Protecting Assets and Guarding Against Counterparty Risk

Below are a number of actions[1] that your company may wish to consider to better protect its assets in the event of insolvency of a bank or other financial institution, including (1) maintaining assets in custodial accounts, (2) taking actions to strengthen the likelihood that custodial assets will be returned to your company in the event of a custodial insolvency and (3) further guarding against counterparty risk:

1. Ensure that your company's assets—including any (i) shares or other interests in money market funds into which cash amounts are swept, (ii) repurchase transactions, related purchased securities and margin delivered for your account thereunder or (iii) deposits at other FDIC-insured banks that are intended to remain within the $250,000 deposit insurance limit—are held in or credited to an account (a "Custody Account") that is in your company’s name and maintained by a custodian (a "Custodian") that is a regulated, FDIC-insured bank, registered broker-dealer or registered futures commission merchant.
   • Ensure that your company has a written agreement (a "Custody Agreement") with the Custodian governing the Custody Account. See paragraph 4 for a description of suggested terms for the Custody Agreement.
   • Note that assets held in "sweep" or similar accounts may have features similar to those of custodial accounts, but are not necessarily custodial accounts.  The documentation matters.
   • Assets held in a deposit account or an omnibus/sweep account pending transfer to a Custody Account are not custodial assets unless and until they are credited to the Custody Account.
   • Implement and monitor triggers with respect to the financial health of each Custodian.  Suggested approaches for such triggers are described in paragraph 5 of this memorandum.
2. If the Custodian is a foreign financial institution, perform due diligence on the legal protections afforded by the laws governing that foreign institution, in particular in the event of such Custodian's insolvency.
3. Ensure that your company has one or more backup Custodians and that any pre-approval requirements for transfers between your company's Custodians have been satisfied such that transfers can be made without delay.
   • Ensure that the Custody Agreement contains provisions that (a) support a legal relationship between your company and the Custodian as a bailor/bailee relationship instead of a creditor/debtor relationship, (b) fall within regulatory pronouncements supporting the treatment of custodial assets in a receivership as assets that fall outside the receivership estate, (c) reduce operational risks and (d) reduce risks of loss due to negligence or fraud.  See Annex 1 to this memorandum for sample provisions designed to achieve these results.  Note that many of these provisions are suggested by the SEC in its proposed rule applicable to registered investment advisers entitled "Safeguarding Advisory Client Assets" (February 15, 2023).[2] Among other things, Annex 1 is intended to address the following issues:
     • A lack of clarity as to whether the relevant bank is actually agreeing to act in the capacity of a custodian.
     • A failure to specify basic Uniform Commercial Code requirements as to the status of the account (including those that relate to governing law).
     • Weakening of cash sweep protection because of bank’s ability to avoid cash sweep obligations based on imprecise exceptions such as its anticipation of its client’s future cash requirements.
     • Unintended duplicative reliance on FDIC insurance at the same financial institution resulting in less FDIC coverage than expected.
     • In the context of multi-tiered FDIC insurance (i.e., deposits in excess of $250,000 being spread across multiple banks), (1) insufficiently precise account designations/ naming conventions that arguably do not meet FDIC requirements and (2) a failure to ensure that subcustodian banks participating in such arrangements are themselves contractually bound by provisions which depend on such subcustodians properly reflecting the nature of the custodial arrangements in their own books and records.
     • Inadequate reporting obligations.
     • Inadequate walling off of the custody arrangements from other contractual relationships with the relevant financial institution such that the financial institution may have unanticipated netting or set off rights against custodied assets.
     • Multiple potentially conflicting agreements, without clarity as to which agreement will prevail in the event of a conflict.
4. Implement and monitor (a) minimum short and long-term ratings-based triggers for the Custodian (or the relevant rated entity within the Custodian's group) and (b) credit default swap spread triggers for the Custodian (or the relevant rated entity within the Custodian's group) (e.g., CDS spread on the Custodian's debt increases by more than a specified number of basis points over a specified period of days or increases above a specified threshold) which, if breached, will result in the movement of all or a part of your company's assets to your company's other Custodians based on a pre-agreed internal risk protocol.  The triggers in clause (b) are more sensitive, particularly because rating agencies may fail to publish downgrades on a timely basis.
5. If your company has other contractual relationships with the Custodian under which your company may from time to time owe amounts to the Custodian (e.g., loans, derivative close-out amounts, etc.), seek to obtain set-off rights against amounts owing to your company by the Custodian.
6. If your company has other contractual relationships with the Custodian's affiliates, to the extent practicable (consistent with regulatory or contractual restrictions that may be applicable to counterparties), ensure that netting occurs across affiliates.  Neither your company nor any of your company's affiliates should have to pay the Custodian if the Custodian is not paying your company or one of your company's affiliates.  Effectiveness of cross-affiliate netting may be compromised absent:
   • Express agreement by affiliates of the Custodian to be bound by the set-off (the affiliate of the Custodian will not be bound by the set-off solely by reason of the counterparty's agreement).
   • First priority, perfected security interest granted by each of the Custodian and its affiliates in all receivables from time to time owing by any of your company and your company's affiliates as collateral security for each payable from time to time owing by the Custodian or any of its affiliates to any of your company and your company's affiliates (because cross-affiliate set-off likely to be subordinate to a perfected security interest, including the rights of a bankruptcy trustee as a hypothetical lien creditor).
7. With respect to paragraphs 6 and 7 of this memorandum, expressly provide for assignments within your company's group (without any required consent of Custodian) so as to maximize the possibility for effective set-off.
8. Where relevant, seek to obtain a guarantee from any more creditworthy entity within the Custodian's group.  If your company is the beneficiary of such a guarantee, ensure that the guarantee expressly provides that any netting/ set-off against the primary obligor will be effective not only against the primary obligor but also against the guarantor (including if the guarantor is insolvent).

