Differing national securities and insolvency laws and the lack of harmonisation at EU level, has resulted in a differing level of protection for financial instruments held in custody for both alternative investment funds (AIFs) and UCITS.

In order to create a harmonised and robust EU level framework on the safekeeping of financial instruments of AIFs and UCITS and to achieve a healthy balance between market efficiency and investor protection, the following delegated regulations were published in the EU’s Official Journal on 30 October 2018:

• Commission Delegated Regulation (EU) 2018/1618 amending Delegated Regulation (EU) 231/2013 as regards the safe-keeping duties of depositaries (the AIFMD Delegated Regulation); and

• Commission Delegated Regulation (EU) 2018/1619 amending Delegated Regulation (EU) 2016/438 as regards the safe-keeping duties of depositaries (the UCITS Delegated Regulation);

(the Delegated Regulations).

The Impetus for Change

In July 2017, ESMA published an opinion on asset segregation and the application of depositary delegation rules to central securities depositaries (the ESMA Opinion).

The ESMA Opinion mentions the difficulties experienced with the Lehman Brothers insolvency in identifying client assets and Lehman Brothers’ own assets.

The Delegated Regulations will apply when depositaries of AIFs and/or UCITS (the Depositaries or a Depositary) delegate their safe-keeping obligations to a third party (a Custodian) and any further delegation of those obligations to another party (a Sub-Custodian). In particular, the Delegated Regulations will apply to delegation contracts, including delegation to a Custodian or Sub-Custodian located in a country that is not an EU Member State (a Third Country), asset segregation and reconciliations.

Delegation Contracts

The Delegated Regulations require contracts delegating safekeeping obligations between a Depositary and a Custodian and a Custodian and a Sub-Custodian, to:

(i) guarantee the Depositary’s right to information, inspection and access to the relevant records and accounts of the Custodian and any Sub-Custodian to enable the Depositary to fulfill its own due diligence and oversight obligations and, to allow it to:

• identify all entities within the custody chain;

• verify that the quantity of the identified financial instruments recorded in the financial instruments accounts opened in the Depositary's books in the name of the AIF/UCITS, or in the name of the alternative investment fund manager/UCITS management company (where appropriate) acting on behalf of the AIF/UCITS, matches the quantity of the identified financial instruments held in custody by the Custodian and/or Sub-Custodian; and

• verify that the quantity of identified financial instruments, which are registered and held in a financial instruments account opened at an issuer's central securities depository or its agent in the name of the Custodian or Sub-Custodian on behalf of the AIF/UCITS or in the name of the alternative investment fund manager/UCITS management company (where appropriate) acting on behalf of the AIF/UCITS, matches the quantity of the identified financial instruments recorded in the financial instruments accounts opened in the depositary's books;

(ii) to put in place a formal agreement between the Depositary and the Custodian providing for sub-delegation (if relevant); and

(iii) require that a delegation agreement between a Custodian and a Sub-Custodian be subject to the rights and obligations that are equivalent to those between the Depositary and the Custodian.

Third Country Custodians and Sub-Custodians

Where a Depositary wishes to delegate its safekeeping obligations to a Custodian/Sub-Custodian in a Third Country, then before or upon conclusion of the contract providing for such delegation, the Delegated Regulation requires the Depositary to obtain independent legal advice confirming that the local insolvency law in that Third Country recognises the following:

(i) the segregation of the assets of the AIFs/UCITS from the Custodian’s/Sub-Custodian’s own assets and from the assets of other clients as well as from the assets held by the Custodian/Sub-Custodian for the Depositary's own account;

(ii) that the assets of the AIFs/UCITS do not form part of the Custodian’s/Sub-Custodian’s assets available for distribution upon insolvency; and

(i)that the assets of the AIFs/UCITS are unavailable for distribution among, or realisation for the benefit of, creditors of the Custodian/Sub-Custodian;

(the Legal Opinion).

A Custodian/Sub-Custodian located in a Third Country must:

(i) ensure, before or upon conclusion of the contract providing for delegation of safekeeping obligations, that the conditions mentioned in the Legal Opinion are met and apply for the entire duration of the delegation;

(ii) immediately inform the Depositary if any of the conditions in the Legal Opinion are no longer met; and

(iii) inform the Depositary of any changes to applicable local insolvency law in that Third Country and its effective application. This is currently a requirement for Depositaries of UCITS^[1] and, once the AIFMD Delegated Regulation enters force, it will be a requirement for Depositaries of AIFs.

The above requirements will also apply in respect of Custodians/Sub-Custodians located in the UK.

Asset Segregation

The Delegation Regulations permit a Custodian and/or Sub-Custodian to hold assets of UCITS, AIFs and other clients in the same omnibus account, provided:

(a) that their own assets, the proprietary assets of the Depositary and assets belonging to its other clients are held in segregated financial instruments accounts;

(b) that they correctly maintain records of all identified financial instruments in the financial instruments account, which is opened in the Custodian and/or Sub-Custodian’s books. Such records must allow the Depositary to establish, at any time, the precise nature, location and ownership status of those financial instruments;

(c) that they provide the Depositary with a statement detailing the assets of the UCITS/AIFs to which the Depositary is appointed to. Such a statement must be provided to the Depositary on a regular basis and whenever there is a change in circumstances; and

(d) that they maintain adequate organisational arrangements to minimise the risk of loss or diminution of financial instruments or rights in connection with those financial instruments as a result of misuse of those financial instruments, fraud, poor administration, inadequate record-keeping or negligence.

Reconciliations

The Delegated Regulations require reconciliations of the internal accounts and records of the Depositary and the internal accounts and records of the Custodian and any Sub-Custodian to be carried out as often as is necessary, taking into account the following factors:

• the normal trading activity of the AIF/UCITS;

• any trade occurring outside that normal trading activity; and

• any trade occurring on behalf of any other client whose assets are held by the Custodian/Sub-Custodian in the same financial instruments account as the assets of the AIF/UCITS.