UK: Financial Services Quarterly Report - Fourth Quarter, December 2010 (Part 2)

Last Updated: 11 January 2011
This article is part of a series: Click Financial Services Quarterly Report - Fourth Quarter, December 2010 (Part 1) for the previous article.


Annual Report

The Law will amend the current law to provide that the annual report (including the report of the auditor and the management report) will not need to be sent to the shareholders of a corporate UCITS or non-UCITS retail fund, together with the convening notice for the annual general meeting of shareholders. This cost-saving measure provides that the convening notice shall indicate the place and the practical arrangements for providing these documents to the shareholders and shall specify that each shareholder may request that the annual report be sent to such shareholder.

Record Date for Shareholders' Meetings

The convening notice for a general meeting of shareholders of a corporate UCITS or non-UCITS retail fund may provide that the quorum and the majority shall be determined by reference to the shares issued and outstanding at midnight (Luxembourg time) on the fifth day prior to such meeting (the "Record Date"). The Record Date would be an improvement for large funds with a large number of investors; for such funds, drawing up of the attendance list of the meeting is not always an easy task.

The important proposed change to allow cross-sub-fund investments has long been awaited by the Luxembourg fund industry.

Articles of Incorporation: Language Requirement

For registration purposes, the articles of incorporation of a corporate UCITS or non-UCITS retail fund drawn up in English must be followed by a translation in French or German. Once the Law becomes effective, if the articles of incorporation of such UCITS or non-UCITS retail fund are drawn up in English, it will no longer be necessary to attach a French or German translation.

Tax Change for Sale of Large Participations

If the tax law change set out in general terms in the Law enters into force, tax would no longer be imposed on any revenues that may result from the sale of shareholdings of more than 10% of the net asset value of a sub-fund of a corporate UCITS or non- UCITS fund held for less than six months.

Taxation of Exchange-traded Funds (ETFs)

UCITS or non-UCITS retail funds are generally subject to an annual subscription tax (taxe d'abonnement). This tax is 0.05 percent (0.01 percent in certain cases and with possibilities for exemptions), calculated on the basis of the total net assets at the end of each calendar quarter. The Bill provides that Luxembourg ETFs will be exempt from the payment of the subscription tax. As a consequence, Luxembourg ETFs would, in principle, not be subject to any taxes.

Provisions Regarding the Entry into Force of the Law

UCITS or non-UCITS retail funds will remain subject to the current law of 20 December 2002 regarding undertakings for collective investment, as amended, until 1 July 2011 and become subject to the Law only as of 1 July 2011, unless such funds elect to become governed by the Law earlier. It is currently anticipated that the Law will enter into force on 1 January 2011. All the tax provisions of the Law will have effect as of 1 January 2011, with retroactive effect to such date if the Law does not enter into force on 1 January 2011.

SEC Proposes Rules to Implement Dodd-Frank Investment Adviser Registration and Oversight Provisions Affecting U.S. and Non-U.S. Investment Advisers

Authored by Julien Bourgeois, Mike Sherman and Alpa Patel

The U.S. Securities and Exchange Commission ("SEC") on November 19, 2010 proposed rules under the Investment Advisers Act of 1940 ("Advisers Act") to implement certain provisions of the Private Fund Investment Advisers Registration Act of 2010 ("Advisers Registration Act"), which was enacted as part of the Dodd-Frank Act. The proposed rules, if adopted in their current form, will have far-reaching implications for registered as well as unregistered investment advisers (including discretionary managers), both in the United States and abroad. Most significantly, the SEC proposes to: (i) increase the asset threshold that U.S. advisers generally must meet in order to register with the SEC; (ii) clarify registration requirements for certain smaller U.S. advisers; (iii) define terms and requirements necessary to implement the Advisers Registration Act's exemptions for foreign private advisers, advisers to venture capital funds and "private fund"1 advisers with less than $150 million in assets under management ("AUM") in the United States; (iv) require all registered and certain exempt advisers to provide specific information about any private funds they manage; and (v) establish a mandatory, uniform method by which an adviser must calculate its AUM for various purposes under the Advisers Act ("Regulatory AUM").2

The proposed rules, if adopted in their current form, will have far-reaching implications for registered as well as unregistered investment advisers, both in the United States and abroad.

Exemptions from Registration Available to Private Fund Advisers and Non-U.S. Advisers

The Advisers Registration Act eliminates the "private adviser exemption" currently set forth in section 203(b)(3) of the Advisers Act, effective July 21, 2011. Currently, section 203(b)(3) exempts from registration any investment adviser that has fewer than 15 clients and does not hold itself out to the public as an investment adviser, provided that the adviser's clients do not include U.S. registered investment companies or business development companies. Historically, private fund managers, as well as many foreign advisers with limited U.S. activities, have relied on this exemption to avoid SEC registration, in part because each private fund managed is considered to be a single "client." With the elimination of this exemption, these advisers will generally be required to register with the SEC, unless another exemption applies.

