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Depositary Lite’ regime in 2023 – theory and practice
Marketing of non-EU[1] and, in some cases, EU investment funds under the AIFM Directive is not easy for fund managers. Even if they manage to get through the complex requirements of the AIFM Directive and growing intricacies of private placement regimes in member states, there is always the question of the depositary at the end anyway.
Therefore, it is worth taking a closer look at the available legal options regarding depositary under AIFM Directive, somehow difficult to understand, often forgotten and sometimes overlooked.
We are referring to Articles 36 and 42 of the AIFM Directive. They are the basis of the regime commonly known as depositary-lite[2] and need more explanation, since the regulation itself raises more questions than it answers.
In this article, we will discuss:
- when the depositary-lite regime will apply in the context of marketing of AIFs under the AIFM Directive[3],
- general legal requirements and responsibilities of the depositary-lite,
- what legal requirements distinguish the depositary-lite from the full depositary,
- practical issues related to the depositary-lite.
Bit of background
First of all, let us consider whether the depo-lite regime still has relevant practical meaning.
The whole depositary-lite concept was expected to lose its relevance, or at least change, due to the extension of the EU passport (which was supposed to facilitate the marketing of AIFs). It was planned to extend the EU passport to non-EU countries that were deemed equivalent to European regulations in terms of systemic risk and investor protection. Some countries even received a positive assessment from ESMA (e.g., Canada, Japan, Jersey), but over the years, EU institutions have not taken further steps to allow them to use the EU passport, and the regulations on the EU passport have not changed at all.
Currently, the EU passport is available only for EU AIFMs marketing EU AIFs, while in other cases of distributing AIFs in the EU, the private placement regime of each member state will apply. Moreover, so far, the planned AIFMD 2 has not shown significant signs of changing course in this regard, due to the lack of consensus on this depositary issue.
On top of that comes Brexit and the growing expansion of AIFs from the US and Asia in the EU, which increase the demand for depositary-lite services and magnify the practical aspect of this system.
Situations in which the depositary-lite regime will apply
All the outline factors mean that the depositary-lite regime will continue to apply in the following situations:
- EU AIFM wishes to distribute non-EU AIF in the EU – Art. 36 of AIFM Directive applies in connection with the private placement regime of each member state of EU,
- Non-EU AIFM wishes to distribute EU AIF in the EU – Art. 42 of AIFM Directive applies in connection with the private placement regime of each member state of EU,
- Non-EU AIFM wishes to distribute non-EU AIF in the EU – Art. 42 of AIFM Directive applies in connection with the private placement regime of each member state of EU.
Examples:
If a Luxembourg AIFM distributes UK AIF in Luxembourg, it must comply with the Luxembourg private placement regime based on AIFM Directive.
If a USA AIFM distributes Luxembourg AIF or Cayman Islands AIF in Luxembourg, Ireland, and Germany, it must comply with the Luxembourg, Ireland, and Germany private placement regimes based on AIFM Directive.
The presented examples, in their simplicity, illustrate an extremely important thing. The fund managers must comply with the regulations of private placement regime of each member state in which they wish to distribute their AIFs – therefore, they must meet the depositary requirements adopted by each EU country. The AIFM Directive sets the general framework, while individual member states can: (i) transpose the provisions of the directive without change, or (ii) tighten these requirements (gold-plating).
It looks intimidating, but it is not that bad.
As for EU AIFM marketing non – EU AIFs, none of the member states have gold-plated the depositary requirements, so the standard principles of the AIFM Directive will apply (depositary-lite regime under Art. 36 of AIFM Directive).
On the other hand, in the case of a non-EU AIFM marketing either EU AIFs or non-EU AIFs, the AIFM Directive under Art. 42 does not impose any depositary requirements. As a result, some member states have introduced depositary-lite requirements (e.g., Germany, Denmark) and some have not (e.g., Luxembourg, Ireland).
So, if the non-EU AIFM wants to market AIFs, for example in Luxembourg as well as in Germany, it must comply with the depo-lite regime adopted in Germany.
Note that if the AIFM meets the higher depositary requirements imposed, for example by Germany, it will also meet the requirements of member states that have not imposed these requirements, such as Luxembourg (it does not work the other way around). Considering Germany is one of the largest fund markets in the EU, it stands to reason more often than not, a non-EU AIFM will have to appoint a depo-lite to perform its tasks.
With these principles in mind, let us clarify what the depo-lite requirements and responsibilities really are.
