The Bright Alternative
UK Depositary Services: The real regulatory risk

comment - 20 November 2013

UK Depositary Services: The real regulatory risk

In the jostle for alternatives business, it seems that the lessons of the PPI mis-selling scandal have been missed by industry and the FCA alike. Depositaries, however, need to be mindful of the FCA’s principles for businesses and the capricious nature of regulatory enforcement. 

In brief, payment protection insurance (or PPI) covered consumer loan or debt repayments in case of redundancy or illness for example. These policies were lucrative and widely mis-sold, and in a series of high profile cases from 2006 to 2013 numerous financial institutions were found to be in breach of the FCA’s principles for business. These principles apply to every FCA authorised firm operating in the UK and require inter alia integrity, fairness and suitability of products. 

Depositary services should be understood as a form of ‘investor’ protection insurance for AIF and in the ‘jostle’ for alternatives business, depositaries, ourselves included, need to be very careful that we do not mis-sell this product to AIFM and investors alike; because, while this particular form of insurance is compulsory, it should be suitable and fair (Principle 6). This requires a proper assessment of the different types of AIF and the risks attaching to each in determining what is a suitable product (Principles 1 and 9) with full disclosure of any tied profits (Principle 8). In particular, the liabilities borne by the depositary should not be overstated in justifying costs and service provision (Principles 1, 6 and 7). 

“We expect firms to take the conduct agenda seriously and ensure that their business models strike the right balance between shareholder returns and keeping their customers and market integrity at the heart of everything they do. This approach should apply to both large and small firms alike”. (A Response to Journey to the FCA, July 2013). 

The liability of depositaries under the AIFMD is straightforward: (i) for assets in a settlement system the safekeeping liability is strict; and (ii) for other assets that are not held in custody (and other obligations more generally), the liability is negligence based (i.e. dependent on fault and loss). This latter form of liability is likely to dovetail with existing contractual obligations and the additional risks assumed are minimal. 

“How do you lose a toll road in Germany? Or a home? The day somebody can explain that in plain English is the day we have concerns about depository liability in AIFMD”. (Justin Partington, Commercial Director at IPES) 

This is of course correct, especially in the first situation, where a team of lawyers is likely to have worked on behalf of the AIF for many months securing good title to the toll road. What can a depositary possibly add? 

Strict liability in the context of custody assets is also less obvious than it seems. This is because securities within a settlement system are often held by a central depositary, and not by a depositary bank at all, and the scope for ‘losing’ these securities is unclear (especially where there is no trade to net-off a disposal). Provided that a depositary or its broker holds custody assets on an insolvency remote basis and has control over dealing, then risk attaches in relation to the trading rather than the loss of these assets. This is important because the exposure on trading errors will be to pricing movements rather than the value of the custody assets themselves. This is obvious and does not justify substantial risk premiums. 

The depositary industry, therefore, needs to be careful that they do not overstate the risks attaching to this role with a view to encouraging clients to insure inappropriate matters; in particular, when the willingness and ability of any depositary to cover the theoretical exposures that exist in a buy-out context are entirely unrealistic (as all market participants are well aware). After all, industry must conduct business with integrity (Principle 1). 

“Boards need to look into the corporate mirror and deliver candid assessments on their products. Good morals are not an infinitely elastic concept. In business or any other part of our lives, Chairs, chief executives and directors should be asking whether products are suitable for the customers they are pitched at. Do they advance their interests? If they can't answer 'yes' to both questions, those products will almost certainly be attracting regulatory attention in future, prompting questions and scrutiny”. (Martin Wheatley, Chief Executive, FCA) 

The recent transposition of the AIFMD raises questions over how depositaries will comply with the FCA’s Principles for Business in the future. In interpreting the strict liability provisions of the AIFMD, the FCA have confirmed that depositaries cannot seek to limit their exposure through counter indemnification and hold harmless protection, even in a professional investor context. This approach, outside the parameters of the UK AIFMD Regulations and likely driven by a political agenda, forces the sale of unnecessary ‘PPI cover’ to all types of investor irrespective of their needs and where there is little ‘value’ afforded by this ‘protection’. Contrary to the provisions of Principle 6 of the FCA’s principles for business, this move may well generate significant conduct risk amongst depositary service providers; ironically, something that the FCA is increasingly keen on reducing. 

“Firms have designed, manufactured and sold products not always with the needs and interests of their customers in mind but instead seeing the customer as someone to maximise profit from”. (Clive Adamson, Director of Supervision at the FCA) 

The FCA may well absolve themselves of responsibility for this issue in due course, but depositaries are likely to be an easy target if large profits have been made. Industry needs to be careful.
 

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