Introduction
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.
Contract Structure
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.
Key take aways
- Review the whole suite of
documentation for consistence.
- Consider consolidating documents
where possible.
License Terms
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.
Key take aways
- Ensure the scope of the license is
sufficient.
- Implement a data inventory to track
licensed datasets and the applicable
usage rights and restrictions.
Affiliates and group structures
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.
Key take away
- Consider whether any group
companies require third party rights
under the agreement.
EU Benchmark Regulation
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
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.
Key take away
- Pay careful attention to the drafting of
charging provisions when linked
to Assets Under Management or
product value.
Liability
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?
Key take away
- Consider the liability profile of the
index license agreement in light of
documentation with investors and
counterparties.
Audit rights
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.
Key take away
- Consider appropriate restrictions on
rights of audit in order to minimise
disruption.
- Consider the necessary protections for
customer and third party confidential
information.
Approval of documentation
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.
Key take away
- Agree the required disclaimer and
attribution requirements up front.
- Agree clear timelines for review of
documentation.
Termination
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.
Key take away
- Agree sufficient notice and/or “runoff” periods to carry out the necessary
exit activities.