Assets such as limited partnership interests, limited liability company interests, shares of closely-held corporations and life insurance policies are commonly subject to broad transfer restrictions. How these restrictions limit transfers (including grants of security) is well understood when such assets are held directly, but when these assets are held in the indirect holding system, the legal analysis of the transfer differs.
A transfer of an asset in the indirect holding system is not simply an "indirect transfer" of the underlying asset. It is a transfer of a new and particular set of rights created under Article 8 of the Uniform Commercial Code. Failing to distinguish these rights from direct rights in the underlying asset denies core principles of the modern indirect holding system.
Hedge Funds: Illustrative Transactions
One subset of transactions involving transfer restricted assets that exemplifies these issues is secured financings for hedge funds known as "funds of funds." A fund of funds is simply a hedge fund that invests in other hedge funds. In the United States hedge funds are typically organized as limited partnerships or limited liability companies. Accordingly, the concepts applicable to fund of funds transactions are illustrative for the broader group of transfer restricted assets.
Like other alternative entity assets, hedge funds are often subject to broad transfer restrictions. Hedge funds utilize transfer restrictions to avoid being regulated under certain securities laws, such as the Investment Company Act of 1940. Without this exemption, a hedge fund that offers or sells its interests in the United States would typically qualify as an "investment company" under the Investment Company Act and would be required to comply with the obligations thereof, which could (1) create potentially significant administrative burdens for the fund, (2) limit the fund's ability to utilize leverage, and (3) limit its use of certain investment strategies (such as short selling). Hedge funds rely on their transfer restrictions to maintain eligibility for these exemptions.
Additionally, funds of funds have an appetite for credit to manage liquidity and leverage needs. On the liquidity side, funds of funds use credit to facilitate portfolio management. If a fund is invested in illiquid assets and becomes obligated to return investor capital (typically through an investor request called a redemption), the fund can readily draw on its liquidity line to meet the applicable redemption deadlines or to avoid liquidating specific assets in a down market. On the leverage side, funds use credit to magnify returns to investors, which strategy also magnifies loses.
To minimize credit risk, fund of funds lending transactions are usually secured. To secure obligations to a creditor, a fund of funds commonly pledges an investment account as collateral. This account is generally established and maintained as a "securities account" under Article 8 of the Uniform Commercial Code. All of the fund's investments (or a specified group thereof) are credited to this account. The fund grants a security interest in the account and that interest is typically perfected through a control agreement. These fund of funds transactions provide a useful model for the application of the concepts addressed in this article.
The Controversy
The controversy for transfer restricted assets in the indirect holding system is whether the transfer restrictions that limit transfers in the direct holding system also limit transfers of such assets once they are credited into the indirect holding system. In the case of a fund of funds transaction, if the pledge of a fund's securities account is analyzed as a pledge of direct rights in the underlying hedge funds, the pledge will likely be viewed as breaching the transfer restrictions incorporated into such interests. The breach of these transfer restrictions can trigger penalties and other negative consequences that diminish the value of the collateral. Additionally, a breach of these restrictions may raise concerns about the fund's compliance with certain representations and covenants incorporated into financing documents and may present issues for the law firm that prepares a legal opinion with respect the pledge of the securities account in such a transaction.
This controversy generates market inefficiencies. The specter of transfer restrictions can sideline assets that might otherwise be available as collateral to secure obligations of indebtedness. These idled assets are significant. In 2011, assets under management in the hedge fund industry alone reportedly exceeded $2.02 trillion dollars--a historical high-water mark. Additionally, analysis by approximation to the direct holding system obscures relevant risks that ought to be highlighted to parties engaged in these transactions.
The resolution of this controversy resides in the core principles of the modern indirect holding system. Article 8 of the Uniform Commercial Code acknowledges that the form of holding is an essential consideration in analyzing transfers. The official comments to section 8-104 provide that "[w]here an item of property can be held in different ways, the rules on how one deals with it, including how one transfers it or how one grants a security interest in it, differ depending on the form of holding." This article identifies key distinctions in the direct and indirect holding systems and addresses how those differences impact the legal analysis of transfers of assets subject to transfer restrictions.
