This briefing looks at proposals in the HM Treasury consultation paper on resolution arrangements for investment banks. The paper sets out possible changes in UK legislation, regulation and market practice designed to ensure that any future collapse of an investment bank is dealt with as smoothly and efficiently as possible. briefing
HM Treasury has published a consultation paper setting out its initial thinking on possible changes to UK legislation, regulation and market practice to enable any future collapse of an investment bank to be dealt with smoothly. The paper is entitled ‘Developing effective resolution arrangements for investment banks’. It might easily have been subtitled ‘Lessons learned from Lehman’. Responses are invited by 10 July 2009.
The collapse of Lehman Brothers in September 2008 triggered a period of severe crisis for the financial system, largely as a result of losses on credit exposures to Lehman and a general evaporation of confidence. These problems were severe, but they were foreseeable (in nature if not in extent) and unavoidable consequences of a collapse. Other significant problems were not widely foreseen and could perhaps be prevented in any future investment bank collapse. Among these are two particular areas of difficulty encountered by clients of Lehman Brothers International (Europe) (LBIE), Lehman’s main UK operating entity. These difficulties concerned:
- trades being stranded in limbo in the settlement system; and
- client money and assets being stuck in the administration.
These and related issues are the subject matter of the consultation paper.
The paper tackles a large number of complex and intricate issues. It is clear that the government’s thinking is still at an early stage. A fuller consultation paper will follow by the early autumn, outlining possible market and regulatory changes and any proposed changes to legislation.
Trading, clearing and settlement
The Lehman experience
At the onset of the LBIE administration, many clients had executed transactions in UK equities through LBIE which had not yet settled. Some of these trades had been executed on the London Stock Exchange, some on other trading platforms (MTFs) and others ‘over the counter’ (OTC). Those traded on the London Stock Exchange were subject to its default rules and those traded on MTFs were generally subject to the default rules of the central counterparties used by those platforms. OTC trades were not subject to any default rules and therefore fell to be dealt with under general contract law and any applicable bilateral terms of business. Clients were often not in a position to know how their trades had been executed and therefore what their contractual rights were.
There were further problems relating to the practicalities of settlement. The operator of the CREST settlement system suspended LBIE’s CREST participation following the administration, with the result that its trades would not proceed to settlement in the system. But the CREST rules also provided that – once matched settlement instructions had been input into the system – settlement could not be countermanded except on the submission of ‘match delete’ instructions by both parties. For various reasons, the LBIE administrators were initially unwilling to provide these instructions, resulting in these trades being stranded in limbo in CREST, neither proceeding to settlement nor being removed from the system. The resulting uncertainty as to whether (and, if so, when) these trades would settle caused great difficulties for parties trying to manage their market exposure. The impasse was eventually resolved when the operator of CREST instructed the LBIE administrators and counterparties to the trades to enter match delete instructions.
The government’s aims
The government is keen to ensure these problems do not happen again and is also taking the opportunity to look more widely at arrangements for clearing and settlement. It starts from the standpoint that diversity, choice and flexibility in trading, clearing and settlement are desirable and should be protected. Its particular objectives are to ensure clarity in the legal and regulatory environment and in contractual arrangements, and to respond to technical challenges relating to trades not executed on recognised exchanges. It is not apparent whether the government has fully appreciated the inherent difficulty in reconciling diversity, choice and flexibility on the one hand and clarity on the other.
Various elements are discussed in relation to ‘ensuring clarity’:
- addressing misconceptions;
- determining the effectiveness of the existing regime and meeting expectations; and
- ensuring there are clear and flexible contractual arrangements.
As regards the first of these, the government believes that the current regime is not well understood, and the paper provides a brief explanation of some aspects of the current system to try to promote better understanding. As the paper seems to acknowledge, determining whether the existing regime has been effective requires agreement on what the regime should achieve. Here there seem to be different expectations between brokers and their clients. The government is investigating this further. But, in broad terms, the government believes that any changes to the regime (encompassing market practice, regulation and legislation) should enable an investor more accurately to quantify and manage its risk when dealing with an investment bank.
