UCC CONTROLS WHICH SHAREHOLDERS GET SHOT AT A BILLION DOLLARS

July 14, 2004

Steven P. Garmisa
Hoey & Farina Attorney
garmisa@hoeyfarina.com
1-888-425-1212

A billon-dollar question in a New York case hinges on the meaning of section 8-302(a) of the Uniform Commercial Code.

When Consolidated Edison pulled the plug on a merger with Northeast Utilities, NU shareholders lost the billon-dollar premium that ConEd had agreed to pay for their shares.

Last year, U.S. District Judge John G. Koeltl of the Southern District of New York ruled that the NU shareholders could sue as intended beneficiaries of the merger agreement. Consolidated Edison Inc. v. Northeast Utilities, 249 F.Supp.2d 387 (S.D. N.Y. 2003).

The next question for Koeltl was which group of shareholders qualifies for a shot at the billon dollars. The competing classes are:
- Shareholders as of March 5, 2001, when the merger was supposed to close (the "March 5 Class").

- Shareholders "at the time that a judgment against ConEd is entered, collected or distributed" (the "Judgment Class").
NU argued that the Judgment Class should get the billon dollars in the "lost premium" if it wins the breach of contract claim against ConEd. But Robert Rimkoski -- who owned NU shares on March 5, 2001, but then sold most of his shares -- contends the lost premium should be paid to the March 5 Class.

Responding to Rimkoski, NU reasoned that members of the Judgment Class would be entitled to the lost premium because of section 8-302 of the UCC, which states:

"(a) Except as otherwise provided in subsections (b) and (c), a purchaser of a certificated or uncertificated security acquires all rights in the security that the transferor had or had power to transfer.

"(b) A purchaser of a limited interest acquires rights only to the extent of the interest purchased.

"(c) A purchaser of a certificated security who as a previous holder had notice of an adverse claim does not improve its position by taking from a protected purchaser."

Based on section 8-302(a), NU contends that shareholders who purchased NU shares after March 5, 2001, acquired "all rights in the security that the transferor had or had power to transfer."

Disagreeing -- but certifying the question for interlocutory appeal (along with the question of whether NU shareholders can recover for breach of the merger contract, as intended beneficiaries) -- Koeltl concluded that section 8-302(a) does not apply. 2004 WL 1105972 (S.D. N.Y., May 15).

Here are some highlights of Koeltl's new ruling (with various omissions not noted in the quoted text):

"NU argues that the plain language of section 8-302(a) requires the automatic assignment of the right to sue Con Ed to purchasers of NU shares."

"Con Ed and Rimkoski respond that New York law generally requires the express assignment of existing causes of action and that section 8-302(a) does not alter this presumption.

"Con Ed and Rimkoski argue that the true meaning and function of section 8- 302(A), as evidenced by its language, statutory structure, legislative history, and relevant case law, have nothing to do with the assignment of contract claims against third parties. Rather, section 8-302(a) only relates to issues of ownership and title and generally claims against the issuer of a security. The provision does not define a claim against third parties as a 'right in the security' or provide for its automatic transfer.

"NU argues that section 8-302(a) does transfer accrued contract claims against third parties because it refers to 'all rights' being automatically transferred without limitation.

"NU contends that because the right to obtain the merger consideration was based on possession of NU stock prior to the alleged breach, the right/remedy to sue for the merger consideration must be a right automatically transferred with the sale of the stock.

"Section 8- 302(a), however, refers to 'all rights in the security.' NU's analysis merely begs the question of whether a third-party beneficiary claim, not against the issuer of the security but against a third party arising out of a separate contract, is a right in the security and not a right or remedy vesting in the person holding the security at the time of the breach.

"NU also argues that because section 8-302(a) provides for the automatic transfer of all rights that 'the transferor had or had power to transfer,' and because Rimkoski 'had power to transfer' the right to sue ConEd, he must have done so automatically when he sold his shares. NU thus interprets section 8- 302(a) as defining 'all rights in the security' as any right that can be transferred and as codifying the automatic transfer of all claims accrued (except fraud claims, apparently) while holding a security.

"The official commentary to section 8-302 undercuts NU's construction of the statute. Section 8-302(a) is a 'statement of the familiar "shelter" principle,' as qualified by subsections (b) and (c), that ensures that a holder in due course gains clear title and may transfer his rights in the security as such.

"As an expression of the shelter rule, section 8-302(a) does not define 'rights in the security' as any right associated with the security that the transferor 'had or had power to transfer.' Instead, the phrase 'had or had power to transfer' stands for the unremarkable proposition that people cannot transfer rights that they do not own or control. See Haber v. Fireman's Fund Insurance Co., No. 98 Civ. 1740, 2000 WL 943562, at *7 (S.D. N.Y., July 10, 2000) (explaining that under shelter rule of section 8-301, which later became section 8-302, transferee 'is only entitled to the "rights" or ownership interest in the security that [the transferor] had in the certificates').

