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Law Commission Review of Intermediated Securities

The Law Commission has published a “scoping paper” on Intermediated Securities (See Reference 1 below). This might sound a pretty dry technical subject but the subtitle of the report asks the important question – it covers “Who Owns Your Shares?”

I have written about the problem of the growth in the use of nominee accounts as on-line platforms have replaced share certificates many times in the past. ShareSoc has a web page with voluminous information on this subject including reports written by me (see Reference 2). It is certainly an area well overdue for reform.

I also submitted a personal response on the subject to the Law Commission (See Reference 3) – the Commission did quote from it in their report, but they did not get that many submissions from investors.

The Law Commission has actually done a good job of explaining most of the problems inherent in the current system of “intermediated securities”, otherwise known as the use of “nominee accounts”. I can do no better than to repeat their summary of the issues: “The system of holding investments through a chain of financial institutions (“intermediated securities”) stops investors being able to exercise shareholder rights and can lead to legal uncertainty”.

Issues Identified in the Scoping Paper

The Commission identifies these advantages and disadvantages of the current use of intermediated securities:

Advantages

The Commission found a number of strengths of the intermediated securities system, including increased efficiency and economies of scale, and convenience for ultimate investors, who may hold a diverse, cross-border portfolio of investments through a single intermediary.

Disadvantages

On the other hand, there are well-founded concerns relating to corporate governance and transparency, and uncertainty as to the legal rights and remedies available to an ultimate investor. An ultimate investor is not a “member” or shareholder of the company under the Companies Act 2006, and it is therefore unlikely that they will receive information from companies, have voting rights (for example at AGMs) or be able to attend meetings. Even where an ultimate investor is able to vote, they may find it difficult to confirm that their vote was received and counted by the company.

There is also legal uncertainty around a number of scenarios that could play out, including what happens when an intermediary in the chain becomes insolvent, and the legal position when intermediated securities are wrongly sold.

The fact that most retail investors do not own the shares they think they do is spelled out in this paragraph in the report summary: “As an ultimate investor, your name will not appear on the register of members and you are not a member of the company. You will not automatically have a direct relationship with the company. Instead, the financial institution (the “CREST member”) at the top of the intermediated securities chain will be the legal owner of the investments and the legal shareholder or member of the company. They will receive information and correspondence from the company, be able to attend company meetings and vote in relation to the shares”.

This is a good quotation from the full report: “When people have money saved, they may wish to invest it. But not all investments are straightforward to own. If you buy a gold bar, you own the gold bar. If you buy a piece of art, you own the painting or sculpture. If you decide to buy securities, such as shares or bonds issued by a company, the position is more complicated”. In essence, way too complicated!

The Scoping Paper explains all the above in a lot of detail, and they conclude by suggesting how the system could be improved, with a number of options covered.

Dematerialisation

They point out that the prospect of “dematerialisation” gives the opportunity to either remove intermediation altogether or introduce a genuine alternative for investors so that they could hold their shares directly if they wished. They favour the latter because they consider it more “proportionate”. But also suggest the Government should consider the long-term systemic advantages of removing intermediation altogether by the use of a “name on register” system.

The Law Commission’s report is very comprehensive (at 200 pages) and well covers the legal complexities. It also provides some useful information on the way shares are held and voting turn-outs.

Shareholder Engagement

One area which they do not cover well is the issue of the engagement with investors by companies and by other shareholders. Companies cannot communicate with their ultimate investors if they hold their shares in intermediated form. This can be very important when takeover bids arise or there are corporate governance issues (see pages 40-41 of the report). This is also very important when shareholders wish to communicate with other “members” (i.e. shareholders) which they have rights to do under the Companies Act. But this is thwarted when most shareholders are in nominee accounts (theoretically they can but practically it is almost impossible to do so in most cases – see pages 63 to 66 of the report where some solutions are suggested). But the Commission does not go into these issues because apparently this policy issue was not included in their terms of reference from BEIS. That is most unfortunate.

