Depositary liability and prime broker segregation
December 2014 | SPECIAL REPORT: INVESTMENT FUNDS
Financier Worldwide Magazine
The credit crisis led to substantial changes in the regulation of global custody. In particular, there have been moves towards a more harmonised approach within the EU to address the fact that regulation of custody in many member states has traditionally been less stringent than in the UK.
The collapse of Lehman Brothers in 2008 highlighted deficiencies in the extent to which client assets are ring fenced on the insolvency of a prime broker (PB). For example, record keeping was insufficient to attribute assets held by Lehman Brothers to the particular clients. Lehman Brothers was also an active prime broker, meaning that it focused attention on the potential threat of the traditional prime broker model which permits re-hypothecation, i.e., the ability of PBs to use amounts posted as collateral by their clients for their own purposes – a practice which has traditionally kept custodian costs low.
UK rules relating to client assets were tightened as a result of the issues that arose following the collapse of Lehman Brothers. There have also been a number of EU level initiatives designed to address client asset safety, including detailed provisions under the AIFMD. These have been extended to UCITs funds under UCITs V to create a level playing field. Under the AIFMD, fund managers must appoint a depositary to hold the client assets and the depositary must comply with the requirements in the AIFMD, including a requirement to segregate the client assets from its own assets and to comply with requirements relating to delegates.
Although PBs can be depositaries, and some have attained permission to do so where they can meet the independence requirements, in most cases the depositary of an alternative investment fund (AIF) will be a depositary bank and the PB would be appointed as a sub custodian – a delegate of the depositary bank.
The concern for PBs is that the requirements of sub-custodians under the AIFMD are unclear. Article 21 states that sub-custodians 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 be clearly identified as belonging to a particular depositary. This is less onerous than the depositary obligation to segregate, and Recital 40 of the AIFMD states that a delegate “should be able to maintain a common segregated account for multiple AIFs”, which appears to permit omnibus accounts. However, the depositary must also ensure that delegates comply with the general obligations and prohibitions in paragraph 8 of Article 21, which indicates that individual segregation of assets is required. This requirement has created uncertainty in the market and is of great importance to PBs as they can only carry out re-hypothecation if they are permitted to open omnibus accounts.
This uncertainty is problematic because, in addition to needing to comply with the delegation requirements in the AIFMD, depositaries are strictly liable for the loss of investments. Liability can only be transferred to a sub-custodian if the sub-custodian agrees to the liability being transferred to it in an agreement, and if the delegation requirements in the AIFMD have been complied with. Liability will not be transferred, for example, if among other things, the segregation requirements at the level of the depositary or the delegate have not been complied with. For the liability transfer to be effective the depositary will also need to demonstrate that it could not have prevented the loss of financial instruments and that the event that led to the loss was not the result of an act or omission by the depositary or the delegate. Liability will not have transferred to the delegate if the loss was caused by an accounting error, operational failure, fraud or failure to apply the segregation requirements at the level of the depositary or the delegate. The depositary will also need to establish an objective reason for transferring liability. It seems likely that objective reasons could only be established in quite narrow circumstances. Interestingly, there is no ability to transfer liability to sub custodians in UCITs V.
Given the uncertainty surrounding when a depositary will be deemed to have effectively transferred liability to its delegate, many depositaries are concerned that regulators or the courts might find that liability has been retained by the depositary, even in circumstances where a contractual arrangement has been entered into attempting to transfer liability to the delegate. Some depositaries have therefore been insisting that PBs segregate assets individually, which has in turn frustrated PBs’ ability to rehypothecate.
Another consequence of the uncertainty surrounding the liability transfer provisions is that depositaries are trying where possible to hold fund assets in their own accounts and those of their networks of subcustodians. If depositaries do allow fund assets to be held by PBs, they are only appointing PBs with a first rate credit rating and operating procedures which are capable of supporting any requirements imposed by the depositary.
Because of the pressure on PBs to segregate the accounts, PBs cannot re-hypothecate in respect of assets held relating to AIFs. The PBs argue that re-hypothecation permits them to keep costs low and if they cannot re-hypothecate, the costs will rise significantly and will need to be passed on to and borne by the AIFs themselves, which means that the end user (the unit holder of the AIF) will suffer.
ESMA has failed to reach agreement on the issue in at least two separate board meetings, most recently on 25 September 2014, and has now indicated that it will be subject to a market review. It is unlikely that the issue will be decided at the November board meeting either. It is difficult to know what the market review will include, but it can be assumed that there will be a review of the risk to client assets of re-hypothecation on insolvency and a review of the cost implications of PBs not being able to re-hypothecate.
The fact that a decision has not been reached at the ESMA level suggests that there is at least one member who feels strongly against omnibus accounts and the market review could be a delaying tactic, trying to appease stakeholders by backing up what will be an unpopular decision for PBs.
If they have not done so already, PBs should review their models when acting as a sub-custodian in relation to AIFs, and to the extent that it does so, to UCITs funds as well, and work on the basis that re-hypothecation will not be permitted. PBs should also review the additional cost involved and consider who will bear the cost. It is by no means certain that AIFs will end up bearing the increased cost of PB services – the PBs may need to absorb some of the cost themselves.
Whatever is decided by ESMA, however, it will be the depositary banks which have the bargaining power and, as a result of the stringent liability provisions in the AIFMD, it is likely that the depositary banks will continue to require segregated assets when they do not use their own internal network of sub-custodians. Even if ESMA takes a pragmatic view and permits omnibus accounts, which is unlikely, there also needs to be guidance provided by ESMA on how the transfer of liability provision in the AIFMD can be effected in practice in order for depositary banks to feel comfortable appointing PBs who open omnibus accounts and permit re-hypothecation. There is currently no plan to do so.
Jacqui Hatfield is a partner and Daniel Weiner is an associate at Reed Smith LLP. Ms Hatfield can be contacted on +44 (0)20 3116 2971 or by email: firstname.lastname@example.org. Mr Weiner can be contacted on +44 (0)20 3116 3000 or by email: email@example.com.
© Financier Worldwide
Jacqui Hatfield and Daniel Weiner
Reed Smith LLP