James Tinworth, partner in the hedge funds practice, Stephenson Harwood

AIFMD: the depositary issue

By James Tinworth (pictured), partner in the hedge funds practice, Stephenson Harwood – Whilst there are many challenges posed by the EU’s directive on alternative investment fund managers (AIFMD), the ones that everyone seems to focus on are those regarding the AIFMD’s depositary requirements. This note looks at these requirements in more detail and considers the extent to which they are relevant to EU managers of non-EU AIFs and non-EU managers of AIFs.

1. EU managers of EU AIFs (from July 2013) 

For each EU AIF it manages, the AIFM shall ensure that a single depositary is appointed in accordance with Article 21of the AIFMD.

Who can be the depositary?

There are various requirements relating to who can be appointed as the depositary.  The depositary must be established in same EU Member State as the EU AIF, although EU Member States may allow credit institutions that are established in another EU Member State to be appointed as a depositary until 22 July 2017.  

A prime broker¹ acting as counterparty to an AIF shall not act as depositary for that AIF, unless it has functionally and hierarchically separated the performance of its depositary functions from its tasks as prime broker and the potential conflicts of interest are properly identified, managed, monitored and disclosed to the investors of the AIF. Delegation by the depositary to such a prime broker of its custody tasks is allowed if the relevant conditions described below are met.  

An AIFM shall not act as depositary. 

Main duties of the depositary

Monitoring of cash flows
The depositary shall in general ensure that the AIF’s “cash flows” are properly monitored. In particular, the depositary shall ensure that:

  1. All payments made by or on behalf of investors upon the subscription of units or shares of an AIF have been received
  2. All cash of the AIF has been booked in cash accounts opened (a) in the name of the AIF or (b) in the name of the AIFM acting on behalf of the AIF or (c) in the name of the depositary acting on behalf of the AIF at a suitable entity in the relevant market where cash accounts are required (provided that certain conditions are satisfied) 

Safe-keeping of financial instruments that can be held in custody
The depositary shall hold in custody (a) all financial instruments that can be registered in a segregated financial instruments account opened in the depositary’s books in the name of the AIF or the AIFM acting on behalf of the AIF, so that they can be clearly identified as belonging to the AIF in accordance

with the applicable law at all times and (b) all financial instruments that can be physically delivered to the depositary. 

The EU Commission’s Level 2 measures will provide more details on those financial instruments that can be held in custody. It is thought, however, that a derivative, a cash deposit, an investment in a privately-held company and an interest in a partnership will not be “financial instruments that can be held in custody”.  The big issue at the moment, however, is whether financial instruments, which can be held in custody, that are subject to security and title-transfer collateral arrangements should be considered to be in held in custody by the depositary.

1 The AIFMD defines a “prime broker” as a “credit institution, a regulated investment firm or another entity subject to credential regulation and ongoing supervision, offering services to professional investors primarily to finance or execute transactions in financial instruments as counterparty and which may also provide other services such as clearing and settlement of trades, custodial services, securities lending, customised technology and operational support facilities” 

The big issue at the moment, however, is whether financial instruments, which can be held in custody, that are subject to security and title-transfer collateral arrangements should be considered to be in held in custody by the depositary.

Safe-keeping of financial instruments that cannot be held in custody
The depositary shall verify the ownership of the AIF or the AIFM acting on behalf of the AIF of such assets and shall maintain a record of those assets for which it is satisfied that the AIF or the AIFM acting on behalf of the AIF holds the ownership of such assets.

Monitoring of AIF share/unit dealing
The depositary shall ensure that the sale, issue, re-purchase, redemption and cancellation of units or shares of the AIF are carried out in accordance with the applicable national law and the AIF rules or instruments of incorporation.

Monitoring (verification?) of NAV calculation
The depositary shall ensure that the value of the units or shares of the AIF is calculated in accordance with the applicable national law, the AIF rules or instruments of incorporation and the procedures laid down in Article 19 of the AIFMD.

Monitoring remittance of transaction consideration
The depositary shall ensure that in transactions involving the AIF’s assets any consideration is remitted to the AIF within the usual time limits.

Monitoring of application of AIF income
The depositary shall ensure that an AIF’s income is applied in accordance with the applicable national law and the AIF rules or instruments of incorporation.

