EUROPEAN UNION: European Commission Publishes Delegated Regulation on Obligations of Depositaries required by UCITS V

Wednesday January 6 2016

On 17 December 2015, the European Commission adopted the first draft of the UCITS V Delegated Regulation. The Regulation contains detailed provisions about the obligations and rights of depositaries taking into account that the core function of such entities is the protection of the UCITS’ investors.

The UCITS V Delegated Regulation will implement UCITS V which will come into force on 18 March 2016. The Regulation still needs to go through a three-month objection period by the Council of the EU and the European Parliament before being published in the Official Journal and coming into force 20 days later.

The Delegated Regulation sets out provisions relating to issues including:

Particulars that need to be included in the written contract (Article 2)

Article 2 provides minimum requirements for the contractual arrangement between the management company or the investment company and the depositary appointed by the UCITS in accordance with Article 22 of the UCITS Directive. The list of requirements which have to be included in the contract sets standards on what is necessary for the appropriate safekeeping of all UCITS’ assets by the depositary or a third party to whom safekeeping functions are delegated and for the depositary to properly fulfil its oversight and control functions.

In order to allow the depositary to assess and monitor custody and insolvency risk, the contract should provide sufficient detail on the categories of financial instruments in which the UCITS may invest in and cover the geographical regions in which the UCITS plans to invest.

The contract should also contain details of an escalation procedure. Thus, the depositary should alert the UCITS of any material risk identified in a particular market’s settlement system.

In order to maintain a high standard of investor protection, requirements for the monitoring of third parties should be applied in relation to the whole custody chain.

Oversight duties (Article 3)

Article 3 contains, in particular, requirements with respect to the oversight and control function of a depositary in order to enable it to properly assess and supervise the management company or the investment company.

Duties regarding subscription and redemptions (Article 4)

The depositary has to establish an appropriate reconciliation procedure in order to ensure consistency between the number of units issued and the subscription proceeds received. It has also to check that the procedures regarding the sale, issue, repurchase, redemption and cancellation of units of the UCITS comply with the applicable national laws and with the UCITS rules or instruments of incorporation.

Duties regarding the valuation of units (Article 5)

The depositary’s oversight function also comprises the obligation to monitor the UCITS’ valuation policies and procedures applied for the valuation of the UCITS’ assets.

Duties regarding the carrying out of the UCITS’ instructions (Article 6)

Another depositary’s oversight task is checking that the UCITS’ investments are consistent with its investment strategies as described in the UCITS’ rules and offering documents and ensuring that the UCITS does not breach its investment restrictions. The depositary should monitor UCITS’ transactions and investigate any unusual transaction.

Duties regarding the timely settlement of transactions (Article 7)

Depositaries have to monitor all operations involving UCITS’ assets and remedy all delays in restitution of financial instruments from the counterparties.

Duties related to the UCITS’ income distribution (Article 8)

The depositary should ensure that the income of the UCITSs is accurately calculated and it should verify the completeness and accuracy of any income distribution.

Cash monitoring (Articles 9 to 11)

Articles 9 to 11 of the Regulation spell out the requirements for access to and flow of information which is necessary to enable the depositary to have a clear overview and effectively monitor UCITS’ cash flows as provided for by Article 22(4) of the UCITS Directive. The depositary has to be also informed about all payments made by or on behalf of investors upon the subscription of units of an UCITS.

Conditions for performing the depositary functions (Articles 12 to 14)

Article 12 sets out the scope of custody. Under this Article, all financial instruments which can be registered in a financial instruments account (essentially, transferable securities, money market instruments and units in collective investment undertakings) and which belong to an UCITS must be held in custody. As clarified in recital 12, assets belonging to an UCITS may not be excluded from the scope of custody simply because they are subject to particular business transactions such as collateral arrangements. Therefore, should an UCITS provide its assets as collateral to a collateral taker, UCITS rules require these assets to be kept in custody as long as the UCITS owns the collateralised financial instruments.

