establishing resolution arrangements for investment banks

ESTABLISHING RESOLUTION ARRANGEMENTS FOR INVESTMENT BANKS

Allen & Overy’s response to the Treasury’s December 2009 Consultation

0010023-0024973 BK:13402686.7 1 26 March 2010

HMT Consultation paper – Establishing resolution arrangements for investment banks

1. INTRODUCTION

We are grateful for the opportunity to respond to the consultation of HM Treasury on its proposed framework for effecting the resolution of failed investment firms (the Paper).

As a law firm, our principal focus in this note is on the matters of legal and regulatory certainty raised by the Paper. We note that other market participants are better placed to address the commercial and economic consequences of the proposals.

This response includes a discussion of the wider issues that the Paper raises, discussed thematically following the format of the Paper.

We would be delighted to meet with HM Treasury to discuss any aspects of this response, whether alone or with other law firms or market participants. Please refer any questions or comments to Bob Penn ([email protected]) in the first instance.

About Allen & Overy

Allen & Overy is one of the world’s leading law practices, with around 5,000 staff and 450 partners worldwide. Since opening its first office in London in 1930, Allen & Overy has grown into a global organisation with 34 offices in 26 countries across Europe, Asia, Australia, the US, South America and the Middle East. Allen & Overy acts for many, if not all, of the systemic financial institutions in Europe.

0010023-0024973 BK:13402686.7 2 26 March 2010

2. KEY COMMENTS

Generally we endorse the proposals and analysis set out in the Paper. Our key comments on the proposals are as follows:

(a) Principles underlying change: Any legal or regulatory change coming out of the Paper should be proportionate, clear, workable, non-discriminatory and justified on cost-benefit grounds. A number of the proposals appear not to meet these conditions – particularly the proposal for a CAT, and elements of the proposals for a resolution plan.

(b) Scope: The scope of the proposals is unclear given the wide scope of the investment firm definition. Each area of the proposal needs to be considered against the functions undertaken by investment firms and/or their systemic importance, depending on the policy objectives of the authorities.

(c) Policy objectives: A linked issue is the lack of clarity as to the authorities' policy objectives with regard to the interests of clients in relation to client assets and money. We see the development of a two-tier approach to the treatment of client assets and money on insolvency, with clients of systemic firms receiving a better outcome than clients of non-systemic firms, as an unwelcome development which could distort competition.

(d) Need for a harmonised international approach to regulation: The vast majority of investment firms operating in the UK, and which might be considered 'systemic', also have (or are part of financial services groups which have) international operations. In that context, minimising possible conflicts of laws and ensuring pre-and post-failure communication across borders becomes crucial. For example, resolution plans will only be workable if they are prepared on a global, rather than national, basis for cross-border firms. Similarly, resolution plans for those firms which are part of international groups need to consider the international, potentially interdependent, nature of the firm and group in question.

The costs of a fragmented cross-border approach to the issues raised by the Paper would be substantial and would fall not just on financial institutions but also on the wider economy, both in the UK and globally. It is critically important that the authorities continue to lead thinking internationally and push towards harmonisation of resolution regimes and appropriate co-ordination of the management of failure of cross-border financial institutions.

(e) Proliferation of insolvency regimes: Without specific reform for investment firms, the UK alone has around 22 insolvency regimes. We do not believe that the UK needs 22 insolvency regimes. We also consider that there is sufficient commonality in debtor circumstances not to require the establishment of completely separate proceedings, bar necessary add-ons.

(f) Application to banks and interaction with the Banking Act 2009: In today's market, much of the traditional business model of investment firms is undertaken by banks, and vice versa.

The Paper appears to be premised on an untested assumption that no investment firm would require a solvent rescue under an equivalent to the Special Resolution Regime. We query how this assumption has been analysed and we would welcome further information as to how the Government defines 'systemic' in this context.

To the extent that investment firms and banks are subjected to differing regulatory and bankruptcy regimes, there will necessarily be an implication for their comparative costs of doing business in those overlapping spheres. This must be seen as an unintended, and unattractive, consequence of regulatory fragmentation – a consequence which, in the interests of financial stability, is best avoided.

0010023-0024973 BK:13402686.7 3 26 March 2010

The Paper also appears to make certain assumptions about the way in which the SAR proposals will interact with the SRR, the BAP and the BIP, which we consider require further consideration and clarification.

(g) Acknowledging the limits of regulatory reform: We are concerned that there is a tendency in the Paper to place too much emphasis on arguable failings of the rules and regulations, and insufficient emphasis on the failure to effectively implement and enforce those rules and regulations. Had LBIE remained fully compliant with all of the rules and regulations applicable to it and its business, notably those set out in CASS, many of the issues faced by its creditors and clients today may have been avoided. The corollary of this fact is that any regulatory or legislative reform is unlikely to achieve its purpose if the authorities do not effectively monitor and enforce firms' compliance. This points to improvements in supervision and firms' operational risk management. Both of these areas are under scrutiny and subject to ongoing change. Any proposals need to take account of those changes and their impact on firms' behaviour and risk profiles.

3. STRUCTURE OF THIS PAPER AND TERMS OF REFERENCE

We have structured our response around the specific questions raised by the Government in the Paper. However, we note that the responses to many of the questions are inter-related and, where it is appropriate to do so, we have provided overview responses at the beginning of our discussions on each Chapters.

Key defined terms:

All references to Chapters and paragraphs in this response are references to the Chapters or Paragraphs of the Paper;

AFME means the Association for Financial Markets in Europe (see www.afme.eu);

Banking Act means the Banking Act 2009 (as amended);

BAP means the bank administration procedure, established under Part 3 of the Banking Act;

BIP means the bank insolvency procedure, established under Part 2 of the Banking Act;

CASS means the Client Assets Sourcebook, which forms part of the Handbook;

FMLC means the Financial Markets Law Committee, an independent committee partly sponsored by the Bank of England (see www.fmlc.org);

FSA means the UK Financial Services Authority;

FSCS means the UK Financial Services Compensation Scheme, established under section 213 of FSMA;

FSMA means the Financial Services and Markets Act 2000 (as amended);

Handbook means the FSA's Handbook;

Insolvency Act means the Insolvency Act 1986;

Insolvency Official means any person appointed as administrator, liquidator, receiver or administrative receiver to a firm;

MiFID means Directive 2004/39/EC on Markets in Financial Instruments;

www.afme.eu

www.fmlc.org

0010023-0024973 BK:13402686.7 4 26 March 2010

MTF means multi-lateral trading facility;

Part 7 means Part 7 of the Companies Act 1985;

SAR means the special administration regime proposed in Chapter 2 of the Paper;

SRR means the special resolution regime, established under Part 1 of the Banking Act; and

WUD(B) means Directive 2001/24/EC on the reorganisation and winding up of credit institutions.

0010023-0024973 BK:13402686.7 5 26 March 2010

4. RESPONSE

CHAPTER 1: INTRODUCTION

1. Do you have any comments on the proposed definitions of investment firm for the purposes of thiswork?

It is imperative that the scope of definitions of terms such as 'investment bank' or 'investment firm', and their application to particular elements of the proposals, is absolutely clear. This is because the proposals have the potential to impose significant costs on firms.

In considering the appropriate form of definition, the Government needs to give consideration to the whole matrix of regulatory permissions and how these might fit together for individual entities, and to consider the most appropriate scope of application of each element of the proposals. At presentthis is far from clear.

At present, it is noted that the definition of an 'investment bank' as provided for in section 232 of the Banking Act does not specifically exclude a 'bank', as defined in section 2 of the Banking Act. Accordingly, if this definition of 'investment bank' was to be adopted in creating a special administration regime for investment firms, a firm which has regulatory permission to accept deposits and which also meets the definition of an 'investment bank' might be subjected to two distinct regimes: the investment firm special administration regime and the BIP or BAP.

The statements in Box 2.A of the paper, which discusses the interaction of the special administration regime with Part 2 of the Banking Act, purports to address this concern. However, insufficient detail has been provided to enable us to fully understand HM Treasury's proposals in this regard. We await the expected consultation paper (referred to in Box 2.A), which is to include the text of the draft regulations on the investment firm special administration regime. We discuss interaction between the Banking Act and proposed regimes further below.

It is also submitted that the MiFID definition of 'investment firm' is too broad to be of assistance in the current circumstances. For example, there is no known justification of why an investment advisor (with no dealing permissions, or client asset permissions) should be within the scope of the Paper. Further consideration needs to be given to the risks, to clients and the market at large, that the current proposals are intended to address, and to the range of firms who have business models which give rise to such risks.

The narrower definition used for the purposes of the SAR would capture a variety of firms which are not investment banks as that term is generally understood, including asset managers, stockbrokers, custodians and investment plan and ISA managers. It is unclear whether these are intended to be within the scope of the SAR. It is a policy rather than a legal matter whether such firms should be within scope. However, we believe that the creation of a two-tier approach to dealing with client assets and client money on the failure of firms, with clients of certain classes of firms effectively receiving preferential treatment relative to clients of other classes of firms, is undesirable. This is made even more undesirable when the criteria by reference to which the clients' treatment is to be determined are unclear. See question 8.

Finally, we note that 'client assets', as that term is used in condition 2 of the definition of 'investment bank' set out in section 232 of the Banking Act, appears to include client money but 'client assets' as that term is used in the Paper generally appears to exclude client money, as the two terms are often used together (e.g. in paragraph 4.5, which refers to "client assets and client money"; see also paragraph 4.3 of the Paper). If 'client assets' is not intended to be used consistently across all of the

0010023-0024973 BK:13402686.7 6 26 March 2010

relevant legislation and subordinated regulation, a specific definition of that term should be included in each document in which that term is used. See to our response to question 51.

0010023-0024973 BK:13402686.7 7 26 March 2010

CHAPTER 2: ENABLING AN ORDERLY RESOLUTION

2. Do you agree with the Government’s proposals for special administration objectives and associated policy measures? Are there any supporting levers not considered in this document that would be critical for the effective functioning of the special objectives?

