UK Government Response to the European Commission s Consultation on Legislation on Legal Certainty of Securities Holding and Dispositions

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1 UK Government Response to the European Commission s Consultation on Legislation on Legal Certainty of Securities Holding and Dispositions January 2011 Summary The UK welcomes the Commission s proposals for legislation on legal certainty of securities holding and dispositions. We support efforts to enhance the protection of market participants by addressing the need for clarity and certainty at every link in a chain of intermediaries between the issuer and the end investor, whether domestically or across borders, and agree with the Commission that a functional and neutral approach is the best way to achieve this framework. It is also important that the legislation takes account of the operations of direct holding models like CREST. Furthermore, a harmonised legal framework is essential to establishing an effective single market for financial services. Addressing the current fragmentation and inefficiency in the EU s financial markets should benefit Europe as a whole. Oxera s 2009 report 1 identified that cross-border custody and safekeeping costs were up to twice as expensive as domestic services. With US$14 trillion of cross-border securities traded within the EU alone in , there is considerable potential to free capital for re-investment in growing Europe s economy. We wish to emphasise the following points from our response: This legislation needs to provide the EU with an internationally compatible legal framework because financial markets are global. It is important that the proposals reflect the articles negotiated in the Geneva Securities Convention and Hague Securities Convention. Control agreements are an important method for acquiring securities, but are given a lower priority than earmarking. This will have adverse effects on liquidity and an increase in settlement times and costs. The efficiency of market infrastructures in some Member States such as the UK s CREST system would be called into question. Member States should have the discretion to determine the priority of earmarking and control agreements in accordance with their applicable law. The Commission s proposal to impose strict liability on account providers could have significant unintended consequences for the provision of custody services by creating regulatory arbitrage, putting EU account providers at a competitive disadvantage to third country peers, and increasing the potential for the transmission of systemic risk. Instead, this proposal should be brought into line with the Alternative Investment Fund Managers Directive which requires depositories to take account of external events beyond the reasonable control of the account provider. The UK strongly supports the Commission s principle that the legislation should not harmonise the legal framework governing the question of whom an issuer has to recognise as the legal holder of its securities. However, the practical effect of some of the 1 Table 7.16, Monitoring prices, costs and volumes of trading and post-trading services (MARKT/2007/02/G), Oxera, July IMF Coordinated Portfolio Investment Survey 1

2 Commission s principles on facilitating the exercise of rights as currently drafted could undermine this. It is important that investors are afforded strong and effective protections. The Commission s principle on innocent purchasers could be significantly strengthened, for example by aligning it with the wider protections provided for by Article 18 of the Geneva Securities Convention. Q1: Do you agree that the envisaged legislation should cover the objectives described above? If not, please explain why. Are any aspects missing (please consider also the following pages for a detailed description of the content of the proposal)? The UK agrees with Principle 1.1 that EU law should regulate the legal framework governing the holding and disposition of securities held through securities accounts and the processing of rights flowing from securities held through securities accounts. As the consultation paper recognises, financial markets are global and the move to holding and disposing of securities in book-entry form through securities accounts is not confined to the EU. In order to realise the full benefits of certainty being sought, this law should deliver an internationally compatible legal framework and reflect the articles negotiated in the Hague Securities Convention and the Geneva Securities Convention. The UK also welcomes the Principle 1.2 as a helpful clarification of the intended scope of the directive. We also agree with the Commission s statement that: Of central importance is that measures at EU level should not seek to harmonise the legal framework governing the question of who an issuer has to recognise as the legal holder of its securities. It is not only extremely difficult to harmonise the national laws of legal ownership of shares between Member States, but it is also unnecessary. A functional approach should suffice. Equally, EU law should not cover the functions of creation, recording or reconciliation of securities, against the issuer of those securities, by a person such as a central securities depository, central bank, transfer agent or registrar. However, its proposals on the facilitation of rights dealt with in Principles 15 to 17 appear to run counter to this objective. This is discussed further below in response to questions 30 to 34. We agree that account providers should be regulated at EU-level, subject to the MiFID authorisation and supervision framework. The UK agrees that conflict-of-laws arrangements should be addressed in the SLD, but considers that the most effective approach would be to bring the SLD in line with the Hague Securities Convention. Existing EU measures should, where appropriate, be amended to be made compatible with this rule. We agree that substantive law arrangements need to be made compatible, but it is also important that they reflect the articles negotiated in the Geneva Securities Convention. We also agree that the full exercise of investor rights must be guaranteed, but it is essential that the directive takes account of the way that the financial markets operate so that it is practical and does not place undue burdens on account holders and providers. The impact on Member States core company law should be kept to a minimum in line with Principle

