Liability for delegation - UCITS V Provision

UCITS V Anatomy™ →Go uptown In a Nutshell™ Clause 24: Article 24 24(1). The depositary will be liable to the UCITS if it (or a third party delegated under Article 22(5)(a)) loses custody assets it is meant to be safekeeping. If it loses an asset the depositary must promptly return a fungible financial instrument in the same nominal amount. The depositary will not be liable if the loss arose through a force majeure which it could not have avoided having taken all reasonable efforts to do so. The depositary will also be liable to the UCITS for all other losses they suffer through the depositary’s negligent or wilful failure to fulfil its obligations under UCITS. 24(2). The depositary cannot discharge its liability if it delegates in accordance with Article 22a. 24(3). The depositary cannot exclude or limit its liability to the UCITS by contract. 24(4). If it tries to, the contract will be void. 24(5). UCITS investors can sue the depositary directly or indirectly through the UCITS management company as long as it does not create duplication or unequal treatment of the investors. view template UCITS V full text of Clause 24: Article 24 24(1). Member States shall ensure that the depositary is liable to the UCITS and to the unit-holders of the UCITS for the loss by the depositary or a third party to whom the custody of financial instruments held in custody in accordance with point (a) of Article 22(5) has been delegated. In the case of a loss of a financial instrument held in custody, Member States shall ensure that the depositary returns a financial instrument of an identical type or the corresponding amount to the UCITS or the management company acting on behalf of the UCITS without undue delay. The depositary shall not be liable if it can prove that the loss has arisen as a result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary. Member States shall ensure that the depositary is also liable to the UCITS, and to the investors of the UCITS, for all other losses suffered by them as a result of the depositary’s negligent or intentional failure to properly fulfil its obligations pursuant to this Directive. 24(2). The liability of the depositary referred to in paragraph 1 shall not be affected by any delegation as referred to in Article 22a. 24(3). The liability of the depositary referred to in paragraph 1 shall not be excluded or limited by agreement. 24(4). Any agreement that contravenes paragraph 3 shall be void. 24(5). Unit-holders in the UCITS may invoke the liability of the depositary directly or indirectly through the management company or the investment company provided that this does not lead to a duplication of redress or to unequal treatment of the unit-holders. view template Resources: UCITS IV (2009/65/EC (EUR Lex)) | UCITS V (2014/91/EU (EUR Lex)) | ESMA Guidance on UCITS | Depositary comparison under AIFMD and UCITS Navigation - UCITS IV: 50(1)(g) Financial derivative instruments Navigation - UCITS V: 22(2) Written contract with depositary | 22(3) (subscriptions, redemptions, valuation by depositary) | 22(4) (cash monitoring | 22(5) (safekeeping by depositary) | 22(7) (no reuse of assets by depositary) | 22a (delegation of depositary functions) Tell me more Sign up for our newsletter — or just get in touch: for ½ a weekly 🍺 you get to consult JC. Ask about it here.

Comare with Art 21(12) of AIFMD.
Not pretty, if you are a depositary, and that means not pretty if you are a delegate either. Since the depositary can’t discharge its safekeeping liability when delegating it even by means of full assumption of liability by the delegate (as is possible under AIFMD 21(12), delegates should expect to be asked to provide eye-watering indemnities to the depositary should they lose assets they are looking after on the depositary’s behalf.

Seeing as a prime broker can’t generally rehypothecate UCITS assets, it kind of makes you wonder why a prime broker would want to hold the assets in the first place.

“External event beyond its reasonable control”

Both AIFMD (Art 21(12)) and UCITS (Art 24) exempt the depositary for liability from loss arising from “an external event beyond its reasonable control”. So the unexpected insolvency of a delegate or subcustodian is an event beyond the depositary’s reasonable control, right? This was certainly the hopeful expectation of the European Banking Federation in its submissions to that effect of September 2011.

Wrong. According to ESMA’s final 500-page bunker-busting advice from 2011:

The depositary will not be liable for the loss of financial instruments held in custody by itself or by a subcustodian if it can demonstrate that all the following conditions are met:

1. The event which led to the loss is not a result of an act or omission of the depositary or one of its sub-custodians to meet its obligations.

2. The event which led to the loss was beyond its reasonable control i.e. it could not have prevented its occurrence by reasonable efforts.

3. Despite rigorous and comprehensive due diligence, it could not have prevented the loss.

The “omission of a sub-custodian to meet its obligations” — albeit through its insolvency (and associated failures in internal segregation etc) is thus not an “external event beyond the reasonable control” of the depositary. Treat this exemption as being limited to genuine force majeure events — acts of God, war, insurrection, malign operation of the trade winds, etc — or peculiarities in the insolvency law in the sub-custodian’s jurisdiction which mean the assets are unavoidably tangled up in the insolvency estate.

Here’s para 27 and 28 of the selfsame opinion:

27. As for the insolvency of a sub-custodian, as suggested in the draft advice in relation to the definition of a ‘loss’, ESMA considers that the financial instruments held in custody by that entity should not automatically be deemed lost since there is a reasonable chance they will be recovered at the end of the legal proceedings thanks notably to the sub-custodian’s obligation to comply with the segregation requirements defined in Article 21(11)(d)(iii) and the corresponding implementing measures. However, ESMA has identified three situations where instruments may be lost following the bankruptcy of a sub-custodian:

(i) where the sub-custodian failed to implement the segregation rules,

(ii) where the law of the country where the instruments were held in custody does not recognise the effects of such segregation requirements and

(iii) finally some industry representatives have highlighted that in any insolvency, a small percentage of the assets may be lost due to the disruption in the entity’s activity in relation to its default.

28. In the second situation, where the financial instruments are ‘lost’ following the liquidation of a sub-custodian despite appropriate segregation of assets, because the law of the country where the financial instruments were held in custody does not recognise the effects of segregation, ESMA believes that the loss of those financial instruments should be considered due to be an external event, i.e. the local legal/regulatory framework. In the two other situations – ceteris paribus – the depositary would be held liable.

These situations aside, the depositary remains liable for the insolvency of sub-custodians. Even unaffiliated ones.

Careful

Note that the prohibition on excluding or limiting liability for delegated obligations under UCITS Art 24(2) is limited specifically to those functions it has delegated under Art 22a - so when giving your indemnities and so on, be assiduous not to indemnify liabilities wider than those covered by Art 22a that the depositary could, if it wanted to, contract out of.

Recital 27:

Where the depositary delegates custody tasks and the financial instruments held in custody by a third party are lost, the depositary should be liable. In the case of loss of an instrument held in custody, a depositary should return a financial instrument of an identical type or the corresponding amount, even if the loss occurred with a third party to which the custody has been delegated. The depositary should be discharged of that liability only where it is able to prove that the loss resulted from an external event beyond its reasonable control and with consequences that were unavoidable despite all reasonable efforts to the contrary. In that context, a depositary should not be able to rely on internal situations such as a fraudulent act by an employee to discharge itself of liability. No discharge of liability, be it regulatory or contractual, should be possible in the case of loss of assets by the depositary or a third party to which the custody has been delegated.

See also

• Art 21(12) of AIFMD
• Delegation under AIFMD.