February 19th, 2018 by Torsten Krebs Tags:
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The first article provided a high-level review of the parties, the agreement, accounts and assets involved in the most standard of custody relationships: namely a commercial bank providing global custody to local institutional investors and local market sub-custody to global custodians from other jurisdictions [= “you” in these articles]. It can be observed in passing that this is not the only model: private persons who own securities may have them held by their bank as custodian; this is standard in, for example, civil law jurisdictions or with universal banks. Institutions which are not themselves banks may provide custody services for their clients, usually as part of a wider service. It is, however, the remit of these articles to consider the various legal issues which arise in the scenario outlined above; a sufficiently lengthy exercise.

This article will progress the review, considering some of the issues involved in actually becoming the “holder” of your client’s assets so that the services can be provided. Having opened the accounts, something needs to be put in them. The first task is to bring all the applicable securities under your control as custodian.


Receive Assets – Transfer of Existing Assets

Your client’s existing holdings will have to be transferred from wherever they have been prior to your appointment, perhaps from a competitor custodian, or from the holdings of investment managers or brokers, perhaps from “self-custody”. There might also be fresh subscriptions or purchases, in particular where the client is a new entity, which will be looked at later in this article. It is in everybody’s interests to make this as smooth and efficient as possible and at as little cost: an orderly transfer. Your client will want to minimise the adverse impact on trading and investment activity during the transfer. So will you, and to have easy reconciliations, minimal requests for further documentation etc…

ASIDE:   A public, statuary insurance body had amassed a very significant portfolio over the decades of receiving and investing compulsory levies. After years with the same global custodian they were required by a new government policy to put the work out to tender. The existing custodian did not win the tender. They were decidedly uncooperative with the transfer. Three years later, when the work was again put out for tender, that previous custodian was not even invited to make a proposal.

There are many, many possible variations and permutations. Thorough preparation is essential and starts with a detailed understanding of the securities to be transferred: what type and where; how they are currently held; any ownership restrictions which apply or disclosure obligations to be complied with… The process of transfer will probably be different for each of the above. The following examples illustrate but a small portion of the matters that might need to be identified and addressed.

For physical, bearer securities, the transfer might entail simply obtaining secure possession of the certificates, verifying their authenticity and implementing secure scrip storage (fire-proof safes etc) movement control, reconciliation and audit procedures.

Securities in registered form, whether physical or book-entry securities, will probably need to be re-registered. How and with what entity will vary depending on the requirements of the issuer, the jurisdiction in which they are issued (possibly also the jurisdiction in which they were acquired, if different from the jurisdiction of issue, e.g. shares admitted to trading on markets in two or more countries) and the rules of any securities depository or other step in the chain from your client, through you to =>, to => to the top level of the issuer’s share or debenture registry. This registry might be maintained by the issuer in-house or out-sourced to a professional registry. It is also possible that registrations of ownership and transfers are dealt with by a clearing house or depository which maintains a “book-entry” transfer system. The most common such systems are either where the name of that clearing house or depository (or its nominee) is recorded on the issuer’s records as the holder (a sort of “jumbo” shareholder) or where the records of the clearing house or depository are deemed to be the (or part of the) records of the issuer.

For those securities in a “beneficial owner” market – where the ultimate owner must be noted in some way in the register of security holders – or where your client requires that securities be registered in its name, your client’s (or your client’s customer’s name…) name ought to already be where it needs to be, so no change will be required at that level. However, your capacity to complete transactions in or to give instructions regarding those securities will need to be set up. A power of attorney from your client or a third party authority over the securities are two examples of means by which this can be achieved. Such authorizations often give rise to “differences” due to the varying exposures of the parties involved: your client might want any such power or authority limited by reference to “as set out in the custody agreement” or “as instructed by us” in order to protect its position if you exceed the instructions or power issued. The issuer or depository will probably not accept such limitations for the same reasons: they wish to be safe when acting on your instructions without having to investigate further by reviewing the custody agreement or receiving a copy of the instructions to you from your client. On balance, it is suggested that the issuer or registrar’s position is to be preferred for both practical and legal risk reasons.