While the Advisers Registration Act repeals the current section 203(b)(3) exemption, the Advisers Registration Act provides three new, albeit narrower, exemptions that may be available to certain advisers currently relying on the section 203(b)(3) exemption.

Foreign Private Advisers

The first exemption from registration provided by the Advisers Registration Act is an exemption for foreign private advisers ("Foreign Private Adviser Exemption"). The Advisers Registration Act defines a "foreign private adviser" as any investment adviser that, among other requirements: (i) has no place of business in the United States; (ii) has, in total, fewer than 15 clients and investors in the United States in private funds advised by the adviser; (iii) has aggregate AUM of less than $25 million attributable to clients in the United States (including U.S.-domiciled private funds) and U.S. investors in private funds advised by the adviser; and (iv) neither holds itself out generally to the public in the United States as an investment adviser, nor advises U.S. registered investment companies or business development companies.

Although the Foreign Private Adviser Exemption is likely to be viewed as the most attractive of the three new exemptions because foreign private advisers are subject to fewer regulatory requirements than advisers relying on the other new exemptions,3 the Foreign Private Adviser Exemption is quite narrow and likely to be unavailable to most foreign advisers who accept clients or investors in the United States. Each of the strict conditions set forth above must be met in order for an adviser to rely on the exemption (i.e., if an adviser has 15 or more clients/investors in the United States, it cannot rely on the exemption, even if the assets attributable to those clients/investors is below $25 million and, similarly, if an adviser has $25 million or more in assets attributable to clients/ investors in the United States, the exemption is unavailable even if all of those assets are attributable to a single client/investor). As a result, a foreign private adviser must carefully and continually monitor and limit both (i) the number of clients and/or investors in the United States and (ii) the amount of assets attributable to such clients and/or investors.

The limit on assets attributable to clients and/or investors in the United States presents particular difficulty as the description of the $25 million limit in the proposed rules would not distinguish between such clients' or investors' initial commitment of capital to the adviser's management and subsequent increases to such capital resulting from an adviser's successful asset management. This may force a foreign private adviser to choose between registering with the SEC and terminating a client relationship or expelling an investor when it appears that the asset threshold is in danger of being breached. It is likely, therefore, that the Foreign Private Adviser Exemption will be of most use not to advisers that seek U.S. business, but instead to advisers who service U.S. persons only as an accommodation.

Venture Capital Fund Advisers

The second exemption provided by the Advisers Registration Act is available to certain advisers to venture capital funds ("Venture Capital Fund Exemption").

The SEC proposes to define a "venture capital fund" as a fund that:

  • is a private fund, as defined by the Advisers Registration Act;
  • invests in equity securities of "qualifying portfolio companies"4 in order to provide operating and business expansion capital;
  • has acquired at least 80% of its equity investment in each qualifying portfolio company directly from the qualifying portfolio company;
  • directly, or through its investment advisers, offers or provides significant managerial assistance to, or controls, the qualifying portfolio company;
  • does not borrow or otherwise incur leverage in excess of 15% of the fund's capital contribution and uncalled committed capital, and any such leverage is for a non-renewable term of no longer than 120 calendar days;
  • does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances; and
  • represents itself as a venture capital fund to investors.5

Although the proposed rule implementing the Venture Capital Fund Exemption would not explicitly preclude reliance on the exemption by an adviser whose principal office and place of business is outside of the United States, the availability and utility of this exemption for foreign advisers is unclear. As a result, non-U.S. managers of venture capital funds (as well as U.S. managers of venture capital funds that invest in companies located outside of the United States) may wish to comment on a number of provisions of the proposed rule (as well as possible changes to the proposed rule suggested by the SEC's requests for comments) that may ultimately make reliance on this exemption difficult or impossible for these advisers. First, unlike the Private Fund Adviser Exemption discussed below, the proposed rule as currently drafted would not allow a non-U.S. adviser to rely on the exemption unless all of its clients (wherever located) meet the definition of a venture capital fund. Second, while the proposed rule would allow a venture capital fund to hold U.S. Treasuries for cash management or similar short-term purposes, a non-U.S. venture capital fund (which would typically not invest in "U.S. Treasuries") would not be able to invest in similar sovereign debt issued by its home jurisdiction. Third, the SEC's requests for comments include whether the exemption should be limited to funds that are formed under U.S. law and/or that invest only in U.S. companies.

Private Fund Advisers with less than $150 Million AUM in the United States

The third and final exemption provided by the Advisers Registration Act exempts from registration any adviser who acts solely as an adviser to certain private funds, provided such adviser's AUM in the United States is less than $150 million ("Private Fund Adviser Exemption"). Consistent with the current rule for counting clients, which requires U.S. advisers (i.e., advisers with their principal office and place of business in the United States) to count all clients worldwide while allowing non-U.S. advisers to count only their U.S. clients, the SEC's proposed rule implementing the Private Fund Adviser Exemption would allow non-U.S. advisers to disregard any account that is not either (i) managed from within the United States or (ii) an account of a U.S. person that is not a "qualifying private fund,"6 while requiring a U.S. adviser to consider all of its management activities worldwide. Specifically, under the proposed rule, a U.S. adviser: (i) would not be permitted to advise any client that is not a qualifying private fund; and (ii) could not exceed $150 million in total Regulatory AUM, regardless of where the adviser's qualifying private funds are domiciled or where the management activity occurs. By contrast, a non-U.S. adviser: (i) would satisfy the requirement to advise solely qualifying private funds, provided that no client other than a qualifying private fund is (a) a U.S. person or (b) managed from a place of business in the United States; and (ii) would count only those assets that are managed from a place of business in the United States toward the $150 million limit.

