DTC is a wholly owned subsidiary of The Depository Trust & Clearing Corporation (DTCC). DTCC’s common shareholders are the banks and broker-dealers that are the participants in and users of its clearing corporation subsidiaries, DTC, NSCC, and the Fixed Income Clearing Corporation (which administers trade matching, clearing, risk management, and netting for trades in U.S. Government debt securities, including repurchase agreements). Other regulated businesses of DTCC include data repository subsidiaries for the U.S. and major foreign markets and other subsidiaries that complement its core operations.
B. Clearing and Settlement (Including NSCC/DTC Continuous Net Settlement (CNS) System)
Securities that are publicly traded in the United States are typically held on deposit at DTC and benefit from book-entry clearance and settlement processes available at DTC and NSCC. “Clearing” of a securities trade has traditionally been understood as the comparison and verification of trade data (i.e., between a buyer and seller) that reliably establishes that a “trade” has occurred. “Settlement” generally refers to the process in connection with a trade by which securities are transferred (a “delivery”) and payment for the securities is made. NSCC’s Continuous Net Settlement (CNS) system handles most broker-to-broker trades (“street-side transactions”) in the United States for equity securities, corporate and municipal bonds, American depositary receipts (ADRs), exchange-traded funds (ETFs), and unit investment trusts. CNS was established in 1974 and its origins date back to the paperwork crisis of the 1960s. Securities transactions cleared through NSCC typically settle by delivery of the securities by book entry at DTC, which holds those securities on behalf of its participants.
In the CNS system clearing is essentially automated. Trade data from both sides of a trade are transmitted in real time from trading platforms (e.g., exchanges) to NSCC’s universal trade capture system, which validates the details of the trade and reports it in real time to the buying and selling brokers. Once the trade is cleared, it is sent to the CNS system for settlement.
For each NSCC participant transacting in a securities issue on a trade date, all obligations to deliver and rights to receive are netted resulting in each participant having an obligation either to deliver or receive one number or amount of that security. In similar fashion, all obligations of each participant to pay or receive payment for all securities for that trade date are netted, with each participant having an obligation to pay or a right to receive a single sum. NSCC functions as a “central counterparty” in the CNS system. It takes on the role of making payments and deliveries to each counterparty and receiving payments and deliveries from each counterparty. The result is that on the settlement date for a trade date each participant has an obligation to deliver to (“short net position”) or the right to receive from (“long net position”) NSCC the netted number or amount for each relevant security issue, and each participant has an obligation to pay to or receive payment from NSCC the netted sum for that participant. In the CNS system the long and short positions of NSCC members always equal zero in the aggregate—for every long position there are one or more participants with offsetting short positions. This multilateral netting allows brokers to trade large volumes with many counterparties while ultimately settling by delivering or receiving only one netted number or amount of a security issue and paying or receiving one netted payment amount. It reduces costs, mitigates counterparty risk, and reduces the number of settlement obligations.
Currently, settlement occurs on the second business day following a trade date (T+2). On each settlement date, NSCC instructs DTC to deliver securities from DTC participant accounts of NSCC short members to the NSCC’s CNS account with DTC and then instructs DTC to deliver the securities from that account to the long members’ DTC accounts. When final figures are posted based on the securities settlement activity, each participant has either a debit or credit money settlement balance. In some cases, a broker is unable to deliver to NSCC the netted number or amount of a security issue as to which it is short, i.e., that it owes (a “fail to deliver” or “fail”). In that case, the securities that are the subject of the fail are “marked to market”—the difference between the current market value at the close of the previous trading day and the original contract price—and that difference is debited (subtracted) from the money settlement balance of that broker. A broker that fails to receive securities, similarly, receives a credit for the marked-to-market amount that increases its money settlement balance. This process of marking to market continues until the securities are delivered, thereby reflecting the continuous nature of the CNS system. In addition, a member with a long position that has failed to receive securities by the end of processing on a settlement date may initiate a two-day “buy-in” process. The buy-in process allows the member with the long position to receive the subject securities either from the broker with a short position or through a purchase in the market at the expense of the broker with a short position.
DTC conducts a netted, combined money settlement with NSCC daily through settlement banks and at the Federal Reserve Bank of New York using the National Settlement Service. Money balance settlements occur at about 4:15 pm on each settlement date through the Federal Reserve Bank of New York and settlement banks acting on behalf of DTC participants. When more than one settling member uses the same settlement bank for making settlement payments, netting also is effected within the settlement bank. The result is that the bank makes or receives only one “net net” payment amount.
Daily settlement for DTC and NSCC (as well as for Fixed Income Clearing Corporation) is supported by a structure for liquidity overseen by DTCC’s Liquidity Risk Management program. This program ensures, with a high degree of confidence, the settlement of payment obligations under various scenarios, including a default by all members of the family of firms with the largest aggregate payment obligation.
C. Roles and Operation of Clearing Brokers and Self-Clearing Firms
Some broker-dealers may not deal directly with trading platforms or the NSCC-DTC clearing and settlement process. Instead, these “introducing brokers” use a “clearing broker” or “clearing firm” to execute trades and participate in the NSCC-DTC clearing and settlement process on their behalf. A broker-dealer using a clearing broker typically holds securities for its entitlement holders through securities accounts with the clearing firm. Other firms are “self-clearing” and handle all trading and clearing and settlement in-house (or through an affiliate) and also engage directly with the NSCC-DTC process. Still other firms not only self-clear but also act as clearing firms for other broker-dealers. Both introducing brokers and clearing brokers may exercise self-clearing by netting and settling internally among their respective account holders. The resulting data is then reported to NSCC for inclusion in the CNS system.
D. Margin Lending
Margin lending generally refers to loans made by a broker-dealer to its customer (entitlement holder) secured by the customer’s securities. The reference to “margin” derives from Federal Reserve Board Regulation T, which governs extension of credit by broker-dealers for the purpose of buying, carrying, or trading in securities. The initial margin requirement for equity securities under Regulation T is (and has been for many years) 50 percent, meaning that margin loans generally are limited to 50 percent of the market value of the relevant securities. Mechanisms for broker-dealers to fund margin lending through rehypothecation and the relationship of rehypothecation to the customer protection rule are discussed below in Subparts E and F.
Margin loans not only provide a convenient means for investors to finance purchases of securities but also facilitate borrowings for other purposes as well. Margin lending also is an important profit center for the broker-dealers.
E. Rehypothecation: Securities Lending and Borrowing, Repurchase Agreements, and “Repledge” Transactions
Consistent with the customer protection rule (discussed below in Subpart F), a broker-dealer may use customers’ margin securities to fund transactions for customers, such as margin loans. In most cases this use of customer margin securities will involve a loan of securities or a repurchase (“repo”) transaction. In a securities loan, the broker-dealer lender transfers the securities to a borrower and typically receives from the borrower cash or liquid securities as collateral to secure the borrower’s obligation to return like securities. Securities borrowers typically borrow securities to meet an obligation to transfer the securities in settlement of a short sale transaction, to meet a settlement obligation in case of a failure to deliver securities, or for other purposes (e.g., as a hedge for a synthetic total return swap). In a repo transaction, the broker-dealer seller transfers securities to a repo buyer in exchange for cash with the broker-dealer being obligated to repurchase the securities for an amount that includes a fee for the repo buyer. The broker-dealer also may obtain funding by using customer margin securities as collateral for a loan of funds to the broker-dealer in a “repledge” transaction.
In both a securities loan and a repo transaction the transfer by the broker-dealer normally involves a debit, for the relevant issue of securities, to the securities account of the broker-dealer with its sub-custodian or with DTC. In that case the broker-dealer would have lost all connection with the securities, which would be “gone” from the broker-dealer’s perspective. The broker-dealer would have only a contractual claim against its counterparty for the return of the securities (or their equivalent). Similarly, a repledge transaction may involve a debit to the broker-dealer’s account with a sub-custodian or DTC and a corresponding credit to (or ultimately for the benefit of ) the funds lender. The funds lender, in turn, may transfer the securities to a third party (perhaps in a securities lending transaction or other sale or in another repledge transaction). In that case the broker-dealer also may have lost all connection with the securities. However, in all three types of rehypothecation transactions the broker-dealer normally would not debit its customer’s account for those securities, which would remain credited to the account. Thus, an imbalance would be created as between the securities credited to the securities account of the broker-dealer (at its custodian or depository) and those credited by the broker-dealer to the securities accounts of its customers. More precisely, the transaction may contribute to the existence of such an imbalance inasmuch as the existence of an actual imbalance would depend on an aggregate analysis that takes into account the number or amount of all securities of the issue credited to the broker-dealer’s customers and the number or amount of that issue held by the broker-dealer in all locations. As explained in Subpart F.2, moreover, the operation and observance of the customer protection rule serves to ensure that sufficient value to satisfy customer claims would be available and so allocated in a broker-dealer insolvency, even in the presence of imbalances in securities of particular issues. Such imbalances are typically referred to colloquially (and in some of the literature) as “shortfalls.” In this Report, however, the term “shortfall” is used only to refer to an intermediary’s failure to maintain and allocate sufficient value to cover customer claims and not to a mere imbalance in securities of particular issues. Of course, an imbalance could contribute to a shortfall.
