Custodial agreement

If you have landed here looking for what a custodian does, you want custodian. This page is about the contract that appoints one.

Appointing a custodian is not optional. Under the SEBI regulations it is mandatory for all AIFs, and the custodian for a scheme must be in place before the date of the scheme's first investment.

The custodian then does a great deal of the fund's back office. It holds the securities, settles the trades, obtains the tax certificate, liaises with companies on corporate actions, and reports to SEBI.

All of which raises an obvious question. If the custodian gets something wrong, who is answerable?

The agreement is the answer. The workbook is explicit that the investment manager must ensure proper responsibility fixation on the custodian for the back-office functions, so that there is enough contractual redressal in any event.

So this is not a form. It is the document that decides whether the fund has a remedy when the plumbing fails.

One more practical point. Each scheme can have a different custodian, in order to keep the assets and liabilities of that scheme separate.

Section 13.7.2 sets out the appointment, the custodian's functions and the contents of the agreement.

What a custodian is, in the workbook's framing. A custodian is a SEBI registered service provider in the capital market facilitating investment activity for FPIs in the Indian capital market. The word has not been specifically defined under the statute, but it encapsulates all the functions an investment back office has to perform: acting as the clearing member of the clearing corporation of the concerned stock exchange for clearing transactions, safe keeping of securities records and physical assets such as commodities, reporting to SEBI, and maintenance of books and records with tax and regulatory compliance.

The statutory basis. Regulation 20(11) of the AIF Regulations provides that:

1. the sponsor or manager of an AIF shall appoint a custodian for safekeeping of the securities of the fund;
2. the custodian appointed by the sponsor or manager of a Category III AIF shall keep custody of securities and goods received in delivery against physical settlement of commodity derivatives;
3. custodians shall report information regarding investments of AIFs as specified by SEBI.

Under the existing SEBI regulations, appointing a custodian is mandatory for all AIFs, and each scheme can have a different custodian in order to segregate the assets and liabilities of that scheme.

Timing. The sponsor or manager needs to appoint the custodian for a scheme prior to the date of the first investment of the scheme — not before first close, and not within some period after launch.

Additional functions performed under the agreement. Beyond safekeeping, custodians appointed by AIFs are involved in obtaining the tax certificate for the AIF, settlement of trades in listed securities, liaison with companies on post-trade corporate action, and any other activity delegated to them as part of the custodial agreement. That last phrase is the point: the scope of the extra work is whatever the contract says it is.

One duty the agreement cannot shift. Where a Category III AIF breaches its permitted leverage limits, the custodian shall report to SEBI, giving the name of the fund, the extent of the breach and the reasons for it, before 10 a.m. on the next working day. That is the custodian's own regulatory obligation, not a service the fund buys.

What the agreement must contain. The custodian agreement is a legally binding contract entered into between the AIF and its custodian. It shall:

• provide for the role and scope of services of the custodian in compliance with regulatory requirements;
• contain all standard provisions with regard to satisfactory performance by the custodian;
• include a covenant of mutual obligations and responsibilities of the parties;
• specify the commercial terms of engagement; and
• fix responsibility on the custodian for the back-office functions, so there is contractual redressal.

A related restriction from Chapter 7. The custodian shall not be a related party to the sponsors or designated partners, unless specific conditions are fulfilled.

Sahyadri Growth Fund II, a Category II AIF scheme with a corpus of Rs 750 crore, declares first close on 10 June and expects to make its first investment on 25 July.

The deadline. The custodial agreement must be signed and the custodian appointed before 25 July — the date of the scheme's first investment. Nothing requires it before 10 June.

The agreement, clause by clause:

At Rs 73.16 lakh on a Rs 750 crore corpus, custody costs about 9.8 basis points a year, borne as a fund expense rather than out of the management fee.

Why responsibility fixation matters. In September the fund instructs the purchase of Rs 40 crore of an unlisted company's shares. The custodian mis-keys the ISIN and the settlement fails, so the fund misses the closing date and the deal re-prices upward by 3%, costing Rs 1.2 crore.

Without a responsibility clause the fund has an argument and no contract. With one, it has a stated remedy. That is precisely the contractual redressal the workbook tells the investment manager to secure.

Why each scheme may want its own custodian. Sahyadri Trust also runs Sahyadri Debt Fund I. If both schemes use the same custodian under one agreement, the trust must still keep the assets, liabilities, bank accounts and securities accounts of each scheme separate. Appointing a different custodian per scheme is the cleaner route, and the workbook says it is permitted for exactly that reason.

And the duty the fund cannot delegate away. If Sahyadri launched a Category III scheme that closed a day at 2.1 times NAV against a cap of 2 times, the custodian would have to report the fund's name, the extent of the breach and the reasons to SEBI before 10 a.m. the next working day. No clause in the agreement can switch that reporting onto the manager.

Chapter 13 (Legal Documents and Negotiations), section 13.7.2 (Agreement with Custodian), carries the definition, Regulation 20(11) and the contents of the agreement. Chapter 7, section 7.1.4.3, introduces the custodian among service providers, and Chapter 17 carries the leverage-breach reporting.

Expect questions on who appoints the custodian (the sponsor or manager, under Regulation 20(11)), by when (prior to the date of the scheme's first investment), and whether it is optional (it is mandatory for all AIFs). Expect the Category III add-on — custody of goods received on physical settlement of commodity derivatives — and the leverage-breach timing of before 10 a.m. on the next working day. The point most often missed is that each scheme can have a different custodian, to segregate that scheme's assets and liabilities.

• The deadline is the scheme's first investment, not its first close. A scheme may hold a close without a custodian; it cannot invest without one.
• The sponsor or manager appoints the custodian, not the trustee. The trustee executes the trust deed and signs the investment management agreement.
• Each scheme may have its own custodian. The purpose is segregation of that scheme's assets and liabilities.
• The word custodian is not defined in the statute. The workbook says so expressly, which is why the agreement has to spell the functions out.
• The leverage-breach report to SEBI is the custodian's duty. The AIF reports the breach to the custodian and to its investors; the custodian reports to SEBI, before 10 a.m. the next working day.
• The custodian may not be a related party of the sponsor or designated partners unless specific conditions are met.
• A custodial agreement is not a custody guarantee. It fixes responsibility for back-office failure; it does nothing about a portfolio that loses money.
• Custodian is not fund administrator. The administrator keeps the books and computes NAV. Custodians commonly sell administration too, which is why the two get merged.