Fund managers and investors alike now have a single point of reference in the event that problems occur in relation to the safekeeping of assets or the performance of oversight functions.

Key Points

  • One of the most significant changes under UCITS V is the expansion of the custodian’s role into the broader role of depositary.
  • Almost all of the changes to the custodian/depositary role are being made in order to align UCITS with the AIFMD.
  • Unlike depositaries of AIFs, it is not possible for a UCITS depositary to exclude or limit its liability under contract.

The change to the role of depositary for UCITS is not quite the ‘big bang’ that it was for AIFMD.  Many of the depositary provisions of UCITS V are taken directly from AIFMD, albeit with some modifications that reflect the difference in the level of risk that investors in UCITS and AIFs can both understand and sustain. In many instances, UCITS V requirements correspond to existing practice for Irish custodians, who already had robust processes in place to deal with Irish regulatory requirements that would have been reviewed to deal with the operational impacts of AIFMD.

The long anticipated fifth UCITS Directive (Directive 2014/91/EU) (UCITS V) which amended Directive 2009/65/EC on undertakings for collective investment in transferable securities (UCITS) came into force on 17 September 2014. EU Member States will have to transpose UCITS V into their domestic laws, regulations and administrative provisions by 18 March 2016. There are a number of structural changes that will have to be made by UCITS, of which one of the most significant is the expansion of the custodian’s role into the broader role of depositary.

Almost all of the changes to the custodian/depositary role are being made in order to align UCITS with the provisions contained under the Alternative Investment Fund Managers Directive (Directive 2011/61/EU) (AIFMD) in order to rectify the absurd position that sophisticated investors in alternative investment funds (AIFs) had greater protection than retail investors in a UCITS. Former EU Commissioner Charlie McCreevy explained this simply when he introduced UCITS V:

“It is not acceptable to have a less stringent regulation for retail investors than for professional investors”

Over the next fifteen months or so, custodians across the EU will have to organise themselves so that they can roll out new contractual arrangements. To illustrate the enormity of this task, Ireland’s almost twenty custodians will have to enlarge the scope of the role that they have to perform for UCITS in line with UCITS V and convert custodian agreements governing that role to enable the 3,462 UCITS Funds in Dublin (statistic from the Irish Funds Industry Association) to comply with UCITS V. Custodians of UCITS in other jurisdictions are faced with a similar task.

So in UCITS V, what is new for depositaries?

Requirement to appoint a single depositary (Article 22(1)) & Restrictions on eligibility to act as a depositary (Article 23(2) and (3))

A UCITS must appoint a single depositary.  Though a new provision for the UCITS Directive, the Irish Central Bank has always considered that a UCITS should have a single custodian and implemented its guidance in relation to UCITS (known as UCITS Notices) on that basis.

The depositary can be an EU credit institution, a national central bank or another entity authorised by an EU Member State to act as a UCITS depositary. The addition of national central banks to the list of eligible depositaries is unlikely to alter the depositary landscape to any great extent, which means that the types of entities that can act as UCITS depositaries is basically unchanged.

What is interesting is that there are some differences between eligibility to act as depositary of UCITS and AIFs which are entirely logical. Many AIFs that are sold in the EU are domiciled outside of the EU and as a result can have as their depositary an institution that is equivalent to an EU credit institution or EU investment firm provided that it is subject to effective prudential regulation (including minimum capital requirements) and supervision having the same effect as EU law.  UCITS is an EU fund industry brand that, other than through promoters or investment managers, does not have this third country element.

In addition the scope of eligible investment for AIFs is much broader than for UCITS and encompasses real estate, private equity and venture capital funds which may not have to use a fully authorised custodian/depositary as it may be sufficient for the AIF to appoint another entity to carry out depositary functions as part of their professional or business activities for the AIF (e.g., law firms, notaries or investment firms holding title deeds or contracts). This role, known as 'depositary-lite’, is not relevant to UCITS, which invest in transferable securities.

Requirement for the appointment of the depositary to be evidenced by a written contract (Article 22(2))

Though a new provision for the UCITS Directive, it is taken directly from AIFMD. The Irish Central Bank’s UCITS Notices have always required a written contract.