With respect to securities loaned or repoed out, the broker-dealer (and, by extension, its customer) will no longer receive direct dividends or voting rights (ownership of the securities having been transferred to a third-party securities borrower or to (or, in tri-party repo, for the benefit of) a repo buyer). Pursuant to the standard documentation for a securities lending transaction or repo transaction, although ownership of the relevant securities has been transferred by the broker-dealer, the borrower or repo buyer has a contractual obligation to the broker-dealer to pay to the broker-dealer an amount equal to any dividends or income received on the securities that the broker-dealer would have received had it not loaned or repoed out the securities (unless the securities are returned before the record date). However, absent a contrary contractual agreement, the borrower or repo buyer is not required to vote the securities at the direction of the broker-dealer lender or repo seller (and, in fact, the borrower or repo buyer itself may on-lend, sell, or deliver the securities to another party and may not itself retain any such rights).
F. Customer Protection Rule for Broker-Dealers (Including “Good Control Location,” Reserve Bank Account, and Hypothecation Restriction)
1. Customer Protection Rule in General: Possession or Control and Reserve Bank Account Requirements
The general description of the U.S. intermediated holding infrastructure in Subpart A reflects the general expectation that an intermediary would have a duty to maintain sufficient securities to cover credits that the intermediary has made to securities accounts of its account holders. This general duty is imposed for purposes of the private, commercial law by UCC section 8-504(a). However, that duty is not absolute. If an intermediary’s duty under UCC Article 8 is also addressed by another statute, regulation, or rule, then compliance with that other law is compliance with the UCC duty. In the case of section 8-504(a), the principal relevant other law for a securities intermediary that is a registered broker-dealer is the SEC’s customer protection rule, SEC Rule 15c3-3.
A central component of the customer protection rule is the possession or control requirement: “A broker or dealer shall promptly obtain and shall thereafter maintain the physical possession or control of all fully paid securities and excess margin securities carried by a broker or dealer for the account of customers.” Although this provision is at first blush straightforward, taking into account the definitions and other details it is anything but. The customer protection rule is fraught with complexity and exceptions and, accordingly, the following general description must be read with that caveat in mind. “Fully paid securities” are those for which the customer (account holder) has made full payment and in which the broker-dealer does not have a security interest. Other securities credited to a securities account in which the broker-dealer does have a security interest (a margin account) are “margin securities.” “Excess margin securities are those with “a market value in excess of 140 percent of the total of the debit balances in the customer’s [margin] account or accounts” (i.e., of the customer’s secured obligation to the broker dealer). For example, assume that margin securities with a market value of $200 are credited to a customer’s account and that the securities secure a debt of $100. The excess margin securities would be those with a value of $60 (140 percent of $100 is $140; $200 minus $140 equals $60).
In this example, the broker-dealer must have physical possession or control of the $60 in market value of excess margin securities. The obligation to “control” the securities may be satisfied, for example, by the broker-dealer holding the securities in a good control location such as its account with a clearing agency (like DTC) or its account with another broker-dealer. It follows that the broker-dealer is not required to hold possession or control of the $140 in market value of the margin securities (i.e., the non-excess margin securities). This allows the broker-dealer to use these securities, for example, to fund its extensions of credit to its customers.
Another requirement complements the possession and control requirement for fully paid and excess margin securities. A broker-dealer must maintain a special reserve bank account (“reserve account”) for the exclusive benefit of its customers. It must deposit (i.e., credit) to the reserve account cash or U.S. government issued or guaranteed securities in amounts based on a reserve formula. Among the required credits are the amounts owed by the broker-dealer to its customers payable on demand—i.e., cash balances in its customers’ accounts.
2. Application of Customer Protection Rule to Broker-Dealer Rehypothecation of Customer Securities
As discussed in Subpart E, a broker-dealer’s rehypothecation (securities loan, repo, or repledge) of customer securities normally is not accompanied by a debit to the relevant customers’ securities accounts to reflect the transfer of securities, thereby potentially creating an imbalance as between the securities of an issue credited to the securities account of the broker-dealer (at its custodian or depository and held in other locations) and those of that issue credited by the broker-dealer to the securities accounts of its customers. The customer protection rule mitigates these imbalances in two respects. First, amounts borrowed and secured by customer securities must be entered as a credit in the calculation of the broker-dealer’s reserve account. Similarly, the greater of the value of cash collateral received by a broker-dealer in connection with securities lending of customer securities and the market value of the loaned securities also must be entered as a credit in the reserve account calculation. Cash “collateral” received by the broker-dealer as seller in exchange for securities sold in a repo transaction also must be entered as a credit in the reserve account.
Second, there is an additional, and substantial, restriction on a broker-dealer’s right to repledge customer securities—the “hypothecation restriction.” A broker-dealer is not permitted to create security interests in customer securities to secure indebtedness in an amount “which exceeds the aggregate indebtedness of all customers in respect of securities carried for their accounts.” The hypothecation restriction does not restrict a broker-dealer from granting security over all of a customer’s margin securities to secure indebtedness in excess of that customer’s individual secured obligations. Moreover, the hypothecation restriction does not apply to securities lending or repo transactions by broker-dealers.
To fully assess the impact of the customer protection rule and the hypothecation restriction it also is necessary to consider the distributional rules for customers in the event of a broker-dealer’s insolvency proceeding under SIPA (a detailed analysis of which is beyond the scope of this Report). Under SIPA, securities are allocated to customers not on the basis of a customer’s rights in securities of a particular issue credited to a customer’s account but on pro-rata sharing based on each customer’s “net equity” in a fund of customer property (which includes customer property of all types). Any analysis also would have to take into account customers’ rights with respect to the broker-dealer’s reserve account, including any cash balances, any advances made by the Securities Investor Protection Corporation (SIPC) to purchase securities for the benefit of customers, and any investor insurance coverage by SIPC.
To sum up: Assuming a broker-dealer’s compliance, the customer protection rule, including the reserve account, the hypothecation restriction, and the application of the SIPA distributional scheme, are intended to result in the availability of sufficient value to satisfy customers’ net equity claims in case of a broker-dealer’s insolvency proceeding—i.e., sufficient to avoid a shortfall. The statutory and regulatory scheme is intended to achieve that result—and only that result. It certainly is not intended or sufficient to ensure that at all relevant times there are sufficient securities of a particular issue on hand to satisfy (match) all of a broker-dealer’s entitlement holders’ security entitlements with respect to those securities—i.e., to avoid imbalances.
G. Prime Brokerage
Securities prime brokerage involves arrangements between a customer, a broker-dealer that acts as the customer’s prime broker, and one or more other broker-dealers that execute securities trades for the customer. In large part prime brokerage customers are institutional investors who are active market participants.
In general, the services offered by prime brokers include (i) execution, clearance, settlement, and custody of securities and related reporting; (ii) financing (including margin lending, securities lending/locating securities for short sales, and enhanced financing); and (iii) ancillary services (such as research and recordkeeping).
The basic securities prime brokerage arrangement often involves three parties: the customer that enters into the trade, the broker-dealer that executes the trade on behalf of the customer (the executing broker), and the broker-dealer that clears and settles the trade, finances the trade, and provides custody and reporting services to the customer (the prime broker). A customer can execute trades through multiple executing brokers while using its prime broker to provide custody and manage its positions. It is also not unusual for sophisticated investors to use multiple prime brokers. For example, investors may use different prime brokers for different investment strategies or to diversify credit risk. This practice of being “multi-prime” became more prevalent after the failure of Lehman Brothers, Inc. in 2008.
The legal requirements applicable to prime brokerage arrangements are based primarily on a series of no-action letters issued by the SEC staff regarding the provision of prime brokerage services by SEC-registered broker-dealers. These letters address the applicability of various provisions of the Exchange Act, SEC rules, and Regulation T to prime brokerage arrangements. They also clarify the division of responsibility for compliance with such provisions between the prime broker and the executing broker.
1. Execution, Clearance and Settlement, and Custody
When the customer places an order with an executing broker, the executing broker buys or sells securities (for example, on a securities exchange) in accordance with the customer’s order. However, rather than booking the trade in the customer’s regular cash or margin account with the executing broker, the executing broker books the trade in a special account in the name of the prime broker for the benefit of the customer. On the trade date, the customer notifies the prime broker of the trade and the prime broker will then affirm trades for which the details match those being confirmed to it by the applicable executing broker (subject to a limited right to disaffirm as provided in the standard Form 150 contract between the prime broker and executing broker). If the details do not match, the prime broker will “DK” (i.e., “Don’t Know”) the trade. If the prime broker affirms the trade, it records the trade in the customer’s cash or margin account and issues a confirmation to the customer that complies with Exchange Act Rule 10b-10. The prime broker may also act as the executing broker on a transaction. The prime broker is responsible for complying with most of the regulatory requirements applicable to the customer’s accounts, including Regulation T (initial margin), SEC Rules 15c3-1 (net capital), 15c3-3 (customer protection rule), 17a-3 (recordkeeping), and 17a-4 (preservation of records), and Financial Industry Regulatory Authority (FINRA) Rule 4210 (maintenance margin).
