3Dematerialisation

The analysis contained in chapter 2 was concerned with securities transfers that are carried out by means of paper documents and applied to listed as well as unlisted securities. In this chapter, securities that are issued without paper certificates and their transfers will be examined, focusing exclusively on listed securities.

Paper documents were, traditionally, used in England to transfer both listed and unlisted securities. This changed when a transfer system was introduced through which transfers of listed securities could be effected by means of electronic instructions. The process whereby paper documents were replaced by electronic instructions is referred to as ‘dematerialisation’.

It is important to stress from the outset that dematerialisation in England developed in a path-dependent manner. To illustrate this, we need first to determine how listed securities used to be transferred prior to dematerialisation (section 3.1). After that, the process which led to dematerialisation will be examined (section 3.2).

3.1 Talisman

Until 1996, securities sold the London Stock Exchange were transferred by means of paper certificates and transfer forms. Successive stock exchange rules implemented continuously refined logistical regimes through which the transfer documents where received from the seller, allocated to the buyers and lodged with the issuers.

One example is the system which was in place between 1979 and 1996.1 This system was known under the acronym ‘Talisman’ which

1J. R. Bird [23.11], in Rt Hon. Lord Millet (ed.), Gore-Browne on Companies, 50th edn. Bristol: Jordans (2004); Robert Pennington, Company Law, 8th edn. London: Butterworths, (2001) 491–2.

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stood for ‘Transfer Accounting, Lodgement for Investors and Stock Management for Market Makers and Dealers’. Securities transfers were carried out every other week on what was called ‘settlement’ or ‘account’ days. Twice a year there was an interval of three weeks between the settlement days. Transfers were effected by means of Sepon (Stock exchange pool nominee), which acted as a nominee between account days on behalf of member firms and their clients who maintained Sepon accounts.

When a share transfer was agreed upon on the London Stock Exchange, both the buyer and the seller notified the stock exchange’s settlement centre. This matched the buyer’s and the seller’s notifications and sent a ‘sales docket’ to them which evidenced the sales contract. The seller then handed the paper documents to the stock exchange and the shares were transferred into Sepon’s name. Sepon became the securities’ legal owner upon entry of its name on the register. Sepon, however, did not hold the securities for its own benefit. In a path-consistent manner, the underlying documentation made use of the principal mechanism available to English property law, the trust. When holding legal title to the securities between account days, Sepon acted as a trustee, thereby giving its clients the benefit of a proprietary equitable interest in the securities.

The securities continued to be held in Sepon’s name until the next account day. Securities’ transfers between account days were not recorded on the issuer’s register, they were recorded only with Sepon. When securities were transferred, Sepon continued to hold the securities on trust. What changed, however, was the identity of the beneficiary. Between account days, equitable title was transferred from one transferee to another by book entry on Sepon’s books.2

On account day, the securities were transferred into the name of the person who was the last buyer to acquire them before account day. This meant that a buyer who bought securities and sold them within the same account period did not acquire legal title to the securities.

The use of Sepon as a nominee reduced the number of transfers that had to be registered. However often securities were sold on the stock exchange between account days, only two transfers had to be registered: the transfer from the first seller to Sepon and the transfer from

2J. Benjamin and N. Jordan, ‘Milking the Bull’, [1993] Butterworths Journal of International Banking and Finance Law 211.

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Sepon to the final buyer. The sales in between were recorded in Sepon’s books only.

The role of the Talisman transfer system was to receive the transfer documents, to keep records of transfers between account days, to issue transfer forms at the end of an accounting period and to pass these transfer forms, together with the securities certificates, to the issuer to allow for registration of the name of the buyer who was the last to buy before account day. Talisman did not keep the issuer’s register; it merely sorted documents and kept track of transfers between account days. Between account days, investors were protected through an arrangement providing for an express trust for the benefit of buyers of securities.

3.2 The need for reform

Paper-based transfer procedures, however sophisticated they may be, have limits as to the number of transfers they can process. In England it had become clear by 1987 that Talisman was unable to cope with the unprecedented trading volumes brought about by the privatisation programme of the 1980s. The need for reform became painfully apparent when the stock markets unexpectedly crashed on 19 October 1987.3

Sharp declines in securities values cause disturbance in any capital market. In England, however, the situation was exacerbated by the time-consuming paper-based settlement process. Because the market was falling rapidly, trading volumes increased and the stock exchange was unable to meet its standard settlement periods. The crux of the problem lay in the cumbersome process making physical delivery of large numbers of paper documents. Buyers who had entered into transactions before the crash took advantage of the delay in settlement to avoid completion of their transactions. This would not have been possible if the London market had had a settlement system that ensured prompt completion of transactions and, at the same time, was able to process large volumes. The obvious solution was to replace paper documents with computer entries. This replacement is often referred to as the ‘dematerialisation of share transfers’.4

3Seligmann, Michigan Yearbook of International Legal Studies, vol. IX, 1988 1 (1).

