Template:External event beyond its reasonable control

“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.