An introduction to the UK FCA’s client money rules for investment firms, with John David Thiede of Sidley Austin LLP

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FeatureLegalRegulation
21 Oct, 2015

They make up one chapter out of 12 in a set of recently revised rules published by just one regulator. Yet it would not be hyperbolic to describe the new client money rules set out in the Client Asset Sourcebook (CASS) of the United Kingdom Financial Conduct Authority (FCA) as one of the most excruciatingly detailed and prescriptive set of operational obligations imposed on investment firms, including asset managers, of any introduced since the financial crisis. They came fully into force on 1 June this year. Dominic Hobson spoke to John David Thiede of Sidley Austin LLP, who was closely involved in their drafting during his time with the FCA.

The spectre of Lehman Brothers continues to haunt the asset management industry. Seven years after the firm failed, and more than three years since the final United Kingdom (UK) Supreme Court judgements in the Lehman Brothers client money cases, the failure of the investment bank in 2008 continues to reverberate through the buy-side. Asset managers in the UK have spent a large part of 2015 updating the terms and conditions agreed with clients and the banks and other third parties by whom they hold client money, and implementing the changes to systems and procedures, to take account of the third and final stage of a comprehensive revision of the custody and client money rules in the Client Asset Sourcebook (CASS) published by the UK Financial Conduct Authority (FCA). Following earlier sets of revisions introduced from 1 July and 1 December 2014, the third and final set of revisions under the 410-page Policy Statement 14/9 came into force on 1 June 2015 (PS14/9).[1]

Understanding, implementing and then complying with the new rules has entailed massive investments of time and resources, including in many cases, the appointment of dedicated staff.[2] “These rules are so comprehensive, and so detailed, that most asset managers of any significance have hired dedicated staff to comply with them,” says John David Thiede, an associate in the EU and UK Financial Services Regulatory Group at Sidley Austin LLP. “If you have a reasonable amount of client cash going through your books, you are going to have at least a couple of employees that are responsible, day-to-day, for your client money operations. They need to know the FCA’s client money rules well. There is considerable complexity in the rules but, in fairness to the FCA, the legal regime that underpins them is complex. The rules are aimed at ensuring that under property, trust and insolvency law, client money is protected on the failure of an investment firm. What we have is quite a detailed set of regulations trying to provide for this outcome.”

Having a high-level understanding of the obligations laid down in these regulations should be every asset manager’s starting point, and there is no better guide to the FCA’s client money rules than Thiede, since he was previously at the FCA, where he co-led the review of the FCA’s client assets regime for investment business, helping to draft the rules that are now in force. As he points out, the FCA’s new client assets regime for investment business really represents an attempt to apply the lessons learned through the failure of Lehman in particular, and later of MF Global. “The failure of Lehman Brothers International (Europe) proved that the UK’s client money rules were not fit for purpose,” explains Thiede. “Although there were operational compliance issues at Lehman Brothers, the client money rules themselves were arguably a light touch in terms of what regulated firms were expected to be doing on a day-to-day basis. In particular, the distribution and insolvency rules that kicked in after Lehman’s failure were not up to the task. Before any money could be returned to Lehman’s clients, a series of legal questions had to be answered. Through that experience, the FCA learned a lot about what works and what does not in its client money rules and the distribution and insolvency rules that underpin them. PS14/9 is the culmination of all that work. We have a complete re-write of the FCA’s client money rules, with final proposals to revise the related client money distribution and insolvency rules expected to be published at the end of 2015 by the FCA and the Government.”

Custody Rules vs. Client Money Rules

Before considering the requirements of the FCA’s client money rules, it is important to first understand the distinction between the separate custody and client money rules in CASS. Cash and non-cash assets are treated differently, both in regulatory terms and in an event of insolvency, for the understandable reason that cash is fully fungible.

The FCA has an entirely separate set of regulations for non-cash assets belonging to clients in Chapter 6 of CASS, known as the FCA’s custody rules. Asset managers – and, for that matter, other types of investment firms, which includes brokers, investment advisers, platforms and custodians/depositaries – must comply with the FCA’s custody rules to the extent they hold non-cash assets for clients.