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This memorandum, which we believe may be of interest to our clients, is for general information only. It is not a full analysis of the matters presented and should not be relied upon as legal advice. This may be considered attorney advertising in some jurisdictions.

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ANNEX 1

Establishment and Maintenance of Custody Account

The Custodian hereby establishes, and agrees to maintain during the term of this Custody Agreement, on its books and records account number [__________] (the "Custody Account"), designated "Custody Account established by [Name of Custodian] as securities intermediary, bailee and agent for the benefit of [Insert Name of Customer]" (the "Customer").[3]

Status of Custody Account

The Custody Account is a Securities Account (as defined in Section 8-501 of the Uniform Commercial Code (the "UCC")) [4] in respect of which (a) the Custodian is the Securities Intermediary (within the meaning of Section 8-501 of the UCC)[5] and (b) the Customer is the Entitlement Holder (as defined in 8-102(a)(8) of the UCC)[6]. [7]

The Custodian agrees that each item of property (whether cash[8], a security, an instrument or any other property whatsoever) standing to the credit of the Custody Account shall be treated as a Financial Asset (as defined in Section 8-102(a)(8) of the UCC).[9] Without limiting the generality of the foregoing, the term Financial Asset shall include any (i) shares or other interests in money market funds into which cash amounts are swept[10], (ii) repurchase transactions, related purchased securities and margin delivered for your account thereunder and (iii) direct or indirect interests in deposit accounts maintained with other banks into which cash amounts are swept.

All Financial Assets standing to the credit of the Custody Account that are in registered form or that are payable to or to order shall be (a) registered in the name of, or payable to or to the order of, the Custodian, (b) indorsed to or to the order of the Custodian or in blank or (c) credited to another Securities Account maintained in the name of the Custodian.[11] In no case will any Financial Asset standing to the credit of the Custody Account be registered in the name of, or payable to or to the order of, the Customer or indorsed to or to the order of the Customer, except to the extent the foregoing have been specially indorsed to or to the order of the Custodian or in blank.