3 Q2: Would a Principle along the lines set out above adequately accommodate the functioning of socalled transparent holding systems? The UK considers that it would and welcomes this helpful principle. Q3: If not: can you explain which aspect is not correctly addressed and what could be improved? Which are, if applicable, the repercussions on your business model? N/A Q4: Do you know any specific difficulties of connecting transparent holding systems to nontransparent holding systems? No. Q5: Would a principle along the lines described above provide Member States with a framework allowing them to adequately define the legal position of account holders? Yes. It reflects Article 9 of the Geneva Securities Convention. Q6: If not, which legal aspects that belong, in your opinion, to an adequate legal position of each account holder could not be realised by the national law under an EU framework as described above? What are the practical problems that might occur in your opinion, if Member States were bound by a framework as described above? Which are, if applicable, the repercussions on your business model? N/A Q7: The Geneva Securities Convention ( provides for a global harmonised instrument regarding the substantive law (= content of the law) of holding and disposition of securities, covering the same scope as those parts of the present outline dealing this subject. Most EU Member States and the EU itself have participated in the negotiations of this Convention. Both the present approach and the Convention are compatible with each other. - If applicable, does your business model comprise securities holdings or transactions involving non-eu account holders or account providers? - Is it, in your opinion, important to achieve global compatibility regarding the substantive law of securities dispositions, or would EU-wide compatibility suffice? The UK believes that achieving global compatibility regarding the substantive law of securities dispositions is essential. The evidence for this is clear. Using data from the International Monetary Fund s (IMF s) Coordinated Portfolio Investment Survey, we were able to examine the importance of non-eu investors and investments by Member State in 3

4 Using Table 8, we looked at inter EU cross-border investment between Member States (with the exception of Lithuania) and extra EU cross-border investment both from and in major international trading partners. 4 Source: IMF Coordinated Portfolio Investment Survey The chart above shows that non-eu investors provided 27% of the total investment in EU crossborder securities. Meanwhile, EU investors directed 32% of their capital into cross-border securities outside the EU. This means that US$5.2 trillion of cross-border investment in EU businesses came from outside the EU. As such, an international framework for legal certainty should be seen as a key enabler for the EU s 2020 strategy for smart, sustainable and inclusive growth. It is also important to protect the rights of EU investors who invested US$6.6 trillion in securities outside the EU. The IMF s data reinforces the need for global compatibility as cross-border investment in EU securities by non-eu investors increased in value terms between and by 26%. In the same period, investment by EU investors in non-eu securities increased by 25%. This trend demonstrates the need for compatibility with an international framework for legal certainty for account-held securities. The Geneva Securities Convention provides such a framework. Q8: Would a principle along the lines described above allow for a framework which effectively avoids that more securities are credited to account holders than had been originally issued by the issuer? These states are Argentina, Australia, Brazil, Canada, China, India, Indonesia, Japan, Malaysia, Mexico, Norway, Russia, Saudi Arabia, Singapore, South Africa, South Korea, Switzerland, Thailand, Turkey, and the United States. 4

5 In the UK s view, the Commission s Principle 1.2 is clear that the principles set out should not affect whom the issuer is bound to recognise as holding its securities. This means that the number in issue of those securities can never be increased by reason of the actions of any one or more account providers downstream. As a result, any discrepancy between the credit balances recorded by account providers and the securities issued by the issuer must be eliminated by rules operating at the level of each account provider. Principle 4 makes it clear that it is for the account provider to make good the discrepancy, either by identifying and reversing a defective entry where that can be done or by buying in securities. This does leave an issue as to the circumstances in which this obligation should operate and where the cost of so doing may be recouped from the account holders of the account provider (see our answer on Q10). However, in our view it is only in the extreme case where there arises a discrepancy that cannot be resolved and the account provider is unable, for example as a result of insolvency, to buy in securities that account holders property rights would be affected. We agree that both the legal framework and the regulatory system should seek to minimize the chance of any such discrepancy arising. No rule can however eliminate the possibility of its doing so, for example through fraud, mistake, negligence or systems error, and the Commission therefore rightly includes principles regulating the consequences if such a discrepancy should arise. These principles serve the familiar and very difficult function of deciding who, among two or more innocent parties, is to bear the loss arising from another's fault or error if that other cannot make it good. This is a policy question involving a balancing of competing interests and priorities - in particular between an investor who has purchased in good faith, and the account holder who needs to have confidence in the security of his holdings. Principle 4 provides for the loss in some circumstances to be spread among account holders in proportion to their holdings. In our view this is an appropriate rule on grounds of fairness and the maintenance of confidence in the security of market transactions. However, we are unsure as to the intended purpose of 4.2(e). CREST is not a Central Securities Depository (CSD) in respect of the operator register. CREST and the registrars do not hold securities. It is important not to apply the perspective of practice of immobilisation in many European CSDs universally. This involves the act of placing securities in a CSD which then creates an account in respect of those securities allowing account providers to take an interest. An important distinction must be made between this and the process in the UK where the electronic entries in the register are the only evidence of the existence of the security. With regard to CREST, paragraph 4.2(e) may be effective in relation to securities that are credited to account holders when they are initially issued. However, there is a practical question as to whether it will work in relation to any subsequent transfer of these securities. Initially, no-one has any other interest in the securities at the time when CREST credits them to the accounts of their first holders. However, on transfer, when the securities move from seller to buyer, CREST does not hold any interest in them. To decide otherwise would appear to allow CREST to credit the accounts of anyone for whom it maintains accounts with securities that it created the initial electronic record for, whether or not a third party holds the interest in these securities. We do not believe that this is the Commission s intention as it would remove a key safeguard against securities inflation. 5

