The Impact of ESMA's Final Advice on Depositaries Under the AIFM Directive, Contributed by Jeremy Pickles and Nora Bullock, Hogan Lovells LLP

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On 16 November, following consultation,1 the European Securities and Markets Authority (ESMA) published its final advice2 to the European Commission on implementing measures to be adopted under the Alternative Investment Fund Managers Directive3 (AIFM Directive). This article focuses on how ESMA's final advice affects the position of depositaries under the AIFM Directive. Alternative investment fund managers (AIFMs) are obliged to: (1) ensure that each alternative investment fund (AIF) that they manage4 has appointed a depositary to safekeep the fund's assets; (2) oversee cash movements of the fund; and, (3) ensure compliance with applicable law and regulation, as well as the AIF's constitution. In particular, we look at:

  • The types of assets that a depositary must hold in custody and those that are subject to verification and a record-keeping requirement;
  • The liability that is imposed on the depositary for the loss of an asset held in custody;
  • The requirements that a third-country domiciled depositary must satisfy to be eligible for appointment under the AIFM Directive;
  • Responsibility to ensure that an AIF's cash flows are properly monitored; and
  • The terms on which a depositary must be appointed.

The publication of ESMA's final advice is a key step in the development of the AIFM Directive and gives us an insight into what the final legislation will probably look like. ESMA's advice will be used by, but is not binding upon, the Commission to prepare implementing measures that will ultimately form the basis of the legislation. Member States must incorporate the provisions of this legislation into national law by 22 July 2013, when the AIFM Directive comes into force.

Introduction to Depositaries Under the Directive

Depositaries are a new category of service provider for the alternative investment industry. For funds that have appointed custodians, the custodian will need to be replaced or agree to take on additional responsibilities on the terms of the AIFM Directive. Other funds will be more affected. Hedge funds that have appointed multiple prime brokers will need to interpose a depositary into their contractual structure (although a prime broker can be appointed as a depositary if, among other things, it has functionally and hierarchically separated its prime broker and depositary functions). Perhaps the most affected will be the private equity and real estate funds that do not typically appoint a third-party custodian, but will now be required to do so, and will have to bear the costs of an arguably unnecessary additional service provider.

Safekeeping or Record-keeping of Assets

Under the AIFM Directive, a fund's assets must be entrusted to its depositary for safekeeping. How a depositary discharges its safekeeping obligations depends on the nature of the assets entrusted to it. The AIFM Directive identifies two broad categories: (1) financial instruments that must be held in custody by the depositary (or its sub-custodian(s)) (Custody Assets); and (2) all other assets that, in contrast, the depositary does not have to hold in custody, and instead must verify the fund's ownership and maintain a record of them. The distinction is crucial; whether or not an asset is held in custody determines the scope and nature of a depositary's liability, as discussed below. ESMA gives a broad definition of Custody Assets, which includes:

  • Transferable securities (including those which embed derivatives);
  • Money market instruments; and
  • Units of collective investment undertakings,

that are registered or held in an account directly or indirectly in the name of the depositary. The aim of the definition is to capture all financial instruments that the depositary is in a position to control, instruct a transfer of and, if need be, retrieve. Consequently, it does not include financial instruments that are directly registered with the issuer or its agent (e.g., a registrar or transfer agent) in the name of the fund, unless they can be physically delivered to the depositary or are registered or held in an account directly or indirectly in the name of the depositary. Financial instruments provided as collateral (either under the terms of a title transfer financial collateral arrangement or under a security collateral arrangement) by which the control or possession of the instrument has been transferred from the fund or the depositary to the collateral taker or its agent are excluded from the custody obligation. On the other hand, financial instruments received as collateral for the benefit of the fund should be held in custody. Assets that do not have to be held in custody include (but are not limited to) the following:

  • Physical assets that do not qualify as financial instruments or cannot be physically delivered to the depositary (e.g., real estate);
  • Financial contracts (e.g., derivatives other than those embedded in transferable securities);
  • All financial instruments, including units or shares of collective investment schemes issued in a nominative or registered form in the name of the fund, provided that they cannot be physically delivered to the depositary or are not registered or held in an account directly or indirectly in the name of the depositary;
  • Cash deposits; and
  • Investments in privately held companies and interests in partnerships.

