JMH/SR EBF Ref.: D2263D Brussels, 30 January 2012

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1 JMH/SR EBF Ref.: D2263D-2011 Brussels, 30 January 2012 Launched in 1960, the European Banking Federation is the voice of the European banking sector from the European Union and European Free Trade Association countries. The EBF represents the interests of almost 5000 banks, large and small, wholesale and retail, local and cross-border financial institutions. Together, these banks account for over 80% of the total assets and deposits and some 80% of all bank loans in the EU only. EBF comments on ESMA s Final Report on technical advice to the European Commission on possible implementing measures of the Alternative Investment Fund Managers Directive Key Points The EBF is concerned that some Level 2 measures seem to contradict the reasonable approach of the Level 1 legislative principle whereby there are extreme situations where the depositary should be exempted from its liability. Therefore the Level 2 measures should not introduce new obligations that would lead to the unintended consequence of transforming the depositary into a guarantor of financial instruments held in custody. The EBF considers that the intensity of control (width, depth, accuracy, frequency) that the depositary is obliged to exert in order to meet its Due Diligence obligations remains to be determined (and certainly is a matter of concern). The requirement to promptly notify the AIF or the AIFM of any change in the risks associated with the delegation of custody would turn depositaries into a kind of a non-recognised rating agency for the account of asset managers. Market abuse fears could arise as a result. The EBF objects to the requirement for depositaries to put in place some measures or arrangements that would replace the effects of the local legal framework regarding segregation. This is a matter of great concern from a legal point of view. The EBF believes that the scope of assets to be held in custody as defined in the ESMA advice should be amended to exclude some cases where the financial instruments are outside the control of the depositary The EBF requests the deletion of the requirement for safekeeping duties to be applied on a look-through basis approach. Situations will arise where this proposal is not workable e.g. a fund of funds. In order to avoid double-checking of every cash movement (implying a complete change to operating model and increased costs) it should be clarified that the depositary should perform only second level controls. Reconciling cash positions would lead to reconciling cash movements. This new requirement seems in contradiction to ESMA's preferred approach. EBF a.i.s.b.l ETI Registration number: , rue Montoyer B-1000 Brussels +32 (0) Phone +32 (0) Fax

2 General Remarks The ESMA Final Report on technical advice on implementing measures for the AIFMD contributes to the clarification of the provisions of the Level 1 text on many aspects. The EBF wishes to submit some comments on the external valuer and on the depositary aspects. Regarding the external valuer, the EBF is of the opinion that the clarification in the ESMA advice on the role of an external valuer (i.e. a third party which carries out the calculation of the net asset value for an AIF is not considered to be an external valuer) is essential and should be retained in the Level 2 Text. Regarding the depositary section, the EBF believes that a number of issues are still to be addressed. The objective is to clarify the duties and tasks to be performed by the depositary, due to a very strict liability regime coupled with the reversed burden of proof. Calculation of net asset value per unit or share- Box 60 The ESMA advice regarding point 25 of the explanatory text on page 117 contributes to a significant clarification of the role of an external valuer. This explanation should be retained in the level 2 Text (Explanatory text - point 25): Third party which carries out the calculation of the net asset value for an AIF is not considered to be an external valuer for the purposes of Article 19 of the Directive, so long as this entity does not provide valuations for individual assets, including those requiring subjective judgment, but incorporates values which are obtained from the AIFM, pricing sources or the external valuer(s) into the calculation process. ) Due Diligence Requirements- Box 89 Article of the Directive details the conditions to be met for the depositary when delegating any of its custody functions. On one hand, the depositary has to ensure that the segregation requirements set out in Article are met by a third party before it can delegate any of its custody functions. On the other hand, ESMA proposes that the depositary has to assess whether the risk of delegating the custody is acceptable. In this respect the depositary has notably to assess: the sub-custodian's financial strength the legal and regulatory framework of the country where the sub-custodian is established in order to assess the degree of enforceability of its contracts and the potential implications of the insolvency of the sub-custodian. 2