6 We are also concerned that the effect of Principle 4.2(e) is to include CREST s operator register and issuer registers in the SLD with implications for the UK s core company law as all the obligations under the SLD would become duties on the issuer company. In summary, it would not be possible for the UK to give effect to this principle unless it is amended, because CREST does not hold securities. The UK believes that Principle 4.2(e) is unnecessary and should therefore be removed. Q9: If not, how could a harmonised EU-framework better guarantee that account providers do not create excess securities by over-crediting client accounts (keeping in mind that all account providers are either banks or MiFID regulated entities)? Please distinguish between regulating the account providers behaviour and issues relating to the effectiveness of excess credits made. N/A. Q10: Is the principle relating to the passing on of costs of a buy-in appropriate? If not, in which way should it be changed and why? What would be the repercussions on your business model? No, the principle on passing on of costs (i.e. that costs of a buy in may only be shared by the account provider and the account holders in circumstances set out in Article 17.3(a) and (b) of the MiFID implementing directive 5 ) is not appropriate. This amounts to strict liability. Such a measure could have significant unintended consequences for the provision of custody services, creating regulatory arbitrage, give third country account providers a competitive advantage, and increase the potential for the transmission of systemic risk. For example, the principle provides that sharing the cost of the provision of additional securities may also be acceptable where the circumstances giving rise to the need for additional securities were not within the control of the account provider for example, where there is fraud or technical malfunction higher in the intermediary chain. In such cases, both the account provider and the account holder are innocent parties, and it is not appropriate for the loss to be imposed solely on the account provider. Where a sub-custodian is located in a non-eu country, where equivalent duties and liabilities do not apply, there is also the additional issue of importing systemic risk into the EU. It has been estimated that the increased capital requirements needed to insure for strict liability would be an additional $1 of capital for each $1 of custody asset, in the context of an industry where the top four custodians collectively hold in excess of $70 trillion in assets under custody. We urge the Commission to redraft this Principle to make it possible for account providers to agree with account holders to share costs in any case where the need to buy in securities has arisen from an event beyond the reasonable control of the account provider, so that it is in line with the 5 (a) Where the nature of the financial instruments or of the investment services connected with those instruments requires them to be deposited with a third party in that third country; (b) Where the financial instruments are held on behalf of a professional client, that client requests the firm in writing to deposit them with a third party in that third country. 6

7 requirement for depositories in Article of the Alternative Investment Fund Managers Directive (AIFMD): The sharing of any cost entailed by the provision of additional securities pursuant subparagraph (b) can be subject to a contractual agreement between the account provider and those account holders holding securities of the relevant description at the time of the occurrence of the loss in non-segregated accounts only: (a) in cases where the account provider held securities of the relevant description with another account provider pursuant to Article 17(3) subparagraphs (a) and (b) of Directive 2006/73/EC; or (b) in cases where the need to provide additional securities arose as a result of an external event beyond the reasonable control of the account provider, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary Q11: Would a principle along the lines described above provide Member States with a framework allowing them to determine legal effectiveness and ineffectiveness to an extent sufficient to safeguard basic domestic legal concepts, like e.g. the transfer of property? Yes. Q12: If not, please specify how and to what extent national legal concepts would be incompatible. Please specify the practical problems linked to these Background, and, if applicable, the repercussions on your business model. N/A Q13: Would a principle along the lines described above provide for a framework allowing effective protection of client securities in case of insolvency of an account provider? Yes. Q14: If not, which measures needed for effective protection could not be taken by Member States under the proposed framework? N/A Q14 [sic]: Is the list of cases allowing for reversal complete? Are cases listed which appear to be inappropriate? Are cases missing? What are, if applicable, the repercussions on your business model? The UK believes that the list of cases is not complete and to treat it as such would have unintended consequences. For example, reversal may also be needed in the case of fraud, illegality, duress, undue influence, misrepresentation or any other case where the relevant transaction in respect of 7