Clear and flexible contractual arrangements
The government also expressly addresses the particular need for certainty as to whether a particular trade with an insolvent investment bank has been or can be cancelled or closed out or whether it will settle. It believes that in many cases there are currently no contracts in place governing this. One possibility would be to establish standard default rules. The market itself might come up with a protocol for adoption on a voluntary basis and a draft of such a document is already being prepared. Alternatively, standard default rules could be established by statute. A wider issue here is whether inequalities of bargaining powers in contract negotiation have in the past hindered the establishment of balanced documents that provide for certainty in the event of broker default – this seems to be an oblique reference to frustration on the part of the investment management community over the seeming unwillingness of the sell-side to engage with them in developing model terms of business.
The government notes that the Financial Markets Law Committee is preparing a report on legal uncertainties regarding open OTC trades. These include:
- whether legislation is needed to prevent a recurrence of the problem of trades being suspended, unsettled, in CREST;
- the implications of the Settlement Finality Directive on these settlement issues; and
- how any contractual default arrangements in force between the parties might be communicated to and relied on by CREST.
Responding to technical challenges
The paper refers to various technical challenges highlighted by the Lehman experience, as follows.
Firms need to strengthen their systems and controls to enable accurate and rapid identification of the venues on which particular trades have been executed.
Clearing: central counterparties
The Financial Services Authority (FSA) is reviewing arrangements for the holding of clients’ positions and margin at a clearing house. Lehman held some client positions and margin in its house account. The FSA is considering whether that should be permissible or whether there should be any change to regulatory requirements here. The FSA is also looking at whether there are any problems with the current default arrangements of the UK recognised clearing houses.
Clearing: margin transfers
Clearing house rules generally allow the positions of a defaulting clearing member to be transferred to another clearing member, but transfers of related margin requires the consent of the defaulter’s insolvency officer. The government is considering whether transfers of customer margin should be made easier.
The government is considering issues related to OTC derivatives transactions, which include the way in which master agreements operate on a broker default and how transactions are valued in those circumstances.
Client assets and money
The Lehman experience
English trust law enables a client to retain (beneficial) ownership of assets and money held by an investment bank on its behalf. Those assets and cash (referred to as ‘client money and assets’) are therefore not available to the firm’s general creditors and should be available for return to the client on the firm’s collapse. The LBIE administration has not revealed any significant problems with English trust law, but it has highlighted severe practical impediments to returning client money and assets promptly if the administration is large and complex. LBIE’s many hedge fund clients have been particularly affected by this as they often held large amounts of client money and assets with LBIE as prime broker. Delay in returning these assets and money has resulted from difficulties in:
- reconciling books and records in a large and complex institution;
- establishing clients’ net claims where there are margin lending arrangements in place;
- establishing the extent of rehypothecation of client assets; and
- securing the return of assets and money from custodians and sub-custodians.
The government has identified a number of objectives to improve the situation for any future investment bank collapse. These are to:
- ensure clarity and address misconceptions as to the protections in place;
- improve transparency by facilitating the identification and legal categorisation of client assets and money;
- improve the speed of return of client money and assets; and
- retain flexibility for brokers and their clients to agree mutually acceptable arrangements.
Ensuring clarity and addressing misconceptions
The paper suggests that, prior to the LBIE collapse, clients may not always have been sufficiently careful in the scrutiny and negotiation of prime brokerage agreements. The government believes that there is a ‘significant role’ for improvements in this area. As to addressing misconceptions, the paper itself gives a brief summary of the legal protections applicable to client money and assets, and how these differ when segregation and/or rehypothecation has or has not occurred. The FSA is reviewing its client asset and money rules and plans to publish a consultation paper towards the end of 2009. The government notes that there may be a case for best practice guidance for prime brokerage agreements, covering the desirability of mutual events of default and netting provisions.
