You find your ideal partner, decide to get married and sign the pre-nuptial agreement. Similarly, on the appointment of a custodian, a legal agreement is needed to spell out what will happen if the relationship ends.
Suppose you wish to terminate your custodial arrangements. Is it clear whether the client or the custodian or both will bear the costs of the termination? The answer often depends on the amount of detail in the custody agreement. For example, if the custodian is prohibited from creating a lien, charge, encumbrance or mortgage over the assets of the client but does so without permission from the client, then the custodian, having breached the agreement, should be liable for the costs of termination. In a comprehensive custody agreement, clear documentation of allocation of costs upon termination linked to the reason for termination will minimise disputes in the event of termination. Examples are given in the table.
There are many other areas where a custody agreement can describe the respective responsibilities and obligations of the client and the custodian, such as confidentiality, retention of records, audit, insurance, costs, expenses and fees.
However, it will not be surprising to learn that many custodians are not comfortable with including details to the level described above in their custody agreements. The custody agreement is a legally binding document - failure to act in accordance with the agreement can be a cause for termination, with the custodian being liable for the costs.
Putting aside any discomfort of a custodian, a client needs to have comfort that its appointed custodian is in full agreement with the services it is to provide and the custody agreement is the most appropriate place to document them. It is critical to client and custodian alike that specific details of the custodian's responsibilities are contained in the custody agreement. This removes any doubt about the role of the custodian in the event of a dispute. Care is therefore necessary in the detailing of both sides' responsibilities. Both parties must be fully aware of each other's role and responsibilities.
An effective structure for a custody agreement is to have a main body which contains the standard of care and duties and obligations of both parties and to supplement this with service schedules which describe the service required by the client. These schedules can also specify performance standards.
In the main body of the custody agreement, a description of the desired standard of care to be applied is more important than providing details on how this is to be achieved. It is necessary to identify that processes are required for various situations, but not to state precisely how the custodian is to provide the services on a step-by-step basis. It is the outcome that is important, not how it is achieved. The level of detail in the main body of a custody agreement could be thought of as what to do" not "how to do it".
For example, the processing of corporate actions is a core custody service provided as part of the safekeeping role. The main body of the custody agreement should specify how the custodian is to act under certain situations, such as accepting compulsory takeover offers on the client's behalf but taking no action in respect of non-compulsory offers. In the service schedules, the reporting requirements of the custodian will be specified, such as hardcopy reports prepared monthly to be received by the client which provide details on the corporate actions processed during the month.
A custody agreement modelled on this structure also means that when a custodian's procedures are improved there is no need to modify the custody agreement. Similarly, if a client requires a new service , a suitable schedule can be added without the execution of a new custody agreement. However, some custodians have expressed some concerns about the format of schedules.
Many service schedules contain performance standards, in addition to the service deliverables. Some custodians have argued that performance standards should not be contractually binding and that their inclusion is too onerous. Details such as timely performance are not viewed as services which should be contractually binding. One argument used by custodians is that timely performance can depend on the timely performance of third parties. While this might be acceptable for third parties not selected by the custodian to perform some of its obligations under the agreement, clients should reasonably expect that the use of third parties selected by the custodian will not reduce the performance standards under the agreement.
Other custodians, whilst willing to include core custody services in the main body and schedules, believe that value and revenue added services, such as securities lending, should be contracted through a separate arrangement, and be subject to contractual standard applicable to a prudent professional offering similar services. As this standard can be lower than that provided in a custody agreement, these custodians are concerned about the contractually binding status of the schedule for these services. However, from a client's perspective, it is contracting with the same entity as that providing all of its other custody services and would therefore expect the same standard of care to be applied in the provision of the value-added services.
In summary, it is essential to ensure the custody agreement fully documents the client's expectations of the services to be provided by its custodian. The service descriptions should be included in the most appropriate place in the custody agreement and the custody agreement must document the desired level of protection for all services.
Suzanne Findlay is an associate with Towers Perrin global custody consulting services"