Legal Structure of an Investment Fund: Segregation of Fund Assets and the Custodian's Liability

What kind of right does a person who invests in a fund have over the assets in its portfolio? If the portfolio management company or custodian gets into difficulty, is the fund's property affected? This article summarises the basic provisions on funds in the Capital Markets Law No. 6362 (CML). It is general information and does not replace an assessment of your situation. For remedies during liquidation, see our fund liquidation guide; for the litigation side, see our article on the competent court and duty to inform.

1. What is an investment fund?

An investment fund is an asset without legal personality, established by a portfolio management company through fund rules, which operates a portfolio on fiduciary ownership principles for the account of savers using money and other assets collected in return for units (CML Art. 52/1). A fund is deemed to have legal personality only for official register transactions such as the land and trade registries (Art. 52/5).

2. Who has which role?

• Portfolio management company (founder): represents, manages or supervises the fund in a way that protects unit holders' rights (Art. 52/3) and must act in the interest of the funds it manages and unit holders (Art. 55/6). The relationship with unit holders is subject, where the law, regulations and fund rules are silent, to the Code of Obligations provisions on mandate by analogy (Arts. 502-514) (Art. 52/4).
• Portfolio custodian: the assets in the portfolio are delivered to the custodian to be kept in a separate custody account opened in the fund's name. The founder must have an agreement with a custodian authorised by the Board for the fund to obtain its establishment permit (Arts. 52/2, 56/1).
• The institution that sells or intermediates the fund: a bank or brokerage; its duties to inform the investor and to assess suitability are assessed separately.

3. Segregation of fund assets

The law substantially protects fund assets for the investor (Art. 53):

• The fund's assets are separate from those of the portfolio management company and the custodian.
• Fund assets cannot be pledged or given as security, other than for borrowing, derivatives and short selling for the fund's account where the fund rules allow it.
• Even if the management or supervision of the portfolio company or custodian is transferred to public bodies, fund assets cannot be disposed of for another purpose, seized, subjected to injunction or included in a bankruptcy estate.
• In liquidation of fund assets, payment may be made only to unit holders.
• Debts of portfolio management companies to third parties cannot be set off against the fund's receivables from the same parties.

These provisions show that portfolio assets cannot be pursued for the management company's debts. This protection does not remove the risk that the value of the assets falls; investment funds are not fixed-return, capital-guaranteed products like deposits.

4. The custodian's liability

Custody services include ensuring the conformity with legislation and fund rules of, for example (Art. 56/1): the issue and redemption of units; calculation of unit value; execution of the management company's instructions where they do not violate legislation or fund rules; use of the fund's income; and the conformity of asset transactions and portfolio structure.

The custodian is liable for losses caused to the management company and unit holders by its failure to perform its obligations (Art. 56/2). The management company and the custodian must each demand compensation from the other for violations of the law, and unit holders' right to sue is reserved (Art. 56/3). The custodian and the management company cannot be the same legal entity and must act independently of each other, only in the interest of unit holders (Art. 56/6).

5. Examples from CMB principle decisions

• CMB principle decision No. 8/184 of 7 February 2019 regulates holding fully provisioned assets of funds to be liquidated in a side account, and states that the founder's responsibilities under Art. 52/3 and the custodian's under Art. 56/1-2 continue when a side account is created.
• CMB principle decision No. 26/1215 of 2 October 2015 regulates how cash obtained from selling units of liquidated funds is to be invested; where the distributor is an investment firm, responsibility for supervising investment of the investor's balance rests with that firm.

These principle decisions apply to particular funds and periods; the rules applicable to current liquidations must be followed from CMB announcements and the fund's liquidation notice.

6. What it means for investors

• Fund assets are, as a rule, protected from the creditors of the management company; payments in liquidation go to unit holders.
• Whether the custodian and the founder performed their obligations is assessed on the fund rules, prospectus and custody records.
• Unit holders may sue for losses from violation of these obligations; which party is liable and to what extent depends on the case.

7. Contact

If you would like your fund documents assessed, you can create an appointment or reach us via the contact page.

This article is for general information only, contains no promise of results and is not legal advice.