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The Business Lawyer

Fall 2022 | Volume 77, Issue 4

Investment Securities

Carl S Bjerre


  • The Investment Securities portion of this year’s Uniform Commercial Code Survey focuses on a fairly routine lost certificate case that, because of errors in the opinion, presents consideration of two larger issues beneath the surface.
  • The first issue is about the difficulties of drafting and interpreting commercial law statutes.
  • The second is about the continuity of property rights in Article 8’s direct holding system.
Investment Securities

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The Investment Securities portion of this year’s Uniform Commercial Code Survey focuses on a fairly routine lost certificate case that, because of errors in the opinion, presents consideration of two larger issues beneath the surface. The first of these issues is about the difficulties of drafting and interpreting commercial law statutes, and the second is about the continuity of property rights in Article 8’s direct holding system.

Secured Lender’s Recovery for Wrongfully Invalidated Stock Collateral

The facts and basic issue presented by the case, In re Karcredit, L.L.C., are simply stated. The registered owner of certificated stock first pledged it as collateral to one lender; falsely submitted an affidavit claiming that he had lost the stock certificate; and then pledged the replacement certificate as collateral to a second lender. After a default, the second lender sought a remedy against the registered owner; the first lender intervened; and the controversy was transferred to the bankruptcy court in an involuntary proceeding against one of the entities on whose behalf the registered owner had executed the pledges.

In ruling on the first lender’s entitlement to a remedy from the issuer, the court walked in a relatively straightforward way through U.C.C. section 8-405(b), which generally governs contingencies arising after the replacement of a stock certificate:

(b) If, after the issue of a new security certificate, a protected purchaser of the original certificate presents it for registration of transfer, the issuer shall register the transfer unless an overissue would result. In that case, the issuer's liability is governed by Section 8-210. In addition to any rights on the indemnity bond [that may have been procured under subsection (a)], an issuer may recover the new certificate from a person to whom it was issued or any person taking under that person, except a protected purchaser.

The court found that the first lender was a protected purchaser; found that the issuer was liable to the first lender because the latter had “lost its first-priority security position in the stock” and that this liability was governed by section 8-210 because of “overissue;” and found damages to be equal to the value of the debt secured (because this value was lower than the value of the securities).

On this generally straightforward level, the case illustrates how Article 8 allocates the potential harms from two conflicting property rights. Both the original certificate and its replacement are generally honored, but the issuer is able to protect itself by requiring an indemnity bond from the person who, by losing the original, caused the problem.

A. Was It Necessary to Consider the First Lender’s Protected Purchaser Status?

The court read section 8-405(b) as requiring the person claiming rights under the original certificate to be a protected purchaser, and accurately (although, as argued below, unnecessarily) found that in this case the first lender (in addition to the second lender) did satisfy that criterion. But what should be the result if the person claiming rights under the original certificate is not a protected purchaser? Perhaps on such facts the person should be able to recover against the issuer anyway, at least in a non-standard sequence of events such as the case involves.

After all, the usual sequence of events that triggers section 8-405(b) is as follows. First, the original certificate is lost; second, the registered owner causes it to be replaced; third, the already replaced but now resurfaced original certificate is purchased by someone downstream; and fourth, the purchaser presents it to the issuer for registration of transfer. In a factual sequence like this—where the problematic downstream purchase of the original certificate follows its having been replaced—the statute sensibly requires the issuer to register the original in the hands of the purchaser because the latter fully satisfies all of Article 8’s elements, set forth in the definition of protected purchaser, for taking free of past circumstances: the purchaser is participating in an economy-expanding transaction by having given value; the purchaser is innocent of any conflicting property rights that might exist by being without notice of any adverse claim; and the purchaser has taken in the formally correct means by obtaining control.