8 which the relevant settlement has occurred is void or voidable under applicable law; or if required by any legislative provision (e.g. in support of anti-avoidance measures under applicable insolvency laws); or if otherwise required by a court order. In order to address this, the UK suggests that Principle 7 be redrafted to act as minimum rather than a maximum harmonisation. All Member States should therefore ensure that book entries can be reversed according to 7.1(a)-(e), but should have the discretion to include further cases if they believe it to be necessary. Q15: Should national law define the extent to which general consent to reversal can be given in standard account documentation? What are, if applicable, the repercussions on your business model in case your jurisdiction would take a restrictive approach to this question and limit the possibility of general consent to reversal? The UK believes that it is important to respect the freedom of contract of the account provider and the account holder to agree the terms upon which the account holder will hold securities and/or maintain securities accounts. Q16: Do you agree with the 'test of innocence' as proposed ('knew or ought to have known')? Do you know of any practical obstacle that could flow from its application in your jurisdiction? What would be the negative consequences in that case? It is essential that the framework establishes strong, effective protection for innocent purchasers. We therefore welcome the inclusion of a provision for this using Principle 8, but believe that it could be significantly strengthened. As currently drafted, it only gives protection against the reversal of a credit made in favour of the innocent purchaser. The protection provided by Article 18 of the Geneva Securities Convention goes much further. It protects the acquirer against the effect of earlier defective entries, provided that the acquirer did not know of the defective entry at the time when the credit was made (under 18.2). It also provides in Article 18.1, that, unless the acquirer knew that another person had an interest in securities or intermediated securities at the time the credit was made: (a) (b) (c) the acquirer s right is not subject to the interest of that other person; the acquirer is not liable to that other person; and the credit, designating entry or interest granted is not rendered invalid, ineffective against third parties or liable to be reversed on the ground that the credit, designating entry or interest granted violates the rights of that other person. Principle 8 does not provide this second form of protection. It is also not subject to the uniform rules of a Securities Settlement System (SSS) as per Article Aligning the principle with Article 18 would also extend protection to innocent acquirers using a control agreement. The UK believes that the Commission should re-draft Principle 8 to align it with the greater protections provided for by Article 18 of the Geneva Securities Convention, making it subject to the rules of SSSs, and extending its protection to control agreement users. 8

9 Q17: Will a principle along the lines set out above, under which the applicable law would need to afford an inferior priority to interests created under a control agreement, be appropriate and justified against the background that control agreements are not 'visible' in the relevant securities account? If not, please explain why. No. The UK considers that interests created under a control agreement are an efficient way of acquiring or disposing of account-held securities and that this is no less effective, transparent and visible than earmarking. The UK believes that if Member States can take into account the pros and cons of earmarking and control agreements in making their decision of what to recognise, then where they decide to recognise both earmarking and control agreements, they should also have the discretion to determine the priority between the two in accordance with their applicable law. To deny this discretion would risk interfering with established rules of priority and other principles relied upon by market participants under Member State law. Inevitably, there would need to be complex transitional provisions in the SLD dealing with security interests created prior to the coming into effect of the SLD, and where such security interests had not been characterised in the nature of earmarking and control agreements as defined in the SLD when they were created. To help expand our reasoning on this, we have provided a paper on Understanding Control Agreements in the annex. Q18: Have you encountered difficulties regarding the priority/rank of an interest created under a mechanism comparable to a control agreement in the context of a priority contest, or, more generally, in an insolvency proceeding? If yes, please specify. We have not encountered any such difficulties. Control agreements ensure efficient and effective enforcement of collateral because the account provider is actively involved in the enforcement process. Please refer to our Understanding Control Agreements in the annex for our examples. Q19: Would there be negative practical consequences for your business model flowing from a Principle along the lines set out above? If yes, please specify. As set out in our Understanding Control Agreements paper, the impact of the legal uncertainty that a failure to recognise control agreements or give them equal priority with earmarking would have severe consequences to the UK s financial markets. We also believe that it is inconsistent with other EU Directives. An example can be provided of the estimated impact if Self Collateralising Repo s (SCRs) were to be used to provide settlement liquidity in CREST instead of control agreements on the basis of CREST transactions from 21 st August 2010: British Government stock = 7,600 transactions Non-government stock = 140,000 transactions 9

