Depositaries, Custodians and Client Money

The changing regulatory landscape

Originally published in the February 2011 issue

The last quarter of 2010 saw a number of significant changes in the regulatory landscape for hedge funds and prime brokers. As a result of the events of the past few years and the insolvency of Lehman Brothers, the regulatory spotlight has, in part, fallen on the provision of custody services and the protection of client money. This has prompted two significant developments which will impact the prime brokerage and hedge fund industry: the reform of the FSA’s client asset rules and the requirement under the Alternative Investment Fund Managers Directive (AIFMD) that a depositary be appointed for each fund covered by the AIFMD. This article examines some of the key elements of both of these developments and focuses on the practical implications for prime brokers, custodians and hedge funds.

The new CASS rules
Following a consultation, the FSA published its final rules amending the Client Assets Sourcebook (the CASS Rules) in November 2010. The new CASS Rules can in effect be divided into two: those directly regulating certain aspects of prime brokerage and those aimed at client money and asset protection.

Prime brokers
The new rules relating to prime brokerage, which is defined as a distinct activity for the first time by the FSA, apply to UK authorised prime brokers who hold client money/assets, including overseas branches of those firms, and UK branches of non-EEA prime brokers who are subject to the CASS Rules. Importantly, the new rules do not apply to UK branches of incoming EEA prime brokers.

From 1st March 2011, prime brokerage agreements will be required to include a disclosure annex that summarises the contractual re-hypothecation provisions and the associated risks on the failure of the prime broker. Prime brokers will therefore be expected to repaper their existing client agreements by this date. In practice, this will likely involve providing existing clients with a disclosure annex as a supplement to existing prime brokerage agreements. Prime brokers will also need to update their template prime brokerage agreements to include the disclosure annex.

Prime brokers will also be required, from 1st March 2011, to provide detailed daily reports to their clients which are to include comprehensive details of the client’s assets and financing obligations in relation to the prime broker. Specifically, prime brokers will be obliged to report to clients the total collateral held by the firm in respect of secured transactions entered into under a prime brokerage agreement, including where the firm has exercised a right of use (re-hypothecation) in respect of that client’s safe custody assets as well as the location of all of a client’s safe custody assets, including assets held with a sub-custodian.

Prime brokers will therefore need to ensure that their operational systems produce the necessary data for the daily reports. The benefits for clients however are twofold: first, clients will now be in a position to monitor their exposure to re-hypothecation risks on a daily basis, and second, in the event of the prime broker’s insolvency, the process of recovering assets and processing claims should be made more efficient by the greater availability of information about the way in which assets are held. The new regime does not impose any restrictions or limits on the activity of re-hypothecation, nor does it affect the underlying legal position that re-hypothecated assets are at risk on the insolvency of the prime broker.

Client money and asset protection
Two significant new rules in relation to the protection of client money and assets have been introduced. These new rules apply to all UK authorised investment firms that hold client money/assets, including overseas branches of those firms, and UK branches of non-EEA firms who are subject to the CASS Rules.

First, from 1st March 2011, there will be a prohibition on the use of general or omnibus liens in custody agreements. Broadly, this means that (subject to certain exceptions) liens that do not relate directly to the provision of services by a custodian to an underlying client will be prohibited. The challenges and delays associated with the recovery of assets from sub-custodians in the Lehman insolvency as a result of the general liens in place appear to have been the driving force behind this prohibition. Although the rules come into force on 1st March 2011, firms have until 1st October 2011 to re-paper their agreements if necessary. Second, from 1st June 2011, there will be a limit on the proportion of client money that can be placed with institutions within the same group as the regulated firm of 20% of the total client money held for clients. This does not cover money placed in transaction accounts, e.g. margin paid to clearing systems.

In addition to the above it is worth noting that from 1st January 2011, firms are obliged to apportion the new CASS oversight controlled function and from 1st June 2011, a Client Money and Asset Return (CMAR) will once again have to be submitted to the FSA on a monthly basis for medium- and large-sized firms.

