Book-Entry Securities

Because no certificate exists, a security has to be identified by something other than a piece of paper. Part 357 defines an issue as a group of securities identified by the same CUSIP number, the identifying number assigned to each separate security issue. The offering circular adds that when Treasury issues additional securities carrying the same CUSIP number as securities already outstanding, it considers them to be the same securities as the outstanding ones. A later sale under an existing CUSIP therefore enlarges that issue; the new and old securities are interchangeable entries rather than two different instruments.

From Paper Certificates to Electronic Records

The TRADES Commentary describes the TRADES regulations as the culmination of a multi-year Treasury process of moving from issuing securities only in definitive form, meaning physical, certificated or paper securities, to issuing them exclusively in book-entry form. TRADES took effect on January 1, 1997, and applies to outstanding securities that had been governed by an older subpart of 31 CFR part 306. It applies on and after that date to all transactions, including those begun before it. Treasury delayed the effective date so that secured parties would have a period in which to take any action needed to continue the perfection of their security interests.

The securities markets more broadly were pushed toward book entry by Congress. In Section 17A of the Exchange Act, Congress found that prompt and accurate clearance and settlement, including the transfer of record ownership and the safeguarding of securities and funds, are necessary for the protection of investors, that inefficient procedures impose unnecessary costs on investors. Section 17A(e) then directs the Securities and Exchange Commission to use its authority to end the physical movement of securities certificates in connection with the settlement of transactions among brokers and dealers. The directive is aimed at settlement between brokers and dealers; it does not, in its terms, abolish the certificate or require an investor to give one up.

Section 17A(f) lets the Commission, on making specified findings and notwithstanding state law, adopt rules on the transfer of certificated or uncertificated securities and on the rights of the parties to such transfers. That power expressly excludes government securities issued under chapter 31 of title 31 and securities otherwise processed within a book-entry system operated by the Federal Reserve Banks under a federal book-entry regulation.

The Three Treasury Book-Entry Systems

Treasury securities are maintained in one of three book-entry systems. In the commercial book-entry system, governed by subpart B of part 357 and called TRADES, Treasury securities are held in a tiered system through securities intermediaries such as financial institutions or brokerage firms; a Treasury security is in that system if a Federal Reserve Bank has credited it to a Participant's Securities Account. Legacy Treasury Direct is a non-Internet book-entry system maintained by Treasury, in which securities are held directly by Treasury in accounts in the investor's name, reached through a designated Federal Reserve Bank or the Bureau of the Fiscal Service. TreasuryDirect is Treasury's online system for buying and holding eligible marketable Treasury securities, savings bonds and certificates of indebtedness as computer records on Treasury's books.

The offering circular explains where newly auctioned securities go. When depository institutions or dealers bid in an auction, the securities awarded to them are generally held in the commercial book-entry system, in which Treasury maintains accounts in the National Book-Entry System for Federal Reserve Banks, depository institutions and other authorized entities such as government and international agencies and foreign central banks. Depository institutions hold securities in those accounts for themselves and for others, who may in turn hold for others.

Movement between the systems is not symmetrical. A security held in Legacy Treasury Direct may be transferred to an account in TRADES or to an account in TreasuryDirect, but securities may not be transferred into Legacy Treasury Direct from the other systems. The Commentary also notes that Legacy Treasury Direct provides no mechanism for exchanging cash to settle a secondary market transaction and does not generally recognize pledges, so it suits investors who plan to hold their securities to maturity and who do not wish to hold through intermediaries.

The Tiered Holding Chain in TRADES

In TRADES, Treasury, acting through the Federal Reserve Banks as its fiscal agents, recognizes the identity only of Participants, the persons that maintain a securities account in their own name with a Federal Reserve Bank. A Participant may itself be a beneficial owner, but many beneficial owners are not Participants. They hold their interests through one or more securities intermediaries, such as banks, brokerage firms or securities clearing organizations.

Part 357 defines a securities intermediary in two limbs. The first covers a registered clearing agency, a Federal Reserve Bank, and a person providing clearance or settlement services that would have to register as a clearing agency but for an exemption, if its clearing activities are regulated by a federal or state authority. The second covers any 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. An individual cannot be a securities intermediary unless the individual is registered as a broker or dealer under the federal securities laws.

