In the previous article, Custody 101 C, we commenced the review of the various things that can happen during the regular course of holding your clients’ securities under custody. That entire article dealt with financial activities; income and capital payments related to the securities. This article will review various regular events that can take place which result in a change to the security itself: “corporate actions” (the expression is to be understood as a lose heading, not a defined term). By “regular” is meant in the normal course of solvent activity. Matters arising out of an insolvency or other incapacity will be considered later under “Trouble”.
The industry divides corporate actions into three types:
- compulsory (sometimes “mandatory”), for example changes of name, share splits or consolidations, merges or spin-offs, changes of legal form;
- compulsory with elections or choices, for example a spin-off with the option to receive differing portions of shares in the new and the continuing company; and
- voluntary, such as meetings of security-holders or creditors, rights issues, tender offers…
The examples given above are by no means a complete list. Further, there will be corporate actions in some jurisdictions which have no parallel elsewhere.
In all cases some action by the custodian will be required. In fact it could well be that you have a quite active role and are exposed to varying levels of risk. By definition all of these activities are initiated by the issuer (or a rival, see later), not by the investor: the first your clients’ hear of it might well be the information you forward. Therein lies the first risk; have you received correct and complete information about what is proposed? Is it comprehensible? With a few significant exceptions, corporate actions begin life at a meeting of the governing body of the issuer – the board of directors of a company, a committee of some sort for a government issuer… – where the action is decided upon. For corporate securities, depending on the proposal (for example, the board of directors is empowered by the articles of association to take some actions without further authorisation whereas others must be approved by a general meeting), a meeting of the security-holders might be required to approve the proposal. Such meetings will be reviewed later in this article. Information about the action will then be distributed to the holders of record and ought to find its way down the chain to the entity who makes decisions about the security. Where a meeting of security-holders is required, information will have to be disseminated twice: once to convene the meeting and then to convey the result. The quality of the initial information can vary significantly; the quality of any translation even more so. It is common for custodians to subscribe to various information services to minimise the risks of missing or misunderstanding anything. Whilst the entity which makes investment decisions over your clients’ assets will probably also receive all this information, that is unlikely to relieve you of the obligation to properly inform your client. Whatever has to be done, will have to be done by you as the custodian with control of the assets. Those who make investment decisions are not in a position to execute their decisions; that separation is a touchstone of contemporary investor protection and one of the bases underlying your appointment.
Once the proposal has been properly activated, for compulsory corporate actions there might be little more to be done. The existing securities might need to be returned to the issuer against receipt of the new ones. With book entry securities this probably occurs automatically. Your records will have to be updated to reflect the new name, number of securities etc as appropriate. Problems can and do occur, however. The most common being with the mathematics, where problems of (at least) two sorts can arise. Your or your clients’ records of their holding in the issuer might not agree with the issuer’s records. Reconciling your records with those of the issuer – including the records of any intermediary custodian or depositary – prior to the action taking place may well save you both a great deal of stress. It is one of the things that ought to be done, indeed is now required by regulation to be done regularly anyway (general obligations such as “make adequate arrangements so as to safeguard clients’ ownership rights” and to “minimise the risk of loss or diminution of clients’ safe custody assets” – UK: CASS 6.2.1 & 6.2.2; IRE: E.U. (MiFID) Regs 23 (1)(k)(i) and Sched 3 cl1 (1)(f); AustRG133.43 (b) to (d) – are given concrete application to reconciliations, for example: “maintain its records and accounts in a way that ensures their accuracy and in particular their correspondence to the safe custody assets held for clients” CASS 6.6.3; E.U. (MiFID) Regs Sched 3 cl1 (1)(b) and “conduct, on a regular basis reconciliations between their internal accounts and records and those of any third parties by whom those assets are held” UK: CASS 6.6.34 and 6.6.35, especially (2) (a); IRE: E.U. (MiFID) Regs Sched 3 cl1 (1)(c); Aust: Corp Act 912AAC(6)(d), AAD (2)(g) and 601FCAB(2)(g). In some jurisdictions there is a regulatory obligation to cover any shortfall, UK: CASS 6.6.54;Corp Act 912AAC (6)(f), RG133.153(b)(iv).