Summary of Implications for Non-U.S. Advisers

  • "Foreign Private Advisers" are exempt from registration, Form ADV reporting and recordkeeping requirements, but are still subject to the anti-fraud provisions of the Advisers Act and certain (but not all) rules thereunder.
  • As proposed, non-U.S. advisers to venture capital funds that are unable to meet the Foreign Private Adviser Exemption may rely on the Venture Capital Fund Exemption if all of their clients (U.S. and non-U.S.) meet the definition of a venture capital fund; however, such advisers:
  • would still be required to report to the SEC on the Proposed Amended Form ADV and would still be subject to certain substantive, anti-fraud and recordkeeping requirements as well as SEC examinations; and
  • should carefully review and consider commenting on the proposed rules related to the Venture Capital Fund Exemption.
  • Non-U.S. advisers to private funds that are unable to meet the Foreign Private Adviser Exemption can rely on the Private Fund Adviser Exemption, and would be required to count only assets managed from a place of business in the United States to determine whether they have Regulatory AUM under $150 million for purposes of the Private Fund Adviser Exemption. Investment advisory activity occurring outside of the United States, even if such advisory activity relates to private funds that are domiciled in the United States or that have U.S. investors, could be excluded for purposes of relying on the Private Fund Adviser Exemption.
  • A non-U.S. adviser that manages from the United States, or for a U.S. person, any account that is not a qualifying private fund would not be eligible for the Private Fund Adviser Exemption.
  • Even if the Private Fund Adviser Exemption applies, the adviser would still be required to report to the SEC on the Proposed Amended Form ADV and would still be subject to certain substantive, anti-fraud and recordkeeping requirements as well as SEC examinations

Non-U.S. (as well as U.S.) advisers relying on the Private Fund Adviser Exemption would, as discussed below, be required to file certain information with the SEC and remain subject to limited substantive requirements under the Advisers Act as well as SEC examination authority. In this regard, the SEC's treatment of non-U.S. advisers is not surprising, given the existing "Regulation Lite" approach, under which a non-U.S. adviser to offshore funds has been able to avoid many of the substantive provisions of the Advisers Act, but has been required to register with the SEC as an investment adviser.7 However, in contrast to Regulation Lite, under the proposed rule a non-U.S. adviser could rely on the Private Fund Adviser Exemption while managing any number of U.S. domiciled qualifying private funds together with any number and kind of clients that are not U.S. persons, provided that: (i) without regard to where management activities take place, every client that is a U.S. person is a qualifying private fund; and (ii) with respect to assets managed from within the United States: (a) all such assets are attributable to qualifying private funds and (b) the total value of such assets does not exceed $150 million. As a result, this exemption may be available to non-U.S. advisers who do not service U.S. clients other than private funds, but are unable to meet the more restrictive Foreign Private Adviser Exemption because, for example, the adviser has significant investments by U.S. persons in an offshore fund.

Reporting Requirements for Certain Exempt Advisers

The Advisers Registration Act requires advisers relying on the Venture Capital Fund Exemption or the Private Fund Adviser Exemption ("Exempt Reporting Advisers") to submit, and update at least annually, certain reports to the SEC disclosing organizational and operational information, including:

  • basic identifying information;
  • other business activities engaged in by the adviser and its affiliates, and information about potential conflicts of interests; and
  • the disciplinary history of the adviser and certain of its related persons and personnel.

The information reported by Exempt Reporting Advisers will be used by the SEC to determine whether the activities of an Exempt Reporting Adviser warrant further SEC attention, as these advisers would be subject to examination by the SEC.

In connection with these requirements, the SEC proposes to amend Form ADV ("Proposed Amended Form ADV") to serve as a registration form for registered advisers and a reporting form for Exempt Reporting Advisers. Exempt Reporting Advisers would file the Proposed Amended Form ADV with the SEC through the Investment Adviser Registration Depository system that is currently used by registered advisers. Exempt Reporting Advisers would be required to pay a filing fee and all reports filed on the Proposed Amended Form ADV would be publicly available through the SEC's Investment Adviser Public Disclosure website. Notably, the proposed rules do not require Exempt Reporting Advisers to complete the entire Form ADV and such advisers would not be obligated to prepare, file or deliver to clients the narrative brochure required of registered advisers by Part 2 of the Form ADV. The SEC also proposes amendments to Form ADV applicable to all registered advisers, as well as Exempt Reporting Advisers, that would require specific disclosure regarding, among other things, any private fund advised by the adviser. These reporting requirements would apply to non-U.S. advisers required to file a Proposed Amended Form ADV, but the reporting requirements would only be applicable to private funds organized in the United States or that are offered to, or owned by, U.S. persons.