The issue here is to enable early identification of client money and assets in the hands of an insolvent firm. The government believes improved documentation and accuracy of books and records could make a major contribution. Additional regular reporting by firms might also be a useful approach, covering matters such as the basis on which money and assets are held, the custodians and jurisdictions involved, information regarding the exercise of any rights of rehypothecation, net claims and the extent of any liens over assets. Information regarding the segregation and rehypothecation of client assets is seen as particularly important, and it seems that prime brokers have been providing more information of this kind recently. The government is also considering how firms might ensure that clients are aware of the implications of giving the firm a right of use, and whether enhanced risk warnings might be appropriate for certain contractual arrangements. The government does not believe there are substantial uncertainties in the law itself, but it is considering whether there may be particular cases where clarification may be useful.
Improving speed of access to client money and assets
While easier identification and classification of client money and assets would itself help improve speed of access, the government is also looking at other ways of achieving this. These include the following.
Use of third party custodians and affiliates
Consideration is being given to possible restrictions on third-party custodians’ liens, security interests or rights of set-off over client money and assets. Other ideas relate to limiting the risks arising where affiliates are used to hold client money assets, given the risk that group companies may collapse together.
The way in which client money is segregated
It has been suggested that, on an insolvency, there should be different client money pools for money relating to particular types of client or business.
Arrangements for set-off and liens
Current arrangements may enable liens and rights of set-off to be exercised in such as way as to compromise client asset protections. The government is looking at the possibility of introducing requirements mandating the application of set-off in a manner that does not have this effect.
Bar dates to crystallise claims
The government is considering whether there should be time limits for clients to crystallise their claims.
Changes regarding rehypothecation
The government is aware that the flexibility the UK regime allows regarding the establishment of rights to use client assets is important to London’s competitiveness. It is also conscious of the need not to impair the proper functioning of repo and liquidity in financial markets. Nevertheless, it is considering whether the UK should impose limits on rehypothecation rights in order to enable more rapid return of client assets.
Special officeholders for client assets
Consideration is being given to creating a new type of officeholder with responsibility for dealing with client money and assets, leaving the administrators free to concentrate on the interests of the general creditors.
The government welcomes the fact that a number of UK prime brokers are developing structures involving bankruptcy-remote vehicles. Typically these vehicles would be separate entities whose sole function would be to hold client assets. The prime broker would either have no security interest in those assets or any such interest would fall away on its insolvency.
The resolution regime itself
The government is considering whether adaptations might be made to the resolution regime in the following areas to ensure a timely and effective response to an investment bank collapse.
Firm-level failure management
Two main issues are being considered here. First, firms might be required to have contingency plans for their own collapse. Second, firms might be required to keep a business information pack detailing matters likely to be of immediate importance to an incoming insolvency officer.
An orderly insolvency process
Some market commentary has compared the UK handling of the Lehman insolvency unfavourably with that in the US. The government believes that, to the extent that the US handling was smoother, this was largely a result of practical actions taken by the US authorities prior to the commencement of the Lehman insolvency. The government is therefore considering proposals for improving the management of an investment bank failure, which might include greater pre-insolvency engagement between the firm and the authorities, more support being provided to administrators, and steps to improve engagement and communication with the market.
Possible reforms to UK insolvency law
Although the government does not believe that wholesale changes are needed to UK insolvency law, it is considering some specific changes. These include:
- imposing obligations on the firm’s administrators and providers of critical services aimed at ensuring the firm can continue to function and provide client services;
- giving the firm’s directors greater discretion on the timing of the initiation of the insolvency process so that client and market interests can be protected;
- facilitating the more flexible exercise of judgement by insolvency officers by relaxing personal liability rules; and
- establishing special objectives for administrators of an investment bank, to prioritise issues relating to client money and assets and to market stability.