Current Legal Issues Affecting Central Banks, Volume IV.

26B. Legal Issues Regarding Payment and Settlement

Robert Effros
Published Date:
April 1997
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Central banks have a natural interest in understanding and improving existing mechanisms for completion of securities transfers. The Group of Ten central banks decided that a comparative study of these mechanisms would yield the greatest benefits and commissioned two separate studies of securities transfer systems. The first was the delivery versus payment study, which focused on direct participation in national settlement systems.1 The second study focused on cross-border security settlements and addressed some of the more basic issues that were put aside in looking at the delivery versus payment issues, including the role of intermediaries in securities transfers and the legal relationships underlying the choices that people make when choosing a settlement mechanism.2 The conclusion reached by the cross-border study group in the legal area was that “[t]he most significant legal distinction between a domestic and a cross-border securities transaction is the potential for issues related to ‘choice of law’ and ‘conflicts of laws’.”3 Stated as a formula, a domestic settlement plus conflicts of laws equals a cross-border settlement.

Domestic Settlement Issues

Technology has taken control of electronic settlement systems and the linkages that now exist among national settlement systems. This development has obscured some of the basic legal issues, which still deserve study. The investor is trying to acquire an interest in a security, which is a performance obligation of the issuer of the security; the object of the investor is to ensure that the performance is received.

The problem today is that almost all securities transactions occur through intermediaries. As each intermediary is added to the process, new legal relationships are created. At each level, there are the same layers of risk, including insolvency, the possibility that the intermediary will act negligently, and the possibility that employees of the intermediary will commit fraud. The goals of these transactions for the issuer and the investor remain the same. The issuer seeks the discharge of its obligations on the security, whereas the investor seeks to receive the issuer’s performance. Through the use of these intermediaries, however, the issuer risks that, despite the performance that it makes, its payment will somehow be diverted. The investor also risks that, somewhere along the way, the investment will be turned to other uses.

It is easy to classify many of the layers of intermediaries as agents of the various parties. The issuers’ agents include the registrars for transfer and the paying agents. Investors pick their money managers, brokers, and custodians. However, at the heart of modern securities markets are mechanisms that cannot easily be classified as acting for one or another of the parties. These are the exchanges, centralized market mechanisms for trading, clearing corporations, and central securities depositories. These mechanisms provide very specialized services for large groups of investors and market participants. In many respects, they resemble public utilities, as they provide services to these parties on a similar basis. However, if a problem develops in one of these mechanisms, it is not easy to say for which party the mechanism was acting in assigning risk of loss in individual transactions.

The problem for issuers and investors is that they have no choice about the mechanisms that will be used. Often, the mechanisms are prescribed by regulatory bodies. Certainly, active market participants—brokers, dealers, and large banks—desire to use the most efficient and least costly means of providing settlements. Consequently, those who want the performance to be complete—the issuers and the investors—have no control over the activities of the intermediaries (the layers between the issuer and the investor) that affect their own legal relationships. In fact, the number of intermediaries involved can multiply without the knowledge of the people who are most directly affected.

Although the legal relationships that arise can be unclear, these modern market mechanisms are essential. Paper-based settlements of securities are increasingly rare. Paper restricts the volume of transactions, causes delays, and increases the risk. It is very difficult to achieve a delivery versus payment with paper securities. The less time between the exchange of the security and the exchange of the payment, the less risk there is in the transaction. However, it is a real challenge to create book-entry securities that embody the rights that were previously embodied in pieces of paper without at the same time creating new risks.

A Group of Thirty study on this issue4 has increased the pressure in world markets to eliminate paper securities. The shift to a uniform settlement of “trade date plus three days” has spurred the development of new mechanisms that will avoid physical settlements of securities. Obviously, these electronic settlement systems are here to stay, and intermediaries will be involved in almost every aspect of securities transactions.

Cross-Border Settlement Issues

In a cross-border environment, the issues that arise in securities systems are compounded by questions of choice and conflict of laws. It is very difficult for investors to protect themselves from risk when they do not know which intermediary is involved, where it is located, and what country may claim jurisdiction over the transaction.

The Group of Ten central banks have done much to explain how payments can be processed efficiently with the lowest level of risk. The problem with applying these concepts to securities transactions is that the laws underlying securities tend to be more idiosyncratic. There are very large differences from country to country in schemes affecting the ownership, transfer, and pledging of securities.

