Certificate of Authority Section IV - Item #11
This guideline is provided to assist applicants and their custodians with drafting custodial agreements that will be acceptable to the department. This discussion is not an exclusive list of provisions which may or may not be used in custodial agreements, but it presents the department's views on the provisions most frequently encountered. In our experience, following the provisions set forth in this guideline will result in a more expeditious review and approval of your application. Sample Custody Agreement.
As used herein, the term "custodied securities" refers to securities held by the custodian, by depositories, by subcustodians or their nominees, or by any other agent of the custodian. The term "agent" means any person or entity used by the custodian to facilitate the handling of custodied securities.
- Standard of Care
The agreement should contain one of two alternative standards of liability:
- Strict Liability - The agreement may provide that the custodian is strictly liable for any loss of custodied securities resulting from fire, robbery, burglary, theft or mysterious disappearance. The custodian may designate certain causes for which it will not be strictly liable if the excluded causes are mentioned by name and are unambiguous. Examples of acceptable exclusions would include war, hurricane or nuclear fission. Examples of unacceptable exclusions include acts of God or a public enemy, strikes or other employee disturbances, civil commotion, a cause beyond the custodian's control, accident, or explosion.
For causes of loss other than fire, robbery, burglary, theft or mysterious disappearance, the custodian will be liable unless it proves that its employees, officers and agents were not negligent and did not act with willful misconduct. The burden of disproving negligence must be shifted to the custodian even if loss occurs while custodied securities are held by an agent of the custodian. The rebuttable presumption should apply to simple negligence, not merely to gross negligence.
- Professional Standard - Alternatively, the agreement may provide that the custodian shall exercise the standard of care which a professional custodian engaged in the banking or trust company industry and having professional expertise in financial and securities processing transactions and custody would observe in these affairs. (See CIC §1104.9)
In addition, if the agreement sets forth a professional standard of care provision, language should be added to explicitly state that the custodian shall be liable to the insurer for loss of securities or other property in the custodial account which result from the negligence or willful misconduct of the custodian, the subcustodian, depository or any of their respective officers, employees, agents or nominees.
- Burden of Proof
The agreement should not limit or reduce the burden of proof placed on the custodian by applicable law in any action for breach of the custodian's standard of care.
Regardless of the standard used, the agreement should specify that no provision in any contract or arrangement between the primary custodian and any agent authorized by the agreement to hold the insurer's assets (whether in definitive or book-entry form) shall diminish or otherwise alter the custodian's liability to the insurer. (See also "Use of Depositories and Other Agents" and "Registration of Custodied Securities" below.)
The custodian should not demand indemnity for all claims, losses, liabilities, damages or expenses incurred in performing custodial duties for an insurer. Indemnification should be limited to situations where the loss, expense, etc., was the fault of the insurer or the insurer's agents, or was incurred while the custodian strictly and diligently followed the insurer's instruction.
The agreement should not provide that brokers or dealers selected by the custodian become agents of the insurer or that the custodian is not responsible for the omissions of those brokers or dealers.
The agreement may relieve the custodian of liability for insolvency or legal inability of brokers or dealers to perform in only two cases:
- When the custodian has not breached its standards of care in selecting or using any such agent; or
- When the agent is not financially affiliated with the custodian.
- Advice of Counsel
A custodian may disclaim liability for acts or omissions resulting from its good faith reliance on the advice of legal counsel only when the advice is received from counsel employed or retained by the insurer. The custodian may not negate liability based on advice received from counsel employed or retained by the custodian.
The agreement should contain a replacement provision which specifies that in the event of loss or damage to custodied securities, the custodian shall, on demand by the insurer, promptly replace those securities with securities of like kind and quality, together with all rights and privileges pertaining to such securities or, if acceptable to the insurer, deliver cash equal to the fair market value of the securities on the date when the loss was discovered.
The replacement provision should remain operative while the parties are negotiating or litigating the cause of the loss. The contract may provide that if the custodian replaces or reimburses for lost custodied securities, and is later exonerated from liability, the insurer shall reimburse the custodian for the cost of such replacement or reimbursement.
