Free Trial Corporate Access


Global Investor Magazine Copying and distributing are prohibited without permission of the publisher
Email a friend
  • Please enter a maximum of 5 recipients. Use ; to separate more than one email address.


EU policymakers close ‘loop-hole’ in Ucits V

02 December 2013


Confusion over a loosely-worded article in the AIFM directive has forced a sudden rewording of the corresponding section in the Ucits V draft. Stephanie Baxter reports

Read more: Ucits V EU AIFMD depositary liability

EU lawmakers have changed the wording of a misleading paragraph in the most recent draft version of Ucits V following concerns over the market’s interpretation of the same section in the Alternative Investment Fund Managers (AIFM) directive.

Global Investor/ISF reported on December 2 that a divergence in the market has emerged over the interpretation of a provision in the depositary liability regime of the AIFM directive where services are provided by securities settlement systems - which are run by central securities depositories (CSDs) and international central securities depositories (ICSDs).

Article 21(11) states that the use of an SSS’s services is not considered delegation of custody functions. Delegation of custody is the precondition for a depositary bank to be liable for loss of assets in the custody chain. The AIFM directive imposes strict liability on depositary banks, even for loss of assets at their sub-custodians.

In light of this, many of the big global custody banks have analysed how they can reduce or avoid liability for loss of assets by holding assets directly with CSDs or ICSDs. At the same time, some of the major ICSDs and CSDs have been marketing their services as a way to help depositary banks reduce their liability.

There has been wide disagreement in the market in the past few months over what services the exemption covers as these entities provide more than just pure settlement services.

Thorsten Gommel, a partner at PwC "There seems to be some confusion about Article 21(11) among both market participants and different regulators. Whereas some regard the exemption granted to SSSs as an institutional designation, others tend to see this applicable only for specific services of an SSS – that is, if it is really the last point in the custody chain."

One particular area of debate is whether depositary banks would be able to depend on the non-delegation clause where a securities settlement system (SSS) uses sub-custodians as its safekeeping agents. One camp believes these agents are a necessary part of the CSD infrastructure and that depositary banks would not be liable for them, while the other camp thinks otherwise.

But in an emailed statement on November 27 the European Commission gave a strict definition of the types of services that would not be subject to delegation of custody and that therefore would not impose liability on depositary banks for loss of assets.

The commission limited the services to "(i) initial recording of securities in a book-entry system through initial crediting, (ii) providing and maintaining securities accounts at the top-tier level and (iii) operating a securities settlement system".

The commission went on to say that as "providing custody is not part" of these services, Article 21(11) "does not state that a depositary bank can extricate itself from liability for the loss of a financial instrument by delegating custody to securities settlement system."

To Global Investor/ISF’s knowledge the commission had not informed market participants of its strict interpretation of Article 21(11) up until that point. Indeed, three senior-level market participants were "surprised" when they saw the commission’s emailed comment and one said this could be a "surprise legal turnaround".

There have been calls for a legal opinion or guidelines to be issued on the matter, urgently, considering the legal text has been or is currently being transposed into national law in member states and many AIFMs must be compliant by July 2014.

In an interesting twist, the same provision in Ucits V was amended in an updated version of the draft released on November 29 and dated November 27.

The article has been altered to include the Commission’s strict definition of the services that the exemption covers.

"(16) When a Central Securities Depositary (CSD), as specified in Article 2 (1)(1) of CSDR or a third-country CSD provides the services of (i) initial recording of securities in a book-entry system through initial crediting, (ii) providing and maintaining securities accounts at the top tier level and (iii) operating a securities settlement system, as specified in Section A of the Annex to CSDR, the provision of those services by this CSD with respect to the securities of the UCITS that are initially recorded in a book entry system through initial crediting by this CSD should not be considered a delegation of its custody functions."

The provision then goes on to say:

"However, entrusting the custody of securities of the Ucits to a CSD as defined in Article 2(1)(1) of CSDR or to a third country CSD should be considered a delegation of custody function."

This is a new insertion in the provision which now makes it clear that a depositary bank entrusting the custody of assets to a CSD would be liable for loss of those assets at that entity.

The sentence directly conflicts with Preamble (42) of the AIFM directive which states that "Entrusting the custody of assets to the operator of a securities settlement system … should not be considered to be a delegation of custody functions."

One interpretation of the Preamble is that if a depositary bank puts assets in custody at a CSD, it is not a delegation of custody and therefore the depositary bank is not liable. However the Preamble is not a legal document but rather explains the rationale behind the law and therefore is not legally binding.

One market participant said the turnaround suggests the European Commission and European Council "have realised this 'loop-hole' could cause problems" and that  they recognise that "too much room has been left to interpretation on this issue".

Christopher Stuart-Sinclair, a director in regulatory consulting at Deloitte, wondered whether the altered text in Ucits V would create precedent for the interpretation of the provision in the AIFM directive and pointed out that the change has been made to the recitals of Ucits V rather than to the text itself.

"One has to wonder how useful a recital is going to be, it has no legal enforceability and takes us back to the conundrum of intent versus legal basis.

"Perhaps the biggest question is why, if there is a growing perception that the clause may not be particularly helpful, it has been left in at all, unless it is to avoid leaving AIFMD orphaned with a reference that is so open to interpretation. It is also tempting to speculate why a change has been made to the recitals and not the text itself. Compromise is always difficult; compromise on ambiguity is in a realm all of its own."

Global Investor/ISF understand that recitals are not legally binding because they are not transposed into national law. However they do form part of the directive and are used to explain the rationale behind the law.

The commission has not responded to further questions  regarding Article 21(11) of the AIFM directive and changes to the corresponding section in Ucits V. The European Securities and Markets Authority (Esma) declined to speak to Global Investor/ISF but said it is "aware of this issue" and is "considering how to take this forward".

The issues over the interpretation of Article 21(11) are discussed in the main feature of the December issue of Global Investor/ISF.


Have your say
  • All comments are subject to editorial review.
    All fields are compulsory.