The prime broker is also responsible for the clearance and settlement of the customer’s trades executed through the executing brokers. Generally, the customer maintains its securities through its account with the prime broker, which maintains custody of the securities for the customer (i.e., generally through the broker’s account with DTC or another securities intermediary). This allows the customer to consolidate its positions with one institution, which facilitates clearance and settlement and enhances the customer’s ability to utilize its positions to obtain financing and obtain the benefits of offsetting positions.
Prime brokers also generally provide reporting services such as daily profit and loss statements, valuation analyses, performance reports, position summaries, and income and expense summaries, among others.
2. Financing
As noted above, prime brokers also typically provide financing to their customers. Customers generally maintain a margin account with their prime broker in order to obtain margin financing of long positions and loans of securities to settle short positions carried in the customer’s prime brokerage account. As with margin lending generally, the prime broker will be granted a security interest in any securities, cash, or other financial assets that are credited to the customer’s account with the prime broker, with the prime broker enjoying rights of rehypothecation.
By consolidating their positions with the prime broker, customers may also be able to reduce margin requirements by taking advantage of portfolio margining methodology. Portfolio margining is a margin methodology that sets margin requirements for an account as a whole based on mathematical modeling of the greatest projected net loss on the portfolio. FINRA Rule 4210 permits portfolio margining for certain equity positions, listed options, security futures products, unlisted derivatives, and certain other instruments.
A prime broker may also in some cases provide “enhanced” financing through legally permissible methods to provide leverage above the limitations generally set forth in the margin regulations. These arrangements may involve credit extended through arranged transactions with non-broker-dealer affiliates or other structured transactions.
A securities prime brokerage agreement between an institutional investor customer and a U.S.-registered broker-dealer is essentially a margin account agreement that, in addition, provides the framework by which a customer may execute trades at multiple executing brokers and settle the trades at the prime broker. The prime brokerage agreement will also typically describe the prime broker’s rehypothecation rights.
3. Benefits of Prime Brokerage Arrangements
Prime brokerage arrangements allow the customer to utilize several broker-dealers for execution of its trades while allowing it to maintain its assets on a consolidated basis with the prime broker. The centralized settlement, custody, and reporting services provided by the prime broker offer administrative efficiency and reduced costs for the customer, while resulting in a more efficient use of collateral to support margin borrowings and other financings. Further, the prime broker serves as a centralized source of recordkeeping and reporting for the customer, providing confirmations, consolidated statements, and other securities information services.
H. Use of Security Entitlements as Collateral
Securities held through a securities intermediary—“intermediated securities”—are used and relied on as collateral in a wide range of financing transactions. In addition to being used in margin lending, prime brokerage arrangements, securities lending, repledge transactions, and as the subject of repurchase transactions, they are a key feature of other financing arrangements and play an important role in the financial markets. For example, in many types of commercial lending arrangements where the collateral consists of or includes securities collateral, lenders typically require that a security interest in securities collateral be held with one or more acceptable securities intermediaries and be perfected pursuant to a control agreement.
Intermediated securities also are important collateral in connection with swaps and other types of derivatives transactions. In swaps, for example, intermediated securities are widely used as both initial margin or independent amount, as well as variation margin. Indeed, the U.S. uncleared swap margin rules require, in certain circumstances, that initial margin be held with an independent third-party custodian. The volume of collateral held in this manner is significant. Based on the 2021 Margin Survey of the International Swaps and Derivatives Association, Inc., for example, the largest twenty market participants collected $459 billion in securities margin on uncleared swaps. Intermediated securities are also used as margin for cleared swaps and futures. Further, intermediated securities play a key role in the repo and reverse repo markets, which are very large and critical components of the U.S. financial system.
From the perspective of the secured creditor, given the current securities holding infrastructure, perfecting a security interest in intermediated securities offers important practical benefits compared to a security interest in directly held securities. Perfection of security interests in security entitlements by a control agreement can cover securities of many issues (including even an entire investment portfolio) in a single step as opposed to perfection by possession of many security certificates or by control of uncertificated securities issued by many issuers. Securities intermediaries also offer consolidated reporting that facilitates monitoring of collateral. Intermediated holding and having control of security entitlements also facilitates a secured party’s enforcement upon a debtor’s default. And security interests in security entitlements held under a single securities account may be governed by a single applicable law.
I. Causes of Imbalances and Shortfalls
As used in this Report, an imbalance exists when the aggregate amount of securities of an issue that an intermediary has credited to securities accounts of its account holders exceeds the number or amount credited to the intermediary’s securities account with an “upstream” intermediary such as DTC or otherwise held by the intermediary. Currently there are no uniform, mandatory, industry-wide methods (or methods visible to the entire custody chain) for a broker-dealer to allocate such imbalances to any particular account holder or even to monitor and calculate the extent of such imbalances in the aggregate.
One common source of imbalances is an intermediary’s failure to receive, in the settlement process, securities that the intermediary is entitled to receive on behalf of its account holders (a “failure to receive” or “fail”). Such a fail is typically caused by one or more failures to deliver securities by one or more other participants in the settlement system. A fail may result in an imbalance, as contemplated here, because a broker-dealer that has failed to receive securities normally credits its account holder notwithstanding its failure to receive securities of the relevant issue. Other common sources of imbalances involve broker-dealers that repledge, lend, or repo out margin securities. Although the securities have lost all connection with the broker-dealer, the broker-dealer normally does not debit the securities account of any of its account holders to reflect the transfer of securities in a repledge, securities lending, or repo transaction. In these examples, the number or amount of particular issues of securities credited to the securities accounts of the broker-dealer’s account holders exceeds the number or amount of those securities that the broker-dealer possesses or holds in good control locations on behalf its account holders.
Even if the credit to a securities account does not exceed the number or amount possessed or controlled by the crediting broker-dealer, the account holder’s property interest nonetheless may not extend to the number or amount credited. For example, if the broker-dealer holds the securities through an account with another intermediary, the other intermediary may possess or control a smaller number or amount than it has credited to its account holders. Or the aggregate in number or amount held by all DTC participants (including the broker-dealer or intermediaries through which the broker-dealer holds) may be less than the aggregate in amount or number credited by those participants to securities accounts of account holders. The upshot is that as to a particular securities issue the number or amount credited to BOs on the books of a broker-dealer may exceed the number or amount of securities of that issue in the possession or control of the broker-dealer (or the broker-dealer’s “upstream” intermediaries) and the aggregate number or amount of a securities issue credited by all intermediaries to their entitlement holders and those held directly may even exceed the number or amount that have been issued by the issuer.
A shortfall may occur when a broker-dealer’s reserve account is insufficient to compensate for any imbalances. This may result, for example, from a broker-dealer’s failure to comply with the customer protection rule’s requirements. Even when a shortfall exists, customers of broker-dealers receive substantial protection from the capital requirements imposed on broker-dealers under the SEC’s net capital rule, which is intended to ensure that a broker-dealer remains financially sound.
J. Bank Custody
Banks play significant and essential roles while acting as securities intermediaries in the U.S.—and global—financial markets. It is customary to refer to banks acting in this capacity as “custodians” and to the services they provide as a securities intermediary as “custody” services. In the United States the Office of the Comptroller of the Currency (OCC) is the primary regulator of national banks. In its custody examination handbook, the OCC describes the bank custody business as “a volume-driven, transaction-processing business, and much of the risk associated with it is operational in nature.”
Clients of bank custodians generally are institutions, including registered investment companies, private funds, bank common trust funds, collective investment trusts, retirement plans, insurance companies, governmental entities, sovereign funds, corporations, endowments, foundations, and other financial institution intermediaries. One important goal of institutional investors appointing a custodian is the safeguarding of their assets in their chosen investment markets. At the same time, institutional investors must operate at scale in a cost-effective and efficient manner; custodian banks provide the necessary infrastructure, technology, expertise, and market access. Custodian bank services are designed to protect investor assets from misappropriation or loss while allowing for diverse and operationally efficient investing.
These bank custody customers have large securities portfolios but may not be eligible to be participants in DTC, the Fed, and mandatory depositories in other countries. Additionally, banks that are not major custodians may provide custody services for their customers through arrangements with large custodian banks that are DTC participants and able to absorb the costs of direct participation in the securities holding infrastructure. Generally, customer assets held in custody are held in the bank’s DTC participant account or in the bank’s securities account with a DTC participant bank.
