I 8-313{2), but characterizing thi result u bizarre). Rote that Mr. Mendelson did not ~icipata in preparing that portion of th cited article dealing with the Bayill, Breslar case. Mandelaon, supra, at n.. Both the Bayill, Br1sl1r court and the author() assaed that the result would be different if the pre-1978 Article 8 (which did not contain transfer provisions equivalent to 1978 S 8-313(l)(d)(ii) and (iii)) were applied. Cohan v. Army Moral Support Fund (In re Bevill, Bresler Scbullllan Asaet Manag-ent Corp.), 67 Bankr. at 615-16: Mendelson, supra, at 1411, n.27. Yet the result should be the same under either version of Article 8. Although the pra-1978 I 8-313(1) dealt only with delivery, tranafara of interest. in fungible bullca of curitias were affective and occurred outaida of Article B' provisions. an Appendix III, infra, not 13-15. Th proportionate property interest rule, likewise, applied under th pre-1978 Article 8. Pre-1978 I 8-313(2) (second sentence). Whan the 1978 I 8-313(1) waa raviaed to cover transfer, not only delivery, the addition of paragraphs (1)(d) (ii) and (l)(d)(iii) aeraly codified existing practice. ,ld.; s11 alap 1978 I 8-313, Raaaona for 1977 Changes (fifth paragraph) csubparagrapha (d)(ii) and (d)(iii) have no counterpart in the pruant atatuta but are conaidered deirable axpru atat-ants in the light of modern curity holding practicof both broker and banks. D final 1ent1nc1 pf prant rpn-1,111 suhsoctign CZ> implies this raault withgut tat;inq it axprly.) (aphai added). DOC. SWP1102 July 17, 1989
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129 could be baaad aolely on a literal, but implausible, raading.257 That interpretation is not what the drafters of any version of Article a had in Iii.net. Tb proportionate property interest rule ahould be rrved for clailu of tho clailling through a coaon intermediary. Bare, only c i clailling through I-1. 'lrmfen to Lower ~ier Claiaut ~int-in-~ia .: .. ~.~,; ... ... ~.,-~-J'.9-J_..~,~;i~~~.~~t .. ~-'~: <: ,# . - ""': ..... -. --~ ,~.. . . :_ . ratberthan after, tlie'craation of.the ~'ity interuts in .. .. . . ~. . . . : : . . . .. 'I,.... . .. . . . . . . . . favor of L and I-2. As a general matter I-2 would not acquire its security interest fre.of C's cla~ unless I-2 were a bona fide purchaaar. However, becauaethe securitiu have not been . . . . ..... : . .. .. = . .. .. .. .. \, .. ...... . . .. . .... .. .-........ ,.:... .......... .. ... ---.. . :.-.. ... -.. .. .. ; .,. . \ .. !_~.a:-: . ,._. . . -. .. .-: . ... .. "' ...... ... ... 267. 1978 I 8-313(1)(d)(iii) does apply to a transfer of an interest in securities that are a part of the account of the transferee's intermediary with "another" intermediary. 1978 8-313(1)(d)(iii). 1978 8-313(2), then, refers to "the fungible bulk). 1978 I 8-313(2). 268. From the very first draft of Article 8 (then Article V), the proportionate property interest concept was to apply as aaong customers of the sue intermediary. laa cpu,ercial coda, Preliminary tem1tivt pratt BP, 1--Art;icla Y, s 13 (April 22, 1946), raprint;ad ill 3 UNIFORM COMMERCIAL CODE PBAm, supra note 196, at 20 (quot..ed in Appendix III, infra, note 3). The comments to 1978 I 8-313 reflect a similar conceptualization. an 1978 8-313, ccmaent 4 (describing proportionate property interest rule of I 8-313(2) as applicable as aaong customers of th sue intermediary). Moreover, the proportionate property interest concept would not apply as aaong cuat011ara and cured creditors of an insolvent intermediary under Chapter 7, Subchapter III, of th Bankruptcy Cod or SIPA. saa generally supra, Part III. 269. 1978 II 8-301(1); -302(3); pre-1978 8-301(1), (2). DOC. SWP1102 July 17, 1989
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130 delivered to I-2, I-2 cannot be a bona fide purchaser. If I-3 were a clearing corporation, however, it is not clear whether I-2 could be a bona fide purcbaaer aa to the transfer of a aecurity interest froa I-1 to I-2.zrl It-odd that l-2' 1UUU1er of 270. 1978 I 8-302(1): pre-1978 I 8-302(1). Exuple 1 aa8\Dle8 that I-3, not I-2, is in physical possession of the ae~_ities invoJv~. Thu, 19~8 I 8-3_02 (~) fa) woul~ not .apply %~~.~:--O~flilaJ.~y-~~~-,~-:"--~~~-:ot~~3-:.'puZ'Suant:-to: 1978' I 8~313 (1) (d). (ii) should not be anointed w~tb constructive .poawaion for pirpoaea af bona. fide purchaser .atatus. Sae supra notu 240-54 and accompanying text (similar argument concerning c a a tranaferee pursuant to 1978 S 8-313(1)(d)(iii)). I-2 also i not the regiatered owner of uncertificated securities or a tranaferee pursuant to 1978 I 8-313 (1) (c), (d) (i), or (CJ). I-2 i a transfer-of a security interest from I-1 pursuant to 1978 I .8-313 (1) (j.). 19 ilUpra note. 89_. Tbua, 1,18 I -302 (1) (b) and Cc:)_ .. d~-~ot apply . f978 8.ia3Q~-(bl, .(c).;._ .i~, on. th .o.tber hand, 1~2--vere it(-pbyii1cal'poaa-..ai~--otr tile aecurlt1 .. nvo1ved, .then '1-2'.c01ilctacb:teve,onat1d.-purchaser tatu~ 1n 1-302c1> ca>. That I-2 took delivery prior to becoaing a purchaser of a security interut from I-1 should not change thia result. ,lsi. But cf, infra note 211. 271. I-2 could have bec011e a bona fide purchaser when the securitiu were originally transferred to it on the books of I-3, aaSUJDing I-3 were a clearing corporation. 1978 II 8-313(1) (g), (2) (first aantance), -320(3): pre-1978 SI 8-313(1)(e), (2) (first sentence), -320(3). But the transfer of a security intereat from I-1 to I-2 occura under 1978 S 8-313(j) without any book entry andis not a transfer under 1978 II 8-313(l)(g) and 8-320. Still, it woulds-unreasonable to deny bona fide purcbaaer atatua to I-2, an earlier transfer on the books of a clearing corporation, aince Article 8 generally treats auch transfers a equivalent to a delivery. 14. A transferee under pre-1978 II 8-313(1)() and 8-320 becOJ1u a holder and aucb a transfer baa the effect of a delivery of a curity in bearer fora or duly indorsed in blank. Pre-1978 II 8-313(2), -320(3). Thus, under the pre-1978 Article 8 I-2 llight be deeaed to be in physical poaauaion of the se~ities at the till of I-1' transfer of a curity interest to I-2 and, consequently, could becmae a bona fide purcbaaer. Pre-1978 I 8-302(1): GtJ'l"l'DH, gpra note 11, at 8-29 to -30. There doe not appear to have bean any intention for the 1978 Article 8 to change this result. 1M 1978 I 8-320, Reaaona for 1977 Change csubaection (3) baa DOC. SWP1102 July 17, 1989
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controlling the sacuritiaa--possassion or non-possession--could detanaine whether I-2 achieves priority over C's interests. Heither c nor C' interaediary, I-1, can dictate (other than by contract) or even ascertain (in the case of fungible bulks) how I-2 cboo to control the securities involvac:l. This result is a product of tbe Article 8 ch-a. A bona fide purchaser cuts off ,,~~ -~;-'~-~~~-~;,~~,~ .. : .. -,. tbat are not a bona fide "purchasers. are subja_ct "to the first-in.. . . ... . . -. .. . : . . ... : ., . : .: .. . time doctrine. L also would not qualify for bona fide purchaser atatus.m L might argue, however, that the securities it claims . .... ~ .. : ~. : .. .. -.. _-.. -,.~-. .. : .. .--.. ... ,, : .. .. . -~-'.-~.f~ by ~~--. to .... ;:-2 ;--that.-.-I.~2. --~, a, bona fide . parcbaer,::~---t .L ~ci~ed-ib -s~~ity interest free of C's claill under the shelter principle.m That argument would face aOlla difficult hurdles. First, I-2 could not be a bona fide purcbaaer unless it were in possession of the securities or, been rewritten to address certain consequences directly, rather than -rely by analogy to the physical delivery of certificated aecuritiu.). But tbe arguaent that I-2 is a bona fide purchaser as to its purc:haae of a curity interest from I-1 would continua to depend on indirection and analogy in construing 1978 I 8-302(1)(a) so as to deu I-2 to bave receivac:l a delivery. 272. As a transferee of an interest in a fungible bulk of aecuritiu on tbe books of an intermediary (I-2), L could not be a bona fide purchaser for the same reasons that c could not be a bona fide purchaser. s11 supra notes 240-54 and accompanying text. 273. In 1978 and pre-1978 I 8-301(1) & comment 11 supra note 101 also 1978 and pre-1978 I 8-313(3). DOC. SWP1102 July 17, 1989
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132 arguably, unless I-3 were a clearing corporation.u. Second, it i far frma clear that there ware two transfers involved (one froa I-1 to I-2 and one froa I-2 to L) when I-1 granted a aec:urity interaat to L.m Third, even if two trans:fera did occur, I-2 uy not have given value ao as to qualify for bona fide purchaser tr-tment. If L'a shelter principle argument :.:f.,.~.~.t-.. :~~~~~;_:;~:-j. __ . ~~P;~i~:f~~;::~e;:.~_;.~,.~~-, ~ight.-._, __ .,,' .-: __ . . . : ' I . . J '. .._ ,, . ."_,' aaaert . ~a:fro~ wa~ty_ ~laia._.again~t. :J:-2, .. L~" If. ~at ci~~-w~~e s~ccessf~l, then I-2 would .b.-r ,.the ~0aa ~though .it .was. not involvedin-.-either the original transfer to C .or the a.ubaequent aeC1U"ed loan from L to I-1 except . . . .. .. . -.. . ... .... : ~. _. .. ,,-.. .. ,. ,., .' . -.;. -to--:act -I ... l"'and .L'intaraadiary-~: =, .'.-:. :_. __ : --_ .. . .. : . .. --~-. '" .':' ... -.-~ ... .. ~.. ,: -:. .... :-_ .. _: ~---,~---.-~.. -..: ........ ... ' .. 274. 111 aupra notes 270-71. 275. 111 infra notes 3,4-97 and accompanying text (arguing that there should be two transfers in the context o:f transferor warranties although the issue is not free from doubt). 276. in 1978 and pre-1978 8-302(1) ("'bona fide purchaser ia a purchaser for value ). Whether I-2 gave value would tum on whether the transfer to I-2 by I-1 (for retransfer to L) was in return for any consideration sufficient to support a simple contract. 1978 and pre-1978 S 1-201(44) (defining value, the other examples of value in paragraph (44) would not apply here). Perhaps I-2's agre-ent to retransfer to L would constitute value, hare. 277. 111 uuniix infra, Part v.a. 278. Of course, I-2 also could make a transferor warranty claill against I-1 under this two transfer paradiga, but I-l'a insolvency ia hypothesized by Example 1 and I-2' recovery as an unaecurad creditor would be uncertain. DOC. SWP1102 July 17, 19M,.. ~~'"' '-..:. \.
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133 Another possible solution of this priority puzzle requires consideration or ca original acquisition of its intareat in the aec:urities involved and tb aubsaquent relationships -ong the partiu. PrasUllably, pr.ior to the trans~er to con the books or I-1, I-2 controlled the securities tor i ta custoaar, I-1, through I-2 a intermediary, I-3 By -~~~.-::. cri_ties, arguably c~.s interat should,. on policy grounds, be . . i : . subordinated.to all subaaqu~nt transferee~.219 But Article 8 does not dictate that resul~ except when it is embraced by the bona tide purchaser rule . Lwould be .to~ad to claim under a theory . .. ' .. . ..... -:. .... _::: :.: .. .: . i. ... .. .. . ,. .. ... .. . . -o~-~-ppi.-1:.-.-:_apparent= autbm:'ity.:~... ,.-.:,. ... ,_ .. : .... . --~ ;.. _... : .-. . .. : -~. : : ~ .. : . .:.. . .. . : . . .. . . . . . .. .. .... ... . . ...... : 279. This argument is developed in connection with subsequent as well as earlier transferees under tbe proposed new model. s10 qenara11y intra Part v.A. 280. The u.c.c. does not generally abolish the doctrines of estoppel and apparent authority. lA I 1-103. Traditionally, estoppel bas bean view as an application of the rules of fair play. In re King Memorial Hospital, Inc., 19 Bankr. 885, 891 (Bankr. D. Fla. 1982). Estoppal of an owner from recovering property from a good faith purchaser requires voluntary conduct on the owner's part which leads the purchaser to change its poaition to its detriment. 31 c.J.s. lt;pppl I 59(a), at 367 (1973, Supp. 1989). For exuaple, an owner may be estopped from recovering its property rroa a good faith purchaser it, by its act or omission, tbe owner entrusts possession to and vests apparent ownership in the seller. MBanlc-Waco, M.A. v. L. J., Inc., 754 S.W.2d 245, 251 (Tax. ct. App. 1988). The doctrine of apparent authority allon an agent to bind its principal when tbe principal givu its agent the appearance of authority and the agent, using that authority, cmmaita a fraud on an innocent third party. RESTATEMENT (SECOND) OF AGENCY I 2611 2A C.J.S. APIDCX I 157(a), at 787 (1973, Supp. 1989). The doctrine of apparent authority sometimes is said to be a specific application of the more_general doctrine of estoppal. a.A, ,q., 2A c.J.s. Agency I DOC. SWP1102 July 17, 1989
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134 Although Article 8 aubjct all non-bona fide purchaaer claillanta to a first-in-tiM regille, the laat-in-till good faith tranaferee rule in tb propoaed 'l'RADBS regulationa would reault in priority for I-2 and Lin tb ca of C' pre-uiatinq i:ntereat.2111 The oppoait ruult would obtain under the propoaed TRADBS regulationa when C' purchase followed the cured loans -~-;,i~a. ~-~!'fl:.:--,.,. -~-.,-., . ~~.:=.~---r.:.:.~.:.,:-,~:-:~".:---:, -... ~::}:;-~ !-.:--::).-;'., :,-=.. :?<-.--;.:-, --:~ .. . -.:.-,, ...... :: . -~ ....... '::: ... :-... ,,~ .. .. .... .. :. .. \:, -~_.-.-~-... ::=: .... .. . . . ~.. .. c. ObaerYatiou . , ... ; ..... . Th emphasis on timing, whether first-in-time or last-~n-t~,-is ... queationabl; considering .. that c has little or no way to_contro~ or find out about the tranaactiona with I-2 and L, . . . . . .. .. . .. . . itttu ,x -,na.-a~-ex imlt; . ---~- can: 1,e .. rd'_ r~r :t~2 and L .-......... ; ....... .. ....... -~: .... ,: : , ...... ,, ... . . w~ch reapect ta I-1' tranaactiona with c. Th principal control available to th partiu li in their reapective lctions of intermediari Yet, a ahown above, c uy aoaetill prevail even though ita intermediary, I-1, baa failed and I-2 and L 157(c), at 789 (1973, Supp. 1989). In Example 1, L would argue that by cbooaing I-1 aa ita intermediary, c veated apparent authority in I-1 and, therefore, c i topped from arting a claia to th curitiu in diapute. 281. S aupra not 168-76 and accrmpanying text. 282. 14. Although the clearing lien priority -y aolve the aaat aignificant practical cancerna, neither th Treaaury Depart:llent nor tho-that cawented on the Propoaed TRADES Regulationa explain why, when a clearing lien 1 not involved, upper tier claiJlanta abould be aenior acme of the tille and lower tier claiJlanta abould be aenior acae of the tiae. Concerns for clearing lieu differ froa cancerna for other upper tier claiunta only in degree, not in character. DOC. SWP1102 July 17, 1989
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135 aoaetiaea vill loH even tbou9b tbeir interaediari bav~ not failed. 'l'b diacaaaion of Jtxaapl 1 indicatu that tbe exiating lepl reqille i Abject to another, aon baaic, -defect it nlatea to conflictincJ claiaa on different tien-ita application ia confaaing, awkward, and unprincipled. Th property intereat ~c~f:f ... ~~:.Hr\;~~--~~-:;.~.-~~~~~::.o~; ._R9,~U~llfil., plaw. :, in' thi cont with liaited exceptiQna, it fail to deal . -...... t . expreaaly vitb tbe unique circmmtancu involved wben aecurities an a part of ~ible bulQ reflected by tbe boolca of interaadiariu. "It abandona priority conflicta to the firat-in. . . . . -~ -... ', .,. .. 0 ', ~ oo :,. .-::.,.,: o .:~~ ~-,.~----~' ,, o :--~ I -:-',' .. ,_ ,,_, ": r 1 .. ~ : 283. If upper tier claiunta aucb u I-2 and L duire ~lete protection froa claiu of aubaequent and future cutaaera of I-1, they could inaiat tbat tbe aecuri tia to be tranaferred to tb-be tranaferred alo119 a route tbat 1-da upatnaa throuCJh the boob of a clearing corporation (or tb Ped, in tile caae of treaaury aecuritiu). IM gpra notu 84, 121-22 and ac:coapanying text. But that approach would reault in additional coata and could be dianptive of otberwiae d .. ireabl market practicu and relationabipa. Praaably tbe relationahips of I-1 and L witb I-2 and I-2 witb I-3 uJce aenae to tbe parties. In aany caau, I-2 and I-3 vill perform clearing or carrying" aervicu for tbeir rapective davnatreaa interaediary cust0111era, but thi i not neceaaarily tb cue. IM q1n1rally Pi tzpatrick caraan, An Analyaia of the Buinea and LecJl Relationship letvaen Introducing and e&rryinCJ Broken, 40 Bua. Law. 47 (1984). Bven if I-2 and L were to inaiat that their aecurity interet be tnnaferred tbroucJb a aeria of tranafera to and by otber interaediari .. tbat involved, at aoae point, entriu on tbe boob or a clearin9 corporation, upon ccmpletion of the trwfen, auuai119 tbat I-2 and L would then claia tbrouCJh a new and different interaediary, it then would be necuaary to work through thue priority puaalu vbil contaplating the inaolvency of the nn intenediary. 214. la 111-313(1)(d) (ii), (d)(iii); -320. DOC. 8WP1102 July 17, 1119
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136 tille principle where bona fide purchaaer atatu i not achieved. Moreover, before appropriate reaolutiona of priority contt can be teaaed out it i neceaaary firat to certain that two coapetincJ claillanta are artiDCJ ri9bta in tbe 11c;uriti But Article 8, tbe exiati119 book-entry Treaaury Regulation, and tbe propoaed TRADES regulationa provide no guidance a to how . . :~~-:~-;_,.. ... .,~4....-.. : .... ~:~:'~~itiu-.-:arlt -part of". : ~~l _bul.ka.-~ ----I.~--la .. t~~linr/ ~a~: codifi~tion -~fort : . . . . 285. For example, the Treaaury Department ha explained tbat book-entry curiti of th aua iaaua are fungible and generally not aubject.to tracing." Noveaber TRADES Summary, ppra note, at [42]. Yet tbe operation of the good faith ~'~r ~1 .:~~~ ,:b. '.~~-~-~a. -~~i:tioM.. depend, in ti. ~textof conflicti11CJc1ailia on ditfer~t-~ien, on an identification :ot c:onfllcting clam'' !n the'liec:arity. -aupra notu 168-a9 and acccmpanying t~. c would face a difficult taak in aaaerting that th curiti tranaferred to I-2 and L were the aa on that were (earlier or aubaequently) tranaferrad to c. But, aaamdng c could offer a rational bai for tracing the curitiu it claiaa to tho alao claimed by I-2 and L, tho partiu alao would find it difficult to utabliah that the curiti they claiaacl were different fr011 tho claiaed by c. Under the proportionate property interaat rule, c would be in a poaition to claim, aa againat I-2 or L, a prgpqrt;iqnt intrt in the curitiu claimed by tho parties even if c: could not trace the curiti atrictly. = R. BROWN, TD L&W OP PERSONAL PROPERTY I 36, at 80-82 (liability of tranafr of wrongfully confused personal property to owner of a proportionate interaat in the property), I 79, at 296-97 (2d ed. 1155) (liability of tranafer froa bail of c01111in9led fungible goods to owner of a proportionate interut in gooda): R. POWELL, P. ROIIAN, POWELL ON mL PROPIRTY (ONI VOLDNI EDI'l'IOH) 1 606, at 101-02 (1118) (one cotanant can aua u a incJl plaintiff, and i not required to join action in vbicb all cotananta are parti, in order to recover property intrt or daaa9u for injury to property interaat). C' proportionate intaraat could be 1001 if curiti of the particular iaaue available to I-1 (but for the transfer to I-2 and L) were (but for the tranafr to I-2 and L) DOC. SWP1102 July 17, 1989
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137 intended to bring clarity and predictability tojtbe law vo~ld opt for auch uncertainty. I .... : .. . .. '. ..... .. : .. ... .... .. ...... -.... ... .. . .. ....... :--~~-':.-.( .._-:,:.;,., :::,._, ..... ~:,._., ... ~ . -~-.'. ,:::.__ .: -.1, .... ;.!_~~,-:-;-:.:. r' :-;::,._A~,. ... '!' .. o'I,' '~! ', o :f, I . ; . .. , aufficient to cover all- tier clailla of I-1' cuatoaera. DOC. SWP1102 July 17, 1989
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138 v. & m JIODBJ, MR U80LffS8 DI~ ~ID CODB'IIBG CLUll8 UD D%0U'IIB8 The foregoing dmaonatrat that uiating law conceming competing clailu on different tiers apawna uncertainty and diaavr-ent conceming ita aJ.1plication as well as arbitrary and fortuitous resulta. Notwithstanding the size and significance of :-i~~tii---~~:-~. ~;-~_._:u,o~.;. ot-:t:Jle~e-----priqrity:: ;_; : ~: . . . . . . . . . . .. .. . . . . . . . : ; 1-~uea, . 1egai, acholors .. bave ,not: subjected the substance of. the . . . . .. ' . . . . . . . relevant existing law to searching analysis and criticism. The relatively little attention paid to the 1978 Article a.has focuaed. _la~ely on tbe perceivec:l significance of uncertificatad : ,'' ." , .. ,, .. ' : '. 1' , ,. , -. " -r ," .. :aaelirit'ieiiand. otliei "Jiattm -u.:1:;; "wilile -fnterestiricj" 'and--: ._ ....... ~:-_ . -.-._ .... !"_. .. _,~..;~=-. ~-. _, .;._ .. --::---:. ,"' .. _._: ... : .. ": .~-= ...... ,: ,,1, . -:. 286. Thia neglect is in triking contrast to the intense intereat shown in matters involving similar or analogous issues, auch as bankruptcy theory, the more general theoretical and empirical bases for cured credit and priorities of security interests, and payment aystm. s11 supra note 229 (citing recent expositions conceming bankruptcy theory and cured tranaaction) Concerning paymenta law, see, , q, Alea, A Jurisprudential Perspective for the TrUe Codification of Payments Law, 53 Fordham L. Rev. 83 (1984): Cooter, Rubin, A Theory of Lo Allocation for Consumer Payments, 66 Tex. L.Rev. 63 (1987): Leary Fry, A syst- Approach to Payment Modes: Moving Toward a Hew Payments Coda, 16 u.c.c. L.J. 283 (1984): Lingl, Risk Allocation in Intemational Interbank Electronic Fund Transfer: CHIPS, SWIPT, 22 Harv. Int'l L.J. 621 (1981): Scott, Corporate Wire Tranafen and the Unifora New Payments Code, 83 Col\DII. L. Rev. 1664 (1983): Scott, Th Riak Pixera, 91 Harv. L. Rev. 737 (1978). 287. s11 gpra note 5. Al though reduction of reliance on certificated securities might be useful, it would have a relatively small impact on the operation, structure, and inherent credit and fraud riJca in the aecurities markets. I supra not 29-30. DOC. SWP1103 July 17, 1989
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139 possibly useful, are immaterial when cmapared to these priority iasues. 'l'he new IIOdel propoaed here would affect the aubstance of exiating law and the outcoae of aoae priority contests. It would offer an understandable and easily applied doctrinal basis and theoretical justification for resolving different tier .f.!-9iP.t!~X~-iP,!.\1;H~-;:.W,P.~J.'~~~t~~--~~P. .. JAt~M~~-~:.-~1111CJil:l:l, --:.'::-.~ ..... -..~-~-...... -.~ ... . ., . -~ : .... : . : -: .. . .. . bullcs o~ ~ecuriti.-controll~ by intenae~iari_-~ It would .. . .. . ... .. . .. ., . . . ., : .. . .. . . .. . provide a sound rule to fill the gap left by Article 8 between bona fide purchaser status _and.the first-in-time rule of nemo 41t. ... . : .. : .. ~:-~ .. ,. : :-: ~~t~e--of.-:tb~. a-.,mdd~l. 1~'. ~~--' overriding -~r~~ipl~-~: Th~ 'Jw~.r~--~f. ~-i~iar:at. in -~ :.i!~gibi-~ bulk of curiti controlled by its intermediary can look only to its 288. Certainly an inordinate amount of energy has been expended on the 1978 Article B's commercially insignificant prohibition of aore than one registered pledgee and the plight of junior security interests. I.la 1978 I a-1oa: Coogan, supra note 5, PAIIW Coogan' article i alaoat exclusively devoted to transfer and pledge of uncertificated securities. Be also foc:uau on such aclntillating issues as whether the rules for perfection of security interests ought to be in Article 8 or Article 9 (J.sl., at 1016, 1052-58, 1069-73), the effects of errors Mde by clearing corporations (J.sl., at 1041-48), and tranafer of aecurities controlled by a financial intermediary whose customer i the owner of the entire isaue of aecurities (J.51., at 1059-60). Suffice it to aay that Coogan nag to overlook or llisunderstand uny aignificant iaauea involving the transfer and pledge of interests in aecurities, including the essential economic role of aecuritie intermediaries. Saa also Rasor, gpra note 90, at 876-78, 883-89 (devoting more than one-fourth of the article to junior security interest issuea). DOC. SWP1103 July 17, 1989