The addition of this requirement appears to be a housekeeping exercise for the purpose of consistency with AIFMD. The UCITS management directive (Directive 2010/43/EC) set out particulars that should be included in a standard agreement between a depositary and management company. In other words, we knew what the contract ought to include. Now we know that there must be a written contract.

Cash monitoring function (Article 22(4))

The original UCITS Directive included fiduciary or oversight duties, some of which related to cash flows (ensuring that the sale, issue, repurchase and redemption of units take place in accordance with fund rules and applicable law and that consideration is remitted to the UCITS within the usual time limits). UCITS V imposes new cash monitoring obligations on depositaries that will enhance the ability of depositaries to act as the 'eyes of the investor' as depositaries will need to have a granular knowledge of the UCITS' cash balances and transfers into and out of cash account, whether this relates to trading or share register activity.

UCITS V is much less detailed in relation to what is expected in relation to cash monitoring for UCITS than AIFMD is for AIFs when AIFMD is read in conjunction with Commission Delegated Regulation (EU) No 231/2012 (Level 2 Regulation).

The Level 2 Regulation sets out how to meet the AIFMD obligations, requiring full visibility of all cash accounts opened for the relevant AIF, whether in its own name, in the name of the AIF or the alternative investment fund manager (AIFM) on behalf of the AIF, the implementation and periodic review by the depositary of cash monitoring procedures, in particular as regards reconciliations, and the notification of the AIFM of any identified discrepancies that have not been rectified without undue delay. In doing so the depositary is heavily reliant on the AIFM or AIF to meet its obligations.

In the absence of specific guidance in UCITS V, it is perhaps unlikely that depositaries of UCITS would implement cash monitoring procedures that depart from those set out in the Level 2 Regulation.

New safekeeping function (assets not capable of being held in custody: verification of ownership and record keeping) (Article 22(5))

In reality, this is not a new function as the original UCITS Directive required that the assets of a UCITS should be entrusted to a depositary for safekeeping. What is new is that UCITS V describes the safekeeping function as either custody or record-keeping depending on the type of asset owned by the UCITS.

The custody function covers those assets which can be held in custody, whether taken into custody by physical delivery or through registration in a securities account in the depositary’s books. The record-keeping function covers those assets which cannot be held in custody, in which case the depositary’s obligation is to maintain up-to-date records and verify ownership. Verification is based on information to be provided by the UCITS, management company or, if available, external evidence.

The Level 2 Regulation sets out the conditions that should be met by AIFs in order to enable the depositary to satisfy itself as to ownership and to ensure such assets cannot be transferred without the depositary or its delegate being informed).  There is no such guidance in UCITS V but as mentioned above it is unlikely that depositaries of UCITS would implement procedures that depart from those set out in the Level 2 Regulation.

Requirement to provide an inventory of assets (Article 22(6))

UCITS V provides that the depositary must provide a comprehensive inventory of all of the UCITS’ assets to the UCITS or its management company or investment manager on a regular basis. This differs from the Level 2 Regulation where the requirement for AIFs is that the depositary should be able to provide such a report at any time, presumably to the same parties.

Prohibition on right of use / rehypothecation of assets (Article 22(7))

UCITS V provides the assets held in custody by a depositary may only be reused where the re-use:

  • is executed for the account of the UCITS, when carrying out the instructions of the management company on behalf of the UCITS;
  • is for the benefit of the UCITS and its unitholders; and
  • relates to a transaction covered by high quality and liquid collateral received by the UCITS under a title transfer arrangement (e.g. for securities lending).

The market value of the collateral at all times has to amount to at least the market value of the re-used assets plus a premium.

There are no such restrictions on re-use for AIFs, where all of the requirements around re-use/ rehypothecation of assets focus on disclosure.

Requirements for Member States to ensure client asset protection on insolvency of the depositary or a third party delegate in the jurisdiction (Article 22(8))

UCITS V includes a requirement that the UCITS’ assets be segregated from the assets of the depositary (and its delegates), so that any assets on the depositary’s books held for a UCITS can be distinguished from the depositary’s own assets (and those of its delegates), and can at all times be identified as belonging to that UCITS. This is not a new concept in Ireland where the UCITS Notices already apply this requirement to Irish custodians but it does align UCITS with AIFs as the Level 2 Regulation provides that the custody function for AIFs includes proper asset segregation on the depositary’s books (and those of its delegates).

