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An AIFM that is fully authorised under AIFMD is required to appoint a single independent depositary in respect of each AIF it manages.
Member States are currently permitted (but not required) to allow EU AIFMs to market non-EU AIFs, and non-EU AIFMs to market both EU and non-EU AIFs, in their territories on the basis of a national private placement regime (NPPR). The depositary requirements of AIFMD apply differently to AIFs marketed under NPPR. An authorised EU AIFM marketing a non-EU AIF to professional investors on the basis of a private placement exemption will not be subject to many of the depositary requirements and a non-EU AIFM marketing EU AIFs or non-EU AIFs to professional investors on a private placement basis will not be subject to any of the depositary requirements (unless Member States impose stricter private placement rules in their territories, notably the case for Germany and Denmark). However, AIFMD contains provisions which, if activated in the future, would require all AIFs to be marketed to professional investors in the EU on the basis of the AIFMD passport and not on the basis of NPPR, thus requiring full compliance with the AIFMD depositary rules for all AIFs marketed in the EU. Please see the “Marketing and Pre-Marketing – Introduction” page for more information.
These rules are set out in Article 21(2), and (7) to (9) of AIFMD.
The appointment of the depositary must be evidenced in writing. The depositary must be appointed to carry out certain functions, including:
These rules are set out in Article 21(3) to (6) of AIFMD.
Typically the depositary must be an EU credit institution or the branch of an EU credit institution, investment firm or other entity which, on 21 July 2011, was eligible to act as a depositary under the UCITS Directive. However, for closed-ended funds which do not generally invest in assets that must be held in custody AIFMD permits Member States to cater for a lighter regime whereby another entity which carries out depositary services as part of its professional activities may carry out the depositary functions. Luxembourg has for this purpose created the “professional depositary of assets other than financial instruments”.
The AIFM itself is not allowed to act as the depositary. Prime brokers acting as a counterparty to an AIF may act as a depositary for an AIF, subject to functional and hierarchical separation of their depositary and prime brokerage roles, and appropriate management of conflicts of interest.
In addition, for EU AIFs, the depositary must be located in the same jurisdiction as the AIF.
Luxembourg depositaries are subject to rather detailed rules, as laid down in a specific CSSF Circular (Circular CSSF 16/644), including the need to apply for a specific permission to act as AIFMD depositary.
AIFMD II introduces the possibility for the home member state of an EU AIF to permit its competent authorities to allow the appointment of a depositary established in another member state provided however that:
Even when those conditions are met, competent authorities may allow the appointment of a depositary established in another Member State only after carrying out a case-by-case assessment of the lack of relevant depositary services in the home Member State of the EU AIF having regard to the investment strategy of the AIF.
These rules are set out in Article 21(12) to (15) of AIFMD, Article 100 to 102 of the Level 2 Regulations and Part III Chapter 5 of the CSSF circular 18-697.
The depositary is subject to near strict liability in relation to the loss of financial instruments held in custody by the depositary or a delegate. In the case of loss of such financial instruments, the depositary is obliged to return identical financial instruments or the corresponding amount to the AIF (or the AIFM acting on behalf of the AIF) without undue delay, even if the instruments were held in custody by a sub-custodian.
However, the depositary will not be liable if it can prove that the loss of financial instruments has arisen as a result of “an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary” (e.g. a natural event beyond human control or influence, a change in the law, or war, riots or another major upheaval). However, this exemption is subject to strict rules which in practice make it less extensive than it may first appear – in particular, the insolvency of a sub-custodian is not covered. Click here for more detail in relation to circumstances in which the depositary may not be liable for loss of financial instruments.
Furthermore, where the assets are held by a sub-custodian, the depositary may be able to contract out of liability for loss of those assets if it has complied with all prescribed obligations in AIFMD in relation to the delegation and there is an "objective reason" for discharging itself of liability (e.g. where the law of a third country requires that certain financial instruments be held in custody by a local entity so the depositary had no option but to appoint a third party delegate). Click here for more detail on the applicable requirements.
In the case of “other losses” which the AIF or its investors may suffer, liability only flows if there is a “negligent or intentional” failure on the part of the depositary to comply with its obligations under AIFMD.
These rules are set out in Article 21(11) of AIFMD, Article 98 and 99 of the Level 2 Regulations, Part II Chapter 2 and sub-chapter 2.4 of the CSSF circular 18-697.
Under AIFMD, the depositary may delegate its safekeeping functions provided that the functions are not delegated to circumvent AIFMD, the depositary has an objective reason for the delegation, and the depositary exercises all due skill, care and diligence in the selection, appointment and ongoing monitoring of the sub-custodian.
Additionally, the sub-custodian must:
The sub-custodian must act honestly, fairly, independently and in the interests of the AIF and the investors of the AIF when carrying out its duties, and must comply with certain general obligations as set out in AIFMD.
