UK FSA Adopts Final Rules on Custody Liens
Christopher Bernard | Bloomberg Law
The UK Financial Services Authority (FSA) has published new rules including changes to its Client Assets Sourcebook (CASS) regarding the granting of liens in custody agreements over client assets. The rules were adopted in response to concerns arising from the application of earlier rules to omnibus accounts and assets held in overseas jurisdictions. The new requirements are the latest development in an ongoing review by the FSA of the UK client asset regime following the financial crisis and the collapse of Lehman Brothers International (Europe).
Previous Changes to Client Asset Rules
In October 2010, the FSA amended its client asset rules, prohibiting firms from granting inappropriate general liens in custody agreements over client assets and client money derived from those assets.1 The rule change was intended to address the practice by some UK firms of permitting custodians and sub-custodians to include inappropriate liens in custody agreements that could prevent or delay the return of client assets and associated client money in the event of a firm’s failure. In some cases, affiliated firms were being granted liens over the assets of clients with whom they had no relationship, and the FSA observed that many clients did not adequately understand the risks associated with these liens.
The rules, which came into effect on 1 March 2011 for new agreements and were intended to apply to all agreements from 1 October 2011, provided that a firm would only be able to grant liens or rights over client assets to a custodian if the liens or rights were:
- Confined to an individual client’s assets or money and extended only to properly incurred charges and liabilities relating to that client;
- Required by a securities depositary, securities settlement system, or central counterparty in whose books or accounts a client’s assets or money was recorded or held, solely to facilitate settlement of that client’s trades; or
- Required by local law or as a necessary precondition to participate in a local market, provided that the firm took reasonable steps to determine that the liens or rights were in the best interests of the client.2
However, after the rules became effective, a number of market participants raised concerns with the FSA regarding some of the new provisions. In particular, many firms would need to change their practice of holding client assets in omnibus accounts and taking liens over the assets in those accounts rather than segregating them into individual client accounts. Firms also expressed concern that they would not be able to meet the “necessary precondition” requirement for liens granted in foreign jurisdictions, because entities with greater bargaining power were able to negotiate the removal of liens from custody agreements in those jurisdictions. Furthermore, the requirement to take “reasonable steps” did not seem appropriate where clients requested that firms hold assets in other jurisdictions or firms were required to do so.
In response to these concerns, the FSA launched a consultation in July 2011 regarding proposed changes to the rules on custody liens3 and suspended application of the rules until 31 March 2012 pending consideration of these changes.4 The consultation closed in October 2011.
New Rules on Custody Liens
The new rules address the issues raised regarding the application of the restrictions on custody liens to omnibus accounts and in foreign jurisdictions. The rules emphasise, however, that rights of set-off prohibited under CASS 7.8.1R and 7.8.2R with respect to client money will not be allowed.
— Omnibus Accounts
The FSA is amending CASS 6.3.6R(1) in order to accommodate the practice of holding client assets in omnibus accounts, which is permitted under CASS 6. A firm will now be able to grant liens and rights over client assets in an account if the liens or rights extend only to properly incurred charges and liabilities arising from custody services provided in respect of client assets held in that account (as opposed to the assets of an individual client). Furthermore, client money derived from client assets may be treated as being held in the same account as those assets, even if they are recorded separately. The FSA, however, rejected one commentator’s request to treat all omnibus accounts held by a firm with a sub-custodian as one account.
Similar changes are being made to CASS 6.3.6R(2) to allow liens over client assets in omnibus accounts if required by securities depositories, securities settlement systems, or central counterparties in order to facilitate the settlement of trades relating to assets held in those accounts.
The FSA has indicated that it may conduct a separate review of the use of omnibus accounts and associated risks generally in future in line with ongoing regulatory developments in Europe.
— Overseas Jurisdictions
The “necessary precondition” requirement in CASS 6.3.6R(3) is being amended so that a firm will be able to grant liens over a client’s assets when such action is necessary for that firm to access a local market, even if other firms are able to participate in the same jurisdiction without taking similar action. Furthermore, a firm will not be required to take “reasonable steps” to determine that liens or rights granted in a foreign jurisdiction are in the best interests of the client, if the client is a professional client and has instructed the firm, after due notification, to hold the assets in that jurisdiction notwithstanding the existence of those liens or rights.
The FSA notes that if a firm is aware that holding assets in a foreign jurisdiction subject to a general lien poses a risk to its clients, it should at least attempt to negotiate for a lien that would otherwise be permitted under CASS 6.3.6R(1) or 6.3.6R(2). In all cases, firms must act in the best interests of the client, in line with Principle 10 under the FSA’s Principles for Businesses (PRIN 2.1) and (where relevant) the client’s best interests rule in the FSA’s Conduct of Business sourcebook (COBS) at COBS 2.1.1R.
The new rules will apply to all new custody agreements from 1 April 2012. Custody agreements entered into before that date must comply with the new rules (and therefore must be modified to the extent necessary) as soon as possible but no later than 1 September 2012.
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