“The board is set; the pieces are moving. We come to it at last.” My husband and I re-watched Lord of the Rings over the holidays and that line stuck with me. The board has been set without us knowing, and when the pieces move, we will lose. A 2016 World Economic Forum video included a young women’s view that in 2030 you will own nothing and be happy. In many ways, 2030 is already here; the board is set.
If you call your stockbroker and put in an order to buy 100 shares of Apple, or any company, you probably think that you own 100 shares in that company. You don’t. In the old days when you bought a stock or bond, you received a paper certificate of ownership: you owned the shares on the certificate, no middleman. But paper certificates are so yesterday.
In today’s enlightened digital age, your purchase is simply an entry at your broker’s computer, and you do not own what you think you own. Under laws in all 50 states what you actually own is a “securities entitlement.” This is a new form of “property ownership” that is more like a contract between you and your broker.
If financial markets are functioning, this new type of “property” is not really a problem. There are some benefits, in fact, such as being able to immediately buy and sell your “stock,” rather than mailing in your grandmother’s IBM stock certificate.
But if the financial system faces a systemic collapse—think 2008 housing bubble but much bigger—nearly every stock and bond that is in electronic (noncertified) form will be taken as collateral by the largest “too big to fail” financial institutions. Sure, it will crush many millions of individual investors (and public pension plans) but it’s all for a good cause: saving the systemically important financial institutions. You can’t make an omelet without breaking a few eggs, right?
This will happen without your knowledge and without any action or fault on your part—even if you are entirely debt free and your stock portfolio is free and clear. If that sounds wrong, it’s because it is. It is also legalized fraud.
So, how did we get here? It is a fascinating story involving some of the most boring and dense state laws on the books. Cut through the fog and there it is. Hat tip to ZeroHedge for posting a article titled “Intentional Destruction: First COVID, Now Comes ‘The Great Taking’” by Matthew Smith that was in part based on the work of David Webb and his book The Great Taking. These resources are well worth your time and got me started down the long road to understanding this ticking financial timebomb.
Most of us have a pretty good understanding of private property. If you buy something outright. you own it. You are free to do what you will with that property. Private property rights were a significant issue at the formation of the United States and played a vital role in the expansion and success of the American experiment.
The concept of private property rights as we know it is not very old. It took root in the 1700s from thinkers like John Locke, the men behind the Scottish Enlightenment, and the Founding Fathers.
Private property rights were well understood and worked fairly well for a few hundred years. In the 1980s, however—as digital technology was gaining traction and stocks and bonds evolved from certificate form to digital entries—some felt that the well-accepted laws and rules for private property rights would no longer work. So, they set about to move the concept of property rights forward.
UCC Article 8
The Uniform Law Commission (ULC) was formed in the late 1800s for the purpose of developing state-level laws that would change the patchwork quilt of state laws into a more uniform set of statutes. This would promote commerce and other matters across the country.
The grandaddy of uniform laws is the Uniform Commercial Code (UCC), a lengthy statute regulating commerce from state to state. There are several separate articles in the UCC, with the most well-known being Article 9, which covers secured transactions. But it is the immediately preceding Article 8, which covers securities, that plays the larger role in the topic of this column.
The ULC formed a drafting committee to bring Article 8 into the digital age. The product of that committee was presented to state legislatures in 1994, and ultimately adopted by every state over the next several years. This revised Article 8 was over 50 pages of complicated legalese drafted by “experts.” And state legislators already cramped for time during the legislative session relied on those experts and quickly and overwhelmingly passed the model legislation.
Sitting inside the new Article 8 language, however, were several provisions that put the rights of individual investors at risk. As I said above, the widespread negative impact of these provisions will surface only if (when?) financial markets face systemic collapse; in other words, right when people will most need access to their financial assets. Until then, the provisions sleep.
The first significant change to Article 8 revision is the concept of “securities entitlement” mentioned above. This is a new form of “property right” that is actually more like a contract between the investor and his or her broker. When you buy 100 shares of stock your broker punches a few keys, and the 100 shares show up in your account. In a normal functioning system, your broker will pass any dividends on the stock into your account, take orders from you to sell the stock, et cetera.
