In July 2013 the Alternative Investment Fund Manager Directive 2011/61/EU (AIFMD) was implemented. After an almost two-year delay since its initial draft, the implementation of the directive set important standards for marketing, capital raising, valuation, risk monitoring and reporting, as well as compliance and accountability for alternative investment funds. The directive applied, among others, to hedge funds, real estate funds and private equity funds.
With its implementation just before the financial crisis, investor protection was at the heart of the AIFMD. Besides the previously existing key players, such as the fund manager and fund administrator, the depositary was introduced for providing a 'supervisory' role for funds that have to comply with the AIFMD or for marketing non-EU funds to EU investors (so-called 'Depo-light' regime).
Today, five years later, the AIFMD and the depositary are unavoidable names in the fund world. However, constant updates and improvements in regulations have already brought several significant specifications to the initial directive. The contribution of government bodies regulating the fund industry at the local level is especially pivotal in this matter. The Luxembourg regulator, Commission de Surveillance du Secteur Financier(CSSF), has published several Circulars in recent years to improve the regulations to which funds, fund and asset managers and any other parties involved, have to abide by.
Most notable of these for depositaries: in October 2016, Circular 16/644 to clarify the UCITs Depositary Regime. Almost two years later, on 23 August this year, Circular 18/697 further elucidates and complements the requirements applicable to depositaries of alternative investment funds (AIFs). The Circular does not only impact the depositary itself, but also the funds and fund managers it supervises.
The Circular applies to:
- AIFs managed internally or by AIFMs;
- Part II UCIs, managed by authorized AIFMs, of which the offering documents expressly proscribe the marketing to retail investors established in Luxembourg;
- Part II UCIs managed by registered AIFMs, of which the offering documents expressly prohibit the marketing to retail investors established in Luxembourg; and
- SIFs/SICARs which are not AIFs and SIFs/SICARs managed by registered AIFMs.
The Circular includes several clarification details for depositaries. Key specifications are:
A (credit) institution desiring to act as an AIF depositary has to be granted with specific approval to act in that capacity. Parties already approved prior to this Circular are not required to apply for a new approval, but must comply with the obligations described in the Circular. This means that the (credit) institutions have to prove that the AIF's depositary managers have the necessary skills and adequate professional experience to fulfill the role. In addition, the CSSF must receive a detailed description of the organization's available human and technical resources. This information should, along with other detailed information and documentation with regards to sub-contracting and sub-delegation, be (periodically) shared with the CSSF.
Clarification on the organisation and governance
With investor protection in mind, the depositary must act honestly, loyally, professionally, independently and solely in the interest of the AIF and the investors it serves. For obvious reasons, the depositary cannot act as an investment manager, nor can it be a shareholder in the fund. However, large services providers usually also provide fund administration and AIFM services.
The Circular allows this only to the degree when there is
- an effectively established, implemented and maintained policy for managing conflicts of interest ;
- a clear identification, management and sharing of adequate information on the potential conflicts of interest;
- a functional and hierarchical separation between the depositary and fund administrator/AIFM or both; ; and
- a contractual separation between the depositary and other rendered services.
To be approved as a depositary for an AIF, the depositary must set up appropriate internal procedures for the correct fund description and fund approval via an internal approval committee. In addition, the manager of the depositary business line or department must be notified to the CSSF. In addition, the CSSF should also receive a precise and detailed description of the organization in terms of the technical and human resources available related to the AIF depositary function. Overall, there must also be a clear description in place on how the depositary will carry out its duties, taking into account the different types of AIFMs it serves.
In addition to the internal procedures and contractual agreements with the AIFM, the depositary must also put in place written procedures or contracts with any other parties with whom they must work with in exercising its duties. These written procedures or contracts may take the form of a formal operating memoranda or service level agreements. In terms of specific requirements, the depositaries will have to maintain a list of delegates that are each subject to a contractual and documented relationship along the Circular's principles. This, too, must be shared with the CSSF on an annual basis.
The fund administrator and AIFM are often the parties providing information and documentation to the depositary. The Circular underlines that the depositary must at all time have the right access to all relevant information to meet its regulatory duties and obligations. This timely access is essential to the depositary's duty of safekeeping of other assets - the depositary has to be informed of any changes without delay. In that respect, the depositary must warrant that procedures are place to ensure that registered assets can only be assigned, transferred, exchanged or delivered if the depositary is properly informed about this.
The Circular also places special attention on segregation rules. It is the depositary's responsibility to ensure at all times that the AIF (or a sub-fund in case of a multi-compartment AIF) is the rightful owner of all portfolio holdings/assets in accordance with the applicable law. To fulfil this duty correctly, the Circular includes the following segregation rules:
- a segregation at the first level of the chain of custody that segregates the AIF's assets from others; and
- a segregation installed by the parties to which the depositary sub-delegates this duty.
Specific obligations and requirements
The Circular also describes the accountability and responsibilities in the relationship structure between the depositary and the fund, as well as at the subsequent levels of (sub-)custodians/(sub) delegates. The depositary has some duties, responsibilities and obligations over the network of the appointed custodians and delegates. The Circular also addresses the obligations per type of asset: financial derivative instruments, real estate and intangible rights (i.e. rights, royalties, patents, etc.) and target funds for fund of funds in terms of ownership verification and reconciliation. In the context of derivative instruments, the depositary must track changes in the margins applied to the fund on a daily basis.
Now all Depositaries have until 1 January 2019 to comply with the organisational and governance regulations prescribed in the Circular. For depositaries the next step will be to determine the degree the Circular will impact their current (internal) procedures, work processes and arrangements with other parties involved and, if applicable, make the necessary improvements to comply with the Circular. While the latest update may initially seem like a new prescriptive layer of obligations, it will, undoubtedly, help navigate the depositary to the purpose for which it was initially created – protecting investors.
Published 9 October in Börsen-Zeitung in German here.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.