The European Commission’s Alternative Investment Fund Managers Directive, (‘AIFMD’), and Undertakings for Collective Investment in Transferable Securities (‘UCITS V’), were introduced, in part, to provide greater comfort to the investment world in the wake of the Madoff scandal. These directives created a responsibility for the custodian community to engage in an increased level of monitoring and supervision of third-party service providers. Both regulations provided a framework where fund managers had to appoint a depositary for each fund, which would then assume responsibility for any administrative losses occurring to the investors in the fund. In order to discharge this liability, depositaries had to prove they were not negligent in the process that gave rise to the loss or intentionally failed to perform their tasks.
The appointed depositary would enter into a contractual relationship with the fund manager and, in turn, the fund manager would provide the depositary with a flow of information that would allow the depositary to perform its functions for the fund. Although, the regulations had created a completely new role for the depositaries, meeting the regulation created a massive amount of extra work.
Closer analysis of the wording of both these regulations created a wider issue:
AIFMD says: “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 ….”
UCITS V says: “the depositary is liable to the UCITS and to the unit-holders of the UCITS for the loss by the depositary or a third party…”
In both directives, it states the depositary is not only liable to the fund but “…to the investors/unit-holder of the AIF/UCITS.” It was apparent that depositaries were not only liable for the losses caused by a third party to investors of the fund where they had been appointed, they were also exposed to the losses of their own underlying investors who may invest in funds where they were not the appointed depositary. As the appointed depositary, (the ‘fund’ depositary), contractually they had access to data provided to them by the FMs, but the ‘investor’ depositaries, were no contract existed, were required to gather data without the assistance of a contractual support - a far more difficult prospect.
Even though neither AIFMD nor UCITS V actually mention ‘transfer agents’ or ‘transfer agency’, the depositaries honed in on these entities, as they were mostly unexamined links in the investment chain and therefore, carried a potentially significant level of exposure.
Transfer agents (TAs) maintain official ownership registries of funds, and settle cash movements, so are a key function in the investment process. The service is often seen as an unglamorous activity, offering low margins and buried deep in the infrastructure. The potential risk and exposure associated with the transfer agency had not always been understood or evaluated.
The investor depositaries were facing a significant data collection exercise. Without a contractual relationship with the third parties under review, to discharge their responsibilities the depositaries, they would have to obtain information from the TAs who had no legal or contractual requirement to supply it.
Many of these depositaries were familiar with Thomas Murray’s long-standing expertise with the post-trade infrastructures, and the technology used to meet similar monitoring requirements with global custodians, sub-custodians, prime broker, and central counterparties. Thomas Murray was perfectly placed to develop a solution.
In 2013, Thomas Murray, in conjunction with over a dozen European depositary banks, formed a working group charged with developing an industry-standard, risk-based questionnaire that would collect information about the TA, providing the depositaries with sufficient data to begin to produce due diligence documentation.
For TAs, this use of the Thomas Murray system would allow them to: take advantage of efficiencies such as being able to replicate and recycle previous responses, reduce the workload, and avoid a multitude of bilateral requests. The questionnaire was piloted with the in-house TAs of service participants and other groups to ensure its fairness and completeness.
Thomas Murray launched the first questionnaire in 2013 issuing over 2,000 questionnaires in over 50 jurisdictions. The following year, over 3,000 questionnaires were issued, and in 2016 the total number of questionnaires issued passed the 9,000 mark.
With three years’ experience of collecting information on TAs, Thomas Murray is uniquely able to use this accumulated knowledge to assist depositaries with their data collection requirements, and consider the wider implications.
From the outset, we found that the term ‘transfer agent’ was not universally recognised. Sometimes referred to as ‘Investor Services’, ‘Unit-holder Record keeping’, or ‘Registrar Services’, among others, finding a commonly acknowledged term was a challenge. We therefore had to write an acceptable definition: ‘the transfer agent for a fund is the organisation responsible for processing subscriptions and redemptions on behalf of that fund, and maintaining the register of owners of units in the fund.’ This definition describes in practical terms the primary functions that we see – the processing of movements on the register, and the maintenance of the register itself. Over the past three years, we have seen a general acceptance and understanding of this definition.
Another obstacle is the obvious lack of a legal or contractual obligation on behalf of the TA to provide any data at all. Unlike the fund depositary where a contract is a regulatory requirement, the investor’s depositary has no direct contractual relationship with the TA. Quite often, the depositaries’ clients invest in an omnibus fund and therefore the TA cannot identify the relationship, either. This has created an unusual situation in the financial world where one entity supports another out of courtesy rather than financial gain. Of course, transparency and due diligence bring comfort to the depositaries and their clients, but also provides TAs with potential marketing and reputational opportunities.