ASIDE – our client held a position in a mining company in an emerging market whose share and debenture registry had been outsourced to a local accounting firm. According to our records the 254,326 shares we held should have given us 508,652 new shares from their 2 for 1 split. When only 450,347 were received, we started asking questions. Many months and the threat of litigation later the error was finally identified: our client had purchased a further parcel a few months ago. Our local sub-custodian had presented the executed transfers to the share registry who had misplaced them.
Issuers organise splits or consolidations of their securities for various reasons. The prime one being to improve their attractiveness to the issuer’s preferred investors. The market price of the securities of a successful business may rise steadily to the point where the price per security makes them unattractive to small investors or active traders. If those sorts of investors are attractive to that business, a split of the securities can improve the situation. Conversely, if the price of the securities has fallen to the point where they are traded very actively, are attracting many smaller investors or are in danger of becoming “penny dreadful”, the issuer might arrange a consolidation.
ASIDE – the attitude to small investors varies considerably. I supported one bank in organising a split of its shares because it wished to encourage small investors “because they are compliant”. A few months later I assisted another bank to organise a consolidation of its shares as it wished to discourage small investors “because they were expensive” (referring to the costs of maintaining the share and debenture registry, distributing information, providing member services etc)
The second mathematical problem arises out of the custodian’s consolidated holding on behalf of numerous investors. If you are holding, say 1,014 shares on behalf of four clients whose positions are 373, 207, 233 and 201 shares respectively in a company which has a 2 into 1 consolidation. You will receive 507 shares. How are you going to distribute these? If your systems can record entitlements to fractions of a security, you can do it 186.5, 103.5, 116.5 and 100.5 respectively. Whilst many custodians can do this, experience has shown that it gets progressively more and more messy. Your client probably cannot sell .5 of a share, nor vote on it, for example. An alternative is for you to sell the 2 awkward shares and distribute the proceeds to your clients accordingly. The authorisation of each of the clients involved will be required. Its good practice to include such a power in the custody agreement.
ASIDE – 1989 and the decision that as securities markets were automating, so should securities custody. We identified a suitable software house to devise and write a system. Every aspect of the business was engaged in preparing the specifications. It took longer and cost more than expected – nothing surprising – but it worked very well indeed until, that is, the first share spilt where some of our clients held odd numbers of shares….
Finally some thoughts about changes to an issuer’s legal form. The number of different types of legal entity and investment vehicle has increased in recent times, but the Anglo-Saxon jurisdictions still offer fewer types then are available in, for example, civil law jurisdictions. If a client of yours has decided to invest in a G.m.b.H., a K.A.G or a S.I.Ca.V., getting comfortable with the features of that sort of legal or investment entity might correctly be viewed as part of the initial investment review and decision; that is to say , a matter for your clients’ investment decision-makers. If such an entity decides to metamorphosize into a different type of legal entity available under the applicable law, a Kommanditgesellschaft for example, you as the “expert” holding or controlling the holding of the shares / units / participations… will need to be more actively involved. The obligations of a custodian usually include providing information about market and issuer events. Simply forwarding what is distributed by the issuer might not suffice, especially if it is a different language. Even translated, it might not mean all that much: G.m.b.H. = Gesellschaft mit beschrӓnkte Haftung translates as “company with limited liability”, but is this the same as a proprietary company, or a limited liability company or …? Is a SICAV really the same as an Oeic?
Part of the challenge is that giving much more information might be regarded as giving legal or investment advice, which the custodian is probably not permitted (or equipped) to do. This can be one of the situations where industry bodies really come into their own. A jurisdiction opinion covering the matter generally might already be in existence. If not, such a group could obtain a generic advice from local counsel covering the specific proposal or such situations generally with permission to make it available to their relevant clients on a “generic information only, you must take you own specific advice” basis and spread the costs amongst the group.
The above observations apply to all corporate actions. Voluntary or compulsory with elective corporate actions bring yet further issues and attendant risks. Firstly, there will be much more traffic. Whilst a compulsory corporate action might require as few as two communications to your clients, which might even be generic information to all clients – advice of the action and advice of its completion and the result – a voluntary corporate action will require two-way communications with each of your clients which holds the securities involved and with the issuer. Secondly, there is much greater variety in the types of corporate action and significantly more information which needs to be relayed between investors and issuers. Consequently, there remains a great deal of manual processing and a great lack of clearly defined standards despite substantial increases in volume. The risks for custodians include misinterpretation of the action itself and of the tasks required, late announcements by the issuers or regulators, late instructions from clients and mistakes in collating and relaying the information.
