The first of these articles looked at the parties to a custody agreement, the accounts to be opened and maintained and the types of assets involved. The second reviewed the process of transferring you client’s assets into your custody. In this and the next article we will review the “business as usual” of such a relationship, albeit that some of the events are not all that usual. Firstly considering the issues that can arise with the cash element – income and principal – of your clients’ investments.
To recapitulate, these articles all consider the situation from the point of view of a commercial bank providing global custody to institutional investors in its home jurisdiction(s) and local market sub-custody to global custodians from other jurisdictions (= “you” in these articles).
On-going holding of assets – Distributions and Contributions
Securities are not commodities; a share or debenture is a contract, a bundle of rights and obligations between the issuer and the holder. These can be divided into economic or financial rights and obligations and membership rights and obligations. 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, starting with cash movements.
DISTRIBUTIONS – INCOME Most (but not all) securities are issued with the intention that their holders will receive regular income from the issuer, either a more-of-less fixed amount payable as interest on debt securities (debentures, bonds etc) or a variable amount theoretically representing a portion of the company’s profits payable on equity securities (shares) and participations in various types of collective investment schemes (“Units” in these articles).
DISTRIBUTIONS – RETURN OF CAPITAL Debt securities are generally issued for a fixed or determinable term, at the end of which the issuer must repay the capital amount to the holder. Discount securities, e.g. bills of exchange, do not usually involve “income” as such at all; the investor’s return or “yield” is in the differential between the purchase price and face value (or resale price). They must be presented to the drawee when they are due. This distinction is not always recognised by other staff in the custody operation. Equity securities, in contrast, are mostly issued in perpetuity (at least in theory) with limited circumstances in which issuers may repurchase or holders may redeem them. Whilst units vary considerably in this as in many other matters, they are usually redeemable by the holder, albeit possibly subject to limitations. Where redemption is not or not yet permitted, holders can (theoretically at least) recover their capital by selling them on the secondary market (if one has developed that is).
CONTRIBUTIONS – CALLS ON CAPITAL
It is not uncommon for initial investments to be made with staggered payments of principal by investors rather than payment of the entire sum up front: a developer, promoter or project manager does not really want any more money than is needed as various milestones are reached, otherwise they would have to make arrangements to do something with that extra money which generated a reasonable return for the investors, which might well not be their expertise. Investment managers do not want to provide the funds they have committed until the development or project is ready to use them, for the same reasons. Hence the creation of investments with differed contributions of principal. Where the investment is securitised, this can be achieved either by issuing partly paid securities (much more common for shares, but in some jurisdictions bonds or debentures can be issued partly paid) or by issuing fully paid securities in batches or tranches. In either case (for the purposes of this article) the investor enters into a commitment for the entire amount and can be “called” on to honour that commitment. This is to be distinguished from situations where the issuer seeks to issue fresh securities to the public to meet or in anticipation of the need for further funds.
It is beyond the scope of these articles to explore the myriads of different financial instruments and hybrids (e.g.: convertible notes, redeemable preference shares, zero-coupon bonds, warrants etc.) or delve into the mechanics of receiving the money in each case. The issues for custodians include tracking and possibly enforcing clients’ entitlements and keeping a firm hand on the flow of funds.
INCOME – dividends, interest and “substitutes”
It is not a simple matter of receiving the funds from the issuer and then crediting them to your clients’ funds accounts. Custodians regularly credit income to clients’ accounts on payment date rather than waiting until the money is actually received: “Payment day income”. When received, the funds might not have come directly from the issuers and wherever they have come from, you might be required to pass them on to a subsequent purchaser. Tracking and then paying or recovering income and other entitlements on heavily traded securities can be quite challenging.
