ISA shares held in Custody. 11 January at 6:19PM in ISAs & tax-free savings 4 replies 167 views

TC56_803_9

I had bought and sold odd shares since the late 90s but did not trouble myself about a Stocks and Shares ISA until about 18 months ago and I transferred in a number of Cash ISAs. My mind was still working with hard copy share certificates and a register of shareholders.  An issue came up on one of my holdings with a shareholder vote so I got in touch with my ISA holder about why I had not been informed of it.  I cannot say I have an answer to that question yet, but one of the reasons given was because my shares are held by my ISA provider, Halifax Share Dealing Service, in CUSTODY.  Ok I understand the relationship  - and translating it into my cynical world view  -  I hand over some money and hope someone somewhere buys some shares on my behalf and holds them against my name.  A piece of paper with a number on that says I should be entitled to something, possibly, maybe.

A quick search brought up the following from the UK Shareholders' Association, from 2014.

"An UKSA member asked his broker – believed to be the second largest, with some 440,000 customers – for clarification of his position. He had found a statement that, “Where your assets are held by a nominee or sub-custodian we cannot ensure that you would not lose any assets if the entity fails.” He was told that this was because the assets would be outside their control, but he could not understand why his brokers could put him at risk and wash their hands of responsibility. He had also noted that, under the terms he had originally signed up to, the broker had stated, “In providing our Custody Service, we are responsible for the safe keeping of your Assets.” This had given him some comfort, but the clause is no longer to be found in its current terms and conditions and, when he asked why, the answer was simply, “Oh our terms have been updated.”

Yes that was exactly what I expected.  A high street name outsourcing custody to an entity who they will not indemnify the retail customer, from whom they received money, against failure of that outsourcing custodian.  And of course with no transparency the retail customer and the high street name will have no knowledge that  X shares held in custody at that third party are held against n x X retail customers, each believing they  hold shares in said company, until the third party custodian has to liquidate their assets due to yet another of those "black swan" events that keep on occurring in the financial services.  By which time the individuals who took the funds under false pretences, are out of the company and out of the country, lying on a beach with a gin and tonic to hand, well out of jurisdiction.  I am confident no one will want this to happen and some checks will be in place to try and stop the crooks doing this - wot they falsified a register, year after year? What naughty people!    My ISA like many other people's ISA is beyond the FCA 80,000 limit.  I am exposed to a loss I cannot control, indemnify against or even know I am subject to.

So - my questions to the IFAs and the like who provide much useful and informed opinion here is - Do any ISA providers offer and ISA where the ISA holder is the actual share holder or are they all "custodians"? 

If they are all "custodians" has the regulator spotted the potential failure mode and mandated that custodianship cannot be subcontracted without full liability, yet?  It is a pretty sort of basic task - don't sell ISAs unless you deal with all custody issues yourself and a requirement of licensing you is that your liability in terms of custodian issues is 100% without limit.  Problem solved.  Obviously the banks would not like that - but they only would not like it if they planned on cutting corners - e.g. 1 share in custody to 5 different retail customers.

If the answers are both negative, I can see my solution, I will have to sell shares and then transfer the cash to a number of ISA providers to ensure I keep each one below the £80,000 threshold.  Obviously that brings with it a lot of hassle but it has to be a work around, after all, we are in volatile times and I suspect there are a flock of black swans about to come out of the reeds.

TC56_803_9

Well that was one of the most disappointing evening’s reading in many a year.  Highly depressing.  The best piece I found on the problems was a discussion paper from the LSE identifying the very clear and obvious, systemic risk that is deliberately designed into the system and suggesting changes via legislative reform.  

The problems I describe do not just apply to Stocks and Shares ISAs but, I would imagine, apply to all low cost “platforms” trading in stocks and shares available to the retail investor.  Don’t say Cassandra did not warn you!  But as ever DYOR.

 The paper can be found by searching   

Custody Chains and Remoteness: Disconnecting Investors from Issuers by Eva Micheler  LSE Research online.

 The outcome of the research and suggested is reform is, I think, best expressed by this statement in the paper.

 “Policymakers should expect intense resistance from existing market participants trying to preserve the incumbent structure.”

 What is the current structure? (the fully referenced paper runs to 31 pages so I have extracted key quotes which will get you to the end point.)

