AIFM Directive: Custody Issues. Article 17

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1 AIFM Directive: Custody Issues Article 17 Introduction: Global custody services process cross-border securities trades, keep financial assets safe and service the associated portfolios for clients. This service is usually provided to institutional investors. The assets can include equities, government bonds, corporate bonds, other debt instruments, mutual fund investments, warrants and derivatives. The service normally comprises of collecting dividends, dealing with tax, valuing of investments, foreign exchange, and the settlement of transactions. A Global Custodian will offer a one-stop shop to service an investor's appetite to access diverse markets. It must do this by operating in tandem with a chain of intermediaries. Typically this includes the appointment of proprietary sub-custodians, third party subcustodians and a series of (mandatory) participations in Central Securities Depositories. A typical Global Custodian may have in excess of 50 third party sub-custodians, depending on the breadth of its network offering to an investor client. It is important to understand that an investors` primary focus is on the yield and the relative performance on the investment ; but there also exists a separate requirement concerning the safety of assets and protection of money (for the investor itself or for the investors` ultimate customer). In line with this, the Global Custodian is expected to address risk asset safety by having in place financial, operational and legal standards which are robust, up-to-date and consistently quality tested. There already exist extensive international regulatory and market driven controls which govern Global Custodians as an industry. There are also a wide range of varying local and market specific requirements which Global Custodians need to ensure are adhered to by their sub-custodians. The task of ensuring that a continuing risk management of the intermediary chain is tested, is performed by Global Custodian network managers. There are two distinct issues that need to be addressed within the custody provisions of the AIFM Directive: (i) clarity as to what a custodian's functions should be; and (ii) what liability attaches to the carrying out of those functions (including as to where the custodian delegates the performance of those functions to third parties). We need to ensure that the EU-based environment remains competitive and creates neither concentration nor systemic risks in the financial system. As such we have put forward below some solutions to various of the draft provisions in Article 17. For reference, in the Annex to this document we have provided a brief outline of the due diligence standards which exist today in the global custody environment. 1

2 1. EU Credit Institution Article 17.3 The depositary shall be a credit institution having its registered office in the Community and be authorised in accordance with Directive 2006/48/EC of the European Parliament and Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions. If a EU credit institution ONLY can act as a depository to an AIF, many prime brokers and other custodians will no longer be able to participate. Danger of concentration of activity into a few banks and priming the pump for a further systemic problem. If custody over AIFs becomes more stringent than custody for UCITS there will be inconsistent regulation. Solutions: Or: Given MiFID Investment Firms are subject to the same supervision and capital requirements as Credit Institutions, we do not see there to be sufficient grounds upon which to disqualify Investment Firms from acting in the capacity of Depositary. The definition should be expanded to include both EU Credit Institutions and MiFID Investment Firms. Remove the substantive custodian provisions from the AIFM Directive and deal with them separately. 2. Strict Liability Article 17.5 The depositary shall be liable to the AIFM and the investors of the AIF for any losses suffered by them as a result of its failure to perform its obligations pursuant to this Directive. Regulation should not result in risk being transferred entirely from investors, their advisers or brokers to a depository. Immediate restitution is unworkable. Strict liability imposes unquantifiable risk on banks. This will have practical consequences (pricing, insurance, contractual terms). Firms are likely to exit the custody business in Europe under the current Directive terms. Unquantifiable risk will be a drag on the capital of major custodian banks. The current directive text would turn counterparty risk into custodian risk. Under strict liability provisions, in a Lehman s type default, without insurance, the custodians involved would have gone bust. 2

3 The FSA independent impact survey showed that custodians would be unable to obtain insurance for immediately liability at any price. Additionally, in the event of a major, Lehman s type default, it is unlikely the insurer would be able to pay out to cover the magnitude of the losses either. This could result in multiple financial firms failure with significant systemic implications. Solutions: Commission should outline the responsibilities and commensurate due diligence custodians should carry out. Should the custodian be unable to show that it had engaged in appropriate due diligence in carrying out its responsibilities, it would be liable to the fund for any loss. The custodian would not however have immediate liability for any and all potential failures of counterparties or sub-custodians, where it had executed the required due diligence to be laid out in the Directive. 3. Delegation Article 17.4 Depositaries may delegate their tasks to other depositaries. Custody is not outsourcing local custody is required and not something which an EU custodian can do (e.g. in Japan, South Africa, Brazil etc). The effect of the current draft delegation provisions is that EU AIF s will not be able to hold assets in many jurisdictions outside the EU (a significant disadvantage to the EU funds industry). Using a local sub-custodian is not, in fact, a delegation. Where there is limited or no choice of sub-custodian in a particular jurisdiction; if custodians are forced to take on liability for that custodian, it is unlikely there will be a workable business model for such an outcome. Solutions: In the instance where there is very limited or only one local sub-custodian that can be used, this should come under the concept of investor risk. The Commission should incorporate the concept of investor risk in the Directive liability requirements for those jurisdictions where the global custodian has very limited or no choice in the use of sub-custodians. Such risk warnings should be incorporated into the custodian s agreements. In the situation where the AIF issues specific instructions to the global custodians on which sub-custodian to use; the global custodian should not be liable for the actions of these parties where losses may be incurred by 3