Services that bank custodians perform for their customers may be categorized into three main functions:
- 1. Holding securities in accounts with central securities depositories or other intermediaries on behalf of clients—investors or other intermediaries;
- 2. Acting on instructions of clients to facilitate trading and settlement of transactions (changes in ownership) in those securities; and
- 3. Facilitating the exercise of other rights associated with ownership of securities (e.g., voting on shareholder or unitholder resolutions or indenture trustee matters or participating in class action lawsuits against issuers) or fulfilling obligations (such as processing the payment of withholding taxes).
These functions are common to securities intermediaries generally and not confined to “global custodians.” They apply to any intermediary in the custody chain. Despite contractual and jurisdictional differences, as a general matter, custody services traditionally consist of a combination of the three main functions described above. However, bank custodians now provide many services beyond those traditionally provided by custodians. As automation of transaction processing continues, custodian banks offer additional services such as applications that monitor and identify exceptions to customers’ internal investment guidelines; asset allocation tools; cash management (“sweep”) services; securities lending; various currency conversion services; collateral agency and management services; compliance monitoring; performance management tools; and back- and middle-office outsourcing services to support customers’ investment management functions. Moreover, global custodians typically also provide access to foreign markets and securities, typically through arrangements with foreign brokers and sub-custodians.
As the OCC has observed, “[c]ustody relationships are contractual in nature and are essentially directed agencies.” The contract between a custodian bank and its client frames the services provided and sets out the legal treatment of safeguarded client assets covered by the contract, the scope of the services the custodian bank will provide, the standard of care the custodian bank will exercise, and the limitations on the liability of the custodian bank.
Asset administration and settlement activities (including delivery of assets in connection with purchases and sales) may have many layers of complexity which are more pronounced in the cross-border setting. These include country-specific laws, regulations, and market practices. Consequently, a custodian’s duties are always affected and constrained by local conditions that may arise indirectly, i.e., at a sub-custodian or a CSD. Certain risks therefore are inherent in the decision to invest in a particular asset or jurisdiction and are not within the custodian’s control.
A bank’s custody activities generally are not considered to be in the bank’s fiduciary capacity under the OCC’s regulations governing bank fiduciary activities. Consistent with the framework established under the UCC, the OCC regulations require that assets held by a bank custodian be kept separate (segregated) from the bank’s assets. The securities are not included on the bank’s balance sheet and are not subject to claims of the bank’s creditors; as such, even in a bank’s insolvency, custodied securities should be returned to customers.
U.S. registered investment companies, such as mutual funds, in general hold their securities assets with a custodian bank pursuant to the section 17(f ) of the Investment Company Act of 1940. Although that Act also permits an investment company to hold securities with a registered broker-dealer or to self-custody, compliance with applicable SEC rules would make holding other than with a custodian bank impractical. Registered investment advisors under the Investment Advisors Act of 1940 also must hold client assets through an intermediary.
Global custodian banks offer custody services across international markets, facilitating non-U.S. investment by U.S. investors. The OCC observes that, to “understand and comply with local laws and regulations” in non-U.S. markets, a custodian bank “will typically rely on a sub-custodian” that is a bank local to the non-U.S. market. By selecting and monitoring sub-custodians and interacting with CSDs, custodian banks create a network that facilitates smooth international investment.
K. Shareholder Voting (“Proxy Plumbing”) and Issuer Communications
An issuer may treat the holder of a security on its books as being exclusively entitled to vote and exercise all other rights of an owner of the security. Shareholders of record of public corporations in many cases do not wish to attend shareholders’ meetings in person and typically give agents—“proxies”—power to vote their shares at shareholder meetings. Moreover, as described below, because BOs in the intermediated holding system necessarily do not hold shares of record, they may vote shares beneficially owned only if they receive a proxy from the record holder, which typically is Cede & Co., DTC’s nominee.
Issuers typically employ proxy solicitors to obtain proxy cards from shareholders and meet quorum requirements for meetings. Most board elections are not contested and issuers or their representatives vote as proxies at the meetings. However, some elections of directors and votes on issues such as mergers and shareholder resolutions are contested, resulting in proxy contests. Some proxy contests are close and some bylaws make accurate vote counts necessary even in the absence of a contest. In general, issuers rely on third-party inspectors or tabulators for determination of voting credentials and counting votes.
The complexity of the “proxy plumbing” results primarily from the intermediated holding infrastructure. As already described, most publicly issued and traded U.S. shares (as well as many privately offered shares) are held by Cede & Co. as the registered owner on the issuers’ books and the BOs hold only on the books of their intermediaries. Consequently, in connection with shareholder voting, DTC facilitates voting by BOs by distributing an “omnibus proxy” to each of its participants holding shares eligible to be voted and credited to the participant’s DTC securities account. The participants (typically through service providers, discussed below), in turn, provide their account holders with proxy materials provided by the issuer and voting instruction forms (VIFs) for shares held for the customers. Institutional investors typically vote their proxies through “ProxyEdge,” the centralized voting platform of Broadridge Financial Solutions, Inc. (Broadridge).
A voting “stack,” then, consists of at least three tiers: (i) DTC, (ii) a securities intermediary (broker-dealer or bank), and (iii) a BO. But the stack may involve more tiers and may be more complex. For example, a DTC participant’s customer may itself be an intermediary that holds for its customers. In addition, an intermediary may hold some securities not with DTC or a DTC participant, but with another intermediary. Moreover, some shares may be held by an intermediary for its own account and held not only with DTC but with another intermediary or directly on the books of an issuer. So, for a given intermediary, there may be multiple channels of communication and ownership that must be tracked for a given vote. Proxies, VIFs, and ownership information must be reconciled up and down each stack for each vote, with a view toward ensuring that the correct number of shares are voted by the person with voting power and that votes are correctly tallied.
The obligations of broker-dealers and banks to distribute proxy materials and VIFs up and down intermediated stacks and their communication obligations are typically assumed by a proxy servicer—Broadridge being the leading provider (but not the only one). This use of servicers offers efficiencies that would not be available were the intermediaries to take on these obligations in-house. But the process involves substantial costs that, together with fees charged by the intermediaries, are generally passed on to the issuers.
In addition to issuers engaging with these various workarounds for shareholder voting in the intermediated holding system, issuers wishing to communicate with their shareholders also must grapple with the intermediated holding system. Issuer communications with BOs in the intermediated system face several hurdles. As summarized in the OBO/NOBO Report:
Under SEC rules adopted in the mid-1980’s, brokers and banks are required to classify beneficial owners as either Non-Objecting Beneficial Owners (NOBOs) or Objecting Beneficial Owners (OBOs), which designation is generally based on indications by investors at the time they open a brokerage or trading account.
Under this framework, public companies and registered investment companies are currently permitted to: (1) obtain a list of NOBOs (with name, address, and share amount) after paying a regulated fee; and (2) mail certain corporate communications, such as an annual report, directly to them. However, a list of NOBOs may not be used for the distribution of proxy materials. With respect to OBOs, names and contact information may not be disclosed to a company for any purpose whatsoever.
Because BOs do not show up on the stock ledgers of public companies, many BOs are not in direct communication with the issuers in which they are invested. Instead, proxy materials and other communications must be handled through the intermediaries (broker-dealers and banks) that hold for BOs in the intermediated system. As noted above, the broker-dealers and banks in general retain service providers for these communications, with most using Broadridge. Issuers do not control the selection of service providers or the services provided or have any input in the negotiation of fees. Issuers can use the NOBO list of BOs only for corporate communications such as annual reports and cannot send to the list proxy materials or permit BOs to vote directly with tabulators.
Pursuant to SEC rule a BO is deemed to be NOBO unless it “opts out” of that status. However, notwithstanding this rule standard contracts with intermediaries often provide that a customer is deemed to be an OBO unless the customer chooses NOBO status.
L. Exercise of Other Rights and Remedies of Security Holders (Including DTC’s Proxy Services and Corporate Actions Processing)
As noted above in the discussion of shareholder voting, an issuer may treat the registered owner as being entitled to exercise all rights and powers of an owner of a security in registered form. It follows that BOs seeking to exercise rights must confront their lack of privity with issuers. When Cede & Co. is the registered security holder in the intermediated holding system, the power to exercise security holder rights must begin with DTC (as with proxies for shareholder voting).
A BO might overcome the privity problem by seeking to hold directly. While that approach may be possible for some securities, such as shares issued by many issuers, that often might be impractical. For example, that could entail substantial cost as well as unacceptable delay. Moreover, for interests in bonds evidenced by global security certificates under BEO indentures, it typically would be impossible (or impractical) for a BO to become a direct holder of the securities.
DTC accommodates some aspects of this situation under its program for “Proxy Services.” Under this program, a DTC participant may request DTC to issue a letter, on behalf of Cede & Co., confirming that a participant, or if applicable another BO (e.g., the participant’s customer), holds a position (e.g., a number of shares or a principal amount of debt securities) in a particular securities issue. If the participant’s customer is itself an intermediary holding for a BO, the participant, in its certification to DTC, must rely on its own customer as to the details of the identity and the position of the ultimate BO. Upon the request of a DTC participant DTC also issues letters in connection with the exercise of appraisal rights and dissenters’ rights, authorization to take action in the name of Cede & Co. relating to shares or debt securities, demands to accelerate debt securities, and relating to other rights of BOs such as corporate actions.
