The Luxembourg financial regulator, the CSSF, released on 11 July 2014 circular 14/587 on UCITS depositaries (Circular). The Circular sets forth rules that apply to depositaries of UCITS, as well as to UCITS and their management companies in their relationships with depositaries.
The Circular will enter into force on 31 December 2015, subject to transitional provisions under UCITS V1 that must be transposed into the laws of the EU Member States by 18 March 2016. Luxembourg depositaries should start an internal assessment to prepare for compliance with the requirements of the Circular.
Alongside applicable provisions in the UCI Law,2 the SIF Law,3 the SICAR Law4 and, more recently, the AIFM Law5 completed by Commission Delegated Regulation,6 chapter E of IML circular 91/75 dated 21 January 1991 was the main source of guidance on the functions and duties of depositaries. While this circular indicates that safe-keeping of assets essentially involves a supervisory obligation with respect to assets, the Circular does not provide guidance as to many important areas under AIFMD7 and UCITS V – such as segregation of assets, due diligence of sub-custodians and conflicts of interests – and will be outdated for UCITS on other points once UCITS V is implemented.
Different Depositary Regimes
The Circular clarifies that there will be three depositary regimes in Luxembourg:
- The UCITS depositary regime governed by part I of the UCI Law and the Circular. The Circular must be read in conjunction with additional guidelines issued by ESMA and delegated acts to be taken by the European Commission in the context of UCITS V.
- The full AIF depositary regime governed by article 19 of the AIFM Law and the Commission Delegated Regulation. The Circular anticipates a certain level of harmonisation of the depositary regimes for UCITS and AIFs, and therefore intends to align both regimes, where possible. As a result, the Circular may become an important source to assess the CSSF’s view on certain obligations of depositaries for AIFs that invest in financial instruments.
- The depositary regime for specialised investment funds (SIFs) and investment companies in risk capital (SICARs) that are either managed under the lighter regime of the AIFM Law or do not qualify as AIFs under the AIFM Law. Chapter E of IML Circular 91/75 will continue to apply to those SIFs and SICARs.
Unregulated AIFs managed under the lighter regime of the AIFM Law, as well as non-AIFs that are neither formed as SIFs or SICARs (e.g., holding companies), are not required to entrust their assets to a depositary. No specific depositary regime is therefore mandated for them.
Key Points Under the Circular
The CSSF outlines the importance of certain aspects of the Circular that are to be considered as essential regarding the depositary function.
Segregation of Assets to be Ensured Throughout Chain of Custody
The depositary and its sub-custodians must differentiate and segregate UCITS assets from: (i) assets that are not collectively managed and (ii) assets owned by the depositary or its sub-custodian. A specific omnibus account opened with a sub-custodian for a UCITS cannot be used for assets of the depositary’s clients that are not collectively managed or for the assets of the depositary.
While an agent of the sub-custodian is not under the same obligation in terms of segregation of assets, the depositary must require its sub-custodian to ensure that assets of the UCITS are protected, to the extent feasible, against the default of the sub-custodian’s agent.
Delegation of Safe-Keeping Subject to Specific Conditions
Any delegation of safe-keeping obligations by the depositary to a sub-custodian must be justified by an objective reason, and the selection of the sub-custodian must be subject to initial and on-going due diligence. In this regard, the depositary must implement and apply an appropriate due diligence procedure. The Circular sets forth elements that must be covered by such procedure, including, among others: verifying segregation of assets, reviewing procedures and internal control mechanisms, and assessing operational capacities of the sub-custodian.
The Circular clarifies that the holding of securities through securities settlement systems is not considered to be a delegation of safe-keeping obligations.
Depository to be Independent
The depositary must act in an independent manner and solely in the interest of the UCITS and its investors. The depository must organise its activities with a view to minimising conflicts of interest.
Portfolio management or risk management cannot be delegated to the depositary or to one of its sub-custodians. However, the depositary or one of its sub-custodians can be entrusted with specific tasks in relation to risk management.
Where a depositary provides brokerage, administration, reporting or collateral management for a UCITS, it must ensure the existence of a functional, hierarchal and contractual separation between these services and the depositary services, and must appropriately disclose the potential risk of conflicts of interests.
Persons entrusted with the conduct of daily management of a UCITS or its management company cannot be employed by the depositary of the UCITS.
Depositary to have Cash Accounting and Monitoring Responsibilities
The depositary is responsible for proper accounting and monitoring of cash flows, relevant reconciliation processes and identification of inconsistencies.
The depositary must have a complete understanding of the UCITS’ assets and liquidities. To this end, no cash account can be opened in relation to the UCITS’ activities without the depositary’s consent and unless the depositary is provided with full access to information in connection with such cash account.
The depositary must ensure proper payments for and by the UCITS, as well as proper booking of cash flows and liquidities. Clearing procedures must be reviewed to assess whether they are appropriate for each UCITS on the basis of its nature, size and complexity.
Depositary Liability Regime
The Circular does not provide guidance on the liability regime applicable to depositaries of UCITS – this continues to be determined by the UCI Law and the general rules on civil liability. Since the UCI Law will be amended in this regard by the transposition of UCITS V into Luxembourg law, these changes were not anticipated to be reflected in the Circular.
The transposition of UCITS V into Luxembourg law will introduce a liability regime inspired by the AIFM Law. The depositary’s restitution obligation with respect to financial instruments that are under its safe-keeping will be a strict obligation – the burden of proof with respect to this liability is upon the depositary. Thus, the depositary will be liable for the loss of assets unless it can prove that the loss has arisen as a result of an external event beyond its reasonable control. Contrary to the provisions of the AIFM Law, a depositary servicing UCITS cannot limit or exclude this liability by contractual arrangements.
The obligations in relation to the notification period referred to in the Circular are without prejudice to notice period(s) required by law for investors to pre-approve relevant changes and to specific requirements of other competent authorities in jurisdictions where the UCITS is registered for distribution.