Note that “beneficial owner” markets are not all the same: in some cases the ultimate owner must be the party to the account at the issuer, i.e. the counterparty to the contract with the issuer represented by the securities, in other cases it will be sufficient if the ultimate owner’s name is noted somewhere, for example as a suffix to the account name of segregated accounts. These situations are to be distinguished from those in which issuers of securities have some power to compel disclosure of the ownership or control of, or other “interest” in, their securities at a particular time (e.g.: U.K. Companies Act s793; Ireland Companies Act s1062; Australia Corporations Act s672A). Those are one-off exercises which must be initiated by the issuer and (generally) do not involve on-going obligations. Also not “beneficial owner” markets or securities are those where disclosure is required solely in order to exercise some right such as attending and voting at a meeting of members or creditors, or when certain levels of holding are reached – “Threshold Reporting” – at, for example, 2%, 5%… of the voting rights or issued capital (U.K.: DTR 5.1.2; Ireland, Companies Act s 1048; Australia, Corporations Act s671B.

The situation with registerable securities which are registered in a name other than that of the ultimate beneficial owner will depend on the number of steps in the chain. For securities in your home jurisdiction, it will probably be your name (or that of your nominee company) which needs to be entered in the records of the issuer or the securities depository involved. Securities in other jurisdictions may well need to be transferred from the name in which they are currently registered – probably the nominee of the local sub-custodian of the transferor custodian – into the name of the nominee of your sub-custodian in that jurisdiction.

Bearer securities in book-entry form seems to be a contradiction in terms. The accounts of the holding are not anonymous or in code; there are named parties to the accounts. There is nothing to “deliver”, so transfer of title cannot take place by delivery. The legal nature of bearer securities, indeed all securities, in book-entry systems has been the subject of investigation in several textbooks and articles. It is beyond the scope of the current review. Suffice it to say that it works and has survived various stress scenarios.

In today’s environment of book-entry securities held by (central) securities depositories, transfer of many securities, in particular listed securities, is much less challenging than it used to be. The further one moves from that – unlisted securities, securities with physical certificates, alternative investments such as hedge fund positions – the greater the challenges will be.

Anticipate that there will be tax forms to be completed: “only two things in life are certain…”. Many governments collect revenue when securities are transferred: stamp duty, transfer tax, capital gains tax etc. The transfer to a custodian does not involve a disposal or transfer of ultimate ownership. Whilst many revenue authorities recognise that and provide exemptions such as “NCBO” (no change of beneficial owner), this might well need to be applied for and the application will require accompanying documentation. As an on-going matter, your clients’ securities in other jurisdictions may be eligible for preferential taxation based on the type of entity; pension funds or charitable foundations for example. Again, these will probably need to be applied for and the securities of various types of clients which quality for preferential treatment might well need to be segregated from those of other types of clients.


Ownership limitations

One regularly encounters securities issued by companies in certain industries which are subject to restrictions on who is permitted to own them. Such limitations include the restriction of the concentration of ownership or control in industries such as media or banking or limitations on ownership by “foreign” persons in industries such as airlines or defence manufacturing. Usually the company concerned is required to track the position, assisted by laws or rules compelling threshold disclosure by the holders and empowering the company to obtain information from the holders or various other persons. The company may be empowered or even compelled to decline to register a transfer to, or to refuse to recognise votes cast by a holder of securities in excess of the limitation. More extreme remedies include divestiture or confiscation and even criminal sanctions. Such limitations might result in the companies’ securities being divided, either formally or de facto, into two classes, domestic and foreign, for example. If the securities are in demand, a price differential could arise and /or a queue for registration of transfers might exist. These situations present demands for the custodian also. A simple example might be where the transferor custodian is a local entity but your sub-custodian in the jurisdiction is a branch of a foreign entity.  At law there is no change in the ownership, so there ought not to be a problem. Is the company’s share registry equipped to recognise that? It can be observed in passing that the definitions will often not be consistent: the definition of, say, “have an interest in” securities subject to ownership limitations will not necessarily be the same as for threshold reporting or demands for information from an issuer. If only it were that straightforward….

