First publised in CRI

In addition to the general insolvency measures found in the Insolvency Act 1986, insurance intermediaries are subject to specific client money rules, which have a particular effect if they become insolvent. Though in the context of investment firms rather than the insurance sector, the recent UK Supreme Court case of Lehman Brothers International (Europe) (in administration) v CRC Credit Fund and ors [2012] UKSC 6 (LBIE) is a useful decision against which to consider the application of many of these client money rules. The decision has highlighted how these rules could, absent reform, result in some confusion in the event of an insurance intermediary insolvency.

Holding client money

Article 4(4) of EU Directive 2002/12 required governments in member states to: “… take all necessary steps to protect customers against the inability of the insurance intermediary to transfer premium to the insurance undertaking or to transfer the amount of claim or return the premium to the insured.”

The UK government complied with that requirement by producing Ch 5 of the (then) Financial Services Authority’s (FSA’s) Client Assets Sourcebook (CASS 5) (now under the remit of the FCA). The rules in CASS 5 have the force of law and a person who suffers loss in consequence of a breach of one of the rules may bring court proceedings under s 138D of the Financial Services and Markets Act 2000.

Under the CASS 5 regime, an insurance intermediary is permitted to hold a client’s money in three ways:

  1. on a “risk transfer” basis;
  2. in a statutory trust; or
  3. in a non-statutory trust.

Risk transfer (CASS 5.2)

Money is held on a “risk transfer” basis when an intermediary holds money as the insurer’s agent pursuant to a written agreement. Premium held as agent for an insurer is treated as having been received by the insurer, so there is no requirement on the part of the insured to pay the premium twice should the intermediary become insolvent. Conversely, where the intermediary holds claims money or premium refunds as agent for the insurer, on insolvency the money is not treated as having been received by the insured. The insurer therefore bears the credit risk in relation to all funds held by the intermediary on a risk transfer basis.

Such funds are not treated as client monies, and cannot be paid into a client bank account without the insurer’s written agreement; it must consent to its interests in the trusts (whether statutory or non-statutory) governing the client account being subordinated to those of non-insurer clients (CASS 5.1.5(2)R).

Statutory trust (CASS 5.3 and 5.5)

CASS 5.3 sets out the regime under which an insurance intermediary holds client monies as trustee (as permitted by s 137B(1) FSMA 2000 (as amended)). The trust arises at the moment client money is received by the intermediary; not at the moment the money is segregated into a client bank account (CASS 5.3.2R and confirmed by the UK Supreme Court in LBIE).

CASS 5.5, which is “consequential and supplementary” to CASS 5.3, governs how client money in trust should be treated. Under these rules, the intermediary must segregate the money by “paying it as soon as possible into a client bank account” (CASS 5.5.5R), ie, not later than the next business day. The rules do not permit the intermediary to provide credit to clients out of client money by, for example, funding premium payments when the monies have not been received from the client.

Non-statutory trust (CASS 5.4)

Where funds are held under a non-statutory trust, the intermediary may provide credit to the client out of the trust funds, but may not advance credit to itself out of those funds. The intermediary must have suitable systems and controls in place to manage any credit risk arising from the trust arrangements.

Money held under a non-statutory trust must be segregated in the same way as money held under a statutory trust. CASS 5 is silent on the issue of when a non-statutory trust arises.

However, a firm may not receive client money unless it does so as trustee (CASS 5.4.6R). This suggests the trust arises at the same time as under the statutory trust regime, ie, when the intermediary receives the client money, not when the money is segregated.

Distribution of client money

Money held on a risk transfer basis

As claims money or premium refunds held by an intermediary on a risk transfer basis are not deemed to have been received by an insured until actually paid to the insured, on the insolvency of the intermediary the insurer will remain liable to pay them (again) to the insured. Equally, it will not be able to recover from the insured premiums that were paid to the intermediary and held on a risk transfer basis, but not paid over to the insurer. The insurer may enter into a special arrangement with the intermediary to protect these monies. Absent such an arrangement, however, the insurer will be an unsecured creditor for those sums.

Money held on trust (CASS 5.6)

The insolvency of an insurance intermediary triggers what is referred to in the rules as a “primary pooling event”. CASS 5.6.7(1) R states that: “If a primary pooling event occurs client money held in each client money account of the firm is treated as pooled.”

CASS 5.6.7(2)R provides that the client money must be distributed:

“… so that each client receives a sum which is rateable to the client money entitlement.”