Exempt Reporting Advisers will also be subject to certain recordkeeping rules as determined by the SEC. The SEC has indicated that it will propose such recordkeeping rules in a separate rulemaking. Most importantly, Exempt Reporting Advisers will also be subject to the anti-fraud provisions of the Advisers Act and certain (but not all) of the rules thereunder and will be subject to examination by the SEC.


The public comment period for the proposed rules ends on January 24, 2011, after which time the SEC will finalize the rules. If the proposed rules are implemented substantially as they are proposed, most advisers can expect to be affected. Advisers that are currently unregistered should begin to consider whether they will be required to register (and if so, whether with the SEC or one or more states) or whether they can rely on an exemption. Advisers that are currently registered with the SEC should determine whether they have sufficient assets (or otherwise will be eligible) to remain registered with the SEC or whether one of the new exemptions would allow them to avoid remaining registered if they so desire. Those advisers who expect to register, or rely on either the Private Fund Adviser Exemption or the Venture Capital Fund Exemption as Exempt Reporting Advisers, should consider what information they will need to compile to complete applicable portions of the Proposed Amended Form ADV and what additional recordkeeping or compliance steps will be necessary given their expected status under the Advisers Act. Advisers should also consider responding to the SEC's requests for comments, in order to influence the final rules and to seek clarification on certain points in the SEC discussion that will accompany the final rules.

For further information regarding the rule proposals, please see December 2010 DechertOnPoint "SEC Proposes New Investment Adviser Oversight Rules" at Proposes_New_InvestmentAdviser.pdf .


1 The Advisers Registration Act defines the term "private fund" as an issuer that would be an investment company for purposes of the Investment Company Act of 1940 (the "Investment Company Act") but for Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act, which captures most investment funds sold through private placements in the United States, including foreign retail funds sold in the United States on a private placement basis.

2 Advisers should focus carefully on the SEC's proposed methodology for determining Regulatory AUM, as an adviser's Regulatory AUM may be the determining factor as to whether, and with which regulator (i.e., the SEC or state regulatory authorities), the adviser is required to be registered. While the proposed methodology is based on the current instructions for calculating AUM for Form ADV reporting and other purposes, changes proposed by the SEC could have the effect of requiring private fund (and other) managers to report significantly higher AUM than under the current methodology. As proposed, an adviser must include in Regulatory AUM the value of securities portfolios receiving continuous and regular supervisory or management services from the adviser. An adviser would also be required to include in its Regulatory AUM the value of any private fund it manages, even if the private fund was not a securities portfolio (and instead principally invested in commodities, real estate or other non-securities assets), including the value of any uncalled capital commitments to its private funds. Additionally, in contrast to the current calculation of AUM for purposes of Form ADV and various registration thresholds under the Advisers Act, an adviser would no longer be permitted to exclude from Regulatory AUM: (i) proprietary assets; (ii) accounts for which no compensation is paid to the adviser; or (iii) accounts managed for clients that are not U.S. persons.

3 While foreign private advisers are exempt from registration, they would still be subject to the anti-fraud provisions of the Advisers Act and certain (but not all) rules thereunder. By contrast, as discussed in the text, advisers relying on the Venture Capital Fund Exemption or the Private Fund Adviser Exemption are, in addition to the anti-fraud provisions, subject to public reporting, recordkeeping and other requirements (including being subject to the SEC's general examination authority) that are in excess of those imposed upon foreign private advisers.

4 A "qualifying portfolio company" would be defined generally as any company that, among other things: (i) is not publicly traded (nor controls, is controlled by, or is under common control with, a publicly traded company) at the time of investment by the private fund; (ii) does not incur leverage in connection with the investment by the private fund; and (iii) is in the nature of an operating company rather than a pooled fund.

5 Because existing funds may be unable to adjust their terms or portfolio holdings to meet each of these elements of the definition, the proposed rule includes a grandfathering clause that would be available if the fund: (i) was held out to investors as a venture capital fund at offering; (ii) sold securities to at least one investor prior to December 31, 2010; and (iii) does not sell any securities or accept any additional capital commitments after July 21, 2011.

6 A "qualifying private fund" would be defined as any private fund that is not registered under the Investment Company Act and has not elected to be treated as a business development company.

7.See, ABA Subcommittee on Private Investment Companies, (pub. avail. Aug. 19, 2006). Although the SEC has not indicated whether it intends to withdraw Regulation Lite or certain related guidance, as a practical matter, if the proposed rule is adopted in its current form, non-U.S. advisers that qualify for the new Private Fund Adviser Exemption should prefer this exemption to Regulation Lite in that, under the proposed rule, a non-U.S. adviser would enjoy slightly more freedom in structuring its management activities by advising domestic private funds while, arguably, being subject to a slightly reduced regulatory burden in that, as discussed in the text, an adviser relying on the new exemption would not be considered to be a registered investment adviser nor required to complete and file Form ADV, Part 2 (a narrative brochure describing business activities, fees and conflicts).

