Megan Butler, the Executive Director of Supervision – Investment, Wholesale and Specialists at the FCA, delivered a speech at PIMFA’s Virtual Festival in June 2020 in which she stated that, "the preservation of client assets and money is central to our focus in the wealth management sector".
Given the current economic circumstances, Butler may have in mind the collapse and subsequent fall out of Lehman Brothers International (Europe) (LBIE), which went into administration in September 2008. The collapse of LBIE posed significant difficulties for its administrators in identifying, reconciling, recovering and returning client assets and money promptly and resulted in years of litigation.
With Butler's above stated focus, the purpose of this article is to highlight key aspects of the FCA's client assets and money regime, the impact of COVID-19 and likely areas for enforcement.
Key aspects of the client assets and money regime
The foundation of the client assets and money regime is set out in Principle 10 of the FCA's Principles for Businesses:
A firm must arrange adequate protection for clients' assets when it is responsible for them.
The custody rules focus on client assets and extend to any financial instrument held by a firm on behalf of clients. The custody rules are designed primarily to restrict the commingling of client and firm assets. The rules intend to minimise the risk of the client's safe custody assets being used by the firm without the client's agreement or being treated as the firm's assets in the event of its insolvency. Among other specific rules, there is a requirement for a firm to introduce adequate organisational arrangements to minimise the risk of the loss or diminution of clients' safe custody assets.
The purpose of the client money rules is to ensure the proper accounting and treatment of client money. Money is any form of money including cheques and other payable orders. The client money rules provide requirements for firms that receive or hold client money, in whatever form. They provide that a firm must, when holding client money, make adequate arrangements to safeguard the client's rights and prevent the use of client money for its own account. Among other specific rules, there is a requirement for a firm to introduce adequate organisational arrangements to minimise the risk of the loss or diminution of client money.
Client assets and COVID-19
The disruption caused by COVID-19 has impacted on firms' abilities to comply with the client money rules. For example the rules require firms to bank cheques received into a client bank account within one business day. However where cheques are delivered to unmanned offices they may remain unbanked. Firms may therefore have to take steps to modify their usual practices, for example by asking clients to make payments directly into a client bank account.
Firms holding physical assets on behalf of customers (such as bearer bonds) are required to perform physical asset reconciliations. However, this may not be possible during a lockdown and firms will need to take steps in mitigation which are possible in the circumstances, to ensure that clients' assets remain protected. Firms should also notify the FCA if they are unable to conduct a physical asset reconciliation.
As a response to the crisis some customers have sought to hold a greater proportion of their assets as cash and some firms have reported increased holdings of client money. Client money rules require firms to exercise all due skill, care and diligence in the selection, appointment and periodic review of credit institutions, banks and money market funds where the money is deposited and must consider the need for diversification as part of its due diligence. Accordingly for example, a firm which deposits all or a substantial proportion of client money in a single bank which has a deteriorating credit rating may be in breach of the client money rules and face enforcement action.
Client assets and money is an area where the FSA, historically, and the FCA have been active. Its priority as an area of enforcement typically becomes more acute following economic crises. Whilst there have not been high profile Enforcement actions related to this regime in recent years, with the world's changing economic fortunes, Butler's speech suggests this may come back in vogue.
An FCA case in October 2016 which involved the fining of Aviva Pension Trustees UK Limited and Aviva Wrap UK Limited £8.2m for client money and assets failings may be of particular interest for two reasons. First, the case highlights that, despite there being no actual loss of client money or assets, the rules are designed to be preventative and the FCA will take action with this preventative mind-set. Second, it emphasises the need for adequate resource and technical expertise in this crucial area.
In short, the salient failings were:
- Aviva failed to put in place appropriate controls over Third Party Administrators to which they had outsourced the administration of client money and external reconciliations in relation to custody assets. See: FCA Reflections: Third party outsourcing expectations for an exploration of the FCA's explicit expectations in this area.
- Aviva failed to dedicate adequate resource and technical expertise to enable them to implement effective CASS oversight arrangements resulting in their delayed detection and rectification of CASS risks and compliance issues.
- Aviva's deficiencies in its internal reconciliation process which resulted in the under- and over-segregation of client money.
- Aviva was unable to meet its obligations under the CASS rules as the requirement to submit accurate Client Money and Asset Returns.
Charles Randall, Chair of the FCA and Payment Systems Regulator, delivered a speech at ICAEW Canary Wharf Members’ Club in September 2018 where he stated: "be warned: we have a very low tolerance for CASS failings, because of the significant customer detriment these can cause, and we expect auditors to identify CASS failings when they report to us."
In light of COVID-19, the FCA has been active in responding to queries and concerns, including on, for example, physical asset reconciliations and CASS audits. Given current circumstances and the FCA's explicit expectations, how is your firm and, where applicable, the senior manager delegated with the relevant responsibility, managing client assets and money responsibilities?