New CSSF Circular 16/644 on UCITS depositaries

On 11 October 2016, the CSSF published its new circular 16/644 on UCITS depositaries (the "New Circular") which replaces the now former CSSF circular 14/587 (the "Former Circular") on the same topic.
The Former Circular was grounded on the pre-UCITS V depositary regime. As from its inception, the Former Circular was meant to be significantly revamped in the advent of the amendments to the law of 17 December 2010 relating to undertakings for collective investment (the "UCI Act") transposing the UCITS V Directive and of the latter’s implementing Commission Delegated Regulation (EU) 2016/438 of 17 December 2015 supplementing UCITS V Directive with regard to obligations of depositaries (the "UCITS Regulation").

The UCITS Regulation and the New Circular both apply as from 13 October 2016.

The New Circular breaks with the past in that it exclusively addresses the new UCITS V depositary regulatory landscape.  Subject to the reorganization or displacements of certain sections and sub-sections (as a matter of illustration (i) the dispositions regarding delegation and outsourcing have now been inserted under the roof of the chapter dedicated to the approval procedure of depositaries by the CSSF and (ii) the structure of the dispositions regarding organisational requirements now match the "trilogy" of safekeeping, cash management and oversight duties), the New Circular nevertheless keeps the same general structure as that of the Former Circular.

With the New Circular, the CSSF avoids two main pitfalls.  Firstly, there is no undue dwelling on topics already covered by the UCITS Regulation. This explains for the most part the substantial shortening of the New Circular compared to the Former Circular.  Secondly, the New Circular refrains from any undue gold plating.

The New Circular conveniently provides clarification and/or confirmation in relation to several topics and issues. A selection of these clarified/confirmed topics and issues are listed below.

• For the most part, the provisions applicable to the eligibility of the depositary (paragraphs 2 and 3 of the New Circular), the CSSF initial approval procedure of depositaries (paragraphs 4 to 10 of the New Circular) and the procedures with external persons (paragraphs 30 to 34 of the New Circular) remain substantially unchanged as compared to the Former Circular. Paragraph 10 of the New Circular now specifically states that additional approval is only required in case of change to a "fundamental" element of the initial approval such as changes in relation to delegation and outsourcing which are specifically dealt with in paragraphs 11 and 12 of the New Circular;
• The New Circular now makes a clear distinction between "delegation" and "outsourcing" by the depositary, with the term "delegate" being reserved to a third party entrusted with the safe-keeping of assets in the meaning Articles 18(4) and 34(3) of the UCI Act, and the regime applicable thereto (definitions, paragraphs 11 to 16, 30, 31 and 33, and item g) of the Annex 1 of the New Circular);
• The New Circular further makes a distinction between the outsourcing of a "material" and a "non-material" activity whereas the outsourcing of a material activity is subject to more stringent rules (paragraphs 12 (risk management) and 16 (prior CSSF approval) of the New Circular);
• The New Circular cuts short with the distinction between "sub-custodians" (appointed by the depositary) and "third-party custodians" (appointed by the UCITS), who are now all referred to as "delegates";
• The New Circular, however, maintains the possibility for the UCITS to open and hold directly with a third party custodian an account on which financial instruments to be held in custody will be held in custody (paragraph 50 of the New Circular);
• The New Circular no longer makes a (specific) reference to the delegation within the depositary group, to IT outsourcing and to the concentration of assets with a limited number of third parties or with a single third party (see the introductory sentence of Article 16(1) of the UCITS Regulation which seems to confirm the validity of such a set up (emphasis added): « Where safekeeping functions have been delegated wholly or partly to a third party, a depositary […] »). Presumably, these situations must consequently now be addressed under the general rules of delegation, including that regarding the objective reason requirement;
• At least until further ESMA guidance is issued (see below), the New Circular confirms the pragmatic position adopted by the Former Circular regarding the duty of segregation throughout the custody chain (paragraphs 45 (segregation at the level of the delegates) and 49 (segregation at the level of the sub-delegates) of the New Circular), whilst providing a welcome definition of the "collectively managed assets" (paragraph 45 of the New Circular);
• The New Circular no longer makes any reference to prime brokers and all provisions specifically applicable to the latter in the Former Circular have been removed.  Prime brokers will hence need to be treated by reference to the general dispositions of the New Circular depending on their actual role, capacity and function vis-à-vis the depositary;
• As a general principle, in line with the foregoing developments regarding prime brokers and in recognition of the liability assumed by depositaries, the New Circular recognizes a right for the depositary to refuse any party chosen by the UCITS to whom delegation of safe-keeping functions would be required (paragraph 70 in fine of the New Circular for an illustration of this principle).

It is also to be noted that:

• The New Circular appropriately confirms that cash is part of the "other assets" to be safe-kept in the meaning of Articles 18(4)b) and 34(3)b) of the UCI Act (see the definitions of the New Circular);
• The right for the depositary to benefit from a pledge on the UCITS’ assets and, as the case may be to reuse these pledges assets, and the right to offset account credits and debits is confirmed (paragraphs 19 to 21 of the New Circular);
• The agreement between the depositary and the UCITS must be subject to Luxembourg law and any dispute in relation thereof is recommended to be subject to the exclusive jurisdiction of Luxembourg courts (paragraph 18 of the New Circular);
• The New Circular confirms the possibility for a UCITS to delegate the asset management function to an entity linked to the depositary by common management or control (paragraph 25 of the New Circular).  In our opinion, depositary should also be allowed under certain conditions to provide UCITS with non-core asset management services (i.e. ancillary cash management);
• The New Circular confirms the compatibility between the function of depositary and a series of other functions or capacities (paragraphs 26 (execution of certain tasks linked to risk management), 27 (receipt and transmission of orders, counterparty, administration and TA agent, collateral agent, collateral manager, tax and reporting services) and 28 (holding equity interests in the UCITS’ management company) of the New Circular);
• The New Circular confirms the possibility to set out the details of the escalation procedure in a separate service level agreement or operating memorandum (paragraph 62 of the New Circular);
• Provisions applicable in case of termination of a depositary agreement have been revamped (see definitions and paragraphs 91 and 92 of the New Circular);
• A few amendments and precisions have been conveyed to the Annex 1 listing the information to be provided to the CSSF on an annual or ongoing basis. The template depositary agreement must now be supplemented with a mapping table evidencing compliance with Article 2(2) of the UCITS Regulation (see item i) of Annexe 1 of the New Circular).

The New Circular does not provide additional guidance on the delicate topic of independence (chapter 4 of the UCITS Regulation). We understand that guidance in relation to this topic should soon be provided, possibly in the form of a FAQ.

The New Circular does not provide additional guidance on the topic of implementation of the new UCITS depositary regime to investment funds governed by Part II of the UCI Act.  Guidance in relation to this topic should be issued separately, in the advent of the amendments to the UCI Act proposed by the Bill of Law 7024 which is contemplating to apply to Part II Funds either the UCITS depositary regime or the AIFM depositary regime depending on whether the relevant Part II Fund may or will not market its shares to the public in Luxembourg.

Finally, the New Circular expressly provides that it may be amended or supplemented in relation to certain topics following certain positions taken by the Commission or the ESMA, possibly via specific guidelines or Q&As (the last paragraph of the introduction of the New Circular). This is notably expected in relation to the topic of segregation.

Finally, it may be worthwhile reminding that, although this is not mentioned in the New Circular, the CSSF expects that UCITS V compliant depositary agreements are filed with them by 13th October 2016 or shortly thereafter.

The New Circular is published in French on the CSSF's website. An English translation of this Circular is published in this compilation.