Use of Depositories and Other Agents
The agreement should clearly state whether or not the custodian may use correspondent banks, subcustodians, depositories, Federal Reserve banks, brokers, nominees, etc. to hold or transfer custodied securities. If the custodian may use any of these facilities, the agreement should specifically deem them to be the custodian's agents and should clearly specify their function. If custodied securities are retained by the issuer (either in definitive or book-entry form), the agreement should so specify and should deem the issuer to be the custodian's agent. (See also "Liability" and "Registration of Custodied Securities" in this guideline.)
Holding of Assets
Only "qualified depositories" should be used for long-term immobilization of custodied securities. A "qualified depository" is:
- A depository that provides for long-term immobilization of securities, or a clearing corporation that is also a depository, which in either case has been approved by or registered with the Securities and Exchange Commission;
- A Federal Reserve bank; or
- An entity approved by the department as a qualified depository and which has been registered with or approved by the Securities and Exchange Commission.
The agreement should use the word "depository" in any authorizing language (although the depository may be defined as a "clearing agency," "clearing corporation" or entity that provides "handling, clearance or safekeeping services," as long as it has been approved by the SEC).
Registration of Custodied Securities
The agreement should specify whether or not custodied securities may be registered in nominee name.
- Permitted Nominees
Only the nominee name of the custodian, subcustodian, or a qualified depository may be used. (See also "Use of Depositories and Other Agents" and "Holding of Assets" above.)
- Nominee Identification
An affidavit, from an officer of the custodian, describing the legal structure of the nominee and its officer, directors or partners should be filed. Alternatively, the agreement itself may specify the nominee's legal structure.
The department generally does not object to custodial nominees consisting of a partnership composed of employees, officers, directors, and/or corporate affiliates. However, the nominee may not be a corporation, and no unaffiliated corporation may be a partner in a partnership.
The name of the nominee used by any qualified depository should be disclosed. To date, the department has approved the nominees of four acceptable depositories: the Depository Trust Company (New York), Midwest Trust Company (Chicago), Philadelphia Depository Trust Company (Philadelphia), and Participants Trust Company (New York).
- Federal Securities
Custodied federal securities usually will be held in book-entry form. The agreement should specifically mention such arrangements and specifically deem the Federal Reserve bank maintaining such book-entry securities to be the custodian's agent. (See also "Use of Depositories and Other Agents" above.)
The agreement should state that custodied securities in bearer form will be maintained in that form and not re-registered in any nominee name, except on specific instruction from the insurer as to a particular security.
Maintenance of Securities
The agreement should specify whether custodied securities will be maintained separate from all securities held by the custodian on behalf of others, or will be commingled.
The agreement should require the custodian to maintain sufficient records at all times to identify all custodied securities held for the insurer. The custodian should provide the insurer with an updated list of custodied securities at least quarterly.
The agreement should require the custodian to allow insurance and banking regulatory authorities to inspect the custodied securities, and all related records, promptly on demand.
The custodian should not be given authority to vote proxies. The agreement should require the custodian to forward to the insurer all proxy statements, proxies (executed in blank), prospectuses and other corporate reports.
Cash accounts maintained with the custodian for deposit of cash, interest, dividends, or proceeds of security sales should be deemed a part of the custody account, subject to all other terms and provisions of the agreement. (See also "Sweep Accounts" below.)
The agreement should specifically state whether a "sweep" account may be used for automatic investment of cash. The agreement should deem the sweep account to be part of the custody account and thus subject to all other terms of the agreement. (See also "Cash Accounts" above.) If multiple accounts or mutual funds are available, the agreement should permit the insurer to select the account or fund to be used.
- Banker's Liens
The agreement should not permit any charge or lien against the custodial account, including any cash account deemed part of the custodial account. (See also "Cash Accounts" above.) The agreement should expressly disclaim such liens because many states' laws provide for banker's liens even without express contractual authorization.
