The Putin factor: are securities safe with depositories at times of international crisis?

Russian President Vladimir Putin has repeatedly shown that economic considerations are not the driving force in the Kremlin’s decision-making. The economic sanctions against Russia imposed by Western states appear to have had little effect on Russia’s destabilisation of  kraine. Many investment funds have already withdrawn, or are planning to withdraw, large parts of their investments in Russia and neighbouring states. But who is responsible for a safe transfer of the assets in times of economic sanctions and geopolitical turmoil?

A nervous market

Unit holders in funds investing in Russia have had a bumpy 2014. The crisis in Ukraine has led to many investors seeing their investments in Russia and the other post-Soviet states fall in value. Moreover, many of them could experience even worse problems than a fluctuating market. Who is guaranteeing that the fund’s assets are safe in an unsecure political environment? The fund’s asset manager? Or the global financial institution acting as the fund’s depositary? Or perhaps the local bank to which the depositary has subdelegated the depositary functions for the Russian assets?

There is some doubt about the actual effect of the international sanctions aimed at checking Putin’s geographical. They have, however, ‘successfully’ created an unsecure situation for many Western financial institutions with investments in Russia. In this unstable political environment, many asset managers are realising that their depositary agreements grant depositaries significant possibilities to avoid liability for events such as international political and economic sanctions that are deemed to be out of the depositary’s control. However, since the risk – but not the precise nature or scope – of economic sanctions is often known well in advance, this notion might be debatable.

The growing risk of further sanctions shines a light on an issue that is often ignored: who bears the burden of proof in the event of the loss of a financial instrument, the UCITS manager or the depositary? And in what situations may a depositary rightfully be discharged of liability for the loss of assets held in its custody?

UCITS V and the regulation of depositaries

UCITS, or “undertakings for the collective investment in transferable securities”, are investment funds regulated at European Union level. They account for around 75 % of all collective investments by small investors in Europe. The legislative instrument covering these funds is Directive
2014/91/EU. The new UCITS V directive (as well as the existing Alternative Investment Fund Managers directive, AIFMD) regulates depositaries. The Directive establishes an exhaustive list of entities that are eligible to act as depositaries for UCITS’ assets: (i) central banks, (ii) credit institutions under Directive 2013/36/EU and (iii) legal entities authorised by the competent authority under the laws of the member states to carry out depositary activities.

The UCITS must appoint a single depositary to have general oversight over the UCITS’ assets.

The requirement for a single depositary is supposed to ensure that the depositary has an overview of all the assets of the UCITS, and that both fund managers and investors have a single point of reference in the event that problems occur in relation to the safekeeping of assets.

Any delegation or sub-delegation of depositary functions by the depositary should be objectively justified and subject to strict requirements in relation to the suitability of the third party entrusted with the delegated function, and in relation to the due skill, care and diligence that the depositary should employ to select, appoint and review such a third party. The new rules shift the balance of power in favour of the funds and their managers. The UCITS V directive clarifies the depositary’s liability in the event of the loss of a financial instrument that is held in its custody. In such cases, the depositary must return a financial instrument of an identical type or the corresponding amount to the UCITS. No discharge of liability in the case of loss of assets should be envisaged, except where the depositary is able to prove that the loss is due to an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary. In that context, a depositary should not be able to rely on internal situations, such as a fraudulent act by an employee, to discharge itself of liability.

Unlike the depositary regime under the AIFMD, there will be no possibility to contractually discharge from liability. It is, however, our experience from negotiating depositary agreements that all too often the depositary is unwilling to accept a definition of loss that includes any ‘temporary’ loss whereby the fund manager is unable to directly or indirectly dispose of a financial instrument for an unknown and unspecified time period (such as might be the case during economic sanctions). The new rules might give investment managers a false sense of security should the depositary’s definition of ‘loss’ be very narrow, excluding all loss during times of political and economic turmoil, such as during Russia’s aggression towards Ukraine and the subsequent sanctions towards Russia. It is thus important when drafting the depositary agreement that fund managers imagine a number of situations in which assets might be indefinitely lost.

We believe that the liability of depositaries for loss (both temporary and permanent) of assets could also be upheld in situations such as the ongoing crisis in Ukraine. But to avoid any doubt, investment managers must still be careful when negotiating and signing depositary agreements.