Delegation by the depositary
The depositary may only delegate its safe-keeping functions and any such delegation will be subject to a number of conditions. In particular, and amongst other things:

  • the depositary must be able to demonstrate that there is an “objective reason” for the delegation (further details are to be provided in the EU Commission’s Level 2 measures)
  • the depositary must have exercised all due skill, care and diligence in the selection and the appointment of any third party to whom it wants to delegate parts of its tasks (further details to be provided in the EU Commission’s Level 2 measures)
  • the depositary must keep exercising all due skill, care and diligence in the periodic review and ongoing monitoring of any third party to whom it has delegated parts of its tasks and of the arrangements of the third party in respect of the matters delegated to it (further details to be provided in the EU Commission’s Level 2 measures)
  • the depositary must ensure that the third party meets a number of conditions at all times during the performance of the tasks delegated to it. These conditions include: 
    • the third party must segregate the assets of the depositary’s clients from its own assets and from the assets of the depositary in such a way that they can at any time be clearly identified as belonging to clients of a particular depositary (further details to be provided in the EU Commission’s Level 2 measures)
    • the third party must not make use of the assets without the prior consent of the AIF or the IFM acting on behalf of the AIF and prior notification to the depositary 
    • in respect of the delegation of safe-keeping of financial instruments that can be held in custody, the third party must be subject to effective prudential regulation, including minimum capital requirements, and supervision in the jurisdiction concerned and the third party must be subject to an external periodic audit to ensure that the financial instruments are in its possession, provided that:
      • where the law of a third country requires that certain financial instruments be  held in custody by a local entity and no local entities satisfy these requirements, the depositary may delegate its functions to such a local entity only to the extent required by the law of the third country and only for as long as there are no local entities that satisfy the delegation requirements, subject to the following requirements:
    • the investors of the relevant AIF must be duly informed that such delegation is required due to legal constraints in the law of the third country and of the circumstances justifying the delegation, prior to their investment; and 
    • the AIF, or the AIFM on behalf of the AIF, must instruct the depositary to delegate the custody of such financial instruments to such local entity. 

The third party may, in turn, sub-delegate safe-keeping functions, subject to the same requirements.

The use of most securities settlement systems should not be considered a delegation by the depositary.

Liability of the depositary

Loss of financial instruments that can be held in custody
The depositary shall be liable to the AIF or to the investors of the AIF, for the loss of such financial instruments by the depositary or by a third party to whom the custody of such financial instruments has been delegated.

The EU Commission’s Level 2 measures will specify the conditions subject to which and circumstances in which financial instruments held in custody are to be considered as lost.

In the case of such a loss, the depositary shall return a financial instrument of an identical type or the corresponding amount to the AIF or the AIFM acting on behalf of the AIF without undue delay.

The depositary shall not be liable only in the following circumstances:

  • 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”. The EU Commission’s Level 2 measures will specify what is to be understood to be such an external event.
  • (in case of a loss of financial instruments held in custody by a third party that is subject to effective prudential regulation, supervision and an external periodic audit to ensure that the financial instruments are in its possession), if it can prove that: 
    • all t he AIFMD’s requirements for the delegation of its custody tasks are met;
    • a written contract between the depositary and the third party (i) expressly transfers the liability of the depositary to that third party and (ii) makes it possible for the AIF or the AIFM acting on behalf of the AIF to make a claim against the third party in respect of the loss of financial instruments or for the depositary to make such a claim on their behalf; and
    • a written contract between the depositary and the AIF, or the AIFM acting on behalf of the AIF, expressly allows a discharge of the depositary’s liability and establishes the “objective reason” to contract such a discharge. The EU Commission’s Level 2 measures will specify what is to be understood to be such an objective reason. 
  • (in case of a loss of financial instruments held in custody by a third party that is not subject to effective prudential regulation, supervision and an external periodic audit to ensure that the financial instruments are in its possession), if the following conditions are met: 
    • the rules or instruments of incorporation of the AIF concerned expressly allow for such a discharge of liability by the depositary; 
    • the investors of the relevant AIF have been duly informed of that discharge and of the circumstances justifying the discharge prior to their investment; 
    • the AIF or the AIFM on behalf of the AIF instructed the depositary to delegate the custody of such financial instruments to a local entity; 
    • there is a written contract between the depositary and the AIF, or the AIFM acting on behalf of the AIF, which expressly allows such a discharge; and 
    • there is a written contract between the depositary and the third party that
      • (i) expressly transfers the liability of the depositary to that local entity and
      • (ii) makes it possible for the AIF or the AIFM acting on behalf of the AIF to make a claim against that local entity in respect of the loss of financial instruments or for the depositary to make such a claim on their behalf.  It is pretty clear that that acts and omissions of an unaffiliated sub-custodian will not be presumed to be “external” and that an event should be deemed “external” if it is not a result of an act or omission of the depositary or one of its sub-custodians to meet its obligations. Generally, hedge fund custodians only accept liability for their own negligent acts and omissions or those of their affiliated sub-custodians. In order to be hedge fund depositaries, these custodians will now have to accept liability (in the case of “lost” financial instruments held in custody at least) for their own non-negligent acts and omissions or those of their sub-custodians (whether affiliated or unaffiliated). Whilst a depositary may contractually transfer its liability in respect of a loss of a financial instrument held in custody to a sub-custodian in the manner described above, hedge fund sub-custodians will generally only accept liability for their own non-negligent acts and omissions. It is likely therefore that a hedge fund depositary will have to accept quasi-strict liability in respect of the loss of a financial instrument that can be held in custody.

