Role of the depositary in a Luxembourg UCITS fund
This article intends to provide general guidance as to the role of a depositary in a Luxembourg investment fund (and more particular in relation to a UCITS fund (part I of the Law of 2002) in the form of a SICAV (“hereafter referred to as the “fund”), and does not purport in any manner to give any opinion or advice on any cases set out hereunder or any other cases related to the Madoff case.
The effect of the alleged Ponzi scheme in which Bernard Madoff was implicated – involving losses of more than $50 billion – are already widespread. The CSSF has recently announced in its press release of 23 January 2009 that a number of funds and sub-funds (as set out hereunder) have decided to suspend their NAV as well as redemptions, subscriptions and conversions of shares/units. A consequence of the Madoff case is that the liability of the main actors of the investment funds involved is called into question.
Any finding of liability in the forthcoming litigations is likely to involve thorny issues. Indeed a fund requires the services of a large number of actors (the board of directors of the funds, the promoter, the depositary, the central administration agent, the auditor, etc.) and it is unclear how far in the hierarchy the (potential) liability shall extend. In any case, the diversity of the regimes of responsibility under which each actor is subject (whether it is contractual liability or not) will probably cloud the issue. Matters will also be made more complex by the wide variety of legislations that come into play as a result of the internationalization of investments.
(I) Duties of the depositary
The role of the depositary bank is set out in the Luxembourg law of 20 December 2002 as amended (the “Law of 2002”), and in the circular of the IML (currently named the CSSF) 91/75 (as amended by the circular 05/177). The Law of 2002 provides that the custody of the assets of the fund must be entrusted to a depositary. However, a crucial clarification by the CSSF in Circular 91/75 provides that: “the concept of custody used to describe the general mission of the depositary, should be understood not in the sense of ‘safe-keeping’ but in the sense of ‘supervision’, which implies that the depositary must have knowledge at any times of how the assets of the UCI have been invested and where and how these assets are available”. The physical deposit of all or part of the assets may be made either with the depositary itself or with any professional designated by the fund in agreement with the depositary. The general mission of a depositary is threefold, encompassing the preservation of the assets of the UCI, the control of some of its operations, and the day-to-day administration of the assets of the fund.
This means that the depositary must inter alia process the receipt of dividends, interests, etc.. However, the depositary does not have to execute itself all the duties incumbent upon it and can be assisted by third parties in the execution of transactions or can delegate to third parties the execution of transactions. However, this cannot lead to a situation where all duties are concentrated in the hands of one and the same party. The depositary must – in order to satisfy its obligation of supervision – organise its relations with the third parties in such way that it is immediately informed of all the transactions that the third parties execute in relation to the day-to-day administration of the assets which they hold.
The depositary must also:
- ensure that the sale, issue, redemption and cancellation of units effected on behalf of the fund are carried out in accordance with the law and the articles of incorporation;
- ensure that in transactions involving the assets of the fund, the consideration is remitted to it within the customary time limits; and
- ensure that the income of the fund is applied in accordance with the articles of incorporation.
The CSSF has argued that the term “ensure” as used in the Law of 2002 implies that the depositary must not “execute” itself the tasks but must verify the execution of the tasks imposed on it. It is important to note the difference between the duties of the depositary of, on the one hand a FCP (fonds commun de placement) subject to part I of the Law of 2002 and, on the other hand a SICAV or any other UCI which has not been constituted as a collective investment fund. In case of a FCP (part I of the Law of 2002), the depositary has two additional specific supervisory and monitoring duties such as (1) carrying out the instructions of the management company, unless they conflict with the law and the management regulations and (2) ensuring that the value of units is calculated in accordance with the law and the management regulations.
(II) Liability of the depositary
If anyone suffering damage must prove the depositary’s negligence in respect of its duty of supervision and the causal relationship thereof, the duty of supervision of the assets of the fund and consequently the liability for such supervision always resides with the depositary. As laid down in the Circular IML 91/75 (as amended by Circular CSSF 05/177), the depositary may, in no case, release itself from the duty of supervision and hence any provision of the articles of incorporation or any other agreement aiming to exclude or limit this liability are null and void, and under Article 34 (2) of the Law of 2002, the depositary’s liability shall not be affected by the fact that it has entrusted all or some of the assets in its custody to third parties. This has also been repeated in a press release issued by the CSSF on 2 January 2009 as a result of the Madoff case. The depositary may only be discharged from its duty of supervision when it is satisfied from the outset and during the whole duration of the contract that the third parties with which the assets of the fund are on deposit are reputable and competent and have sufficient financial resources. Importantly, the CSSF stated that it would not limit its analysis to the depositary banks concerned but would verify that all the parties involved acted with the diligence imposed by Luxembourg law.
