Contractual Relations between Pension Fund Administrators and Pension Fund Custodians

1. Contractual Relations between Pension Fund Administrators and Pension Fund Custodians Consultative Forum on Pension Fund Custodians & Custody Organised by National Pensions Commission Protea Hotel, Oakwood Park, Lekki, Lagos Paper presented by Dr. A.O. Austen-Peters 26 April 2005

2. Summary • What is custody • Importance • Substantive law issues • Issues to be addressed by law and contract • Local and foreign treatment of custody issues • Minimum content of a contract between PFA and PFC for custodial services

3. Custody • Two core activities: • safekeeping – preservation of assets – physical and data protection/management resources • administration – account to owners for benefits – record-keeping, settling trades, corporate action • Value-added roles, such as stock lending, risk measurement and collateral management. • Typically refers to debt and equity securities, but also encompasses the range of investment assets from the more mundane such as property to the more exotic such as derivatives

4. Importance of Custody Business/Why use custodians? • Safety, efficiency, more services. • reduced risk of theft or accidental destruction – economies of scale for custodians to put strategies and resources in place to achieve this • lets PFA devote his energies to core business, administration of retirement benefits and selection of investments • facilitate corporate action e.g. collection of dividend, payment of taxes • immobilised investments – efficiency of action in relation thereto, less risk of loss or destruction in transfers of interests • dematerialisation – efficiency

5. Substantive Law Issues - 1 • In using custodian, how does one protect against risks caused by loss of direct ownership and control of the assets? • If safety and efficiency are the motives for using custodians, how should contractual relations be established to achieve this? • Investor’s concern – proprietary interest - that survives insolvency of custodian – implications for duties on custodian, and remedies open on breach of duty

6. Substantive Law Issues - 2 • Proprietary rights depend on relationship with the asset or someone holding the asset: • bailor of assets in custody • beneficiary under a trust in relation to assets in custody • Challenges to bailment: • dematerialisation and immobilisation – no physical asset – no bailment • where asset is vested in custodian, he cannot be bailee of assets that belong to him, but he can be trustee • Challenges to trust: • fungibility and pooling of assets are hurdles to identification

7. Substantive Law Issues - 3 • Consensus amongst common law lawyers: • certificates in custody – investor owns securities, bailment over the res of certificates only (assuming in name of PFA, etc) – so still in fiduciary relationship vis a vis the underlying rights • assets vested in custodian (certificated or otherwise) – trust – tenancy-in-common between beneficiaries or rights to a specific number of allocated or unallocated units in the pool

8. Substantive Law Issues - 4 • Effect of true intermediation, e.g. immobilisation – assuming sub-trusts: • Tiers of trusts – each trustee holds only for the party to whom he is accountable for the benefit • One tier – PFA enjoys direct (albeit equitable) interest in the assets • If more than one tier, though PFA is entitled to substance (albeit for account-holders), it does not enjoy direct link to the assets - PFA holds for RS account holder as ultimate beneficiary

9. Substantive Law Issues - 5 • Assuming ABC shares – CSCS as depository/sub-custodian – PFC – PFA – Account holder • CSCS holds for PFC only – PFC holds interest for PFA only – Account holder takes beneficially from PFA • PFA cannot interact directly with CSCS or issuer: no privity of contract, PFA is not on the issuer’s register, PFA is not the beneficiary of CSCS • PFA: rights relating to PFC’s interest and personal rights against PFC

10. Risks to be addressed • If claims against custodian and there is one or both: • Uncertainty in relation to investors’ ownership rights • Fraud or mismanagement – caused or permitted by: • inadequate physical or IT resources • weak internal controls/supervision systems • There is risk of loss of custody assets because: • No trust – assets vest in PFC – PFC creditors can claim them • Even if trust or bailment, savvy and determined fraudster can alienate assets in a manner that leaves them untraceable – e.g. bona fide purchaser • Risk is addressed by one or combination of legislation clarifying legal uncertainty; documentation; licensing; and standard-setting

