I. Introduction
In July 2022, the UK Government set up the Digitisation Taskforce to eliminate paper certificates and to improve the current system of indirect share ownership.Footnote 1 In July 2023, the Digitisation Taskforce proposed to eliminate certificated shares, requiring existing holders of these shares to move them to indirect accounts. It also suggested that disclosure and a common messaging protocol will cause the market to make improvements to the position of indirect shareholders.Footnote 2
The present article criticises this approach and adds to the debate in two ways. Firstly, it is the first academic contribution to examine the most recent initiative advanced in this area and to connect competition law with the topic of intermediated securities. Secondly, the article integrates empirical evidence into the academic legal analysis of the topic. To our knowledge, this is the first academic article to do so.Footnote 3 The existing literature discusses the advantages and disadvantages of the current system but does not support the analysis with empirical evidence.Footnote 4 With funding from the British Academy, we conducted 18 semi-structured interviews with legal practitioners, investors, custodians, registrars, technology experts and voting agents.
We selected our interviewees on the basis of their respective roles and expertise. Initial contact was made via email and informed consent was obtained, ensuring confidentiality. We prepared a questionnaire, for which we received ethical approval by the grant’s host institution, covering: (1) the ability of investors to vote and exercise other corporate rights; (2) omnibus accounts and stock lending; (3) shortfalls (losses due to insolvency, negligence, or fraud by intermediaries); and (4) the role of technology. Interviews, conducted online, lasted 60 to 90 minutes and the questions were sent in advance. Some interviews required follow-up sessions for additional clarification and depth. Although limited in number, the interviewees are representative of standard market practices due to their respective professional backgrounds and the dominance of a few large custodians with similar business models in the market. We have anonymised their contributions and refer to them by number (interviewee 1, interviewee 2 and so forth).Footnote 5 The interviews have enabled us to develop a deeper and empirically grounded understanding of the current model of holding securities.
In the following sections, we firstly explain that shares in the UK are currently held in one of four forms. We will show that only certificated shareholders and those who hold uncertificated shares directly either as participants in the central securities depository in the United Kingdom (CREST) or as sponsored CREST members have full access to the rights associated with their shares. Investors who hold shares through nominees and custodian do not have the same rights.
In Section III, we discuss the Digitisation Taskforce and its Interim Report. This is followed by Section IV, where we use our empirical evidence to analyse the ability of the market to achieve reform justifying the elimination of paper certificates and improving the intermediated holding model.
In Section V, we examine the Government’s previous and failed attempt to encourage the industry to carry out reform. Section VI shows that the Shareholder Rights Directive II,Footnote 6 which imposes mandatory requirements on the industry, triggered reform, but did not improve the ability of all investors to enforce claims. The Directive does not apply to retail investors.
Section VII argues that a lack of competition may explain the poor quality of the current infrastructure. We observe that operational availability of enforcement rights is important for the oversight of issuers and argue that it would be wrong to rely exclusively on large institutional investors to oversee them.
Section VIII discusses the solutions proposed by the Digitisation Taskforce, the “Industry Group” and the Law Commission. It concludes that the “proof is in the pudding”. The market does not need the Government to eliminate paper certificates. If it offers an attractive model for holding uncertificated shares directly, investors will give up their certificates. To facilitate this, we propose that the Competition and Markets Authority (CMA) investigate the excessively high fees charged for sponsored CREST accounts. We further believe that legislative intervention is required to impose a duty on custodians to facilitate the exercise of shareholder rights by intermediated investors. We also support the Law Commission’s proposal to enfranchise ultimate investors by amending the Companies Act (CA) 2006 and the Financial Services and Markets Act (FSMA) 2000.
II. Four Forms of Holding Shares
A. Certificated Shares
Certificated shares are the traditional method through which investors hold shares. Holders of certificated shares have their name entered on the register of members of the issuer and receive a paper certificate evidencing this entry. They are considered legal owners and can hence exercise all the rights associated with their shares.Footnote 7 They receive dividends directly from the issuer, can vote and enforce any claims they have against the issuer.
Mark Austin estimated that issuers in the FTSE 100 and in the Premium Equity Commercial Companies segment of the Official List currently issue three per cent or less of their share capital in certificated form.Footnote 8 For the alternative investment market (AIM) companies there appear to be more certificated holders.Footnote 9 The Law Commission reports that registrars, who assist listed companies in maintaining their share register, indicate that there are in excess of 10 million investors who hold their shares in certificated form.Footnote 10 We understand that holders of certificated shares are typically retail investors.Footnote 11 As already mentioned, the Digitisation Taskforce has proposed legislation to eliminate this form of holding shares.
B. Uncertificated Shares (CREST Participants and Sponsored Members)
Uncertificated shares are administered through the central register for all uncertificated shares in the UK, CREST,Footnote 12 which is operated by Euroclear UK & International.Footnote 13 If an investor decides to hold shares directly in uncertificated form, they can either become a CREST participant or a personal CREST member.Footnote 14
CREST participants have a secure connection through which they send messages instructing the system to transfer securities to someone else’s account, for example. They connect to their computer a hardware unit supplied by CREST, which contains unique software keys.Footnote 15 The unit authenticates the messages that are sent between a participant and the CREST system. Personal CREST members are investors who have a CREST account in their own name but operate that account through a CREST participant, who sponsors them.