DTC’s Corporate Actions Processing programs provide services for its participants for processing for DTC eligible securities. These processing services include (i) the ClaimsConnect program for bilateral management and settlement of claims among DTC participants and those claiming directly or indirectly through participants, (ii) distributions of cash and stock dividends, principal and interest on debt securities, and capital gains distributions, (iii) redemptions, including calls and maturities, and (iv) mandatory and voluntary reorganizations, including exchange offers, conversions, and Dutch auctions.
M. Book-Entry-Only (BEO) Debt Securities
Most (non-United States Treasury and Agency) debt securities (bonds) are issued and maintained under DTC’s Book-Entry-Only (BEO) structure. Under the BEO structure, only one registered security certificate (a “global certificate”) is issued for each issue of securities (or, if the principal amount of an issue exceeds $500 million, a global certificate for each $500 million of principal amount or fraction thereof ). The global certificates are registered in the name of Cede & Co. and held in custody by the indenture trustee (typically a bank custodian). Under this structure BOs must hold in the intermediated system on the books of a DTC direct or indirect participant and have no option to hold directly as registered holders. Many issues of BEO securities allow the issuer, at its discretion, to issue definitive registered security certificates to BOs in exchange for the global certificates. Moreover, issuances of definitive security certificates to BOs in exchange for global certificates generally are permitted if DTC can no longer serve as the depository and no successor depository is timely appointed. In some cases, exchanges for definitive security certificates also are permitted at the discretion of DTC or a successor depository. Most issues also allow for amendments of the indenture by the issuer and indenture trustee if the amendment would not impair the rights of bondholders, as would be the case for amendments that would permit bondholders to hold directly.
N. DTC’s Fast Automated Securities Transfer (FAST) System and Direct Registration System (DRS)
DTC’s FAST system and DRS each deal with the transfer of registered ownership of securities in and out of DTC’s intermediated holding system. The FAST system involves contractual arrangements between DTC and issuers’ transfer agents. The system allows adjustments in the registered ownership of Cede & Co., DTC’s nominee, without the time and expense of the movement of physical security certificates. The Deposit/Withdrawal at Custodian (DWAC) system employs the FAST system to allow transfer agents to transfer electronically newly issued shares or certificates to and from Cede & Co. DTC participants may use DWAC with FAST to request the movement of shares electronically.
DTC’s Direct Registration System (DRS) allows an investor to hold registered ownership of equity securities held in book-entry form at the transfer agent without the issuance of a physical certificate. An investor that acquires securities through a DTC participant can have the securities transferred through FAST to be held through DRS. Likewise, an investor can have its securities transferred through FAST to Cede & Co. and credited to its account with a DTC participant for a disposition. Investors who hold through DRS receive a statement reflecting their registered ownership instead of a stock certificate. The issuer or its transfer agent distributes to the investor, as the registered owner, all communications (including proxy materials) and dividends.
O. Fund/SERV
Fund/SERV is a set of services provided by NSCC to the mutual fund industry that facilitates direct registration in that market. It provides back-office operations for mutual funds (issuers) and their relationships with broker-dealers, banks, insurance companies, and other financial intermediaries, not withstanding that the interests in funds are not eligible for holding through DTC and instead are held directly on the books of the fund issuers. It provides automated trade processing and standardized procedures that eliminate paper, streamline money settlement, and offer economies of scale.
IV. Identification and Assessment of Problems Associated with Intermediated Securities Holding Infrastructure
This Part identifies and assesses in general terms the “problems associated with the infrastructure” for the intermediated holding of securities in the United States, as contemplated by the Task Force Mission Statement. These are problems that would not exist but for, or are materially exacerbated by, the prevailing omnibus-account-based intermediated securities holding infrastructure. This infrastructure may be contrasted with an infrastructure that provides for some variation (or variations) of either the direct holding of securities on the books of issuers or an intermediated system that is “transparent”—i.e., one that readily and reliably enables the accurate and definitive identification of the ultimate beneficial holders of securities by persons with legal entitlements to access that information. Part Two of this Report will address the Mission Statement’s charge to identify and assess the “plausible means of addressing” the intermediated holding infrastructure–associated problems considered here.
Among the discussions of problems associated with the intermediated securities holding infrastructure, Subpart A is sui generis. It considers risks associated with intermediated holding, and, in particular, the risks for investors upon the failure of an intermediary. The other topics addressed in this subpart consider problems that arise from the arrangements for dealing with the attributes of the intermediated holding systems.
Compared with other problems considered here, the shareholder voting issues considered in Subpart B.2 have received considerably more treatment in the literature and attention from the SEC (although the SEC’s palliative interventions have been relatively limited). Moreover, the discussion of shareholder voting issues is highly relevant and illustrative for understanding and assessing the challenges presented by intermediated holding in the other contexts.
A. Intermediary Risk and Attendant Costs of Protecting Customer Assets
The fundamental risks associated with intermediated holding of securities are the failure of a securities intermediary accompanied by a shortfall in the securities and other assets available to satisfy the claims of customers. Additional risk is the potential delay in the recovery by customers of like securities or monetary compensation and the costs of pursuing claims. These risks have been managed well in the United States and also in many other countries. This general success is attributable to substantial regulatory intervention, both prudential and supervisory, designed to avoid intermediary insolvency and failure in the first place and from the regulatory apparatus designed to ensure that in the event of insolvency sufficient securities (or other assets) are on hand to satisfy customers’ securities claims. Registered broker-dealers are heavily regulated by the SEC under the Exchange Act and eligible customers have SIPC protection. As described above, for present purposes a centerpiece of the U.S. regulatory framework for broker-dealers is the customer protection rule.
That intermediary risk has been managed well in the United States and actual losses have been minimal does not mean that risks of intermediary failure and losses from shortfalls and delay are not real and serious. The existence of the pervasive regulatory regime for broker-dealers demonstrates the reality of the risks. On the international level, the attention given to the protection of client assets offers additional strong evidence. However, the risks of actual failure and shortfall and the resulting eventualities of losses and costs imposed on investors are not the only—and probably not the largest—costs of intermediary risk imposed on market participants and government (and thereby on society more generally). These other costs are discussed below in Subpart E.
B. Exercise of Security Holder Rights by Beneficial Owners
1. Role and Significance of Imbalances
The number or amount of a security issue credited to the securities account of an account holder with a broker-dealer generally reflects the account holder’s security entitlement as between it and the broker-dealer (although in the case of margin accounts the credit alone generally does not reflect or otherwise take into account any rehypothecation of securities underlying those entitlements). Taking into account rehypothecation, fails to deliver, and other sources of imbalances, the number or amount credited does not necessarily reflect the extent of the account holder’s property interest. The number or amount of securities credited to the securities accounts of the broker-dealer’s entitlement holders often exceeds the number or amount of those issues that the broker-dealer possesses or holds in good control locations on behalf its account holders. This is a result of the ubiquitous imbalances that are permitted, indeed occasioned by, the customer protection rule. And even if the credit to a securities account does not exceed the number or amount possessed or controlled by the broker-dealer, the account holder’s property interest nonetheless may not extend to the number or amount credited.
Notwithstanding imbalances, the value of a credit to an account holder’s securities account normally will be equal to or approach the value of the number or amount of securities so credited (less the amount of any encumbrances). This results from the operation of the customer protection rule, including the reserve account, and the hypothecation restriction. That said, the imbalances are problematic. It is the amount or number credited that is the basis for preparing and obtaining proxies in the process of shareholder voting, for the exercise of rights in connection with corporate actions, and for the issuance by DTC of letters identifying the positions in securities held by BOs in the intermediated holding system.
2. Shareholder Voting (“Proxy Plumbing”) and Issuer-Shareholder Communications
Shareholder voting plays a central role in corporate governance. But the system for voting by BOs is problematic in the United States due to its imprecision and high costs. While shareholder voting is unremarkable in routine situations, as discussed below, it is unreliable in the most critical situations—close contested elections and other close proxy fights, in which the accuracy of voting results is most crucial. The principal problems burdening the U.S. shareholder voting system result primarily from the complexity of the intermediated holding structure.
As explained in Part III, an issuer may treat the shareholder of record as the person exclusively entitled to vote and the approach normally followed by public corporations is to rely exclusively on record ownership. Consequently, BOs are entitled to vote only if they have received a proxy from the registered owner, which for most publicly traded shares is Cede & Co. Despite the importance of voting for corporate governance, no organization has effectively ensured the adequacy of the voting process. Industry experts have called for SEC intervention to address the system’s shortcomings.
