It is a widely held belief among institutional investors that custody accounts are protected against a bank’s insolvency in the United States. This assumption undergirds trillions of dollars of assets held in custody in U.S. banks. However, despite the 2008 financial crisis, little if any attention has been paid to analyzing whether this belief is, indeed, valid. This article argues that while the FDIC, as receiver of almost all failed banks in the United States, will likely protect custodied assets to the extent permitted by law, clients bear several significant legal and operational risks that could limit recovery of their custodied assets. While investors can protect against some risks, others may be outside their control. The article outlines these risks and proposes ameliorative steps for institutional investors.

It is an article of faith among institutional investors that assets held in custody are protected against a bank’s insolvency in the United States. It is such commonly accepted wisdom that there has been little, if any, analysis of the topic since the 2008 financial meltdown. This seems surprising when contrasted with the sudden, widespread focus on the risks of prime brokerage after the collapse of Bear Stearns and Lehman Brothers. This disparity would seem to confirm the accepted view among institutions that a custody account is the “safest place” for their assets.¹

This article of faith undergirds the U.S. banking system. There are trillions of dollars of institutional investment assets held in United States custody accounts,² and undoubtedly the assumption of most institutional investors is that if the bank fails, assets would remain theirs and beyond the reach of the bank’s creditors and general depositors. If this assumption were wrong, then the assets could be reduced—perhaps significantly—to satisfy the claims of those other parties. Loss of these assets could be cataclysmic for mutual funds, pension plans, hedge funds, endowments, and other depositor institutions,³ and needless to say, their clients and beneficiaries.

Along with this assumption is the notion that custodied assets will become available almost immediately for repossession by the investor, as contrasted with claim resolution in a bank’s insolvency proceedings, which might take years.

The attributes of custody are so widely recognized that since 2008 many hedge funds have moved their “net long” positions from prime brokerage to bank custody accounts,⁴ and similarly, since passage of the Dodd-Frank Act (“Dodd-Frank”),⁵ swap dealers and traders have explored holding margin or collateral in a custody account.⁶ Dodd-Frank itself imposes new custody requirements for investment advisory assets and futures collateral.⁷

Investors have good reason to trust bank custody. The Office of the Comptroller of the Currency (“OCC”) advises that “[a]ssets held by banks in a custodial capacity do not become assets or liabilities of the bank. . . . They are not subject to the claims of the bank’s creditors.”⁸ In addition, the American Bankers Association assures that “a failure of a bank will have no adverse effect on trust, fiduciary or custodial accounts: they remain the property of the account owner(s).”⁹

Thus, it is with good reason that bank custody is seen as best practice, and directors and officers of institutional investors may feel with confidence that they are properly discharging their fiduciary duties by entrusting assets with a bank custodian. If the financial community regards the sanctity of custody accounts as a truism, it is worth asking whether this assumption is, in a word, true. This is what this article sets out to do.

After surprisingly lengthy research, the answer is not simple. The challenges in understanding U.S. custody law start with the fact that “custody” is not usually a legal term of art, and while traditionally most analysis starts with common law concepts of trust, agency, and bailment, no one—including legislators, courts, and even the U.S. Federal Deposit Insurance Corporation (the “FDIC”)—applies them consistently or always accurately.¹⁰ (And slight differences in terminology can be significant. For example, while some states consider a custodial account to be a trust by operation of law,¹¹ under federal law a custodial account is not a “fiduciary account” unless the custody bank provides investment advice or has investment discretion.¹²)

Next, consider the fact that the United States has a “dual banking system” of national and state banks, each with its own rules. While the FDIC typically acts as receiver of all insolvent banks, regardless of whether the bank is nationally or state chartered, it will apply federal or state law to insolvency issues depending on which set of laws governs the issue at hand. Then, to the extent the FDIC looks to state laws of custody, those laws not only vary across jurisdictions but the laws within a given state can be confusing. In this regard it is important to highlight Article 8 of the Uniform Commercial Code (the “U.C.C.”), as revised in the 1990s (“Article 8” or “Revised Article 8”), which overrides some common-law concepts of bank custody (as discussed further in Part IV). Additionally, while the topic of bank custody is broad, there is surprisingly little published guidance by courts or commentators. Along the same lines, many of the practices relating to bank custody are matters of “lore, not law,” and are not always fully disseminated by regulators or banks.

Indeed, there is little consistency among experts on what the law says, or even what the relevant law is. The written opinions of leading law firms addressing this topic are surprisingly scattered. Perhaps mindful of this, the outside counsel of at least one major custodian chose not to issue its advice as an opinion but rather as a “memorandum” in order, I assume, to avoid liability in the event of errors.¹³ In summary, then, this area of the law is, at the least, challenging.

If we move beyond these hurdles, as this article discusses in greater detail, apart from cash,¹⁴ assets held in bank custody in the United States should be protected from a bank’s insolvency by reason of strong, long-standing principles of the FDIC. But insofar as the FDIC implements relevant state law, state law can present its own challenges, which include U.C.C. Article 8. And then, turning from strictly issues of law, there is the “inevitable” risk of entrusting assets to any third party.¹⁵

There are at least four risks that can undercut if not eliminate the protections of a custody account. These are

• Documentation Risk: The risk that the “custody agreement” fails to meet legal requirements.
• Segregation Risk: The risk that the bank fails to segregate assets. This includes the risk that the bank fails properly to identify client assets internally or with securities depositories or other third parties.
• Article 8 Risk: The risk under the rules of Article 8 of the U.C.C. that the client’s securities are not recoverable from bank assets in the event of the bank’s insolvency.
• Bank Misconduct Risk: The risk of the negligence or misconduct of the bank as custodian (an even more acute concern in the wake of MF Global which, though not a bank, highlights the risk of negligence or misconduct by any financial institution to which assets are entrusted). ¹⁶This includes the risk that a bank misdirects assets borrowed from a custody account or improperly exercises the general lien that custody agreements typically grant custodians to assure payment of their fees and expenses.

As a lawyer working in the field of institutional investment, my impression is that many investors know nothing of these risks and assume that bank custody is in essence a guaranty: once an investor signs the custody agreement, the investor is automatically and fully protected. Investors are not entirely blameless on this front, as noted above.¹⁷

The rights of institutional investors in custody accounts are neither self-effective nor guaranteed as reliable sources seem to suggest.¹⁸ An investor cannot assume that its custody agreement will be recognized as such under law or that its assets will remain intact even if it has an effective agreement. Investors must actively guard their assets from loss arising from a custody bank’s insolvency. The loss of these assets is a frightful outcome for mutual funds, pension plans, hedge funds, endowments, and other institutional investors, but it is largely (but never completely) avoidable.

This article explores the laws of custody and how the FDIC protects the rights of custody clients in a bank’s insolvency.¹⁹ It then looks at U.C.C. Article 8 as it may challenge those rights. The article addresses some related topics and then closes with recommendations for investor best practice and conclusions.

A few notes on scope. First, as stated above, this article focuses on the insolvency rules of U.S. banks as they affect custodial assets of institutional investors. Largely beyond the purview here are insolvency rights of customers of U.S. or non-U.S. brokers or dealers, including prime brokers,²⁰ or non-U.S. custodial banks. Along these lines, the article does not address custody rights under brokerage accounts, including rights under Rule 15c3-3,²¹ or broker-dealer rights in special deposits held in bank custody.²² Also, the article does not focus on custody rules relating to repurchase agreements, swaps, and other “Qualified Financial Contracts,”²³ or accounts managed by a bank directly, including securities lending programs.²⁴

I. OVERVIEW OF THE ISSUE; CUSTODY TODAY

The use of custodied accounts at U.S. banks has never been more important. As a result of the 2008 financial meltdown, and especially the Lehman failure, ²⁵institutional investors have grown increasingly aware of their exposure to the creditworthiness of third parties who hold their assets. As many hedge funds and other investment firms discovered to their surprise four years ago, assets held with some offshore brokers, and specifically prime brokers in the United Kingdom, are not immediately available upon recall.²⁶ Local rules, especially those permitting the brokers to rehypothecate²⁷ customer securities, caught many of them unaware, and some were unable to immediately recall or move their securities to the United States, where stronger brokerage rules exist.

As market acuity increased, it became clear that the rules protecting brokerage accounts in the United States—the rules to which institutional investors flocked in 2008—are not as generous as those believed to protect bank custody accounts here. Under the Securities Investor Protection Act of 1970 (“SIPA”),²⁸ brokerage clients stand as general creditors of the bankrupt firm to the extent that their losses exceed the amount insured by the SIPC, currently $500,000.²⁹ When contrasted with the rules of bank custody as they are commonly understood, an elementary risk analysis demonstrates the appeal of bank custody over brokerage.

Bank custody offers one other advantage as well. While broker insolvencies proceed under either SIPA or the U.S. Bankruptcy Code,³⁰ banks that are subject to the Federal Deposit Insurance Act (the “FDI Act”)³¹ are excluded from those rules. Instead, the FDIC acts as receiver³² not only for insolvent national banks but typically for insolvent state banks as well.³³ FDIC receiverships are generally viewed as efficient and speedy, with the FDIC promptly returning custodied assets to the client or transferring them to the client’s designated successor custodian.³⁴ Indeed, the FDIC has stated that it performs this function “automatically” without the need for any action by the bank.³⁵ As the old adage goes, possession in this situation is surely nine-tenths of the law. Custodial assets are often transferred from the bank’s books before creditors have time, or the right, to object. ³⁶Claimants must pursue administrative remedies against the FDIC as receiver before the FDIC can be sued in court.³⁷ This means the custodied assets will be off of the bank’s books long before litigation ensues to bring them back. If this were not enough, the agency will trace and recover missing assets.³⁸

But while the demand for custody accounts is on the upswing, and financial institutions are happy to offer accounts styled as “custody” accounts,³⁹ it has become more difficult for some banks to agree to act as a fiduciary, one of the two pillars of custody as traditionally recognized in the United States and by the FDIC (the other pillar being segregation of assets, as discussed more fully below).⁴⁰ The reasons for this include bank consolidation, which has reduced competition;⁴¹ client lawsuits regarding foreign exchange, which may have made some banks wary of their clients and more highly attuned to the burdens of custody, a traditionally lower risk business;⁴² and the overall financial climate after 2008 in which immoderate caution sometimes seems to prevail, even in traditional areas of banking such as custody.⁴³

This heightened aversion to fiduciary undertakings appears grounded on the fear that the bank will be held responsible for the client’s investment decisions. It is true that status as fiduciary over custodied assets may imply broader fiduciary duties, such as investment discretion, as may be the case with accounts covered by the Employee Retirement Income Security Act (“ERISA”).⁴⁴ But, as may be obvious for clients who are not subject to ERISA or other special regulatory requirements, a bank can delineate its role as fiduciary by contract and thus avoid liability for services expressly excluded. This is how some thoughtful custodians have addressed it.⁴⁵

While banks may legitimately point out that the risk/benefits of the custody business today are not what they used to be, it is troubling to see a custody bank refuse to undertake requisite duties. This presents a trap for the unwary. ⁴⁶As already noted, bank custody is widely known but little understood by institutional investors and others. In other words, while bank custody is something everyone thinks they understand, its foundations under law are unclear.