A rights issue is where an issuer offers its existing security-holders the option to acquire additional securities directly from the issuer in proportion to their existing holding, usually at a discount to the prevailing market price. There will usually be Ex-dates and books close dates as there are for distributions of income. Further, a time will be set by which the security-holders must advise whether they wish to participate or not and a time fixed for the payment of the price. The rights might be transferable, meaning a security-holder might chose to sell the rights as such rather than take them up. In some jurisdictions issuers are required to offer the same percentage to all security-holders; in other jurisdictions issuers might be free to make the offer on some sort of sliding scale; e.g. 1 new share for 10 shares currently held up to 1,000 shares currently held, then 1 new share for 50 shares currently held. Or the other way around, depending on the issuer’s attitude to small cf large shareholders.
The custodian must provide all the information to its clients, which can probably be done as one exercise forwarding the documentation received from the issuer, and then deal with each client’s instructions individually as they are received. It might not be acceptable to the issuer for responses in respect of a large holding to be received piece-meal. For example, if your total holding in a particular security is 2 million shares, which you hold on behalf of Clients 17 clients, you might be able to forward each client’s response as it is received. However, the issuer is not necessarily required or equipped to deal with that and is probably within its rights to require one response from each holder, even if that response is not the same for the entire holding. So you could send one instruction to, say, exercise the rights for 1.3 million of those shares and no action for 700,000, but not to send 17 separate instructions, one for each of your clients’ holdings. It becomes more challenging as clients often do not make the decision until very late: they wait and watch the market price for the security involved. Further, some clients who have decided to sell the rights find that they are unable to do so and instruct that they be taken up, again at the last moment. For these reasons there is often a very large volume of manual work to be done in the final day or two, even the last hour or two, with attendant risks of errors.
On a related issue; occasionally you might be asked what your other clients have instructed regarding taking up rights or tender offers, or to vote on an issue. You ought to decline to provide such information, even on an anonymised basis. To do so would be to provide some investors with information which was not available to investors generally and a failure to treat all your clients equally and impartially. It might also risk revealing one investment advisor’s strategy to other investment advisors. However difficult it might be to tick all the elements of any particular offence in an individual jurisdiction in such circumstances – is it insider trading? Is it Market manipulation? – the market regulator is likely to take a very dim view, to say nothing of the reaction of those of your clients whose information was provided to other clients. For completion on this matter, you must certainly not provide your clients with information about an issuer’s or another client’s relationships or activities with you as custodian or with your organization in any other capacity, in particular as banker, lender, underwriter…
ASIDE – In the course of quite hard negotiations with a large potential domestic client for master custody services, we wished to reword the “Information” provisions for various reasons, including that it could be interpreted as requiring us to inform them if we were about to take any action pursuant to a loan or other banking facility against any business in which they had invested. The bright but somewhat inexperienced young solicitor acting for the potential client thought it would be a very good idea for our bank to provide such information. The penny did not appear to drop when I shook my head subtly and opened my eyes widely, so I took my red pen, wrote INSIDER TRADING on a piece of paper and slipped it to him. His face went as red as the writing and the matter was dropped.
The issue with the simple mathematics outlined earlier can be much more significant in the case of rights issues with entitlement determined by a sliding scale. The custodian’s holding on the books of the issuer is often a consolidated position for many of the custodian’s clients. The number might equal more or fewer new shares than each holding individually would have. If the number of rights offered to you is more than the sum of your clients’ entitlements, you are probably required to simply take no action on the extras, thereby allowing them to lapse. Apportioning them amongst your clients might make them happy but risks angering the issuer as it compromises the issuer’s intention in setting a sliding scale. The angered issuer may well have means to thwart your plan… On the other hand, if you have received fewer rights than the sum of your individual clients’ entitlements, they will be unhappy. You might be able to assist those who wish to take up their rights by distributing the rights from those clients who decline, if there is time. You might be able to come to a suitable arrangement with the issuer.