The information we have collected and are assimilating suggests that transfer agencies are as diverse as they are numerous. Some are huge, global organisations providing the service. Others can be tiny; they can even be, to quote a discussion with one regulator, ‘an office above a tattoo parlour in Vegas’!
We are discovering that many TAs offer a diverse range of value-added services, but the levels of quality vary. Most appear to provide a service in isolation from their competitors, perhaps because their businesses were established locally and developed by providing a specific need in that marketplace.
The TA segment remains only indirectly regulated, but most appear to be aware of the risks in their industry, and many of the larger transfer agents are managing their risks in a satisfactory manner. However, there are a number of transfer agents still performing poorly, in our view, and showing little apparent initiative to resolve twenty-first century challenges.
Added to this, there appears to be a lack of a formal selection process. TAs are appointed for no discernable reason other than perhaps through an existing relationship, or a recommendation.
Conclusion, for Now
The regulations have only been in place for a relatively short space of time. The vast majority of transfer agencies have now accepted that these requests are not going to go away, and courteously provide data to the depositaries. In general, it has been accepted that this is an added cost of doing business in the EU. However, there are still some that choose not to cooperate with the depositaries, citing anything from the lack of a legal obligation, to confidentiality, to disputing the exact interpretation of the legislation. Some are reluctant to provide the information without compensation for the costs of completing the questionnaire and some dismiss the requests out of hand.
The patience of depositaries is growing thin, and although our clients are still helping us with the negotiations with the reluctant TAs, we have heard that some depositaries are taking action. By determining that the lack of engagement generates an increased level of risk and exposure, they are asking their investor clients to dis-invest from funds where they have been unable to find TA transparency.
Depositaries could, as identified in the AIFMD documentation, enter ‘a contractual transfer of liability’ with the TA or fund manager to mitigate the burden of proof. How successful these contracts would be is open to legal review of enforceability.
Another option would involve Fund Managers selecting another, compliant TA for the fund. However, this would involve a robust selection process, something we have already identified as apparently lacking!
A transfer agent that continues to deny transparency to depositaries is making a business choice. In the highly complex financial system, transparency is essential, not only from a regulatory perspective but also to support fairness and competitiveness. Those who do not support this objective and the spirit of the legislation should be aware of the possible consequences of their behaviour.
The data represents responses from the medium to small organisations, amounting to around 50% of the total universe.
We asked: ‘If you were to begin insolvency proceedings, can you confirm that the register would not be affected and would be made available/ transferred to the new provider?’
This question tries to understand the portability of a register. If the business were to cease or be suspended, how easy would it be to move the register to another provider without there being a break in service or a loss of data?
Transferring a register can be extremely complicated. It is understood from comments provided, that few, if any, vendor-supported platforms can automatically import registers from every platform or container. For some legacy systems, the only method might be manual re-keying. Even with modern platforms, the preparation for merging registers can take many weeks of development and testing, or longer!
It is reassuring that 55% believed their register was portable and would not be affected by insolvency. The 44% that didn’t respond may simply not know if the register is portable or not. Either way, for the 1% that responded ‘No’, clients should be asking questions.
We asked: ‘As well as recording the "legal" owner of the units in your system, do you also record the underlying beneficial owner if this is advised to you?’
A significant number of respondents do not record the beneficial owner, even if this information is provided to them. However, as the following question reveals, even a ‘yes’ to this question, may not provide comfort!
We asked: ‘Is this information (recording of the legal owner of the units), maintained on the register or separately?’
Even though this probably reflects nominee or omnibus accounts, one has to ask, if the name of the beneficial owner of unit in the fund is provided to you but is not kept on the register, then where is this information kept and why?
We asked: ‘In case of litigation, does your jurisdiction recognise the legal ownership of the final beneficiary (underlying client) which is a client of the intermediary or nominee, even though the units may be registered in the name of the nominee, intermediary or custodian?’
This question tries to understand whether the underlying beneficial owner of the assets would have any ability to be identified and involved in any distribution if the fund enters any legal dispute. Merging the ‘No’s’ with the ‘Not Answered’ data, broadly suggests that less than half of the small to medium respondents would be able to recognise the beneficial owner if they are a client of an intermediary or nominee. Difficulties aside, perhaps in the wake of such massive losses seen in the industry over the last 20 years and the constantly changing regulatory landscape, this should be an area where TAs should be looking to provide more comfort to investors?