11. The Current Legal and Regulatory Treatment of Custody • Ownership rights not provided for in legislation – similar to UK • ISA does not define scope of custodial regulations: • License: s 29(3) ISA – registration – but rules 26 and 27 of the Rules and Regulations under ISA are blank. • Standards: s 31(h) and (i) ISA - Part VII of ISA is applicable - focus on dealers and fund managers (e.g. no insider dealing) - different functions to custodians – limited application • No general standards, rules and regulations under ISA attempt to correct this: • rule 191 brief general prescriptions for how fund managers should conduct the custody of client assets • rule 206 on custody by trustees is yet to be drafted • sub-parts E13 and E14 on the custody of investments and depositories have yet to be drafted

12. Experiences Elsewhere - 1 • International central securities depositories - Euroclear and Clearstream (formerly Cedel) - Belgium and Luxembourg - civilian countries, no trust - risk of contractual rights only – legislation giving revendication rights which rank ahead of ordinary creditors : • Art 10 of Belgian Royal Decree No 62 of 10 November 1967 Facilitating the Circulation of Securities • Art 9 of the Grand-Ducal Decree of Luxembourg dated 17 February 1971 on the Circulation of Securities (as amended by the Grand-Ducal Amending Decree of 8 June 1994)

13. Experiences Elsewhere - 2 • USA: Art 8-503(a) of the Uniform Commercial Code (UCC) clarifies ownership rights held via intermediaries assets can not be claimed by intermediary’s creditors • Other legislation governs who can conduct custody business and how, e.g. US Investment Company Act of 1940 governs foreign investment by US investment firms • rules 17f-5 and 7 on which foreign sub-custodians and depositories US investment firms may use • risk assessment of the foreign institution • criteria includes: reputation, financial strength and internal controls

14. Experiences Elsewhere - 3 • UK – no legislation on ownership rights, left to common law - a statutory instrument was passed by Parliament in 1996 that: • defined which custody is a regulated activity – distinguish incidental custody, e.g. docs with lawyer, accountant, priest, etc as compared with commercial or investment custody • who is regulated • bringing this activity under the Financial Services Act of 1986 – Financial Services Authority published market guidance documents explaining the precise standards required of custodians and their agents

15. Content of a contract for custodial services between PFA and PFC - 1 • Industry standard documentation has not yet evolved – good for this to evolve – predictability industry-wide, and as between different clients of one PFC • ISA is of little help • What in general are the issues that should be covered by PFA/PFC relationship documentation, i.e. the contract for custodial services? • Could be oral, but better and normal to be in writing • Clarify ownership rights – by legislation, or in practice by segregation or designation – 60(1) • Statutory, regulatory and general compliance obligations should be documented to put matters beyond dispute – if not omnibus – even if not necessary to reflect statutory prescriptions, clarify how compliance obligations will be met

16. Content of a contract for custodial services between PFA and PFC - 2 • Duty of PFC in relation to assets and re: PFA • Exercise of rights attached to underlying assets • PFC liability in relation to PFC assets • Standards: physical environment – data processing and backup facilities – maybe too intrusive, but for a new industry some thought should be given to this • Cash – especially for non-bank custodians – before or in between transactions should be provided for • Allocate responsibilities between PFA and PFC, and between PFC and other sub-custodians, e.g. depositories, settlement systems and foreign custodians • Governing law

17. Content of a contract for custodial services between PFA and PFC - 3 • What does PRA and any associated guidelines say to help on this? • Compliance obligations may run counter contractual provisions for custodial services; to avoid disputes, these should be made clear contractual provisions, e.g. on disclosure of confidential information to PenCom, whistle-blowing obligation, etc. • In the event that the compliance obligations run counter actual contractual provisions, the PFC should make it clear that it will at least be relying on its own expressly stipulated indemnity

18. Content of a contract for custodial services between PFA and PFC - 4 • The following PRA provisions seem relevant: • 11 PFC should receive contributions from employers, to be held for PFAs to the exclusive order of the PFA that nominated that PFC to receive the contribution; and PFC to notify PFA of contribution made upon receipt – PFAs may want to make this a contractual provision as well, especially if there are precise modalities by which this is to be done • 39, 40, 46 closed PFA assets shall be held by PFC