Finally, the FSA published, as part of its October 2010 policy statement, a high-level review of the SPV structures established by some prime brokers to hold client money and assets and designed to be insolvency remote. The FSA, whilst noting that the financial institutions creating these structures were confident that they are sound and that there had been some buy-side support, concluded that none of these SPV structures had yet been tested in real insolvency proceedings in court and that consequently “buy-side participants should consider whether such services are suitable for their own needs and those of their clients”. It is notable that the FSA’s amended custody regime does not give any formal role to such SPV structures and it is likely that such structures will remain the exception for most investors due to the higher costs involved.

The AIFMD and depositaries
The AIFMD, which was passed by the European parliament in November 2010 and must be implemented into national law by around the beginning of 2013, contains a requirement that a depository be appointed for each fund caught by it. The Commission has been charged with adopting measures specifying certain issues (the Level 2 Rules).

Depositary functions
A depositary should not be confused with a custodian; a depositary’s functions are broader than those of a custodian and include:

• ensuring the proper monitoring of the fund’s cash flows;
• ensuring that investor money and cash belonging to the fund, or as the case may be, to the manager acting on behalf of the fund, is booked correctly in an account opened in the name of the fund or in the name of the manager acting on behalf of the fund or in the name of the depositaryacting on behalf of the fund;
• the safekeeping of any financial instruments which belong to the fund;
• ensuring the value of the shares or units of the fund is calculated in accordance with applicable national law and the fund’s rules, instruments of incorporation and valuation procedures; and
• ensuring that the fund’s income is applied in accordance with applicable national law and the fund’s rules.

Exemption to the depositary requirements
Many of the depository requirements will not however, be applicable where an authorised EU manager managing a non-EU fund or a non-EU manager managing a fund is marketing that fund to professional investors without a passport pursuant to the private placement rules of a member state. This exemption may cease to be available however if the private placement regimes are phased out from 2018.

Identity of the depositary
The depository should be an EU credit institution or investment firm or a third country equivalent that is subject to the same standard of prudential regulation and is effectively supervised. The manager of the fund cannot act as the depository for that fund. A prime broker acting as counterparty to a fund can act as a depositary for that fund provided that the depository function is “functionally and hierarchically separate” from the rest of the prime broker’s business and conflicts of interest are appropriately managed. Until the Level 2 Rules are published however, it is not clear the extent to which the prime broker’s depositary and non-depositary functions should be operationally separate, although it can be assumed that in any event this will go beyond the MiFID management of conflicts obligation. A depositary may delegate the custody functions to a prime broker provided that the relevant conditions are met, as set out below. Even where the prime broker is only acting as custodian and not as depositary, the wording of the text of the AIFMD suggests that the prime broker would be required to comply with the “functionally and hierarchically separate” requirement.

Location of the depositary
In the case of a fund established in the EU, the depository needs to be established in the jurisdiction of the fund. In the case of a non-EU fund, the depositary needs to be established in the same jurisdiction of the establishment of the fund or the home member state or the member state of reference of the manager. A depository in a non-EU third country may only be appointed provided certain conditions are met, including, that: (i) there are appropriate co-operation and information sharing arrangements in place; (ii) the depositary is subject to effective prudential regulation and supervision; and (iii) the depositary will be contractually liable to the fund or investors in the fund, for, inter alia, the loss of financial instruments held in custody. The Level 2 Rules are expected to set out the criteria for assessing whether the prudential regulation and supervision of the third country is satisfactory.

