Intermediated Securities (as not sold by Tesco) December 2019Damian Morris
Managing Partner Markets Regulation
The recent case of SL Claimants v Tesco plc  is the latest authority concerning the nature of interests held by end investors through an intermediated securities custody chain. It is welcomed as a well-reasoned contribution to the ongoing narrative surrounding what rights ultimate investors have in respect of their securities positions, but is perhaps more confirmatory than revolutionary in nature. Nonetheless it will take its rightful place as part of the ongoing debate both generally and, more specifically, as a result of the UK Government’s direction to the Law Commission to conduct a “scoping study of investor rights in a system of intermediated securities.”
The case concerned a strike-out application in relation to the availability of remedies to ultimate investors for untrue or misleading statements relied on for investment decisions. Simply put, Tesco argued that ultimate investors holding through an intermediated securities custody chain did not have standing to sue for compensation under section 90A and Schedule 10A of the Financial Services and Markets Act 2000 (“section 90A”, Schedule 10A” and “FSMA” respectively). Tesco’s argument was based on its narrow construction of the statutory provisions of paragraph 8(3) of Schedule 10A and rested on two limbs:
- none of the Claimants had an “interest in securities” within the meaning of paragraph 8(3) in Schedule 10A because none had ever acquired an equitable interest in Tesco shares; and
- in any event, and even if they did have such an interest, none of the Claimants had “acquired” or “disposed” of an interest in securities or “contracted to acquire or dispose of securities or of any interest in securities” pursuant to the transfer of legal ownership in the CREST register.
The Court rejected both limbs of argument and dismissed the strike out application. In doing so Hildyard J followed the principles laid out by Briggs J (as he then was):
- in Lehman Brothers International (Europe) (In Administration), (often cited as the Rascals case) at paragraph 226:
“it is common ground that a trust may exist not merely between legal owner and ultimate beneficial owner, but at each stage of a chain between them, so that, for example, A may hold on trust for X, X on trust for Y and Y on trust for B. The only true trust of the property itself (i.e. of the legal rights) is that of A for X. At each lower stage in the chain, the intermediate trustee holds on trust only his interest in the property held on trust for him. That is how the holding of intermediated securities works under English law, wherever a proprietary interest is to be conferred on the ultimate investor.”
- In the matter of Lehman Brothers International (Europe)at  where he stated that:
“It is an essential part of the English law analysis of the ownership of dematerialised securities that the interests of the ultimate beneficial owner is an equitable interest, held under a series of trusts and sub-trusts between it, any intermediaries and the depository in which the legal title is vested: see paragraph  of my judgment in the RASCALS case.”
- Together with several further references to the ultimate investor as the “ultimate beneficial owner” in each of the cited cases.
Accordingly, it remains settled law that the issuer cannot see the ultimate investor does not mean that the ultimate investor does not have an interest in the securities. But the question of the nature of that interest continues to give rise to significant debate, with dichotomies between legislation, practical realities and academic assumptions and arguments.
At this point, it is perhaps useful to pause to clarify what the confusion is not concerned with. To start with, it is not about the risks of the intermediated securities custodial chain in respect of failure or insolvency of the links in the chain. Although jurisdictional risk exists, as a matter of English law the contractual arrangements seek to ensure that their clients’ holdings are held and kept separate from all their own proprietary assets, and therefore remote from creditors of that intermediary should it fail and/or go insolvent. Nor is the flow of the economic benefit to the ultimate investor generally in question; gains and losses in the value of the shares together with dividends etc. will, in the ordinary course, clearly flow through to the ultimate investor.
The issue is rather that of how the ultimate investor may enforce the rights attaching to the securities and the potential hardship the ultimate investor may face when the issuer does not recognise that ultimate investor as a registered member. However, this fact pattern occurs as a result of the split of the legal and beneficial ownership of an asset, which is a centuries-old and accepted ownership pattern much loved by equity and trust lawyers, and not because of the intermediated securities holding pattern, which is a more recent development.
The exercise of rights attaching to securities are exercisable only by registered members, the legal owners, of the shares. When talking about dematerialised securities, the legal owner will be the member on the issuer’s register, and for UK Companies the register of members is held as part of the CREST system. By and large, the members on the CREST registers will be custodians or nominees of major banking corporations. Those legal owners may be obliged to exercise those rights in accordance with the instructions of their immediate beneficiary in the chain, assuming they receive valid instructions, but the fact that ultimate beneficial owners can only exercises their rights through the agency of the legal owner is hardly new: the chain created by intermediated securities custodian holding structures merely stretches the distance between the ultimate beneficial owner and the legal holder, it did not create it.
