AIFMD and the depositary liability

From a depositary perspective, Article 21 of the Alternative Investment Fund Managers Directive (AIFMD) is where the liabilities – and the opportunities – lie. The Article clearly defines the role of the depositary in the AIF industry within a Directive that is aimed at harmonising the way in which the industry is regulated. Every AIFM must ensure that a single depositary is appointed for each AIF that it manages.

On the part of the depositary, it must assume responsibility for monitoring an AIF’s cash flow (Article 21.7), safekeeping of an AIF’s, or AIFM’s acting on behalf of an AIF’s, assets (Article 21.8) and ensure that in reference to these two aspects of depositary duty, everything is conducted by the AIF’s or AIFM’s in accordance with the appropriate national law.

Whilst these processes of performing these functions and complying with Article 21 of AIFMD have been expensive and time consuming for depositaries, there is the risk of increased liability upon depositary shoulders under Article 21.12 – “The depositary shall be liable to the AIF or to the investors of the AIF, for the loss by the depositary or a third party to whom the custody of financial instruments held in custody… has been delegated.”

The depositary can delegate Article 21.8 – safekeeping of assets. “We are requesting a lot more information from our clients, especially around investment strategies,” says Peter Craft, EMEA head of trustee and depositary business at BNY Mellon. “If it is collateral, we are responsible for custody as well now so we want to see collateral agreements and assets being held with agents that we are comfortable with. We cannot insist that it is held at a CSD because we would be limiting the types of collateral that clients can use.”

As well as increased information for their clients, depositaries will also need to closely monitor their network of transfer agents, prime brokers and sub-custodians. “We have a pan-European compliance monitoring function with staff in Ireland, Luxembourg and the UK who have a table of visits with transfer agents, fund accountants and sub-custodians and produce annual, or bi-annual, compliance reports on them,” says Peter. “We have been doing this for years, but have intensified the custodian element of this due to the increased liability we are now facing as a result of AIFMD.”

Given that these processes have, out of reasons of basic competence, been in place for years, is the extended liability towards depositaries necessary? “I think that it is a consequence of the Madoff situation,” explains Peter. “The industry has always been liable for its negligence, malfeasance and plain stupidity – this is just a more digital way to keep track of it. The directive emphasises depositaries’ responsibilities. It is cutting down the delivery timeline of the restitution. Instead of going through actions and courts and looking at indemnities, it simplifies the process to a certain extent.”

There has, however, been some confusion and some differing interpretations as to the extent to which depositaries are liable and whether they can remove this liability from themselves. “The discharge of liability to a third party is, in my view, not welcomed by the regulator and if you have a look at the regulation detail, it is an extremely difficult thing to achieve,” suggests Peter. “The client must agree to it, the person you are discharging it to must agree to it and there has to be a proper process and reason for it. We see no proper process or reason for it in the UK. We have, therefore, taken on full restitution trustee liability for our UK AIFMD related clients for the type of funds we service.”

As well as Madoff’s much-publicised Ponzi scheme that cost the industry dearly, there were also elements of restitution in the Lehman Brothers collapse that took unacceptably long. That is why AIFMD is so keen that AIF’s assets are individually segregated in their safekeeping by the depositary. This makes it clear who owns what and, as Peter points out, simplifies the process.

The element of strict liability upon the depositary is only applicable, however, to European Union (EU) domiciled AIFs and AIFMs. As AIFMD is phased in, starting as it did in July 2013, non-EU funds will be incorporated into the Directive. At the moment, they can in some cases rely upon the Private Placement Regime (PPR) or reverse solicitation to market their funds to EU clients, but in July 2015, subject to the European Securities and Markets Authority (ESMA) approval, they will be eligible for the AIFMD passport, and by July 2018 the PPR will be abolished and they will have to be fully AIFMD compliant.

This phased approach has given rise to the depositary lite, or depo-lite, regime. The model is the same as for full AIFMD compliance, except the depositary does not have to assume strict liability for losses and the fund does not have to appoint a single depositary to cover points 7, 8 and 9 of Article 21.