Relationship with Banking Act

The Paper raises a significant question about the policy of the authorities in looking to implement a resolution regime for investment firms based only on insolvency tools. The Banking Act provides for various pre-insolvency SRR tools, including share and business transfers on a pre-insolvent basis. The Banking Act regime is predicated on the twin objectives of financial stability and depositor protection. Investment banks (other than mixed banks) do not present depositor protection issues, but present the same potential threat to financial stability. At one level, it may be argued that if investment banks pose the same risks, they should be within the regime. The Paper does not explore why the authorities consider that investment banks should not simply be brought within the Banking Act regime. We believe that this should have been explored by the Paper. We also believe that the ramifications of an insolvency-only resolution tool by the authorities need exploration.

A detailed consideration of the implications of separate regimes is outside the scope of this response, but we would make a few points about some of the issues we see with having a separate insolvency-based resolution regime:

(a) The proposal of a narrower SAR seems predicated on an assumption that no pure investment firm could fail in circumstances where a pre-insolvent rescue along the lines of the SRR tools was needed. While we have no view as to the veracity of that assumption (and understand that the various steps dealing with interconnectedness could reinforce that position) we would query on what basis the authorities have reached this conclusion, and how they will monitor its continuing applicability (particularly in the event that banks restructure their activities to split investment banking from deposit-taking activities as a result of regulatory change).

(b) As indicated above, the SRR is predicated on the twin objectives of financial stability and depositor protection. There has been some cynicism within the industry about whether the SRR is in fact a disguised means of retail depositor preference. Having the split approach seems to reinforce that impression. This in turn could well have implications for the cost of (non-retail deposit) funding for banks.

(c) The differential approach is also likely to impact on competitiveness of pure investment banks relative to mixed (deposit-taking and investment) banks. The SRR carries with it substantial rights of the part of the authorities to intervene in private law rights – including overrides of contractual rights. The inapplicability of the SRR to investment banks carrying on the same activities that UK banks traditionally carry on will create incentives counterparties to use pure investment banks – which could have structural implications for UK banks.

SAOs

The proposed special administration objectives (SAOs) are:

(a) Prioritise the return of client money or assets.

0010023-0024973 BK:13402686.7 8 26 March 2010

(b) Provide services and facilities to businesses transferred both in the run up to and post-insolvency.

(c) Ensure timely engagement with market infrastructure bodies and the Authorities.

(d) Wind-up the investment firm in the best interests of the creditors as a whole.

We broadly support HM Treasury's proposals for the SAOs. We expect that insolvency practitioners will welcome the additional clarity such SAOs may bring to their role however, in practice, we expect that the proposed SAOs largely echo the objectives pursued by Insolvency Officials appointed to investment firms in any event.

We would also stress the need to ensure that any SAO's, and accompanying policy measures, are expressed in terms which are sufficiently broad and flexible to accommodate the vast variety of business models pursued by investment firms.

It is also important that any accompanying policy documents recognise that even a procedural priority, which the Government has proposed that the SAOs should have, will have a practical impact on the timing and quantum of returns to creditors. In particular, where creditors have been procedurally subordinated to clients, so as to allow a prioritisation of the return of client assets and client money, this will cause comparative delays in the timing of the return to creditors; this, in turn, inevitably means a reduced return to such creditors as the increased time frame will have lead to greater administration or liquidation expenses (not to mention the time value of money).

The (procedural) prioritisation of the return of client assets or client money, without careful drafting and consideration, raises the following concerns:

(i) Where the firm in question is a 'mixed' bank (i.e. a firm having both deposit-taking permission and permission to hold and safeguard client assets), this SAO may conflict with the depositor protection objective of the BIP, as set out in section 99(2) of the Banking Act. (See further our response to question 8).

(ii) Where the firm in question has sub-custodied assets with a third party institution, the return of client assets may not be entirely straightforward. (See further our responses to the questions raised in Chapters 4 and 5).

(iii) Post-insolvency, there will necessarily be operational issues for the appointed insolvency practitioner to resolve; these may be alleviated to some degree by the business information packs (the Information Pack) proposed under Chapter 3, but it is unlikely that a seamless transition will ever be achievable. Thus, there will inevitably be a delay before client money and client assets are returned.

Further, the comparison between this proposal and the depositor protection objective of the BIP, as set out in section 99(2) of the Banking Act, ignores the inherent difficulties in facilitating a return of trust assets. The deposits referred to in section 99(2) of the Banking Act are independent from one another, and are subject to the protections provided by the FSCS. Conversely, the experiences of administrators of LBIE has shown that in order to determine the proper trust assets or client money claim of a client of a failed firm the insolvency practitioner must: (i) determine what assets or money should be held on trust, a process which is often complicated by the existence and exercise of rehypothecation rights; (ii) determine the extent of any shortfall; (iii) allocate an appropriate pro rata distribution; and (iv) protect against possible later claimants, usually by retaining a portion of the assets or money. The proposals outlined in the Paper are intended to reduce the impact of, or remove altogether, these complications, but it is submitted that the process will never be so straightforward as that of returning eligible deposits.

0010023-0024973 BK:13402686.7 9 26 March 2010

We do not believe that the second proposed SAO is relevant or appropriate. Again, the analogy to the objective of the BAP, provided for under section 137(1) of the Banking Act, is potentially misleading. The BAP is specifically designed to follow an SRR, which has involved a partial property transfer (see section 136(2)(a) of the Banking Act), such that the transferred business(es) that the firm in administration is required to support will have all been transferred pursuant to an order or instrument made under that Act. Conversely, no SRR equivalent is provided for under the Paper. Rather, any business transferred in the lead up to insolvency will presumably have been transferred under commercially negotiated terms. Footnote 6 to paragraph 2.16(2) of the Paper notes that the kind of transfer agreements to which this objective applies could be specified in the special administration procedure; it is submitted that this is a necessary corollary of including such an objective, and that the appropriateness of this objective is dependant on that specificity.1 In addition, in the BAP context the creditors of the residual company have an economic interest in the success of the transferred business via the bank resolution fund: they have no such interest in the case of the SAR. To provide for a continuity of service objective in this context seems illogical and too detrimental to creditors' interests. See also question 8.

3. What are your views on introducing a limited restriction to the liability of the administrator, restricting creditors from taking action in certain circumstances, related to administrators’ actions in pursuit of the SAOs?

In practice, we would be sceptical about the potential beneficial impact of introducing such a limited restriction. There is an argument to be made that any reduction in the standard of care required of administrators may lead to a loss of confidence in the office generally, and in particular appointed administrators.

However, we support the suggestion that the administrators duties should be linked to pursuit of the SAOs.

4. What are your views on the suggestion that the personal liability of administrators should not be greater than that of the company’s directors before the company went into insolvency?

Directors and administrators fulfil two entirely different functions for the companies to which they are appointed – the former has a primary duty to the company's shareholders, the latter has a primary duty to the company's creditors (and, where the company is (i) a bank, to its depositors; or (ii) an investment firm, if the proposals in the Paper are adopted, its clients). As stated in our response to question 3, the duties of an investment firm administrator should be linked to the pursuit of the SAO's.

5. Do you agree with the Government’s approach to the court process for clarification around liability? What kind of expedited court process could be considered? Should one be required?

In principle, yes. Although we submit that due process, including the rule of law and the right to be heard, must not be jeopardised by any modification to the usual process and procedures of the UK courts. We also note that any court dispute, even a matter brought on an expedited basis, inherently brings with it the possibility of delays.

1 In addition to transfers on commercially negotiated terms, we would question whether the Government intends the objective to apply to overseas

businesses or former group companies based outside of the UK.

0010023-0024973 BK:13402686.7 10 26 March 2010

6. Is there any other approach the Government could consider with respect to the modification of administrator liability for the purposes of the special administration regime for investment firms?

In accordance with our answer to question 4 above, there are questions as to whether such a modification is appropriate. We make no submissions as to possible alternative approaches.

7. Do you agree with the Government’s approach in providing a special defence for directors of investment firms against actions taken by administrators and others, to enable directors to implement resolution plan actions in the interests of the firms’ creditors and of financial stability? What specific modifications could the Government consider applying?

If anything, in such circumstances, there may be a greater case for liability. Case law on wrongful trading has established an appropriate means for assessing the circumstances in which a director should be found liable for breaching their duties, including by placing a company into an insolvency procedure before it is was appropriate to do so, and we would submit that no modification to the common law precedent is required in this regard.

8. Do you agree with the proposals for the initiation and scope of the special administration regime for investment firms and its interaction with the provisions of Part 2 of the Banking Act 2009, as described in Box 2A?

There are two interrelated issues raised by paragraphs 2.48-53: the first is the conditions to the operation of the SAR, and the second the interaction with the Banking Act.

Initiation of SAR

We believe that the Conditions 1 and 2 to the operation of the SAR are appropriate. However, we believe that the inclusion of Condition 3 is of concern. A condition which effectively reserves the operation of the regime to firms whose failure would affect the stability of the UK financial system or affect public confidence creates a two-tier system. Under a two-tier system, clients of systemic firms will have the return of client assets and money prioritised: clients of non-systemic firms will not.

As indicated above, we believe that the creation of a two-tier approach to dealing with client assets and client money on the failure of firms, with clients of certain classes of firms effectively receiving preferential treatment relative to clients of other classes of firms, is undesirable. There are several reasons for this. The first is simply a policy question of fairness: we see no reason in principle why clients should not be dealt with in the same way as between systemic and non-systemic firms in relation to the return of client money and client assets. The second is certainty: creating a regime in which holders of client money and client assets may have return of their money and assets prioritised, but have no certainty as to that, does not seem to us to be likely to improve confidence in the UK markets. We therefore believe that the regime should apply on a mandatory basis rather than at the discretion of the FSA. The third is a competitive issue. If clients have confidence that they will obtain better treatment on the failure of a systemic firm than would be the case if they dealt with a non-systemic firm, they will have an incentive to place client money and assets with systemic firms. This creates competitive distortion and has the effect of concentrating the market in a way which arguably increases (rather than reduces) systemic risk.

0010023-0024973 BK:13402686.7 11 26 March 2010

We question the need for the limiting the power to initiate a special administration to the FSA. If the directors of an investment firm are of the view that the firm should be placed into administration, and that firm holds client money or client assets, on the basis of the proposals set out in the Paper, it would seem prudent to allow the directors the option of choosing to place the firm into special administration. Any analogy with the SRR appears to us to be faulty – the SRR provides for a number of different options, and has an objective of financial stability, which means that the FSA is likely to be best placed to assess the impact of the available options against the relevant objectives. The SAR does not, as currently drafted, have such optionality.