Payment day income:
It is common for custodians to provide clients with “payment day income”; the anticipated dividend or interest income is credited to clients’ funds accounts on the day it ought to be paid by the issuer, irrespective of when the funds are actually received by the custodian. Such payments are an advance made by the custodian and ought to be covered by claw-back or other reservation provisions. Whilst payment systems have become increasingly efficient and the time involved in even international remittances has reduced substantially, interest or dividends paid by a company to the holder of record on payment date will still not be received in the account of an investor in another country at the other end of a chain of custodians for a few days at least. Nevertheless, accounting principles allow, perhaps require, the investor to record those funds as cash on the day they are to be paid by the issuer, whilst the people making investment decisions usually want to spend all available money. They might even be required to reinvest promptly in order to comply with liquidity to investment ratios. Finally Basel III has made it unattractive for banks to hold large cash exposures to individual clients. Payment day income probably no longer provides any competitive advantage between custodians as it has become so common. It will not necessarily be offered for all securities in all markets; a custodian might feel more comfortable with providing such a facility in respect of income from investment grade securities than from “toxic waste”. Further, it ought to be drafted as a “may at its option, make funds available” rather than as a commitment so to do, as the treatment in the custodian’s books and the impact on its capital adequacy requirements will be different. The risks involved in providing payment day income are less than the problems which would be encountered – failed trades, buy-ins from counterparties etc. – if funds were not credited to clients’ funds account until there were received by the custodian from the issuer via other custodians in the chain of ownership.
ASIDE: In a long career supporting custody and related businesses (securities lending, repo, FX, liquidity, brokerage, e-commerce) I have done many things, but I have never had to run a dispute with a client over income paid on payable date later clawed back by the custodian. I have, however, managed a dispute with an issuer. A client relationship manager come into my office in total distress: the dividend cheque for some 1.5 million received from a large gold-mining company had been returned by the bank “refer to drawer”. The first telephone call to the office of the company secretary was not returned. On the second call about an hour later I stressed that it was a matter of great significance and that it was imperative that I discuss the matter with the company secretary immediately and asked to be put through: “the secretary is in an important meeting, I will ensure that he is informed of your call” (or something like that). I thought it politic not to detail the situation to the receptionist as I did not want to panic the staff. Half an hour later, still with no response I did in fact request that the secretary be interrupted with the information that their dividend cheque had been returned unpaid and that if the matter was not dealt with immediately we would regard it as appropriate to discuss the matter with the listing committee of the stock exchange. The phone rang within five minutes: the secretary and some other senior officers were most apologetic, they had someone on the telephone to their bank at that very moment, their bank had accepted that an error had been made and that the replacement cheque would be honoured… A replacement cheque was not acceptable to us as our clients’ accounts had already been credited with the funds. I did need to explain how and why. The company’s options were to arrange a teletransfer of the funds or to pay interest on the full amount for the days involved in the delay. The funds were received within an hour.
Entitlement to income
Three dates are important in tracking entitlements:
- Payment date; which is the date on which the income will be paid by the issuer: cheques dispatched, payments into bank accounts made etc. This is set by the issuer, perhaps when the dividend is announced or as part of the terms of a fixed income security.
- Record date (a.k.a “books close”); which is the date by which holders of securities must be entered as such on the books of the issuer in order for the income to be sent to them. This is also set by the issuer, usually following an applicable market convention regarding the number of local “business days” prior to Payment Date.
- Ex date (exclusive of dividend or interest date) is the date by which a sale / purchase of the securities must be entered into (not settled, just a valid contract in existence) in order for the transferee to be entitled to the income. This date is usually set by the exchange or trading venue.
A purchase entered into before the Ex date entitles the purchaser to the income = “cum dividend”. Purchases entered into after the Ex date do not include entitlement to the income = “ex dividend”. The market price usually falls after the Ex date. On payment date the issuer will pay the income to the entity recorded on its books on Record Date. If the transfer is settled and the issuer informed of the details for the transferee before then, the transferee will receive the income directly. If that is not done, the payment will be sent to the transferor, who is supposed to forward it to the transferee, often with “good value”; interest on the amount of income for the days between payment date and the transfer to the transferee. A heavily traded security on a rising market might change hands several times in these few days, resulting in a string of transferors / ees. Each one of these has an obligation to their transferee to pay the income to that transferee. The timing might be dependent upon the payment being received from the issuer or prior vendor; the obligation to make the payment at all is not dependent upon the funds involved having actually been received: a demand from a transferee for payment of the income from their transferor cannot be defeated or even deferred by “the money has not yet been received from a prior vendor” type responses.