Liability of Depositaries

The AIFM Directive sets out two standards of liability for a depositary:

  • First, where the depositary or its sub-custodian has lost a Custody Asset, the depositary must return identical financial instruments or an equivalent amount of cash to the fund (or the manager acting on its behalf) without undue delay; and
  • Second, all other losses suffered by the AIF or its investors as a result of the depositary's negligent or intentional failure to properly fulfil its obligations under the AIFM Directive, regardless of any exclusion or limitation of liability in the contractual arrangements.

The final advice only considers the liability for the loss of a Custody Asset. This aspect of the proposed depositary's liability regime has been highly controversial and subject to intensive lobbying throughout the legislative process. Concerns have focused on the near strict liability position for the loss of Custody Assets, particularly where held by sub-custodians. Unfortunately, the final advice does not address all of the industry's concerns, and a depositary is only able to discharge its liability in limited circumstances. These are where:

  • The depositary can demonstrate that the loss has 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; or
  • In the case of loss by a sub-custodian, the depositary has transferred its liability to the sub-custodian.

The concepts of "external event," "beyond reasonable control," and "having taken all reasonable efforts" are restrictively defined in the final advice. The result is therefore a near strict liability regime for the loss of Custody Assets. For example, a depositary would not be liable in the case of an act of State (e.g., nationalisation) or of God (e.g., a natural disaster) but, in general, would be liable in the event of the insolvency of a sub-custodian, even if it is not an affiliate. ESMA justifies this latter position as financial assets will only be lost on the insolvency in limited circumstances, such as the failure of the sub-custodian to segregate its assets, which the depositary should have oversight of. The industry, however, in general, fails to see how the insolvency of a third-party sub-custodian could be other than an unavoidable external event outside the depositary's reasonable control. A depositary can also discharge its liability by transferring it to a sub-custodian where it can show that it has no other option but to delegate, or that the AIFM believes the delegation is in the best interests of the fund. This would include, for example, where there is a legal requirement to appoint a specific sub-custodian in the country in which the manager wishes to invest or where the sub-custodian has specific expertise. In any event, the delegation must be effected in accordance with the AIFM Directive and, in addition, there must be: (1) a written contract between the depositary and the sub-custodian transferring liability and making it possible for the AIF/AIFM to claim directly against the sub-custodian in addition to the depositary; and (2) a written contract between the AIF/AIFM and the depositary, expressly permitting the transfer of liability on objective grounds.

Regulation & Supervision of Non-EU Depositaries

While an EU fund is required to appoint an EU-based depositary, a third-country AIF (which is managed by an EU AIFM or is to be marketed to investors in the EU under the EU-wide passporting regime) may appoint a third-country depositary, so long as the depositary is eligible under the AIFM Directive. To be eligible:

  • The competent authorities of the Member States in which the AIF is to be marketed and the AIFM's home Member State must have entered into co-operation and exchange of information arrangements with the competent authorities of the third country;
  • The depositary must be subject to effective prudential regulation, including minimum capital requirements, and supervision which have the same effect as EU law and are effectively enforced;
  • The third country must not be listed as a Non-Cooperative Country and Territory by the Financial Action Task Force;
  • The Member States in which the AIF is to be marketed and the manager's home Member State must have entered into a tax information exchange agreement with the third country; and
  • The depositary must agree to the liability and delegation requirements of the AIFM Directive.

