Alert July 30, 2013

UK Financial Conduct Authority Proposes New Rules For Pooling and Distribution of Assets Held by Failed Investment Firms

The United Kingdom’s Financial Conduct Authority (FCA) has issued a Consultation Paper proposing new rules intended to streamline the process for recovering assets from a failed investment firm (the “Proposed Rules”).  The Proposed Rules are far-reaching in scope, and, if enacted, will have a significant impact on the segregation of assets within an institution’s various custodial accounts and the priority of recovery in the event of failure.  The Proposed Rules would apply to approximately 1,500 investment management firms authorized to hold client assets and regulated by the FCA.  Given London’s position as a leading market for investment management, the Proposed Rules should be of interest to investment firms and clients around the world.

The Proposed Rules address the process for recovering client funds following the insolvency of an investment management firm.  Under existing rules, the failure of an investment firm triggers the pooling and retention of all client assets pending a re-distribution to clients based on the priority of their respective claims.  The existing rules thus prioritize legal and financial accuracy in the eventual return of client assets.

The Proposed Rules, in contrast, prioritize the speed of return of client assets.  To achieve a faster recovery, the Proposed Rules envision a two stage client money distribution process upon an event of insolvency:  First, an immediate pooling of all money held in client accounts or transaction accounts followed shortly thereafter by an initial distribution of funds based strictly on the records of the failed investment company; and second, the collection of a residual client money pool comprised of any remaining client money not swept into the first pool, plus any residual amounts left over following the initial distribution.  The residual client money pool would be distributed under a more traditional claims process.

Underlying the Proposed Rules is a debate about the benefits of accuracy in distribution of client funds versus speed of recovery.  The FCA cites the insolvency proceedings for Lehman Brothers International Europe, MF Global Ltd., Pritchard Stockbrokers Ltd. and Worldspreads Ltd. as examples of failed investment firms in which this pooling and claims adjudication process required an excessive amount of time, to the detriment of clients and broader interests of market stability.  Based on this experience, the FCA asserts that a faster return of client money yields greater benefit in the form of increased market confidence and reduced impact on clients and contractual counter-parties of the failed firm.  The Proposed Rules thus favor speed, even while acknowledging that certain clients may enjoy increased recoveries while others may receive less, or even nothing, as compared to the eventual distributions under existing rules.

The Proposed Rules would dramatically alter the process, and, potentially, the bottom line recovery upon the failure of an investment firm.  In their current form, the Proposed Rules raise several matters of concern to clients.  For example, the proposed “speed” process relies almost entirely upon the accuracy of investment company records, but history demonstrates that the records of a failed investment company may not always be the most reliable or complete.  Clients with otherwise valid priority claims could lose out in the immediate distribution scenario contemplated by the Proposed Rules.  As a result, clients will bear a greater burden to monitor and ensure that records are accurate.

The FCA seeks comment on any aspect of the Proposed Rules, including an alternate proposal that would effectively codify the existing process for pooling and claims adjudication, a process that in current form operates primarily on the basis of insolvency and company law.  The Proposed Rules are complex and contain many aspects not addressed in this summary.  Please contact Goodwin Procter for further guidance or assistance in preparing a written submission to the FCA.  The submission deadline is October 11, 2013.