2. Consequences of unauthorised debits, etc

15-23. Article 15(2) provides that the non-Convention law determines the consequences of unauthorised debits, unauthorised designating entries or unauthorised removals of such entries, but with respect to unauthorised designating entries, this is subject to the overriding principle that an innocent acquirer should be protected, so the fact that a designating entry is unauthorised would not prevent an innocent acquirer from enjoying the protection of Article 18(2).

UNIDROIT 2009 – CONF. 11/2 – Doc. 5 – Article 16 67.

15-24. Where applicable and to the extent permitted by the non-Convention law, account agreements and the uniform rules of a securities settlement system may also be determinative.

The definitions of “account agreement” and “uniform rules of a securities settlement system” are laid down in Article 1(f) and 1(p), respectively.

15-25. The proviso “subject to Article 18(2)” regarding an (unauthorised) designating entry will protect the acquirer of an interest under Article 12 in cases where the earlier credit of the securities, which is the prerequisite and basis for making subsequently the designating entry, was a “defective entry” as defined in Article 17(d), i.e., invalid or reversible. Unless the acquirer of the subsequent designating entry actually knows, or ought to know as determined by Article 17(b), at the relevant time as defined in Article 17(e), that the earlier credit was a defective entry, the designating entry may not be treated as an “unauthorised” entry under Article 15.

EXAMPLE 15-2: Account holder A’s securities account with IM I is credited with 1,000 X-shares. This credit is the result of an embezzlement committed by an employee of IM I in collusion with A who bribed this employee. One month later, A grants B a security interest in those 1,000 X-shares as collateral for a loan and instructs IM I to make a corresponding designating entry to A’s securities account. The designating entry was made by another employee of IM I who had no knowledge of the earlier fraudulent action. B has no knowledge thereof either.

By virtue of Article 18(2), B’s security interest is protected; B is not liable to anyone. The applicable non-Convention law determining the consequences of an unauthorised designating entry may not impair this protection of B.

15-26. An innocent acquirer to whose securities account securities are credited is protected under Article 18, even if, for instance, the non-Convention law requires matching of debits and credits and the corresponding debit may be treated as invalid under that non-Convention law. In such a situation, the legal consequences of the credit are determined by the non-Convention law (generally see the commentary on Article 16, especially at 16-10).

Article 16

Invalidity, reversal and conditions

Subject to Article 18, the non-Convention law and, to the extent permitted by the non-Convention law, the account agreement or the uniform rules of a securities settlement system determine whether and in what circumstances a debit, credit, designating entry or removal of a designating entry is invalid, is liable to be reversed or may be subject to a condition, and the consequences thereof.

Commentary

I. Introduction

16-1. Article 16 addresses three topics relating to debit, credit, designating entry and removals of a designating entry: invalidity, reversibility and conditionality of such book entries. Subject to the innocent acquisition rules of Article 18, all three topics are governed by the non-Convention law and, to the extent permitted by the non-Convention law, by the account agreement or the uniform rules of a securities settlement system. Such non-Convention law rules also determine the

consequences of book entries which are invalid, or reversible and, if an entry is conditional, the consequences of the fulfilment or fulfilment of the condition. Any rule under the non-Convention law is subject to the innocent acquisition rules of Article 18.

II. History

16-2. Until the first session of the diplomatic Conference, the content of Article 16 was part of a broader article, the first paragraph of which concerned the authorisation rule which is now contained in Article 15. Throughout the negotiations, effectiveness, validity, reversal and conditionality and their consequences were some of the most controversial topics.

16-3. The Study Group’s first draft of the Convention (UNIDROIT 2004 – Study LXXVIII – Doc. 18) provided in paragraphs 2 to 5 of Article 5 for rules on:

- conditional debits, credits and designating entries with mandatory retroactive effect upon fulfilment of the condition (paragraph 2);

- debits or credits which, under the applicable law, are liable to be reversed on the ground of fraud or misrepresentation or any other ground; the applicable law would have to determine whether such debit or credit had any effect against third parties and, if so, what that effect was (paragraph 3);

- subsequent innocent acquisitions despite the fact that an earlier credit or designating entry was not effective or was liable to be reversed (paragraphs 4 and 5).

16-4. During its first session, the CGE approved some fine-tuning on these provisions and inserted two new paragraphs (2 and 3) which were deleted at the second session and which are not relevant to this discussion. (Paragraph 2 had provided that except when made conditionally, a debit, credit or designating entry would take effect when it was made. Paragraph 3 had related to the time at which intermediated securities would be treated as having been delivered into the possession or control of a collateral taker. See Articles 7(2) and 7(3) in UNIDROIT 2005 – Study LXXVIII – Doc. 24.)