The Commentary illustrates a chain running from Treasury to a Federal Reserve Bank, then to a Participant, then to a broker-dealer and finally to an individual holder. The Reserve Bank, the Participant and the broker-dealer are all securities intermediaries, and the Participant, the broker-dealer and the individual are all entitlement holders. The same firm can therefore be an intermediary toward the customers below it and an entitlement holder toward the intermediary above it, and Participants usually are securities intermediaries.

The Security Entitlement

An entitlement holder is a person to whose account an interest in a book-entry security is credited on the records of a securities intermediary, and a security entitlement is the rights and property interest of an entitlement holder with respect to that security. A holder in the tiered system therefore owns a security entitlement against its own intermediary rather than a piece of paper or a direct registration with the issuer.

A Participant's security entitlement is created when a Federal Reserve Bank indicates by book entry that a book-entry security has been credited to the Participant's Securities Account.

The Participant's entitlement is not the same as one described by Revised Article 8. Federal law defines its scope and nature, and it differs in the Participant's rights against the issuer: a Participant has a direct claim against the United States for interest and principal, although under state law an entitlement holder would have a claim only against its own securities intermediary. For an entitlement holder below the level of a Participant, such as the broker-dealer and the individual in the chain above, the scope and nature of the entitlement are defined by applicable state law, to the extent consistent with the regulation.

Federal Law and the United States as Issuer

Except as section 357.10(b) provides for security interests not recorded on a Reserve Bank's books, section 357.10(a) provides that the rights and obligations of the United States and the Federal Reserve Banks with respect to a book-entry security or security entitlement and the operation of TRADES, and the rights of any person, including a Participant, against the United States and the Reserve Banks, are governed solely by Treasury regulations, the applicable offering circular, the announcement of the offering and the Federal Reserve Bank Operating Circulars. An Operating Circular is the publication in which each Reserve Bank sets the terms on which it maintains book-entry securities accounts and transfers book-entry securities, and each Reserve Bank may issue Operating Circulars consistent with part 357.

The Commentary calls this a fundamental principle and a divergence from Revised Article 8. Those parts of Revised Article 8 that set out the obligations of issuers or their agents do not apply to the United States or the Reserve Banks, and neither has any obligation to persons holding their interests below the level of a Participant, apart from one limited exception for interests recorded on a Reserve Bank's books. There are no derivative rights against either of them.

The federal rule is narrow in scope. It governs only the matters listed in section 357.10(a), and other law continues to apply. The tax treatment of security entitlements is left to the federal income tax law, nothing in the section limits whether the activities of Participants or intermediaries are subject to banking or securities laws, and state laws on divorce or intestate succession can still affect which persons have rights in an interest in a Treasury book-entry security.

Choice of Law for Interests Held Through Intermediaries

For matters not reserved to federal law, section 357.11 adopts the general choice-of-law rule of Revised Article 8. The law of the securities intermediary's jurisdiction, excluding its conflict-of-law rules, governs when a person acquires a security entitlement from the intermediary, the rights and duties between the intermediary and its entitlement holder, whether the intermediary owes duties to an adverse claimant, whether an adverse claim can be asserted against a person who acquires a security entitlement, and the perfection and priority of a security interest in a security entitlement. For these purposes, the Reserve Bank maintaining the account is treated as a clearing corporation and the Participant's interest is a security entitlement.

The intermediary's jurisdiction is found by working down a ladder. First comes a jurisdiction that the account agreement expressly names as the intermediary's jurisdiction; next, a jurisdiction whose law the agreement expressly says governs it; next, the location of an office at which the agreement expressly says the account is maintained; next, the location of the office that an account statement identifies as serving the account; and only if none of these applies, the jurisdiction of the intermediary's chief executive office.

One matter takes a different rule. Whether and how a security interest may be perfected automatically or by filing a financing statement is governed by the law of the jurisdiction in which the person creating the security interest is located. The Commentary explains that filing systems are organized by the location of the debtor, so this rule reduces uncertainty and preserves the normal practice of searching records by the debtor's location. If the jurisdiction chosen under these rules has not adopted Revised Article 8, its law applies as though it had.

Whom the Treasury and the Reserve Banks Deal With

Under section 357.13(a), the United States and the Reserve Banks treat the Participant as exclusively entitled to issue a Transfer Message, to receive interest and other payments, and to exercise all the rights and powers with respect to a security credited to its account, even if Treasury or a Reserve Bank has information or notice to the contrary. The rule yields only for a security interest in favor of the United States or a Reserve Bank and for interests the Reserve Bank has agreed to recognize.