By contrast, the FCA’s client money rules in Chapter 7 of CASS apply to investment firms when they carry on regulated activities which could give rise to them holding cash for clients (i.e., “client money”). For asset managers, client money is most likely to arise in the context of handling subscription and redemption proceeds.

This article sets out at a high level the key changes introduced to the FCA’s client money rules through PS14/9 that are likely to be of most relevance to the asset management industry. This includes obligations relating to the use of third parties to deposit or hold client money, client consent and disclosure of information to clients, operational requirements around segregated client accounts and general provisions on reporting, governance and audits.

Use of third-party banks or other intermediaries to deposit or hold client money

Due diligence

In most instances, asset managers must ensure client money is deposited in an account at a third-party bank which is identified as holding cash belonging to clients of the manager and separate from any account at that bank holding the manager’s own funds (referred to in the FCA’s rules as a “client bank account”). The FCA also specifies a detailed list of criteria an asset manager must apply during the due diligence process that precedes the appointment of a bank to hold client money. “They have beefed up the criteria to apply when selecting a third-party bank, and codified the obligation to keep records of the due diligence carried out,” explains Thiede.

As it happens, this really amounts to no more than a codification of existing legal obligations. Even before this latest re-write of the FCA’s client money rules, asset managers were subject to a statutory trust over the money that they take from clients and deposit with third-party banks. For example, being in a position of trust as a manager operating in England would have attached the whole of English trust law to the manager’s arrangements with clients, which means asset managers had duties as trustees to safeguard the money, to segregate it from house funds and record the money as client money, and to carry out proper due diligence when selecting a bank with which to deposit it, even before having to take the CASS client money rules into account.

The FCA’s previous client money rules implemented the European Union's (EU) Markets in Financial Instruments Directive (MiFID) and similarly copied the MiFID requirement for managers to “exercise all due skill, care and diligence,” when selecting a bank to hold client money and periodically reviewing that relationship. So managers have for some time had obligations under both trust law and the FCA’s rules implementing MiFID to conduct due diligence on the banks they use to deposit client money even before the FCA’s recent re-write of its client money rules.

“The good news is that, if you follow the FCA’s new requirements and guidance, you have likely met both the MiFID obligation and your duties as trustee,” says Thiede. “Neither MiFID nor trust law provided the industry meaningful guidance on what constituted good or bad due diligence, but the FCA’s client money rules stipulate an achievable standard. Whether you agree with them or not, the FCA’s revised guidance specifies the core criteria you should follow when carrying out due diligence. If you follow this guidance and document your rationale for degree and frequency of due diligence undertaken, you should not have to worry about the FCA coming after you for poor due diligence.”

Diversification

Firms also are expected to consider diversifying their client money deposits among a number of banks. The purpose of diversification is chiefly to spread the credit risk associated with client money holdings, so that on the failure of any one bank at which client money is deposited, there is client money which remains accessible by the investment firm for return to its underlying clients. “Diversification is not there to mitigate the failure of the asset manager, and the consequences of that, but to mitigate the exposure of the client to the failure of a third-party bank the manager has deposited client cash with,” notes Thiede.

Despite the understandable benefits of diversification, it can introduce considerable operational complexity and expense. “Diversification is quite difficult for a number of firms,” says Thiede. This is chiefly because it requires firms to have payment and accounting arrangements in place to move and track money between multiple bank accounts. Where firms operate under the normal approach to client money segregation (discussed below), firms may be receiving payments from clients direct into one client bank account and then periodically transferring some part of those receipts into a second bank account. “It can prove complicated for some firms to, in effect, separate out a portion of their operational flows of client money into a second bank account, if the only purpose of that second account is to achieve diversification,” suggests Thiede.