II. WHAT IS “CUSTODY”?

A. COMMON LAW SOURCES

At a recent presentation entitled “Observations on the Custody of Institutional Assets,”⁴⁷ members of the American Bar Association’s Institutional Investors Committee were asked to guess which set of legal principles traditionally defines the relationship between custody bank and client: trustee and beneficiary; principal and agent; or bailor and bailee. Most hands remained motionless. Those who were reluctant to guess were either better or less informed than those who did, because the laws of trust, agency, and bailment have all been cited as the underpinning of custody.⁴⁸ This is intriguing insofar as the three areas of law present inconsistent principles. Trust typically requires transfer of title to the trustee, while agency and bailment do not;⁴⁹ trust and agency create fiduciary responsibilities while bailment does not;⁵⁰ and a trustee typically is vested with broad decision-making authority, an agent has some defined area of action, and a bailee follows directions.⁵¹

The authorities are far from clear. For example, one treatise, speaking of custody accounts as “special deposits,” states:

A special deposit becomes such by specific direction or agreement to create a trust. . . . To create such a deposit, the bank must be made an agent or trustee, and agency or trusteeship cannot be created out of the mere external relationship of debtor and creditor unless the deposit is wrongful or the law forbids the bank becoming a debtor. . . . A special deposit is sometimes said to be equivalent to a bailment, but it is not always of that order. . . . Special or specific deposits are of a trust nature, and the relationship between the depositor and the bank is that of principal and agent or bailor and bailee.⁵²

Even the FDIC has been inconsistent. It has opined at various times that the custodial relationship is a bailment,⁵³ a directed agency,⁵⁴ or a trust account.⁵⁵

Adding to the murkiness here is the imprecision of the word “custody” under law. The term can be used to describe a specific legal relationship, as in the case of a custodian under the Uniform Transfers to Minors Act,⁵⁶ or generically to describe the holding of a “thing,”⁵⁷ but for the most part it is not used in statutes or cases. More typically, statutes either avoid specific terminology in favor of general descriptive language⁵⁸ or employ another phrase, such as “fiduciary accounts,”⁵⁹ while caselaw and treatises focus on the concept of “special accounts,” discussed further below. The point here is that a lawyer seeking to learn about this area of the law will discover that research of the term “custody” is generally fruitless.

Regardless of terminology, the common law found adequate legal basis to recognize that assets held in a properly formed custody account remain the property of the customer and escape the bank’s failure.⁶⁰ The client placed securities and other valuables in the safekeeping of a bank, and the bank segregated those assets in its vault or a safe deposit box, and in return received a fee.⁶¹ Its duty was to protect the client’s assets as it would protect its own.⁶² This concept made sense in a preelectronic era when stocks, bonds, and other assets like jewels and deeds were physically stored in custody of a bank’s trust department. Even today, while the preponderance of assets in institutional accounts are securities held indirectly through a central depository such as the Depository Trust Company, custody banks continue to hold physical assets on behalf of institutional clients, such as gold bullion⁶³ or, for example, original evidence of ownership of interests in real or personal property or synthetic instruments linked to property.⁶⁴ (Such custody is called “on-premises” or “direct” custody. Custodial “possession” of the legal rights to assets located elsewhere, such as those held through a depository, is called “off-premises” or “indirect” custody.⁶⁵)

B. STATE LAW AND “SPECIAL ACCOUNTS”

Courts have generally acknowledged a trust, agency, or bailment relationship in the case of “special accounts.”⁶⁶ Special accounts are recognized under general powers granted to banks under state law.⁶⁷ Custody accounts, as “special accounts,” denote assets distinguishable from the bank’s general assets and which will revert to the customer outside a bank’s insolvency.⁶⁸ Courts have held that these assets not only pass outside insolvency but may be recoverable if wrongly transferred or converted; the OCC and the FDIC recognize this in the national banking context.⁶⁹ (Query whether tracing of assets is permitted, or possible, for indirectly held securities.⁷⁰) Arguably, then, a special account does not even form a “claim” subject to insolvency proceedings but rather is a contract right that passes outside the claims process.⁷¹ This is a sensible reading insofar as the FDIC, on the one hand, will convey custodial assets outside of an insolvency case but, on the other hand, is charged with treating claims ratably in the course of maximizing the insolvent estate.⁷²

Because special accounts enjoy such extraordinary treatment, courts typically presume that all bank deposits are general assets⁷³ and so a claimant must clearly show the parties’ intent to establish a special account in order to overcome the presumption.⁷⁴ Courts have stated this imposes a “heavy” burden of proof ⁷⁵ or that this burden can be “difficult.”⁷⁶ No particular wording is required to evidence intent,⁷⁷ but there must be clear evidence of a trust relationship,⁷⁸ or an intent to segregate the assets for the client’s benefit.⁷⁹ And, as further illustration of the inconsistent nomenclature used on this topic, the caselaw holds that simply calling or treating an account as a “custody account” does not mean it will be respected as a “special account” unless there is a convincing showing of a trust relationship.⁸⁰ Parol evidence generally will not suffice,⁸¹ particularly as FDIC regulations require identification of accounts in the custodian’s records⁸² (and indeed, the FDIC has power to invalidate written contracts if it believes they are burdensome or not consistent with an orderly liquidation⁸³).

Apart from the cases cited, there is little modern caselaw on the ownership rights of special accounts. This is probably because the FDIC so efficiently distributes custody assets from failed banks that generally there is no cause for litigation to arise later. Nonetheless, the cases demonstrate that the validity of a custody account requires clear evidence; that the assets are segregated in the client’s name; and that the elements of the custody account satisfy relevant legal standards. Thus, institutional investors should retain competent counsel to review the law and negotiate the custodial agreement, and should seek a legal opinion from the bank’s law firm confirming that the custody contract creates a valid and enforceable custody account (or “special” or “fiduciary” or “trust” account) under law.⁸⁴

As noted, the FDIC will typically be the receiver of state bank insolvencies and will apply the relevant state law except to the extent that federal law is not inconsistent with state law or expressly preempts it.⁸⁵ While a number of federal laws do preempt state law, and in recent years the Supreme Court has ruled on whether certain federal banking regulations are within federal banking power, ⁸⁶I have found no federal laws that preempt the manner by which relevant state law would apply to custodial accounts in insolvency. Indeed, the FDIC has stated that it defers to state law on what constitutes a trust account at a state bank.⁸⁷ Thus, it appears that state laws of custody should govern the FDIC’s actions as receiver of national banks as well as state banks.⁸⁸ (Note, however, the distinction that suits involving the FDIC “are deemed to arise under federal law.”⁸⁹) The relevant state law should be the law of the contract rather than the law of the state in which the account is located.⁹⁰

C. NATIONAL BANKING LAWS

1. Substantive Law of Custody at National Banks

Under their general statutory powers, national banks may “receiv[e] deposits” and all other “incidental powers as shall be necessary to carry on the business of banking.”⁹¹ This language, found in 12 U.S.C. § 24, Seventh, is the font of federal law of custody for national banks,⁹² and reflects statutory intent to create the dual system of national and state banking discussed above. The dual banking system seeks equivalency, or an even playing field, between national and state banks, ⁹³and therefore, presumably, a customer holding a custody account at a national bank will have the same rights in insolvency as a comparable client at a state bank across the street. Accordingly, like state banks, national banks may offer what the OCC calls “client-directed” custody accounts—in which the client or its investment advisers make investment decisions⁹⁴—and “fiduciary accounts”— trust accounts authorized under section 92a of the FDI Act⁹⁵—for which the custody bank delivers investment advice or makes investment decisions.⁹⁶

The FDIC has furnished advisory opinions confirming that custodial assets will be excluded from a bank’s general assets in insolvency, and these opinions appear not to distinguish between client-directed accounts and trust accounts, or (as noted above) between state banks and national banks.⁹⁷ However, one fairly recent advisory opinion is noteworthy because even though it responds to a question specifically about a trust account, it offers guidance that seems equally instructive to client-directed accounts. In that opinion, the FDIC advised that it is “well settled” that “the ‘general assets’ of [a] failed institution are subject to the claims of creditors but the ‘trust assets’ may be recoverable in full by the trust customers.”⁹⁸ In this circumstance, the FDIC noted, holders of fiduciary accounts must

(1) establish the existence of a fiduciary relationship between themselves and the failed institution with respect to the assets; and (2) trace the assets into the hands of the institution’s receiver (i.e., the FDIC). The satisfaction of the first requirement will depend upon the terms of the agreement between the trust customer and the depository institution; the satisfaction of the second requirement will depend upon whether the depository institution—in accordance with this agreement—con-tinues to hold the asset (separate and apart from its general assets) at the time of the institution’s failure.

   In most cases, the satisfaction of the requirements above will not be a problem. Indeed, the FDIC (as the failed institution’s receiver) will surrender the trust assets to the trust customers (or arrange for the holding of the trust assets by a substitute fiduciary) without requiring any action by the trust customers. Please note, however, that the FDIC cannot guarantee that every depository institution—after receiving or purchasing assets in a fiduciary capacity—will honor its obligations to handle these assets in an appropriate manner.⁹⁹

Thus, it appears well established that the FDIC will assure a custodial account validly formed under state law will pass outside a bank’s insolvency, absent bank misconduct.

As noted in Part II.B., state laws of custody should govern at national banks. Insofar as U.C.C. remedies are matters of state, not federal, law, U.C.C. remedies may override state law protecting custodial assets to the extent the two sets of laws are inconsistent. See Part IV below.

2. The FDIC as Receiver

In a receivership, all claims against a failed bank “are fixed at the time of the declaration of insolvency,” and the FDIC “stands in the place of the bank.”¹⁰⁰ The FDIC has only the rights that the bank had at insolvency, so that “the rights of third parties are not increased, diminished or varied” by receivership.¹⁰¹ However, as recognized in FDIC Advisory Opinion No. 03-01 cited above, the FDIC is authorized as receiver to avoid any fraudulent or other transfers before a bank’s insolvency.¹⁰² The potential loss of assets through negligence or fraud highlights the importance of continuing due diligence by clients, although it may be impossible for diligence to prevent it. As highlighted in the brokerage setting (e.g., MF Global), clients should not ignore the risk of a custodian negligently or otherwise depleting client assets immediately before insolvency. As suggested in Part VI, it is a good idea to have a second custodial relationship in place in case there is enough time to heed warning signs of a bank’s failure. It is important to note again here that the U.C.C. may override marshaling claims, especially if the bank can lend assets or has a lien for fees as typically granted under a custody agreement. Sometimes the lien covers all custodied assets or only enough assets to secure the amount of fees it is owed from time to time. In any event, Article 8 raises questions whether the client would later recover securities that the bank transferred out of the custody account’s records pursuant to lending rights or a lien (or otherwise).¹⁰³

D. CONCLUSION

In sum, the most important protection for institutional custody clients is the FDIC acting as receiver. The OCC and the FDIC each has stated a clear intent to respect custody accounts that satisfy legal prerequisites unless the bank failed to “honor its obligations to handle these assets in an appropriate manner.”¹⁰⁴ Thus, the FDIC’s decision to release custody assets “immediately”¹⁰⁵ will be para-mount,¹⁰⁶ although it remains unclear whether it will honor U.C.C. Article 8 and not seek tracing of assets lost to the client under Article 8, even though the FDIC has the right to do so. The issue may be moot, however, insofar as the drafters of Revised Article 8 have observed that tracing of indirectly held securities is neither possible nor economically desirable following a financial intermediary’s insolvency.¹⁰⁷

Two other questions come to mind here.

• What if the bank fails to hold custody assets in “trust”? This is a real-life problem, in my experience, because as noted some custodians resist assuming fiduciary duties as custodian,¹⁰⁸ either perhaps out of fear of fiduciary liability¹⁰⁹ or the belief that fiduciary status is not required by law.¹¹⁰ The answer here is that it should be irrelevant whether the account is styled as a “trust” account so long as the bank assumes fiduciary duties and agrees to segregate assets, and takes any other additional steps as may be required by relevant state law so that the client can clearly demonstrate the existence of the custodial relationship.¹¹¹
• What if the client discovers that the assets are held outside the trust department of a national bank? The FDI Act defines “deposits” to include funds held in a fiduciary capacity, whether held in the trust department or any other department of a bank or savings association.¹¹² The FDIC’s Trust Examination Manual confirms that custodial accounts need not be maintained by a trust department.¹¹³ So here it would appear that the FDIC as receiver would apply its rules to custodied assets held outside a trust department.