A full explanation of a securities entitlement is beyond the scope of the column, but the key takeaway is that you do not fully own the 100 shares of stock because other parties also have a claim. The real problem with Article 8 is the section entitled “Priority among security interests and entitlement holders.” In simple terms, a brokerage company has two accounts with a custodian, which is a company a few levels above the brokerage company. One account holds the brokerage company’s own financial assets (the securities entitlements to the underlying security) and the other account holds all of their customers’ securities entitlements, including the entitlement to your 100 shares of stock.
When the brokerage company borrows money from their bank, the assets of the borrower are pledged as collateral for the loan, which makes sense. But if the brokerage firm becomes insolvent, say due to a systemic financial crisis, a secured lender has priority over all of the accounts of the brokerage firm, including your 100 shares of stock.
UCC Article 8 provides:
A claim of a creditor of a securities intermediary who has a security interest in a financial asset held by a securities intermediary has priority over claims of the securities intermediary’s entitlement holders who have security entitlements with respect to that financial asset if the creditor has control over the financial asset.
Clear as mud, right? Here is what it says in English. A secured lender (creditor) who has control over the financial asset, as a custodian for example, has priority (meaning they can take ownership of the financial assets) over the securities intermediary’s (the brokerage firm) entitlement holders (this means you and all other individual investors with accounts at the broker). Another conspiracy theory?
Here is a summary of a proof-of-concept example offered by David Webb in The Great Taking:
Lehman Brothers filed for bankruptcy when the 2008 housing bubble burst. One of the primary lenders to Lehman Brothers was JP Morgan Bank (JPM). A subsidiary of JPM was Lehman’s custodian, both of Lehman’s own assets and the assets of Lehman’s customers. As custodian JPM had control of Lehman’s assets and as lender JPM had a security interest in Lehman’s assets. As a result of UCC Article 8 (and a friendly change to the federal Bankruptcy Code made in 2006) JPM took all of Lehman’s accounts as collateral for the loans that Lehman could no longer pay.
It gets worse. The next provision of Article 8 gives clearing corporations—securities intermediaries that handle the flow of stock and bond transactions—priority over you even if the clearing corporation does not have control of the financial asset.
At this point, you may be asking yourself: why would the Article 8 drafting committee do this? The individual investors have no role in the lending practices of their broker, why does the law allow the taking of their assets?
To answer that question, you need to know the fundamental objective of the Article 8 revisions and you need to know more about the composition of the drafting committee. The driving motivation was systemic risk in the financial markets (if they were worried about systemic risk in 1994 what do think about it now?). Importantly, the Article 8 revisions did not do anything to reduce the likelihood of systemic risk. In fact, the committee made it worse by removing risk and consequences for shady financial activity. Instead, what the changes actually do is protect the “too big to fail” banks if a systemic financial collapse occurs.
This motivation makes perfect sense once you understand that the attorneys driving the committee’s revisions worked for law firms whose clients were the large money-center financial institutions who are the beneficiaries of the revised Article 8.
What Can Be Done?
The United States is mired in debt. Wall Street continues to create derivative securities out of thin air. All this debt and all of the derivatives are backed by the stocks, bonds, IRAs, and 401(k)s as collateral. And the dirty secret is that each $1 of that collateral is “backing” multiple dollars of debt. Because there are not nearly enough assets to back the debt and derivatives tied to those assets if the financial system crashes, there will be cascading insolvencies of financial institutions up the food chain. Investors, including public pension plans, will be in the back of the line in bankruptcy court as unsecured creditors.
But, because the UCC is state law, state legislators can restore the rights of investors by giving them priority over secured lenders. Moreover, a few other simple changes to the UCC can reduce the impact of the theft authorized in current law. But time is ticking, and despite what the Biden administration says, the economy is on shaky ground.
What event could set off a systemic financial crisis? Over the last three years, it seems like every news cycle brings a major new event. Will it be the next crisis that finally tips the scale? Or will it simply be the collective weight of debt, prior crises, and loss of trust? One thing is certain: we are far closer to a systemic financial crisis in 2024 than we were in 1994.
As states step up to protect their citizens, the “too big to fail” financial institutions will likely claim that any changes to Article 8 will bring down the financial system; that it will be the end of the world as we know it. Perhaps it will, but for me, any system that requires the people to sacrifice their property to support the financial institutions that built this mess in the first place is not a system worth saving.