Financial Services Quarterly Report - First Quarter 2013: The Role of the Depositary Under the AIFM Directive

by Dechert LLP
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The Alternative Investment Fund Managers Directive (the “AIFM Directive”) requires that private funds appoint a “depositary”. To date, there has been no cross-border regulatory requirement for hedge or other private funds to appoint a depositary. This article looks at the source of this requirement, who may act as the depositary, and what functions the depositary is expected to perform.

Overview – the Difference between a Custodian and a Depositary

In essence, a depositary acts not only as custodian but also as a sort of monitor or auditor of the fund. In this latter role, it ensures that the fund’s assets are held independently of the investment manager, that the fund’s accounting records are reconciled (where appropriate) with third-party records, and that investors’ entitlements are correctly calculated. Ultimately, it seeks to safeguard against fraud, book-keeping errors and conflicts of interest between the manager and the fund.

The AIFM Directive is modelled on the UCITS Directive, which, since 1985, has required all UCITS regulated funds to appoint a depositary. The UCITS Directive describes a depositary’s role as the “safe-keeping” of assets and “ensuring” that, for instance, the issue and redemption of units is carried out in accordance with law and the fund’s rules. The UCITS Directive’s provisions are concise and have been subject to different interpretations. The AIFM Directive is far more detailed and prescriptive as to the depositary’s role and liability.

Who May Act as the Depositary?

The AIFM Directive states that the depositary must be a “credit institution” (meaning a deposit-taking bank) or an investment firm with the regulatory permission to act as custodian. The AIFM Directive stipulates that the fund’s manager (the “AIFM”) cannot act as depositary and that the fund’s prime broker can only act as depositary if there is clear separation (meaning, for instance, separate personnel and separate supervision) of the depositary function from the prime brokerage function.

The Depositary’s Role

Custody

First and foremost, a depositary acts as custodian. This means that, among other matters, it holds (as intermediary) the fund’s assets, arranges settlement of transactions and administers income, proxy voting and corporate actions. Customarily, assets are held in custody only where this is required as a condition of dealing and settlement – most commonly in relation to securities such as listed equities.

The AIFM Directive distinguishes between “financial instruments that can be held in custody”, which in fact must be held in custody, and “other assets”, of which the depositary must keep a record and verify ownership.

The European Commission’s ("Commission") Level 2 Regulation (which is legislation subordinate to the AIFM Directive and is intended to flesh out its framework provisions) defines “financial instruments that can be held in custody” as assets that are (i) transferable securities, money market instruments or units in collective investment undertakings and (ii) capable of being registered or held in an account directly or indirectly in the name of the depositary. The latter requirement may be understood to mean that all financial instruments that can be registered in the name of the depositary in an account opened at a securities depositary or settlement system must be held in custody. If the assets can be (and are) registered directly with the issuer in the name of the fund (so that there is no need to register the interests with a securities depositary), the assets need not be held in custody. Examples of “other assets” are non-financial assets such as commodities, interests in other funds, unlisted equities and debt.

In addition, any assets that are provided as collateral to a third party must be held by the depositary in custody. To the extent that an entity such as a prime broker re-hypothecates the assets (i.e., borrows by taking temporary ownership), the assets will fall outside the custody net.

Other Functions

As well as acting as custodian, the depositary’s functions comprise: (i) monitoring cash flows; (ii) ensuring that the dealing of units is carried out in accordance with national law and the fund’s rules; and (iii) ensuring that the valuation of units is carried out in accordance with national law and the fund’s rules. The Level 2 Regulation provides more detail on these functions.

The key question when looking at these additional functions is determining whether this envisages day-to-day reconciliations and checks (potentially overlapping with the fund administrator’s role) – or is more a matter of checking that proper procedures are in place and then verifying on a regular basis that those procedures are effective and are being applied properly (an ex post function). The Level 2 Regulation and the Commission’s accompanying Impact Assessment provide answers to these questions.

In terms of monitoring cash flows, the AIFM Directive states that the depositary must “ensure that the AIF’s [i.e., the fund’s] cash flows are properly monitored, in particular ensure that all payments made by investors on subscription of units have been received and that all cash has been booked in cash accounts in name of the fund, manager or depositary”. The Level 2 Regulation talks in terms of “implementing procedures to reconcile all cash flow movements and performing reconciliations on a daily basis or when cash flow movements occur” and providing the depositary “with information about payments made by investors on subscription of units at the close of each business day.” In practice, the Commission will require and expect the depositary to act as a central hub – recording and reconciling all information relating to the fund’s cash flows, and making (possibly daily) reconciliations between its records and third-party records. This means that the depositary will need to be privy to every instruction relating to every cash account maintained by the fund – this clearly points to the Commission envisaging a system that goes beyond the depositary simply verifying that the administrator has procedures in place to monitor the fund’s cash flows.

In terms of duties such as ensuring that the dealing and valuation of units is carried out in accordance with law and the fund’s rules, and the calculation of the fund’s income, the Commission regards these as ex post functions. These functions typically would be fulfilled by the depositary reviewing the relevant policies and procedures (such as the valuation policy) and checking samples to ensure compliance with the policies.

Impact on a Fund’s Existing Arrangements

For a typical hedge fund, the prime broker also acts as the fund’s custodian. This ensures that the prime broker controls the fund’s accounts, can settle trades on behalf of the fund, and has a security interest over the fund’s securities. The fund’s administrator typically performs roles covering asset price and NAV valuations, reconciliation of the fund’s accounting records and calculation of redemption prices.

The requirement to appoint a depositary will have a significant impact on these roles. Although the prime broker may continue to act as custodian, it is likely do so as a delegate of the depositary. Given the depositary’s responsibility for monitoring the whole custody chain, it will need a comprehensive line of sight into sub-custody networks – which to date have been maintained and supervised by prime brokers. Prime brokers will have to ensure that these networks have the connectivity or capability to report the required data to depositaries.

The depositary’s cash monitoring role, involving day-to-day maintenance and reconciliation of the records, appears to involve significant overlap with the administrator’s function. On the face of it, the depositary will need direct reporting from administrators and, conceivably, third parties such as prime brokers or other account providers, to ensure that this function can be carried out properly.

Much work remains to be done to implement the changes to prime brokers’ and administrators’ roles that are required by the introduction of the depositary concept. The challenges involved in making changes to custody and administration systems and procedures will be considerable, and the time to implement these changes is, of course, ticking by.

For further information contact Richard Frase 
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For further information contact John Young 
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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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