EC Raises Bar For Liability of Custodian Banks for Loss of Hedge Fund Assets
Should one financial firm be held responsible for the mistakes or wrongdoing of others?
Apparently, the European Commission thinks when it comes to custodian banks servicing hedge funds which could end up with a lot more operational headaches.
The Alternative Investment Funds Managers Directive (AIFMD) calls for "depositaries" to make the hedge funds whole in certain circumstances if their assets were lost by others -- namely sub custodians and prime brokers -- unless the "depositaries" can prove it wasn't their fault. The nitty-gritty rules on how the legislation should be implemented could be out as early as July.
While most of the AIFMD addresses expanded disclosure and reporting responsibilities for hedge fund advisers, the heightened standard of liability for depositaries -- or custodian banks -- is drawing the most attention. At issue: just how they can validate they performed such a high level of due diligence that they couldn't have prevented any loss -- namely missing client cash and securities. The phrasing, in its current form, is so vague that custodian banks contacted by www.iss-mag.com won't venture any interpretation or provide too many details on how they will comply beyond broad statements.
So far, the EC doesn't appear willing to bow to requests from hedge fund managers and custodian banks that it eliminate any mention of depositary liability and retain the status quo. That involves a custodian bank doing its fair share of due diligence or practically speaking best effort. The final rules could take effect in July 2013 for new hedge fund managers while existing managers are given a grace period until July 2014. Hedge fund managers distributing their funds across Europe will be the most affected by the legislation; non-European funds distributing offshore won't be. US hedge fund managers distributing their funds in Europe where private placements are permitted might be able to bypass the issue of liability, temporarily, say legal experts, although custodian banks aren't certain how long that will last.
As the deadline for compliance quickly approaches but details still up in the air, custodian banks are carefully weighing the AIFMD's ramifications. "The future standard of liability will be much higher than the current one because custodian banks will have to prove in certain circumstances they weren’t at fault. Therefore, it is likely that there will be a lot more oversight of sub custodians, says Ian Headon, hedge fund product director for Northern Trust in Dublin. Translation: a lot more onsite visits, questions asked and required reports delivered particularly about where customer assets are being held. Daily reconciliation of cash and positions will likely become required business practice.
The AIFMD requires that alternative investment fund managers appoint a depositary bank for each fund they manage assuming they want to take advantage of the passport regime to market their funds across the European Union. Those depositaries are responsible for safekeeping alternative fund assets and monitoring fund cash flows, hence it is likely that custodian banks will take on those tasks. Those custodian banks, in turn, hire sub custodians to take care of assets in other markets. However, the hedge fund manager is responsible for hiring prime brokers for trade execution and securities borrowing activities. The AIFMD's wording suggests that prime brokers act in the role of sub custodians.
The EC's stance is in sharp contrast to U.S regulations where Rule 17f5 of the Investment Company Act hold the global custodian servicing mutual funds and pension plans liable only for errors or fraud it commits. Global custodians are responsible for performing due diligence in hiring sub custodians, but the terms of liability are set between the global custodian and local agent banks in separate contracts.
So why is the EC taking such a different viewpoint? As is the case with many of its initiatives harmonization is a key goal. The EC wants to create policies in EU member states around a stricter interpretation of liability and align the AIFMD's interpretation with that of the next version of UCITS known as UCITS V. UCITS refers to legislation allowing the cross-border marketing of investment funds. Most European countries don't make custodian banks liable for the wrongdoing of other financial institutions, but France appears to be a notable exception based on recent court rulings. Cases in point: in 2009, a French appeals court agreed with the country's securities watchdog AMF that Societe Generale Securities Services and RBC Dexia Investor Services were responsible for making investors whole due to losses resulting from the rehypothecation policies of Lehman Brothers International Europe.
The ability of prime brokers to rehypothecate -- or use client assets to finance their own trading activities -- appears to be causing the most angst for custodian banks when it comes to preparing for additional liability. The practice is far more liberal in Europe than the US leaving custodian banks a lot more exposed. "We expect custodian banks will spend more time asking exactly what the assets are being used for," says Chris Adams, head of hedge fund services for BNP Paribas Securities Services in London. "The depth and frequency of reporting will increase and banks will become more proactive rather than rely on the word of prime brokers."
As the need for additional operational work increases so does the prospect of higher costs. And that's just the tip of the iceberg. "The proposed reforms -- especially the new liability -- will create a contingent risk for all European depositaries forcing them to hold additional capital against potential loss. This means a capital charge in addition to the set-up costs and ongoing expenses of the new monitoring and reporting requirements," says Ernst & Young in a March bulletin to clients about AIFMD.
The level of costs, writes Ernst & Young depends on just how far the liability of custodian banks extends. It will be substantially higher if the entire chain of service providers including "unaffiliated agents" is included than if it is limited to "directly controlled affiliates."
With additional costs comes the question of just who bear the burden. "It's a critical issue. Banks will need to determine how much they are willing to absorb or pass along to hedge fund clients in the form of higher fees," says Michael Newell, a partner in the law firm of Norton Rose in London specializing in hedge funds.
"Depositaries plan to pass most of these costs to alternative investment managers and alternative investment managers, in turn, will pass on these increased costs to funds and ultimately to investors," says Ernst & Young in its March bulletin.
Newell predicts that smaller sized hedge funds will be affected the most. "Larger hedge fund managers have a lot more negotiating power with custodian banks on fees," he says. The ramification: hedge fund managers will likely need to determine whether the additional cost of complying with AIFMD outweighs the benefit of marketing their funds in multiple countries. "They may determine it just isn't worth it," says Newell.
Written by Chris Kentouris, Editor-in-chief (Chris can be contacted through Chris.Kentouris@hotmail.com)