In the same way as certificated shares, an investor who holds uncertificated shares directly with CREST is considered the legal owner of these shares and can exercise all rights associated with them against the issuer. When CREST was first set up, the taskforce responsible for its design and implementation stressed that the sponsored membership was important for enfranchising smaller investors.Footnote 16
C. Uncertificated Shares Held Through an Intermediated Account
The fourth option is for an investor to hold shares in uncertificated form but indirectly through a nominee account administered by a custodian. This form of holding shares increased after the introduction of uncertificated shares and has become the most common form for holding shares not only in the UK but world-wide.Footnote 17
In this model, the names of individual investors are not recorded on the shareholder register. Instead, CREST records the names of nominees. The custodians who operate the intermediated account directly with CREST often hold accounts for a further level of custodians. Sometimes there are several levels of custodians operating between issuers and ultimate investors.Footnote 18
As we have pointed out, only registered shareholders have legal ownership and can exercise rights directly against the company.Footnote 19 Intermediated investors have a mere beneficial right in the interests held by their immediate custodiansFootnote 20 and consequently face legal and operational barriers to the exercise and enforcement of their rights.
Legal barriers arise from section 112 of the CA 2006, which requires companies to accept as shareholders only those individuals whose names are entered on the register of members. Investors who hold shares through one or more intermediaries, consequently, have no rights to vote, attend meetings, or enforce their rights against an issuer.Footnote 21 In theory, custodians should pass rights to ultimate investors,Footnote 22 but custody agreements can exempt them from relaying information and facilitating voting, or allow them to charge expensive fees for this service.Footnote 23 Intermediated accounts can also undermine the ability of investors to enforce rights against issuers. For example, in 2014 the High Court held that an intermediated investor did not have standing to enforce a remedy under section 98 of the CA 2006 (re-registering a public company as private).Footnote 24 Due to its similar wording, it is likely that courts will reach the same conclusion for section 633 of the CA 2006 (variation of class rights).Footnote 25 Intermediated investors are not able to vote on schemes of arrangement (section 899 of the CA 2006).Footnote 26 Concerns have also been raised over the difficulties experienced by ultimate investors to enforce sections 338 (power to require circulation of resolutions for AGMs),Footnote 27 570 and 571 (disapplication of pre-emption rights)Footnote 28 of the CA 2006 and also section 90A of the FSMA 2000.Footnote 29
The operational problems caused by the current system are due to the complexity and opacity of the holding chain. There are numerous layers of intermediation (often spanning multiple jurisdictions). Neither ultimate investors nor issuers know the identity of all the intermediaries operating along the chain.Footnote 30 We will see below that this structure limits the investors’ ability to benefit from the rights associated with their shares.Footnote 31
D. Summary
The four forms through which investors can hold shares differ substantially. Shareholders of certificated shares and shareholders of uncertificated shares, who have their names entered directly on the CREST register (as participants or as sponsored members), benefit from the full set of rights associated with their shares. Shareholders who hold shares indirectly through custodians do not.Footnote 32 In the following subsection, we will discuss the proposal of the Digitisation Taskforce.
III. The Digitisation Taskforce
We have already reported that HM Treasury has appointed a Digitisation Taskforce.Footnote 33 Its terms of reference state that the existence of certificated shares causes costly arrangements but neither quantify nor substantiate this point.Footnote 34 The Taskforce’s “Interim Report” concludes that, for listed companies, paper certificates need to be removed “as a matter of urgency”.Footnote 35 It recommends legislation abolishing these shares and requiring existing holders of certificated (paper) shares in listed companies to hold these through a nominee. We have seen above that this would substantially modify the legal position of existing holders of certificated shares, transforming them from direct legal owners into intermediated beneficial owners.
The proposal deviates from a model advanced by the industry at an earlier stage, which envisaged that certificates be replaced with “unique reference number[s]”.Footnote 36 These were going to be used, together with other security information, to authenticate transactions on behalf of shareholders.Footnote 37 The registrars, who, in addition to CREST, assist issuers with maintaining shareholder registers, would provide digital access to the register that they maintain. The earlier proposal would have enabled the current holders of certificated shares to retain legal ownership albeit through a digital account administered by registrars, which might, with time, have attracted fees.
With a view to improving the current intermediated system of shareholder ownership, the Taskforce recommends legislation requiring intermediaries (1) to be transparent about the services they offer and (2) to use a common messaging protocol that enables messages to be distributed between issuers, intermediaries and investors. Otherwise, the Taskforce believes that we should rely on the market to make improvements.Footnote 38
IV. The Ability of the Market to Make Improvements
A. Introduction
In this section, we examine the problems affecting the current market in more detail and assess its ability to make improvements. We base this assessment on our empirical study. In addition to our empirical results, the section also contains our own assessment and analysis, which will be clearly identified in the text.
It has already been mentioned that CREST operates in the market as the register for all uncertificated shares issued in the UK. We have also said that there are registrars, who assist companies in maintaining their respective shareholder registers. Registrars mirror the CREST register for uncertificated shares and manage the register for shares that are held in certificated form. In addition, there are custodians, who operate nominee accounts either with CREST directly or through other custodians.
We will see that the market for direct CREST accounts suffers from a lack of competition. The providers of intermediated accounts also appear to lack competitive spirit. This may prevent the market from providing retail investors with a service that gives them full access to the corporate rights associated with their shares. Institutional investors and high value private investors are in a better position. They can access direct forms of holding securities. Recent legislative reforms have improved the ability of institutional investors with an intermediated account to vote but have unfortunately not improved their access to enforcing rights in court.