ASIDE: in the months after the October 1987 market melt-down we progressively reconciled the position for each of our clients and made claims for income or entitlements not received. The responses varied considerably from “agreed, here is your money” through review of our numbers against the counterparty’s and some discussion and compromise to flat denial or refusal. “The money has not yet been received from the prior vendor” was a common response. Where a timescale for chasing the money could be agreed, that period was allowed to run. If a satisfactory response was still not received, the matter was escalated, sometimes litigation commenced. None of these actions went to trial, let alone judgement, so whether the obligations of a “cum dividend” vendor to pay income to the purchaser are contingent or not upon that money having been received from the issuer or a prior vendor is not confirmed by case law. From general principals of law that would seem to be the case: our argument was that each transaction is an independent sale & purchase; the obligation to complete the transfer of the securities is not contingent upon their receipt from a previous vendor and the provision of the income associated with them is part of the sale, reflected in the price and therefore also not contingent either. None of the defendants in those actions were prepared to contest the matter to a trial.
Finally, it is worth mentioning that not all income from securities is paid to holders in cash funds. Issuers might offer “stock dividends”, where new shares are issued to the holders as income on the shares held, or “dividend reinvestment plans”, where dividends are issued in cash but some or all of this is used to buy new shares. In each case the shares issued are new; the issuer’s capital is increased. The price of these new shares is usually a significant discount on the prevailing market price. These offers are (usually) elective: shareholders may choose to participate in full, partly or not at all. From the issuer’s perspective income which would be distributed to holders of securities is cycled back into the business. This choice is for each holder to make based upon their investment strategy, tax position and other considerations. The mathematics is not perfect, it is neither a “magic pudding” (where the part eaten one day grows back overnight) nor a ”zero sum”: The share price will probably fall due to the higher number of shares issued, but not by an amount equal to the equation “price = market capitalization ÷ total shares issued”. These matters have a lot in common with offers of new securities to existing holders, but are not identical save for the source of funds. We will consider such matters further when looking at “new issues of securities” generally.
RETURN OF CAPITAL
[Terminology: in these articles “maturity” refers to regular return of the capital at the end of the life of the investment as set out in the terms governing or creating the security, whilst “redemption” refers to return of the capital at any time prior thereto other than in a distressed situation. These expressions are not used consistently in sources from the same jurisdiction, let alone from different jurisdictions.]
Debt and discount securities (other than perpetual bonds) have an in-built “shelf life”: on a fixed or determinable future date the security matures; principal becomes due and payable to the then owner. At that time the securities must be “presented” for repayment. The mechanics will vary between types of security, issuer and jurisdiction but the outline is relatively constant. It is usually the custodian’s task to attend to this, which will require familiarity with the applicable procedure in each case. Errors will be embarrassing and possibly incur costs, but are unlikely to result in loss of the principal. In fact, the possibility of late presentment or late redemption might well be dealt with in the prospectus covering the issue: it’s relatively common for the issuer to be required to set aside an equivalent sum of money, perhaps placing it in an account or with trustees, for bonds or debentures which have matured but not yet been presented. On late presentment a holder is entitled to the appropriate portion of that money plus whatever interest is actually earned rather than the rate applicable to the bond or debenture, perhaps less some administrative fee. This will vary between issues, issuers and jurisdictions.
Units in collective investment schemes vary considerably in this as in many other respects. Those permitted for retail investors or admitted to trading on a regulated venue probably don’t have maturity dates but do include a capacity for the holder to redeem at certain times, perhaps at any time. More restricted participations – hedge fund or private equity investments for example – sometimes include a time horizon to maturity or roll-over and probably significant restrictions on redemption by either party such as a minimum holding period or maximum percentage of capital redeemable per month or quarter.
Equity securities, on the other hand are issued in perpetuity, at least in theory. They do not usually mature at all and can only be redeemed in limited circumstances. The shareholder (theoretically) has the option of selling their holding on the secondary market. There are exceptions to every rule: some jurisdictions permit the issue of equity securities with a fixed or determinable life-span or as redeemable shares.