So what are the FCA’s expectations for diversification? Thiede explains that, “the FCA’s new rule says you have to 'consider' whether or not you should be diversifying your deposits of client money. Some in the industry believe that the FCA is really saying everybody needs to diversify anyway, even though the final rule does not say this. Through the consultation process for PS14/9, the FCA recognised that diversification would be disproportionate for some firms. While there is no black and white rule on when diversification is required, this is an area where the FCA expects managers to think about how much client money they are holding, how many clients they have, and the risks to client money that arise in their operations. Management will then need to take a decision as to whether it is necessary for their business to diversify their client money holdings, and operate more than one client bank account with different credit institutions. The regulatory obligation is to 'consider' the potential need so, from a client perspective, managers should give due consideration, reach a decision and document it. Many in the industry are taking the view that, if they have more than insignificant amounts of client money, that they really should be diversifying those holdings and making sure that they are spread across different institutions.”

In other words, larger institutions are now taking the view that it is effectively a requirement to diversify their deposits among a number of banks to spread the credit risk. The FCA Guidance during the consultation process for PS14/9 initially suggested that it expected investment firms subject to CASS to be depositing client money with more than one bank. However, the FCA eventually rescinded this position for a more pragmatic approach.

Acknowledgement letters

Another obligation that asset managers must fulfil when depositing client money with third-party banks or other intermediaries – and it has proved in recent years to be the biggest source of regulatory fines[3] – is the obligation to secure from third parties an “acknowledgement letter.” Asset managers are obliged by the FCA to secure from any institution with which they deposit or place client cash – whether it is a bank or a broker – a written acknowledgement that the cash to be held by that entity does not belong to the asset manager but to the clients of the asset manager, that it will be held in a way that enables it to be identified as such, and that any charges, liens or rights of set-off or retention over the cash are waived. “The asset manager should be ensuring that, if it were to fail, the bank or broker holding client cash on behalf of the manager does not seize it to cover the manager’s own liabilities,” explains Thiede. “If the asset manager has secured an acknowledgement letter over a client account maintained in the UK, the FCA expects that the bank or broker will not have an ability to use the money in that account to cover the proprietary liabilities of the failed asset manager to that bank or broker, or other third party. Once the asset manager fails, that bank should quickly return the client cash to the estate of the failed firm.”

The immediate aftermath of the failure of Lehman Brothers, in which certain banks in the UK initially withheld client cash on the grounds that Lehman Brothers owed them money for other reasons, was a vivid illustration of the importance of valid and tightly drafted acknowledgement letters. Yet even since 2008, firms have failed repeatedly to secure acknowledgement letters at all, or failed to eliminate simple errors in the letters (such as an incorrect address of the bank or broker, or the name or number of the account to which they refer). In response, the FCA has taken the extraordinary step of drafting templates for asset managers to use. There is now no discretion over how acknowledgement letters are drafted – the templates are accompanied by 15+ pages of guidance to compliance officers on how to complete and negotiate the terms with a bank or broker – and until an acknowledgement letter in the correct format is countersigned by the bank or broker, the asset manager cannot deposit client cash with that institution. “Operationally, firms have welcomed this approach,” says Thiede. “They no longer have to draft anything and incur the cost of lawyers to do so. For a client bank account, they just take the template, fill in the relevant names and account details and send it to the bank. But firms still need to periodically review whether they have one of these letters in place for each client bank account, and that the returned letter has been countersigned and dated without any amendments or additions. Firms should then re-open the file at least once a year, and ensure that they have a current and valid acknowledgement letter in place for every account in which client cash is held. The FCA keeps repeating that this is one of the most important things for investment firms to get right.”

Key arrangements that require client consent and/or disclosure

The need to get clients to agree in advance to, or acknowledge the risks associated with, certain arrangements is another example of the detailed requirements within the FCA’s client money rules that require careful attention. “As a general principle, asset managers should be explaining clearly to their clients what they are doing,” says Thiede. “They have a general regulatory obligation to be fair, clear and not misleading to client communications. We are being asked questions such as: Can we obtain consent to our client money arrangements on `a one-way basis’? If you are going to update your terms and conditions, does the client have to countersign and return them? You can imagine how difficult this process is to document and implement. What do you do with clients that you send the revised terms and conditions, and the mail is returned? What do you do with clients who call you up and say they wholly disagree with what you are doing and ask you not to update their terms and conditions?” Asset managers should have a plan for how they will handle these circumstances and to minimise any resulting legal and regulatory risks. Lack of attention to detail and a failure to adequately consider legal and regulatory requirements could expose the firm to significant risks.

