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September 24, 1991
TO: BOARD OF GOVERNORS NO. 73-91
MEMBERS - ONE PER COMPLEX NO. 42-91
OPERATIONS COMMITTEE NO. 29-91
SEC RULES COMMITTEE NO. 58-91
RE: SAFETY OF CASH HELD BY CUSTODIAN BANKS
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The Institute has been examining the extent to which
uninvested cash held by investment companies in their custodian
banks may be at risk in the event of the custodian bank's
failure. The Institute has obtained from its counsel, Kirkpatrick
& Lockhart, a memorandum discussing: (i) the extent to which
the failure of a custodian bank could result in the loss of cash
assets; (ii) several options that may permit an investment
company to better protect cash held in custodial accounts; and
(iii) whether the Investment Company Act imposes a duty on the
directors of investment companies to take special steps with
regard to the safety of custodial cash. While the focus of the
review concentrated on cash in custodial accounts relative to
portfolio activity, members should be aware that the status of
cash relative to transfer agent activities may be subject to the
same possible risks. A copy of counsel's memorandum is attached
for your information.
The memorandum notes that each investment company is
generally entitled to a maximum of $100,000 in FDIC insurance in
a given custodian bank and that there is no "pass-through" of
deposit insurance to investment company shareholders.
Furthermore, custodial cash generally is not entitled to any
secured or preferential status in bank insolvency proceedings.
Consequently, an investment company that maintains large cash
deposits with its custodian bank may be exposed to a significant
risk of loss in the event of the bank's failure.
Counsel's memorandum discusses several arrangements that
may improve the safety of custodial cash. The staff of the
Institute also has met with a number of major custodian banks to
discuss this issue and to suggest that they develop mechanisms
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that offer better protections for cash held in a custodial
capacity, including the creation of a "narrow" or "core" bank
facility devoted primarily to servicing and protecting cash in
mutual fund custodial accounts. Nevertheless, it appears that
there is no particular arrangement that can absolutely guarantee
the safety of cash held in a custodian bank. Moreover, there may
be significant costs and practical impediments associated with
devices designed to reduce or better protect cash on deposit with
custodian banks.
The safety of cash held in custodian banks is likely to
continue to be a significant issue given the absence of special
protected status for such cash, the current problems of the
banking system, and the proposals under consideration by Congress
for limitations on government assistance to uninsured bank
depositors. Consequently, members may wish to review the safety
considerations relevant to their custodial relationships.
Counsel's memorandum notes that the Investment Company Act
does not impose any specific requirements for assessing the
safety of cash deposits at custodian banks provided the banks
meet the $500,000 capitalization requirement of Section 17(f).
However, under the Act and applicable state law, the directors of
an investment company are charged with a general fiduciary duty
to safeguard the assets of the fund. In fulfilling this duty,
investment company directors might be expected to evaluate a
number of relevant factors, including the financial health of the
fund's custodian and transfer agent bank or banks, the extent to
which the fund regularly maintains cash deposits in excess of
FDIC insurance, any existing or available arrangements to further
safeguard cash assets and the cost and practicality of such
arrangements. In considering these issues, it may be appropriate
to consult directly with the banks concerned and to institute a
system to monitor on an ongoing basis the financial condition of
bank custodians and banks holding cash in transfer agent
accounts. In some cases, contingency planning may be prudent
regarding steps to be taken should a bank's condition materially
deteriorate.
To date, the Institute is aware of no actual losses
associated with the failure of banks holding cash of a fund or
its transfer agent. However, given public concerns over the
difficulties of financial institutions generally, members may
wish to carefully consider the matters discussed in the attached
memorandum and their applicability to their own custodial and
transfer agent relationships. In so doing, members may wish to
review and balance costs with risks in structuring and monitoring
these relationships.
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The Institute will continue to discuss this issue with
custodian banks. We will keep you advised of developments and
welcome any comments or suggestions regarding this issue.
Lawrence A. Rogers Donald E. O'Connor
Senior Counsel Vice President-Operations
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