3. Time framework: paragraph 3

24-20. Paragraph 3 of Article 24 provides the timeframe within which an intermediary shall comply with the requirement promulgated by paragraph 1, and refers to the non-Convention law on this issue. A failure to comply with the requirement may arise for different reasons. It may be the result of a deliberate decision (fraud or misconduct) or of an inadvertent breach by the intermediary of its obligation. In addition, such failure may be downstream or upstream: either because the intermediary credits securities to its account holder’s securities account in circumstances where a corresponding increase in the underlying securities or intermediated securities held by the intermediary does not take place, or because securities are debited from the intermediary’s holdings without a corresponding debit to the account holder’s securities account. In both cases, the Convention assumes that the new or remaining credit in the account holder’s securities account is valid and effective even though there is no matching book-entry at an upper-level.

24-21. If this circumstance arises, the intermediary must correct it. The operations to rectify the situation can take different forms. The situation can be rectified either by increasing the holdings of the intermediary (e.g., purchasing securities or intermediated securities from the market) or by reducing the holdings of its account holders (e.g., purchasing intermediated securities from the account holders or using a securities lending arrangement to borrow securities from an account holder). The timeframe for carrying out these operations is found in the non-Convention law. The non-Convention law also governs the liability of the intermediary for the violations of these obligations under Article 24 (see Article 28).

III-4. Paragraph 4

24-22. Finally, paragraph 4 contains an additional referral to the Convention law. The non-Convention law or, to the extent permitted by the non-non-Convention law, any provision of the uniform rules of a securities settlement system or of an account agreement may set out rules in respect of two aspects. Firstly, they may specify the method of compliance with the obligation to hold or have available sufficient securities under this article. That is, the standard for the intermediary’s compliance with its obligations under this provision can be set by agreement or by the rules of a securities settlement system; for example, the rules of a securities settlement system may permit temporary, intra-day shortages or may permit provisional credits. Secondly, they may determine the allocation of the costs of ensuring compliance and other consequences of failure to comply with the obligation to hold or have available sufficient securities.

EXAMPLE 24-6: IM 1 has credited 100 ABC shares to the securities account of one of its account holders, X. IM 1 holds those 100 ABC shares with an upper-tier intermediary, IM 2.

If IM 2 goes bankrupt and there is a shortfall, an imbalance may arise. If IM 1 acquires additional shares to correct the imbalance, the non-Convention law determines whether this cost is borne by IM 1 or by X.

Article 25

Allocation of securities to account holders’ rights

1. Securities and intermediated securities of each description held by an intermediary as described in Article 24(2) shall be allocated to the rights of the account holders of that intermediary to the extent necessary to ensure compliance with Article 24(1).

UNIDROIT 2009 – CONF. 11/2 – Doc. 5 – Article 25 115.

2. Subject to Article 20, securities and intermediated securities allocated under paragraph 1 shall not form part of the property of the intermediary available for distribution among or realisation for the benefit of creditors of the intermediary.

3. The allocation required by paragraph 1 shall be effected by the Convention law and, to the extent required or permitted by the non-Convention law, by arrangements made by the relevant intermediary.

4. The arrangements referred to in paragraph 3 may include arrangements under which an intermediary holds securities and intermediated securities in segregated form for the benefit of:

(a) its account holders generally; or

(b) particular account holders or groups of account holders,

in such manner as to ensure that such securities and intermediated securities are allocated in accordance with paragraph 1.

5. A Contracting State may declare that, where all securities and intermediated securities held by an intermediary for its account holders are in segregated form under arrangements such as are referred to in paragraph 4, under its non-Convention law the allocation required by paragraph 1 applies only to those securities and intermediated securities and does not apply to securities and intermediated securities held by an intermediary for its own account.

6. This Article applies notwithstanding the commencement or continuation of an insolvency proceeding in respect of the intermediary.