There are a number of client consent and disclosure requirements in the FCA Handbook which relate specifically to a firm’s client money arrangements. For most asset managers, the key requirements will arise in the context of delivery versus payment transactions, gone-away clients and transfers of business. However, managers should also be aware of certain other arrangements which might impact the protections available when they deposit client money or otherwise arrange for client funds to be held by a third party; this includes both the FCA’s banking exemption and the use of title transfer collateral arrangements.

DvP exemption

The FCA has radically tightened its delivery versus payment (DvP) exemption for asset managers. Under the previous regime, asset managers were obliged to transfer any cash received on behalf of an investor to the bank account of the client, the fund or a segregated client bank account within four days of receipt. In practice this meant firms treated the client money rules as not applying during this four-day window. But from 1 June 2015, managers must obtain the written agreement of their clients to the manager’s use of the exemption, and the length of the window has been reduced to a single business day. In other words, by close of business on the day following receipt of subscription monies from an investor, or receipt from the depositary or trustee of redemption proceeds from the sale of units in a fund, the relevant sums must be treated as client money in accordance with the FCA’s client money rules.

Understandably, these requirements have proved difficult for the fund management industry to meet because, once the client money rules apply, detailed records and procedures have to be created and audited, controls put in place, and designated senior managers given responsibility for compliance. “It is a huge shift,” explains Thiede. “Previously, many asset managers who held client money for a few days may have gotten away with not having to think about the client money rules. Now the entire industry has to think about the rules because, even if you are set up to pay out any client money you receive within a business day, inevitably there are going to be settlement failures or errors, such as paying money into the wrong account. The client money rules now, in effect, require managers to cover those failures. Because some settlement failures will inevitably occur, managers need to be set up to comply with the client money rules anyway.” Operationally, the new rules eliminate a practice in which asset managers routinely commingled client and house monies in a single account for a sustained period, because they had four days to distribute client funds before the client money rules applied in full. Now, client monies have to be distributed to the client investor or the fund (as the case may be) or moved to a segregated client bank account by close of business on the day following receipt or the full client money rules will apply.

Additionally, the client consent obligation has caused some asset managers to decide to no longer make use of the DvP exemption. It will clearly be off-putting to some clients, especially among retail clients, if they were told their monies will not be protected for a certain time period during the subscription and redemption process.

Unclaimed client money

Another client consent and disclosure issue addressed by the new rules is what to do with unclaimed client money. Investment firms in the UK hold hundreds of millions of pounds in legacy balances, where they have lost contact with the client. These cash balances often are subject to the protection of the FCA’s client money rules, and firms are frequently unable to escape the compliance obligation without an FCA rule waiver because they cannot pay the money away to beneficiaries whose whereabouts are unknown to them. “The FCA has created a mechanism for firms that are holding cash for `gone away’ clients that frees them, after a six-year time period, to pay the money away to charity,” says Thiede. “But it is quite an onerous set of steps to follow, so it remains to be seen if asset managers will go down this path.” Chief among those steps is an off-putting obligation to warn clients in advance that their cash may be paid to charity if they do not keep in touch, even though the firm also remains liable to re-pay the money if the client subsequently re-emerges.

Transfers of business

Another obligation of the kind unconducive to a good relationship with clients is the need to explain to them in advance that their business may be transferred between subsidiaries within the group, or be merged with or sold to a third party. In the past, managers would seek a waiver of the relevant client money rules when a transfer of business was to occur. Now, they must follow a detailed set of rules laid down by the FCA. “The FCA has codified its advice on transfers, so managers no longer need to approach the regulator on an ad hoc basis for permission, so long as you follow the steps the FCA has laid down,” explains Thiede. “But you will run into difficult legal and regulatory issues if you have not obtained the consent of clients in advance to the potential transfer of their business.”

Banking exemption

The banks with which investment firms deposit client cash are in practice usually exempt from the FCA’s client money rules. If that sounds odd, it is not. Banks typically take client money on to their balance sheet as deposits, and so ownership is transferred: banks are looking after their own cash, not that of their depositors.

