Sub-Custodian Agreement

The depositary

According to Law 35/2003 of Collective Investment Schemes (CIS), these need a management company and a depositary. The Collective Investment Schemes are also named as investment funds.

The depositary is a firm which custodies the securities that make up the fund and its cash. This is established in Article 57 of Law 35/2003. This entity signs a contract with the management company to perform this function. In addition, its actions are supervised and authorized by the CNMV.

Normally, this function is carried out by banking institutions, but also by broker-dealers or brokers. As the depositary controls the securities, it monitors the actions of the management company. In fact, it is required to notify the CNMV of any of its irregularities. The depositary is the one that performs the daily calculation of the net asset value. It is also responsible for the settlement of securities, subscriptions and redemptions of units. It will also collect and pay any interest and dividends that may accrue.

In terms of custodial functions, the depositary is also referred to as the custodian. The custodian will have legal ownership of the securities but will not be able to trade in them. Besides the custody of the assets that form the CIS portfolio, the units of its investors are custody. This translates into the obligation of making the appropriate book entries in the name of the unit-holders. An example of a custodian is JP Morgan Chase. The figure of the custodian is regulated in title V of the CIS Spanish Regulation, articles 126 and following. Usually the depositary performs custodial functions at the national level but subcontracts at the international level. This gives rise to the figure of the sub-custodian. However, this role it is also performed at national scale as we will see.

Delegation of functions: the sub-custodian

The sub-custodian is the third party that takes care of the custody of specific securities generally in foreign territory. For its bookkeeping, it usually uses omnibus accounts. Omnibus accounts are general segregation accounts in which the units of each unit-holder are not broken down. Thus these accounts will be in the name of the CIS. The investors’ identity is only reported when there are significant holdings, more than 10%, to the Spanish regulator (CNMV).

The sub-custodian will be a firm of the same type as the depositary but authorized by its home regulator. It must also comply with the minimum requirements imposed by that regulator regarding solvency and equity. Examples of sub-custodians are Caceis Bank or BNP Paribas.
Depositary companies have a policy for safeguarding financial instruments. This policies are accessible to everyone through their websites. They tell you who their sub-custodians are and for what type of assets and regions. Thus, for example, for equities there will be some custodians and others for derivatives. There will also be a distinction between sub-custodians in the European Union and those in third countries.

This delegation will be formalized by a contract between the depositary and the sub-custodian. The contract will include clauses on technical aspects such as the reconciliation of differences in the valuation of units. This action is consequence of their responsibility of calculating the net asset value.

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Brief note on Asset Management Companies in Spain

Spanish legislation

The power of delegation is included in Article 135 of the CIS Spanish regulation. Also it is in Circular 4/2016 on the functions of depositaries of collective investment schemes.

The delegation will be necessary when one situation arises. When the depositary does not participate directly in the liquidation and registration of the assets in which the fund invests. In fact, this Circular specifies the obligations of depositaries to their sub-custodians. Thus, the above-mentioned value reconciliations are required to be performed at least weekly.

It also requires the depositary to monitor the custody and its risk of the sub-custodian at least annually. In the event of market turbulence, this will be done on a more regular basis, reflecting the situation at Covid-19.

There are also minimum requirements in the selection of this sub-custodian. In fact, the depositary must assess the country risk, custody, asset segregation and even the enforceability of the contracts it signs with them. All this information cannot be obtained from the sub-custodian itself.

In the case of UCITS, an intermediary is required to be used to provide legal advice when the sub-custodian is from a third country. This advice will mainly revolve around insolvency, to ensure two issues. On one hand, how the contract will be enforced in case of sub-custodian´s insolvency. On the other hand, assure that the CIS accounts are not part of the sub-custodian assets in case of bankruptcy procedure.

If the sub-custodian does not meet the requirements, e.g., by not having enough own resources, the custodian must inform the manager. In that case the custodian must appoint another sub-custodian. If the replacement of sub-custodian is not possible, the manager should immediately sell the sub-custodian’s financial instruments. To prevent such situations and act quickly, the custodian should create contingency plans.

