CHAPTER III – TRANSFER OF INTERMEDIATED SECURITIES
III- 3. Conditional entries
16-22. A credit, debit, designating entry or removal of a designating entry may be made subject to a condition. It is again the non-Convention law (and, if so allowed by the non-Convention law, the account agreement or the uniform rules of a SSS), and not the Convention, which determines whether, and if so with what consequences, such book entries may be made conditional.
EXAMPLE 16-3: Under the non-Convention law of country A, the settlement period for stock exchange trades is T+2. This rule is also applied to OTC trades unless agreed otherwise.
Under A’s law a bank executing a sale or purchase order for a customer has to inform the customer without delay that its order has been executed and at which price. Such
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information statement has to be sent out to the customer at T+1 at the latest.
Furthermore, banks acting as intermediaries as defined in Article 1(d) are obliged to inform their customers without delay of any credit or debit to their securities accounts. In order to be able to combine both statements in a cost efficient way the banking industry in country A (where the broker and the intermediary function is, as a rule, fulfilled by one and the same bank) has developed – with the consent of the supervisory authorities – the practice of making the credits and debits to the securities accounts of their customers on, or immediately after the trading day, as soon as they know that the order has been executed. Since the settlement of any trade takes place only on the second stock exchange trading day after the trade day (T+2), any such credit or debit is made under the condition that the respective trade is duly settled on T+2. The legal purpose of this condition is to postpone the legal effect of any credit or debit until the moment when either (i) in case of a credit, the securities account of IM I with the national CSD has been credited accordingly;
or (ii) in case of a debit, this securities account has been debited. Since the settlement system in country A is based on the DvP-system (“delivery versus payment”), each participating intermediary can also rely on the due settlement of the payment side. If those credits and debits were not made subject to the condition precedent that corresponding credits and debits on the upper-tier CSD level would be made, the DvP-principle would not work since the payments would be made only on the settlement date. Furthermore, temporary shortfalls would occur since the CSD only credits and debits the securities accounts of its participants on the settlement date (T+2).
When the condition is fulfilled the credit or debit becomes effective. The book entry may have retroactive effect depending on the non-Convention law and/or the account agreement if so permitted by the non-Convention law. The more practical solution, however, may be not to provide for a retroactive effect but to couple the moment of the effectiveness of the credit or debit with the moment of the fulfilment of the condition (“ex nunc”). This also makes it easier to determine the moment of the effectiveness in a general way applicable to all trades in country A.
If the condition is not fulfilled, the provisional debit or credit does not have its intended effect and has to be “undone” by a respective action (credit or debit). This counter-action has only a rectifying effect in the sense that the book entry situation which existed before the conditional credit or debit was made is reinstated. However, this result is subject to Article 18 (protection of an innocent acquirer).
EXAMPLE 16-4: Account holder A instructs its bank (IM I) to purchase 1,000 X-shares.
After the execution of the trade, IM I makes a respective credit to A’s securities account. As stipulated in IM I’s general business terms, which form part of the account agreement with A, such credit is conditional upon delivery of the securities through the national CSD on the settlement date. The delivery fails.
On T+1, A grants a security interest on those 1,000 X-shares to B as collateral for a loan. A instructs IM I to make a designating entry on its securities account regarding those 1,000 shares. IM I acts accordingly on the same day T+1. Since the settlement fails, IM I wants to debit A’s securities account in order to “undo” the provisional credit. What happens to B’s security interest? B did not know that A bought the X-shares just one day before it granted the security interest thereon and that the credit was only conditional.
Result: B’s securities interest is protected by Article 18(2) although the credit of the 1,000 X-shares to A’s account was a “defective entry” within the meaning of Article 17(d). IM I should not have made the designating entry in respect of the 1,000 X-shares before the
settlement occurred. IM I has to buy-in 1,000 X-shares for the account of A and to credit A’s securities account accordingly so that B’s security interest is duly funded. Note that IM I may protect itself by making a note in the designating entry or, as the case may be, the control agreement that the credit of securities is or may be conditional or otherwise liable to be reversed. However, in a system in which IM I merely receives a notice of a control agreement (see Article 1(k)), it would not be in a position to protect its ability to reverse the credit.