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140 interaediary for the benefits of the securities transferred. Stated otherwise, claimants on a higher tier will always prevail over claiaanta on a lover tier. Th new aodel doea not reject the notion that a tranaferH claiaing through a lower tier interaediary receiv a property intereat. Rather, it deals with bow interuta in securities are to be divided and prioritized in ~~--~-.;.~-----~~ ~4-c.~~1~.~-tJ.~.,~ ;;_:'1'ba'.:Pr.oper1:y-~ :. -... -.; .-. .. . .' . , . \ ,. . : .. .. . .. . . vai~able _to .. ~a~~~fy. -~--clai of ~owr_.tier:,intermediary I o o o transfer would be limited to the securities that have not been transferred by the lower tier intermedia:ry on a higher tier and tha~ are.not otbarwi aubjct. to ccmpeting claiaa on ~igher .... :. ;_.-;.; .: \: ~:\ .. :.:, .'-~:;.\;-:-.~ : .. ~ ... <:. ::._: .. _~-~---:.~:~~_}:-. .'. _-.... ..:.~--.:.: .... _., .... , .. -. ~-'. ,::.. :: ., ..,, -.... :-... !..~, ... -:. .... ,_.., ...... :.~ ..---.. ~-. .. ,-:: ."-: '-1' . : .-~ ...... - .... 289. Although the intermediary' failure i the principal context in wbicb prioritiu will be relevant, exiating diatributional rules in insolvency proceedings provide an incomplete treatment. Saa fUPra not 232-35 and accompanying text. DOC. SWP1103 July 17, 1989
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141 tien. Application of the new aodel to Exuapla 1 would resolve the priority disputes in favor of I-2 and Lin every instance.291 290. The new IIOdel would not, however, pr011ote involuntary, non-reliance tranafr-wbo are not purchasers, such as lien creditors, even if such claillanta could be characterized as upper tier. In II 1-201(32) (defining purchase as a taking M, ' - (al .. 'VoJ.UDiffi .trafta.Gt,-lon 1:I:''-', fdfin-1 ... -... .. -: ....... ,--. -, ~~;;.;.~ t_:- ,.,. ;.---~4 ""d :, .:.:~ ... --~ --~-., .. _~ -~~' .. -:i; .,. .. t. , .... :_. :.., ..... ~~u--,t'~uit.~-?_ t .~.ui-~nq -~ er 'end tar }'1. a: IQ,. _. .. 1,q,,azer v. Willim iroa., 337 A,2d_559 (Pa. 1975) (lien creditor i."not a purchaser)~: .... In tile tting of Example 1, a judgaent creditor of I-1 would, of necessity, be required to eaploy judicial process against I-l's intermediary, I-2, in order to ru~-securities controlled by I-2 for its custOllar, I-1. &B I 8-317(4) (debtor' interest in securities controlled by a financial. interaediary ay be reached by a creditor by legal proc~a upon .the .. flnanci-.1. intozmadiar.yon -wbo-books the .J.n~.~f .d~r~ ~--~):. .-~Bxeapl l;bec:aue-th ~i~iu an,in tbe.~---i_on or are .registered in .the name of I-3, a financial_.. iiltaraediary, a creditor of I-1 would reach them by judicial proc against I-2, I-l's financial intermediary. In any event, judicial proc on behalf of a creditor of a securities interaediary would be an extraely unlikely avant. s11 supra note 183. 291. Aa a Giber of the Book-Entry Regulation Task Force of the Ac:l Boe COllllittH on Uncertificated Debt Securities of the ABA Section of Business Law, which was charged with making c01111enta on the Proposed TRADES Regulations during 1986 and 1987, I was the principal proponent of a priority rule along the lines of the new model proposed here. Katzman criticized an alternative proposal (which I supported) of that task force for such a priority rule because it preclude any form of first priority claill. Katzman, gpra note 84, at 199. In the March 'l'RADES Summary, the Departaent of Treasury observed that a priority rule that would always favor either upper tier or lower tier claiJlanta would be unjustifiably arbitrary. Karch TRADES 1111--ry, gpra note 31, at 8849. But neither Katzman for the DepartJlent of Treasury pursued the analysis. Part IV of this article donatrat that both the first-in-tiJlle rule of currant law and the laat-in-tille rule of the good faith transferee rule under the Proposed TRADES Regulations can produce arbitrary ruulta. Thia Part daonatrat that the priority scheme of the new aodel i principled. DOC. SWP1103 July 17, 1989
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142 The new model cont-plates tbe adoption of two corollary rules. First, an intermediary on whose books an interest in a fungible bulk of curiti i transferred would, aa a aatter of law, warrant that the transferee will receive (and will continue to receive) th benefits of the interest being transferred. Second, an upper tier claimant would achieve =l~~::~~)1~_; 1a~--: cl~~nt'ia' n~tice o.f an ~dv~~-~aim.. . . .. . .. . . .. .. The following discussion examines the claim that adoption of the .new model would ba beneficial. The discussion f~~on ce~in p~inciplu_. of. conoaic analysis as well as '.. .. -........ .. \""' .. . .... --.. ... : ... . .-: .. . :. an&1ogia"Uldc011p11risons~to existing ~nana1 proputy law and ::.-:: r... ... ~~-... -~-\:.-:-"--~,.,i.,:.~. .. -:~--~ ... .-,.a:.:..: .. ., ........... ; :. .... : . "... ., "': .... doctrine. a. ft Buie Principles Priority for Upper ~ier C1aimts Whatever priority rule is chosen, and whatever doctrinal basis or other technique is chosen for illpluenting that rule, the result will be a principle of loss allgcatign. Returning to Example 1, the loss involved baa resulted froa the convergence of (i) th insolvency of I-1 and (ii) the insufficiency of securities available to I-l's estate to satisfy th claiaa of I-2 and L, on the one band, and C (and the other cust011ers of I-1) on th other. As a participant in the 292. s11 uo1ra11y infra Part v.s. 293. s11 a1n1ra11y infra Part v.c. DOC. SWP1103 July 17, 1989
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143 aecuritiu -rket, I-1 baa axposed other participants to both a credit risk and a riak that I-1 11ight aisbehave. I-2 and L each cboN to land aoney to I-1 and to receive a transfer of (aecurity interaat in) sacuritiu to cur its loan, but neither chose I-1 to be ita intamediary for purposof controlling the aac:uritiu. c cbo to purchase securiti from (or through) I-1 .. -~~:~.,.,.~~~,!~=1;~.,.~--~9-~-J~~n~~;,. ~~~----~:'. -.':, .-_.: :':-,: ~--~--~-.".:~ ... ~-"':',; : ... :: :~~-.--.. ~.=-~---... ~:-.:_.,.: .:_ : .. .:-_t __ ..... . ... ..... aacuritiu. The. isaue posed is which class Qf. innocent -.rket .. . . . . . .. .. . . . ... .. . ... . . . . . . . participants should bear the loss--the upper tier claimants, I-2 and L, or the lower tier claimant, ~-ZM 1. aa aolioaia balyaia .. . I ' ._ .. , :"' , J '"'. -,'. ' . ... :. .. ::-~-.. -. .. :. :: ... ~.fol:l~U.IC) .--analyaia --i. anclut u,.ita acopa -and _._ . -. .-..._:.:.". __ .. _-~-.._:_ ........ -."". . .:-. . .. pilrpoe. .. ito clana iii ade that it necessarily leads to the appropriate policy result (judged on any possible normative basis) or that it is more than a useful heuristic. Yet an 294. Ware the second corollary to the new model adopted an upper tier claimant with Jcnowladga of existing lower tier claims would be given seniority, although it would not be "iMocent." Saa qanarally infra Part v.c. However, such a non-iMocent clai.Jlant would not be absolved of 1iability under the second corollary. Sa infra not413-14 and accoapanyinq text. For diacusaions of innocent purchaser risk in other contexts, sea carlaon, Rationality, supra note (priority rules for secured parties under I 9-312 (5)); Weinberg, Sales Law, Economics, and the Negotiability of Gooda, 9 J. Legal Stud. 569 (1980) (rights of owners and innocent purchaaers of stolen goods). 295. an Kennady, Coat-Benefit Analysis of Entitl-ent Probl-: A critique, 33 Stan. L.Rev. 387, 444 (1981) ("[I]s there any role at all for the notion of efficiency in law and aconmdca? I believe that the answer is that the concept has a limited hauriatic uaefulneas.). In recent years the explanatory, the positive, and the normative alaents of economic DOC. SWP1103 July 17, 1989
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144 econoaic analyaia, however aoclut, i an appropriate beginning for conaideration of the propoaed new oclel. Because the conflict addresaed i between 1l8llbers of two different cl of innocent property claimants that are each c01Dpriaed of aecurities aarket prot .. aionala, a priority rule baaed on an econoaic analyaia-vith enhanced efficiency as the goal--ia not likely to -o~fend o~r Jlql"IIS .~ .-.. SWl~~y,; .: -~wa _.j:ll~ ;~9JDPe1:inCJ:, cl~1;;,-.;,:; ~; ,_,-:,4;._,:. .:.-: ;.!'~;: ; A-~:-':\ .: :0:.."}~\' ,,.,:.; '.:,.". '.;" .-,t.~; .~: ~:~ '>: .. ,_-: .. "'.':: _ .. ,' ;: -~. . . . . > -~lyaia .Of law-have -~encrlticiz~ .. .au, e.g., Baker, The Ideology of Econoaic Analysis of Lav, 5 Phil., Pub. Aft. 3 (1975); carlson, Is Fraudulent Conveyance Lav Efficient?, 9 cardozo L. Rev. 643 (1987) lher~inaf~er.Ia It Efficient]; Kelman, Choice and Utility, 1979 Wis. L.Rev. 769; Kennedy, supra; Lett, Econoaic Analysis of ~v: SOiie Reali-About Noainali-, 60Va. L.Rev. A51 (19?~).-: T~. c;y~illpJUy; .olie,-peraiatent component of. -m,~~-~:-.i~-:~t... ~-itc;iancy, ,=u a: nonativegoal', often ~doftfll~_-vi'.t:b.:~t;b,.~ .. 11:aluu .. ,~-., cUatz.-i!Ntive .. justice; wlfan; fraedoa, and faim .. a. Por a reaponse to aoae of these critiqu .. ... R. POSRD, ECOHOIIIC ANALYSIS OF LAW 22-26 (3d ed. 1916) [hereinafter POSRD]. 296. Bconomiata give a variety of Maninga to the concept of efficiency. e.g., R. COOTER' T. ULEN, LAW AND BCONOIIICS 44-45, 49-51 (1988) [hereinafter C00'1'ER, ULEN]; POSRD, supra note 295, at 12-15; carlaon, Ia it Efficient, supra note 295, at 646-49; carlaon, Reforming the Efficiency criterion: C01111enta on srme Recent Sugqaationa, a cardozo L. Rav. 39 passim (1986); Col-n, Efficiency, Exchange, and Auction: Philosophic Aspects of the Economic Approach to Lav, 68 cal. L. Rev. 221, PIIIPI (1980). In thia article, efficiency ans the ao called Kalder-Bicu, or potential Pareto-superior, concept of efficiency: If the loaau (coats) imposed on society by a particular legal rule are more than offset by the gains (benefits), the rule ia efficient. a.a POSRD, supra, at 12-14; carlaon, I It Efficient, gpra, at 647-49; Shupack, Puzzle, gpra note 229, at 1070-71, n.10. 297. I do not claill, however, that other non-econrmic, value ahould not be considered in fashioning legal rules merely because the interuta of potentially large, wealthy parties are at atake. I infra not .. 413-14 and accompanying text (diacuaaing liability of upper tier claimants that have knowledge DOC. SWP1103 July 17, 1989
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145 ari in the context of the securities -rkets, economic analysis -to be an appropriate (even if incomplete) aethodology. The dicuaaion aaaUllea that the legal regill will continue to intervene by utabliahing priority rules to aort out conflicts between upper tier and lower tier claills. In theory, the law aigbt rely on private agr-ents aaong aarket ~"'-~~-t~~~~~t,:~~-,~<;r~.J':~~~~----:~~ .. ~-. ~+0~-~ty .. contuta. --ecaua thu-. pri~ri'ty contests aria~ in tbe ii '! .. : . . . .. preaence of a cl-r aarket failure, however, reliance on private . .. .. ,. . ~. ,.. . .. -.. : . . : ... . .. -~ . ... .,: .. -.-~ .. _~: .. -.. .:. :_ : ...... ._ ..... : .. ...... ,. -~-. ;_;'.' .. _--..:-.......... _. or'.-ide -~t" i~:tiuad,tm~-clahm). 298. In Cooter, Rubin, supra note 286, at 66 ("[B]ecause lo allocation in the payaents aytia a technical and largely aonetary aubject, economic analyi intuitively-to be an appropriate and proaising place to start."). Views about the aoundnus (however judged) of noraativ law and econoaics aay vary conaiderably depending on th context. For example, Margaret Radin' efforts to develop the concept of "personbood" in property law-to abed little light on the equities among profusional claimants to fungible bullcs of securities on different tiers. Jin Radin, Property and Personbood, 34 Stan. L. Rev. 957, 1015 (1982). Bven the abarpeat critics of nonaative econoaic analyai of law aigbt concede that wealth aaxiaization i one appropriate standard for ruolving priority disputes aaong profuaional participants in the aecuriti aarkets, at least when tbe players involved are not wrongdoers. 299. an CWI-Jm ULEN, supra note 296, at 105 (stating the "Poaitive Coase Theora as "when partiu can bargain together and settle their diaagre-enta by cooperation, their behavior will be efficient regardlesa of the underlying rule of law.). Por pruent purpoau, the point i that in theory negotiationa &JIOftCJ urket participants would result in an efficient priority rule. DOC. SWP1103 July 17, 1989
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146 bargaining would not be likely to nsult in an efficient outc:maa. O.ezri., of tf:La:La07 Jllpl:laat:Lou of a.llaT:Lor ad l'araept:lou of Market: hrt:la:Lpaata 'l'h behavior of market participants under currant law _ia affac;tad by tha~r perca~i~~-~-f-.:~,.-,l~~i.Uioo;l:;~~---::-. __ .-_. :.:,.-_. .. .._: .. .. -.: ,::; f,. _. .;., -~-_;. :../~-. .:.:~:;. ~:: \.:-";.~ .:.-~ -:f .,..;:-: ~----.";!-"\";.':' :--.-;~~ ;-, ?"' '-!'.: ,' . : . _.. aac;:iir1tiu.-Intanediaey vill fail -4 the pro~ility ~~t. a . . . . ... lover tier cla~t ~ill prevail in a .priority dispute resulting frma th inability of a_ failed'intermediaey_to satisfy customer ,. . .. . . . . ..-........ _;! .. .. :-:. .. ... ~ -,.; _;._ :_,: .. :. : .. : .~ _.' ... :-.' .. .. -:. : ..... .... \ ...... . . : .---.. .. --.. ... ,:-:. . .. ... ,-~ :;.----~. -~.: -~ ......... .. . :... : ... . -._ ..... '".,ii __ -r-~ ,.~ ... ,._ .. -: -~ '' :; ..... ....... : .... .... : ... 300. 'l'h aarket failure spring, in part, from th atructur of aec:uritiu aarkata and th pattern of claiaing throuqh intU'llediariu, ruulting in inadequacy of information available to th urkat participants as to who the other participants are and what aacaritiu they claill. Givan this situation, it is lilcaly that infor111ation available to market participants would be aayaatrical (although it ia not clear that the asymaatry could consiatantly favor or diafavor eithr upper or lowar tier clailllmts). In COOTER ULElf, supra note 296, at 48-49 (aaymaetrical information laadinq to aarkat failure). Perhapa aore aiqnificant, th tran1act;ign c;pru involved in negotiations aonq market participants would ba enormous and would Mk actual agreement unlikely. 1ml J.d. at 100-102 (diac:usinCJ th Jfen,1tiy1 c;a11 'l'barrn; s1;rgc;t;ur:, t;h law 1;0 rlPPD t;h impactim1 tp priyat CRTIID'IDA> (amphai in original); Coaae, Th Problof Social Cost, 3 J. L. Bcon. 1, 15 (lt,o) (Th .. operations [transactions costa] are often axtraaaly costly, aufficiantly coatly at any rate to prevent llBnY transactions that would be carried out in a world in which the pricing ayat-worked without coat.). Thus, a priority rule tbat repruanta what .. rkat participants yquld agree to if negotiations took place J1aY produce th ot efficient result. DOC. SWP1103 July 17, 1989
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147 and aecuracl creditor claims to aecurities ., Lower tier claiJlanta generally have ore at stake, and consequently greater riu, u a reault of their interaediary' insolvency than upper tier tranafereu and sec:aracl lenders. 'l'he pos.aibility of a windfall gain in the fora of a claim against (or a.senior claim to aecuriti alao claiaed by) an upper tier transferee or :-~~~~-;~i:-!.~~r~~-~~-:--~!~~~~----~:~,~.-~!~'7;;~~-~----: _;~-,._ --~--:. cl~iaant; in i1:aael~c;:tio~.of an int~iary.~ ~us~ it is _. . . : . . ..... .. .. . . . , . .. . : , . praclictabla that the market behavior of lower tier claimants under the proposed new odel would ba consistent with behavior that occurs undv currant law. Bacause_th p~ospact for :#~ -~..ta~i~_.,avc\.-_;_-~. t:i~---d~~ ia. 1ike1y to be ?. ,. . "' ,; :.-" . -: . . . .. . .. 301. Th aaauaptiona that are 11ad in the following analyais. concerning market participant IMahavior and perceptions draw upon the diacuaaion gpra not 45-49 and accoapanying text. 'l'h following discussion also aa11UJ1ea no change in currant law ggg as it would be changed by the new odel. Although one cannot aucc-fully argue the nonative from the positive, except for th iau-addr-sed by th new model there appears to be general aatisfaction with the basic principles under currant law concerning th transfer and pledge of interests in securities. 302. Thi is ao because of the riak aharing formula _applicable under SIPA and Subcbapter III. s11 qanarally supra Part III. Even it that fol'IIUla does not apply because the intanediary is a bank, for exuple, the claim of cuat011ers of the failed intermediary would be axpoaed to dilution under the proportionate property intareat rule. s11 aupra note 222. 303. I gpra notu 269-78 and accompanying text (diacuasing circ:U11Stancu where a lover tier claimant may have a claill prior to that of an upper tier claimant). The highly risk aver -rket behavior d-onatratad by market participant in aelacting intaraediariu supports this apeculation. I supra notea 45-48 and accmapanying text. DOC. SWP1103 July 17, 1989
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148 ignond, wen the new IIOdel in effect a lower tier participant voald be likely to cbooN the -interaediary. In contraat, upper tier claiaanta do not Abject their property claim to the general riak tbat a downatreaa interaediary vill becoae inaol vent. 'l'bey bave cboaen not to allow the dovnatreaa interaediary to control their curitiea. :~-~-::,---~~:~~r~~----~~~.-;:-~~~---~--~:-~:~--:-::_;::~.-~-.. .. :.-~ c:uatmaera of the.dawnatreq intaraediary,. and under current lav : . . .. .. .. .. . . . . . . are not aubjectecl to the rik sharing fonmla in th event of inao~vency. Upper tier claillanta oft,n obtain collateral preciaely.in o~er to ainim. the impact of a lower tier firm' . : -. .... . --. . . '. .: . . . . . . imolvenc, .:or lli---"iar~ ....... -_ ~iar ci~amntii that --::: :: ..: ;.:,..~-. .._ ::-. ........ : , ... . ,: ,I, -~ .: . 304. It would, however, be an overatat-ent to aay that an upper tier aecared creclitor aucb a I-2 or L baa DR credit riak ariaing fraa extending credit to the downstreaJI intenediary, aucb u I-1. la STIGUII, TRADB, IJ1PD note 13, at 178-79 (diacuaaing cleariracJ bank perceptions of credit riak). Moreover, the pouibility that the collateral value uy fall below the a.aunt of outstanding credit alvaya u:iata. 'l'b point i that the upper tier claiJlanta vill not expect their baaic clailll to the aecuriti to be upaet by the insolvency of the debtorinteraediary. That i vhy they inaiat on collateral in the firt place. 305. IM IPPD note 189-91, 232. 30a. In Example 1, the principal purpoN of the collateral transferred by I-1 to I-2 and Li to ldnilli the illpact of I-1' inaolvency and lliabebavior. Landen to curiti finm report that there are J1&11Y inatancu vben credit would not be extended u:cept on a fully aecured baaia, regardlua of any riak preaiua that could be cbar9ed for unsecured credit. [Intervieva]. credit extended by banks that perform clearing aervicea for government aecuriti dealers are u:tr-exaapl IM IJlPD not 41-42 and accoapanying text. In alq Kripke, IJ1PA note 229, at 941 ([I]n aoat aituationa involving cured DOC. SWP1103 July 17, 1989
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149 cbooae an intanaediary are alr,ady aubject to aubatantial rialcs, lovar tier claillanta ar la riak avn than upper tir c:laiaanta vith rupac:t to tbat interaediary. 'l'h C)Z'Utr upper tier claillant avanion to riak Y lud thoM participanta to cweraapbaaia th riak that a lover tier claillant vill prevail in a priority diapute (or at 1-t 9iv C)Z'Utar vigbt than lowr ,;-.~~~-~~ .. ,~Y.~--~-~--~i~ici~t: .. beba'.9'ior on th~ of tb. upper tier claiaanta. ' ". , ~-. 1" o I. I : . . ... .. . . . .. .... -.. . . I .. are41~ .. tha. cz.Ut rmld not. baM been: abtainact vit:bout grantinq .aarity,:):. I .clo nat.-.a.JrN .witll my_.aapac:ta_ of Kripke' ratbr traabincJ of th ca-rcial law-related law and ~ca literature. a. Jacaon Schwartz, IJ1PA not 229. Bovever, uauaincJ, u I do, that the law will continu to praaerv Ncured er.Sit that vill generally be protactad in bankruptcy and apinat third partiu, Kripke' atataaant to apply to Ncured cradit utandad in th MCUriti -rkts. For a convincing U'l)Ullallt tbat in acme contata credit vill not be axtandad without collateral and that MCUrad tranaactiona can be (but are not nacuaarily) efficient, w Shupack, Puzzl, upra note 229. Noreovr, revitred broar-d .. ln 9enerally are liaitad to obtainin9 aacured financing froa banlcs. In 15 u.s.c. I 71h (1912, supp. 1981). And bank landinCJ i rutrainad by prudancy conaiderationa. la, ,q,, 12 u.s.c. I 1818(b) (1982, SUpp. 1911). 307. 'l'lli point aarely recogniau th daonatrated villinCJn of the lover tier claiaant to ..... riau in connection vith the particular intuaadiary it Mlecta and th corrapondiftv daaonatntad unvillingnaa of the upper tir claillant to uauaa tboM riau. It i no vay inconaiatent with the aore 9aneral uMrtion tbat lover tier claiaanta ar bi9hly riak avan and Nlactiv in tbir selection of intnadiari IM ppra notu 45-41 and accmapanyinCJ tut. 301. au infra not 313. DOC. SlfP1103 July 17, 1989
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150 By reducing perceived riau for upper tier claillanta without increaaing perceptions of riak for lover tier claiaanta, the new aodel would reault in a net efficiency gain for ociaty. '1'be uauaptiona and analyi jut pruented can be evaluated in light of thrH conventional IIOdl for conaidering the efficiency of legal rul that allocate lo- :.... . : ... l :., ... . :.. ,' ; . . . . . : ;. ,.~._.; .-.-_..,.-.: :-~~ :: -.!.-. ,,: "~~4151:. :_:~~~.-t;-oC a.41101-) ... or -.&YOlti.111 liO . . .: . .. : .. ." . . I~ ~na-.t.c.-terJ1!18, .. afficien~ of the -rket c~uld be . . . .. enhanced by adopting a priority rule that aiCJD the lo to the cl of participant. that could.avoid or reduce th lo at tha lower coat.~ 'l'h aingla, aoat powerful, control that a . . . . .. .-, ...... .. : ... -.. -... ~--~-: ._ .. :.,, ..... :.:~ _..-.: .. ; ~-.:.-. .... ~-. ... .<-~-~--, . _.._,. ft9 ~l:1bliii19,ana1yai. fo11ava c001:uanci Rublii by focuaing on th efficiency of the new model in tena of the principle of lp radpgt;ipn, lp 1Prtt4ing, and lp ippaitipn. In Cooter Rubin, &PA note 286, Plim. 310. It-to be wall accepted in the law and economics literature that igning lo to the lover-coat lo avoider enhancu efficiency. Ila ,q,, COOTER ULEN, fUPA note 296, at 153-54 (efficiency of rule that good faith buyer of atolen goods talcaa aubjac:t to, or fr of, interest of rightful owner depends on which party could protect against the lo at the lover cost); POSHER, aupra note 295, at 71 (That bona fide purcbaaer of goods frma owner' agent (who aiaundaratanda ber authority) takes fr of owner' intaraat i a simple ca of [tb owner'] being the lover-coat avoider of the aiatak than [the purchaaer].); Cooter Rubin, IJ1PD note 286, at 73 ([A]n efficient legal ayat .. igna liability to the party that can reduce lo at the lowest coat.); Weinberg, gpra note 294, at 583 (1980) (An efficient rule placu riak on the cl of persona that can pr.vent it with the -11ut efficient expenditure of reaourcu.). The concept i a failiar one, bow.var, and need not be couched in econaaic teraa. Ila, ,q,, u.c.c. I 3-418, ccmaent 1 ('l'b traditional justification for tbe reault [of Price v. Heal, 3 Burr. 1354 (1762)] i that the draw i in a auperior position to detect a forgery because be has the maker' aignatur and i expected to Jcnov and coapare it ). DOC. SWP1103 July 17, 1989