Again, the OCC and the FDIC treat custodial assets as client property which is to be passed back to the client in the event of a bank’s insolvency. Where there is no clear statutory confirmation, the FDIC’s position should be given “considerable weight.”¹¹⁴

III. SOME WORDS ON CASH AND STIF AND MONEY MARKET FUNDS

Savings, checking, and CD accounts are typically treated as general assets of a bank and are not afforded the protections of the custody account.¹¹⁵ However, FDIC insurance would cover up to $250,000 of cash assets held at an FDIC-insured bank.¹¹⁶ This explains a recent report that a hedge fund deposited approximately $249,000 in cash with several hundred different banks.¹¹⁷ (Note that the FDIC is temporarily offering unlimited insurance on non-interest bearing accounts.¹¹⁸)

FDIC insurance covers all “insured deposits,” or deposits for which there is a net amount due to the depositor.¹¹⁹ Under the statute, unpaid deposits include not only cash but checking, savings, time or thrift accounts, and certificates of deposit.¹²⁰ However, the FDIC has opined that U.S. Treasury securities are not “cash” and therefore can be part of a custody account.¹²¹

Despite the general rule on cash and cash equivalents, in some states they may be considered part of the custodial account. One test can be whether the obligation bears interest.¹²² According to the 2003 Merrill Lynch case,¹²³ New York law provides that a special deposit can include money and cash equivalents, and that:

The fact that the Custodial Account was, or could have been, a time deposit or demand account, interest bearing, or a business checking account is not material and does not affect the determination that the Custodial Account was a special deposit. The form of the account (checking, interest-bearing, etc.) does not matter. The critical point is whether a bank and a depositor have agreed that an account is to be a special deposit or not. (“A certificate of deposit can be either a general or special deposit, depending on the agreement between the bank and the depositor.”)¹²⁴

Oftentimes an institutional investor’s cash resides in a short-term cash (also called “STIF”) account. Although STIF funds are not FDIC-insured, they should be protected from bank insolvency as a collective investment fund (“CIF”) under the OCC fiduciary rules established under 12 C.F.R. § 9.18.¹²⁵

However, contrary to popular wisdom, money market funds are not governmentinsured, although if held through a brokerage firm then SIPC insurance should cover balances of up to the $250,000/$500,000 limit discussed earlier. ¹²⁶In this regard, it is worth noting that some brokers offer institutional clients supple-mental insurance above SIPC limits through third parties such as Lloyds.¹²⁷ I am not aware of banks offering something similar to custody clients, but needless to say the value of any such insurance will depend not only on the coverage amounts and other terms and conditions but the continuing creditworthiness of the insurer.

IV. U.C.C. ARTICLE 8 AND “SECURITY ENTITLEMENTS”—A THREAT TO THE TRADITIONAL LAWS OF CUSTODY?

A. OVERVIEW

Article 8 of the U.C.C., as amended in the 1990s, imposes a significant limitation on custody rights. Custody clients, as “entitlement holders,” no longer own securities held at a securities depository but rather possess “security entitlements” against the bank as a “securities intermediary.”¹²⁸ Imposed between the custody account and the securities lie the concepts of “vertical priority” and “horizontal priority”¹²⁹—the claims of other investors and the claims of the bank’s creditors.

Revised Article 8 addresses “systemic risk”¹³⁰ arising from the meteoric acceleration of securities trading and clearing via electronic platforms and the shift from direct custody of securities at a custodian to indirect holding through a depository, and the modern interbank lending system in which banks lend to, and take credit from, other banks.

As noted by the drafters of Revised Article 8, the earlier Article 8 provided antiquated rules in which physical possession of securities was the norm.¹³¹ In that era, security interests in securities were perfected by possession. That template needed to be modernized to address electronic trading and the fact that while custodians continue to keep records of their clients’ securities holdings, those holdings often are held elsewhere, e.g., at a central depository such as Depository Trust Company.

Unfortunately, as Article 8 deals with the complicated issues of securities clearance and bank lending, it is also one of the most difficult areas of the U.C.C. to understand, being described by the official reporter of Revised Article 8 (certainly a sympathetic observer) as “recondite.”¹³² This is regrettable, because its impact is so important and (as best as I can tell) not understood by many institutional investors.

It is also problematic as it applies to traditional rules of bank custody. On the one hand, a goal of Article 8 is to create a system for record keeping ¹³³and, therefore, is meant to effect no substantive change of creditor rights. ¹³⁴Indeed, Revised Article 8 recognizes, as stated in the Official Comments to

Article 8, “the ordinary understanding that securities that a firm holds for its customers are not general assets of the firm subject to the claims of creditors.”¹³⁵ But Revised Article 8, on the other hand, by changing ownership interests in securities to entitlement claims against securities intermediaries, supplants the common law of bailment and is deemed the exclusive source for claims relating to securities.¹³⁶ Thus, it would appear that Article 8 overrides any conflicting law regarding claims to securities by custodial clients.

Relevant defined terms in Article 8 include “securities intermediary,” which includes banks, brokers, and, notably, clearing corporations;¹³⁷ “entitlement holder,” which is a person identified in the securities intermediary’s records as having a security entitlement against the securities intermediary;¹³⁸ and “security entitlement,” which comprises the rights and property interest of an entitlement holder with respect to a financial asset.¹³⁹ These terms are essential units of Article 8’s treatment of securities, whether certificated or uncertificated,¹⁴⁰ and whether held in the bank (called on-premises custody) or through a clearing-house or other intermediary (off-premises custody).¹⁴¹

Another term, “control,”¹⁴² is key to understanding the rights of custodial clients in the event of competing claims to a security entitlement.¹⁴³ A purchaser ¹⁴⁴has “control” of a security entitlement if (i) it has become the entitlement holder, that is, the purchaser is recorded in the records of the securities intermediary as having a security entitlement,¹⁴⁵ (ii) a securities intermediary has agreed to hold the relevant asset for the purchaser, or (iii) a third party has control of the asset on behalf of the purchaser or previously obtained control and has acknowledged that it holds the asset on behalf of the purchaser.¹⁴⁶ With “control,” the controlling party is in a position to sell or transfer the security entitlement without further action by another party.¹⁴⁷ So, hypothetically, if a custody bank takes control of a security entitlement pursuant to a lien it was granted by the client or otherwise, and then the custody bank sells or transfers the security entitlement to an innocent third party or a bank creditor, then, if the bank becomes insolvent, the question is whether the lower priority claimant—i.e., the custodial client—has means of recovering the asset to which the entitlement claim is affixed. Here, there is a conflict between Article 8, which does not permit tracing of lost securities (except for fraud),¹⁴⁸ and the FDIC’s rules, which do.¹⁴⁹ This is discussed below.

B. SECURITY ENTITLEMENTS AND WAYS TO LOSE THEM

A custodial client acquires a security entitlement, and thereby enjoys the rights of an entitlement holder, in one of three ways: the bank (securities intermediary) credits the asset as a book entry to the client’s account; the bank accepts the asset for the client’s account; or the bank is legally obligated to credit the asset to the client’s account.¹⁵⁰ As noted, the foregoing applies regardless of whether the bank physically holds the asset, so the rules also apply to securities held through a depository.¹⁵¹

So far, then, simply put, the custodial client has an entitlement claim to its securities holdings, and therefore the claim should remain with the client in the event of the bank’s insolvency, so that, for example, the securities on record in the custodian’s books will be transferred to the books of the client’s successor custodian.

There are exceptions to the general rule of security entitlements set forth above. One exception is akin to the concept of the “holder in due course” found elsewhere in the U.C.C.¹⁵² Here the entitlement holder may recover a financial asset from a purchaser who acquired it “for value” and “controls” the asset only if (i) the now-insolvent securities intermediary lacks sufficient assets to restore the security entitlements of all entitlement holders, (ii) the securities intermediary violated its duties under section 8-504 by transferring the asset, and (iii) the purchaser acted “in collusion” with the securities intermediary. ¹⁵³In other words, whether the loss occurred by mistake or otherwise, the custodial account cannot recover a security previously documented in its records at the custodian bank so long as the current holder of the security entitlement did not collude with the bank. Thus, as noted, Article 8 introduces what can be described as the concept of “horizontal priority.” Without collusion, the custody client enjoys no priority over innocent investors who have acquired the rights to the client’s securities claims. This explains in part why Article 8 rejects tracing of assets—in addition to Article 8’s premise that a security entitlement is not a claim against a specific security but against the assets of the financial intermediary, tracing not only would pit one innocent party against another but would subvert the crucial goal of assuring market participants that the securities they buy are free of prior competing claims.

A related exception, in section 8-511(b), applies to bank creditors, or the rule of “vertical priority.” If a bank creditor has a claim to a financial asset held by the bank and “controls” the asset, the creditor’s rights will prevail over a custodial client who has a claim to the same asset. So if, say, a bank transfers a financial asset from a custodian account to a bank creditor,¹⁵⁴ then the creditor’s claim is superior, notwithstanding the client’s contractual rights under a valid custody agreement, or even the client’s vigilance (recognizing that clients may not have access to real-time transactions), unless it can be proven that the bank’s creditor colluded with the bank. While the U.C.C. requires good faith in all transactions,¹⁵⁵ query whether the transfer of a financial asset to a creditor of a now insolvent bank will be unwound if the bank acted other than in good faith but did not actually collude with the creditor.¹⁵⁶ Under my reading of Article 8 and especially its no-tracing rule, the answer is that it will not. The result, then, would appear to be a case of Article 8 trumping the common law of custody and bailment (as intended by the drafters of Article 8¹⁵⁷) and, for that matter, federal banking regulation as implemented by the FDIC.

The result, in the case of a failed bank, is that the custodial client has a pro rata interest in the relevant security¹⁵⁸ under insolvency proceedings.¹⁵⁹ This pro rata right may not be to recover the account shortfall for a relevant security but, depending on relevant insolvency laws, a right to a portion of the bank’s available assets based on the value of the client’s claims measured as a percentage of all claims against the debtor bank.¹⁶⁰ The Official Comments to Article 8 suggest that this may be relevant for broker insolvencies under SIPA, and I am not aware of state or other insolvency laws that would follow the SIPA approach. If there are laws that do, then if the estate of an insolvent bank lacks sufficient security entitlements in, say, Stocks A, B, and C, to satisfy client claims, while still retaining 100 percent of the security entitlements for Stocks X, Y, and Z, all of its clients would bear a proportionate loss arising from the A, B, and C shortfall, even those clients who may have felt fortunate because their only claims were for Stocks X, Y, and Z. Contrast this with how customary FDIC rules would allow those clients to keep their 100 percent positions in Stocks X, Y, and Z. This example highlights the question of remedies for securities shortfalls under Revised Article 8.

As the Article 8 drafters noted, asset tracing is inapposite, even if it were fea-sible.¹⁶¹ To this extent, Article 8 would appear to override the FDIC’s duty to marshal assets for custody accounts. In this sense, Article 8 seems inconsistent with the recognized principle—whether called preference avoidance under bankruptcy law or the D’Oench Duhme doctrine as recently expanded under bank insolvency law¹⁶²—that assets that are improperly transferred proximate to a firm’s failure may be restored to their rightful owners. There could be a tort claim in this circumstance,¹⁶³ but a tort claim may be of little value when the bank-tortfeasor is insolvent.

C. CHOICE OF LAW

Article 8 applies the relevant laws of insolvency.¹⁶⁴ As noted, the FDIC will apply state laws of insolvency to state banks and, to the extent not inconsistent with federal law, to national banks. But even state law may be uncertain as to how custodial accounts are to be treated in insolvency. For example, one prominent law firm has stated that the banking statutes of Massachusetts do not address how custody accounts are treated in insolvency, and believes that the common law of bailment would be applied.¹⁶⁵

D. CONCLUSION

Now that I have painted this gloomy picture, I should point out that many banking law experts say that there is no reason for custody clients to be concerned about Article 8. They point out that segregation of client assets is an essential duty of banks that is faithfully discharged, and there is no basis to question whether any bank in the institutional custody business does not fulfill its duties in this regard. But in a post-2008, post-MF Global environment, I worry nonetheless whether in the future a bank could make a mistake, or worse, when there is no time to remedy the problem before insolvency, and leave the custodial client with Article 8 remedies to the extent they displace FDIC regulations. It has been noted that Revised Article 8 “does not, nor could it, eliminate theft risk, that is, the risk that an intermediary will dispose of securities that should have been for customers and abscond with or dissipate the proceeds.”¹⁶⁶ Indeed, insofar as the risk of theft of financial assets is inevitable,¹⁶⁷ the FDIC has advised that it “cannot guarantee that every depository institution—after receiving or purchasing assets in a fiduciary capacity— will honor its obligations to handle these assets in an appropriate manner.” ¹⁶⁸So while I hope this discussion remains purely theoretical, it is important for custody clients and their legal advisors to make their own analyses, draw their own conclusions, and consider how best to protect their holdings.¹⁶⁹

As noted, despite the analogy discussed above, Article 8 is not strictly a record-keeping statute. It supersedes the common law of custody, and specifically it places a custodial client as a general creditor of an insolvent bank with respect to financial assets that were removed from its account either by bank error or malfeasance. To this extent, the bank is not a “mere recordkeeper” but rather an interested party.