Commentary

I. Introduction

25-1. Article 25 provides another core rule for investor protection. The principal purpose is to protect account holders by ensuring that enough of an intermediary’s securities or intermediated securities are allocated so as to cover its account holders’ rights. Paragraphs 1 and 2 of Article 25 state the main idea and its consequence. The securities or intermediated securities held by an intermediary under any of the methods listed in Article 24(2) must be allocated to the account holders to the extent necessary to ensure compliance with Article 24(1). Paragraph 2, in turn, states that the securities or intermediated securities that are allocated to account holders do not form part of the intermediary’s property and are not available to the creditors of the intermediary.

This provision is, however, subject to Article 20, which means that the priority given in that provision to the intermediary’s secured creditors over account holders must be respected.

25-2. Paragraphs 3 and 4 relate to the methods of allocation. Paragraph 3 refers to the non-Convention law with respect to this issue and, to the extent required or permitted by that law, to arrangements made by the relevant intermediary. This latter method is elaborated upon in paragraph 4, which specifies two kinds of segregation arrangements: either for the benefit of account holders generally or for the benefit of particular account holders or groups of account holders.

25-3. Paragraph 5 foresees a declaration mechanism. A Contracting State may declare that, where the securities held by the intermediary are in segregated form, the allocation set out in paragraph 1 does not apply to the securities held by the intermediary for its own account.

25-4. Finally, paragraph 6 clarifies that this provision applies notwithstanding the commencement or continuation of an insolvency proceeding in respect of the intermediary.

II. History

25-5. The principle underlying this provision was already contained in the first version of the preliminary draft Convention (UNIDROIT 2004 – Study LXXVIII – Doc. 18). Article 15 of this text established that the securities held by the intermediary were appropriated to the rights of its account holders to the extent necessary to satisfy their credits. It also contained the main consequence of this principle, i.e., in case of insolvency of the intermediary, the securities belonged to the account holders and were not available for the other creditors. Finally, it also recognised that the non-Convention law would determine the precise technique by which the appropriation should be effected and the procedure by which the account holders’ rights should be enforced.

25-6. In the first session of the CGE (UNIDROIT 2005 – Study LXXVIII – Doc. 24), the provision was redrafted basically to make clear that it could be applied to both jurisdictions where intermediaries segregate accounts (i.e., differentiate between its own securities and its account holders’ securities) and those where they do not. In addition, a declaration mechanism was introduced for allowing Contracting State to impose segregation. Finally, the concept of

“appropriation” was replaced by a more neutral term: “allocation”. Under the new numeration of the text, former Article 15 was moved to Article 17.

25-7. During the second session of the CGE (UNIDROIT 2006 – Study LXXVIII – Doc. 42), the provision was not practically modified. Only the paragraph allowing for a declaration was changed to clarify its meaning, i.e., the possibility of Contracting States to give proprietary-law consequences to regulatory rules on segregation. After that session, the provision corresponded to Article 19.

25-8. During the third session of the CGE (UNIDROIT 2006 – Study LXXVIII – Doc. 57), apart from slight drafting changes, two elements were added: (a) a cross-reference to the provision dealing with the priority of particular creditors of the intermediary, and (b) a specification of the arrangements that an intermediary may have to effect the allocation required by paragraph 1. In the text adopted after this session, the provision corresponded to Article 21.

25-9. During the fourth session of the CGE (UNIDROIT 2007 – Study LXXVIII – Doc. 94), the only relevant modification introduced was a clarification in the sense that the allocation applies to all securities held by the intermediary irrespective of the method (i.e., directly or through another intermediary). The provision corresponded to Article 22.

25-10. Finally, during the first session of the diplomatic Conference, the provision was adopted without any substantial modifications (UNIDROIT 2008 – CONF. 11 – Doc. 48 Rev.).

UNIDROIT 2009 – CONF. 11/2 – Doc. 5 – Article 25 117.

III. Analysis