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151 -rket participant can employ to avoid intermediary risk is to exerciae precaution by electing an intermediary to control its aecuriti tbat will not fail.511 Thi approach, then, predicts that aarkat participant would be highly lectiva in their relationship and would cboo to be exposed only to the possible failure of intarmediariaa that they perceive to be exceedingly -~~ilY to. f~il -~~-.: ~,. nn~ r~~--~~.,. :iJa.:,..-.C~l,a._ ... 1,. .:.al+.-.-::. ~.-:, . ,~1-1.1,,. ...... .; '!f';,~ .; -,-:, ~. "'0-~'llllr. -~ I, (. -~ .... ..... ..... _., .. .,t ,.._, ,- .. .-~--~, ..... ; ~-.t ..... :-. : -.-: ~-:_ ..... ~: .. ..... . . : Cilrlao~ explained that [b]y imposing the ':ioss :Ori the least COSt avoider, perfection rules (or their absence) facilitate the aovaent of goods from a comparatively low valuing user (LW) to comparatively high valuing user (HW). Carlson, Rationality, supra note 131, at 212-13. However, because set:Uritias are fungible and both upper tier and lower tier claimant& are highly rik. .. v~~;, .. *-t:~a.:_nat liltely tb~t. either -claaa,-vould value their ,in~t9 ... in: ~n.Uea::t1i9bar:.~. .. other~ =: Weinberg, .. gpra;,-:a~ 592: (.['r]hete :i nq., rea~n to: ua. that e~ther owners or legally innoce11t pUrcbaaan would value more highly goods that become the aubjact of title disputes.). 311. Cooter and Rubin identified tour distinct elements of the [lo reduction] principle's operation: precaution, innovation, reaponsiveness, and learning. Cooter, Rubin, supra note 286, at 73. 'l'be first two approach discussed above also focused on the exercise of precaution by claimants. My argument here i that th proce of lecting an intermediary is the most affective means of exercising precaution. Givan the assumption that the claimants discussed here--both upper and lower tier--are -rkat profaasionala, I assume that no aignificant differences axiat among claimant in their ability or propensity to learn or reapond to rislca imposed by legal rules. Innovation is discussed intra~ text accompanying note 330-34. Market participants also could avoid relationship with intarmadiari that would expose their interat to riJca should tho intermediaries fail, but -rkat participant mu.at involve and aploy curitie intaraadiarie in order to participate in the -rkat, and in theory any aucb intermediary could fail. 312. Evidence of currant markrt behavior appears to comport with this prediction. Participant who claim through intarmadiarie, and who are not fully protected by SIPC, tend to lct ultra-aafa, axtraely low riak intermediaries to control DOC. SWP1103 July 17, 1989
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152 three innocent parti--I-2, Land c--would be forced to choose between refusing to do business with I-1 or being exposed to I-1' credit and integrity risks. By inaiating that securities be tranaferred to yet another intermediary through a clearing corporation (and thereby incurring or paaaing on to I-1 additional coats), under current law I-2 and L could have made :-~<-~~:J.~:-~:t-~ .. ~-:~-~-~ '.~4 .!~~~---:-'.:a-i~~-.-.from:: :. = . . .. ':' . i. ,_. : ... :su : . . . o~ through, I-1 wh~l~ :~voi4,inq ~. mq,.o.-ur ,. . .. . . . ~., /. : . ,. . . . ... . . . ... The new model would place the risk of loss on c, the party tht chose 1 .. -1 as. its intermediary, and would promote I-2 and_. L _in every .c:u,-~ca\\;8e. th,y ~id ~ot choose I-:-1 as. their . ,. . .-. . . . .. .. . . , .. . . .. ':":.~-,,.-:.-: .. _, ... .. ... .. :',:---,:" .. .... :_..... .-: ::, .. _.::~:,:~ .. -.-:,':-::,:.-;~: .... \. ',: .. '. :--;: ... ... : -.. ,.. . .. . ... .. : ... .. j .. . ~: .. -~~-,., ... 'II:-;._:.: .... ,~:.,,,;._,~.-,-:_:.:, . ;.: .,.: . .-......... their curiti The small incidence and amount of losses incurred by market participants who are not provided SIPC protection are consistent with this behavior pattern. The potentially diaaatrou consequences for such a claimant in the event of an intermediary inaolvency offers a reasonable explanation for this behavior. Saa qanerally supra notes 45-48 and accompanying text: supra Part III. 313. Sae supra note 84 (bona fide purchaser status of tranaferee on books of a clearing corporation). Thereafter, I-1 would not be in a poaition to create any subsequent claims that would be prior to the interests of c, I-2 or L. If c were not an inveator entitled to delivery against payment privileges, however, there could be some short term risk between the time c pays I-1 for the aecuritia and the tille that a transfer ia effected to con the books of another intermediary. In addition to saving cota of laundering aecuritia though a clearing corporation, there aay be efficiencia and coat savings ariing out of the relational aspect of the arrang-nta between parties. For example, I-2 aay be acting as a carrying or clearing firm for I-1. Saa 111pra note 283. In that situation, it would disrupt the baais of the I-2 -I-1 relationship if yet another intermediary were to become involved in a secured loan from I-2 to I-1. DOC. SWP1103 July 17, 1989
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153 intermediary to control the securities. But the new moc:lel would not force I-2 and L to incur (or paaa on to I-1) any additional c:oata in order to enaure their priority.314 By hypotbeaia, upper tier claimants are leas willing than lower tier claillants to be exposed to credit and integrity riak of a given downstream intermediary. Al though landers may be 1!,!1 .. .-~f,:~~ ;-~~~:it!~!~,~ .... -~~-;-~-'~!~"-,~~~~~~~~,!.=.\.~~:. I .-:- "\, 'o 'o e .~,.-'\' -,, .. ,, :'1: .. :_-6 ..... ,1' ,, o 'o I I :, f o ,, .ia -~~ideriibiy --i~ -~~i-~ive bai~ .than that ~pplied by :. . .. . . . '.: . . .. : .. ::, -~ .. .. : .. ,. . .. . . . -. . .. . . claimants who select intermediaries to control their securities, upper tier secured lenders often may not view the limited potential for subordination to lower tier claimants as a -~. :.. .. -~--=.:~ ::.'.;~. :.-. .. ..... ~: ;::: .= __ ... -~ ......... : . J ., =.. ..... .. .. ... --~"i~g~~e, .. riak -~ot~ .. cuta~y:. ~~----= intaaaadiariea that -~. :. .. :: .. :.. .. -.~ . ., .. : ... :,;: __ ... : _,' .,,~ .. -.. ~..-.; .. .. Mne a cl.-ring :or :carrying function find intolerable any p~tential for interference in their security interests by claims of customers of downstream intermediaries for whom they perform clearing services. 315 However, other secured lenders and repo purchasers of securities, not acting as clearing lenders, also must be concerned with risks of conflicting claims of their securities intermediary-debtors customers. These risks and coats would be eliminated by the new model. 314. Ill id. 315. The debate surrounding the proposed TRADES Regulations and the inaiatenca upon explicit protection for clearing liens" illuatrataa these concerns under currant law. Saa aupra notes 177-79 and accompanying text. DOC. SWP1103 July 17, 1989
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154 It follows that allocation of downstream intermediary credit riak to upper tier claimants (even in the liaited and larvely fortuitous cirCU11Stancu applicable under current law) illpo coats on aucb claimants tbat are greater than tbe coat tbat would be iapoaed on lover tier claiaants var auch risks allocated to tba. Thi i ao becauae the coat of iapoaing all :4~--~~~----.-~i~~-i ~.~-~~~~z-.:.ci.~~ .. :_1.-.::~~: or: n~,.. -.~ro~ -an~ c~~t 9t_~.-i~9 .audl .. risk ~n -~ier. . . . . . . . claimants, as under current law, is materially in excess of zero .-317 Itfoll ova that moving from current law to the new modal would enhance efficiency.311 I.over tier claiaanta would continue o .. I 'o o I , 00 -... ,: :' ' ~:-: ;:f, :::: .,,: I ::.1 ".; =~.r: .,,": .. :_-; t\.,-.: '0 ; ... :\,.. f._. .. .~ -. : ._.; 3is.-: M: .argaec1abav~ over~t1ar c1ahiant:s veneraiy disregard tbe potential benefits of a claill against or aeniority to upper tier claillants and lover tier claillanta already exercise precaution in lecting their intermediaries. Ill supra notes 302-03 and accompanying text. 111 also carlson, Rationality, supra note 131, at 221, n.46 (Because advantages of mortgage and security interest recording acts to unsecured lenders are highly contingent on factors beyond the lenders control, it is doubtful that recording act protection is an important factor in pricing unsecured loans.) (footnote omitted). 317. Ill supra notes 304-07 and accompanying text. 318. Because a change in law can enrich th beneficiaries of the change (hare, upper tier claillanta) and impoverish the losers (here, lower tier claimants), the wealth effects of the change can affect the demand of both losers and winners and, consequently, necessitate continual readjustments in order to -intain an efficient rule. "Thi never-ending modulation between two efficient universe i called the scitovsky Paradox. a.a carlaon, I It Efficient, aupra note 295, at 650 (citing ScitovaJcy, A Rote on Welfare Propositions in Economics, 9 Rev. Econ. stud. 77 (1941)1 Kennedy, aupra note 295). As to the iaaue at hand, it i a reasonable assumption that aucb vealtb effects of a move from current law to the new model would be ainimal or non-existent. Lover tier claimants value the DOC. SWP1103 July 17, 1989
PAGE 350
155 to choo the intenec:liary under the new aodel, which is efficient becauae they generally can avoid or reduce lo at tbe lower coat by axarciaing precaution in the lction of interaadiariu. Moreover, under th new aodal lower tier claillanta would aaaUlla the naqligibl additional risk only aa to their chosen interaediary, while upper tier claimants would be ~~~~~r.~~'.;~~.:-=t~e~-~~llc:~~1~~~-~--~~---~~~~~~-:.~-~~-~1/.~ ~,.;~ "JIOre urke~ parti~ipanta, _1n connacti;,n "1th QDY ore -. .. : : : .. : -. 'I .'.. .. : ~ ' 1:ranaactiona.319 There are thr other ~eana_of lowering th~ coat of reducing oravoiding loss that ought to n~ioned. But none . ,. ~ -: .. -. ,., - .. .. :,. .: . : . ,I . . . -.tJla. baic:--concluai~n tbat: aaaiping-priority to upper ;ti~--~1abantli.i~:-. il ca!~~-i..i iti.:~o~~ er"tici~~~--~-one aaana i to make it aor likely that such interaec:liari do not fail. 'l'h regulatory and prophylactic potential for seniority to upper tier claimants at zero or near zaro. The new aodal would rely reflect the existing expectations of upper tier claiaants, aave for largely fortuitous and infrequent circuaatancu where lower tier claillants aay achieve priority under current law. It i difficult to see how daaand of either cla of claillanta would be affected -terially. Hvrthl, quutioning the efficiency of aoving froa current law to the new aodal givu the benefit of any doubt to current law. Ila carlson, Ia It Efficient, supra note 131, at 950-51 & n.30. If ay fa~ual aD1Ptiona and conclusions are correct, upper tier claimants would, in theory, be willing to pay lower tier claiaant, in exchange for a aove froa currant law to the new aoc:lel, an -ount that would be readily accepted by lower tier claimants. 319. s11 supra note 47. DOC. SWP1103 July 17, 1989
PAGE 351
156 approach are directed to this end. It is doubtful that either upper tier or lower tier claimant are poitioned to aaert a -terial influence on the railure or urvival of a curitiu intermediary through direct upervision.311 However, the behavior of ecuritiu interaediari uy be influenced by Mrket discipline as well as aore direct supervision. To the :_~ >~~-.o~::~~--likely: .to,, do . . . . . . b~in vj.t1-.a. -~~iti .. inianaediry baaed on their .. .... .. . . . . .. . . .. asuaents of its creditworthiness and integrity, the interaediary may be discouraged from engaging in-risky activities or aiabehavior. :m Th~, i;he "lection or .. raj action. of an . '. . : .. . ~....---"'1!1111'"~---~"'-!'9-;:;-.... _.,,..._. .;..:,\ . .i"l~.:-:~:1:-~ . ,., .. :_ . ,_..:;~ti. . ..,,. \'. ,I,,: ''-''' -.~, ... .-.~3:io~--' IM a-ra11fmo not ~3~!57 and accoillpanying text. 321. I aean, by direct supervision, policing prudency and olvenc:y by activitiu such as audits, axuinationa and inspections. Although in aoaa ca claimants llight detect cirCUJ111tancu that regulators have overlooked, or at least dicover th-earlier, it eunlikely that either lower tier custoaars or upper tier transfer would improve materially on existing regulatory supervision. 322. Monitoring by creditors of firas can discourage risk taking (opportunistic) behavior. a.& 1-,q,, Macey Garrett, Market Diciplin by Depositors: A Smmary of Theoretical and Bllpirical Arguaents, 5 Yale J. on Reg. 215, 223-39 (1988): Macey Killer, Bank Pailuru, Risk Monitoring, and the Market for BanJt Control, 88 Colma. L. Rev. 1153, 1162-65, 1172-91 (1988). In the curitiu intenaediary context, analogi to creditor behavior and influence i appropriate; the concern, ban, is with the failure of the fira, not protecting specific property interests. In Bxapl 1, I-2 and L are cured creditors of I-1 and, by virtue of th SIPA/Bankruptcy Code rik sharing formula (or even the proportionate property interest rule, vben applicable), lower tier claiaants uc:h as care treated entially aore like creditors that property claimants. custoar that are fully protected by SIPC, however, cannot be expected to provide effective onitoring. Tb aoral hazard probla i induced by DOC. SWP1103 July 17, 1989
PAGE 352
157 intenaediary a9ain becoaea the crucial -an of control. Because lover tier claimants are expoaed to greater intermediary risk, it lliqht be expected tbat lover tier claillants would be the more accurate, thouCJhtful, and effective diaciplinarians.:m anal09oua depoait inaurance protection for depositors of depoaitory inatitut~ona, and is.exacerbated by market perceptions (and ~ig,) -~~.all de~i~.bave. n--tfc;tg .. depoait,,inaurance -,rot~!mi:$,.:Ti~;-ttoa~tr~-4'.stil~aan~ The aegulati"on o~ ~-and Bank.Bolding Coapania, -,3 Va. L. Rev. 301,. 313_ t1987): llacy Garrett, -ra-~ at 236; Note, The Brokered Depoait Regulation: A Response to the FDIC's and FHLBB's Efforts to Lillit Deposit Insurance, 33 UCLA L. Rev. 594, 606 (1985). Thus, financially weak depoaitory institutions are not diaauadad by depoaitor concern from undertaking risky, opportuniatic behavior. . . . .... ; . ... : .. ....... -! .. ."-. : ..... : .' . -. . .. ....... . ..-.. .. ~3.--.. Intn;matim:~ .-vho~u.--rarely:-choaan by-lower tier c:~~ .(11ot_;fu,lly,-p~tected:by._SJ.PCJ'aybe .exposed ~o little aonitorinCJ fraa any quarter (except aonitoring and supervision illpoaed by r8CJU1atory requiruaents). For example, it is unlikely that -11 curiti firms would be chosen to control portfolios of large inv-tors not matter what the strength of market diacipline. In effect, in many cases lower tier claimants may iaposa market discipline by rejectin9 certain intermediaries rather than by nitorin9 intenaadiaries with wh011 they have a relationship. In the absence of material unsecured creditors, such intermediaries are exposed to the moral hazard problem that is exacerbated by SIPC protection: only the regulatory and prophylactic restraints are available to discourage risky, opportuniatic behavior. It does not follow, however, that efficiency concems dictate that upper tier claimants be exposed to riau of aubordination to lower tier claimants. Lower tier claiaanta likely would not be attracted to weaker intermediaries rely because of an incraaaad potential for a windfall claim againat an upper tier claimant. And, under current law, upper tier tranafar of and cured lenders to such intermediaries (who, by hypothai, are not villin9 to be exposed to insolvency riau of a lower tier intermediary who they would not choose to control their aecuritias) aight be driven away or might charge a higher riak praiWD. Mora plausibly, in many cases the upper tier claiaanta mi9ht be forced to incur deadweight costs of ensuring that they achieve bona fide purchaser status. see supra note 313. DOC. SWP1103 July 17, 1989
PAGE 353
158 Another poaaibl -ana of reducing or avoiding losses attributable to interaediary failuru i to -k it aor likely that vben interaediariu do fail then will be nfficient HC:Uriti available to aatiaty all claiu, both upper and lover tier. It i doubtful that either upper tier or lover tier claiaanta can effectively aonitor the relationship between aecuritiu cla~ ~9.~_. iJJ~~~r;l . .,;.~.;~--~~S..~es. . . .. ; . : .. ., ... ... :,:.; ....... ),.,., ... .. .. ."\:. -.:. ................. -_, . . ~,~i~~i:~~t~--~-'~ti;ly ~til~;. ~1~-~-~-Aa: praci;i~~----~tr, ~f~-;oi"'fnt~~~ iii-~-f~gibl ~n -th. books of. intenaediariu cannot detenaine the provenance of or the existence of.adverse claims against the curitiu purchaaed.326 Batabli~ --aft!! ~.it~---~~.:,~-=-~ ~f,"-~3:ie:~1:ice_ ~or :.-~-~'----~-<~~-<-:--_::".-.-~~~... .... ....... ~-.. .. -.:-, ...... : .cla~-to: intenatii!iitanqn,ie tniib ,it ~itiu controlled by 324. Again, this is an illportant goal of the regulatory and prophylactic approaches. 325. In Example 1, I-2 and L have no feasible aeans of finding out about C's claias, whether or not the transfer from I-1 to c occur before or after th transfers to I-2 and L. The -can be said for c as t~o th claias of I-2 and L. sea supra note 107. 32&. Thi i in contrast to the ca of tranafers of interuta in diacrat goods. A proapective transferof diacrate goods can reduce the innocent purchar risk by invutigatinq the source of ita tranaferors title. ba, a,q,, Mooney, gpra note 93, at 749-51; Weinberg, supra note 294, at 584. Sillilarly, an owner of gooda can take precautions to reduce the riak of lo or theft. I.ta, , q, C..W-1-IR ULEN, gpra note 291, at 153-54; Weinberg, IJ1PA, at 584. 'l.111 public notice provisions of Article 9 alao provide a Mana for a secured party to obtain protection against subaequent claias againat goods collateral and for a prospective purchaser to discover that a aec:urity intereat Y exiat. an infra note 327. DOC. SWP1103 July 17, 1989
PAGE 354
159 intanaediariu would involve enoraoua coats and would almost certainly be illpracticable. Nor can lower tier transferees effectively protect apinat aubHqQent tranafera to other tranafana, acme of vboa aay beccme bona fide purchasers. Bven if either upper tier claiJlants or lower tier clailllanta could avoid or reduce loaa at a lower cost by ascertaining the status .... .. .. .,._. ~. :. -.. ..... ....... : .. : ... : :, . . 327. Although there are disagre-ants at the margin, most cmservera agree that Article 9's perfection rules and its generally applicable first-to-file-or-perfect rule are useful becauae info~tion is provided to prospective purchasers about t:ba,pquUll .. J.atenc:e.of.c:onflictincJ claiaa and because -P~iori is -.affo~ ~--ear1.iu-1n-tille aec:ured -parties. In .~c..~._ .. ,11 ~30~ to-~3-05, ~3J:2(5) (a}-1 an umra11y, 1,a,, Baird, n note 1311 Baird Jac:Jcson, supra note 1311 carlson, Rationality, supra note 1311 Mooney, supra note 931 Phillips, supra note 131. An Article 9-type filing ayatfor interests in fungible bulks of securities, however, would be wholly unvorlcable. First, to addraa fully th priority contests raised by Example 1, it would be necessary that the filing systbe extendec:l to ownership interests, as well aa security interests. Second, because the aecuriti are fungible, it would be difficult to prepare collateral descriptions that would not be overbroad. By the same token, because securities intermediaries such as I-1 may typically make transfers (as collateral and otherwise) to many, uny transferees, broad filings (1,q,, "all securities) would necessitate subordination agreaenta on a -ive scale or exceptions to the first-to-file rule that would leave the conflicting priority issues largely unchanged. Finally, the high voluae and velocity of transactions probably would overwbfnl.m (or be overwhelaed by) any sort of filing regime heretofore en by the world. sn also Coogan, IJ1PD note 5, at 1021-22, n.32 (augg .. ting that filing aight be appropriate means of perfecting a security interest in uncertificated securities in run of the 111111 transactions, but acknowledging that perfection by entriu on the boob of intenaediari .. would be deaireabla "[i]f uncertificated securities become widely tradec:l"). 328. Ill supn notes 82-85 and accompanying text. DOC. SWP1103 July 17, 1989
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160 of conflicting claiaa to, and policing, tb aecuriti tbey claill, it i likely that the coats would av&J1p the benefits. 'I'll final aeana of reducing or avoiding lo i 1- obvioua. Allocating loato th cla of claimants that can beat caw loaa reducing innqyatign in the -rketplac aight provide a aore efficient -ans of loss reduction tban would . ~.i~1~u.:::.J..ou-~on;.-.~e.'.~d.~~~:1;Jla~:.Jiarut-.;a1:r11c:tun:.and . ,, : ": . : I .' o .' prac::ticu .vill. aore or .. le-static-. But tb. potential . for lo reduction through innovation is enonaously difficult to aaae By-definition, we cannot knowspeciticallY what the innovation would vbat tacbniqu would be inyolved or . . : . .. -.... . ... .. . . . . . . . . vtultber by::-~~J:iij,ciacjie. .. ot' 1.U~u_--cf"be: achieved. Dt In . ,: .... . ~-. "!"": ... : -~~------~:_:. . ... __ ... =-~ ., ._...... . : 329. Certain upper tier claillanta, auch as carrying or clearing broken for other (downatr ... ) intenaediariea, -Y have an information advantage over lower tier claimants who are custoaen of the carrying or clHring broker' downstream interaediary-cuatcmer. The carrying or clearing broker is likely to have access to infonaation concerning the customers of it's cust011er. an Fitzpatrick, canaan, supra note 283, at 53-54. But the carrying or clearing broker's costs of verifying the abaence of lower tier cuatcmer claiu probably would be prohibitively high. carrying and clearing firms are aubagents of their downstra-intarmediary-c::ustoaers vho are, in tum, agents of their downatrm customers. .In Fitzpatrick carman, supra, at 63-64. Illpoaing on the carrying or clearing fina tbe risk of wrongful inatructiona by ita principal, vith the aasociated costs of verifying auch inatructiona vith the cuat011an of its principal, prcmably would offaet the efficiencia aought to be obtainad by carrying and clearing arrang-ants. 330. Ila Cooter, Rubin, supra note 286, at 77-78. 331. Obviously, if we knew the answer to th- questions than the atep to be taken would not constitute innovation. DOC. SWP1103 July 17, 1989
PAGE 356
161 addition, aaa1111in9 tbat innovation considerations were to favor allocating lo to upper tier claimants, the benefit of such allocation lli9ht not be aufficiant to offset tb other lower-cost loa avoidance facton. Moreover, oat curi~i prof-ional aoaetillea are upper tier claillants mm s011etilles an lover tier claillants. In part because securities ~~~:~~~,~~~tf;;_.~:--.~~~-~-~:~~t-~'f::.:~+~,-.-~~~-~~-,.,---~---~cauae of varranti~ ad ,y interaediariu to their ~t011ers, ... . . . . .:. ....... \.. -.. . .. ... .. . . . : -... ' ..... .. ..~:~i.-. :-,.~: ..; ...... -: ...... :, 9 - ... 00 0:, 0 0,t :,.,.', ",0t0 ..... 0o If O ,' :, o .. ,,' 0 ..... :, 0 ,:',, ; o ... . l3a.. _A9W: ~t. .( ID11Pl. 1) typically would be an inatitutioilal invutor aucha an insurance cmapany, investment coapany, autual fund, or pension fund. Further um that I-2 and L would be aecuritiu firms, banlcs or other securities profusionals. Given th reasonable asswaptiona, arguably the securities protusionals would be better positioned than the institutional investors td influence innovation in the securities urkets. But, if it is correct that the lower tier claimants are otherwise tb lower-coat lo avoiders, it would not be efficient to assign loss to upper tier claimants unless innovation considerations were sufficient to offset the other lower-cost loss avoidance factors, and this would notsto be the case. If the goal of the loss allocation rule bare were to encourage innovation by securities professionals, then loss should be allocated to upper tier claimants in All ca rather tban only in a lillited set of cases under current law. Such a loss allocation would -trially incr- coats to th upper tier claimants without corresponding reductions of costa for lower tier claimants. (Preamaably, seniority to upper tier claimants would not produce uterial additional comfort to lower tier claimants who would r-in aubject to dilution under tb SIPA/Subchapter III risk spreading formula. S supra Part Il:I.) And there would be no assurance that those coats ultimately would be reduced by successful innovation. 333. saa qanara11y intra Part v.s. DOC. SWP1103 July 17, 1989
PAGE 357
