Publication of proposal for UCITS V Directive

The European Commission published a proposal for amendments to the UCITS Directive1 on 3 July 2012 in the form of a draft directive to be known as UCITS V2. Many of the provisions in UCITS V reflect corresponding provisions in the Alternative Investment Fund Managers Directive ("AIFMD")3. The main purpose of UCITS V is to align the two Directives so that the same obligations apply to custodians of both UCITS and non-UCITS funds. These proposed changes came about as result of the concern around the role of the custodian arising from both the Madoff fraud and the Lehman collapse. The other proposals in UCITS V address remuneration policies and sanctions. The purpose of this briefing is to consider each of the proposals.

Depositaries

Eligibility

The UCITS Directive gives a degree of discretion to Member States as to the institutions they deem eligible to act as depositaries or custodians. This has led to a divergence in approaches adopted by Member States. UCITS V provides that only EU authorised credit institutions and investment firms authorised under MiFID4 may act as a depositary of a UCITS. There is a one year grandfathering period for UCITS to comply with this requirement if the depositary the UCITS uses does not fall within either category.

Currently, the Central Bank permits additional categories of institutions which are not banks or MiFID firms to act as the custodian of an Irish fund. For example, a company owned and guaranteed by a credit institution may act as a depositary of an Irish fund.

Oversight Cash Monitoring Role

In addition to its current oversight functions, the depositary under UCITS V will have an additional cash monitoring role. In particular it must ensure that all subscription payments have been received and all cash is booked correctly in cash accounts that are opened in the name of the UCITS, the name of the management company or the name of the depositary acting on behalf of the UCITS.

Where the cash account is opened in the name of the depositary acting on behalf of the UCITS, none of the depositary's own cash may be deposited in such account.

These provisions mirror the cash monitoring obligations contained in AIFMD.

Safekeeping

UCITS V introduces an additional obligation on depositaries in relation to assets that cannot be held in custody or physically delivered. The depositary will now be obliged to verify the ownership of such assets as being owned by the UCITS or the management company acting on behalf of the UCITS (in the case of a unit trust or CCF) and maintain a record of those assets which it is satisfied are owned by the UCITS (or management company) and keep the record up-to-date.

This imposes onerous obligations on depositaries in respect of assets that are not capable of being held in custody in the same manner as securitised assets, e.g. OTC derivatives, as they are contractual rights not capable of physical custody. The depositary must verify ownership of OTC derivatives and keep a record of such derivatives.

Delegation

Under UCITS V, the depositary can delegate its safekeeping function to third parties provided it meets a number of conditions which include the depositary demonstrating that there is an objective reason for the delegation and that "the depositary has exercised all due skill, care and diligence in the selection and the appointment of any third party to whom it wants to delegate parts of its tasks and keeps exercising all due skill, care and diligence in the periodic review and ongoing monitoring of any third party to whom it has delegated parts of its tasks and of the arrangements of the third party in respect of the matters delegated to it."

Currently the UCITS Directive does not define the standard of care a depositary must exercise in relation to the appointment and monitoring of its delegates which UCITS V proposes to clarify as outlined in the paragraph above. Nonetheless, the Central Bank of Ireland already requires that the depositary exercise a similar standard of care in relation to its delegates to that proposed in UCITS V so there has been no significant change for Irish UCITS.

UCITS V provides that the depositary can only delegate to a third party who at all times satisfies a number of requirements. These include a requirement on the delegate to segregate the assets from its own assets and in the event of insolvency of the delegate, assets held in custody on behalf of the UCITS will be unavailable for distribution to the delegate's creditors. In addition the depositary must ensure that where the delegate holds assets in custody that the delegate is regulated (including being subject to minimum capital requirements) and supervised in the jurisdiction concerned and is subject to external periodic audit to ensure that the assets are in its possession. This will lead to depositaries amending their sub-custodian agreements with their sub-custodians to ensure that all of the requirements imposed on delegates under UCITS V are set out in the agreements between them. The depositaries are also likely to seek an indemnity from sub-custodians in the event of a loss of any assets held by such sub-custodian, given that under UCITS V the depositary will ultimately be liable for the loss of any assets held by such delegate.

