Security Interests in Investment Property


This article should be of immediate interest to all persons who are currently or may become either a lender or a borrower in a secured debt financing in which the collateral includes one or more types of investment securities, including stock, limited partnership or limited liability company interests, mutual funds, brokerage accounts or money market or commercial paper accounts.

As of the end of February 1997, more than thirty states, including California and most other western states, have adopted a wholly revised Article 8 (entitled "Investment Securities") to the Uniform Commercial Code (replacing prior Article 8) along with related amendments to Article 9. In most states, including California, revised Article 8 and the related amendments to Article 9 became operative as of January 1, 1997. In addition, the U.S. Treasury has adopted Treasury/Reserve Automated Debt Entry System ("TRADES") regulations making revised Article 8 and the related amendments to Article 9 applicable to all U.S. Treasury securities. Article 9 (entitled "Secured Transactions") itself is in the process of being wholly revised and it is expected to be presented to the states for adoption in the fall of 1998.

Prior Article 8 - The "Direct" Holding System

Prior Article 8 was premised on the traditional "direct" holding system requiring possession and delivery of physical certificates as fundamental to the ownership and transfer of securities (with the securityholder having a direct relationship with the issuer). Article 8 was last revised in 1978 to incorporate the concept of uncertificated securities, then thought to represent the future, but now largely limited to mutual funds.

New Article 8 - The "Indirect" Holding System

Revised Article 8, while generally continuing the existing rules for securities held directly, makes a significant leap forward by recognizing that in today's world the substantial majority of publicly traded securities are held "indirectly" through intermediaries and transfers are accomplished by book entries. The physical stock certificates, typically in the form of jumbo certificates, are held by a securities clearinghouse (Cede & Co., the nominee name of The Depository Trust Company (DTC), currently holds over half the outstanding shares of all U.S. public companies). A security intermediary, such as a securities broker, will participate in DTC and maintain a book entry account at DTC in which the ownership interest of the securities intermediary is noted. Customers of the securities intermediary, the ultimate beneficiaries of the securities, in turn maintain a book entry account with the securities intermediary. Accounts at DTC are settled daily by a netting of all trades.

In accommodating the reality of the "indirect" holding system, revised Article 8 and the related amendments to Article 9 also set forth some very significant changes in the rules pertaining to the creation, perfection and priority of security interests in investment securities (the new rules are described below). Importantly, these rules have also largely been removed from Article 8 and placed in Article 9 where they belong (although many key definitions remain in Article 8).

Transition Rules

The changes to the creation, perfection and priority rules raise the important question for lenders (and borrowers) in existing secured debt transactions documented under the prior Article 8 regime in which the collateral includes investment securities (typically a stock pledge) as to whether the lender continues to have a perfected security interest in such securities under revised Article 8. In most instances, but not all, the answer will be yes.

Revised Article 8 and the related amendments to Article 9 includes transition rules which have been adopted by California and most other states. In general, if a security interest in a type or item of "investment property" (a new definition discussed below encompassing, among other things, prior Article 8 notions of certificated and uncertificated securities) was perfected under prior Article 8 by a means which is also sufficient to perfect a security interest in the same investment property under revised Article 8 and the related amendments to Article 9, then the security interests will continue to be perfected.

If the prior means of perfection is no longer sufficient to perfect a security interest in such investment property, the transition rules provide a window of four months from the operative date of revised Article 8 for a secured party to perfect its security interest by a means set forth in the related amendments to Article 9, with the secured party's security interest then being deemed to have been continually perfected.

For purposes of continuing perfection from the old rules regime to the new regime, the transition rules also specifically permit a secured party to file a financing statement, without the requirement of obtaining the debtor's signature, describing the covered investment property, provided the financing statement is filed within the four month transition window and includes a statement that it is filed pursuant to the transition rules (UCC Section 8603(b)).

In California and in other states, the transition period will be over May 1, 1997. Secured lenders and borrowers, if they have not done so already, should review their loan documentation, and consult with counsel as appropriate, to determine what, if any, steps should be taken to continue the perfection of existing security interests in investment property.

