Treatment Of Hybrid Accounts Under Articles 8 and 9 of the UCC

Overview of Interplay Between
Securities Accounts and Deposit Accounts

Article 8 of the Uniform Commercial Code (the “UCC”) sets out the rules for evidencing and transferring financial assets held through direct registration or the indirect holding system. ¹This article focuses on certain aspects of the indirect holding system and does not address directly held financial assets. To utilize the indirect holding system, a customer will typically establish a relationship with a financial institution. In setting up this relationship, the customer and the financial institution will enter into a custodial or account agreement that memorializes the responsibilities of the parties and the operational and logistical aspects of the relationship and the accounts. These accounts can be established to hold a wide range of financial assets.

There are certain key concepts relating to the categorization of property rights for the indirect holding system under Article 8 of the UCC (“Article 8”). One of these key concepts is the definition of “securities entitlement.” An asset will consist of a security entitlement when it is both a (1) a “financial asset” (See UCC Section 8-102(9)), and (2) held in an Article 8 “securities account.” In many cases, the assets held in a securities account will consist of uncertificated equity and debt securities that are “dealt in or traded on financial markets,” “securities exchanges or securities markets.” See UCC Section 8-102(9) and (14). These types of assets are by definition a financial asset, so once they are credited to a securities account, they create “securities entitlements” under Article 8. In the indirect holding system, a customer’s rights are in the security entitlements to that underlying security. Official Comment 4 to UCC Section 8-501 states that “persons who hold securities through brokers or custodians have security entitlements..., rather than being treated as the direct holders of the securities.”

The holder of the securities entitlement rights (i.e., an “entitlement holder” as defined in UCC Section 8-102(a)(7)) has the right to give entitlement orders to the financial institution that holds the securities account, deemed in Article 8 as the “securities intermediary” (See UCC Section 8-102(a) (14)), which includes orders to buy, sell and vote shares and to collect dividends or interest payments. The securities intermediary is obligated to comply with these orders from the entitlement holder with respect to financial assets held in a securities account.

For a variety of reasons, the customer will also need the securities intermediary or custodian to hold its cash deposits, which could derive from dividends, interest or sale proceeds or through a direct deposit of cash by the customer.

In order to create operational efficiencies, many of the large custodians utilize a so called “hybrid” account structure. A typical hybrid account will be assigned a single account number and title and is deemed by the parties to consist of both (i) a “deposit account” with respect to any cash held in that account, and (ii) a “securities account” with respect to any securities credited to that account. The custodian will typically represent that it will keep proper records regarding the allocation of the cash and securities to the different components of this single account.

The usage of the hybrid account has raised certain concerns for secured parties under the UCC with respect to obtaining perfection by control of such an account. This article will address these issues and discuss the reasons why a hybrid account should not adversely impact a secured party’s perfected interest in such account.

Cash as a Financial Asset

It should be first noted that a customer and a securities intermediary are free to elect to treat cash as a financial asset. ²For example, an account holder and a securities intermediary can elect to treat cash as a financial asset by including language in the custodial or account agreement similar to the following: “Any property (including cash) held in the Account shall be deemed to be a “financial asset” for purposes of Article 8 of the Uniform Commercial Code.” The ability of the parties to treat cash as a financial asset is set forth in clause (C) of the definition of “financial asset.” See UCC Section 8-102(a)(9)(C). This clause expands the definition from simply equity and debt securities to include any property held by a securities intermediary for a customer if the securities intermediary has expressly agreed that the property shall “be treated as a financial asset under” Article 8. See UCC Section 8-102(a)(9)(C). The party’s ability to mutually elect to treat any type of asset held in an account as a “financial asset” is reflective of the progressive nature of Article 8. The drafters of Article 8 anticipated that the operational aspects and market procedures of the indirect holding system would evolve over time, so they created significant flexibility and bilateral rights in Article 8 to accommodate the evolving markets. ³James Steven Rogers, Policy Perspectives on Revised U.C.C. Article 8, 43 UCLA Law Review 1431 (1996).

Even though parties can treat cash as a financial asset, custodians typically push back on making this election. One of the primary reasons for this market practice is the requirements of UCC Section 8-504. Under UCC Section 8-504, any cash (or other asset) held as a financial asset in a securities account will require the securities intermediary to maintain sufficient financial assets to satisfy all entitlements that are owed in favor of a customer. This requirement – better known as the “perfect match” system – mandates that the custodian or securities intermediary has to reserve against cash on a dollar for dollar basis. Such matching then prevents the securities intermediary from utilizing such cash as liquidity for its lending operations and can create operational issues for certain custodians.

At the same time, sophisticated customers have also shown little appetite for letting cash sit in a deposit account portion of the hybrid account due to the low interest return to be earned and potential risks in a bank failure scenario. To provide customers with additional options, certain intermediaries offer an automated cash sweep program. These sweep platforms move cash on a daily basis into money-market or treasury funds selected by the customer. ⁴For example: https://www.wellsfargo.com/investing/cashsweep/ The shares of money–market funds or treasuries purchased through the sweep program will then be credited as financial assets into the securities account. The sweep program is noted in this article because in many cases any perfection concerns about the hybrid account may be further limited by the fact that cash deposits will only sit in the account for one business day before conversion into a form that expressly falls within the definition of “financial asset.”

