Client Assets: overview and update

1
Client Assets overview and update

• Simon Crown
• Clifford Chance LLP
• 11 October 2010

2
Consequence of failings

• Enforcement actions and fines
• Rowan Dartington - 511,000
• Chase Investments - 98,000
• J.P.Morgan Securities Limited - 33 million
• Popularity of FSMA section 166 appointments
• Lessons from Lehman and related litigation

3
General - Client Money Rules

• Main purpose firm must arrange adequate
  protection for clients assets when the firm is
  responsible for them (CASS 7.1.16G)
• CASS 7.3 requires adequate arrangements and
  adequate organisational arrangements (no
  guidance on meaning)
• CASS 7.4 requires segregation, achieved through a
  statutory trust
• Intention is no credit exposure as regards the
  firm i.e. client money not available to firms
  creditors if firm insolvent (BUT on distribution
  following insolvency, distribution expenses can
  be deducted)
• Segregation client bank account, must not
  contain firms own money (essential for operation
  of trust) NB normal approach v alternative
  approach (CASS 7.4.14G)
• CASS 7 applies to firm that receives money from
  or holds money for, or on behalf of, a client in
  the course of, or in connection with EITHER its
  MiFID business (7.1.1R) or its designated
  investment business

4
When CMRs dont apply

• Title transfer collateral client transfers full
  ownership of money to a firm for the purpose of
  securing or otherwise covering present or future,
  actual or contingent or prospective obligations
  (CASS 7.2.3R). NB doubtful applies to retail
  clients (and see FSA CP 10/15 proposal to
  prohibit use with retail clients)
• Two-way opt-out for non-MiFID business for
  professional clients ONLY
• Affiliates non-MIFID business - cash held for
  such must NOT be treated as client money (subject
  to exceptions e.g. money belongs to a client of
  the affiliate, or deal at arms length, CASS
  7.1.12A)), BUT if MiFID business, affiliates MUST
  be treated same as other clients (CASS 7.1.12G).

5
Effect of CMRs the creation of a statutory
trust (CASS 7.7.2R)

• NB - CRC Credit Fund v GLG (Lehman litigation)
  trust applies on receipt of client money (not
  just when segregated)
• Notification of trust to bank (CASS 7.8.1R)
  bank must acknowledge cash held by firm on trust,
  limit set-off and designate account (if not, must
  change bank).
• Firm holds client money on trust
• For the purposes of and on the terms of CMRs and
  CMDRs
• For clients for whom the money is held
• On firms failure (NB in this context means
  insolvency), for payment of costs attributable to
  distribution of client money (note potential
  concern re extent of this right on insolvency)
• For the firm (after claims and costs as above
  have been met)

6
Discharge of CMR statutory trust

• Cash held for a client ceases to be subject to
  the client money trust (CASS 7.2.15R) if such
  cash is
• Paid to the client
• Paid to a third party on the clients
  instructions (unless CASS 7.5.2R applies -
  transfer funds to third party (exchange/clearing
  house/intermediate broker) in course of effecting
  a transaction and intend such party to
  hold/control client money permitted not
  required)
• Paid to the firm when due and payable to the firm
• Paid to the firm as excess on the account

7
How to hold client money under CMRs

• CASS 7.4.1R in client bank account (central
  bank, BCD credit institution, bank authorised in
  third country) or qualifying money market fund
• CASS 7.5.2R exception to the above person
  such as an exchange, clearing house or
  intermediate broker may hold or control client
  money, but ONLY if transferred to such entity by
  firm for the purpose of a transaction for a
  client through or with that person or to meet a
  clients obligation to provide collateral for a
  transaction. If client is a retail client,
  client must be notified client money may be
  transferred to such person.
• Non-bank not required to give same trust
  acknowledgement as bank, but CASS 7.8.2R where
  firm undertakes contingent liability
  investments for client through exchange,
  clearing house, intermediate broker or OTC
  counterparty, such person must agree to limit its
  set off rights.

