Investors advised to review managed account custodian contracts
Institutional investors have been urged to carefully monitor the custodian agreements they have signed if they invest in a managed account or fund of one that is not subject to the Alternative Investment Fund Managers Directive (AIFMD) or UCITS V.
Managed accounts are not within the jurisdiction of AIFMD and UCITS V. Accordingly, there is no obligation to appoint a depositary bank to provide the additional requirements of cash-flow monitoring and oversight of fund compliance, or to take strict liability for loss or misappropriation of assets at the sub-custodian level.
“While there are a number of benefits of investing into a managed account such as enhanced liquidity and better corporate governance, managed accounts are not covered by these EU Directives. This means custodian agreements remain unchanged insofar as the custodian is typically only liable to return any lost or misappropriated assets in an insolvency at the sub-custodian if it can be proven that the custodian failed to take reasonable care when selecting and monitoring its sub-custodian,” said Nick Bradley, Managing Director at Thomas Murray IDS.
The imposition of strict liability has come unstuck with AIFMD. A number of depositary banks have negotiated indemnifications or contractual discharges of liability excusing them from repairing losses under some circumstances at the sub-custodian level, such as at the prime broker or emerging market agent bank.
While the rules have not been legally tested, it does reduce the ability of an investor to recover assets should the sub-custodian fail. The ability to discharge this liability is one reason why the cost of appointing a depositary bank is around three basis points, much lower than the initial cost forecasts of around forty basis points being circulated when the Directive was first announced and reflective of the extent to which depositaries consider that they have reduced their liability.
Importantly, there is no such leeway under UCITS V. The regulation, which is due to be implemented by EU member states in March 2016, also requires managers to appoint a depositary to perform similar functions but explicitly prohibits the discharge of liability to sub-custodians including market infrastructure utilities such as central securities depositories (CSDs). In other words, if a sub-custodian that is holding assets on behalf of a UCITS were to enter into insolvency, the depositary would have to return those assets to the UCITS and its underlying clients.
Regulators have made it abundantly clear they want convergence with UCITS and AIFMD and as such there is a distinct possibility that the ban on discharging liability to sub-custodians will be imposed on AIFMs. This would be a significant challenge for depositary banks as AIFMs have fewer investment restrictions than UCITS, the latter of which is usually consigned to vanilla instruments, markets and strategies.