Application to mixed banks

The Government's consideration of mixed banks which are also investment banks for the purposes of the consultation (mixed banks), as described in Box 2.A of the Paper, is limited to the interaction of the BIP and the SAR. The interaction of the two regimes is described only at a high level. In the absence of proposed legislation it is difficult to comment meaningfully on the legal aspects of the proposals. However some high level observations may be made.

The key starting point of principle when looking at the interaction between the two regimes is legal certainty. Creditors and holders of client assets and client money have a legitimate interest in certainty as to their legal rights on the failure of the firm. The proposals need to provide that certainty.

If they do not do so, then it will be in the interests of clients and creditors of mixed banks that the grounds for applying the SAOs are set out clearly. In the context of the resolution of mixed banks this would at least merit amendment to the existing guidance provided by the authorities on the application of the SRR under the Banking Act.

Given that the potential complexity of the interaction between existing insolvency law as it applies to banks (including the two modified insolvency regimes under the Banking Act), the authorities should take steps to ensure that the revisions proposed by the consultation are clear as to their application and effects on the rights of stakeholders. This is likely to require an end-to-end review of the Banking Act framework, and also consideration of the inter-relationship between the proposals and other measures set out in the Paper, such as living wills.

On this basis, we are unsure why the Government's consideration of 'mixed banks' is limited to the interaction of the BIP and the SAR. The analysis provided in the Paper appears to ignore the following:

(a) It is understood that the SRR process under the Banking Act will apply to mixed banks. Accordingly, the stabilisation powers including, in particular, a property transfer instrument (both where such transfer is in whole or in part) may be exercised in respect of a mixed bank. Pursuant to section 34(7) of the Banking Act, the property transfer may include a transfer of client assets and client money (but it need not do so); similarly, a partial property transfer under section 33(2) may include deposits, but it may not do so. The need for, and objectives of, a SAR could differ dramatically between these various scenarios.

(b) Following the use of the SRR in relation to a failing bank the BAP is likely to need to be put into effect to deal with the residual company following the transfer. Where a failing mixed bank is subject to partial transfer under the SRR, it is for the authorities to decide whether to transfer client money and/or client assets to a private sector purchaser or bridge bank. Where they choose not to do so, it is not clear in the Paper whether the BAP will be modified to accommodate the SAOs in relation to mixed banks. It would appear that:

0010023-0024973 BK:13402686.7 12 26 March 2010

(i) for those 'residual banks' (as that term is used in Part 3 of the Banking Act) who have retained a business involving the holding and safeguarding of client assets or client money, the SAR will be most appropriate and the application of the BAP should be modified to accommodate the relevant SAO; and

(ii) for those residual banks which have retained a business regarding the holding and safeguarding of client assets or client money, the BAP will remain the most appropriate tool, and it should be clarified that the SAR modifications should not apply.

(c) No comment is made in the Paper as to whether the BIP is intended to be modified for mixed banks. Assuming that the BIP is not intended to be switched off for mixed banks, the logical extension of the proposals in the Paper is that a third objective should be added to those given in section 99 of the Banking Act, to echo SAO 1: namely, to prioritise the return of client money or client assets.

Further, the statement that the pursuit of the objective set out in section 99(2) of the Banking Act would involve no payout of estate or client assets is, in our view, fallacious. In this regard, we draw your attention to the comments made by the City of London Law Society in paragraph 13 of their response to Parts 2 and 3 of the Banking Act 2009 (accessible at: http://www.citysolicitors.org.uk/FileServer.aspx?oID=488&lID=0) – the transfer of deposits to a third party institution will likely require the transfer of equivalent assets; such assets may or may not be provided by the FSCS.

Further, in circumstances where a mixed banks' resources are finite, and may be limited, there is potential for a very real tension between the use of assets for the purposes of meeting the depositor protection objective and the use of assets to meet the return of client assets and client money objective. Similarly, administrators (and possibly bank liquidators as per sub-paragraph 1(c) above) may face tensions between applying their resources to one objective or the other, where such resources (including available staff) may be finite.

These concerns, which in effect are concerns that the addition of the depositor protection objective to the SAOs will create a conflict of interest, are exacerbated by the current lack of clarity on:

(i) the proper interpretation of CASS, as it is currently written (notably, the question of whether a client may be able to assert a trust claim over unsegregated assets of the firm – a question which has been asked, and remains subject to appeal, in the court case discussed in Box 4.B of the Paper (the LBIE Client Money Application)); and

(ii) the FSA's intentions as regards any amendments to CASS. Ultimately, there may be a tension between a firm's clients and a firm's body of creditors, including depositors, which would mean that simultaneous pursuit of both objectives could be difficult (or impossible).

We look forward to receiving the anticipated FSA consultation paper on the review of CASS.

9. Is there a case for considering provisions in the special administration regime for investment firms in relation to new financing? The Government also welcomes feedback on the potential legislative or other hurdles to an investment firm obtaining additional funding from third parties in the period immediately before insolvency to close out its positions. Are there other issues or options in relation to intra-day support that the Government might need to consider?

www.citysolicitors.org.uk/FileServer.aspx?oID=488&lID=0

http://www.citysolicitors.org.uk/FileServer.aspx?oID=488&lID=0

0010023-0024973 BK:13402686.7 13 26 March 2010

We agree with the Government's view that public funds should not be expected to be available to allow investment firms to continue to trade pre- and post- insolvency. The LBIE administration has demonstrated that funding can be available to firms post-insolvency on commercial terms and we do not believe that there is sufficient empirical evidence to justify providing for special funding provisions in the context of investment firms, over and above access to funding which might be available to distressed entities generally.

10. The Government considers the costs to market participants of implementing the special administration regime, with provisions for special administration objectives, liability of insolvency professionals and directors, and possible legislative changes for intra-day support to be negligible.

Do you agree with the cost suggested in the paragraph above? If not, please provide an estimate of the costs that are likely to occur, stating your assumptions.

We make no response to this question.

11. The Government would welcome views on the types of communications methods market participants would prefer and the type of information they would like to receive from the Authorities in case of an investment firm failure.


12. The Government considers the costs to market participants of a resource centre providing best practice guidance to administrators, and plans for coordinated market communication in the event of investment firm failure to be negligible, as these would require no market action.



13. Do you agree with the Government’s proposal for international entities not subject to these proposals to be able to ‘opt in’ to the firm-level resolution regime?

It is impossible to comment on the 'opt-in' proposal without clarification of how it is expected that such a proposal might work.

The suggestion that an opt-in would be available in circumstances where there is no requirement on a firm to be wound-up under their home-state law is overly simplistic, for several reasons:

(a) there are very few, if any, jurisdictions which do not have an insolvency regime providing for the winding-up of a commercial entity in some specified circumstances; and

(b) if, at the point at which the proposed resolution regime is triggered, the firm is not currently subject to a home-state insolvency process, whether it might subsequently be subject to such a process is most likely to be a question of home-state law. This leaves open the possibility

0010023-0024973 BK:13402686.7 14 26 March 2010

of conflicting insolvency processes. It is also worth noting that the entry into a UK resolution regime might itself operate as a trigger for a home-state winding-up process.

We also note that European legislation would operate so as to prohibit the possibility of an opt-in for those EEA investment firms which also have permission to accept deposits (i.e. mixed banks):WUD(B) provides that deposit taking institutions whose home-state is an EEA jurisdiction may be wound-up in their home-state jurisdiction only.

In practice, we expect that very few foreign firms would be in a position to 'opt-in' any meaningful way.

14. Are there any other specific issues in relation to cross-border investment firms, not considered here or in Chapter 8, that need to be addressed?

There are considerable issues that are still to be worked through in relation to cross-border financial institutions. The problem of banks being global in life and national in death is a fundamental driver of legal and regulatory change. As Lord Turner pointed out in the Turner Review in talking of "more Europe" or "less Europe", this is a problem that can drive legal and regulatory travel in one of two directions – towards an internationalist approach or a nationalistic one. The mitigation of the need for taxpayer support through resolution regimes is only one part of this multi-faceted problem.

While it is outside the scope of our expertise to quantify the costs of a nationalistic approach to the problem, we believe that it would be potentially very costly for firms: a nationalistic approach involves effectively reversing globalisation by requiring decentralisation. We are already seeing developments towards that approach through the FSA's liquidity regime: the output of the living wills exercise could be much more onerous.

Chapter 8 rehearses the various initiatives relevant to this problem, including the Basel CBRG, the European Commission work on cross-border bank failure, and recent work undertaken by CEBS. However, outside the European framework the initiatives in this area are largely regulatory, not legal, and international agreement is on co-operation and information sharing. These do not address the problem, which goes to substantive questions of insolvency. The creation of a system of mutual recognition of resolution tools – including insolvency – of cross-border financial institutions and their groups is in our view the only solution that would continue to provide the benefits of globalisation without the risks of national detriment (creditor loss, taxpayer support and/or systemic failure). This requires a renewed effort at creating a meaningful framework of recognition which goes far beyond the initiatives undertaken to date. We believe that the Government should be pushing this as part of the international agenda.

15. The Government welcomes views on the extent to which the package of measures proposed in Chapters 2 and 3 will contribute to achieving the effective resolution of investment firms. Do you believe there is a case for the measures to be further enhanced by a special resolution regime for investment firms?

See our response to question 2.

0010023-0024973 BK:13402686.7 15 26 March 2010

CHAPTER 3 - REQUIRING FIRMS TO MANAGE FOR FAILURE

As a general comment on Chapter 3, we support the notion of the living will but believe that any requirements must be both proportionate and workable. Proportionality and workability demand that recovery and resolution plans be looked at not in the context of the solo position of the investment firm, but at a consolidated position. The right approach is to look at the whole group of which an investment firm is part – both at the recovery and resolution stages of the plan. Resolution plans need to work for the group as well as the entity: in a cross-border situation failure to recognise that will leave the authorities with unworkable plans.

We believe that the following principles should apply to this area:

Recovery plans

• The objective of a recovery plan should be to enable the efficient recovery of the institution and its group, drawing a balance between the needs all of regulators and stakeholders internationally.