It would seem, then, that institutional investors must remain vigilant as circumstance permits in overseeing all intermediaries, including bank custodians, and have alternative arrangements in place if the bank or other intermediary seems to be near failure.

V. A NOTE ON FOREIGN SUBCUSTODY

Foreign custody is outside the scope of this article.¹⁷⁰ Needless to say, however, as institutional investment becomes increasingly multinational, with emerging and frontier markets posing particularly challenging custody issues, foreign custody may be a concern of many U.S. institutional investors. While in the past a U.S. custodian would typically agree to stand behind all activities of foreign subcustodians, including the duty to segregate assets and to indemnify the client for all losses, today’s custody agreements often offer less protection. In my experience, custodians now may offer to apply due care in the selection and monitoring of foreign subcustodians and a limited guaranty for subcustodian negligence or willful misconduct (but not for losses from insolvency).

Contrast this, however, with the foreign custody protections afforded to investment companies under the Investment Company Act of 1940 (the “Company Act”).¹⁷¹ In my experience custodians do not offer these rights to non-investment companies. This is important because the Company Act requires, among other things, standards of quality for subcustody banks, as well as requirements that:

• The foreign subcustodian assume a standard of “reasonable care, prudence and diligence such as [the U.S. custody bank] would exercise, or to adhere to a higher standard of care, in performing the delegated responsibilities”;¹⁷² and
• The subcustody contract provide, among other things, that (1) records identify the assets as belonging to the client or a third party for the benefit of the client, (2) there is adequate indemnification against risk of loss of subcustodied assets, (3) no liens may be created against the subcustodied assets, and (4) the subcustodian report developments relating to the safe-guarding of the assets and any transfers thereof.¹⁷³

State rules also may hold the custodian to a higher standard than that it might otherwise be willing to agree to under a custody agreement.¹⁷⁴

VI. RECOMMENDATIONS FOR INSTITUTIONAL INVESTORS

As discussed, institutional investors too often incorrectly assume that custody is a guarantee of safety.

The risks discussed in this article can be ameliorated (but not necessarily eliminated) by pre-retention due diligence, contractual terms, post-retention due diligence, and extra-contractual protections.

A discussion of each of these topics follows.

PRE-RETENTION DUE DILIGENCE

Before retention, consider the following diligence items. Outside counsel can assist with analyzing the governing law to confirm that it protects custodial assets as anticipated.

Initial legal due diligence issues include

• Which specific entity in the banking institution’s cadre of affiliates will be the custodian?
  • Confirm the custodian is an insured depository institution under the FDI Act.
  • Confirm the contract correctly identifies the custodian entity.
• Is the custodian properly authorized to hold custody assets? This would mean the bank has a trust department, if state law requires it. In the case of fiduciary accounts at national banks, has the custodian been approved to provide trust services?
• Ask for the form of legal opinion that the custodian’s outside law firm will furnish as part of the contractual documentation. Is it a “clean” opinion with only appropriate exceptions and limitations?
  • For example, if the opinion assumes a valid claim so long as the custody agreement grants the bank no right to any lien on custodial assets, make sure the agreement prohibits such liens.

On the business side, due diligence issues include

• Does the custodian have an adequate credit rating? If not, will a deep pocket affiliate guaranty its indemnity and other obligations to the client?
• What are the spreads on the bank’s credit default swaps (“CDS”)? Some analysts use CDS spreads as another piece of data to evaluate a firm’s creditworthiness.
• Does the custodian meet the requirements of being “well capitalized” ¹⁷⁵ and “well managed”¹⁷⁶ under banking regulations?
• What are the custodian’s practices regarding segregation and identification of client assets? What safeguards are in place to prevent improper transfer of client assets recorded on the depository’s books to the bank’s proprietary accounts? Ask to see the custodian’s internal controls materials.
• Where does the custodian sit in terms of interbank lending? clearing?
• How does the custodian assure that all accounts are fully credited on securities transactions? Are there many mistakes and how quickly are they corrected?
• Does the custodian intend to borrow against custody assets and will it seek a lien on assets, such as a lien to ensure payment of custody fees?
• Are any issues raised by the custodian’s SAS 70?
• How does the custodian pick and monitor foreign subcustodians? To what extent does it track the solvency of foreign subcustodians, and does it have in place appropriate alternatives if it needs to transfer those assets quickly?
• Are there directly held securities that the client could maintain in custody without affecting trading?

Be sure to address the resolution of all business issues in the custody agreement.

As part of the first stage of diligence, speak to the bank’s other institutional clients. If none are known, get names from the bank. Ask these clients about the topics noted above and specifically ongoing monitoring issues such as the custodian’s compliance with segregation and proper account identification; client access to bank records to confirm daily reconciliations; and the quality of and access to reports from foreign subcustody banks. More generally, it is worth inquiring about the custodian’s attentiveness to clients; the amount of red tape it requires; and to what extent the client service team can make red tape disappear.

Also, on the assumption that strong compliance generally cannot thrive without a top-down commitment, speak to senior management and the executives who are responsible for key elements of the custodial business.

CONTRACTUAL TERMS

As noted, apply the knowledge learned in due diligence to the custody agreement. For example, if the custodian’s foreign subcustody practices are good, seek to incorporate them as covenants. Combine items learned in diligence with advice of outside counsel expert in the relevant custody laws. While using counsel’s template is advantageous, the bank might want to use its own form.¹⁷⁷ This can add to the volume of comments from client counsel (as well as raise counsel fees). As already discussed, negotiating appropriate terms from a custodian in 2012 is not for the faint-hearted. It may require hard work.

Among the terms to be addressed in a custody agreement would be the following:

• The custody agreement is with the proper bank entity.
• Due authority—specifically, the bank is duly authorized to furnish custody of assets.
  • As noted, the bank may be required to have a trust department and to manage the custody account at the trust department.
• The agreement clearly establishes the requisite legal relationship between the custodian bank and the investor. Ordinarily this would include an explicit fiduciary or trust relationship.
  • For client-directed accounts, there can be appropriate carve-outs to assure the bank is not somehow assuming investment discretion or other regulatory duties that are irrelevant to the client.
• The bank will segregate the investor’s assets and keep records in the client’s name.
• If the bank is not permitted to borrow any custody assets (in other words, no securities lending), say so explicitly to avoid any misunderstanding later.
• The bank will place no liens against the custodial assets, even to the limited extent to secure the bank’s fees.
  • The bank’s template agreement often will include an unlimited lien on assets, but on request the bank should agree to limit the lien only to cover the amount of custody fees outstanding at any given time. In light of U.C.C. Article 8 risk, in lieu of any lien, a better course might be for the investor to furnish a separate guarantee letter with re-course (if any) only to non-custodied assets.
• Although many custody agreements require thirty to ninety days’ notice prior to termination, the agreement could allow the client to move its assets to another custodian at any time for any reason. It is hard to imagine the custodian objecting to this so long as the contract adequately addresses the payment of its fees on termination.
• Consider seeking the full measure of foreign subcustody rights as those afforded to investment companies under the Company Act. In any event, it would seem appropriate for the custodian to undertake:
  • To require each subcustodian to assume the same standard of care as what the custodian owes the client;
  • To confirm that each subcustodian satisfies the requirements of being an “eligible foreign subcustodian” under the Act;
  • To monitor regularly each subcustodian, and promptly notify the client of any material change in these risks; and ultimately
  • If the custodian reasonably believes that a subcustodian is at risk or otherwise no longer satisfies the requirements of being an “eligible foreign subcustodian,” to withdraw client assets from the subcustodian as soon as reasonably practicable and deposit them with a successor subcustodian under equal if not better terms.
• Cash management should be addressed. If cash is invested in a STIF or money market fund, confirm whether the cash can be withdrawn daily or on short notice.
• Ask for annual or quarterly certification that the account is being held and documented in accordance with the agreement. Seek audit rights regarding segregation, account names, and the timeliness and effectiveness of securities accounting. If the bank will not agree, ask for regular up-dates of the SAS 70 and/or the appointment of an independent firm to conduct a regular audit for the benefit of all custodial clients. (The bank may come to appreciate the insights this firm could offer, especially if by allowing the firm to visit, the bank can eliminate the distraction of responding to many more auditors representing a variety of clients.) As-suming the bank is subject to Dodd-Frank’s “living will” requirements, ¹⁷⁸ask for copies of the bank’s resolution plan or at least the sections dealing with material developments.
• Ask the bank for a written opinion of its outside counsel that, subject to acceptable exceptions and qualifications, the custodied assets will pass to the client or its successor bank outside the custodian bank’s insolvency.

POST-RETENTION DUE DILIGENCE

Post-retention due diligence is of at least equal importance as pre-contract diligence since rights of custody are not self-effective. As noted, the bank’s actions or inactions, and those of its foreign subcustodians, can undo custodial rights.

Post-retention due diligence issues may include

• Continual monitoring of financial statements, credit ratings, CDS spreads, and capitalization tests, including the living will resolution plan, if relevant, not just of the custodian but of all of its affiliates.
  • The issue here is the contagion effect. In the Lehman Brothers case, only several Lehman companies actually filed for bankruptcy.
  • This includes information about the resolution plan under Dodd-Frank, if relevant.
• Regularly review accounts to confirm segregation and account names, and prompt and correct settlement of open securities positions.
• Monitor and enforce rights obtained under the custody agreement, such as periodic bank certifications. Exercise audit rights.
• Review SAS 70s and all other audit-related information to which one is entitled.
• Regularly meet with the bankers responsible for safekeeping and accounting of custodial assets.

As noted above, clients may consider hiring an outside auditor or consultant to help monitor the bank’s processes.

EXTRA-CONTRACTUAL PROTECTIONS

If it is valid that the client should treat its custodian like any of its other unsecured counterparties, then the client may wish to consider several additional avenues of protection.

• Set up at least one additional custodial relationship. By having multiple custodians, the client has the flexibility to move assets, promptly if necessary, without having to negotiate a new custody agreement at the last minute. As with the initial custodian, conduct diligence. If it is best practice for hedge funds to have multiple prime brokers to avoid insolvency risk, then the same principle should apply to custody.
• There appears to be a trend of some U.S. institutions to establish at least a second custody relationship offshore, e.g., Canada (a country that has experienced no recent banking crisis similar to that in the United States). It could well be that offshore custody may offer clearer laws and a strong commitment to their custodial clients. But this may be of limited utility to the extent foreign banks must use U.S. banks as their subcustodians of U.S. securities.
• Consider hedging exposure against the bank’s failure via shorts or options. Some newer financial products are specifically targeted to protect against credit exposure.¹⁷⁹ Perhaps buying CDS protection may also be worth exploring, although the costs can be high and legal impediments may exist in various jurisdictions. In this regard, many experts believe that “naked CDS,” that is, the buying of short (protection) CDS without an underlying ownership of the reference bank’s bonds or other debt— will be prohibited or significantly restrained.
• I do not know if custodial insurance exists now, but if not there could be a market for it.
• Perhaps while impractical in most situations, there may be particular securities that an investor can hold through a physical certificate without making trading cumbersome. This may be relevant, for example, if an investor has a significant equity position in a particular company that it intends to hold long-term.¹⁸⁰

As a final thought on this topic, it is sad to say that in the post-2008 world of MF Global, LIBOR price rigging, and other events yet to come, even all of these precautions, diligently pursued, may not be enough to prevent loss arising from intermediary misfeasance or malfeasance, especially acts occurring at the last minute before insolvency.

