France has been at the forefront of the technical debate regarding the liabilities of depositaries of collective investment schemes (CIS), taking the form of a fonds commun de placement (FCP) or a société d'investissement à capital variable (SICAV).
The bankruptcy of Lehman Brothers International (Europe) (Lehman) and the Madoff scandal have drawn the attention of the Autorité des Marches Financiers (AMF) to the scope of the liabilities of depositaries vis-à-vis investors in CIS. Following orders issued by the AMF, which were resisted by French depositaries, a French court recently considered for the first time the depositary's liabilities in respect of its defaulting sub-custodian.
Regulatory background
The legal and regulatory regime for French depositaries derives principally from the provisions of the UCITS Directive and a recent reform of the Règlement Général of the AMF (General Regulation) that came into force on January 1 2008.
Pursuant to the French monetary and Financial Code, the depositary is appointed in the by-laws of the SICAV or by the management company of an FCP with a view to performing two main functions: (i) acting as the sole depositary of the CIS to hold the CIS's assets and carrying out all the required safekeeping, administration and custody of the assets (the custody obligation) and (ii) monitoring and supervising the decisions taken by the management company or the SICAV to ensure that such decisions comply with their full prospectus and the applicable laws and regulations (the monitoring obligation).
The performance of the custody obligation comprises two main activities: (i) custody activities: account keeping and custody of financial securities (save for pure registered financial instruments) and (ii) book keeping: registering in a position-keeping book pure registered financial instruments and any further assets of the CIS other than the financial securities referred to in (i) above.
The monitoring obligation is usually satisfied by setting up various control and supervision procedures. For example, an alert procedure in case of a CIS default that may occur if an investment restriction is not complied with.
Conservative approach for sub-custodied assets
The key question surrounds the nature and scope of the liabilities of the depositary for acts or omissions, or even the insolvency or fraud, of its sub-custodians.
The UCITS Directive set out the basic position. It states that "a depositary's liability ... shall not be affected by the fact that it has entrusted to a third party all or some of the assets in its safe-keeping". The Financial Code faithfully implements this position, stating that the liabilities of the depositary are not affected by the fact that the safekeeping (la garde) of the CIS's assets is entrusted (confiés) to a third party (the depositary liability principle).
In addition, Article 323-14 of the AMF General Regulation, which details the conditions under which the depositary may appoint a third party (or sub-custodian) to perform all or part of its custody obligation, clearly states that the fact that the depositary appoints the sub-custodian as its agent for the safekeeping and custody activities of the CIS's assets does not affect the depositary's liability.
The depositary liability principle is in line with the liability position of a custodian vis-à-vis its sub-custodian under the AMF General Regulation (the custodian liability principle). However, the AMF General Regulation also authorises the sharing of liabilities between a custodian and its client provided that the client is a qualified investor. The critical point here is to determine the scope of the liabilities of the depositary in any default of its sub-custodian.
In accordance with the AMF General Regulation, the depositary must return the CIS's assets recorded in its books "as they stand". There is no similar express obligation for the CIS's assets ultimately recorded in the books of the sub-custodian. However, based on the depositary liability principle, a French court may require the depositary to return or indemnify the CIS up to the value of the CIS's assets recorded in the books of its defaulting sub-custodian. Further, the ability to share liability between a custodian and its client set out in the AMF General Regulation is not applicable to depositaries, as the depositary liability principle set out in the Financial Code prevails.
However, since Ordinance 2008-1081 of October 23 2008 and decree 2008-1312 of December 12 2008, the depositaries of a CIS set up as an OPCVM à règles d'investissement allégées and OPCVM contractuels (together Alternative Funds) may restrict or limit their liabilities in respect of their obligation to return the assets of the Alternative Funds (the derogatory liability regime). These new provisions came about as a result of lobbying by depositaries, allowing them to reduce their liabilities when Alternative Funds appoint prime brokers that ultimately act as sub-custodians.
New Articles L.214-34-1 and D.214-28-1 of the Financial Code allow depositaries of Alternative Funds to provide in the depositary agreement for some limitations of liability for assets held with a sub-custodian. Article D.214-28-1 does not restrict the circumstances or the events that could limit the liabilities of the depositary for the obligation to return assets. However, considering the depositary liability principle, one could argue that such a restriction would not discharge the depositary of its liability to return assets ultimately received from the defaulting sub-custodian.
