PS14/9: New CASS Rules Trigger Documentation Avalanche

DRS’ Michael Beaton offers a review of the recently published policy statement and guidance note on CASS rules in the UK.

Introduction

On 10 June 2014, the FCA published its long-awaited policy statement and accompanying guidance note detailing changes to the client assets regime in the UK following the proposals made in Consultation Paper CP 13/5, published in July 2013.

The policy statement represents a material rewrite of the CASS regime in the UK.  The most significant amendments, many of which will have an impact on firms’ documentation processes, are detailed below.  However, of note is the fact that the FCA does not intend to proceed with its main proposal – regarding changes to the client money distribution rules (i.e. the rule that ‘speed’ should take priority over absolute accuracy), although it will keep these rules under review and further consult on the topic later in the year.[1]  In addition, it believes that a number of the recommendations made by Peter Bloxham regarding the operation of the Special Administration Regime (see here for more information) are likely to be addressed by the changes detailed within the policy statement[2].

Multiple Client Money Pools

Under the final rules, clearing members of EMIR-authorised or recognised central counterparties (CCPs) will be permitted to operate multiple discrete ‘pools’ of client money in relation to net margined omnibus client accounts[3] (OCAs) in order to support the porting of net margined OCAs under EMIR.  In the event of a firm failure, each pool would be distributed only to the beneficiaries of that pool and separately from any other pool.  Any shortfall would therefore be suffered only by the pool’s beneficiaries and not by the firm’s clients more generally.  Each client invested in a particular sub-pool will be required to provide its consent via a “sub-pool disclosure document” and notification requirements apply to the extent that a firm intends to make a material change to a sub-pool.

Custody Rules (CASS 6)

The major changes to CASS 6 are detailed below.

Physical share certificates

Where a firm is administering an asset for which it is holding a physical share certificate (e.g. processing corporate actions), it must comply with the custody rules with respect to those assets.

Registration of firm and custody assets

Broadly, a firm will be restricted from registering its own assets in the name of the client or any nominee in whose name a custody asset is also registered, except where doing so arises:

• incidentally to the investment business the firm carries on for the client or to other steps taken by the firm to comply with the custody rules; or

• only as a result of the law or market practice of a jurisdiction outside of the UK.

Depositing assets when using third party custody services

Clarification is provided with respect to the factors which the FCA expects a firm to consider before choosing to use a particular third party to hold custody assets.  A new rule is also introduced which requires a firm to conduct and record periodic reviews of the grounds upon which it satisfies itself of the appropriateness of its selection and appointment of a third party to hold custody assets.

Written custody agreements

Firms are required to have a written agreement in place whenever they place custody assets with a third party custodian, even if that third person is an affiliate of the firm.

Right to use arrangements

Guidance is introduced reminding firms that they must consider their client’s best interests when agreeing to a “right to use” arrangement with a retail client for that client’s custody assets.  Blanket arrangements that automatically require all retail clients to agree to right to use arrangements through a firm’s standard terms of business will be frowned upon and may trigger a further FCA review in this area.

Custody asset recordkeeping, record checks and reconciliations

The new rules require firms to:

•   maintain a “client specific safe custody asset record”: an internal record that identifies each of the custody assets the firm holds for each client;

•   where relevant, undertake an:

◦   “Internal custody records check”: a replacement for internal custody reconciliations – to be performed as often as necessary (and at     least monthly) using either the “internal custody reconciliation method” or the “internal system evaluation method”;

◦   “Physical asset reconciliation”: across all the physical custody assets held by the firm for clients using either the “total count method” or the “rolling stock method”; and

◦   “External custody reconciliation”: requiring all firms to undertake external custody reconciliations as regularly as is necessary but at least on a monthly basis.

In addition, firms will be required to review, on at least an annual basis, the frequency at which they undertake internal custody record checks, physical asset reconciliations and external custody reconciliations, unless already performing these checks on a daily basis.