French Financial and Banking Regulation Law Enacted in Response to the Financial Crisis

Authored by Olivier Dumas and Christophe Garcia

The French Parliament recently voted to enact legislation that seeks to address many of the perceived causes of the financial crisis and its effects on the financial system. The Financial and Banking Regulation Law (Loi de Régulation Bancaire et Financière) of October 22, 2010 (the "Law") contains six main measures: (1) creation of the Council of Financial Regulation and Systemic Risk (Conseil de Régulation Financière et du Risque Systémique—the "Council");1 (2) enhancement of the powers of the Financial Markets Authority (Autorité des Marchés Financiers—the "AMF"—French regulator); (3) implementation of a new financial supervisor authority; (4) regulation of derivative instruments and short sales; (5) regulation of credit rating agencies; and (6) reinforcement of the regulation of providers of financial products and services.

Creation of the Council of Financial Regulation and Systemic Risk

The Council will be a public authority composed of eight members, including representatives of the Banque de France, the AMF and the Autorité des Normes Comptables (Standards Accountant Authority). The Council's role will be to: ensure cooperation and information exchange between the different financial authorities in France, monitor the financial markets, evaluate systemic risk, facilitate coordination between international and European standards, and express any opinion or position that it may consider relevant. The Council was created to address the causes and effects of the financial crisis and ensure that French measures are consistent with the European and U.S. responses to the financial crisis. The Council will have no power to make decisions, but may advise the French government on decisions.

Enhancing the Powers of the AMF

The Law contains several provisions that enhance the authority of the AMF. The French regulator aims to protect investors and ensure that market information is accurate and the market functions properly. In addition, the AMF is now required to take into account European standards and practices and cooperate with other European regulatory authorities. In the case of exceptional circumstances threatening the stability of the financial system, the president of the AMF will be authorized to restrict the terms of trading of financial instruments for a maximum of 15 days. As a consequence, in the case of a systemic risk, the AMF may impose restrictions on transactions in certain financial instruments. The new regulations also reinforce the AMF's authority to impose penalties. In particular the AMF's General Secretary Assistant (Secrétaire General Adjoint) can determine whether to initiate investigations; a member of the AMF's College (internal committee of the AMF, with several powers of decisions) has been authorized to attend the meetings of the Commission des Sanctions (AMF's Penalties Committee); penalties have been increased from €10 million to €100 million for corporations and from €1.5 million to €15 million for individuals; and the penalties will now be made public, except if the publicity of the decision may seriously affect financial markets or may cause disproportionate damage to the parties. One of the key provisions of the Law empowers the AMF to apply a settlement procedure in case of non-compliance with the regulations. The parties and the AMF's President also have the right to appeal the decisions of the AMF Commission des Sanctions (an independent committee within the AMF, separate from AMF's department in charge of inquiries and prosecutions).

Implementation of a Prudential Supervisor

The Law ratifies the creation in January 2010 of the French entity called Autorité de Controle Prudentiel (the "Authority") and makes some changes to its system. The Authority, which resulted from the merger of four regulatory entities in the banking and insurance field, was created in order to preserve the stability of the financial system; protect clients, investors and insured persons; and regulate professionals under its authority. Its main role is to supervise the activities of banking and insurance in France. The major changes effected by the Law relate to the composition of the Authority (an increase from 16 to 19 members), the penalty process (e.g., increase of the penalty amounts, establishment of a rapporteur in charge of the investigation procedure, and public disclosure of sanctions) and granting right to the Parliament to conduct inquiries.

Regulating Derivatives Instruments and Short Sales Derivatives

French law has traditionally punished "market abuses" (e.g., insider transactions, market price manipulation and misinformation) relating to financial instruments traded on regulated markets The new regulation extends the AMF's authority to include financial instruments "related to one or several financial instruments traded on a regulated market." As a consequence, market abuse involving derivatives instruments will be punishable; this provision applies in particular to credit default swaps.

Short Sales

In response to criticisms of short selling practices during the recent financial crisis, a new provision in the French monetary and financial code will prevent a seller from short selling financial instruments traded on a regulated market if the seller does not have for its own account sufficient financial instruments to cover the seller's position or if the seller has not taken necessary measures with a third party to have "reasonable assurance" for the seller's ability to deliver the financial instruments. In addition, delivery times have been reduced.

The reforms should seek to reach a balance between the drive for regulation and the need to ensure Paris' competitiveness as a financial center.

Although this restriction does not apply to financial instruments that are not traded on a regulated market or to buyers, the government and the AMF may, in the future, provide for comparable restrictions to cover such instruments and cover buyers.

Monitoring Credit Rating Agencies

In light of the role played by credit rating agencies in the recent crisis, the Law is designed to increase regulation of such agencies. As a consequence, the AMF will be the competent authority for the registration and supervision of such agencies. In addition, new article L.544-5 of the French monetary and financial code establishes a mechanism of civil liability (responsabilité délictuelle et quasi-délictuelle) that applies to credit rating agencies in case of fault or negligent failure resulting in damages for their clients or third parties. Moreover, any clause excluding such liability is prohibited.