B. CREST Participants and Sponsored Members
CREST operates the only central register for uncertificated securities on the basis of a licence by the Government, which was issued under the Uncertificated Securities Regulations 2001.Footnote 39 One interviewee pointed out that, in their view, this monopoly status increases the level of operational risks.Footnote 40 Fees for CREST participants are high. They pay an account charge of at least GBP 650 per month for low volume users and GBP 1250 per month for standard users. In addition, there are service charges for individual transactions such as, for example, settlement charges, own account transfer charges, non-settling own account transfer charges, asset maintenance charges, fee per line charges, netting fees, Central Counterparty fees, or settlement discipline charges.Footnote 41
The market for sponsored accounts suffers from a similar lack of competition. There are only a few operators offering CREST-sponsored accounts to retail investors.Footnote 42 CREST membership is now rarely used by them. The number of individuals holding securities directly through CREST had decreased from approximately 50,000 members in 2003 to 4,200 members in 2020.Footnote 43 None of the major investment platforms offer a direct CREST account.Footnote 44 Two registrars and one retail investor told us that stockbrokers use intermediation as the default option in their standard terms, without informing investors about the available option to hold shares directly.Footnote 45
In 2020, the Law Commission identified only four brokers that offered personal CREST accounts at annual fees ranging between approximately GBP 400 and GBP 500.Footnote 46 This was confirmed by one retail investor who told us that in 2019 he switched from a sponsored direct CREST account to a “nominee account” when the annual account fee charged by the broker had increased from approximately GBP 10 to GBP 500.Footnote 47 Since then, fees have increased further. We identified and contacted three brokers, who currently offer this service, and requested information about their respective tariffs. Fees now range between GBP 2000 and GBP 3000 per annum.Footnote 48 Two of the brokers also require a minimum portfolio size ranging between GBP 500,000 and GBP 1,000,000, respectively.Footnote 49
The reluctance of stockbrokers and investment platforms to offer direct CREST membership is sometimes attributed to the administrative burden associated with these accounts.Footnote 50 We note that the CREST tariff charges participants GBP 120 per year as a fee for maintaining a personal account.Footnote 51 This is high but also suggests that brokers are requesting a significant mark-up. We also learnt that intermediation provides firms with a greater control over the securities, optimising the speed at which transactions are processed and facilitating certain activities generally associated with custody, such as stock lending and high frequency trading.Footnote 52 Service providers argue, unsurprisingly, that the demand for this model is limited.Footnote 53
The picture is different for institutional and large-scale private investors. Some institutional investors (e.g. mature sovereign wealth funds, central banks, or certain government institutions) set up their own CREST accounts and grant providers a power of attorney to operate such accounts on a day-to-day basis.Footnote 54 They sometimes also set up a contingency plan which requires the appointment of another provider that will step in and take over as an account operator in those circumstances where the first provider becomes insolvent. These plans “pop up” from time to time and are intended to avoid any type of disruption including the risk of a break down in communications with CREST.Footnote 55
It is possible that the lack of bargaining power of retail investors, together with the lack of competition in this market, could have led to a situation where retail investors have been priced out of holding uncertificated securities directly. There is also a risk that the lack of competition may not give Euroclear and/or its participants an incentive to develop a business model improving the status quo.
C. Intermediated Accounts
1. Introduction
In the following subsections, we analyse the market for intermediated shareholdings. For this, we have collected empirical evidence. We will discuss pooling, securities lending, technology, the resulting levels of service standards and the attitudes of custodians.
2. Pooling
In a custody chain, each custodian records how many securities they have undertaken to hold for each of their clients. They then ensure that they themselves hold a corresponding amount of such securities at the next level. Custodians prefer to hold securities at this next level on a pooled or omnibus basis, where they hold the shares for several of their clients in the same account.
Custodians charge lower fees for pooled accounts.Footnote 56 Pooling, however, has disadvantages. It creates a structure that is prone to errors in the handling of client voting instructions, makes it difficult (if not impossible) for issuers to link votes to specific investors, prevents investors from ensuring that their instructions have been voted correctly,Footnote 57 and may significantly limit the client’s voting choices in those circumstances where intermediaries have terms whereby they vote the same way for all the shares in the pool.Footnote 58 Unfortunately, investors are usually not fully aware of these disadvantages.Footnote 59
Our study shows that, in practice, omnibus accounts have become the default market standard.Footnote 60 Custodians sometimes offer segregated or designated accounts, but these are more likely to be available to institutional than to retail investors.Footnote 61 The BIS study found that most retail investors are not aware that securities can be held in designated accounts.Footnote 62
Moreover, it appears that segregation in any step of the custody chain does not necessarily resolve the operational problems that arise with omnibus accounts. We were told that, when clients opt in favour of a segregated account, corporate rights may be jeopardised when their immediate custodian agrees to hold the shares in an omnibus account with a sub-custodian placed further up the chain.Footnote 63 We have also been told that investors are not always fully aware of these implications of pooling.Footnote 64
3. Securities lending
Securities lending generates income for investors, who are paid by the borrower for making their securities available to them. We have been told that pension funds, in particular, benefit from securities lending.Footnote 65 Custodians also make money by charging fees for their services in organising lending for investors, allowing them to charge lower fees.Footnote 66 Lending also constitutes a source of money-market funding and plays an important role in short selling, facilitating more accurate market pricing.Footnote 67
Like pooling, lending has disadvantages for investors. They temporarily lose ownership of the shares and need to recall them to exercise voting rights. A recall request is passed on from one custodian to the next. Information can get lost, such that a custodian further down the chain does not receive details on “which [shares] to recall and when”.Footnote 68 When lending is arranged by a custodian close to the record date for a shareholder meeting, lenders may send voting instructions before they have received confirmation of the completion of a lending transaction. It can then happen that borrowers also send voting instructions through their own respective custodians and that both sets of instructions reach the issuer simultaneously. This can result in over-voting.Footnote 69
4. Technology
Unfortunately, the operational problems that complicate the exercise of corporate rights also occur when shares are held in segregated accounts and there is no lending activity. This is because several custodians need to work together, one after the other, to facilitate the exercise of rights by ultimate investors. This can entail (1) delays and errors in passing information through the chain, (2) failure to inform the investors about corporate events, (3) difficulties in receiving voting forms or links to online voting and (4) problems for investors in obtaining confirmation that their votes have been received and/or counted.Footnote 70 One interviewee explained that the reason for this is that the procedure and technology used along the custody chain can differ from one provider to another. Some firms use automated voting systems while others use manual arrangements.Footnote 71
We have mentioned above that the Taskforce proposes to address operational problems through a common messaging protocol. We note that this could provide all levels in the chain with greater awareness of what information is needed but does not improve the procedures and systems used by each of these intermediaries.
