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The new role of custodian banks

(Article published in the Sept 6, 2006 issue of Manila Standard Today)  

Many years ago, when I had more in hair and was less in years, I sought, at a lecture given at the 1st Institute of Banking conducted by the UP Law Center in 1974, to classify the services rendered by trust departments to their clients into four functions. Making sure that the boundaries are as clear and distinct as René Descartes would have it in order to put up a credible pretense at expertise, I identified the four categories as that of (1) a custodian; (2) an adviser; (3) an agent; and (4) a fiduciary.  I then proceeded to describe the role of a custodian as limited in scope and implied by its juxtaposition in the enumeration constructed in the order of ascending involvement with a client’s affairs, that the custody function was the least important.

 Today, with more in years and less in hair, but with the same spirit of pretense, I would like to recant.  The role of a custodian bank, has since then metamorphosed into a crucial component in the country’s financial system. 

 It was easy, back in 1974, to belittle the role of a custodian.  Section 72(a) of the then General Banking Act (R.A. No. 337 gives banks the power to “receive in custody funds, documents, and valuable objects, and rent safety deposit boxes for the safeguarding of such objects.”  The general thrust is that “safeguarding of such objects”, i.e. the  safekeeping of the items received in custody.  

          The main duty of the bank is thus that of a depositary who was merely required “to keep the thing safely and to return it, when required, to the depositor, or to his heirs and successors, or to the person who may have been designed in the contract.” (Art. 1972, Civil Code).  And the standard of care is no more than that of a “good father of a family”(Art. 1163).

 Just about the only specific duty with respect to what banks hold in custody is found in Art. 1975.  It provides that when the deposit consists of certificates, bonds, securities, or instruments which earn interest, the bank is required to collect the interest “when it becomes due, and to take steps as may be necessary in order that the securities may preserve their value and the rights corresponding to them according to law.”

 The first break legally from the purely warehousing function of a custodian bank is, I believe, the unbundling of the powers granted to banks under Section 72(a) of the General Banking Act.  The new law, the General Banking Law of 2000 (R.A. No. 8791), in its subsection  53.1 (which is the counterpart of Section 72(a) of the old General Banking Act) took out the previous reference to safe deposit boxes and mentioned the authority to rent them out as a separate power under subsection 53.5.  

 In effect, the authority to receive items into custody was purged of the baggage of being simply a safekeeper. (For other implications of such unbundling on the power to rent safe deposit boxes, please read the excellent analysis in Morales, The Philippine General Banking Law (Annotated), 2d. ed. pp. 133-141.). And it was not long before the Bangko Sentral ng Pilipinas (BSP), the new central bank under R.A. No. 8791, would enlist the services of custodian banks to manage systemic risks that had endangered the banking sector and to instill  the transparency and objectivity needed to gain the confidence of investors, both local and foreign.

 For instance, obviously to prevent a repeat of the Bancap Scam of 1994, which was made possible by the then practice of some financial institutions of trading government securities without the simultaneous delivery of the securities against payments, BSP issued Circular 392-03.  The issuance required that securities subject of quasi-banking functions or sold without recourse by or to banks be delivered, upon payment, to a BSP accredited custodian, or, in the case of the latter, to the purchaser itself.

 Likewise, to avoid the “intergenerational inequity” of the accrual method of unit valuation which resulted in later investors absorbing the losses suffered by funds prior to their entry or participation, the BSP issued Circular No. 447, series of 2004.  In this circular that laid out the regulations for the creation, administration and investment of Unit Investment Trust Funds (UITFs), a subsection, among other rules was put in place, that required UITF investments in securities to “be held for safekeeping by BSP accredited third party custodians which shall perform independent marking-to-market of such securities.” 

 What an accredited securities custodian is supposed to do are enumerated Section 6 of Circular No. 428-04.  A securities custodian (a) safekeeps the securities of the client; (b) holds title to the securities in a nominee capacity; (c) executes purchase, sale and other instructions; (d) performs at least a monthly reconciliation to ensure that all positions are properly recorded and accounted for; (e) confirms tax withheld; (f) represents clients in corporate actions in accordance with the direction provided by the securities owner; (g) conducts mark-to-market valuation and statement rendition; and (h) does earmarking of encumbrances or liens.

 In addition, a securities custodian is also permitted by the circular to perform value-added service to clients, such as (a) acting as collecting and paying agent; and (b) securities borrowing and lending operations as agent.

 This last function is a perfect fit for the latest recognition of the value of a custodian bank, namely, SEC Memorandum Circular No. 7 issued 09 June 2006 which deals with the “Rules on Securities Borrowing and Lending” (SBL).

 SBL is “the lending of securities from a lender’s portfolio on a given date to a borrower’s portfolio to support the borrower’s trading activities with the commitment of the borrower to return or deliver said securities or equivalent to the lender on a determined future date.”  As recognized in a companion issuance from the Bureau of Internal Revenue, Rev. Regs, No. 10-06, it is “ an important element in securities trading and capital market development among emerging markets.  It is a vital facility behind the efficient trading settlements and growth of derivatives and options markets.”

 As can be seen from the BSP enumeration of its functions, an accredited securities custodian, though pithily described in SEC Memo Circular No. 7 as “a juridical entity that performs the functions of safekeeping securities for clients, holding title to securities as nominee, valuing securities, administering dividend, reporting and other services,”, can really provide the whole gamut of requirements of a securities lending system that is required of a lending agent under Section 6 of the SEC memo.  Indeed, it is able, as stated by BSP Circular No. 428, to act as its clients’ lending agent itself.

 The custodian bank has thus risen above its previous role of being merely a warehouseman.  It has returned to the original meaning of its root, the latin verb, custodio, custodire, which means not just to keep safely, but rather to watch over.  Moreover, its role is now that of a guardian, not just of the assets of its clients, but of the integrity and safety of the market they operate in.  Indeed, it is now a true blue “fiduciary.”