ASIDE: It will be clear that several individual people or entities might well need to be included in information demanded by issuers and/or whose securities are subject to ownership limitations: each of Mr and Mrs when shares are owned jointly; plus the beneficiaries if there is a family trust; both vendor and purchaser for unsettled trades… Securities lending can lead to a very substantial increase in this number. One company, a flagship airline subject to limitations of “foreign” ownership, became concerned that it might be in breach of the limitations. It issued notices to all the shareholders on its share registry requiring information regarding all persons or entities who had an interest (as defined) in the shares. The company involved received responses which totalled many, many times the number of shares it had issued. In an attempt to reconcile the matter, that company chose to disregard the interests of lenders pursuant to loans of securities. Shortly afterwards the borrower of a parcel of these shares (the borrower was a local entity, so not subject to any limitations) returned them pursuant to the securities lending agreement. Registration of the shares back into the name of the custodian’s nominees on behalf of clients identified as “foreign” was rejected on the basis that it would cause the company to exceed its foreign ownership limitation. The custodian asserted that at all times since initial acquisition the foreign entity had maintained an “interest” in the shares, that the company had been duly notified of this situation at the time the loaned shares were registered into the name of the borrower (there is a standard procedure for identifying transfers of registration pursuant to loans of securities as opposed to outright dispositions) and therefore ought to have reserved the space within its foreign-owned shares. Finally, that if the transfer back to the nominee on behalf of the foreign client was not registered an action for rectification of the share register would be commenced. The company found some space and registered the transfer …

Not long afterwards the secretary of that company and the general manager of their share and debenture registry requested meetings with each of the larger custodian banks to discuss ways in which such problems could be avoided; suggesting that custodians be responsible for maintaining the records of how much space was required within the share registry for foreign ultimate owners. It was pointed out to them that maintaining records of the shareholding, including the foreign ownership percentage, was a duty imposed on the company by statute, so custodians could not relieve them of that duty. Whilst it might be possible, for a suitable fee, to assist them to fulfil that duty, how could that be done any better than the information already provided on each such transfer? It seems that they had been using the information so provided to correctly assess stamp duty and capital gains tax (there are exemptions for such transfers), but not for tracking foreign ownership. Nothing more was heard of the matter.


Receive Assets – New Investments

Your client will want to minimise the adverse impact on trading and investment activity during the establishment of the custodian relationship, in particular if the client is a new investment entity; a start-up fund being launched for example. On-going, your client’s holding is unlikely to be static, although that does occur from time to time. Your clients’ likely trading and holding strategy and other requirements ought to have been discussed as part of the pre-contract discussions, as custodians’ fees are often a combination of a percentage of assets held plus fees per activity. The activity fee may well vary for different activates, reflecting the effort, expense and exposure involved: receiving dividend income in the home market might be at the lowest end whilst settling a purchase or claiming in an issuer’s insolvency in a “frontier”, beneficial owner market would probably incur a significantly higher fee. Significant variation in the anticipated activity and actual activity could well impact on the profitability of the relationship.

The custodian operation must not have any involvement whatsoever in the selection of investments or review of their performance: the staff in the custody operation are unlikely to have the required expertise or any information about the client’s strategy, risk profile etc and are probably not charging fees appropriate to this sort of service (but would probably be just as liable for errors). More importantly, to do so risks compromising the independence and impartiality of the custodian’s position in respect of both the various assets held for a client and between the holdings for various clients; that is to say, it could give rise to conflicts of interests. This entire matter is now governed by regulation requiring policies and procedures to identify and prevent, monitor and manage conflicts of interests – disclosure to the client is not sufficient – (MiFID II Arts 16 (3) & 23, MiFID II Regs Art 34; AIFMD art 21(10) + (11)(d)(v), AIFMD regs Art 80; UCITS V Directive art 25 + 22a (3)(d); U.K. Principles for Business 8, SYSC chap. 10, FUND 3.11.9 + .28 (e), COLL 6.6B.3 + .24(e); Ireland E.U. (MiFI) Regs 2017 r23(1)(b) & 30, E.U. (AIFM) Regs 2013 r 22(10)(b) + (11)(d), E.C (UCITS) Regs 2011 rr 22(2)(b), 24(1)(d) & Sched 5, rr54, 65 – 76. The various regulations go on to require functional and hierarchical and even physical separation of staff involved in different functions such as investment management, brokerage, custody…, controls on the exchange of information and any linking of revenue or remuneration between such business. The most detailed requirements encountered (so far at least) are those in the Australian Corporations Law, provisions. Sections 601FCAA (2) & (3) and 912AAC (7) & (8) set out requirements which cover not only all of the above, but also staff education and training, vetting and supervision.