In the event of any inconsistency between the provisions of this Custody Agreement and any other agreement relating to the Custody Account to which the Custodian and the Customer are parties, the provisions of this Custody Agreement shall prevail.

The Securities Intermediary's Jurisdiction with respect to the Custody Account is the State of [__________].[12]

Representations and Warranties of the Custodian

The Custodian hereby represents and warrants to the Customer as follows:

(a)    The terms and conditions of the Custody Account and this Custody Agreement will at all times during the term of this Custody Agreement be maintained and properly reflected in the official books and records of the Custodian.[13]

(b)    The assets standing to the credit of the Custody Account (other than deposits of cash made with the Custodian in its capacity as a depository institution) will at all times during the term of this Custody Agreement be held by the Custodian pursuant to the Custodian's exercise of authority under applicable banking law to hold assets in safekeeping (or, alternatively, in a fiduciary capacity).[14]

(c)    If the Federal Deposit Insurance Corporation (the "FDIC") becomes receiver for the Custodian, the FDIC will recognize the Customer's ownership interest in all assets standing to the credit of the Custody Account (other than deposits of cash made with the Custodian in its capacity as a depository institution), and such assets will not constitute part of any receivership estate.

Covenants of the Custodian

During the term of this Custody Agreement:

(a)    The Custodian will maintain possession or control[15] of all Financial Assets standing to the credit of the Custody Account.  For this purpose, "possession or control" of any assets means a manner of holding such assets such that the Custodian is required to participate in any change in beneficial ownership of such assets.

(b)    If possession or control of Financial Assets standing to the credit of the Custody Account is maintained by the Custodian through another custodian, the other custodian will satisfy the requirements described in this Custody Agreement that are stated to be applicable to the Custodian.

(c)    If interests in insured deposit accounts held through another custodian are standing to the credit of the Custody Account, the official books and records held by the insured depositary institutions will recognize that there are multiple layers of ownership of such insured deposit accounts.

(d)    In the case of any cash or other assets that are swept from an operating, omnibus, pooled or other similar account to the Custody Account, the Custodian will cause such sweep to occur no less frequently than each business day.[16]

(e)    The Custodian shall provide the Customer (or, if requested by the Customer, the Customer's accountants) with the following:  (i) promptly following the customer's request, copies of all records relating to assets held in the Custody Account; (ii) periodic (and no less frequently than monthly) written statements showing each asset credited to the Custody Account and a summary of all transactions in the Custody Account; (iii) online access at all times during normal business hours; and (iv) no less frequently than annually, a copy of a written internal control report of the Custodian that includes an opinion of an independent public accountant regarding the adequacy of the Custodian's controls.

(f)    The Custodian will (i) exercise due care in accordance with reasonable commercial standards in discharging its duty as custodian (including as to the selection of any sub-custodian) and implement appropriate measures to safeguard client assets from theft, misuse, misappropriation, or other similar type of loss and (ii) indemnify the client against losses caused by the Custodian's negligence, recklessness or willful misconduct.

(g)    If a receiver or conservator is appointed with respect to the Custodian or its assets, the Custodian will promptly transfer the Customer's assets (other than deposits of cash made with the Custodian in its capacity as a depository institution) to a substitute custodian or as ordered by a court of competent jurisdiction.[17]

Waiver by the Custodian

The Custodian hereby waives (a) any and all contractual or statutory rights of set-off, pledge, lien or compensation in favor of the Custodian and (b) any and all statutory, regulatory, contractual or other rights to put on hold, block transfers from or fail to honor instructions with respect to the Custody Account, except for (i) payment of custodial fees owing by the Customer to the Custodian under or in respect of this Custody Agreement and (ii) as otherwise expressly agreed by the Customer.

