Magazine article The Journal of Lending & Credit Risk Management

Investment Property: Perfection of Security Interests through Control Agreements

Magazine article The Journal of Lending & Credit Risk Management

Investment Property: Perfection of Security Interests through Control Agreements

Article excerpt

Collection on the loan remains the lender's goal. As the lending transaction grows in complexity, the amount of information needed to ensure collection grows as well. This article presents the need for a thorough understanding of the various investment properties used in securities lending and the role of a control agreement in the perfection of security interests.

The 1994 revisions to the Uniform Commercial Code (UCC), now in the process of being adopted by various states, effected a number of changes to the rules governing investment property as collateral. Two of the most important developments were the recognition of indirect ownership of investment property through security entitlements and the use of "control" agreements as a method for perfecting a lender's security interest in investment property.

Understanding what is, and more importantly, what is not obtained as collateral through "control" agreements is critical to credit policies and credit judgments. Understanding the various types of investment property and indirect ownership of securities is equally critical to the credit process.

Where's the Security?

Perfection of security interests begins with the most basic factual question a lender must ask a borrower when taking an investment property as collateral (for discussion purposes, 100 shares of Acme Manufacturing Corp. stock): Where are the shares of stock? How the borrower answers that question will determine what steps the lender must take to obtain and perfect a security interest. The answer also will tell the lender what kind of investment property is actually being offered as collateral: an actual investment security or something inherently different - the borrower's right to an investment security from a third party - a security entitlement.

Certificated Security

If the borrower's response to the question is the production of an actual stock certificate registered in the borrower's name, the lender's job is an easy one. The value of the collateral can be determined, and the steps required by the UCC are simple. A security agreement is signed by the borrower and the certificate is delivered to the lender with a proper endorsement by the borrower, either on the certificate or on a stock power.

Broker Account

If the borrower informs the lender that the borrower's 100 shares are being held by a stockbroker, the process for the lender becomes more complicated. Upon contacting the broker, the lender may learn that the broker is, in fact, holding the stock certificate (registered in the borrower's name and with no endorsement) in safekeeping. In that event, the collateral is an investment security, and the steps that the lender should take are, again, simple. A security agreement is signed by the borrower and the certificate is delivered to the lender with a proper endorsement by the borrower, either on the certificate or on a stock power. (Please note that other steps for perfection are permissible under the new UCC, but they are less desirable from the lender's viewpoint.)

Indirect Ownership of a Security

It is more likely that, upon contacting the broker, the lender will learn that the borrower has an account with the broker to which the 100 shares of Acme stock have been credited. However, the lender also will learn that the broker does not have the certificate purportedly owned by the borrower and that the borrower is not the registered owner of the 100 shares. The stockbroker, instead, has an account with the Depository Trust Company (DTC), and the DTC has credited the stockbroker's account with 100 shares of Acme stock. The DTC has in its possession a certificate for the 100 shares. However, the DTC itself is the registered owner of the certificate on the books of Acme Manufacturing Corp. (The DTC, in its nominee name, Cede & Co., is the registered owner of approximately two-thirds of all of the shares of all publicly traded companies. …

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