6. Article 12 interests and Article 19 priority rules

18-16. The definition of “acquirer” includes persons who acquire rights or interests in inter-mediated securities by credit under Article 11 or by a method provided in Article 12. However, competing interests in the same intermediated securities (i.e., securities credited to the same securities account) are governed by the temporal (e.g., first-in-time) priority rules of Article 19, not by the last-in-time rule of Article 18. Paragraph 6 makes this clear. This should apply to the situation where priority is determined under Article 20(2) (see the commentary on Article 20).

EXAMPLE 18-6: Account Holder (AH) agreed to grant an interest in intermediated securities to Collateral Taker 1 (CT-1) and AH, CT-1 and AH’s intermediary (IM) entered into a control agreement covering the intermediated securities. Later, AH agreed to grant an interest in the same intermediated securities to CT-2 and on that date AH, CT-2 and IM entered into a control agreement covering the intermediated securities in favour of CT-2. Under the priority rule promulgated by Article 19, CT-1's interest has priority over CT-2's. There is no room for CT-2 to be protected by Article 18(1) or 18(2), namely, CT-1 does not lose priority over CT-2 by virtue of Article 18(1) or 18(2). Article 18 simply does not apply (Article 18(6)). For details, see the commentary on Article 19, section 19-11.

EXAMPLE 18-7: Account holder (AH) granted a security interest to Collateral Taker (CT-1) and AH, CT-1 and AH's intermediary (IM) entered into a control agreement. Later, AH obtained a second secured loan from CT-2 and instructed IM to transfer the relevant intermediated securities to CT-2's account with IM. IM credited the intermediated securities to CT-2's account and debited them to AH's account. Assuming that the control agreement provides for negative control (see Article (1)(k)(i)), the debit is unauthorised under Article

15 and thus ineffective. However, CT-2 is protected if the conditions of Article 18(1) are satisfied.

EXAMPLE 18-8: Intermediary (IM) granted to Collateral Taker (CT-1) a security interest effective under Article 12 in intermediated securities held in a segregated account for the benefit of IM’s account holders (AHs). The security interest secures a loan from CT-1 to IM.

CT-1 knew about IM’s purpose for the borrowing, but both the loan and the security interest are permitted by the applicable law and regulatory regimes. Later, one of AHs granted a security interest to its collateral taker (CT-2) to cover a loan made by CT-2 to that AH. IM is now in insolvency, and the AH also is in insolvency. There is a shortfall in the intermediated securities subject to the security interests – there are insufficient securities to satisfy both IM’s debt to CT-1 and the AHs’ debt to CT-2. CT-2 asserts that its interest is protected under Article 18(1). CT-2's claim for innocent acquisition is without merit. The priority conflict between CT-1 and CT-2 is addressed in Article 20(2).

For details, see the commentary on Article 20, in particular, Example 20-2 and Example 20-3 and the explanations of them.

Article 19

Priority among competing interests

1. This Article determines priority between interests in the same intermediated securities which become effective against third parties under Article 12 or Article 13.

2. Subject to paragraph 5 and Article 20, interests that become effective against third parties under Article 12 have priority over any interest that becomes effective against third parties by any other method provided by the non-Convention law.

3. Interests that become effective against third parties under Article 12 rank among themselves according to the time of occurrence of the following events:

(a) if the relevant intermediary is itself the holder of the interest and the interest is effective against third parties under Article 12(3)(a), when the agreement granting the interest is entered into;

(b) when a designating entry is made;

(c) when a control agreement is entered into or, if applicable, a notice is given to the relevant intermediary.

4. Where an intermediary has an interest that has become effective against third parties under Article 12 and makes a designating entry or enters into a control agreement with the consequence that an interest of another person becomes effective against third parties, the interest of that other person has priority over the interest of the intermediary unless that other person and the intermediary expressly agree otherwise.

5. A non-consensual security interest in intermediated securities arising under the applicable law has such priority as is afforded to it by that law.

UNIDROIT 2009 – CONF. 11/2 – Doc. 5 – Article 19 87.

6. As between persons entitled to any interests referred to in paragraphs 2, 3 and 4 and, to the extent permitted by the applicable law, paragraph 5, the priorities provided by this Article may be varied by agreement between those persons, but any such agreement does not affect third parties.