 “2. Custody Chains

 “In modern securities market shares and other securities are held indirectly through financial service providers who hold securities on behalf of clients. These service providers will be referred to as custodians in this paper.6 A custody chain is made up of one or more custodians. Connections are made through bilateral contracts. The ultimate investor has a contract with custodian 1. Custodian 1 has a contract with custodian 2. Custodian 2 has a contract with Custodian 3. Custodian 3 has a contract with the CSD. The CSD is connected with the issuer.7

 “One important feature of custody chains is that the contracts are entered into bilaterally only. The investor is normally not a party to the contract between Custodian 1 and Custodian 2. The contract between Custodian 1 and Custodian 2 does not normally give direct rights to the investor.8 Each custodian enters into a bilateral relationship with his immediate client and another bilateral relationship with his immediate sub-custodians. The contract with the client is independent from the contract with the sub-custodian. It will be shown below in the next two sections that this erodes the interest of the ultimate investor and compromises the enforcement of the rights by the ultimate investor.”

 The fallacy of the current widespread acceptance of this position is explained in this section.

 “Ultimate investors believe these chains to be mere technicalities and consider themselves to be shareholders. In fact they are holders of an economic interest, in an economic interest, in a share and that is in the most simply of cases where there are only two intermediaries.”

You own no shares and the law does not view you as a shareholder as you most clearly are not.  Oh, you might have a statement saying in your portfolio you have a variety of economic interests spread around devices as shown, but you own zero actual shares. But that is not the risk.  You pay money into the bank.  The local bank do not keep your deposit there as cash, it quickly becomes other assets.  But you are protected.  With share ownership ....well you see you don't actually own any shares and so ......

 Chains of custody remove that ownership, the paper explains as follows,

 “This is because a custodian is not liable for the acts or omissions of the staff of a sub-custodian in the same way as it is liable for its own staff.

“This is reasonable. A custodian has no control over the level of services delivered by individuals outside its own organisation and is therefore entitled to reject liability if a loss occurs as a result of their negligence.17

“From the perspective of the custodian delegation has the effect of reducing liability. By outsourcing the holding of assets a custodian can transform liability from a liability for its own mistakes to a more remote and less likely liability for not having properly identified or instructed a sub-custodian.18 “

And just why does all take place, why does the financial services industry so love chains of custody?

“This incentivises custodians to employ sub-custodians and prolongs chains. Bilateral links enable custodians to reduce potential liability for their services. This dilutes the rights of ultimate investors. This also creates an incentive for custodians to employ subcustodians. That prolongs chains and causes the number of custodians involved in the chain to increase. “

The outcomes?

“Matters are made worse by the fact that the more organisations are involved the more likely it is for mistakes to occur. Adding further members to the chain increases the likelihood of mistakes to happen and at the same time makes remedying these mistakes more complicated and more costly.”

And the stark staring obvious...

“Matters are made worse by the fact that lower levels of service are normally associated with lower cost. Subcontracting to a sub-custodian that offers a better price may be in the interest of the custodian instruction(sic)  the sub-custodian, but can dilute the rights of the ultimate investor.”

As a consequence of all these custody chains, the legal remedies available to the investor are trivial and cases where substantive groups of private investors investors sought to exercise their rights via the Companies Act 2006 are exampled as failed.  They cannot exercise the rights as shareholders , because these investors do not own any shares only an economic interest in an economic interest, in an economic interest etc etc.   

Their rights would have been without debate had the old system occurred as I used to buy shares in the 1990s.  I would go along to the district bank HO and at the share dealing desk, arrange for a quote.  I would wait around for a few minutes, sometimes be given a coffee even, receive the quote, agree it and the bank would transfer money from my account and I would take away a carbon copy of the record of the transaction.  About 10 days later a share certificate would turn up in the post.  I never had an instance of the certificate never turning up.  The broker representing the company whose shares I had bought would have my name and address on file, on their register of shareholders because he had printed and sent me the certificate!  Job done, no dispute. I have my certificate and I am on the register of shareholders. If the certificate had not turned up I would have called the bank and they would have confirmed my tale by looking at their own carbon copy held on my file and they would have sent a re-issue request to the broker.  It all worked. It might not have been quick but it sure was safe.

 In one of the failed legal cases exampled in the paper, the custody chain started at BNY Mellon and then went out on a big loop of sub custodians before coming back to BNY Mellon.  Which reminds me of what a fuse in an electrical circuit does.  When the circuit gets stressed, it blows and isolates one end from the other.  Security is designed in  - for one party!  The other party?  Well they get nothing.  The company you are invested in does not need to fail.  It can remain very healthy but if any one of those custodian links is negligent, fails or needs to liquidate some assets to salve its own position - your recourse?

 Where we appear to be now is summed up in the conclusions to the LSE paper.

 “The thesis of this paper is that custody chains leave investors vulnerable when services are provided for by custodians negligently. They undermine the contractual arrangement between investors and their immediate service provider. They make the enforcement of securities against issuers very costly and complex and can thus reduce the value of the securities concerned. This can have systemic implications. Legal rules cannot ultimately address the problems associated with custody chains. Structural reform is required. A central, direct and transparent holding mechanism should be created. “

 The final sentence of that discussion paper?

