Delegation of depositary’s functions - AIFMD Provision

AIFMD Anatomy™ →Go uptown In a Nutshell™ Section 21(11): 21(11). The depositary may delegate its paragraph 21(8) custody functions (but not its other functions), as long as: (a) it isn’t trying to avoid its AIFMD obligations; (b) it has an objective reason for doing so; (c) it has exercised all due skill, care and diligence in selecting its delegate, and must continuously monitors that third party; (d) it ensures the delegate meets the following conditions: (i) it is sophisticated enough to properly look after the AIF’s assets; (ii) it is effectively regulated, capitalised, supervised and audited to holds financial instruments in custody; (iii) it segregates the AIF’s assets from its own and from those of the depositary so they can be clearly identified as belonging to clients of the depositary; (iv) it does not use the assets without the AIF’s prior consent and prior notification to the depositary; and (v) it complies with paragraphs 21(8) and 21(10). Where assets have to be held in a jurisdiction where no local entities are effectively regulated, capitalised, supervised and audited, the depositary may appoint a local entity which isn’t, but only as long as there are no local entities that satisfy the delegation requirements, and: (a) the depositary informs AIF investors must that such a delegation is required, and why, before they invest; and (b) the AIF instructs the depositary to delegate the custody of such financial instruments to such a local entity. The third party may sub-delegate these functions, subject to the same requirements mutatis mutandis. Use of a securities settlement system does not count as delegation of custody functions. view template Full text This is an unoffical transcription, may be wrong, buggered up, out of date etc. You should Google the original. 21(11). The depositary shall not delegate to third parties its functions as described in this Article, save for those referred to in paragraph 21(8). The depositary may delegate to third parties the functions referred to in paragraph 21(8) subject to the following conditions: (a) the tasks are not delegated with the intention of avoiding the requirements of this Directive; (b) the depositary can demonstrate that there is an objective reason for the delegation; (c) the depositary has exercised all due skill, care and diligence in the selection and the appointment of any third party to whom it wants to delegate parts of its tasks, and keeps exercising all due skill, care and diligence in the periodic review and ongoing monitoring of any third party to whom it has delegated parts of its tasks and of the arrangements of the third party in respect of the matters delegated to it; and (d) the depositary ensures that the third party meets the following conditions at all times during the performance of the tasks delegated to it: (i) the third party has the structures and the expertise that are adequate and proportionate to the nature and complexity of the assets of the AIF or the AIFM acting on behalf of the AIF which have been entrusted to it; (ii) for custody tasks referred to in point (a) of paragraph 21(8), the third party is subject to effective prudential regulation, including minimum capital requirements, and supervision in the jurisdiction concerned and the third party is subject to an external periodic audit to ensure that the financial instruments are in its possession; (iii) the third party segregates the assets of the depositary’s clients from its own assets and from the assets of the depositary in such a way that they can at any time be clearly identified as belonging to clients of a particular depositary; (iv) the third party does not make use of the assets without the prior consent of the AIF or the AIFM acting on behalf of the AIF and prior notification to the depositary; and (v) the third party complies with the general obligations and prohibitions set out in paragraphs 21(8) and 21(10). Notwithstanding point (d)(ii) of the second subparagraph, where the law of a third country requires that certain financial instruments be held in custody by a local entity and no local entities satisfy the delegation requirements laid down in that point, the depositary may delegate its functions to such a local entity only to the extent required by the law of the third country and only for as long as there are no local entities that satisfy the delegation requirements, subject to the following requirements: (a) the investors of the relevant AIF must be duly informed that such delegation is required due to legal constraints in the law of the third country and of the circumstances justifying the delegation, prior to their investment; and (b) the AIF, or the AIFM on behalf of the AIF, must instruct the depositary to delegate the custody of such financial instruments to such local entity. The third party may, in turn, sub-delegate those functions, subject to the same requirements. In such a case, paragraph 13 shall apply mutatis mutandis to the relevant parties. For the purposes of this paragraph, the provision of services as specified by Directive 98/26/EC (EUR Lex) by securities settlement systems as designated for the purposes of that Directive or the provision of similar services by third-country securities settlement systems shall not be considered a delegation of its custody functions. view template Directive 2011/61/EU (EUR Lex) | Implementing regulation 231/2013 (EUR Lex) Navigation directive - 21 (depositary) | 21(4) (conflict management) | 21(8) (custody function) | 21(11) (custody delegation) | 21(12) (liability for loss of assets) | 21(13) (discharge of liability on delegation) | 21(14) (discharge of liability for Non-EU subcustodians) | 36 (depo-lite) | 36(1) implementing regulation DR20 (Due diligence when appointing counterparties and prime brokers) | DR76 (objective reason) | DR89 (Safekeeping duties with regard to assets held in custody) | DR91 (reporting obligations for prime brokers) | DR98 (due diligence) | DR99 (segregation obligation) | DR100 (Loss of custody asset) | Tell me more Sign up for our newsletter — or just get in touch: for ½ a weekly 🍺 you get to consult JC. 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Overview

On what on earth this is all about.