162 aubatantial and adequate inducaant for innovation 11ay already axiat. o. r.ou lpmcliBCJ 'l'h foregoi119 indicata that allocating lo to lover tier claiaanta, -under th new IIOdel, conform. to the lover cost lo avoidance paradiga. But the efficiency of a lo ~-~~~~~.-.-,.--,.~~~ -~ :~--.~:-,.,,!J.,. .-:~.~~~---:~~-:-~ _pri.ncipl ~f lg IW9o4inq. .xf,. .... a-~-~--~f. lo~ ~preadinq, lower ,.. ,. . . .. 334. 'l'he last twenty yeara have en vid-pr-d innovation raultincJ fraa anoraoua afforta by th aec:uritia induatry to reduce riak and-enbanceafficiency in NCUriti-tradinq, 'clearing,,,UMt'Nttl~-;.:-:-; ;:;g,;: lliipq :-Ii~-_21~2, and accJilplllyUIIJ: ~(daMl.op1111nt and opiration of D'l'C-IISCC clearing and Httlaaent ayst) gpra note (new P1'C ayata for cl-ring and ttlaaant of Ginni Nae trwactiona): STIGOM, TRADE, 1upra note 13, at 257-62 (davelopaant of Govarnaent Sacuriti Clearing Corporation); me 1988 Report, ppra note 18, at 12-26 (expanaion of eli9il,le in-(by 241 during 1988), s--oay Punda Sattlaent ayata, liunicipal bond prograa, book-entry only curitia, Inatitutional Delivery Syat .. autaaation of dapoaitory ayat .. doaeatic and international interfaca clearing orvanizationa); caotJP OP TIIDtff, SBCORI'l'IBS CLEARANCE AND SE'l".rLDIDT S'l'UDY (1989) (recmmandationa for practice and atandarda for 11ajor world curitia 11arketa) Government a9anci-and official alao have been inat%Ullantal in encouraging and foc:uainCJ innovation. In, l,S,, BAHmS TRUST COMPANY, S'l'UDY OP DTDHA'l'IOHAL CI.DRIMG ARD SB'1"1'LDIIHT (1989) (adJliniaterad under contract to united St:ata Office of Technology Aa-ant: ppra note 12 (AM Advio~y Camitt .. formed at the requeat of SBC Chairman Ruder) 335. -Cooter, Rubin, gpra note 286, at 84 ('l'h lo apreadiftCJ, lo reduction, and lo iapoaition principle identity the -jor conaidarationa for fraaiDCJ legal rulto allocate loin an efficient aanner. llban the principle convrv, the beat rule i obvioua, but vben they divrv, their relative econoaic affect. auat be cmapared to determine which legal rule ainilliz their combined effect.) (footnote oaitted). DOC. SWP1103 July 17, 1989
PAGE 358
113 tier claillanta can bt1r loam reaultinq frma intermediary riak at a lover coat than upper tier claillanta, the latter would be villinrJ to pay tile fonaar to unae aucb lo and iCJDiftCJ loam to lover tier claillanta vould prcmot efficiency. Th loa apreadin9 principle will be aoat effective when the party to vboa lo are allocated can apr-d the lo aaonq a large ;~~,-~f?;~:.-~~i~~~~f..',1~~~~-i~~~~.,~_-~eel loaau an mll in"caapariaon to that party' capital, and vben th . : .. .. . . . . ,, . . occurrence of the lo-are aufficiently frequent ao to be predictable.D1 At fint bluab, upper tier claillanta wouldto be aom-effac:ti~ j,. :ap~d~ ----~ -thq can lie expected to bave any aec:uriti~ intanediari.ia a cuatoae~ or bbr:towr vbil lover tier claillanta normally lct only a few 33,. In, ,q,, Cooter, Rubin, 1J1Pr1 note 286, at 71 (Whenever one peraon can bear riak at a lower coat than another, there i an opportunity for a 1111tually beneficial exchange, becauae rik averae people will pay riak neutral people to um th riak of loaa.); alp a. DDIHBDG, R. EILERS, J. MELONE, R. ZELTEH, RISK ARD IHSURANCI 3-29 (2d ed. 1974) [hereinafter DDDIBERG]. Of courae, it i not contemplated here that either lover tier or upper tier claimant. would act;ually pay -br of the other cl. Rather, the qu .. tion poaed reflecta one tecbnique of exploring vbether one cl or the other could better bear th lo 337. In Cooter, Rubin, upra note 286, at 71. Lo apr-ding, or pooling, i the baaic economic principle that underli .. inaurance. In DENENBERG, upra note 336, at 10, 1214. DOC. SWP1103 July 17, 1989
PAGE 359
164 intenaediari to control their curitiea. But the losses arising troll an intermediary insolvency do not fit the lo spreading paradip. They are potentially quite large and the occurrence i relatively infrequent and unpredictable. Allocating such lo either to upper tier or lower tier claillanta baaed on a lo spreading rational would be of ~~i1!1l.--rY~~~~.~.;:~~~~~~,~~.;1~~:-~~~J~i:4~:~:i~ ;,~ .:: ~ .. .. <~-:. ... . . : . . . . nevertbl appear ~over.tier claiant~.can.~tter bear . .. . .. : . . .. credit risks of their securities intermediaries. .... .. ... .:. .. -ra n..,.._ .. -:;.-, -: ..... .'. ........ .-.~.--, ... :.-.,;:., .. '. .. ;. :. .,, .aJV -:!,la,i ____ .,.,.....____ VIit '9 . 0 '. 0 : ; '-~ ,,. ....... -~ ..... :: .. ... i :.:--... . :,, ... -:, . : :...... '. ~--:. . \ 339. When the failed intermediary i a curiti firm, under SIPA and the Bankruptcy Code the risk sharing formulation for claimant on the same tier is a form of lo spreading. JJ1A supra Part III. Would expanding that formulation to upper tier clailumta, including secured creditors such as I-2 and L (in Exuaple 1) have merit based on the loss spreading principle? Under aucb a formulation, lo would be spread among upper and lower tier claimant rather than allocated to one class or th other. an supra not 265-68 and accompanying text (discussing a aimilar approach under the I 8-313(2) proportionate property intereat rule). That approach also would not be likely to enhance efficiency. Although it would be more beneficial to upper tier claimant. than reducing their claiu to an unsecured atatua, the lo would rmin potentially quite large and unpredictable. Although this riak sharing approach may be sound when applied on the same tier, and it might be wise to extend it to non-aecuriti firm intermediaries such banks, it is doubtful that it would provide much comfort (i,t,, reduction of riak aversion) to lower tier claimant or to upper tier claiunta, viewed 1x ant. 340. Because lower tier claimant are alrady subject to substantial intermediary credit risk, a rule that would subordinate lower tier claims in all ca would not materially incr that risk. DOC. SWP1103 July 17, 1989
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165 4. Cot of rtiatin9 an4 lllpoia9 LO alloaation Any legal rule or tandard that allocates loss to one peraon or another impo coat on the parties. When a loss occur and a dispute arises, coats of anforc-ent are borne on both parties. In econamic tenaa, these costs represent .. .. -!.~Ji~:-.=~~\ J!~9~: .~.4'~~ .~C?~~. ~.,..,: .... ,.: ..... !':.--.~: "'::-:............. _.:..: . ....... ... -. eff icien~ 341 .. . . . .... : . -... .. . . . Loss allocation rules that are definite, clear, and 'simple involve lower coats ~f imposition than rules that are uncertain, unclearand complex.JG It is dif.ficult to imagine a -.~re .detin1~---~ .c~~-~.-~impl~ ,'~i~'th~ :~1i~tion of loss to '. .lower ~tier. ~la~ta iri' , ail 'priority cilisi,~t-~ with uppe~ tier 341. I.IA Cooter & Rubin, supra note 286, at 78: one feature that all these [enforcement] mechanisms share is that they are costly: they represent a deadweight loss to the participants in the payment system. To achieve efficiency, therefore, the enforcement process should be as inexpensive as possible. The most inexpensive approach to loss imposition would be to allow the losses to fall where they may. In the context of a priority contest, in contrast to a damage claim, it would be impoaibl to lat the lo "fall where [it] may." When two claimants are competing for priority as to a property interest the lo does not "fall" anywhere except as the allocation is directed by the applicable priority rule as interpreted and applied by a court. 342. In j.d. DOC. SWP1103 July 17, 1989
PAGE 361
166 claimant, aa th new model cont8Jlplates.w Issues present under current law, such as timing of transfers, tracing of interests in aecuriti, denomination of accounts with intermediaries, and the like diaappear when the new aodel is aubstituted for currant law. Yet a simple, lower-coat loss allocation rule sometimes uy hinder efficiency. For example, if a rule were to impose the ~i~'-' .. : ~: ~-~f,9~~,:~~,~ .. ~-~.G.~,-~,~i~i~\-~~~ :'?J\:;:~~-':~P~Y...-~a~:-ls .tha_" ... . . . . . . ':' . .. . . . . 1uat abl to apre~.d or. o~arwiae be~r. loqes ,~ the ovrall. effect .. . \ . . .. : . .: -: . . . . . .. . . . could be less efficient. In the caae of the new model, .~ow~r, ~11.ocation of loss -to lower tier claiants appears to be the more efficient rule baaed on consideration of these other ', ... . . . . . ": . . ., . ,. .. . . . ..... .factor., .. ft lowr -~Cl!ltS .o'f :$llpoing' :the -~loaii: alJ.'bcation :.under . .. ..... .. .-; ::. ... .......... : ... -. ,. .. .. -: .... : ...... ,. -. .. : ... ..... the new modal, then, would further enhance ita efficiency. Attempts to achieve the result of the new model's loss allocation scheme could take other approaches. For example, assume that the lawmakers ware to conclude that lower tier claims should be junior to upper tier claims in every instance. A priority rule, to be applied inside and outside of insolvency 343. The lower costs of loss allocation also could be achieved by a priority rule that always assigned the loss to upper tier claimants, rather that lower tier claimants, or a rule that allocated the loss proportionately uong lower and upper tier claiunta. Thu, the lower lo imposition costs claimed for the new model are neutral aa to which class will bear the lo 344. sae generally supra Part IV. 345. see supra note 335. DOC. SWP1103 July 17, 1989
PAGE 362
167 procaedinga, aigbt provide that transfers of interests in aacurities to lower tier claimants will always subject to the intereata of upper tier claimants and that transfers to upper tier claimants will always be free of any interests of lower tier claimants. If, as is claimed here, upper tier priority would be the more efficient outcome, then such a priority rule would be -~-.:~~~~~~~._!!V,~.-.~_.ep;;;;}tJ~ .. ,~.;:~~~f,~:.~.::f~~~:~.9~-:.:~P;OS_ipg ,.~at :"~,':--i~ .. ..... :-._ .., . =. :-" / .... .. .-~ .. : : . : .. . . : ,. ..... . . ruJ.eJlight ruuiiil relatively high. If, at: the times transfers o . ; ', 0 ' -~ :, : 0 o o O o' ._ 0 0 I : i o O '." l ', 0 0 ,' 0 '. o ., 0 ,' ware made to the upper tier and lower tier claimants, there were sufficient securities c~ntrolled by the intermediary to satisfy All claims, that priority rule would not resolve the dispute. It ', ' '1:' ,, '.' .., ,, ', ,. 0 1,.:1 , ""I'"":, .. t ', 0 1' "' 1 0 ,""\ 0 ', :,. ' ,: ., I., ,. -~cl :!:)e_~~.c .. _~-to .f~~rmin_-;--alao;:. wbether.--e~ities that . :.-. . .... . :. : . .:;:. ..... .... ........ '. .. . .. .. . . .. ._ .. were tranaferred away to bona fide purcbaaars prior to the intermediary's inaolvancy, and securities that remain, were the securities previously transferred to the upper tier claimants or those transferred to the lower tier claimants. Some sort of tracing system would be necessary. I suspect that AJ1X priority rule tor fungible bulks of aecuritiea that follows the property law construct of identifying property interests associated with particular property would involve substantial complexity and uncertainty. one could continue to axplicata with layers of rules and exceptions in the Z46. Thia is tha approach taken by tha Proposed TRADES Regulations in the limited context of "clearing lien priority." I aupra not 177-79 and accompanying text. DOC. SWP1103 July 17, 1989
PAGE 363
168 hopes that all of the possible scenarios would be covered, but one could never be aura that something had not been missed.347 Bxiatinq and proposed rulu that purport to apply the traditional property law construct and doctrine in this context appear to fit this hypoth-is in every case. Although the traditional approach could produce simplicity and certainty, it has not done _,, :;.~t.t~N.4\:~ri,; ;be.:-no:,:;----~: oift1'ilii;r-ij~n-~ _. ; Tile .-iw1,-:aocie1 : .... . : . . . . .. . .. . . . . , . 'I ;_ ', '~ , .: .- . . ,, . ' .. ', ' '., , w~d not. a~ek. to .identify. __ property-and ~n determine who took . . . what property subject to or free of whose claims. It would, simply and-clearly, subordinate the lowertier claimants in every inatance. ""' :, , : i, ,, # ', o .; ,"' , ,o I .-. -~ / ;.,. -.~::~Piil'aliY./-'1:Jie(tiew. -ii~i~i .apptci;:~-~-.t~----iQaa 'aiiocation .-. ..... _:: ... :-"' .. ~.--=-.. :\ .. .. -. -. --~-~ ... . .. ; ', _. ... ., : '. .. could reduce coats for aecurities -rket participants in cirCUJ1111tancea other than the ax post resolution of disputes and 347. Layers of explication do not necessarily add to clarity, much less simplicity. an Manning, Hyperlaxis and the Law of Conservation of Ambiguity: Thoughts on Section 385, 36 Tax Law. 9, 11 (1982): Elaboration in drafting doe not result in reduced ambiguity. Each elaboration introduced to meet one problem of interpretation imports with it new problems of interpretation. Replacing one bundle of legal words with another bundle of legal words does not extinguish debate, it only shifts the terma in which th debate is conducted. In physics, we are all f1111iliar with the Law of Conservation of Energy: in law, there is an analogous Law of conservation of Ambiguity. 348. S qanarally supra Part IV (discussing different tier priorities under pre-1978 and 1978 Article 8, existing Book-Entry Treasury Regulations, and Proposed TRADES Regulations). DOC. SWP1103 July 17, 1989
PAGE 364
169 tbe enforcement of rights. Indeed, past experience indicates tbat relatively few instances of actual priority conflict reaolution will ariae. Perhaps the aost significant effect of tbe new aodel's approach would be tbe establishment of certainty and predictability as to different tier priorities so that market participants could, with comfort, adjust their transactions and --~~7,~::~'-'~~~\~~~~--:~~-~-.-_.,._:.: ... -; ~---~ .. -~; ~ia4Fe~ _w'ith -~~-.-_for~o~~~ _an~iyais of_ ~e~e. -p~iori.ty issues , ., ' .' . .I . . under current law, the uncertainty that confronts market participants and their-counsel is undeniable. . . .-~ Obaena1:ioiaa .. . . ... ... ... .. ..... ... .. .; ,.,,. . .: ". . ... .. .... ... ... . ' ... -... -; :: .. _:,. ; . ,. Th~se: ~t. pars~i'Y' ~idenc .;of-aarket. behavior and .. ~.:.,-, .. -~_.t, . ~:~.-... :_ .,_,._. :~--~}: ... :_. : . :-.. < :.-_ .. .. : .:: -..--~-~-. . ...... structure that aupporta various assumptions and evaluations necessary to the claim that tbe new model would provide an efficient rule. But, like other efforts to apply economic analysis to law, the absence of empirical data and the simplicity of manageable models necessarily means that this claim remains uncertain, even if persuasive. Lawmakers, unlike scholars, must act baaed on the moat persuasive arguments and ayailable evidence (recognizing, of course, that inaction is itself a profound decision to leave the law as it is). In that connection, rejection of the new model because, like any priority rule, its wisdom is inherently uncertain would be paralyzing. That approach would defer to existing law by default. And it would DOC. SWP1103 July 17, 1989
PAGE 365
170 11i.th point that there is little to commend the arbitrary and fortuitous results that SOlletilles favor lower tier claimants under current law. a. AllalOCJU ucl coapariaou 1111der carrat Law ucl Doatrin Th new model is novel because it would not seek to ~~t~f.:~-~;t~t:~~-~~~tei /~t~i:,ot:~pz:o~y.-~ ~ .:our. ~ontii~ cla.iu ba~-on ~~~inea. ~~di as firat-in.:.tille and . . .. . .. . . .. .. . bona fide purchase. Yet it shares that novelty with the risk sharing formula 1;hat is the fundamental loss allocation principle among .... tier ~t011ers of an insalvent cur;tiea f_irm.349 . . . . . . .. '\ . .. . . . . . . . .' . . . .... JIDftaVer :=tJl teaUl-t tit~ th.-. n -~wcldai~s\i1SC:ird'1natio1f Of 1ower .. .. ,\ ..... -.,.-.! .,. :.: ,,._ ..... .. ; ....... -: ..... _.:. --~---::..: .. .... ,. :'. .. :. ... ..... : .. : ' .. . .. tier claiaa to upper tier claims-is consistent in many respects with reault that obtain under current doctrine in other contexts. a. Beqotiallilit7 ud Bona Pi4 Purchase Th new model is consistent with existing law conceming negotiability of securities in that it would leave intact the rule that a transferee of an interest in a fungible bulk through an intermediary cannot achieve bona fide purchaser status. It would change current law by modifying the default 349. I so1ra11y supra Part III. 350. I supra note 85. DOC. SWP1103 July 17, 1989
PAGE 366
171 priority rule of first-in-ti.lie that applies as a11ong non-bona fide purcbasers.351 'l'be uaence of negotiability i that a transferee of a negotiable inatruaent can acquire it fr of competing claims of ownership. The conventional visd011 baa long been that the attributu of negotiability are essential to c0111J11erce and trac;le .,~--.. ~-.-. c;i-itic .... o~ .-.~ -~d.~P.l!~t-ion ... of---.~--... .......... -... .. ..-.~~ .: :'~~:;:-_-.f':-'~"'i ... ,:-:~";~--.:.i -:t:_.:;~ ~--r--"':t~ -~-:--. ':"'-...... ,_.,. :--~ .... _. :" :-.. ... ?': .. ,: ; :.-. :. .. : ........ -. . .. . . .. . 3. Sa1 .. IPiU1t note 70;. i1 qan1rillj. supra Part. IV. 352. Under Article 3 a bolder in due course"of a negotiable instrwaent takes free of conflicting claims to the instrmaent (and fr of most of the obligors defenses to payaent). 11 "3-302, -305. Sl.Jiilarly, under Article a, a _c;:_~i.ficat..S .. ~ity. ~ a. ~JM190t:iatil inatruMnt and a bona .. f~~--.. -.-: .... ;--at,qal~-:~ -:intena~:-in, .. tbe, security free of ~Y .a~U11 .. c~~1a. . .. ,.11 .. ~105(~)-; ,.-~302.; IN aupra .not.. and acccmpanyiD9 text. A central component of the negotiability doctrine i the merger or reification of tbe obligations of the obligor or issuer of the instrument with the piece of paper itself. S.., ,q,, GilllOre, Th Comercial Doctrine of Good Faith Purchase, 63 Yale L.J. 1057, 1064 (1954). 353. In, ,q,, Rosantbal, Negotiability--Who Needs It?, 71 Colum. L. Rev. 375 (1971) (It is generally assumed, without careful inquiry, that protection of the good faith purchaser helps the flow of collJllerce.). For discussions of the historical development of the negotiability doctrine for commercial paper and investJDent securities pursuant to common law and codifications, see Gilmore, aupn note 352, at 1062-76: Gilmore, Formali-and the Law of Negotiable Instruments, 13 Creighton L. Rev. 441 passim (1979) [hereinafter Formalism]. It seems obvious that requiring purchasers of securities to undertake an investigation of the provenance of th securities as a means of achieving assurance of good title would impose substantial transaction coats and reduce efficiency. Nor would a filing or recording systa JDak sense. Ill supra note 131. But, it protecting purchasers were the only consideration in sorting out cmapeting property claims, then perhaps other personal property, such as goods and cho in action, should be made fully negotiable. Because a bona fide purchaser cuts off adverse clailla, the negotiability doctrine necessarily impairs the DOC. SWP1103 July 17, 1989
PAGE 367
172 negotiability doctrine in Article 3 acknowledges that negotiability i uaeful in a -rket where instruments, such as HCariti-, an actively traded. Article a experta bave proclaiaed that negotiability i a central, evan essential, eleaent of a legal regi.M dealing with transfers of aecurities.m But, if negotiability i so crucial to the 11arket1a operation, . ~.,rbY--.'d~_.., ~:.J.~--~'1"~J:--:~,:~!.~o:lua . ;--~~ue .. -.r:ket ..... :. ~~~c~pan~--t~--f.~rv~ -~~de_ sta~us?35' I o #, .. _... ..... .' -~ rlCJb~ f:--.ctv~ t:iabiailts;bc:ludincf those ttit:h l89i~iaate cJ;aiJul . _. lleqottilbil'ity~-t:ben, int*feres with the aec:urity of property interuta of preexisting claillants. When an owner of property does not have assurance that its interest is p~tected against IIUbaaqyent; claills, such as tho of a bona fide purchaaer, coats are illposad that can reduce the efficiency of a aarket. Bow the law d-1 vitb such conflicting claills ultimately 11USt reflect a balance between the interests of purchasers and preexisting claillants. 354. In Roaentbal, supra note 353, at 398, n.97 ("[T]here appears to be a strong c01111lercial need to continue the protection of the good faith purchaser of investment securities [wbicb] A expected to be transferred with some frequency.") (aphasia in original): 11 alag Gilmore, Formali811l, supra note 353, at 454 ([T]b law of negotiable inatruaents reflects the 11arket: if instruments, whatever their fora, do not circulate in a urket, tbe negotiability id-becomes irrelevant."). 355. In, Aronatein, Haydock, Scott, supra note 5, at 895-9, (observing, in reaponae to the quution posed by Roaenthal, aupra note, that juat about everybody that deal in aecurities" needa negotiability). 35,. outside of the few hundred securities firms and banks that participate in a depository-clearing ayst-, it is the nprm for aarket participant DS2ta to become bona fide purchasers. DOC. SWP1103 July 17, 1989
PAGE 368
173 There are at least two good answers to the question poaed.s First, the structure and operation of modem securities llllrketa i inccmpatible with the notion that transfer will routinely beccme bona fide purchasers. Second, even if IIBllY 357. A third answer is that negotiability is ngt crucial to the operation of the curi tiu markets. JaJ1es Rogers bas made a c~ent .armmant .to-this effect.: -1.a-~fra,--ff-.gotiability ..... a .. 's,,i1!a:'~:~fi~h.=~t1:iliri; ~-1, .. ~o"b'!c{ st: ~:~-~-.:l.91 ""(1f: .. : Rogers arguu tha~ negotiability dou no,t operate. as a title recognition ayat ... tor Articl -3 !utruaants drawn or ude to order or for Article 8 certificated securities in registered form, primarily because. th existe11ca of a forged indors-ent on sucti paper prevents a transferee from becoaing a holder in due course or a bona fide purchaser. 151., at 211-14. In the case of registered securitiu, Rogan explains .that the risk of prior ovnerahip ,al.~~-ara. aolved. lllt-~_..the. ~na ,fide .. purcbue rule but by r.rtt9isb:atio~-.I. aec:uri~i. on th~iaauen -boob-, theraby ~~-~inf t.he... ~f~N. to-.~. trN. -of .. any; claiJI, of unauthorized indoraaent. 1s1., at 214-15, n.72; a.. 1978 I 8-lll(a); pre-1978 I 8-311(a). Consistent with Rogers' thesis, DTC routinely re-registers deposited securities in its nominee's name. in OTC 1988 Report, aupra note 18, at 13, 27 ("Registration of securities deposits in D'l'C's Cede, co. noainee name enables the depository to: Proaptly determine whether certificates are transferable or whether replacement securities should be required froa the depositing Participant On receipt of registered certificates, quick transfer into DTC's noainee name, Cade, co., allows for prompt validation of certificates."). Issuers normally protect th-elves against liability to prior owners by obtaining signature guarantees covering all indorsaments. in Rogers, supra, at n.72; 1978 I 8-312(1); pre-1978 I 8-312(1). Rogers fails to confront the fact that payment settlement for securities normally occurs at or prior to the time of delivery, not at the time of a successful re-registration. However, bis arguaent can be saved because a transferee who is unsuccessful in an attapt to re-register because of an unauthorized indorsement also can rely on a aignature guarantee. That th syata thus tum on unsecured obligation of banks issuing signature guarantee further supports the new model' de-emphasis of property rules and underscores the crucial role of intermediaries in the securities markets. 358. supra notes 13-48, 82-85 and accompanying text. DOC. SWP1103 July 17, 1989
PAGE 369
174 iJlportant ..rket participants do not routinely achieve bona fide purcbaaer atatus, it -y be illportant that amga securities interaediari-becoae bona fide purchaaera by takinCJ phyaical deliverior through book entriu on the booka of a clearing corporation. Transfers on tbe books of a clearing corporation ll&Y ;~*~-~::~~-.t=--~ocJio, ... ~~-fc,r._~t.1w.rul~-ot.c:-new ,. . . . -IIOdel . Although auch:a tranafer can confer bona.fide purchaaer . . _.. . . . atatua, that resultto be equally as deviant from the paradigaatic physical delivery of a neg~tiable instrument as otber-tranafera of.interuts in a fungible bulk.effected on the ....... .... .-..,. .. ., .. ... .... . ...... ... . . ... .. :, ..... ;,.,: : -..: ::: -:: .' ... -~ 1 .. .:--:'I\.-~-~ ...... ..... : .... .. .: .. -...... .. . .~_.: .. .-.,::~. :. ,.'-:. _.._, .. : c-._ ... ;. ;.. ~----~--359. bA 1978 11 a-313(l)(g); -320; pre-1978 11 a-313(1)(e); -320; supra note 84. DOC. SWP1103 July 17, 1989 I .......