Problems in shareholder voting within the intermediated securities system are well-documented in ongoing critiques. Kahan and Rock’s study highlights three voting “pathologies”: (i) complexity issues, such as the lack of end-to-end vote confirmation, (ii) determination of ownership, resulting in problems such as overvoting or undervoting, and (iii) misalignment pathologies, in which BOs may not have an economic stake in the relevant securities. The SEC’s engagement with proxy plumbing also reflects the persistent and complex nature of these issues. In its 2010 Concept Release on the proxy system, the SEC acknowledged its foundational role in regulating proxy processes since 1934 and detailed numerous concerns about the system’s effectiveness, calling for public comments to address and improve these problems.
At the SEC’s 2018 Roundtable, both commissioners and experts concurred that the investor voting system in America requires reform. Commissioner Roisman observed that issues like overvoting and undervoting remained unresolved since the 2010 Concept Release. Problems identified included (i) reduced retail investor participation due to the OBO/NOBO system, (ii) a lack of vote confirmation, i.e., difficulties in verifying that votes or voting instructions actually have been carried out, and (iii) mismatches in information resulting in disqualification of votes. The SEC’s Investor Advisory Committee (IAC) issued its (relatively modest) recommendations on proxy plumbing in 2019, citing historic examples of problems, including (i) mismatches between intermediary credits to BOs and the intermediary’s actual holdings, usually resulting from share lending, (ii) large costs of proxy contests and of materials distributions, and (iii) opacity of the system as to both investors and issuers, including adverse impact on issuer-investor communications. The IAC recommended that the SEC (i) require end-to-end vote confirmations to be sent to authorized voters, (ii) require all participants in the voting process to cooperate in the reconciliation of ownership and voting information on a regular basis, (iii) require its staff to study in depth BO anonymity (e.g., reasons for and extent of choosing “objecting beneficial owner” (OBO) status and the impact of share lending on voting errors, overvoting, and undervoting and whether share lending is adequately disclosed to voters), and (iv) mandate a “universal proxy” or “universal ballot” by updating and revising its 2016 proposal. Citing the IAC Recommendations, the SEC adopted rule and form amendments to its proxy rules to require the use of a “universal proxy card” in non-exempt director election contexts, with certain exceptions.
Both the SEC’s 2010 Concept Release and the 2018 roundtable acknowledge ongoing issues with proxy system accuracy and transparency, supported by investor complaints and technical issues with electronic voting. Following the 2018 Roundtable, five informal working groups were organized: Universal Proxy Cards, OBO/NOBO, End-to-End Confirmation, Proxy Distribution Fees, and Long-Term Proxy Reform. The Universal Proxy Cards Working Group submitted a letter in support of the SEC’s universal proxy proposal. The OBO/NOBO Working Group issued a report in 2021 that detailed problems relating to issuer-shareholder communications. The End-to-End Confirmation Working Group Operations Subcommittee issued a report in April 2023.
The Task Force meeting on June 24, 2020, featured a case study of the 2017 Proctor & Gamble Company–Trian Fund Management, L.P. proxy contest. Edward Rock moderated a panel composed of John Coates, Lawrence Hamermesh, Brian Schorr, Darla Stuckey, and Scott Winter. The P&G–Trian contest underscores the proxy system’s flaws, such as overvoting and chain of custody issues, especially in close elections, and illustrates the urgent need for reform in shareholder voting processes.
Scott Winter, who advised Trian, noted two intermediated holding–related problems. First, he noted much “sloppiness” by intermediaries (banks and brokers) in handling the chain of voting authority of shares. Second, the proxy staffs of intermediaries lack sufficient education and knowledge of the process, largely because Broadridge has assumed so much responsibility. John Coates agreed and emphasized that the SEC should mandate both end-to-end confirmations and reconciliation more generally, including off-cycle rather than only for elections. Darla Stuckey, chair of the End-to-End Confirmation Working Group, also noted her view that undervoting is a bigger problem than overvoting.
Lawrence Hamermesh speculated that simplifying the voting process may not boost low retail investor turnout due to “rational apathy.” He questioned the frequency and impact of voting on director accountability, suggesting an alternative system like Minnesota’s, where a 3 percent shareholder percentage can call for a vote on directors. Edward Rock advocated for a central registry to simplify share transactions to address the proxy plumbing issues. Rock noted that situations like the P&G proxy contest hurt the legitimacy of corporate law. John Coates observed that few would choose OBO status if they understood the limitations of anonymity—tax authorities, regulators, and other entities have access to BO identities. Suggestions by commenters included calls for improved transparency and efficiency in vote confirmation and assigning process responsibility to specific market entities to stimulate a market-based solution. For example, if mutual funds insisted on precise vote counts, significant changes might follow.
The OBO/NOBO Report also highlighted communication issues between issuers and investors from the perspectives of affected market participants. Issuer-BO communications face the same structural intermediation-based impediments that prevail for proxy plumbing in the voting context, complicated by the OBO/NOBO system. Public company issuers question the system’s restriction on accessing BO data and their lack of control over service providers and fees for proxy communications. They are unable to send proxy materials directly to NOBOs, and NOBOs cannot vote directly with the tabulator. Issuers advocate for NOBO to remain the default status and for better-informed BO decisions between OBO and NOBO options. Investment companies, like mutual funds and ETFs, echo public companies’ concerns about the costs and limitations of NOBO lists. The Investment Company Institute (ICI) has pressed the SEC for NOBO system reforms to give funds more control over the distribution and pricing of regulatory materials to investors.
Institutional investors value privacy for their holdings and trades and often avoid solicitations, leading about 72 percent to choose OBO status. They commonly delegate proxy voting to asset managers or proxy advisory firms that typically vote through Broadridge’s voting platform (ProxyEdge) and are concerned that OBO/NOBO system changes might raise their costs. Institutional investors also worry about reduced retail voting, attributing it to the Notice and Access format, and they advocate for a proxy system that better facilitates issuer-NOBO communication without compromising OBO anonymity. However, the view of broker-dealers appears to differ markedly from those of the principals in public securities market transactions, and they view the current proxy system as efficient and problem-free, citing a lack of complaints from clients as evidence.
In 2022 the End-to-End Confirmation Working Group’s Operations Subcommittee performed end-to-end vote confirmation on 2,484 meetings tabulated by four participating tabulators and achieved a 99.85 percent vote acceptance. The goal of these confirmations was for investors to confirm that their votes were counted. However, institutional investors found the process to be too cumbersome and time consuming (for example, being required to retrieve vote confirmations on a custodian-by-custodian basis and not having confirmations sent to them). Although participants in the confirmation process generally supported an expansion of end-to-end vote confirmation for proxy contests, the costs of this expansion and who would pay were not resolved. The project also validated the potential of vote confirmation (or rejection) from the tabulator to proxy service provider to BO. However, the project fell short of the expectations of investors, given the cumbersome process of accessing individual vote confirmations. Moreover, because the project was a one-off effort, how the process could be regularized also remains unresolved. The view of many participants is that the expected benefits may not justify the costs on a large scale, considering the manual nature of the early-stage reconciliation in the pilot.
The core issues in shareholder voting and issuer-BO communication stem from complex layers of intermediation. Current measures have not effectively addressed these problems, partly due to misaligned incentives and a monopolistic market, where a single provider dominates, reducing competitive drive for cost-effective solutions. This scenario is compounded by the high fixed costs and economies of scale in the proxy system, which discourages individual companies from investing in improved technologies or services. The problems in shareholder voting are worsened by a lack of centralized responsibility, with no single entity like the SEC taking charge. Discrepancies in share accounting (i.e., imbalances in shares credited at different levels of intermediation), often due to share lending and the absence of a continuous, systematic reconciliation process add to these challenges, hindering accurate reflection of BO holdings.
3. Exercise of Security Holder Rights (Other than Shareholder Voting), Remedies, and Claims (Including Delegation and Assignment of Powers)
Problems associated with shareholder voting have received considerably more attention, including from the SEC, the academic literature, and practitioners, than the exercise and enforcement of rights and remedies by security holders in other contexts. However, as with shareholder voting, in these other contexts the lack of privity with issuers (and, where applicable, with indenture trustees or other agents) resulting from intermediated holding imposes considerable transaction costs on both shareholders and bondholders.
Enforcement of Bondholder Rights: In General
The predominant BEO structure for publicly traded bonds exacerbates the complexity of the inherently complicated indenture trustee structure for enforcement of bondholder rights and remedies. But, with one exception, the problems addressed here are not those arising from these complexities. The exception is that under the BEO structure, unlike for shares, even the option for an investor to hold directly typically does not exist. An investor must hold through an intermediary because direct registration is available only for global security certificates held by Cede & Co. (or a depository successor to DTC), with limited exceptions. The principal problems addressed here arise from intermediated holding when a BO seeks to exercise rights and remedies that, under the applicable bond documentation, are afforded to a registered holder. Under the BEO structure Cede & Co. is the registered holder of the global security certificate (or certificates).
