Depositary banks warned on restitution of assets in sub-custody at US primes
There are questions as to whether depositary banks with assets held in sub-custody at US prime brokers will be subject to strict restitution liability under the Alternative Investment Fund Managers Directive (AIFMD) for assets lost during re-hypothecation should the prime broker default.
It is a common practice under US law to allow re-use of assets by US prime brokers without transfer of legal title. The implications for depositaries of alternative investment fund managers (AIFMs) transacting in US securities held in US prime brokerage accounts are potentially significant.
“Assets that are validly re-hypothecated by European prime brokers count as off-balance sheet as there is typically title transfer, meaning the depositary is not liable in restitution for them – since they are not ‘there’. The legal premise is different in the US as there is – typically -no title transfer, meaning that the depositary could potentially be liable in restitution for the loss of assets should the prime broker default,” said one depositary bank executive, speaking under strict anonymity.
Depositary banks have sought to mitigate the liability by discharging restitution liability for the return of AIF assets to prime brokers, which must be appointed as sub-custodians if they hold AIF assets, and by seeking indemnities against any losses. However, there is no legal precedent for these arrangements meaning the discharge mechanism, and the required “objective reason” to support it, are open to interpretation by the courts.
Depositaries have been advised to alert clients with US prime brokerage relationships of the risks that this presents, particularly around the restitution of assets. The depositary is also advised to conduct rigorous due diligence on any US prime broker holding AIFM assets to ensure that their business practices adhere to the highest standards and meet all compliance obligations. If the depositary can show it has performed its due diligence to the highest standard, this should reduce the risk of being forced to make right any losses.
UCITS V, meanwhile, explicitly prohibits depositary banks from discharging liability for loss of assets to sub-custodians and there is speculation this could be extended to AIFMD when the European Securities and Markets Authority (ESMA) conducts its wholesale review of AIFMD in 2015. This could have significant implications. AIFMs – unlike UCITS fund structures – can adopt more esoteric, complex strategies and are not subject to leverage and liquidity restrictions. This makes them a riskier proposition for depositary banks to service, which suggests the need for the discharge mechanism is more evident in the context of AIFMD.
ESMA is currently reviewing whether to force prime brokers to segregate AIF assets from those of non-AIF assets in what could be potentially very burdensome for prime brokers to implement. It is also likely to pose a significant challenge to the rehypothecation practices at prime brokers.