Terms used in Chapter III
In this Chapter:
(a) “acquirer” means
(i) an account holder to whose securities account securities are credited; or
(ii) a person to whom an interest in intermediated securities is granted under Article 12;
(b) in determining whether a person ought to know of an interest or fact:
(i) the determination must take into account the characteristics and requirements of securities markets, including the intermediated holding system; and
(ii) the person is under no general duty of inquiry or investigation;
(c) where a person is an organisation, such person actually knows or ought to know of an interest or fact from the time when the interest or fact is or ought reasonably to have been brought to the attention of the individual responsible for the matter to which the interest or fact is relevant;
(d) “defective entry” means a credit of securities or designating entry which is invalid or liable to be reversed, including a conditional credit or designating entry which becomes invalid or liable to be reversed by reason of the operation or non-fulfilment of the condition;
(e) “relevant time” means the time that a credit is made or the time referred to in Article 19(3).
17-1. Article 17 contains three definitions and two rules of construction. The definitions are provided here, not in Article 1, because they are used only in Chapter III.
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17-2. Article 17 was added during the first session of the diplomatic Conference. The definition of
“acquirer” was included in order to shorten and simplify the drafting of Article 18, which deals with the innocent acquisition of intermediated securities. Similarly, the rule of construction for determining the circumstances in which a person ought to know of an interest or fact and the definition of “relevant time” simplify the drafting of Articles 18 and 20, where the phrase “ought to know” and the term “relevant time” are used. The rule of construction for when an organisation ought to know of an interest or fact and the definition of “defective entry” were formerly included in the predecessor of Article 18.
17-3. The principal change in substance made by Article 17 at the first session of the diplomatic Conference was the addition of the rule of construction on “ought to know”, reflected in paragraph (b). All earlier drafts contained a version of the so-called “willful blindness” test for when a person has knowledge of an interest or fact. That test is met when a person “deliberately” (i.e., intentionally) avoids actual knowledge. For example, Article 14(4)(b) of the draft submitted to the first session of the diplomatic Conference provided that a person has knowledge of a fact or interest if the person has “actual knowledge” or “has knowledge of facts sufficient to indicate that there is a significant probability that the interest or fact exists and deliberately avoids information that would establish that this is the case”. See UNIDROIT 2008 – CONF. 11 – Doc. 3, Article 14(b).
However, at the fourth session of the CGE, the text providing for the willful blindness test was placed in square brackets in order to indicate the absence of a consensus as to the appropriate test for knowledge. As was eventually made obvious, the disagreement among delegations on the test of knowledge was not one of actual substance or result but instead a disagreement over the appropriate Convention text. For example, there was no substantial support for a standard that generally would require an acquirer to undertake investigation or other due diligence. Moreover, as the analysis of paragraph (b) below indicates, proper application of the “ought to know” standard essentially captures the substance of the “willful blindness” test.
17-4. A second change of substance was incorporated in the definition of acquirer. Earlier drafts of Article 18(1) protected only persons who acquired interests in intermediated securities by way of credit or designating entry. Article 18(1) now extends its protection to those who acquire interests under a method provided in Article 12, but only when the priority rules in Article 19 do not provide a different result.
17-5. The term “acquirer” is defined broadly to mean any person who acquires an interest in intermediated securities by a method provided in the Convention. These methods are the credit of securities to a securities account of an acquirer, addressed by Article 11, and the granting of an interest by a method provided in Article 12 (by a grant to the relevant intermediary, by a designating entry or by a control agreement). The term is used only in Article 18 in order to specify persons who are eligible for innocent acquisition protection under the article.
17-6. While invalidity mentioned under Article 16 does not preclude protection under Article 18 (Article 16 is subject to Article 18), Article 18 protection for an acquirer to whose securities account a credit or designating entry is made requires the existence of a credit or designating entry. What is or constitutes a credit or designating entry to a securities account is determined by the non-Convention law.