Other losses
The depositary shall also be liable to the AIF, or to the investors of the AIF, for all other losses suffered by them as a result of the depositary’s negligent or intentional failure to properly fulfil its obligations pursuant to the AIFMD.

The Issues
The main concern is that having a depositary will increase an AIF’s operating costs. Whilst this increase may not, perhaps, be as high as originally feared, there will be an increase nonetheless. There will also be initial costs of compliance and even the documents and arrangements of “AIFMD-ready” EU AIFs such as Irish QIFs and Luxembourg SIFs will need to be amended. 

The other concern is that not many institutions will wish to be depositaries given, amongst other things, the quasi-strict liability in respect of the loss of a financial instrument that can be held in custody. Ignoring concerns about systemic risk, this will have an impact on choice and, given that there may only be six months between finalisation of the AIFMD requirements and implementation, the relevant entities will have more leverage when it comes to negotiating their terms of appointment.

The duty of the depositary to monitor/verify the NAV calculation has not received as much attention as the safekeeping functions but could be quite influential in shaping the post-AIFMD hedge fund structure. Finally, the AIFMD's treatment of collateral provided by an AIF needs to be monitored because, as things stand, depositaries may be required to treat third parties (e.g. brokers, collateral agents etc.) as delegates of the safe-keeping function whenever these third parties hold “financial instruments that can be held in custody” as collateral for either party to a particular transaction. At the very least, this could potentially cause large scale changes to all counterparty trading arrangements involving the use of collateral. 

2. Non-EU managers of EU AIFs (from July 2013-2015 – if the relevant provisions are introduced in 2015)

This will be left to the national law of the EU Member State of the EU AIF. Presumably, however, all of the AIFMD’s depositary requirements that would have applied to an equivalent EU manager would apply.

3. Non-EU managers of EU AIFs (from 2015 – if the relevant provisions are introduced)

All of the AIFMD’s depositary requirements will apply.

4. EU and non-EU managers of non-EU AIFs which are not marketed in the EU (from July 2013)

None of the AIFMD’s depositary requirements will apply.

5. EU managers of non-EU AIFs which are marketed in the EU without a marketing passport (from July 2013) 

None of the AIFMD’s depositary requirements will apply, although the AIFM must ensure that one or more entities (but not the AIFM itself) are appointed to carry out the duties of the depositary.

The depositary issue therefore is not just an issue where an EU AIF is involved. It should also be noted that the AIFMD expressly provides that EU Member States may impose stricter rules on an EU manager in respect of the marketing of units or shares of non-EU AIFs to investors in their territory.  Because of the polarised framework of the AIFMD, some EU Member States may require that all of the AIFMD’s depositary requirements would need to be satisfied before an EU manager could market a non-EU AIF in its territory. This will need to be monitored. 

