Functions of depositary
Article 21 requires the AIFM to employ a single depositary for each AIF managed.
The depositary's appointment must be in writing. That contract must, in particular, regulate the flow of information required for the depositary to perform its tasks.
The depository must be either:
- a credit institution having its registered office in the European Union and authorized in accordance with Credit Institutions Directive1,
- or an investment firm that:
- has its registered office in the European Union;
- is subject to capital adequacy requirements according to Article 20(1) of the Capital Requirements Directive;2
- provides the ancillary service of safe-keeping and administration of financial instruments for the account of clients in accordance with Section B(1) of Annex I to that Directive; and
- has own funds not less than the amount of initial capital referred to in Article 9 of the Capital Requirements Directive; or
- other categories of institutions which are subject to prudential regulation and ongoing supervision and which, at the date of entry into force of the Directive, are eligible to be depositaries of UCITS funds.
Relaxation of rules for certain closed-ended funds
Member States may relax the rules on the appointment of depositaries for certain AIF which have no redemption rights exercisable during the period of five years from the date of the initial investments and which have a restrictive core investment policy (Article 21(4)). In these circumstances, it may be possible for title documents and certificates to be held with a notary, lawyer or similar person. This will be particularly useful for real estate funds as well as venture capital and private equity funds that do not hold liquid securities.
Avoidance of conflict of interests
In order to avoid conflicts of interest:
- an AIFM is not allowed to act as depositary; and
- a prime broker acting as counterparty to an AIF is not allowed to act as depositary for such AIF, unless such prime broker has functionally and hierarchically separated the performance of its depositary functions from its tasks as prime broker and the potential conflicts of interest are properly identified, managed, monitored and disclosed to the investors of the AIF. Delegation by the depositary to such prime broker of its custody tasks is allowed if the relevant conditions for delegation are met.
Location of depositary
The depositary must be located as follows:
- for EU AIF, the depositary must be established in the home Member State of the AIF; and
- for non-EU AIF, the depositary must be established in the third country where the AIF is established, or in the home Member State of the AIFM managing the AIF, or, as the case may be, in the Member State of reference of the AIFM managing the AIF.
See here in relation to conflicts of interest more generally.
Additional conditions to third country depositaries
Where an AIFM appoints a depositary in a third country, the appointment of that depositary must at all times be subject to the following conditions:
- depositaries must be subject in their home jurisdiction to effective prudential regulation (including minimum capital requirements) and supervision which are to the same effect as the provisions laid down in EU law and which are effectively enforced;
- the third country where the depositary is established must not be listed as a Non-Cooperative Country and Territory by the Financial Action Task Force on anti-money laundering and terrorist financing;
- the Member States in which the shares or units of the third country AIF are intended to be marketed, and, if different, the home Member State of the AIFM, must have signed an agreement with the third country where the depositary is established which fully complies with the standards laid down in Article 26 of the OECD Model Tax Convention and ensures an effective exchange of information in tax matters including, if any, multilateral tax agreements; and
- the depositary must, by contract, be liable to the AIF, or, as the case may be, to the investors of the AIF, consistently with the requirements of Article 21(12) and (13) and must expressly agree to comply with Article 21(11).
In the penultimate version of the Directive, there was an additional requirement that there must be a co-operation agreement in place between Member States and third country jurisdictions where a third country depositary is situated. This has been deleted from the published text of the Directive. Interested parties should keep close watch to see if a similar requirement is subsequently added by way of the Level 2 measures (see here).
The depositary must hold all negotiable financial instruments in custody in a securities account opened in the depositary's books. All financial instruments that are capable of physical delivery must physically be delivered to the depositary. For this purpose, the depositary shall ensure that all registrable financial instruments are registered in the depositary's books in segregated accounts opened in the name of the AIF or, as the case may be, the name of the AIFM acting on behalf of the AIF, so that they can at all times be clearly identified as belonging to the AIF in accordance with the applicable law.
For all other assets of the AIF, the depositary shall verify the ownership of the AIF (or, as the case may be, the AIFM acting on behalf of the AIF) of such assets and shall maintain a record of those assets for which it is satisfied that the AIF (or, as the case may be, the AIFM acting on behalf of the AIF) holds the ownership of such assets. The assessment of whether the AIF (or, as applicable, the AIFM) holds the ownership shall be based on information or documents provided by the AIF or the AIFM and, where available, on external evidence. The depositary must keep up to date records of this assessment.
