A Better Grasp of Non-financial Risks

The European Fund Management Industry Needs a Better Grasp of Non-financial Risks — December 2010

3. Risks and Responsibilities in the Fund Industry

euros are entrusted to sub-custodians. These sub-custodianship agreements are usually the responsibility of the depositary when they have brokered these agreements (in France, except for prime- brokerage agreements, they are always the responsibility of the depositary). The level-1 AIFM directive (EP 2010) was approved on 11 November 2010 by the European Parliament (at the time of writing, the Council had yet to endorse the directive, usually a nearly automatic step). Depositary liabilities are made stricter, since depositaries are fully liable for the restitution of assets—barring exemptions— and the burden of the proof is shifted to the depositary. The directive notes: “The depositary shall not be liable if it can prove that the loss has 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” (EP 2010). The practical definition of events that are beyond the reasonable control of depositaries and allow a “natural” exoneration of the liability of the depositary needs to be written in the yet-to-be-drafted level-2 directive. Depositaries can also be exempted from the obligation to return assets held in sub-custody if the exemption is provided for in the terms of the contract. 34 Because international funds rely on sub-custody, it is important that liability exemptions be workable. For assets that must be kept in local custody in countries with immature legal frameworks or no central securities depositories, exemptions, whatever technical forms they may take, should be automatic. Contractual exemptions may be

made explicitly workable in the end in the level-2 AIFM directive, but depositaries may find it hard to reword existing contracts, so, for some assets, exemptions should be made automatic by the directive. Exemptions should naturally be accompanied by oversight of sub-custodians. The first thing to do is ensure that assets in the accounts of the sub-custodian are segregated. Segregation is a strong guarantee that the depositary can recover investors’ assets entrusted to a failed custodian. But the return of assets held at a failed foreign institution depends on national law, which may not be compatible with EU laws. There are even discrepancies between country frameworks even in Europe: after the failure of Lehman Brothers, the UK bankruptcy code resulted in some assets held by Lehman being frozen, whereas at the same time French law required depositaries to return frozen assets immediately; 35 the claw-back clause in US law, by which the liquidator can require unit-holders to pay back undue profits earned in the six years preceding bankruptcy, may soon be another example of legal discrepancies. Shareholders of UCITS funds do not expect to have possible liabilities after they exit a fund. The demise of Lehman Brothers showed that sub-custody risk could be great even when well known and highly regulated institutions were involved; the EU should not rely on the pre-conception that sub-custodians other than prime brokers will never fail. Should exemptions for sub-custody risk not be workable, the failure of a large foreign sub-custodian would involve losses that exceed depositaries’ capital: the largest sub-custodian of the many large European depositary banks holds assets of a value

34 - The directive states: “provided (i) that the depositary is explicitly allowed to discharge itself from its liability subject to the condition precedent of a contractual transfer of such liability to that third party, pursuant to a written contract between the depositary and the AIF, or as the case may be, the AIFM acting on behalf of the AIF, in which such a discharge is objectively justified, and (ii) that the third party can indeed be held liable for the loss based on a contract between the depositary and the third party, the depositary can discharge itself in such a case of its liability if it can prove that it has duly performed its due diligence duties and that the specific requirements for delegation are met. By imposing the requirement of a contractual transfer of liability to the third party, the Directive intends to attach external effects to such contract, making the third party directly liable to the AIF, or as the case may be, the investors of the AIF, for the loss of the financial instruments held in custody” (EP 2010). 35 - As illustrated by the Lehman bankruptcy, segregation is less effective when investors have debt with the sub-custodian and when segregated assets can be reused.

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An EDHEC-Risk Institute Publication