3 In this section, following requirements proposed by ESMA, major areas of concerns remain for the depositary. ESMA s advice requires the depositary to promptly notify the AIF or the AIFM of any change in the risks associated with the delegation of custody, according to the assessment made by the depositary using its own criteria (Box 89-iii). The EBF objects to this requirement which would turn the depositary into a kind of a nonrecognised rating agency for the account of asset managers. The disclosure (and dissemination) of an internal assessment could be detrimental to some market participants and/or to the market as a whole. Mis-use of this information could not be prevented and could qualify as a breach of the market abuse regulation. It could also have systemic consequences and create a case for litigations against markets and/or entities (in such a case the depositary could be held liable for originating disputable information). Assessment of custody is undoubtedly part of the internal procedures in place at the level of the depositary and should not be made public (depositaries may not be used as a substitute for rating agencies and the competent authorities, securities and banking regulators and supervisors). As the separation of assets is only one way to protect them from the results of an insolvency of the sub-custodian, it is inappropriate to state the obligation in Box 89 1 lit. a i. Instead of this, the general provisions in the first sentence are sufficient and match with the obligation of Level 1. Finally, information provided to the AIF (or AIFM) from the depositary does not alter the liability regime of the depositary. For all these reasons, the EBF suggests deleting this requirement in the ESMA advice. We would reiterate that if due diligence requirements have been fulfilled, a depositary should not be liable in the event of a loss of assets due to the misconduct of sub-custodians. Segregation obligation for third parties to which depositaries have delegated part or all of their safekeeping functions Box 90 ESMA s advice requires the depositary to take additional measures to minimize the risk of loss when the legislative and regulatory framework of the sub-custodian's country may be not sufficient to protect the assets entrusted to the sub-custodian despite appropriate segregation rules (Box 90-2) This requirement is beyond the ability of the depositary to protect the assets held in the account of its clients as it is equivalent to putting in place some measures or arrangements that would replace the effects of the local legal framework. The EBF questions whether this requirement is acceptable from a legal point of view as it presupposes that contractual arrangements could supersede the applicable law and contradict local provisions related to fair and equal treatment between creditors. 3

4 The EBF views this requirement as a clear contradiction to the recognized fact that the depositary cannot be held liable for all circumstances. Indeed this particular requirement will lead to an extreme difficulty (not to say impossibility) for the depositary in terms of demonstrating that it has effectively taken all possible appropriate measures to ensure the protection of assets in all situations. In these conditions the EBF is of the opinion that this requirement goes beyond the provisions of the Level 1 text on due diligences to be performed by the depositary. It contradicts the Level 1 text which clearly states that the depositary shall be exempted from its own liability in case of external event beyond its reasonable control. Furthermore this requirement contrasts with the ESMA explanatory text (paragraphs 27 and 28) related to Box 92 regarding definition of external event beyond the depositary's reasonable control. ESMA clearly considers in this section that the depositary should not be held liable where the law of the country where the instruments were held in custody does not recognise the effects of segregation requirements. EBF proposed amendment to Box 90 The EBF requests the deletion of the requirement in Box 90(2), as proposed in the ESMA advice. Furthermore, as it is not the common procedure to open different accounts for customers' and own money at central banks, the provision in Box 90 (1)(e) should be deleted. Definition of external events beyond the depositary s reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary (Box 92) More globally the Level 2 measures should be consistent with the intent of the Level 1 legislation which clearly states that the depositary should not be held liable as soon as it can demonstrate that it has performed its duties and tasks on a reasonable basis, through reasonable control and reasonable efforts. This principle should be reflected in the Level 2 measures that consequently should not refer to rigourous and comprehensive due diligence as this formulation definitely contradicts the approach set out in the Level 1 legislation. In addition the scope of events referred to in Box 92 should be restricted to the circumstances where the depositary has the ability to perform effectively its due diligence duties on a reasonable basis. 4

