Liability for loss of assets - AIFMD Provision

AIFMD Anatomy™ →Go uptown In a Nutshell™ Section 21(12): 21(12) Liability for loss of assets: the depositary is liable for the loss of assets by the depositary or a third party to whom custody has been delegated. In the case of such a loss the depositary shall return an identical financial instrument or the corresponding amount to the AIF without undue delay. It will not be liable if the loss arose 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. view template Full text This is an unoffical transcription, may be wrong, buggered up, out of date etc. You should Google the original. 21(12). The depositary shall be liable to the AIF or to the investors of the AIF, 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 paragraph 8 has been delegated. In the case of such a loss of a financial instrument held in custody, the depositary shall return a financial instrument of identical type or the corresponding amount to the AIF or the AIFM acting on behalf of the AIF 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. The depositary shall also be liable to the AIF, or to the investors of the AIF, 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. 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. Ask about it here.

See also Article 21(13) relating to discharge of liability for delegation. Also, compare with Art. 24 of UCITS: the equivalent and even more restrictive provision.
A key part of the depositary’s responsibility which it will be very keen to foist onto the prime broker who wishes to hold custody of the AIF’s financial instruments.

See also Article DR100 of the delegated regulation for even more detail.

You what?

Fun fact: the drafting — perhaps during translation — lost its way in the first paragraph. When you peel away the flannel, it amounts to this:

The depositary is liable if it, or someone to whom it has delegated the custody of financial instruments, loses —.

Now we think — all right, we know — this is meant to say “... loses the financial instruments it is holding in custody”.

“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.

See also

• Art. 24 of UCITS
• Art. DR100 of the delegated regulation