21(13) - AIFMD Provision

AIFMD Anatomy™ →Go uptown In a Nutshell™ Section 21(13): 21(13) Liability not affected by delegation except in certain circumstances: The depositary’s liability won’t be affected by any delegation under paragraph 21(11). However the depositary may discharge itself of liability if it can prove that: (a) all requirements for the delegation of its custody tasks set out in paragraph 21(11) are met; (b) a written contract between the depositary and the delegate sub-custodian expressly transfers the liability of the depositary to that delegate so that the AIF can claim directly against it; and (c) AIF expressly discharges the depositary’s liability under a written contract and establishes an “objective reason” for a discharge. view template Full text This is an unoffical transcription, may be wrong, buggered up, out of date etc. You should Google the original. 21(13). The depositary’s liability shall not be affected by any delegation referred to in paragraph 21(11). Notwithstanding the first subparagraph of this paragraph, in case of a loss of financial instruments held in custody by a third party pursuant to paragraph 21(11), the depositary may discharge itself of liability if it can prove that: (a) all requirements for the delegation of its custody tasks set out in the second subparagraph of paragraph 21(11) are met; (b) a written contract between the depositary and the third party expressly transfers the liability of the depositary to that third party and makes it possible for the AIF or the AIFM acting on behalf of the AIF to make a claim against the third party in respect of the loss of financial instruments or for the depositary to make such a claim on their behalf; and (c) a written contract between the depositary and the AIF or the AIFM acting on behalf of the AIF, expressly allows a discharge of the depositary’s liability and establishes the objective reason to contract such a discharge. 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(12) of AIFMD relating to liability for Loss of Financial Instruments Held in Custody.
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, 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? 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.

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

• The Depositary regime under AIFMD generally
• 21(11) - criteria for delegating depositary functions to third parties
  
• 21(12) - Liability for loss of assets
  
• 21(13) - Liability not affected by delegation except in certain circumstances