PAGE 370
175 boob of an intermediary. Because securities transferred on the boob of a clearing corporation generally consist of a fmlqible bulk controlled by the clearing corporation,1 the intert of a transfer.a would be subject to the proportionate property intereat rule of ction 8-313(2). Nevertheless, clearing corporations generally are not perceived to impose the . 'ho . , .;.. ........... l.. .......... :: .... : .:. ' . :..;. ~ ~--:~ ... .~-c... .;.~.: ."ti4~,/ -~~-~~:-.:..~* .... .,, .. ,I. -,., . _;, I > t--.; , .. .:"'~:,._--.,: .. ... -_ ~;. 1~ ;_,.1."': _; : .. _..,.,.. ." : .; ,-.,,. ':\... ... , , ,. .... ,. .. : ,I t , '"" ..... , , : o '' -, I o ~: .... -. . ... .. .... . : 360. in 1978 1.8-313(l)(d)(ii), (l)(d)(iii). Other than creating a transferee's expectation that it will receive the economic benefi'ts of an interest in securities, the transfer of an intert ina fungible bulk of curiti through, and on the ~-of~--~ tnt~mcdiuy .. (inclucU.nq. a.clearinCJ corporation) .-rm li~tl-:~~1-.n,,tlllblianc:. to. -1:ba pbyaical deli.very ot a .ap,cific .cuti.ficat.ad MC11rity to. a. tranaf.eree that becoaes a bona fide purchaser. The transferee on an intermediary' books nothing but the intermediary' confirmation, and even a confirmation is not required in the case of clearing corporation book-entry transfers. 1978 I 8-313(1)(g); pre-1978 I 8313(l)(e). A fungible bulk of aecuriti is the antithesis of a discrete certificate, and the transferee lacks any meaningful method of ascertaining the existence or size of the fungible bulk and the other claima that -Y be asserted to or against it. bA supra note 107. Because a clearing corporation normally has physical control of securities registered to its nominee, the transferee cannot effectively prevent it from later transferring superior rights to a third person. And, the transfer must be concerned with the creditworthine and integrity of the intenaediary. s11 qanarally supra Part III. 361. St supra note 52 and accompanying text. 312. ba 1978 II 8-313(2) (second ntence) (proportionate property intereat of claimant to a fungible bulk), (4) (clearing corporation i a financial intenaediary): pre-1978 I 8-313(2) (second aentence): supra notes and accompanying text. Note that because DTC i a banking corporation (a New York limited purpose trust cmapany) and i not a regiatered broker-dealer, neither SIPA nor Subc:hapter III would impo the riak sharing fonaulation on customer property were DTC to fail. S supra notes 221-22. DOC. SWP1103 July 17, 1989
PAGE 371
176 -credit and aiabehavior riaka on -rket participant aa tho b,poaed by other aecuritiu intermediariu. conceptual diatinctiona and aiailariti aaid, conferrinC) bona fide purcbaaer atatu on clearing corporation participant-tranafenu eto provide obvioua benefit to the 1111rketplace. Hot only dou the bona fide purchaaer tranfr -:~:pf-~~~-::,~--~-~-,:!~-.:p&n,~~~~ P.-;tlla:,c~rin.cr-.. . . . . .. . ~qao~tion~ tn"it, it .... f.ne of .ali .. ~d.vrs.. c~aiu .of all. lgwar . . . . . . . . . : . . tir claimanta in the chain below the transferor. Th quality .of~-inter .. t rcived by downstream.customers.of a clearing corporation participant-~ferH,. and other lower tier . . . ~-.... .. .-. . . . . .. .. ... . . .. . .. . ... : ... : ... .. . cl!Mnts:tn .... -~ drain" 'ttflij~"-tbtt 'traiurme/ ara ":, "":---~ :.: ', : w.", -.":: ~,,_ .. _.. :;~, Ill'!'., .. ,. ,., ,; indirectly enhanced by the cleanaing effect of a clearing corporation tranafer at the top of th chain. 363. Ho doubt that perception stm from the regulated nature of clearing corporationa, their ownership, and the fact that they do not trade in aecuritie tor their own account. an 1978 I 8-313(3) (defining clearing corporation): pre-1978 Sa313(3) cs-e): also Aronstein, Haydock, Scott, supra note 5, at 909 (To auggut that a clearing corporation would intentionally permit a participant or anyone el to acquire the power to tranafer ita aecuritie flies in the face of reality."). 364. s11 supra note 82. 365. Such downatream claimants benefit directly or indirectly fraa the ahelter principle. an 1978 I a-301(1): pre1978 I 8-301(1): gpra note 70. Moreover, clearing corporation participants would be unlilcely to undertake warranty and contractual obligationa to cuatoaen in the absence of aaaurance that they have received good title to securities involved. Sn infra Part v.a. (diacuaaing warranty obligations of securities intenaediaries). DOC. SWP1103 July 17, 1989
PAGE 372
177 The new odl fita camfortably with the clearing corporation transfer phenomenon. Indeed, tbe abarpest vision of bona fide purcbaaer treatllent for clearing corporation participant-tranafereu appeara fram recognizing that tb nee of auch treat11ent i -rely the new model writ mll. Priority for nch clearing corporation transfer is a subset of the more :i~~-,.~~-~~~-~~:~~~~~~y.,;;,.tq.:e;:~~---~--~~-~ta~Althouqh_the_nev.llOdel genaraily're.jcta bona _fide purchaser .. ,. . . .. . .... .. . .. . treatment for transfer of interasts in fungible bulks through intermediaries, transfers through clearing corporations are u~ptional for one simple reason: Transfers on the books of a '. ~.. ... ......... ,.:_ .. 'I., .... ,..~,. ...... . ... .. _.: :-. ... ~-'c:iearuw, .. corpora'.t,iona menially occar onlyat -th-tml tie;:.366 ;., . ;_ . ,Ill~ : ..... ., _._.' ..... -': 1' . 366. Assuaing a clearing corporation is at the top tier, the same result would be obtained under tbe new model whether or not bona fide purchaser status were conferred on clearing corporation book-entry transfer As a technical matter securities transferred pursuant to 1978 and pre-1978 8-320 can be controlled by a clearing corporation through a custodian bank or another clearing corporation and, consequently, are not neceasarily at the highest tier. 1978 8-320(1)(a): pre-1978 8-320(1)(a). This approach can be rationalized on the basis of the inherent safety perceived to be associated with clearing corporation control generally. Ill supra note 363. 'l'he wisdom of bona fide.purchaaer status for clearing corporation participant transferees l been questioned, apparently on the basia that clearing corporations are conceptually the same as other financial intermediaries. Aronstein, Haydock & Scott, supra note 5, at 909-10 & n.99. But the vision of a clearing corporation at the top tier effectively neutralizes this critici-. Bona fide purchaser status for a transferee under 1978 I 8-313(1)(c) (customer name securities) and (d)(i) (specifically identified certificated securities) also conforms to this vision. au 1978 I 8-313(1) (c), (d)(i): pre-1978 8-313(1)(b), (c). Becauae such a transfer' intermediary (though it i not a clearing corporation) is in p0111ssign of a specific certificated aecurity, that intermediary necessarily is at tbe DOC. SWP1103 July 17, 1989
PAGE 373
178 The new model enhances and complements the negotiability doctrine aa embodied in Article a by providing a priority ch-, other than firt-in-time, a among market participant. that do not achieve bona fide purchaser tatua. And it provide a clearer doctrinal explanation for Article as treatJDent of bona fide purchaser status in cases where the . --~iii-,. .. _' ... vefflP--na,;.a'di~ ... _~ n.;._. .. -it.p1 y :; . ._. :,. ., .. ; -: . . ;._: .: -.... ~~:--'~~.. -.... ...-,. -: .. ~~----" """"~~..... .._. ...... :. ..... ..... ......... . . .. It. lbltrutaat-~d-tlle Likes Patting caooa. and lecuriti "In Playn :An "entrusting of possession of goods to a merchant who deal in goods of that kind" ~en.the merchant to transfer ._ ... ,. ,' ., .. ........ ~-"', .. ~. ., ~: .. an rigl)ti:' ~t .. :tJia : en#,iator -~,,.-.... buyer_n ordin~rs/ couriita ci"t .. : .. 'l -~ : : ... ;,_,: buainess.317 'l'hi entrustment rule recognizes that, as between top of the chain and there can be no upper tier claimants. To the extent that the doctrine of constructive possession is applied in this context, however, the analogy admittedly is weakened. See supra note 242. Bona fide purchaser treatment for transferees of specifically identified securities also has been criticized on the basis that risks are greater when securities are controlled by "ordinary" intermediaries than by clearing corporations. Aronstein, Haydock, Scott, supra note 5, at 910. That treatment can be rationalized by recognizing that such identifications are unusual and normally occur only in the process of making a physical delivery to a customer. l.U Appendix III, infra, note 14. 367. I 2-403(2) & (3): Dtl I 1-201(9) (defining "buyer in ordinary course of busines): see generally R. BROWN, supra note 220, I 9.7, at 202-06: Leary, Sperling, The Outer Limit of Entruating, 35 Ark. L. Rev. 50 (1981). For a critical view of the reach of the entrustment doctrine, see Gilmore, The Good Paith Purchase Idea and the Uniform Commercial Code: Confessions of a Repentant Draftsman, 15 Ga. L. Rev. 605, 618-19 (1981). DOC. SWP1103 July 17, 1989
PAGE 374
179 the entruator and certain buyers, the loss should fall on the entruator. The new modal embraces a similar result. By allowing ita securities intenaeciiary to control its securities, a lower tier claimant has put th securities "in play, and the new modal would subordinate the lower tier claim to that of upper tier transferees. \~ -:= :_..~~;;,,;..;f~,;~~=~:~~-:~~~~:._:~tl,-:.~:-,~~~~~---~.i~,~--:.to :~ f~~_c-iple of :tli~-.en~-~-~~ -p~radigm, .it ;V~~-i~s fro~ ._it. in certain -tters of . ' . : .. . .. . . .. -. . . det~ii. There are ~ther u.c.c. analogues to the new model that also subordinate or cut off the rightsof those who put property ~n play,369 although these analogues also differ in detail and ................. ... ......... .. ,., .... : . .. ..... ........ ... ...... ~. .. ."T.'."'. : ....... . ;:ontext f~. ~, -new .aoclel-.: aut it ia clar enough that the new -. . . ; I ' ,,, o ' ',lo:I'', ',~':.,, I ,' (." :.,, .-., ',,, .'',, ,_., ,; ,. I 368. The differences flow from differences in context rather thar. principle. For example, the entrustmant rule favors a comparatively narrow class of beneficiaries --"buyers in ordinary course of business. sea supra note 367. The new model would provide priority for all upper tier transferees, including a secured party--who could not qualify as a "buyer in ordinary course of business." In affect, the new model would conclusively presume that transfers between and among securities intermediaries and investors are ordinary course transactions. 369. For example, one with property rights in goods that pre-date the bailment of the goods and the issuance of a negotiable document of title generally will retain senior rights in the goods even if the document is subsequently duly negotiated. II 7-502(1), -503(1). But, when the earlier claimant to property rights has itself put the goods in the stream of commerce, its rights will be cut off by a subsequent claimant to whom the document is duly negotiated. 7-503(1). The interest of a consignor of goods delivered to another person for sale also may be subordinated to claims of creditors of the person in possession of the goods unless the consignor complies with certain public notice requirements. I 2-326. DOC. SWP1103 July 17, 1989
PAGE 375
180 model i in the mainatream of a general principle that appears in varioua ahap and forms in the u.c.c.--one who puts property "in play -y be expoed to having its righta cut off or ubordinated by certain cla of later-in-time competing claimants. a. lloney and Bank AGGOUll~. The treatment of money and bank accounts also provides .u~---t~'; .... ~,r:.Jiod~:~!\:J1on..y:,~.,~aJUt...t~ .. :"c;:0Qait-larqely ... : : .. : : :: ~'-.'7 .. :."'. .' ..... : ., .. '. . . . .. . . o '. I .. ,,I o 370. -. Aa to upper tier claimants that are earlier-in:-1:ime, -.nmordination ,: of J:'owar tieri~. C'lailian~'. followi '.'froii. the 'ngp. dat principle .. l-upnnote-~,, t "alaoc:onfonia to certain proviiona of the u.c.c. and other law that may apply when a buyer leaves a llar in possession. For example, the better (but not uniform) view is that a buyer will not be entitled to "buyr in ordinary course of business" status unless it obtains possessory rights in goods (which normally mean that delivery must have occurred). a.a Frisch, Buyer status Under the u.c.c.: A Suggeated Temporal Definition, 72 Iowa L. Rev. 531, 556-67 (1987). The retention of possession by a seller also might constitute a fraudulent conveyance. In, e.g., Mooney, supra note 93, at 726-29 and authorities cited therein. And the denial of senior rights to such a transferee of securities is consistent with the most appropriate analogue of all--denial of bona fide purchaser status under Article 8. see supra note 85. 371. Tracing the evolution of money and payment mechanisms from the exchange of tangible currency (including privately issued negotiable instruments) to the exchange of unsecured clai .. against banlca (deposits) is beyond the scope of this article. See qenarally w. CARLILE, THE EVOLtJ'l'ION OF MODERN MONEY (1901, reprinted 1967); J. HURST, A LEGAL HISTORY OF MONEY IN THE UNITED STATES, 1774-1970 (1973); J. GALBRAITH, MONEY, WHENCE IT CAME, WHERE IT WENT (1975); J. MELITZ, PRIMITIVE AND MODERN MONEY (1974). Yet even an exceedingly superficial consideration of the role and legal contemplation of bank deposits in the payments syt-may provide some insights for the securities world. DOC. SWP1103 July 17, 1989
PAGE 376
181 of unsecured claims against banks--deposits.m 'l'he inadequacy of physical deliveries of currency as a means of payment in a cmaaercial aociety i obvious. Adopting a legal regime reflecting a property construct that mandates tracing property interet in currency to deposit that are ultimately "owned" by a bank depositorridiculous. t::;_::.::f:,:\~ .. ;,-_;~r~:, ~ff~~:,'.~~-f.;~,--;r~~~i~,.,f :;~ol v~n~y on cuatomer of_ th~ interied:iary well aa modern ~curities I 0 ; f .., , \ I market operations and.practices each bear much in common with . depositor claims again~t an insolvent bank and transfers of m~ney. Small customer _claims, like small depositor claims, are i1fote~ed~bY.::-. :i:~~-:~( :~-~~~~--,~: .. .If .. there a~e. insufficient o 0 I 0 ', 0 : ' I : '. ,: ' , 0 : :, .,-0 o '-t 0 ' 0 curities to satisfy customerclaima, moat customers will share PEP rata,m as is the case tor uninsured depositors in a bank 372. A bank deposit normally creates a debtor-creditor relationship between the bank and the depositor (customer). ill 9 c.J.s. Bankings 267c, at 546 (1938, supp. 1989). The proposed new u.c.c. Article 4A--Funds Transfers provides a striking example of the extent to which claims against banks typically constitute money: A payment to a payee is completed when the payee' bank becomes obligated to the payee. 4A104(1) 'COJIIJllent 1. 373. Deposit accounts up to $100,000 are insured by the FDIC. 12 U.S.C. I 1817(1), 182l(a) (1982): 12 C.F.R. 330.2, 330.10 (1988). see supra note 188 (SIPC protection for customers of registered broker-dealers). 374. see generally supra Part III. DOC. SWP1103 July 17, 1989
PAGE 377
182 insolvency wbo are treated as general creditors.m In many (but not all) ca claims of customers of a securities intermediary will be junior to claiunt that are transfer on an upper tier, and, in any event, tracing of property interests in curities is often illpracticable. If a bank or a securities firm fails, depositors and customers alike may well be losers. : r /-:i;c:,::. :::;,: ;.;-:~~-~~lf.\~.~--~ ... ~.: .)iapP~i .. t~iq~a~ .. : 4D~-.l~CJa::l ~if~-r~~~--. be~~en ;a~ney a~i; ~-poi~ and ti~ claimed . through intermediaries.Jrr But consider that securities generally were not treated as.negotiable instruments ~til this century.371 And only in laat fa~ decades have securities market practices and vol~-; ~-t~ilted. that phyical 'deliveries and "the ... .-~ ......... .. .,.. .............. .. ... '._ .. ~. ,'.375. 12 u.s.c. s 194 (1983); DA Macey, Garrett, supra note 322, at 217; Note, supra note 322, at 617. customer claims in respect of customer property, however, are senior to general c1:-editor claills under SIPA and Subchapter III. sea supra note 191. 376. see generally supra Part IV. 377. Because money is inherently fungible, depositors' claiu against banks are fundamentally different from claims to specific types of aecurities controlled by securities intermediaries. Indeed, money is the medium through which all claiu ultimately can be satisfied. Moreover, banks create money: bank d&posits are not "backed up" by equal value in currency or other reserves of money-like quality. &u, e.g., M. STIGUM, THE MONEY MARKET 13-15 (Rev. d. 1983). In Article 8 terminology, banks are the issuers" of deposit obligations. Securiti, however, are not auppoaed to be created" by curiti intermediaries (although fraud and mistake may yield that result in the ca of intermediary inaolvenciea). 378. saa generally Gilmore, supra not 352, at 1012-16. DOC. SWP1103 July 17, 1989
PAGE 378
183 routine eatabliatment of issuer-beneficial owner relationships are not feasible.319 Because the functional similarities of bank depoaitor and aacuriti intenaediary-cuatomar ralationahips are of auch recant origin, it should not be aurprising that the property construct persists so strongly in the legal regime for transfers of curitiea. In this sense, the new model can be ::o:t-.:~-. !:~-~ t~. ~ realities oriaa~ket expectati~n and behavior. .. . .., . ... . . . d. Olaarvationa Where the new model would override the first-in-time principle it is genraily analogous to corresponding exceptions ~0-:.~~~--~-.in-.-~-u~c~c~~--. 0Tb-i~--9~n~ral ... ~onformity with traditi~ri. doctrin~ ~n~s"~~~t--law doe~ .. h~t, alone~ d-onstrate the wisdom of upper tier priority. Yet this consistency provides powerful support for the new model's approach when considered together with economic analysis grounded on reasonable assumptions. Th harmony indicates that the new model is viable baaed on practical as well as conceptual grounds.311 It also 379. Saa supra notes 5-6, 18 and accompanying text. 380. ID, JL.Sla., supra notes 359-70 and accompanying text (bona fide purchaser status for clearing corporation transferees and entruatment doctrine). 381. Because the new model contemplates a change in law, it cannot claim complete support from the existing legal regime. But it can be characterized as an evolutionary step that would conform the law to existing practices and expectations. bA Clark, Abstract Rights versus Paper Rights under Article 9 of the Uniform Commercial Code, 84 Yale L. J. 445 (1975). Clark DOC. SWP1103 July 17, 1989
PAGE 379
184 au99uta that the new aodel i not likely to conflict with widely beld noraative views. . 1 :.\i ... -....... '-,-:.~.-.-.;.: .. .~ ,, . ~~--~: ... .. ~.-;,_,:_ -'("' ... .,-,:_1: ._. .. ,... ,_ k-;~ ..... : .. .,,,, ...,. ,:~ .. ,& ~:--i :a. "'' -~, -.~, 0 ;;..::. .: ........... . :' .. .-"_". .. :-"-. .~--' .-:_ ........ _. ... :. ''-~~ ---~--... -.:-: . ~. ;#, -~"'._. ... .... .. _;. -:,..-; .... :... :"' ;: ~... .-.. , ,,I ...... ____ ..... : .. ... ., .. "' -~ .. / .. :.~. ;,. __ ., .. .:-,-.... ,.",o I' I' . , .: .. . . .... . .:_ .. .: . ,,_ ;_. analyzes the "paperizing" of abstract rights into a single piece of paper (such as a negotiable promissory note or a certificated aecurity) and th more "advanced" recording principle" whereby priorities are determined by a aysta of public notice. Isl-, at 478-79. Clark concludes that no particular principle for ordering priorities i necessarily superior in all contexts. ld-, at 475 ("0n must look instead for the priority rule which, within a mixed systa and in particular context of commercial practices and expectations, will moat efficiently reduce coats.). 382. ID Phillips, supra note 229, at 290 ("[T]he commercial culpability acale [a normative pattem in the u.c.c.] can be a powerful tool botb to understand current co-ercial law and to identify areas for legislative reform.). DOC. SWP1103 July 17, 1989
PAGE 380
185 a. ft 1':lrat corollary: Broad J:ntezaetiuy warrut:l Th new aodel' basic principle cont-plat that the tranfr of an interut in a fungible bulk of securities on the books of an intermediary uy look only to that intermediary for satisfaction. It !1lllows that, as a general proposition, the ::~~t-~~,~-.. -~~~,'J~~:--~~~ --+~~Bf.._.~~~~1~~u.d -~.con~l~*:.~itiea..traftat~ed-to tb tranaf.erea in a .. : . ., . . . . . : . . . . .. . ~ . .. . . . . . _.. . . 'sufficient quantity and free of adverse claims--in effect, a warranty of good title. In the absence of a broad warranty of good title, th existence of an upper tier adverse claim might ~j,i~:.n,_o:~tia~j ~---~ au. ;'even ,though its . . . . . . iiltena.idiary ~--i~ed ~ol vent' -~a 'vlabie. -A broad warranty of good title would recognize that the intermediary, rather than the transferee, could reduce or avoid losses arising from adverse claims for a lower =ost. It would 383. The obligations of the intermediary could, of course, be made the subject of a contract with its customer. And in many situations an intermediary will be required by applicable law and regulations outside of the u.c.c. to uintain control of customer securities free of adverse claims. see supra notes 56-57 and accompanying text. 384. see supra note 310. By taking possession and examining the securities to ensure that a good delivery has been made, or by receiving a transfer to the account of the intermediary with a clearing corporation, the intermediary could ensure that it achieved bona fide purchaser status. or, the intermediary could choo to receive a transfer of the securities in its account with another intermediary that is not a clearing corporation. In the latter case, the intermediary could protect itself (and the transferee) by choosing its upstream intermediary DOC. SWP1104 July 17, 1989
PAGE 381
186 encourage the intermediary to control securities for the transfer in a aanner that reduces the risks and costs of advn clailUI. And the warranty received by the interaediary froa ita upstr-intermediary would enhance th~ ability of the interaediary to give and honor its own warranty to the transfer The first corollary not only follows from the new . :-.clal'--~~:-Pz:inp.ipl~lt~1:.:Al~.waulcl,~~i~ _,from. that .. . .. . . . . . principle because-. the s~~inati~n of lower tier claills would .. . . . facilitate warranties by intermediaries. Although Article a imposes certain warranties on transferors of curitiu, in at least tbr respects Article 8 -uy" tail" to c:on'fcma .-1U:t11 th, t;road tarranty enviaioned by the . , . : : : . .~ .. :;._. "". . . : ,. . . . . ~. . . . : . . ... . with care. The transferee, on the other hand, would have little or no control (except by contracting with the intermediary) over the means of protecting against adverse claims. In addition to inducing care on the part of intermediaries, a broad statutory warranty also might encourage ir.novation in the marketplace that would further reduce the incidence of adverse claims. 385. The absence of such warranty obligations could present a moral hazard problem. The intermediary could choose to control its transferees securities in the least costly manner, even if it were risky, in order to reduce its own costs. The existence of adverse claims would be riskless to the intermediary. 386. Returning to Example 1, the new model would award seniority to I-2 and to L, as I-2's transferee, as against lower tier claims by tranfr from I-1. I-2, then, would incur less riak in making a broad warranty in favor of L because I-2 need not worry about lower tier adverse claimants, such as c, who are claiming through I-1. 387. au 1978, pre-1978 s 8-306; see generally GtJ'rrMAN, supra note 11, at 6-5 to 6-9, 6-21 to 6-25. DOC. SWP1104 July 17, 1989
PAGE 382
187 first corollary. First, Article 8 does not expressly provide that a transferor of a security gives a warranty of good title. Rather, a tranaferor of a security varranta to a purchaser for value that the transfer is effective and rightful. Properly construed, however, rightful should encompass a warranty of good title and freedom fr0111 adverse claims. :~}_-~~,--~;.,_~-;/~"-1na-:t.:11:l_301~ftfr~1 .. :ctr~tii~~: ~t.c~~ifi~tecf-'' ... .. ., -~iq'l:1 .11:"1_8a:l .~306(9_) ._(tnuf~r .. of. uncertificated aecurity, who-does not originate an instruction). The transferor of an uncertificatad aecurity who originates an instruction, however, warrants to a purchaser for value that the-transfer will be registered by the issuer free from all liens, security interests, restrictions and claims other than those specified in the instruction, and, in addition, that "the ,~ted .~fer.-~~11, b.a. righUU]., ~I 8-3.0fi (7) .(c) ( ii) ( iii) DoM .. thi,_,.illply ~t ... ~rightful':' is. .wbolly_ aepante concept .tbat doea.J'.lot .. en~oapa good _t~:tle. and. tree. of adverse claims? (The concept.of good title is not mentioned in 8-306.) Th official c011111ent indicates that no such implication should be drawn. bA 8-306, comment 7 (The warranties [under 8-306(7)] are similar to those made by one transferring a certificated security, subsection (2), the principal difference being the absolute warranty of validity): see also Reporter's co-ant, supra note, 8-306, at 846 ("Subsection (7) is essentially identical to the warranty of the transferor of a certificated security under subsection (2).). 389. bA Morgan Guar. Trust Co. v. New England Merchants Nat'l Banlt, 438 F. Supp. 97, 101-02 (D. Mass. 1977) (when bona fide purchaser of security re-transferred to second transferee, second transferee took free of adverse claims and, therefore, 8-306(2) wa~ranty of rightful" transfer to second transferee was not breached). Other provisions in Article 8 support this conclusion. bA 1978 8-302(2) (defining adverse claim to include claim that the transfer was or would be wrongful): 304(3) (purchaser's notice that security bald for third person or registered to or indorsed by fiduciary "does not create a duty of inquiry into the rightfulness of the transfer or constitute constructive notice of adverse claims): -315(1) (remedies of person against whom the transfer of a security is wrongful") & (2) (remedies of owner of security when "transfer is wrongful because of an unauthorized indorsement): see also 1978 8-306, DOC. SWP1104 July 17, 1989
PAGE 383
188 The cond poaaibl deviation is more problematic. Bven if the tranaferor warranties are aufficiently broad in acope, it i not clear that an intenaediary that effec::ta a tranafer on ita boob i, itaelf, neceaaarily a transferor." Conaider the transfer of a aecurity interest to Lin Example 1.JP1 The loan and underlying security agreement was between I-1 and L, ~-.-~~.:-.~~~~\~.-.o~::b~~:-.o,!;.-;t.~2-.:(~o_::va~.--~ a. party ta th ~erlyi119. transactio~) . All' aspects of the : tranafar were within the sole control of I-2, however. As to the transfer, L knows only that it received a confirmation from I-2 and that, under.its-agreaaent with I-2, I-2 is required to . . .. . . . . . . . . : 'ri'fiect .thi -~f'u'ori: its'boot.-.;19.:. s:"t'..;;% the:.1:ftnstaror to L? . ... .. ;.. . . . .. . , -. : : -:~: .. .. . . ... Is I-1 the transferor to L? Are they both transferors to L? Is c0J1111ent 7 (quoted supra note 388). Provisions elsewhere in the o.c.c. also are supportive. b,I I 2-312(l)(a) (warranty by seller of goods that title conveyed shall be good, and its transfer rightful"); 3-417(2) (a) (transferor of instrument warrants that "he has good title to the instrument and the transfer is otherwise rightful). Guttman agrees with the conclusion stated in the text except that he extracts a warranty of freedom from adverse claims from the word effective. in GO'l"l'MAH, supra note 11, at 6-7. 390. Th warranties to such a transfer are made by the person wbo transfers the securities. II 8-306(2), (9). 391. see supra pp. c114-1s1. 392. bA 1978 I 8-313(l)(d)(ii) (iii). 393. 14. DOC. SWP1104 July 17, 1989
