Global | Publication | December 2019
Indices play a crucial role in asset management, most clearly in passive investment, but also for measuring the performance of active funds and informing investment strategy. Contracting for indices has received relatively little attention, but there are specific market norms for this type of contract (which may at first seem unusual to those more used to other types of commercial contract) and there are a number of issues for the asset manager that merit careful consideration. This article considers some of the key issues to be addressed when negotiating an index license agreement and some practical steps for managing index licensing1.
Index license agreements are often structured as a suite of separate contracts. The structure varies by provider, but the core element is a license to receive the data itself (for example, index values on a real time or end of day basis or constituent files). This is often supplemented by additional documentation that grants rights such as the right to create derived data, the right to issue funds or products that track an index, rights for non-display use of the data (for example for algorithmic trading or for use in risk modelling) and rights to publish or distribute data. Finally, this is often supplemented by extra-contractual “living documents” such as usage policies, index rules or methodology documents (which often set out key principles on matters such as dealing with errors, recalculation and restatement).
First, this complexity means that the documentation must be reviewed in the round to ensure uniformity. For example, are the data license and fund license coterminous? Do the documents contain conflicting provisions or inadvertently double up on rights (for example, two separate provider audit rights)?
Further complexity is added when the documentation takes the form of a framework. It is often the case that individual datasets are purchased on a case by case basis under the same framework, with each order incorporating separate addenda and additional terms. This can create a patchwork of contractual documents that makes it difficult to keep track of the terms applicable to any one dataset and to ensure that the data is being used in compliance with the contract. This structure can also create risk of contamination, where a breach of the framework terms in one part of the customer’s business risks termination of the right to use a dataset that is crucial for the operation of another part of the customer’s business.
For customers that consume large volumes of data from the same provider, it may be worth consolidating the patchwork of contractual documents into a single master agreement that clearly sets out the applicable terms in one place. This exercise may also allow the customer to achieve savings by negotiating commercial terms in the round, rather than on a piecemeal basis.
The license to use the index is usually structured as a right to do certain things with the data accompanied by separate contractual restrictions. Structuring the license in this way allows the provider to enforce contractual restrictions (ie. covenants not to do certain things with the data) in order to protect its position rather than seek to rely on intellectual property rights (such as database right or database copyright), which are uncertain in the context of index data.
A key concern of the provider is likely to be control on leakage of data, as distribution of data to a third party potentially means that the provider is forgoing an opportunity to license that data to the third party for a fee. It is therefore common to see license terms that are limited to internal use only or limitations on rights to distribute.
The right to create derived data and ownership of derived data by the customer can also create leakage risk for the provider. If derived data effectively acts as a proxy for the original data, then this can be used instead of purchasing a license of the original data from the provider. On the other hand, the right to create derived data is often very important to the customer and can play a crucial role, for example in risk modelling. Definitions of derived data are often complex and heavily negotiated. A common concept is that the customer may only create and own derived data which does not act as a proxy for the original and cannot be reverse engineered to the original. When contracting for a right to create derived data it is important for the customer and provider to discuss the derived data that will be created in practice and ensure the derived data definition accurately describes this.
Going forward, it will be common for customers to find new use cases for their existing datasets. In this context it is crucial to ensure that license restrictions are properly recorded and tracked, as without proper management and record keeping the customer may find itself in breach of license restrictions and facing underlicensing claims from the provider.
Fund structures are often complex, involving multiple entities each of which may use an index in a slightly different way. Further, a breach of contract by the provider may lead to another entity in the structure suffering a loss. Regardless of which entity executes the documentation, care must be taken to ensure that each relevant entity in the structure has the neccessary rights under the contract.
A full discussion of the EU Benchmark Regulation is outside the scope of this article, but it should be noted that since it came into force, providers have been proposing various provisions to address the new regulatory landscape. For example, it has become more common to see extensive reporting obligations in index contracts because a benchmark is (in part) classified under the EU Benchmark Regulation by reference to the value of business linked to it. In some cases providers include provisions that explicitly prohibit the use of an index in such a way that it triggers a requirement to seek authorisation under the EU Benchmark Regulation.
Charging structures for indices tend to follow either a flat fee or volumetric model (for example, linked to the value of assets under management or value of contracts linked to the index). In volumetric models, care must be taken to ensure that the unit of count and method and regularity of calculation is clearly identified.
As index license agreements are often based on the provider’s standard terms, they tend to reflect the provider’s risk appetite. It is relatively common for such agreements to include an indemnity from the customer in favour of the provider for third party claims arising out of the customer’s use of the index. The purpose of this indemnity is to reallocate the downstream risk of claims (for example, claims from investors who may have suffered a loss as a result of investment in an index linked product) from the provider to the customer and to place the onus on the customer to include appropriate exclusions and disclaimers with their investors and counterparties.
In addition to the usual matters that need to be considered in relation to the liability provisions in a commercial contract (for example, the quantum of the caps and scope of exclusions), consideration should be given to any particular losses that might arise as a result of defaults or errors on the part of the provider. For example, in the context of an index-linked fund, is there scope to recover the costs of trades that must be made because an index has been restated to correct an error?
It is common for index license agreements to include audit rights in favour of the provider, in order to verify compliance with the contract and the charges. Frequent or extensive audits can prove disruptive and costly, so care should be taken to ensure that parameters are placed on audit in order to ensure that disruption is minimised (for example, by specifying that sufficient notice must be given and that audits must be conducted at appropriate times), as well as ensuring that confidentiality is maintained.
Index license agreements commonly include a requirement to include certain disclaimers and attributions where the index is referenced in issue documentation or reports, and may also require that such documentation is approved by the provider prior to distribution. It is understandable that the provider wishes to control the way that its products are presented (both from a reputational stand point and to manage liability to third parties) and it is in the interests of both parties to ensure that the characteristics of the index are accurately stated. On the other hand, lengthy review and discussion can prove an administrative burden and slow down time to market.
Where a fund or product is linked to an index, careful consideration will need to be given to notice requirements for termination. For example, if an index license is terminated while there are still open contracts linked to the index, this may prevent the issuer from accessing the data required to close those contracts. Likewise, if a fund is linked to or measures performance against an index, then it will take time to make the necessary notifications and (in the case of an index linked fund) the necessary trades to switch benchmarks following termination.
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