An exception might be providing generic information on the requirements in a particular market or for various types of investments. If one of your clients is considering expanding its portfolio into a new jurisdiction, perhaps an “emerging market”, or a new type of security, the things to be considered include how the assets would be held, valued, reported on, what obligations are entered into by becoming a holder of that asset and how will they be fulfilled etc and at what cost. Custodians must tread a fine line between providing general advice, such as “market bulletins” and giving legal on investment advice. On the other hand, your capacity in that new jurisdiction or experience with the type of investment will be important to both you and your client, providing such information is not only permitted but required. Separating these two is not always easy.. Consider that, whilst your client carries the economic, market, counterparty etc risk,  it could still be your (or your nominee’s) name on the issuer’s registry, in which case you might well be liable for the obligations undertaken by investing in that asset and have to rely on your client’s capacity and preparedness to make reimbursement to cover your exposure. It ought not to be assumed that an instrument whose name translates into English as “share” or “debenture” will have all of and only the features of those instruments in a long-established English-law-and-language jurisdiction. If you are not comfortable about the exposure that would be undertaken, don’t do it: refer back to the definition of “assets” in your custody agreement, which ought to contain a “subject to the custodian’s acceptance” escape provision. Alternatively, you might be able to set a fee appropriate to cover the expenses and risks involved.

Your client’s new investments might be made either as initial investments in newly issued securities perhaps by subscription to a public or limited offer or in an “OTC” (over the counter) transaction – the “primary market” – or by purchasing existing securities from a vendor on a trading venue such as a stock exchange or as a bespoke, off-market transaction – the “secondary market”.

Primary Market:   As a general observation, inviting the public to invest in securities can only be done by way of a prospectus meeting stringent requirements. This is not the place to review the prospectus requirements in various jurisdictions for various types of security. Making the investment – purchasing the new shares or participating in the new collective investment scheme – requires investors to sign-up or subscribe. Custodians should consider very carefully whether they are prepared to sign the subscription documentation. The holder of securities is a party to and bound by the contract between the issuer and the investor, the terms of which are set out in the company’s Articles of Association. The subscription agreement will probably contain further provisions relevant to the initial investor. Your client, who has reviewed these matters and made the decision to proceed with the investment, is the party who ought to be bound by these provisions. Consider whether your position is better served by having your client execute the subscription with the securities to be delivered to and/or registered in your (nominee’s) name, or whether your service also includes shielding your client from the terms of the prospectus? If the investment performs badly, are the representations and warranties, acknowledgements, releases and indemnities in your custody agreement sufficient to enable recourse if worse comes to worst? Can you be certain that your client’s instructions will be able to be found and produced and then enforced possibly several years later?

Secondary Market:  The normal course of events is for your client’s investment decision-makers to decide to buy, say, X,000 shares in A inc. This order is passed to your client’s brokers to fulfil; meaning to find the shares for sale. (These various functions might all be performed by different staff of your client, or by independent businesses; it makes little difference from the custodian’s point of view). When a vendor is found, the purchase transaction is entered into between your client and the vendor. At about this point you as custodian will receive an “Authorised Instruction” from your client (which might actually be from a third party acting with your client’s authority, more on this later under “Authorised Instructions”) roughly along the lines of “receive [number] of [name of the security: e.g. “common shares of A Inc”] ISIN [international securities identification number] trade reference [a reference code and the date of the transaction] from [details of the vendor;] at [information about the venue] against payment of [purchase price] to [details of vendor’s bank account] due for settlement on [date settlement should take place]. NB: this will vary from market to market, even for different types of security on the same trading venue.

Trade reporting – the provision of volume, price and venue information to the market for public dissemination – ought to have already been attended to by your client’s broker. It is supposed to be “real time” and might well be automated into the order place, match and confirmation process.

Transaction reporting – the provision of some 60 pieces of information including the above plus details of parties and much more to the regulators for supervision of market behaviour, not available to the public – might require the custodian’s involvement. The timing is more flexible, from T+1 (the day after the trade date) in the E.U. to post settlement in some jurisdictions.