VII. CONCLUSION

The law of custody is diffuse and inexact. Consider the following points noted in this article:

• There is no standard term used to describe custody accounts, and indeed “custody” is generally not a legal term of art.
• The common law of custody is imprecise, and traditionally courts analyzing the existence of “special accounts” have not consistently answered the question whether the underlying principle of law supporting custody accounts is trust, agency, or bailment.
• The FDIC acts as receiver for almost all bank insolvencies in the United States, and while it is charged with following state law for state bank insolvencies, the state laws of custody can be uncertain, and it does not appear that Congress has adopted a federal law of custody in respect to national bank insolvencies, leading the FDIC and courts to point to state law.
• Courts require proper evidence of a custody relationship as determined under relevant law. This may require not only the presence of something called a “custody agreement” but also fiduciary or trust undertakings by the custodian and an affirmative covenant to segregate client assets.
• Revised Article 8 of the U.C.C. overrides traditional custody law by turning an absolute right to assets into a claim, and for electronically traded securities held at a central depository, the claim may fail to the extent the client’s securities (or, more accurately, the client’s security entitlements) were transferred to an innocent third party, whether by mistake or mis-appropriation. While the FDIC will seek to marshal custodial assets the tracing of indirectly held securities is no longer apposite under Article 8. Thus, unlike an action in bankruptcy to recover an asset by avoiding a preference transaction, or the tracing of a security certificate that a custodian lost or wrongly converted, the risk of loss arising from the improper transfer of electronically traded securities under Article 8 is irreversible, assuming the estate of the insolvent bank has no assets to cover them. If this is indeed the result, the law seems to offer the custody client no analogous right to undo what a bankruptcy trustee is empowered to correct or, for that matter, the FDIC may cure in other situations. I find it hard to square this outcome with statements in the Official Comments that Article 8 makes no substantive changes in the law and may be likened generally to a real estate recording act. While a local government real estate office should have no vested interest in making sure that deeds, mortgages, and other liens are properly recorded, securities intermediaries such as custody banks may have a lien or other right to client assets (such as securities lending), and unlike a government office a bank can go out of business suddenly without the opportunity to correct mistakes.

For the reasons noted above, an institutional investor should not assume that simply having a custody agreement is enough to protect it in case the bank should fail. The investor must continue to monitor the custodian’s financial health and client protection protocols, and have a back-up plan in case worse comes to worse.

Despite these conclusions, I share the confidence of many banking law experts in the dedication and effectiveness of the FDIC in seeking to exclude custodial assets from a bank’s insolvency and to make the client whole to the extent legally permitted. Also, as discussed, these experts do not believe that Article 8 presents any real risk to custodial clients because the separation of client assets from proprietary assets is one of the most important and elemental functions of any major bank. This is comforting, but after the last four years it is safer (even if, one hopes, ultimately unnecessary) to be skeptical. In this context, as the saying goes, it is better to “trust but verify.”

As banking and finance become more mechanized and the securities trading system more complex, and after the Madoff, AIG, MF Global, and the LIBOR scandals, no institutional investor can safely rely on the proper conduct or undying good faith of any financial intermediary, including its custodian, especially when the firm is in extremis, and the investor’s board, clients, and fiduciaries will likely accept few excuses for any loss, no matter how unavoidable. The institutional investor must treat bank custody as another form of counterparty risk, and an unsecured one at that. It is incumbent upon the institution to do the best it can to protect its assets—wherever held—for their intended purpose.

_____________

* General Counsel, University of Virginia Investment Management Company. The thoughts and opinions expressed here are entirely my own and do not necessarily reflect those of the University of Virginia Investment Management Company or the Rector and Visitors of the University of Virginia. This article does not convey legal advice and no one may rely on it as such.

I could not have written this article without the help of Marty Lybecker of Perkins Coie; Jim Frazer, Linda Hayman, Bill Sweet, and their colleagues at Skadden Arps; and Craig Unterberg of Haynes and Boone. I thank the editors of The Business Lawyer as well as William Kroener and Howard Darmstadter for their comments. In addition, I am grateful for the advice and encouragement of Larry Kochard, the CEO/CIO of UVIMCO. Finally, I thank my family, Susan, Jessica, and Rachel, for their constant support and patience during my work on this article.

1. Frances Denmark, Hedge Fund Investors Want Safe Havens for Managers’ Cash, INSTITUTIONAL INVESTOR ( June 18, 2012), http://www.institutionalinvestor.com/Article.aspx?ArticleID=3042680tLS=EMS669907 [hereinafter Hedge Fund Investors Want Safe Havens for Managers’ Cash]; see also infra notes 8–9 and accompanying text.

2. In September 2011, Institutional Investor reported that over $94 trillion of assets were held in custody by the top fifteen worldwide custodians, of which approximately $67.8 trillion were custodied with five U.S.-based banks (in order of size): BNY Mellon, J.P. Morgan Chase, State Street, Northern Trust, and Brown Brothers. Julie Segal, Custodial Clients Push Regulation, INSTITUTIONAL INVESTOR, Sept. 2011, at 136, available at http://www.institutionalinvestor.com/Article/2660428/Asset-Management-Archive/Custodial-Clients-Push-Regulation.html; see also Office of the Comptroller of the Currency, Interpretive Letter No. 1078, 2007 WL 1726580 (Apr. 19, 2007) [hereinafter OCC TLDA Letter], available at http://www.occ.gov/static/interpretations-and-precedents/may07/int1078.pdf.

3. See Office of the Comptroller of the Currency, Answers and Solutions for Customers of Custodian Banks—Answers About Bank Custodians, HELPWITHMYBANK.GOV ( Jan. 2010), http://www.helpwithmybank.gov/get-answers/asset-management/bank-custodians/faq-assetmgmt-bank-custodian-03.html; see also OFFICE OF THE COMPTROLLER OF THE CURRENCY, COMPTROLLER’S HANDBOOK—CUSTODY SERVICES 1 ( Jan. 2002) [hereinafter CUSTODY SERVICES HANDBOOK], available at http://www.occ.treas.gov/publications/publications-by-type/comptrollers-handbook/custodyservice.pdf.

4. See, e.g., Hedge Fund Investors Want Safe Havens for Managers’ Cash, supra note 1.

5. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) [hereinafter Dodd-Frank Act].

6. See, e.g., INT’L SWAPS & DERIVATIVES ASS’N, INC., MANAGED FUNDS ASS’N & SEC. INDUS. & FIN. MKTS. ASS’N, INDEPENDENT AMOUNTS 16 (Mar. 1, 2010) [hereinafter INDEPENDENT AMOUNTS], available at http://www.isda.org/c_and_a/pdf/Independent-Amount-WhitePaper-Final.pdf; cf. Liquidity Directions— Margin DIRECT and Dodd-Frank: Mitigating Counterparty Risk Amid New Regulations, BNY MELLON (3Q 2011), https://liquiditydirect.bnymellon.com/public_content/data/Liquidity_News_Letter/LiquidityDirectionsQ32011.pdf?SMSESSION=NO.

7. Dodd-Frank Act §§ 411, 929Q(b), 15 U.S.C. §§ 80b-18b, 80b-4(d) (2006 & Supp. IV 2010).

8. Office of the Comptroller of the Currency, Answers and Solutions for Customers of Custodian Banks— Answers About Bank Custodians, HELPWITHMYBANK.GOV ( Jan. 2010), http://www.helpwithmybank.gov/get-answers/asset-management/bank-custodians/faq-assetmgmt-bank-custodian-03.html; see also Scott Mar-tin, When a Bank Fails, Are Trust Assets at Risk?, TRUST ADVISOR BLOG (Mar. 12, 2010), http://thetrustadvisor.com/news/when-a-bank-fails-are-trust-assets-at-risk (“The fiduciary assets simply roll over” to the client’s successor bank and “[n]obody’s even going to get a haircut.”).

9. Are My Trust, Fiduciary and Custody Accounts Safe?, AM. BANKERS ASS’N ( June 30, 2009), http://www.aba.com/Press/Pages/ConsumerBanking_120508AssetSafetly.aspx.

10. I have often observed misuse of the term “custody,” particularly by brokers, in describing asset services. For example, a broker recently assured me that a securities brokerage account is a bank “custody account.”

11. Merrill Lynch Mortg. Capital, Inc. v. FDIC, 293 F. Supp. 2d 98, 107 (D.D.C. 2003) (applying New York law).

12. 12 C.F.R. § 9.2(d), (e) (2012); see infra Part II.C.

13. This memorandum is on file with the author.

14. The treatment of cash in a bank’s insolvency is discussed in Part III.

15. James Steven Rogers, Policy Perspectives on Revised U.C.C. Article 8, 43 UCLA L. REV. 1431, 1530 (1996).

16. As widely reported, the management of the brokerage firm MF Global allegedly diverted customer assets to satisfy company obligations. See, e.g., James B. Stewart, Trustee Sees Customers Trampled at MF Global, N.Y. TIMES ( June 8, 2012), http://www.nytimes.com/2012/06/09/business/trustee-suggests-mf-global-misused-customers-money.html?pagewanted=all; James B. Stewart, A Loop-hole Big Enough to Lose a Billion, N.Y. TIMES ( June 22, 2012), http://www.nytimes.com/2012/06/23/business/mf-globals-billion-dollar-loophole-common-sense.html?_r=1.

It appears that the custody services handbook for bank examiners published by the Office of the Comptroller of the Currency fails to address bank negligence or bank misconduct. See CUSTODY SERVICES HANDBOOK, supra note 3; infra Part II.

17. See supra notes 8−9 and accompanying text.

18. See supra notes 8−9 and accompanying text.

19. With respect to terminology used in this article, the term “bank” includes national and state banks as well as trust companies. Trust companies are banks that limit their activities to trust services. See 2 ROBERT M. TAYLOR, III, BANKING LAW § 34.02, at 34-5 (2008) [hereinafter TAYLOR ON BANKS]. And, despite the various synonyms preferred by legislatures and courts to describe bank custody, I employ the term “custody” as it is used in the vernacular of business persons and banks. Last, unless I refer specifically to custodial accounts in which the custodian acts as investment manager or advisor, all discussions of custody accounts focus on “client-directed custody” in which the bank exercises no investment discretion and simply follows the directions of the client or its advisors.

20. For information on prime brokerage insolvency issues, see, for example, Exceptional Insolven-cies: Provisions of the Bankruptcy Code and SIPA Regarding Broker-Dealers and Other Financial Market Participants and Contracts, WILMERHALE (Sept. 17, 2008), http://www.wilmerhale.com/exceptional_insolvencies_provisions_of_the_bankruptcy_code_and_sipa_regarding_broker-dealers_and_other_financial_market_participants_and_contracts_09-17-20081/; The Risks Associated with Financial Counterparties, SCHULTE ROTH & ZABEL LLP (Mar. 19, 2008), http://www.srz.com/Financial_Counterparties/; What Would Happen to Your Account Holdings if Your Prime Broker Failed?, AKIN GUMP STRAUSS HAUER & FELD LLP (Aug. 23, 2007), http://www.akingump.com/files/Publication/df60b21b-2a41-4cb6-a4a5-c54aae759a7c/Presentation/PublicationAttachment/6a3f3df5-9786-4588-8f5f-c70674b7114b/1019.pdf [hereinafter AKIN GUMP]; E. Klees, After the Economic Meltdown: Legal Issues for Endowments 1−3 ( June 28, 2010) (unpublished material) (on file with the National Association of College and University Attorneys).

21. SEC Rule 15c3-3 under the Securities Exchange Act of 1934, as amended, sets forth custody rules for securities accounts held at broker-dealers. 17 C.F.R. § 240.15c3-3 (2012).

22. These programs, called Trust Ledger Deposit Accounts, are discussed in, for example, the OCC TLDA Letter, supra note 2.

23. 12 U.S.C. § 1821(e)(8) (2006).

24. The FDIC has a set of “fiduciary account” custody rules that apply only if the bank has investment discretion. 12 C.F.R. §§ 9.1−9.20, 9.100−9.101 (2012). See Office of the Comptroller of the Currency, Fiduciary Activities of National Banks; Rules of Practice and Procedure, 61 Fed. Reg. 68543, 68546 (Dec. 30, 1996) (to be codified at 12 C.F.R. pts. 9, 19). The Custody Services Handbook summarizes rules relating to securities lending. CUSTODY SERVICES HANDBOOK, supra note 3, at 26– 36. Written before the 2008 crisis, the Handbook heralds securities lending as “one of the most important value-added products custodians offer to their customers.” Id. at 26. Some clients would disagree with that assessment today.