Changes to Both CASS 6 (Custody Rules) and CASS 7 (Client Money Rules)

Title transfer collateral arrangements

The new rules will have a significant impact on title transfer collateral arrangements (TTCA).  Firms will be required to ensure that a written agreement covers the client’s agreement to the terms of any TTCA, any terms under which ownership of relevant assets can transfer back from the firm to the client (‘switching’), and any terms for the termination of the TTCA.  In addition, the FCA has proposed a process for clients wishing to bring money or assets previously covered by a TTCA back under the protection of the client money rules/custody rules. This requires the firm, on agreeing to such a request, to notify the client of its agreement and to state when the protection would come into effect.

Delivery versus payment exclusions

In certain circumstances, firms are allowed to disapply the CASS regime with respect to a delivery versus payment transaction through a commercial settlement system (the ‘DvP window’).  The final rules maintain this exclusion but confirm that a firm will be required to ensure each client agrees in writing to the holding of its assets within the DvP window.

Unclaimed custody assets and client money

The final rules confirm that a firm must wait at least 6 years (in the case of client money) or 12 years (in the case of custody assets) since the last activity on the client’s account before the firm can trigger a procedure to pay or transfer client money or custody assets, or the liquidation proceeds, away to a registered charity (and only then if this is consistent with their arrangements with the client in question).  The firm must be able to demonstrate that it has taken reasonable steps to trace the client, and any costs associated with the paying away of unclaimed assets or money must be paid out of the firm’s own funds.  Firms can adhere to a process involving fewer steps if the amount of client money to be paid away is less than a de minimis threshold, being £25 for retail clients and £100 for other clients.  However, no de minimis threshold applies in relation to unclaimed custody assets.

Client Money Rules (CASS 7)

Banking exemption

The FCA has clarified that, for firms which are able to disapply client money rules through the use of the banking exemption, the default position is that money relating to investment business is held by that firm on deposit or in an account with themselves under the ‘banking exemption’ but should be allocated to the client promptly and in any event within ten business days of receipt.  Firms seeking to take advantage of the banking exemption are required to notify clients of the circumstances in which money would (or would not) be subject to the client money rules.  In addition, although the FCA does not impose a requirement on firms to renegotiate their terms of business with clients, it does explicitly state that firms will be required to provide updated terms of business to clients to reflect the circumstances (if any) in which money would cease to be treated within the banking exemption and be treated as client money.

Trustee firms

The final rules disapply the client money distribution rules to trustee firm client money, although they do allow trustee firms to opt in to the more general requirements of the CASS regime separately with respect to each trust it administers so as to enable the firm to use the same systems and controls for its trustee firm client money and its non-trustee firm client money.  However, trustee firm client money must remain segregated from non-trustee firm client money. 

Delivery versus payment exclusion – regulated collective investment schemes

Authorised fund managers (“AFMs”) are allowed to disapply the client money rules with respect to delivery versus payment transactions in regulated collective investment schemes (the ‘DvP CIS window’).  Under the final rules, a “one-day” DvP CIS window is retained, such that when a firm receives money (that, but for the operation of the DvP CIS window would be client money) in relation to the issue/redemption of units in a regulated CIS, if the AFM has not, by the close of business on the business day following receipt, passed this money to the trustee/depositary (in the case of the issue of units) or the client (in the case of redemption of units), the AFM must segregate this money and treat it in accordance with the client money rules.  The final rules also require firms to evidence each client’s agreement in writing to the firm’s use of the DvP CIS window.

Interest

The final rules clarify that firms are able to contractually agree how much interest on client money they will pay to clients.  Where a firm is not going to pay all interest on client money to the client, the client must be notified of this fact in writing.

Money ceasing to be client money

The final rules confirm that money will cease to be client money if it is paid into a bank account in the sole name of the client without the need to obtain the client’s instruction or specific consent to each payment. However, firms are prohibited from making payments into any bank account of a client that has been opened without the consent of that client.  To the extent that this occurs, the money paid into the account will continue to be treated as client money.