While it would, of course, be possible for all custodians to switch over to a shared database, an individual intermediary will only make such an investment if they have an incentive to do so. The fact that some intermediaries continue to operate manual models suggests that no such incentive is present. It is possible that they do not experience sufficient competitive pressure to improve their respective systems.
5. Low service standards
The operational problems prevailing in the custody chain are reflected in the legal documentation underpinning the industry. During our study we identified contracts according to which, “[u]nless expressly agreed in writing”, intermediaries are exempt from passing information and facilitating voting.Footnote 72 Furthermore, even in circumstances where the ability of an investor to exercise corporate rights is expressly recognised by the agreement, such rights may be subject not only to the payment of an additional fee but also to a series of other conditions. For example, contracts sometimes impose tight deadlines on submitting voting instructions to the intermediaryFootnote 73 or limit the investor’s ability to attend shareholder meetings. Custody contracts also frequently exclude assistance with enforcing rights.Footnote 74
6. Attitudes of custodians
In principle, the industry possesses the technical skills and means to overcome the operational problems currently troubling the intermediated infrastructure. The problem is not the lack of suitable digital technology. The problem is that intermediaries do not have sufficient incentives to develop a better business model.Footnote 75
The Chartered Governance Institute Registrars’ Group told the Law Commission that votes are more likely to be “communicated and actioned in a timely, accurate and effective manner … when a direct financial consequence hangs on the process” (e.g. in the context of takeovers or restructuring).Footnote 76 They stress that facilitating more engagement by investors is not always a priority for custodians and that it is more “a lack of will rather than process-failure which inhibits the exercise of voting rights”.Footnote 77
D. Summary
It is possible that Euroclear UK & International and the few intermediaries offering CREST-sponsored accounts do not experience a sufficiently competitive environment. The reason for this could be that retail investors do not have enough bargaining power to negotiate reasonable fees that would allow them to connect to CREST through a sponsor. We believe that the CMA should investigate this further.
Intermediated services are provided either through segregated or pooled accounts. The pooling of accounts and securities lending, while making custody cheaper, trigger operational problems, which severely undermine the ability of investors to exercise rights. Unfortunately, operational problems also arise with segregated accounts that do not permit lending. Custodians do not appear to have the incentives to improve the quality of their service.
V. The Previous Attempt by the Government to Encourage a Market-Led Solution
The inability of the market to make improvements is evidenced by a previous attempt to bring about a market-led solution. In 2001, the Company Law Review Steering Group observed that the existing arrangements for indirectly held securities were “obscure and unnecessarily complex”.Footnote 78 They also mentioned that they had “great concern that solutions should be found”Footnote 79 and that they hoped that the market would produce these. They accepted assurances from market participants that, “in regard to the right to vote, practical advances in the use of electronic technology would very soon make it feasible, at low cost, for the intermediary who is the registered holder to collect diverse instructions from beneficial owners, reflect them accurately in proxy voting instructions passed to the company registrar, and obtain and pass back to the beneficial owners confirmation that the votes had been recorded”.Footnote 80 With a view to assisting the market to produce these solutions, three provisions were added to the CA 2006. These are analysed in turn below. We will see that this enabling legislative regime did not deliver the desired result.
Under section 324 of the CA 2006, a registered “member is entitled to appoint another person as his proxy to exercise … his rights to attend and to speak and vote at a meeting of the company”. This would enable the custodian, who administers legal ownership of the shares, to appoint the ultimate investor as a proxy, enabling them to participate in shareholder meetings. In our interviews we learnt that custodians sometimes offer this service,Footnote 81 but retail investors use it only rarely.Footnote 82 Our interviewees explained that proxy voting services are often subject to limitations and to the payment of an expensive fee.Footnote 83
Section 145 of the CA 2006 enables a company to make provisions in its articles for a member to nominate another person “as entitled to enjoy or exercise all or any specified rights of the member in relation to the company”.Footnote 84 The provision only operates if the company’s constitution permits this. In practice, companies have not used this provision.Footnote 85 This has been attributed to “the complexity of arrangements required to administer this provision”.Footnote 86 We were told that issuers and their agents are too concerned about the integrity of the custody chain to accept a nominated individual as the ultimate investor.Footnote 87 This occurs despite the fact that section 145 of the CA 2006 does not require the issuer or its agent to make further enquiries once a nominee has been identified by a registered shareholder.