10 Current SCR process multiplies transaction count by a factor of 5 and the new repo to settlement banks by 3 therefore: British Government transactions using SCR = 7,600 x 5 = 38,000 New repo transactions = 140,000 x 3 = 420,000 Extending repo functionality across a wider spread of securities would generate an extra 280,000 transactions per day (which translates into an increase of c. 7m per month) These figures are based on a reasonably quiet day s trading (518bn) whereas settlement values in the CREST system have exceeded 1 trillion during busier periods. This represents a 189% increase in transaction volume. Each transaction generates extra cost. They also add additional strain to systemically important infrastructure. Any comprehensive impact assessment would also need to include the transitional costs involved in adapting systems and processes to run on SCRs instead of control agreements. Additionally, in the context of corporate actions, where securities are transferred to settlement banks and are sitting in the CREST accounts of those banks at the relevant date for determining entitlement to corporate actions proceeds, such proceeds will go to the settlement bank rather than the repo-ing CREST member. It will be necessary for settlement banks to agree and administer arrangements with their clients for dealing with corporate actions proceeds. Therefore, if control agreements are not recognised or given a lower priority by the SLD, then the use of account-held securities as collateral in the financial markets will only be possible through credit (or possibly earmarking) methods with consequential adverse effects on liquidity and an increase in settlement times and costs. In addition, the efficiency of market infrastructures in some Member States such as the UK s CREST system and its use of settlement banks to provide liquidity will be called into question. Q20: Would a Principle along the lines described above pave the way for the national legal frameworks to effectively protect client securities in case of the insolvency of an account provider? Yes. However, as currently drafted, 10.2 is unclear. We would suggest redrafting this to specifically refer to the allocation of losses to clarify what is intended. Q21: If not: Which mechanisms should be available which could not be implemented under a framework designed along the lines described above. Please specify. N/A. Q22: Should the sharing of a loss in securities holdings (occurring, for example, as a consequence of fraud by the account provider) be left to national law? Would you prefer a harmonised rule, following the pro rata principle or any other mechanism? Yes, the sharing of a loss in securities holdings should be left to national law. This would enable Member states to provide for losses to be shared on a pro-rata basis where they consider that 10

11 appropriate. In our view this is an appropriate rule on grounds of fairness and the maintenance of confidence in the security of market transactions. Q23: Would a Principle along the lines described above provide for a framework allowing the national law to effectively apply restrictions on whose instructions to follow for purposes of investor protection, notably in connection with the envisaged Principle contained under section 4 (Paragraph 2)? If not, please explain why. Yes. However, we also think that this rule could be improved by inserting a reference to the insolvency practitioner i.e. where the account holder is insolvent, it should be clear that the insolvency practitioner should be able to give instructions. Q24: Would a Principle along the lines described above provide Member States with a framework allowing them, in combination with the envisaged Principle on shared functions, to effectively reflect operational practice regarding attachments in your jurisdiction? If not, please explain why. Yes. Q25: Have you ever encountered, in your business practice, attempts to attach securities at a tier of the holding chain which did not maintain the decisive record? If yes, please specify. N/A Q26: Would the proposed framework for protecting client accounts be sufficient? Should the presumption that accounts opened by an account provider with another intermediary generally contain client securities become a general rule? If not, please explain why. Yes, the proposed framework for protecting client accounts is sufficient. The presumption that an account held by an account provider with an upper tier account provider should be considered to contain client assets is also sensible as a rebuttable presumption. The securities in an account held by an account provider with an upper tier account provider may be held for its own account. Q27: Would a Principle along the lines described above allow for a consistent conflict-of- laws regime? If not: Which part of the proposal causes practical difficulties that could be addressed better? The UK remains concerned that the Commission s proposal does not deliver ex-ante legal certainty to an account holder wishing to know which law governs its account. The test for identifying the relevant governing law initially appears to be where the relevant securities account is maintained (Principle 14.1). We note, however, that if the account provider is acting through branches it is necessary to identify where the relationship with the account holder is handled. Application of the maintenance or handling test raises significant potential difficulties. Although it is intended that the location approach should be based upon a single factual criterion, in practice 11

