Madoff Litigation: UCITS Investor Rights and Depositary Liability
The Irish Commercial Court (Costello J) has recently clarified a number of issues regarding an Irish investment company authorised as a UCITS fund which will also have relevance for investment companies generally. 
The judgment: (i) clarified the difference between an "investor" and a "unit-holder"; (ii) restated long-established rules of company law, including who can sue when a company suffers loss; and (iii) opined on the liability of depositaries under the European Communities (Undertakings for Collective Investment in Transferable Securities) Regulations 2003 (as amended) (the "2003 UCITS Regulations"), implementing Directive 85/611/EEC (as amended) (the "Directive") (which are commonly referred to as the "UCITS III" regime). 
Thema International Fund plc ("Thema") is an Irish regulated investment company governed by Irish company legislation. It appointed HSBC Institutional Trusts Services (Ireland) Limited ("HSBC") as the depositary (known as a "trustee" under the 2003 UCITS Regulations) for its assets. A central requirement of the UCITS regime is that fund assets are entrusted to a depositary for safekeeping, which must then hold such assets separate from its own assets, and generally its liability is not affected when delegating safekeeping to any sub-custodian.
HSBC appointed Bernard Madoff Investment Securities LLC ("BLMIS") as sub-custodian of substantially all of the assets in the Thema fund. The entire Thema fund was lost due to the collapse of the enormous Ponzi scheme operated by Bernard Madoff and BLMIS.
In December 2008, Thema instituted proceedings against HSBC arising from the Madoff fraud, alleging various wrongs against HSBC and its agents, including breaches of the 2003 UCITS Regulations, breach of contract, breach of fiduciary duty and tortious breaches. HSBC ultimately settled with Thema. 
The plaintiffs (Alico Life International Ltd and Mr Shmuel Harlap) instituted proceedings against Thema and HSBC in 2009. In response, Thema and HSBC contended that they did not owe any actionable duty to the plaintiffs in circumstances where the plaintiffs were not unit-holders in the fund.
They also contended that, even if the plaintiffs were unit-holders, any duty to the plaintiffs was barred by operation of the rule in Foss v Harbottle  and/or the rule against reflective loss.  HSBC also argued that the plaintiffs did not enjoy any direct right of action under the 2003 UCITS Regulations against it in its capacity as depositary/trustee.
Meaning of "Unit" and "Unit-Holder" 
The Commercial Court determined that "units" in the context of an investment company  are the shares in that company, and not any other type of interest or instrument in the company.
The plaintiffs argued that they were unit-holders in Thema notwithstanding the units in question were held through nominees, meaning they were investors and not registered shareholders in Thema.
The court rejected this and concluded that the definition of "unit-holder" in the 2003 UCITS Regulations can only mean a registered shareholder in the case of an investment company, and does not mean a beneficial owner or the person who invested capital indirectly (e.g. via a nominee arrangement).
Unit-Holder Claim against the Depositary
The plaintiffs made a separate argument that as unit-holders in Thema  they should have a direct right of action against HSBC pursuant to Article 16 of the Directive.  That provision states a depositary is liable to the investment company and the unit-holders for loss suffered by them as a result of the depositary's unjustifiable failure to perform its obligations, or its improper performance of them. 
The court took the view that Article 16 did not confer a direct cause of action by unit-holders in an investment company UCITS against a depositary.
Article 16 did not require Ireland to grant a cause of action to a unit-holder in an investment company against a depositary, if Ireland wished to do so it could enact legislation to that effect (which it did not); therefore the court was satisfied that Article 16 introduced no such direct cause of action.
Rule in Foss v Harbottle
The defendants (Thema and HSBC) argued that, even if they were unit-holders, the plaintiffs' cases were not maintainable as it offended the rule in Foss v Harbottle. This is an established principle of company law which dictates that where damage has been suffered by a company, the proper plaintiff is the company itself and not a shareholder (subject to certain exceptions).
The court, observing that the assets which were lost by the Madoff fraud were clearly those of Thema (and not the shareholders), held that the plaintiffs had no right to sue for that loss.
Rule against Reflective Loss
Finally, the court held that, even if it was wrong in all of its other conclusions, the plaintiffs' cases were still barred by the application of the rule against reflective loss.
Where a company suffers loss as a result of the conduct of a third party, a shareholder will often suffer a loss in the form of a diminution in the value of his shareholding. The shareholder's loss would be made good in those circumstances by the company enforcing its rights against that third party. In such a situation, the rule against reflective loss prevents a shareholder from recovering separately for the diminution in the value of his shares as this would constitute double recovery for the same loss, i.e. the loss in value of the shares is reflective of the company's loss.
The test for determining whether the loss is reflective in nature is whether a full recovery by the company of its loss in an action against the wrongdoer would make good the loss suffered by the shareholder.
Thema had sued HSBC for the loss of the assets of the Thema fund. The plaintiffs here sued for the loss in values of their shares attributable to the diminution in the fund's net asset value. Thus, their loss was identical to that claimed by Thema.