This means the client of a bank takes on the credit risk of the bank as any depositor would. But the FCA takes the view that the client is adequately protected by deposit insurance and bank equity capital requirement. “One might say that it is easier for a non-bank investment firm to fail than a bank. As a result, the FCA is interested in ensuring that assets and cash belonging to clients are held in such a way that they can be returned to clients as quickly as possible in the event of the failure of the investment firm,” explains Thiede.

Nevertheless, the CASS client money rules do insist that banks explain to clients in writing when they will hold their cash as banker, rather than under the FCA’s client money rules. Asset managers and their clients should be alert to these arrangements, as it will mean that on the failure of the bank, the relevant claim against the bank will likely be unsecured and they will not be able to benefit from the protections the FCA’s client money rules would otherwise have conferred.

Title transfer collateral arrangements

Of course, some asset managers also receive and post cash as collateral on behalf of the funds they manage. Hedge asset managers have long given prime brokers custody of their funds’ cash, as well as securities, with full rights allowing the prime broker to do whatever it wants with the cash, on the understanding that the investment bank will furnish the fund with equity and synthetic financing on attractive terms. If the hedge asset manager posts it by title transfer – which they do, in securities lending, repo and swap transactions in the UK – the cash fully belongs to the prime broker. Under the client money rules, the prime broker needs to secure written consent from its clients, the fund, to confirm the fund (likely acting through its manager) understands the nature of the transaction, and the risks it represents. Asset managers and others who act on behalf of funds should be familiar with these arrangements and the associated risks.

There is a clearly traceable reason why the FCA now insists on documented client consent to transfer title of cash as collateral. One of the issues litigated in the wake of the collapse of Lehman Brothers was the argument by the liquidators of the American arm of the failed firm that the US entity did not understand the consequences of, or otherwise intend for, a title transfer collateral arrangement in the UK. But since the cash transferred by Lehman Brothers in New York to Lehman Brothers International in London was moved by title transfer, the client money protection rules did not apply, and there was no special protection of the client cash under UK insolvency law. The current FCA insistence that investment firms (e.g., prime brokers) make sure their clients understand and expressly agree to these arrangements is a direct response to that litigation. “It is fair to say that clients of all types, including professional clients, did not really understand the consequences of a title transfer collateral arrangement,” says Thiede. “This is why the FCA has beefed up the consent and risk disclosures firms have to make around those arrangements.”

Operational requirements around segregated accounts

One of the key obligations under the FCA’s client money rules is the duty to segregate client money; what this means in practice is less than obvious. Certainly it means recognition in the books and records of the asset manager that it owes money to its clients, that the money held on their behalf does not belong to the firm, and that holdings and transactions in client monies must be recorded separately from the firm’s house monies and transactions. Equally certainly, it means segregation of client money at the third parties which hold them on behalf of the firm. “That means opening a client bank account at the bank and obtaining a countersigned acknowledgement letter from the bank, ensuring that the bank recognises in its books and records that that account is separate from any accounts at the bank that hold proprietary funds of the asset manager,” says Thiede.

Thiede explains that the FCA distinguishes between “normal” and “alternative” approaches to segregation.

Normal approach to client money segregation

Asset managers should be following the “normal” approach to segregation. This entails receiving client monies directly into a segregated client bank account that is separate from any house accounts. “In the past, the FCA rules in this area were rather grey,” states Thiede. “You did not have to receive client money direct into a client bank account provided it found its way into one by the close of the next business day. Operationally, this means most asset managers not making use of the DvP exemption now have to ensure clients and depositaries receive and use the correct payment details for the client bank account, because if a client’s subscription or redemption proceeds are received into a proprietary bank account of the manager, that would result in a technical breach of the FCA rules.” Thiede also noted that such breaches will need to be recorded and shared with their CASS auditors, “meaning that once a year those breaches are going to be reported to the FCA.”[4] There are further rules on the treatment of different types of receipts. Physical receipts, such as cheques, are subject to special rules on how they must be held and recorded in the books and records of the firm precisely because they cannot be paid into a client bank account immediately. In the case of large digital flows into a client bank account, asset managers are given five days in which to earmark and allocate payments between individual clients.