• Recovery and resolution plans need to be workable and proportionate. It is not possible for the plans to predict the causes of failure of an institution: they must therefore be flexible and create procedures for dealing with stress and/or failure generally rather than a pre-determined approach.

• In particular, the likelihood of leakage of information about the implementation of a recovery plan, and its effect on confidence in the financial institution, should be taken into account by regulators when considering recovery plans.

Resolution plans

• Resolution plans are workable only if prepared on a global, rather than national, basis for cross-border financial institutions.

• Resolution plans for financial institutions should be designed to provide a road map of the structure, funding, liquidity, systems, governance and business of a financial institution at a high-level. Resolution plans need to be high-level and flexible in order to mitigate, rather than increase, the risk and/or consequences of a financial institution's failure.

• Resolution plans should not be used as a tool to dictate organisational structures for unjustified nationalistic ends: any requirements as to decentralisation of cross-border financial institutions should be justified by cost-benefit analysis, taking into account the possibility of agreement with other jurisdictions as to cross-border crisis management to mitigate the need for decentralisation of institutions.

16. Do you have views on the coverage or detail of the BRO’s responsibilities as outlined here? Are these consistent or compatible with existing templates for the corporate governance structure of firms?

If the proposals in the Paper are implemented as contemplated, the scope of a BRO's responsibilities would be very broad and prescriptive, and also potentially duplicative of certain risk management and compliance requirements that currently exist.

We noted in particular that, even in a "business-as-usual" scenario, the BRO would have a significant amount of day-to-day responsibility. Managing the process of ensuring the regular

0010023-0024973 BK:13402686.7 16 26 March 2010

update and audit of a firm's Information Pack, for example, could prove to be very time-consuming. Similarly, the obligation of the BRO to identify key workers and ensure that suitable contracts are in place at all times with such staff may prove to be an onerous obligation. Since large investment firms often experience a high turnover of staff (and often have staff that are mobile within the organisation itself), identifying key staff may not be entirely straightforward (particularly in the case of cross-border firms, which have workers operating outside the UK who nonetheless exert significant influence on UK operations).

As such, we are of the view that the responsibilities of the BRO should be articulated by way of a clear set of principles and not a disparate set of prescriptive rules. This would provide firms with sufficient flexibility to implement the regime in a manner that is efficient and workable for their business. Any reporting requirements imposed on the BRO should also be proportionate and in alignment with any existing reporting obligations of the firm to prevent unnecessary duplication.

Furthermore, we feel that the Information Pack should be primarily for the board of a firm to update (subject to oversight by the FSA, and that there should not be an onerous requirement for frequent and ongoing audits by the FSA.

We discuss corporate governance in our response to question 18.

17. Do you agree with the basic policy of establishing a role for business resolution officers in investment firms and do you believe that this is an effective way for the FSA to ensure that the firm implements resolution actions effectively?

Yes.

18. What are your views on the nature of appointment of the BRO? Do you agree with the Government’s suggested approach for implementing this policy, for example, the role being additional to a Board member’s pre-existing duties and part of the FSA’s Approved Persons regime?

We support the idea of establishing a role for a BRO in investment firms and think that such person could (and should) fit within existing corporate governance structures. As such, we think that it would be appropriate for a BRO to be an existing board-level company officer.

We note, however, that it is possible to conceive of certain situations, such as in a distress scenario, where a potential conflict of interest may arise between the duties of the BRO under the resolution regime, and the duties incumbent on him as a senior manager or officer of a company. In a distress scenario, an obligation on the BRO to commence limiting risk and/or prepare for failure under the resolution regime for the benefit of the financial system as a whole, may place him in conflict with his duties to act in the best interests of the company. A key element of a working living will will be clear rules on how such conflict would be managed or regulated in practice. This may require amendments to corporate law on directors' duties.

For the prudential supervision of the BRO, we agree that bringing the BRO within the Approved Persons regime could be a sensible approach, although we would require clarification of what additional responsibilities (if any) the BRO would have as such an Approved Person.

Increasing the engagement of investment firms with the authorities should be a priority for the proposed framework and we feel that greater emphasis should have been placed on this in the Paper.

0010023-0024973 BK:13402686.7 17 26 March 2010

19. Discussions with stakeholders indicate that the additional responsibilities of a board-level officer as a BRO would require 10-20 per cent of their time on an annual basis or £100,000 to £200,000 per annum.



20. Do you agree that investment firm resolution plans can consist of internal actions followed by market-facing actions as proposed above?

We have considerable reservations about how these proposals would work in practice.

Workability - in practice, a wind-down plan effectively has to predict the nature of the failure of the financial institution to be effective: as such, this appears to be a 'shot in the dark' at forecasting the nature of the failure of the institution, and hence the response needed to be taken to avoid or mitigate it. In practice a wind-down plan would be unlikely to cope with the causes of failure, which are inherently unpredictable.

Conflicts – the interests of the institution versus the interests of the financial system: the implementation of wind-down plans necessarily must take effect pre-failure. This gives rise to considerable corporate governance concerns: senior management are generally required as a matter of corporate law to act in the interests of the institution while it is solvent, and in the interests of creditors on and following insolvency. A requirement to commence limiting risk and/or prepare for failure in the interest of the wider financial system would place them in a situation of conflict between their duties to the institution or creditors on the one hand, and their duties to the wider financial system on the other. That conflict could ultimately carry legal liability for the senior management of the institution if their implementation of the wind-down plan is successfully challenged by shareholders or creditors following a failure of the institution.

Confidentiality: the wind-down plan as self fulfilling prophecy: the implementation of a wind-down plan carries with it a serious risk of becoming a self-fulfilling prophecy. In any significant financial institution, the commencement of a wind-down plan would be likely to become a matter of public knowledge in a short period of time. As soon as it is public knowledge, counterparties will seek to close out positions, commencing a run on the institution. We therefore believe that there is a very serious concern that implementing a wind-down plan risks precipitating failure at a time when it would otherwise not be certain that the institution would fail. This arguably amplifies, rather than mitigates, systemic risk.

This last concern is fundamental. It seems clear that, in order for market confidence to be maintained, any wind-down plan would have to be implemented only from the point at which it was already clear that the institution would fail. At that point, however, the amount of damage limitation that could be achieved may be relatively minimal.

On this basis we believe that there is unlikely to be any real utility in a wind-down plan. In practice the supervisors' understanding of, and engagement with, the institution are likely to be far more useful in managing the process of failure than a formal wind-down plan.

The proposals drafted in the Paper also pre-suppose that it is possible for the senior management of a firm to make a judgement as to what period of time constitutes "the period leading up to insolvency" of a firm on the one hand, and the time period which represents "the pre-insolvency corridor" on the

0010023-0024973 BK:13402686.7 18 26 March 2010

other. According to the Paper, in the former time period, firms would undertake certain "internal actions", whereas in the latter, they would undertake certain "market-facing" actions. We are of the opinion that there is no coherent distinction to be drawn between these two time periods.

According to the proposals laid out in the Paper, firms would only "stop taking on new risks or new business" as part of their market-facing actions. This leads to the inference that, notwithstanding any internal actions during "the period leading up to insolvency", the firm would nonetheless continue to trade, which creates the potential for the senior management of an investment firm to commit the offence of "wrongful trading" during the timing gap between the two periods. Clarification is needed as to how these time periods could be more clearly distinguished in practice.

If the management of a firm are uncertain as to when they must commence market-facing actions, their concerns over potential liability for wrongful trading could cause them to take premature market-facing action, that is, at a time when failure could have been averted. Once a firm's market-facing actions have become public, counterparties are likely to withdraw support from the firm, seek to close out positions, and could even commence a run on the firm. This could have the perverse effect of creating a situation whereby market-facing actions become a self-fulfilling prophecy and are actually responsible for precipitating the failure of a firm.

21. What are the obstacles to implementing investment firm resolution plans as suggested in this paper? What policies could the Government consider to address these, if any?

There a number of potential obstacles to implementing an effective resolution. In particular, we note that an effective resolution would depend on:

(i) the availability of key personnel to assist in preparing and executing the resolution plan;

(ii) the accuracy, sufficiency, accessibility and currency of existing data;

(iii) the extent to which there are complications arising from the fact that the resolution takes place on a cross-border basis;

(iv) the clarity of regulation and regulatory guidance; and

(v) the security and confidentiality of data in the Information Pack, recovery plan and resolution plan.

These are primarily operational in nature: the success of a resolution plan will depend largely on the ability of the institution to maintain records and resources through failure, and the ability of the authorities to use those resources and records. This requires better systems at the level of the institution, and better supervision by regulators.

22. Initial discussions with stakeholders indicate that for the prime brokerage business, initial costs of setting up investment firm resolution plans could be about £1-£3 million, with a team of about ten people from different parts of the business working on them. The prime brokerage business may incur an additional £0.5-£1 million per year for continually updating the resolution plans, with a team of three people working on them.

0010023-0024973 BK:13402686.7 19 26 March 2010

Stakeholders have suggested that costs for the entire investment banking business, including prime brokerage, would be approximately five times the costs for the prime brokerage business mentioned above; £5-15 million one-off costs, and £2.5- £5 million annual costs.

There may also be ongoing benefits to the investment banking business from having in place continually updated resolution plans. These may include, for example, increased operational efficiency from identification of interdependencies between business units. However, these are not taken into account here, as it would be challenging to estimate the effect of resolution plans separate from that of other factors.

These costs will ultimately depend on the final proposals put forward by the FSA. As discussed above, the FSA will be conducting a full cost-benefit analysis of its proposals.

Based on the proposals for resolution plans outlined here, do you agree with the suggested costs for the prime brokerage business?


23. What resources do you expect the entire investment banking business of the firm to spend on resolution plan implementation? Costs would include those related to: (a) designing and setting up resolution plans in collaboration with the FSA; (b) the ongoing audit and update of resolution plans and their inclusion in the firm’s corporate governance activities; and (c) the additional resources required to implement resolution plans in a distress situation, if any.


24. Do you agree that business information packs will be useful to administrators and will fulfil the Government’s objectives for a managed wind-down of investment firms?


25. Initial discussions with stakeholders indicate that for the prime brokerage business, initial costs of setting up BIPs would be similar to those of investment firm resolution plans, at about £1-£3 million, with a team of about ten people from different parts of the business working on them. The prime brokerage business is likely to incur an additional £0.5-£1 million per year for continually updating the BIPs, with a team of three people working on them.