PAGE 384
189 I-1 the transferor to I-2 and is Id. I-2, in turn, the transferor to L? Article 8 provides no clear answers to these questions. Even if I-2 is not a transferor, I-2 will -ke the -~ varranti--d by a transferor because I-2 is a broker, acting as such, in this transaction. Assuming an intermediary that effects a transfer on its books is not necessarily a _:~f --~~t --~~ .. ~' varranu .... if. .it. 1. not ac:ting .. ~-. l,~ker, .. the" definition. of ... -.. -.-.. . . . -. .. . . -. . 394~ Although 1978 Article 8 expressly provides for transfer of interests in fungible bulks of securities by -~~~iary._~_k .ezi~i-~~.-.it .~i~ ~Q follow .with a treatment of -~c;, ~s:-~ ~f.~r. _fc,~.purpo._-of: .. ansferor .. warranti \ .... s.-' an i,,, ,,, a-30,c10, A broker gives to bis customer and to the issuer and a purchaser the applicable warranties provided in this section and bas the rights and privileges of a purchaser under this section. The warranties of and in favor of the broker, acting as an agent are in addition to applicable warranties given by and in favor of bis customer. "Broker" is defined as "a parson e~gaged for all or part of his time in the business of buying and selling securities, who in the transaction concerned acts for, buys a security from, or sells a security to, a customer. 1978 I 8-303. 396. Section 8-306(10) implies that an intenediary affecting a transfer on its books is not necessarily a transferor; otherwise, imposing warranties on a broker, as such, might not be necessary. Under this conceptualization, I-2 would be acting merely as an agent of L, a disclosed principal, and as an agent for I-1, another disclosed principal, as well. But it is also arguable that I-2 should be treated as a transferor. Imposing warranty liability on intermediaries acting as brokers can be viewed as merely a means of overriding any arguments based on agency that an intermediary should be relieved of otherwise applicable warranties. DOC. SWP1104 July 17, 1989
PAGE 385
190 financial intermediary contemplates that some financial interaec:liaries will ngt be brokers. Third, transferor warranties extend only to purchasers for value. 'l'h basic principle of the new model is groundec:l on the notion that a claimant can best protect itself by careful selection of its intermediary. consider, then, the claimant that ~~-~---~J'.U.S=~;~,:.=;: o~~---~l~ t.t~ied .1rith:, .. its .. ~.. : .,.: .. intenaediary. -. Such a. claimant_ might request its intermediary to transfer securities credited to its account to another, new, intermediary who the claimant desires to control-its securities in the future. Surely it i just u crucial to the claimant that ... -.. .. .. :. .. .. .. :.~ :...r. .. ,.,:.,, ... :-.;-:" .:. ::J.: .. -....,,. ...... .;,,. ,. ~,. :. ,.: :"\'p -: ... -.: ; _., i~-! .. ..... -..... : :' = .. -.. : .. .. .. ,: 397. Although it would seem that a financial intermediary effecting a transfer on its books would always be act[ing] for a customer, some financial intermediaries, such as certain custodian banks and clearing corporations, may not be "in the business of buying and selling securities. in I a-303 (defining "broker) (quotec:l supra note 394). Yet it would be anomalous if such an intermediary, normally viewec:l as the safest type of intermediary, would not be held to any warranty liability. Certain intermediaries are expressly relieved of transferor warranty liability pursuant to I 8-306(3) when "a certificated security is delivered by an intermediary known to be entrustec:l with delivery of the security on behalf of another Such intermediaries warrant only their own good faith and authority., 1978 I a-306(3): 111 qenarally GUTTMAN, supra note 11, at 6-22 to -24. (But I 8-306(3) would not apply in the normal book-ntry transfer that involves no "delivery." ,bA supra notes 76-78 and accompanying text.) Considering that such intermediarie do make some warranties, it seems unlikely that Article a would entirely abaolve non-broker intermediaries effecting transfers on their books from warranty liability. Thus, the better interpretation is that such intermediaries are transferors when they effect transfers by book entry. 398. I 8-306: HA I 1-201(44) (defining "value). DOC. SWP1104 July 17, 1989
PAGE 386
191 it receive warranti of good title from the new intermediary, even tbougb the claiaant baa not given value (other than a tranafer f, perbapa) in connection with the new tranafer. The new intentediary i (a waa the old) in excluaive control of th aeana of receivi119 a tranafer and controlling the aecuritiea. Warranti illpoaed by the propoaed TRADES Regulation ~9r;. ~~,~:.. ~,.o .J~-.. PrC?J;,1...-~i~. tr;. . ... : "~-:~ .. ,,~. .... . .,_, ....... -... "-! -.,-~ ., .: -~ --. .. ...... ,.' .. .-_:., .. ". .. .. ,. . .. . po~_ialr -.PP:J.ic;atio~,. _iDterpr.e~tj.an . _.ruulta. . In certain .. . . . 399. For an extr ... example, suppose that the new intermediary cho to allow the old intermediary to continue to control the curiti a part of a fungible bulk by ~ly crediting the new interaediarys account with th old intaned~ar,y._ .. If .th ~i~i~.vare already .IIUbject to an V.~. ~-~, tba:; clillant .. cc;mld .be. diNdvanta9ecl becaua the _n.., .. inte~iary ... ~OM riot .. ~o .ncaiv aecuriti in a unner that would afford bona fide purchaaar atatua to the new interaediary. 400. Unl th book-entry custodian i itself a tranaferor, the warranty made by a book-entry custodian "[i]n connection with any tranafer of a curity coven freedom from adver claiu granted by the custodian (unl diacloaed) and tho of which the cuatodian baa knowledge-but it fall short of a ccmplete warranty of good title and freedom from adver clalJu. Propoaed TRADES RecJUlationa I 3!57.17(a). If the book entry cuatodian i the tranaferor, however, it additionally warrant to the tranafr that the transfer i rightful and effective (i,t,, a warranty of good ti~l and freedom from advar claiu). Propoaed TRADES Regulationa I 357.17(b). au aupra note 389. A tranaferor who i not a book-entry cuatodian also make the rightful and effective warranty. Propoaed TRADES Regulationa I 357.17(c). Presumably, when two parties to a trade are known to each other the tranaferring party will be a (non-book-entry cuatodian) tranaferor for purpo of that warranty. But the TRADES frmvork fail to illuainate th cil"C'IDl8tancu that will cauae a book-entry cuatodian to be a tranaferor to ita cuatoaer. Preaumably if the cuatodian i a dealer, or, perbapa acting a a broker for it cuatmaer, it will be a tranaferor, but there i no analogue tot a-306(10). In aupra note 395. It atrongly auggeata, however, that a clearing bank or cuatodian that act only to receive tranafr of DOC. SWP1104 July 17, 1989
PAGE 387
192 raapecta the TRADES warranty proviaion do not conform to th new aodal' tint corollary. Tb propoaad TRADES Regulation alao contain an unuaual prohibition of diclailler and liaitation of varranti. Warrantiu under Article a, on the other hand, 9enerally aay be varied by agreaant.411 Althou9h the firt corollary contaplat a baaelin rule that would allocate lo ... /~C~i':,~: .who,-;~_ec,t;:~-~--~.-~i~.-~OO~i:.-bllt . it _:_: . . doea not toilov. that .th! lo. --~location bo~ld be inflexible. Broad warranti provide fallback rules that, when modified, force affinaativa discloaure and explication of deviation from tbe atandard-. At lea~ a UIOIICJ profional wbolual urkat .. . ~ . . , . . .. i-rticipailta,. 11:'IIOUlCI ._''that the --~tlir ;-ot ita~antie couid. ~:_I .'I. . . ',1 t ., _I, ,,.!, ';', ', > '.. i ;, . be left to agre-ant of th parti Notvithatanding the rationale for the firat corollary and the foregoing critique, uncertainty a to the acope of tranateror warrantiu and any defecta in regulatory protections do not appear to have given ri to many problems or disputes. The warranty proviion under Article 8 have figured in few reported deciaiona relating to freedom from advr claim. There are aaveral plauaibl explanation for tbi phenomenon. curiti for ita cut011er will not be a tranaferor and, conaaquantly, will not uk a warranty of good title and freedom fr011 adver claim. 401. Propod TRADES Regulation I 357.17(f). 402. I 1-102(3). DOC. SWP1104 July 17, 1989
PAGE 388
193 Perbapa -rket practice and aor appear to bav dictated that aolvent and bont intenaediari do not k to pa on riaka of advene clailla to their tranafer and c:uatoaen.411 And when an intenaediary beccmu inaolvent a warranty claim would achieve only the atatua of an unaecured claim in any event. But the paucity of litigation doe not undermine the importance of the ~F.+~~!!.q~~~-~~~~=;>:.-~~.-:.~~.f P..~-~ .l~-~t;.: ... ~~~----~.i:~~ .. -~ ~-ic _. : .. .. principle-~.-the--~ .IIOdel: .. b~d. ~ep, the fi:1:'9t c;:orollary -in. .. ind. The rationale for allocation of loss to lower tier claimants vis~a-vi~ upper tier claimants necessarily requires, as a baaelin rule, the ultimate allocation of lo to the .. ., . . ......... . ... "\,. t''" ... .... ~. . ......... .. ~... \ inta~iaria .,qt incaa, .low~: ti~ .claiaanta .... :. ,._ : .. : .... .. .: .. : . 403. [Interviewa.] Moreover, transferor warranties, a. u, are only part of t?le picture. In organized markets a form of broad warranty generally prevails among market participants. When a market participant transferor fails to conform to standards of "good delivery" tbe transferee is granted a right of "reclamation." s11 generally GUTTMAN, supra note 11, at a-31 to -37. And after a transfer that complies with all applicable warranties and delivery standards, customer protection rules dealing with segregation and control of securities by intenaediarie afford additional protections. s11 supra notes 56-57 and accompanying text. 404. Another fona of risk posed by intermediary control of curiti alao warrants attention. Assume that a securities iu~ pays dividends, principal or intarest to security holders of record and thereby i diacbarged of its obli,1ation. AssWDe further that a diaruption in the payment ayatua (perbapa caused by a bank failure) prevents a lower tier claimant's intermediary frcm receiving that payment for redistribution to its customers. It i not cl-r who would bear the lo Perhapa th matter is beat left to payment law entirely, but certainly this risk ought to be adclrd and dealt with. DOC. SWP1104 July 17, 1989
PAGE 389
194 c. ft aeaoad coroll&r71 aellior:lty of Opper 'l'ier ft-fr otwitlaat-d:la9 ot:lae or lblowled9e of Lower 'lier &clTene Claiu 'l'h aecond corollary would pruerve niority for upper tier claimant over lower tier claillant to intrt in fungible bulJca of curiti, even when an upper tier tranfr baa ~~~-~J'-r,:~~~;;w;t~-:";;l:OV~~-~i~ -~.cl~raa: c:Iaia,~.:_:::At; -fitat .. . .,. . .. . . . . blush-the:. cond coro1lary'. vo~ci: t~ at -~ck ~ith basic . . . . notion of bona fide purcha in the u.c.c. But the second co~~llary i novel: .only_ in._ degree .. rather. than in character-. Prioritiu a maong -cured.creditora tum on th time of filing . . . .. .. . . . . . .. . : .Z.. pd'feation i;ttllastiu: .:of tnov1'4ge::bJ' a~ party of an .. ": ... .. ~. ~. : .. ... _. . : .. ~;-_; . ,.~ ~1. :-~. :i~ ;,'..~_,. .:-,~-:_ . '. .. .. : ... 405. Although the property rights of the upper tier transferee would be protected under the second corollary, it does not ncarily follow that the upper tier tranfr would cape liability for wrongful its behavior. s11 infra notes 413-14 and accompanying text. 406. In, ,q,, II 3-302(1)(c) (bolder in due course must take instrument "without notice of defenses or claims to it"); -304(1) (what constitutes notice of claim or defense); 7-501(4) ("due negotiation requires purchaser without notice of any defense against or claim to negotiable document of title); 8-302(1) (bona fide purcbaaer of security must purchase "without notice of adverse claim"); -304 (what conatitutes notice of adverse claim). "Good faith" of a purchaser also sometimes encompasses the absence of notice or knowledge of a competing claim. an, ,q,, Johnaon, Jobnaon Prada., Inc. v. DAL Int'l Trading co, 798 F.2d 100, 103-04 (3d Cir. 1986) (The relevant legal queation wa "[w]hetbar [th purchaaer] aubjectivaly Jcnew or auapectad there waa a flaw in th title of one of its predaceaaors.); Air Vermont, Inc. v. Beach Acceptance Corp. (.ln m Air Vermont, Inc.), 44 BanJcr. 433, 436-38 (Bankr. D.Vt. (1984) (buyer' knowledge of advr claim reaultad in it having no legal intereat in the property). DOC. SWP1104 July 17, 1989
PAGE 390
195 unperfectad curi ty intereat that i pr.i=>r J.n ti.,,., Other purchar alao can achieve nior atatua notwithatanding knowledge that a conflicting clai uiata, provided that the purcbaaer do not know that ita purcha violate the right of the conflicting claimant. The cond corollary, however, would award niority to the upper tier transferee regardless of that .:~~:,,!~~:~~:~!i~--~-~,-~~~ .. -~~~t~. !.~d. -.reqHdl~' oi kn~lac,ga. -~t th ~anafer ._. unauthorized and o I violated the0righta of the l~wer0 ti~r claimant.'' The_virtue c~ ~~-econ~ corollary lies in the reduction of coata and riska ~or upper tier .claimants that fora . .. . ,. .. ', ' 0 t , ,o,O ,, !',',,,: ,,,...,, ': I,. e 1: '' : ._, ', t 1 -: 0 .' ,. .. : _. . : :-.. ~-\ .. : ..... : : ... ~.. 'i" .;:._: . --. ; .. . ,:.". :,-4 .. .. .... .. : .. .. ...... :.. -~. .... '\... .... .. .. 407. au I 9-312(5)(a). There ia disagreement aa to whether this rule represents an appropriate standard on normative grounds. compara carlson, Rationality, supra note 131, passim (arguing that knowledge standard should be applied on normative grounds), with Baird & Jackson, supra note 131, at 314-18 (arguing that knowledge standard should not be applied based on excessive costs and non-equivalence of knowledge and bad faith). 408. an II 1-201(9) (defining "buyer in ordinary course of busin" so as to exclude buyers with "knowledge that the sale is in violation of th ownership right or aecurity interest of a third party); 2-403(2) (entrustment of goods to merchant dealer gives power to tranafer entrustor' rights to buyer in ordinary course of business); 9-307(1) (buyer in ordinary course of buain tak fr of aecurity intereat crea1:ed by ller). 409. The aecond corollary also contaplatea that upper tier transfer seniority would not be impaired even if the upper tier tranafere did not give value. Such a transfer might be avoidable aa a fraudulent transfer, however. au Bankruptcy Code I 548(a)(2). DOC. SWP1104 July 17, 1989
PAGE 391
196 tbe con of the rationale for the new aodel. 411 Al though the aecond corollary aaaU111ea an upper tier claiJDant' knowledge or notice of a lover tier claia, under c:arrent law it can be expected that aucb JmovledCJ or notice will be artd by unaatiafied cuatmaera of an inaolvent intenaediary.411 Preawaably moat auch claima would fail becauae of the inherent difficulties ~~-;ta~.:~-~ ..:-~~-,. ~~--i~;_,~~'V.S...:~ .: .. .,,.r:thalaa,. .DIM ... ".. .. ... . . . . . . . . . that .1over tir ciailia v111 .,. 111aw1 ar 1apoaec1 on. a~ .i upper I tier claimant, not only on tho that misbehave. The second .co~ollary would protect another class of u;,pe~ tier claimant. a~. well-tho who ~o not have kn0wled9 or ,noti~:~t 1~~. ~f~ c:111bt, v1to.-an :not ~ha itil purchar, : .... ,' ... : \, . .. ... ,I. and who are immediate or mediate transfer fr011 an upper tier claimant who do have knowledge of a lower tier adverse claim. Under c:arrent law, aucb second-in-time iMocent transfer would be aubordinatad to lower tier advar claims. 412 410. Th argument for the aecond corollary is, in one respect, las compelling than th argument for th new model's baaic principle. That principle is supported to aom extent by aaauming the difficulty that claimant would face in attapting to discover adver claima. The cond corollary postulates, however, that the upper tier claimant already baa knowledge of the lower tier claim. 411. consider th priority dispute that occurred in the ca cited IJ1PA not 243, 246. 412. If aucb a transfer war afforded broad warranty protection purauant to the first corollary (or current law) and such protection var not modified by aCJr-nt, the transfer could receive aatiafaction from its intermediary. s11 qanarally supra Part v.a. But th second corollary would fr such DOC. SWP1104 July 17, 1989
PAGE 392
197 Allowin9 upper tier tranfr to receive property intereata that are nior to lower tier advr claiu would not nec:eaaarily ..an that upper tier claiunt would be inaulatad froa liability for vron9ful behavior. Upper tier tranafar who acquired tbeir intrta vitb Jcnovlad9 of conflicting lower tier claiu could be -d liable to raapond in damagaa.40 Thi approa~ ~uld. not ~urdan the .. interut, .in aacm;iti invol vad 1;. .,. .. ': ... ,. -~~" .r" llaJ :;t;1,:, .(.~ .,, .:-J '\:-~: .\"-. .:.,--.,,,,.,-.-~-..:. ~-.,,.-,. .. ~-... '. _, . .. e '' f! I o o : ... o ' ', o o with. a lin9ari119 a4vana_..claia tbat-vould aurviv future . . . . . tranafr 'to innocent non-bona fide purchaser. But, it would c0111port vi~ a normative atandard: It i wrong to knowingly divt a par.on of its property rights, Pcially when acting in . . ,. .. 1 :, : .. ~~~-j.c~~y. vi~ .. a:.'party,._. .(~ucb. the .l~r. tier claimant' a .... ,.. -~.. ... .. ...... . tranfr from axpoure to assertion of adverse claillla and dependence on any applicable warranty rigbta. Protection also could be provided to uch innocent transfer by a priority rule that denied niority only to upper tier claimants with knowledge or notice of adverse claims. But that approach would involve a more elaborate priority Yta and would reintroduce the property law contruct (including tracing and identification of interests) that the new modal i intended to eliminate. 413. Thi i the approach taken in th proposed revised Article ,--Bulk Sal IAa u.c.c. [Revised] Article 6--Bulk Sal, Prgpg Final praf1i (April 5, 1989), 1 ,-107(1). The knowledge by a secured party that i cond-in-tim of an earlier, albeit unparfectad, security intrt may expo th second-in-time cured party to liability in tort for interference with tbe contractual ri9bta of the first-in-time cured party. ID RES'l'ATDIN'l' (SECOND) OF TORTS I 766 (1979); gf. Firt Wyoming Bank v. Mudge, 748 P.2d 713 (Wyo. 1988) (secured lander vbo took security intert with constructive notice of negative pledge covenant, in favor of earlier unaacurecl lender, liable for intentional interference with contract rights). DOC. SWP1104 July 17, 1989
PAGE 393
198 interaediary) that i violating it obligations to that peron. Inaofar upper tier clai-nt r-ined expoaed to the artion of liability, a principal benefit of tbe aecond corollaryeliaination of coata and riau--vould be undeEmined. Adjuataent of tb atandard for liability, however, aigbt reacue tbi approach. 416 ,;-~ >.:~: ; .. >:i:~.--.~~n~t;:mq:.ol~UJ ... ~rrant=.-i~l:. doa~.: of 9loa. . . . . .. . ... ., Aaauaing .. that under certain c~tancea upper.tier transfer -y be liable in daaag on account of lower tier advr claima, the lover ~ir ~laimant 11ay not be the moat.appropriate party to recover tbe daaagea. Arguably tb repruentative of th lower : .. ..... tier -c1afilant-a-: inao1Vtm1: nt~liiil'i4r,. ould. auccaec:1 :0 auch a ;, ~. ..... ...... .... . ..... ~.-: _... '. .. ..... t . _. claiJI for tbe benefit of all cuat011era of that intenaediary.415 414. In Exuple 1 I-2 may be in poion of much infoZ'lllltion concerning I-1 and ita cuat011era aa a reault of trade tickets, ub-account, and tbe like. Charging I-2 with knowledge, or at leaat notice, of inference that could be drawn froa auch infoZ'lllltion would Id tb point that I-2 normally would not be equipped to take account of such information. The probla i greatet when an upper tier intermediary rvs a clearing function for a downatreu intermediary. Imposing such liability only on tbo upper tier claimant who receive transfer with, ay, actual fraudulent intent (unadulterated by any duty to invtigate), might be a useful compromi Riske to upper tier claimants could be meaningfully reduced without condoning clearly wrongful mibebavior. The point b&re i not to propo and upport any particular tandard but to aphasize that, in tbe world of fungible bulks of ecuritiea, traditional atandarda -y be unrealiatic and unreaaonable. 415. It i raonable to expect that in aucb ca the lower tier claimant' intenaediary will be inaolvent. Otherwise, that claimant probably would be aatified by it intermediary, either on a warranty theory or bad on the intermediary' obligation to control curiti fr of adverse claima on behalf DOC. SWP1104 July 17, 1989
PAGE 394
199 Clearly, thi 910 would require a fundamartal departure from lon9atandi119 bankruptcy principle that penait for a rapraaantativ to auccaad only to the avoidance powers, not ctaaa9 claim, of actual creditor.'" Yet allowing auch a recovery i fully conaiatant, to clailla of lower tier claiJlanta that are cuatmaara, with th riak aharing diatributional. rulu in. curJ. ti f ina inaolvanci-. ~17 'l'bu, it ~-~ ~~:1.~~.\--:.-.,.:-.-.:.-,:-.~-:,:_::./~:~:: .. :~ . ~:-.... =~---: ':':~ .. ,:.-: '::: . _:c.:'.i :-:~ ,,','~'-:~~= ,:.. ... -;. .. .... . . :. ,. ... , , I '. ' : ': .. ', ,, of.the over tier clalunt. Were tha.intanaadiary not inaolvant, it i likely that th lover tier claimant would never diacovar the upper tier tranafer. 416. Ila Bankruptcy Cod I 544 (b) (trustee in bankruptcy aan avoid transfer of property or obligation incurred by debtor ~t, be avoid~ _by .n ... ~l. IUIScurad creditor under .. appl,i-~. la1i1) .. :. ~--~~oidallce. ,polfer ~and& to th entire -~~r~t _!J:l _propert:y_ and ia .. not .liaitad by the extant to vbicban actual unsecured creditor could ao avoid a tranafar. Moore v. Bay, 284 o.s. 4 (1931). Although a trust in a Subchapter III proceeding can exercise avoidance powers with raapact to pre-petition tranfr of property that would have been customer property, th claiu of lower tier-claimants would not be unaecurad claims and, therefore, avoidance under Bankruptcy Code SI 544(b) would not be allowed. Bankrllptcy Code II 544(b); 749(a). 'l'h reaults under SIPA would be the aame. In SIPA II 6(b), 7(a), 8(c)(3); 15 o.s.c. IS 78fff(b), 78fff l(a), 78fff-2(c)(3) (198 ). 417. In the absence of such a wrongful transfer to an upper tier ~ranafarea, under SIPA and Subchaptar III the lower tier cuatomar-advarse claimant would be forced to ahara the value of the curiti with other cuatomera. Sa q1n1ra11y supra Part III. Aaawaing the rik haring formula i juatified, allowing the trustee, rather than an individual customer, to recover from the wrongful upper tier transferee, would not unduly violate the cuatmaer' property rights. The trut alao might be more favorably aituatad, becau of batter infonaation and economies of acale, to puraua aucb claims. Moreover, the trut would not naceaaarily be required to prove that the upper tier transfer' conduct waa wrongful a to any particular customer' securities. A lower tier cuatoaar, however, would be forced to d-onatrate, auch aa through tracing, that J.ta property waa wrongfully DOC. SWP1104 July 17, 1989
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200 i ancmaloua that currant law doe not parait the inaolvent interaediary' repreaentativ to recover auch da-9 clailla.4 In aua, tbe eliaination of notice and knovladCJ a fapacU.aenta to Hniority for upper tier claiaa dou not n1e111arily follow froa tbe new aodel' baaic principle of upper tier priority. And relieving upper tier claiunta fraa liability : al~-~--tq~ ,-~o.~i~. -~vio~ ,-,~1,~,,._'li-low~-. ui~,. claiaanta 'I "' I -I .... I I '-,. e' :. ,.. . t ~ ~ ,I,(, ,; I . : -~d-11:~ -j~ti~iabie.onno~ti,; grobnda. But .th. ad~ption : t of a atrict atandard for upper tier claiJDant liatility (or aubordinati~~) wo~ld compl~~t and anban~ the new model' baaic . . ~rinciple~ -~il -intaini~~ ~pPropriate _co~eque"c for o : o , ," 'I : o o Io 'I, I e f~ o .' o : a.tebebav.iu-.. ~~-uppar.-~-.r-~ala-iaanu.,ra9ftr, -expending the : 0 \ ~.,.. ,._,,: 0r, . ',: ..... Jr,' ,,;. .~ ." ~ 00' ." r. baai for repruentativ of inaolvant intenaadiari of lower tier claiJDanta to recover dmCJ from upper tier claimants could provid a aore rational and conaiatant an of diatribution. coacLV8IO Thi article tell three important stories that need ~lling, and that ought to be told together. Each story must be played out to (or near) the end lest its meaning be lost. The firat atory is about the phenomenon of intenaediary control of tranaferred to the upper tier transfer 418. Similar anoaali exiat with respect to preference under SIPA and Subchaptar III. 111 supra note 218. DOC. SWP1104 July 17, 1989
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201 aecnaritiu, and the role and attribute of that control in aodem cnaritiu 11aruta. Si911ificantly, the atory focu on tb relationahip of thi pbenoaenon to the property rul affectinq tranafer and pledCJ of interuta in HCUriti Tbe Hcond atory i l intrtincJ and bi9hly tecbnical, yet jut u illlportant: What i the proper "-~'-:~~-Pl~~ p~ii~ in.A.11:~cl.I .. t.belooll~lntry .Truauxy ltegulationa? ftia-atory : . . . coft8\lllu a large portion of the article. It i -inly a tory about aiainterpretation. Aa Appendix III d-ontrate, the drafting biatoryof ction 8-313 cata auch li9bt on om . : . . ..., .. .. . .. . ...... -.... .' ... . . . . ~eiviae. perp~~ .. ~tu~ry .1anqua9e .... Nor~er, tbe effect of r , .. '- -~ '11, .. '. . tranafen and"pledqu of lnteruta in curitiu controlled by interaediariu can be en and undertood only if conaidered in the context of inaolvency proceeding of intenaediariu. Tb third tory draw froa and builda upon tb firt two tori It i nominally about th propod new model for reaolution of different tier claiu--a ignificant iu of great practica! concem. But it i alo about a more refined viion of th aui q1n1ri1 characteriatic of the (not-quite-property, not quite-unaecured claim) relationahip that reulta when intrt in fun9ible bulb of curiti are tranaferred on tb boob of intenaec:liari In tbi na th atori are not ao much about preci, codified rule, or even doctrine, but about DOC. SWP1104 July 17, 1989
