Madoff’s domino effect on European depositary liability
The recent implementation of European rules on depositary liability in the Dutch Financial Supervision Act illustrates the blurring distinction between Dutch public and private law and the growing European influence on national tort law.
In 2008, the world was shocked when it turned out that Bernard Madoff had constructed a gigantic Ponzi scheme. Madoff’s Ponzi scheme has duped many (sophisticated) investors and is even considered the largest investor fraud ever committed by a single individual. On the outside, Madoff appeared to run a highly successful asset management business. In reality, Madoff raised funds from investors but, despite what he had promised, he did not use these funds to purchase securities. Instead, he used the contributions of new investors to pay returns to earlier investors and lined his own pockets with the investors’ contributions. When the fraud was discovered, it turned out that there were no securities corresponding to the funds and that the funds were lost.
Investment funds such as Madoff’s – in the EU: UCITSs (Undertakings for Collective Investment in Transferable Securities) and AIFs (Alternative Investment Funds) – raise funds from investors and collectively invest these funds in, inter alia, securities. Such ‘collective asset management’ benefits investors, allowing them advantages such as risk diversification. At the European level, investment funds are regulated under the Directive on Undertakings for Collective Investment in Transferable Securities (‘UCITS V’) and the Alternative Investment Fund Managers Directive (‘AIFMD’).
Under UCITS V and AIFMD, investment funds are obliged to appoint an independent depositary that supervises the investment fund’s transactions and acts as a custodian over the investment fund’s assets. The depositary is the ‘legal conscience’ of the investment fund and acts as a safekeeper in the interest of investors. One of the reasons why Madoff could run his Ponzi scheme without being discovered was that the appointed depositary had delegated its custody tasks to an entity run by Madoff itself. Hence, Madoff’s business lacked a form of independent control. This practice raised questions on the role and liabilities of depositaries of investment funds. In response, UCITS V and AIFMD have introduced rules on (the liability of) the depositary and on the delegation of its tasks to sub-custodians. In my analysis, these European provisions on depositary liability and the way in which they have been implemented in the Dutch legal system illustrate two important developments: the blurring distinction between Dutch public and private law under the influence of European law and the growing European influence on national tort law.
Under Article 24(1) UCITS V and Article 21(12) AIFMD, Member States need to ensure that a depositary is liable to investment funds and investors for the loss of assets held in custody and for all other losses that result from a depositary’s negligent or intentional failure to fulfil its obligations under UCITS V or AIFMD. Both directives do not specify whether the basis for liability should be of a contractual or non-contractual nature, but it is likely that an investment fund will base claims on its contractual relationship with the depositary and that an investor will base claims on tort – as an investor has no contractual relationship with the depositary.
As from 18 March 2016, Article 24(1) UCITS V and Article 21(12) AIFMD have been implemented in the Dutch Financial Supervision Act (Wet op het financieel toezicht, Wft). Under Article 4:62p(1) and (4) Wft, a depositary is liable to an investment fund for the loss of assets held in custody and for all other losses that result from a depositary’s negligent or intentional failure to fulfil its obligations under the Wft. According to the Explanatory Memorandum, if an investment fund does not hold the depositary liable, investors can base a claim against the depositary on tort under Article 6:162 of the Dutch Civil Code.
As stated above, the current regime for depositary liability illustrates two developments. First, Article 4:62p draws attention because it forms an example of the blurring distinction between Dutch public and private law: Article 4:62p implements private law rules on (non-)contractual liability into legislation with a public law character (the Wft). At the European level, no such distinction is made and rules with a public and private law character are combined in the same piece of legislation. However, usually, the Dutch legislature implements such provisions separately in Dutch codes of public and private law. For example, the implementation of the Payment Services Directive entailed amendments to the Wft and the Dutch Civil Code. By contrast, under the new Article 4:62p, if it comes to private law litigation, investment funds can base private law claims against depositaries on a public law provision. In the long run, implementing European provisions that concern private law in legislation with a public law character could contribute to the fragmentation of Dutch private law and might affect the coherence of the Dutch private law system. In this specific situation, it can be debated whether such a deterioration of coherence causes problems in relation to, for example, legal certainty and transparency. As this manner of implementation raises questions on the coherence of the Dutch private law system and on the potential consequences of this manner of implementation, it would have been desirable if the Dutch legislature had paid more attention to these topics.
Second, from the perspective of European integration, it is noteworthy that UCITS V and AIFMD address the rights of private parties – thereby indirectly influencing tort law as regards the position of investors versus depositaries – because tort law has traditionally belonged to the exclusive competence of the Member States. Even though UCITS V and AIFMD do not harmonise the legal ground for liability, these Directives do harmonise substantive norms governing the private law relationships between a depositary and investors. Hence, the depositary liability regime shows that, in times of public and political indignation with regard to malpractices of the financial sector such as the Madoff scandal, little pieces of national tort law are being harmonised. Although this process is proceeding only one tiny step at the time, eventually, it will take us closer to a European tort law in the context of the financial sector.