Sixth Circuit Decision Raises Question About Effectiveness of Broker-Dealer Liens on Customer Assets

February 15, 2012


A recent affirmation by the U.S. Court of Appeals for the Sixth Circuit of a lower court decision in Monticello Banking Company v. Flener1 raises concerns about the ability of a broker-dealer to obtain a lien on a customer’s assets that it holds as custodian without using specific Uniform Commercial Code (“U.C.C.”) terminology to describe the assets that is not commonly used in customer agreements in the securities industry.

Under the “indirect holding system” set forth in the U.C.C., broker-dealers, rather than directly holding certificates evidencing customer securities, can utilize sub-custodians, such as The Depository Trust Company, to hold securities. In U.C.C. terminology, a broker’s customer has a “security entitlement”2 in the “financial assets”3 held by the broker in the customer’s “securities account.”4 Securities entitlements and the securities account are “investment property” for purposes of the U.C.C.5 Each of the broker-dealer and the sub-custodian holding the securities is a “securities intermediary.”6

In order to obtain a lien on customer assets, or a “security interest”7 under the U.C.C., the broker needs to enter into a “security agreement”8 with the customer granting the security interest. Almost universally, brokers use the customer agreement as a security agreement.

Under the ruling in Monticello, a broker that fails to describe a customer’s interest in securities or other property by using technical terminology from the U.C.C., such as “security entitlement,” despite describing the underlying property itself, would not have a valid security interest. In our experience, very few, if any, broker-dealers use the U.C.C. terminology such as “security entitlement,” “securities account,” or “investment property,” in customer agreements. Instead, more common terminology such as securities, property, etc., is used.

While the ruling in Monticello is based upon a unique set of facts and is inconsistent with the plain language of the U.C.C., the general lack of judicial guidance in this area may permit a customer to use the Monticello decision to argue that a broker does not have a security interest in a customer’s securities and other financial assets.

Security Interest Attachment in Investment Property

Under U.C.C. § 9-203, a broker-dealer’s security interest attaches to its customers’ investment property (security entitlements and security accounts) if (1) value has been given; (2) the debtor has rights in the collateral or the power to transfer rights in the collateral; and (3) the debtor has authenticated a security agreement that provides a description of the collateral.9 U.C.C. § 9-108(d) provides a list of ways to describe collateral that is investment property to satisfy the description requirement. Specifically, § 9-108(d) states that a description of a security entitlement, securities account, or commodity account is sufficient if it describes:

  1. the collateral by those terms or as investment property; or
  2. the underlying financial asset or commodity contract.

Also, under U.C.C. § 9-203, a securities intermediary may gain an enforceable security interest against the debtor and third parties through control of the debtor’s collateral.10 Control, for purposes of the U.C.C., is the power of the secured party to direct the disposition of collateral without further action or consent of the debtor.11 U.C.C. § 8-106 provides “[i]f an interest in a security entitlement is granted by the entitlement holder to the entitlement holder’s own securities intermediary, the securities intermediary has control”.12

The Monticello Decision

In Monticello, the Sixth Circuit affirmed a decision of the United States District Court for the Western District of Kentucky holding that, under Kentucky law, in order for a security interest in a customer’s security entitlement in certificates of deposit issued using Promontory Interfinancial Network LLC’s Certificate of Deposit Account Registry Service® or CDARS® (the “CDs”) to attach, the security agreement signed by the customer must contain a description of the CDs as a “security entitlement,” “securities account,” or “investment property,” or a detailed description of the CDs themselves.13 The court held also that “without an adequate description, Monticello cannot have a secured interest through control.”14

Using CDARS, a bank acts as custodian for its customers in holding CDs issued by other banks. The custodial banks are “securities intermediaries” for purposes of the U.C.C. Each CD is evidenced by a book-entry on: (1) the records of the issuing bank reflecting ownership of the CD by The Bank of New York Mellon (“BNYM”); (2) the records maintained by BNYM as sub-custodian reflecting the ownership of the CD by the custodian bank; and (3) the records maintained by the custodian bank reflecting ownership of the CD by the customer. Though not a “security”15 for purposes of Article 8 of the U.C.C., each CD is a “financial asset.”16

The District Court stated that nothing in the security agreement “described, or even acknowledged the existence of, underlying financial assets”17 and therefore, the description was insufficient to grant a security interest in a security entitlement under KRS 355.9-108(4) (U.C.C. § 9-108(d)).

