UCITS V: Just When Are Depositaries Liable, or Not?

When operations executives, their relationship management colleagues, not to mention their compliance directors can’t agree on how to talk about a topic, it qualifies as organizational confusion.

When it’s industry-wide, it’s a bona fide hot potato.

That is the situation today as custodian banks in Europe, acting as depositaries for traditional investment funds, attempt to make sense of the possibility they may be held financially liable for any loss of investor assets. Or they might not.

They won’t know for sure until the UCITS V directive is adopted by the European Parliament as it stands, or possibly not as it stands, if action is not taken before the Parliamentary elections in May 2014.

UCITS V is the newest incarnation of the decades-old Undertakings for Collective Investment in Transferable Securities, a pan-European legislation initially adopted in 1985. Intended  to make it easier for traditional investment fund managers to market themselves across continental borders without needing to establish new investment vehicles, it has been updated to gain consistency with the Alternative Investment Fund Managers Directive (AIFMD) to regulate private equity and hedge funds. The AIFMD is already in effect in some EU nations and still being transposed into law in others.

There are a number of highly controversial elements in UCITS V particularly when it comes to fund manager remuneration and restrictions on performance fees. However, for financial professionals who will have to be compliant, the issue of depositary liability is surely one of the murkiest.

Without clearcut answers, custodians can’t operationally prepare for the greater oversight of the third-party service providers under UCITS V. They also can’t effectively price their depositary contracts with customers. “We are waiting for the legislation to be adopted on a pan-European level before making any decisions,” one asset servicing director at a European custodian bank tells FinOps Report.

In a post-Madoff era, better safe than sorry has become the motto for European regulators and they now want depositaries to be responsible for any loss of investor assets, even if it wasn’t their fault. As previously defined in AIFMD, depositaries selected by hedge fund and private equity fund managers not only provide standard custody services, but far greater oversight and recordkeeping of client assets for potential mismanagement or fraud.

Under the previous incarnations of UCITS, depositaries were typically held liable for loss only if they were at fault. Now the legal standard of strict liability is being applied: depositaries must prove they weren’t negligent.

However, there might be one critical exception — when assets are held by either a national or international securities depository such as Euroclear or Clearstream. That sounds like good news, except for one critical gap: there is no consensus on whether that is true or not.

A survey of operations and legal experts at five custodian banks operating in Europe shows two opposite opinions; some believe they are always liable for the loss of investor assets regardless of where they are held, while others say that under UCITS V they can discharge the liability to either a national depository or an international securities depository if they are the ones holding the assets under custody.

How big is the financial risk faced by custodians acting as depositaries? Given that a large percentage — no one would specify how much — of assets are held by global custodians at market infrastructures which may use their own subcustodian network, it stands to reason that global custodians would be concerned about their level of responsibility.

Given the continuing lack of clarity over potential loopholes in depositary liability, custodian banks could find themselves in the hot seat pretty soon. They may need to revise their stance with fund managers if they have misinformed them about their liability, albeit unintentionally.

Five large European fund managers consulted by FinOps Report on Monday say that they have been given conflicting explanations by different custodians. “It’s been very ambiguous,” one operations executive at a fund management shop tells FinOps.

“The UCITS V legislation says that if the assets are held at a central national or international securities depository, then the depositary will no longer be on the hook,” one manager of an asset servicing unit at a European custodian tells FinOps.

Yet, that’s not what a peer at a competing bank says. “No, it’s well understood that we will be liable no matter what.”

The reason for the confusion: UCITS V is supposed to match the liability of a depositary as explained in the AIFMD. One of the introductory explanatory paragraphs in the AIFMD says that the use of a securities settlement system (SSS) is not legally considered a delegation of custody functions. Delegation of custody is a precondition for the custodian to be held liable for the loss of assets in the custody chain.

But it is unclear whether introductory paragraphs called “preambles” carry the same legal clout as the text within the AIFMD itself.

In late November, the same provision on liability in the UCITS V legislation appears to have been amended to add a sentence that entrusting the custody of securities to a securities settlement system (SSS) shall be interpreted as a “delegation” of custody functions. Therefore, custodians could be back on the hook for the loss of any assets held at a central securities depository or international securities depository as those fall in the category of SSS.

If that’s the case, it’s even more unclear why all the uncertainty remains. Some custodian and fund management specialists say they haven’t been made aware of the November change to UCITS V by either their external legal counsel, their internal compliance departments, or the European Commission. Yet others tell FinOps that the change to UCITS V was made in the language affecting the”recitals” or guidance on implementation and not in the actual text. Therefore, they are not certain whether it’s actually legally binding.

Neither the five custodian bank officials nor the five fund management operations executives would publicly disclose their interpretation of UCITS V’s provisions on depositary liability. Those who initially did, subsequently contacted FinOps Report to insist that their names as well as those of their organizations be deleted.

Apparently, their internal compliance and external legal counsels became concerned about being called to the carpet by investors for providing erroneous interpretations. C-level relationship management teams are also worried about the prospect of misinforming clients — aka overcommitting or undercommitting about their liability. The difference could ultimately end up coming out of investors’ pockets.

Those who haven’t had the time to read the fine print had better start now. The European Commission and Parliament are trying to work out the final details of the legislation before the May elections, so that it can finally be adopted and transposed into local European legislation in 2016 without having to re-start discussions with the new Parliament.

That would still leave two years before the first deadlines. While that might sounds like a long time, it isn’t in the world of custody. Contractual agreements — and pricing schedules — take a long time to iron out, and the prospect of having to change them to comply with new rules is something that everyone would like to avoid.

“It may not be law now,” says one of the custody experts who spoke with FinOps, “but we should be preparing now in our operations and our contracts. As it stands, no one is precisely sure what to prepare for.”