AIFMD, requires an AIF to appoint a depositary to perform certain administrative functions: managing cashflows, supervising subscriptions and redemptions, and custody of the AIF’s assets labelled “safekeeping” in the argot of European Regulation. The depositary cannot have any financial transactions or other conflicts of interest with the fund and must be organised in the fund’s home jurisdiction. Therefore a prime broker cannot be an AIF depositary: it is (usually) not incorporated in the right jurisdiction, and in any case is definitely involved in financial transactions with the AIF. That’s what it is there fore.

Now a big part of a prime broker’s business is margin lending, which involves custody and reuse of the AIF’s assets. What to do? Well, AIFMD allows a depositary to delegate its custody safekeeping function (but only that function) to a third party where there are objective reasons for it doing so.

It has (i) a limited ability to delegate that responsibility to a third party and (ii) an even more limited ability to discharge its liability for that responsibility to a third party.

The risk to the depositary is: - That its delegation of the custody function is not permitted; or that - that it is permitted to delegate the custody function, but that having done so, it is held responsible under AIFMD for the loss of assets by its delegate, for some reason (ie that any the purported discharge of liability is invalid)

Therefore what the depositary needs to achieve is - Establishing valid “objective reason” for delegating the custody function to UBS as prime broker. This we think is tried and true and not controversial: AIF depositaries delegate safekeeping to PBs all the time. - To the extent allowed by AIFMD, discharging its personal liability to the AIF for the loss of assets held by its delegate custodian by transferring that liability directyly to that delegate custodian

Delegation of depositary’s functions

You will see from 21(4) the depositary’s role in toto is not really suitable for a prime broker. However, the depositary may delegate some of its functions, and a prime broker may act as:

• A custodian, but will have certain conditions to that appointment (set out in Art 21(11), including the famous “objective reason”), and you may expect the depositary will seek to delegate the safe-keeping function on those exact conditions, and (as far as it can) transfer outright its liability for those responsibilities to the prime broker, on exactly the terms required by AIFMD and AIFMR.
• A “depositary lite” to certain non-EU domiciled AIFs who aren’t obliged to have a full-blown depositary. The depo-lite regime, and the delegated safe-keeping regime, are different but in many respects quite similar things and it is easy to conflate them.

“Delegation” versus “sub-contracting”

These terms are easily conflated. Indeed, AIFMD conflates them. But, in this commentator’s view, they are different in important ways. Read more about this here. But in any case our — well, contrarian — view is that a custodian who appoints a sub custodian in its sub custody network is not “delegating” its AIFMD custody obligations “at the first level of the custody chain”, as Art 21(11)contemplates, and hence sub-custodians do not have to:

• Segregate the AIF’s assets from the depositary’s assets in their books (as would be required of a delegate custodian under Art 21(11)(d)(iii)),
• Hold assets in their books in the name of the AIF (or the AIFM acting on behalf of the AIF) (as would be required of a delegate custodian under Art 21(11)(d)(v), incorporating as it does Art 21(8)(a)(ii)).

Conditions to delegation by a depositary

The depositary can only delegate in certain circumstances:

• It must have an “objective reason” for the delegation.
• it must exercise due skill, care and diligence in the selection, appointment and ongoing monitoring of the delegate;
• The delegate:
  • must have structures and expertise proportionate to the nature, scale and complexity of the assets of the AIF
  • must be subject, in acting as a custodian, to effective prudential regulation and supervision in its local jurisdiction and periodic external audits;
  • must segregate AIF assets from its own and the depositary’s assets
  • may not reuse the AIF’s assets without the AIF’s express consent.

We read this as referring only to a delegation of the “head” custody function, not to a custodian’s holding of assets in its own sub-custody network: it can’t do; sub-custodians operate on an omnibus basis and don’t segregate assets belonging to the main custodian’s individual clients’ interests in their books (so can’t segregate, for example, the depositary’s assets from the AIF’s assets: they don’t have enough information to do this.

Conditions to discharge of liability when delegating by a depositary

It is one thing for a depositary to delegate performance of a safekeeping function to a prime broker (21(11)); it is another for it to discharge its liability for the safekeeping of assets (21(13)). That can only happen if:

• All the conditions to delegation are met;
• There is a written contract transfers that liability so the AIF can claim directly against the PB — which contractual privity freaks will immediately realise will require either artful use of the Contracts (Rights of Third Parties) Act 1999, or that the AIF should be party to that contract. In practice the AIF will of course be party to a contract with its prime broker.

Custody delegation under UCITS and AIFMD looks kind of similar doesn’t it?

Yes, it does. The textual differences betwixt UCITS (Art 22a) and AIFMD (Art 21(11)) are largely formal, or mutatis mutandis in style. The substantive differences are that a UCITS depositary:

• cannot reuse the UCITS’ assets at all, whereas an AIFMD depositary can, with prior notification and consent;
• must take all necessary steps to ensure UCITS’ assets aren’t caught up in the bankruptcy estate of an insolvent delegate custodian — there isn’t an equivalent provision under AIFMD, though perhaps you might imply it;
• must notify UCITS investors of the risks of delegation where a non-EEA jurisdiction requires use of a local custodian and no local entities satisfy the delegation requirements and not just the fact of, and circumstances justifying, it.

See also

• Delegation under AIFMD: Art. 21(11)
• Delegation under UCITS: Art. 22a