12 the actual process of deciding which branch is maintaining or handling the account will depend upon the identification (and balancing) of a number of operational and administrative factors, including the branch through which the account was opened, the branch which handles the commercial relationship with the account holder, and the branch which administers payments or corporate actions. The location of some of these may be different and may change from time to time. And the different factors will often point to different locations, reducing the level of legal certainty obtainable. Although the Commission s guiding principle is that the account holder should know which law governs its account, under the proposals as drafted only the account provider will have this information and know where the account is actually maintained or handled; the account provider must therefore impart this information to the account holder through communication in writing. However, the account holder may not rely on this communication. The communication may actively mislead the account holder. The account provider may also be genuinely mistaken in its assessment of where the account is maintained, given that the question will depend on an analysis of the factors referred to above. The result is a framework where the account holder can have no certainty as to the relevant governing law, because the factors determining that law are dependent on and within the control of the account provider, either deliberately so (i.e. the account provider may decide to move the entirety of the location/maintenance/handling of the account) or unintentionally so (i.e. by the account provider altering the balance of the operational features between different locations). These difficulties are multiplied to the extent that any chain of holding goes through several intermediaries, and in particular, in a cross-border context. The ability to undertake an analysis of relevant governing laws (and associated interconnected relationships and legal risks) based on a such a combination of operational and administrative factors related to account handling would be time consuming and expensive, and, we believe, may even be impossible in practice. In view of these concerns, the UK continues to believe that the adoption of a governing law of the account agreement approach would be preferable. Unlike the location approach, this would also be consistent with the benefits of maintaining global compatibility (as per the Hague Convention). Q28: Would the mechanism of communicating to the client, whether the head offices or a branch (and if a branch, which one) is handling the relationship with the client, add to ex-ante clarity? Is it reasonable to hold the account provider responsible for the correctness of this information? If applicable, would any negative repercussions on your business model occur? See our answer above to Q27. Q29: The Hague Securities Convention ( provides for a global harmonised instrument regarding the conflict-of-law rule of holding and disposition of securities, covering the same scope as the proposal outlined above and the three EU Directives. Most EU Member States and the EU itself have participated in the negotiations of this Convention. The proposed principle 14 differs from the Convention as regards the basic legal mechanism for the identification of the applicable law. However, the scope of principle 14 is the same than the scope of the Convention: 12

13 property law, collateral, effectiveness, priority. Do you agree that this will facilitate the resolution of conflicts with third country jurisdictions? If not, please explain why. No. Without the same basic legal mechanism to identify the applicable law, it will not facilitate the resolution of conflicts with third country jurisdictions. Therefore, it is irrelevant that the range of questions to be subjected to the Commission s proposed principle is the same as in the Hague Securities Convention. In practice, the rule used to determine the applicable law usually depends on the conflicts of law rules followed by the lex fori the law of the country in which the court proceedings are being brought. The result of the EU adopting a different conflicts-of-law rule to the rest of the world will mean that in courts of the Member States, for disputes covered by the SLD, the Community conflicts law will apply to determine the applicable law and in courts of third countries, the local conflicts law will be applied (which may be the Hague rule). This could well increase forum shopping i.e. people choosing to bring proceedings in the country where it is most likely that a law favourable to their case will be determined to be the applicable law. The best solution for assisting the resolution of disputes with third country jurisdictions (especially in the context of growing cross-border transactions illustrated in our response to Q7) would be to align Principle 14 with the Hague Securities Convention. Q30: Would a general non-discrimination rule along the lines set out above be useful? Have you encountered problems regarding the cross-border exercise of rights attached to securities? Yes as long as Principle 15 respects a functional and neutral approach and does not require Member States to amend their law on the issue of securities and the way that securities are held. To do so would radically extend the scope of the proposed directive in a way that would significantly impact Member States core company laws. The UK supports the ultimate account holder being able to exercise rights flowing from his securities, where he, the legal owner and the issuer agree. This is because he only has the rights that the registered legal owner has agreed to give and hold for him e.g. by way of a trust agreement; and such agreement might state that voting is exercised by a third party This is one of the reasons why it is essential that the ultimate account holder is not allowed to leapfrog the holding chain. This would also contradict the Commission s principle that the SLD is not intended to affect who the issuer has to recognise as the holder of securities. Therefore, the ultimate account holder should be enabled to exercise his rights through the holding chain in a way that achieves legal clarity and least cost for all those involved. Q31: If applicable, would a Principle along these lines have (positive or negative) repercussions on your business model? Please specify. If Principle 15 requires the law to be amended to allow the ultimate account holder to exercise or to control the exercise of the rights attached to the securities, then from the perspective of the UK, corporate law may need to be amended to require the issuer to recognise the ultimate account holder as being entitled to exercise the rights attached to the securities in place of the legal holder of the securities. 13

