Regulations formed in the wake of the financial crisis have troubling and far-reaching implications for custodians. A court ruling in France earlier this year was a case in point, writes Nick Fitzpatrick...
The consultations that have flowed from governments in the wake of the financial crisis have potentially far-reaching consequences for custodians and those that use them. Some regulatory moves are central to custody, such as Europe’s proposals for the depositary banks of Ucits funds – a service offered extensively by custodians.
Others impact them, such as the ECs proposed Directive for Alternative Investment Funds (AIFM), which covers many issues for non-Ucits funds including depositary arrangements.
These are still in draft form, but one outcome already reached is the move by a court in France, sitting at the French regulator, the AMF, to force custodians to restitute assets from failed intermediaries, such as a broker, immediately.
This stemmed from the collapse of Lehman Brothers’ European business. Assets owned by three hedge funds were placed in the custody of two custody banks. But these custodians were contractually obliged to delegate custody of the assets to Lehman Brothers’ prime broker unit for collateral and rehypothecation. When Lehman collapsed the two custodians – RBC Dexia Investor Services and Société Générale Securities Services (SGSS) – were found liable for returning them.
The measure is particularly punitive as it means the two custodians had to return the assets even though there was no guarantee that they would be able to claim equivalent sums back from Lehman’s own insolvency administrator.
Further, the rule is considerably unpleasant to the custodians because they did not appoint Lehman as the prime broker/custodian; the hedge funds did.
Bruno Prigent, deputy head of SGSS, which provided custody for a fund operated by Day Trade Asset Management (DTAM) involving around €3m of disputed assets, says: “The AMF said that we must return all the assets held by Lehman to the fund manager, even though they were not on our books.”
There were two agreements in place that affected the outcome. The first was between the asset manager and Lehman Brothers; the second was between the asset manager, SGSS and Lehman Brothers.
“The second agreement required that SGSS would delegate custody to Lehman Brothers, but that SGSS would retain responsibility for the custody,” said Prigent.
“We said that it wasn’t possible to return all the assets immediately. The prime broker agreement was made under UK law and a UK lawyer agreed with our calculation of how much we should return to DTAM at once. But there is no specific article in French law about this.
“The Court of Appeal upheld the AMF view that all the assets should be returned to the asset manager immediately, whether or not the assets had been – or would be in future – fully returned to us.
“We have now returned the assets to DTAM and we are waiting for the transfer of the original assets from Lehman Brothers. The insolvency administrator will determine this.”
RBC Dexia Investor Services is appealing to the Supreme Court in Paris. SGSS is considering an appeal.
Prigent says the need to return assets immediately leaves custodians exposed to market risk.
“If a custody bank has to restitute assets before they are returned to it by the insolvency administrator, then it has to go to the market to buy them. The market price could change throughout the process, meaning the custodian could make a profit or a loss. But it is my principle that we should neither lose or profit from this process.”
The French have made their decision,
but the European Parliament’s AIFM Directive is trying to bring a harmonious approach to the liabilities of depositary banks across Europe. It is no less worrying to custodians than the French legal judgement. Article 17.5 of AIFM says a depositary should be responsible for “any loss of financial instruments” that occurs unless it can prove that it “could not have avoided the loss”.
Custodians feel this may impose strict liabilities on depositaries, including for complex securities where investor entitlements may stem from a chain of interconnected intermediaries beyond their control. They think this is wrong.
The Association of Global Custodians (AGC) responded by saying: “This change would transfer risk to the depositary beyond what is reasonable or appropriate.”
The AGC also notes that the liability that AIFM places on them for failure to perform duties lacks a qualification found in the Ucits Directive that says this failure must arise from “improper performance” or “unjustifiable failure”.
The AGC wants to see a standard of “due care” introduced, which would be similar to the Ucits qualification of improper performance. For example, if a custodian cannot demonstrate due diligence when selecting a sub-custodian, such as that it checked financial strength and competence, then it would fail the due care test and be liable for assets.
Current proposals could harm investors, says the AGC, because the proposals may lead to the curtailment of important intermediary services and cause investors to discontinue or rework contracts with global intermediaries.
Similarly, Prigent, at SGSS, says: “If a custodian reduces the risk it is willing to take, what affect will this have on clients?
“The Lehman Brothers and Madoff episodes helped us identify clearly the different risks that we have when we provide depositary services or fund administration services. Now we have to address these different risks by identifying the consequences for different services. This might mean increasing prices, or discontinuing a particular service.”
©2009 funds europe