Stakeholders have suggested that costs for the entire investment banking business, including prime brokerage, would be approximately five times the costs for the prime brokerage business mentioned above; £5-15 million one-off costs, and £2.5- £5 million annual costs.

As in the case of resolution plans, there may be ongoing benefits to the investment banking business from having in place continually updated BIPs, but these are not included here.

Based on the proposals for BIPs outlined here, do you agree with the suggested costs for the prime brokerage business?


0010023-0024973 BK:13402686.7 20 26 March 2010

26. What resources do you expect the entire investment banking business to spend on BIPs’ implementation? Costs would include those related to: (a) the designing and setting up of BIPs in collaboration with the FSA; (b) the ongoing audit and update of BIPs and their inclusion in the firm’s corporate governance activities; and (c) the additional resources required to supplement the BIPs in a distress situation.


27. The Government would welcome views on what incentives and disincentives are likely to be effective and whether there are any concerns with the ones suggested above.

There may be human rights implications for the structuring of incentives and disincentives for key members of staff. We note that, for example, any provisions purporting to provide for the clawback of remuneration should be considered in light of Article 1 to the First Protocol to the European Convention on Human Rights, which provides for the right to peaceful enjoyment of one's possessions. Provisions purporting to prohibit staff from terminating their contract of employment on the insolvency of their firm may raise additional human rights and restraint of trade issues.

With regard to the possibility of imposing a moratorium on service providers to prevent them from terminating their contracts with the firm, we feel this should generally be dealt with by way of commercial negotiation between the parties, rather than by way of regulation2. In competitive markets, market-standard fees in supply contracts should emerge and suppliers should eventually find themselves in competition with each other for the business of investment firms, which should exert downward pressure on prices.

28. Are there any other areas and activities for which key staff should be retained? Do you agree with the Government’s proposed approach for the firms to identify key staff to be retained?


29. What do you consider would be an appropriate measure to ensure that the fees that suppliers charge post-insolvency are not inordinately high? Do you believe the Government can take specific action in this regard?

This is a commercial issue, not a legal one. We also make the point that many suppliers are based overseas, and the Government has no power to intervene in foreign law; any actions taken by the Government in this regard must be recognised as having limited application.

30. Costs associated with this policy would depend on exact conditions of contracts and the number of key staff or nature of services required. The Government recognises that cross-border groups with investment banking business may negotiate contracts with staff and service providers on a central, group-wide basis. The policy proposed here is likely to lead to additional costs for negotiating contracts specific to individual legal entities.

2 It should be noted, in particular, that such moratorium would be unlikely to bind foreign entities providing outsourced services.

0010023-0024973 BK:13402686.7 21 26 March 2010

Stakeholders consider the legal costs of renegotiating contracts for both staff and suppliers to be in the region of £40,000 to £200,000. Although it is possible that these costs are high, the Government understands that they are unlikely to be as substantial as costs of on-shoring systems and services. The cost implications of associated policy measures such as an operational reserve for the payment of staff and essential services, the BIPs and BRO are examined in the relevant policy sections.

Do you agree with the cost estimates suggested above, for contractual provisions for key staff and suppliers? What are your views on the incremental costs of: (i) renegotiating contracts with vendors; (ii) putting in place appropriate contracts with key staff and (iii) creating an on-shore IT infrastructure to the extent that it is essential for wind-down in an insolvency?

We make no response to this question

31. What alternative policy tools could be considered to ensure continuity of essential services and key staff post-insolvency? Are there any likely impacts on the competitive position of UK firms from this proposal?


32. What are your views on legislative changes requiring administrators to use the operational reserve only for operational expenses?

We are of the view that any such legislative changes are unnecessary, and could potentially have a negative impact on the flexibility currently available to firms and administrators. The administrators' expense regime (provided for under paragraph 99 of Schedule B1 to the Insolvency Act) in effect provides that administrators may use any funds which are unencumbered, or at least not subject to a fixed charge, of the firm in furtherance of their duties and that their expenses will be repaid ahead of any debts due to holders of floating charges. The current regime is therefore, in our view, appropriately permissive.

It appears inherent in the proposals that the operational reserve should only be available for use by administrators (see paragraph 3.76 of the Paper). We are of the view that this proposal could have unintended negative consequences for firms. For example, absent insolvency, a firm may have temporary cash flow difficulties resulting in it being unable to meet its wages bill from its usual operational funds; if the firm was able to temporarily dip into its operational reserve it may be able to trade through the temporary difficulties and thus avoid insolvency.

In other words, the requirement to maintain an operational reserve for use only by administrators may have the perverse effect of forcing a firm into insolvency when it might otherwise have remained a viable going concern.

33. Initial discussions with stakeholders indicate that an operational reserve of $25-50 million would be required for the investment firm’s prime brokerage business and the annual opportunity cost of such funds is likely to be about 30 to 40 basis points.

In addition, the firm may need to include funds within the operational reserve for incentivising key staff to continue post insolvency. This is likely to amount to approximately $10-30 million for key

0010023-0024973 BK:13402686.7 22 26 March 2010

staff only of the entire investment banking business of a firm. As above, the annual opportunity cost of such funds is likely to be about 30 to 40 basis points.

Do you agree with the suggested cost estimates above? What is your estimate of the value of the operational reserve for the entire investment banking business of the firm, including monetary incentives for key staff, if any?


34. Do you have any views about the operational reserve proposed in Chapter 3?

We think that requiring firms to maintain an operational reserve is a good idea, and we note that a number of firms in the market are already required to do this.

We also note that the reserve represents a potential liquidity cost to firms and so should be set at a an appropriate and a proportionate level. With reference to our response to question 32, we would also welcome clarification as to whether there are any exemptions to the general position that the operational reserve cannot be used prior to insolvency.

0010023-0024973 BK:13402686.7 23 26 March 2010

CHAPTER 4: RECONCILING AND RETURNING CLIENT PROPERTY

35. Should the Government look to provide clarity over how shortfalls in client asset omnibus accounts are treated on insolvency? Should the Government look to provide clarity over when clients’ entitlement to their assets should be calculated?

We support the suggestion that the Government should look to provide such clarity. Our remaining comments are to the effect that, in order to provide certainty, there is a large number of inter-related questions, considerations and possible alternatives of which the Government will need to be mindful when seeking to provide such clarity.

We understand this question to refer only to assets, and not to money. If this is correct, then the reference to the LBIE Client Money Application in paragraph 4.28 is somewhat misleading. While the High Court has indeed, in that case, considered the appropriate date at which client entitlements ought to be calculated, the High Court's judgment is limited to entitlements to money and to the context of the client money rules, which include certain rules and guidance upon which the High Court's judgment was based. Accordingly, it is not necessarily the case that the High Court's ruling is an appropriate analogy for client assets, indeed there are several reasons why we think it might not be, and the Government should not assume that it is.

What the LBIE Client Money Application has made clear, however, is that the two questions asked here are inextricably linked: whether a shortfall in a pool of assets (or money) exists and the size of any such shortfall, will be determined in part by the method by which a clients' entitlements to claim against that pool are calculated.

Moreover, in order to answer the questions posed, it is first necessary to consider:

(a) what assets should be available for distribution to clients post-insolvency; and

(b) on what basis a pooling of assets, if any, should occur.

The FMLC paper referred to in paragraph 4.26 of the Paper left open for further consideration the question of what might constitute the 'pool': "[w]hether the pool is to be confined to securities held in the intermediary's account or is to include securities held in its house account… are issues to be determined later…"3. To the extent that a 'pool' is found to include all assets held by the investment firm in question, regardless of the account in which such assets are held, the likelihood of a shortfall arising at all is significantly decreased. However, any scheme of law which sought to protect clients in this way will almost certainly do so at the expense of the firm's creditors.

In relation to the second question, the possible options would appear to be:

(i) No pooling is to occur. All clients are to rely on equitable principles of tracing4, as they would in any other trust. This option may be feasible in a small investment firm with a limited number of clients, and limited rights of rehypothecation. But the likelihood of clients asserting an effective tracing claim becomes far more remote when multiple clients seek to recover securities of the same type, which are likely to have move in and out of various accounts held by the investment firm.

3 See footnote 18 to that FMLC paper. 4 A trust beneficiary will ordinarily have the right to 'trace' his assets into any mixed account – to the extent that his assets remain identifiable as his,

the beneficiary will be entitled to a return of those assets in full.

0010023-0024973 BK:13402686.7 24 26 March 2010

(ii) Client assets could be pooled on a stockline-by-stockline basis, such that all clients with an interest in ICI shares (for example) have an entitlement to receive a pro rata proportion of all ICI shares held by the firm, but those clients who had no prior interest in ICI shares would have an entitlement to share in the distribution of those ICI shares.

(iii) All client assets could be pooled and valued, in conjunction with a valuation of the interests of all clients in any assets, as at the date of commencement of the insolvency process and a pro rata distribution made. (We understand that this is the approach adopted under the US SIPA rules for the distribution of client assets that are 'street name' securities, and is similar to that followed in the current client money rules in relation to client money).

(iv) Under either of options (ii) or (iii), separate pools could be constituted for different types of clients (for example, pure custody clients and all other clients). In this way, it might be suggested that pure custody clients might avoid the risks faced by, say, prime brokerage clients who have given the investment firm in question rights of rehypothecation. (See further our response to question 47).

The Geneva Securities Convention (the Convention), referred to in paragraph 4.24 of the Paper, supports option (ii) above: see Article 26 of the Convention.

The discussion above demonstrates that there are a number of competing interests and complexities to be considered when seeking to put in place a scheme for the return of client assets. While we agree that there is room for the Government to provide clarity by way of legal or regulatory reform, any such reform should remain flexible enough to deal with investment firms of different sizes, and having different business lines.

36. Do you agree with the Government’s proposal of mandating warnings over the implications of allowing rehypothecation and omnibus accounts in relevant agreements? Should firms be required to offer clients designated named accounts at custodians?

These are two entirely separate questions.