The above elements are likely to be crucial in the litigations flowing from this groundbreaking swindling. The current regime governing the liability of a depositary is likely to be subject in the forthcoming months to substantial reforms, involving the enactment of more stringent – and probably more precise – investor protection rules. Indeed France, backed by Mr. Luc Frieden, the Luxembourg Minister for the Treasury and Budget, is currently calling for legislation to strengthen the protection of investors across Europe.
Footnote
Funds mentioned in the press release of the CSSF of 23 January 2009
- Herald (Lux)
- Sub-fund US Absolute Return Fund
- Luxembourg Investment Fund
- Sub-fund U.S. Equity Plus
- Luxalpha Sicav
- Sub-fund American Selection
- Norvest
- Sub-fund Arbitrage
- Global Fund Selection Sicav
- Sub-fund Balanced Sub-fund
- Sub-fund Growth Sub-fund
- Sub-fund X-tra Alternative Investments Sub-fund
- Carat (Lux) Sicav
- Sub-fund Global One
- LRI Invest Alpha Stable €
- BG Umbrella Fund
- Sub-fund BG Global Classic
- Sub-fund BG Global Dynamic
- Sub-fund BG Global Challenge
- Sub-fund BG Global Balance
- Sub-fund BG Global Discovery
- Sub-fund BG Stable Value
- M.A.R.S. Fund
- Sub-fund One (c)
- Pareturn
- Sub-fund Best Selection
Luxembourg - Investment Funds - Impact of the Madoff fraud case
The Luxembourg regulator (CSSF) has on 22 December 2008 issued a press release analysing the impact of the Madoff fraud case on the Luxembourg investment funds.
The CSSF noted that the impact on Luxembourg investment funds which are directly or indirectly exposed to the Madoff case amounts to 1.9 billion Euro which represents only 0.15% of the total net assets of undertakings of collective investment as at 30 November 2008. The CSSF furthermore noted that it does not imply that this amount is entirely lost but that it represents the maximum responsibility at stake.
Investment Funds - From UCITS III to UCITS IV
Undertakings for Collective Investment in Transferable Securities (UCITS III) were introduced by the law of 20 December 2002 (the “2002 Law”), and benefit from a European Passport enabling them to be freely marketable throughout the EU countries. However, unsatisfactory elements relating to the current state of the Law paved the way to discussions about a possible ‘mutation’ from UCITS III to UCITS IV.
Those include, inter alia, details in the cross border distribution, in the simplified prospectus, and in the management company passport. In this context, the European Commission on 16 July 2008 published proposals to enhance the efficiency of the current legislative framework for UCITS. This could create, more than 20 years after the enactment of the first UCITS Directive, a genuine pan-European single market for investment funds, which would improve market efficiency and investor protection. Two types of legislative changes are contemplated: some aiming to enhance the working of existing provisions (in particular in relation to the notification procedure, the management company passport and the simplified prospectus), and others intended to introduce new single market freedoms (by creating inter alia a facilitating framework for fund mergers).
Cross Border Distribution
The first proposal aims at simplifying the procedures enabling the cross-border distribution of UCITS. In the current regime, detailed documentation must be filed on behalf of the UCITS with the regulator in the host Member State, which has theoretically two months to confirm compliance with the host Member State’s advertising laws. However, in practice, this process usually takes much longer and it is therefore unnecessarily time-consuming and costly. Consequently, it impedes greatly cross-border distribution and calls into question the concept of a single market to its very roots.
To cope with this problematic deficiency, it is proposed to replace the current regime with a simple, electronic, regulator-to-regulator notification procedure by which a UCITS seeking to market its units in another Member State informs its own regulator of its intention to do so and sends to it the necessary notification documents. Those documents shall consist of a Key Investor Information Document (see below) - which the UCITS is in the obligation to translate into the local language of the host Member State -, the full prospectus, the constitutive documents and the latest annual and any subsequent half yearly reports. A consequence of the new regime is that the marketing of units in the funds will be possible within three days of the file’s transmission from home to host regulator.
The home regulator reviews that information, and, if complete, transmits them within one month of receipt of the documents to the host regulator with an attestation confirming that the UCITS fulfils its obligations, and the UCITS may commence inward marketing in the host Member State from the date of transmission. The transmission of that information should take place electronically (see point II of this newsletter).
