Client money – change please

The Financial Services Authority is on a mission – to restore investor confidence. This mission has recently brought the watchdog’s focus onto client money and assets with a warning of tighter rules and increased supervision following some dramatic instances of large-scale mismanagement.

Although there are already well established rules about the treatment of client money and assets in the UK cases such as the collapse of US investment bank Lehman Brothers have made it clear that firms have not always followed them. Earlier this year the City watchdog wrote to the chief executives of the top 1,000 investment companies and insurance brokers expressing concern that firms are not according adequate protection to client money and assets and announcing that it would be stepping up its supervision and enforcement in this area. It also attached its latest Client Money and Asset Report and asked the CEOs to reply, confirming compliance with their firms’ obligations under the FSA’s Client Assets Sourcebook (CASS) and naming the person at their firm who has oversight responsibility for CASS compliance. Requiring CEOs to give what seems to be a written warranty shows that FSA means business.

Client money and assets belong to a client but are held for safekeeping by an investment firm on behalf of the client under a statutory trust. The firm may be holding the money/assets to enable the provision of brokering, trading or portfolio services, and unlike banks, investment firms are generally required to separate client money and assets from their own. The liquid nature of client money (as opposed to assets) means that client money accounting systems in larger firms can be hugely complex. However, with billions of pounds of client money at stake at any one time, the message from the FSA is clear – it has a low tolerance for CASS compliance failures and will take enforcement action where necessary. In particular, it will look to pin the blame on senior management.

Inadequate supervision

The FSA’s report and letter followed the High Court judgment of 15 December relating to the distribution of more than $2bn of client money held by Lehman Brothers International (Europe) (LBIE) when it went into administration in September 2008.

The Court ruled that clients of a firm in administration are entitled to their share in the client money pool constituted as at the time of administration, and that if the pool were not big enough to cover each client’s entitlement, the pool must be shared in proportion with the size of each client’s claim at the time of administration. Central to the Court’s findings was that if a client’s money was not segregated properly by the firm in accordance with CASS before administration, clients would not
have an entitlement in that pool and would instead have to bring a separate proprietary claim. In practice, this may have little more chance of success than an unsecured creditor claim, since the client would need to “trace” the money in question within a potentially complex and lengthy history of credits and debits. This ruling acknowledges that MiFID, from which CASS derives in large part, creates no new legal safety net for clients whose funds are misappropriated by firms and that legal remedies against firms must instead be found in general UK law.

Although this judgment is being appealed, it still casts huge doubt over CASS as a framework for client money protection. It also serves as a stark reminder that LBIE’s systems and controls were inadequate, resulting in its failure to carry out proper reconciliation of its house accounts and to segregate its client money. That this was not picked up on by the FSA is a clear testament to insufficient supervision and enforcement on its own part. HM Treasury has already issued a lengthy consultation paper on the failure of investment firms, parts of which look to address some of the defects highlighted by the judgment.

FSA reaction

The City watchdog’s reaction has been swift. Besides writing to the CEOs of the industry’s top 1,000 firms, it has also committed considerable resources to assessing standards of compliance with CASS and is pursuing a much more intrusive approach to enforcement. In March last year it created a CASS Risk Team to visit investment firms and insurance brokers and the conclusions of its Client Money and Asset Report are largely based on this team’s findings.

The visits revealed that compliance with CASS, as well as levels of awareness of compliance, is generally poor across the industry and in many cases the FSA took disciplinary action including forcing firms to hire outside consultants to examine their systems and controls, freezing a firm’s assets and even imposing a ban on taking on new business.

The FSA is keen to emphasise that this is just the beginning – there will be more visits, with similar action taken where necessary. It has also warned that in the context of client money protection it believes the responsibility for compliance ultimately lies with senior management, even if failings are on the part of junior staff.

It is also keen to work with the accounting profession to improve standards in CASS audits and has set up a number of trials with firms to find a suitable client money reporting system with a view to rolling it out by 2011.

Firms take note

The FSA is focusing on weaknesses found by the CASS Risk Team, including poor management oversight and control; over-simplified due diligence into institutions holding client money and issues with the letters with those institutions acknowledging trust status; segregation and/or reconciliation failures and breaches of trust/contract; vulnerability during M&A/restructuring; inadequate monitoring of third-party administrators and over-reliance on client money audits.

Given its increased interest in this area, all firms subject to CASS are well advised to carry out thorough checks of their governance arrangements, reporting lines, policies and procedures, and systems and controls relating to client money and assets. More particularly, firms should ensure they have taken the following steps:

- Governance - put in place robust governance arrangements and detailed management information to help senior management evaluate, monitor and mitigate the firm’s CASS risks. Senior management must have a genuine understanding of why those policies are required and how the mechanics of their firm’s particular arrangements work.

- Verification - verify that each institution appointed to hold client money has provided a letter confirming the firm’s status as trustee in respect of each of its client money accounts. These letters must quote the name and number of each account and be signed by an identifiable representative of the institution in question. Each account must have a unique name and the letter must confirm that the bank may not exercise any lien or set-off against the firm in respect of balances in the client money account.

- Due diligence - thoroughly check out any bank or institution before transferring client money and consider whether it is in the interests of the client to appoint several institutions to hold client money to reduce risk. Details of this due diligence should be recorded.