25. The collapse of Lehman Brothers in 2008 was widely reported. See, e.g., ANDREW ROSS SORKIN, TOO BIG TO FAIL: THE INSIDE STORY OF HOW WALL STREET AND WASHINGTON FOUGHT TO SAVE THE FINANCIAL SYSTEM—AND THEMSELVES (2009). Lehman’s role in the rehypothecation crisis is addressed in, for example, Rehypothecation by Lehman Leads to Fund Litigation, ORRICK CLIENT ALERT (Oct. 3, 2008), http://www.orrick.com/fileupload/1494.pdf.

26. There is no statutory limit on rehypothecation in the United Kingdom. Christopher Elias, MF Global and the Great Wall St. Re-hypothecation Scandal, THOMSON REUTERS (Dec. 7, 2011), http://newsandinsight.thomsonreuters.com/Securities/Insight/2011/12_-_December/MF_Global_and_the_great_Wall_St_re-hypothecation_scandal/.

27. Rehypothecation is the pledging of customer securities or other assets as collateral for the broker’s obligations. See discussion of rehypothecation in materials at supra notes 25–26.

28. 15 U.S.C. §§ 78aaa–78lll (2006 & Supp. IV 2010).

29. The $500,000 coverage includes up to $250,000 of cash. How SIPC Protects You, SEC. INVESTOR PROTECTION CORP., at 4 (2011), http://www.sipc.org/Portals/0/PDF/HSPY_English_2011.pdf.

30. See, e.g., AKIN GUMP, supra note 20, at 2–3.

31. 12 U.S.C. §§ 1811−1835a (2006 & Supp. IV 2010).

32. Banks insured under the FDI Act may not file for bankruptcy. Bankruptcy Code § 109(b)(2), 11 U.S.C. § 109(b)(2) (2006). Instead, the FDIC will act as receiver of insolvent national banks and state banking authorities may appoint the FDIC to act as receiver of insolvent state-chartered banks, FDI Act § 11(c)(4), 12 U.S.C. § 1821(c)(4), and typically do so. Banks may be appointed as conservators rather than receivers, but this rarely occurs. FDI Act § 11(c)(2)(A)(i), (ii), 12 U.S.C. § 1821(c)(2)(A)(i), (ii); see Rich Hynes & Steven D. Walt, Why Banks Are Not Allowed in Bankruptcy, 67 WASH. & LEE L. REV. 985, 987 n.3 (2010).

33. 12 U.S.C. § 1821(c)(3) (2006).

34. Under relevant rules, the FDIC will close custody accounts and transfer the underlying assets pursuant to an order of the OCC and of the court with jurisdiction of the matter. See, e.g., 12 C.F.R. § 9.16 (2012) (for “fiduciary accounts,” i.e., accounts for which the bank has investment discretion); see also supra note 24.

35. FDIC Advisory Op. No. 03-01 ( Jan. 3, 2003) [hereinafter Advisory Op. No. 03-01], available at http://www.fdic.gov/regulations/laws/rules/4000-10190.html. But cf. FDIC Interpretive Letter No. 93-61, 1993 FDIC Interp. Ltr. LEXIS 91, at *4 (Aug. 25, 1993) (“Securities held in custody may take longer to return to or transfer for a customer, because the obligation is not the FDIC’s own and is part of an often complex estate requiring inventory and evaluation.”). Holders of “fiduciary accounts” (see supra note 24) will also have a lien on the securities in the account in addition to their claim against the bank’s estate. 12 U.S.C. § 92a(e) (2006). It is unclear how this is juxtaposed with U.C.C. Article 8. See infra Part IV.

36. 12 U.S.C. § 1821( j) (2006); id. § 1821(d)(5); see Bank of Am. v. Colonial Bank, 604 F.3d 1239 (11th Cir. 2010). In In re Corestates Trust Fee Litigation, 39 F.3d 61, 66–67 (3d Cir. 1994), the court held that there is no private right of action to contest the FDIC’s exercise of its trust powers under section 92 of the FDI Act, but noted discordance among the federal circuits on this issue.

37. 12 U.S.C. § 1821(d)(5)(E), 1821(d)(6) (2006). Cf. U.C.C. § 8-503(d) (2011).

38. See infra note 69.

39. See supra note 10.

40. See infra Part II.

41. In addition, at least some of the banks that have survived can appear, in my opinion, less customer-friendly than those they acquired.

42. See, e.g., Joel Rosenblatt, BNY Mellon Faces 8 Lawsuits Over Currency Trading in New York, BLOOMBERG NEWS (Apr. 17, 2012), http://www.bloomberg.com/news/2012-04-18/bny-mellon-faces8-lawsuits-over-currency-trading-in-new-york.html; Christopher Condon, SEC Investigates State Street Over Foreign-Exchange Pricing After Lawsuits, BLOOMBERG NEWS (May 12, 2011), http://www.bloomberg.com/news/2011-05-12/sec-probes-state-street-foreign-exchange-pricing.html.

43. On this topic generally, see Steve Rosenbush, Custodian Banks Facing Yet More Consolidation, INSTITUTIONAL INVESTOR (Aug. 11, 2011), http://www.institutionalinvestor.com/article.aspx?articleID=2881998.

44. See 12 C.F.R. § 9.2(d), (e) (2012); see also discussion of “fiduciary accounts” at infra Part II.D.

45. See McLemore v. Regions Bank, 682 F.3d 414, 423 (6th Cir. 2012) (custody of assets does not by itself make a bank a fiduciary under ERISA); cf. Paloian v. FDIC, 2011 U.S. Dist. LEXIS 127376, at *11−13 (N.D. Ill. Nov. 2, 2011) (applying Illinois law and finding custodian has no duty to inves-tigate misuse of custody account by corporate officers). I am familiar with a recent custody agreement that obligates the bank to act as fiduciary with respect to the custodial duties it assumes under the agreement, but states that the bank’s fiduciary duty excludes any duty to exercise investment control, to make investment recommendations, or to oversee the conduct of the client’s authorized traders with respect to the assets held in custody.

46. Contractual risk does not appear to be addressed in the OCC’s Custody Services Handbook. See CUSTODY SERVICES HANDBOOK, supra note 3. The movement away from fiduciary responsibilities does not seem widely known. Recently I sought input on custody issues from the New York State Department of Financial Services, http://www.dfs.ny.gov (successor to the State Banking Department). The lawyer to whom I was directed expressed surprise and concern when I told her that to my knowledge it is not uncommon for banks to disclaim a fiduciary duty as custodian.

47. Am. Bar Ass’n, Annual Meeting—Bus. Law Section, Institutional Investors Comm. (Aug. 8, 2011).

48. See infra notes 52–55 and accompanying text.

49. AMY MORRIS HESS, GEORGE GLEASON BOGERT & GEORGE TAYLOR BOGERT, THE LAW OF TRUSTS AND TRUSTEES §§ 11, 15 (3d ed. 2007 & Supp. 2010); RESTATEMENT OF TRUSTS §§ 5, 8 (1935).

50. See supra note 49.

51. See supra note 49.

52. 5B MICHIE ON BANKS AND BANKING § 328, at 430–32, 436–37, 467–69 (1991 & Supp. 1996) (citations omitted) [hereinafter MICHIE].

53. FDIC Advisory Op. No. 88-14 (Feb. 4, 1988) [hereinafter FDIC Advisory Op. No. 88-14], available at http://www.fdic.gov/regulations/laws/rules/4000-3030.html (the custodial relationship is “in the nature of a bailment”); FDIC Advisory Op. No. 87-7 (Aug. 17, 1987) [hereinafter FDIC Advisory Op. No. 87-7], available at http://www.fdic.gov/regulations/laws/rules/4000-2390.html (assets held in custody are there for “safekeeping,” i.e., a bailment).

54. CUSTODY SERVICES HANDBOOK, supra note 3, at 3.

55. FDIC Advisory Op. No. 03-01, supra note 35; see also infra Part II.C. The question presented here related to a trust established under state law.

56. UNIF. TRANSFERS TO MINORS ACT § 1(7) (1986). See discussion of fiduciary accounts at infra Part II.C.

57. See, e.g., Merrill Lynch Mortg. Capital, Inc. v. FDIC, 293 F. Supp. 2d 98, 106−07 (D.D.C. 2003).

58. E.g., N.Y. BANKING LAW § 96.3(a) (McKinney 2008 & Supp. 2012) (every bank is authorized “[t]o receive upon deposit for safe-keeping for hire upon terms and conditions to be prescribed by the bank or trust company, money, securities, papers of any kind and any other personal property”).

59. E.g., 760 ILL. COMP. STAT. ANN. § 75/2(b) (West 2007); 7 PA. CONS. STAT. § 408 (West 1995).

60. See, e.g., “special account” cases discussed at infra Part II.B.

61. This arrangement is described by the language of the New York Banking Law cited at supra note 58.

62. E.g., Henry Ridgely Horsey, The Duty of Care Component of the Delaware Business Judgment Rule, 19 DEL. J. CORP. L. 971, 974 (1994) (citation omitted) (traditionally, bank directors were required to exercise “the same degree of care and prudence that men prompted by self-interest generally exercise in their own affairs”).

63. According to reports, in 2011 the University of Texas Investment Management Company (“UTIMCO”) acquired $1 billion of gold bullion that was delivered to its custody bank. See, e.g., Robert Lenzner, University of Texas Endowment Holds $1 Billion Gold, 5% of Its Portfolio, FORBES (Apr. 17, 2011), http://www.forbes.com/sites/robertlenzner/2011/04/17/university-of-texas-endowment-holds-1-billion-gold-5-of-its-portfolio/; “Don’t Sell Gold Bars” Says Texas Fund Director, GOLD NEWS (Feb. 3, 2012), http://goldnews.bullionvault.com/gold_bars_020320121 (citing UTIMCO’s chief execu-tive officer); see also U.C.C. §§ 8-102(a)(9), 8-501(a) (2011) (custodial client’s rights under Article 8 of the U.C.C. apply equally to securities and other “financial assets” that the bank agrees to accept as such).

64. As noted in the Custody Services Handbook, banks can offer “document custody services” to support mortgage-backed and asset-backed securities and presumably other commercial products for which rights and obligations are evidenced by an original signed contract or other writing. CUSTODY SERVICES HANDBOOK, supra note 3, at 38–39.

65. See id. at 15–17.

66. See infra note 68.

67. See, e.g., 760 ILL. COMP. STAT. ANN. 75/3 (West 2007) (“fiduciary accounts” are to be segregated); MASS. GEN. LAWS ANN. ch. 167G, § 4 (West 2003) (a special deposit held by the trust department of a Massachusetts bank “shall not be mingled with” other assets); N.Y. BANKING LAW § 96.3(a) (McKinney 2008 & Supp. 2012) (banks have power “[t]o receive upon deposit for safe-keeping for hire . . . money, securities, papers of any kind and other personal property”). New York regulations also address common trust funds. N.Y. COMP. CODES R. & REGS. tit. 3, § 22.9 (2012). National bank law is discussed at infra Part II.C.

68. Cf. 3 MICHIE, supra note 52, § 184, at 484 (citations omitted) (a special deposit or deposit that is to be segregated from bank property will be entitled to priority of payment on a distribution of assets of an insolvent bank).

69. 12 U.S.C. § 91 (2006); 2 TAYLOR ON BANKS, supra note 19, § 36.05, at 36-17 to -18; cf. 3 MICHIE, supra note 52, § 189, at 508 (citations omitted); Hibernia Nat’l Bank v. FDIC, 733 F.2d 1403, 1407 (10th Cir. 1984) (addressing set-off rights); see also 12 U.S.C. § 1821(d)(17), (e)(1) (2006 & Supp. IV 2010).

