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Virginia Business Trust Act


How Do Stocks Get Traded in Today's Market?

Recent years have seen extreme volatility in the stock market, often without giving us a clue on what has caused a violent swing one way or another.  It has been our experience that clients of Saunders & Brown often have misconceptions about how trades are handled and such misconceptions have influenced their investment strategies. 

It is not the purpose of this article to delve into the mysteries of computer trading where trades may be accomplished in nano-seconds, thus throwing settlements into a cocked hat.  Rather I will briefly trace the evolution of stock holdings from the traditional possession and delivery of physical certificates to the current “indirect holding system.”  As we shall see, much of the current law has been in effect for quite a few years, but many still think of stock in terms of paper certificates that are transferred by endorsement and physical delivery.  In fact, that will still be the case with most small, closely held corporations but much of the following discussion will be relevant to you as an investor, buying and selling publicly traded securities.

The “law of stock holdings”, as it were, is found in Article 8 of the Uniform Commercial Code—“Investment Securities”.  The original version of Article 8 was based on the assumption that possession and delivery of physical certificates are the key elements in the securities holding and trading system.  The traditional certificate-based system of transfers was a complicated, labor-intensive process that reached crisis proportions in the late 1960's. So in 1978, Article 8 was amended to provide for "uncertificated" securities.  However, the system contemplated by these amendments differed from the traditional system only in that ownership of securities would not be evidenced by physical certificates.  Changes in ownership would continue to be reflected by changes in the records of the issuer, but instead of surrendering an endorsed certificate for registration of a transfer, an instruction would be sent to the issuer directing it to register the transfer.  But the principal mechanism through which securities trades are settled today is not delivery of certificates or registration of transfers on the issuer's books, but accounting entries on the books of a multi-tiered pyramid of securities intermediaries through which investment securities are held.  Individual investors who wish to be recorded as record owners on the issuer's books still may obtain and hold physical certificates. The certificates representing the largest portion of the shares, however, are not held by the beneficial owners, but by clearing corporations. Settlement of securities trading occurs not by delivery of the certificates or registration of transfer on the records of the issuers or their transfer agents, but by notation on the records of clearing corporations and securities intermediaries.  So a wholesale revision of Article 8 was enacted, effective in Virginia January 11, 1997.

What caused these sea changes that took but a short time to upset the way stocks had been handled for hundreds of years?  At the time of the paperwork crunch in the late 1960's, the trading volume on the New York Stock Exchange that so seriously strained the capacities of the clearance and settlement system was in the range of 10 million shares per day.  Today, the system can easily handle daily trading volume on routine days in the range of 150 to 200 million shares (the system even functioned smoothly during the October 1987 break when trading volume reached a record 608 million shares). Obviously, this processing capacity could have been achieved only by the application of modern electronic information processing systems.  Physical delivery of certificates plays only a minor role in the settlement system, yet the legal rules under which it operates are not the uncertificated securities provisions of Article 8. So let's take a look at what actually happens.

If one examined the shareholder records of any large corporation whose shares are publicly traded on the exchanges or over the counter market, one would find one entity - Cede & Co. - listed as the shareholder of record of somewhere in the range of 60% to 80% of the outstanding shares of all publicly traded companies.  Cede & Co. is the nominee name used by The Depository Trust Company (DTC), a limited purpose trust company organized for the purpose of acting as a depository to hold securities for the benefit of its participants, some 600 or so broker-dealers and banks.  Essentially all of the trading in publicly held companies is executed through the broker-dealers who are participants in DTC.  So rather than having to transfer shares back and forth between these broker-dealers and banks each time a trade is executed, all that needs to be done to settle each day's trading is for DTC to adjust the amounts shown in the participants' accounts.  And DTC does not record each transaction on its books one by one.  Significant processing efficiency has been achieved by netting all of the transactions among the major players that occur each day, so that entries need be made on the depository's books only for the net changes in the portions of each participant at the end of the day.  This clearing function is carried out by a separate corporation, the National Securities Clearing Corporation (NSCC).

