Download Enhancing client asset protection: the FSA`s first moves

slaughter and may
Enhancing client asset protection: the FSA’s
first moves
April 2010
At the end of March, the FSA published a consultation paper (CP10/9, Enhancing the Client Assets
Sourcebook). The consultation paper is explicitly a response to the problems with the existing regime
highlighted by the Lehman Brothers administration (for a discussion of the first stages of the litigation over
the client money failings at that firm, see the Slaughter and May briefing paper on Client Money Protection
after the Lehman Case, March 2010).
The consultation paper includes proposed new rules for both client assets and client money and is
represented as the first stage of a thorough overhaul of the existing regime. As noted below, the FSA is still
considering taking further steps using its current rule-making powers. Other issues must necessarily await
the final outcome of the Lehman litigation and/or the granting of further powers to the FSA by legislation,
especially in respect of any proposal to modify UK insolvency law principles.
The FSA’s proposals
The current proposals, which are open for consultation until 30 June 2010, include:
„„ Mandatory disclosure of the re-hypothecation rights taken by firms in respect of client assets belonging
to their prime brokerage clients. The FSA proposes that agreements with such clients should have
a ‘disclosure annex’ which will highlight the effect or potential effect of any contractual right in the
agreement for the firm to use client assets for its own account.
„„ Detailed daily reporting to prime brokerage clients on money and assets held by the firm.
„„ A limit on the amount of client money which can be held at a bank in the same group as the firm to 20
per cent.
„„ A prohibition on a firm agreeing that a custodian may apply a ‘general lien’ to client assets held with
that custodian in respect of the indebtedness of the firm’s group; any lien is to be limited to unpaid
charges in respect of the assets held.
„„ A new controlled function for a senior individual to have overall responsibility for client money and asset
protection, the regulatory requirements applying to that individual varying with the size of the firm.
„„ An obligation to provide a ‘client money and assets return’ to the FSA, the frequency of the return again
depending on the size of the firm.
Further work to follow
The consultation paper mentions further work to be carried out by the FSA in the near to medium future.
This work includes:
„„ Clarification of the circumstances in which it is permissible for firms to transfer ownership rights over
client money to the firm itself, where the FSA has concerns that clients may currently be (wrongfully)
deprived of protection.
1
Enhancing client asset protection: the FSA’s first moves
April 2010
„„ Assessing the feasibility of the use of SPVs to hold client money and assets in order to secure a more
rapid return to clients upon a firm’s insolvency and, linked to this, the proposal for establishing a client
money and assets trustee and/or agency (a proposal floated by the Treasury in its earlier discussions of a
special resolution regime for investment banks1).
Important issues on which the consultation paper is silent
It is noteworthy, though, that some significant and important matters are not addressed either by the
proposals in the FSA’s consultation paper or the list of further work summarised above. In particular:
„„ The ‘Lehman issues’ surrounding UK insolvency law principles regarding the rights of clients whose
money was wrongly (or carelessly) not recognised as client money and mingled with the firm’s own
money. Depending on the outcome of the Lehman litigation, it may be that changes to the law (for
example, by giving the FSA powers to modify creditor priorities on an insolvency) will be proposed.
„„ The practice permitted by existing client money rules which allow for the so-called ‘alternative
approach’ of a firm ‘temporarily’ mixing client money with the firm’s own money in its general bank
accounts, pending a daily calculation and reconciliation of the amount which should properly be
segregated as client money. When the Lehman insolvency took hold, significant sums were awaiting
segregation in the firm’s general bank accounts; that segregation process was then interrupted by the
onset of insolvency. As matters currently stand in the Lehman litigation, the clients whose money was
thus trapped have no client money entitlements. The Judge in the Lehman case called this provision
a “black hole” and suggested that it could be improved by the FSA within the scope of its existing
rule-making powers. Surprisingly, the FSA has not taken up the court’s invitation, notwithstanding the
importance of the issue. It may be that it feels that it cannot do so in advance of the final disposal of
the Lehman litigation, which is currently proceeding to the Court of Appeal.
Commentary on certain of the proposals
Some of the proposals contained in the consultation paper merit further comment.
‘One size fits all’ no longer
The Judge at first instance in the Lehman case commented that the FSA’s client assets and money
sourcebook, CASS, is at present a set of rules which does not distinguish between the complexities
involved in holding client money and assets by an investment bank of Lehman’s nature and the relatively
simpler business models of a small agency broker.
That aspect of CASS will begin to change if the current proposals are adopted, certainly in respect of
the treatment afforded to the money and assets of hedge funds and institutional investors to whom an
investment bank serves as prime broker. These clients are to receive additional disclosures in respect of
re-hypothecation rights and, probably more importantly, daily and detailed reports as to the status of their
assets and money.
In the case of Lehman, the FSA notes that there was widespread uncertainty regarding:
„„ whether clients’ instructions issued pre-insolvency had been executed;
1
Establishing resolution arrangements for investment banks, December 2009
2
Enhancing client asset protection: the FSA’s first moves
April 2010
„„ which of the clients’ assets had been fully and/or properly segregated; and
„„ which of the clients’ assets had been re-hypothecated.