Since custodied securities represent the insurer's required reserves, those reserve assets must remain free from encumbrances. Charges or liens against such assets would give the custodian preferential treatment over policyholders and would be inconsistent with California insurance insolvency laws. A custodian can always seek recovery of its compensation and expenses from the insurer itself. Similarly, when the agreement is terminated, the custodian may not refuse to release any custodied securities or cash due to nonpayment of the custodian's compensation or expenses. (See also "Termination" below.)
An exception to the rule on banker's liens is permitted when the custodian advances its own funds at the insurer's request to pay for securities purchased by the insurer. (This exception does not apply to other out-of-pocket expenses of the custodian in such acquisitions or to expenses incurred in processing sales, conversions, redemptions, etc., for the insurer.) The contract should require the custodian to notify the insurer promptly of the amount and nature of the debit to the custody account.
- Authorized Debits
The agreement may permit direct recoupment of expenses incurred by the custodian only if the custodian receives the insurer's specific written authorization to debit a specific sum, and only after the custodian has provided the insurer with an invoice for the specific amount to be charged. This exception does not apply to the custodian's fees. Neither custodied securities nor a cash demand account may be debited to recoup custodial fees.
Statute of Limitations
The agreement should not directly or indirectly shorten the time period of any statute of limitations otherwise applicable to actions brought against the custodian by the insurer.
An example of such an unacceptable indirect limitation would be the following:
"The custodian shall mail monthly statements of the securities accounts and cash account to the client. The client agrees that each such statement shall be binding on the client thirty days after it has been mailed."
Investments by Custodian
The agreement should not authorize the custodian to make investments on behalf of the insurer without specific instructions from the insurer in each instance. Such authority would be an excessive delegation of an essential managerial function, which the insurer must retain unless the function has been formally delegated to an investment advisor (which may be the custodian) pursuant to a separate contractual arrangement with appropriate safeguards. (See the guidelines for Item 12 in this Section.)
Investments in Custodian
The agreement should not give the custodian carte blanche authority to invest in debt obligations, commercial paper, mutual funds or other instruments issued by the custodian or by its financial affiliates while insulating the custodian from liability for financial loss resulting from those investments. These arrangements create inherent conflicts of interest between the custodian's own financial interest and its role as a fiduciary. The conflict can be alleviated if the agreement specifies that: (a) all such investments require specific prior approval from the insurer; (b) no commissions will be paid to the custodian or its financial affiliates for arranging or participating in such transactions; and (c) all such investments will be purchased at fair market value.
Delivery of Securities
The agreement may disclaim liability for delivery of securities prior to payment by the purchaser only if the delivery is made at the specific request of the insurer in a particular instance.
The agreement should allow either party to terminate without cause on at least 60 days' written notice. The agreement should also provide that, upon termination, the custodian will return to the insurer all custodied securities. (See also "Compensation" above.)
The agreement should require the custodian to transfer the securities to the successor custodian, if one has been arranged, along with all records pertaining to the securities held by the depository (including those records pertaining to securities held in book-entry form, by Federal Reserve banks, or retained by the issuer). The agreement should also provide that the custodian's responsibilities continue until the successor custodian's appointment becomes effective and all custodied securities have been transferred.
If the insurer is domiciled in California, then both the custodian and the custodied securities must be located in California pursuant to California Insurance Code Section 1104.1, except as provided in Department Bulletin No. 87-7 or in California Insurance Code Section 1104.9.
Except as provided in Department Bulletin No. 87-7 and in California Insurance Code Section 1104.9, the custodian may not, with or without a subcustody agreement, hold securities in out-of-state subcustodians, Federal Reserve banks, depositories, or any other entity.
Bulletin No. 87-7 and California Insurance Code Section 1104.9 set forth alternative procedures for holding securities out of state. Domestic insurers should contact the department for further information concerning filings and determinations to be made to hold securities out of state.
Agreements may contain provisions, or provide for services, not discussed in this document. Those provisions or services will be reviewed and evaluated on their own merits and under the circumstances presented.