- Segregation – where client money is mixed with house money, however temporarily, the portion of that money that represents client money must not be put at risk pending the next reconciliation and segregation process. Firms must ensure that there are adequate arrangements to safeguard clients’ ownership rights.

- Legacy balances - these must be dealt with promptly and the transfer of client money to the firm may only be made in very limited circumstances and must require the firm to fully discharge its obligations under any credit write-back.

- Reconciliations - record accuracy is key and firms need to consider how often reconciliations need to be done to maintain accurate records that correspond to client holdings and to distinguish client money and assets at any time and without delay.

- Third-party agreements - these should be reviewed and updated periodically and firms should visit third-party administrators to assess security and CASS compliance, and should meet them regularly to discuss performance, regulatory matters and assess business continuity matters including plans for disaster recovery back-up facilities. If there is any evidence of non-compliance, firms must have a right to, and must take appropriate remedial action.

- Terms of business - firms should review all agreements they enter into with clients to ensure they comply with CASS and other applicable FSA rules, particularly in respect of any “title transfer collateral arrangements” (see below), which the FSA has indicated are no longer suitable for use with retail clients.

- M&A - where a firm is looking to acquire another, it must carry out due diligence and assess and mitigate any risks to the appropriate segregation of funds. Such risks include the impact of non-compliant terms of business on trust arrangements and the implications of any transfer of funds between the client accounts and the firm’s accounts.

- Records - proper records explaining transactions and commitments of its client money must be kept by firms for three years and information on fiduciary obligations kept on an on-going basis.

- Auditors - firms must verify that the appointed auditor has the appropriate skills to conduct client money audits and firms must retain oversight over the audit process as auditing by a third party does not guarantee regulatory compliance. The firm remains responsible for any breaches.

- Training - staff must receive on-going training on the protection of client money and assets and at any given moment a firm must be satisfied that its systems and controls, policies and procedures and senior management could withstand the scrutiny of an on-site ARROW visit.

But it’s not just down to the firms to maximise the protection of client money. In light of the lessons learned from the failure of LBIE, there are a number of steps clients should take to minimise the risks they may be exposed to. These include:

- Rights - clients should ensure they understand their contractual rights in relation to i) money they pay to the firm (or that the firm receives from third parties) and ii) money the firm owes them in the course of providing services.

- Protection - clients using firms offering investment services that are also a licensed bank may not enjoy any client protection whatsoever. Their money will be treated as a deposit, ie as a debt, and will fall outside CASS.

- Terms of business - do these provide for any “title transfer collateral arrangement”? These arrangements are common where services provided by firms include the execution of margined transactions. In these cases the firm will not be acting as a trustee in respect of the money it received as this is deemed as held by the firm as collateral. Full title of the money actually passes to the firm and the client becomes a creditor. In some instances, a firm may be satisfied with a “right to use” client money under charge, rather than a full title transfer so it is worth raising this possibility.

- Time scales - if the service a client is using could result in the firm owing the client money as a debt, such as profits from a contract for difference, it should be clear how quickly the firm will discharge this debt. The safest option is to require immediate payment, but sometimes money could be retained for future services. This should be segregated into a client money account as soon as possible.

- Due diligence - does the firm comply with its obligations under CASS and does it use the “normal” or “alternative approach”? While the normal approach to handling client money means firms are required to receive and pay client money directly from a client money bank account and regularly clear that account of any of its own money, firms operating in a multi-currency and multi-product environment may use the FSA’s alternative approach for client money segregation. This involves receiving and paying client money directly from the firm’s own house accounts and segregating an amount equal to the value of client money into a client account through a daily reconciliation process.

- Liquidity management process - firms operating the alternative approach are riskier in the sense that long-running undetected failures to reconcile and segregate may significantly harm the chances of a client successfully recovering its money. This may be particularly relevant where a firm operates a liquidity management process, which sweeps up banked cash into one centralised location on a short or medium-term basis until their original source is identified, or until required elsewhere.

- Client money buffer - this can mitigate the risk of failing to segregate the correct amount of client money for firms operating the alternative approach. It is a fixed amount segregated daily into the client account, calculated on an historical average of the amount required. Interestingly, LBIE maintained such a buffer with the blessing of the FSA and in theory this should have reduced the risk to clients. In the event, the size of the buffer did little to compensate the overall shortfall, but it is still worth inquiring about.

- Location - firms are allowed to hold client money in a number of different locations. Choosing a firm that uses a location outside of its group may reduce the risk of a huge funding shortfall in the case of insolvency.

- Check - the chances of recovering client money from the client money pool if a firm becomes insolvent will be affected by whether that client’s money has in fact been segregated by the firm and is therefore part of the pool at the time of administration. This means clients must check any statements from the firm and do their own reconciliations, confirming they match their understanding of what should be happening with their money.

The FSA has got the bit between its teeth. It has published its report, put CEOs on notice and will continue to liaise with and visit firms to assess levels of CASS compliance. The watchdog will this year consult on amendments to CASS 7 to take into account the eventual outcome of the LBIE case, and also the recent bold measures being consulted on by the Treasury, which are aimed at increasing the protection afforded to client money.

With so much going on, firms should work closely with the legal advisers and auditors to confirm that their systems and controls are compliant and being run in accordance of the rules in respect of all clients, which may include affiliate companies. For clients, the picture is equally clear – review existing arrangements as there is plenty that can be done to maximise protection for their money under the existing legal and regulatory framework.