Alternative approach to client money segregation

By way of contrast, asset managers should be aware that certain larger global institutions are permitted to follow instead the “alternative” approach to segregation. “The alternative approach allows one not to segregate client money on receipt (i.e., you do not have to receive it into a client bank account and, in fact, when you receive it, you have until the end of the next business day to decide whether or not you need to segregate it or pay it out),” explains Thiede. “There are detailed rules around the use of the alternative approach which have been introduced, in reality, to limit its use to the 10 or 20 global investment firms (e.g., international investment banks and prime brokers) for which it is operationally more risky to segregate client monies on receipt than not given the range of jurisdictions and time zones involved. The FCA recognises that large firms have cash coming in from different places, for different reasons, throughout the day. Because they have money coming from many jurisdictions and markets all around the globe, there is significant complexity in their operations. Part of the policy behind the alternative approach is that it is actually better for clients if the firm does not receive all client cash directly into a segregated account. “Nevertheless, the way the FCA mitigates the risk of client money being un-segregated is by obliging these firms to set aside an amount of their own cash as client money. The amount that should be set aside is determined periodically by the firm based on several metrics, including the average amount of client money held by it at anytime outside of a client bank account.”

Prudent segregation and “cleared” funds

Asset managers operating the normal approach will also be permitted to hold their own cash as client money in a client bank account to cover specific risks to clients as a form of “prudent segregation.” However, the FCA has of course recognised the risk that firms might use this option as a cash buffer to cover up failings in their client money arrangements, and so it insists that they document the circumstances under which they might pay their own money into the client account, and the occasions when they do so, and secure senior management approval for any such payments. Managers can also expect their CASS auditors to verify that they are in compliance with that policy.

One reason prudent segregation might be operated is to cover uncleared client payments. During the consultation for PS14/9, the FCA proposed that all firms be prohibited from carrying out a transaction for a client until the firm has received sufficient cleared funds from that client, since the funds may be clawed back by the firm’s bank until irrevocable settlement is achieved. Due to the difficulties with determining what constitutes “cleared funds,” the FCA abandoned this proposal, but reinforced existing requirements with guidance that firms should ensure their organisational arrangements are adequate to minimise such a risk. It is obvious that the intra-day risk of investing uncleared funds constitutes such a risk. Asset managers therefore find themselves in an awkward, uncertain and unresolved position.

“The FCA has not told investment firms what it thinks the solution to this problem is,” says Thiede.[5] “A number of managers that are able to do so have decided that the only way to manage the uncleared funds risk is to quantify the value of the payments that might be clawed back on an average basis, and pay that amount of cash up-front, and maintain it on an ongoing basis in the client bank account (as a form of prudent segregation). The FCA is comfortable with you paying your own cash into the client bank account, as long as you have justifiable reasons for doing so, have followed the criteria in the rules, documented the decision, and senior management has signed off on the approach. But not all firms have the capital to do this.” In other words, it is mainly large managers that will be tempted to use prudent segregation as a solution; some even maintaining such amounts of their own funds as client money permanently, despite the cost. As it happens, the FCA was at one point considering the imposition of a requirement on asset managers to maintain a sum equivalent to between 5 and 10 per cent of their average client money balances, as an appropriated amount to cover this kind of risk. “The FCA realised early on in its consultation process that it would put the majority of asset managers in the UK out of business,” says Thiede. “The industry as a whole is lightly capitalised (when compared to credit institutions) and the buffer would have in effect hugely increased capital charges, making it impossible for many firms to continue in business. In summary, the FCA has championed `prudent segregation’ but it is not a solution for all firms.”

