Security Entitlements under California Law

The Commercial Code, in Division 8, Chapter 5, deals with security entitlements for investment securities. Section 8501 defines the term “securities account.” A person acquires a security entitlement if a securities intermediary does any of the three specifies actions. If a condition has been met, a person has a security entitlement even though the securities intermediary does not itself hold the financial asset.

If a securities intermediary holds a financial asset for another person, and the financial asset is registered in the name of, payable to the order of, or specially endorsed to the other person, and has not been endorsed to the securities intermediary or in blank, the other person is treated as holding the financial asset directly rather than as having a security entitlement with respect to the financial asset. Note that the issuance of a security is not establishment of a security entitlement.

Section 8502 specifies that an action based on an adverse claim to a financial asset, whether framed in conversion, replevin, constructive trust, equitable lien, or other theory, may not be asserted against a person who acquires a security entitlement under Section 8501 for value and without notice of the adverse claim.

Section 8503 provides, to the extent necessary for a securities intermediary to satisfy all security entitlements with respect to a particular financial asset, all interests in that financial asset held by the securities intermediary are held by the securities intermediary for the entitlement holders, are not property of the securities intermediary, and are not subject to claims of creditors of the securities intermediary.

An entitlement holder’s property interest with respect to a particular financial asset is a pro rata property interest in all interests in that financial asset held by the securities intermediary, without regard to the time the entitlement holder acquired the security entitlement or the time the securities intermediary acquired the interest in that financial asset. Also, an entitlement holder’s property interest with respect to a particular financial asset may be enforced against the securities intermediary only by exercise of the entitlement holder’s rights.

An entitlement holder’s property interest with respect to a particular financial asset may be enforced against a purchaser of the financial asset or interest therein only if all of the four specified conditions are met. An action based on the entitlement holder’s property interest with respect to a particular financial asset, may not be asserted against any purchaser of a financial asset or interest therein who gives value, obtains control, and does not act in collusion with the securities intermediary in violating the securities intermediary’s obligations.

Section 8504 requires a securities intermediary to promptly obtain and maintain a financial asset in a quantity corresponding to the aggregate of all security entitlements it has established in favor of its entitlement holders with respect to that financial asset. The securities intermediary may maintain those financial assets directly or through one or more other securities intermediaries. In general, a securities intermediary may not grant any security interests in a financial asset it is obligated to maintain. A securities intermediary satisfies the duty if it does either of the two specified acts.

Section 8505 requires a securities intermediary to take action to obtain a payment or distribution made by the issuer of a financial asset. A securities intermediary satisfies the duty if it does either of the two specified acts. In addition, a securities intermediary is obligated to its entitlement holder for a payment or distribution made by the issuer of a financial asset if the payment or distribution is received by the securities intermediary.

Section 8506 requires a securities intermediary to exercise rights with respect to a financial asset if directed to do so by an entitlement holder. A securities intermediary satisfies the duty if it does either of the two specified actions.

Section 8507 requires a securities intermediary to comply with an entitlement order if the entitlement order is originated by the appropriate person, the securities intermediary has had reasonable opportunity to assure itself that the entitlement order is genuine and authorized, and the securities intermediary has had reasonable opportunity to comply with the entitlement order.

In addition, a securities intermediary satisfies the duty if it does either of the two specified acts. If a securities intermediary transfers a financial asset pursuant to an ineffective entitlement order, the securities intermediary is required to reestablish a security entitlement in favor of the person entitled to it, and pay or credit any payments or distributions that the person did not receive as a result of the wrongful transfer. If the securities intermediary does not reestablish a security entitlement, the securities intermediary is liable to the entitlement holder for damages.

Section 8508 requires a securities intermediary to act at the direction of an entitlement holder to change a security entitlement into another available form of holding for which the entitlement holder is eligible, or to cause the financial asset to be transferred to a securities account of the entitlement holder with another securities intermediary. A securities intermediary satisfies the duty if it does either of the two specified acts.

Section 8509 provides that, if the substance of a duty imposed upon a securities intermediary is the subject of a federal statute, regulation, or rule, compliance with that statute, regulation, or rule satisfies the duty. In addition, to the extent that specific standards for the performance of the duties of a securities intermediary or the exercise of the rights of an entitlement holder are not specified by other statute, regulation, or rule or by agreement between the securities intermediary and entitlement holder, the securities intermediary is required to perform its duties and the entitlement holder must exercise its rights in a commercially reasonable manner. The obligation of a securities intermediary to perform the duties imposed is subject to the two specified requirements.

Section 8510 states, in a case not covered by the priority, an action based on an adverse claim to a financial asset or security entitlement, whether framed in conversion, replevin, constructive trust, equitable lien, or other theory, may not be asserted against a person who purchases a security entitlement, or an interest therein, from an entitlement holder if the purchaser gives value, does not have notice of the adverse claim, and obtains control.

In a case not covered by the priority rules, a purchaser for value of a security entitlement, who obtains control has priority over a purchaser of a security entitlement who does not obtain control. Purchasers who have control rank according to priority in time of any of the three specified situations. Also, a securities intermediary as purchaser has priority over a conflicting purchaser who has control unless otherwise agreed by the securities intermediary.

Section 8511 states that, if a securities intermediary does not have sufficient interests in a particular financial asset to satisfy both its obligations to entitlement holders who have security entitlements to that financial asset and its obligation to a creditor of the securities intermediary who has a security interest in that financial asset, the claims of entitlement holders, other than the creditor, have priority over the claim of the creditor.

In addition, a claim of a creditor of a securities intermediary who has a security interest in a financial asset held by a securities intermediary has priority over claims of the securities intermediary’s entitlement holders who have security entitlements with respect to that financial asset if the creditor has control over the financial asset.