In February 2011, the Association of Investment Companies (AIC) published a paper exploring the risks associated with third party custody of an investment company's assets. Investment companies rely on custodians to safeguard and process their assets. Services provided by custodians include trade settlement, income collection and processing and dealing with corporate actions, and safe custody normally involves the transfer of legal title from the investment company to the custodian. While the organising and monitoring of custody arrangements is often delegated by the board of an investment company to its manager, it is the board that is ultimately responsible for ensuring that its shareholders' assets are protected and kept safe. Although the AIC accepts that it is not possible to eliminate custody risk entirely (the risk that the assets held in custody are lost or access to them is compromised due to, for example, the custodian's insolvency, negligence, or fraud) in light of experiences such as the collapse of Lehman, the AIC believes investment company boards may wish to review their current custody arrangements to ensure that the most appropriate structure available is in place to protect the company's assets.

As a starting point, the AIC suggests that boards should review their existing custody arrangements. The paper includes a list of questions for boards to ask of both their custodian and investment manager if that manager arranges custodial services and, in carrying out their review, boards are advised to consider how their arrangements fit with current market practice. On completion of their review, if the arrangements are not felt to be satisfactory and the board feels that the security of the assets is compromised, the board will need to decide whether to renegotiate the existing custody agreement or consider using another custodian.

The paper also looks at how investment companies should report on their custody arrangements to shareholders. A description of the current arrangements, the scope and outcome of the board's review and the nature of ongoing monitoring could be included in the corporate governance statement in the annual report. The statement could also be included as part of the board's disclosures on internal risk and custody risk could be covered as part of the disclosures on principal risks and uncertainties in the business review.

The implementation of the Alternative Investment Fund Managers' Directive will replace the traditional custodian framework in due course with a broader, more regulated depositary function and the paper provides a general overview of this new framework and considers its implications for many investment companies.