5 EBF proposed amendment to Box 92 Despite rigorous and comprehensive due diligence the fact that the depositary has exercised all due skill, care, diligence in the selection and appointment of any third party to whom it wants to delegate parts of its tasks and in the periodic review and ongoing monitoring of these third parties, it could not have prevented the loss. (a) It has ensured that it has the structures and the expertise that are adequate and proportionate to the nature and complexity of the assets of the AIF, to identify in a timely manner and monitor on an on-going basis any an event it could reasonably identify which it considers may result in a loss of a financial instrument held in custody. Definition of financial instruments to be held in custody - Box 79 Globally the following elements should be taken into consideration when defining the scope of financial instruments held in custody: The AIFMD will cover all non-ucits funds which are designed for institutional investors. The AIFMD does not introduce any investment limits on the financial instruments in which the AIF can invest nor any restriction on the level of leverage taken by the AIF contrary to the UCITS Directive. Institutional investors are supposed to have a good knowledge of assets in which the AIF invests in (according to the definition of professional investors in MIFID). In addition they are informed about the investment policy of the fund through the information provided by the AIFM which had also the obligation to conduct an appropriate policy of risk management. Specific rules have been introduced on the depositary in order to protect the AIF against the risk inherent to the custody of financial instruments that constitute property rights for which the depositary is enabled to instruct the transfer from an intermediary to another within the intermediary chain. This intermediary chain excludes the issuer or its agent. The following risks are not to be covered by the depositary : o Risks linked to the maintenance of a register by the issuer of the financial instrument or its agent o Risks linked to the execution of transactions on listed derivatives which do not constitute property rights and which cannot be transferred by the depositary o Risks linked to the investment decision of the fund manager to transfer financial instruments given or received in collateral at a third party As soon as the conditions listed below are not met, the depositary is not to be held liable. Alternative solutions to ensure the asset protection should be a reinforcement of the risk management and procedures at the AIFM level and/or introduction of quantitative limits as proposed in the UCITS IV Directive : 5

6 The depositary may be held liable for a loss resulting from a fraud or improper performance of a third party only where the following conditions are met: o The depositary has selected the third party according to its own criteria of due diligence and can control the operations performed by the third party on an ongoing basis. Where the third party has been selected by the AIFM (e.g. a clearing member or a collateral agent), the depositary has no contractual link with it and cannot check that it complies with the requirements on sub-custodians as defined in Article of the Directive. In the case of a registrar (or its agent) and of a CSD, it is a decision of the issuer of the financial instrument to use a registrar or a CSD (which is a monopolistic entity by nature and a regulated entity contrary to the registrar) for the settlement of the financial instrument. This is an investment decision of the AIFM to invest in such instruments (the AIFM has to inform investors accordingly). o The activity performed by the third party should be in the scope of the activities which are performed by the depositary in the normal course of its custodian capacity (as referred to in the Directive, i.e. safekeeping function and oversight function). The depositary cannot be requested to control such market participants such as clearing members or collateral agents as this requires another type of expertise and competence. Consequently the depositary cannot be required to carry out due diligence as specified in the Directive nor to prevent any loss that could result from an event which occurred at the level of this third party. o The depositary shall have the both legal ownership and beneficial ownership of the financial instruments which qualify as being held in custody. Where those have been transferred to a third party on the decision of the AIFM and are not consequently thereafter in the custody of the depositary, the depositary cannot be asked to have a restitution obligation for financial instruments which do not belong to the AIF anymore and for which the depositary has no view on the corresponding exposures. This is typically the case for financial instruments in collateral. Thus the EBF has some comments on the ESMA advice regarding requirements on financial instruments that can be held in custody. Assets that can be physically delivered to the depositary. This formulation suggests that if an asset can be both certificated or non certificated, even if not certificated, it should be in the scope of the custody. Consequently the depositary would be liable for financial instruments outside of its control. The EBF suggests the following amendment: 6