Reinforcing the Obligations of Professional Sellers of Financial Services and Products to their Clients


The Law has consolidated statutes regulating activities of various intermediaries involved in the provision of financial products and services. The Law covers, among others: intermediaries in banking transactions and payment services (intermédiaires en opération de banque et en services de paiement), financial investment advisors (conseillers en investissement; these are not professionals regulated as investment services providers – prestataires de services d'investissements, or "PSI"), and tied agents (agents lies), by listing them as professionals subject to a common requirement to be registered. This list of professionals will be managed by the Agency for the Register of Insurance Intermediaries (Agence pour le Registre des Intermédiaires en Assurance, or "ORIAS"). ORIAS is in charge of verifying that theses professionals comply with applicable regulations.

Direct Marketing

Regulation of direct marketing activities (démarchage) has been expanded to a cover larger number of financial participants, including intermediaries in banking transactions and payment services and tied agents. In particular, tied agents are now allowed to directly market financial services to the public through any means, including telephone, email and direct contact at the clients' residences. In addition, the Law states that persons can now carry out direct marketing activities on behalf of banking and financial services providers, within the limits of the services, transactions and products for which the principal has been approved. These regulations are designed to increase professionalism and the responsibility of participants in the field of marketing financial services and products.


The Law is just one part of the French government's response to the financial crisis and the systemic risks that contributed to it. It is a first step in regulatory reform of the financial sector that, among other processes, will involve France's implementation of the EU's UCITS IV and AIFM Directives. However, any efforts made by the French authorities to significantly increase the level of regulation should be tempered by the need to avoid excessive constraints for professionals. In addition, the reforms should seek to reach a balance between the drive for regulation and the need to ensure Paris' competitiveness as a financial center.


1 Articles L.631-2 et seq. of the French monetary and financial code.

Depositary Liability Under the EU AIFM Directive

Authored by Jim Baird

The European Alternative Investment Fund Managers Directive (the "AIFM Directive" or the "Directive") will, for the first time, impose European-wide regulatory standards on Alternative Investment Fund Managers ("AIFM"). The Directive, which was first proposed in April of last year, has been highly controversial and politically driven. Each of the numerous iterations published since April of last year has stimulated fierce debate over a range of issues, and there has been significant change in the Directive during its passage through the legislative process.

While much attention has focused on the restrictions on management and marketing rights for third country AIFM and Alternative Investment Funds ("AIF"), the provisions relating to depositaries are also of critical importance (and while the impact may not be as immediately visible as the third country restrictions, the cost and other implications are potentially more than just statistically significant).

Requirement for a Depositary

While EU retail funds established under the so-called "UCITS" regime are required to appoint a depositary, until now there has been no equivalent requirement for alternative funds in Europe. The provisions now introduced in Article 21 of the AIFM Directive will require each AIFM authorised under the Directive to ensure that each AIF it manages, has a single depositary.

The provisions specify the categories of entities that may act as depositary. For EU AIF, the depositary must be an EU credit institution, a MiFID investment firm or a UCITS approved depositary. For non-EU AIF, the depositary must be an entity of a similar nature and be subject to effective prudential regulation and supervision of the same effect as that applying to EU credit institutions or MiFID investment firms.

The depositary for an EU AIF must be established in the home Member State of the AIF. For non-EU AIF, the depositary must be established in the jurisdiction where the AIF is established (or alternatively the EU Member State where the AIFM is located or regulated). For non-EU depositaries, there must be cooperation and exchange of information agreements in place between each Member State in which the AIF is to be marketed and the third country of the depositary. In addition, the depositary's third country may not be blacklisted by the Financial Action Task Force.

Responsibilities of the Depositary

Article 21 dictates certain activities for which the depositary must take responsibility.

The depositary will be required to hold "financial instruments" in custody if they can be registered in a financial instruments account or physically delivered to the depositary. For other assets the depositary must verify and record ownership by the AIF of the asset.

Each of the numerous iterations published since April of last year has stimulated fierce debate over a range of issues, and there has been significant change in the Directive during its passage through the legislative process.

In addition to the traditional depositary functions, the depositary will also be required to carry out certain functions based on parallel requirements for UCITS depositaries. These include: ensuring that the sale, issue and redemption of AIF units comply with the AIF's national law and its constitution; ensuring that the valuation of the AIF units is in accordance with applicable national law and the valuation procedures in Article 19 of the Directive; carrying out the instructions of the AIFM unless they conflict with the applicable national law or the AIF's constitution; ensuring that in transactions involving the AIF's assets any consideration is remitted to the AIF within usual time limits; and ensuring that the AIF's income is applied in accordance with the applicable national law and the AIF's constitutional rules.

There are additional obligations beyond the extended UCITS functions. These include ensuring that the AIF's cash flows are properly monitored, and that subscription and redemption payments and all cash of the AIF have been booked in cash accounts in the name of the AIF with qualifying institutions.