"NU's reading of section 8-302(a) transforms it to provide for the automatic transfer of all rights related to the security or accrued while possessing the security, instead of what the statute actually says, which is 'all rights in the security.' NU's reading also ignores subsections (b) and (c), which qualify subsection (a) and help to make it clear that section 8- 302(a) is a statement of the shelter rule.

"The legislative history of the predecessor provision to section 8-302(a) and the structure of UCC Article 8 confirm that section 8-302(a), rather than defining what rights are in the security, involves the mechanism for transferring rights and applies primarily to disputes over the quality of title and the competing ownership rights passed from transferor to transferee.

"UCC section 8-301, originally enacted in 1962, is the predecessor to the current section 8-302.

"As the official comment to section 8-301 explained, Article 8 'views the concept of negotiability from two aspects: issuer's defenses and adverse claims.' Section 8-301/8-302 thus anticipates two situations. One involves 'adverse claims' where a prior security holder asserts a claim to the security against the current holder.

"The other situation -- 'issuer's defenses' -- envisions actions to enforce rights against the issuer where the issuer may defend by arguing that the right or status necessary for the action was not transferred to the plaintiff, perhaps because the transferor did not have 'actual authority to convey' the right.

"This case, however, deals neither with competing claims to the security, nor with an action based on the security against the issuer where defects in the security transferred may raise a defense. There are no questions about the quality of the transfer or title conveyed in the NU shares; the only question is whether the security itself embodies the contracts rights against ConEd arising out of the merger agreement.

"The statutory scheme of Part 3 of Article 8 involves rules for the negotiability and transfer of securities, and section 8-301/8-302 is part of that statutory scheme, which deals with the rights and liabilities of successive holders of a security as between themselves. Article 8 as a whole does not set forth general rules defining property rights that accrue to holders of securities and instead simply sets forth rules relative to the transfer of the rights.

"As the [3d U.S. Circuit Court of Appeals] has explained: 'Article 8 was designed to facilitate the negotiability and trading of securities by assigning responsibility for certain steps involved in a stock transfer to the principal parties in the chain, thus relieving each party to the transfer of the need to check all aspects of the transaction -- from the validity of the issuance to the validity of the stock owner's identity and signature -- at each step of the stock transfer.' N.J. Bank N.A. v. Bradford Sec. Operations Inc., 690 F.2d 339, 346 (3d Cir. 1982).

"Section 8-302 does not define 'rights in a security' or codify a rule assigning to purchasers any claim accrued while possessing the security. The provision simply provides that whatever 'rights in the security' are, they are automatically transferred to a purchaser unless (a) the transferor did not own or control them, (b) the purchase was for a limited interest or (c) the purchaser is a prior holder with notice of an adverse claim taking from a protected purchaser.

"NU cannot rely on the plain language of section 8-302(a) because the language itself does not control what 'rights in the security' are. Nothing in the provision's language, its history or the statutory structure indicates that the statute governs the claim arising under the merger agreement, as opposed to an action arising from a contract transferring the security or a defense by an issuer in an action under the security.

"The few cases construing section 8-301/8-302(a) confirm that the statute does not address rights of third-party beneficiaries arising out of agreements separate from the contract embodied in the security.

"ConEd and Rimkoski acknowledge that the term 'rights in the security' does not involve only rights to title as between transferors and transferees. It also generally includes rights vis-a-vis the issuer arising out of the security itself. There is no support, however, for NU's proposition that 'rights in the security' include rights from a separate contract as to which shareholders are third-party beneficiaries.

"A security itself is essentially a contract between the issuer and the holder that, in the case of certificated stock for example, provides rights through the terms of the certificate and incorporated documents. A holder's rights in the security thus include the rights against the issuer under the contract embodied in the security as supplemented by federal and state law.

"With stock, these rights in the security against the issuer generally include participatory rights in the corporation, such as the right to attend meetings, vote, and inspect corporate records, as well as rights to corporate assets, such as the right to receive dividends.
"The official comment to UCC section 8-114, which governs evidentiary rules for 'actions on certificated securities,' explains that ' "an action on a security" includes any action or proceeding brought against the issuer to enforce a right or interest that is part of the security.'

"Understanding 'rights in the security' as against the issuer is consistent with the statement in the official comment to section 8-301 that Article 8 concerns negotiability in relation to two aspects. While one aspect is adverse claims -- that is, claims between transferors and transferees -- the second aspect is 'issuer's defenses.' That aspect involves 'actions on a security' against the issuer to enforce 'rights in the security' but where there is a defense that, for example, the transferor did not own the rights or title needed for the claim.

"In sum, upon the transfer of stock, the transferee receives rights in the security vis-a-vis the issuer and rights vis-a-vis other potential holders, including, for example, good title and bona fide purchaser status.

"Nothing in the text of section 8-302(a), in its history or commentary, or in other provisions of the UCC supports NU's proposition that 'rights in the security' include contract rights against third parties or that section 8- 302(a) codifies a rule for the automatic transfer of such rights to subsequent purchasers of the stock."

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