Section 146 of the CA 2006 gives the right to a member of a company “whose shares are admitted to trading on a … regulated market” to nominate another person to enjoy certain “information rights”. Information rights include “the right to receive a copy of all communications that the company sends to its members”.Footnote 88 Unlike the right contained in section 145 of the CA 2006, this right is available on a statutory basis rather than on the basis of the company’s constitution. The Chartered Governance Institute (CGI), previously known as The Institute of Chartered Secretaries and Administrators (ICSA) has observed that section 146 of the CA 2006 “is not as widely used as it could be”.Footnote 89 This was attributed to a perceived lack of interest from investorsFootnote 90 and the failure of intermediaries to make this option available to their clients.Footnote 91
Attempts by the Government to use enabling legislation allowing issuers (together with the respective financial services providers) to develop solutions which offer intermediated investors the full set of rights associated with their shares have failed. One proxy advisor told us that, if anything, intermediation has increased in most recent years.Footnote 92 Kathryn Judge observed that the increasing length and complexity of the financial sector has created “new opportunities for intermediaries to earn fees, increase parties’ tendency to rely on intermediaries, and obscure intermediaries’ profits”.Footnote 93 As the structure of the market has further tilted towards intermediation since 2006, the Taskforce’s suggestion to rely on market forces to achieve improvements would seem rather optimistic. We will see in the next section that legislative intervention can be successful in bringing about reform.
VI. Shareholder Rights Directive II
The Shareholder Rights Directive II (SRD II) has improved voting services for institutional investors.Footnote 94 The Directive affects UK service providers who serve customers in respect of shares of companies with their registered office in a Member State and admitted to trading on an EU regulated market.Footnote 95 We note that even in relation to institutional investors, who have bargaining power in their relationship with custodians, legislation was required to improve communication between issuers and ultimate investors. In this section, we use Proxymity and the Minerva-Nexus Model as case studies illustrating the improvements following the implementation of the SRD II.
Proxymity is a computer system set up by a consortium of well-known service providers.Footnote 96 It was set up to facilitate compliance with the intermediaries’ duties under the SRD II.Footnote 97 We were told that, as of September 2022, the firms committed to using Proxymity represent approximately 75 per cent of the global assets under custody.Footnote 98 It does not remove intermediation or change the legal position of ultimate investors but connects issuers, intermediaries and investors and passes data (such as voting instructions, corporate information and shareholder disclosure requests) along the chain.Footnote 99 The collection of data in one single database does, nevertheless, make errors and discrepancies visible and rectifiable.Footnote 100
From the perspective of this paper the system has two significant design limitations. It only improves voting and information sharing. It does not improve the ability of investors to enforce claims against issuers. In addition, the service is available only to institutional and high net-worth individual investors.Footnote 101 It has not been programmed to provide voting solutions for firms dealing with high volumes of individual investors.Footnote 102
The Minerva-Nexus Model is another industry initiative set up in response to the SRD II.Footnote 103 Its aim is to facilitate the exercise of corporate rights for securities that are used for lending, assisting all intermediaries in a chain with processing recall request rights.Footnote 104
In this section, we have observed that the market for services facilitating the relay of information and the transfer of voting rights along custody chains between issuer and investors has seen technological advancements, enhancing service quality, in response to the SRD II. This shows that legislative intervention is essential for fostering better connections between issuers and investors. We also note that the improvements are confined to voting processes. The SRD II has not aided investors in enforcing claims. Retail investors, who are outside the scope of the SRD II, have not benefitted from this reform.
VII. Why We Need Reform
A. Introduction
We could conclude that the difficulty in accessing direct share ownership and the poor quality of intermediated share services should be accepted as a normal evolution of the market. Why should we care about the enforcement of claims against issuers? Why should we care about retail investors if their numbers are small and few of them vote?Footnote 105 The reasons why we should address both topics are set out below.
B. Shareholder Preferences
It is possible that the lack of interest from retail investors in exercising their rights and the cost of providing these services are overstated. We have already mentioned that the absence of competition, combined with the lack of bargaining power of retail investors, could prevent infrastructure providers from developing business models that facilitate direct holdings of uncertificated securities at a reasonable cost and the supply of high-quality services for intermediated accounts.Footnote 106
We are not alone in suggesting that, if retail investors had access to a straightforward way of exercising their rights, they might well be interested in doing so. Austin wrote that there is a “cogent argument” that the claims of market participants – that there is not sufficient demand amongst investors – create a “self-fulfilling prophecy”.Footnote 107 Firms “do not invest in easy to use services or place high charges on them and do not actively market them”.Footnote 108 This leads to such services being unattractive or unknown to retail investors,Footnote 109 “which is then used as a justification for lack of investment by intermediaries”.Footnote 110
This observation is supported by recent developments in the US. Blackrock, having embraced environmental and social investment goals, came under political scrutiny and decided to back out of the ensuing political debate by announcing a system that gives clients the “option to have a say in how proxy votes are cast at companies their money is invested in”.Footnote 111 We observe that, once incentives are in place, market practice can shift.