The Systems of Holding
The direct holding system (Direct Holding System) is a system in which rights originate from an issuer of a security (or similar asset). This is the traditional form of holding a security. A holder of rights in the Direct Holding System (Direct Holder) includes a person that holds a certificated "security" in its own name or is the registered owner of an uncertificated "security" on the books of the issuer. For purposes of this paper, a Direct Holder also includes a person that holds a security or similar asset through another entity, where that entity is not a "securities intermediary." For example, if shares of a corporation (Corp. A) are held by single member limited liability company (LLC A), the individual that holds the membership interests of LLC A would still be a deemed Direct Holder with respect to the Corp. A shares. As used herein, the indirect holding system (Indirect Holding System) refers to the holding system described under Part 5 of Article 8 of the Uniform Commercial Code as modified by the 1994 revisions thereto (1994 Revisions) and an indirect holder (Indirect Holder) is a holder of rights arising in the Indirect Holding System. Assets credited to the Indirect Holding System are referred to as "financial assets." Under the definition of "financial assets" in section 8-102 of Article 8, parties are free to agree to treat any asset as a financial asset, unless such asset is excluded as a "financial asset" under section 8-103 of Article 8 (such as "commodity contracts").
The key to determining the applicable holding system is the source of the relevant rights at issue. If the rights at issue are directly traceable to an underlying issuer of a security (or similar asset), the rules of the Direct Holding System apply. If the rights at issue are directly traceable to a "securities intermediary" (as defined in Article 8), the rules of the Indirect Holding System apply. Applying this framework, where the sole member of LLC A transfers all of its interests in LLC A to another party, the transfer (with respect to the Corp. A shares) would be analyzed under the Direct Holding System because the rights at issue are directly traceable to Corp. A (as the issuer of the corporate shares), not a securities intermediary.
The Modern Paradigm: A Brief Overview
The 1994 revisions to Article 8 fundamentally changed the rights of a person holding a security in the Indirect Holding System. Prior to such revision, whether a person held a security directly or indirectly, the person was deemed to be the owner of that security. This framework changed, however, when the 1994 Revisions created a distinction between the rights of Direct Holders and Indirect Holders. To implement this conceptual change, the 1994 Revisions created a new section in Article 8 - Part 5, entitled "Security Entitlements," which describes the primary rights and duties of parties in the Indirect Holding System.
Security entitlements are the keystone of the Indirect Holding System. A security entitlement is both a package of personal rights against a securities intermediary and a property interest in the assets held by the securities intermediary. A person that holds an asset through a securities intermediary pursuant to Article 8 has a "security entitlement." The property interest that comprises that security entitlement is described in the official comments of Article 8 as a "sui generis property interest." Article 8 provides that the incidents of such property interest "are established by the rules of Article 8, not by common law property concepts." The 1994 Revisions created a clear distinction between the two holding systems. The rights of an Indirect Holder are new rights and separate from the rights of Direct Holders. Consistent with this paradigm, the 1994 Revisions incorporated new and separate substantive rules for the two systems.
Separate Substantive Rules
The 1994 Revisions introduced separate substantive rules to be applied in the Direct and Indirect systems, including rules on (1) property interest remedies, (2) governing law, and (3) warranties upon transfer. These different substantive rules reinforce the unique nature of the rights arising under the two systems.
Limitations on Remedies
The remedies with respect to property interests arising in the Indirect Holding System are limited under section 8-503 of Article 8. While the securities intermediary is solvent, the entitlement holder must look to the intermediary to satisfy its claims. The entitlement holder cannot assert its property interest directly against other parties, except in extremely unusual circumstances. This remedial limitation is intended to promote the sound and efficient operation of the securities holding and settlement system by eliminating the need for purchasers to investigate whether a securities intermediary acted wrongfully in transferring a financial asset. This limitation also promotes an understanding that the property interest of an entitlement holder is a unique right, which originates from its securities intermediary, not the issuer.
Different Governing Law
Similarly, the rules for identifying the applicable governing law support the distinction of the rights in both systems. In the Direct Holding System, pursuant to 8-110(a), the local law of the issuer's jurisdiction governs concepts such as: (1) the validity of a security and (2) the rights and duties of the issuer with respect to registration of transfer. In the Indirect Holding System, pursuant to 8-110(b), the local law of the securities intermediary's jurisdiction governs analogous concepts such as: (1) the acquisition of a security entitlement from the securities intermediary, and (2) the rights and duties of a securities intermediary and entitlement holder arising out of a security entitlement. Under these provisions, the governing law is determined by reference to the originator of the relevant rights. In the Direct Holding System the originator is the issuer. In the Indirect Holding System, the originator is the securities intermediary. Where the nature of the rights held in the different systems is determined by reference to different governing laws, the rights themselves must be understood to be separate rights.