4 the fund. Except in the case of gross negligence on the part of the global custodian. Custodian s should carry out appropriate due-diligence and provide full disclosure to the AIF regarding the investor risk they are taking by investing in jurisdictions with a limited or no choice of local sub-custodians. ANNEX I: DUE DILIGENCE STANDARDS IN GLOBAL CUSOTDY 1. Introduction Global Custody originated because of investor's demand to hold securities certificates in a safe place. It has evolved - concurrent with further investor demand - beyond physical safekeeping into a range of banking services (consolidating information in respect of an investor's international portfolio). 2. Due Diligence Standards Set forth below is an account of the issues, a typical Global Custodian network management function deals with. Broadly the issues can be divided by risk type : Financial (including selection of appropriate intermediaries within the chain ) ; Operational ( including concentration and systemic) ; Credit (i.e. ongoing assessment of the creditworthiness of the investor or the investor-side parties (investment manager/broker) ; and Legal ( loss of a right due to a law, regulation or contractual term being rendered in applicable or unenforceable).there follows a short (but inexhaustive) description of how these matters are addressed by a well-run Global Custody network manager. 2.1 Some key considerations (a) An investor client needs to evaluate the financial health of its Global Custodian during appointment (on an ongoing basis). Of course, public authorities and regulators oversee banks to ensure prudent management, capital adequacy and risk weighting of assets and liquidity, as associated with the specific activity they undertake. The risks which an investor faces viz a Global Custodian are reflected down the chain in relation to the issues a Global Custodian must assess (in sign cant detail) in connection with the appointment of sub-custodians (see 2.2 below). (b) Operational risk presents vulnerabilities across the entire trading, clearing and settlement environment. It may be systemic in nature and its containment will be managed only by preparedness of all participants for localised or widespread disruption. Investors, who are global custody clients, should prudently manage their credit and liquidity needs by employing a range of banking/service providers. A Global Custodian must be able to present a picture of integrity and efficiency in terms of operational controls, continuity of business arrangements and a proven error resistant track record which benchmarks favourably against the best standards in the market. The 4

5 quality of management and operational controls is determinant in Global selection. Custodian Global Custodians may mitigate the effect of an operational risk event at sub-custodian level by careful selection and ongoing risk assessment within the intermediary chain. However in certain markets, where the choice of providers (sub-custodian, CSD or local law/regulation) is limited, there is an inevitable risk associated with investment in that market and that is a risk which is borne by the person who seeks the return from that same market (i.e. the investor). (c ) Credit risk is mostly a concern for the Global Custodian itself - as it is usual for the Global Custodian to advance money to the investor to facilitate settlement and intraday payments. Custodians which are banks are - through national and regional legislation - subject to capital and liquidity requirements and the extent to which an exposure needs to be collateralised prudently by its investor clients. (d) Legal risk occurs where a contract party is unable to enforce rights under a law, contract or other arrangement. The main legal risk for investors clients of Global Custodians is the risk of loss of title to assets. This is a major and well known area, much debated but still very much "unharmonised" given that local insolvency, collateral and settlement finality rules remain local. This is a risk arising from cross-border investments There are however practical mitigants which Global Custodians undertake covering for example (securities) asset segregation, cash account procedures and treatment of client money (where appropriate), the extensive procurement and updating of opinions (particularly through the SEC 17-f 5 rules), and adherence to rules (e.g. MiFID) which prohibit the use of assets without client instruction (lending/rehyopthecation etc).these conventions are embedded within a Global Custodian's environment and are passed down direct by the Global Custodian to their sub-custodians. 2.2 Practical evaluation (a) A Global Custodian will have in place a Network review committee composed of senior managers who - on an ongoing basis - review country coverage and possible expansion into new markets - depending upon investor demand and assessment of the robustness of local market infrastructure. (b) Typically, business analysis will be undertaken to decide on whether to build a proprietary capability or employ a third party sub-custodian. * If the decision is to build an operation, a comprehensive plan will be devised to cover every aspect of the custody business, including the appropriate technology to best meet client needs. In markets where the Global Custodian already has a presence, it is likely to develop services internally To do this the Network Team would impose Network standard policies, procedures, and securities processing technology. The team would work with local country management to select and/or train staff for the custody operation. Prior to opening a branch for custody and clearing operations, Risk Management would review the entire operation and associated documentation and certify that the branch is ready to do business. * Where it is decided to develop a third party sub-custody facility, this must satisfy what is considered to be "best market practices" - the benchmarks being those identified 5