In the context of obligations on the depositary to "ensure" certain matters, there has been suggestion that this will be more in the nature of a supervision requirement than an obligation to procure the specified outcome.

Liability of the Depositary

There are a number of ways in which the liability of a typical AIF custodian acting as a depositary under the Directive will be impacted.

Strict Liability and Reverse Burden of Proof

The Directive imposes liability on the depositary for the loss of assets held in custody (whether held by it or by a sub-custodian) and limits the circumstances when this liability can be discharged. The Directive specifically requires the depositary to replace assets that have been lost with equivalent assets of a corresponding amount.

Under the Directive, the depositary can avoid liability if "it can prove" that "the loss had arisen as a result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary". The general concept of liability for depositaries mirrors that in the UCITS Directive. However, the Directive goes further than the UCITS Directive in some important respects (which seems inconsistent given the professional nature of AIFM investors where the justification for investor protection measures is very much reduced).

First, the broad scope of the liability and the limited exclusion mean that liability under the Directive could arise even where the depositary is not negligent or otherwise at fault. Under the UCITS regime, the depositary is not liable unless a loss arises from an "unjustifiable failure" on its part. Therefore, the Directive seems to impose more of a strict liability regime than even the retail benchmark set by the UCITS Directive.

Secondly, in order to avoid liability under the Directive, the consequences leading to the loss must have been unavoidable despite "all reasonable efforts to the contrary". Thus, the depositary will be liable unless it can show that it exhausted all reasonable steps which might have prevented the loss.

Thirdly, the burden of proof under the Directive now falls on the depositary to demonstrate that it satisfies the requirements in order to avoid liability. The combination of a reverse burden of proof applied in relation to the exhaustive test of having to show that all reasonable measures had been taken, creates an extremely onerous liability regime for depositaries.

In particular, it is not clear how the "all reasonable efforts" requirement will be interpreted. Would the depositary be required to have taken all reasonable steps to prevent the loss prior to it arising or would it be sufficient to show that all reasonable steps had been taken once the risk was identified?

Liability for Non-Custody Assets

For losses incurred by the AIF or its investors other than in relation to custody assets, the Directive provides that the depositary is liable where loss is suffered as a result of the depositary's negligent or intentional failure to perform its obligations under the Directive. Thus, for non-custody assets or losses related to the other required functions of the depositary, the extent of liability is closer to the market norm.

Scope of Activities and Standard of Care

In parallel with the express scope of depositary liability outlined above, the Directive imposes what appears to be a sort of standard of care by requiring the depositary (and the AIFM) to act "honestly, fairly, professionally, independently and in the best interests of the AIF and the investors of the AIF".

It seems unlikely that this provision would reduce the existing standard of care for negligence in any Member State (where domestic law would continue to apply as normal), although it does seem to have the potential to raise the standard of care required and give rise to claims where none existed before.

In addition, extending the duty of care to both the AIF and its investors may distort the normal position of the depositary acting in the interests of the AIF as its direct client.

Liability for Third Country Depositaries

The Directive permits the appointment of third country depositaries for third country AIF managed under the Directive. In such cases, as the depositaries would not be subject to the laws of an EU Member State, the Directive requires that the depositary must agree to the Directive's liability provisions by contract. Thus, even though not in the EU, a broadly equivalent level of liability will apply as a contractual matter.

Liability on Delegation

The general position under the Directive is that the depositary's liability is not affected by delegation to a sub-custodian. However, the depositary can limit its liability for acts of sub-custodians if it can meet a number of detailed requirements including:

  • There must be a written contract between the depositary and the AIF permitting the discharge of liability.
  • There must be an "objective reason" for the discharge of the liability and the delegate must satisfy and continue to satisfy certain criteria (e.g., expertise, prudential regulation, audit and segregation of assets).
  • There must be a written contract between the depositary and the delegate "explicitly transferring the liability" and making it possible for the AIF or its investors (or the AIFM on their behalf) to make a claim against the third party in respect of loss of financial instruments.

If all the delegation pre-conditions cannot be met (and where local law requires that assets are custodied locally), sub-custody liability can still be excluded provided this is expressly permitted by the AIF's constitution, certain notice and consent requirements as regards the AIF have been met and the delegate assumes the liability as a matter of contract.

Typically custodians would limit their liability in respect of unaffiliated sub-custodians to losses arising from the custodian's negligence in appointment or supervision of the sub-custodian. Under the Directive, the liability will now be materially increased unless the depositary can pass on liability to the sub-custodian. Local custodians are likely to be reluctant to assume the higher European level of liability or will charge for doing so.

If liability is passed on, it is not clear how the requirement for the AIF or its investors to be able to claim directly against the sub-custodian would be achieved in practice. In addition, the reference to the investors claiming directly against the depositary or through the AIFM creates uncertainty for AIFM as to the nature of any obligation to bring a claim on behalf of investors.

