Monitor Daily

In the latest variation on “April Fool,” the Hague Convention on the Law Applicable to Certain Rights in Respect of Securities Held with an Intermediary will become effective in the U.S. on April 1, 2017. In one of its parting actions, the Obama administration ratified and accepted the convention, making the U.S. the third nation to do so. The convention, which had languished since its text was concluded in 2006, will enter into force on the first day of the month following three months after ratification. The other two nations that have accepted the convention are Switzerland and Mauritius. Are you asleep yet?

The reason readers need to pay attention is that the convention will apply, however inadvertently, to any securities account where there is a non-U.S. element. So even if the holder (the securities intermediary), the owner/pledger and the pledgee of the securities account are undeniably U.S. citizens, the convention nonetheless will apply if, for example, securities of a non-U.S. issuer are credited to the account at any time. Even if the parties were to prohibit the account from holding any non-U.S. securities, the convention still would apply if, at any time, a non-U.S. entity were to make a claim against the account or any of the assets in the account. Are you awake now?

Why Care?

Readers may ask, “Why do I care?” Possibly, the nature of your business never contains any non-U.S parties or assets. But securities accounts (rather than deposit accounts) have been the mechanism of choice for holding assets in a reserve account created as credit enhancement for a securitization transaction, for a holdback account in a portfolio sale or for a security deposit in a project financing or a substantial equipment lease transaction. If your business involves any of these situations, then you need to know more.

The purpose of the convention is not to establish any new substantive law rules. Instead, it provides a framework to determine which nation’s law (or the law of which territorial unit, such as a state of the U.S.) would apply to “all cases involving a choice between the laws of two different” nations. Fortunately, the basic rule is the applicable law is the law of the nation or territorial unit “expressly agreed in the account agreement.” The account agreement — not the control agreement, unless it expressly amends the account agreement — can either specify that the law of New York State can govern any dispute arising under the agreement, or it can specify that New York law will apply merely to the securities account issues listed in Article 2(1) of the convention.¹

Operational Presence

The primary rule will apply only if the securities intermediary has an operational office in the chosen jurisdiction.² That office must be engaged in the business of maintaining securities accounts, including administering payments relating to securities held generally by the intermediary. The office cannot simply be a call center, a mail drop or a tech support location. This alters the familiar rule under Uniform Commercial Code Article 8, in which the parties can stipulate that a particular jurisdiction is the securities intermediary’s jurisdiction for purposes of determining which law applies to perfection of a security interest.

If the operational presence test has been not met, the convention permits the parties to specify “expressly and unambiguously…in a written account agreement that the relevant intermediary entered into the account agreement through a particular office,” and hence that “the law applicable to all [Article 2(1)] issues…is the law in force in the [nation or state] in which that office was then located,” so long as that office had an “operational presence” at that time.

If the account agreement designation is not “expressly and unambiguously” stated, or if the “operational presence” for that office was not met at that time, then the applicable law is that of the jurisdiction where the intermediary was organized at the time the account agreement was entered into or, in the unlikely event that there is no account agreement, at the time the securities account was opened. The rules become even more complicated if, as is the case with the U.S., the nation is a multi-unit [nation], in which event the principal place of business (PPB) of the intermediary at the time the account agreement was entered into will control which law applies. And yes, if there is no account agreement, then the convention will look to the PPB at the time that the securities account was opened.

That’s a mouthful to swallow. Helpfully, the convention mentions four factors that do not affect the operational presence test: 1) where the issuer of the securities in the account is organized, 2) where certificates evidencing the securities are located, 3) where the register of the securities is maintained and 4) where any other intermediary, such as an owner trustee, might be located.

The convention applies “whether or not the applicable law is that of” the three countries that so far have adopted the convention, so merely designating Canadian law (or the Ontario PPSA) will not escape the Hague effect. More ominously, the convention declares that it also applies to any account agreement entered into, and to any securities account opened, before the convention entered into force. Unless the account agreement contains “an express reference” to the convention, then two alternatives are provided for pre-April 1, 2017 account agreements.

In the first, a designation of the law of a nation or state to govern the Article 2(1) issues will be given effect “provided that the relevant intermediary had, at the time the agreement was entered into, an office” in that designated jurisdiction which satisfied the “operational presence” condition. If the first alternative is not available, and if the parties to the account agreement “have agreed that the securities account is maintained in a particular” jurisdiction, then the law in force in that jurisdiction will govern the Article 2(1) issues, so long as — you guessed it — the relevant intermediary, at the time the agreement was entered into, had an office in that jurisdiction which satisfied the “operational presence” condition.

What Do We Do Now?

People can speculate why the Obama administration took action, during its waning days, on a relatively obscure international convention, which had not been ratified by any of Canada, the UK, the EU or Japan. Whether or not it resulted from the global emphasis that administration had evoked during its eight years in office, the equipment finance community needs to react. Here are some takeaways:

1. Continue to deal with securities accounts under the UCC. The convention is simply a choice of law artifice and does not obviate the need to comply with the UCC regarding creation, perfection and priority of security interests in securities accounts.
2. Include an “express reference” to the convention in your account agreements. Failure to do so will not be fatal, because of the alternatives described above, but doing so will avoid any further inquiry under those alternatives.
3. Have the intermediary agree not to change the choice of law. This can be covered via the typical “no amendment of any kind without investor consent” covenant. You do not want the choice of law to be changed to a jurisdiction that does not comport with the convention.
4. Consider prohibiting non-U.S. securities from being held in the securities account. This will reduce the likelihood that the convention would apply to that transaction.
5. Consider prohibiting non-U.S. investors in the transaction. This measure may not be necessary in a portfolio sale, and may be impractical in a securitization, project financing or syndicated lease or loan transaction.

You may wish that you had not read this far. But it’s better to be informed and do what is necessary than to become an April Fool when the convention takes effect.

Footnotes

1. The text of the convention can be accessed at hcch.net under the heading “Conventions.” Article 2(1) lists seven circumstances in which the choice of law would be pertinent.
2. However, that office can be anywhere in a multi-unit nation such as the U.S., so New York law can be a valid choice even if the intermediary’s operational presence is in another state.

“Don’t Be an April Fool: How to Avoid the Hague Hangover,” by Stephen T. Whelan was published in Monitor Daily on March/April 2017. Reprinted with permission. To view the article online, please click here.