CASS 5.6 applies whether client money is held under a statutory or non-statutory trust.

CASS 7.9 (which has since been revised and re-named CASS 7A) contained an identical provision which (together with the remainder of CASS 7) became the subject of litigation in LBIE. The Supreme Court determined, by a 3:2 majority: (a) what money is pooled on a primary pooling event; and (b) how that money is shared.

In our view, the purpose (and wording) of the rules regarding pooling in CASS 5.6 and the former CASS 7.9 are so similar that the decision in LBIE, at least in relation to (a), should apply to both. As will be seen below, the ruling in relation to (b) may not be binding on a court construing CASS 5.6, but we believe that it will be at least persuasive. These questions are important because the reality is that client money may not in all cases be properly segregated by even the most scrupulous intermediary and, as noted by Lord Clarke in his judgment, firms close to failure are perhaps less likely to have carried out the requirements properly.

The Supreme Court held that a primary pooling event captures not only money held in client accounts but also identifiable client money not yet segregated into client accounts. Lords Hope and Walker gave dissenting judgments, saying that pooling captures only the money that has been segregated.

Under the majority’s ruling, the principles of tracing would need to be applied to find client money that had not been segregated into a client account. The Supreme Court also held that the pooled client money is to be distributed rateably among all the clients. Dissenting, Lords Hope and Walker held that clients whose money had yet to be segregated should receive nothing from the pooled funds and should not benefit from the distribution arrangements provided for by this regime.

The former CASS 7.9 did not create two classes of client as CASS5.6 does: as mentioned above, under CASS 5.1.5A(2)R client accounts may contain money held for insurers, but their claims on the balance will rank after those of the insured. Applying LBIE to CASS 5, it is arguable that, pursuant to CASS 5.3.2(3)R and CASS 5.4.7(3)R, client monies, including funds not yet segregated in the client account, would first be distributed rateably among non-insurer clients up to the limit of their actual contributions; any funds left over would be distributed rateably among insurer clients.

If there is any shortfall, once the pooled money has been distributed the intermediary’s clients will need to turn their attention to other money held by the firm. CASS 5.6.8G (which is classified as “guidance” rather than a “rule”) states: “A client may claim for any shortfall against money held in a firm’s own account. For that claim, the client will be an unsecured creditor of the firm.”

CASS 7.9.8G was worded very similarly and this wording was examined by the courts in LBIE. Each of the High Court, the Court of Appeal and the UK Supreme Court found this “guidance” to be lacking.

Indeed, in her judgment for the Court of Appeal, Arden LJ commented:

“This note is highly inadequate.”

In essence, the judges at all levels found an inconsistency within CASS 7.9: clients could not be unsecured creditors in relation to money that was held for them under a trust and where they would have a proprietary claim for those sums. CASS 7A.2.1(4)G, in the post-LBIE incarnation of CASS 7.9, now provides that a client experiencing a shortfall will receive its funds in accordance with the client money distribution rules. As such, it may be that the final sentence of CASS 5.6.8G is wrong.

In the Court of Appeal, Arden LJ disposed of an issue that was not appealed to the Supreme Court. That issue concerned money that a firm owes to its client. Does the firm “hold” that money on trust? The clear ruling is that such money is not held on trust and, in respect of it, the client is an ordinary unsecured creditor.

Potential reform

In June 2014, the FCA published its policy statement detailing changes to CASS following the decision in LBIE. It has been said that the changes are essentially a “re-write” of the CASS rules – other than CASS 5. The FSA issued a consultation paper on CASS 5 in 2012 (CP12/20) the consultation process has been taken over by the FCA. The following proposals are of note:

  • Giving the intermediary’s insolvency practitioner the option to make reasonable endeavours to complete open transactions, as well as to consider selling the firm along with its clients’ money (subject to consent).
  • Introducing a “resolution pack” that would give easy access details of all the intermediary’s statutory trust and non-statutory trust arrangements.
  • Encouraging intermediaries to hold client money in a wider range of banks.
  • Requiring intermediaries to calculate the balance held in each non-statutory trust every seven days.

No amendments have yet been made to CASS 5, but a review of the consultation is expected to be published in the second quarter of 2015 (FCA Policy Development Update (No 20), February 2015). As yet there has been no sign of this, but if the proposals are anything like the changes to the remainder of the CASS rules following LBIE, we should expect major changes to CASS 5 and how insurance intermediaries are to deal with client monies on an insolvency event.