European Union legislation

At European level there are two rules that also go into this figure in greater depth. One of them is the Delegated Regulation (EU) 2018/1618 on depositary obligations in relation to custody.

This regulation establishes the sub-custodian to be able to operate with omnibus accounts. This requires separating the depositary’s own assets and the sub-custodian’s own assets from those of the CIS. As well as separating the CIS account from the accounts of the rest of its clients.

This rule protects the investors and the custodian itself as it is necessary to formalize the delegation in a written contract. This regulation requires the depositary to review the periodic reconciliations and other technical aspects. Such as assure that financial instruments are correctly registered, being able to observe the location and nature of such assets. The sub-custodian must also make a periodic declaration of its circumstances to enable the custodian to monitor them. These regulations apply to alternative investment funds from April 1st 2020.

On the other hand, UCITS Directive V, 2014/91/EU also requires that the sub-custodian may use an omnibus account under the above conditions. Also, it requires verifying that such sub-custodian actually holds the securities in its possession by performing regular external audits. It asks for the separation of the CIS assets from those of the sub-custodian in bankruptcy procedures too. UCITS are required to comply with the other measures, stated above, of the alternative investment funds.

Risk of insolvency of sub-custodians

If the sub-custodian became insolvent, there could be a limitation on the recognition of CIS as owners of their securities. This is why strict separation of its assets from those of the managers’ omnibus accounts is required in general. And more specifically separation of these securities is also required in the event of bankruptcy.
Three risks could therefore be generated by this insolvency. One, the delay in the execution of the CIS manager’s own orders on its assets. Two, risk of a partial loss of the assets under custody. Three, risk of fraud in the bookkeeping caused by the segregation of assets in omnibus accounts.

UCITS V Directive states the depositary is liable for the actions of the sub-custodian against the CIS and its participants. Thus, in the event of a loss by the sub-custodians, the depositary will return an asset with identical characteristics. And if that is not possible it will provide its value in cash. However, it shall have no liability if the loss is due to an unavoidable event beyond its control. It shall also be liable for losses suffered due to negligence or breach of its obligations by the subcustodian. As provided in the Directive, the depositary’s liability is not affected by the sub-custodian agreement. In other words, even if the depositary delegates its custodial functions, it remains liable for them.
The depositary’s liability for the subcustodian is also regulated in Article 62 LIIC. Circular 4/2016 states depositaries of non-UCITS CIS may be exempted from liability by contract. A limit to this liability is usual in contracts with individuals. There will be no liability of the depositary for damages arising from the sub-custodian’s insolvency. With the exception that if the sub-custodian was not properly selected and supervised, it will be liable.

Marketing of third party CIS

The Spanish regulator, CNMV, and Royal Decree 217/2008 require a sub-custodian agreement at the national level. The custody of securities is an auxiliary investment service in accordance with article 141 of the Securities Market Law. And by its article 139, investment firms are considered to be those that perform investment services. Thus, there is a case in which a CIS management company is an investment firm. This case is when it markets third party´s investment funds. With this action, it performs the function of custody by keeping the individualized register of participants of those CIS. This is established by the CNMV in its MiFID questions and answers document updated at the beginning of 2020.
For this case, the sub-custodian is required for a different purpose than the above, not to delegate functions. Its function is to ensure that the units are not loss. So, when the management company marketing third-party funds goes bankrupt these securities will be passed on to a third party. This obligation is required by Article 30 quater of Royal Decree 217/2008. An example of subcustodian is Inversis.

Conclusions

The hiring of sub-custodians is a common practice in terms of investment in foreign assets. In order not to harm either the investment funds or their participants, the regulations maintain the responsibility of the depositary. When hiring a depositary in an investment fund, it is therefore advisable to look at who its sub-custodians are. Their insolvency will have an impact on the fund if there are exemptions from liability. This market practice is also required at national level when a management company markets third-party funds. For such marketing, the manager will be considered as a custodian and will have to enter into a sub-custodian agreement. This agreement shall be made with the objective of ensuring the custody of the units in case of the insolvency of the custodian.