Securities Services: A matter of choice
Andrew Baker says the Alternative Investment Fund Managers Directive could restrict choice and impose some unreasonable burdens on depositaries
A good deal of the debate around the Alternative Investment Fund Managers
directive (AIFM) has focused on how the directive- as currently drafted - would affect hedge funds and their managers in third or non-EU countries. This is indeed an important and controversial issue, yet the proposed provisions relating to the concept of ‘depositaries' are no less contentious, and we have been working hard to push for changes.
What is proposed would dismantle the current hedge fund/prime broker/administrator model and replace it with something loosely based on the Undertakings for Collective Investments in Transferable Securities (UCITS) concept
Managers of non-UCITS funds employ a prime broker - a large bank or securities firm - to provide various execution, financing and back-office services to the fund, while a custodian physically holds the fund's assets. While depositaries are used in the UCITS space, the AIFM proposal aims to make the depositary regulation much more stringent by, for example, introducing a draconian concept of depositary liability or by severely restricting the freedom of the depositary to be able to delegate certain important functions to other service providers.
Such requirements undermine prime broker business models and may discourage some from performing a depositary role at all, reducing choice for managers and concentrating risk among a smaller group of players. This would run counter to the basic lessons learned from the collapse of Lehman Brothers.
And those banks that do decide to act as AIFM depositaries could be expected significantly to raise their fees as a result of taking on such liability. We are far from being alone in saying so: the Association of Global Custodians has said the AIFM could have "negative consequences for both investors and asset managers".
The AIFM depositary provisions are being discussed as part of the trialogue meetings involving representatives of the European Parliament's Economic and Monetary Affairs Committee (ECON), the Belgian presidency of the council of the EU and the European Commission (EC). On the negotiating table are the draft Parliamentary text and the draft council text - the two different versions of the directive, with their different approaches to depositaries and other issues.
Both texts require an appointment of a depositary, although each one takes a different approach to the issue.
In many areas, the council version is more sensible and pragmatic (for example, the council text allows for much greater flexibility in the delegation of custody tasks by the depositary to sub-custodians). But there remain three fundamental problems with both texts, which, when taken together, could lead financial institutions to withdraw from the market and curtail the choice available to managers.
The first of these problems relates to the depositary's location. Both the parliament and the council text require the depositary of an EU-based fund to have a registered office in the same EU country as the fund. This requirement is difficult to understand. It is one of many provisions copied from the UCITS directive that make little sense when applied to alternative asset managers. After all, most prime brokers are located not in the jurisdiction of the fund but in the jurisdiction of the fund manager.
Furthermore, the whole issue of using third country depositaries or entities that fulfil a depositary function is an extremely contentious issue in the negotiations. While the council allows for an exemption from the depositary requirement if the fund managed by an EU manager is established in a third country, the parliament text is much more restrictive.
The parliament text does allow for non-EU based depositaries, but only if a long list of requirements is met: the depositary must be a bank; the regulators of the manager and the fund must have signed a co-operation agreement; the fund's domicile must be subject to "effective prudential regulation and supervision"; the depositary is contractually liable to the manager and the investors of the fund; the fund's domicile meets financial action task force (FATF) standards on anti-money laundering and terrorist financing; and the manager's home country must have signed an OECD model tax convention agreement with the fund's domicile.
The second problem relates to delegation. The major lesson of the Lehman collapse was that managers should avoid using a single prime broker/custodian. Interestingly, both the council and the parliament texts require that managers appoint a single depositary. This means that the need to delegate custodial and prime broking activities in order to benefit from multiple prime brokerage services and gain access to global custodial networks is great.
The parliament text is restrictive as to whom the depositary may sub-delegate certain functions, as well as how long the chain of delegation may be. The council text is more sensible, saying that a depositary may delegate functions to a third party subject to having undertaken appropriate due diligence, and that the third party in turn may sub-delegate these tasks.
But even the council text contains provisions that are difficult to understand and which may pose unreasonable obstacles to designing an efficient and safe business model. For example, one condition that a depositary must meet to be able to delegate custody tasks is that there must be an "objective reason" for such a delegation. So far, nobody has been able to explain what this provision means and under what concrete circumstances will the depositary fulfil this condition.
Liability for losses
The third area of concern relates to the approach the two text take to depositary liability for investment losses. It would be preferable to apply a traditional form of commercial liability under which the depositary would be responsible for losses only if it had been guilty of gross negligence or a failure to perform its duties.
Under the parliament's version, the depositary would be liable to the manager and the investors in the fund for losses suffered as a result of the depositary's intentional or negligent failure to perform its obligations or its improper performance of them. However, where a financial instrument which is in the custody of the depositary is lost, the depositary will be liable unless the loss has been caused by an external unforeseeable event. This raises the question as to whether a depositary that is the only link in the chain between the fund and a local central securities depositary (CSD) would be liable for any losses occurring as a result of mistake at the level of the CSD.
Under the council text, the depositary must return, without undue delay, financial instruments held in custody in case of a loss of those instruments, irrespective of the reason for such a loss. The depositary then remains liable to the manager, fund and investors in the fund for any other losses (other than of financial instruments held in custody) suffered as a result of its failure to perform its obligations.
The council text states that a depositary may discharge its liability to a sub-custodian if it carried out proper due diligence of the sub-custodian, the sub-custodian agreed it could do so by contract, and if it is deemed reasonable for the depositary to have contracted out that liability. In all other circumstances, the depositary would still be liable for the losses.
Those exemptions are sensible But a mere cursory examination of the depositary articles shows that this remains a complex area where neither the true intention of the legislator nor how some of the proposed provisions will be applied in different member states is clear.
It is already obvious that some member states with clear divides between private and public law could find it difficult to implement legal provisions that attempt to establish a liability regime which determines the parties' liability ex-ante, without giving due regard to the particular circumstances in which losses or damages occur.
Indeed, it is not surprising that the parliament and council negotiators have failed to reach an agreement so far. It can only be hoped that a sensible and workable compromise is reached, and with the help of our contacts in council, the commission, the parliament and national governments, we are working hard to secure the best possible outcome for the industry.
Andrew Baker is CEO of the Alternative Investment Management Association (AIMA), the global hedge fund trade body