Ethics and governance in the European Financial centers

As Luc Frieden stated in 2004, "Based on clear and pragmatic legal rules that are fully compliant with the EU legal framework as well as on the unique international experience built up over the past decades, the Grand-Duchy of Luxembourg will continue to undertake every effort to develop Luxembourg as the European hub for investment funds both for European and non-EU financial operators." Cf. article « The art of Communication », Fundlook, July-September 2004, page 3)

We have seen that the fully compliance with the EU legal framework is a charade for the depositary duties.

 

 

What about the Responsibility regime?

 

Investors may face a risk associated to the depositary function not only if the depositary fails to perform its duties ('improper performance') and if the depositary defaults, as it is stated in the working paper, but as well at the beginning if a requirement is not enforced so that the set of relating duties cannot exit, what could be called ‘performance denial’.

In the Luxembourg situation, the safe keeping duty was dropped in the law, so that there cannot be any performance in the scope of the safekeeping requirement.

As far as the delegation to a third party is concerned, what is stated in the Luxembourg law is worth reading (click on the table):

It is interesting to see that the Luxembourg law of 2002 does not refer to the article relating to the depositary’s liability when assets are entrusted to a third party. The Irish law does. The Luxembourg law of 2002 admits the custody duty where the directive and the Irish law use the word safekeeping.

Additionally, what is stated in the Luxembourg Circular AML 91/75 demonstrate the lack of responsibility of those - lawyers and other professionals - that formulate the way the depositary may discharge its duty of supervision:  when it is satisfied from the outset and during the whole of the duration of the contract that the third parties with which the assets of the UCI are on deposit are reputable and competent and have sufficient financial resources.

 

This is not compatible with the supervision duties as stated in the directive and as recalled in the working paper:

 

Article 22 of the UCITS Directive stipulates that a "Depositary shall:

- ensure that the sale, issue, re-purchase, redemption and cancellation of units effected on behalf of a common fund or by a management company are carried out in accordance with the law and the fund rules;

- ensure that the value of units is calculated in accordance with the law and the fund rules;

- carry out the instructions of the management company, unless they conflict with the law or the fund rules;

- ensure that in transactions involving a common fund's assets any consideration is remitted to it within the usual time limits;

- ensure that a common fund's income is applied in accordance with the law and the fund rules."

 

Luxembourg was not allowed to discharge the depositary’ liability to a third party as it is stated in the so called legal and regulatory framework that is not the faithful transposition of the UCITS directive.

 

 

The European Commission yesterday circulated a consultation paper on the UCITS depositary function.

The document formulates 31 questions that are divided into sections:

-          Depositary’s duties – safekeeping duties (questions 1 to 5)

-          Depositary’s duties – Supervisory duties (questions 6 to 9

-          Responsibility regime – Liability regime in case of improper performance (questions 10 to 14)

-          Responsibility regime – Liability regime in case of delegation (questions 15 to 17)

-          Responsibility regime – Default (bankruptcy) (questions 18 to 19)

-          Organisational requirements (questions 20 to 23)

-          Eligible depositary institutions (questions 24 to 26)

-          Supervision issues – Supervision by auditors (question 27)

-          Supervision issues – Supervision by national regulators (questions 28 to 29)

-          Other investors protection issues (questions 30 to 31)

 

In the next days I would like to comment every section.

 

I will begin today with the Depositary’s duties – safekeeping and Supervisory duties sections.

 

The development on the safekeeping duties in the working paper observes that “According to Article 22 of the amended UCITS Directive : “a common fund’s assets must be entrusted to a depositary for safe-keeping”. The UCITS Directive does not define the meaning of “safe-keeping”. At national level, approaches differ as to what exactly a depositary is expected to do when it is entrusted with the task of safe-keeping the funds assets.”

 

 

I am afraid the analysis prior to the questions does not tighten up the ship.

 

As far as the Luxembourg (you know, the jurisdiction that transposed faithfully the UCITS directive) legal and regulatory framework is concerned, it is not a question of divergence of interpretation, but a question of knowingly fallacious transposition.

 

What was enforced in Luxembourg does not comply with the directive: in the implementation of the UCITS directive, Luxembourg clever pragmatic lawyers and professionals removed the safekeeping duties to only state limited supervisory duties, while the UCITS Directive is clearly stating both duties : safekeeping and supervisory duties.

 

Why was the word “safekeeping” removed in the law of transposition (Cf. article 17 of the Luxembourg Law of 20 December 2002) as is in one of the depositary’s duties stated clearly in article 7 of the directive?

