Peter O’Dwyer looks at the onerous depository rules being introduced in Europe and assesses how they are threatening the regions previously highly successful and popular funds regime.
Locusts and Termites
As a director of a number of funds and fund management companies, one of the most frequent items of discussion I have noticed in recent times at board level is: “What is it exactly that custodians do?”
In the aftermath of the Madoff affair and the bewildering arrangements that seem to have emerged in that case, there has been a lot of understandable confusion around the precise roles of custodians, trustees, depositaries, sub-custodians, agents and brokers. These issues are currently being actively pursued through the law courts of several nations. Many fund boards are urgently dusting off their custody agreements and somewhat belatedly becoming acquainted with the finer points of contract law vs fiduciary responsibility and that in several jurisdictions.
They would do well to consider the unfortunate case of Mr Dwarika Prasad, pictured above, as reported by the BBC World Service in April 2008. Mr Prasad, a trader in the Indian State of Bihar, tragically lost his life savings, which he had deposited in a safe deposit box in the government-owned Central Bank of India in Patna. The trader says he had deposited 450,000 rupees (US$11,000) in currency notes, investment papers worth 232,000 rupees (US$5,660) and some gold and silver jewellery in the safe deposit box.
When he returned to the bank, a number of months later, termites, which had infested the bank’s safe deposit boxes, had eaten all his bank notes and securities. The bank said that it had put up a notice warning customers of termites, but Mr Prasad claims that he hadn’t seen the notice.
"I'm shattered. I do not know what to do as I had kept the money for my old age," Mr Prasad said.
Mr Prasad further told the BBC that relations with his wife and children were unfortunately strained and he wanted to put the money in the safe box to keep it safe from them. "I wrote to the head office of the Central Bank of India and the regional offices of the Reserve Bank of India," Mr Prasad says. "Even after two months, I'm waiting for a response from them.”
Those of us in the hedge fund world are by now familiar with the fact that German politicians consider us as financial locusts, who allegedly strip companies bare of assets and employees and then move on to enjoy our ill-gotten gains on the sandy beaches of some sun drenched tax haven. Must custodians now get used to being compared to termites?
Strange as the above tale may seem, custodians of investment products may in future need to become very familiar indeed with the precise means by which the assets of their clients are safeguarded.
Alternative Investment Fund Managers’ Directive (AIFMD)
Just over two years after it was first tabled by the EU Commission, this highly contentious directive was finally published in the Official Journal on 1 July 2011. The Directive is to be transposed into national laws by July 2013. As a new era Lamfalussy directive, however, the details (with accompanying devils) of the Directive are to be contained in the so-called Level II “implementation measures”, which form the engine room of the law.
On 13 July the European Securities and Markets Authority, (ESMA), in a 450-word advice document, reported back to the Commission, proposals for implementation measures as well as setting out a number of still to be resolved questions.
One of the most contentious areas of the Directive is the determination of the liability of depositaries (as custodians are called in EU-speak). This is particularly controversial where assets are held, as is frequently the case, by sub-custodians in a third country.
The Directive sets out the two primary functions of the depositary as the safekeeping of the fund’s assets and the overseeing of compliance with the fund’s rules and instruments of incorporation and with applicable law and regulation.
What Actual Level of Liability is a Depositary taking on?
The Directive distinguishes between the loss of financial instruments held in custody and any other losses. For custody assets, the Directive imposes liability on the depositary for the loss of assets held in custody (whether held by it or by a sub-custodian) and limits the circumstances when this liability can be discharged. The Directive specifically requires the depositary to replace assets that have been lost with identical assets, or a corresponding amount.
The depositary can avoid liability if "it can prove" that "the loss had arisen as a result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary". We must await Level II rules to eventually understand precisely what this means. For example, ESMA has made clear that fraud by an employee does not constitute such an external event.
The burden of proof under the Directive, therefore, now falls on the depositary to demonstrate that it satisfies the requirements in order to avoid liability.
The broad scope of the liability and the limited exclusion mean that liability under the Directive could arise even where the depositary is not negligent, or otherwise at fault. Under the UCITS regime, the depositary is not liable unless a loss arises from an "unjustifiable failure" on its part. Therefore, the Directive seems to impose a stricter liability regime than even the retail benchmark set by the UCITS Directive.
In order to avoid liability under the Directive, the consequences leading to the loss must have been unavoidable despite "all reasonable efforts to the contrary". Thus, the depositary will be liable unless it can show that it exhausted all reasonable steps which might have prevented the loss.
The combination of a reverse burden of proof in addition to the exhaustive test of having to show that all reasonable measures had been taken, creates a highly onerous liability regime for depositaries.
The Yanks are going?
In all the Commission and ESMA agonising over the definitions of loss and the strict liabilty of depositaries, what seems to have been totally missed is that the risk reward ratio for the provision of custody services is becoming increasingly more skewed. What is clear from the Madoff litigation is that in return for fees of hundreds of thousands of dollars, companies may be exposed to liabilities in the tens of billions of dollars.
While statistics for the share of the market for custody services in Europe alone are hard to come by, according to the latest Global Custodian worldwide figures (June 2011) of the world’s top five custodians, four, (or some 92 per cent by assets) are US based (BNY Melllon, State Street, JP Morgan, Citi) and some76 per cent by assets, or five of the top 10 (including Northern Trust) are also US based.
If the EU continues on its path of making the business of custody in the EU uneconomic, or just too complicated and risky, what would happen if the US custodians just picked up the football and walked off the field?
It is all very well having the most onerous depositary rules in the world, but if there are no custodians to supply the services then the EU is in danger of destroying its previously highly successful and popular funds regime and with it tens of thousands of highly skilled jobs in Ireland and Luxembourg and the tax revenues they and their businesses generate.
For industry veterans, it often seems as if the EU has handed over the running of its financial regulation to the termites!
Peter J. O’Dwyer is a business and financial consultant with a number of interests. He primarily specialises in providing bespoke advice to cross-frontier businesses, in particular to those involved in international investment funds, holding company structures and structured finance and to Governments and regulatory authorities. He is Managing Director and proprietor of Hainault Capital Limited, based in Ireland. He is a non-executive director of several private and public companies, including investment companies, mutual funds, energy, property and hedge funds domiciled in Ireland and the Cayman Islands for amongst others; HBOS, Barclays Capital, Citigroup and BNP Paribas. He is a former director of a Shari’a hedge fund and has lectured widely on the subject of Shari’a investment funds.