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[1] Of course, there are other factors that your company would normally consider, such as credit quality, diversification, etc.  This memorandum focuses on legal and documentary means of controlling custodian/counterparty credit risk.

[2] These provisions need not be included verbatim if other language is included that achieves the same legal effect.  Of course, certain provisions have to be modified in the case of a US-registered broker dealer or futures commission merchant acting as Custodian.

[3] This is a clear statement of the custodial relationship that will appear in the title of the Custody Account.

[4] A Securities Account is an account to which one or more Financial Assets may be credited in accordance with an agreement under which the person maintaining the account (the Custodian) undertakes to treat the person for whom the account is maintained (the Customer) as entitled to exercise the rights that comprise those Financial Assets.

[5] A Securities Intermediary is (a) a clearing corporation such as DTC or (b) an entity (such as a bank or broker-dealer) that in the ordinary course of its business maintains securities accounts for others and is acting in that capacity.

[6] An Entitlement Holder is a person identified in the records of a Securities Intermediary as the person having a Security Entitlement against the Securities Intermediary.

[7] This is the UCC's description of a custodial relationship. The definition of Securities Account is interpreted in light of Part 5 of Article 8 of the UCC, which describe the core features of the relationship for which the rules of Article 8 concerning security entitlements were designed.  See Section 8-504 through 8-509 of the UCC for a description of the duties of a Securities Intermediary.  Most importantly, Section 8-504(a) of the UCC imposes a duty on a Securities Intermediary to "promptly obtain and thereafter maintain a financial asset in a quantity corresponding to the aggregate of all security entitlements it has established in favor of its entitlement holders with respect to that financial asset".

[8] Cash may be held in the Custody Account.  But assets held in the Custody Account as cash will create risk to the depository bank at which the cash is held.

[9] Some Custodians will resist treating certain types of assets (e.g., rights of the Customer as lender under a loan agreement) as Financial Assets.  Carve out of such assets from these provisions may have to be made in that event.

[10] We have seen instances where the nature of the Custodian's contractual arrangements with a particular money-market fund precludes interests in such money-market fund being credited to your account.  If this is the case, you should have access to an alternative money-market fund which is not subject to this preclusion.

[11] If a Securities Intermediary holds a Financial Asset for another person, and the Financial Asset is registered in the name of, payable to the order of, or specially indorsed to the other person, and has not been indorsed to the Securities Intermediary or in blank, the other person is treated as holding the Financial Asset directly rather than as having a Security Entitlement with respect to the Financial Asset.

[12] This establishes the law that will govern the Custody Account.  See Section 8-110(e) of the UCC.

[13] Important for compliance with Section 13(e) of the Federal Deposit Insurance Act.

[14] Include if the Custodian is a bank.

[15] See the SEC's proposed rule applicable to registered investment advisers entitled "Safeguarding Advisory Client Assets" (February 15, 2023) for this concept.

[16] See 12 C.F.R. Section 360.8, which provides that (i) in the case of sweep accounts that provide for a sweep to an external institution, the FDIC will treat swept funds consistent with their status in the end-of-day ledger balances of the depository institution and the external entity, as long as the transfer of funds is completed prior to the earlier of the end of day and the time of the FDIC's appointment as receiver and (ii) for repurchase agreement sweep accounts, where, as a result of the sweep transaction, the customer becomes either the legal owner of identified assets subject to repurchase or obtains a perfected security interest in those assets, the FDIC will recognize, for receivership purposes, the customer's ownership interest or security interest in the assets.  Insured depository institutions must prominently disclose in writing to sweep account customers whether their swept funds are deposits within the definition thereof under the Federal Deposit Insurance Act.  If the funds are not deposits, the institution must further disclose the status such funds would have if the institution failed.  Such disclosures must be consistent with how the institution reports such funds on its quarterly Consolidated Reports of Condition and Income.

[17] Although this provision may not be legally binding on the FDIC, it reflects the FDIC's policy.