The factual sequence exemplified by Karcredit, though, differs in that the purchase of the original certificate precedes its replacement. (Stated less abstractly, in Karcredit the registered owner was not correctly informing the issuer that the original certificate had been lost; instead, he was falsely doing so, apparently in a deliberate attempt to execute what the court called a double-pledge “scheme.”) And while on the facts of Karcredit the actual purchaser of the original certificate (i.e., the first lender) did happen to be a protected purchaser, one can readily imagine a variety of changes to the facts that could have kept this from being the case. (For example, the first lender might have had notice of an unrelated adverse claim by a fourth party, Claimant X; or the first lender might not have control, having chosen to perfect by delivery alone, without a signed stock power.) Under those circumstances, the first lender would of course not take free of adverse claims—but this should only be relevant to a dispute between the first lender and a fourth party such as Claimant X, and not to a dispute between the first lender and the issuer (let alone to a dispute between the first lender and the second lender, who, recall, was a purchaser of the replacement certificate). When a purchaser takes free of adverse claims, this means that the purchaser cuts off claims of a property right to the security that exist at the time of the purchase. It is a negotiability rule, and thus it concerns the purchaser’s freedom from past circumstances, not about the purchaser’s immunity from future events. So there is no evident reason why, when on less routine facts like in Karcredit the purchase of the original certificate precedes its replacement, the purchaser’s lack of protected purchaser status should expose the purchaser to loss of a remedy for the issuer’s later-to-eventuate invalidation and replacement of the certificate. On the contrary such property rights as the purchaser acquired before the invalidation and replacement should be protected, particularly if those property rights involve possession or even control. Indeed the Karcredit court itself writes (criticizing its own reasoning without realizing it) that the first lender, “as the holder, had a right to rely on its physical possession of [the original certificate] as protection from any erroneous exchange or transfer of the shares of stock represented by it.”

In going to the trouble to establish that the first lender was a protected purchaser, perhaps the Karcredit court was accurately reading the statute. For the statute is likely to have been drafted with an eye to the usual factual sequence (purchase of the original coming after its replacement) rather than to this case’s more unusual one (purchase of original preceding its replacement). Drafters of statutes are human beings and cannot be faulted for failing to expressly anticipate every eventuality. But the sounder reading is that the Karcredit court was inaccurately reading the statute, inferring a negative implication that the drafters did not intend. For the statute clearly states only that “the issuer shall register the transfer” if the person presenting the original certificate is “a protected purchaser,” and this does not logically entail the converse (that the issuer shall not register the transfer if the person presenting it is not a protected purchaser). Judges, just as much as drafters of statutes, are human beings, constantly and sometimes unconsciously drawing inferences from language that may or may not have been intended. The outcome of the Karcredit case itself is correct, but perhaps its reasoning points up the advisability of adding a new comment to section 8-405 that would clarify the application of the statute to the more unusual factual sequence.

B. Did the Two Lenders Have a “Priority” Dispute About “The Same” Collateral?

As noted above, the court characterized the issuer’s liability to the first lender as stemming from the first lender having “lost its first-priority security position in the stock.” At the time that the first lender made its loan, it was fully secured by a first-priority (and only) security interest; and when the issuer invalidated and replaced the first certificate, this position was lost. But it would have been much more accurate for the court to say that the first lender’s collateral simply became valueless upon the invalidation by the issuer.

There are two reasons for this. First, the harm to the first lender was from the invalidation by the issuer, not, strictly speaking, from the reissuance to the second lender. And second and more interesting, loss of priority is a sensible way to describe the harm to the first lender only if the second lender had a security interest in “the same” stock—which is clearly, but very dubiously, the way that the court conceptualized the relationship of the two transactions. In the very first paragraph of its opinion, the court explains, “[t]his case involves the double-pledging of collateral. In a double-pledge scheme, a borrower or guarantor pledges the same collateral to different lenders.” And in the next paragraph, the court writes, “[h]ere, the double-pledge occurred after the issuer of the stock issued a replacement stock certificate. The result was two original certificates representing the same shares of stock.”

Certainly the second certificate replaced the first certificate, and certainly the two certificates represent the same fraction of ownership of the issuer. But the soundest view from a Uniform Commercial Code perspective is that the two certificates were not “the same,” and did not even “represent[] the same shares of stock.” As a matter of simple doctrine, U.C.C. Article 9 provides a clear priority rule for conflicting security interests in securities, both of which are perfected by control, namely that they “rank according to priority in time of . . . obtaining control.” On the facts of Karcredit, if this priority rule were to apply, then the first lender would have priority, which would be contrary to the result that the court reached and also contrary to Article 8’s foundational rule that a protected purchaser takes free of adverse claims. This alone shows that the court was incorrect in thinking that the relationship between the two lenders was a question of priority in the same property.

