Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry

Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry - December 2012

2. Key Topics on the European Regulatory Agenda

that harmonisation was a long-term goal requiring important efforts and instead advocated greater flexibility in the organisation of the depositary function through delegation and/or sub-custody arrangements (COM (2005) 314 and SEC (2006) 1451) as a cost-effective way to support the development of the UCITS market. 37 Recent traumatic events have thus radically modified the priorities of the Commission; clarifying and harmonising the duties and liabilities of depositaries became so urgent that these issues were dealt via the AIFM and the draft UCITS V Directives rather than a horizontal depositary directive. The AIFM depositary is liable to the AIF or its investors for assets lost in custody (unless “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.”); it is also liable for “all other losses suffered by them as a result of the depositary’s negligent or intentional failure to properly fulfil its obligations.” This liability regime is much more onerous that the one currently in force for UCITS 38 , especially since the delegated regulation 39 detailing the implementing measures of AIFMD give restrictive meanings to “external event” (e.g. the operational sphere of a depositary’s network of sub-custodians is not external; this comprises, inter alia, fraud, failure to implement the segregation requirement or other operational requirements. External events are thus restricted to Acts of Nature and acts of States.) and “reasonable efforts” (e.g. depositaries are required to identify, monitor, and assess risks of events deemed

beyond their control which could lead to a loss and to take appropriate action when needed (Article 101-1-(b) and (b) ); informing the AIFM of the risks identified may not be sufficient to discharge liability since the depositary is also expected to take “appropriate actions, if any, to prevent or mitigate the loss of financial instruments held in custody, where actual or potential external events have been identified which are believed to present a significant risk of loss of a financial instrument held in custody.” 40 (Article 101-1-(c)-(iii)). AIFMD allows contractual discharge when objective reasons to do so exist (Article 21(13) of the Directive) but requires a written contract to that extent between the AIF or the AIFM and the depositary as well as a written contract between the depositary and the third party transferring liability to the latter and allowing for the AIF or AIFM (or the depositary on their behalf) to make a claim against the third party in respect of the loss of financial instruments. When reliance on a sub-custodian that is not adequately regulated or supervised is unavoidable (which arises when the law of a third country requires that certain assets be safe kept by a local entity and there is no entity satisfying the Directive’s delegation requirements), delegation with liability discharge is still possible provided investors have received pre-contractual information on that discharge and its justification. The proposed Delegated Regulation clarifies that “the depositary shall be deemed to have objective reasons for contracting the discharge of its liability” when the fund manager insists “on maintaining an investment in a particular jurisdiction despite warnings by the depositary as to the increased risk this presents” (Article

37 - Article 23 of UCITS requires the depositary to either have its registered office or to be established in the UCITS home Member State; in other words, there is no passport for depositaries. 38 - At the same time, it may be less onerous that regimes already in force in Member States where domestic regulations create liabilities far in excess of the minimum harmonised standards of the UCITS Directives. 39 - To ensure uniform application of AIFMD, the Commission chose the form directive that would have required transposition by Member States with the usual risks thereof. 40 - In its technical advice to the commission, ESMA explained that the depositary should be required to make a judgment on whether the assets it considers at risk should be disposed, communicate it to the AIFM who then needs to make a decision and instruct the depositary in writing (V.V.2-34); still this may not be sufficient to discharge liability since ESMA invites depositaries whose warnings are ignored to request a transfer of liability to a sub-custodian or terminate their relationship with the AIFM (V.V.2-35). of a directly applicable regulation instead of a

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An EDHEC-Risk Institute Publication