 “The paper observes that existing market participants have opposed previous attempts to put in place reform and predicts that they will continue to do so.”

 I am sure they will oppose attempts at reform.  If the financial system becomes stressed and a bank has to default, your assets - well they will be liquidated to pay their debts and we all know who is at the top of the list of liabilities they must reimburse, your shares mate, you never owned a single one pal.  The Intermediary custodian blew mate, sorry about that. there all gone, you've nothing nothing left.  It's all there in the small print if you care to look. Yeah I know Widget Corp are a good company and still trading but sadly you never ever did have any shares in that sound company.  You just had an NFT in our, now bust, platform.

As always I advise DYOR.

Reed_Richards

TC56_803_9 said:

The problems I describe do not just apply to Stocks and Shares ISAs but, I would imagine, apply to all low cost “platforms” trading in stocks and shares available to the retail investor.  

You are correct.  I have used a variety of "low cost platforms" over the last two decades and I have never had hard copy share certificates, either for regular accounts or for ISAs.   This means:

1. This particular forum, being specific to ISAs, is probably not the best place to express your concerns.
2. This issue has persisted for at least two decades, so far without any problems arising (it's taken you a long time to notice).  Sooner or later something bad will happen but I doubt there will be any changes until after the event.

masonic

Could you summarise the problem you think exists in a few sentences? Despite not being directly listed on any shareholder register, I have been able to vote, had the option to avail myself of shareholder perks, move my assets between nominees etc. Others have been able to assert their ownership of their assets when a platform went bust, and received compensation from the FSCS where some of their assets could not be returned to them. I'm struggling to see why holding assets in electronic form via a nominee company is such a bad thing. Of course, FSCS protection is not unlimited, so choosing a well established and regarded platform is wise if holding 6 or 7 figure sums.

This potentially affects anyone with a General Investment Account, S&S ISA, SIPP, workplace pension, etc. So probably everyone reading this forum. As far as I can see the major players use a nominee company that is part of the same group as the operating company. Any firm holding client assets must be FCA authorised, follow CASS rules, and have the appropriate regulatory permission.

TC56_803_9

Masonic - I admire your trust. 

The custody chains are set up so that all contracts between the links are bilateral.  Legally enforceable accountability stops after link 1.  After that actions become entirely at the gift of the next link in the chain and so on.  Why should that party spend any of their money enforcing your claims or your "rights" when they have not been negligent in any manner?  There is no legal compulsion.  And if they enforce your claim they will reap no gain from the action. That is the current system.

Platforms taking the RI's money and the banks with the omnibus accounts both have to be registered and comply with FCA rules but the elements of the extended custody chains do not.  Nobody is checking their daily re conciliations, did they uncross at the end of the day at that disadvantageous price?

Voting - somebody listened very nicely and took a note of a voting intention or it was logged on a system.  They might have given the RI a reference number to reassure and stop complaints.  Did that vote go back down the custody chain?  Timing and resource work against this. A platform may have opened up the vote 4 weeks before the corporate event and closed their window 2 weeks later.  Shares in the company will be bought and sold on the platform between the closure of their window and the corporate event date.  The actual record of votes getting back to the agent or company secretary is fraught.  Too many votes cast against the nominee holding at the point in time when the vote has to be made.  A entity, say 3 links away from a number of platforms is not going to reconcile holdings at an exact moment in time.  It is too costly, for all the parties, to resource and there is absolutely zero mandate on them to do so.  Yes, the platform may actually made a contract with the RI, usually in the form of charging a fee to record the vote, in which case they may have a liability to the investor that they have no ability to enforce and if the RI can prove that their individual vote did not pass down the chain then the RI may be able to take out a claim for their losses, emotional and financial, due to negligence.  You see where that went?  The vote window for the corporate event is at a given point in time and later than when the platform opens their access, so a judgement on proportions of the holding voting each way  has to be made, or maybe not even made at all by a separate body. And that judgement has to be passed on or not passed on to the agent or company secretary.  Some platforms just do not bother.  Their formal position is that they will not engage in advising or executing corporate events.  The Dept of BIS in the Govt recorded examples of all of these when they responded to the LSE discussion paper. 

Summary, you must hand your money over.  You may or may not be able to vote but it may not be counted. 

Ownership - the FSCS protection is not free and, as we all know, limited.  It would not have to be paying out anything if any link of the custody chain went  bust but had actually been passing on ownership. Its failure would be irrelevant to the ownership of the shares.  Ditto platforms because the ownership would be registered where it is required to be registered. This is a service the FSCS should not be providing. 

Voting it doesn't work.  Ownership, I agree,  whilst is works, it all works.  But it is fails?  Well I am going to be splitting up my portfolio.