Prime Brokers, Trusts And The Meltdown Of Custodianship

One of the issues which caused consternation in relation to the

insolvency of Lehman Brothers was the fate of securities held by a

prime broker in custody for its clients.

A prime broker is typically an investment bank which buys or

sells securities on behalf of clients, such as hedge funds. The

broker holds the securities in custody for the client.

Custodianship of securities is a form of trust. Custodianship in

particular, and trusts in general, are crucial for the safety of

markets. Along with security interests and insolvency set-off, they

are one of the trilogy of financial risk mitigants in a case of the

bankruptcy of a counterparty.

Trusts have had an astonishing history. A leading French jurist

observed in the 1930s that trusts are used for "almost

everything". A Scottish professor said recently in answer to

the question of what trusts are used for – "one

might almost as well ask what are contracts used for". So why

is the idea rejected in more than half the world's

jurisdictions?

These days family trusts and will trusts of the estates of a

deceased are tiny minority uses. The largest trust in the world

holds securities worth more than half the world's GDP. It is

called the Depository Trust Corporation. The largest trust in

Europe holds securities worth more than the entire GDP of the EU.

It is called Euroclear. Both the Depository Trust Corporation and

Euroclear are settlement systems for securities. They are

custodians of securities for the benefit of clients so that the

clients can transfer securities from one account to another easily

and quickly without having to transfer the actual securities

themselves. They are both classical trusts. If you add, for

example, custodianship, investment trusts, bondholder trustees,

trustees for security interests, pension trusts, equipment trusts,

deposit funds, and all the rest you get a legal construct of

immense utility which involves colossal amounts worldwide.

Yet there are large risks, often unnoticed.

France has recently re-introduced a hesitant trust –

back to history, an unquestionably sound step.

Under a trust one person (the trustee) holds the public title to

the asset for the real owner (the beneficiary). The asset is immune

from the private creditors of the trustee if the trustee becomes

insolvent. The client or real owner or beneficiary gets them back

in full, free of the claims of the creditors of the trustee.

The trustee has to hold the title to the asset so that it can

deal with the asset. In the case of goods and bearer bonds, this is

possession of the asset. In the case of assets whose ownership

title is registered in an asset title register, such as land,

aircraft, securities and intellectual property, this is

registration of the trustee as the owner in the register.

Therefore, if I deposit my furniture with a warehouse and the

warehouse becomes insolvent, I get my furniture back. Virtually all

countries accept that the goods are immune from the creditors of

the warehouse. This is an ordinary deposit or bailment of goods.

The warehouse holds the public title – the possession of

the furniture which everyone can see.

But if the asset is anything else – land or

securities, for example – the picture changes. So if I

deposit a bearer bond with a bank as a warehouse/custodian, then in

numerous countries I do not get my bearer bond back on the

insolvency of the bank. The bond goes into the pool of assets

available to the...