Transfer of business

The final rules clarify that there are three ‘ways’ in which a firm may transfer client money to a third party in the context of a transfer of business and in doing so that money will cease to be client money of the transferor:

• Consent: it may obtain client consent at the time of the transfer;

• Transfer Clauses: it may include in its client agreement a clause which allows the firm to transfer the client’s client money to a third party  in the future should the situation arise; or

• De Minimis Threshold: if the client holds client money less than or equal to £25 (in the case of retail clients) or £100 (in the case of all  other clients), neither form of consent is required (but notification requirements apply).

The transferring firm must ensure that certain notifications are made to the clients no later than seven days after the transfer has taken place. The notifications include: how the money will be held by the transferee firm; the relevant applicable compensation scheme; and the option for a client to have transferred sums returned as soon as possible.

Client bank accounts

The current rules place firms under an obligation to ensure that a maximum of 20% of the client money that they hold is deposited with intra-group institutions (the ‘20% limit’).  In addition, the final rules clarify that a firm will be required to periodically assess whether it is appropriate to diversify (or further diversify) the third parties with which it deposits some or all the client money it holds.

Due diligence

Firms are already required to undertake due diligence on the banks with which they choose to deposit client money.  In addition, under the final rules, the FCA will introduce an explicit requirement for firms to make a record of each periodic review of a bank and to keep that record from the date it conducts the periodic review until five years after the firm ceases to use that bank to hold client money.

Unbreakable client money term deposits

In light of the feedback received in relation to the proposal to prohibit the use of unbreakable term deposits (“UTDs”), firms will be allowed to place client money in UTDs for up to a maximum unbreakable term of 30 days.

Immediate segregation

Firms will be required to “immediately segregate” client money – meaning that it must be received directly into a client bank account and not the firm’s own account (unless the firms are using the alternative approach to client money segregation).  In particular, where a firm receives physical payments of client money such as cash and cheques it should record the receipt immediately and deposit the client money in a client bank account promptly and no later than on the business day after the money has been received, unless the firm is unable to meet these requirements because of restrictions under the regulatory system or law regarding the receipt and processing of money.  In these circumstances, it must record the receipt, hold the cheque in a secure location and deposit the cheque as soon as possible.

Cleared funds

In the original consultation, the FCA proposed to restrict the ability of firms to carry out business for a client using that client’s client money until that money has cleared into a client bank account.  In recognition of the fact that it will be difficult in practice to determine precisely when clients’ funds have cleared the rule was revised.  Instead, the final rules provide explicit guidance to the effect that a firm should ensure its organisational arrangements are adequate to minimise the risk that client money held by the firm may be paid for the account of a client whose money is yet to be received by the firm.  This does not affect the ability of a firm to use its own money to fund clients’ transactions.  Rather, it just restricts the use of one client’s money to fund other clients’ transactions.

Allocation of client money receipts

Under the final rules firms will be required to allocate client money receipts promptly, and in any case, within ten business days of receipt, and record this money as ‘unallocated client money’ while working to allocate the payment.

Prudent segregation of client money

Firms will be required to maintain a ‘prudent segregation record’ during segregation and for a period 5 years after the firm ceases to prudently segregate.  This will record amounts of payments and withdrawals from a client bank account, the reasons for such payments or withdrawals, the fact that each payment or withdrawal was made in accordance with the applicable internal policy and the relevant client money rules, and the total amount of client money segregated pursuant to the rules.

Alternative approach

In the final rules, the use of the alternative approach will not be restricted to large investment banks.  However, firms will be required to assess whether the use of the alternative approach is appropriate on a per business line basis.  In addition, any firm wishing to use the alternative approach will be required to review at least annually its reasons for continuing to do so.  A firm will have a maximum of six months following the review to stop using the alternative approach if that is the conclusion to be drawn from the review.  Firms using the alternative approach for a particular business line will be required to calculate and maintain a Mandatory Prudent Segregation Amount (“MPSA”) for the forthcoming three months and review the sufficiency of the MPSA on a quarterly basis.

Client money and assets held by third parties

The final rules clarify that, if a third party holds money for a client of the firm (rather than a client of the third party), that money remains client money of the firm, should be held in a client transaction account, and should be included in the internal client money reconciliations of the firm.  Firms that deposit custody assets with third parties must recognise any money derived from these assets as client money.