The failure to have all shareholders on the share register fatally undermines shareholder democracy. But even if the use of intermediaries was retained it is still possible to have all shareholders (including beneficial owners) on the share register. Technically that is not difficult to achieve (I speak as an former IT system designer). That would solve many of the problems associated with voting and shareholder democracy.

Chapter 3 of the Report on “Voting” gives you a good picture, if not understanding as it is horribly complex, of how shareholders can vote at General Meetings. This is normally possible, if your broker (nominee operator) agrees but perhaps at some cost. But it typically does not allow someone in a nominee account to appoint someone else as a proxy – you can only appoint your nominee operator. This is a big defect as it makes it difficult for any person or organisation to collect proxy votes.

Unfortunately the Commission only proposes minor improvements in the voting system, not a wholesale reform. But they do discuss extending the Shareholder Rights Directive to cover beneficial (ultimate) owners which it certainly should have done anyway, but did not as implemented in the UK.

Shareholder Rights

Chapter 4 of the Commission’s report covers the problems related to Schemes of Arrangement. The “headcount” test can result in bizarre consequences when such schemes are voted upon as only Members are counted, not beneficial owners. Or it can result in exploitation of the anomalies by clever persons. The Commission recommends the headcount test be removed which I consider makes sense but other provisions to protect small minority investors should preferably be added (relying on a court’s discretion to protect minorities does not in my experience work).

The Commission’s discussion of the “No Look Through” Principle in Chapter 5 makes for interesting reading. This principle in contract and trust law prevents any beneficial owner in a nominee account from pursuing the share issuer (company) in law as they only have a contract with their nominee operator. The Commission suggests some improvements that might assist in this area and which appear to be sensible.

Insolvency of Intermediaries

In Chapter 6 the insolvency of an intermediary is discussed, i.e. what happens if your stockbroker or platform operator goes bust. This is big concern for investors as the use of intermediaries undermines your legal rights of ownership to shares, and there have been a number of examples of where ultimate owners were prejudiced, or lost money, as a result. The use of “omnibus” or “pooled” nominee accounts is particularly dangerous.

The position of investors was improved when the Special Administration Regime was introduced but it has not resolved all the problems. The Commission proposes some improvements that might help but also suggests more research and consideration is required in this area. This area could justify a 200-page report alone and the solutions are not at all obvious.

Legal Matters

Chapter 7 of the report covers the legal problems associated with the sale and purchase of intermediated securities. It may be of more interest to lawyers than casual readers.

Chapter 8 covers dematerialisation (scrapping paper share certificates) and the opportunities for reform it creates. It covers the proposals developed by the Dematerialisation Working Group and Registrars Group to create a replacement electronic system. That would support a “name on register” system and hence preserve voting and information rights to certificated shareholders. But extending such a system to cover intermediated securities might be a very big and costly task it is suggested. It would also create some legal issues apparently.

Best Practice Principles and Further Work

The Commission recommends, in Chapter 9, that a new set of best practice principles be developed in regard to intermediated securities. The report explains how that might assist. The discussion makes it clear that a lot more work would be required in this area to develop a code of practice that was both clear and understandable by retail investors.

The report concludes by covering the areas where further work is required, which is clearly very extensive. It is does however provide a very comprehensive review of the legal and technical aspects of this subject and I could not find any inaccuracies therein.

It is good that they have clearly read, reported and understood the submissions not only by several individual investors like me, but also of ShareSoc and UKSA. I am hopeful the report will lead to some improvements in due course, but regrettably the pace of change is slow.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson  )

Reference 1: Law Commission – Intermediated Securities Scoping Paper: https://www.lawcom.gov.uk/project/intermediated-securities/

Reference 2: ShareSoc Shareholder Rights Campaign: https://www.sharesoc.org/campaigns/shareholder-rights-campaign/

Reference 3: Roliscon Submission to Law Commission: https://www.roliscon.com/Intermediated-Securities-Consultation.pdf

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