At a conceptual level, too, it is clear that the priority framework should not be applied to these two certificates. This will be best seen by beginning with Article 8’s indirect holding system and then proceeding back to the direct holding system, because insights from the more modern holding system can shed light on what the more traditional one had been doing all along. Under the indirect holding system, as by now is well established, when Investor A liquidates a position with her broker and Investor B acquires a corresponding position with his broker, the two investors do not buy or sell a security entitlement; rather Investor A’s security entitlement is extinguished and a highly congruent but conceptually independent security entitlement is created in favor of Investor B.

In retrospect, the same insight—that it is possible and indeed sound to sever what might superficially appear to be continuous property claims—should be applied to the direct holding system. Jim Rogers, the Reporter for the 1994 revision of Article 8 that codified the indirect holding system, wrote:

Even in the simple world of a sale of certificated securities effectuated by delivery of an indorsed stock certificate from seller [say, Jones] to buyer [say, Smith], it is far from clear that the transaction can appropriately be regarded as the transfer from Jones to Smith of the “same thing.” . . . [T]he way that a buyer of securities in such transactions obtains assurance of good title is by surrendering the certificate to the issuer or transfer agent for registration of transfer and issuance of a new certificate in the name of the buyer. If Smith has done that, does it really make any sense to say that Smith now owns the same 100 shares of IBM stock that Jones used to own? Before the transaction, Jones had a right against the issuer to a certain package of rights of participation in the control, ownership, and earnings of the enterprise. After the transaction, Jones no longer had that entitlement against the issuer, but Smith did have an economically equivalent entitlement. . . . [T]he concept of transferring items of property just does not fit. It is entirely unnecessary to describe the result of the Jones–Smith transaction as a “transfer” to Smith of the same 100 shares that Jones formerly owned. A far more accurate description would be to say that the Jones–Smith transaction was [merely] the efficient cause of the extinguishment of Jones's rights against the issuer and creation of a new package of rights in favor of Smith. That the two packages of rights are economically equivalent does not mean that they are the same.

At one spot, current Article 8 does refer to the old and new certificates in a sale of certificated securities together, suggesting a continuity between them—but even this instance can be reconciled with the severing of the two property rights. U.C.C. section 8-106(b) provides that a purchaser of a certificated security in registered form has control

if the certificated security is delivered to the purchaser, and (1) the certificate is indorsed to the purchaser or in blank by an effective indorsement; or (2) the certificate is registered in the name of the purchaser, upon . . . registration of transfer by the issuer.

Subsection (b)(2) thus provides that if a first certificate is reregistered in the name of a purchaser (which results in a new certificate being issued to the purchaser), then the purchaser has control of “the . . . security,” which does suggest continuity between the two certificates. However it is highly revealing that this continuity is suggested only in the context of control, which is at the heart of Article 8’s rules for taking free of adverse claims—and that subsection (b)(2) broadens the availability of control and hence taking free. In effect, the continuity between the two certificates is suggested only for the purpose of denying it.

Before the formulation of what today is section 8-106(b), Rogers explained the same idea in the context of what today is section 8-404’s provisions on wrongful re-registration:

The significance of abandoning the property transfer conceptual structure becomes apparent when we consider the resolution of problems left by the intervention of scalawags, thieves, and insolvents. Suppose that Tom steals Jones's stock certificate, forges his indorsement and sells the stock to Smith, who succeeds in getting the issuer to register the transfer. Under present law, the result is that Smith is entitled to be treated as owner of 100 shares and Jones has a cause of action against the issuer for wrongful registration. Jones's remedy for that wrong is to have 100 shares reissued in his name. Asking who got Smith's [sic] 100 shares is unnecessary and unhelpful. If one must ask such a question, the best answer is something like the answer that the North Carolina Supreme Court gave in 1876 when asked what happened to the owner's tree when it was wrongfully cut and made into a canoe: “[t]he trespasser by so doing destroys the original article, as if he had burned it, and is responsible to the owner, as if he had burned it.”

To be sure, wrongful registration is different from invalidation and replacement at the instance of the registered owner as in Karcredit. (With wrongful registration, there are no relevant requests or commands from the registered owner, but with invalidation and replacement the issuer is following the registered owner’s request.) Nonetheless the same concepts apply—and as Karcredit reminds us, invalidation and replacement just as much as wrongful registration can involve scalawags, thieves, and insolvents.