The depository must:
- ensure that the sale, issue, re-purchase, redemption and cancellation of shares or units of the AIF are carried out in accordance with applicable national law and the AIF's constitutional documentation;
- ensure that the value of the shares or units of the AIF is calculated in accordance with the applicable national law and the AIF's constitutional documents together with the procedures laid down in Article 19 (Valuation) (see here);
- carry out the instructions of the AIFM (unless those instructions conflict with the applicable national law or the AIF's constitutional documents);
- ensure that, following a transaction involving the AIF's assets, any consideration is remitted to the AIF within the usual time limits; and
- ensure that an the AIF's income is applied in accordance with applicable national law and the AIF's constitution.
Depositaries face restrictions on their ability to delegate their functions. Article 21(11) provides that a depositary may only delegate its functions if:
- the delegation is not done to avoid the requirements of the Directive;
- the depositary can demonstrate that there is an objective reason for the delegation;
- the depositary uses all due skill, care and diligence in the selection and monitoring of the delegate;
- the depositary has conducted detailed due diligence on the delegate (including as to its systems and controls, prudential regulation and segregation of assets); and
- the depositary has obtained the consent of the AIF to the delegation.
The depositary's delegate may in turn, under certain conditions, sub-delegate the safe-keeping functions. There is an exemption from the restrictions on delegation in situations where local law requires that assets are held within the jurisdiction and it does not have any appropriate depositaries that would meet these requirements (although the consent of the AIF to that must have consented and its investors been informed).
These restrictions could introduce significant administrative and cost burdens to the custodians of AIFs in maintaining sub-custody networks (which will presumably be passed on to the investors in the AIFs).
The depositary is liable for the loss of financial instruments held in custody by the depositary or a third party to whom custody has been delegated (Article 21(12)). Liability will not attach automatically in this way for assets that are not capable of being held by a custodian (for which the depositary's duty is to verify ownership or to maintain a record of ownership).
In the case of such a loss, the depositary must replace the lost financial instruments with ones of an identical type or otherwise credit the account with a corresponding amount without undue delay. The depositary will 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 (i.e., the Directive is seeking to impose a standard concept of force majeure across Europe, to be set out in the Level 2 measures, in respect of which, see here).
Discharge of liability by depositary
The depository can discharge itself of its liability for the loss of financial instruments held in custody by a third party to whom the custody has been delegated third party, if it can prove that:
- all requirements for the delegation of its custody tasks, as set out in Article 21(11)(a) to (d) are met, and
- there is a written contract between the depositary and the third party that explicitly transfers the liability of the depositary to that third party and makes it possible for 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.
Information to competent authority
Pursuant to Article 21(16), the depositary must make available on request to its competent authorities all information which it has obtained while undertaking its duties and that may be necessary for the competent authorities of the AIF or the AIFM. If the competent authorities of the AIF or the AIFM are different from those of the depositary, the competent authorities of the depositary must share the information received without delay with the competent authorities of both the AIF and the AIFM. This could impose additional reporting costs on custodians which are likely to be passed on to the AIF's investors.
Failure by AIF to appoint a depositary
It is acknowledged in Recital (11) that an AIF may be structured such that the AIFM cannot direct the AIF's operations. In the context of appointing a depositary it is stated that, where the AIF has not appointed a depositary, the competent authorities can require the AIFM to take steps to remedy the situation and, failing that, require the AIFM to resign its appointment as manager of the AIF.
Detailed requirements on depositaries to follow
Article 21(17) makes it clear that there is a significant amount of regulation relating to the appointment of depositaries and their delegates that has been left to the Level 2 measures. This will include additional regulation relating to: particulars to be contained in the agreements; criteria for assessing delegates (including on prudential requirements and due diligence); and, as discussed here, what will be considered to be events outside a depositary's control.
Footnotes: 1. Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (recast).
2. Directive 2006/49/EC of the European Parliament and of the Council of 14 June 2006 on the capital adequacy of investment firms and credit institutions.