Investment Property

The amendments to Article 9 create a wholly new class of personal property collateral called "investment property" (distinct from existing classes such as accounts, chattel paper, instruments and general intangibles) which will need to be described in the granting clause of a security agreement in order for a security interest to be created in such property. "Investment property" includes:

  1. certificated and uncertificated securities;
  2. security entitlements;
  3. securities accounts;
  4. commodity contracts; and
  5. commodity accounts.

A "Security" is defined in revised Article 8 to mean an obligation of any issuer or a share, participation or other interest in an enterprise of an issuer that:

  1. is in bearer or registered form or may be registered on the books of the issuer;
  2. is one of or is divisible into a class or series; and either
    • is, or is of a type, dealt in or traded on a securities exchange or market or
    • is a medium for investment and by it terms expressly provides that it is governed by Article 8.

A "securities entitlement" includes all rights and property interest of an entitlement holder in a financial asset while a "securities account" refers to an account to which a financial asset is credited in accordance with an agreement under which the person maintaining the account (the security intermediary) undertakes to treat the person for whom the account is maintained (the entitlement holder) as entitled to exercise the rights comprising the financial asset.

"Financial assets" (an Article 8 definition not to be confused with its Article 9 cousin "investment property") includes:

  1. securities;
  2. obligations of a person or a share, participation or other interest in a person, property or an enterprise of a person that is, or is of a type, dealt in or traded on a financial market or is recognized in any area where it is issued or dealt in as a medium for investment (including certificates of deposit, money market instruments and commercial paper); and
  3. any property held by a securities intermediary in a securities account for another person under an agreement that the property is to be treated as a financial asset.

Interests in limited partnerships and limited liability companies are not securities unless they are actually dealt in or traded on a security exchange or in a securities market or by their terms are expressly stated to be governed by Article 8. However, interests in limited partnerships and limited liability companies are deemed financial assets if they are held in a securities account; otherwise for all purposes they would be treated as general intangibles.

Perfection of Security Interests in Investment Property

Under revised Article 8 and the related amendments to Article 9, a secured party may perfect its security interest in investment property in any of three different ways:

  1. For certificated securities only, by delivery of possession of the certificate to the secured party or to a third party (not a security intermediary) on behalf of the secured party;
  2. For any investment property, by filing a UCC-1 financing statement describing investment property as collateral (either generally as a class or more specifically by subclass, type or item) with the applicable governmental filing office; or
  3. For any investment property, by exercising control over the investment property.

In general, for a secured party to have control, some act must have occurred sufficient to enable the secured party to sell the investment property without the further consent or cooperation of the debtor. A secured party obtains control over a certificated security which is delivered to the secured party in bearer or registered form and, if in registered form, is either indorsed to the secured party or in blank or is registered in the name of the secured party in the books of the issuer.

As to all other types of investment property, the secured party obtains control either by becoming the entitlement holder or, as we expect will increasingly become the common practice, by entering into a control agreement with both the securities intermediary and the debtor pursuant to which the securities intermediary agrees that it will comply with all entitlement orders given to it by the secured party without further consent from or action by the debtor. Importantly, the control agreement generally should not lessen the debtor's ability to deal with its own investment property for purposes of managing its investment assets (at least until such time as the secured party exercises its remedies in a default situation).

Priority of Perfected Security Interests

A security interest in investment property perfected by control will have priority over a security interest in the same property perfected by any other means. However, if two or more secured parties have perfected their security interest in investment property by control, those security interest will rank equally, regardless of when or how control was obtained. An exception is that a security interest held by a security intermediary (such as over a margin account) will defeat all other perfected security interests. As to all security interests perfected by means other than control, the general first to file or perfect rule of Article 9 applies.

Choice of Law

As stated above, a substantial majority of the states as well as the federal government as to U.S. Treasury securities have adopted (substantially without change) revised Article 8 and the related amendments to Article 9. In undertaking or reviewing any secured financing, it is extremely import to check the choice of law rules to determine what state's laws apply to the perfection and priority of any security interest in investment property, including what transition rules apply as states convert from prior Article 8 to revised Article 8. In general, if perfection is achieved by:

  • delivery of possession of a certificated security, the laws of the state in which the certificate is physically located will govern;
  • filing a UCC-1 financing statement, the laws of the state in which the debtor is located will govern; and
  • control, the laws of the state of the security intermediary's jurisdiction will govern (typically the choice of law stated in the agreement between the security intermediary and its customer).