AIFMD II provides that where a depositary delegates custody functions to a central securities depository (CSD) acting in the capacity of an investor CSD, that depositary will not need to comply with the due diligence requirements applicable for the appoint of such CSD as delegate. For the avoidance of doubt, the provision of services by a central securities depositary acting in the capacity of an issuer CSD shall not be considered a delegation of the depositary’s custody functions.
When a depositary delegates the custody function to a sub-custodian, it must comply with detailed rules which are set out in the Level 2 Regulations. In summary, under Article 98 of the Level 2 Regulations, the depositary must:
In addition, as set out in detail in Article 99 of the Level 2 Regulations, the depositary must:
The requirements of Articles 98 and 99 of the Level 2 Regulations generally apply on the same basis with respect to any further sub-delegation by the sub-custodian of its safe-keeping functions.
These rules are set out in Article 21(2) of AIFMD, Article 83 of the Level 2 Regulations and the CSSF Circular 18-697.
Unless otherwise required by national law, an AIFM will not need to enter into a specific written agreement for each AIF. It is therefore possible for the AIFM and the depositary to enter into a framework agreement that applies to a number of AIFs managed by the AIFM.
In practice, however, we see that there is always a separate agreement for each AIF.
Article 83 of the Level 2 Regulations specifies the matters which must be addressed in the written agreement between the depositary and the AIFM and/or AIF. These matters are extensive, and include the following:
These rules are set out in Article 21(7) of AIFMD and Articles 85 and 86 of the Level 2 Regulations.
As part of its obligations relating to cash-flow monitoring, the depositary must ensure that payments made by or on behalf of investors and those received for the benefit of investors are booked in segregated accounts opened in the name of the AIF (or AIFM or depositary acting on behalf of the AIF) at a central bank, an EU authorised bank or a non-EU authorised bank. It falls on the AIFM to ensure that the depositary is provided with all relevant information it needs to comply with this obligation. To ensure that the depositary has access to information regarding the AIF’s cash accounts and an overview of all the AIF’s cash flows, the depositary must:
The depositary’s cash-flow monitoring obligations also require it to:
These rules are set out in Article 21(8)(a) of AIFMD, Articles 88 and 89 of the Level 2 Regulations.
The depositary must hold in custody:
The depositary’s custody obligation does not, however, extend to financial instruments which, in accordance with applicable national law, are only directly registered in the name of the AIF with the issuer itself or its agent, such as a registrar or a transfer agent.
The scope of the depositary’s custody duty covers the following:
Where a depositary has delegated custody functions to a sub-custodian, the depositary will nonetheless be required to ensure proper registration of the relevant financial instruments, maintain accurate records and segregated accounts, to conduct reconciliations as often as necessary between its internal accounts and records and those of the sub-custodian, to exercise due care so that the exercise of the custody function ensures a high standard of investor protection, to assess and monitor all relevant custody risks, and to inform the AIFM of any material risk. The depositary will also need to ensure that the sub-custodian duly performs the custody functions listed above (with the exception of registration of financial instruments), and complies with the segregation obligations in the Level 2 Regulations. See above for further information in relation to requirements that apply to a depositary which delegates safekeeping functions to a sub-custodian.
The depositary’s duties above apply on a look-through basis to underlying assets held by financial and/or legal structures controlled directly or indirectly by the AIF (or the AIFM acting on behalf of the AIF), although they do not apply to fund-of-funds structures or master-feeder structures where the underlying funds have a depositary which keeps the assets of these funds in custody.
These rules are set out in Article 21(8)(b) of AIFMD and Article 90 of the Level 2 Regulations.
In respect of assets which do not constitute financial instruments that can be held in custody, the depositary must verify the ownership of the AIF (or the AIFM acting on behalf of the AIF) of such assets and maintain a record of those assets for which it is satisfied of such ownership. This ownership assessment must be based on information or documents provided by the AIF or the AIFM and, where available, on external evidence. The depositary must also ensure that it keeps its records relating to this assessment up to date.
The AIFM is under a separate obligation to provide the depositary, and to ensure relevant third parties provide the depositary, with all relevant information the depositary needs to comply with its ownership verification obligations.
The arrangements relating to ownership verification and related record-keeping must be such that:
The depositary must also ensure the AIFM implements appropriate procedures to verify that the assets acquired by the AIF it manages are appropriately registered in the name of the AIF or in the name of the AIFM acting on behalf of the AIF, and to check the consistency between the positions in the AIFM’s records and the assets for which the depositary is satisfied that the AIF (or the AIFM acting on behalf of the AIF) holds the ownership. The AIFM must ensure that all instructions and relevant information relating to the AIF’s assets are sent to the depositary, so that the depositary is able to perform its own verification or reconciliation procedure.