Dual Arrangements:
Securities Account and Deposit Account

Without the agreement to treat cash as a financial asset, financial institutions may bifurcate their relationship with a customer into two separate accounts. In those cases, the financial institution will hold financial assets for a customer as securities intermediary and establish a separate securities account. In addition, the financial institution will act as a “bank” (as defined in UCC Section 9-102(a)(8)) and hold cash in a separate demand, savings or similar account, which the UCC defines as a “deposit account.” See UCC Section 9-102(a)(29). This arrangement has become the minority method among the large custodians, who have moved to the hybrid arrangement discussed above that uses one account to serve as both the securities account and the deposit account.

Perfecting a Security Interest in a
(i) Securities Account with Cash and (ii)
Dual Securities Account/Deposit Account Arrangement

Perfection of a security interest in a securities account and in a deposit account are generally accomplished in the same manner: by obtaining “control” over the relevant account, which is typically done through a tri-party agreement among the customer, the secured party and the securities intermediary or bank, as applicable. ⁵A secured party may also obtain control (i) with respect to a deposit account, by being the bank with which such account is maintained or becoming the bank’s customer with respect to such account or (ii) with respect to a securities account, by delivery of the securities to the secured party, with a proper indorsement in certain circumstances. See UCC Sections 8-106 and 9-104. Unlike a securities account, where filing is a permitted method of perfection, a primary lien in a deposit account can only be perfected by control. See UCC Sections 9-104(a), 9-312(a) and (b) and 9-314(a). ⁶Note that this limitation on perfection of a lien in a deposit account does not apply to the perfection of proceeds held in such account, which proceeds may be perfected by filing in accordance with UCC Section 9-315. In both cases, by perfecting in a securities or deposit account, the secured party becomes automatically perfected in all of the pledgor’s rights to the assets held in those accounts.

Assuming the cash is not treated as a financial asset and the custodian sets up a separate deposit account and a separate securities account, the secured party can perfect by control on each account independently.

But, what happens when a secured party is faced with a “hybrid account”?

STRICT DEFINITIONAL ARGUMENT:

As mentioned above, Article 8 is intended to adapt to the evolving practices of the indirect holding system. Some commentators, however, have proposed a strict definitional argument with respect to the hybrid account by suggesting that such structure may prevent a secured party from perfecting by control in a customer’s rights in the cash held in such accounts. This argument goes as follows: (1) by assigning only a single account number to the titled account that is at issue, the custodian/intermediary and the customer have only created a single account regardless of the contractual agreement between the parties; (2) if there is only a single account, then it must be a securities account since an account that holds securities and securities entitlements is expressly excluded from the definition of “deposit account,” (See UCC Section 9-102(a)(29)); (3) therefore, if it is a securities account and the cash is not treated as a financial asset, then the control agreement alone may not serve to perfect the secured party in such cash (i.e., the rights in the cash could be classified as a general intangible and may not be perfected through a securities account control agreement). This account number and definitional argument goes against the intent of Article 8, which was set up to adapt to, and not serve as an obstacle against, market changes, such as development of the hybrid account. In fact, in Official Comment 1 to UCC Section 8-501, the commentators explicitly state that the status of an account as a securities account is determined by “the expectations of the parties to the relationship.” The purely operational decision to consolidate a relationship under a single account title and number for purposes of the customer’s statements and for internal efficiencies does not change the expectation of the parties that the cash will be held in a deposit account and the securities will be held in a securities account. In addition, in Official Comment 1 to UCC Section 8-501, the commentators state that in determining whether an account is a securities account, such determination should not be decided by “dictionary analysis of the words.” The only difference between the hybrid account and the two separately titled and numbered accounts is the fact that the custodian has opted to only have a single account title and number. As discussed below, Article 9 does not even require a secured party to list account numbers when taking a lien in an account. Putting aside the account number issue, the custodian is still required in the hybrid account structure to maintain substantive safe keeping obligations of a securities account and a deposit account under the applicable regulatory schemes.

RELATIONSHIP ARGUMENT:

Using the relationship test that is based on Official Comment 1 to UCC Section 8-501 and assuming a securities intermediary is applying the proper substantive (back-office) treatment of a hybrid account, the following rationale should apply: (1) the customer and the custodian should be able to utilize one master account (or hybrid account) to serve as both a securities account and a deposit account through a proper description of the hybrid account in the account agreement or account control agreement, (2) the hybrid account should create a proper securities account and a proper deposit account for purposes of Article 8 and Article 9 to hold financial assets and cash, respectively, and (3) therefore, a secured party should be able to perfect its lien by control over the securities account component and the deposit account component of such hybrid account.