Finally, a generational shift is underway.Footnote 112 The demographic of those who hold shares is changing. Shareholders used to be almost exclusively white retired males. In the last few years, young and ethnically diverse investors have started to buy individual shares. These are not only growing in number but are also about to inherit significant sums of money from their parents and grandparents. They care about voting rights and exercise these not only in pursuit of financial gain but also to steer companies towards wider societal goals that they believe to be important. It would be wrong to design the mechanics of holding shares in a way that undermines the ability of this group of retail investors and (for that matter) any other individual who is (or will be) prepared to exercise rights as corporate shareholders.Footnote 113
C. Oversight for Issuers
Secondly, the operational ability to vote and enforce claims against issuers is important for their governance. An argument is sometimes made that smaller investors (retail and institutional) are rationally apathetic. They face a collective action problem as the cost of exercising their rights is not outweighed by the benefits.
The corporate governance literature, however, discusses rational apathy not as a desirable outcome but as a problem. There is debate about how much influence shareholders should have as compared to directors or other stakeholders such as employees.Footnote 114 Corporate lawyers discuss the fine tuning of these rights.Footnote 115 Shareholder oversight may not be as effective in controlling directors as some would hope, but the discussion in corporate law assumes that there are shareholders who have the uninhibited operational ability to make use of their respective rights.
Shareholders have the role of overseeing the directors of companies. They may not do so on an ongoing basis. But this does not mean that they are uninterested when fundamental decisions are taken that affect their rights.Footnote 116 Moreover, the ability of shareholders to exercise their rights sends an important signal to directors.Footnote 117 The fact that there are shareholders who can spring into action has a disciplining effect on the directors.Footnote 118 Along similar lines, Holger Spamann recently observed that “gadfly” investors are an indispensable catalyst for shareholder votes on items not desired by either management or required by law.Footnote 119 He also pointed out that individual named plaintiff investors operate as figureheads in shareholder litigation, which forms part of an institutional ecosystem protecting the interests of all investors, including those who hold through passive funds.Footnote 120 To perform this vital function, figurehead investors require standing in claims against companies. In the UK, this means that their name has to be entered on the shareholder register.
In constitutional law, voters are also sometimes disengaged. Nevertheless, the government’s knowledge that it will face the electorate from time to time ensures accountability. In a democracy, the argument that voters have different levels of competence and are sometimes passive does not justify removing voting rights or accepting a system that creates barriers to the exercise of these rights.
If small retail and institutional investors are blocked from standing in claims against issuers, the governance of companies will be exclusively overseen by large-scale institutional investors.Footnote 121 When institutional investing first rose to its current prominence, it was considered a welcome development. The expectation was that the institutionalisation of shareholding would lead to greater scrutiny of companies.Footnote 122 However, this has not been the case. The 2008 Financial Crisis has shown that the investment chain that operates between the ultimate beneficiaries of institutional investors drowns out the preferences of ultimate beneficiaries. While these have long-term goals, their service providers regularly respond to more immediate pressures. The current set-up of institutional investing transforms long-term goals into short-term signals.Footnote 123
To increase engagement by institutional investors, the Financial Reporting Council has adopted the UK Stewardship Code.Footnote 124 The Code encourages (institutional) asset owners, asset managers and related service providers (such as investment consultants, proxy advisors, data and research providers) to exercise the governance rights they hold on behalf of their clients in a responsible way.Footnote 125 There are signs that the market participants have accepted their role as stewards and are reporting on their stewardship activity.Footnote 126
The fact that institutional investors are adopting the UK Stewardship Code and reporting accordingly does not mean that their activity leads to effective oversight of directors. Institutional investors are not acting for their own benefit. They watch their own bottom line. This undermines their ability to provide the required quality of oversight.Footnote 127
Moreover, asset managers have come under fire for their dominance in markets. There is an ongoing academic debate as to whether asset managers (as the “common owners” of large sections of the economy) have a negative effect on competition between their investee companies.Footnote 128 Given these uncertainties, it would be wrong to delegate the governance of companies to a highly concentrated industry whose impact on the economy we are only beginning to understand.
D. Summary
There is a cogent argument that a lack of competition, rather than a lack of interest by investors, is responsible for the market’s failure to develop a cost-effective infrastructure that enables all shareholders to exercise their rights. In addition, corporate governance scholars express concern about rational apathy, but this does not lead them to recommend or condone the imposition of operational barriers for voting and exercising other shareholder rights. Indeed, the corporate governance literature stresses the importance of figurehead gadfly investors in corporate governance and litigation.
VIII. Solutions
A. Introduction
If we accept that the absence of a competitive market, combined with the desirability of oversight for issuers, justifies reform, we need to discuss how this reform should be designed. We have already seen that the Digitisation Taskforce and the “Industry” have each advanced models for the elimination of certificated shares. These will be analysed below.
With a view to improving intermediated services, the Law Commission has recently set out five options. We have put these to our interviewees and will discuss them below. We will analyse the Digitisation Taskforce’s proposal further and give our own view.
B. Eliminating Paper
As mentioned at the beginning of this paper, the Digitisation Taskforce concluded that certificated shares should be eliminated “as a matter of urgency” and that existing certificated shares should be transformed into intermediated uncertificated holdings.Footnote 129 We also pointed out that this transforms direct legal ownership into intermediated beneficial ownership.