This ability of a depositary to limit its liability is restricted to Alternative Funds. So it seems that a depositary cannot limit liability when acting for any other form of CIS, such as UCITS funds.
Lehman: A new major case
The depositary liability principle had not really been tested before a French court until very recently. Three court decisions of the Paris Court of Appeal dated April 8 2009 addressed for the first time the nature and scope of the liabilities of depositaries vis-à-vis their sub-custodians.
The court decisions considered the situation where three French hedge funds had appointed Lehman as their prime broker and also as a sub-custodian under a tripartite sub-custodian agreement (between Lehman, the depositary and the fund represented by the management company) which resulted in most of the funds' assets being recorded in the books of Lehman in the name of the funds. Following the start of insolvency proceedings against Lehman Brothers Inc, an administration order dated September 15 2008 was put in place against Lehman effectively freezing any claims for the return of the funds' assets it held. The management companies of the funds requested that the depositaries return the funds' assets sub-custodied with Lehman. The depositaries argued against this obligation on the basis that (i) the depositaries cannot technically return assets that are sub-custodied, (ii) the prime broker had been appointed by each depositary at the instruction of the management company, such delegation relieving the depositary of any obligation to return the assets, and (iii) such obligation should not be enforceable prior to (a) the effective close-out between each fund and Lehman and (b) the release of the security interest granted by each fund to Lehman over the fund's assets .
The management companies drew the attention of the AMF to such differing views and the AMF issued a ruling requesting the depositaries to return the assets sub-custodied with Lehman immediately. The depositaries resisted the AMF's ruling and applied to the court for its cancellation.
The court decisions ruled that the depositary is subject to an absolute obligation to return the CIS's assets, whether or not they had been entrusted to a third-party sub-custodian, such obligation characterised as a mandatory rule to protect the savings invested in financial products and the sound operating of the financial markets. As a mandatory rule provided under the Financial Code (mainly to protect the financial markets to the extent the funds were only marketed to qualified investors), the depositary cannot restrict or limit this absolute liability by way of contract, including under a delegation agreement.
The court decisions raise a number of questions in practice, including how the depositary's liability interrelates with the security interest granted by the funds to Lehman. As a security interest would have been granted over the fund's assets in favour of Lehman, no obligation on the depositary to return assets would be enforceable before the release of the security interest.
Regarding the scope of the absolute obligation on the depositaries to return assets, the AMF and the court confirmed that this obligation is restricted to transferable debt or equity securities as well as shares or units of a CIS that fall within the scope of the custody activities. Any further assets, including cash deposits or any claims of the funds relating to OTC forward financial instruments are excluded from the obligation to return assets.
Consequently, the depositaries must only return the fund's assets credited or recorded in the securities account open in the name of the fund in the books of Lehman. However, to take into account the debts of the fund vis-à-vis Lehman, the AMF assessed the obligation to return assets based on the net settlement amount due from the prime broker to the fund. Moreover, any assets appropriated by Lehman as a result of its right of use duly exercised in compliance with the laws, regulations and terms of the prime brokerage agreement are excluded from the assets to be returned. In one of the cases, Lehman had appropriated the fund's assets without any right to do so. In this instance the court confirmed the AMF's view that unjustified re-used assets must still fall within the scope of the obligation on the depositary to return assets. This is controversial, as the unlawful appropriation of assets is a breach of the depositary's monitoring obligation as opposed to its custody obligation. While a breach of a custody obligation would trigger the return obligation, a breach of a monitoring obligation should generally only trigger a potential liability to pay damages.
One may therefore conclude that French depositaries are subject to an absolute obligation to return any CIS assets recorded in their books or those of their sub-custodians, subject to the ability to contract out of this obligation for Alternative Funds.
A confusing EU approach
Amendments to, or clarification of, the UCITS Directive provisions dealing with the liabilities of depositaries has never been a priority for the EU Commission. Indeed it provided a report to the Council and European Parliament dated March 30 2004 highlighting the absence of clarity in the safe-keeping function, the relationship with sub-custodian or delegate and the nature of the depositary's liabilities throughout the EU, without recommending any concrete legislative actions.