The broker-dealers and banks who are participants in DTC-NSCC in turn provide analogous clearance and settlement functions to their own customers.  For example, If you buy 100 shares of XYZ Co. through Broker, and B sells 100 shares of XYZ Co. through the same Broker, the trade can be settled solely by entries on the Broker's books.  Neither DTC's books showing Broker's total position in XYZ Co., nor XYZ Co.'s books showing DTC's total position in XYZ Co. need be changed to reflect the settlement of this trade.

Virtually all publicly traded corporate equity securities, corporate debt securities, and municipal debt securities are now eligible for deposit in the DTC system.  For trading in mortgage-backed securities, such as GinnieMae's, a similar depository settlement system has been developed by the Participant's Trust Company.1 For trading in U.S. Treasury securities, a system somewhat analogous to DTC was put into place by the Treasury and the Federal Reserve System in the mid-1970's.  The Federal Reserve Banks, acting as fiscal agent for the Treasury, maintain records of the holdings of member banks of the Federal Reserve System, and those banks in turn maintain records showing the extent to which they are holding for their own customers, including government securities dealers, institutional investors, or smaller banks who in turn act as custodians for investors.

Both the traditional paper-based system, and the uncertificated system contemplated by the 1978 amendments to Article 8, can be described as "direct" securities holding systems; i.e., the beneficial owners of securities have a direct relationship with the issuer of the securities. In contrast, the DTC depository system for corporate equity and debt securities, or the Treasury-Federal Reserve system for government securities, can be described as "indirect" holding systems; i.e., the issuer's records do not show the identity of all of the beneficial owners. Instead, a large portion of the outstanding securities in any given issue are recorded on the issuer's records as belonging to a depository.  The depository's records in turn show the identity of the banks or brokers who are its members, and the records of those securities intermediaries show the identity of their customers.

Even after the 1978 amendments, the rules of Article 8 did not deal effectively with the indirect holding system because they are based on the assumption that changes in ownership of securities are effected in either or both of two ways: (1) delivery of physical certificates, or (2) registration of transfer on the books of the issuer. Yet in the indirect holding system, settlement of the vast majority of securities trades does not involve either of these events. So how do the 1997 revisions (Article 8A of the UCC) deal with this?

Direct Holding System. With respect to securities held directly, Article 8A retains the basic conceptual structure and rules of the “old” law. Therefore, two significant categories of securities will be relatively unaffected by the revision: (1) transactions involving securities issued by close corporations, and (2) transactions in publicly traded securities held by investors who chose to hold their own securities, registered in their own names.

Indirect Holding System. The starting point of Revised Article 8's treatment of the  indirect holding system is the concept of "securities entitlement." The term is defined as the package of rights that a person who holds securities through a securities intermediary has against that securities intermediary (not the company issuing the stock) and the property held by the securities intermediary. The term "entitlement holder" is used to refer to a person who has a securities entitlement. So the property interest of an investor who directly holds a security is still a security; the property interest of one who holds in indirect form is a securities entitlement.

Under the prior law, the you, the investor, is treated as a purchaser to whom an interest in a security is transferred when the securities intermediary makes entries on its books reflecting that a quantity of securities held by the intermediary in fungible bulk now belong to the customer.  The revised law does not describe the transaction as a "transfer" of an interest in some portion of a fungible bulk of securities held by the intermediary, but rather as the creation of a package of rights against the intermediary, and an interest in the property held by the intermediary.

Security Interests in Stocks.  What if you’re involved in a transaction that involves taking stock as, for example, security for a deferred purchase price.  The conceptual structure of the traditional possessory pledge remains the basis for security interests in securities, certificated or uncertificated, held directly or through intermediaries.  In many instances you will be dealing with a small, closely held corporation in which he stock is still evidenced by paper certificates.  But the notion that a security interest in a security can be created only by a method akin to the traditional possessory pledge had been abandoned.  

1 The recent implosion of some mortgage backed securities is a story for another day.