4Consultation Paper on Dematerialisation of Share Certificates and Share Transfers, (London: Department of Trade and Industry) (DTI), 30 November 1988.

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We have already seen that in English law certificates for registered instruments are documents of evidence only. When registered instruments are transferred a paper transfer form is completed to notify the issuer of the transfer. These two steps have historically evolved because the most reliable legal method through which registered securities could be transferred when securities started to appear first was by way of novation.

When paper documents were to be eliminated from the process of transferring and holding registered securities market participants did not first decide on the optimal operational solution and then create a new legal regime around it. Paper was rather eliminated by building on the existing legal framework: paper certificates and paper transfer forms were simply replaced by electronic instructions leaving the previous doctrinal analysis intact.

The Companies Act was amended in 1989 to allow for shares to be evidenced and transferred without a written instrument.5 CA 1989, s. 207 enables ‘The Secretary of State . . . [to] . . . make provision by regulations for enabling title to securities to be evidenced and transferred without a written instrument’. The regulations may make provision for procedures for recording and transferring title to securities, and for the regulation of those procedures and the persons responsible for or involved in their operation.6 CA 1989, s. 207 gives power to the Secretary of State to reform only the transfer procedure, and does not contain a power to change substantive property law. This means that any change based on the statutory provision must not interfere with the common law governing transfers of registered instruments. This is the framework within which the market participants masterminding the reform had to operate.

The policy reasons justifying the limitation of the power given to the Secretary of State by the Companies Act 1989 are explained in a consultation document published in 1988.7 The document reveals that the government had the following main matters in mind when considering the principles of the new regime:

5CA 1989 s. 207 (1989 c. 40) authorised the Secretary of State to adopt a respective regulation.

6CA 1989, s. 207 (2).

7Consultation Paper on Dematerialisation of Share Certificates and Share Transfers. (London: Department of Trade and Industry) (DTI), 30 November 1988.

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*There should be no change to the detriment of the shareholder or of the company either in the relationship between them, or in the position of the company’s register.

*The existing structure of rights and liabilities should be the basis for making corresponding provisions governing the obligations and liabilities of the operator of the system administering transfers

of paperless securities which are referred to as uncertificated securities.8

*The government also aimed to avoid imposing on a new scheme advantages or disadvantages over the existing paper-based system.

The cautious approach adopted by the government at the time may have been a reaction to institutional pressure to protect vested interests. It is, however, also attributable to the fact that, as a matter of principle, radical change is seen as being undesirable: remaining as closely as possible within orthodox legal doctrine when creating new legislation is an end in itself. Governments aim at implementing policy objectives as effectively as possible; when drafting legislation government lawyers are instructed to achieve the highest possible degree of legal certainty.9 This causes them to use well-established legal terms and legal concepts rather than creating a new statutory regime that does not fit with existing doctrine. This limits the range of choices available to law reformers and causes path-dependent legal development.

In addition to doctrinal constraints, market institutions also influence legal development. Their influence is, however, also shaped and constrained by the legal doctrine already in place. In England, the influence of financial market institutions on law reform became visible when the first attempt to create a dematerialised system was advanced under the acronym of TAURUS.10 TAURUS was launched by the London Stock Exchange. The stock exchange and its participants were, however, unable to implement a transfer mechanism that would both be efficient and satisfy the desire of all parties involved to maintain as far as possible the role they had played in the process prior to dematerialisation.11

What we observe here is an example of the influence exercised by the institutions prevailing in the English capital market. Incumbent

8Securities for which a paper certificate is issued are referred to as ‘certificated securities’ (para. 3, Uncertificated Securities Regulation (USR) 2001, SI 3755/2001).

9This argument applies irrespective of whether a particular legal system uses rules or

standards to regulate a certain matter (p. 226).

10TAURUS stands for ‘Transfer and Automated Registration of Uncertificated Stock’.

11Brian Cheffins, Company Law (Oxford: Oxford University Press, 1997) 369.