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Comment: Quis custodiet ipsos custodes?

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Charlie McCreevy, the European Commissioner responsible – albeit reluctantly – for the draft EU Directive on Alternative Investment Fund Managers, has announced plans for tighter regulatio

Charlie McCreevy, the European Commissioner responsible – albeit reluctantly – for the draft EU Directive on Alternative Investment Fund Managers, has announced plans for tighter regulation of custodians of Ucits funds with the aim of ensuring that they do a better job of protecting investors’ assets.

The move has clearly been prompted by the fallout from the Madoff scandal, in which investors in a Luxembourg fund, LuxAlpha, found that their investments had disappeared despite the protection supposedly afforded by the grand duchy’s rules governing the safekeeping of assets by a fund’s custodians.

Luxembourg has been pilloried by French investors and politicians for failing to implement and enforce EU rules adequately, although fund industry representatives say its regulations are virtually identical to those in France, where there have been similar cases (unconnected to Madoff) of fund assets going astray despite oversight by a custodian.

The European Commission says that EU fund rules have been transposed into national law in different ways, leaving some investors better protected than others. Whether this is true or not, the fund industry welcomes the idea of clarifying exactly what the duties of a custodian toward a Ucits fund should be.

Still, it should be careful. Hard cases make bad law, and the LuxAlpha affair is particularly tricky. Its custodian, UBS, has been accused of standing by, pocketing its fees, while billions of euros in investors’ assets disappeared into Madoff’s imaginary investment scheme.

The general rule in Luxembourg, according to its regulator, the Financial Sector Supervisory Authority (CSSF), is that a custodian has the obligation to return to investors the assets for which it has responsibility for safekeeping. However, this principle is subordinated to the terms of the custody contract, which can explicitly stipulate that the custodian has no such duty.

This was the case for LuxAlpha, according to UBS. The Swiss bank – which has just shed around 50 employees in Luxembourg against the backdrop of the Madoff affair and the impact on private banking business of the grand duchy’s decision to loosen its financial confidentiality rules, as well as falling revenues from fund services business – took on the fund after another custodian decided it did not wish to keep the business. UBS says it did so only under the express condition that it would not be under an obligation to make restitution to investors if things went wrong.

It can be argued, of course, that under these circumstances UBS should never have taken the business in the first place. The Luxembourg government and the CSSF have put pressure on the bank to ‘do the right thing’ by investors, although their powers to enforce this are limited.

The regulator did require UBS to demonstrate that it possesses the infrastructure and resources to carry out a custodian’s duties properly, under threat of action that could even have included suspension or loss of its licence, but last month the bank handed over a report setting out internal changes to its custody arrangements and procedures, to the CSSF’s satisfaction. It says that the courts may have to decide any question of investor compensation.

But if investors believe that new EU rules will confirm that the buck stops with custodians in the event of investment manager fraud or negligence, they may have another think coming. Quite simply, custodians are paid peanuts for their oversight duties (although they will in general earn more from providing third-party administration).

‘We receive just a handful of basis points for taking on investment banking-scale risks,’ says one Luxembourg custodian. ‘If we were effectively to provide insurance for investors, our charges would have to increase by a huge order of magnitude.’

The cost of paying a custodian to take on these risks would likely wipe out most investor returns. It may be, of course, that UBS will eventually be found to have acted so negligently that it has a legal liability to the LuxAlpha investors, but overall the responsibility for assessing and acting on the risks posed by managers, certainly those of non-Ucits funds, seems set to remain with investors. As arguably it should.

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