ASIDE – a small but quite profitable listed corporation made a rights offer on a quite steep descending sliding scale; so the custodian’s consolidated position gave many fewer shares than the individual holders would have received had they each been registered as direct holders. Several of our clients were not happy. Discussions with the issuer prior to books close date were amicable but could not devise a better solution than to separate out each holding into a segregated account on the register opened for no other purpose than to enable each of our clients to receive their entitlement in full. The positions were transferred back into a single nominee account after the rights were exercised and the shares issued. A laborious and time-consuming manual exercise which fortunately went off without any errors.
The timing can also cause issues. The security-holders choice must be communicated to the issuer, usually before close of business on a date set out in the initial information. Close of business where? The issuer’s registered address, the place where its share and debenture registry is administered, the place where a meeting will be held…? In a large country these could be several hours apart.
ASIDE – At 17:45 one afternoon one of the senior managers came to see me somewhat concerned. A company registered in a state in the west coast had made an offer of new shares to existing shareholders. Their share and debenture registry was outsourced to an accounting firm on the east coast. Our clients’ responses had been consolidated and transmitted by SWIFT to their registered office at 17:15 (we were based on the east coast) but rejected by the company on the basis of being out of time as the instructions were required to be delivered by close of business that day to their share and debenture registry. Upon review of the prospectus I found no such information, so we telephoned the company secretary. The initial stance was that the tear-out-and-post response form at the back of the prospectus had the address pre-printed on it. That was actually true, but none of the custodians or large investment managers complete such documents manually. So we called our colleagues at Z bank – same problem and they were right at that moment on the telephone with colleagues at W Bank. Conference call and then another multi—party telephone call to the company secretary. Between the three banks we held a quite significant portion of their shares. A number of observations concerning the completeness of the information in the prospectus and “not sure it would be in [the company’s] best interest for this to become public knowledge” later and the company agreed to accept the responses.
The custody people involved in that matter discussed the question of whether a custodian, or any sort of trustee that does not have investment discretion, can properly use its position as security-holder to influence the issuer in the absence of instructions from a client on whose behalf the securities are so held. The lose conclusion was that addressing general investor-servicing issues or other matters with an issuer which could reasonably be regarded as benefiting all clients / ultimate owners of the securities was probably fine, but that actually exercising a power such as voting, convening a meeting or adding items to the agenda of a meeting could not be done without instructions from clients and in particular not for the benefit of the custodian companies’ other businesses.
Segue into the even more varied and challenging field of security-holders exercising their membership rights. Such rights vary enormously between types of security, types of issuer and jurisdiction. They commonly include the right to attend, speak and vote at meetings of members or creditors, at least in some circumstances; to require that such a meeting be convened; to require that the agenda of such a meeting include a particular matter; to be sent notices of meetings and to receive financial statements and reports and other information about the state of the business. Companies in many jurisdictions have fairly wide discretion to allocate different rights to different classes of shares. This might have to be tempered significantly if the company wishes to list its securities for trading on a public exchange as the listing rules often require that all securities of the same type have the same rights and limit the capacity to have different classes of shares, some of them listed and some not listed for trading.
ASIDE – we remember one media mogul who wished to list the company on a national stock exchange in order to raise capital for expansion, but to retain the effective control of the company within the family by issuing class A shares to the general public with one vote per share whilst issuing class B shares to the family with 50 votes per share. Repeated applications, each a variation on the same idea, were repeatedly refused by the listing committee.
Other common rights include: to require a company to convene a meeting of members, to require that an item be included on the agenda of a meeting, to require that a statement they have prepared be circulated to all shareholders, to require that the appointment of the company’s auditors be terminated, to require that a matter being voted on be so voted by a poll rather than a show of hands, to direct the board of directors to take some particular action or to voluntarily wind-up the company, to consent to meetings being held at shorter notice than the statutory period. Other rights are given in some jurisdictions but not others, including for example members’ rights to obtain information from the company which is not available to the general public, to circulate a written resolution for approval by the members or to themselves convene a meeting of the members (rather than requiring the board to convene a meeting). Each of these requires some sort of threshold volume to be exercised; 5 individual holders, 10% of the voting rights or 15% of the issues capital for example. (Generally regarding members’ rights in respect of meetings see U.K.: Companies Act Part 12; Australia Corporations Act Part 2G.2; Ireland Companies Act Part 4. There will be other rights in various places of the legislation, regulations and probably in the Articles of Association or other constituent documents of each issuer)
ASIDE – Businesses with a strong retail or public presence might also offer shareholders preferential treatment in their products of services. One national supermarket chain offered shareholders above a certain threshold a 2% discount card. The bank’s staff pension scheme considered taking this up for the benefit of the staff cafeteria. The idea could not be realised as they were separate legal entities and the discount benefit was not transferable, but we amused ourselves for ages with lines like how to reconcile the discounted tim-tams with the bank’s staff health and exercise policy.
