21(13) - AIFMD Provision
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AIFMD Anatomy™
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The great question of who should be liable for third party sub-custodians. The depositary will say, “well, by dint of 21(12), I am stuck with more or less absolute liability for loss of the AIF’s assets wherever they may be, unless I can get my delegate to accept liability for them.”
The delegate will say, “okay, I can probably live with that for my own affiliates, but what about unaffiliated subcustodians in weirdo jurisdictions? All, kinds of crazy stuff can go on there.” It may even start mumbling about incurring capital charges if it takes on liability for third party entities, but is unlikely to be specific because it isn’t clear whether there would be any, and no-one wants to have to enter the netherworld of dialog with the financial reporting folk, to find out. One is never the wiser after a conversation with financial reporting.
The depositary says, “well, do your freaking job would you? You are meant to be a professional custodian. You are meant to be able to control these things. It is your sub-custody network. Put some controls in place. At least you have the contractual privity to exercise controls. I don’t even have that.”
This is liable to go on for a long time. In any other context, they will both agree that the person least able to argue about it — namely, the client — should wear the risk of random sub-custody failure (hey — its their asset after all!) but, alas and alack, that is not an option under UCITS (Art. ) or AIFMD (Art. 21(12)). You can’t stiff the client with liability for your subcustodian failures.
The JC’s sympathy here is with the depositary.
Subcustodian risk
Custodians and depositaries will try to disclaim all risks of the failure of their custody network, as indeed they will try to disclaim all other risks, real and phantasmagorical. Be watchful of this.
Custody risks ought to be fairly minimal: Unless the sub-custodian is in a weird jurisdiction[1], it should never take beneficial title to the assets it holds, and should have segregated them from its own assets, therefore beyond the putative reach of its ordinary creditors — so the assets remain the client’s at all times — so they should return to the client even on the custodian’s insolvency. It follows that, if client assets are not where they are meant to be on a custodian’s insolvency, there must have been some kind of operational mismanagement, negligence or fraud on the custodian’s behalf (and its insolvency). Since the operating cause of the loss is the mismanagement, not the insolvency itself, any capital charge should reflect operational risk and not credit risk.
None of this will stop custodians invoking the “Lehman” horcrux, of course.
Now if a sub-custodian profoundly breaches its custody obligations — which it owes to the main custodian, of course — should that custodian be able to pass its loss back to its innocent client?
It will say “yes” — of course it will — but to what degree has it been complicit in its delegate’s failure? Was it properly monitoring the sub-custodian’s performance? Was it duly diligent in appointing it? The custodian will wail, chomp and complain that it can’t be expected to price flakiness of unaffiliated third parties in far-flung locales into its business offering. Fair, perhaps — but then it did hold itself out as being in some way competent in the safe-keeping of customer assets didn’t it? Wouldn’t that include being diligent in monitoring the performance and capabilities of its custody network?[2] After all the custodian is usually a sophisticated global multinational with experience managing sub-custodians in far-flung locales and it does have contractual privity with them.[3]
The one place it makes some sense is in one of those weird jurisdictions where, by law or market convention, one cannot isolate custody assets from a local custodian’s insolvency. There, it is fair for the client to bear that risk (as it is the client’s choice to take on that “country” risk, and the main custodian cannot avoid it however prudent or diligent it is).
In most jurisdictions, exposure to a custodian for the return of client assets is not a solvency risk as such, seeing as the custodian should not beneficially own client assets and should have segregated them from its own assets, therefore beyond the putative reach of its ordinary creditors. It follows that, if client assets are not where they are meant to be on a custodian’s insolvency, there must have been some kind of operational mismanagement, negligence or fraud on the custodian’s behalf (and its insolvency). Since the operating cause of the loss is the mismanagement, not the insolvency itself, any capital charge should reflect operational risk and not credit risk.
See also
References
- ↑ Being one where by law or market convention one cannot isolate custody assets from the bankruptcy of the local custodian.
- ↑ A diligence standard that, for Europeans, is enshrined in AIFMR (Delegated Regulation DR20) and UCITS (Article 22a2(c)).
- ↑ Yet another argument, wonders this old contrarian, for tactical deployment of the Contracts (Rights of Third Parties) Act 1999?