The collapse of Lehmans Brothers and MF Global outlined commercial challenges in respect of client assets and client money, including the role of regulated investment firms, the regulator, administrators and external auditors and focused attention on the management and protection of client money and assets, to avoid the impact of an insolvency.
Following a detailed review by the Financial Conduct Authority (the FCA) of its legislative framework, the FCA introduced significant changes to the rules that govern investment firm’s conduct when handling client money and custody assets, aimed at improving firm’s systems and controls around segregation, record keeping and reconciliations. Amongst other things, investment firms will need to provide the FCA with clear reporting of how their funds are being handled and where the assets are located.
These regulatory changes are being implemented in three phases by way of amendments to the Client Assets Sourcebook (CASS). The first phase was implemented in 1 July 2014, with the second and third phases to be effective from 1 December 2014 and 1 June 2015 respectively. In many cases, the 1 December deadline applies the changes to the rules to new clients and the 1 June 2015 applies to changes to the rules to existing clients.
The phased approach is designed to allow investment firms more time to implement the changes. But even with the phased in approach, the timescales remain challenging and some investment firms may decide to implement the changes for both new and existing clients at the same time.
Implementation of the changes will be a costly affair for investment firms and must be implemented effectively and within the time limits specified. Fines for non-compliance with the rules are likely to be tough and there is likely to be little sympathy for misinterpretations of the rules or for non compliance within the deadlines.
This client alert highlights some of the key forthcoming provisions that will, for most affected investment firms, necessitate changes to their internal policies and client facing documentation.
Changes applicable to both client money and custody assets Whilst the rules in many instances will provide for more stringent conditions to be observed by investment firms, certain sections of the CASS rules are being liberalised.
Investment firms will be permitted to transfer unclaimed client money or custody assets to a registered charity if there has been no activity on the client’s account for at least six years for a bank account and more than twelve years for a custody account. The investment firm must take reasonable steps to return the unclaimed assets to the client and if such attempts are unsuccessful then it will be allowed give the proceeds to a registered charity. This change helps deal with unclaimed client funds, such as dividends on shares or manufactured income from stocklending activities and stops investment firms holding them as client money indefinitely.
From 1 December 2014, an investment firm will have a number of methods at their disposal to transfer client money to a third party during the course of the firm transferring its business, thereby ensuring that the money in question will cease to be client money. To do so, it may either (i) obtain consent from each affected client; or (ii) provide for such a right in its terms of business. Consent will not be required where the monies held amount to less than £25 for a retail client and £100 for other clients but where there is a right in the terms of business or this de minimis carve out is relied upon the FCA must be notified seven days before and the relevant client seven days after the transfer.
Modified client money rules A number of CASS rules have been amended to strengthen protections afforded to clients by requiring investment firms to segregate client money. In particular:
- Under the so called "normal approach" each investment firm will be obliged to ensure that the client money it receives is paid directly into the client's bank account held with a CRD credit institution, a qualifying money market fund or other eligible institution specified in CASS, rather than first receiving the client money into its own account and then segregating it before it is paid to the credit institution. Under certain limited circumstances, where the use of the normal approach could lead to significant operational risks to client money protection for a particular business line of an investment firm (e.g. due to the complexity of client transactions), an "alternative approach" may be used, where the client money is received into the investment firm's own bank account and then paid over. The ability to use the alternative approach is subject to meeting a number of strict conditions laid out in CASS, including the submission of a written report to the FCA prepared by an independent auditor which addresses ,amongst other things, the suitability of the firm’s systems and controls for the alternative approach.
- Increased record keeping requirements, especially in respect of reconciliations. Accurate records must be kept to ensure that the investment firm can accurately determine the total amount of client money that it should be holding for each client within two business days of having taken a decision to do so or upon the request of the FCA.
- Investment firms will need to repaper their existing acknowledgement letters by 1 June 2015, using the templates set out in CASS. The acknowledgement letters will need to be countersigned by the relevant counterparty (e.g. exchange clearing house, intermediate broker) to ensure that it acknowledges that money deposited with it is client money and consequently that it does not have any recourse or rights against the money standing to the credit of the client bank account that it holds.
Custody of assets There is also to be a tightening up of the rules applicable to client assets:
- Investment firms will only be permitted to register their own assets in the name of the client in limited circumstances, such as correcting transaction errors relating to client positions, allocating transactions for bulk deals, addressing a shortfall in custody assets using the investment firm’s own assets. It should be noted that this rule is not designed to prevent investment firms from retaining nominal amounts registered in the same name as the client custody assets, as long as it is done for the purposes of facilitating the client’s transactions.
- Investment firms will have to follow a new set of criteria when selecting third parties with which to deposit custody assets. They will also have to document how they satisfied themselves as to the appropriateness of their selections.
- Written agreements meeting the provisions in CASS will need to be in place whenever custody assets are placed or arrangements are made to place custody assets with third party custodians even where that third party is an associate of the investment firms.
- Written agreements meeting the provisions in CASS will need to be in place for all title transfer collateral arrangements.
- Information requirements currently in place for retail clients will apply equally to professional clients and eligible counterparties and with respect to all types of assets.
- The new rules reinforce the obligation of an investment firm to consider retail clients’ best interests when agreeing a right of use arrangement with the client.
- From 1 June 2015, the internal policies of investment firms will need to comply with the new guidelines relating to discrepancies and shortfalls. If a discrepancy leads to a shortfall in a client’s assets and the investment firm is unable to determine that another person is liable for such discrepancy, it is required to cover the shortfall of the client from its own resources until the discrepancy is resolved.
Conclusion Investment firms clearly have a number of important changes to contemplate and adhere to by 1 December 2014 or 1 June 2015 as the case may be. They will need to consider carefully the new CASS rules to ascertain their impact on their business lines and customers. It is advisable for them to review their internal policies and customer documentation to determine what changes are required to meet the new requirements, in particular their proforma client facing documentation to ensure that it adequately addresses all the matters that investment firms are required to disclose pursuant to the new CASS rules.
Client Alert 2014-284