You might from time to time receive an instruction to forward a demand to a company that a meeting be held or that an item be included on the agenda. I don’t actually recall any such event and I can’t image the operations staff dealing with such an unusual mater without checking with Legal. Instructions to vote and how to vote, on the other hand, are standard events. The way in which voting rights are exercised varies between issuers and varies significantly between jurisdictions. The latter is not widely appreciated by people who make investment decisions. Generally, there will be some physical place to function as a centre at which the meeting will be held, these days perhaps including an electronic link-in to other major venues for the convenience of shareholders. Smaller issuers might be able to hold the entire meeting by electronic connection. Natural persons who attend such a meeting by any of the means permitted are “present in person”. Corporate shareholders who wish to attend will have to appoint a “corporate representative” in accordance with the company’s articles or perhaps the relevant Company Law and are then regarded as being “present in person”. Shares owned by an entity which is not a separate legal entity, a partnership or trust for example, will require individual consideration: probably one of the partners or trustees could attend and thereby be “present in person”. It is usually possible for a shareholder to appoint another person or entity to attend, speak and vote on the shareholder’s behalf. A limited power of attorney could be issued, but it is a common practice for companies to provide a pre-printed form for such appointments. Using such a form significantly easies the tasks required to verify the validity of the appointment. That shareholder is still “present in person”.
Actual entry to the meeting must be controlled to ensure that only those who are entitled to attend, speak and vote actually do so. For registered shares this used to be achieved by carrying a share certificate and some standard identification. Bearer shares actually did not usually entitle access simply by carrying the certificate: an entry card had to be requested from the company in advance = the shareholder had to identify themselves to the company in order to attend, speak and vote. This system is now the one often adopted for exercising voting rights on electronic securities.
In many jurisdictions that is the end of the possible ways of exercising voting rights. In other jurisdictions, in particular Anglo-Saxon jurisdictions, a shareholder might also be “present by proxy”. This has come to be treated as a means of voting by post, even though that is not what the word “proxy” means (or at least meant). It has several serious limitations, which must be understood if voting rights are to be effectively exercised by proxy. Where voting by proxy is permitted, each company often has a certain amount of freedom to set the rules. The person appointed as proxy might have to be another shareholder. There might well be a default appointment of the president of the meeting or the chairman of the board of directors. Companies usually require that proxies be appointed and the votes exercised using the forms they provide with the notice of meeting – so a manual exercise. The company or perhaps the applicable legislation often requires that proxy forms be received by the company some time before the meeting; forty-eight hours is a period often given. The company is thereby on notice of the voting intentions of those shareholders who will be present “by proxy”. Whilst shareholders are usually not compelled to vote all of their shares the same way on any particular matter – a shareholder with 10,000 shares might well be entitled to vote 7,000 “Yes” and 3,000 “no” on a particular item on the agenda – actually doing so by proxy might not be physically possible. It is, or at least was, common for companies to provide two proxy forms per shareholder only, irrespective of how many shares were held or how many items were to be voted on at the meeting. After receiving all its clients’ instructions, a custodian has got to try to squeeze these into the two proxy forms. You could complete one form for 7,000 shares to vote “yes” and the other form for 3,000 shares to vote “no”, but that will apply to all the items to be voted. It is not possible to vote differentially, to change the percentage for different items; i.e. to vote 7,000 “yes” and 3,000 “no” for the first item, but 5,000 “yes” and 5,000 “no” for the second item. The forms did not provide for that level of splitting of voting. You must inform your clients accordingly. If the issues are significant, you might have to send a representative. It can be a very interesting experience…
Generally, items to be voted on at company meetings are so voted by a show of hands: “those in favour, please raise your hands.” “Thank you”. “Those against, please raise your hands”. In this procedure each shareholder has one vote, irrespective of whether they own five or five thousand shares and proxy votes are or at least might not be included at all. A representative of a custodian some of whose customers have instructed to vote in favour of but other customers have instructed to vote against a particular issue might be able to raise their hands both times, but that could be open to challenge by other shareholders present or by the chairperson or scrutineer of votes. Perhaps you’d be better off not raising your hand, but is that correctly giving effect to your customers’ instructions? If the show of hands does not give a clear indication of the result, a poll – a paper ballot – could be called for by the chairman. Alternatively, a minimum number of persons or security-holders holding the required percentage of voting shares (5 shareholders or 10% in the U.K., 3 shareholders or 10% in Ireland, 5 shareholders or 5% in Australia) present in person or by proxy can demand that a poll be held. When a poll is held, each share has the number of votes to which it is entitled by the articles of association. The default position is one vote per share. Ballot papers will be distributed for each attendee to complete, including the number of shares they are voting and other details. The person acting as proxies will need to attach or show the proxy appointment for scrutiny by the person counting the votes. This is quite a time-consuming exercise, such that the meeting might need to be adjourned while the votes are counted.
