The Aifm Directive has placed much stricter liability on depositories regarding assets. Nicholas Pratt examines how these changes could impact the servicing of emerging market funds.
The Alternative Investment Fund Managers (Aifm) Directive has found little favour in the funds industry. It has been viewed as a politically motivated piece of legislation designed to safeguard European investors from the vagaries of unregulated alternative investments. However, the problem is that by adding extra layers of regulation these alternative investment vehicles will simply become unavailable to those investors.
The hazard of unintended consequence is particularly apparent in emerging market funds which have been hugely popular of late but often involve intermediaries that are far from being in a position to meet the demands of the European Commission’s directive. For depository banks this is particularly worrying as the directive places them in a position of assuming strict liability for any loss of assets.
It is Article 21 which concerns itself with the functions of a depository and the issue of liability. As the directive states: “The depository is liable for the loss of financial instruments
held in custody by the depository or a third party to whom custody has been delegated (Article 21(12)”.
To put it crudely, and in terms of emerging market funds, the Aifm directive has transferred the risk normally assumed by investors as part of the inherent risk in an emerging market fund to the depositories. However, there are more detailed and dynamic aspects to the directive than a binary transference of risk, but they will only become evident once more finalised details emerge.
The latest version of the directive was passed on May 27 by the European council so, effectively, the directive has been finalised. What could yet prove to be influential in how the directive is implemented is the guidance that is presented by the European Securities and Markets Authority (Esma). For the depository banks, the hope is that this guidance will offer them a number of ways to challenge or mitigate the seemingly onerous obligations they face under the directive. And this is where the hopes of the depository banks lie.
There are a number of potential get-out clauses contained within the directive that depository banks are likely to seize on in the hope of escaping liability. For example, the directive also states: “The depository 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.”
“It is likely to be a fertile area for discussion,” says Phillip Morgan, financial services partner at UK-based law firm K&L Gates. For instance, the definition of an external event beyond its reasonable control could be quite broad. This definition becomes particularly important when dealing with emerging market funds which have become increasingly popular in the last two years with investors but could be off-limits to European investors, institutional or otherwise, if the Aifm directive goes through as it currently stands, say depository banks.
Their concern is that they are being asked to take liability for risks that are uninsurable in certain less-developed and emerging markets. In the developed market, there are sub-custodial networks where the depository bank and the sub-custodian lie within the same company. In these instances, where the events are “internal” to the depository itself, the depository bank will readily accept strict liability. These are events which they can control and would expect to take liability for their own actions.
Depository banks are less keen to take liability for events which they cannot control as is often the case when dealing with emerging markets funds, says David Aldrich, managing director at BNY Mellon. “For any ‘external’ events beyond the control of the depository, we perform all the necessary due diligence to comply with the directive but it is a fact that in certain emerging markets it is not possible to impose EU legal requirements over market practice.
“In the emerging markets there is the whole issue of segregation of assets. Some jurisdictions have no concept of segregation. It is either not recognised or not accepted as standard practice. If there is no segregation of assets possible under local law, then a loss becomes an ‘external’ event in which a depository bank cannot be held liable.”
Even where the sub-custodian does have a segregation process in place, the operational realities of an insolvency case could leave the depository bank having to reimburse investors until the case is resolved, insofar as the Aifm level 1 is currently drafted.
“It is not always clear when or how the assets will be returned to investors and the process can take weeks, months or even years to resolve – as is the case with the Lehman Brothers default,” says Aldrich. “For this reason, the work of the European Securities and Markets Authority level 2 taskforce on depositories, headed by Patrice Berge-Vincent, is at a critical juncture in determining where the liability lies in different scenarios. It has especially significant impact for investors in emerging markets where it is critical that the rulemakers avoid creating uninsurable loss situations for depositaries, as it would be uneconomic to provide such services under a strict liability regime.”
As well as deciding whether an event is external or internal, there is also likely to be a lot of legal argument about whether an asset is actually lost. For example, one would assume that the Bernie Madoff case represented a clear case of assets being lost. However, it is possible to argue that the asset never existed in the first place so was never lost.
The issue of unquantifiable liabilities is particularly vexing for depository banks involved with emerging markets funds, particularly given that these funds are much in demand among investors but also exposed to political risk, as has been evident in many of the Middle East and North African funds. This heightens the concerns around the loss of assets and creates much more of an issue when it comes to depository liability, particularly in situations where prime brokers have adopted
a custodian role in the past, says Ian Headon, senior vice president at Northern Trust.
Post-Aifm, in certain circumstances there would need to be a depository bank sitting at the top of any asset servicing arrangement that would assume liability should any assets be lost.
“The commercial reality of the Aifm is that if depository banks’ liabilities go up, then the price of servicing will go up and we don’t yet know how much investors are willing to pay for the extra protection that the Aifm supposedly gives them,” says Headon. “We are talking to managers who have been planning to set up an emerging market fund and they are thinking seriously about these issues before they commit to any decision or choose a domicile. There is a genuine concern about the uncertainty.”
The concern over the directive’s rules on liability is exacerbated by the fact that a depository provision already exists for all funds domiciled in Ireland and Luxembourg. While the new rules will change these provisions, it is notable that institutional investors have consistently demonstrated comfort with less regulated jurisdictions such as the Cayman Islands – essentially saying that they do not need this extra safety layer, particularly if they are going to have to pay for it, says Headon.
“Institutional investors may be looking for more transparency but not necessarily more regulation. In fact, the extra cost from new regulation may well be what decides whether they choose to invest or not, particularly for emerging markets funds. The directive is definitely going to happen, that is clear. We just hope that it is proportionate and does not put the investor in a straitjacket.”
The concerns of the depository banks are understandable. There may be a number of potential get-out clauses available given that there is significant room for legal argument in the interpretation of the broad statements of the directive. Wherever the word “reasonable” appears, it is inevitable that months of legal argument will follow. However, it is significant that the burden of proof lies with the depositories which could prove expensive if they are to compensate for lost assets while the legal argument lumbers on, especially in complicated cross-jurisdictional cases, as would be the case with many emerging market funds.
For managers that have a number of emerging markets funds and may be considering establishing more, there is no paralysis caused by the uncertainty around the Aifm directive, says Morgan. There is concern though about exactly what changes will result. “For the managers who we are advising, they are concerned about the need to change their structures and the extra cost involved,” he says.
In terms of investors getting access to emerging market funds, in theory it ought to be possible for funds domiciled and managed outside Europe to be made available to European investors, says Morgan. For example, in cases of reverse solicitation where the investors approach the funds, it would not be judged as marketing into the EU. “The larger the investor, the easier it will be, but I imagine that investors will be able to find a way to invest in emerging markets if they wish to.”
Despite the uncertainty, this does not mean managers or investors have to sit idly by until the situation becomes clearer, says Morgan. “It may be too early in terms of reconfiguring contracts between managers and depositories, but not in terms of understanding the structure of the directive. Fund managers need to understand what their funds are and how they can be managed undergoing relevant due diligence.”
©2011 funds europe