It should be noted that where the local law requires that certain assets are held in custody by a local entity and there are no local entities that satisfy the delegation requirements laid down in UCITS V, the depositary can delegate its functions to such local entity provided investors have been informed and the UCITS or the management company on behalf of the UCITS instructed the depositary to delegate to such local entity.

UCITS V clarifies that the provision of services by securities settlement systems shall not be considered a delegation of custody functions.

UCITS V stipulates that the prospectus of the UCITS include an additional disclosure describing the safe-keeping functions delegated by the depositary, the identification of the delegate and any conflicts of interest that may arise from such delegation. This enhanced disclosure requirement could prove difficult from a practical perspective, particularly given that delegates can change regularly depending on where the UCITS invests.

Liability

Currently the depositary is liable for any loss suffered by a UCITS as a result of "its unjustifiable failure to perform its obligations or its improper performance of them". There has been no legal interpretation of what this liability standard actually means and it has never been tested before the Irish courts.

UCITS V seeks to significantly extend the liability of the depositary to the UCITS or shareholders for loss of any of the assets held in custody by it or its delegates. This reflects the corresponding provisions in AIFMD. The depositary will be obliged to return assets of identical type or corresponding amount to the UCITS (or management company acting on behalf of the UCITS) without undue delay. However the depositary will not be liable if "it can prove that the loss has arisen as a result of an external event beyond its reasonable control, the consequences of which would have been avoidable despite all reasonable efforts to the contrary".

It should be noted from the above that the depositary will not be liable to return assets not capable of custody, such as OTC derivatives, where the depositary has an obligation to verify ownership instead. However most notably the depositary will remain liable for any loss of assets held by any of its delegates or safe-keeping agents. This should be considered in light of the Central Bank's current approach that the depositary will only be liable if it fails to: (i) exercise care and diligence in choosing and appointing a delegate to ensure that the delegate has and maintains the expertise, competency and standing appropriate to discharge the responsibilities concerned; and (ii) maintain an appropriate level of supervision and make appropriate inquiries from time to time to ensure that the obligations of the delegate continues to be competently discharged.

In addition the depositary shall also be liable to the UCITS and to shareholders for all other losses suffered as result of the depositary's "negligent or intentional failure to properly fulfil its obligations" under UCITS V. This would include a failure to verify the ownership of assets not capable of physical custody (e.g. OTC derivatives) now required under UCITS V.

The liability provisions in UCITS V mirror those in AIFMD except UCITS V does not permit the depositary to exclude or limit its liability for assets held in custody by a delegate by contract which is in marked contrast to AIFMD where the depositary can discharge itself of liability by contract between itself and its delegate.

This new liability standard should give more clarity for UCITS. However, as the proposals impose almost strict liability on the depositary, it may lead to custodians having to take out additional insurance to cover this liability and to increased costs for investors.

Manager Remuneration

UCITS V requires management companies to put in place remuneration policies and practices that are consistent with and promote sound and effective risk management and discourage disproportionate risk taking by UCITS.

The remuneration policies and practices shall apply to senior management staff and/or those whose professional activities have a material impact on the risk profiles of the management companies or of UCITS they manage. This new requirement is limited in scope given that it will not affect SMICs and many of the management companies who do not have any employees.

These provisions mirror the corresponding provisions in the AIFMD.

Administrative Sanctions

UCITS V obliges EU Member States to give their competent authorities wide-ranging investigative powers and the ability to impose administrative sanctions in relation to a range of regulatory breaches.

Next Steps

The final form of UCITS V is currently expected to be approved by the end of 2012. Members States usually have two years to transpose the provisions into their national law. Level 2 rules to implement UCITS V will be prepared during that time, meaning UCITS V could apply by the end of 2014.

Conclusion

UCITS V imposes significant obligations on depositaries, in particular near strict liability for any loss of assets held by the depositaries or any of their delegates.

Footnotes

1 Directive (2009/65/EC) on the co-ordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS)

2 Directive amending the UCITS Directive as regards depositary functions, remuneration policies and sanctions

3 Alternative Investment Fund Managers Directive (2011/61/EU)

4 Markets in Financial Instruments Directive (2004/39/EC)

This article contains a general summary of developments and is not a complete or definitive statement of the law. Specific legal advice should be obtained where appropriate.