Key requirements of depositary-lite
According to Art. 36 of AIFM Directive, AIFM is not required to appoint a full depositary for AIFs (as referred to in Art. 21 of AIFM Directive). That AIFM shall however ensure that one or more entities are appointed to carry out the following depositary duties:
- cash flow monitoring,
- safekeeping of assets,
- oversight of the fund,
- referred to in Art. 21 (7), (8) and (9) of the AIFM Directive.
The obligations of depositary-lite are similar to that of the full depositary, but at the same time strict liability for loss of financial instruments does not apply to entities which are performing these functions, that is why the whole concept is known as the depositary-lite.
For non-EU AIFs the oversight duties may be completely new phenomena. They are aimed to ensure that the AIF acts in accordance with applicable law and regulations, and include, among others: oversight of the valuation of the AIF, subscriptions and redemptions, settlement of transactions, or investment restrictions.
What about Art. 42 of the AIFM Directive? – as we mentioned earlier, it does not contain any requirements for a depositary.
In this case, national private placement regimes take a lead because some EU member states adopted the requirements of depositary-lite through the implementation of Art. 42 of AIFM Directive into national law.
Let us focus on the Germany private placement regime, as it is one of the biggest markets in Europe. EU AIFs and non-EU AIFs managed by a non-EU AIFM are required to appoint a depositary-lite entity to provide depositary services, and the requirements are the same as in the terms of AIFMD (not gold-plated on this level). Therefore, to meet the depositary-lite requirements in Germany, AIFMs must follow the standard rules which applies for depositary-lite regime under art. 36 of AIFM Directive[4].
It is important to pay attention to the master-feeder structure as well because the depositary-lite requirements may apply also to the master AIF.
To conclude this part, we would like to point out that the main differences between the depositary-lite and the full depositary are as follows:
| DIFFERENCES | DEPO-LITE | FULL DEPOSITARY |
| No liability for loss offinancial instruments | Yes | No |
| Multiple entitiesallowed | Yes | No |
| No locationrequirements | Yes | No |
| No restrictions on delegation of functions | Yes | No |
| Different type of entities allowed (e.g., prime broker, administrator) | Yes | No |
Practical Issues
Finding the right depositary-lite service provider these days is easier than it was a few years ago, but that does not mean it is a simple task. Fund managers still face some challenges in this regard on the market, if they are not part of big capital groups.
The different nature of the AIFs and the wide range of assets in which they invest across the globe, makes fund managers look for client-oriented depositary-lite providers.
While cash flow monitoring and safekeeping duties generally do not cause practical problems, the oversight function itself may generate some risk. As a result, various depositary service providers may be more or less interested in serving as depositary-lite for some funds, and this depends on the nature and investment policy of the fund.
That is why, managers often look for an EU-based depositary with sufficient knowledge and experience, covering different jurisdictions in changing regulatory environment, interested in performing this function.
Keep in mind that even though depositary-lite service providers are exempt from strict liability for loss of assets, they are not absolved from liability to the AIF as a result of negligence in carrying out the oversight duties.
On the other hand, the depositary-lite providers must be operationally capable of performing the depositary duties required. They need to tailor their services to the nature of the AIFs, adjust the procedures, implement relevant systems and infrastructure to ensure the proper performance of the depositary-lite functions provided under AIFM Directive.
Demanding depositary services comes with increasing costs for fund managers. That is why this function is often divided into several entities, to diminish the costs (mixing models with prime brokers, administrators etc.). In this case, it is necessary to introduce appropriate procedures and ensure that there is no conflict of interest or duplication of duties.
Conclusion
This is just a brief overview of the depositary-lite legal regime which, whether on paper or in reality, is much more complex and continues to generate many challenges for both fund managers and depositary providers themselves.
What about the future? It seems that in 2023 and the years to come, the depositary-lite regime will continue to play a significant role in the European investment funds market.
We will certainly face issues such as new types of assets, increasing automation of processes, reorganization of markets etc., and thus maybe changes in law or changes in supervisory approaches.
That is all the more reason why fund managers and depositary providers must constantly face depositary issues and monitor the development of the existing system.
[1] AIFM Directive has the same legal effect in non-EU countries within the EEA (i.e., Iceland, Liechtenstein, and Norway).
[2] In practice, the term ‘depositary-lite’ is more often used in the context of Art. 36 of the AIFM Directive.
[3] In this article, we do not address issues related to the marketing itself and refer to cases where AIFs are distributed only to professional investors.
[4] At this point, it should be mentioned that there are different positions on whether the European Commission’s Delegated Regulation (EU) No 231/2013 of December 2012, also applies to the depositary-lite regime.