Key Investor Information
The concept of simplified prospectus is deemed to be another failure of the UCITS III regime. Originally, it was intended to provide investors with all basic information relating to the UCITS, in order to enable them to make an informed investment choice. In practice, the simplified prospectus failed to meet those expectations, as it is often very lengthy, and implemented differently across the EU.
It is therefore suggested to replace this simplified prospectus by a ‘key investor information’ document, which will provide key facts to investors before the conclusion of a contract. It will have to be set out in a common format in all Member States, thereby allowing for effective comparison, and shall be presented in a brief manner and in non-technical language, likely to be understood by retail investors. Key information shall include a short description of the investment objectives and policies of the UCITS, past performance, costs and associated charges and risk/award profile of the investment including appropriate risk warnings. Investors should note that this document is considered as pre-contractual information and hence liability should not be imposed solely on the document itself unless it is misleading or inaccurate.
Fund Mergers
Pursuing its general aim of promoting a single market, the European Commission proposed to remove barriers to amalgamation of funds which would, inter alia, cope with the proliferation of small and inefficient funds.
In this context, the proposal provides a framework for domestic and cross-border mergers of UCITS, introducing a basic principle that all UCITS are entitled to merge, regardless of the structure (e.g. corporate, unit trust or contractual). It should be pointed out that approval by investors is only necessary if required by national law. However a maximum threshold ceiling of 75% of the votes cast by unit holders is envisaged and this will be especially significant in Luxembourg since 100% unit holder approval is currently required to merge a Luxembourg UCITS with another UCITS. The proposals are however silent as to whether merging funds must have similar investment objectives and policies.
Master-Feeder Structures
The European Commission also innovated by proposing to introduce the ability to establish limited master-feeder structures. This could result in significant economies of scale and a reduction of charges for investors. The feeder UCITS and the master UCITS must enter into a legally binding agreement in which the feeder fund will be required, inter alia, to have at least 85% of its assets in a single master fund. Additionally, the feeder fund will have to act in the best interests of its investors and to monitor effectively the master UCITS.
Management Company Passport
The most controversial element introduced by the UCITS III regulation was undoubtedly the management company passport, originally designed to enable a manager that managed UCITS in a number of jurisdictions to centralise its activities within a single jurisdiction. The rationale being that this would result in significant economies of scale and better control as all activities would be carried out in a single company. However, the lack of EU-wide consensus on what the passport entailed resulted in different opinions when it came to interpreting the meaning of the management company passport concept. Opponents to a full cross-border passport point out that the regulator of a UCITS having a management company not regulated in the same jurisdiction could deprive the UCITS regulator of the means to monitor and enforce compliance with regulatory provisions in force in the UCITS domicile. Others are concerned with the fact that such a measure would be likely to create problematic regulatory and tax issues. The Commission has therefore requested CESR to provide advice on how to operate by 1 November 2008. On 31 October 2008, CESR had completed their work on the management company passport issues and published their advice to the European Commission. For more information, we refer to the CESR advice that can be found at the following address: http://www.cesr.eu/popup2.php?id=5367. It mainly followed the draft paper that was issued in September 2008 containing advice on issues relating to definition of domicile, applicable law and supervisory responsibilities, authorisation procedures for UCITS funds whose management company is established in another Member State, on-going supervision of the management of the fund, and finally on how to deal with breaches of rules governing the management of the fund.
The controversy over the management company passport shows how much the mutation from UCITS III to UCITS IV is far from being achieved. The UCITS proposals will however be presented to the EU council of Ministers and the European Parliament for approval. If they are adopted by mid 2009, it is contemplated that these provisions will come into force in mid 2011.
Investment Funds - UCITS risk management process - clarification on the information to be provided to the CSSF
Two particularly relevant pieces of legislation in the context of eligible assets for investments by UCITS have recently been implemented in Luxembourg. The first one is the Grand-Ducal Regulation dated 8 February 2008, which amends certain definitions specified in the 2002 Law, and which replicates closely the EC Directive 2007/16/EC.
The other piece of legislation is the groundbreaking CSSF Circular 08/339 (released on 19 February 2008) which points out, inter alia, that the provisions of the above Grand-Ducal Regulation must be read in conjunction with the CESR guidelines.
Investors should first note that UCITS already set up at the time of the implementation of the guidelines will benefit from an extension until 23 July 2008 at the latest to comply with the guidelines.