Where the third-country AIF is marketed in each Member State separately under that Member State's national law (i.e., a private placement regime (PPR)) rather than under the EU-wide passporting regime, the above depositary eligibility requirements do not apply. However, it is still necessary to appoint an entity (other than the manager) to carry out the typical depositary duties. The AIFM is also required to inform its supervisory authorities of the entities appointed. In light of these less burdensome depositary requirements, the PPR may be a more attractive route for AIFMs than passporting, but the intention is that this route will be phased out in 2018. ESMA's final advice provides guidance about the co-operation arrangements, the tax information exchange agreements, and, of specific relevance to depositaries, how to assess whether the prudential regulation and supervision of third-country depositaries has the "same effect" as EU law. The precise details of this latter requirement have been hotly contested both during the negotiation of the AIFM Directive and the recent consultation: if third-country regulatory and supervisory regimes are assessed too stringently, then it would be difficult to see how depositaries of otherwise AIFM Directive-compliant funds could be based outside the EU. The final advice adopts the more relaxed (although still not ideal) view that the industry lobbied for; however, it will ultimately be for the Commission to identify third countries whose regulatory environment is of the "same effect" as EU law and is effectively enforced in this regard.

Cash Monitoring/Oversight

As part of its oversight role under the AIFM Directive, a depositary is required to ensure that the AIF's cash flows are properly monitored. In order to do so, the final advice requires a depositary, as a minimum, to:

  • Ensure that an AIF's cash is booked in one or more accounts at an appropriate bank or credit institution.
  • Guarantee that there are proper procedures in place to reconcile all cash flow movements and verify that these are performed at an appropriate interval (e.g., weekly for an AIF that reconciles cash flow movements daily).
  • Make sure that appropriate procedures are implemented to identify significant cash flows, particularly those which would be inconsistent with the AIF's operations.
  • Review the adequacy of such procedures periodically. ESMA recommends that the reconciliation procedures should be fully reviewed at least annually.
  • Monitor the outcomes and actions taken as a result of any discrepancies identified by the reconciliation procedure and alert the manager or AIF if the anomaly has not been rectified without undue delay.
  • Check the consistency of its records with those of the AIFM.

To enable the depositary to fulfil this role, the AIFM is responsible for ensuring that the depositary receives all the relevant information timely and accurately, either via itself or directly from appropriate third parties, such as the AIF's administrator or prime broker.

Particulars of Contract

The final advice contains ESMA's proposals on the content of the contract to be entered into between the AIF and the depositary. In an approach broadly supported by the industry, ESMA stopped short of insisting upon the use of a model contract, instead setting out a list of particulars that must be included in each contract. In order to ensure consistency across the asset management industry, these particulars are based on UCITS5 requirements but have been expanded in an attempt to address the wide variety of funds within the scope of the AIFM Directive. For example, included are provisions addressing the depositary's liability and ability to delegate, the flow of information to the depositary, and rights of the depositary to re-use assets entrusted to it.

Next Steps

The Commission will use ESMA's final advice as a basis for the Level 2 implementing measures, which are due to be adopted during the course of 2012. The final advice is not binding on the Commission, and the Commission has already indicated that it does not agree with all of ESMA’s conclusions. No indications have yet been given as to whether the measures will be in the form of further directives, regulations, or a mix of both. © 2012 Hogan Lovells LLP Jeremy Pickles is a senior associate in the investment funds group in Hogan Lovells' London office. Jeremy has broad experience of advising on the structuring, establishment, marketing and reorganisation of a wide variety of investment funds, and on associated legal and regulatory issues. He also advises institutional investors in relation to their participation in investment funds. E-mail:; Telephone: +44 (0) 20 7296 2000.

Nora Bullock is a professional support lawyer in the investment funds group in Hogan Lovells' London office. Nora has broad experience of advising on the structuring, establishment, marketing and reorganisation of (and investment in) a wide variety of investment funds, and on associated legal and regulatory issues. E-mail:; Telephone: +44 (0) 20 7296 2547.

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