Separate Warranties
Additionally, the warranties to be provided upon a transfer of rights in the two systems differ with respect to violations of transfer restrictions. Under sections 8-108 (a), (b), and (c), a person transferring or effecting a transfer of a directly held "security" provides, among other warranties, a warranty that the transfer "does not violate any restriction on transfer." This warranty is appropriate under section 8-108 because transfers of securities in the Direct Holding System may violate issuer transfer restrictions.
This warranty is also appropriate for transfers that occur at the interface of the Direct Holding System and the Indirect Holding System because such transfers may also result in the violation of issuer transfer restrictions. Such transfers occur, for example, when (1) a person delivers an asset to a securities intermediary to be credited to a securities account or (2) a securities intermediary causes its entitlement holder to be registered as the owner of an uncertificated security. In both of these transfers, the Direct Holder changes. Because these transfers involve rights in the Direct Holding System, the issuer's transfer restrictions apply and potentially limit such transfers. Accordingly, the package of warranties provided for such transfers, under sections 8-109(b) and (c) for these interface transfers, include a warranty that such transfers do not violate any restriction on transfer.
In contrast, no such warranty is required in connection with instructions to effect transfers occurring entirely within the Indirect Holding System. Because the rights in the Indirect Holding System originate from the securities intermediary, not the issuer, it is appropriate that transfers occurring entirely within the Indirect Holding System should not be constrained by issuer-originated transfer restrictions. Consistent with this view, the package of warranties provided for such transfers under section 8-109(a), does not include a warranty that the transfer does not violate any restriction on transfer. Unlike the Direct Holding System, rights arising under the Indirect Holding System are not expected to be subject to transfer restrictions.
Understanding the two systems as separate regimes permits the isolation of certain commercial law issues in a manner consistent with the core principles of the modern Indirect Holding System. The 1994 Revisions to Article 8 distinguished the Direct Holding regime from the Indirect Holding regime. Accordingly, the grant of a security interest in rights of an Indirect Holder does not breach transfer restrictions originated by an issuer of the underlying asset because the rights being granted originated from the securities intermediary. This simplifies the analysis of transactions involving the transfer of transfer restricted assets, such as fund of funds transactions. Such simplification, however, is useful only if it can be reconciled with other law that may find an issuer's transfer restrictions to be lawful and enforceable.
Preserving the Expectations of Issuers: The Intermediary as Legal Owner
Issuers rely on the effectiveness of transfer restrictions to limit transfers by holders of their interests for a variety of reasons. To be effective, these restrictions may need to exclude certain parties from being both legal and beneficial owners. Deeming issuer transfer restrictions to be imported into the Indirect Holding System, however, is not the appropriate mechanic to give effect to such restrictions because such approach is inconsistent with the core principles of Article 8. To understand how Article 8 reconciles the expectations of issuers with the structure of the Indirect Holding System we need to review (1) a hedge fund's need to restrict transfers, (2) the relevant securities intermediary's awareness of such transfer restrictions, and (3) the provisions of Article 8 that enable the securities intermediary to preserve these expectations.
As noted previously, one common reason why a hedge fund seeks to restrict transfers is to comply with certain exemptions to federal securities laws, such as the Investment Company Act of 1940. Eligibility for such exemptions can be contingent on the identity of legal and beneficial owners of an issuer's interests. In the case of the Investment Company Act, such exemptions can require that the number of "beneficial owners" be limited to not more than 100 persons or that "owners" be "qualified purchasers." If an underlying hedge fund's transfer restrictions are not effective to stop the transfers of its "beneficial owners," the hedge fund's compliance with such exemptions could be threatened, potentially subjecting the fund to registration requirements under the Investment Company Act.