Of course, that can generate practical difficulties. Intermediaries generally only accept an obligation which is something short of an absolute commitment, such as “best efforts” or “reasonable endeavours” in respect of (i) notifying their clients down the chain that certain rights and options have become exercisable and conversely (ii) in acting in accordance with the instructions received, either directly – if the intermediary is the relevant member – or by passing instructions up through the intermediary chain.
The jeopardy in this state of affairs is open to debate. Unless you really have not been paying attention over the last 25 years or so, this holding pattern is well understood. The majority of end investors do not have a primary expectation of exercising voting rights in respect of the securities for which they are the ultimate beneficiaries whether they be held via pension funds, unit trusts, trusts, hedge funds or other investment vehicles, at least not without engaging with the structure in which they hold the asset. Consequently, if you are not expecting to exercise voting and other rights and are not concerned either way, the fact that it can be difficult to do so is scarcely a matter of import.
Stewardship rules and the growing importance of Environmental, Social and Governance (“ESG”) investing criteria, on the other hand, may require more direct engagement with an issuer. Matters such as potential acquisitions, new product lines, board remuneration, withdrawal from sectors etc. may provoke the desire for the exercise of shareholder rights. However, for a large proportion of asset and wealth management companies this is just not an issue; they have no difficulty in engaging with issuers, regardless of the fact that primarily these managers’ investment vehicles will hold as beneficiaries under an intermediated securities structure rather than as registered members. But then, as we know, theory and practice often diverge.
This is just as well, because the implementation of the EU Revised Shareholder Rights Directive, as transposed into UK law, requires managers to set out and adopt policies on this engagement, which should describe, amongst other things, how the firm integrates shareholder engagement in its investment strategy, conducts dialogues with issuer companies and exercises voting rights attached to shares. Managers should not consider the intermediated securities structure as necessarily frustrating their obligations under this Directive, notwithstanding the practical flaws that may occur in having instructions passed through an intermediary chain on a “reasonable efforts” basis only.
So where does this leave us? There are, we think, several points of clarification and matters that investment managers may consider merit further action.
The points of clarification are that: (i) ultimate investors have the protections offered by FSMA and so are a class of people that issuers should have in mind (although perhaps the starting point should be that companies should not make untrue or misleading statements in the first place); (ii) ultimate investors are to all intents and purposes “beneficial owners” and therefore have the right to pass instructions up the intermediary chain to the registered member in respect of voting and other rights – it does not matter if you are the beneficiary of the first trust, which is over the equitable interest in the shares, rather than a sub trust further down the holding chain, which only gives “a right over a right” (to the equitable interest in the shares held further up the chain) which is, legally, a different thing altogether; and (iii) the risk in the execution of actual engagement should not disturb compliance with obligations under the EU Revised Shareholder Rights Directive.
The matters for further thought are: (i) if a manager wishes to be truly activist, while being a direct shareholder guarantees skin in the game, it is by and large impractical to have an account at CREST. Absent that, being the beneficiary of the first trust of the registered member (rather than a subsequent sub-trust), is most likely to ensure your views are counted – as a matter of practice, and common sense, the less links in the chain, the less chance there is of something going wrong in the passing of instructions and, consequently, the more likely it will be that the instructions reach their destination and get actioned; and (ii) managers should ensure that their offering documents and periodic updates reflect the distinction between the protection afforded by recognition under FMSA and the risks involved as a result of the intermediated securities holding structure, which FSMA will not cure.
If you wish to discuss this topic in more detail, please contact your relationship partner or Damian Morris at firstname.lastname@example.org.
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  EWHC 2858 (Ch)
 Law Commission, ‘Intermediated Securities: Call for Evidence’ (August 2019), available at: https://www.lawcom.gov.uk/project/intermediated-securities/.
  EWHC 2914 (Ch),  11 WLUK 494.
 At para 226; see also decision in Tesco.
  EWHC 2997 (Ch)
 Directive 2017/828.
 FCA Rules COBS 2.2.3R.