7. A Contracting State may declare that under its non-Convention law, subject to paragraph 4, an interest granted by a designating entry has priority over any interest granted by any other method provided by Article 12.

Commentary

I. Introduction

19-1. Article 19 determines the priorities among interests in the same intermediated securities (i.e., securities of the same description, credited to the same securities account, and as to which there are conflicting claims). It covers only interests that become effective against third parties under Article 12 or Article 13. Article 19 provides (with some exceptions) a first-in-time priority rule for interests granted under Article 12. It does not apply to interests acquired by credit pursuant to Article 11. Article 20, not Article 19, addresses priority conflicts between account holders and the persons to whom the relevant intermediary has granted an interest under Article 12 or Article 13.

II. History

19-2. The draft Convention considered by the first session of the Committee of Governmental Experts contained a last-in-time innocent acquisition rule for interests acquired by credit and also for security interests acquired by another method under the Convention. The draft also contained a first-in-time priority rule that applied to the same types of acquisitions. See UNIDROIT 2004 – Study LXXVIII – Doc. 18, Articles 9 (priority) and 10 (innocent acquisition). Consequently, every such acquisition would have been both senior to earlier interests (assuming qualification for innocent acquisition protection) and junior to earlier interests. This anomaly persisted in the draft produced at the conclusion of the first session. See UNIDROIT 2005 – Study LXXVIII – Doc. 24, Articles 10 (priority) and 11 (innocent acquisition).

19-3. Between the first and second sessions, one delegation observed:

The Convention should adopt those principles of priority among competing claims which are reflected by the majority view of the September 2005 Berne Working Group on Effectiveness of Book-Entries, Priority And Loss Sharing, Study LXXVIII - SEM. 1, Appendix 9. In particular, the first-in-time priority rule of Article 10 [now 19] would apply only to priority contests among collateral takers who have security interests in intermediated securities credited to the securities account of a collateral provider. Priority among these collateral takers would not be covered by the innocent acquisition (last-in-time) rules. Article 10 [now 19] would not apply to security interests when the collateral taker itself receives a credit to a securities account under Article 5 [now 11].

See UNIDROIT 2006 – Study LXXVIII – Doc. 35, Comments by the Government of the United States of America, p. 2.

19-4. This problematic situation was rectified in the draft produced at the conclusion of the second session. The priority rule was limited to “priority between security interests in the same intermediates securities” and the innocent acquisition rule was limited to acquisitions by credit.

UNIDROIT 2006 – Study LXXVIII – Doc. 42, Articles 6 (priority) and 7 (innocent acquisition).

19-5. The draft that emerged from the third session expanded the scope of the priority rule beyond the priority of security interests. The article providing for the grant of security interests was expanded to cover “an interest in intermediated securities, including a security interest or a limited interest other than a security interest.” See UNIDROIT 2006 – Study LXXVIII – Doc. 57, Article 8 [now 12]. This resulted in the corresponding expansion of the priority rule. Id., Article 13 [now 19].

In addition, at the third session, a new article was added which provided that the Convention would not determine the relative priorities between an intermediary’s account holders and a person to which an interest was granted by that intermediary under the expanded article providing for the grant of interests other than by way of a credit. Id., Article 14 [now 20(1)].

19-6. At the fourth session, this new article with an exclusion from the priority regime was narrowed. A rule was added that would award priority to the grantee of an interest from the intermediary over the intermediary’s account holders if the grantee acquired its interest without wrongful knowledge under the test for innocent acquisition. UNIDROIT 2007 – Study LXXVIII – Doc. 94, Article 16(2) [now 20(2)]. No other material changes to the priority rules were made at the fourth session. Id., Article 15.

19-7. One material change to the priority rules was made during the first session of the diplomatic Conference. A declaration mechanism was added under which a Contracting State could declare that interests granted by a designating entry have priority over interests granted by another method under Article 12. See Article 19(7).

III. Analysis

III-1. Scope

19-8. Paragraph 1 specifies the scope of Article 19. Article 19 determines the priorities only among interests in the same intermediated securities (i.e., securities of the same description, credited to the same securities account, and as to which there are conflicting claims) and it covers only interests that become effective against third parties under Article 12 or Article 13. It does not apply to conflicting interests acquired by way of credits, because that situation necessarily means that the conflicting claims arose out of credits to different securities accounts.