Impact of the Changes

While depositaries have clearly been considering these issues for some time, the redevelopment of their business models is still very much an ongoing process and will undoubtedly be dependent on the detail that emerges from the so-called "Level 2" process (involving the passing of secondary legislation). However, one can speculate as to some of the potential impacts and how this might play out in practice.


One of the most obvious consequences of the depositary liability provisions is the potential for increase in costs. To the extent that the strict liability for custody of assets continues in its current form, it seems inevitable that there will be some impact on costs (and a portion of these will ultimately be passed on to end investors). The cost impact will, to a significant degree, be a factor of the relative increase in the risk arising from the increase in liability.

For developed markets where well-established sub-custodians are readily available, there may be a greater degree of comfort (and lower cost) than for emerging markets where qualifying sub-custodians may be harder to find. In addition, the impact for the depositary will be dependent on the willingness of sub-custodians to agree to assume liability responsibilities to the AIF (and the costs that they will charge for doing so).

The concentration of risk that would result from this would seem to be contrary to the intended purpose of the Directive (i.e., to reduce systemic risk) and have adverse consequences for the European fund industry.

It seems likely that custody services in higher risk jurisdictions will offer less choice and/or come at a higher cost (where the risk of loss of assets will be greater but the standard of liability under the Directive nonetheless remains unchanged).

Concentration of Risk

Another likely consequence is that large custodians with global custody networks will be better placed to address these difficulties and internalise the sub-custody risk. The result is likely to be that custody of European AIF assets becomes more concentrated among a smaller number of larger custodians who are better placed to manage the liability issues. The concentration of risk that would result from this would seem to be contrary to the intended purpose of the Directive (i.e., to reduce systemic risk) and have adverse consequences for the European fund industry.

Another presumably unintended consequence of the requirement to use qualifying custodians in third country jurisdictions is that exposure of all EU AIF assets in any given jurisdiction may be concentrated in a few custodians, or even a single custodian, able to meet the delegation criteria.

Prime Brokerage

While earlier drafts of the Directive made no reference to the concept of prime brokers, the versions leading up to and including the final version do contemplate prime brokers and the concept of rehypothecation (although the references give only very basic details).

The Directive provides that "a prime broker acting as counterparty to an AIF is not allowed to act as depositary for this AIF, unless it has functionally and hierarchically separated the performance of its depositary functions from its tasks as prime broker". The Directive also allows delegation of the custody tasks by a depositary to a prime broker, provided the normal requirements for delegation of custody functions are satisfied.

The Directive also provides that the assets may not be "re-used" (or rehypothecated) by the depositary or its delegate without the prior consent of the AIF.

Put together, these provisions would seem to provide scope for arrangements that would facilitate a functional prime brokerage arrangement. However, there will be issues to be addressed depending on which model is adopted.

Provided that the necessary segregation of functions can be achieved, the same entity could fulfil both the depositary and prime broker roles. However, not all entities will have the infrastructure to provide this range of services (particularly given the requirement for the depositary to be in the same Member State as the AIF). Combining the depositary and prime brokerage functions in this way, however, would tend to discourage the use of multiple prime brokers, an approach many funds have increasingly adopted in order to spread their risk.

An alternative model would be to have a separate depositary and one or more prime brokers (either appointed directly or as sub-custodians). However, a third party depositary is unlikely to appoint a prime broker as a sub-custodian unless it is able to divest itself of liability for loss of custody assets by the prime broker (particularly as the prime broker would typically have broad powers to demand re-use of custody assets).

There are issues for the depositary in retaining sufficient control over the custody pool (particularly in light of the strict liability for loss of assets) while also facilitating the constantly changing margin and collateral requirements of the prime brokers or other counterparts. If the increased liability for depositaries results in a need to retain greater control before releasing assets from the custody pool, this could result in more cumbersome and inefficient processes for providing collateral to support the fund's trading requirements.

Another, possibly unintended, consequence of the increased depositary liability is that funds may be incentivised to allow more flexible rehypothecation rights in order to reduce the associated cost. Finally, while the depositary can delegate its custody function, it cannot delegate other functions. Therefore, even where substantive custody functions have been delegated, the depositary would still have to monitor cash flows, redemptions and valuations.

Operational Issues

By virtue of the extension of the responsibilities the depositary is required to assume, potential liability would already have been increased. This is particularly the case given that some of the required activities are functions that historically have been carried out by administrators. It would therefore be necessary to put in place operational and control processes to ensure that these functions can be monitored.


While many were surprised by how far the AIFM Directive's liability provisions have extended (particularly in the way they leapfrogged the less onerous UCITS Directive's retail requirements), it would seem that the UCITS Directive requirements are likely to be conformed to match the AIFM Directive (and not vice versa).

At present, many industry participants are keeping a watching brief. However, increased custody costs seem inevitable, and the question is how significant any increase will be. A degree of concentration seems inevitable and a trend towards larger custodians also likely. The focus for now will be on seeking to ensure these issues are addressed in the Level 2 process.

* The author appreciates the input of Dick Frase regarding this article.

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This article is part of a series: Click Financial Services Quarterly Report - Fourth Quarter, December 2010 (Part 1) for the previous article.
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