When institutions place custody assets with a financial institution, little attention is given to what would happen in the event of the institution’s insolvency. An interesting article appeared in the November 2012 Edition of The Business Lawyer (Volume 68, Issue 1), a publication of the Business Law Section of the American Bar Association. It is entitled “How Safe Are Institutional Assets in a Custodial Bank’s Insolvency?” It was written by Edward H. Kleas, General Counsel, University of Virginia Investment Management Company. If you have placed assets in a bank which is serving as custodian, you should read Mr. Kleas’ article.
Many people feel protected based on Office of the Comptroller of the Currency(OCC) guidance. The OCC advises that “assets held by banks in a custodial capacity do not become assets or liabilities of the bank… They are not subject to the claims of the bank’s creditors.” Kleas points out that while most clients are comfortable placing custodial assets with a bank, there are at least 4 significant risks that can undercut this protection. These include:
- Documentation risk
- Segregation risk
- Article 8 risk
- Bank misconduct risk.
All of these risks need to be addressed prior to establishing of a custodial account with the bank. Mr. Kleas suggests that these risks can be ameliorated but not eliminated.
He recommends that clients undertake a thorough pre-retention due diligence review prior to entering the custodial relationship. He also recommends adding protective contractual language, spelling out the terms and conditions of the relationship. In addition, the institution should conduct post-retention due diligence since rights of custody are not self-effective. It would be also prudent to obtain certifications from the custodian as a part of this process.
Since custodial assets can be substantial, close attention should be given to establishing the custodial relationship with a bank.