The description utilized by the custodial bank provided that the depositor granted the bank

a security interest in all Debtor’s demand, time, savings, passbook or similar accounts maintained at Bank, and any other bank or financial institution, including but not limited to, those deposit accounts styled and numbered as follows: …assignment of Certificate of Deposit #—-2581 at CDARS CD dated September 30, 2005, issued in the amount of $200,907.28, at the rate of 3.85%, maturing on March 30, 2006. . . . as well as all rights title, interests, and choses in action associated with the deposit account(s) and the proceeds thereof [.]18

Because the description of the collateral did not describe it as a “security entitlement,” “securities account,” or “investment property,” the District Court focused on whether the security agreement adequately described the underlying financial assets, which all parties agreed were the CDs. As described above, the description of the underlying financial assets, the CDs, included the name – CDARS CD, the custodial account number – 2581, the date the CDs were issued – September 30, 2005, the aggregate principal of the CDs – $200,907.28, the interest rate payable on the CDs – 3.85%, and the CDs’ date of maturity – March 30, 2006. The District Court held, and the Sixth Circuit agreed, that “none of the underlying CDs are in any way identified in the security agreement” and that without sufficient description, there was no attachment of the security interest.19 The District Court held also that an enforceable security interest did not exist through control. The District Court reasoned, “[i]f the security agreement does not have a sufficient description to meet the requirements of attachment, it also leaves unclear which accounts, exactly, the debtor was giving up control of.”20

The Effect of Monticello on Brokerage Agreements

The Monticello decisions provide a legal foundation to debtors and third parties wishing to challenge a broker-dealer’s security interest in securities and financial assets held by a broker for its customers. Seemingly, the description in Monticello identifies the underlying financial assets as required by U.C.C. § 9-108(d)(2), and any party would have notice from this description that CDs issued using CDARS were a part of the collateral.21 While we do not agree with the court’s decision, as a result of this holding, and even when the broker-dealer has control of the collateral, the broker-dealer should (1) consult with counsel to determine whether, under relevant state law, the broker-dealer’s customer agreement adequately describes customers’ security entitlements held in customers’ securities accounts and (2) consider adding the technical terms under U.C.C. § 9-108(d)(1) – “security entitlement,” “securities account,” or “investment property” – to customer agreements.

For additional information, please contact Tony Nuland at (202) 737-8833 or Paul Clark at (202) 737-8833.


1 Monticello Banking Company v. Mark H. Flener, No. 1:10-CV-121-R, 2010 U.S. Dist. LEXIS 132300 (W.D. Ky. Dec. 14, 2010), aff’d sub nom. Joe S. Alexander, et al. v. Monticello Banking Company, No. 11-5054 (6th Cir. Dec. 14, 2011) (“Monticello”).

2 “Security entitlement” means the rights and property interest of an entitlement holder with respect to a financial asset. U.C.C. § 8-102(a)(17).

3 A “financial asset” is a security; an obligation of a person or a share, participation, or other interest in a person or in property or an enterprise of a person, which is, or is of a type, dealt in or traded on financial markets, or which is recognized in any area in which it is issued or dealt as a medium for investment; or any property held by a securities intermediary for another person in a securities account if the securities intermediary has expressly agreed with the other person that the property is to be treated as a financial asset under article 8 of the U.C.C.. U.C.C. § 8-102(a)(9).

4 “Securities account” is an account to which a financial asset is or may be credited in accordance with an agreement under which the person maintaining the account undertakes to treat the person for whom the account is maintained as entitled to exercise the rights that comprise the financial asset. U.C.C. § 8-501.

5 “Investment property” means a security, whether certificated or uncertificated, security entitlement, securities account, commodity contract, or commodity account. U.C.C. § 9-102(a)(49).

6 A “securities intermediary” means: (i) a clearing corporation; or (ii) a person, including a bank or broker, that in the ordinary course of its business maintains securities accounts for others and is acting in that capacity. U.C.C. § 8-102(14).

7 A “security interest” means an interest in personal property or fixtures which secures payment or performance of an obligation. U.C.C. § 1-201(b)(35).

8 A “security agreement” means an agreement that creates or provides for a security interest. U.C.C. § 9-102(a)(73).

9 U.C.C. § 9-203 (emphasis added).

10 In lieu of the third requirement of U.C.C. § 9-203 (a security agreement that provides a description of the collateral), a security interest attaches and becomes enforceable against the debtor if the “…secured party has control…pursuant to the debtor’s security agreement.” U.C.C. § 9-203(b)(3)(D).

11 See U.C.C. §§ 8-106, 9-104 and 9-106.

12 U.C.C. § 8-106(e).

13 Monticello, 2010 U.S. Dist. LEXIS 132300 at *6.

14 Id. at *11.

15 U.C.C. § 8-102(a)(17).

16 See U.C.C. § 8-102(a)(9), supra note 3.

17 Monticello, 2010 U.S. Dist. LEXIS 132300 at *8.

18 Id. at *6.

19 Id. at *8.

20 Id. at *12.

21 Official Comment #4 to U.C.C. § 9-108 states that “the use of the wrong Article 8 terminology does not render a description invalid (e.g., a security agreement intended to cover a debtor’s ‘security entitlements’ is sufficient if it refers to the debtor’s ‘securities’).” The District Court acknowledged that the CDARS CDs are financial assets but stated that nothing in the agreement describes, or even acknowledges the existence of underlying financial assets. This statement is contradicted by the description of the collateral in the security agreement, which describes “Certificate of Deposit #—-2581 at CDARS CD” and lists the total amount of the CDs, as well as the date, interest rate, and maturity date, which are the same for all three CDs.