In typical fund of funds transaction, a securities intermediary is able to give effect to issuer transfer restrictions, without having to import such restrictions into the Indirect Holding System. In such transactions, the fund of funds, as the entitlement holder, becomes the beneficial owner. The securities intermediary becomes the legal owner of each hedge fund in which the fund invests by completing each hedge fund's subscription documents. In the subscription process, the securities intermediary identifies and agrees to comply with the transfer restrictions of the hedge fund. Additionally, the securities intermediary (as legal owner) commonly affirms representations, on behalf of itself and the beneficial owner, that both parties meet the criteria to hold the hedge fund's interest (i.e., both parties qualify as "qualified purchasers"). To avoid breaching these representations and related obligations owed to the hedge funds, a securities intermediary must be able to limit transfers by the beneficial owners. Fortunately, the securities intermediary is able to do so because entitlement holders cannot effect outright transfer of security entitlements without the involvement of the relevant securities intermediary.
The Concept of Eligibility
While a securities intermediary is obligated to comply with "effective" entitlement orders of specified persons under section 8-507, this obligation is not unconditional. Where a securities intermediary receives an effective instruction to transfer a security entitlement to a third party and that third party does not satisfy the beneficial owner criteria of the underlying hedge fund or such instruction is not consistent with the intermediary's obligations as the Direct Holder, the intermediary might deem such transferee not "eligible," as permitted under section 8-508 or deem such instruction inconsistent with its obligations, under section 8-509. In either case, the preservation of the issuer's expectations is effected through the securities intermediary, consistent with the securities intermediary being a Direct Holder of the underlying asset. This approach avoids the need to import issuer transfer restrictions into the Indirect Holding System.
Consistent with the preservation of issuers' expectations, pledges of rights arising in the Indirect Holding System can be implemented without effecting a transfer of the legal or beneficial owner. Where a fund of funds pledges its securities account to a creditor and the creditor perfects that security interest by entering a control agreement consistent with section 8-106(d)(2) of Article 8, there is no transfer of the security entitlement and the fund remains the beneficial owner.
Redemption as an Adequate Remedy
Where a perfected secured creditor with "control" (as defined in Article 8) seeks to enforce its interest in a debtor's securities account by directing the intermediary to delivery the financial assets to a new securities account (either its own or that of a third party), the beneficial owner of the underlying hedge fund interest would change. To the extent such change is inconsistent with the obligations the securities intermediaries undertook with respect to the underlying hedge fund, or if the hedge fund is unwilling to permit such a transfer upon request by the securities intermediary, the secured creditor may not be able to effect its transfer. This limitation on enforcement may exist notwithstanding the secured creditor's perfected security interest in the securities account and may significantly diminish the value of the collateral in the judgment of the creditor. In a fund of funds transaction, however, the creditor has the option of redemption, which provides an avenue of enforcement.
The benefit of redemption is that it does not require any transfer of legal or beneficial ownership of the security entitlement. Consequently, where a perfected secured creditor enforces on the collateral in the typical fund of fund transaction, it will be able to instruct the securities intermediary to redeem the hedge fund interests that have been credited to the securities account. The securities intermediary will be obligated (pursuant to the relevant control agreement and applicable provisions of Article 8) to request a redemption of the hedge fund interest from the underlying hedge fund. The hedge fund, under its subscription documents, will be obligated to redeem the hedge fund interest (subject to the terms of its subscription documents, which may include gating limits or other restrictions). Accordingly, the secured creditor has a means of exchanging the collateral for value that is not contingent on the cooperation of the securities intermediary or the issuer (other than their cooperation to comply with their respective obligations under Article 8 and the relevant subscription documents).
Conclusion
When an asset is held in the Direct Holding System, issuer transfer restrictions provide a direct restraint on a holder's right to transfer such asset. This direct restraint is not applicable to the same asset held in the Indirect Holding System because the source of the rights and the law governing those rights is different. In the Direct Holding System, the source of the rights is the issuer. In the Indirect Holding System, the source of rights is the securities intermediary. Importing issuer-originated transfer restrictions into the Indirect Holding System is inconsistent with the modern Indirect Holding System.
Where a secured creditor has the option of redemption and such option provides adequate value to the creditor (in its own judgment), the Indirect Holding System may afford holders of assets subject to transfer restrictions a means of using such capital to secure obligations that is not available in the Direct Holding System. This conclusion gives effect to the core principles of Article 8 without rendering issuer transfer restrictions ineffective. This conclusion also simplifies the commercial law analysis of pledges of transfer restricted assets held in the Indirect Holding System, which promotes efficiencies in the market and, potentially, the broader use of such capital as collateral for secured financings.