Modern securities markets are moving away from a paper-based direct holding system to an intermediated holding system, which provides for electronic book-entry debits and credits to securities accounts irrespective of the political or geographic location of the securities. While efficient and cost-effective in practice, these changes have created uncertainty as to what law applies in cross-border securities transactions. The Hague Convention on the Law Applicable to Certain Rights in Respect of Securities held with an Intermediary (the Convention) was conceived as a response to that problem. While much could be said about the Convention, we focus this discussion on the differences between the default choice of law rule under the Convention compared with those under Articles 8 and 9 of the Uniform Commercial Code (UCC) and the ramifications of such differences on existing and future transactions.
The Convention was formulated at The Hague Conference on Private International Law by 45 countries, with substantial participation by the U.S. private sector. Although the United States and Switzerland signed the Convention together on July 5, 2006, the Convention does not go into effect until it is ratified by three countries. On Dec. 15, 2016, the United States deposited its instrument of ratification of the Convention and became the third country to ratify the Convention, following the lead of Switzerland and Mauritius. Pursuant to the terms of the Convention, the Convention will come into effect beginning on April 1, 2017 (the Effective Date), the first day of the month following the expiration of the three-month period after the third instrument of ratification is deposited. The Convention is “self-executing,” which means that on the Effective Date, it will be controlling law within the United States with respect to cases or transactions to which it applies, without any need for further legislative enactment or implementation. In addition to the United States, Switzerland and Mauritius will also then be bound by the Convention.
There are some limits on the scope of the Convention. First, the Convention does not apply to all securities but only those held indirectly with an intermediary. This means that any securities directly held by an issuer, a transfer agent or an investor would not be subject to the Convention. Second, there is a threshold level of “internationality” which would have to be satisfied in order for the Convention to apply. This threshold is considered to be fairly low — unless there is absolutely no element in the facts of a case that might require a choice as to two or more legal systems, the Convention applies. Lastly, the choice of law rules under the Convention do not apply to all legal issues that may arise out of or be related to situations where securities are held with an intermediary and the internationality threshold is satisfied. The substantive scope of the Convention is limited to a certain set of enumerated issues identified in Article 2(1) of the Convention (Relevant Issues), which includes the perfection and priority of a security interest in securities entitlements credited to a securities account.
Choice of Law Under the Hague Convention
Under traditional conflict of laws principles, the question as to what law applies is determined by looking through the intermediaries to the location of the securities in question (the lex rei sitae rule), which inquiry becomes increasingly difficult for intermediated and dematerialized securities. In contrast to the lex rei sitae rule, the Convention adopts a variation of the Place of the Relevant Intermediary Approach (or PRIMA), which focuses on the relationship between the account holder and the intermediary.
Under Article 4 of the Convention, the law applicable to the Relevant Issues is the law expressly agreed to in the account agreement between the account holder and the relevant securities intermediary, which could take the form of a general governing law clause or a clause that focuses directly on the Relevant Issues.1 The parties, however, do not have complete freedom to stipulate the applicable jurisdiction. The Convention provides that the securities intermediary also has to have a “qualifying office” in the stipulated jurisdiction.2 Notably, since the United States is a “multi-unit state,” as defined in the Convention, if the chosen law is that of a U.S. state, the qualifying office test is satisfied if the securities intermediary maintains an office in any U.S. state.3
If the account agreement is silent as to the applicable law or if the intermediary does not have a qualifying office in the stipulated jurisdiction, the analysis then turns to the fallback rules set forth in Article 5 of the Convention. Article 5 provides that, to the extent it is clear that the relevant intermediary entered into the account agreement through a particular office, the applicable jurisdiction shall be the jurisdiction in which that office is located. In the event the account agreement is silent on that point, the applicable jurisdiction shall be determined by reference to the jurisdiction under which the securities intermediary is organized and, if the jurisdiction of organization is either undeterminable or insufficient because the country in question is a “multi-unit state,” then by reference to the securities intermediary’s principal place of business.
Choice of Law Under the UCC
Similar to the Convention, the UCC had adopted a variation of the PRIMA principle — the default rule is that the applicable law is the law of the jurisdiction expressly agreed to in the account agreement as being the securities intermediary’s jurisdiction. Unlike the Convention, however, this UCC choice of law rule does not have a qualifying office requirement. To understand how this difference may play out in practice, consider the following example.
A French securities intermediary without a qualifying office in the United States and a Delaware account holder stipulate New York as the jurisdiction of the French intermediary in the account agreement. Under the UCC, perfection of a secured party’s security interest in the securities entitlements credited to a securities account with the French intermediary would be determined by reference to New York substantive law. Under Article 4 of the Convention, to arrive at the same conclusion, (i) the account agreement would need to provide that New York law is either the governing law for the account agreement or the applicable law with respect to the Relevant Issues, (ii) the French intermediary would need to have a qualifying office in the United States and (iii) the account agreement would need to specify that the securities intermediary’s jurisdiction is New York. If the governing law is French law and the account agreement is silent on the law applicable to the Relevant Issues, then notwithstanding the stipulation that the jurisdiction of the French intermediary is New York, French substantive law would govern perfection instead of New York law. If the French intermediary does not have a qualifying office in the United States, irrespective of whether there is an express agreement in the account agreement as to applicable law, the analysis would be redirected to the fallback rules set forth in Article 5 of the Convention, which would likely point to French substantive law. Assuming the first two requirements are satisfied and we have arrived at New York substantive law as the applicable law, then the last step of the analysis mirrors the analysis under the UCC. Under New York law, perfection of a secured party’s security interest in the securities entitlements credited to a securities account is determined by reference to the law of the jurisdiction expressly agreed to in the account agreement as being the securities intermediary’s jurisdiction.
To reduce the cost and disruption that might be caused by the need to amend pre-Effective Date account agreements to reflect the choice of law rules under the Convention, Article 16 of the Convention loosens the express agreement requirement in the following two scenarios: (i) if there is an agreement, implied or otherwise, that the securities account is maintained in a particular state, then the law of that state shall be applicable to the Relevant Issues and (ii) if the express words in the account agreement would, under the law governing such account agreement, have the effect of determining the law governing any of the Relevant Issues, then such law shall apply to all the Relevant Issues; provided that, in each of the foregoing scenarios, the related intermediary satisfies the qualifying office requirement.
Impact on Existing and Future Transactions
After the Effective Date, by virtue of the Supremacy Clause, the Convention will pre-empt the choice of law rules under Articles 8 and 9 of the UCC to the extent inconsistent with the Convention, and this has implications for not only new transactions going forward, but also the transactions in effect prior to the Effective Date. Accordingly, secured parties should review their proposed and existing collateral packages to understand the actions needed to obtain and maintain perfection with respect to intermediated securities subject to the Convention.