19. Content of a contract for custodial services between PFA and PFC - 5 • 47 PFCs carry out the following functions, and a PFA may want to include those of direct concern to it in the contract for services to establish the minimum scope of work that the PFC should cover for it: • receive contributions – this one • notify PFAs of contribution within 24 hours of receipt – this one • hold assets in safe custody on trust for employee and beneficiary of RSA – this one • settle transactions on behalf of PFA and take relevant corporate action, e.g. collect dividend – this one • report to PenCom on such matters that PenCom requires at such regularity that PenCom determines – not this one • undertake statistical analysis on the investments held by it and report thereon to PFA and PenCom – this one • give PFAs proxy to vote on securities held by it – this one • 52(1)(d) No PFC licence if no guarantee from PFC or its parent body to full sum and value of assets held or to be held by it – PFAs may make this a contractual provision so that it can take action on breach and not rely on PenCom

20. Content of a contract for custodial services between PFA and PFC - 6 • 52(1)(e) No PFC licence if no undertaking to hold assets to exclusive order of PFA on trust for the employees as instructed by PFA – for avoidance of doubt, PFA may want to get PFC to agree that statutory obligations to hold assets on trust for employees or beneficiaries of RSAs should be taken to refer to the accounts maintained by the particular PFA that instructs it with respect to the holding of those assets • 54(1)(c) If conduct of affairs of PFC is inconsistent with PRA or regulations the PFC licence may be revoked – the PFA may wish to make this an issue upon which it may terminate the contract even if PenCom does not act • 54(1)(e) If PFC breaches terms of its licence the PFC licence may be revoked, this could be a severe penalty for breach of PFA/PFC contract if observance of contract is made a condition of licence – also PFA may make this an issue upon which to terminate the contract, even if PenCom does not act

21. Content of a contract for custodial services between PFA and PFC - 7 • 54(6)(b) If PFC licence revoked, PenCom shall transfer assets to another PFC – effectively this would over-ride any contractual provision which went counter to this – typically upon termination of a contract for custodial services the client would have the right to determine how the assets were to be treated, in this case PenCom has assumed this right • 56(1) PFC to keep proper books of account and records showing income, expenditure, assets, investments and returns on investment – it is in the interest of PFA to ensure that this happens, for information and reconciliation purposes, it may want to make this a contractual term so that it does not have to rely on PenCom for this • 57 PFC must report on assets held by it to PenCom – this may impact on confidentiality clauses in the contract, these should be drafted in a way that permits PFC to observe its compliance obligations

22. Content of a contract for custodial services between PFA and PFC - 8 • 59 PFC shall ensure that safekeeping is done in the best interests of beneficiaries; report any unusual occurrence in respect of assets which in its view could harm interests of beneficiaries – whistle-blowing obligation may breach typical confidentiality provisions, whether or not they are, PFC is obliged to fulfil its statutory obligations • 60(1) PFC to keep assets to exclusive order of PFA – to ensure that beneficial ownership and trust relationship for RSA holders is established • 60(2) PFC not to use assets for own or other person’s financial obligations – to ensure that beneficial ownership and trust relationship for RSA holders is respected • 81(1)(e) PenCom may request any information or explanation to enable it determine compliance of PFC – even if in breach of contract, PFC must do this and should be indemnified for so doing

23. Content of a contract for custodial services between PFA and PFC - 9 • 98 No pension assets kept with PFC can be used to meet creditors of PFC, whether in insolvency or not – assuming that trust is established, this is the normal course of events, as a contractual provision, it further buttresses the establishment of the trust and promotes the security of assets for the PFA and its beneficiaries • Requirements for PFC licence include: • Services should include custody, investment accounting, performance measurement, risk management and compliance reporting – these should constitute the minimum scope of services that any PFA/PFC contract contains, the contract can be expanded to meet particular requirements that PFA wants and PFC is ready to meet • Adequate insurance against fire, theft, natural catastrophe, as well as fidelity cover – again a standard provision that should be put in the contract in order to comply with the terms on which licences are issued

24. CONCLUSION • Substantive law issues e.g. ownership are left to common law • Operational risks of PFC are only addressed in general terms by statute – e.g. no fraud or negligence • Legislation, ISA & PRA, are not all-embracing • Contractual terms are therefore critical in addressing ownership and operational risks • They can be used to support compliance issues • Industry standard draft would promote clarity on key issues, and consistency between different clients of a PFC