However, more fundamentally, what should be raised is the somewhat more flexible attitude adopted by the CSSF, particularly in circumstances where there is further need of interpretation of the provisions of the Grand-Ducal Regulation and the CESR guidelines. The impact of this Circular should however not be overestimated since the CSSF already fully applied the provisions of the Directive and the related CESR advices, and hence no significant changes are to be expected in practice. However, this evolution of the CSSF’s practice is especially remarkable throughout the appreciation of the circumstances in which a security embeds a derivative or permitted investment within the 10% trash ratio (e.g possibility to include regulated open-ended hedge funds, funds of hedge funds, real estate funds and commodity funds). This more flexible attitude of the CSSF is also to be noted in its administrative practice.
Investment Funds - Update on the eligible assets for investments for UCITS
Two particularly relevant pieces of legislation in the context of eligible assets for investments by UCITS have recently been implemented in Luxembourg. The first one is the Grand-Ducal Regulation dated 8 February 2008, which amends certain definitions specified in the 2002 Law, and which replicates closely the EC Directive 2007/16/EC.
The other piece of legislation is the groundbreaking CSSF Circular 08/339 (released on 19 February 2008) which points out, inter alia, that the provisions of the above Grand-Ducal Regulation must be read in conjunction with the CESR guidelines.
Investors should first note that UCITS already set up at the time of the implementation of the guidelines will benefit from an extension until 23 July 2008 at the latest to comply with the guidelines.
However, more fundamentally, what should be raised is the somewhat more flexible attitude adopted by the CSSF, particularly in circumstances where there is further need of interpretation of the provisions of the Grand-Ducal Regulation and the CESR guidelines. The impact of this Circular should however not be overestimated since the CSSF already fully applied the provisions of the Directive and the related CESR advices, and hence no significant changes are to be expected in practice. However, this evolution of the CSSF’s practice is especially remarkable throughout the appreciation of the circumstances in which a security embeds a derivative or permitted investment within the 10% trash ratio (e.g possibility to include regulated open-ended hedge funds, funds of hedge funds, real estate funds and commodity funds). This more flexible attitude of the CSSF is also to be noted in its administrative practice.
Investment Funds - securities lending in relation to UCITS
A new regime applicable to securities lending operations performed by UCITS – and, in principle, by other UCIs subject to the 2002 Law – was introduced by CSSF Circular 08/356 released on 4 June 2008. The main point of this new regime is, by reforming the previous one (referred to in the Commission Directive 2007/16/EC, and the corresponding CESR guidelines) set out in 1991 (by CSSF Circular 91/75) to take into account the fast growing number of securities lending transactions Luxembourg UCITS and UCIs have recently been engaged in.
This Circular lays down the techniques and instruments which may be used by UCITS, comprising in particular securities lending transactions. The criteria to be fulfilled by the techniques and instruments subject to the Circular are threefold, namely that:
- They are economically appropriate (= realised in a cost-effective way);
- They are entered into for one or more of the following specific aims
- reduction of risk
- reduction of cost
- generation of additional capital or income for the UCITS with a level of risk which is consistent with its risk profile and the risk diversification rules applicable to it; and
- The risks they entail are adequately captured by the risk management process of the UCITS.
The Circular provides broad guidelines on, inter alia, how the fund may lend its securities, which assets are eligible as collateral, and on the content of the prospectus of the fund addressed to investors, which overall reveals a more flexible administrative attitude adopted by the CSSF.
Crucial points to be noted may be summarized as follows:
- A Fund may lend its securities
- Directly;
- Via a standardized lending system organized by a recognized securities lending institution; or
- Via a lending system organized by a financial institution subject to prudential supervision rules considered by the CSSF as equivalent to those laid down by Community law and specialized in that type of transactions.
- The assets eligible as collateral include:
- Liquid assets (cash and short-term banking deposits, money market instruments, and letters of credit or guarantees on first demand issued by a first class credit institution non affiliated to the counterparty);
- Bonds issued or guaranteed by an OECD Member State or a first class issuer offering adequate liquidity; and
- Shares or units issued by daily valued money market UCIs (assigned a rating of
AAA or its equivalent) or a UCITS investing in bond / shares referred to in the Circular.
- The prospectus of the fund must indicate:
- That the Fund intends to enter in securities lending operations;
- The purpose of such securities lending transactions;
- The conditions and limits of such securities lending transactions;
- The conditions and limits of collateral cash re-investment if the Fund intends to do so; and
- As the case may be, a description of the risks inherent to such securities lending operations.