Delegation of the depositary’s functions
A depositary may delegate the custody function to a third party. It may only do so however, to the extent that it can demonstrate that there is an objective reason for the delegation. The fact that the fund has chosen a particular prime broker and that the provision of custody services is an integral part of the prime brokerage arrangement may be sufficient to satisfy this although this is subject to the Level 2 Rules. The depositary must also show that it has exercised all due skill, care and diligence in the selection of the custodian, periodically reviews its selection and monitors the custodian on an ongoing basis. In addition, the depositary must ensure that the custodian, amongst other things, segregates the fund’s assets from its own and from those of the depositary and does not use the fund’s assets without the prior consent of the fund or the manager acting on behalf of the fund. There is a limited exception where the law of a third country requires financial instruments to be held in custody by a local entity.

The depositary’s liability
Whilst the final text of the AIFMD took a step back from the initial draft’s controversial strict liability imposed on a depositary for the loss of custodied assets, it still imposes a high standard of liability for the loss of custodied assets. Where assets held in custody are lost, the depository is obliged to return identical financial instruments or the corresponding amount to the fund or the manager acting on behalf of the fund without undue delay. There is a limited exception under which “[t]he depositary [will] not be liable if it can prove that the loss 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.” The depositary’s liability extends, except in certain limited circumstances, to the loss of assets by a custodian appointed by the depositary.

The Commission has been specifically charged with adopting measures specifying both the conditions and circumstances under which financial instruments held in custody will be considered “lost” and what is understood by “external events beyond reasonable control.” It has been suggested that “lost” should mean irretrievably and permanently lost with no real prospect of recovery, in other words, “lost” should not include financial instruments that are merely unavailable or temporarily frozen. Until the final Level 2 Rules are published however it is hard to tell the exact extent of a depositary’s liability. A depositary can transfer liability for the loss of a financial instrument held by a custodian appointed by it to that custodian provided that:

• there is a written agreement between the depositary and the fund or the manager acting on behalf of the fund, discharging the depositary and transferring liability to the custodian; and
• there is a written contract between the depositary and the custodian explicitly transferring liability to the custodian and that makes it possible for the fund or manager acting on its behalf, to make a claim against the custodian for the loss of financial instruments or for the depositary to make such a claim on their behalf.

A custodian can similarly transfer liability for the loss of a financial instrument held by a sub-custodian appointed by it to that sub-custodian.

In the wake of the Lehman insolvency, the protection of client money and assets is coming under increased regulatory scrutiny. The FSA’s focus on this area should not be underestimated. In June 2010 for example, the FSA handed out its largest fine to date, £33 million for breaches of the client money rules. At the same time, the FSA launched a specialist Client Asset Sector unit.

It is difficult to assess the impact of some of the rules relating to depositaries under the AIFMD until the Level 2 Rules are published. Notwithstanding this, it is clear that the developments outlined above will have a number of immediate and ongoing practical implications, including:

• the costs associated with the provision of prime brokerage and custodial services will necessarily increase which prime brokers and custodians will in practice seek to pass on to their buy-side clients;
• firms, particularly prime brokers and custodians, will likely need to dedicate increased resources in the immediate future to ensure a smooth transition to the new regulatory requirements and moving forward to ensure compliance with the new regime on an ongoing basis;
• buy-side clients will take some comfort in the additional new protections that will be afforded them under these new rules but should be aware of the initial costs and resources associated with the repapering of existing agreements and on an ongoing basis as a result of these changes; and
• ultimately the risk of custodian insolvencyis not removed by the new rules although greater transparency and some safeguards have been introduced. Funds are therefore still well advised to diversify their prime brokerage relationships.

Finally, in addition to the forthcoming Level 2 Rules, it is worth noting that the recitals of the AIFMD invite the Commission to consider the possibility of a horizontal legislative proposal in relation to the provision of custody services in the EU, including the possibility of a passport for custodians to offer their services on a cross-border basis within the EU.

Jonathan Haines is a partner at Ashurst LLP. He is a member of the securities and derivatives group and has wide experience advising financial institutions on cross-border capital markets, financing and derivatives transactions. Richard Small is a senior associate at Ashurst LLP. He regularly advises financial institutions on a wide range of financial regulatory issues. Nick Terras leads the structured funds team within the international finance department at Ashurst LLP in London