French Depositaries and Prime Brokers

The impact of the decision by the French Court of Appeal

Originally published in the May/June 2009 issue

The recent decision by the French Court of Appeal (handed down on 8 April 2009) has sparked a great deal of comment in the financial press. In summary, the decision effectively imposed an obligation on a French depositary to return assets sub-custodied by a prime broker – even though the depositary had no access to the assets to be returned.

Some international commentators declared that this decision heralded the end of the short marriage between prime brokers and French depositaries, whilst others merely scoffed that French hedge funds have shot themselves in the foot. The truth of the matter is that the decision will impact the French hedge fund world, but not in the manner suggested by recent press articles.

The reason why we remain relatively blasé about the decision is that industry concerns had already caused certain pertinent aspects of the French fund legislation to be amended four months prior to the date of the decision. If this new legislation had been in force at the time of the administration of Lehman Brothers International Europe (LBIE) then the outcome of the case would have been very different. As a result, it is highly unlikely that we are witnessing the demise of French domiciled hedge funds.

Case summary
For those who have not followed this case in detail, the key facts to note are that:-

– in accordance with French regulations, a custody agreement had been entered into between a French depositary and a French domiciled hedge fund,

– the French depositary and the French hedge fund entered into a tri-partite prime brokerage agreement with LBIE, this tri-partite agreement (which was submitted to the AMF when the French hedge fund was authorised) stated that the French depositary was not liable for the actions of LBIE,

– once LBIE entered administration proceedings, the French hedge fund (advised by Simmons & Simmons, Paris) together with two other French hedge funds in similar situations, tried to recover from their respective French depositary the cash and/or securities sub-custodied by LBIE,

– the AMF issued an injunction forcing the French depositary to return equivalent assets to those held in the books of LBIE,

– on 8 April 2009, the Paris Court of Appeal confirmed the AMF’s position. In effect, the Court of Appeal acknowledged that French law states that a delegation by the depositary of its custody functions does not affect its liability towards the relevant fund. As a result, and notwithstanding the existence of any contractual limitation alleged by the depositary on its obligations, the French depositary had to return equivalent assets to the French hedge fund (to the tune of €18.4 M).

Legal argument
The key argument used by the Court of Appeal hinged upon the fact that the French Financial and Monetary Code (FMC) did not allow depositaries to contractually derogate from the obligation of restitution in the context of a sub-custody arrangement.

As a result, the tripartite agreement entered into by the depositary with the French hedge fund and LBIE could not release the depositary from its obligation of restitution. French law on this point was of a public order nature and so no derogations were permissible. Thus the fact that the French hedge fund had contractually agreed to the depositary’s attempted limitation of liability was irrelevant.

New legislation
Noting that fatal flaw in the depositary’s defence, market participants (sensing the way that the wind was blowing) managed to lobby for change to the FMC and, as a consequence the French rules relating to the liability of a depositary were amended by an ordonnance and a Décret in October 2008 and December 2008 respectively.
In effect, and as a direct result of these legislative amendments, the revised FMC now allows the depositary (in the context of a sub-custody arrangement) to limit its obligation to return the hedge fund’s assets provided that the constitutional documentation for the relevant fund allows this.

Although it is important to highlight that the amendments to the FMC only affect French ‘ARIA’ funds and French Contractual Funds, given that these types of funds are the ones most used by French hedge fund managers, the new FMC rules significantly dilute the impact of the Court of Appeal’s decision.

As a result of the Court of Appeal decision there is likely to be significant pressure from French depositaries to either (i) amend the fee arrangements agreed with their hedge fund clients; and/or (ii) to alter (a) the relevant constitutional documents of their hedge fund clients, and (b) the depositary agreement with their hedge fund clients in order to take advantage of the new FMC rules and thereby enable the depositary to limit its obligations in a sub-custody context.

From the perspective of a French hedge fund manager the new FMC rules allow counterparty risk to be transferred from French depositaries to sub-custodians. As a result, French hedge fund managers will need to remain vigilant with respect to the sub-custodians that can be appointed by their depositary and (if appropriate) consider appointing additional prime brokers (if they have not already done so) in order to diversify their counterparty risk.


Ian Rogers heads the asset management practice in Paris, advising on arange of regulatory issues as well as helping fund managers launch and develop their hedge fund and/or their regulated fund business. Ian also assists exchange traded funds and UCITS funds with their entry into the French market and compliance with ongoing regulatory obligations.

Eric Boillot runs the finance litigation practice in Paris where he focuses on financial and corporate matters before the French courts. He has a strong experience in proceedings before the French market regulator (AMF), where he advises companies from the finance, industry and service sectors, hedge funds and auditors.