“We are currently engaged in a number of detailed conversations with clients that require depo-lite services, whether that’s full depo-lite service or on a modular basis. It is down to what the client is looking for and it is absolutely about client choice,” says Peter. “The full service depo-lite model is where we will act as the depositary for sections 7, 8 and 9 of Article 21 under AIFMD. Alternatively, if you want to employ us for each section individually, we will look at doing that on a modular basis.

“We usually find it is Article 21.8 (safekeeping) where clients wish to deploy multiple depositaries as some products invariably have more than one custodian. The other services under 21.7 and 21.9 lend themselves to single appointments.”

The cost of full AIFMD depositary services and depo-lite services are very similar, owing to an almost identical operational impact upon the depositary. A lot of companies have established, or are establishing, depo-lite models, but with ESMA set to review AIFMD in 2015, there has been talk that it could abolish the depo-lite model. “There are an awful lot of people who have set up depo-lite models in the expectation that it is not going to end next year!” remarks Peter. “I think they may well keep it until 2018. It is a model that is an accommodation; you are a depositary or you are not a depositary; it is unclear exactly what ‘lite’ indicates.”

It is clear that non-EU AIFMs must appoint a depo-lite, but there is an issue for some EU domiciled funds where their Member State has not yet transposed AIFMD into national law and there are no depositaries within that jurisdiction. Article 21.5 states that, “The depositary shall be established… for EU AIFs, in the home Member State of the AIF.” Are the depositaries going to expand into these countries, such as Slovakia?

“We are very clear on our business model,” says Peter. “We have opened branches where we have need to and will expand further as required. We will look at other European opportunities, but it is unlikely they will be in, for example, Slovakia. We are likely to focus on the main markets like France, Spain, Italy and Switzerland.

“Those countries that have no depositaries may follow the example of Malta which, I believe, has taken a very pragmatic view on depositary domicile. As it stands at the moment there is no depositary passport so you have to be in the jurisdiction to provide the service. Malta will consider alternative depositary domiciles.”

There is the option for competent authorities to “refer the matter to ESMA” where they disagree with this assessment. If there is no depositary within the jurisdiction, then they surely have no other option.

BNY Mellon has enough on its plate readying itself in the markets in which it is operational for now. “It has been a huge undertaking,” asserts Peter when talking about preparing for AIFMD. “We have had our project committee on AIFMD running for around a year and a half now with every part of the business involved, including: custody, transfer agents, fund accounting, collateral. We have also consulted our extensive network of European depositary offices in Frankfurt, Brussels, Netherlands, Ireland, UK and Luxembourg. So there has been an enormous amount of time, money and energy spent to ensure that we are AIFMD compliant in all of these centres.”

This Directive has not just been a challenge for the buy-side. In amongst the challenges, however, there have been opportunities presented as companies that have not previously utilised depositary services are now mandated to do so. “The UK investment trusts have been a major opportunity for us,” says Peter. “In the Netherlands, there has been a massive opportunity with the pension funds that will be affected, as have hedge fund businesses in Ireland. Private equity is an area to watch, depending on how funds decide to adapt their activity. The depositary function is probably not a best fit for what private equity firms want to do. They bring a host of new asset classes and depositaries need to adapt quickly to service them.”

With the phased implementation of AIFMD and the phased obligation of non-EU funds to fully comply, AIFMD continues to evolve. The fact that it is a directive and not a regulation, has also led to some discrepancies over transposition. “Implementing Article 21.7, cash monitoring, has been our biggest challenge, because there is still confusion in the industry on what the European Commission’s vision is and whether we should, in effect, act as quasi fund accountants,” says Peter. “It is the biggest and most expensive change that is being brought about. Furthermore, certain jurisdictions have interpreted it in different ways, so there is no continuity.”

Whilst these challenges remain, to a certain extent, unresolved, what of the future? “There is some uncertainty around whether assets held with CSDs are subject to trustee restitution or not,” says Peter. “I think the next area that needs clarifying is around segregation of assets.”

With ESMA conducting a review of AIFMD in 2015, there will doubtless be more changes along the way.

Tags: AIFMDBNY MellonRegulationEuropean CommissionEuropean UnionESMA