What Circular AML 91/75 states emphasizes the issue: The concept of custody used to describe the general mission of the depositary should be understood not in the sense of “safekeeping”, but in the sense of “supervision” as it confirms the drop of the duties of safekeeping.

 

The working paper observes that The UCITS Directive does not define the meaning of “safe-keeping”. If the UCITS directive doesn’t, the dictionary does. So it defines the meaning of "supervision".

  

What circular AML 91/75 states about the supervision (“The depositary has discharged its duty of supervision when it is satisfied from the outset and during the whole of the duration of the contract that the third parties with which the assets of the UCI are on deposit are reputable and competent and have sufficient financial resources“) is not an efficient supervision  as it cannot ensure a critical watching and directing.

  

As far as the word safekeeping is concerned, the dictionary states:

1 : the act or process of preserving in safety

2 : the state of being preserved in safety

 

Preserve means:

1: to keep safe from injury, harm, or destruction : protect

2 a: to keep alive, intact, or free from decay b: maintain

3 a: to keep or save from decomposition b: to can, pickle, or similarly prepare for future use

4: to keep up and reserve for personal or special use

 

Keep means:

(…)

4 a: to retain in one's possession or power <kept the money we found> b: to refrain from granting, giving, or allowing <kept the news back> c: to have in control <keep your temper>

(…)

 

The meaning of "safekeeping" is therefore clear enough and Luxembourg was not allowed to change the duties.

 

 

In a nutshell, Luxembourg with its pragmatic lawyers and professionals not only dropped the duties of safekeeping that was clearly stated in the directive but formulated the duties of supervision in a way that did not comply with the common meaning of the word supervision.

 

That is the reason why the communication about the “faithful transposition” of the directive (see what stated the ALFI before the EFAMA late January 2009) is not acceptable as it is a huge breach in the confidence in UCITS funds so is the recent EFAMA support to the jurisdiction.

 

 

The European Commission has launched a wide-ranging public consultation on the UCITS depositary Function. This consultation will play an important role in identifying and shaping the European response to vulnerabilities emanating from the UCITS depositary sector, with a view to improving the level of protection for UCITS investors.

Commissioner Charlie McCreevy said: " The Madoff fraud has revealed that the requirements of the UCITS Directive have been transposed in very diverging ways creating an unlevel playing field in the protection of retail investors. Also, the Commission's recent proposal for an Alternative Investment Fund Managers Directive includes stronger requirements governing depositories and their liability. It is not acceptable to have a less stringent regulation for retail investors than for professional investors. Therefore, UCITS requirements need to be harmonised and strengthened."

This public consultation is part of a comprehensive review of the existing European regulatory principles which are applicable to depositary functions. It will make an important contribution to clarifying and strengthening the regulation and supervision of UCITS depositaries, in particular in the light of recent Madoff fraud.

Commissioner McCreevy announced his intention to launch the consultation in the press statement released on the 28th June (Midday Express EXME09 / 28.05 ).

Issues addressed by the consultation

In particular, views and evidence are sought in the following areas, to serve as guidelines for appropriate initiatives that might be taken:

• Depositary’s duties: The consultation invites views on how depositary safe-keeping and supervisory duties should be better harmonised. It seeks clarification on the depositary safe-keeping duties for each class of assets that are eligible within a UCITS portfolio and invites views on whether supervisory duties should also be further clarified and harmonised, and if so how to do so.

• Responsibility regime: The consultation invites views on how to improve UCITS investors' protection if a depositary performs its duties improperly or if it becomes insolvent. To that end, it attempts to identify the relevant risks that might materialise. The Commission considers that the burden of proof should be borne by the depositor. The Commission also proposes that there should be additional requirements where assets are entrusted for safe-keeping through a network of sub-custodians. It also seeks views on the form of a liability regime which would allow investors to adequately mitigate losses.

• Organisational requirements: The consultation invites views on the introduction of rules on organisation and conflict of interests based on existing rules (the Markets in Financial Instruments Directive).

• Eligibility criteria and supervision: According to the AIFM proposal depositories should be credit institutions based, authorised and supervised in the EU. The consultation asks whether a similar approach should be adopted for UCITS depositaries and how supervisory rules might be strengthened.

The consultation also covers issues which are not directly linked with depositaries duties but which are particularly relevant for ensuring an increased level of investor protection within the UCITS framework (for example valuation).

The consultation is available at:

http://ec.europa.eu/internal_market/investment/depositary_en.htm

The deadline for responses to this consultation paper is 15th September 2009.

Responses should be addressed to: markt-depositary-consultation@ec.europa.eu

 

 

I will contribute.