We believe that the urgency for the elimination of paper certificates is overstated. The number of certificated shares in listed companies is relatively small.Footnote 130 We agree with the UK Individual Shareholders (ShareSoc) and UK Shareholders’ Association (UKSA) that “forced dematerialisation of the remaining certificated shareholdings is not being proposed to meet any real needs of certificated shareholders, since by and large they are happy with the current position. (Otherwise, they would already have dematerialised their shareholdings)”.Footnote 131
The Taskforce’s proposal reflects the preferences of issuers,Footnote 132 registrars and other intermediaries.Footnote 133 The Digitisation Taskforce has neither quantified nor substantiated the cost associated with certificated shares. Arguably, most expense arises when investors trade their shares or when certificates are lost, stolen, or damaged. In both cases, costs are passed to investors through (1) higher brokerage fees for trading and managing paper certificates,Footnote 134 and (2) replacement fees for issuing new paper certificates in cases of loss, damage, or theft.Footnote 135 Some brokers also charge transfer fees when converting electronically purchased shares to paper certificates.Footnote 136 Once a share certificate is issued there are no more costs to brokers, issuers, or anyone else and consequently investors pay no fees for holding a share certificate. Paper certificates are a highly cost-effective option for holding shares in the long term.Footnote 137 ShareSoc reports that typical holders of certificated shares are retail investors who have held their shares for a long time and who prefer direct ownership and value direct communication from companies.Footnote 138 Eliminating paper certificates would significantly affect them.Footnote 139 They would not only lose direct access to corporate rights but also become exposed to the risk of losses caused by the insolvency, negligence, or fraud of any one of the intermediaries in the chain.Footnote 140
We have reported earlier that, under the “Industry Model”, certificated shareholders would receive a unique reference number for their shares instead of a paper certificate. They would also open an account with the issuer’s registrar. The proponents of the model are reported to have said that investors “would not be charged for holding their investments” but that “fees for actions such as effecting transactions would remain”.Footnote 141
This proposal is better for shareholders than that of the Digitisation Taskforce. It nevertheless puts investors in a position where they need to rely on registrars to give them access to the digital system through which they hold their shares, without necessarily being in a bargaining position to resist fee increases once certificated shares have been eliminated. ShareSoc and UKSA favour digitisation in principle, provided that individual investors can continue to hold shares in their own name at reasonable costs.Footnote 142 The Law Commission also stressed that the overall cost associated with the model should be “proportionate”.Footnote 143
Both the Digitisation Taskforce and the proponents of the “Industry Model” are confident that it is possible to eliminate paper certificates, trusting that the market can deliver a cost-effective dematerialised way of holding shares. We would point out that the “proof is in the pudding”. If, despite the lack of competition and past performance, the market succeeds in developing an attractive uncertificated way to hold shares directly, there will be no need to abolish certificated shares. Investors will of their own accord take up that model. In recent years, we have all switched from predominantly using cash to using card payments almost exclusively, precisely because of the inconvenience associated with paper bills and metal coins. The market can improve the existing model of sponsored CREST membership, enhancing the system to the point where paper certificates become undesirable and obsolete.
The Government should nevertheless intervene, but not by eliminating certificated shares. As we have mentioned, the fees for direct personal membership in CREST have recently increased steeply. CREST operates the only system in the UK for uncertificated securities. Only a very limited number of brokers offer sponsored CREST membership. The CMA has the authority to open an investigation, if it has concerns about service providers abusing their dominant position in the market.Footnote 144 The European antitrust regulator has recently investigated similar cases, which resulted in a settlement where Thomson Reuters, Markit, the International Swaps and Derivatives Association, Inc. and others modified the terms for their main products.Footnote 145 We recommend that the CMA investigate the provisioning of CREST-sponsored accounts.Footnote 146
C. Improving the Intermediated Holding Model
1. Introduction
We have argued above that certificated shares should be retained to enable those who prefer to hold shares directly to do so at a reasonable cost. We also believe that intermediated holdings require reform. The legal and operational problems affecting the current market have been acknowledged by the Company Law Review Steering Group,Footnote 147 the Kay Review,Footnote 148 the (then) Department for Business, Innovation and Skills (BIS), the Law Commission and, more recently, Austin’s “UK Secondary Capital Raising Review” report.Footnote 149 In 2016, the BIS confirmed that the voting process in custody chains is “opaque” and “of questionable accuracy”.Footnote 150 The UK Law Commission has, over an extended period of time, done work in this area evidencing the existence of significant and persistent problems.Footnote 151 Austin concluded that the “level of intermediation and specialisation has … arguably become a barrier … for end users of the system”.Footnote 152 He also observed that the “ability for underlying owners to exercise entitlements around voting or to participate in fundraises is not uniformly enabled across retail platforms” and that there can be “breakdowns in information flows … relat[ing] to voting at meetings and exercising entitlements in connection with a pre-emptive offer”.Footnote 153 We believe that the infrastructure through which the majority of investors hold shares should enable these investors to oversee issuers adequately.
2. Technology
We have explained earlier that the Digitisation Taskforce recommended a common messaging protocol. The Law Commission wrote that distributed ledger technology (“DLT”) could “enable the creation of a direct relationship between investors and companies”,Footnote 154 but stressed that technology does not change the legal position of ultimate investors and will only enhance their rights where intermediaries are motivated to invest in it and use it for this purpose.Footnote 155
Our interviewees said that DLT has the potential to enhance investors’ rights but requires a substantial transformation of the market and this takes time.Footnote 156 Two interviewees further pointed out that the development of DLT could also be adversely affected by the role played by the intermediaries in financial markets.Footnote 157 Intermediaries are unlikely to be interested in investing in the technology if it undermines their ability to generate returns.Footnote 158 Three of our interviewees felt that it was more realistic to expect immediate improvements from legislative intervention.Footnote 159
A common messaging protocol will ensure that all intermediaries are aware of which data points are relevant at other levels in the chain.Footnote 160 However, it does not prevent errors, which occur as information is transferred from one organisation to another. A standard messaging protocol also does not provide intermediaries with an incentive to provide the services of enabling the exercise of rights by shareholders.