In principle, we see no problem with the idea of mandated risk warnings (although we would query the need for it given the levels of awareness in the market following LBIE's failure). We note that the HMT paper proposes that the Government "ask the FSA to consider whether product warnings should be mandated" – this suggests that a consultation process will be undertaken by the FSA, in which case the appropriate time to address this question would be in response to the FSA's consultation document. At that time, it would be appropriate to note that the FSA's rules already contain requirements for firms to ensure that they treat customers fairly and that all communications are fair, clear and not misleading; these requirements could undoubtedly be bolstered by the addition of service-specific risk warnings.

In relation to the offering of designated named accounts, in our view it is not for the Government (or, indeed, the FSA) to mandate the scope of services which a firm may offer. The costs implications of such accounts have been noted and, to the extent that a client is willing to accept those costs in exchange for a decreased risk profile, such services are available; it is to be expected that more firms will offer such services as and when market demand drives them to do so. If such designated named accounts are required by clients, it should be for individual firms to set out the terms on which they are willing to offer such accounts.

0010023-0024973 BK:13402686.7 25 26 March 2010

37. Do you agree with the Government’s aim to encourage clarity in contractual agreements? If so, how is this best achieved?

In principle, we support the Government’s aim to encourage clarity in contractual agreements. In practice, we expect that achieving this may not be entirely straightforward.

In particular, we agree with the observations around event of default arrangements. We think that mandating the use of two-way event of default clauses, and close-out netting provisions, would go a long way towards providing the market with greater certainty. By way of example, many of Lehman’s contractual documents provided only for an event of default upon the breach, or failure, of the client. Those clients subsequently had a difficult time following the collapse of Lehman determining what rights they had to close-out their positions or terminate the contracts; the effects their doing so were similarly uncertain.

However, we are unsure at this stage whether the greater awareness of these issues means that there is still any market failure to be addressed by regulation. Any steps in this area should be market led initially. Any effort to require bilateral close-out rights in terms should be subject to detailed separate consultation given the complexity of the legal issues it raises, and the possible unintended consequences for firms.

38. Initial discussions with stakeholders indicate that there would be a one-off cost of £9,000 per warning in legal costs (calculated at 30 legal hours at £300 an hour) for firms to integrate additional text around each of the following areas in standard contractual agreements:

• warnings on rehypothecation; and

• warnings on omnibus accounts.

Do you agree with the costs suggested above? If not, please provide an estimate of the costs that are likely to occur, stating your assumptions.


39. Do you agree with the Government’s proposal of increased reporting requirements for systemic investment firms? If so, are there any issues around the timing or content of reporting that the Government should consider?

We agree with the principle underpinning this proposal – namely, that of increased transparency. However, we have some concerns around the possible practical implementation of these proposals.

As with our comments to questions 2 and 8, we submit that careful consideration needs to be given to the identification of those investment firms which are, in the Government's view, systemic, so as to ensure that the application of these enhanced obligations is clear. We also reiterate our concerns as to the negative consequences, including disparity of costs of business, of creating an unlevel 'playing field' for firms.

The paper correctly identifies clients and administrators or trustees as the parties who would most benefit from the receipt of such reports. However, we expect that many clients would have little appetite for receiving such reports on a daily basis (if they did have such appetite, we expect firms would be attempting to meet that need). Moreover, administrators and trustees are not identifiable

0010023-0024973 BK:13402686.7 26 26 March 2010

until the point of, or shortly before the point of, failure. We would question the value of such reports being provided to the FSA, particularly as we do not see how the FSA could determine the accuracy or otherwise of such reports.

It should be noted that reports, in and of themselves, are useful only to an extent. During the course of the LBIE Client Money Application, suggestions were made that certain clients of LBIE had received periodical statements of account showing client money holdings, only to find that those statements were not reflected by LBIE's holdings in fact. It is arguable that any reporting should be tied to the internal reconciliations and accounts of firms, and that clients and the FSA have appropriate tools at their disposal to ensure the accuracy of those reports, or to take retrospective action on the basis of such reports.

40. Do you agree with the Government’s proposals for increased record-keeping requirements for investment firms? Should the Government require settlement date record-keeping, as well as trade date record-keeping on custody systems?

We expect that many firms already undertake daily record-keeping exercises (many systems may, in fact, be real time). However, we would support any proposals to ensure that record-keeping and reporting requirements are aligned and that a firm's internal systems are fully reflective of reports made to clients and/or the FSA.

In theory, we support the proposals for settlement date record-keeping. Such records would need to ensure that proper identification of any internalised trades (e.g. where a purchase trade for client A is offset by an opposite sale trade for client B, such that there has been no movement of securities in the relevant settlement systems). Proper record keeping in this regard should attempt to enable clients to effectively assert a tracing claim, even where no actual transfer of securities has occurred.

41. Do you agree with the Government’s support for increased audited disclosures by firms around client money and assets? Should Government require firms to make available audited client money and assets reports to clients?

As noted in the Paper, the CASS rules and SUP already provide for the detailed requirements around client money and client assets account keeping, records and reports. We would question whether any issues identified around reporting requirements, record-keeping requirements, and audited disclosures are the result of weak or ineffective rules or a failure to properly supervise and enforce compliance with those rules. (This comment applies equally in response to questions 39 and 40.)

We would also question whether such audited reports might be of any benefit to clients, given that they will necessarily be historical reports and not at all reflective of the firm's current holdings.

42. Should the Authorities clarify the scope of FSA CF-29 and centralise CASS oversight under one individual?

Arguably, SUP 10.9.10(1)(d) R (being the description of the CF29 function) captures client asset supervision in the same way it covers client money supervision, as this rule refers to payments and settlements. However, further clarification in this regard is to be welcomed.

0010023-0024973 BK:13402686.7 27 26 March 2010

That said, we question the extent to which such an amendment would in fact "increase the transparency over the management of client property and will help enhance trust in the system, as well as enforcing against breaches" (see paragraph 4.60 of the Paper). Attempts to enhance the responsibility of a particular individual over the client money and client assets business units necessarily ignore the reliance of such business units on appropriate systems. Perceived failings in the current regime will not be addressed merely by altering the way in which firms must oversee compliance with the FSA's rules; rather, the rules need to better address what happens in circumstances where a firm has failed to comply with the rules.

43. Our initial discussions with stakeholders indicate that:

• there could be a one-off cost of $1.5m for a firm to build a reporting system, assuming that they did not have such a system already in place. If it did have a reporting system in place, it could cost an estimated $0.5m to expand its capabilities. Ongoing maintenance of a reporting system could cost up to $2m. Record-keeping costs could be subsumed within the costs of the reporting system;

• requiring firms to increase their audited disclosures could lead to ongoing annual costs of £30,000, based on 200 additional auditing hours at £150 per hour; and

• there would be a negligible cost of clarifying the scope of controlled function 29.

Do you agree with the above costs? If not, please provide an estimate of costs that are likely to occur, stating your assumptions.


44. Should the Government support the establishment of bankruptcy-remote vehicles for client assets through regulatory or legislative measures? If so, how could Government provide effective support?

It seems to us that there are a number of practical and legal hurdles to establishing such bankruptcy–remote vehicles (BRVs) for the purposes of holding client assets within the current UK regulatory environment. Traditionally, BRVs are structured so as to ensure that their liabilities will not pass to any other member of the corporate group upon their insolvency. This will ordinarily mean that:(i) the liabilities of the BRV will not be guaranteed or otherwise supported by any other entity, including by way of a charge over assets; and (ii) the liabilities of the BRV will be limited and quantifiable.

For a BRV to hold client assets, it would need to be a member of various clearing and settlement systems; under current requirements, it would also need to be authorised by the FSA for the purpose of holding and safeguarding client assets and to meet all of the FSA's requirements as to record-keeping. On this basis, we expect that it may difficult to quantify and limit the potential liabilities of the entity.

Arguably, there is also a tension between ensuring such remoteness and providing clients with recourse against their custodian in circumstances where there may be an asset shortfall, or any kind of breach of regulatory requirement or contractual obligation. Were clients to have such recourse against another group entity (for example, the provider of prime brokerage or other investment services, who had delegated the custody function to the BRV), the BRV would no longer be entirely ring-fenced from the rest of the corporate group.

0010023-0024973 BK:13402686.7 28 26 March 2010

That said, we can see that the potential benefits of a BRV solution might make exploration of such hurdles a worthwhile exercise. We expect that such initiatives would be most effective if they were to be industry led, although some regulatory reform may make structuring solutions more straightforward.

45. Do you agree with the Government’s proposal of limiting the transfer of client money to affiliates, and jurisdictions where there are potentially interoperability issues with CASS?

We agree with this proposal, provided that there should be an exception to enable firms to do business as mandated by the client.

For example, if a client wishes to hold Ruritanian corporate securities, which are dematerialised in a Ruritanian settlement system, the client should not be prevented from doing so through its custodian simply because the laws, or rules of the settlement system, in Ruritania may not allow the custodian to operate segregated accounts. Rather, firms should make it clear that clients wishing to do business in certain 'risky' jurisdictions do so at their own risk.

46. Should firms that manage client assets be required to obtain letters from custodians stating that there are no set-off and liens over client assets in respect of liabilities owed in a principal capacity by the firm?

We broadly agree with this proposal, provided it is implemented flexibly so as to allow custodians full access to global custody networks.

Custodians operating in certain jurisdictions may be unable to provide such letters (i.e. Ruritania in the example given in response to question 45). Underlying settlement systems may have statutory encumbrances. Again, we submit that such foreign legal concerns should not result in firms being unable to provide clients with services in problematic jurisdictions, where clients wish to do such business.

Further, where a custodian operates a single omnibus client account (which is segregated from their proprietary account) with a settlement or clearing system, it is likely that all assets in that omnibus account will be subject to a lien in respect of all liabilities arising in connection with the assets held in that account. In other words, client A's assets will be used as security for client B's indebtedness. It may be difficult, and certainly costly, for custodians to operate fully segregated accounts and thus clients of a firm need to be aware that even where they are not taking credit risk on the firm itself, they will most likely be taking credit risk on the firm's other clients.

Given the limits of regulation in this area, the key seems to be disclosure. Custodians generally undertake detailed legal analysis of their holdings in particular jurisdictions. Mandated disclosure of the results of that analysis so far as it pertains to encumbrances would give clients choice and incentivise custodians to avoid allowing encumbrances.