The Commentary draws the consequence for a customer further down the chain. A beneficial owner that is not a Participant has no ability to direct a transfer on the books of a Federal Reserve Bank; it exercises its rights only through its own securities intermediary, which in turn acts through the Participant above it.

The Reserve Banks and Treasury are not liable to a person asserting an adverse claim to a security entitlement or to a book-entry security in a Participant's account, including a claim arising from a transfer that a Reserve Bank made under a Transfer Message it reasonably believed to be genuine. More generally, section 357.42 allows Treasury and the Reserve Banks to rely on the information in a tender, a transaction request form or a Transfer Message without verifying it, and relieves them of liability for action taken in accordance with that information.

Payment and Redemption of Book-Entry Securities

A funds account is a reserve or clearing account at a Federal Reserve Bank. The obligation of the United States to pay interest on a book-entry security in TRADES is discharged once a Reserve Bank credits the interest to a funds account at the Bank or pays it as the Participant directs.

At maturity or on a call, the securities are redeemed according to their terms: the Reserve Bank withdraws them from the Participant's Securities Account and either credits the redemption proceeds, principal and any interest, to a funds account or pays them as the Participant directs. The regulation states that no action by the Participant is required in connection with the redemption.

The Commentary adds that Treasury discharges its payment obligation when payment reaches the Participant's account or is paid on the Participant's instructions, and that neither Treasury nor a Reserve Bank has any payment obligation to a beneficial owner that is not a Participant. A customer whose intermediary fails to pass on a coupon payment therefore looks to that intermediary, not to Treasury. In Legacy Treasury Direct, by contrast, Treasury discharges its obligation when payment is credited to the depository institution the owner has specified, paid by check, or paid as the owner instructs.

Security Interests and Pledges in TRADES

A security interest in a Participant's security entitlement that is in favor of the United States, is marked on the books of a Federal Reserve Bank, and secures deposits of public money, such as Treasury tax and loan accounts, or another security interest required by federal statute, regulation or agreement, is created, perfected and has priority over any other interest in the securities. Where such an interest is marked, the Reserve Bank may rely, and is protected in relying, solely on the order of an authorized representative of the United States directing the transfer of the security.

A security interest in favor of a Reserve Bank or any other person may also be created and perfected by a Reserve Bank marking its books, to the extent required by law, regulation, an agreement with the Reserve Bank or an Operating Circular, and an interest so marked has priority over any other interest except one in favor of the United States. When a Reserve Bank lends at the discount window, for example, collateral securities are deposited to a pledge account on its books; for a borrower that is not a Participant, the borrower's securities intermediary makes that deposit.

Marking is not the only route. A security interest, including one in favor of a Reserve Bank, may be perfected by any method available under the applicable law, and a Reserve Bank's interest is then treated as that of a clearing corporation. A Reserve Bank's interest in a Participant's entitlement that is not marked on its books, which may arise when a delivery of securities to the Participant creates an overdraft in its funds account, is governed by the law of the state where the head office of that Reserve Bank is located.

How Creditors Reach a Book-Entry Holding

Section 357.15 deals with a creditor who wants to seize a debtor's Treasury holding in TRADES. The debtor's interest in a security entitlement may be reached by creditors only by legal process upon the securities intermediary with which the debtor's securities account is maintained. If the security entitlement is maintained in the name of a secured party, the debtor's interest may instead be reached by legal process upon that secured party. The regulation does not say whether a Reserve Bank must honor an order or notice of attachment in any particular case.

The rule follows from the tiered structure: the debtor's entitlement exists on the records of its own intermediary, while the Reserve Bank recognizes only the Participant.

The Fedwire Securities Service

The Federal Reserve Banks provide the Fedwire Securities Service, a securities settlement system that lets participants hold, maintain and transfer Fedwire-eligible securities. Fedwire-eligible securities include securities issued by the Treasury, by other federal agencies and by government-sponsored enterprises, and by certain international organizations such as the World Bank, and they are held and transferred in book-entry form.

Transfers may be made free of payment or against a designated payment, and most are made against payment. All Fedwire securities transfers are final at the time of transfer.

The Reserve Banks act as fiscal agents of the United States. Section 357.14 gives each Reserve Bank authority to perform functions connected with the issuance of book-entry securities, to service and maintain them in accounts, to make payments of principal and interest as the Department directs, and to effect transfers of book-entry securities between Participants' Securities Accounts as the Participants direct.

