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Are the Assets in Custody?

March 22, 2017

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Are the Assets in Custody?

March 22, 2017

Authored by: Matthew D'Amico

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 lender 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.

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IPO Market for Closed-End Funds Poised for Serious Rebound

March 1, 2017

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It’s clear to anyone paying attention that the market for initial public offerings of closed‑end funds has fallen off dramatically over the last few years.  Undoubtedly, the primary cause of this fall off has been the gaping average trading discount of existing closed‑end funds (i.e., on average these funds have been trading at steep discounts to net asset values).  That made it difficult, if not a practical impossibility, for asset managers to sell shares of a new closed-end fund when investors could simply purchase shares of a similar, existing closed-end fund at a significant discount.

Also contributing somewhat to this fall off has been the relative increase in the cost of leverage as a result of the phasing in of new capital rules for banks.  Many closed-end funds employ leverage to deliver additional returns to investors; these increased costs (which correspondingly reduce returns to investors) have made it incrementally more difficult for asset managers looking to launch new closed-end funds to make their case to investors.

On top of all of this, according to many industry observers the so-called “fiduciary rule” (finalized on April 6, 2016) would make it nearly impossible for financial advisors to recommend to investors that they purchase shares of a closed‑end fund at the IPO stage.  The key problem for closed-end fund IPOs under the fiduciary rule is not necessarily inherent; it arises out of the fact that, at times, while many closed-end funds trade at a premium at and shortly after the initial offering, thereafter they begin to trade at a discount.  This can have the effect of creating at best a short-term paper loss, and at worst a short-term actual loss, for investors.

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