47. Should firms be required to have the capacity to separately pool client money relating to riskier activities?

0010023-0024973 BK:13402686.7 29 26 March 2010

This proposal would require significant changes to the client money rules under CASS 7 and CASS 7A. In their current form, the pooling of client money is a function of the rules and not of the capability of individual firms.

The policy options around pooling of client money were considered in detail in the FSA's consultation paper number 38 (CP38), dated January 2000. We consider that the advantages and disadvantages of the three options considered in CP38 remain an appropriate starting point for any further consideration of options for pooling of client money. It is perhaps also worth noting that the response to CP38, the FSA's consultation paper 57, dated July 2000, stated that "[t]he view of an overwhelming majority of respondents was to retain the current single pool method of pooling".

We would also note that any definition of 'riskier activities', whether imposed by law or regulation or determined by the firm itself, will be necessarily somewhat arbitrary – the nature and impact of the risks involved in any particular activity are subjective and the line between risky and non-risky will almost certainly contain several shades of grey.

48. Do you agree with the Government’s proposals for establishing bar dates for client claims? How should clients’ rights to their money and assets be affected by a failure to submit a claim by a bar date? Should the Government impose a legal duty on an administrator or trustee to impose a bar date?

In principle, we think there is merit in providing for the possibility of an administrator imposing a bar date for client assets claims and/or client money claims, in that this may lead to a speedier resolution of client claims and thus a faster return of client assets and/or client money. The overriding concern in relation to bar dates must be one of legal certainty – there must be absolute clarity between clients, creditors, insolvency practioners and the market as to what rights are to be affected by the imposition of any bar date.

Requiring administrators or trustees to impose a bar date would add an element of certainty but we are not convinced that a 'one-size-fits-all' approach is appropriate. The imposition of a bar date may only be necessary for those firms who had complex client assets holdings or where the beneficiaries of the client money pool are uncertain. (As regards client money, it is worth noting that the judgment in the LBIE Client Money Application may render the need for a bar date in relation to client money claims null and void; this is because client money claims are shown to be dependant on the segregation reconciliations undertaken by the firm, and thus the identity and entitlement of all client money claimants should be within the knowledge of the administrator, having access to those reconciliations.) Similarly, we think that the length of time prior to the bar date should be left to the discretion of the administrator, on the basis of what is appropriate for the firm in question.

We think it is a essential, so as to provide the certainty referred to above, that the imposition of any bar date protects the recipients of assets or money from any tracing claim or attachment which may otherwise be brought by a third party claiming an interest in the assets or money distributed. Similarly, the administrators should be entitled to rely on the firm's books and records in order to determine the entitlement of any client who has failed to submit a claim by the relevant bar date.

49. Our initial discussions with stakeholders indicate that:

• requiring investment firms to limit the transfer of client money to affiliates could cost around £15,000 (50 legal hours at £300 per hour) in legal costs;

0010023-0024973 BK:13402686.7 30 26 March 2010

• there could be a one-off cost to firms of £15,000 (50 legal hours at £300 per hour) in legal costs per custodian to renegotiate their agreements over liens. Additionally there could be other charges: for example, custodians may charge a fee (a basis point charge calculated on activity) or they may require average turnover pledged on an account;

• there could be a one-off cost to firms of £15,000-£1m depending on the extent to which firms already have the capability of dividing client money into different pools. There could also be an annual maintenance cost to firms of around £750,000 to maintain these separate pools; and

• there would be negligible costs to clients of requiring them to submit their claims by a bar date.

Do you agree with the costs suggested above? If not, please provide an estimate of the costs that are likely to occur, stating your assumptions.


50. Would the Government’s proposals in the area of client money and assets allow sufficient flexibility to enable investors and investment firms to meet mutually acceptable outcomes? Are the proposals ‘futureproof’ and do they have a limited negative impact?

We make no response to the first question. In response to the second question, we note only that it is virtually impossible to be assured that any proposals are “future proof” – predictions as to how the market may develop and change in the future are necessarily uncertain.

51. Do you have any other views on the issue of client money and assets that you feel are important for the Government to consider?

Client assets and client money need to be conceived of, and consulted on, as two entirely separate classes of holdings. The legal structures and conventions underpinning assets (i.e. securities) and money are entirely different and as such the means by which clients rights in such holdings might be protected are similarly different. It is important that this distinction remains clear at all times so as to avoid confusion or, worse, a regime which fails to meet its objectives.

0010023-0024973 BK:13402686.7 31 26 March 2010

CHAPTER 5: PROVIDING CLEAR AND EFFECTIVE SUPPORT FOR CLIENTS

52. Do you agree with the duties and proposed scope of the CAT? Should the scope be widened to include all investment firms? Should the Insolvency Practitioner be appointed from the same insolvency practice as the administrator or from an independent firm?

53. Do you agree with the Government’s suggestions for how the CAT could be established? What do you see as the advantages and disadvantages of the two suggested legal methods of establishing a CAT?

54. Should the costs of the CAT be funded from the client money and assets of the firm, or from the insolvent estate?

55. Do you agree with the proposal to establish a CAT? Should the Government favour alternative measures for improving client outcomes, such as the proposal in Chapter 2 to amend the legal duties of administrators to require them to prioritise the return of client money and assets?

We respond here to each of questions 52 – 55. In short, we do not agree with the proposal to establish a CAT and we think that certain alternative measures are more likely to prove effective in ensuring the speedy return of client money and client assets, in the most cost effective way.

Notwithstanding the suggestion of a 'mutual obligation of cooperation', there is a high likelihood of disputes between the CAT and the relevant Insolvency Official because of the different constituencies they would represent. This is because the interests of the administrators in protecting the general estate will be at odds with the interests of the CAT, who will be seeking to maximise the assets available for return to clients. The likelihood of such disputes will be greatest in relation to firms which have operated the alternative approach to client money (thus creating scope for arguments that some client money is held in house accounts) or have exercised rights of rehypothecation over client securities.

The LBIE Client Money Hearing has demonstrated the divergence in interests between the general estate of a firm and a firm's clients, as well as differences among clients. The appointment of representatives for classes of clients and creditors has proved, in that case, to be an effective way of ensuring that all of the divergent views are put forward and heard. Even in circumstances where an insolvent firm had both an administrator and a CAT appointed to it, the CAT would likely find it difficult to avoid disputes between various classes of clients and may be forced to remain neutral in any such dispute. This would, in turn, lead to increased costs as there would in effect be two such neutral parties in any dispute (i.e. the Insolvency Official and the CAT).

56. It is expected that any additional costs of the CAT proposal would be negligible due to the assumed faster return of client money and assets by the CAT, and the resulting fall in expected administration costs. Do you agree? If not, please provide an estimate of any costs that are likely to occur, stating your assumptions.

No. Disputes between the CAT and the Insolvency Official (as discussed in our response to question 55 above) are likely to provide both time consuming and expensive. Such costs are impossible to quantify in advance, and will depend on the circumstances of each individual firm, but it is likely that they will be borne by both the general estate (as an administration expense) and the trustee, presumably to be deducted from distributable trust assets or client money.

0010023-0024973 BK:13402686.7 32 26 March 2010

57. Do you agree with the proposal that an individual from the CAA should be able to perform the CAT role, where this is desired by the regulator?

In view of our response to questions 52 - 55, the short answer to this question is no.

58. Do you agree with the Government’s proposal to set up a CAA? Do you agree that this should be established as a distinct body within the Financial Services Authority?

It is clearly desirable that there be sufficient expertise within the FSA to police client money. We see no reason, however, why that needs a specialist CAA, as a distinct body within the FSA.

59. Should the FSA be granted powers to sit on the creditor and/or client assets committee by right, to enable it to monitor and, if required, challenge the administrator or CAT? Should such a power include the right to vote?

The proposals are somewhat unclear in that they do not specify whose interests it is supposed that the FSA's involvement in a creditors' or a client assets committee is intended to protect. To the extent that the proposal is intended to ensure that administrators (or the CAT) act in the bests interests of the creditors or clients, we would see this as unnecessary. Administrators (and, presumably, any CAT) are obliged to abide by duties of good faith; more particularly, any trustee has a fiduciary obligation to act in the interests of the trust beneficiaries. Further, as such committees are made up of the creditors or clients themselves, any FSA involvement would seem redundant (although we see no issue with the FSA being allowed to sit passively on any such committee).We think it would be particularly inappropriate for the FSA to have the right to vote in such committees as they have no financial interest in the firm's estate or the trust (as the case may be).

60. Should all firms currently regulated by the FSA and holding client money and assets, as defined by the FSA’s CASS rules, fall within the jurisdiction of the CAA?

Yes, but please see our response to question 58 above.

61. It is expected that the FSA will allocate more resources to client asset risks in the future, to perform work that could be taken on by the CAA. The incremental costs of the CAA are therefore expected to reduce. Do you have any comment on this?

We have no comment in this regard.

62. Do you have any other views on the establishment of a CAT or CAA that the Government should consider?

We have no further comments to make.

0010023-0024973 BK:13402686.7 33 26 March 2010

0010023-0024973 BK:13402686.7 34 26 March 2010

CHAPTER 6: RECONCILING COUNTERPARTY POSITIONS

63. Throughout this document, the Government is seeking stakeholder input to assess the likely costs of proposals. Preliminary work with the industry indicates that regulatory action to address incorrect TSO flagging, should it be needed, would have a negligible cost for firms, as it would simply be a matter of reiterating to staff the meaning of different flags and when they should be used.

Do you agree with this assumption? If not, please provide an estimate of the costs that are likely to occur, stating your assumptions.


64. What action should market participants take to address incorrect TSO flagging? Do you believe regulatory action to address the issue of TSO flagging is needed?


65. What would be the advantages and disadvantages of extending Part 7 type protection to cover the default rules and trades of Multilateral Trading Facilities for all affected parties, including creditors? What other options should the Government consider?

In principle we see no issue with allowing MTFs which use clearing infrastructure, on a voluntary basis, to opt into Part 7 – albeit that the benefits would be relatively limited as set out in paragraph 6.22 and consideration should be given as to how best to disclose to market participants such limitations to avoid the risk that Part 7 protection is perceived as providing more protection than it really does.