Internal and external reconciliation of client money holdings

The last major set of operational requirements concerns reconciliation of internal and external records of client money. The latest changes to the CASS rulebook mean asset managers now face detailed rules and procedures covering reconciliation processes to ensure internal records match exactly what the firm believes it is holding on behalf of clients and that the external records maintained by service providers agree. Inconsistencies must be investigated, and any anomalies in favour of the client paid back immediately. In the past, the FCA requirements for reconciliations of books and records were mostly in the form of guidance. Now they are highly prescriptive rules, and the threat of fines is real.[6] “There are about 10 pages of rules on the internal reconciliation alone,” says Thiede. “This is in part due to the sub-sets and variations of the type of internal reconciliations which are permitted. The FCA sets out a detailed procedure for `standard’ internal client money reconciliations. However, firms are free to operate other procedures. If they do, the reconciliation is deemed `non-standard’ and they have to carry out an assessment of whether or not they think those procedures would deliver certain outcomes required by the FCA’s client money rules. They also have to commission a report from an independent auditor to confirm that the procedures would meet the relevant standards.”

Reporting, Audits and Governance

Asset managers should note that there are other relevant requirements in CASS and the FCA’s Supervision Manual (SUP) and Conduct of Business sourcebook (COBS) which are likely to apply to an asset manager as a result of holding client money under the FCA’s client money rules, each of which were revised and/or updated to reflect the changes introduced in PS14/9.

This includes specific requirements relating to matters such as content of client statements. For example, when reporting on client money holdings, managers are now required to honour all client requests for information and to ensure that it is clear from the report when monies are, or are not, protected under the client money rules.

Another set of new requirements relate to the information provided to clients. Whereas the previous requirements in COBS on information to clients concerning client money generally only applied in respect of retail clients, PS14/9 expanded the relevant disclosure obligations to now apply in respect of all client types (including professional clients). “The FCA took the view that as clients of all types throughout the financial crisis often were unaware of the arrangements in place for the protection of their assets, greater information in the market was required. The hope is this will reduce client queries and disputes that might arise on the failure of an investment firm,” Thiede explains.

The FCA has also conformed its requirements for the CASS Resolution Pack to the changes in PS14/9. Asset managers that hold client money are expected to gather in one place the documentary evidence that underpins their client money arrangements and compliance with CASS. This includes the so-called CASS Resolution Pack, a monument to the ambition of the FCA to ensure that the prolonged and litigious aftermath of the Lehman debacle never happens again. Thiede reports that "the Resolution Pack must contain copies of the client money and custody policies and procedures of the firm, client agreements, the letters of acknowledgement from the banks with which client money is deposited and/or the custodians and brokers by which client assets are held, and the books and records which detail the cash and assets held by asset managers and of any transactions in them." The contents of the Resolution Pack, which must be made available to the FCA or an insolvency practitioner within 48 hours of a firm failing, must necessarily be kept up-to-date. Thiede notes, “to ensure that they are, the FCA can subject them to spot checks and number of asset managers received visits from the FCA during 2014-2015 for this purpose.”

Asset managers must additionally report to the FCA periodically on their total holdings of client cash and other assets through the client money and asset return (CMAR). The CMAR form for monthly submissions – contained in SUP 16.14 – has also been updated to reflect the changes introduced in CASS through PS14/9.[7]

Additionally, once a year, asset managers holding client money must obtain from an independent auditor a report on their client money arrangements and compliance with the FCA’s client money rules (the "auditor’s client assets report"). This report must be submitted to the FCA within four months of the end of the relevant period. Thiede notes that, "in conjunction with PS14/9 the FCA has been working with the Financial Reporting Council (FRC) while it consults on a new assurance standard for these reports. While this new guidance from the FRC should mostly be welcomed, many firms should expect greater scrutiny of their client assets arrangements and in some cases a corresponding increase in the cost of these audits."

Finally, while not new in PS14/9, asset managers that hold client money should be aware that they must allocate responsibility to a senior manager of the firm responsibility for the firm’s client money and, if relevant, custody arrangements. Depending on the average balance of client money and assets held by the firm, this may be a FCA-controlled function (the CASS operational oversight function) and the relevant senior manager may be subject to the FCA’s approved persons regime.


 

[1] Financial Conduct Authority, Review of the client assets regime for investment business: Feedback to CP13/5 and final rules, June 2014, Policy Statement 14/9.