Countries have used various methods to ease the transition from paper-based settlements to electronic-based settlements. Book-entry securities can be fitted into two different types of schemes. Under the first type of scheme, book entries are fitted into a country’s existing legal regime for physical securities. Often, this is accomplished through legal fictions and the immobilization of physical securities, upon which book-entry systems are then imposed.

Other countries have used the second type of scheme, which explicitly recognizes electronic securities. However, these schemes can take very different forms; even though systems may look the same, different legal relationships can arise. Some of these schemes attempt to preserve the individual identity of the security, while others specify that book-entry securities are essentially fungible and create new forms of property interest in those securities. Securities may be owned by all of the holders in a single system on a co-ownership basis with a proportional property interest, or there may be no specific property interest at all. Also, the relationship that arises may be a debtor-creditor relationship; if so, the security may be analogous to a bank deposit with special performance characteristics. Under that kind of scheme, it may almost be fair to call the instruments derivatives rather than securities.

The schemes can also be refined further. The interests in a debtor-creditor system can be secured by the particular securities that the investor is seeking to buy, or the scheme can create a preferred class of creditors secured by all of the securities that are held in the depository.

There are probably 50 different securitization schemes in use today, but the variety of legal approaches to the same question is obscured by the trading and settlement mechanisms that are used to create the interests. For example, country A may still use a paper-based legal system while country B has a dematerialized (electronic-based) system of some sort. If the central securities depository holding the securities of country A and country B is located in country A, there is a serious question about what investors get when they acquire country B securities. If country A does not recognize the country B electronic securities as securities—even though they are maintained on the same system as paper securities recognized by country A—investors in the country B securities held in country A may get a very different package of rights from investors in the same securities held in country B. This may sound like an issue that is not very common; in fact, however, as the linkages among national settlement systems become more common and the barriers to foreign participation in domestic markets become lower, as in the European Community, the risks of these problems will rise. One of the findings of the study of cross-border securities settlement cited above5 is that a large number of these linkages already exist. For example, there are more than 30 linkages alone among the Group of Ten countries. Some of these mechanisms are, of course, more active than others.

The shift from paper to book-entry securities has challenged those charged with overseeing domestic market activity. The goals were very simple in the past: count the securities and examine the vault procedures. The supervisor could be reasonably certain that the securities corresponded to the accounts held by the bank. Now, the process is one of reconcilement. The supervisor looks at the bank’s electronic records and determines whether they correspond to the electronic records of the bank’s intermediary. However, there is no way to verify independently that those electronic accounts anywhere equal the obligations issued by the issuer.

This is an area in which supervisors and central banks will need to do additional work. Even in systems in which property interests still arise when securities are turned into electronic forms, the supervisors may not be equipped to monitor that activity differently from debtor-creditor relationships in bank accounts.

Questions relating to the insolvency of intermediaries become more complex in the international environment. If an intermediary in country A becomes insolvent while holding securities for customers in different countries, there will be much dislocation as investors try to determine what law applies to their rights in the insolvency.

A number of countries have in recent years enacted new laws to minimize the complexities that arise in bankruptcy. In particular, all of the countries in the Group of Ten that had zero-hour bankruptcy rules have eliminated or narrowed the scope of them. These rules determined that a bankruptcy dated back to the beginning of the day of bankruptcy, so that all activity happening on the day of the bankruptcy actually counted for nothing. For settlement systems, this was critical because an insolvency occurring after the close of a settlement system but before midnight negated the activity of that day with respect to the insolvent participant.

It is unlikely that all countries’ laws on the transfer, pledging, and ownership of securities will be harmonized any time soon. However, predictability of outcome is still essential to make these markets work. Banks, investors, and supervisors must try to understand where the legal relationships arise and attempt to identify what law governs those relationships. If parties to transactions can identify all of the layers of intermediaries that affect their rights, the risks can in theory be assigned and compensated. However, it is essential, as a starting point, to determine the laws that will govern the relationships that concern the parties.

Most law that applies to these relationships is contractual, coming from agreements, market conventions, rules of self-regulatory organizations, and trade associations. However, the most complex form of agreement is the multilateral relationships that are created in the central market mechanisms, largely through those mechanisms’ rules. Direct participation is often limited, and, even though the rules may affect the rights of parties who are not participants, such as issuers and investors, those rights are rarely acknowledged. Consequently, if there is one thing that must be done, it is to identify—no matter how difficult the task—the intermediaries involved in securities transactions, as well as the countries asserting jurisdiction over those intermediaries and the claims that arise from their activities.

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