Where interest rates have fallen significantly since bonds or debentures were issued, issuers would like to be able to redeem the entire series prior to maturity. This is usually not permitted. They might, however, be permitted to redeem a portion of the issue and are usually not prohibited from buying back their own bonds, debentures etc. on the open market or even by off-market purchase (in contrast to shares). Buy-backs present few issues for custodians; the transaction would be settled on your client’s instructions just as any other sale. Partial redemptions can present difficulties. Where it is permitted, the issuer might be empowered or even required to select the holders whose bonds are to be redeemed rather than redeeming a percentage of the entire issue evenly across all holders. Where selection applies, it is usually by lottery. A custodian which holds all its clients bonds in a single (nominee) name which is drawn in such a lottery must have some fair and impartial procedure for determining which of its clients will have to surrender their bonds in this process. One must be prepared for a challenge from a disgruntled client, so the procedure needs to be robust and demonstrably fair and impartial. It is rare for individual holders to be able to initiate redemption. If interest rates have fallen there is no advantage in doing so; if rates have risen it would be unfair to permit some of the holders to redeem. The secondary market serves to enable holders to realise their investment by sale.
The redemption of shares is often the subject of significant regulation on the basis of the importance of preserving the capital base of the company. Shares may be issued as “redeemable” from the outset with either a fixed term (which is really a “maturity”), an event which triggers redemption (e.g.: employee leaving the company) or at the option of the issuer or the holder (UK: Companies Act s684; Australia: Corporations Act s254A (1) and (3); Ireland: Companies Act s66(4)). Alternatively the company might initiate a repurchase or buy-back of its own shares. There is even more variation between jurisdictions on the detail of this matter than other issues considered so far. Generally a company may not simply be the purchaser in regular sales of its shares, in contrast to debt securities. Some sort of particular approval is required (save in some jurisdictions for quite limited volumes purchased in regular transactions) and in most cases payment must be made out of profits or the proceeds of a new issue made for this purpose. (UK: ss687(2) and 693 et seq; Australia: ss254K and 257 et seq; Ireland: Companies Act s105(2)).
Units, on the other hand, are usually redeemable as the investor wishes (subject to limitations in the prospectus); that is one of their attractions. There might well not be a secondary market at all or a capacity for the issuer to record transfers of the same unit: redemption and issue of a fresh unit to the “transferee” might be necessary to achieve the same result.
The custodian’s task is to present the security for payment on maturity or redemption, which might be to the issuer or to a nominated paying agent. Instructions from your client are generally not required for maturity; such collections of funds are usually regarded as business as usual, indeed often listed in custody contracts as tasks to be performed without instructions. You may be expected, even obliged, to pre-advise the client of pending maturities and of successful collection and crediting of the funds. Redemptions, in contrast, not being “B.A.U.” will require that your clients be informed, if on the initiative of the issuer, or that you receive instructions from your client where they are initiating the redemption.
The custodian’s tasks do not include supervising an issuer’s compliance with the rules or laws applicable to the issuer in respect of these, or indeed any other, matters. Any shortcomings ought to have been thrashed out at the applicable meeting of holders or perhaps in the courts on the initiative of disgruntled holders. The custodian’s tasks do include forwarding the communications from the issuer, probably relevant communications from regulators or supervisors, and following its clients’ instructions. The custody contract ought to include an exemption where instructions reasonably appear to be contrary to the applicable law. If a client expressly instructs that, say, shares not be returned on a redemption which appears to have been properly dealt with, your best option might be a procedure such as applying to a court for directions or delivering them to the court to let the client and the issuer fight it out.
The matter of obtaining capital back in an insolvency of an issuer will be considered later under “Insolvency”.
