You see custodians mentioned in the context of a bankruptcy, as some kind of insolvency administrator. That’s a different sort of custodian and not really what we're talking about here, which is that chap who looks after client assets
- There are “main” or “first level” custodians, who face end clients directly, and sub-custodians, who face main custodians and other sub-custodians in the custody chain but do not face end users directly.
- A custodian’s main liability to its client is for the safekeeping and timely return of the client assets.
- A custodian generally will segregate clients assets from its own assets.
- The legal theory is that the client is the beneficial owner of the custody assets at all times. Therefore, assuming the custodian diligently performs its role custody assets are not part of the Custodian’s insolvency estate, and as such the custodian has no economic exposure to the custody assets.
Sub-custodians and the custody network
Where a custodian has no physical presence in a local market, it will appoint a network of sub-custodians to hold client assets in that market on its behalf. Generally the sub-custodian must hold assets on the same terms that the custodian does: designated as client assets of the main custodian, and segregated in its records from its (and the custodian’s) own assets.
Generally client assets should be isolated from the sub-custodian’s bankruptcy. In certain far-flung jurisdictions, local regulation or market practice may differ so that the custodian does not segregate its own assets from client assets. Custody rules would generally exclude the custodian’s liability for losses in this case provided it had diligently selected and monitored the sub-custodian in question.
Actually, while we’re on that topic:
Custodians and depositaries will try to disclaim all risks of the failure of their custody network, as indeed they will try to disclaim all other risks, real and phantasmagorical. Be watchful of this.
Custody risks ought to be fairly minimal: Unless the sub-custodian is in a weird jurisdiction, it should never take beneficial title to the assets it holds, and should have segregated them from its own assets, therefore beyond the putative reach of its ordinary creditors — so the assets remain the client’s at all times — so they should return to the client even on the custodian’s insolvency. It follows that, if client assets are not where they are meant to be on a custodian’s insolvency, there must have been some kind of operational mismanagement, negligence or fraud on the custodian’s behalf (and its insolvency). Since the operating cause of the loss is the mismanagement, not the insolvency itself, any capital charge should reflect operational risk and not credit risk.
Now if a sub-custodian profoundly breaches its custody obligations — which it owes to the main custodian, of course — should that custodian be able to pass its loss back to its innocent client?
It will say “yes” — of course it will — but to what degree has it been complicit in its delegate’s failure? Was it properly monitoring the sub-custodian’s performance? Was it duly diligent in appointing it? The custodian will wail, chomp and complain that it can’t be expected to price flakiness of unaffiliated third parties in far-flung locales into its business offering. Fair, perhaps — but then it did hold itself out as being in some way competent in the safe-keeping of customer assets didn’t it? Wouldn’t that include being diligent in monitoring the performance and capabilities of its custody network? After all the custodian is usually a sophisticated global multinational with experience managing sub-custodians in far-flung locales and it does have contractual privity with them.
The one place it makes some sense is in one of those weird jurisdictions where, by law or market convention, one cannot isolate custody assets from a local custodian’s insolvency. There, it is fair for the client to bear that risk (as it is the client’s choice to take on that “country” risk, and the main custodian cannot avoid it however prudent or diligent it is).
In most jurisdictions, exposure to a custodian for the return of client assets is not a solvency risk as such, seeing as the custodian should not beneficially own client assets and should have segregated them from its own assets, therefore beyond the putative reach of its ordinary creditors. It follows that, if client assets are not where they are meant to be on a custodian’s insolvency, there must have been some kind of operational mismanagement, negligence or fraud on the custodian’s behalf (and its insolvency). Since the operating cause of the loss is the mismanagement, not the insolvency itself, any capital charge should reflect operational risk and not credit risk.
Custodians sometimes act to hold pledged collateral away from its owner, but outside the bankruptcy estate of the pledgee, under an account control agreement. This can put the custodian in an invidious position, because when the treacle hits the fan, everyone will be shouting at it at once, and it won’t know what to do. That will mean it won’t do anything. Unless you are prepared to give an indemnity.
- AIFMD and UCITS require custodians to accept strict liability for all losses from safe keeping (even where they have diligently selected and monitored a custodian which is insolvent). Therefore, regardless of how diligent the custodian has been if either:
- A sub-custodian has negligently failed to respect appropriate segregation and insolvency remoteness; or
- The sub-custodian is in a jurisdiction where it cannot,
and there is a loss to the client, the main custodian would have to accept some or all liability for that loss.
- Being one where by law or market convention one cannot isolate custody assets from the bankruptcy of the local custodian.
- A diligence standard that, for Europeans, is enshrined in AIFMR (Delegated Regulation DR20) and UCITS (Article 22a2(c)).
- Yet another argument, wonders this old contrarian, for tactical deployment of the Contracts (Rights of Third Parties) Act 1999?