Intermediated Securities – Who owns your shares? February 2020Damian Morris
Managing Partner Markets Regulation
On 11 November, the Law Commission published its response to the UK Government’s Department for Business, Energy and Industrial Strategy’s request for it to undertake a “scoping study” into investor rights in a system of intermediated securities (the “Paper”)1.
As a scoping exercise, it was not the purpose of the Paper to draw definitive conclusions, merely highlight particular problems and possible solutions. Accordingly, for those of you interested only in the punchline, “watch this space” and/or “back to the UK Government to determine next steps (if any)” just about sums it up.
On the other hand, in accumulating a thorough overview of the benefits and problems associated with intermediated securities and their associated custody chains, the Paper puts down the ground- work for (what we can hope may be) thoughtful and proportionate developments in respect of a complex set of issues.
There is no need to revisit here the legal workings of the chain of trusts, sub trusts and tangential contractual nexuses between the Company, each intermediary in the custodial chain and, finally, the ultimate investor. Nor to spend time considering the nature of the “beneficial” (not “legal”) interest that the ultimate investor holds. It is though useful to consider the numerous and significant benefits that intermediated securities holding patterns have brought to the market, including:
- increased efficiencies and economies of scale (particularly in using omnibus accounts);
- lower costs (because of efficiencies ) passed on to ultimate investors;
- convenience for ultimate investors, particularly where they hold a diverse and large portfolio (which can be multi-jurisdictional) through a single intermediary; and
- speed of execution, together with lower trading costs and administrative
On the debit side of the ledger however, the intermediated securities structure receives significant criticism for (i) corporate governance and transparency issues, and (ii) lack of certainty as to legal rights and remedies.
On the first of these, the most obvious example is the inability of the ultimate investor to exercise voting rights owing to the fact that, not being a direct member and shareholder of the company in question, the ultimate investor is therefore not known by the company. Of course, voting is not the only issue: under English law members of companies have a number of other rights including being able to challenge resolutions to re-register a public company as private2, participate in schemes of arrangement3 and bring contractual claims against the company (the “no look through principle)4. Further, while the recent Tesco5 case clarifies that a person who has acquired “an interest” in securities is able to bring an action against a company for issuing misleading information6, commentators and market participants argue that the relevant legislation should be amended to make this explicit.
Turning to problems with legal certainty, further clarity is considered useful in respect of remedies for wrongly sold securities, the formalities required for transfers of securities7, asset distributions to investors (and share of shortfalls) following an intermediary’s failure and what “possession” and “control” actually mean in the context of giving or taking a security interest and complying with the Financial Collateral Arrangement (No 2) Regulations 2003.
Accepting the need for a proper cost/benefit analysis, the Paper splits its proposals into two. For investor rights, corporate governance and legal certainty, the Paper suggests a range of targeted solutions. These include extending existing regulation (e.g. the Shareholders Rights Directive II) to cover off perceived gaps, making certain focused amendments to existing legislation (e.g. the Act or FSMA) so as to fix or clarify recognised uncertainties, together with supporting the implementation of previous recommendations from, and further ongoing work by, the Law Commission itself. With regards the question of holding securities, the Paper makes three proposals8:
- remove intermediation altogether, so that all investors are direct shareholders and named on the register of members;
- retain the current model of intermediation, but also introduce a genuine alternative to allow investors to hold shares directly if they so wish; and
- look to Distributed Ledger Technology (“DLT”).
These proposals assume that the move towards “dematerialisation” is unstoppable. This is surely true, and while the consensus is that dematerialisation is net positive (and inexorable anyway), that result may not be quite as obvious as it first seems. To start with, in excess of 10 million investors currently hold shares in paper certificated form. In addition, the dematerialisation process was formalised in EU Legislation by the Central Securities Depositories Regulation (“CSDR”)9, and the UK is, of course, leaving the EU prior to the specified implementation deadlines of 202310 and 202511, which means the CSDR requirements no longer apply.
Nonetheless, assuming dematerialisation is here to stay, perhaps the most interesting of these three solutions is DLT. It is becoming more widely accepted that DLT could have many benefits with the data of shareholders not maintained by a central administrator but rather maintained collectively by a network of computers (“nodes”). Such a ledger can demonstrate a direct relationship between the investor and the company – good for voting rights and claims against the company etc. – but, inevitably, is not without its own structural difficulties. To take just two examples: (i) if the ledger is spread across a number of nodes, which in turn are located in a number of jurisdictions, where is the “lex situs” of the asset, and what does that mean vis a vis legal certainty for contracts, transfers, charges, liens, disputes and conflicts of laws questions; and (ii) what exactly is, legally speaking, a DLT record that is accessible through numerous nodes – is it a property right itself or evidence of a property right?
As for the other two proposals, while the direct name of the investor on a company’s register should promote better governance and transparency, together with settling a number of legal certainty complexities, it throws out many if not all of the benefits of intermediated securities. Consequently, and absent profound changes in the market, this would presumably lead to increased costs, less efficiencies and a significant additional administrative burden for each investor. On the other hand, retaining the current model of intermediated securities maintains the established benefits without requiring material changes in the market. The Paper acknowledges that this second solution is the more proportionate response, which nonetheless leaves scope for the development of a realistic, cost effective option of direct ownership for investors who want it, whether for their whole portfolio or in respect of certain securities holdings only.
The Law Commissions’ work is done, at least for the time being. It is now for the UK Government to decide whether there should be further work undertaken on this topic. So, watch this space (or did I say that already?).
If you wish to discuss this topic in more detail, please contact your relationship partner or Damian Morris at email@example.com.
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1 The Paper considers solely investments in UK Plc’s and, as a result, holdings via CREST and does not include within its scope pooled funds, such as unit trusts and open-ended investment companies.
2 Section 98 Companies Act 2006 (the “Act”)
3 Section 899 ibid
4 For completeness, it should be noted that this limitation doesn’t affect the ultimate investor’s ability to bring a claim in tort against the company
5 SL Claimants v Tesco plc  EWHC 2858 (Ch)
6 Pursuant to section 90A Financial Services and Markets Act 2000 (“FSMA”)
7 Section 53(1)(c) Law of Property Act 1925
8 Presumably to be implemented alongside the targeted solutions
9 Regulation No 909/2014 of the European Parliament and of the Council of 23 July 2014 on improving securities settlement in the European Union and on central securities depositories and amending Directives 98/26/EC and 2014/65/EU and Regulation (EU) No 236/2012, Official Journal L 257 of 28.8.2014 p 1
10 Ceasing to issue paper certificates for most new publicly traded securities
11 Dematerialisation of existing paper certificates for publicly traded securities