Lender Beware: The custody assets you are lending against may not actually be held in custody.

Lenders to funds and other borrowers often extend credit based on a security interest over assets that are held in custody. The lender is granted a security interest in the relevant custody account and all of the cash, securities and other assets therein, and then perfects the security interest by entering into a “control agreement” with the custodian. The l

ender may have made two big assumptions: (1) the custodian has “custody” of the assets, and (2) upon receipt of instructions from the lender after default, the custodian can readily transfer or otherwise dispose of the relevant assets. Upon closer examination, however, these assumptions may prove to be incorrect.

There are two broad categories of assets that are capable of being held in custody:

(1) Assets such as a bearer bond, a stock certificate in the name of the borrower (together with an undated stock power in blank), or gold bullion. This is referred to as “on premises custody” or “direct custody”; the custodian has physical custody of the asset. In each of these cases, the custodian has the power to transfer title to the asset by delivery thereof – it may not have the right vis-à-vis the borrower (i.e., the custodian may be liable for breach of its duty to the borrower), but it does have the power.

(2) Assets that are held in an indirect holding system. This is referred to as “off premises custody” or “indirect custody.” One typical example of how an indirect holding system works: a clearing company (such as Depository Trust Company) holds a master share certificate for 500 million shares of an S&P 500 publicly‑traded company. The clearing company identifies on its books and records 10 million of such shares as being held for the account of the custodian (in its capacity as a member of the clearing company) and, in turn, the custodian identifies on its books and records 100,000 of such shares as being held for the account of the borrower. In this case, the custodian has the power to (a) “move” some or all of those 100,000 shares on its books and records to another of its custody clients, or (b) advise the clearing company that some or all of such shares have been transferred to a third party that does not maintain an account with the custodian (in which case the clearing company would revise its books and records to reflect that such shares are held by or through another member of such clearing company). In any event, as a general rule, the custodian has the power to transfer the borrower’s interests in these shares.

But what about an asset such as the borrower’s investment in a bank loan. The bank loan may have a CUSIP number, the borrower may have alerted the custodian that it purchased an interest therein, and the custodian may have noted on its books and records that the borrower has an interest in such bank loan. Notwithstanding the foregoing, the custodian does not have “direct custody” of any asset that is capable of being transferred by delivery. Nor does the custodian have “indirect custody” of any asset that may be transferred on either its books and records or the books and records of any third party (e.g., the administrative agent for such bank loan or any clearing company). Most if not all bank loans are transferrable only upon the execution and delivery of an assignment agreement by the holder thereof, together with the consent of both the underlying “borrower” of such bank loan and the relevant administrative agent. So, as it turns out, the bank loan is not in custody at all: the custodian has no power to transfer it, at the direction of the lender after default or otherwise. And, in the above example, if the lender’s security interest is limited to the custody account and the assets therein, the lender would not have a security interest (not even an unperfected one) in the bank loan, period. This result is not just limited to bank loans, but to other assets as well.

My take: Lenders taking a security interest in a custody account and/or assets purportedly held therein need to make sure they are aware which assets are actually held in custody (direct or indirect), which are not, and the consequences thereof (the consequences of an asset not being held in custody may, at a minimum, be significant limitations on the lender’s ability to foreclose after default).