We are not hopeful that DLT will change anything. We have seen above that custodians currently lack sufficient incentives to take advantage of existing technology to improve links between them. We doubt that they will invest in DLT. Moreover, the current opportunity for the use of DLT for this purpose appears to be going to waste. The Bank of England and FCA are jointly working on the Digital Securities Sandbox (“DSS”) aimed at supporting new business models for trading and settling securities based on developing technology (such as DLT). They state that they aim to streamline the processes of issuing, trading and settling securities, and to reduce the need for intermediaries. But the guidance for service providers envisage outsourcing and consequently intermediation and do not require applicants to provide avenues for investors to hold digital securities directly.Footnote 161 Disappointingly, the sandbox appears to be designed with a view to replicating the current intermediated market structure.
3. Legal interventions
Proposals by the Law Commission and the Digitisation Taskforce. The Law Commission observed that no progress had been made since the Company Law Review Steering Group pointed out the problem,Footnote 162 and proposed that a statutory obligation be imposed on intermediaries to arrange, upon request, for an indirect investor to exercise shareholder rights.Footnote 163 Austin endorsed this proposal.Footnote 164 Alternatively, the Law Commission suggested to draw inspiration from the SRD II.Footnote 165 The SRD II contains provisions imposing on intermediaries a duty to offer companies the right to identify their shareholder, to pass information between the company and shareholders, and to facilitate the exercise of voting rights.Footnote 166 As a substitute to hard law, the Law Commission considered the introduction of a “non-binding set of principles of best practice or code of practice”.Footnote 167 Along similar lines, the Digitisation Taskforce recommended a requirement for intermediaries to disclose their service levels.
In addition to facilitating voting, the Law Commission proposed to amend the CA 2006 and the FSMA 2000 to enable ultimate intermediated investors to better exercise and enforce shareholder rights. This would entail, for example, changes to sections 98,Footnote 168 899,Footnote 169 633, 338, 570 and 571Footnote 170 of the CA 2006. It would also involve clarifying section 90A of the FSMA 2000.Footnote 171
Our interviewees. Our interviewees were against a “non-binding set of principles of best practice or code of practice”.Footnote 172 They believe that hard law better enhances investors rights.Footnote 173 They also rejected the model adopted by the SRD II,Footnote 174 favouring statutory intervention to impose obligations on intermediaries to facilitate voting and to amend the CA 2006 and FSMA 2000. Most of them said that this solution would be a step forwards to improve the practice of intermediated securities.Footnote 175 They observed that, without the introduction of a formal obligation, intermediaries lack an incentive to make improvements.Footnote 176
Our view. We have seen that the market promised to solve the problems of intermediated securities 20 years ago but has yet to deliver a solution. We argue that a lack of competition undermines service providers’ ability to develop business models that better serve investors and issuers. We predict that infrastructure providers will, like they did before, express intentions to improve, only to find they lack sufficient incentives. Better transparency by intermediaries does not address their underlying incentives and disclosure does not give small-scale investors the bargaining power to demand better service at lower costs.
The ability of the market to make promises of any kind is further undermined by the fact that the market infrastructure is constantly changing. These changes are frequently carried out through the outsourcing of activity.Footnote 177 One proxy voting advisor mentioned that fund managers are increasingly outsourcing administrative functions and compliance tasks (including voting activities) to third parties, which adds another layer of complexity to the system.Footnote 178 This development is likely to continue.Footnote 179 From the perspective of this paper the effect of this is that any promises made by current market participants will not, of course, bind intermediaries to whom the activity will be outsourced in the future.
We note, further, that the recent improvements of corporate communication services occurred in response to the obligations imposed by the SRD II rather than through voluntary industry-led improvements. We believe that it is unlikely that the market will succeed in creating a model that makes it possible for retail investors to exercise, at a low cost, the corporate rights associated with shares held through custody chains.
We mentioned above that our interviewees largely agree that a formal legal duty is necessary to improve intermediated holdings. We note here that there is a difference between saying that statutory intervention will help and volunteering to accept a formal duty imposed upon oneself.
We therefore believe that a duty should be imposed on intermediaries requiring them to assist their clients, who hold securities through a nominee account, to exercise their rights against the issuer of shares. We also endorse the Law Commission’s proposal to clarify the wording of section 90A of the FSMA 2000 and to modify the CA 2006. Further work will be needed to define ultimate investors for this purpose. This will not be straightforward,Footnote 180 but, as Secure Capital S.A. v Credit Suisse A.G. has shown,Footnote 181 other legal systems have been able to find a workable solution.
IX. Summary
In this article, we argue that paper certificates should not be eliminated. The industry does not need the Government to intervene to present retail shareholders with a cost-effective model for holdings shares directly. Instead of removing paper the Government should encourage the CMA to investigate the price structure for CREST accounts. We also believe that legislation is required to remove the barriers that currently prevent intermediated investors from voting and otherwise exercising rights against issuers.
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