Delegation of depositary’s functions - AIFMD Provision
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AIFMD Anatomy™
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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 for.
Now a big part of a prime broker’s business is margin lending, which depends on the prime broker having not only custody but rights of reuse over 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. There is more commentary elsewhere, but take it as read that “because the PB need to hold assets for margin lending, reuse, security and so on” does count as an objective reason.
Right. So AIFMD says a depositary may (with such an objective reason) delegate that responsibility to a third party and may even discharge its liability for asset safekeeping by transferring liability to a third party, but this is even more limited: see Article 21(13): the depositary can only discharge its liability where (i) it was entitled to delegate responsibility per 21(11), (ii) there is a written contract expressly transferring liability to the delegate, so the AIF can expressly claim against it, and (iii) the AIF expressly discharges the depositary’s liability under a written contract and there is an objective reason for doing so.
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