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202 broader principl for cbarac:terizi119 aucb tranafen and pledge that could be woven into nal and doctrJne. Th arvuaenta aupportincJ and defendi119 the new IIOdel, properly CJr8aped, are a atep toward tbe developaent of a tbeoretical and-noraative bai for t.beN principlM. Ironically, the actual cbancJu in outcoae that would be -~-a,,.:adi-.Of, t11aodel_, .... :~t aodeat. Indeed, tb raid.ta ~-exiatincJ law. (properly interpreted)upper tier claimant priority in aoat circuaatan~ vher fungible bulb: are~concerned--and analogiu to exiating doctrine ar illportant eleaenta of the claia that ~ion ~t tb new aodel . . . . . -~er be' 111 .. ~-~-.. liut u. 'fttni:~1-ia:'zwjec:tf~= of' . property' lav ; -" .. ,. . i. . . . conatruct vrow,ded on traci119 interata in property 1 aor triking and, perbapa, ore illportant. Thou9htful articulation of a better way to conceptualize thue tranaten and pledge aigbt bave prevented the i8CJUided, backward atep epitoaized by the CJood faith tranafr rule of the Propoaed TRADES Requlationa. Perhapa thia article vill encourage that reault yet; at the till of thia writing it i& not yet too late. Pinally, tbr i another atory tbat i iJDplicit in tbi article, althou9h it i not fully told. LeCJl nal covering private property ri9bta aucb a Article a, tbe Book lntry Truaury RecJulationa, and the Propoaed TRADES Raqulationa are unlikely aedia for adequately addrinCJ concerna tor DOC. SWP1104 July 17, 1989
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203 protection and Nfety of tbou vbo receive tranafen and pled9 tbrowJb intaraediari-. Tb approach of tbe new aodel would be protective of tranaferee intereata priaarily aa a atem minder that tbe Nleetion of an interaediary 1 of paraaount iaportance. 'l'be NCUrity of property intaruta of aucb tranafereea will riN or fall vitb tbe 9eneral financial condition and inteqrity P.~.,t~ -~~~~~~-~1,-.., ... ~D!.-,~l~ .. af .. Af~Yaon plauil,ly liu vitb continued innovation and illproveaenta in . . tbe proc of clearinq and aettleaent and in th rec)Ulatory and prophylactic approacbu to interaediary riak. But, to repeat, that i anot.ber atory . " .-, 'I I .', . . f . : ... ... 'I ~. .. r .. DOC. IWP1104 July 17, 1111
PAGE 399
UnaDIZ J I ," -, ., ,.., l > ., I ~ '_.._, u.c.c. aeatioa 1-JlJ. .. [DelirJJ zru1f1r to [tile] ftrallaaer oacnaraa [I urabr lrokerJ rtngaial 1n,1m14iry cao1derl IAP 11011Rrab111rr "liPMA a11n,1n1iKT". (1) [Delivery] tran1t1r qt a 11curity qr a 1imit14 interest (inglydinq I aw;yrity int,nt) th1r1in to a purchaaer occurs pnly [vbenJ: (a) at, t,ha t,iN be or a peraon dignated by him acquires poawsion of a c1rt,iticat,l4 security1 [or) ;.-~-;,.-.:~-~:.:e~ w,=1iW1M;."frtftiit#'r':~.taiUcit{:,, .. nljti11~ at'.,a.-.::, .. ::> .Yl'MCiticat,14 ilGPl'it,y i r,ai1t1ract tp hi pr a MnRD 4nignat;l4 DY htr JJU. [(b)J at, t,h t,i hi [broker] financial intermediary acquiru posausion of a c1rt,iticatad security specially indoraed to or issued in the name of the purcbaHr r [ or J . ' ..... .... ... :'I, -.. : . .J.dl.. ( (o):J .ag P ttm tbia ~arr i financ;ial .... i.DteDlfliary, npt; ,I glaaring gprppratipn, sends hilll 'confination of the parchaH and alao by book entry or otbervi-identifiu [a specific -curity in the broker' posion] as belonging to the purchaser[: or) lJ.l a ucitic c1rt,iticat14 11curity in the financial int1adiary R 0i0n; (ii) a qyantit,v qt cyriti11 that constitute or are part, gt a tunqihl bulk gt cart,iticated 1cyriti11 in th financial intarmediarys PAipn or pt yncrt,iticat,14 11curit,i11 raai1t,1rt0 in th n-ot t;h tinancia1 int,nfdiary; or (iii) a qyant,ity gt 1cyriti11 that cgnstituta or ara part, ot a tynqibl bulk gt 1cyriti11 1b0wn AD t;h account pt t,h financial int,adiary an the bqpkf ot anot;hr financial int1a10iary; .Lil [(d)] vitb rupect to an identified c1rt,iticat,ad security to be delivered while atill in the possession of a third person, npt, financial int,1rmt0iary, [when] at P t,iu tbat person acJcnow~edgu that be bolds for tbe purcbaaer, [or] DOC. SWP1104 July 17, 1989
PAGE 400
I -ii ill yith nns;t tq a sncific uncart,ificatad sacurity th plad,q qr tranfr pf which ha bo r1qist1r1d tq 1 third MDRD, nqt I financial int1rm1diary, at th ti that PIDRO acJcnqyldq that b hqlds fqr th PYrcb111r1 .Lal [ (e) l at th ti,N appropriate antrie tq th accqunt pf th purc;ha11r qr a MDRD 01siqnat14 by him on the booJca of a clearing corporation are ude under Section 8-320(.], ,.w_ '. ~xit,b anast :tP :tb :~naiv pf. a. 11garity int;1r11t ... v=i::sttl:!c!t:it!:":t ti:=r~;-:: th, a vritt1n nqt;ificatign~ Ybisb ,' in th c111 pf th cnatiqn pf th 11curity intnt, i iqnO by the d@tqr CYbich may bt I cppy pf th 11curity aqrenot> qr yhich, in th ;111 pf th ni1111 qr 11siqnmant of th 11curity int1r11t craat14 pur1uant to tbi Nnanph, i iqn14 by th 11curl4 party. is racaiyed -u ... .~ ..... .: :,-i .''", .:--~, . ... ~ 4t"'-~-._: .. . -.. .,,~_ .... ...... ~..;. ... ,.~_., ... ~: .... r .. : .~ .... ---.W. ,. : ..... flpnqial intaEN4iary RD YbAH hqqka Sib iutns of th tran1f1rqr in th 11curity aPPlaD; (ii) (iii) liy) 1 third par10n, nqt a financial intarmadiary. in pq1111si0n of th s1curity, if it is c1rt,ificat14; a third RIDRD, not a financial int1rm1diary. YbR i th r;wi1t1r1d qwnr of th 11curity if it i uncartificatd and not subject to a raai1t1m p114qa: qr a i,hird PIDRO, not a financial int1rm1diary, YbR i th r19i1t1m p1t4a11 pf th 11curity. if it i unc1rtificat"4 and ub1 to 1 r;witrad pll4qa; .LU yith nns;t tq th tran1f1r af a 11curity int1rt Xhn th tranafaror ha 1iqn14 a 11curity aqrm1nt cqntaininq a dcriptiqn pf th 11curity. at th ti on val i sixo bX th cum party; qr .Lil. yith nact t;q th tran1f1r or a 11curity int1rt ur Sib 11curt4 party i a financial intrmdiary and tb 11curity bo alraady ao tran1t1rr1d tq tb DOC. SWP1104 July 17, 1989
PAGE 401
I -iii financial intarmediary undar paragraphs Co>, Cb). Cc), CO>, or Cg), at tbo timo the transferor has siqnad a curity agragent containing I description pf the 11curity and v11u1 i qiyan by the 1ecured party, (2) 'l'h purchaaer i the owner of a curity held for him by [hi broker] a financial intermediary, but Ci not the holder] cannot a a bQna fid purchaaer pf I aecurity A hald except [as] in tba cin;mpatanca1 pacified in [aubparagraphl paragraphs [(b)] (c), ld)Ci), and [(e)] J.al. of aubaection (1). (Where] If a curity 10 bald i part of a fungible bulk, as in the circmpatanc11 specifid in paragraphs C4)Cii) and Cd)Ciii) of ..,.;t,iop Jl)i, -.~-.-P~~.-.i-.. .:1:.~~ .~a,:-,.:.C?.t _.a._p;w;-op~~i.ona~ .. .. P:~rt: tnter ~-nt1t ..... ..:~tbl'" w11:~-~ .~ .. .. ....... -~~-: :r ... .. ~-.. :: .. .. .... lo:_._::\ ..... :; ....... .. .... .. .. . (3) ."lfotica--of -.... n. clam received by the. [broker] financial intarmadiary or by the purchaser after the [broker] financial intermediary takes delivery pf a certificated security as a holder for value or after the transfer, pledge, or release of 10 uncartificated security.has been registered free of the claim to I financial int1rmediary who hasqiyan yalue is not ~~_t,~Jr~-~~~~--'-.:,~o .... ~~-.tb~brl. fjnancial intaQlldiary or as -~--~.-~:.,.~~ aa.f"-~~~en.,-tbe ,{br~ke;r.J financial intgmdiary ... ~-:thtp --~ --~~-~--uy d~nd [delivery] t;ran1f1r or anequivalant aecurity as to which no notice of (an] adverse claim has been received. <> A financial intermediary is I bank. brqker, clearing corporation or otbr p1r1on tor th nqminee pf any of them) which in th ordinary cqurse of its business maintains security account for its customers and is acting in the capacity. A financial intarmediary may haye I security interest in securities held in account for its customer, DOC. SWP1104 July 17, 1989
PAGE 402
URIID%Z %% 31 c.w.a. I 301.118 ~ranafer or pledqe. (a) A transfer or a pledge of book-entry Treasury securities to a Reserve bank (in its individual capacity or as fiscal agent of the United States), or to the United States, or to any transferee or pledge eligible to maintain an appropriate book entry account in ita nue with a Reserve bank ~dar this subpart, i affected and perfected, notwithstanding anyprovision of law to th contrary, by a Ruarva bank making an appropriate entry in it records of the securities transferred or pledged. 'l'he making of such an entry in the records of a Reserve bank shall: .. ,:1.1\ .: Rava -tbe .-.ttct at: .,.'.r1i.v"""'-in:kAare~:. fona .. _. -_ .-: ... J, .,..u, ... ~~11:~-:J'.~:u~r:--~.;<:.,;p:..,~iii-"t'-1.... ~--~, ~:le,,:IJ", ... ~.,-1~1 :. --~ ,;;.; .,,: ....... ... .:~--..;., \.,.:,;-j-:: -~-::_. ... 11~~.1.v~ .. ea~ ~-=ur "'-~: ... _:. : .. J . ,': ....... f2) :have'. th'i. effect' of . taking ~taeliveryby the transferee or pledgee: . (3). constitute the transferee or pladgee a hold~r: ~nd ,, ... ... ~-. .f,J.: -~it.~. Pl.Sg:,--.-tt: a .perf,o;tad security ... :.:=..,. .... .--.. :in~rat .. ~~rein-.in-.-f-.:vozi .-o.f: tl-..:Jll.edpe. :.A.. :_.._. _'. .--~f'-"~J:',J)l~g --~ ~lt"'!'entry-.,~aasury securities effected under this paragraph shall have priority over any transfer, pledge, or other interest, theretofore or thereafter effected or perfected under paragraph (b) of this section or in any other manner. (b) A transfer or a pledge of transferable Treasury securities, or any interest therein, which is maintained by a Reserve bank (in its individual capacity or as fiscal agent of the United States) in a book-entry account under this subpart, including securities in book-entry form under 306.117(a) (3), is affected, and a pledge is perfected, by any means that would be affective under applicable law to affect a transfer or to effect and perfect a pledge of the Treasury securities, or any interest therein, if the securities were maintained by the Reserve bank in bearer definitive form. For purposes of transfer or pledge hereunder, book-entry Treasury securities maintained by a Reserve bank shall, notwithstanding any provision of law to the contrary, be deemed to ba maintained in bearer definitive form. A Reserve bank maintaining book-entry Treasury securities either in its individual capacity or as fiscal agent of the United States is not a bail for purposes of notification of pledges of those securities under this section, or a third person in possession tor purposes of acknowledgment of transfers thereof under this DOC. SWP1104 July 17, 1989
PAGE 403
II -ii subsection. Where transferable Treasury securities are recorded on the books of a depositary (a bank, banking institution, financial firm, or similar party, which regularly accepts in the course of its business Treasury securities as a custoclial service for customers, and maintains accounts in the names of such customers reflecting ownership of or interest in such securities) for account of the pladgor or transferor thereof and such securities are on deposit with a Reserve bank in a book-entry account hereunder, such depositary shall, for purposes of perfecting a pledge of such securities or effecting delivery of such securities to a purchaser under applicable provisions of law, be the-bailee to which notification.of the pledge of the ;-~~=it-~a .;;~x . :.~ ;~iv,~t9Z!,~~--~thi~1 ~rao.n.-:i~-:J)O~st~n ..~rpa._,. .. 1ih~c:h ~qknowladpe_nt_ .. of .tMe holc!ing of the securities for the ~aaa;r may be obt.ainad .. A Ru.~rve .bank will npt .accept notice or advice ofa transferor pledge affected or perfected under this subsection, and any such notice or advice shall have no affect. A Reserve bank may continue to deal with its depositor -in accordance with the provis-ions of this subpart, : notwithstanding any transfer or pledge effected or perfected under this section. . . . . ... . . ~-~;,,~-(C) ; __ Ho--~fl~ncf "or ziecctdfncj .... "ltlth a p-1miic:--recorciing of.fice or orficer ahaJ:lbe' n-=ey or--ffa~ive '.witb
PAGE 404
UnllDIZ %%% Draftia9 Biatory of u.c.c. aeation a-313 1. irat Draft The first public draft of what was to become Article 8 (then called Article V) was aubmitted to the members of the American Law Institute in 1946.1 Section 13 of the First Draft . ., . "'"'' ... . . '., ..... .......... -~-..... _,,.,, . -1,,,; ... ..... . ' . ~..:r6v1d .. ,!;-..M,"-~::~ .... ;.... -'1,);.~~-.,.,,-, .. ;~"'-'1i,.:.-~."!.-.,..-~ . :)~---:-,.;.!".., ... ,, ........ ~~-,.c.~~;. 4 ....... ........ =. -:~ :i:-= _._ .. < ..... -:-~ r aa . -.-'::', .... : -. .. ... ,.~ :. .......... .... .... ... ... ~._ .... .-, . . '. . . . :. section 13.; WRD. DBL?VIRY Erti:CTIVB TO COMPLETE NEGOTIATION. . (1) Except as otherwise provided in this Section, delivery completing negotiation is received by a transferee when he or bis. agent acquires physical possession of an :: :,.-'. ~--.. i:nv~~t~ .J.nst~~-,;._bq.1: a ... J:,:rokK .f~r. ~-transferee is ..... ... -:.-.no~;-~ia .. agent. for. ,tbi pm:po ... ::~-the... instrument is . :: : ... ~-p~ia~-4 -.by .. ~c::~al. incloz;"sa~t to, tb~ .cuatomer or by new iasua in 'hi name. . .. (2) Where a broker does not receive an instrument in the name of his customer or specially indorsed to him, delivery to the customer occurs when the broker aenda confirmation of the purchase and also by book entry or otherwise identifies a specific instrument in bis possession aa belonging to the customer. In the absence of such 1. uniform commercial coda. Preliminary Tentative First pratt--Articla Y (April 22, 1946) reprinted in 3 UNIFORM COMMERCIAL CODE DRAF'l'S 1-23 (E. Kelly ed. 1984) [hereinafter Firat Draft]. carloa Israels waa the original reporter for Article v, but when he resigned in December, 1985, Soia Mentschikoff (then Assistant Chief Reporter for the commercial code project) waa asked to serve aa reporter for Article v. Pirat Draft, aupra, raprintad in 3 UNIFORM COMMERCIAL CODE QRAP'J'S, supra, at 5. Prior to the u.c.c. stock certificates were given attributes of negotiability under the Uniform Stock 'l'ranafer Act. UNIFORM S'l'OCK 'l'RAHSFER ACT, 6 U.L.A. 1 (1922) (withdrawn). Pora diacuasion of negotiability of investment securitie prior to the u.c.c., see Gilmore, The commercial Doctrine of Good Faith Purchase, 63 Yale L.J. 1057, 1072-76 (1954). DOC. SWP1104 July 17, 1989
PAGE 405
III -ii identification the broker is the holder of the instrument despite confirmation of purchase or book entry or other indication that the instrument is part of a fungible bulk held for customers and despite the customer' acquisition of a proportionate property interest in such fungible bulk. (3) Whan an identified instrument is in the hands of a third party the tranafaraa2racaivu delivery on attornmant to hill by the third party. The Note to section 13_of the First Draft st~~ad, in pertinent .... ... -~.; .... ...... ... : -:.-. \9.~-,:,.,;:-... :.:?-..:.,,, ..... .. ......... .... ." .-. ., ......... : ... ,..;att ...... ' --~ ,.., \I ,.,~ v . ,;.. . .~. '.,,..11 - .. a. ~-.... .,,,,_ .... ,;,., . .. '-i. ,: . .... : . ": r.-.-.=, .... .-~: ... .. .-.~: .. ,:.: . ~:... : :_: : ::-.. .. ... : .. 'l'hi section deals wi~ 1:h kind of delivery which is. nacauary to affect a formal negotiation under section 9. . In this section the emphasis.is put upon the receipt of .piyatcal poaausion.ottb -~trmllant except in.the case _.. .... _.. ..__ --~__.. .. __ "' and .. .~=-: -----------~..-:~,a.u.: !IIW'!'~~...,~; ... :.. . .;,;:_,,.<."_ .: .... ~,: .. :' : .. :. -_.;.-;._ ..... ... ......... f. ; . ... '. ,, ... ........ :, .... : .. : -~~--._:_ . . :.. ;. ,,..,;,, . ........ ... .. . .. ,. .. ........ : iuhiact;fqn. 2 conforms with .. th ... practd.ce in "brokerage houses so far as we have been able to determine what that practice is. We understand, however, that this particular practice applies in volume to only a vary mll percentage of the number of purchases made by a broker and that normally no such pr1cis1 idantificatign of an instrument takes place until such time as the customer demands delivery from the broker. Subsection 3 deals with the case where an identified instrument is in the hands of a third party. It should be noted that so far as transfer of an instrument is concerned, notice of confirmation of a purchase should normally ba sufficient to create ownership rights in the transferee even though the instrument itself 2. First Draft, s 13, aupra note 1, reprinted in 3 UNIFORM COMMERCIAL CODE DRAFTS, supra note 1, at 20. DOC. SWP1104 July 17, 1989
PAGE 406
III -iii may be merely in a fungible bulk aafekeepirg account or may in fact not be in the hands of the broker. The Fint Draft incorporates four important and related principle that ahed light on the meaning of both the pre-1978 and 1978 veraiona of section 8-313. a. lrat ftinaiplea a ~rokar l not u agent for puzpo o, del~v.ezy aaept in the a of apaaially lnd.oraad -~: ... _.:, .. .,, ..,;; . :.*t. 1 :t "";,, . .. : .:,' : .,., .... f ~: ~ JJ~ \ ;. 1ri .~ -~ .:_l"a ' ~; :": ---~~. .-,;: ; .. ,.,.- ;, :.,:-,4_ '"' -:~ '-:i ."~ ~-: ;:<" .. '-. --. .. '# --~,-~.\.a,1,,..,"'''C .~,,~ '!I' '~I ... t' "9,-!".. "' -~_..-,,.., .. ... _, . _'~ ~, ......... -a UIAS~--r ll-8 ._u~raaa -~ .. . .. . . . . . .. . ... .. ... . . . . .. . . .. .. . .. Section (1">. first states a -~eneral rule that delivery to a transferee occurs when "he or his agent acquires physical possession of an investment instrument," thus incorporating and . c:Jmowi_edg_ing._ :CJ,Oera1 principl~-of agency-. 4 . But-. that rule is I''";,,' ...... :,: o ,,::,,;~ :,l:":.:, . .... :,_,,,t. lo"., i'o: '.,:, . ,.,., ... ... 0 o , .', .fol~~~-_,by.~an-.. .XCepi:iOD-'!"'a, .. brokr.. ia. not_ the. transferee IS agent . . ex~ept when the instrument involved is specially indorsed to the customer or issued in the customer's name.5 3. Id-, Note to section 13, reprinted in 3 UNIFORM COMMERCIAL CODE DRAFTS, supra note 1, at 40 (emphasis added). 4. First Draft, supra note 1, I 13(1) (emphasis added). This clause is tlle forebear of both pre-1978 and 1978 I 8-313(l)(a). Except for substituting the word security" for the words investment instrwnent" and the words "a person designated by hill" for "his agent", the first clause is essentially identical to the operative language of pre-1978 I 8-313(l)(a). Chang in style and terminology in the 1978 version were not intended to change the aubatanca of paragraph (1) (a). a.a 19"'.'8 I 8-313(1)(a); 1978 I 8-313(l)(d)(i); u.c.c., app. 1, I 8-313, Reasons for 1977 Change, at 855 ("The rules of the present statute [pre-1978 I 8-313(1)] are preserved in subparagraphs (a), (c), (d) (i), (e) and (g) [of 1978 I 8-313 (1)]. ") 5. IdDOC. SWP1104 July 17, 1989
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III -iv b. 1eao114 1tri11aiple1 01117 a 0apeaifia iaatruaeat11 ia a broker poaaeaaioa au be delivered to a broker cnaater by aoafinatio11 u4 ideatifiaation. Section 13(2) provide another exception whereby delivery to a cuatoaer can occur while a broker retain actual pbyaical possession. The exception depends on the broker's . ,_.,~t~t~q~:,ctt.;:, .. ~~;:_-4 :.*d.Mt~'ti~i~_n:: --of:, :~a-: peci~ic.-. :i~ hi ~~io~. ~~--~~Qngi~~ :.the ~ato~~r.116 The language "specific instrument" could hardly be more clear. In the -1:)aence of a good reason tor a different. _interpretation, apecific inlltrmaent" could only be. ~onatrued to an a . .. .. . . ,~ .... . .. . . .. . . . ,. , :~~~~-,~:~~~:=.~--~~:-.~~ :-._~r~_ every other.piece of paper in the world. The aec~nd sentence of section 13(2), specifies that unless "such identification" is made it ia tbe br.Jker, not the customer, that would be the "holder.117 The second sentence clearly implies that an "indication that the instrument is part of a fungible bulk" is ,. First Draft, supra note 1, I 13(2) (first sentence). The language of pre-1978 I 8-313(1)(c) is closely pattemed on the wording of this portion of I 13(2) and 1978 I 8-313(1)(d)(i) is aubatantively the aame. 7. First Draft, supra note 1, S 13(2) (second sentence). DOC. SWP1104 July 17, 1989
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III -v I -not an adequate identification so as to constitute a delivery under the first sentence. The Rote to section 13 further supports this vary narrow construction of what constitutes a specific security. Such an identification was presumed by the drafters to occur only in a very -11 percentage of brokerage transactions and in the ~~~~~~~~~~~~:'.'m~-~-~~~~t~.'l~~:,+~~~-,~~t-.f.Y.!l~~~:~P.~~:1\f:v~~~~,~~~--~ :: duaand.' ,,: ..... ........ . .. .. .. ' ., ..... .. :-.., ,; a. ftird Prinaiple: b instrmaent can ~e delivered to a . transferee t~oug~ atto~ent ~Ya.third p~rty (vbo is not tbetruaafer' broker> only i~it iaan , .......... -.: :. ....... : . :_ :. ""'~ ---~-~ ,.'~- :: ............ ~: --~:_;\ .. \. --~ . . t . ,: .. :--. ,,_;",,&." ,;~i--~fle&l-.~-~t~~ .. --:; . : ....... , ,.; .. :. . ':: ........ I : ., :,, ; ' , :., ', ,.,. ' ._ .. ,.-. '". ,'. , :0 ,1 .:. ., .:. ;_ '.:_I :,,:' ,I:,,; , / ~-: .. .. ,": ~., _"1ri! ; -~.. .. . Thi principle, whicb springs from section 13 ( 3) of the First Draft, 11 addresses two separate issues. First, who can be a "third party? In view of the references to a transferee's and 8. First Draft, supra note 1, 13(1) (second sentence). Certainly a book entry specifying a customer's interest in a specified quantity of a particular issue, of which an instrument is a part, would be inadequate to constitute such an identification of a specific instrument. When a fungible bulk is involved, presumably the quantity being transferred to a customer would always ba indicated. And instruments comprising a bulk would not be fung~le at all unless the instruments ware of the same issue. 9. Ila First Draft, supra note 1, Rote to section 13, supra note 3. 10. First Draft, supra note 1, 13(3). Thia subsection waa the ancestor of what became pre-1978 8-313(1)(c) and 1978 8-313(1) (e). DOC. SWP1104 July 17, 1989
PAGE 409
III -vi a cuatOJDar' broker in aubsections (1) and (2), it i obvious that a third party" does not include the transferee's broker.11 Praawaably, however, the tranafargra broker could bathe third party. Second, what ia the meaning of identified instrument? 'l'h mot plausible anawer is that an identified instrument in subaaction (3) bas the same meaning as a specific instrument" :-~~J~.--..~::~id..,lU:t:,d~~~un~t'-.:.~C'.tion::.t2.i:~?~:-:.:.i.'hr-would. .;~ ti~ .. ~--~o ~~--on .for a ~tz~i..:~:i:.tfii~t .requ~~ed -~ stringent test for identification of a specific security" in the case of a broker's delivery to its customer and a more relaxed standard for attormNllt by a third party to one not its customer. . ': . .... . \ .. ., :, 1..-.:.~~!=a:.~~ ... Naftll,ftianti\::. nwier-~ .~ . a~aer nter ot a :-.,-:. . ..... .,1., .. : ','\:-~: ._ . .:--~"' ,i,._-.~.: . ; .... : .. : :. . . .... : !: ...... ~--: .... :_. .. ,. property iatereat ia iatraaut aoatrolla4 by the broker au oaaar without a 4elivezy of the inatrmaent. A fourth principle also clearly emerges from section 13(2) of the First Draft. The drafters contemplated that in the typical brokerage transaction, where no delivery by identification of a speci~ic instrument" occurs, a transfer of 11. It would be anomalous that a transfer by a broker to its customer could take two different forms--confirmation pursuant to section 13(2) and attorm1ent pursuant to section 13(3). 12. The first sentence of subsection (2) refers to a broker that "identifies a specific instrument. Th second sentence than refers to such identification." Because these are the only other references to the concept of identification, "identified instrument in subsection (3) would appear to carry the sue meaning. DOC. SWP1104 July 17, 1989
PAGE 410
III -vii ownerahip right to th broker' ew1tomer nevertheless would occur.0 The second ntence of section 13(2) d-onstrated the drafters awarns of the diatinction between transfer of a property intereat and delivery of an inatrument. As drafted, however, the proviaion did not expressly provide that such a tranafer would occur. Rather, it merely contemplated that such a -~~~~!F~~~-f.~!::~~~.F-~\-~~--~4~=.~@!J~~-,~~~:~~~:~~~ ~-~~=:: ~> .. :: . ~lcle V .Yn au!=h ~ojt~eliveey t~a~-~-r~, broker would be .- .,. . the "holder of the instrument even if the instrument is part of a fungible bulk held for customers" and even if the customer acquire a.proportionate property intrt in auch fungible :: . : ............. .. -~.::: .. ".: . .. '-~:-.... .. . :.: .. =_~.... .. :.i~ : .,: .,. .:. :-~ ~--1 ~ 4'; ... -:. :.~ .... -: -~ .. : ~=-_ .. :. ~--:~"' ... -~ .. . :. ; .... ' ._. ,, : .. ~.'~ .. :.~. ~.-.. .':: .. ; :,. :.. ,::-,. -~'. :.:::: . ,.; .. :-: .:. .. a,.' 13. First Draft, supra note 1, I 13(2) (second sentence). 14. an Fir.st Draft, supra note 1, Note to I 13(2) (quoted supra text at note 3) (notice of confirmation of purchase should normally be sufficient to create ownership rights"). No other section of the First Draft contained any provision dealing with the method of non-delivery transfer of a property intereat. a.. also STATE OF NEW JERSEY, COMMISSION TO STUDY AND REPORT UPON THE UNIFORM COMMERCIAL CODE FOR NEW JERSEY, SECOND REPORT TO THE GOVERNOR, THE SENATE AND THE ASSEMBLY OF THE STATE OF NEW JERSEY 642, I a-313, New Jersey Study Comments (1960), discussing preu.c.c. New Jersey common law: It is clearly accepted that the moment a broker acquires securities for his ew1tomer, be it for a cash or similar consideration or on margin, the title to th securities vests in the customer, the broker retaining a right to be reimbursed for co-isaion or balance of purchase price Noter the fact that title vests, must be considered subject to the broker's power to pledge fungible bulk. Be need not deliver a specific security, but only a similar curity, until the security becomes specified. (citations omitted). DOC. SWP1104 July 17, 19l'9
PAGE 411
III -viii bulk.9 'l'bua, if no apecific inatrwaent were identified, the cuat011er would not receive an ownerahip intereat in any particular inatrmaent and the cuatoaer' intereat would be only in the funqible bulk. 2. aeaoad uad ftird Drafu Section 30 of the aecond public draft waa aubatantially --~-~--~~:.;~~~:,:1~.-:"f::J'.i~t. ,D,ntt;~-~-:~-.S~Dd Draft did. . . .._,. -~ t I: o , '1 .. I/ . :,: .. .,.,,:_~f !', ~,~-:"'.: :.~.-:,-.-'.:.__-:"-~_,-:._:.~.:'.:. -.!~~-... l .-.. 1,-~::.-... .. ": : ... : :.,.,,: .... ~.r, -: . .. . ... ... .... ..... : ":."' I ,, I _: , ., \ ... ,. .. . .. .... .. "" .. ' 15. Firat Draft, aupra note 1, I 13(2)
PAGE 412
III -ix not diturb tbe four principlu of Pirt Draft.a Moreover, the Second Draft clearly identified the purpg11 of delivery and holder atatu under the tatutory acb--li9ibility for bona I .J. .. 0 ; ,,,._ ...,; ill' 0 0 e _, ,i._it..' I ;0 ,,, ,1 0 ', , I : ...... ,'"-.'I'! .. ~:'-:~:~:~,;; ....... ,l. ,-~ .. ,:-~~-;~.-: . ~ ... :,,-~ ..... ~~-,l ............. _~ ......... i". .. :..., . .:..: . :, ... .t .. ,-' ,, I I ., ,,,'., , ,,.. I , o o . 17. In particular, tbe Note to aection 30 of that Second Draft undancored tba 4raftan' parcaptionthat tranaactiona -~~Y~_-J.,..if~t:ion of. --~it,io c:arity _.var not tba JIC!z:a .. .. -: ~-:.; -~ .......... ,, .. : ' ... _.. ~... .v. .. -... .. . : .. ,; ,,~o' ,.~,. :,-',,, 0 .... ,:, ,-,, ,, ,\"' 0 lo,': I', .. '0 1 ~-I o Generally under thi uc:tion [30] the aapbaai i placed upon actual receipt or pbyaical poueaion of the aacurity. Subaection (2) i duiCJfted to fit tba practice in broJcara9a houaea vben an identified aac:urity i ! ecliately Ht uida for the cuatoaer. 'l'hi i far froa tb COW110n practice, however, aince normally no identification taku place until delivery i daandecl by the cuatoaar. In auch cam confirmation of the Alai aufficiant to c:mte ovnerahip ri9bta in the c:uatoaar but be dou not bacoaa a bona fide purchaaar under Section 18 until apacific identification of th Hcurity. second Draft, IJlRA note 1,, Not to section 30, nprintl4 in 3 UlfIPOD.COKaUCIAL com: PBAm, IJ1PA note 1, at 313. 18. _, ,q,, Pattaraon, Witt9wtein and tba Code: A Theory of Good Paitb Perforaance and lnforcaant Under Article 9, 137 U. Pa. L. Jtev. 335, 371-33 (footnot oaittad): To Jcnov vbat 9ood faith aeana, n neecl to conaidar tba purpoau that tba concept aarvu in laval dicoun. By diacloainCJ tba purpoaiva rationale of laval diac:ouraa, ve can provide th analytical fraaevork vitbin vbic:h participant. in that diacourae are able to anchor claim about vbat the lav raquiru in adjudicative context.. DOC. 811P1104 July 17, 1119