CONTRIBUTIONS TO CAPITAL
The title makes the first important point: where your clients’ investments include assets on which money is or may become payable, you need to exercise particular care that the amount is indeed limited and determinable, that it will be a capital contribution and accounted for as such – including both increase in the issuer’s capital base and reduction in the amount that could be called in the future – and that you have access to that client’s other assets to cover any payment you might be compelled to make. Where a security has been purchased in an on-market transaction on a regulated trading venue, the first two might perhaps be assumed as the rules of admission to trading ought to cover them. Contrast this with a proposed initial subscription to an alternative collective investment registered in an off-shore financial centre… These later might well be very good investments, but whether they are suitable for holding under custody ought to be very closely reviewed. Wherever you have misgivings or concerns, you might wish to require some further commitment or support from the client concerned, perhaps even move a suitable sum of money or investment grade assets into a frozen account or one covered by a purpose-specific lien or pledge ( as in over and above what is in the custody agreement) in your favour. Some banks have a separate, low profile subsidiary nominee company in whose name this sort of investment is registered in order to strength the segregation from all clients’ regular investments.
With the exception of that rare species the “no liability” company – a legal form which appears to be unique to Australian mining companies – the payment of calls on partly paid shares and other investments is not optional. Issuers are often empowered to enforce payment of calls by freezing, confiscating, declaring forfeit or even disposing of shares on which calls have not been paid, to withhold or cancel payments of income or to exclude the holders from the exercise of voting and other membership rights. That choice is a choice for the issuer, not the holder. Further, the debt to the company will not necessarily be thereby extinguished, perhaps not even paid to the extent of the money the company receives from any sale of the shares or confiscation of income. In some jurisdictions issuers are permitted to have and to exercise such powers as a bludgeon to coerce the holder to make the payment. Whilst it is unlikely that the issuer could keep any windfall or overpayment – receive the eventual payment of 100% of the call from the holder and retain income which had been withheld, the proceeds of sale etc – whilst it was solvent, there will probably be expenses to be meet out of the funds received. Further, a liquidator or receiver might regard retaining any overpayment as acting in the course of the duty to maximise the funds available in the insolvency or at least view the forced-to-pay holder’s claim for any excess as just one of the unsecured claims to be included in the list.
ASIDE – Urgent call to the General Manager’s office, where I found several of the senior staff on a conference call with the general manager, client relationship manager and two lawyers for a non-household name firm of private banquiers. The quick recap that the firm were a long-standing but low key client whose securities included a large position in a company which had recently made a call on partly paid shares. The firm had sent us instructions that the call not be paid, rather that the shares be surrendered. The telephone call had come about because we had in fact paid the call monies demanded by the company, the surrender of the shares having been rejected, and debited the money to the client’s account. Why we had not followed their instructions? They had clearly elected to forfeit the shares. The funds debited should be returned to them….! It was pointed out that we had followed their instructions so far as the possible within the applicable law, that the issuer was entirely within its rights – payment or surrender where not options for the shareholder but for the issuer; in this case the issuer had chosen to enforce the call rather than accept surrender of the shares in lieu of payment and had served a demand for payment – and we had acted in accordance with the provisions of the custody agreement. The client asked for detailed information regarding the shares concerned and the applicable law, which we advised we were not permitted to give as a custodian is not authorised to give legal advice. We could (and did) forward copies of the company’s articles of association and the applicable legislation for them to review with their legal advisors. The client then maintained that our actions were not reasonable in view of the investment position; they had reason to believe that the company would fail. Our response was that a custodian cannot and must not make investment decisions; they (or their clients) employed staff or engaged firms with the required expertise to consider and select investments. We also pointed out that if indeed the company went in to liquidation, all debts, including uncalled capital, would probably be collected, by legal action if necessary, which would entail further expense for no better result. We were thanked for our professional performance.
The upshot was a review of the relevant provision of our custody agreement. There was already a “within applicable law and practice” limitation on our obligation to act in accordance with instructions, an acknowledgement that the custodian was not involved in investment review or decisions and a representation that the client had considered, accepted and was the party bound by the applicable law and practice and the terms upon which any assets was issued. We added a further representation that issue of any instruction to receive, purchase, subscribe for… any security was deemed to include a repeat of those acknowledgements and representations.
Further articles will consider other types of corporate action, including offers and new issues of various sorts, meetings of members and creditors, and then corporate events – mergers, spin-offs etc. before moving on to review the problems that can arise and the “housekeeping” provisions found in a custody contract; arrangements, powers and authorities such as Authorised Instructions, Delegation etc necessary to enable you as custodian to do your job.