Best Practice in Custody Agreements

The major custodial banks have long advertised themselves as global. They engage with clients from around the world, holding and servicing the widest range of securities on the investors’ behalf.

On the face of it, this implies that the contractual terms between you, as an investor, and your custodian should be standardised, wherever you are located. In fact, this is not necessarily the case: the contractual positions offered by custodians to clients in one market may be significantly better than in another.

Although these differences in legal terms may reflect local regulations or differences in market structure, Thomas Murray IDS believes that there are global standards of best practice to which investors should adhere when negotiating legal terms with their custodians. Below, we highlight five areas in custody agreements that are worthy of particular note.

Who takes responsibility for corporate actions?

Corporate actions and events—dividends, share splits, mergers, rights issues—are an area of potential complexity for custodial banks and their investor clients, as well as representing significant risk. In most other areas of custody, such as an interest claim relating to a trade settled late, losses are recoverable. If a corporate action or event is mishandled, a loss can be total.

What can go wrong? For example, a custodial bank may fail to inform a client that a corporate event is happening or, if it does so, informs the client late or inaccurately (see the table). 

What can go wrong when a corporate action occurs?

The minimum standard of service offered by a custodian when it comes to corporate actions is to act as a “postbox” (see Corporate Action 1 in the table). Imagine that a Russian company announces (in Russian) an imminent meeting of shareholders somewhere in Siberia: a postbox service would imply that the notice is merely forwarded to the client, as is.

Of much more use to the investor is a service where the custodian receives translated notifications of corporate actions from its sub-custody network adds information it has sourced directly from its data vendors, uploads the information into a data warehouse for comparison and creates a definitive version before forwarding it to the client within a specified timeframe. 

Another area of potential risk is where an investor passes an instruction to a custodian but, for whatever reason, it fails to act on it. The wording of custodial agreements can be crucial in determining the extent to which the custodian agrees to cover losses in the case of a missed instruction.

Can the custodian take possession of my assets?

A lien is a right to keep possession of someone else’s property until that person settles an outstanding debt. While it would be highly unusual for a lien to be exercised and would certainly damage a relationship, the custodian sensibly has to seek to protect its interest.

While best market practice (from a client’s perspective) may be the total absence of a lien clause from the custody contract, most large clients of custodians would settle either for a right of set-off against the assets held by the custodian on the investor’s behalf, or for a right of retention on the investor’s securities. This gives the custodian the right to block a portion of the securities until the debt is settled, but not to sell them.  

However, the absence of restrictions surrounding a lien might potentially cause an issue. An unrestricted lien may grant the custodian the right to seize and sell client assets at rates that the custodian deems reasonable (that perhaps the client wouldn't) in settlement of the outstanding debt.

Who else has a claim on my assets?

The client of a global custodian has a contractual relationship with that custodian, not with the custodian’s agents (sub-custodians) in local markets. However, the custody agreement may grant those sub-custodians a claim on the investor’s portfolio. This would enable the custodian to pass on a claim from a sub-custodian (for example, in connection with unpaid fees) directly to the investor who has invested in the local market.

However, best practice would specify that, as the investor does not have a formal relationship with the sub-custodian, the sub-custodian should not be granted any rights over the investor’s portfolio. An option to mitigate such exposure would be to include a separate clause in the custody agreement, setting out the custodian’s obligations to indemnify the investor against  the exercise of such a right being exercised.

How do we terminate the contract?

The custody agreement will include as standard the notice period for the client to terminate its relationship with the custodian, and vice versa. While it may seem fair to grant both parties the same notice period, there’s no reason why the custodian and the investor should have identical exit terms: if the client wishes to end its relationship with the custodian, it typically wishes to do so as quickly as possible; if the custodian wishes to end its relationship with the client, it needs to bear in mind the client’s need for an alternative supplier.

What’s the right standard of care?

The language in the custody agreement detailing the standard of care to be offered by the custodian to the client can have a material impact, since it can determine to what extent the burden of proof falls on the client if it were to suffer losses as a result of fraud, negligence or wilful default by the custodian.

At a more mundane level, the standard of care specified in the agreement may determine a custodian’s policy for dealing with errors and omissions. Does the custodian act as any “prudent and professional person”, “reasonably” or “according to local market convention”? The wording of this clause can result in significantly different outcomes for clients.