19-9. Several of the complexities raised by the following examples arise from the possibility that a Contracting State could make a declaration under Article 12(5)(a) to the effect that all three of the conditions to effectiveness specified in Article 12(3) may be utilised where that State’s law is the non-Convention law. Moreover, such a Contracting State also could make a declaration under Paragraph 7 that would afford special priority to interests granted by designated entry, making possible still additional complex priority contests.

III-2. First-in-time priority rule

19-10. Paragraph 3 provides the basic, traditional first-in-time priority rule for interests granted by a method provided by Article 12. Such competing interests rank according to the time when they have been made effective against third parties. This time depends on the method by which the interests were granted. Where the relevant intermediary is the grantee of an interest granted pursuant to Article 12(3)(a), the “relevant time” (see Article 17(e)) for priority purposes is the time

UNIDROIT 2009 – CONF. 11/2 – Doc. 5 – Article 19 89.

at which “the agreement granting the interest is entered into”. For a designating entry, the relevant time is the time at which the entry is made (see Article 12(3)(b)), and for a control agreement it is the time at which the agreement is entered into, or, where applicable, the time at which notice is given to the relevant intermediary (see Article 12(3)(c)). As a general matter, grantees of interests under Article 12 will have no means to discover earlier-in-time interests except for reliance on representations of the account holder, the relevant intermediary or both.

EXAMPLE 19-1: On 15 January, Account Holder (AH) agreed to grant an interest in intermediated securities to Collateral Taker 1 (CT-1) and on that date AH, CT-1 and AH’s intermediary (IM) entered into a control agreement covering the intermediated securities.

On 1 March, AH agreed to grant an interest in the same intermediated securities to CT-2 and on that date IM made a designating entry covering the intermediated securities in favour of CT-2. On 15 April, AH agreed to grant an interest in the same intermediated securities to CT-3 and on that date IM made a designating entry covering the intermediated securities in favour of CT-3.

Under the first-in-time priority rule of paragraph 3, CT-1 is first priority, CT-2 is second, and CT-3 is third.

19-11. In some circumstances the first-in-time rule, while never achieving an improper result, may not actually operate as a “priority” rule. This is because an interest granted under Article 12 may be an outright, ownership interest in intermediated securities. If such an interest is made effective by a control agreement, for example, then under the applicable law the account holder would have no remaining rights or interest whatsoever that it could grant to a second-in-time grantee, even though it remained the account holder on the books of the relevant intermediary. In that case, if the account holder purported to grant a second interest to a putative grantee, the grantee would not receive a “second priority” interest as it would not receive any rights or interest at all. This is simply a case where an outright ownership interest is made effective under Article 12. Note also that there is no room for the second grantee to be protected as an innocent acquirer under Articles 18(1) or 18(2) (see Article 18(6)). The important point is that one should not read into Article 19 any implication, from its structure as a priority rule or because interests granted under Article 12 can be full ownership interests, that it empowers an account holder to transfer full ownership. Of course, if an account holder first granted an effective security interest and subsequently granted an effective full ownership interest to another person, then the second grantee would hold its interest subject to the first priority security interest.

EXAMPLE 19-2: On 15 January AH agreed to grant a full ownership interest in intermediated securities to Buyer and on that date AH, Buyer and AH’s intermediary (IM) entered into a control agreement covering the intermediated securities. (Although a buyer conventionally would take its interest by way of a credit, this sale may be the first leg of a short-term “repurchase” or “repo” transaction, for example, and taking by control agreement may be a more efficient structure for the parties.) On 1 March AH agreed to grant an interest in the same intermediated securities to CT-1 and on that date IM made a designating entry covering the intermediated securities in favour of CT-1.

The full ownership interest of Buyer became effective against third parties on 15 January.

Consequently, if under the applicable law on 1 March AH had no rights or interests that it could grant to CT-1, CT-1 received no interest whatsoever. If the grant of an interest to Buyer was the first leg of a repo transaction, then upon payment of the repurchase price and termination of the control agreement the intermediated securities will revest in Seller, Buyer’s interest will cease to exist, and at that point CT-1’s interest will become effective, if such after-acquired collateral is recognised by the applicable law.