Supplements » Luxembourg 2010

BEST PRACTICE: Safe and secure

burglerFollowing the Madoff fraud, the duties of depositary banks were highly scrutinised. Regulators found that requisite checks were in fact made and new guidelines are simply a reassertion of best practice. By Angele Spiteri Paris.

Best practice guidelines issued by the Association of the Luxembourg Fund Industry (Alfi) for depositary banks in relation to the safekeeping of assets in Ucits funds were seen to reassert current procedures rather than change them. But it’s not business as ususal. The potential for depositories to be lumped with added responsibility is a grave concern – and one that could spell the death of custody as we know it.

Industry players are vocalising their anxiety around the possibility of pending regulation from Europe forcing them to effectively become insurers for the fund management industry.

Rafik Fischer, general manager and head of global investor service at KBL European Private Bankers, says: “We have to do our job correctly. We have to know where the assets are invested, where they’re being safe kept and work with counterparties who are diligent. Until someone proves that we have not done so, we have no reason to assume responsibilities, which are not ours.

“We’re not being paid to be the ultimate guarantor, security and safety net for investment decisions being taken by an asset manager. We’re not an insurance company.”

There is currently the risk that the EU’s Alternative Investment Fund Managers (AIFM) Directive places additional responsibility squarely on the shoulders of the depository – something that cannot be classified as being totally fair.

The AIFM has proposed that the principal depository be liable for the activities of the sub-depository and those in its network with respect to the delegated risk. This could result in situations where the principal depository is made to take responsibility for a decision that had nothing to do with it.

Fischer says: “A good example is an emerging market fund that wants to invest in Kazakhstan. You can do that under Ucits, but obviously in Kazakhstan there may be little choice when it comes to appointing a sub-custodian. Is the principal depository responsible for all the misdeeds happening in that market? Are they responsible for political risk in a specific emerging market where the assets could be frozen and not be sold? No they are not.

“Risks inherent to an investment decision are to be borne by the investor. You should only be responsible for your own decisions not those of somebody else.”

Another example can be taken from past events. In September 1998, Malaysia’s prime minister, Mahathir Mohamad, introduced controversial new laws on currency trading, as a form of economic protectionism after the country had been severely hit by the Asian crisis. The new controls required foreign investors to keep their money in Malaysia for a year. The Malaysian government also demanded that all foreign holdings of the Malaysian currency be liquidated and repatriated to Malaysia within a month of receipt.

In this case, what was a custodian bank supposed to do?

Fischer says: “In this case there is no restitution of assets possible, since even if the assets held in Malaysia were liquidated they could not be repatriated outside of the country. But this would not have been the fault of the custodian bank.”

Jean-Marc Goy, counsel for international affairs at the Luxembourg supervisory authority, the CSSF (Commission de Surveillance du Secteur Financier), says: “In principle, the depository cannot be held responsible for negative developments on the financial markets. That is a matter that relates more to the investment policy of the Ucits fund. What the depository has to check for within contractual Ucits is whether or not the instructions of the Ucits management company comply with the law and the management regulations.”

Rolf Weber, director of the European Law Institute, says: “The decision to take risks and the adequate management of these risks lies with the management or investment company. The depository has to ensure that the company manages the investments as promised and complies with relevant legal requirements.”

The status quo
As with many of the subjects currently talked about in Luxembourg, this discussion is rooted in the aftermath of the Bernard Madoff scandal. The Alfi guidelines were drawn up by the association’s Madoff Task Force and it was the discovery of the fraud that had regulators taking a closer look at custody banks and the way they operate and monitor their sub-custodian networks.

It wasn’t just Alfi that analysed the duties of the depository banks.

The European Commission launched a public consultation on the Ucits depositary function and the Committee of European Securities Regulators (Cesr) has also taken up the issue.

Goy of the CSSF says: “Cesr set up a dedicated working group that is considering the issue of the functions, missions and responsibilities of Ucits depositories. This dedicated working group is a sub-group of the Expert Group on Investment Management and it is chaired by the French supervisory authority.”

Most actors in the industry agree that the way depository banks currently do business is in no way flawed and several say that their controls and systems would have never allowed Bernard Madoff to be used as sub-custodian to the extent that he was in fact used.

Following consultation at the European level, it was agreed that Luxembourg had adequately transposed the Ucits directive. In fact, actors in the market say there was nothing wrong, from a legal perspective, with the way things were being done.

The Alfi guidelines, they say, are just a formalisation of what was done in the past and a reassertion of how the custody banks already carry out business.

In fact, Luxembourg was always prudent in its transposition of European directives and kept investor protection at the forefront.

Goy says: “In Luxembourg, when we implemented the Ucits directive we took the position that we wanted to go further than what was required in the directive and provided more and better protection of the investors. We did this by requiring the depository to be a bank. This is not the case in all the other European Union countries and its something that the directive does not require.”

Furthermore, the CSSF carries out a further, more in-depth, analysis of the banks that want to act as depositories to make sure they have the necessary human, technical and organisational infrastructure to do so. This means depositories in Luxembourg are supervised in both their banking and Ucits depository capabilities.”

It was unfortunate that Luxembourg was made to prove itself following the scandal. Fischer says: “The Madoff case is, in my opinion, clearly the wrong anchor to attack the quality of services provided by custodian banks. I think Ucits provided an adequate level of corporate governance for custodian banks.”

The whole industry shouldn’t be made to suffer just because one player may have gone wrong and strayed from the guidelines. And if certain provisions with the AIFM directive are not clarified then the custody business could be in serious trouble.

Cost concerns
If the responsibility and legal liability of depository banks is increased dramatically, then the cost to bear that additional risk could potentially be stratospheric.

Fischer says: “The operational risk would be tremendously high which means you have to put a large amount of capital aside to guarantee against that operational risk.

“No insurance company is ever going to be prepared to cover the risk because these would be amounts of money that cannot be assured as such. Therefore there will obviously be a hike in prices for those who are actually willing to stay in that business.”

And investors will most probably not be willing to pay those prices. As things stand, custody receives the smallest portion of investment management fees and therefore investors are not used to considering custody as a pricey service.

From the CSSF’s point of view, however, this does not seem to be a likely scenario. Goy, of the CSSF says: “In my understanding, the majority of Cesr members are not asking for a legal and regulatory framework where the depository could be held responsible even in cases where it would not have committed any wrongful negligence or carried out insufficient controls. We do not want to turn the depository function into an insurance guarantee. The majority view of Cesr members is that this would be going one step too far.”

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