Conditions for delegation of safekeeping function (Article 22(a))

Depositaries may delegate responsibility for their safe-keeping functions to third parties. They cannot delegate their fiduciary oversight responsibilities or their cash monitoring responsibilities. Delegation is permitted provided that:

  • there is an objective reason for the delegation;
  • the guiding intent of the delegation is not to avoid the requirements of UCITS V;
  • the depositarymust exercise “all due skill, care and diligence” in the selection and appointment of its delegates and continues to do so in relation to the ongoing review and monitoring of its delegates.

Where there is a necessity, due to the laws of a third country, to delegate custody of  financial instruments to a local entity but there is no local entity meeting the above listed requirements, a depositary may still delegate custody provided that:

  • Investors in the UCITS are informed, prior to making their investment, of the reasons and justifications for the delegation; and
  • the UCITS, its management company or investment manager on behalf of the UCITS instructs the depositary to delegate to such local entity.

The Level 2 Regulation lists specific tasks that a depositary should implement in order to comply with its due diligence duties. This list could be said to be a basic code of practice, requiring procedures to be put in place to document the following reviews in respect of each delegate:

  • country, legal and custody risks;
  • internal controls and procedures;
  • financial strength and reputation; and
  • operational and technological capabilities.

This detail is missing from UCITS V but depositaries of UCITS would do well to implement procedures which are in line with the Level 2 Regulation.

Revised strict liability for loss of custody assets (Article 24)

The current standard of care for a depositary of a UCITS is that a depositary is liable for:

  • unjustifiable failure to perform its obligations; or
  • its improper performance of them.

While this terminology has the benefit of being consistently used across EU jurisdictions, it has been interpreted differently across the EU. Common law jurisdictions, for example look at this language through the binoculars of more usual and court tested liability standards of negligence, wilful default etc. As a result, UCIT V introduces a new harmonised standard:

  • If it is deemed liable for the loss of a custody asset, a UCITS depositary is obliged to return a financial instrument of the identical type or corresponding amount to the UCITS, without undue delay.
  • The depositary will only be able to discharge liability if it can prove that the loss of custody assets is due to an “external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary”.
  • The depositary’s liability will not be affected by the fact that it has delegated some or all of its safe-keeping duties to a third party. This means that the depositary will be liable for the loss of custody assets even where the loss is caused by a sub-custodian.
  • In addition to the loss of a financial asset, the depositary will also be liable to the UCITS and the investors for all other losses suffered as a result of the depositary’s negligence or intentional failure to properly fulfil its obligations under the UCITS Directive.
  • For other assets that are not held in custody such as OTC but which are subject to ownership verification and recordkeeping duties, a depositary will not be liable to return an identical asset but will instead only be found liable if the loss is due to the depositary’s negligence or intentional failure to properly fulfil its obligations under the UCTS Directive.
  • Significantly, the burden of proof rests with the depositary. It must be able to demonstrate through documented and applied procedures that it has carried out its duties.

For the most part, UCITS V depositary liability provisions are consistent with those under AIFMD. One key point of difference is that depositaries of AIFs can contractually limit their liability for loss of assets in custody (provided that such discharge is objectively justified). It is not possible for a UCITS depositary to exclude or limit its liability under contract. This difference reflects the view that UCITS are much more widely held than AIFs and that retail investors in UCITS require a higher degree of protection than professional investors who invest in AIFs.

Redress of Investors against the Depositary (Article 24)

UCITS V gives new rights to all UCITS investors so that they may invoke the liability of the depositary directly or indirectly through the management company or investment manager. This language differs to that of AIFMD which states that the right to invoke claims depends on the legal nature of the relationship between the depositary, the AIFM and the investors. This difference reflects the view that retail investors in UCITS require a higher degree of protection than professional investors who invest in AIFs.

This article first appeared in the January 2015 issue of Butterworths Journal of International Banking and Financial Law.