One Madoff aftershock that has hit the backoffice is custodians’ caution towards hedge funds domiciled overseas. The service providers want to ensure they can’t be liable for any fraud or investment risk involved with the offshore managers’ actions. This carefulness follows moves to limit, or ‘cap’, their liabilities for unit pricing errors and managers’ breaches of investment mandates.

Bryan Gray, domestic sales chief at JP Morgan Worldwide Securities Services, says the custodian has stopped short of capping its liabilities for offshore hedge fund assets in the event of fraud, but exercises more caution when taking on the responsibility for safekeeping a local institution’s investments in hedge funds headquartered overseas, such as the Cayman Islands. “The issue is: do you know the assets that the fund is investing in? We would feel less comfortable with a hedge fund domiciled offshore that is being self-administered, but if it’s administered by a third party, we’re more comfortable,” he says. “The due diligence that custodians do has been extended to include this as a result of Madoff.”

When it comes to liabilities for investment risk, custodians “make it clear that our role is an administrative role and not vouching for the underlying assets,” he says. “Custodians act upon an instruction. It’s not our job to question whether it’s a good investment or not.” It’s not just custodians’ due diligence that has been stepped up: Gray says the addendums of contracts have been extended to explicitly define a custodian’s ability to verify underlying assets. “What we need to do is highlight the situations beyond our control, like vouching for assets where we can’t get transparency on them, or stop investment losses from occurring. “You can’t take on liability for market risk or for investors losing money when you can’t control it. We can only provide information.”

Liability caps are usually struck as a multiple of the annual fee paid to a custodian, and are most frequently used to limit the fallout from unit pricing errors, says Lounarda David, regional boss of Mercer Sentinel. These mistakes, which result in incorrect valuations of members’ accounts, can run up huge losses for funds, particularly those with billions under management. The fees custodians are paid for their services can be dwarfed by the the costs of these errors. Liabilities have always been a grey area in backoffice outsourcing relationships: which errors should the custodians be liable for, and for how much should they be on the hook?

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