6 by the industry, investor clients, and competitors. It is considered that the selection of a third party custodian is, in effect, an "absolute" in terms of standard of care - i.e. to appoint the best provider in a market (as a result regional alliances rarely satisfy selection criteria). * Network Management due diligence is comprehensive and documented thoroughly. The evaluation process requires on-site reviews of each possible provider as well as the provision of clearly documented service agreements. > Steps include: Identifying sub-custodial service providers in the market and requesting information on their custody service capabilities On-site review of multiple providers Completion of market analysis questionnaire to each potential provider. Visiting each sub-custodian in the market. Identification of unique service features and service deficiencies. Choosing the appropriate agent based on their ability to meet stringent Network Performance Agreement and Standards of Care documents. > The criteria used to evaluate prospective sub-custodians (both proprietary and third party) are : Ability of the sub-custodian to meet performance standards and operational work flow requirements. Ability to meet regulatory conditions imposed by SEC 17f-5 (U.S.), NP39 (Canada), ERISA (U.S.) and FSA (U.K.). On an annual basis, the sub-custodian network must demonstrate compliance evidenced by their submission of a detailed information package. This includes copies of legal contracts, local external legal opinions and financial assessments of agents and representatives, relative to the security and safety of assets held in their custody on our behalf. Failure to demonstrate compliance with any of the regulatory conditions will result in immediate action, and could result in elimination from the network. > Specific third party sub-custodian selection criteria: The local provider will preferably be a branch or wholly owned subsidiary of an international bank providing custody to global custodians; Minimum capital requirements; Clean balance sheet for last 3 years i.e. no unacceptable qualification of accounts by auditors; Evidence of a proper internal audit system; 6

7 Satisfactory external credit ratings from a reputable agency e.g. Moody s or S&P; Satisfactory internally assessed credit rating; Acceptable insurance arrangements covering and its clients against fraud, negligence etc.; Acceptable safe custody arrangements for physical scrip (if market is physical). Vault should be minimum UL2 standard (cash safe equivalent); High reputation in the local market as an institution; Properly registered and licensed entity as per local authority requirements; Satisfactory standing as per local regulatory authorities; High expertise as perceived by the local and international market; High degree of commitment to technology and level of automation; Evidence of long term commitment to the custody business; Perceived strength of management team; Availability of staff who can converse in the same language as the Global Custodian ; Contractual compliance with FSA and SEC regulations as applicable to subcustodians; Waiver of all rights of lien over client assets whether enshrined in law or not; Accept Service Level Agreement and operating standards; Satisfactory risk assessment of the prospective sub-custodian's operating processes; Willingness to provide feedback and data on client and Global Custodian's performance and to work to resolve deficiencies; Willingness to respond to Quarterly Self Assessments and to host annual Due Diligence review; Accept jurisdiction of US or UK courts and to accept Global Custodian's standard subcustodian agreement as the basis for the contractual relationship. * Ongoing Monitoring of Sub-Custodian Network - The performance of third party sub-custodians is tracked by the Network Management team. Any variance from documented standards must be explained in detail. Often, a monthly variance will initiate discussions with representatives from Network, Operations and Product Management teams. Action plans are then developed and enforced. 7

8 - Information reported by the sub-custodians is validated against actual performance experienced by Network centres in New York, London, and Hong Kong on a quarterly basis. The Network Management team continually monitors actual performance against these standards and initiates action steps to address performance issues. Continued non-performance will result in elimination from the network, even for proprietary entities. - Network Management tracks the following indicators monthly: Failure to Deliver. Failure to Receive. Corporate Action notification (timely notification of all corporate action/income collection announcements). Income collection (the timely posting of income to clients accounts). Settlement confirmations (timely notification of trade settlements). Problem resolution (responsiveness to client inquiry). - Annual Due Diligence Reviews All third party sub-custodians are reviewed through a due diligence process conducted on an annual basis. On-site visits are made to sub-custodians where the Global Custodian holds total assets of more than $10 billion, or those where specific issues have been encountered in the market that require detailed investigation. Remote due diligence reviews are conducted where the Global Custodian holds assets totalling less than US$10 billion and/or market activity is minimal. For a proprietary network, on-site reviews are conducted through regional management teams, typically several times a year. 8