Internal client money reconciliations

The final rules confirm that all firms should undertake internal client money reconciliations^[4] on a daily basis.  Firms will continue to be allowed to employ a non-standard method of internal client money reconciliation^[5] but will be required to obtain an auditor’s report beforehand and should consider whether the method achieves the same specified outcome as if the firm had used one of the standard methods.  In addition, only material changes (rather than any changes) to a firm’s non-standard method of internal client money reconciliation will trigger a requirement on the part of the firm to repeat its assessment of whether the use of the non-standard method is appropriate and to provide an auditor’s report to the FCA.

Only loan-based crowdfunding firms as well as asset managers which do not undertake margined transactions for clients (i.e. derivatives business) will be allowed to use the “net negative add-back” standard method to calculate its client money requirement.

External client money reconciliations

Under the final rules, firms are required to undertake an external client money reconciliation^[6] as regularly as necessary but no less often than once a month.  In addition, most firms will be required to undertake a review of the frequency at which they undertake external reconciliations on at least an annual basis (unless the firm in question already undertakes external reconciliations on a daily basis).

Recordkeeping and notifications

The FCA consulted on a number of additional recordkeeping and notification obligations as a result of which firms will be required to make and retain copies of each internal and external client money reconciliation, each review it conducts of reconciliation arrangements and its policies and procedures in this area.  Moreover, records must be maintained in such a way as allows the firm at any time to be able to “promptly”^[7] determine the total amount of client money it should be holding for each client.

Acknowledgment letters

All firms will be required to complete and exchange standard template acknowledgment letters, according to a set process and using their own letterhead, when arranging to deposit or place client money with a bank or other third party.  It will not be possible to agree to any alteration to the substantive matters covered by the acknowledgment letter.  More importantly, a firm will be prohibited from depositing client money, even on an overnight basis, in a client bank account or allowing a third party to hold client money on a client transaction account, irrespective of the jurisdiction in which the third party is established^[8], until the acknowledgement letter has been signed and returned by the relevant bank or third party.  In other words, the previous 20 business day grace period in which firms were allowed to use a client bank account or client transaction account without obtaining a duly countersigned acknowledgment letter in respect of that account has been removed.  The only exceptions to this rule are:

• Following a primary pooling event – in which case the 20 business day grace period will continue to apply to any account opened by the  firm or its insolvency practitioner; and

• When a firm places client money with a CCP – in which case it must write to the CCP to notify it of specific matters using a template acknowledgement letter but is not required to receive a countersigned letter.

Firms will be required, at least annually, to review their acknowledgement letters but there is no automatic requirement to repaper letters on an annual basis.  Whenever a firm becomes aware of an inaccuracy it must promptly organise a replacement letter and whenever a client bank account or client transaction account is transferred to a new entity, a new letter must be put in place.  Firms need to employ the same level of assurance with respect to the authority of an individual to countersign an acknowledgment letter as the firm would employ when managing its own commercial arrangements.  Electronic signatures are permissible, provided that the firm has satisfied itself that the electronic signature would be admissible as evidence in any legal proceeding.  Every acknowledgment letter must be retained for a period of five years following the closure of the account or accounts to which it relates.

Mandates (CASS 8)

The final rules extend the definition of a mandate to include mandates that are not in written form.  Firms will not be required to separately document non-written mandates, but specific information about each non-written mandate will need to be recorded in the firm’s list of mandates and the firm will need to establish systems and controls to ensure that all such information is captured. 

Client reporting and information (CASS 9)

With respect to any firm holding custody assets or client money, except for insurance intermediaries or debt management firms, the final rules introduce a number of proposals concerning the frequency of reporting to clients, the information that should be provided to clients before the provision of investment services and the creation of a standalone disclosure document to summarise key provisions within client agreements.

Regular reporting to clients

If a client so requests, firms will be required to report on their holdings of client assets more frequently than is otherwise required.  Where such requests are received, any charges for providing the information to the client must reasonably correspond with the firm’s actual costs for providing the information requested. 