Daily reporting will certainly go far towards preventing these particular defects from recurring (some prime
brokerage firms have already moved to daily reporting) although doubtless not without financial cost. The
question is whether the cost of prevention will be proportionate to the mischief.
The proposal for a new controlled function, requiring there to be an individual within the firm with specific
responsibility for client money and assets, will be calibrated according to the size of the firm (judged
according to the amount of client money held in the previous calendar year). The largest firms (some fifty
in number, according to the FSA) will not only have to appoint such an individual – the individual will also
be subject to vetting for competency under the FSA’s recent proposals in respect of senior management
positions2.
The FSA has not yet articulated the expected skills and qualities of a client assets and money officer, but
investment firms will need now to identify who among senior management is likely to be best placed to
assume this role.
Monitoring compliance with the CASS requirements
One of the many failings in the Lehman case was the inability of the firm to identify client money and
afford it the appropriate treatment. Daily reporting, at least in respect of prime brokerage clients, will
mean that clients should be readily alert to such failings (for example, if a client is not getting a report
where it thinks it should be getting CASS protection). In addition, the FSA is to receive a client money and
assets return from the investment firms, on a monthly basis in respect of ‘medium’ and ‘large’ firms, which
may enable the FSA to identify potential problems.
These measures are not foolproof, but it must be the case that had they been in force for Lehman the
consequences of the insolvency of that firm for its informed clients would have been far less severe.
Use of group banks
The FSA’s consultation paper contains an interesting discussion of the use by investment firms of group
banks to deposit client money. The point of the client money regime is to ensure that clients do not take
a credit risk on the investment firm itself, but rather on a bank which is prudentially supervised to ensure
protection for depositors (or at least, that is the regulatory theory). However, given that a firm’s financial
difficulties or failure are likely to be highly correlated to difficulties or failure of any group of which it is a
part, it could be argued that for a firm to use a group bank to deposit client money does not really mitigate
credit risk in the manner intended by the regime.
Further, it is likely that at a time of financial difficulties (especially liquidity problems), a firm will have an
incentive to place more of its resources, including its clients’ funds, at the disposal of the group bank, for
recycling within the group to meet liquidity needs.
On the other hand, because the group bank (in collaboration with the firm) is better placed to judge the
length of time for which client money may be deposited, clients often get a better rate from a group bank
than would apply if third party banks were used.
2
CP 10/3 Effective corporate governance, January 2010
3
Enhancing client asset protection: the FSA’s first moves
April 2010
By proposing to limit the proportion of a firm’s client money holdings which may be deposited with group
banks to 20 per cent., the FSA has clearly come to the conclusion that the advantage of decreased credit
risk outweighs other considerations.
But, the FSA also acknowledges that there may be occasions where the obligatory use of third party
banks to hold client money could lead to more risk being incurred rather than less, especially in ‘stressed
markets’, where a large number of banks may be in difficulties.
The above in turn raises possible competition issues, as the FSA also concedes. Passporting EEA firms,
subject to different home state regimes, may, for example, be able to offer more attractive rates for
clients’ funds because they are not subject to a group bank restriction.
Conclusion
The FSA’s consultation paper addresses some of the genuine concerns of both clients and regulators of
investment firms as to the robustness of the current protections for client money and assets which have
come to light, in particular as a consequence of the financial crisis and the insolvency of Lehman Brothers.
In view of the stark empirical evidence of the Lehman insolvency, there is therefore unlikely to be
much objection in principle to the proposals. But there will certainly be costs associated with their
implementation which will affect both the firms concerned and their clients. In particular:
„„ there will be direct costs of additional compliance requirements, such as enhanced reporting (to clients
and the FSA) and additional senior management resources; and
„„ there will be indirect costs, likely to be borne ultimately by the clients of investment firms affected,
arising from possible diminished use of re-hypothecation rights, the loss of liquidity benefits arising from
the limit in respect of group banks holding client money, and the likelihood of lower rates when funds
are deposited with third party banks.
Finally, it is worth reiterating that these proposals represent just a first step in reforming the client money
and assets regime. Further reforms will follow, although the exact nature of many of those further
reforms will depend on both the final outcome of the Lehman litigation and the Government’s appetite for
legislative reforms – the latter being subject to the political uncertainties of the General Election.
If you would like to discuss the issues raised in this briefing paper, or any other financial regulatory
matter, please contact one of the following or your usual Slaughter and May adviser:
Ruth Fox: [email protected]
Jan Putnis: [email protected]
Ben Kingsley: [email protected]
Slaughter and May
One Bunhill Row
London EC1Y 8YY
United Kingdom
T +44 (0)20 7600 1200
www.slaughterandmay.com
© Slaughter and May 2010
This material is for general information only and is not intended to provide legal advice. If you require further
information please speak to your usual contact at Slaughter and May.
jlc44.indd410