 

[2] A useful summary of the changes, published by the FCA, can be found here: https://www.fca.org.uk/your-fca/documents/summary-of-changes-to-cass-rules-for-investment-firms.

 

[3] For example, in June 2010, J.P. Morgan Securities was fined £33.32 million by the Financial Services Authority (FSA) for failing to protect its clients’ money by lumping it in with its own over a period of almost seven years. In September 2012, the FCA fined BlackRock Investment Management (UK) Limited (BIM) £9.5 million for failing to protect client money adequately by not putting acknowledgement letters in place for certain money market deposits, and for failing to take reasonable care to organise and control its affairs responsibly in relation to the identification and protection of client money. Under the FSA rules, a firm had to have an acknowledgement letter from any bank holding its client money to ensure that, in the event of the firm’s insolvency, client money is clearly identifiable and is ring-fenced from the firm’s own assets so that it can be promptly returned. Between 1 October 2006 and 31 March 2010, BIM failed to obtain such letters in relation to some of the money market deposits it placed with third-party banks. The error occurred as a result of systems changes that followed on from BlackRock Group’s acquisition of BIM, which had previously been known as Merrill Lynch Investment Managers Limited. These changes rendered BIM’s procedures for setting up acknowledgement letters ineffective. The average daily balance affected by this failure was more than £1.36 billion. Had BIM become insolvent at any time during this period, clients would have suffered delays in securing the return of their funds and may not have recovered their money in full. In September 2013, Aberdeen Asset Management was fined nearly £7.2 million by the FCA for failing to identify and properly protect client money placed in Money Market Deposits (MMDs) with third-party banks between September 2008 and August 2011. Aberdeen placed the clients’ money in the MMDs to get a better return for its clients and for risk diversification purposes. However, it did not obtain acknowledgement letters from the banks with which it placed these deposits, confirming that the money held in these accounts was client money, as required by the CASS rules. This was an inadvertent breach, as Aberdeen believed, at the time that these accounts were not covered by the CASS regime on the basis that it did not receive the money itself, and it believed that the arrangements for placing money made it clear to the banks that it was the clients’ money. Once Aberdeen identified the issue, it reported it to the FCA itself and took the appropriate steps to ensure full compliance. There was no client loss and the monies were not mixed with Aberdeen’s own money. If Aberdeen had become insolvent, the only risk was that there may have been a delay in the return of the money while the relevant banks categorically established that it was client money. There was also no risk of set-off by the banks as Aberdeen did not have any borrowings with the relevant banks.

 

[4] Fines for breaches are published in tabular form by the FCA, and its predecessor the FSA, back to 2002.

 

[5] An open question is whether existing real-time payment services (such as Faster Payments) eliminate this risk by guaranteeing irrevocability even though the bank continues to bear credit risk until the payment finally settles in the RTGS, or whether it will take universal real-time payment, as proposed in Europe, to eliminate this risk.

 

[6] In November 2013, for example, SEI investments Europe (SEI) was fined £900,200 for shortcomings in internal reconciliation that failed on several occasions between November 2007 and October 2012 to ensure that any shortfall or excess identified in its internal client money reconciliation was paid into or withdrawn from the client bank account by close of business on the day of the internal reconciliation, and failed to appreciate that it was using a non-standard method of internal reconciliation. SEI therefore failed to ensure that it maintained its records and accounts in a way that ensured their accuracy. Failings were found throughout the SEI client money processes, indicating that its client money arrangements were inadequate. SEI failed to train employees with operational oversight and responsibility for client money. On one occasion, an SEI employee who had not received any CASS training manually adjusted the client money requirement of the firm from the £14 million calculated using the internal client money reconciliation to £932,000, on the basis of his assumption that the £14 million shortfall was of an unprecedented amount and was therefore inaccurate. The FCA pointed out that, had SEI become insolvent, these failings could have led to complications and delay in distribution and placed client money at risk. The average daily balance of the client money accounts during the relevant period was approximately £84.3 million.

 

[7] The CMAR form can be found here: http://fshandbook.info/FS/html/handbook/SUP/16/14.

 

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