16-5. At its second session, the CGE deleted the paragraph on conditional book entries on the understanding that conditional book entries could be subject to the rules on effectiveness of the non-Convention law (Article 8(2) and (3) in UNIDROIT 2006 – Study LXXVIII – Doc. 42). Under the new Article 8(2), the non-Convention law and, to the extent permitted by the non-Convention law, an account agreement or the rules and agreements governing the operation of a settlement system may provide that a debit or credit or designating entry is not effective or is liable to be reversed.

According to Article 8(3) the consequences of such ineffectiveness, reversibility and reversal shall also be determined by the non-Convention law, subject, however, to the protection of an innocent acquirer.

16-6. At the third session, the provision on conditional book entries was re-introduced as paragraph 2(d) and (e) of the renumbered Article 11 (UNIDROIT 2006 – Study LXXVIII – Doc. 57).

The CGE felt in particular that the possibility to make credits subject to a condition would be of great importance to the market and that there should be no doubt that the Convention permits conditional book entries (see UNIDROIT 2007 – Study LXXVIII – Doc. 58, section 61). The CGE also affirmed the conclusion of the second session that there should be full flexibility for the non-Convention law to determine whether, and in what circumstances, a debit, credit or designating entry may be made subject to a condition (Article 11(2)(d)) and, where such a book entry is made subject to a condition, its effect (if any) against third parties before the condition is fulfilled and the consequences of the fulfilment, or non-fulfilment, of the condition (Article 11(2)(e)).

UNIDROIT 2009 – CONF. 11/2 – Doc. 5 – Article 16 69.

16-7. Regarding the rules on effectiveness and reversibility the term “effectiveness” was replaced by “validity”. The determining role of the non-Convention law was not affected by this change in terminology. The overriding importance of protecting an innocent acquirer was reemphasised, and the article was provisionally amended through making the non-Convention law subject to priority rules of the Convention regarding competing interests.

16-8. At its fourth session, the CGE left Article 11 (which was renumbered as Article 13) substantially unchanged with the only amendment being the addition of the phrase “subject to paragraph 1(a)” in paragraph 2(a) to clarify and underline the overriding principle that, whatever the non-Convention law would otherwise determine, the protection of the account holder against unauthorised debits or designating entries would prevail due to the Convention declaring such unauthorised book entries to be invalid (cf. section 15-10 of the commentary on Article 15). The reference at the beginning of paragraph 2 “subject to Article 15” was left in square brackets. See UNIDROIT 2006 – Study LXXVIII – Doc. 94.

16-9. At the first session of the diplomatic Conference, an extensive discussion on Article 13 took place and resulted in the following changes: The authorisation rule in paragraph 1 and the rules on validity, reversal and conditionality in paragraph 2 were placed into two separate articles.

Article 15(1) now contains the authorisation rule, while Article 15(2) leaves the consequences of unauthorised book entries to the non-Convention law. Invalidity, reversal and conditions now form the subject of Article 16. The text was streamlined but not changed in substance. The reference in square brackets to former Article 15 on priority (now renumbered as Article 19) was deleted.

III. Analysis

16-10. Article 16 is a prominent example of the difficulty of harmonising the substantive rules on debits and credits of intermediated securities to securities accounts. Like Article 15, Article 16 is an important complementary provision to Article 11 (acquisition and disposition by credit and debit) and Article 12 (acquisition and disposition by other methods). The rules under Article 11(1) and (3) as well as Article 12 are expressly made “subject to Article 16”. Regarding Article 12, however, Article 16 refers only to the “designating entry” or the removal of a designating entry (Article 12(3)(b)). The scope of Article 16 does not cover the other two methods of granting an interest pursuant to Article 12, namely, (i) by agreement between account holder and relevant intermediary in favour of the intermediary (“self perfection” – Article 12(3)(a)), or (ii) by a control agreement in favour of a third party (Article 12(3)(c)). This is because the validity of control agreements and the validity of automatic perfection agreements are governed by the applicable law. This would not preclude the interests that have become effective against third parties pursuant to control agreements or automatic perfection agreements from being subject to innocent acquirer protection under Article 18 (see the commentary on Article 18, especially at 18-16).

16-11. Invalidity, reversal and conditionality relate to the legal effects of book entries, i.e., even where a credit, debit, designating entry or removal of a designating entry has been made, the effect intended by Article 11 or 12 may not occur (invalidity), may have to be undone (reversal) or may depend on the fulfilment of a condition (conditionality). The Convention does not define any of these effects. Article 17(d) only defines credits or designating entries which are invalid or reversible as “defective entries”. This approach applies also to conditional credits or designating entries which become invalid or are reversible by reason of the operation or the non-fulfilment of the condition.