It would not be appropriate to mandate default rules for all MTFs: MTFs operate under a variety of models, including some which do not utilise centralised clearing at all: it would be inappropriate to mandate that these have default rules. Further, an MTF which does not utilise centralised clearing would need significant structural changes to its business model, systems, and contractual documentation to be able to identify market contracts and enable enforcement of default rules.

Equally, the FSA should also apply a threshold test, on a case-by-case basis, as to whether a particular MTF should be entitled to opt-in to Part 7 protection, looking at its governance, systems experience etc. The exercise of default rule powers comes with significant responsibilities and an MTF's capacity to perform its functions appropriately should be considered before the benefits of Part 7 protection are applied in individual cases.

66. Do you agree that the AFME Protocol is a sufficient solution for the issues identified around OTC cash equity trades not covered by default rules or default terms of business? How could the Protocol be improved?


0010023-0024973 BK:13402686.7 35 26 March 2010

67. Do you believe the AFME Protocol, or an equivalent, should be placed on a regulatory footing? What would be the advantages and disadvantages of this step?


68. Do you have views on the valuation mechanism which should be used in a market Protocol on OTC cash equity trades? In particular, should it be gross or net, and what would be the advantages and disadvantages of each methodology?


69. Are there any other asset classes that the Government should consider for which lack of default terms has proved problematic in the event of the insolvency of a counterparty, or may in the future? If so, please specify.


70. What would be the advantages and disadvantages of extending the protections provided by Part 7 of the Companies Act 1989 to cover underlying client trades for clients, counterparties and creditors? Can you give any indication of the possible costs and benefits of intervention in this area, and its distributional impact?

In principle we believe there would be benefits in clarifying and extending elements of Part 7appropriately to facilitate the effectiveness of clearing house rules which seek to preserve client margin and facilitate portability of client positions and margin in the event of a clearing member insolvency.

Key clarifications under Part 7 would, in our view, include: (1) the clear ability of the clearing house to have broad discretion to offer multiple separate accounts in the name of a clearing member which are to be treated separately in the event of the clearing member's default, so as to facilitate different models for segregated client services, and (2) the inclusion within the clearing house's powers of the express right to utilise and transfer margin held on a member's account to a third party (or return it to the underlying client) in order to facilitate default management processes and the transfer or close-out of positions.

It is however also important to note the international nature of clearing business, particularly as to the relationship between clearing members and their clients who may be based anywhere in theworld. Since Part 7 is UK legislation only, and therefore not necessarily going to be recognised by overseas insolvency officials, there is merit in seeking to avoid use of Part 7 as the primary tool for protecting aspects of default management arrangements which extend beyond the immediate relationships of the clearing house and can be sufficiently addressed by other well-understood risk management tools.

The relationship between clearing members and their clients is generally a complex one which may include a broad range of business activities including cleared business, OTC business, lending and a host of other services. We would expect that other elements of the relationship between a clearing member and its client are better left outside the remit of Part 7 and addressed bilaterally, together with such elements of standardisation as a clearing house may seek to impose upon its clearing

0010023-0024973 BK:13402686.7 36 26 March 2010

members in order to make segregated client services available. Many of the issues that need to be addressed in order to facilitate effective protection of client positions can be achieved in this way. For example, close-out netting as between a clearing member and its client in relation to cleared trades can be achieved by means of industry standard documentation and supporting opinions.

We make no response to the question of costs and benefits of intervention in this area.

71. Are there any other solutions the Government should be considering to promote margin portability?

Consideration should be given to the interaction between (i) a clearing house's default rules as they relate to client positions and margin and (ii) applicable client asset protection regimes. It will be important to ensure that statutory arrangements around pooling and distribution of client assets upon a clearing member default do not compromise the ability of a clearing house to manage client positions and related margin in accordance with its default rules.

72. Initial discussions with stakeholders indicate that there would be negligible costs for market infrastructure providers and market participants in mandating the offer by CCPs of segregated accounts, as this is already offered as standard by CCPs in the UK. The Government would welcome comments on this assumption.

A number of the CCPs based in the UK, including LCH and ICEClear, do provide the option for clearing members to operate a segregated client transaction account (although the nature and extent of such segregation varies).

Initial discussions also indicate that mandating investment firms to offer a choice of account at clearing would have an average one-off cost, per investment firm, in the region of US $5-10 million for an investment firm to develop this capacity, and an approximate annual maintenance cost of $5 million. The Government would welcome feedback to improve this estimate and, in particular, how it might impact on firms of different sizes.

Do you agree with these costs? If not, please provide an estimate of the costs that are likely to occur, stating your assumptions.

We make no response to these questions as regards costs.

73. Do you agree there would be value in the introduction of an explicit requirement that CCPs offer facilities for members to segregate their business?

We do not believe that regulating CCPs to mandate offering of segregation is an appropriate or proportionate regulatory response to the issues raised in this Chapter. For non-UK CCPs, segregation may be problematic in light of market norms and/or the domestic legal structure. For UK CCPs and other CCPs for which there are no obstacles to running segregation, a mandatory requirement to offer segregated clearing presents costs to the CCP with no necessary regulatory benefit if it is left to investment firms whether to clear client business on a segregated basis. Accordingly, if the authorities are to seek to create incentives to segregated clearing (as to which see the response to

0010023-0024973 BK:13402686.7 37 26 March 2010

question 74, below), we believe that the correct regulatory lever should be a requirement at the level of the investment firm, not the CCP.

74. To what extent is it necessary to require clearing member investment firms to offer their clients a choice of account types for the purposes of clearing? What would be the advantages and disadvantages?

It is our experience that following the failure of LBIE, clients are now keenly aware of the differences between segregated and unsegregated clearing models. The market is developing rapidly in this area to deal with the new focus of buy-side clients on counterparty risk management. While it is clear that there has been market failure, demonstrated by the failure of many participants to understand their counterparty risk on clearing arrangements, it is clear that the market is adjusting to that failure. In light of this we do not believe that regulatory tools are needed to mandate segregated product offerings.

75. Are there any other issues which you believe need to be resolved at clearing level, regarding the insolvency of an investment firm? If so, please provide details.

Although not strictly raised by the Paper, we believe that greater focus should be given to the position of CCPs within the system. The growth in the number and variety of CCPs, and in regulatory incentives to their use, have the effect of increasing the likelihood of their failure, and potentially the negative externalities associated with that failure. In short we are concerned that CCPs have or will become a new class of 'too big to fail' institutions. We believe that active consideration should be given to how a CCP's failure would impact on the UK markets and how that impact should be mitigated.

76. Does EUI’s proposed approach to settlement provide greater predictability and are there ways it could be improved?


77. Have the key consequences of EUI’s proposal to increase certainty of settlement been identified correctly and do the benefits for the market as a whole of the proposed revised approach outweigh these consequences?


78. Do you believe that Government action is required to address contractual terms issues?

We do not believe that Government action is appropriate to deal with an essentially private matter between buy-side and sell-side firms, unless a demonstrable market failure exists which would be proportionately addressed by legislation or regulation. No case has been made that demonstrable market failure exists in this area: disputes between the buy-side and sell-sides over terms are typically questions of allocation of legal and commercial risk. Were those disputes to have systemic

0010023-0024973 BK:13402686.7 38 26 March 2010

consequences, then a case could be made for legislative or regulatory intervention: we believe that they do not.

79. If you do believe regulation or legislation to address terms of business between investment firms and investment manager is required, which issues do you think are the highest priority? Which types of measures would best address them?

See our response to question 78.

0010023-0024973 BK:13402686.7 39 26 March 2010

CHAPTER 7: MANAGING COMPLEX CREDITOR POSITIONS

80. Do you agree that regulatory or legislative action is not required if a suitable market solution is reached with respect to the issue of terminating derivatives contracts as set out above? Do you have views on what type of regulatory or legislative action will be most appropriate should there be no market solution to this issue?

We endorse the answer provided by ISDA in their response to the Paper.

81. Do you agree with the proposal for a resource centre to aid administrators of investment firms?

We endorse the answer provided by ISDA in their response to the Paper.

82. Do you have views on the difficulties that repo market transactions could pose for the insolvency of an investment firm, affecting value recovered for creditors? If this is a concern, what kind of policy action could the Government consider to address it?

Over collateralisation and associated insolvency risk in the repo market is really a matter of improving collateral management in firms and their clients. The government should not seek to legislate in this area. The FSA is looking at collateral management and should seek to improve regulated market participants' systems, but should not seek to impose detailed rules or requirements, given the different systems and structures employed by market participants.

83. In relation to the areas listed here, are there any concerns that would substantially change the distribution of the outcome? Are there any other areas not covered here that may create negative externalities for unsecured creditors?

We make no response to these questions.

84. Are there any specific factors with respect to the loss of market confidence and complexity of business that affect unsecured creditors, which are not addressed here and which the Government should consider?


0010023-0024973 BK:13402686.7 40 26 March 2010

ANNEX C: CONSULTATION STAGE IMPACT ASSESSMENT

We make no response to these questions.

85. Do you have any suggestions which could help improve the Government’s proposed quantification strategy? If so, please specify what these are.

86. Are you able to provide an estimate of the financial impact of any delays or issues with LBIE’s resolution process on your firm, as a counterparty, client and/ or creditor? If so, please provide an estimate for losses in the areas below, and what caused them. Please give the Government an idea of your firm’s size.

• For counterparties, please provide any information about the cost to your firm of uncertainty about what would happen to trades at trading, clearing and settlement, inability to hedge exposures, and the need to double-margin.

• For clients, please provide any information on resources allocated to sorting out an investment bank failure, and any cost from inability to use capital and assets tied up in the investment firm.

• For unsecured creditors, please provide any information about losses caused by destruction of the intrinsic value of the firm’s estate as a result of events occurring after the administration.

87. Are you able to provide any information which might help the Government quantify the ongoing or broader ‘ripple’ impacts of issues with the resolution process of a failing investment firm as described above? If so, please provide an estimate.

88. Are you able to provide any information that would help the Government to assess the loss of confidence caused by any problems with the resolution process itself, as described above? If so, could you please provide an estimate of costs associated with the loss of confidence?

89. By what percentage do you believe the proposals in this document might reduce any issues associated with the resolution process for an investment firm? Do you agree that, as a minimum, the overall package of measures proposed has potential to reduce any difficulties by 50%?

establishing resolution arrangements for investment banks

Documents