14 This would not be functional or neutral and would undermine the concept of an equitable interest in securities. It does not respect the position of the legal holder. It should be made clear that Member States may protect the rights of the ultimate account holder by imposing obligations on the legal holder of the securities. This is not best achieved by a non-discrimination requirement. Q32: Is the duty to pass on information adequately kept to the necessary minimum? Is it sufficient?: If applicable, would there be any (positive or negative) repercussion of such a Principle on your business model? Please specify. With regard to the exercise of a right attached to the securities, this appears to refer to the rights comprised in the securities e.g. the right to vote. However, it does not seem to address the question of the rights over the security i.e. the rights of property, for example the sale and pledge etc. Therefore, information in the context of a takeover bid, i.e. an offer to purchase the securities, would currently appear to fall outside of the scope of the directive. If the Commission intends that information includes voting instructions, this raises the question whether the whole process can be completed within the timescales in the Shareholder Rights Directive. Further, the drafting would require a rule that the account provider of the ultimate account holder must pass on the information to the issuer. This provision should provide not only for the transmission of information from the ultimate account holder, but also of their instructions in relation to the exercise of rights attached to the securities. It is also necessary for all account providers in the chain to be subject to the same obligation to pass on information and instructions if these rights are to be effective, in the same way as information from the issuer to the ultimate account holder. We would therefore suggest the following redrafting: 2. The account provider of the ultimate account holder must pass on information and instructions with respect to the exercise of rights attached to securities received from the ultimate account holder to the issuer of the securities where the account provider is the registered holder of the share or, if applicable, the following account provider without undue delay, as far as information is provided by the ultimate account holder in the course of the exercise of a right attached to the securities. Such information and instructions must also be passed on by the following account provider to the next account provider in the chain without undue delay. Q33: How do you see the role of market-led standardisation regarding the passing on of information? What are your views on a regulatory mechanism for streamlining standardisation procedures? The industry-led Market Standards for General Meetings (MSGM) initiative has already made inroads into the operational problems of creating Europe-wide standards for cross-border voting, and has the potential to act as a foundation for further work on the passing on of information. Standardisation of operational procedures and key dates used by issuer and financial intermediaries would be a complex task. The UK would welcome further information from the Commission as to how it would intend to address this task, including its analysis of the costs and benefits involved. 14

15 With the background of the Shareholder Rights Directive in mind, EU proposals in this area will need to take into account the diverse nature of Member States legal frameworks and securities markets. This includes: The existence of registered and bearers shares; Dispersed and block-holding markets; Direct and indirect holding systems and the differing roles of Central Securities Depositories. Q34: If you are an investor, do you think that a Principle along the lines described would make easier any cross-border exercise of rights attached to securities, provided that technical standardisation progresses simultaneously? If not, please explain why. The UK welcomes the non-mandatory nature of Principle 17.1 as it requires that the account provider of the ultimate account holder should act if requested by ultimate account holder. However, we are concerned at the implications of Principle 17.2(a-c). The account provider must, at the request of the account holder arrange for either the ultimate account holder or a third person nominated by him to be appointed representative of the registered holder of the securities. Under English law, the account provider of the ultimate account holder will not be able to do this unless he is himself the registered holder, or if he holds directly from the registered shareholder. The decision to appoint a proxy lies with the registered holder. It is often the case that the account provider of the ultimate account holder is not the registered holder. Paragraph 2(b) requires the account provider of the ultimate account holder to exercise the rights attached to the securities upon authorisation and instruction and for the benefit of the ultimate account holder. But under English law, the account provider of the ultimate account holder will not necessarily be entitled to exercise the rights attached to the securities unless he is himself the registered holder of the securities. Under Paragraph 2(c), the account provider of the ultimate account holder is now required to provide evidence of the holdings of the account holder to enable them able to exercise the rights attached to the securities against the issuer or a third party. This would appear to be contrary to the Principle 1.2 which states that the legislation should not harmonise the legal framework governing the question of whom an issuer has to recognise as the legal holder of its securities. Aside from this, the Principle does not specify whether this evidence should be provided in an electronic or physical format, and what information it should communicate. There is a risk of reintroducing certification into a system that has increasingly become dematerialised. This would have significant associated costs that would be passed onto the investor. We wish to emphasise the importance of a robust cost-benefit analysis for the proposed mechanism for facilitating the rights of the ultimate account holder, including its anticipated demand for this measure, as it is important that the costs do not outweigh the benefits they would bring for investors and would welcome sight of the analysis. We would also welcome further information on 17.3 on specifically which contractual agreements the Commission intends to limit for the purposes of client protection as this proposal may have a negative impact on service provision for investors. 15