This leads into the next issue: who to appoint as proxy? The articles of association of the company concerned or the applicable companies’ legislation might require that the appointee be another shareholder, a member of the board of directors or even the chairperson, or perhaps an independent firm to whom this function had been outsourced. Alternatively there might be a default appointee, whether specified in some source or simply practice in the jurisdiction concerned, which the shareholder is free to override.
ASIDE 1 – a large client made contact with us after a company meeting as an issue on which they felt very strongly had been decided at the meeting contrary to their wishes. They had issued instructions to appoint a proxy and how that proxy should vote but had not specified any particular person as their proxy. We had followed the local practice of appointing the chairman of the board as the proxy. Our client regarded this as unreasonable because the chairman was in favour of the matter whereas they were against it, which we ought to have known. I pointed out that we were not privy to the detail of each matter to be determined at every meeting of the thousands of companies in which we held shares on their behalf, to say nothing of a many other customers; that we felt it was our job to act completely neutrally in such matters, following their instructions so far as possible and conforming to applicable law or practice. In this case they had not instructed who to appoint as proxy, so we had followed the applicable practice. I went on to state that the proxy was compelled to act in accordance with the voting instructions on the proxy form; they had no discretion on the matter. This information satisfied the client to a certain extent. It resulted in amendments to our standard custody contract to require complete instructions and an acknowledgement that voting rights would be exercised in accordance with applicable local law, regulation and practice unless the instructions where specific on any matter.
ASIDE 2 – What is the position if the proxy exercises the voting rights differently to that set out on the proxy form? Following the incident above I posed this question to the company secretaries of several large companies and received completely different answers. Some stated that, assuming the appointment to have been validly made, the manner in which the proxy exercised the powers granted was a matter between the two parties to the appointment; the company would regard the exercise as valid and the appointee would have to take some action against the proxy for breach of or abuse of the authority granted. Others took the view that the proxy was effectively a puppet with much less discretion than a representative or the holder of a power of attorney, able only to do what the appointee shareholder had instructed. Questioned further, this group were divided whether the non-compliant vote would simply be regarded as invalid and therefore not counted or whether it would be counted in accordance with the proxy form signed by the shareholder, irrespective of what the proxy had put on the ballot paper.
Corporate governance practice or even regulations in some jurisdictions might cover the several open issues outlined above, e.g. Australia: Corporations Act s250BB
Tender offers – where a person or entity outside a company offers to purchase a significant volume of the “target” company’s securities directly from existing holders – require particular care and attention to detail. There might well be more laws and regulations related to, and more emotional involvement in mergers and acquisitions than any other area of business save for insolvency. These laws and regulations might well be similar in most major jurisdictions, but the devil could well be in the detail and the consequences of an error could be quite significant. If the matter is taking place in a jurisdiction in which you have your own presence – your home jurisdiction, or where your services are provided through a branch or subsidiary – you will have to get it right. If it’s a place in which you have appointed a sub-custodian or other agent, you are relying on them to get it right.
