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 and (ii) repurchase transactions, related purchased securities and margin delivered for your account thereunder—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.
  4. 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]
  5. 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.
  6. 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.
  7. 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).
  8. 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.
  9. 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 "Custodial 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] and (ii) repurchase transactions, related purchased securities and margin delivered for your account thereunder.

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.

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 is maintained by the Custodian through another custodian, the other custodian must the requirements described in this Custody Agreement.

(c) 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]

(d) 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.

(e) 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.

(f) 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.