- ASIC has released a report (Report 291) in relation to custodial and depository services in Australia. While the report focuses on the industry from the perspective of custodians and their clients, there are some important take outs from the report for responsible entities (REs).
- PDS disclosure: ASIC recommends that REs consider whether clearer disclosure is required in relation to the role of the custodian. While there isn’t an express PDS requirement for REs to identify the scheme’s custodian and describe its role and its terms and conditions of appointment, ASIC considers that this disclosure would be appropriate in many cases.
NTA compliance: REs should check that their scheme property holding arrangements are adequate, both in terms of risk mitigation and whether NTA requirements are satisfied.
- A RE who relies on a custodian to meet reduced net tangible asset requirements should check that all scheme property (other than certain assets and scheme property that are excluded under its AFSL) is held by the custodian.
- If the RE’s AFSL conditions require cash to be held on trust, the RE should check that the custodian is holding cash on trust (rather than on deposit).
- Selection and monitoring: ASIC considers that custodians are financial services ‘gatekeepers’ and perform an important fiduciary role to their RE clients. It would be appropriate for a RE, when selecting a custodian or reviewing custody arrangements, to have regard to the custodian’s reputation, financial position, compliance culture and risk management arrangements.
- ASIC proposes to consult on a number of custody related issues including PDS disclosure, financial requirements and potential NTA exemptions for REs.
In recognition of the widespread and increasing use of custodians in the financial services industry, ASIC has prepared a detailed report on the custodian industry based on a review conducted since 2009.
The report focuses on trends and issues within the industry from the point of view of both custodians and their clients, with a particular focus on REs.
A large part of the report considers the operational and compliance aspects of the industry, addressing key areas such as:
- the potential for fraud and unauthorised use of client assets
- the need for robust systems for giving and receiving authorised instructions
- the stability and safety of IT systems
- operational risks created by manual and disparate systems
- risks associated with transitioning a portfolio of assets from one custodian to another
- breach and suspicious matter reporting, and
- the risks inherent in corporate actions, which are often manually processed.
This article concentrates on the report’s implications for RE clients of custodians.
ASIC’s review found that many REs hold some scheme assets directly, even where a custodian has been appointed. These assets typically included:
- ‘over the counter’ (OTC) derivative contracts
- cash accounts
- unlisted property, and
- loans and mortgages.
ASIC acknowledges that directly holding these types of property is common industry practice, often because the custodian is not willing or able to accept the risk or legal responsibility attaching to the property.
However a RE that does not meet the maximum net tangible assets (NTA) requirement (currently $5 million) and holds scheme property directly may be breaching the NTA requirements set out in its Australian financial services licence (AFSL).
A common practical example is the entry into interest rate and other types of swap contracts used by REs for hedging scheme risk. These OTC derivatives are contractual arrangements rather than certificated or registry titled investments such as shares or units. Custodians are often reluctant to enter into contracts that set out a range of obligations, undertakings and warranties. The result is that REs typically enter into OTC derivatives, which involves the holding of contractual rights (and therefore scheme property) by the RE rather than the custodian.
ASIC has also noted that scheme cash is often held on deposit with the custodian (where the custodian is also an ADI) rather than in an account in the name of the custodian on behalf of the RE. If the RE’s AFSL conditions require cash to be held on trust, the RE should check that the custodian is holding cash on trust (rather than on deposit).
ASIC’s view is that REs that rely on custodians to meet reduced NTA requirements must ensure that all scheme property is held by custodians. However, ASIC indicates that it will consider whether a broader allowance should be made for holdings of cash, derivatives and other assets that carry liabilities for the holder.
Disclosure of custodial arrangements in offer documents
ASIC recommends that REs consider whether clearer disclosure is required in relation to the role of the custodian. ASIC identified an ‘expectation gap’ between a custodian’s obligations and what the public expects of a custodian.
ASIC acknowledges there is no express PDS requirement for REs to identify the scheme’s custodian and describe its role and the terms and conditions on which it has been appointed. However ASIC considers that this would be appropriate in many cases.
ASIC intends to consult with industry on this issue, although it is not clear whether it will seek a change in law or simply encourage such disclosure through published policy. Given ASIC’s statements about disclosure in the report, it may be prudent for PDS issuers to ensure that PDSs include an overview of the custodial function, regardless of whether such information is already required under the general disclosure obligation in section 1013E Corporations Act for ‘long form’ PDSs. Short form PDSs (for ‘simple managed investment schemes’) are not subject to a general disclosure test, but ASIC notes that such disclosure could be achieved through incorporation by reference.
Nature of custodians role
The report also sets out ASIC’s views on the legal nature of a custodian’s role.
ASIC acknowledges that industry generally regards a custodian as a ‘bare trustee’ and that generally it is the responsibly of the custodian to act only on authorised instructions, but also notes that the nature of the relationship is ultimately determined by the substance of the obligations the custodian and client enter into.
In the report ASIC made some interesting observations that may challenge the widely accepted understanding of the custodian’s legal position. For example, ASIC considers that custodians should not simply accept asset valuations and that any ‘concerns’ should be raised with the client and if the concerns are not allayed, raised with ASIC.
In describing custodians as gatekeepers in the financial services industry, ASIC states:
the custodian has an important fiduciary role to their responsible entity client to discharge, and we have identified some areas on which we will consult and that may require regulatory change.
Although trustees fall within an established category of ‘fiduciary’, custodians have not generally considered to be fiduciaries and have generally been regarded as bare trustees, being ‘bare’ of the active duties of the trustee, other than the duty to safeguard the trust property.
We will watch with interest for further developments in this area.
ASIC suggests that REs ensure that the custody agreement clearly records the authorised instruction processes and that, to mitigate the risk of faxed instructions with call back procedures, uses straight-through processing procedures where commercially viable. Where there is a transition to a new custodian, e.g. after a fund consolidation, ASIC recommends that the RE undertakes a review to confirm assets and records have been appropriately transferred.
It would be appropriate for a RE, when selecting a custodian or reviewing custody arrangements, to have regard to the custodian’s reputation, creditworthiness and financial position, compliance culture and risk management arrangements.
Insolvency of custodians and omnibus accounts
ASIC recognises that custodially held assets will generally fall outside the winding up of a custodian in the case of its personal insolvency. ASIC notes however that offshore custodians may be subject to different insolvency laws and further that assets may be caught up in the winding up of a custodian if they are not appropriately segregated within the custodian’s records. Accordingly the quality of the custodian’s records and systems and its selection and management of sub custodians will be critical in minimising insolvency risk.
Where to from here?
REs should ensure that:
- all arrangements for holding scheme property do not involve a breach of their NTA requirements, and
- appointed custodians have robust systems and procedures in place that effectively minimise the risks associated with holding property on behalf of others.
ASIC has indicated a number of areas on which it will consult and the results should be monitored closely. These areas include:
- PDS disclosure about the custodial function
- financial requirements for custodians
- NTA relief for holding of certain property by REs
- the legal duties of custodians, and
- ASIC’s overall regulatory policy framework for custodians.