In developed markets for on-market transactions, the settlement of this purchase and sale will take place at a fixed time after the trade is executed – currently T+3 (third business day after the transaction is entered into), moving progressively to T+2 – and can all be attended to electronically. The issuer, or (more likely) a central securities depositary, will receive two instructions, one from you as the purchaser’s custodian, the other from or on behalf of the vendor. If they match, an entry will be made in the register to transfer ownership of the parcel of shares from the vendor (or their custodian, its nominee…) to you or your nominee. Unless the market or the issuer requires – “Beneficial Owner” market or stock – this entry probably will not actually include “on behalf or” or other words indicating the relationship between registered holder and ultimate owner, albeit that registration in the name of “ABC Nominees” will indicate something further. Recording such matters on the registry is actually prohibited in U.K. (Companies Act s126) and in Ireland (Companies Act s170) and limited in Australia (Corporations Act 1072F (10)). There will be some mechanism for these entries to be suspended or be only provisional until the electronic movement of funds is confirmed. You will debit your client’s funds account and remit the funds to the vendor’s bank account. The issuer or depositary is informed of the successful transfer of funds and the entries in the register become final. That at least is the outline of a true “DvP” – delivery versus payment – situation. The reality will vary.

In the days of physical certificates the situation was even more challenging. A shareholder with, say, 50,000 shares in A Inc did not have 50,000 individual pieces of paper; rather a single certificate showing 50,000 shares. If they sold 25,000 of these shares, the certificate had to be sent to the issuer together with a completed transfer document (probably accompanied by evidence of identity and validation of the signatures, possibly yet more documents). In due course two new certificates would be provided by the issuer, one in each of the names of the shareholders. The time involved varied considerably. Trading in these shares was not required to stop while this process ran its course. To make the situation even more challenging, the two portions of the transaction – money from the purchaser to the vendor, securities from the vendor to the purchaser – did not necessarily take place simultaneously. It was actually unusual for the parties to meet and exchange a cheque for a share certificate and completed transfer form.  The time for the payment was more or less determinable, often by the trading rules of the exchange, but one had to wait for the certificates and other documentation. Custodians, brokers, fund managers etc regularly spent days and thousands playing catch-up. This inefficiency might have contributed to the securities markets melt-down in October, 1987; it certainly caused the post-trade processes to cease up in the aftermath. Many entities involved chose to rule a line under their position at some time in the following months, to pursue vendors for certificates outstanding and income owed but to respond only to those claims actually received from their transferees.

ASIDE: Many, many demands and claims were made, some even commencing litigation, but I’m not aware of a single case that actually went to judgement. The greatest challenge was carrying a big enough stick to actually get the other side to give the matter the attention it required. After that point a negotiated settlement was always reached. We all won a few and lost a few: “a bad settlement is better than a good judgement”. It was probably three years before all was finalised (if it every actually was).

Every cloud has a silver lining: whilst lawyers for the custodians, brokers etc reviewed evidence, drafted claims and negotiated settlements, lawyers for the exchanges and the government departments drafted rules for DvP –“Delivery versus Payment” regimes (no more paying your money but waiting for your certificates), fixed settlement cycles (where transfers have to be settled on or before a particular day, usually the third business day, after the trade is entered into), for central counterparties – CCP – (where every bilateral sale / purchase becomes a two-step sale to the CCP and a purchase from the CCP) and for book-entry securities ownership and transfer. The later has two basic models: “Immobilisation” – where securities are issued in physical form but then deposited in a secure facility, the manager of which is recorded as the “holder” in the issuer’s records and in turn maintains an accounting record of the individual “owners” of the securities as these change. “Dematerialization” – where the securities only exist as entries in the accounts of the issuer’s registry (or its delegate, subregister…) where “ownership” is recorded and transfers entered.

Both then and now there is an initial, market-internal procedure for enforcing the contract of sale / purchase. If one party is ready, willing and able to perform but the other is not, the first party is not required to wait, at least not indefinitely. Whilst the time required will vary, at some point the party who is ready may designate the trade as “failed” and initiate a “buy-in” or “sell-out”: the exchange or trading venue is informed and either: “buy-in” – the purchaser obtains the securities elsewhere; or “sell-out” the vendor makes another sale, in each case at the cost of the late-performing counterparty often with a penalty imposed by the trading venue. The system is designed intentionally so that it is never advantageous to renege on a transaction and accept the buy-in or sell-out. Healthy, efficient securities lending or repo services contribute significantly to avoiding failed trades by providing either the securities or the funds required. A detailed review of these products is beyond the scope of these articles.


Now you have your client’s assets under custody. Securities are not commodities; a share or debenture is a contract, a bundle of rights and obligations between the issuer and the holder. Various things will happen to your clients’ securities whilst you are holding them in custody. We will look at some of the more common ones in the next instalment.

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