8
Default by firm or approved bank/ intermediate
broker under Client Money Distribution Rules
(CMDRs)

• CMDRs are in CASS Chapter 7A these rules seek
  to facilitate the return of client money to a
  client in the event of insolvency of firm (or 3rd
  party bank with whom hold client money)
• primary pooling event means firms insolvency
• Pooling of ALL client money in all client money
  accounts, however designated
• Distribution rateably according to entitlements
• Client money received after this event not pooled
  but returned to client (unless due to firm or
  relates to unsettled transaction)
• secondary pooling event means insolvency of
  approved bank or intermediate broker
• Firm may decide whether to
• top up with own money to cover shortfall or
• for any shortfall to be borne rateably by all
  clients according to entitlements
• Designated client bank accounts and designated
  client funds account NOT included in same pooling

9
FSAs increased focus

• FSA focusing on how client assets are protected
  general letter to all Compliance Officers (20
  March 2009), and all CEOs (19 January 2010)
• Client Money and Asset report, January 2010.
  General view that much more must be done to
  ensure firms are in compliance with CASS rules
• CP 10/9 (March 2010) Enhancing the Client
  Assets Sourcebook. Included proposal to limit
  client money holdings with group bank to 20 of
  total client money holdings CASS oversight
  controlled function new client money/client
  assets return
• CP 10/15 (July 2010) Quarterly consultation.
  Title transfer of cash collateral by retail
  clients to be prohibited.
• CP 10/20 (September 2010) new audit report
  requirements proposed

10
Custody legal analysis - Securities

• Intention client retains ownership to
  securities, and will still have property rights
  if custodian insolvent (securities are not
  available to custodians general creditors), but
  custodian has authority to control/transfer title
  to assets as legal owner
• Possible legal analysis of custody relationship
  under English law
• Holding of securities may be bailment OR trust
• Bailment requires possession/tangibles (rarely
  feasible unless holding only physical assets e.g.
  bearer securities, bullion, coins and notes)
• Trust need certainty of intention, beneficiary
  and subject matter (not essential to refer to
  securities being held on trust but clearer if
  do)

11
Custody legal analysis - Cash

• Cash different from securities since cash is a
  debt owed
• Custodian may (1) have mandate to control
  clients bank account OR (2) hold as banker
  (i.e. owes debt) OR (3) hold as trustee (i.e.
  holds on trust a debt owed to it by third party
  bank)
• Other issues if not a bank, a UK custodian
  holding cash for clients will be subject to the
  FSA client money rules (unless relevant exemption
  applies) and must hold on client money trust
• Note Custodian may have some agency functions
  but does not HOLD securities or cash as agent

12
Custody - FSMA RAO

• Main legislation -Financial Services and Markets
  Act 2000 (FSMA) regulatory regime, and The
  Financial Services and Markets Act 2000
  (Regulated Activities) Order 2001 (SI 2001/544,
  the RAO)
• The following constitute regulated activities-
• RAO Article 40 safeguarding AND administering
  (see Article 43 for what is not administration)
  securities or contractually based investments
  (see definitions broadly financial instruments
  not e.g. real estate, bullion) or arranging
  provision of such
• RAO Article 64 agreeing to safeguard/administer
  or arrange
• Possible exemptions e.g. RAO Art 41 (nominees)

13
Custody CASS COBS

• COBS general requirements (client
  classification etc), see also 6.1.7 (risk
  warnings) and 16.4 (statements)
• CASS 6 broad general requirements CASS 6.2.1R
  requires adequate arrangements so as to
  safeguard clients ownership rights, especially
  in the event of the firms insolvency, and to
  prevent the use of safe custody assets belonging
  to a client on the firms own account except with
  the clients express consent (copies MiFID Art
  13(7) but no guidance) CASS 6.3.1R requires all
  due skill, care and diligence in selection,
  appointment and periodic review of delegate
  CASS 6.3.4R, cannot use unregulated subcustodian
  in jurisdiction which regulates holding of client
  assets
• CASS 6.2.3R, specific requirements regarding
  registration of title (not a requirement of MiFID
  or the Implementing Directive )
• Limited application of CASS to arrangers,
  trustees (i.e. trustees not relying on RAO
  Article 66) and depositaries

14
Custody other issues

• Liability for delegates
• Custody as outsourcing?
• Depositary liability under proposed AIFM
  Directive
• FSA CP 10/9 Enhancing the Client Assets
  Sourcebook Firms to be prohibited from
  allowing delegates lien/retention rights over
  client securities except regarding their
  "charges" in respect of those securities. Query
  what charges means, and whether this is
  reasonable (already is a disclosure obligation).

15

• Simon Crown
• Partner
• Clifford Chance LLP
• 44 20 7006 2944
• simon.crown_at_cliffordchance.com