PAGE 413
III -x fide purcbaHr atatua ao a to cut off competing clai.19 The third public draft of contained no -trial changea. 1. ftllrtll ... l'iftll Dnfu 'l'be fourth public draft of Article V incorporated aipificant atyl and atructure chancJ to tb former ction 30. Section 21 of tbe Pourth Draft provided: .... ... ~~ion .2~ .. ~:-~ ..... :, :-. :. -~,.s IRODR uavLDD;.-AT'l'ORRIIIR'l': .-.. ...... .. (1) Delivery to a purcbaaer occun when: (a) be acquir poion of tbe curity; or (b) hi broker acquir poion of a aecurity apecially indoraed to tbe purcbaHr or iaaued in bia .... ,or .-; ....... :, .. ,~ ::~.::.,. :-:-:~ .. ,_ .... ,_.-:. . ,~-:i;,::,-?'.:."~~:, .. .... .~ ... -. '. -. .. '" :-:---~. . -. . . I' r". : .. .. . ... 11. 'l'be Second Draft provided that a bona fide purcbaaer vaald acquire a perfect title to tbe aec:urity. Second Draft, &PD, note 1,, I 11(2), J'IPrint;,O in 3 UHIPORM CbNNERCIAL CODE PBAm, IJ1PD note 1, at 210. Tb definition of bona fide purcbaaer in the Second Draft vu lillited to purcbaaera that tau delivery of a c:urity. ld-, I 18(1), at 210-11. A bolder, aiailarly, waa liaited to one in poion of a aec:urity. ld, I 11(2), at 280. In view of thi effect of delivery and bolder atatu, th purpo of lilliting delivery and denying holder atatua except in tbe ca of actual pbyaical delivery, apecially indoraed and cuatomer nu aec:uritiea, and aecuritiu that are apecifically identified by a broker or attomin9 third party, under I 30 of tb Second Draft, ia made clear. Th abaurdity of conferring bona fide purchaaer atatua on a purcbaaer wbo dou not take poaauaion of a negotiable inatruaent in tbe abaence of an identification of a particular inatrmlent ia patent. IU ORA, Part II, note 85. Tbe First Draft contmaplated a aiailar operative rule tbat would be denoainated due n-,otiation. la Pint Draft, aupra note 1, II 10, 17. 20. Qnifpn GRW11rsi11 cpc1,. 'J'nt;at;iy 11cpnd Qr1C-Art;ic11 Y, II 11, 11, 3 Hot (Auguat 21, 1947) [hereinafter Third Draft], rgriM,0 1ft 3 UlfIPORM COIINIRCIAL CODE PBAP'J'S, mmn note 1, at 521-27, 531-32, 553-54, 559. DOC. IWP1104 July 17, 1989
PAGE 414
III -xi (c) hi broker aanda him confirmation of the purch and alao by book entry or otberwi identifies a pacific curity in the broker' poion belonging to the purchaar; or (d) attomaant i aade by a person other than the tranaferor with repect to an identified curity. (2) A broker not within paragrapha (b) or (c) of aubaction (1) i the bolder of the aacurity deapita a confirmation of purcha and a book entry or other ,.;.!... . ,iad~~-tion '.~t, .. t!h.~ity.\ia._..fta,,. QC.~fu.ngible ... bulk-held ,: .-~--~~tor~~~:~~-pit: -~i' fu7miar . 'acquiai tlon of a .. propo~ionata p~~Y ~tert in .. th fungible bulk.: .. . . . (3) Attornmant i th acknowladCJ11lant of a person in poion of a curity th~t ha hold the aacurity for or on behalf o~ the purchaaar. ParaCJRph (1) (bt of 1".~urth Draft ieft the. Firat '.",~!.,' .~,,,,,,, 0 :, ', 'o ,, ........ ,l"'t' ... , .. A ,If,,,.;:,~,,,, r10 ''..,, :, .. : ,.,, ','"' , :Princ~pla in~ .. i,y. affinat.ival.y-.providi119 ~or delivery to a ... . ', 0 ,' 'I 00 .' ,, 0,' ,,\ 0 ''l,t., '' : ,, : ,,i, '',;,,, ',,. !",' " .' 0 ', llt'.,' ,, ',' , ,~ : purchaaer of specially indonad and c..-uat011er n- aacuriti in a broker' poion. Likawi, the Second Principle, delivery by a broker' identification of a pacific aacurity, wa praaarvad. Indeed, for moat purpoau tba CJ of the Second Principle can and hara. The lanCJUCJ of ction 26(1) (c) is identical to the v1rion of pre-1978 aection 8-313(1)(c) that was 21. Prppg Pinal Pirt pratt--Art;ic11 y, I 26 (April 26, 1948) [hereinafter Pourth Draft], rnrinttd, in 4 UNIFORM COIDIIRCllL CODI QBAD'I, IJlPD note 1, at 340. 22. Paragraph (1) (a), however, dropped any aention of th a9ancy concept. Pourtb Draft, aupra note 21, I 26(1)(a). DOC. SWP1104 July 17, 1989
PAGE 415
III -xii eventually promulgated.ZS Moreover, except for dealing with tranafer (inatead of delivery) and expanding the scope beyond brokera to elll:)race financial intenaediaries, 1978 section 8-313(l)(d)(i) also -d no substantive change. Although the 1978 veraion no longer provides for a delivery, it reaches the s-re.ult by providing that a transferee pursuant to 1978 :.~.~q~::.t~313(.):._(i)i i~.-~~~a-l>~: :f.iC,;t :p=-~,~~~-' ~-...It .. ._ ralloinf that .. th.-intetpreta.tion 'gi~en 'to_ d~liv~ry-"i:,y ideut.ification of a apecific instrument under the First Draft26 applies equally to identification of a specific security under pre-1978 section 8-313(1)(c) and 1978 section a-313(1)(4) (i).27 . ... . . . ...... ':-, .. ,.,:,.,-.. : ,-. -fli ... ctiangeil;' .. i)i i'tl"l: bboaied' !'in.' sect:[on""&. a1.c;. . ., : ... .: .. :, .:;:~ .. ,:-: ... -:. .... .. .. ,'. .. ,.: . : ._ ...... ., .. ,:.~ .. , ,,.-... prervad, without change in aubatance, the 'l'hird Principle, 23. For discussions of the various official texts of the u.c.c., infra not 40-54. Pre-1978 I a-313(1)(c) remained unchanged through all of the various official texts of the u.c.c. until I 8-313 was aubstantially rewritten in the 1978 Article 8. ld-24. an u.c.c., app. 1, I a-313, Reasons for 1977 Change, at 855 (quoted in part supra note 4). 25. 1978 SI a-302(1)(c), -313(2) (first sentence); supra Part v, note 244. 2fi. a aupra not ,-a and accompanying text. 27. In a review of the subaequent pre-promulgation drafts, the not to tho draft, the various promulgated official texts of the u.c.c., and the official comments to those texts, I have found nothing that would indicate a different interpretation by the draftera. DOC. SWP1104 July 17, 1989
PAGE 416
III -xiii attornment only as to an "identified security," as well as the Fourth Principle, transfer of a property interest through a broker in the absence of a delivery.29 Section 27 of the fifth public draft was identical to aection 26 of the Fourth Draft. ,. liztla, levatJa a4 igJatll Draft 'l'he Investment Securities article was first 31 ... .. -,~~)>)~~~~\'..~ ... ~~!\; >:-~:-~~-~~~-= .... ,.:'i..,,;.;, .......... ......... ., . "!',:. : .: ......... ., .... aection 8-313. ot. the Sixtb.Draft deieted .. t!i definition ot. : .... .... I ' , : ',, ': . . : ._ ',. : . ":' . attomment that appeared in.the Fourth Draft and Fifth Draft,32 the op~rative provisions did not change the_substanca of the Fourth and Fifth Drafts and riot:hing in stiction 8-313 or the .. .. ,_..t'.': ::-.: .. ;, ~---.~:.,.~ ::;t:.-~ ; __ ~::. -~;-,./.;. :.:/ ... i;~ .. .. r.:~:.:r.."t": ,,--:'\' .'., :..... _. .'; .. ... .. : '. ... -~.:-: t ~--: .... :_ .... -.-.. ~. :~ ....... ,. ;_~ . ,:!,:,:!-.!,. ".": :::: .. ....... 1 .,# .~: ., ;"': .. -: .... .... .: :::: . .,;_.,. ..... . ,.' .... : ,.:,_ .. :,.., ..... .... . .. .. .. ...... .. :.-.: .... ~;--_.-. ... ; . : ... ~--~.-.;~~.:-:. ..... ,.1 ...... . i : . : -~< . .. 21. Fourth Draft, supra note 21, s 26(1)(d): see also 26(3) (adding a definition of "attornment"). Although the drafters did not elaborate on the style changes incorporated in section 26, the Notes to Fourth Draft stated that section 26 was "in substantially the same form as when before the Institute last year (referring to Second Draft, supra note 16). Fourth Draft, supra, Notes to sections 26, 27 28, reprinted in 4 UNIFORM COMMERCIAL CODE DRAFTS, supra note 1, at 382. 29. Fourth Draft, supra note 16, I 26(2). 30. Proposed Final Draft No. 2--Article Y, I 21 (August 9, 1948) [hereinafter Fifth Draft], reprinted in 5 UNIFORM COMMERCIAL CODE DRAffl, supra note 1, at 203. 31. u.c.c., May, 1g49 Dratt, Article --Investment securitie [hereinafter Sixth Draft], reprinted in a UNIFORM COMMERCIAL CODE DRAFTS, supra note 1, at 203-57. The May, 1949 Draft was the firat publication of the u.c.c. that included Article 1 and was complete with Comments. 32. s11 supra notes 28, 30. DOC. SWP1104 July 17, 1989
PAGE 417
III -xiv C01111ant deviated from the four principles outlined above,ss with ona poaaible exception (which was resolved in a subsequent draft).36 In the aavanth public draft aaction a-313 was 33. Section 1-313 of tha Sixth Draft made only alight wording changes in paragraphs _(l)(b and (l)(d): (b) his broker acquires possession of a security speci_ally .. / ........ ;;:. :. -: ... --~P.-4:.ltQ . tb~ .. p~~u~-l .or.-.:isa-.. in {hialtba~~me :. /: .at 1:b wrclj1lii:f or: ... ... .. .. (d) attornment [is made by a parson other than the tranferor] with respect to an identified security ia NOa by I person other than the transferor. -Sixth Draft; &RA nota-li,. 1 a-:JllCi> (b), Cl) (d)-,--raprintad in a Ull'IPORII. .cc,iJNBR~IU,!",CO'DaPBIITS' ,-:. iUJmt note.--1 >.--'at .(bracketed worda-indicate:daletiona-froarand italicized words indicate additions to language of Fifth Draft, supra, I 27(b), (d). 34. The last two sentences of comment 1 to I 8-313 stated: "[D]alivery may be completed while the security ia still in the hand of tha broker. When the factual si tuationa described in Subsections (l)(b), (c) and (d) occur the customer becomes a bona fide purchaser." Sixth Draft, supra note 31, I a-313, co1111Dant 1, raprintad in 8 UNIFORM CONMERCIAL CODE DRAP'l'S., supra note 1, at 239-40 (emphasis added). This formulation might be read to suggest that a broker's "attornment" to its own customer would constitute a delivery under I 8-313(l)(d), thus conflicting with the Fourth Principle. However, a similar statement in a later version of the comment to I 8-313 substituted the word purchaser" for the word customer." Saa infra note 39. comment 2 also indicate that a purchasing customer's broker would not be a "person other than the transferor" as used in paragraph (l)(d). 2. The provisions of Subsection (l)(d) as to delivery by attornmant ara directed primarily toward the margin trading situation where the securities are pledged by the broker to secure funds tor the r-inder of the purchase price not advanced by the customer, but, of course, apply alao to any other situation where the security is in the possession of a third party. DOC. SWP1104 July 17, 1989
PAGE 418
III xv identical to the Sixth Draft except that the reference to attormaant in paragraph (l)(d) was deleted and paragraph was reworded with no apparent change in meaning. In the eighth public draft section 8-313 waa not changed.36 s. :latJa, ~nth, act BlnatJa Drafts ad 1112 Off:la:lal ~at The ninth public draft of section 8-313 included ~~~~,~~,,~j.p.9~~~!J.,,. ... .. ~~-.,~>; -~,,.~)?~~~-;~--'i, ..... ';::, .. : : ,: o,oII. :" .,. ,.-::.-= ' .:-.,,,', ;,,,': .. , .. ,,.,: ' o ,'.:; I o, _.i~~atantive~the .reference t.o p~ra(Jrapli_ .(1) (C) was.d~leted _from ., . . ... :.,.:. .. . . ... ... ,;. . .. . , .. .. .. . . .. ,:.:~: .... ._ 0.,1-.~.-~-~.:\/:~::,,~\-~-~ :\:~:;,'~.-.~:,; .. ;1 .. --=;,L._ "; .;:--;.,-;\ --~:,.,,,'.~.---. 1,, ..... .-.,:,' j,,.i. 00.''.0 . o , . .. ', .... ... "'-, .',\'1. , :, -~-~ : ... o '~ ' , / .. ; ;_. I .. ,.... ~ .. ~\ . '1: ' .. s~ ~.t.t,. -iPD, >I-i~3l3f:-]:i-.t:.1., ;.raprint;ad in. a -maFoRM cormcnt. CODE PRAPTS, supra, at 239-40. 35. u.c.c., Text only Printing Except for the Article on sales {Article a> and the Article on Effective Date and Bepea1er {Article 11), s 8-313 (March 1, 1950), r1printed in 9 UNIFORM COIDIERCIAL CODE DRAFTS, supra note 1, at 132 [hereinafter seventh Draft]. Paragraph (l)(d) of Seventh Draft S B-313(1)(d) provided: (d) [attornmant] with respect to an identified security [is made by] a parson other than the transferor ackngwldges that he holds for th purchaser. seventh Draft, s 8-313(1)(d), supra, raprintd in 9 UNIFORM COIDIERCIAL CODE DRAPTS, supra, at 239, (bracketed words indicate deletions from and italicized words indicate additions to language of Sixth Draft, s 8-313(1)(d), aupra note 31). 36. u.c.c., Prgpgd Pinal Draf1i, Text and cen1nt1 Editipn, s 8-313, c01111ent (Spring 1950), raprintad in 11 UNIFORM COIDIERCIAL CODE QRAPTS, supra note 1, at 175-77 [hereinafter Eighth Draft]. c01111ant 2 waa modified to conform to the deletion of the word attornmant and the aubatitution of "delivery by acknowledgment" made in the seventh Draft. ld-: sea supra note 35. DOC. SWP1104 July 17, 1989
PAGE 419
III -xvi section 8-313(2).37 The deletion of that reference probably was inadvertent, however, as it was reinserted in section 8-313(2) of the tenth public draft, which otherwise waa identical to section ... .. ~7.,.. ; .. lJ-.C~.c ,. n:O1i2Pl@d fina;Jr")P:r:1tl:: No.,. 2 . Text Edition, S.: a,.-: .. -~:r(Spring, 1951)'~ tOPrintad. tn tJNI!'ORM coMMERCIAL CODE . DRAP'l'S .. :aupra note 1, at 232 [hereinafter Ninth Draft] provided, in pertinent part: Section 8-313. When Delivery to the Purchaser occurs; Purchaser's Broker as Holder. (1) Delivery to a purchaser occurs when . -. : . , o I .. i .;.-.,:. ...... f); 1:.?-~J.Ql'&.,perapn::'dnlsu:ittad, ,by-bi;m acquires ... .-.~ ... :: ..... '":,.po~-.i.on~.of.,.~: security;. or.._..-... ..... .. ,,. (b) his broker acquires possession of a security specially indorsed ,:tQ or issued in the name of the purchaser: or (c) [unchanged] (d) with respect to an identified security to be 4eliyered while still in the possession t I third person when that [a] person [other than the transferor] acknowledges that be holds for the purchaser. (2) Excapt 11 specified in subparagraph [A broker not within paragraphs] (b) [or (c)] of subsection (1) is not the holder of securities held for him by his broker [the security] despite a confirmation of purchase and a book entry and other indication that the security is part of a fungible bulk held for customers and despite the customer's acquisition of a proportionate property interest in the fungible bulk. Ninth Draft, supra .. 8-313, reprinted in 12 UNIFORM COMMERCIAL CODE DRAFTS. supra .. at 232, (bracketed words indicate deletions from and italicized words indicate additions to language of Eighth Dr~t, supra note 36, 8-313). DOC. SWP1104 July 17, 1989
PAGE 420
III -xvii 8-313 of the Ninth Draft. The text of section 8-313 in the eleventh public draft remained unchanged from the Tenth Draft.39 Hor wa there any further changes to aection 8-313 and the c01111ent thereto in the next public draft, which was the final version of the 1952 Official Text.' Thus, the Four Principles of ection 13 of the First Draft emerged in the 1952 Official : ... ..... : . .. . : .. I <# ,. : .. ... .. . 38. u.c.c., Final Text Edition, 8-313 (Hover 1951), raprintad in . 13 UNIFORM COMMERCIAL CODE DRAPTS, aupra note 1, at .22~;~.[-~~~~ 'l'~tll .Dnt~l~i, .. Seation-.. ,a~3.1~ (2)-,,. aa .. o .. revised, -;p_rov:i.S .. Bxc::ept--... :.ilpcifiecl -~ -~agrapha~:(~) and le)-.. n 'I~~-:DJ:aft, .. l,_.8-~3.13(-i) .. ... gpra._..(itali~ized .. wor.da-indicate addition to languageof Ninth Draft, supra note 37, i-313(2)). 39. u.c.c., official Draft. Text and C9JPJPents Edition, s s-313 & comment (1952), reprinted in 15 tJHIFORM COMMERCIAL CODE DRAFTS, supra note 1, at 154-56 [hereinafter Eleventh Draft]. COllllllent 1 to Eleventh Draft 8-313. The last sentence of comment 1 replaced the inapt reference to a "the customer," in the context of paragraph (l)(d), with a reference to "the purchaser. a.a Eleventh Draft, supra, 8-313 comment 1, reprinted in 15 tnfIFORM COMMERCIAL CODE DRAFTS, supra, at 155-56; supra note 1. Comment 3 continued to state that under subsection (2) the broker is the holder when paragraphs (l)(b) or (c) do not apply, thus indicating that the Ninth Draft's change to subsection (2), from a positive statement that the broker is the holder to a negative statement that the purchaser is not the holder, waa not substantive. bA Eleventh Draft, supra, 8-313 comment 3, reprinted in 15 tJHIFORM COMMERCIAL CODE DRAFTS, supra, at 155. 40. u.c.c., official Draft. Text; and S9JPJPents Edition Is-313, comment (1952) (with change and modifications approved by the Enlarged Editorial Board at meetings held on December 29, 1952, February 16, 1953, Nay 21, 1953 and December 11, 1953), reprinted in 17 UNIFORM COMMERCIAL CODE DRAD'S, supra note 1, at 154-56 [hereinafter 1952 Official Text]. DOC. SWP1104 July 17, 1989
PAGE 421
III -xviii Text, following a aeries of drafts spanning more than seven years, without dilution or change in substance.41 41. Commenting on I 8-313 of the 1952 Official Text, it was obaerved: [S]ubaection l(b) rely describes an ordinary bailment aituation, where the broker, acting as agent for a disclosed principal, has received, and holds, a security issued or indorsed to his principal ... :_ : .::_/:-,:, .. ;' i~,:abdi~r. aituatjbn. -~c~--~w)ieif 'the :.broker;. by .. bo:~k entry or otherwise-~ (physical segregation) (tagging) identifies a particular security as belonging to the customer. It appears that, as far as it goes, subsection (l)(c) does not affect present law. Subsection (l)(d) contemplates the situation where the lling broker, or aome other parson, appropriates the .. ;aecurity tor th cuatomer with his. uaent... Since .. ,. ~:.."~~-C~il.-,0) _.._appli-~to;,specific;h. ident,ified--=toc:k;, -title would ~-,.: ~ccrcU.n9 .. i:o. =~~-_-pru1111'4 .' ut-.t .. _of, .the. parties, at the tilla the offer to buy is accepted by the sanding of the confirmation In subsection (2), however, the exclusionary effects of subsection (1) are sat forth. It provides that unless the broker has a security indorsed to or issued in the customers name, or identifies a specific security as belonging to the customer, the customer does not hold any specific security. In other words, there is no delivery of a aecurity not indorsed to of issued in the customer's name unless the broker confirms the purchase order and picks a particular certificate. [T]ba implication from Section 8-313(2) that the customer acquires a "prgperty interest in fungible shares, even though he is not a holder of any particular certificate, may actually mean thia: that title to the ahare passes imlediately to the customer on notification, but delivery requires earmarking. As suggested above, this is not a change in the law. DOC. SWP1104 July 17, 1989
PAGE 422
III -xix I. 1112 uad 1178 Offiaial ~at: Section 8-313 was revised two more times, pursuant to the 1962 Official Text and the 1978 Official Text.42 The 1962 Official Text added a new paragraph (l)(e), dealing with transfer on the books of clearing corporationa,41 added a new ~ .. -.;. ........ -.. ,2~ ._., .. p ... .... ,.i1.ea. .. om.CUL .. ;HXT..1'Iff,. CONIID'l'S., 1 .8.~113 t!OPN',1~~-DPrigt;l4 .10:-~~---UE_,OD, CQDB, DRAP'l'S,. supra n~t- .. J.:,~--at-,.~$4~57 .[b~~ftU::~--.2. :Qffici.-1-,Text.l.1:-.u~c.~., 1978 OITICIAL TEXT WI'1'R CONMEN'l'S, 8-313 [hereinafter 1978 Official Text]. The text of and (with one exception) the comment to 8-313 in the 1957 Official Text and the 1958 Official Text was identical to that in the 1952 Official Text. u.c.c., 1957 official Text with GRJDJP1nt;1, 8-313, comment, reprinted in 20 lJNIFORM COMMERCIAL CODE DRAFTS, supra note 1, at 95-96: o.c.c., 1958 Official Text with cppent;s, s 8-313, comment, reprinted in 21 lJNIFOJUI COMMERCIAL CODE DRAFTS, supra, at 347-48. The penultimate sentence of comment 3 to the 1957 Official was revised to state more directly that a customer can refuse to accept delivery from a broker when the customer receives notice of an adverse claim prior to delivery to the customer but after delivery to the broker. 1957 Official Text, -313 comment 3: .m supplement Bo, 1 tg the 19s2 official Draft ot Text and PJPD1,nt;1 of tha u,c,c, 169-70 (January, 1955), reprinted in 11 lJNIFORM COMMERCIAL CODE DRAPTS, supra, at 487-88 (explaining this change to comment 3). The text of and the comment to 8-313 of the 1966 Official Text and the 1972 Official Text wa identical to that in the 1962 Official Text. u.c.c., 1966 OFFICIAL TEX'l' WI'l'B COMMEN'l'S I 8-313 & comment; u.c.c., 1972 OFFICIAL TEXT WITH COMMENTS I 8-313 & comment. 43. 1962 Official Text, supra note 42, I 8-313(1)(e), raprintad in 23 lJNIFORM COMMERCIAL CODE DRAFTS, supra note l, at 355. DOC. SWP1104 July 17, 1989
PAGE 423
III -xx subaection (3), dealing with notice of adverse claims in the brokerage context," and substantially revised the wording of aubaection (2), but with no apparent change in substance." The reviaion of ction 8-313 in tbe 1978 Article a changed its focus froa that of delivery to an exclusive listing of means of tranater ... Although it is clear that the drafters intended to .pr~se~e-~e-Fo~.Prin9~p~-.. in~~rp~ra~~~ in.th~ _variou~ pre-1978 . .. . .. . , . . . ... -~-:~ ;'-:4.j-~-. :-11e2:-om-c::ta1= Tat;--'l)ij,ra'--not ~---1 ~-, ... 3-13 (3). : & comment 3:; DPd,Qt;ad in :23 mfIPORM COMNBRCDL CODE -QRAP'l'S; supra note 1, at 355-56. 45. The revised subsection (2) provided: (2) The purchaser is the owner of a security held tor him by his broker, but is not the holder except as specified in aubparagraphs (b), (c) and (e) of subsection (1). Where a curity is part of a fungible bulk the purchaser is the owner of a proportionate property interest in the fungible bulk. 1962 Official Text, supra note 42, I a-313(2), reprinted in 23 UHIFORM COMMERCIAL CODE DRAPTS, supra note 1, at 355. The new subsection (2) acc011JDodated clearing corporation transfers in paragraph (l)(e) and anointed clearing corporation transferees with holder status. The other principal change was the addition of affirmative statements of ownership by a broker's customer who is not a holder in lieu ot tba mare implication of this result under the prior versions However, the first sentence ot the revised version should not be read to provide that a non-holder customer owns any particular security. Rather, the ownership ot a non-holder customer in both sentences of the revised subsection (2) contemplate an ownership in a fungible bulk. 46. Saa supra, Part II, notes -75 and accompanying text. DOC. SWP1104 July 17, 1989
PAGE 424
III -xxi veraion of section 8-313,47 aome of the wording of 1978 section 8-313 isl than felicitous in this connection. All to the First Principle, it remains clear that a transfer' financial intermediary cannot be a parson designated a used in paragraph (l)(a).41 'l'h Second and Third Principles have become obscured, however. 'l'ha pre-1978 versions 5~J.~~~r ~-~-~k:~-~A-~;;:-,~~,.~f.,,~~ .. : -~-::~ ::. -~ .:~~ forbeara, -eel 'th -~rdti. ~-id~'ntity _and identified"' only in the 1.... .. ::-:..... :: .. :. :. .. ~. ~-. .... :. . .... .. . .... . .. ; , . . context of identification of a specific security-~a particular pie~e of pape~.49 1978 section 8-313(l)(d). now employs the ,o , ' o o , 0 'O :. I 'o O o' ,I' 'o ,_-o0 0 0 : concept of identification to apply also to the identification of ~t1~i--:ai_:.:i~1~ .. --~;~:~ i~ljii_ .. ;.~~ik: :th~-foi~, the ,word~ . . . . . . .. :-.-..., .... -~ -: .... .. -. ..-.. ,.; -:; .. ... -::-.-:-:~: .......... -.. ~--~,.a:.. ,. ........ :. .. .. _' ... !i-pecific" in paragraph (1)(d) (i) to boulder a heavy burden. 4 7. see supra note 24. For this reason this Appendix does not deal with the various interim drafts that culminated in the 1978 Article a. 48. Because only certain transfers can result in bona fide purchaser status under 1978 I 8-313(2) when a financial intermediary controls securities for a transferee, paragraph (l)(a) cannot be used to bootstrap such a transferee into receiving actual possession under agency principles. In 1978 II 8-302(1): -313(2). 49. au Aronstein, Security Interests in Securities: How Code Revision Reflects Modern Security-Holding Practices, 10 u.c.c. L.J. 289, 298 (1978) ("The requirement of a speciric security in paragraph (c) [of pre-1978 I 8-313(1)] and an 'identified security in paragraph (d) rule out their application to situations where there is no partic;ular piaca pt papar raprasantinq tb rights to be transtarred but where all other relevant considerations are identical.") (emphasis added). 50. 1978 I 8-313(1)(d)(ii), (d)(iii). DOC. SWP1104 July 17, 1989
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III -xxii Moreover, tbi drafting approach tend to -k tba aeaning of th word identified" in 1978 paragraph (l)(e)--tba aucceaaor to pra1978 paragraph l(d)-whicb, properly construed, contmaplataa tbe notion of a apecific curity.51 To ll&ke_uttera vorae, 1978 paragraph (l)(f) provide for tranafer by a (non-financial intermediary) third peraona acknowledgaent witb reapoct to a pacific JlllCertificated curity.52 Finally, the change from a delivery-baaed ction 8-313(1) aakaa it unclear whether a tranfr of a specific identified security purauant to paragraph (l)(e) receives a delivery so aa to qualify for bona f id purchaser __ treatm~n:t. 9 :..,.~,./:I:..: ._ .- c' :;: ... .:::.-:-:.~_:.~ .. .. ~-,.:;.:'!.:., ... .. : ."~ :. .. , .. ,: ... -5111-IN apn note 12 and,accmapanying text~ 1978 I 8-313(1) (e), however, does not apply when the tbird person is a financial intenediary, unlike pre-1978 I 8-313(1)(4), whicb was n so limitad--except that paragraph (l)(d) did not apply when th third parson was th tran1t1n11 broker. saa supra note 11 and accompanying text. 52. 1978 I 8-3-13(1) (f) (aphasia added). Martin Aronstein, the Reporter for tbe 1978 Article 8, has auggeated to me that specific in paragraph (l)(f) i intended to limit its operation to cirCUJUStances where tbe uncartificatad security registered to the third person can be traced to a particular initial tranaaction stat-ant. [Interview]. Tbus, under this analysis, a third person tbat ia the registered owner of a large number of fungible uncartificated securitia could not tranafer an interest in a fractional portion thereof by acknowledgment to a tranfr 53. It was clear under tba pra-1978 versions of I 8-313(1)(d) tbat a third peraon acknowledpent could reault in a delivery and, therefore, bona fide purcbaaer treatment. IU, ,q,, pre-1978 I 8-313 comment 1 ("When tbe factual aituationa deacribed in aubaection (l)(b), (c) and (d) occur delivery to th purchaser is complete, and no intervening notice of adverse claims before ha takes actual physical poion of the security can diveat him of hi rights.). Although the exception in preDOC. SWP1104 July 17, 1989
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III xxiii 'l'o AY tbe leaat, the language of 1978 ction 8-313 i illMllllitive to tbe Second and Third Principlu that bad urvived ao 10119 ~b ao aany drafta and official texta. Hopefully tb coarta will honor tbe draften declared intent tbat the aubatance of prior lav -preaerved." unfortunately, however, it i virtually illpoaaibl to read 1978 NCtion 8-313 correctly .. ~:;>~: ~}~";-~i~ ~~~-ry-~ ... ., ..... : . . . . .. .. .. . ... . ... --~ .: . ,. .. : ~II-~-i .... ,, .. . . : .. : . . .: -~.... ................. .. ,,: ; ., o;_ ':, : ~, I . --~. ; "" ' ,' " 1 , I -. , -.. , . :: . _.,, .. _. ,. .. . : = ... _;: ., r -~.--.:. . -~-:. ... r . 1978 I 8-313(2) addrued only deliveriu under paraqrapba (l)(b) and (c), not (l)(d), tho uceptiona applied only to purcbaaen vbo curitiu were controlled by their broker. Th acJcnovled9i119 tbird penon under pre-1978 paraqrapb (l)(d), of coune, could not be th purcbar' broker. I aupra note 11 and accoapanyinq text. 54. IN aupra not 2,. DOC. SWP1104 July 17, 1989
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