Safe-keeping of assets under AIFMD and UCITS Directive: European Commission consults on rule changes

​On 29 May 2018, the European Commission (Commission) published for consultation draft delegated regulations proposing amendments to the safe-keeping duties of depositaries under the Alternative Investment Fund Managers Directive (AIFMD) and the UCITS Directive. The consultation period closes on 26 June 2018.

Update (30 October 2018):

The final Delegated Regulations were published in the Official Journal of the European union (OJ) on 30 October 2018, in respect of the UCITS Directive and the Alternative Investment Fund Managers Directive. The published texts show no changes from the proposals (summarised below) on which the European Commission consulted.

On 29 May 2018, the European Commission (Commission) published for consultation a draft Delegated Regulation (the Draft Regulation) which contains proposals to amend certain rules relating to the safe-keeping duties of depositaries under the Alternative Investment Fund Managers Directive (AIFMD).

Essentially identical measures were simultaneously proposed in respect of the UCITS Directive. The feedback period closes on 26 June 2018, following which the Commission will finalise its proposals and work with the Council of the EU and the European Parliament to agree final texts.

Background to the Commission’s proposals

The AIFMD is supplemented in a number of areas by more detailed Level 2 measures set out in the Commission Delegated Regulation (EU) 231/2013 (the AIFMD Level 2 Regulation). Similarly, additional detail in relation to aspects of the UCITS Directive is provided by the Commission Delegated Regulation 2016/438 (the UCITS Level 2 Regulation).

By way of example as to how Level 1 and Level 2 work together, while Article 21(11)(d)(iii) of the AIFMD (and Article 22a(3)(c) of the UCITS Directive) requires that, where a depositary delegates its safe-keeping function to a third party, the AIF’s (or UCITS’s) assets must also be segregated at the level of the delegate, it is Article 99 of the AIFMD Level 2 Regulation (and Article 16 of the UCITS Level 2 Regulation) which provides detail as to how this obligation should be fulfilled.

However, since the introduction of the AIFMD and UCITS Level 2 Regulations, it has become clear that National Competent Authorities and market participants have applied these rules in different ways in different Member States. For instance, some interpret the Level 2 Regulations as requiring separate accounts (a) per depositary and (b) per type of fund to be created at each level of the custody chain, while others consider the same rules to allow assets of UCITS, AIFs and other clients to be comingled at the level of the first third party delegate so long as they are initially held by the same depositary.

In the Commission’s view, it is “imperative” for there to be common rules to ensure protection of assets safe-kept by depositaries or their delegates. As a result, the Draft Regulations contain proposals to clarify the safe-keeping rules and ensure their uniform interpretation.

What is the Commission proposing?

The Commission has, therefore, invited feedback from stakeholders on proposed amendments to certain articles of the AIFMD and UCITS Level 2 Regulations. This follows work by the European Securities and Markets Authority (ESMA) on asset segregation - in particular, its Opinion, “Asset segregation and application of depositary delegation rules to CSDs” of 20 July 2017 (the ESMA Opinion).

The ESMA Opinion identified issues where understanding among stakeholders differed. As a consequence, ESMA invited the Commission to clarify certain obligations applicable to depositaries where they delegate safe-keeping functions to third parties and, in particular, suggested:

  • defining the asset segregation requirements more clearly and complementing these with additional safeguards (in particular, the requirements to contractually ensure a sufficient flow of information between the depositary and the third party delegate or a sub-delegate of it)
  • strengthening the requirement to maintain accurate record-keeping and reconciliation systems, including calibrating the frequency of reconciliations with respect to the frequency of trading activities relating to all the assets that may be kept in an omnibus account, and
  • supplementing the due diligence duties of depositaries by requiring them to have a good understanding of the implications that the insolvency laws of a third country could have if safe-keeping is delegated to custodians located outside the EU.

