The discussion on the obligations of deposiary banks in the light of the Madoff affair
Christine Lagarde publicly compared the Luxembourg fund model negatively to the French one, particularly in respect of the obligations of depositary banks. Luc Frieden was provoked to respond at the beginning of the year (at a point when the CSSF still had not named any Luxembourg based institutes in the Madoff case). Luc Frieden’s description of a depositary bank’s obligations was wider than the current understanding in Luxembourg, being more closely aligned to the French model.
The deposit bank obligations he noted were to : be a depositary of cash and securities (conservation), to monitor assets (surveillance), to check the assets held (contrôle) and to repay deposits (restitution). The first in this list is uncontroversial. The other points were later qualified by the CSSF, putting the record straight on the official Luxemburgish understanding of depositary bank responsibilities.
The Luxemburgish depot bank model
According to the explanation of the CSSF, depositary banks in Luxembourg are first and foremost responsible for monitoring the assets they take in trust. They must know which assets are located where at all times. This is not understood as protecting these assets (conserver), merely watching over them (surveiller).
There are couple of points which can be made before getting into the controversial issues of control and repayment. One of these is that depositary bank obligations are not seen as fundamentally different for UCITS or other fund type. The other is that the idea of surveillance presents its own problems, especially in models where the fund holds assets which are not securities and where managing these assets has been outsourced by the fund.
There is universal agreement at least on the obligation of the depositary bank to monitor the materiality of the investments. The agreement stops however at the doors of the Luxembourg courts. In the case of the Luxalpha, there was a clear lack of materiality. In an original verdict won by Oddo, who held units in Luxalpha, UBS (Oddo’s depositary bank) had to pay the value of the units sold in November 2008 (before UBS announced any problems). On appeal by UBS, the verdict was overturned and Oddo must repay the money to UBS, despite the fact that the assets managed by Madoff were evidently non-existent. A further appeal by Oddo is still pending- clearly not a helpful sign to reassure investors about their security in Luxembourg in grim times.
Surveillance poses special problems for funds with investments in non-traditional assets. These assets could be other hedge funds, private equity funds, real-estate, objet-d’art etc. Not many depositary banks will want to go and check themselves that a shopping centre in Poland really exists, nor do they want their vaults full of (fake ?) paintings. The specialist nature of this kind of investment means that funds outsource these tasks to service providers. One would hope these service providers are sufficiently serious and experienced to provide value for money.
It is exactly here that depositary banks are already in something of a quandary within the existing Luxembourg regulatory framework : monitoring is meaningless without a certain amount of control. Presumably no depositary bank will simply accept a fax or letter from someone the fund investors have retained as a service provider, confirming the purchase of an asset without details on this service provider.
The details required by the depositary bank from fund service providers will depend on the kind of service rendered, but a depositary bank could be expected to ask for details on the legal status, regulatory position, ownership and management of such a service provider. Further, the depositary band will need some proof of the seriousness and qualification of the service provider. This is clearly entering into the scope of control rather than simple monitoring.
Similarly, the depositary bank will require not only a confirmation of purchase (validated copy of the sale documentation sent to the asset manager). Other documentation for non-securities assets will also be required, such as a periodic up-date on the status of the asset, confirmation of insurance (and insurance value ?), up to date copies of the cadastre and periodic independent qualified valuation. Here again the depositary bank can hardly avoid accepting the need for some degree of quality control, if it does not want to leave itself wide open to regulatory criticism and possible investor claims.
Even securities investments require some sort of confirmation of materiality, if they are held indirectly by a fund, either as a participation in another fund (as is the case with fund of funds) or embedded in a derivative structure.
Likely changes in the regulatory environment
The European Commission is currently conducting hearings on changes in the regulatory environment. The EU has 2 main objectives here : one is to provide a framework for equal completion across European markets for investor services. The other is to level out a point remarked on by commissioner Mcreevy. He pointed out that the last changes introduced for alternative investment funds made some adjustments to the advantage of investors in this type of closed funds over those in open traditional funds. As he remarked, investors in traditional open funds should at least be equally well protected.
The Luxembourg authorities have already indicated that they will introduce the European directive without many additional elements. Still, there remains heavy political pressure on the Luxembourg government from the two big neighbours to provide investor protection at an equivalent level to the French and German home markets. Compromises by Luxembourg on bank secrecy indicate a certain willingness to compromise, if this is required to maintain the attractiveness of the Luxembourg for investors.
The response of depositary banks
Depositary banks have become more cautious of accepting SIFs and SICARs as clients. There is clear some doubt about how well the Despite the fact that depositary bank costs will ultimately be paid by the funds as fees, there is some doubt about how exactly to apply the first 2 principles of conservation and surveillance to alternative investments and what this could cost. Looking forward to the new EU directive it is also not completely clear how differences in the European framework for depositary bank obligations of control and restitution are going to be resolved.
It is already standard practice for depositary banks to ask sub-custodians to complete a fairly exhaustive questionnaire (The Association of Global Custodians Questionnaire). Many banks ask the service providers of their clients to complete the same kind of questionnaire. Combined with effective monitoring of the fund service provider responses and deliverables this can provide at least an early warning system of problems of materiality. It is most certainly an effective response to the requirement for surveillance.
Ultimately, being a depositary bank to funds investing in real-estate, alternative investments or private equity is not going to be a low cost product.
Elements in the existing legal framework
The current relevant framework defining depositary bank responsibilities is defined at the level of EU directives, Luxembourgish law, CSSF directives and industry best practices proposed by the fund and bank associations ALFI and ABBL.
The EU directive 85/611/CEE set the basis for UCITS in 1985. In Luxembourg various laws have been passed reflecting the development of the fund industry, including the UCI law in 30 March 1988, SICAR 15 June 2004 and SIF 13 February 2007. Luxembourg is currently investigating changes to the existing company law of 10 August 1915 (proj. 5730), which will have implications for private equity activities. The regulatory body CSSF was establish by a law 23 December 1998. CSSF directives regulate the application of existing laws and may be regarded as the executive interpretation of these. The CSSF also tries to incorporate EU directives into its own directives, when no legislative changes need be made. The relevant directive on SICARs is 06/272, 08/376, on SIFs is 07/307, 08/372.
There is however, little or no explicit detail on special responsibilities of depositary banks in these later CSSF directives. Most of the obligations of depositary banks stem from the original EU directive on undertakings of collective investment from 1985. The EU Commission is aware that there is a demand for clarification of some points regarding alternative collective investment forms and the commission is currently conducting consultations with participants with the aim of a new directive.
The EU consultation paper explicitly aims to balance some of the uneven treatment of depositary bank obligations in different European jurisdictions. We can expect a directive giving a clearer framework on depositary bank financial liability and control and surveillance obligations. These will presumably also provide a framework for the responsibilities of depositary banks with regard to tasks executed by specialist external providers.