70. See SEC v. Credit Bancorp, Ltd., 2000 U.S. Dist. LEXIS 17171, at *75–77 (S.D.N.Y. Nov. 29, 2000), aff ’d sub nom. United States v. Rittweger, 524 F.3d 171 (2d Cir. 2008), cert. denied, 555 U.S. 1202 (2009) (Revised Article 8 supplants the common law of bailment; “the property rights of securities [sic] entitlements [sic] holders over assets held by securities intermediaries are defined by Article 8 rather than by common law”). See also infra Part IV.

71. See Merrill Lynch Mortg. Capital, Inc. v. FDIC, 293 F. Supp. 2d 98, 104 (D.D.C. 2003). See further discussion of “claims” in national bank insolvencies at infra Part II.C.

72. Seattle-First Nat’l Bank v. FDIC, 619 F. Supp. 1351, 1360 (W.D. Okla. 1985); see also, e.g., 12 C.F.R. § 360.8(c) (2012).

73. 3 MICHIE, supra note 52, § 184, at 484.

74. Peoples Westchester Sav. Bank v. FDIC, 961 F.2d 327, 330 (2d Cir. 1992).

75. Seattle-First, 619 F. Supp. at 1360.

76. Swan Brewery Co. v. U.S. Trust Co., 832 F. Supp. 714, 718 (S.D.N.Y. 1993).

77. 3 MICHIE, supra note 52, § 193, at 525.

78. See Goldblatt v. FDIC, 105 F.3d 1325, 1329 (9th Cir. 1997) (a trust relationship is typically a prerequisite for special account status); see also FHLMC v. FDIC, 1985 U.S. Dist. LEXIS 19725, at *6–7 (E.D. Ky. May 17, 1985). New York law automatically applies a trust relationship if evidence establishes the existence of a special account. Merrill Lynch Mortg. Capital, Inc. v. FDIC, 293 F. Supp. 2d 98, 107 (D.D.C. 2003) (citing Genesee Wesleyan Seminary v. U.S. Fid. & Guar. Co., 159 N.E. 720 (1927) (Cardozo, J.)).

79. Merrill Lynch, 293 F. Supp. 2d at 106; cf. 12 U.S.C. § 92a (2006). Some older resources required a finding that the parties intended the return of specific assets to the customer, not their equivalents. This position appears to be long dismissed, Genesee Wesleyan, 159 N.E. at 722, although the argument was raised recently (and rejected by the court). Merrill Lynch, 293 F. Supp. 2d at 108–09.

80. Goldblatt, 105 F.3d at 1328–29; Peoples Westchester Sav. Bank v. FDIC, 961 F.2d 327, 330 (2d Cir. 1992); Paloian v. FDIC, 2011 U.S. Dist. LEXIS 127376, at *13 (N.D. Ill. Nov. 2, 2011) (fiduciary relationship not established simply by furnishing a custodial account); Merrill Lynch, 293 F. Supp. 2d at 103; cf. Sav. Bank of Rockland Cnty. v. FDIC, 668 F. Supp. 799, 805−06 (S.D.N.Y. 1987), vacated, 703 F. Supp. 1054 (S.D.N.Y. 1988).

81. E.g., Fletcher Vill. Condo. Ass’n v. FDIC, 864 F. Supp. 259, 265 (D. Mass. 1994).

82. 12 U.S.C. § 1822(c) (2006 & Supp. II 2008).

83. 12 U.S.C. § 1823(e) (2006). This language, which was adopted as part of the Financial Insti-tutions Reform, Recovery, and Enforcement Act of 1989, codifies and expands the federal common law doctrine known as “D’Oench Duhme.” The doctrine, following a Supreme Court case of that name, permits disallowance of claims not recorded on the bank’s books if doing so would be inequit-able. D’Oench, Duhme & Co. v. FDIC, 315 U.S. 447, 458–60 (1942).

84. This topic is discussed more generally in Part VI.

85. 12 U.S.C. § 1821(g)(4) (2006); see also FED. DEPOSIT INS. CORP., TRUST EXAMINATION MANUAL § 10.A (2005) [hereinafter TRUST EXAMINATION MANUAL], available at http://www.fdic.gov/regulations/examinations/trustmanual/section_10/section_x.html (the FDIC will “always defer to state law” regarding trust powers of state banks).

86. E.g., O’Melveny & Myers v. FDIC, 512 U.S. 79, 89 (1994); see also Watters v. Wachovia Bank, 550 U.S. 1, 21 (2007).

87. TRUST EXAMINATION MANUAL, supra note 85, § 10.A.

88. Further support for this conclusion comes from the absence of any distinctions drawn between national and state banks in advisory opinions issued by the FDIC on the treatment of custodial assets in insolvency. See FDIC Advisory Op. No. 03-01, supra note 35; FDIC Advisory Op. No. 88-14, supra note 53; FDIC Advisory Op. No. 87-7, supra note 53.

89. FDIC v. Prince George Corp., 58 F.3d 1041, 1045 (4th Cir. 1995).

90. See, e.g., Merrill Lynch Mortg. Capital, Inc. v. FDIC, 293 F. Supp. 2d 98, 104 (D.D.C. 2003).

91. 12 U.S.C. § 24, Seventh (2006); see also 2 TAYLOR ON BANKS, supra note 19, § 26.02, at 26-5.

92. See OCC TLDA Letter, supra note 2, at 3.

93. First Nat’l Bank of Logan v. Walker Bank & Trust Co., 385 U.S. 252, 261 (1966); see also, e.g., 2 TAYLOR ON BANKS, supra note 19, § 34.02, at 34-4 (for trust accounts).

94. The OCC has stated that “[n]ational banks’ custody activities developed from providing safe-keeping and settlement services to customers for a fee, and historically are viewed as permissible incidental activities under 12 U.S.C. § 24 (Seventh), and often are in conjunction with the delivery of fiduciary services.” OCC TLDA Letter, supra note 2, at 3 (emphasis added).

95. 12 U.S.C. § 92a (2006).

96. Id. § 92a(a); cf. 12 U.S.C. § 1813(p), 1817(l) (2006) (discussing the general treatment of fiduciary accounts under section 92a in “trust funds” at FDIC-insured depository institutions); 12 C.F.R. §§ 150.10−150.60 (2012) (containing the OCC’s rules for trust accounts at federal saving associations).

Banks have specific duties relating to trust funds, including:

• The bank must be authorized by the OCC to provide trust services (see generally 2 TAYLOR ON BANKS, supra note 19, §§ 34.03–34.05);
• The bank must segregate trust assets from the bank’s general assets and keep a separate set of books and records of transactions (12 U.S.C. § 92a(c));
• The bank must implement written rules and procedures relating to custody accounts, including those preventing self-dealing, conflicts of interest, and use of confidential information (12 C.F.R. § 9.5); and
• The bank owes undivided loyalty to custody clients and must avoid self-dealing and conflicts of interest (12 C.F.R. § 9.12).

Importantly, the bank’s board of directors must conduct an audit of its trust department at least annually to determine whether the trust department is properly administering its responsibilities (12 C.F.R. § 9.9). The audit may be continuous rather than annual (12 C.F.R. § 9.9(b)), which would certainly be more comforting to clients. I do not know how common this is.

97. E.g., FDIC Advisory Op. No. 03-01, supra note 35 (question pertains to a “regulated financial institution” without further description).

98. Id.

99. Id. (citations omitted).

100. FDIC Advisory Op. No. 88-14, supra note 53; cf. O’Melveny & Myers v. FDIC, 512 U.S. 79, 86 (1994) (citation omitted) (the FDIC “steps into the shoes” of the insolvent financial institution).

101. FDIC Advisory Op. No. 88-14, supra note 53.

102. Id.; 12 U.S.C. § 1821(d)(17) (2006 & Supp. IV 2010).

103. In the case of accounts for which the custodial bank has investment discretion, such as ERISA plan accounts, section 92a(e) of the FDI Act grants holders of “funds held in trust for investment . . . a lien on the bonds or other securities so set apart in addition to their claim against the estate of the bank.” 12 U.S.C. § 92a(e) (2006). I have found no sources analyzing the meaning of this language. Presumably, it grants trust clients a lien on securities or security entitlements that left the account prior to insolvency. This is not different from the rule at common law, and to the extent banks adhere to it or the FDIC enforces it, this lien possibly offers better protection to ERISA clients and others who meet the trust account requirements of section 92a than other custodial clients. See supra Parts II.A. & B. But, as discussed in Part IV, this lien is inconsistent with Article 8 of the U.C.C. to the extent it covers securities that are no longer credited to the account.

104. FDIC Advisory Op. No. 03-01, supra note 35.

105. See supra notes 35–36 and accompanying text.

106. See supra notes 36–37 and accompanying text (discussing private rights of action against the FDIC in the exercise of its receivership powers).

107. See infra note 148 and accompanying text.

108. See supra notes 40−43, note 46, and accompanying text.

109. See supra note 42 and accompanying text.

110. Recently, a lawyer representing a large U.S. custody bank told me that, before I had men-tioned it, none of its lawyers was aware of FDIC Advisory Op. No. 03-01, supra note 35, and that their view was that the opinion is wrong because it adds a fiduciary duty that does not exist under current law.

111. See, e.g., TRUST EXAMINATION MANUAL, supra note 85, § 10.A (although state laws “do not always uniformly identify what functions constitute ‘fiduciary’ activities requiring trust powers” and “a bank may claim it is not acting in a ‘trust’ capacity,” state law will determine whether an activity constitutes fiduciary or trust powers).

112. 12 U.S.C. § 1813(l) (2006 & Supp. IV 2010).

113. TRUST EXAMINATION MANUAL, supra note 85, § 10.D.

114. E.g., FDIC v. Phila. Gear Corp., 476 U.S. 426, 439 (1986) (citation omitted). The principle of Philadelphia Gear—that Congress may be deemed to accept an established regulatory rule or practice if it fails to address it in legislation relevant to the general topic—may explain why the “living will” provisions of Dodd-Frank do not require covered banks to address their treatment of custodied assets as part of their resolution plans. See Dodd-Frank Act §§ 165, 166, 12 U.S.C. §§ 5365, 5366 (Supp. IV 2010). For more on the Dodd-Frank living will provisions, see generally, e.g., Eugene A. Ludwig, As-sessment of Dodd-Frank Financial Regulatory Reform: Strengths, Challenges, and Opportunities for a Stronger Regulatory System, 29 YALE J. ON REG. 181 (2012); Margaret E. Tahyar, Living Wills: Key Lessons from the First Wave, HARV. L. SCH. FORUM ON CORP. GOVERNANCE & FIN. REG. ( July 24, 2012), http://blogs.law.harvard.edu/corpgov/2012/07/24/living-wills-key-lessons-from-the-first-wave/.

115. 12 U.S.C. § 1821(a)(1) (2006 & Supp. IV 2010); see also Insured or Not Insured?, FED. DEPOSIT INS. CORP. (Apr. 11, 2011), http://www.fdic.gov/consumers/consumer/information/fdiciorn.html[hereinafter Insured or Not Insured?]. But see infra notes 122–24 and accompanying text.

116. 12 U.S.C. § 1821(a)(1)(E) (2006 & Supp. IV 2010). The law provides for inflation adjust-ment to this figure. 12 U.S.C. § 1821(a)(1)(F) (2006).

117. Hedge Fund Investors Want Safe Havens for Managers’ Cash, supra note 1.

118. At last report the program is available through December 31, 2012. See Temporary Liquidity Guarantee Program, FED. DEPOSIT INS. CORP. (Oct. 2, 2012), http://www.fdic.gov/regulations/resources/TLGP/index.html. However, banks can opt not to offer the insurance or to charge a fee for doing so, thus resulting in negative interest costs.

119. 12 U.S.C. § 1813(m) (2006).

120. 12 U.S.C. § 1813(l) (2006 & Supp. IV 2010).

121. FDIC Advisory Op. No. 88-14, supra note 53 (treasury bills do not create a deposit relation-ship; rather, the relationship is “in the nature of a bailment”); see also Insured or Not Insured?, supra note 115.