The first major difference from other corporate actions is that the information will probably not come from the company in which you are holding shares – the “target – , but from a public announcement by the intended acquirer. The acquirer might be able to send material to the holders on its own initiative, depending on whether it either has access to that information or can compel the target to forward the offer details to holders. Customers expect reputable international custodians to be on top of this sort of thing; to have sources of corporate action information wider than just the entities in which their clients have invested. In fact this is usually included in their initial and on-going review of the suitability of the appointment of a custodian. Your best approach might well be to contact the acquirer and request sufficient copies of the offer document (there usually is one; putting the offer in writing is usually required by the relevant laws) to forward to each of your customers. There will almost certainly be a reaction from the target, which will also have to be forwarded to your customers. There may well be a general meeting of the target’s security holders with all that entails. In due course you will need to advise the acquirer of your various customers’ responses and possibly to freeze the securities for which you have instructions to accept the offer. That might be required by the applicable laws or by the terms of the offer document. Even if it is not, it is very good practice so as to avoid complications.
In due course, which might be some time, the tender will either be successful or not. You need to take the appropriate action as set out in the tender offer or the applicable law or practice; you probably will not receive further instructions from your customers as this is necessarily implied in their earlier instruction to accept the offer.
Two issues (at least) need to be considered: compulsory acquisition by the successful acquirer and incompatible instructions. In a situation where an acquirer has succeeded in gaining control of the target company they might well be entitled, or even compelled, to acquire the remaining smaller holdings. This is intended to be a protection for all concerned, in particular the remaining shareholders who could otherwise be left with unsaleable holdings whose future value is doubtful. It also enables the target to be completely closed down, merged into the acquirer or whatever the intention is. Those of your customers who rejected the offer might well not be happy, which will require some tactful discussion which must not amount to giving legal or investment advice. This is another situation where generic outlines of such matters, perhaps prepared for investors generally on the instructions of an industry group, can be really worthwhile.
A more awkward situation is where a customer who has instructed that the offer be accepted does something incompatible with the securities in that period between acceptance and the final outcome of the tender offer. This could be weeks or even months. Remember that, in Anglo-Saxon jurisdictions at least, “equity deems done that which ought to be done” = the acquirer will have some sort of interest, possibly amounting to equitable title, in those securities. It is unlikely that a standard market sale would be entered into with those securities as the offer price is usually a substantial premium on the prevailing market price, but these things can happen inadvertently. A customer which is an investment fund might need to liquidate investments to meet redemptions, for example. A more likely scenario is that the securities concerned become involved in some other, non-permanent transaction such as a loan of securities or a repurchase transaction, or provided as collateral for such transactions or as margin for derivative exposures. Whilst those situations can theoretically be unwound – loaned securities can be recalled, collateral can be substituted – that assumes the availability of alternative collateral and that the timing of recalls or substitutions will synchronise effectively with the requirement to deliver the tendered securities to the acquirer as required. Hence the common practice of transferring securities for which a tender offer has been accepted into a separate, frozen account.
Finally, a few thoughts on the “collective knowledge” in the custodian’s office. If you actually do become aware or have good reason to suspect that one of your customers is using you as a front, a straw man to evade position-reporting or some other legal obligations or to exercise control of a company surreptitiously, the applicable laws will make your obligations clear. Long gone are the days when banks could regard it as part of their service to assist their customers to hide from revenue authorities or securities regulators, market supervisors or issuers. Your Compliance department will determine what action to take in consultation with senior management. However, between your client facing staff and your operations staff in various activities there could well be enough information so that, if that were all held in one head, “knowledge” would be present. Are you thereby, as an institution vested with “knowledge”? A very difficult question. You are almost certainly required to have proper internal reporting and supervision in place. The details of the Conduct and Supervision regimes will vary depending on your jurisdiction and Corporate Governance will probably add a layer or three, but most of that is intended to prevent conflicts of interest and misconduct by staff or institutions. To what extent you are required to actively search for misconduct by your customers which is only identifiable by putting several disparate pieces of information together? Can this question be answered? At a generalised level such as these articles, probably not, but that doesn’t mean that it can be ignored.
In following articles we will consider the provisions in custody agreements which equip you to carry out your tasks – instructions, authority and delegation for example – common ancillary requirements such as statements and reporting, audit and inspection, information, and your protections such as representation and warranties, liability and indemnity, liens or security interests over your clients’ assets and termination before considering the various issues which arise with insolvency and other trouble.