In one of the largest bankruptcies in US history, futures broker MF Global entered insolvency in the US and the UK at the end of October 2011. In the US, the Securities Investor Protection Corporation initiated the liquidation of MF Global Inc. under the Securities Investment Protection Act. The UK affiliate, MF Global UK Ltd., became the first company to be placed into a new special administration regime for investment banks. Richard Fleming, Richard Heis and Mike Pink of KPMG in the UK were appointed as Joint Special Administrators.
Subsequently, more than US$1.6 billion had been reported as being “missing” from MF Global’s US client accounts at the time of the collapse. It has been alleged that MF Global used client money to trade from its own accounts, in contravention of regulations requiring segregation of customer assets. Allegations of improper behavior aside, experience with the MF Global collapse and subsequent insolvency proceedings highlight four main structural weaknesses in the way the sector operates.
First, the law surrounding the insolvency administration of global investment firms like MF Global is complex and has not kept pace with the scale and global nature of the businesses involved. In the UK and Australia, for example, the legal principles are founded in the common law concept of trust and are steeped in often long-established case law, the set of existing legal rulings that can be cited as precedent. The problem is that insolvencies of large global financial entities are new and the case law is limited. This means that during the insolvency, there are no existing answers to many of the issues and the parties have to go to court for a ruling – a costly and time-consuming process during which client assets (both money and securities) cannot be returned.
Second, there is inconsistency between jurisdictions in the rules on important operating issues like segregation of client assets and rehypothecation of collateral. For example, under US rules, a prime broker may rehypothecate assets to the value of 140 percent of the client’s liability. But in the UK, there is no statutory limit on the amount of assets deposited by clients that can be re-hypothecated. It is up to clients to negotiate a limit, or prohibition, on hypothecation. When the investment firm is global, such differences create opportunities for regulatory arbitrage in which client assets may be shifted from one jurisdiction to another.
Third, it appears with MF Global that clients may not have fully understood what they were signing up for. US clients of MF Global appear not to have been fully aware of the differences in legal protection between jurisdictions. They simply assumed that the protections afforded by US legislation would apply and were largely unaware of the extent to which their agreements allowed the broker to move certain assets outside their local jurisdiction to take advantage of international variations in regulation. The same happened with Lehman Brothers. Even apparently sophisticated financial entities that were clients of MF Global may not have done their due diligence, read and understood the fine print of their agreements and thought through the implications of the powers they were granting their broker to leverage their assets in pursuit of its own business activities.
Fourth, there is a common misperception about the insolvency process and, in particular, the retrieval and return of client assets. There is no readily accessible discrete bank account for each client’s money that can be closed and the funds disbursed to that client. Quite the reverse. Ownership of assets can be unclear and open to legal challenge. The Lehman insolvency has been shrouded in so much litigation that, some five years into the insolvency, substantial amounts of client money and assets have yet to be returned. This problem has been recognized by regulators. For example, the new special administration regime in the UK is specifically intended to speed up the return of client assets by tracing specific assets handed over for investment and returning them to the investor. But these assets still have to be carefully tracked within the labyrinthine global financial systems used by international investment firms to optimize business performance. In the case of MF Global, there was the additional difficulty in the US of finding where the US$1.6 billion went, as well as complex legal issues surrounding the ownership of MF Global’s assets – and especially the large exchanges of funds between the US parent and its UK unit in the final days of the firm. MF Global went into insolvency over 16 months ago. Still the work of recovering assets and proving ownership goes on, although there have been some positive developments in the form of a high projected payout to clients and creditors.
Understandably, investors are demanding a greater level of protection and faster recovery of their assets in the event their investment firm fails. In response, regulators around the world are reviewing their rules concerning the segregation of customer assets with a view to strengthening protection, preventing assets going missing in future and making the assets more readily available to customers in the event of insolvency (see table below).
However, while there is a clear need for greater alignment between jurisdictions, at the moment it is difficult to see how this will be achieved unless the regulators coordinate their reviews and the legal principles of insolvency in those jurisdictions allow for greater cooperation and coordination (currently it relies on the skills and attitudes of the various Insolvency office holders).
Implications for investors and investment firms
Whatever the outcome of these regulatory reviews and however strong client asset protection becomes, experience with MF Global and Lehmans suggests investors will have to play a more robust role in the future and recognize their responsibilities as ‘informed buyers’. This means understanding the fine detail of the agreements they have signed and deciding whether they provide, in reality, the level of protection they want.
For investment firms, this tightening of regulation may have profound implications. For example, if rehypothecation of all client assets is severely circumscribed or banned altogether, this may mean the loss of a major source of funding. Similarly, if an investment firm’s access to excess margin is restricted, this may limit its ability to earn income. If full segregation of client assets is demanded, this will require fundamental changes to the business model. This is likely to be challenging in a time when margins in the sector are, at best, slim. Actions being taken by regulators to accelerate the return of client money after insolvency will also create challenges. For example, the UK Financial Services Authority’s proposal for multiple client money pools would prove operationally challenging for both investment firms and central counterparties, both in terms of day-to-day reconciliations of those accounts and the requirement to notify clients about the pool to which their dealings relate. Nor is it clear that such a change would, in practice, speed up the return of client money without complementary changes to the legal framework governing the insolvency of investment firms.
Other emerging regulations may change the way investment firms manage their client relationships. For example, a comprehensive repapering exercise will be needed to establish a new baseline, contractual terms will have to be reviewed and potentially revised, more transparency and information will need to be provided and more reconciliations will have to be conducted with investors. All of this will require operating models to be re-examined, driving up the cost of doing investment business and, potentially, leading to higher charges for clients.
This is not just an issue of compliance with an increasingly complex set of rules. The changes post-MF Global and Lehman may have a fundamental impact on the investment industry’s business and operating models. At the same time, clients can be expected to demand more transparency and greater contractual protection. It is vital investment firms now review their business models and operating practices in the context of an in-depth understanding of both the future direction of regulation in relevant jurisdictions and the spirit of customer concerns. Armed with this knowledge, they can ensure they have their house in order and position themselves for success and growth in a very different regulatory and business environment.