Proposed changes to the Client Assets sourcebook (CASS) rules: distribution of client money

19/09/2013

Proposed changes to the distribution rules (CASS 7A)

Current situation and reasons for the proposals

Currently, distributions are governed by CASS 7A. On an investment firm’s insolvency, which is a primary pooling event (“PPE”), all client money held in client bank accounts and transaction accounts is notionally pooled. This pool is known as the client money pool (“CMP”). This is then distributed to clients on a pro-rata basis in accordance with their agreed claims. The Lehman/MF Global experience has shown that this can unfortunately take years to achieve. For example, because the insolvency practitioner (IP) may be personally liable to clients, IPs are understandably keen to ensure that claims are correctly quantified which can be a pain-staking process involving court approval.

The ‘speed’ proposal

The FCA proposes introducing a new client money distribution procedure in which an initial distribution will made by the IP or firm from money held in client money and transaction bank accounts. This will be based on the firm’s records and will only be appropriate where the IP believes that the records reasonably allow a determination of entitlements to be made. The IP will be required to repeat the firm’s reconciliation calculation to ensure the firm’s records are up to date at the point of the PPE. This would allow at least an initial distribution to be made within a few weeks of the firm’s insolvency, inevitably resulting in some clients receiving an increased recovery and some clients receiving less (or nothing, if they do not appear in the records as being eligible for a distribution).

A second distribution would then follow comprised of any surplus left in client money pool 1 (“CMP1”) and also identifiable client money held in the firm’s house account, if any (“CMP2”). This could therefore lead to a potential increase in the costs of distribution. Where a two-stage distribution is not possible (because there has been a systems failure preventing a reconciliation calculation being carried out or because there is a difference of more than 10% between the amount the firm should be holding and what it is actually holding), the IP may form a single, combined CMP1 and CMP2 pool and then make one distribution based on the amount that the IP considers should have been segregated under the CASS rules. Once the client money entitlements are determined, clients could claim for an amount in the CMP under an established procedure and the IP would pay clients rateably; a similar process to the existing regime.

The FCA considers that requiring the IP to distribute client money based on the firm’s records (even if they are not entirely correct) should reduce the basis on which clients may be able to bring claims against the IP.

Codifying the existing regime

As an alternative to the ‘speed’ proposal described above, the FCA is consulting on retaining the current rules but clarifying what money makes up the CMP, requiring a corrected reconciliation to be carried out at the time of the PPE, and setting out the procedure for determining each client’s client money pool entitlement.

The FCA is keen to restrict the current ‘alternative approach’, whereby firms receive client money and pay it out to clients from their house accounts. In future, if this approach used, firms would need to demonstrate why this approach is appropriate.

Further proposals

The FCA considers that the following proposals may be desirable even if the ‘speed’ proposal is not implemented:

• Removing the prohibition on the CMP being transferred to a purchaser. This would be subject to transfer within 14 days of the PPE and the purchaser agreeing to make the necessary client notifications. Clients would be entitled to the return of their money from the purchaser.

• The number of PPEs could be reduced so that the following would not constitute PPEs: (i) the coming into force of a requirement for all client money held by a firm; or (ii) notification by a firm that it is unable to comply with its record keeping requirements, following a secondary pooling event.

• Hindsight will be used to value a client’s open position when determining their entitlement to the CMP, rather than their open position at the point of the PPE based on notional closing or settlement prices (as is currently the case). The proposal is for client’s margined transactions that are open at PPE and (i) cleared through a central counterparty (CCP) or (ii) placed with a third party intermediary, to be valued at the amount at which they are liquidated to determine entitlement to the CMP.

• Instead of a firm being able to treat unclaimed client balances as non-client money, this money could be used to make good any shortfall in the CMP (subject to taking reasonable steps to trace the relevant clients). Where the sum involved is less than £10, only one attempt at tracing the client will be necessary.

• Any interest earned on pooled client money after a PPE should be converted into the most prevalent currency in that pool and used to reduce any shortfall in the CMP.

• Client money received after a PPE should be placed in client money bank accounts opened after the PPE or accounts that existed at the time of the PPE, if the money constituting the CMP has already been transferred out of such accounts. The firm would be entitled to retain costs attributable to the distribution of client money received after the PPE and where any money is owed from a client to the firm (because of the application of the ‘hindsight’ principle discussed above) but money is received post-PPE, that money could be retained by the firm.

• Secondary pooling events are currently triggered where a bank or third party holding client money (an intermediate client broker, a settlement agent or an OTC counterparty) fails and there is a shortfall for clients. Under the proposals, the rules will be extended to apply to the failure of an exchange or CCP. Where a CCP fails, client money in individual client accounts should not be pooled as this would produce an unfair outcome, namely that all clients would share in the shortfall, whereas had the investment firm itself failed, not all clients would have shared the benefits of such accounts (such as a direct return of money).

• A requirement to notify the FCA as soon as a firm becomes aware of the failure of a third party holding client money (and confirm whether it will be able to make good the shortfall to clients) will be removed on the basis that there is already a requirement to notify the FCA if a firm is unable to identify and allocate in its records all claims arising as a result of the secondary pooling event.

Links with the Special Administration Regime

The Special Administration Regime (SAR) was introduced in February 2011 following HM Treasury’s review of resolution arrangements for investment banks and firms carried out under powers granted under the Banking Act 2009. The regime is applicable to investment banks, and sets out special administration objectives for administrators to pursue in unwinding an investment firm’s business. The main objectives are:


• ensuring the timely return of client assets and money;

• engaging with market infrastructure bodies and authorities; and

• winding-up or rescuing the firm.

The proposed changes to the distribution rules are clearly compatible with the first of these objectives. Indeed, the FCA notes that the distribution process could be speeded up further by legislative changes to the Special Administration Regime (SAR). The FCA considers that if changes are made to the SAR then some of its proposals would not need implementing, while others would be enhanced.

On 23 April 2013, HM Treasury published the interim report by Peter Bloxham in respect of his review of the SAR. In addition to recommending that the SAR be retained, Bloxham suggests a number of changes including the introduction of a mechanism to facilitate the rapid transfer of customer relationships and positions as well as further consideration of whether limited immunity should be granted to administrators.

The second and final phase of the Bloxham report is due out shortly, which is expected to contain further proposals in relation to client money and assets. This is likely to have a greater impact on the efficiency and effectiveness of the distribution regime than the proposals currently set out by the FCA.

Timescale for implementation

If the FCA proposals are implemented, it is estimated that the changes will come into effect during the first half of 2014. Some of the rules may come into effect sooner if they are not dependent on changes to the client money and custody rules also being proposed (which are outside the scope of this note).

We are here to help

If you would like to discuss any of the above proposals then please speak to your usual CMS contact or to one of us below.