EUROPEAN UNION: European Commission Draft Regulation on Safekeeping Duties of Depositaries for Alternative Investment Funds

Friday June 8 2018

The European Commission acknowledges that securities and insolvency laws are not harmonised at EU level. However, it is imperative to have common rules to ensure protection of assets safe-kept by depositaries or custodians for their clients. This should lead to the clear identification of assets belonging to a particular AIF and to the protection of such assets in the case of insolvency of the depositary or the custodian. The dedicated provisions of Directive 2011/61/EU and Delegated Regulation (EU) No 231/2013 pursue these objectives. However, diverging applications by national competent authorities and market participants of the obligations for depositaries as regards safe-keeping of AIF clients’ assets risk undermining the objectives pursued by the above-mentioned EU legal acts. The Commission is therefore proposing amendments to Regulation (EU) No 231/2013 to clarify these rules in order to facilitate their uniform interpretation.

This proposal follows up on the opinion of the European Securities and Markets Authority (ESMA) on asset segregation. ESMA identified issues where the understanding among stakeholders differs and invited the Commission to clarify certain obligations of depositaries in case they delegate safe-keeping functions to third parties. ESMA proposes that the asset segregation requirements be better defined and complemented by additional safeguards, in particular the requirements to contractually ensure a sufficient flow of information between the depositary and the custodian or sub-custodian. It also suggests strengthening the requirement to maintain accurate record-keeping and reconciliation systems, including calibrating the frequency of reconciliations with respect to the frequency of trading activities relating to all the assets that may be kept in an omnibus account. ESMA further suggests that the due diligence duties of depositaries should be supplemented by requiring them to have a good understanding of the implications that the insolvency laws of a third country could have if safe-keeping is delegated to custodians located outside the EU.

In order to minimise the risk of loss of assets held in omnibus financial instruments accounts provided by third parties, to whom the custody function has been delegated, the frequency of reconciliations between the financial securities accounts and the records of the depositary of an AIF client and the third party or between the third parties, where the custody function has been delegated further down the custody chain, should ensure a timely transmission of the relevant information to the depositary. Moreover, the frequency of those reconciliations should depend on any movement in that omnibus account, including transactions relating to the assets belonging to other clients of the depositary that are kept in the same omnibus account as the AIF’s assets.

The depositary should be able to continue to carry out its duties effectively where the custody of assets belonging to its AIF clients is delegated to a third party. It is therefore necessary to require that the depositary maintains a record in the financial instruments account it has opened in the name of its AIF client or in the name of the AIFM, acting on behalf of the AIF, showing that the assets kept in custody by a third party belong to that particular AIF.

To strengthen the depositaries’ standing in relation to third parties to whom the custody of assets is delegated, that relationship should be documented by a written delegation contract. That contract should allow the depositary to take all the necessary steps ensuring that the assets kept in custody are properly safeguarded and that the third party complies at all times with the delegation contract. Furthermore, the depositary and the third party should formally agree whether the third party is allowed to further delegate the custody functions. In that instance, the arrangement or contract between the delegating third party and the third party to whom the custody functions are further delegated should be subject to rights and obligations which are equivalent to those established between the depositary and the delegating third party.

In order to enable the depositary to fulfil its functions it is necessary to strengthen depositaries’ oversight over the third parties, regardless of whether they are located inside or outside the Union. It should be required that depositaries verify whether financial instruments of AIFs are correctly recorded in the books of a third party and that the records kept are sufficiently accurate in order to be able to identify the nature, location and ownership of the assets held in custody. To facilitate effective fulfilment of the depositaries’ duties, third parties should provide them with a statement on any change affecting the assets held in custody for the depositaries’ AIF clients.

As part of the depositaries’ obligations to exercise care and diligence in cases of delegation of the custody functions, before delegating this function to a third party located outside of the Union, the depositary should receive an independent legal opinion assessing the insolvency law of the third country where that third party is located this includes an evaluation of the level of protection afforded by segregated financial instruments accounts in that jurisdiction. The opinion provided for each jurisdiction by relevant industry federations or by law firms for the benefit of several depositaries should be acceptable. Furthermore, the depositary should ensure that the third party located outside the Union informs it of any change in circumstances or in that third country’s insolvency law that may affect the status of the assets of the depositary’s AIF clients.

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