TreasuryDirect

TreasuryDirect is an online account system administered by the Bureau of the Fiscal Service. A TreasuryDirect account is maintained solely in the owner's name. Only an individual or an entity may open one: an individual, or the account manager of an entity, must have a valid Social Security number, be at least 18 and be legally competent, an entity needs a Social Security or employer identification number, and the owner needs a United States address of record and an account at a United States depository financial institution that accepts Automated Clearing House debits and credits.

An individual's primary account can be linked to other accounts. In a custom account, the owner may informally label a purpose, such as a college fund, but the label has no legal effect; the registration of the securities in the account determines who owns them. In a minor account, which an entity may not open, the minor owns the securities and the custodian controls the account. A transaction in TreasuryDirect is effective when Treasury posts it to its records, and a transfer can move a marketable security within TreasuryDirect, between TreasuryDirect and the commercial book-entry system, or into TreasuryDirect from Legacy Treasury Direct. Delivering a gift savings bond to its recipient is a delivery, not a transfer.

Book-entry savings bonds carry tighter limits than marketable securities. They may be transferred to another person's account only as a gift or under a final judgment, court order, divorce decree or property settlement agreement, never for consideration, and they may not be pledged or used as collateral. Treasury will not accept a notice of an adverse claim or of pending judicial proceedings involving a security in TreasuryDirect, and neither Treasury, the Fiscal Service nor the Reserve Banks are proper defendants in a dispute between competing claimants. It will honor an Internal Revenue Service levy against the owner, but it will not recognize a court order that attempts to defeat or impair the survivorship rights of a beneficiary or secondary owner.

Legacy Treasury Direct

A Legacy Treasury Direct securities account consists of an account master record, holding the registration, address and payment instructions, and a securities portfolio describing each security. Registration conclusively establishes ownership, except that for partnership nominees Treasury reserves the right to treat it as conclusive.

Treasury will not recognize any notice or claim of a lien, encumbrance or security interest, including a pledge, in a Legacy Treasury Direct security, apart from court orders it recognizes and bills, notes and bonds that it accepts under 31 U.S.C. 9303 in place of a surety bond as security for a duty required by federal law. Where a security is registered in beneficiary form or with a right of survivorship, the beneficiary or survivor becomes the sole and absolute owner on the owner's death, notwithstanding any contrary will or state law.

Treasury may delay the transfer of a newly purchased security out of Legacy Treasury Direct to the commercial book-entry system or TreasuryDirect for up to 30 calendar days from the date of issue, which gives the investor time to become aware of any unauthorized debits. A depository institution or other entity that transfers a security to or receives one from Legacy Treasury Direct is deemed to act as agent for its customer and agrees to indemnify the United States and the Reserve Banks against any resulting claim, liability or loss.

Book-Entry Settlement Beyond Treasury Securities

Book entry is not confined to Treasury securities. Corporate and municipal securities are generally held at a securities depository and settled between firms by entries on its books, under the clearing-agency framework of Section 17A rather than part 357.

The two frameworks meet in the definition of a securities intermediary. Because a registered clearing agency is a securities intermediary under part 357, a clearing agency that holds Treasury securities for its participants is one more tier in the TRADES chain, and its participants' interests in those securities are security entitlements governed by the choice-of-law rules described above.

Common Errors and Exam Traps

A common error is to think that a customer of a broker-dealer holding Treasury notes has a claim against the United States. In the commercial book-entry system only the Participant at the top of the chain has that direct claim; every holder below it looks to its own securities intermediary.

Another is to assume that serving notice on Treasury or a Reserve Bank stops a transfer. The Reserve Banks act on the Participant's Transfer Message even with notice of a contrary claim, and a creditor reaches a debtor's entitlement only through the debtor's own intermediary.

A third is to treat the three Treasury systems as interchangeable: Legacy Treasury Direct accepts no transfers in and recognizes no pledges, and TreasuryDirect savings bonds move only as gifts or under court orders.

Examination Relevance and Key Takeaways

Questions on book-entry securities test how ownership is recorded and who can enforce it. Treasury bills, notes and bonds are issued only in book-entry form and held in TRADES, Legacy Treasury Direct or TreasuryDirect. In TRADES, Treasury and the Reserve Banks recognize only Participants, a Participant's entitlement is created by the Reserve Bank's book entry and carries a direct federal claim for principal and interest, and everyone below holds an entitlement against an intermediary under the law of that intermediary's jurisdiction.

Payment is complete when the Reserve Bank credits the Participant, a marked security interest outranks all but the United States, and creditors proceed against the debtor's own intermediary.