9 th February Meeting the challenges of CASS requirements for June Ash Saluja. CMS Cameron McKenna LLP

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1 @uktisa Ash Saluja CMS Cameron McKenna LLP Outstanding PS14/9 issues a legal perspective Ash Saluja, Partner, CMS 9 February

2 Two remaining areas of legal uncertainty Authorised fund managers and the DVP exemption Cleared funds/intra-day shortfalls 21 Authorised fund managers and the DVP exemption A few caveats: do not get too hung up on the terms "delivery versus payment" or "DVP" for the purposes of the exemption true DVP would eliminate the principal risk involved in transactions (on settlement, the buyer would always get the asset and the seller would always receive the cash) Principle 10 still requires firms to provide adequate protection for client assets need to think about the broader risk of your insolvency regardless of any technical arguments under the rules there are numerous exceptions whether by design (e.g. in specie transfers) or accident (late renunciations, failed settlements etc.) need to consider processes and requirements applicable those as well 22 2

3 The current exemption Under CASS 7.2.8B, money need not be treated as client money in respect of a delivery versus payment transaction, for the purpose of settling a transaction in relation to units in a regulated collective investment scheme, if: the authorised fund manager (AFM) receives it from a client in relation to the AFM s obligation to issue units or to arrange for the issue of units in accordance with COLL; or the money is held in the course of redeeming units where the proceeds of that redemption are paid to a client within the time specified in COLL (i.e. cash transferred or cheque issued to client by T+4) Most AFMs do not need to think about whether they hold client money or not as the exemption applies to the full dealing cycle no need for money to be segregated into a client money bank account in the ordinary course of transactions carried out in accordance with COLL 23 Is the fund a client of an AFM? Client defined as: A person to whom a firm provides, intends to provide or has provided a service in the course of carrying on a regulated activity, or in the case of MiFID or equivalent third country business, an ancillary service FCA Glossary states that the definition includes a fund even if it does not have separate legal personality Some ACD agreements expressly state that the fund is a professional client of the AFM However, many in the industry (and some parts of COLL) do not view the fund as a client of the AFM in practice Proposed CASS rules and FCA comments indicate that protection of the fund's cash is equally important as protection of individual investor's cash However, COLL requires fund to be paid by T+5 for units issued is there a CASS breach if fund is a client and is not paid within time? 24 3

4 The problem raised by CP13/5 Removal of this DVP exemption was proposed by the FCA in CP13/5 what happens to money if DVP transaction fails to settle in time? more importantly, what happens if firm becomes insolvent before transaction has settled? Industry concerns raised in response AFMs would be expected to adopt the normal approach to segregation effectively means that AFMs need to receive subscription monies into and pay redemption proceeds out of a client money bank account only liquidity issues for AFMs as currently redemption proceeds paid to investors are funded temporarily by new subscriptions/uncashed redemption cheques what about AFMs who deal as principal using a manager s box is it client money if money is received for existing units in issue that are sold to the investor rather than issued specifically on subscription? 25 Briefly, what does COLL say about the process? First, an AFM is responsible for arranging for the issue and the cancellation of units for the fund and an AFM is generally permitted to sell and redeem units for its own account (i.e. run a manager's box dealing as principal) Secondly, there is an obligation for the AFM to record the issue and cancellation of units and the time of such issue or cancellation is when the record is made Thirdly, the AFM must, by the end of the fourth business day following the issue or cancellation of any units, arrange for payment to the depositary in cash or cleared funds for the issued units or require the depositary to pay the AFM and make payment to the unitholder for the cancelled units Fourthly, a unitholder is not liable to make any further payment after he has paid the price of his units. For AUTs, the register is conclusive evidence of the persons entitled to the units entered in it. 26 4

5 What COLL does not say about the process If the AFM receives money from the investor or the fund, but this is never sent on to the depositary or the investor, who bears the credit risk here if the AFM becomes insolvent? The investor or the fund? If the AFM deals as principal then as soon as it receives the money for the units from a subscribing investor and updates the register, then arguably the unitholder has the units (even if they have not been paid for by the AFM) If the AFM deals as agent for the fund, then arguably receipt by the AFM of money from the investor should be good receipt by the fund and money paid by the depositary to the AFM would still be owed to the investor if it had not yet been paid on to the investor (i.e. risk transfer principles apply) But COLL and CASS do not address these issues 27 The compromise Following a huge lobbying effort by the industry, the FCA proposed a compromise in PS14/9 DVP exemption remains but narrowed under CASS R if the AFM has not, by close of business on the business day following the date of receipt of the subscription or redemption money, paid this money to the depositary, the fund, or to the client, the AFM must stop using the DVP exemption for that transaction (i.e. the money must then be transferred to a client money bank account) Seems to address some of the liquidity concerns However, the FCA clearly does not like the exemption due to the (perceived) risks raised it could disappear in the future 28 5

6 The remaining concerns Still the implication under the revised exemption that the AFM is dealing as agent (i.e. issue and redemption of units) rather than dealing as principal (i.e. sale and purchase of units) FCA ducked the questions raised on AFMs dealing as principal following CP13/5 in its response in PS14/9 It is for AFMs to assess on the basis of their business models and relevant client money rules when their activities are subject to the client money rules Where an AFM is carrying out principal or other transactions for its clients and the client is legally entitled to a unit(s) in a regulated collective investment scheme either before or when the AFM receives money from the client, the money may not be client money under the client money rules as the money is owed to the AFM on receipt. However, firms must assess their own business models against the client money rules. Principle 10 AFMs need to think about the broader risk to clients of their insolvency, as well as whether/when they hold client money 29 One solution full client money model With industry involvement, CMS put together a high level paper on a potential solution for AFMs dealing as principal who want to adopt a full client money model Redemption proceeds and subscription monies held by an AFM (regardless of whether or not they deal as principal) would always be held as client money under CASS and segregated into a client money bank account 30 6

