The Central Bank of Ireland (CBI) has issued a Consultation Paper on the requirements for Irish firms undertaking the AIFMD Article 36 ‘Depositary-Lite’ duties.

Article 36 of the AIFMD applies where non-EU AIF are marketed to EU investors through private placement by EU AIFM (and in the case of certain countries such as Germany and Denmark, marketing by non-EU AIFM). One or more entities are required to perform the duties of cash flow monitoring (Article 21(7)), safe keeping of assets (Article 21(8)), and oversight (Article 21(9)). The AIFMD does not set out eligibility criteria for businesses performing these duties and various EU regulators are taking different positions with respect to the regulation of such firms.

In December 2013, the CBI issued an update to its AIFMD Q&A stating that where an entity is only providing one or both of the services referred to in Article 21(7) and Article 21(9), it will not issue an authorisation under the Irish Investment Intermediaries Act 1995 (IIA), but that if an Irish entity proposes to provide the safe-keeping duties set out in Article 21(8) it must have authorisation to provide “custodial operations involving the safe-keeping and administration of investment instruments” under the IIA. The CBI’s position contrasted most notably with the position taken by the UK Financial Conduct Authority (FCA), which requires any UK firm undertaking one or more of these duties to hold an ‘Article 36 Custodian’ authorisation.

A number of commentators have questioned whether it is appropriate that fiduciary duties such as depositary oversight are not regulated activities. Others have sought clarification whether performing the asset verification duties of Article 21(8)(b) should require a custody authorisation.

The CBI consultation paper confirms Article 21(8)(b) will require a custody authorisation. It also states that any Irish fund administrator seeking to provide one or both of the Article 21(7) and 21(9) duties will need to do so via a functionally and hierarchically separate subsidiary with strict Chinese Walls in place between the entity and its parent administrator. Whilst the paper does not amend the previous Q&A position and the duties will remain unregulated, the CBI acknowledges that “such conflicts will arise and we believe they may be substantial”.

Whilst some will welcome the consultation, this will be unlikely to include independent administrators seeking to provide depositary-lite services to their existing clients. Whilst administrators are authorised by the CBI under the IIA most do not hold a custody authorisation, so it will be a challenge to provide a complete and joined-up depositary-lite service which includes Article 21(8)(b) — of particular importance to hedge fund managers that will generally hold “other assets” such as derivatives. Short of establishing a separate regulated entity where only Article 21(8)(b) duties would be regulated, performance of the other two depositary-lite duties will need to be via a separate unregulated entity. Some managers and investors may question the appropriateness of such a solution.

The CBI consultation will close on 30 May 2014, less than three weeks before UK firms seeking to comply with the depositary-lite regime need to inform the FCA of their final depositary arrangements if they wish to market their funds to EU investors through private placement from 22 July – the end of the AIFMD transitional year.

Faced with the uncertainty, a number of administrators had already planned to establish depositary-lite businesses in the UK, for which they will seek FCA authorisation. There are doubts whether all such businesses will obtain regulatory authorisation and be in a position to on-board clients by July.

For most existing UK hedge fund managers, the depositary-lite regime, which will apply in order to continue to market their non-EU funds in the EU, will take effect on 22 July 2014. Current FCA guidance states managers should notify the FCA of their chosen depositary provider(s) by 21 June assuming they are still targeting 22 July as their date of authorisation. With less than 4 months to go, time is running out.

Given AIFMD has been in the making since early 2009, the lack of preparedness in many parts of the administration and depositary industry to take on business is surprising. Despite the potential advantages of the AIFMD marketing passport few managers of EU funds have been authorised as AIFMs to take advantage of the passport. What is more, some depositaries and prime brokers continue to negotiate terms and operating models for the single depositary model which is required in order for AIFMs of EU funds to become authorised. For established providers, this has had a knock on effect on depositary-lite which has been a lower priority to finalising models for EU funds. Newer entrants, typically independent administrators seeking to provide depositary-lite services to their existing administration clients, have in several cases simply left it too late to be operationally ready in good time for the deadline. Some firms seeking to pursue UK regulatory authorisation have either only recently, or not yet, applied to the FCA. We are only aware of one firm that has admitted to clients that it won’t be ready to offer depositary-lite services by the July deadline. Managers are advised to put pressure on providers to clarify their situation.

Whilst some managers of non-EU funds will choose to rely on reverse solicitation and side-step the depositary-lite requirements altogether, many recognise that marketing in the post-AIFMD era will be a grey area for some time to come.  Some managers are viewing depositary-lite as a necessary building block to manage the regulatory and general business risk of non-compliance with the marketing rules. What this means in practice is that there are going to be many hundreds of offshore funds looking to on-board depositary-lite providers in a very short period.

In normal circumstances, two months would typically be sufficient to complete on-boarding in a controlled way. Given the volume of funds involved, this is by no means a normal situation. Sufficient time should be allowed for the on-boarding process in a controlled manner and in order to ensure the manager gets the best commercial deal.

Looking at what on-boarding involves, it can take time to agree the roles and responsibilities of the depositary, prime brokers and administrator. Two way due diligence is required between the manager and provider. Legal terms require negotiation and disclosures are required in offering documents. As a general rule, leaving agreement of operating models, fees and legal terms to near the regulatory deadline will result in a more favourable outcome for providers – something a cynic would argue providers know only too well.

There are already some reports that established depositaries may experience capacity constraints or impose a cut-off for new client take-on. New entrants that are not yet operationally ready and don’t hold their regulatory authorisation are increasingly unlikely to be a viable solution for managers given the timeframes involved.

Considering these factors, managers really ought to be selecting their depositary providers in the near future. Delaying decisions could result in depositary-lite compliance becoming increasingly more difficult than it needs to be.

This Indos article was first published by HFM Week on 5th March 2014 (Issue 331) and can found by clicking here (subscribers only).

INDOS Financial’s Bill Prew will be presenting at the GAIM Ops conference being held between 7th – 9th April in the Cayman Islands. Bill will participate in a panel discussion on the impact of AIFMD on global custody and depositary liability.  For more details or to register for the event Click here.

INDOS Financial’s Bill Prew presented an overview of the AIFMD depositary-lite regime to the 6th Euromoney AIFMD conference on 4th March 2014. A copy of the presentation can be found by clicking here.