The court upheld and restated the rule against reflective loss, meaning the plaintiffs' claims were barred.
(a) A "unit-holder" in the context of an investment company UCITS means a shareholder in that company, and therefore, investors who hold units in an investment company UCITS through a nominee are not unit-holders. If they choose not to become unit-holders and instead invest via a nominee or other intermediary, it is their responsibility to ensure that the nominee ensures they are indirectly afforded the relevant benefits and protections under the Directive.
(b) A unit-holder in an investment company UCITS did not enjoy a direct right of action against the depositary/trustee under Article 16 of the Directive (see further below).
(c) Proceedings brought by a unit-holder seeking the recovery of the net asset value of their shares in an investment company will generally be barred by both the rule in Foss v Harbottle and the rule against reflective loss.
Depositary Liability after UCITS V
As mentioned, the court held that, although Article 16 imposed liability on the Depositary, it did not confer a direct cause of action on unit-holders. In this regard, it should be noted that, under the Directive and the 2003 UCITS Regulations, there was a difference between depositary liability for unit trusts/contractual funds and investment companies. Both provided that the depositary would be liable, in accordance with the laws of its home Member State, to the fund and unit-holders for loss suffered as a result of its breach of the prescribed liability standard, but for unit trusts/contractual funds there was additional wording stating that "Liability to unit-holders may be invoked either directly or indirectly through the management company, depending on the legal nature of the relationship between the trustee, the management company and the unit-holders."
Costello J took the view that this second sentence "had to be given a meaning" and agreed with HSBC that it should be interpreted as meaning that unit-holders in a unit trust/contractual fund could have standing to sue the depositary directly where there is a legal relationship between them (or indirectly through a management company).
There was a conscious decision of legislators to remove the above distinction in amending the UCITS regime for "UCITS V". Article 24(5) of Directive 2009/65/EC  now provides that "Unit-holders in the UCITS may invoke the liability of the depositary directly or indirectly through the management company or the investment company provided that this does not lead to a duplication of redress or to unequal treatment of the unit-holders"  (emphasis added). Since UCITS V came into effect, unit-holders in all UCITS funds, regardless of legal form, may now have a right to sue the depositary directly.
The only qualification is that unit-holder claims should not lead to the duplication of redress or unequal treatment of unit-holders. Interestingly, this seems to echo existing Irish company law principles summed up in the rule in Foss v Harbottle and the rule against reflective loss. However, the courts will interpret this provision "harmoniously and autonomously" as EU law, and not necessarily in the same way as domestic legislation.
What therefore remains to be seen is how an Irish court (or indeed another EU court) will interpret Article 24(5) in any future case involving depositary liability and unit-holder loss; the primary question being whether they will find that a direct cause of action is conferred on unit-holders, and, if so, how the above qualification impacts on this.
Any such decisions could have major implications for the depositary regime for UCITS funds and investors.
For further information and details of our expertise in this area, please speak to your usual Maples and Calder contact.
 Alico Life International Ltd v Thema International Fund plc and HSBC Institutional Trusts Services (Ireland) Limited and Shmuel Harlap v Thema and HSBC  IEHC 363.
 The 2003 UCITS Regulations were restated and replaced under UCITS IV and subsequently amended under UCITS V since the issuance of these proceedings. For the purposes of these proceedings, the 2003 UCITS Regulations were those which were applicable.
 At the date of judgment of Costello J, the settlement amount had not yet been distributed to shareholders pending resolution of a separate issue in the US courts involving BLMIS and the defendants.
 (1843) 2 Hare 461 (a decision of the English Court of Chancery). See the paragraph on Rule in Foss v Harbottle.
 See the paragraph on Rule against Reflective Loss.
 Neither "unit" nor "unit-holder" is defined in the Directive. Those terms are, however, both defined in the 2003 UCITS Regulations.
 The Directive and the 2003 UCITS Regulations identify three distinct legal forms which UCITS may take: (i) common contractual funds managed by management companies, in which case the assets are beneficially owned by the unit-holders; (ii) unit trusts, in which case the assets are legally held by a trustee and the unit-holders have a beneficial interest in the assets of the undertaking; and (iii) investment companies. The terms unit and unit-holder are designed to apply to all three forms of fund.
 Ignoring for these purposes the court's rejection of the plaintiffs' status as "unit-holders".
 Implemented in Ireland by Regulation 43 of the 2003 UCITS Regulations.
 Note the liability standard for depositaries has changed post UCITS V (18 March 2016 onwards).
 As amended by Directive 2014/91/EU
 This provision is implemented in Ireland pursuant to Regulation 36(7) of the European Communities (Undertakings for Collective Investment in Transferable Securities) Regulations 2011 (as amended), as follows: "Liability to unit-holders may be invoked either directly or indirectly through the management company or the investment company provided that this does not lead to a duplication of redress or to unequal treatment of the unit-holders"