Financial instruments which are held in custody should be subject to due care and protection at all times. To ensure that the custody risk is properly assessed, in exercising due care, the depositary should, in particular, know which third parties constitute the custody chain, ensure that the due-diligence and segregation obligations have been maintained throughout the whole custody chain, ensure that it has an appropriate right of access to the books and records of third parties to whom safekeeping functions are delegated, ensure compliance with these requirements, document all of these duties and make these documents available to and report to the UCITS.

Due diligence duties of depositaries (Article 15)

In order to ensure a sufficient level of protection of assets, Article 15 lays down certain principles that should be applied in relation to the delegation of safekeeping functions.

When selecting and appointing a third party to whole safekeeping functions are to be delegated the depositary has to assess the regulatory and legal framework, including country risk and custody risk and the enforceability of the third party’s contract. In case the third party is located in a third country the assessment of the enforceability of the contract has to be based on the legal advice from an independent source. The obligation to monitor on an ongoing basis the third party, to whom safekeeping functions have been delegated, should consist of verifying that this third party correctly performs all the delegated functions and complies with the delegation agreement.

The contractual arrangement with the selected third party to whom the safekeeping functions are delegated should contain an early termination clause. It is necessary that the depositary is in position to terminate its contractual relation with a third party to whom the safekeeping functions have been delegated in cases where the law or case law of a third country changes in such a way that the protection of the UCITS’ assets is no longer ensured.

Segregation obligation (Article 16)

When delegating safekeeping functions, the depositary should ensure that the requirements of Article 22a(3)(c) of the UCITS Directive are fulfilled and that the assets of the UCITS clients of the depositary are properly segregated. This obligation should particularly ensure that assets of the UCITS are not lost due to insolvency of the third party to whom safekeeping functions are delegated.

Insolvency protection of UCITS assets when the depositary delegates safekeeping functions to a third party (Article 17)

Before and during the delegation of safekeeping functions, the depositary should ensure by means of its pre-contractual and contractual arrangements that the third party takes measures and put in place arrangements in order to ensure that the UCITS assets are protected from distribution among or realisation for the benefit of creditors of the third party. The UCITS Directive requires all Member States to bring all their insolvency laws in line with this requirement. It is therefore necessary that the depositary obtains independent legal opinion about the applicable insolvency laws and case law of a third country where the UCITS’ assets are required to be held. The contractual arrangement with the third party to whom the safekeeping of assets is to be delegated should contain the due diligence and information obligations enabling the depositary to monitor whether UCITS assets are appropriately segregated and unavailable for distribution among, or realisation for the benefit of creditors of the third party. A third party has to inform the depositary about any changes to the insolvency law and case law. A third party is also obliged to put in place operational arrangements allowing immediate identification of the UCITS assets and conducted transactions which are necessary for the depositary to enable it to conduct its oversight duties laid down in the UCITS Directive and this Regulation.

Conditions subject to which and circumstances in which financial instruments held in custody are to be considered to be lost (Article 19)

With respect to the liability regime Articles 18 and 19 ensure uniform interpretation of Article 24(1) of the UCITS Directive. Article 19 provides the conditions for using the liability discharge and specifies what is to be understood by external events beyond reasonable control, the consequences of which would have been EN 9 EN unavoidable despite all reasonable efforts to the contrary.

Conditions for fulfilling the independence requirement (Chapter 4)

The UCITS Directive delegates the task of establishing the conditions and criteria to ensure that management companies, investment companies, depositaries and third parties to whom the safekeeping functions has been delegated act independently. In establishing these criteria, Section 4 takes into account the features of both one-tier and two-tier corporate governance systems. Common management rules ensure that the management body of the management company or the investment company, and the depositary or the third party to whom the safekeeping functions have been delegated do not comprise members of the management body of the other entities or the other entities’ employees. Bodies discharging supervisory functions may only have one third of members who are at the same time members of the management body, the body in charge of the supervisory functions or employees of the other entity. The selection of the depositary by the management company or the investment company must be based on robust, objective and pre-defined criteria and has to warrant the sole interest of the UCITS and its investors. The same applies to the depositary in cases where it delegates the safekeeping to a third party.

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