All things being equal, the preferable option for a BO of bonds seeking to exercise rights might be to request that a definitive security certificate be delivered out to (or an uncertificated security be registered in the name of ) the BO, which would then become a registered holder. However, that approach is rare because, as noted above, under the predominant BEO structure only Cede & Co. would be a registered holder of global certificates. Moreover, even if that option is available, the process of becoming a registered holder may impose unacceptable delay in cases where a very short turnaround is necessary. One practitioner noted during a Task Force meeting that the process of obtaining delivery of physical certificates turned out to be more time-consuming than obtaining litigation authorization through DTC.
Courts generally have accepted that in appropriate circumstances BOs may have standing to exercise rights and assert claims against issuers of bonds or representatives (such as indenture trustees or fiscal agents). However, issues sometimes arise in connection with a BO’s assertion and proof of its entitlement to such standing. This proof sometimes has become a procedural hurdle that produced substantial litigation. To have such standing BOs must identify themselves as such.
BOs normally seek to exercise rights based on letters issued by DTC under DTC’s Proxy Services program. Obtaining such documentation in timely fashion sometimes may be difficult in case of an urgent need to file suit in injunction proceedings, so navigating this process is vital to litigators asserting the rights of BOs in court. However, DTC internal counsel often work with the BO counsel to meet timing needs and can sometimes provide flexibility to expedite the process. Documentation may be more challenging if the BO’s securities account is with an indirect participant rather than a direct DTC participant.
DTC provides authorizations that permit its participants, and ultimately BOs, to bring actions as a matter of course, but courts may demand clear evidence of the authorization. In general, courts recognize rights of BOs to bring actions based on security entitlements and reject defense objections that the BO is not in privity as the record holder. Although the issue may sometimes be easily resolved, in other situations, courts may be strict in requiring evidence of authorization from the record holder. In such cases, even if the BO’s right of action is not ultimately at risk, the defendant may succeed in delaying proceedings by insisting on the inevitable documentation. Suffice it to note that although DTC authorizations are usually accepted, the authorization process and use can involve considerable transaction costs.
Should a case proceed to trial or other adversary proceeding, a person asserting BO status may be held to strict proof as to its holdings. For example, although DTC documents have met the Federal Rules of Evidence business record exception, defendants have challenged the DTC documentation from intermediaries as hearsay. Litigation in foreign jurisdictions may present additional difficulties. For example, Brazilian bankruptcy proceedings consider digital evidence inadequate and require certified copies of documents, including DTC authorizations. As a result, bondholders may not have prompt access to this documentation—thereby emboldening “a debtor to file frivolous objections regarding a bondholder’s claim separation application in order to create strategic delays.” The intermediated system also may complicate litigation over the choice of law where courts have produced conflicting rulings. While the choice of law may typically depend on where the contract was negotiated and where parties were located during contracting, DTC’s role in securities transactions may raise venue and choice of law questions that permit forum shopping for parties.
Further difficulties may arise in foreign litigation in which different standards may be applied to intermediated holding. The “no-look-through” principle under English law can prohibit BOs from pursuing claims that are only available to the record holder of securities. Although BOs may seek to apply the law of a different forum where the depository sits, which may have more favorable opportunities for BOs to enforce their rights, litigation on the choice of law may be necessary. One practitioner noted during the August 11, 2020, Task Force meeting that in a foreign litigation the issue arose as to whether an entitlement holder was a creditor and expert testimony was required as to the operation of UCC Article 8 in the intermediated holding system.
Enforcement of Bondholder Claims in Bankruptcy Proceedings of Issuers
The problems outlined above relating to the enforcement of bondholder claims under bonds governed by the BEO structure also arise in the context of a bond issuer’s bankruptcy. But the intermediated holding of debt securities may present additional obstacles in an issuer’s bankruptcy.
Setoff Rights
A right of setoff is effective under Bankruptcy Code section 553 only if the right exists under nonbankruptcy law. Section 553 recognizes and preserves an existing setoff right but does not create or grant the right. A BO’s right of setoff under section 553 is subject to a temporal requirement that the BO’s and issuer’s mutual claims must have arisen before the bankruptcy petition. Additionally, courts have held that a BO’s and issuer’s mutual postpetition claims may be offset. Whether a BO of a debt security would have a right of setoff in bankruptcy would depend on whether the BO has an enforceable claim against the issuer under nonbankruptcy law, as discussed above.
Numerosity Requirements
The Bankruptcy Code contains certain numerosity requirements for the exercise of rights by holders of claims. For example, if a debtor has more than twelve creditors, then an involuntary petition under Chapter 7 or 11 may be filed only by three or more holders of claims. Acceptance by a class of creditors of a plan of reorganization under Chapter 11 requires acceptance by at least one half in number of the holders of allowed claims of that class.
Anecdotal experience suggests that for numerosity purposes a BO of bonds would count as one creditor for purposes of an involuntary petition. Anecdotal experience also suggests that in a Chapter 11 case ballots for acceptance of a plan typically are prepared for BOs of bonds based on DTC position reports for the BOs’ relevant intermediaries (broker-dealers and banks). Although some anecdotal experience indicates that in some Chapter 11 cases the number of securities accounts voting, and not the number of BOs (holders of claims), may have been counted, any approach that does not view each BO as a holder of bonds in which the BO has an interest, regardless of the number of accounts in which the BO may hold bonds, seems inconsistent with the language of the Bankruptcy Code. However, bankruptcy courts may not be entirely consistent in their approaches.
Enforcement of Shareholder Claims Under Federal Securities Laws
The issues described above concerning the exercise of bondholder claims by BOs—in particular, establishing through DTC authorizations the right to bring claims—also apply in general to claims of BOs of shares. For purposes of most shareholder rights, such as collecting dividends, bringing derivative suits, and transferring shares, the shares are treated as fungible. However, in some cases it matters which shares are owned by a shareholder claimant. For example, under section 11 of the Securities Act of 1933 purchasers of securities sold under a registration statement that is materially misleading have a claim. Such a claim is easily established for a purchaser of shares in connection with the issuance and underwriting of shares pursuant to the registration statement. The situation is quite unclear, however, for secondary purchasers of securities. Although the circuits are split on the standing of a secondary purchaser to assert a section 11 claim, in circuits in which secondary market claims are allowed, claimants face difficult obstacles. As Geis has explained:
From the case law, it seems clear that impeccable share provenance is still the standard for Section 11 litigation, and statistical tracing is not current law. At the same time, definitively tracing shares back to a given issuance is exceedingly difficult—usually impossible—in a world of fungible bulk clearing. The upshot, then, is that most secondary market Section 11 claims are denied, even when it is highly likely that a plaintiff bought some shares from a “tainted” pool.
To be clear, the difficulties in pursuing section 11 secondary market claims arise in large part from fungibility, not intermediation. However, tracing issues sometimes may be less problematic in the case of shareholder claims based on direct holding.
Shareholder Claims for Appraisal Rights Under Corporate Law
Shares held in fungible bulk in the intermediated holding system also can present problems in the context of appraisal rights held by shareholders who do not vote in favor of a merger or another fundamental transaction. Under Delaware corporate law and that of some other states, only shareholders that do not vote in favor of the transaction may seek appraisal rights to recover the judicially determined fair value of their shares. As with shareholder voting and corporate actions generally, there is always a possibility of mistakes and errors in the process of voting in the merger context. Aside from such errors, problems may arise in connection with voting by BOs of shares that are acquired after the record date for voting (when voting rights are severed) and before the time for claiming appraisal rights has expired. Delaware authority resolved this problem by relying on shares voted against a merger by Cede & Co., the shareholder of record. So long as Cede & Co.’s votes against the merger exceeded the number of post-record-date-acquired shares voted by the claimant, the claimant’s claim is allowed to proceed. (Of course, the proper treatment of voting in these “appraisal arbitrage” situations under non-Delaware law may be unresolved and unclear in the absence of precedent.) This approach leaves unresolved situations in which appraisal rights are sought for a number of shares that exceeded Cede & Co.’s negative votes, either by a single claimant or multiple claimants, and the treatment of shares held of record by Cede & Co. that were not voted (which normally would be considered shares not voting in favor of the merger).
C. Execution and Attachment Against Intermediated Securities
A creditor of a debtor BO may reach the interest of the BO in a financial asset credited to the BO’s securities account only by legal process against the securities intermediary maintaining the securities account for the BO. As a general matter this rule is both intuitive and practical. In the normal situation it is only the debtor BO’s intermediary that has any information about the nature and extent of the BO’s interest. For example, assume that the BO debtor has a securities account with Intermediary-2, that Intermediary-2 has a securities account with Intermediary-1, and that Intermediary-1 is a direct participant of (i.e., has a securities account with) DTC. Normally, Intermediary-1 would have no information about the BO debtor, its securities account with Intermediary 2, or the financial assets credited to the BO debtor’s securities account. In that situation it would make little sense for legal process to be issued against Intermediary-1. Moreover, if such process were allowed against a different intermediary, it could result in that intermediary blocking financial assets of the issue involved and potentially disrupting transactions and settlement involving those financial assets. In addition, if attachment at such an “upper tier” (in the holding chain) were permitted, entities at lower tiers might continue to trade and act on instructions of entitlement holders, thus potentially further compromising the integrity of the holding system.