  • In any event, the main duties of the depositary (which are described above) are: 
  • Monitoring of cash flows
  • Safe-keeping of financial instruments that can be held in custody
  • Safe-keeping of financial instruments that cannot be held in custody
  • Monitoring of AIF share/unit dealing
  • Monitoring (verification?) of NAV calculation
  • Monitoring remittance of transaction consideration
  • Monitoring of application of AIF income

From 2018 it may only be possible for EU managers to market non-EU AIFs in the EU with a marketing passport. In this case, all of the AIFMD’s depositary requirements will apply.

Issues
Whilst one or more entities must provide the safe-keeping functions of the depositary, crucially the AIFMD’s provisions relating to the depositary (chiefly, those relating to the liability of the depositary in respect of these functions and the delegation of these functions) do not apply.

At the very least, however, there will be initial costs of compliance as existing documents and  arrangements may need to be amended and new arrangements may need to be put in place. There will also be an increase in costs as, amongst other things, it would appear that a separate entity (a second administrator?) will need to be paid to verify the calculation of NAV by the administrator/external valuer.

It will be interesting to see how these requirements affect the standard hedge fund model where the prime broker would also act as the custodian and whether more hedge funds would elect to appoint a separate custodian (which is not a milllion miles away from appointing a full depositary).

6. Non-EU managers of non-EU AIFs which are marketed in the EU without a marketing passport (from July 2013)

None of the AIFMD’s depositary requirements will apply. On the face of the AIFMD, therefore, EU managers who market non-EU AIFs in the EU wihout a marketing passport would have to comply with more onerous requirements. It should be noted, however, that the AIFMD expressly provides that EU Member States may impose stricter rules on non-EU managers in respect of the marketing of units or shares of AIFs to investors in their territory and, presumably, most, if not all EU Member States will ensure that there is (at least) a level playing field for EU and non-EU managers.

From 2018 it may only be possible for non-EU managers to market non-EU AIFs in the EU with a marketing passport. In this case, all of the AIFMD’s depositary requirements will apply.

7. EU and non-EU managers of non-EU AIFs which are marketed in the EU with the marketing passport (from 2015 – if introduced) 

All the AIFMD’s depositary requirements (as described above) will apply, save that:

  • the depositary shall be established in (a) the non-EU country where the AIF is established or (b) the home Member State of the EU AIFM managing the AIF or (c) the “Member State of reference” of the non-EU AIFM managing the AIF.
  • the appointment of a depositary established in a non-EU country shall, at all times, be subject to the following conditions:
    • the competent authorities of the EU Member States in which the units or shares of the non-EU AIF are intended to be marketed, and, in so far as different, of the home Member State of the AIFM, have signed cooperation and exchange of information arrangements with the competent authorities of the depositary.  
    • the depositary is subject to effective prudential regulation, including minimum capital requirements, and supervision which have the same effect as EU law and are effectively enforced (further details are to be provided in the EU Commission’s Level 2 measures). 
    • the third country where the depositary is established is not listed as a Non-Cooperative Country and Territory by FATF.
    • the EU Member States in which the units or shares of the non- EU AIF are intended to be marketed, and, in so far as different, the home Member State of the AIFM, have signed an agreement with the non-EU country where the depositary is established which fully complies with the standards laid down in Article 26 of the OECD Model Tax Convention on Income and on Capital and ensures an effective exchange of information in tax matters including any multilateral tax agreements.
    • the depositary shall by contract assume the same liability to the AIF or to the investors of the AIF as that assumed by an EU depositary and shall expressly agree to comply with the AIFMD’s provisions regarding the delegation and sub-delegation of safe-keeping functions.

8. Smaller managers which are not required to be authorised under the AIFMD

This will be left to the national laws of the relevant EU Member States. Please refer to our briefing note titled “Smaller hedge fund managers and the AIFMD” for more information.

James Tinworth is a partner in the hedge funds practice, Stephenson Harwood. To contact James, please email: james.tinworth@shlegal.com or telephone +44 (0)20 7809 2082 www.shlegal.com

Further reading



Upcoming events

1 day 23 hours from now - Miami
1 day 23 hours from now - Dubai
1 day 23 hours from now - San Francisco
2 days 23 hours from now - Toronto
2 days 23 hours from now - New York

Upcoming training

Mon, 29/09/2014 (All day) - London
Thu, 02/10/2014 (All day) - London