In particular, the Draft Regulation would make the following changes to the AIFMD Level 2 Regulation and UCITS Level 2 Regulation:

Article 89 (of the AIFMD Level 2 Regulation)/Article 12 (of the UCITS Level 2 Regulation) would be amended:

  • To establish the factors that determine how frequently the financial securities accounts and internal records (a) of the depositary and (b) of the third party(ies) to which safe-keeping functions have been delegated should be reconciled. (The proposed factors would be: the normal trading activity of the AIF or UCITS, any trades occurring outside this normal trading activity and any trade carried out for other clients, whose assets are held in the same omnibus account by the third party delegate.)
  • To require the depositary to maintain a record in any financial instruments account opened in the name of an AIF or UCITS client (or in the name of the AIFM acting on behalf of the AIF or UCITS ManCo acting on behalf of the UCITS as applicable) which shows that the assets being kept in custody by a third party belong to a particular AIF or UCITS client. The depositary would also be required to have, at all times, a complete overview of the assets of its AIF or UCITS clients where custody has been delegated to a third party.

Article 98 (of the AIFMD Level 2 Regulation)/Article 15 (of the UCITS Level 2 Regulation) would be supplemented by a new paragraph setting out the minimum details to be contained in the contract between a depositary and the third party where custody of the depositary’s AIF or UCITS clients’ assets is delegated.

The depositary must be able not only to identify all the entities in the custody chain but also to secure access to all the relevant information in the third party’s possession which is necessary to verify the quantity of identified financial instruments which the third party is keeping in custody.

Where the custody function is sub-delegated, the third party would have to secure contractual rights from the sub-delegate equivalent to those which it had, itself, granted to the depositary.

Article 99 (of the AIFMD Level 2 Regulation)/Article 16 (of the UCITS Level 2 Regulation) would be amended:

  • To clarify that the third party to which the safe-keeping function has been delegated would be able to hold assets of AIFs, UCITS and other clients of a single depositary comingled in the same omnibus account. (Where custody is sub-delegated, the sub-delegate would similarly be able to comingle assets of clients initially held by the same third party delegate.) The third party’s own assets, proprietary assets of the depositary and assets belonging to other clients of the third party, however, must be held in segregated financial instruments accounts.
  • To ensure increased asset protection and to enable the depositary to comply with its oversight obligations, the third party delegate would be required to issue the depositary with a statement detailing the assets of the depositary’s AIF or UCITS clients (a) on a regular basis and (b) whenever “a change in circumstances” occurs. There is nothing in the proposed text to specify how the term “change in circumstances” should be interpreted.

Article 99 of the AIFMD Level 2 Regulation is further amended to introduce new obligations for depositaries which delegate the custody of assets to a third party located outside the EU. In such a case, the depositary would be required to obtain legal advice from an independent source confirming that the insolvency laws of the third country recognise:

  • the segregation of the assets of the depositary's AIF clients from its own assets, from the assets of its other clients and from assets held for the depositary's own account
  • that assets of the depositary's AIF clients would not form part of the third party's estate in case of the third party’s insolvency, and
  • the assets of the depositary's AIF clients would be unavailable for distribution among creditors of the third party to whom safekeeping functions have been delegated.

The depositary would also have to ensure that the third party (a) complies with its national laws securing the benefits of asset segregation and (b) communicates to the depositary any changes to the applicable insolvency law and its effective application.

Article 22 of the UCITS Level 2 Regulation would be amended to require the UCITS ManCo to demonstrate to the UCITS’s home regulator that it is satisfied with the appointment of the depositary and that such appointment is “in the sole interest of the UCITS and the investors of the UCITS”.

What happens next?

The draft proposals are open for feedback until 26 June 2018. The Commission will consider responses received and will, in due course, put forward (or adopt) its final proposals to amend the AIFMD and UCITS Level 2 Regulations.

These proposals will be scrutinised by the Council of the EU and, separately, by the European Parliament. When each has agreed its preferred position, the Council and Parliament will join with the Commission in "trilogue" negotiations to agree a compromise text. When formally approved, this will be published in the Official Journal.

This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.