Article 22 of the Geneva Securities Convention (“GSC”) provides a baseline rule with effects substantially similar to those of section 8-112(c). Article 22(1) prohibits attachment of intermediated securities of an account holder that would affect a securities account of a person other than the account holder. The effect is to prohibit an attachment that would affect a securities account other than the debtor account holder’s account with its intermediary (the “relevant intermediary”)—i.e., prohibiting “upper-tier attachment.” However, GSC Article 22(3) provides an exception—it permits a Contracting State to declare that under its law an attachment can be made at an upper tier with the attachment being effective against the relevant intermediary. This accommodates the laws of states with “transparent” holding systems and other states in which attachment is to be made against the CSD.
The prohibition against upper-tier attachment is particularly problematic when it is impossible or impractical to attach intermediated securities held by a debtor in a foreign securities account. This situation is illustrated by the facts in Bank Markazi, aka Central Bank of Iran v. Peterson, in which the judgment creditors were victims of Iran-sponsored acts of terrorism, the victims’ estate representatives, and the victims’ surviving family members. The creditors sought to attach bond assets of Bank Markazi, the Central Bank of Iran (which was wholly owned by the Iranian government). Bank Markazi held these assets through a chain of intermediaries. It maintained an account with Banca UBAE SpA in Italy, which was an account holder of Clearstream Banking S.A. in Luxembourg, which in turn held an account with Citibank N.A. Contrary to UCC section 8-112(c), a terrorism-related federal law permits legal process against “blocked assets”—which in Bank Markazi included the assets held in the account with Citibank in New York.
The Bank Markazi case is instructive here because the relevant information on the assets in question was available at the higher-tier intermediary—Citibank—because the assets were already “blocked” without any of the disruption that the prohibition of upper-tier attachment is intended to avoid. However, because most situations are not covered by the special federal exception to 8-112(c), judgment creditors may be without any effective means of reaching assets held by intermediaries in the United States.
The upper-tier attachment limitation will be problematic so long as intermediated holding is an available alternative. Even if a direct-holding model were predominant, it is unlikely that any debtor interested in shielding assets would hold in its own name on the books of an issuer ( just as in many cases it may not hold in its own name in the intermediated system). The upshot is that addressing this issue in the United States would require changes to the UCC (or enactment of a preemptive federal law). Such a change would be feasible and appropriate only if an exception could be narrowly crafted to avoid the adverse effects of upper-tier attachment and to be available only in very limited circumstances.
D. Compliance Issues: Anti-Money Laundering, Sanctions Compliance, and Anti-Terrorist Financing
This seems an appropriate place in this Report to address anti-money laundering (AML) regulation and other compliance issues, although it is not clear that these compliance matters necessarily involve “problems” associated with the intermediated securities holding infrastructure. But compliance certainly involves the need for intermediaries and regulators to grapple with the infrastructure as it exists. It is equally clear that the compliance topics addressed here are outliers among the other issues and problems addressed in this Report. AML regulation, for example, seeks to look through corporate legal entity ownership, intermediate holding entities, special purpose vehicles, and the like to determine who are the natural persons who actually control and benefit from a corporate customer bank or securities account. The goal is to detect criminal and illicit activity and to trace the proceeds of such activity moving though the financial system. On the other hand, the Task Force is looking to find means to clarify who ultimately has the legal rights that attach to securities (voting, enforcement, economics benefits, etc.), whether that may be a natural person or a legal entity. The Task Force, and this Report, primarily address problems associated with the determination of the BO within the intermediated holding system (i.e., the ultimate BO at the lowest tier that is not acting as a securities intermediary) and the number/amount of the BO’s holdings. Chief among these problems is the associated friction that exists in connection with the exercise of the BO’s rights with respect to securities that result from the absence of privity with the issuer. It follows that the nature of the inquiry and goals of AML regulation (and similar inquiries and goals in connection with sanctions compliance and anti-terrorist financing) differ substantially from those addressed by the Task Force and this Report.
These profound differences notwithstanding, any examination and potential modification of the intermediated securities holding infrastructure must keep at least one eye on AML and similar compliance requirements. For example, depending on the details of the infrastructure, increased transparency as to the BO within the intermediated holding system, including a greater incidence of direct holding, could shorten the link to the ultimate beneficial owners that are the targets of the “know your customer” (KYC) diligence required under AML regulations. Moreover, greater transparency might encourage the development of more sophisticated and effective techniques for monitoring for fraud and other illicit behavior. In these ways infrastructure modifications could support the goals of AML. But modification also could be problematic. It could actually increase burdens associated with KYC due diligence obligations, possibly without any increased benefits, and also might involve conflicts with applicable rules relating to privacy and data protection.
There is no clear answer as to whether and how infrastructure modifications that would promote the goals addressed in this Report would impact AML and other compliance considerations. What does seem clear, however, is that any infrastructure modifications should be carefully coordinated with the various compliance regimesthat the modifications might affect and should proceed with caution in this context.
E. Costs and Errors
Endemic in the intermediated holding infrastructure are various costs and errors that arise from its operation and maintenance and the many workarounds that it necessitates. Costs and delays may result from causes as simple as mistakes in preparing a letter of instruction to DTC or clerical errors in the exchange of documents between BOs and intermediaries. No doubt more significant are the costs inherent in the proxy plumbing supporting shareholder voting, the authorizations dealt with by DTC’s Proxy Services, the use of DTC’s Corporate Actions Processing, other exercises of security holder rights, or the protection of the rights and interests of BOs from the risks of intermediary failure or default. The latter costs include those arising from the regulatory supervision and intermediary compliance. Prime examples are costs of compliance with the customer protection rule by all broker-dealers and protecting the assets of entitlement holders pursuant to the Securities Investor Protection Act. Infrastructure modification that would reduce the prevalence of intermediated holding could reduce these costs substantially. However, it is a reasonable assumption that some intermediated holding necessarily would persist, at least in connection with trading and settlement as well as, perhaps, attendant to margin lending and securities lending.
Costs associated with intermediated holding are not necessarily “problems.” For example, the systems that protect BOs from intermediary risks appear to be working well. But there is a substantial volume of opinion that the same cannot be said of the proxy plumbing. To the extent that costs could be reduced while achieving commensurate benefits through infrastructure modification, that would directly impact a benefit-cost analysis of an independent study as recommended in the Interim Report.
V. Overview of Part Two and Conclusion
The U.S. intermediated securities holding infrastructure is mature and sophisticated. DTCC lies at the core of the infrastructure. Today’s DTCC has emerged from incremental changes in organization of several entities and many enhancements in services and technology over more than five decades. This evolutionary process successfully solved the paperwork crises of the 1960s and has met the many challenges in the clearance and settlement of transactions in the public securities markets in the United States. As part of this development, DTC’s nominee, Cede & Co., has become the holder of record of the vast majority of publicly traded equity and debt securities in the U.S. markets. The result is that the predominant means of post-settlement holding of securities by investors of all types is now through securities accounts with broker-dealers and banks. This infrastructure, supported by statutory and regulatory frameworks, both state and federal, also has been successful in protecting the rights and interests of investors against losses arising out of the default, defalcation, and insolvency of securities intermediaries.
Notwithstanding the successes of the current infrastructure for its intended purposes, it is not surprising that given its size and complexity several problems and areas in need of improvement exist. Moreover, the costs of maintaining this infrastructure are significant. This Part One of the Report meets the charges of the Task Force Mission Statement to examine the infrastructure and identify, analyze, and assess its problems. Its credibility is evidenced by consensus views on important points as described in the Interim Report. No doubt this results from the involvement in the work of the Task Force by participants reflecting a broad spectrum of the securities and banking industries, regulators, legal practitioners, and academics.
The forthcoming Part Two of the Report will meet the additional charge of the Mission Statement to identify and assess plausible means of addressing the problems that have been identified. For example, Part Two will build on the Interim Report and consider potential infrastructure modifications that would provide enhanced transparency as to the identification of BOs. It also will consider the possibility and plausibility of moving toward a norm of post settlement direct holding while preserving the essences of the convenience, flexibility, and efficiencies of the existing intermediated holding infrastructure.
This Report aspires to be the beginning of a process, not an end. Its principal recommendation, made in the Interim Report and to be reiterated and elaborated in Part Two, is for an independent study and benefit-cost analysis of the current infrastructure and the potential means of addressing problems, including any needed infrastructure modifications. As Part Two will explain, the proposed study and subsequent processes likely will require regulatory intervention (or at least support). However, the support by the ABA Business Law Section’s Council for the principal recommendation provides important recognition of the need for a thorough assessment of the infrastructure. The Council action also lends important recognition and support for necessary interventions and acknowledges the need to seriously consider infrastructure improvements.