16 Q35: If you are an account provider, would you tend towards the opinion that your clients can exercise the rights attached to their cross-border holdings as efficiently as their domestic holdings? What would be the technical difficulties you would face in implementing mechanisms allowing for the fulfilment of the duties outlined above? What would be the cost involved? N/A. Q36: If you are account holder, have you encountered differing prices for the domestic and the cross-border exercise of rights attached to securities? If yes, please specify. The UK requests the Commission to provide specific detail about which services to which it proposes to apply Principle 18. We also request that the Commission provides its cost-benefit analysis for this proposal. The UK is concerned by the potential unintended consequences of this principle. Account providers may react in two ways. Rather than lower their cross-border fees as the Commission wishes them to do, they may raise their domestic fees instead to the level of those for cross-border services. Alternatively, they may decide to withdraw their cross-border services. Neither option is in the interests of Europe s investors. Q37: If you are an account provider: do you price cross-border exercise of rights differently from domestic exercise? If yes: on what grounds are different pricing models necessary? N/A Q38: Have you encountered difficulties in using non-eu linkages as regards the exercise of rights attached to securities? If yes, please specify. If not, please explain why. The UK questions whether the provisions in Principle 19 would be effective. The most effective way to ensure that obligations are exercised through third countries would be to ensure that the directive is aligned with the provisions in the Geneva Securities Convention. Q39: Admitting that non-eu account providers cannot be reached by the planned legislation, which steps could be undertaken on the side of EU account providers involved in the holding in order to improve the exercise of rights attached to securities through a holding chain involving non-eu account providers? It would be possible to require EU account providers to include certain provisions in any agreement they make with non-eu account holders which are themselves account providers, under which the non-eu account holder undertakes to fulfil certain obligations, such as passing on information from the EU account provider to the non-eu account provider s own account holder, and relaying instructions and information from its account holder to the EU account provider. However, this could only realistically provide for the next link in the chain. In theory, it would be possible to require an obligation for the non-eu account provider to include similar provisions in its own agreements with its account holders, so that they too are required to accept these obligations. But in practice this would almost certainly not be enforceable by the EU account provider. 16

17 Q40: Do you think that a general authorisation to exercise and receive rights given by the account holder to the account provider should be made subject to certain formal requirements? Please specify. The answer to this is dependent on the formal requirements proposed, and we could welcome further explanation from the Commission as to their nature. Q41: Should the status of account provider be subject to a specific authorisation? If not, please explain why. Yes. Q42: If yes, do you think that MIFID would be an appropriate instrument to cover the authorisation and supervision of account providers? Yes. Q43: Do the terms used in this glossary facilitate the understanding of the further envisaged Principles? If no, please explain why. Yes Q44: Would you add other definitions to this glossary? No. 17

18 Annex Understanding Control Agreements Overview This paper is intended to provide a straightforward guide to control agreements. It explains what control agreements are, and addresses questions commonly raised about their use. The UK recognises that some Member States may have concerns about control agreements. In this paper, we aim to demonstrate that control agreements are an efficient way of acquiring or disposing account-held securities that are no less effective, transparent and visible than earmarking. If control agreements are not recognised, or given a lower priority than earmarking in the Securities Law Directive (SLD), the UK is concerned that liquidity could be harmed and settlement times and costs could increase. Their key role in the efficient operation of market infrastructures in some Member States such as the UK and Ireland could also be undermined. In stating this position, the UK is not advocating that the SLD should mandate equal priority for control agreements in all Member States. We support the Commission s proposal that Member States should have discretion as to whether they choose to recognise earmarking and control agreements. However, in line with that proposal we consider that Member States should also have the discretion to determine the priority between the two in accordance with their applicable law. What s a Control Agreement? A control agreement is a method of acquiring or disposing of an interest in securities held by an account holder with an intermediary without making a book-entry. It is similar to an earmarking, with the most obvious difference between the two being the requirement for an entry or mark to be made on the account if an earmarking is used. As currently drafted, the definition of a control agreement in the SLD is complex and difficult to understand as a legal concept. However, there are many forms of control agreements, for example as floating charges, pledges, or usufructs, with which other Member States will be familiar. While credits to securities accounts are generally used by participants to perform straightforward sales and repurchase agreements (repos), when faced with a variety of methods of creating interest over securities held in accounts with different effects, financial law experts reacted by employing a functional and neutral approach to design the concept of a control agreement 6. The functional method was developed to provide uniform rules based on principles that can be implemented by Member States without requiring them to fundamentally change their national legal concepts. Using the term control agreement instead of floating charge or pledge 6 Pg. 45, Second Advice of the Legal Certainty Group, Solutions to Legal Post-Trading within the EU, August 2008, states...a sheer unlimited variety of legal concepts is used throughout Member States, in particular pledge, legal or equitable mortgage, repo, fixed and floating charges, etc. It is worth noting that even if legal concepts of two or more jurisdictions are termed the same way they most probably differ at least regarding the details of their legal requirements. 18