7 EBF proposed amendment to Box 79 "Financial instruments that are directly registered with the issuer itself or its agent in the name of the AIF should not be held in custody unless they are certificated and physically delivered to the depositary. Received collateral: A new paragraph inserted requires the received collateral to be in the scope of the custody. If this would include collateral transferred to third-party collateral agents, the depositary would be liable for financial instruments outside of its control. It should be made clear that the depositary is not obliged to check if the collateral manager has secured the securities. We suggest the following amendment : EBF proposed amendment to Box 79 "Any financial instruments received as collateral and held at the depositary for the benefit of the AIF..." Furthermore, there should be a clarification that a transfer agent is not recognised as a subcustodian, so that sub-custody obligations are not applicable. Financial instruments held at registrars: The proposed wording does not provide enough certainty regarding the liability of the depositary when financial instruments are held at registrars. For "financial instruments to be held in custody" ESMA proposes" to capture all financial instruments the depositary is in a position to control and, if needs be, retrieve." The EBF believes, however, that the following criteria/question is also relevant: Was the depositary in a position to duly select the institution holding the assets? In case of (fund) shares held at a registrar, the depositary typically has no choice in the selection of this institution. Applying the criteria proposed by ESMA in explanatory text 15 "to capture all financial instruments the depositary is in a position to control and, if need be, retrieve" could impose portfolio management responsibilities on the depositary. This is because a decision not to use the only registrar which holds a certain financial instrument could be considered as an investment decision against this specific instrument instead of the decision against the institution or the registrar. 7

8 In order to avoid conflicts of interest (and in reference to Article 20 (2)a AIFMD), the proposed interpretation of "instruments to be held in custody" should be amended. Therefore, we propose, additionally, to provide for a certain amount freedom in selecting the institution where the titles are held. The text could be amended in the following way: EBF proposed amendment to Box 79 (3) "3. they are registered or held in an account directly or indirectly in the name of the depositary at an institution chosen by the depositary." EBF proposed amendment to explanatory text [ ] to capture all financial instruments the depositary is in a position to control and, if needs be, retrieve, which are held at an institution chosen by the depositary. 8

9 Safekeeping duties applied on a look-through basis approach Box 80 & 81 The ESMA advice requires that the depositary s safe-keeping duties apply on a look-through basis approach to underlying assets held by financial and/or legal structures controlled directly or indirectly by the AIF (Box 80(3) and Box 81(5)). This requirement goes beyond the level 1 text and it is beyond the ability of the depositary to perform its duties in some cases, in particular where the depositary controls temporarily openended legal structures and where the regulatory frameworks that apply to these structures already require a specific entity to be in charge of the safekeeping of these structures' assets. For specific types of funds, such as for real-estate funds and private equity funds, this approach would be acceptable under the following conditions: the structures are closed-ended structures, and there is no variation in the control level of these structures by the AIF (or the AIFM acting on behalf of the AIF),and the regulatory framework that applies to these structures allows the depositary to ensure the safekeeping of the assets of these structures. As an illustration for situations where this proposal is not workable, let's take the example of a fund of funds. The investment fund A has invested in an investment fund B which has not the same depositary as the fund A. At the beginning of the year the fund A owns 30% of the fund B. At the end of the half-year, due to redemptions by other units holder of the fund B, the fund A holds 60% of the fund B. It would not be workable to require the fund B to change its depositary in such a case if the measure proposed by ESMA is to be interpreted as such. EBF proposed amendment to Box 80(3) & Box 81(5) The EBF requests the deletion of the requirement for safekeeping duties to be applied on a look-through basis approach, as proposed in the ESMA advice. Furthermore, although the first sentence of Box 81 points out, that it is the Asset Manager`s duty to provide the depositary with all relevant information, it should be underlined that he has to act pro-actively, i.e. not only "on demand" 9

