One of the by-products of the Lehman insolvency is an increased focus on client money protection. The decision of Briggs J in the Lehman case concerning client moneys, reported as Lehman Brothers International (Europe) (in administration) v. CRC Credit Fund Limited & Ors, [2009] EWHC 3228, highlights a number of deficiencies in the current regime.
The client money rules are to be found in the Client Assets Source Book ("CASS") of the Financial Services Authority (“FSA”), which sets out the regulatory framework under which regulated firms operate. These rules were made pursuant to the European Markets in Financial Instruments Directive (“MIFID”), which requires member states to implement the directive as closely as possible, without adding gold plating.
Under CASS, there is an “alternative approach” to protecting client money, under which, instead of segregating client money on receipt, a firm is permitted to receive client money into a house account and meet client money obligations from house accounts (e.g., when paying money to the client), on the basis that there is an obligation to perform a daily reconciliation of client money and transfer the relevant amount to segregated client accounts as soon as such a reconciliation has been effected. In the Lehman case, it was held that where client money is received from a client or from a third party for the account of a client, the trust arises upon the firm’s receipt of the money. The obligation to segregate arises when the firm comes under an obligation to appropriate money and pay it into a segregated account to meet the client money obligation or, to pay into a segregated account, money paid in by or for the account of a client. Until the monies are appropriated and transferred to a segregated account, this obligation is a purely contractual obligation. Where client money is received by a firm using the “alternative approach,” it does not cease to be client money when received by the firm and become client money again on segregation: It remains client money throughout. Until it is, in factm, segregated by a firm using the alternative approach, the firm is not free to use the money for its own general purposes, which goes into its house accounts, but must deal with such money in such a way that clients are not put at risk.
On the failure of a firm (which includes entering administration), client money is pooled. On the construction of CASS, it was held that the client money pool extends only to client money that has been segregated and includes all segregated money. Two consequences of this are (1) even if a particular segregated client account has been used specifically for one client only and the whole of the money in that account belongs to that client whilst the firm is a going concern, on failure of the firm that money is pooled and does not belong wholly to that client; and (2) clients whose client money has not, in fact, been segregated do not share in the pool and need to be able to trace in order to establish trust rights over any assets of the firm. Clients’ shares in the client money pool are assessed by reference to the amount which has been segregated (the contribution basis) not by reference to the amount which should have been segregated (the entitlement basis). The date for calculating clients’ shares in the client money pool, where a firm enters administration, is the date when the company enters administration (the date of the administration order where the administrator is appointed by the court).
It follows from the above that, where there has been any defective compliance with the client money rules, clients are at risk. It is likely that where money has not been segregated and held in the manner in which trust money should be held, ordinary trust law will not operate so as to rescue clients from the consequences of the defective compliance, unless they are able to trace and this will remain the case, whatever client money rules might say in the future. The whole system, therefore, depends on strict compliance with the client money rules, and it is relevant and topical to consider what steps are being taken to improve compliance.
In its “Client Money and Asset Report” in January 2010, the FSA reported on the result of visits to a range of investment (and other) firms to review their compliance with CASS. These visits identified a number of failings. Examples of poor practice highlighted in that report were: (1) some firms could not locate trust acknowledgement letters from banks or other third parties for each of their client money accounts; (2) many firms had not checked whether the acknowledgement letters contained the required details; (3) due-diligence concerning the selection and use of banks was often inadequate or poorly documented; (4) client money and asset reconciliations were delayed or completely overlooked; and (5) inappropriately claiming ownership rights over client money.
All of these failings mean that client money could be at risk on the failure of a firm. Therefore, it is important that the FSA take steps to improve compliance. The report was sent to firms with a request that they respond to the FSA confirming that they were satisfied with the arrangements their firm had for the handling of client money and client assets. A chaser was sent by the FSA in May 2010 to those who had not responded, reminding them of the need to confirm, by June 30, 2010, that the firm had properly considered the content of the January report, whether or not the firm was complying with its obligations for client money and assets and the name and contact details of the person in the firm who had overall responsibility for such compliance.
Compliance failures are not new. In June 2010, the FSA published details of fines on a number of firms for failing to segregate client money. One investment firm was fined £100,000 for not properly segregating or holding in trust accounts money relating to unregulated collective investment schemes which the firm managed. Another investment firm was fined £500,000 for problems with new software, which the firm did not properly test, led to a breakdown in its reconciliation process so that it could not be sure how much money it should segregate; it also failed to segregate client money for some parts of its business. Enforcement action has also been taken against two individual insurance brokers for other breaches of the client money rules.
By far, the largest fine was imposed on JPMorgan Securities Limited, which was fined £33 million for failing to segregate overnight money of futures and options business clients held by an affiliated bank. The problem resulted from the merger with Chase; it was not deliberate and the firm reported the failures itself, and took action to remedy the problem as soon as it was discovered. The fines related to up to £15.6 million of client money and the problem had continued over a period of seven years. The FSA reported that “[h]ad the firm become insolvent at any time during this period, this client money would have been at risk of loss." The FSA warned that it had similar cases in the pipeline and called on the City to take notice of its compliance crackdown.
Looking forward, should we expect to see better compliance with the rules? Here, besides compliance checks by the regulators, one might expect auditors to have a significant role to play. On one view, client money and client assets, being trust assets, are outside a firm’s asset pool, and therefore are not a subject for a routine Companies Act audit. Nevertheless, since the ability of a company to continue in business, and avoid being subject to fines, can be said to depend, at least in part, on proper compliance, one might expect auditors to address the level of compliance. It will be interesting to see whether auditors devote more attention to this area.