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.
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.
Cost
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).
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.
Conclusion
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.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