10 Inspection could pose a problem in practice. The information that the depositary is bound to rely on is in most cases delivered by the sub-custodian. Even if the former conducts on-site inspections from time to time, in the majority of cases it must rely on data supplied by the subcustodian when concerned with checking the portfolio and segregation. This causes dependence by the examining body on the examined entity (which is a classical principal agent problem situation). If the supplied data is inaccurate, it is impossible to conduct testing which is compliant with regulatory requirements. Regardless of the cause of the inaccuracy of the data supplied by the sub-custodian the depositary should have no liability with respect to the accuracy of data in case of damage to or loss of assets. Given the complexity of Alternative Investment Funds it will be extremely difficult to develop a checklist for reviewing the due diligence tasks for every possible case. A certain degree of flexibility must be maintained so that the legal requirements can be met even in unusual cases. Proper monitoring of all AIF's cash flows - Box 78 ESMA's advice requires the depositary: to ensure there are procedures to reconcile all cash flow movements and verify they are performed at an appropriate level Box 78 (2) to ensure appropriate procedures are implemented to identify on a timely basis significant cash flows and in particular those which should be inconsistent with the AIF's operations. It is the responsibility of the AIFM or the duties of its delegates to implement appropriate procedures. In order to avoid double-checking of every cash movement (which would lead to a complete change to the existing operating model and to significant additional costs), ESMA has clarified in its explanatory text that the depositary should perform only second level controls. Consequently it should be expected to perform ex-post verifications of the procedures that are to be produced and implemented by the AIF (or the AIFM on behalf of the AIF). This could be clarified with the following amendment to stipulate that ESMA's advice requires the depositary: EBF proposed amendment to Box 78(2) to ensure to there are procedures at the AIFM level to reconcile all cash flow movements and verify they are performed at an appropriate level Box 78(2) to ensure appropriate procedures are implemented at the AIFM level to identify on a timely basis significant cash flows and in particular those which should be inconsistent with the AIF's operation. 10

11 In addition, ESMA s advice has introduced a new requirement (in Box 78-6) related to the checking of the depositary records against the AIFM's. Reconciling cash positions would lead to reconciling cash movements. This requirement corresponds to option 1 presented in the Consultation Paper was rejected by the ESMA advice. Consequently this new requirement seems in contradiction with the ESMA decision to reject option 1. Furthermore it will be very onerous for the depositary as it implies a complete change to the existing operating model and significant additional costs. We believe this new requirement should be deleted. This would not prevent the depositary from performing activities which it currently carries out and considers necessary to reinforce its capacity of control over the AIF/AIFM. Oversight duties / Duties related to the carrying out of the AIFM's instructions - Box 86(1) ESMA 's advice requires the depositary to set-up and implement appropriate procedures to verify the compliance of the AIF with applicable national law and regulation as well with the AIF's rules and instruments of incorporation (Box 86-1). This requirement goes beyond the monitoring of the AIF s instruction compliance and consequently goes beyond level 1 text. The EBF proposes the following amendment. EBF proposed amendment to Box 86(1) "1. Set up and implement appropriate procedures to verify the compliance of the AIF / AIFM with applicable national law and regulation as well as with the AIF s rules and instruments of incorporation. In particular, the depositary should monitor compliance of the AIF with investment restrictions and leverage limits defined in the AIF s offering documents rules and document of incorporation. Those procedures should be proportionate to the nature, scale and complexity of the AIF." Finally, the EBF disagrees with explanatory text 55 that in practice will obligate the depositary to act as the AIFM, which will be extremely costly for the depositary i.e. "ESMA considers the depositary should, for example, check that the AIF s investments are consistent with its investment strategy as described in the AIF s rules and offering documents with a view to ensuring it does not breach its investment restrictions, if any. The depositary should also monitor 11

12 the AIF s transactions and investigate any unusual transaction it has identified in conjunction with its cash monitoring duties." Oversight duties /Duties related to the timely settlement of transactions - Box 87 ESMA's advice requires the depositary to set-up a procedure to detect any situation where a transaction is not settled within the usual time settlement limit. Regarding assets not held in custody, this is already a part of the asset manager s duties. Consequently the EBF suggests that for these assets the depositary has to verify that the AIFM has set-up a procedure to detect any situation where a transaction is not settled within the usual time limit settlement. 12