A question may be raised whether a collateral description that includes a single account number for two separate arrangements between a financial institution and a customer is sufficient for purposes of the UCC. Article 9 makes it clear that a secured party does not need to include the account number to have a sufficient description of a securities account or deposit account. UCC Section 9-108 rejects the “requirement that a description is insufficient unless it is exact and detailed (the so called ‘serial number’ test).” See Official Comment 2 to UCC Section 9-108. This language supports the argument that each arrangement between a customer and a financial institution does not require a separate account number to be identifiable.

Credit Balances

Assuming, for the sake of argument, that a court reviewing the hybrid structure adopts the “Definitional Argument” (discussed above) by determining the hybrid account is only a securities account, there are two potential treatments of a customer’s rights in the cash. The first argument is that the cash collateral is deemed to be a credit balance in the securities account, and the second argument is that the cash collateral is treated as a contractual arrangement and is some other form of collateral (e.g., general intangibles).

A secured party with a perfected security interest over a securities account also has a perfected security interest in any “credit balance” in the account. Any cash held in such account that is not held as a financial asset pursuant to an agreement of the parties will be a credit balance. Pursuant to Official Comment 4 to UCC Section 9-108, “given the broad definition of ‘securities account’ in UCC Section 8-501, a security interest in a securities account also includes all other rights of the debtor against the securities intermediary arising out of the securities account…[which] would include credit balances due to the debtor from the securities intermediary, whether or not they are proceeds of a security entitlement.” According to Official Comment 3 to UCC Section 9-314, “a ‘credit balance’ in the securities account … is a component of the securities account even though it is a personal claim against the intermediary.” The official comments and the commentators do not require that the credit balance (or free credit balance) be treated as a financial asset in order for it to be part of the securities account. ⁷While the terms “credit balance” and “free credit balance” are not defined in the UCC, the General Instructions to the Form Custody for Broker-Dealers as proposed by the Securities and Exchange Commission (the “SEC”) in Release No. 34-64676; File No. S7-23-11 (June 15, 2011), states that “free credit balance” means “any liabilities of a broker-dealer to customers and non customers that are subject to immediate cash payment to customers and non-customers on demand, whether resulting from sales of securities, dividends, interest, deposits, or otherwise ….” In reliance on this definition of “free credit balance” proposed by the SEC (and applying it to the financial institution regardless of whether the financial institution is a broker-dealer), any cash collateral held in the hybrid account, which for the sake of argument is assumed to be entirely a securities account, would represent a free credit balance, regardless of whether such cash collateral entered the hybrid account by means of deposit, dividend, sale or otherwise. Accordingly, a security interest in cash that is treated as a free credit balance in a securities account is perfected so long as the secured party’s security interest in the securities account is perfected. In addition, there are other situations where cash held in a securities account could also be perfected as “proceeds” of the financial assets credited to such account (e.g., when such financial asset is sold). See UCC Section 9-315.

A proper application of the intent of Article 8 and Article 9 should not result in the consolidation of a hybrid account into a single securities account, but even if that result occurs, a secured party should still remain perfected in the cash as a “credit balance” of such securities account.

Control Agreements Terms
For Hybrid Account Structure

To provide further clarity on this issue, when a secured party intends to perfect by control over a hybrid account, a secured party should consider including the following representations in the control agreement:

• With respect to financial assets, the financial institution agrees to act as a securities intermediary (as defined in UCC Section 8-102(a)(14)); and
• With respect to cash, the financial institution agrees to act as a bank (as defined in UCC Section 9-102(a)(8)).

In addition, any hybrid account arrangement should specifically state how the assets will be credited or held in the hybrid account and, therefore, a secured party should also consider including the following language in any control agreement covering a hybrid account:

• The hybrid account will serve as “securities account” with respect to all financial assets and financial entitlements credited to the account;
• The hybrid account will serve as “deposit account” with respect to cash deposited in the account;
• The financial institution will agree to follow instructions (including, entitlements orders) as to the securities, securities entitlements and cash held in the account without the customer’s further consent; and
• The custodian will agree to maintain proper records allocating the cash to the deposit account portion of the hybrid account and the securities/financial assets to the securities account portion of the hybrid account.

About the Authors:

Craig Unterberg is a New York partner at Haynes and Boone, LLP, who heads the firm’s Prime Brokerage and Equity Lending practice group. He concentrates his practice in the representation of borrowers and lenders in secured and unsecured lending and finance transactions, including margin stock lending, private equity and hedge fund financings, syndicated financings, mergers and acquisition financings, and distressed debt transactions. He can be reached at craig.unterberg@haynesboone.com. Alex Grishman, an associate at Haynes and Boone, LLP in the New York office, focuses his practice on commercial and corporate finance transactions, including the representation of banks, financial institutions and private investment funds in connection with margin stock lending, asset-based financings, acquisition financings, and the restructuring of existing credit facilities. He can be reached at alexander.grishman@haynesboone.com.