New asset protection rules proposed for the United Kingdom
Consultation paper CP 13/5, published by the Financial Conduct Authority (FCA) on Friday, sports the unenticing title of Review of the client assets regime for investment business. But it is of more than usual interest to fund managers, since it is the latest stage of a prolonged review by the FCA of its own rules on how regulated firms should safe-keep and segregate client cash and securities, how quickly and fully they can be retrieved if a firm fails, and of how expeditiously collateral and positions held through clearing brokers and central counter-party clearing houses (CCPs) can be ported from an insolvent clearing broker to a solvent one.
The consultation paper is, in other words, part of the regulatory response to criticism of the speed at which insolvency practitioners in the United Kingdom returned assets to their owners when Lehman Brothers International and MF Global failed. Many fund managers were dismayed to find that assets they thought were held in segregated client accounts - as prescribed by the client money protection rules of the then-regulator, the Financial Services Authority's (FSA) rule book - could not be returned to them until the administrators had worked out whether or not they were available to cover third party costs or belonged to someone else to which Lehman had re-hypothecated them.
Lehman failed in September 2008, and the FCA and its predecessor have had a Client Assets Unit looking at the issue of client money safety and segregation since 2010. Yet it was not until the conclusion of the Lehman Brothers International Supreme Court case in February 2012 that the regulator was free to undertake a fundamental review of its rules on the treatment of client money. That case, concluded three and a half years after the failure of Lehman Brothers International, established that client monies trapped in failed firms, whether they are segregated in client bank accounts or transaction accounts or simply should have been properly segregated under the rules of the regulator, were entitled to share in any distribution by the administrators.
The fact that it took more than three years for PwC, the administrators to Lehman Brothers International, to establish in law what it could do with client monies, ending in a judgement which ensured that every creditor received less because it widened the pool of eligible claimants, clearly necessitated a review of rules that had created such prolonged uncertainty and such an unsatisfactory outcome. As the FCA concedes in CP13/5, a large part of the purpose of the current review is quite simply to “improve the speed of return of client assets” and “achieve a greater return of client assets” following the insolvency of an investment firm.
The consultation paper proposes distributing client monies based on the records of the failed firm rather than waiting to establish the soundness of the claims of clients. The FCA reckons this change could see assets returned within weeks rather than years, albeit at the cost of disappointing some claimants completely. Lehman Brothers International had actually segregated $2 billion of client money properly, and the goal of the new regime is to release such readily identifiable assets quickly. The FCA explicitly recognizes that it is sacrificing accuracy for speed, but reasons the negative impact on firms of prolonged loss of control of assets outweighs the risk of injustices occurring.
However, even the reformed regime would still see interim distributions only: assets not clearly held in named client bank accounts, or readily identifiable as belonging to the client in a transaction account, would be held back in a “residual client money pool.” Worse, if splitting the money between easy-to-identify-the-owner and hard-to-identify-the-owner assets proves impossible – and the improved regime hinges on the accuracy of the records maintained by the failed firm - something very like the current combined pool would persist. After all, Lehman Brothers International may have segregated $2 billion, but plenty of other assets were not earmarked properly.
Fund managers based outside the United Kingdom may well wonder why the FCA cannot attain a combination of the speed and accuracy achieved in other jurisdictions, notably the United States and Canada. But the FCA reckons this is all it can promise without the government making further changes to the law on the management of insolvencies. A large factor in the delays is a peculiarity of United Kingdom law on insolvency: the imposition of personal liability on insolvency practitioners for any errors in distribution. This, coupled with another factor absent in North America – the liability of client monies to contribute to the costs of an insolvency administration - naturally predisposes insolvency practitioners to undertake painstaking investigations of all possible entitlements.
The United Kingdom government has in fact altered the insolvency regime somewhat, introducing the Special Administration Regime (SAR) in 2011. It was used for the first time in the MF Global insolvency, and did see some assets released more promptly, but Peter Bloxham, the former Freshfields partner invited by the government to review the SAR regime concluded it had “proven helpful, though it has not proven to be a panacea.” Interestingly, his first recommendation was the introduction of a mechanism “to facilitate rapid transfer of customer relationships and positions, where feasible,” not least because the European Market Infrastructure Regulation (EMIR) that makes centralised clearing of swaps mandatory in Europe also introduces the concept of porting positions and collateral.
So it is no surprise to find CP 13/5 also proposing changes to the FCA rules to put an end to the current practice of all client monies being pooled for pro rata distribution to clients in the event of a failure by a market participant. Instead, clearing brokers can put client monies posted as margin to clearing brokers and CCPs into separate client money pools that insulate client assets from the risk of loss to a particular clearing broker default or type of business being cleared. A substantial benefit of this form of segregation is to facilitate porting of collateral alongside positions if a clearing broker fails.
The FCA consultation document has other detailed proposals on which the regulator is seeking comment. For example, it is also arguing that the liquidation value of collateral posted against positions held by a failed clearing broker – not the value determined by the closing out of the open positions – should govern the value paid to clients. If a CCP fails, and a shortfall arises in client accounts, the FCA is proposing that the clearing brokers apportion losses between the clients affected and not all clients on whose behalf they hold funds.
In an event of default, or the failure of a firm, such details matter. And there is plenty of detail in a document that includes 80-odd pages of closely typed text discussing the proposed changes to the rules alone. They will take time to digest and understand. For managers already grappling with AIFMD and FATCA, keeping on top of the changes to client asset protection rules in the United Kingdom is an unwelcome addition to the growing burden of regulatory change. But getting asset safety and segregation arrangements right, as the victims of Lehman Brothers International can testify, is not a luxury but a necessity.