Information on client assets protection arrangements

Going forward, investment firms subject to the CASS rules will be required to provide information concerning safeguarding client assets to all clients prior to the provision of investment services. In other words, this requirement will apply irrespective of client type (i.e. not just to retail clients) and asset type (e.g. not just designated investments, but any custody asset a firm may hold).

Client assets disclosure document

In the consultation paper, the FCA had proposed introducing a requirement for all firms subject to the CASS rules to have in place a Client Assets Disclosure Document (‘CADD’).  This would take the form of a standalone document which would summarise key provisions within client agreements which modified rights or protections that would otherwise be available to the client.  However, the FCA has decided not to proceed with this proposal at this time. 

Key Date Summary

The revised CASS rules are being introduced in three stages, as detailed below.  Broadly, the changes in the first stage (1 July 2014) are either optional or impose a minimum regulatory burden on firms.  The changes in the second stage (1 December 2014) may require firms to revise some existing documentation.  All remaining changes come into force in the third stage (1 June 2015).

Key Requirement Summary

The table below summarises the documentation requirements associated with the new CASS rules, by reference to specific aspects of the CASS regime – specifically whether the particular regulation results in a requirement to amend agreements, provide client notifications, establish a periodic review process, or keep records.

Final Thoughts

The full force of the changes to the CASS regime will not be felt until 1 June 2015.  By this date, contract portfolios documenting relationships with all clients and counterparties will be required to have been repapered in full; and processes will have to exist to ensure that appropriate notifications are given, periodic reviews are conducted and proper records are maintained.  Nonetheless, 1 December 2014 is the real date upon which firms must focus.  This marks the commencement of the transitional period in which the amended CASS rules apply to new contractual relationships.  As such, planning and implementation of the organisational changes necessary to comply with the new rules will have to be completed well in advance of this date in order to allow new processes to have been tested and documentation to have been amended.  The question then becomes one of how to manage this change.

The ultimate success of any large-scale documentation project depends on the creation of a streamlined process formulated with clearly defined goals in mind.  A number of familiar elements define this process.  First, a current state analysis will enable the firm to develop a clear understanding of the current state of its CASS compliance.  A target state analysis will then allow the firm to identify the goal in terms of future CASS compliance.  The gap analysis which follows highlights the route between current state and target state and is critical in the development and sequencing of strategies to close this gap.  Finally, the strategies identified as necessary in order to achieve the target state are implemented and monitored.

In practice, project implementation is often the area that causes most problems due to headcount constraints, tight deadlines competing priorities and lack of preparation.  However, most pitfalls can be avoided if proper consideration is given to:

• identification and prioritisation of clients;

• validation of client contact details and other static data;

• creation of template documentation, internal negotiation and escalation policies and exceptions handling procedures;

• internal training requirements;

• creation of processes to ensure that ‘lessons learned’ inform future negotiations;

• controls to be applied in the drafting and dispatch of agreements;

• the education of clients;

• client response monitoring and follow-up schedules;

• document execution and storage policies; and

• data capture and internal system update processes.

The drafting of the CASS rules was criticised by every court before which the Lehman litigation was heard as being both unclear and incomplete.  In part, this contributed towards the “shocking underperformance” of Lehman and its “massive non-compliance with CASS 7”[9].  In response, the FCA vowed to re-write the CASS rules so as to ensure that client assets were adequately protected.  It has been as good as its word.  Through its re-draft, the FCA has raised the bar, enforcing stricter and more robust process and significantly increasing the evidential burden on firms.  The emphasis placed on well-documented processes is typified by the new requirement that a firm must be able to determine the total amount of client money it should be holding for each client within 2 business days^[10] and to notify the FCA immediately if this is not the case^[11].  In essence, a framework has been created, off which an enormous paper trail will hang.  Documentation and recordkeeping will act as the smoking gun which evidences CASS (non) compliance.  Some firms will inevitably be forced to go back to the drawing board although most should be able to achieve CASS compliance by extending, rather than fundamentally re-engineering, existing processes.  Unfortunately, either way, timescales for achieving CASS compliance under the FCA policy statement are short, meaning that firms need to start grappling with the realities of the new CASS regime now.