122. See, e.g., Peoples Westchester Sav. Bank v. FDIC, 961 F.2d 327, 331 (2d Cir. 1992) (an interest component is “very strong evidence” that an account is a general asset absent other evidence of parties’ intent (citation omitted)). But cf. Merrill Lynch Mortg. Capital, Inc. v. FDIC, 293 F. Supp. 2d 98, 108 (D.D.C. 2003) (declaring that Interest on Lawyer Account (“IOLA”) obligations should be considered custodied assets despite the interest component because New York law required that these accounts bear interest); Peoples Westchester, 961 F.2d at 332–33 (Altimari, J., dissenting).

123. See Merrill Lynch Mortg. Capital, Inc. v. FDIC, 293 F. Supp. 2d 98, 107 (D.D.C. 2003) (applying New York law).

124. Merrill Lynch, 293 F. Supp. 2d at 108 (citations omitted); cf. Peoples Westchester, 961 F.2d at 331 (“We do not say that an IOLA can never be a special deposit. We simply conclude that in order for an IOLA to qualify as a special deposit, the parties must explicitly provide that it be one.”).

125. Department of the Treasury, Office of the Comptroller of the Currency, Short-Term Investment Funds, 77 Fed. Reg. 21057, 21058 (proposed Apr. 9, 2012) (to be codified at 12 C.F.R. pt. 9).

126. Insured or Not Insured?, supra note 115; see also Frequently Asked Questions About Money Mar-ket Funds, INVESTMENT CO. INST. ( July 2012), http://www.ici.org/mmfs/background/faqs_money_funds#Doesthefederalgovernmentinsuremoneymarketfunds.

127. E.g., MORGAN STANLEY PRIVATE WEALTH MANAGEMENT, TERMS & CONDITIONS 3 (2011) (on file with The Business Lawyer).

128. SEC v. Credit Bancorp, Ltd., 2000 U.S. Dist. LEXIS 17171, at *75–77 (S.D.N.Y. Nov. 29, 2000); aff’d sub nom. United States v. Rittweger, 524 F.3d 171 (2d Cir. 2008), cert. denied, 555 U.S. 1202 (2009); Rogers, supra note 15, at 1506.

129. I thank Linda Hayman of Skadden Arps for introducing me to these terms and the underlying principles.

130. Rogers, supra note 15, at 1433.

131. See generally U.C.C. Article 8 Official Prefatory Note § I.A.−D. (2011); see also Rogers, supra note 15, at 1435–36.

132. Rogers, supra note 15, at 1432.

133. See generally Rogers, supra note 15, at 1499–1502. The Official Prefatory Note to Article 8 analogizes the recordkeeping function to real estate recording:

Article 8 deals with how interests in securities are evidenced and how they are transferred. By way of a rough analogy, one might think of Article 8 as playing the role for the securities markets that real estate recording acts play for the real estate markets. Real estate recording acts do not regulate the conduct of parties to real estate transactions; Article 8 does not regulate the conduct of parties to securities transactions.

U.C.C. Article 8 Official Prefatory Note § III.B; see also Rogers, supra note 15, at 1499–1500 (“The expectation is, and should be, that the keepers of the real estate recording system will promptly, efficiently, and carefully record whatever documents are presented to them. The same approach is appropriate for the legal rules governing the mechanics of the system of securities holding through intermediaries. The principal objectives of such a body of law should be to assure that the record-keepers can operate the system rapidly, efficiently, and at low cost, and that investors can be assured that their record-keepers will, promptly and without question or inquiry, implement changes in the records at the direction of the customer.”).

134. The Official Prefatory Note states:

Many, if not most, aspects of the relationship between brokers and customers are governed by the common law of contract and agency, supplemented or supplanted by federal and state regulatory law. Revised Article 8 does not take the place of this body of private and regulatory law. If there are gaps in the regulatory law, they should be dealt with as such; Article 8 is not the place to address them.

U.C.C. Article 8 Official Prefatory Note § III.B. However, as noted at infra note 136, Article 8 supplants the common law of bailment. This may create a challenge when a bank plays the dual role of securities intermediary and trustee of custodied assets. The Official Prefatory Note states that:

Bank, qua securities custodian, might be holding securities for a large number of customers, including Bank’s own trust department. Insofar as Bank may be regarded as acting in different ca-pacities, Part 5 of Article 8 may be relevant to the relationship between the two sides of Bank’s business. However, the relationship between Bank as trustee and the beneficiaries of the trust would remain governed by trust law, not Article 8.

U.C.C. Article 8 Official Prefatory Note § III.C.5. Query how this is possible to the extent that Article 8 does not allow tracing and instead requires proportionate recovery of shortfalls. See infra notes 158–159 and accompanying text.

135. U.C.C. § 8-503 cmt. 1 (2011). In my view, the fact that a bank typically plays more than strictly a role of fiduciary or trustee highlights the limits of the real estate recording analogy discussed at supra notes 133–34. See infra Part VI.

136. SEC v. Credit Bancorp, Ltd., 2000 U.S. Dist. LEXIS 17171, at *79–80 (S.D.N.Y. Nov. 29, 2000) (citing U.C.C. § 8-503 cmt. 2), aff ’d sub nom. United States v. Rittweger, 524 F.3d 171 (2d Cir. 2008), cert. denied, 555 U.S. 1202 (2009); Rogers, supra note 15, at 1506 (“Under Revised Article 8, the relationship between a securities custodian and its customer is no longer treated as an aspect of common law bailment. Rather, the relationship is defined by the statement of the statutory duties of an intermediary in Part 5 [of Revised Article 8].”). Note, however, that when a bank holds securities that are titled in the name of the client, the securities are held as a bailment, not a security entitlement. U.C.C. § 8-501 cmt. 8 (2011).

137. See U.C.C. § 8-102(a)(14) (2011) (definition of “securities intermediary”), id., § 8-102(a)(5) (definition of “clearing corporation”), id., § 8-102(a)(3) (definition of “broker”).

138. Id. § 8-102(a)(7).

139. Id. § 8-102(a)(17).

140. See id. § 8-102(a)(4) (definition of “certificated security”), id., § 8-102(a)(18) (definition of “uncertificated security”).

141. Note that the terms “direct” and “indirect” as used in the custody context (see supra note 65 and accompanying text) may create ambiguity when referring to the custody of financial assets. Under U.C.C. Article 8, a client holds a security “directly” only if it is registered as the holder on the issuer’s books. So if a security intermediary holds a security certificate for the client, the client holds directly if the certificate is registered in its name, and indirectly (that is, the client only has a security entitlement) if the certificate is registered in the intermediary’s name. A complication to the foregoing is when a stock certificate is registered in the client’s name but the client has endorsed the certificate or given the intermediary signed stock powers. In that case, the customer is deemed to hold the security indirectly. See U.C.C. § 8-501(d) (2011).

142. Id. § 8-106.

143. Note that the term “control” has separate definitions for control of securities (certificated and uncertificated) as distinguished from control of a security entitlement. Compare id. § 8-106(a)−(c) with id. § 8-106(d).

144. A “purchaser” acquires an asset “by sale, discount, negotiation, mortgage, pledge, lien, issue or re-issue, gift or any other voluntary transaction creating an interest in property.” U.C.C. §§ 1-201(32), 1-201(33) (2011); see also U.C.C. § 8-116 (2011).

145. U.C.C. § 8-102(a)(7) (2011).

146. Id. § 8-106.

147. U.C.C. Article 8 Official Prefatory Note § II.D (2011).

148. U.C.C. § 8-503(d), (e) (2011) (recovery against a third party is prohibited if it gave value, obtained control, and did not act in collusion with the bank). U.C.C. § 8-503 cmt. 2 states:

A security entitlement is not a claim to a specific identifiable thing; it is a package of rights and interests that a person has against the person’s securities intermediary and the property held by the intermediary. The idea that discrete objects might be traced through the hands of different persons has no place in the Revised Article 8 rules for the indirect holding system. The funda-mental principles of the indirect holding system rules are that an entitlement holder’s own intermediary has the obligation to see to it that the entitlement holder receives all of the economic and corporate rights that comprise the financial asset, and that the entitlement holder can look only to that intermediary for performance of the obligations. The entitlement holder cannot as-sert rights directly against other persons, such as other intermediaries through whom the intermediary holds the positions, or third parties to whom the intermediary may have wrongfully transferred interests, except in extremely unusual circumstances where the third party was itself a participant in the wrongdoing.

149. See supra note 69.

150. U.C.C. § 8-501(b) (2011).

151. Id. § 8-501(c).

152. See U.C.C. § 3-302 (2011).

153. U.C.C. § 8-503(d), (e).

154. Since banks clearly demarcate client assets, I would presume that if this were to happen it would occur in more than one step, say, the asset (or, more accurately, the record of ownership of the asset) moves from the custody account to the bank’s proprietary account, and from there to a creditor account, in circumstances where the matter cannot be corrected before the bank’s insolvency.

155. U.C.C. § 1-203 (2011) (“Every contract or duty within this Act imposes an obligation of good faith in its performance or enforcement.”); see also U.C.C. § 8-511 cmt. 1.1 (2011).

156. Note that in New York mere knowledge may satisfy the collusion requirement. See Howard Darmstadter, Three Article 8 Cases, 57 BUS. LAW. 1741, 1746–50 (2002) (citing New York legislative history).

157. See supra note 136.

158. U.C.C. § 8-503(b) (2011).

159. See id. § 8-503 cmt. 1.

160. Id. (“Although this section [section 8-503] describes the property interest of entitlement holders in the assets held by the intermediary, it does not necessarily determine how property held by a failed intermediary will be distributed in insolvency proceedings. If the intermediary fails and its affairs are being administered in an insolvency proceeding, the applicable insolvency law governs how the various parties having claims against the firm are treated. For example, the distributional rules for stockbroker liquidation proceedings under the Bankruptcy Code and the Securities Investor Protection Act (‘SIPA’) provide that all customer property is distributed pro rata among all customers in proportion to the dollar value of their total positions, rather than dividing the property on an issue by issue basis. For intermediaries that are not subject to the Bankruptcy Code and SIPA, other insolvency law would determine what distributional rule is applied.”).

161. See supra note 148 and accompanying text.

162. See supra note 83 and accompanying text.

163. See Rogers, supra note 15, at 1501.

164. U.C.C. § 8-503 cmts. 1, 2 (2011); see SEC v. Credit Bancorp, Ltd., 2000 U.S. Dist. LEXIS 17171, at *70 (S.D.N.Y. Nov. 29, 2000), aff ’d sub nom. United States v. Rittweger, 524 F.3d 171 (2d Cir. 2008), cert. denied, 555 U.S. 1202 (2009).

165. This document is on file with the author.

166. ROGERS, supra note 15, at 1513.

167. See id. at 1530.

168. FDIC Advisory Op. No. 03-01, supra note 35.

169. For example, as discussed further in Part VI, an institution with a concentrated exposure in a particular security—say, a foundation that is endowed with a large position in its founder’s company—may wish to retain a physical certificate in such number of shares that it intends to retain for long-term investment.

170. See supra notes 20−24 and accompanying text.

171. 15 U.S.C. §§ 80a-1 to 80a-64 (2006 & Supp. IV 2010).

172. 17 C.F.R. § 270.17f-5 (2012).

173. Id.

174. For example, New York law relating to common trust funds requires that the custodian’s subcustody contracts with foreign banks require client securities be kept free of creditor claims and be identified as being owned by the U.S. custodian as fiduciary. N.Y. COMP. CODES R. & REGS. tit. 3, § 22.9 (2012). The law also requires proper recordkeeping and audit rights. Id.

175. 12 C.F.R. § 208.43(b)(1) (2012); id. § 225.81(b)(1).

176. Id. § 225.81(b)(2).

177. The OCC’s Custody Services Handbook recommends that a bank use a “standardized” custody agreement “when possible.” CUSTODY SERVICES HANDBOOK, supra note 3, at 8.

178. See supra note 115.

179. For example, last year the Chicago Board Options Exchange began offering CEBOs—Credit Event Binary Options—that trade based on the likelihood of a company experiencing a “credit event.” See Credit Event Binary Options (CEBOs) from CBOE, CHI. BD. OPTIONS EXCH., http://www.cboe.com/micro/credit/introduction.aspx (last visited Oct. 21, 2012).

180. See supra note 169.