The Green Paper dated July 12 2005 subsequently considered that the UCITS regime was sufficient, noting that "there have not been notable financial scandals involving UCITS in Europe. UCITS has provided a solid underpinning for a well-regulated and generally well-managed industry. The investment limits, capital requirements, and organisational controls on asset segregation and safekeeping, disclosure obligations or the oversight responsibility of depositaries introduced by the Directive have been important contributing factors." Later on, as part of the list of non-legislative actions of the EU Commission set out in the White Paper dated November 15 2006, there was only a "communication/recommendation on delegation of custodial functions by depositaries" with an expected timing of early 2008.
In the light of the Madoff scandal involving Luxembourg and Irish UCITS, the French Ministry of Finance drew the attention of the Commission to the need to harmonise the approach of the EU member states regarding the liabilities of the depositaries. A press release issued by the Commission on January 26 2009 confirmed that the implementation of the UCITS Directive dealing with the liabilities of depositaries is not consistent throughout the EU. According to the Commission, the Madoff scandal revealed "differences in the way that the requirements of the UCITS Directive are given expression in national law. It has revealed different expectations as to whether the depositary is required to keep assets under its control so as to be able to return them to investors, or whether its responsibilities are confined to monitoring the security of the assets. It also suggests differences as to where the burden of proof lies in establishing responsibility and liability." All of these discrepancies were already alluded to in the 2004 EC Report.
The EU Commission and Cesr (Committee of European Securities Regulators) agreed to review the manner in which member states have implemented the relevant provisions of the UCITS Directive with a view to identifying any practices or outcomes that may affect the principles set out in the Directive. There will be a particular focus on the liabilities of the depositaries vis-à-vis their sub-custodians. This review of the liability regime of the EU-based depositaries will not be part of the UCITS IV Directive, which has already reached the final legislative stage.
Finally, according to an AMF press release on the court decisions, the obligation on the Depositaries to return assets is described as a key point for the protection of the investors, and the AMF is ready to ensure a similar view throughout the EU.
In the meantime, the Commission released on April 29 2009 a proposal for a directive on Alternative Investment Fund Managers (AIFM Directive) that sets out the following liability principles in relation to depositaries of alternative investment funds (AIF):
the depositary shall be liable to the AIFM and the investors of the AIF for any losses suffered by them as a result of its failure to perform its obligations pursuant to the AIFM Directive;
in case of any loss of financial instruments that the depositary safe-keeps, the depositary can only discharge itself of its liability if it can prove that it could not have avoided the loss that has occurred;
liability to AIF investors may be invoked either directly or indirectly through the AIFM, depending on the legal nature of the relationship between the depositary, the AIFM and the investors; and
the depositary's liability shall not be affected by any delegation granted by the depositary to another depositary.
The draft of the AIFM Directive seems therefore to confirm recent French case law, in that the depositary is liable for any losses suffered by investors, including as a result of a defaulting sub-custodian, unless the depositary is technically able to argue a force majeure event. It appears to be more conservative than French law since the derogatory liability regime is aimed at precisely restricting or limiting the obligation on the depositary to return in respect of AIFs.
The coming months will be critical in reshaping the liability regime of the EU-based depositaries. An absolute liability regime would inevitably push up the price for depositary services. The technical and political debate around the controversial AIFM Directive will hopefully result in a consistent and balanced approach to the depositary's liabilities and responsibilities vis-à-vis the investors of CIS/AIF.
| Author biographies |
Brice Henry
Allen & Overy LLP
Brice Henry is a counsel in Allen & Overy LLP, Paris. He is a member of the Regulatory Group and the Investment Funds Group. He advises on financial services and investment fund matters, including the distribution of non-EU based investment funds in France and within the EU, the structuring of investment funds, including private equity and real estate funds, French guaranteed funds and funds of hedge funds. In addition, Brice also has experience advising asset managers, prime brokers, depositaries and investment banks in connection with setting up French collective investment schemes as guaranteed funds, private equity funds, contractual and simplified rules funds and so on, as well as drafting fund's constitutional documents and the agreements to be usually entered into by fund managers (eg investment management agreement, distribution agreement, investment advisory agreement, shoring commission agreement, custody and depositary agreement). Brice was in particular a member of the working group set-up by the AMF for the reshaping of the French regulation governing the depositaries which came into force on 1st January 2008. |