7 What do you need to do? Fund documentation and contractual terms with investors must provide that for subscriptions the AFM is required to hold any cash which it receives prior to the settlement date as client money (held for the investors) until the settlement date at which time it is passed to the fund/depositary for redemptions an investor s contractual entitlement to receive the beneficial interest in the proceeds arises at the same time as the AFM receives monies from the fund/depositary (note COLL implies that investors must be paid regardless of whether the AFM has been paid by the fund/depositary) the fund has no contractual entitlement to receive incoming cash or have it segregated as client money ahead of the settlement date 31 Investor purchases through box (full client money) Investor/Agent Investor bank account/agent s client money bank account Instructions (before or on T) Cash (before or on T+4) Key points: - CASS Money held as client money becomes due and payable to the firm or for the firm's own account, for example, because the firm acted as principal in the contract The circumstances in which it is due and payable will depend on the contractual arrangement between the firm and the client - AFM undertakes to hold incoming monies on (statutory client money) trust for the incoming investor until the settlement date, when they will be applied to the trade and paid on to the fund this ensures that the investor does not provide consideration for the units prior to the settlement date and cannot become irrevocably entitled to them (i.e. irreversibly entered on the unitholder register) before this point - No Principle 10 concern for purchasing client as cash is either with the client/its agent s client money account or in AFM s client money account, or the client/its agent has the unit irrevocably - Fund not exposed to AFM insolvency prior to settlement as register may be reversed if cash is not received for any newly issued units Manager Transfer to client money bank account only Entry on fund register only irrevocable following T+4 (transaction may be reversed if cash not received by AFM by end of T+4) Fund Fund Register 32 7

8 Investor sales through a box (full client money) Investor/Agent Investor bank account/agent s client money bank account Instructions (before or on T) Cash or cheque (on T+4 assuming renunciation at T) Manager Client money bank account only Key points: - Investor comes off the register on renunciation (usually at T) but amount only due and payable by the manager to investor at T+4 - Therefore, investor does not have the unit or the cash for a short period of time, but the cash is either with the fund/depositary or in the AFM s client money bank account - If AFM becomes insolvent between T and T+4 then new, replacement AFM can receive and then pay out monies from the fund/depositary to the redeeming investor - Sales cannot be funded by purchase monies from other clients, so AFM needs to be careful in light of FCA s comments on intra-day shortfalls on the client money account if redemption proceeds are in fact paid out before receipt of monies from the fund/depositary Fund Fund Register Fund register updated at T (assuming renunciation at T) 33 Another solution utilise the DVP exemption 34 8

9 Purchases/redemptions using DVP exemption principal or agent Investor/Agent Investor bank account/agent s client money bank account Key points: - DVP exemption allows monies to be paid into a corporate account provided paid to client or fund/depositary by close of business on the day after receipt (the circa 24 hour window ) - Helps with intra-day liquidity issue - Assumes the money is only ever due and payable on the settlement date (T+4) and full title to unit only passes on that date like the full client money model - Fund should not be exposed to AFM insolvency either has the cash or can cancel the unit - Clients still exposed to AFM insolvency prior to settlement where money is held within the circa 24 hour window as register may be reversed if cash is not received for any newly issued units Instructions (before or on T) Cheques/direct debits Manager Client money bank account Electronic transfers made by client prior to T+3 go into client money Manager Corporate account Fund Fund Register Net payment or gross payments due on T+4 Net payment or gross payments due by T+5 35 Which is the best route? AFMs that follow full client money approach would ensure that incoming monies received from investors for subscriptions are provided with client money protection (as client money held for those investors) until the settlement date redemption monies are provided with client money protection from the point of receipt from the fund/depositary until the investor has received value both the investor and the fund (even if not a client) are protected at all times Would not solve the liquidity issue if firms choose to send out redemption proceeds to investors prior to receipt of funds from the fund/depositary need to consider the intra-day issues raised by the FCA and/or use another solution which may or may not make use of the DVP exemption model There are other routes that may be adopted these are just two approaches 36 9

10 Next steps on the approach Choose which route you want to adopt in consultation with TA/depositary/auditors/lawyers Review and amend contractual/fund documentation Consider how to obtain customer consent if using DVP update terms of business with existing clients by notice or two-way consent (depends on terms) issue new terms of business for new clients or clients with no terms in place Design, implement and test systems and controls and operational procedures to give effect to the new arrangements 37 A brief word on cleared funds Generally accepted principle that one client s money should not be used to fund another s business need to identify, quantify and mitigate intra-day funding risks FCA states that firms may use organisational arrangements to minimise the risk of using one client s money to pay another on an intraday basis Cannot eliminate risk generally, for example, if cheque bounces after T+2/T+4 but before T+6, firm could either pre-fund amounts (effectively lend to client) or use prudential segregation Insolvency/primary pooling event can occur at any time if you consistently pay sums out of your client account in the expectation that equivalent sums will be paid in later in the day, how have you minimised the risk? Making up shortfall at end of day is not minimising the risk that you have already used one client s money to pay for someone else s business Need a consistent approach across the industry and FCA needs to recognise the practical difficulties that firms face 38 10

11 Any questions? Ash Saluja, Partner, CMS London E ash.saluja@cms-cmck.com T +44 (0)