The depositary must implement an escalation procedure for situations where an anomaly is detected, including notification of the AIFM and of the competent authorities if the situation cannot be clarified and/or corrected.
The depositary’s duties above apply on a look-through basis to underlying assets held by financial and/or legal structures controlled directly or indirectly by the AIF (or the AIFM acting on behalf of the AIF), although they do not apply to fund-of-funds structures or master-feeder structures where the underlying funds have a depositary which provides ownership verification and record-keeping functions for these funds’ assets.
These rules are set out in Article 21(4)(b) of AIFMD and Article 91 of the Level 2 Regulations.
A prime broker acting as a counterparty to an AIF may be appointed as the depositary for the AIF provided that it has functionally and hierarchically separated the performance of its depositary functions from its tasks as prime broker, and that potential conflicts of interest are properly identified, managed and disclosed to the investors of the AIF.
In addition, depositaries of AIFs can delegate custody tasks to one or more prime brokers provided that they meet the conditions above and below.
Where a prime broker has been appointed as sub-custodian, it must provide to the depositary of the AIF, no later than the close of the next business day to which it relates, a statement in a durable medium which contains the following information:
In Luxembourg, a list of the prime brokers or collateral agents has to be part of the information on depositary functions to be kept updated and to be provided to the CSSF on a periodic, ad hoc or annual basis.
These rules are set out in Article 21(12) of AIFMD, Article 100 and 101 of the Level 2 Regulations.
A loss of a financial instrument held in custody by a depositary (or a sub-custodian) is deemed to have taken place when any of the following conditions is met:
In general, the depositary is strictly liable with respect to any loss of the AIF’s financial instruments. However, in the case where the loss of financial instruments resulted from an external event beyond the depositary’s reasonable control, the consequences of which were unavoidable despite all reasonable efforts to the contrary, the depositary may be able to discharge its liability for the loss provided the depositary can prove that all the following conditions are met:
a) the event which led to the loss is not the result of any act or omission of the depositary or a sub-custodian, and the depositary could not have reasonably prevented the occurrence of that event despite adopting all precautions incumbent on a diligent depositary as reflected in common industry practice.
Such events include:
natural events beyond human control or influence;
the adoption of any law, decree, regulation, decision or order by any government or governmental body, including any court or tribunal, which impacts the financial instruments held in custody;
war, riots or other major upheavals,
but exclude cases such as accounting errors, operational failures, fraud and failure to apply the segregation requirements at the level of the depositary or a sub-custodian.
b) despite rigorous and comprehensive due diligence, the depositary could not have prevented the loss.
Such rigorous and comprehensive due diligence includes:
establishing, implementing, applying and maintaining structures and procedures and insuring expertise that are adequate and proportionate to the nature and complexity of the assets of the AIF in order to identify in a timely manner and monitor on an ongoing basis external events which may result in loss of a financial instrument held in custody;
assessing on an ongoing basis whether any of the events identified under the first indent presents a significant risk of loss of a financial instrument held in custody;
informing the AIFM of the significant risks identified and taking appropriate actions, if any, to prevent or mitigate the loss of financial instruments held in custody, where actual or potential external events have been identified which are believed to present a significant risk of loss of a financial instrument held in custody.
In the case where the depositary has delegated the safekeeping of an AIF’s assets to a sub-custodian, and the depositary has contracted out of its liability and transferred it to the sub-custodian, the sub-custodian may discharge its strict liability provided it can fulfil the conditions listed in paragraphs (a) and (b) above.
These rules are set out in Article 21(13) and 21(14) of AIFMD and Article 102 of the Level 2 Regulations.
When a depositary delegates the custody of an AIF’s assets to a sub-custodian, the depositary remains strictly liable for any loss of financial instruments. However, the depositary may discharge itself of liability if it can prove that:
a) the delegation complies with AIFMD;
b) a written contract between the depositary and the sub-custodian expressly transfers the liability of the depositary to the sub-custodian and makes it possible for the AIF or the AIFM acting on behalf of the AIF to make a claim against the sub-custodian in respect of the loss of financial instruments or for the depositary to make such a claim on their behalf; and
c) a written contract between the depositary and the AIF or the AIFM acting on behalf of the AIF expressly allows a discharge of the depositary’s liability and establishes the objective reason to contract such a discharge.
Such an “objective reason” must be established each time the depositary intends to discharge itself of liability, and must be:
In addition, in situations where the depositary has no other option but to delegate its custody duties to a sub-custodian, the depositary will be deemed to have objective reasons for contracting the discharge of its liability. In particular, this is the case where:
Where the law of a third country requires that certain financial instruments are held in custody by a local entity and there are no local entities that satisfy the delegation requirements laid down in AIFMD with respect to effective prudential regulation, supervision and external periodic audit, the depositary can discharge itself of liability provided that the following conditions are met:
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