Special Administration for Investment Firms

Following the 2008 financial crisis and the subsequent difficulties encountered in returning client assets following the collapse of Lehman Brothers, the UK government enacted the Banking Act 2009 (BA 2009)[1] with the aim of preserving financial stability and confidence in the banking system.

BA 2009 enabled HM Treasury to create a new procedure for the administration of “investment banks” working in place of, or alongside, existing UK insolvency legislation. This led to the creation of the Special Administration Regime (SAR), comprising of the Investment Bank Special Administration (England and Wales) Regulations 2011[2] and the Investment Bank Special Administration (England and Wales) Rules 2011.[3]  Subsequent updates were made to the regime in 2017.[4]

The SAR works in parallel with the “ordinary” administration procedures available to companies under the Insolvency Act 1986.[5] It is not mandatory, and an investment bank may still choose the ordinary administration route.  However, the main distinction between the two regimes is that SAR specifically emphasises:

1. the timely return of investment assets to clients; and

2. the importance of co-operating with the relevant authorities to achieve the above.

 Client assets

The SAR works closely with the FCA’s client assets sourcebook (CASS),[6] a regulatory framework for investment firms that hold client money and assets.  The framework comprises a catalogue of rules designed to protect client money and assets that includes the requirement for investment firms to segregate client money from their own funds and the creation of a statutory trust with the firm acting as trustee.

On the failure of an investment firm, CASS continues to provide protection.  A “primary pooling event” is triggered, requiring that all client money held by the firm be pooled together and subsequently distributed back to clients in proportion to the value of their entitlements. 

In theory, all client money should be successfully returned to clients although this is dependent on the firm’s compliance with the FCA’s CASS rules prior to entering administration.

 What does SAR apply to?

While the regime refers to investment banks, it applies to a much wider range of firms.  An investment bank is defined as:

An institution that has permission under Part 4a of the Financial Services and Markets Act (“FSMA”) 2000 to carry on the regulated activity of:

1. safeguarding and administering investments;

2. managing an AIF or a UCITS;

3. acting as trustee or depositary of an AIF or a UCITS;

4. dealing in investments as principal; or

5. dealing in investments as agent.

The SAR is not therefore limited simply to traditional deposit taking banking institutions.  Indeed, it applies to a broad range of far smaller firms which, subject to the scope of regulatory permissions, may include discretionary investment managers and private client stockbrokers.

 Grounds for applying for special administration

An investment firm must apply to the courts for special administration.  It is a serious matter and will be granted only where the court concludes that one or more of the following apply:

1. the investment firm is, or is likely to become, unable to pay its debts;

2. it would be fair to put the investment firm into special administration; and

3. it is expedient in the public interest to put the investment firm into special administration.

The FCA may apply for a special administration order where it considers ground a) or b) is met.

The Secretary of State may also apply for a special administration order but only if it appears to the Secretary of State that grounds b) and c) are met.

Preparation by an investment firm to apply to the courts for the appointment of special administrators usually takes place several weeks in advance.  The application must be made in writing and signed by the applicant investment firm.  It must also be accompanied by a statement from the proposed special administrator, in which details including the administrator’s ability to act in this capacity are noted, together with a witness statement. 

The witness statement will be provided either by one of the investment firm’s directors, a representative of all creditors to the investment firm, or a person of sufficient capacity at the FCA.  The witness statement must:

1. set out the reasons by which the applicant believes the application is based is satisfied;

2. state the investment firm’s current financial position, specifying (to the best of the applicant’s knowledge and belief) the investment firm’s assets and liabilities, including contingent and prospective liabilities;

3. specify any security known or believed to be held by the creditors of the investment firm;

4. specify the amount of client assets held by the investment firm to the best of the applicant’s knowledge and belief;

5. specify how functions are going to be allocated where more than one person is to be appointed as administrator (stating in particular whether functions are to be exercisable jointly or by any or all of the persons appointed); and

6. specify any other matters which the applicant thinks will assist the court in deciding whether to make the special administration order.

 Special administration objectives

Special administration involves either rescue of the company as a going concern or the formal winding up of a company’s affairs in the best interests of creditors.  The latter will entail the realisation of the firm’s assets and distribution of the proceeds in a prescribed order of priority. 

On successful appointment, the administrator has three statutory objectives.  In order of priority, these are:

• Objective 1: ensure the return of client assets as soon as is reasonably practicable;

• Objective 2: ensure timely engagement with market infrastructure bodies and the financial authorities; and

• Objective 3: to either:

-          rescue the investment firm as a going concern, or

-          wind it up in the best interests of the creditors.

The FCA may direct the administrator to prioritise one or more special administration objectives having regard to the public interest in:

1. the stability of the financial systems of the United Kingdom; or

2. the maintenance of public confidence in the stability of the financial markets of the United Kingdom.

 Costs and remuneration

When an investment firms enters special administration, in most instances, the costs are paid out of:

1. the Company's assets; and

2. deducted from the client assets it holds, in specific circumstances.

Clients and creditors, who hope to recover monies or assets due to them, therefore have a direct interest in the costs charged and the remuneration of the administrator.

In pursuit of Objective 1, the return of client assets, costs are typically paid out of the client asset pool in what appears to be a contradiction of the protection intended by the CASS framework.  The ability to claim costs from the pool is however limited to the following conditions, which in order of priority are:

1. expenses properly incurred by the administrator in pursuing Objective 1;

2. any necessary disbursements by the administrator in the course of the special administration specific to the achievement of Objective 1;

3. the remuneration of any person who has been employed by the administrator to perform any services for the investment firm specific to the achievement of Objective 1; and

4. the administrator’s remuneration.

Costs payable in pursuit of Objectives 2 & 3 are paid from the firm’s assets.  The basis for determining costs in respect of all 3 objectives is normally decided by a creditors' committee. However, if a creditor’s committee has not been appointed, or the committee makes no decision as to the basis of determining costs, the order of priority will be:

1. the clients in respect of Objective 1; and

2. the clients and creditors in respect of Objectives 2 and 3.

Interaction with the FSCS

The Financial Services Compensation Scheme (FSCS) is a protection scheme which aims to pay compensation to “eligible claimants” if a firm is unable, or likely to be unable, to pay claims made against it.  It is the UK’s statutory fund of last resort for most failed financial services firms and was introduced by FSMA 2000 and launched in December 2001.

FSCS can cover client asset and money shortfalls including where a shortfall arises because of costs associated with an administrator’s pursuit of Objective 1. However, the FSCS will only be able to provide such cover if it determines that it can do so under the rules set for it by the FCA, and subject to the qualifying conditions for providing such cover.

Further, the FSCS will only consider claims after the firm has been declared ‘in default’.  While a firm is still trading or still has sufficient assets to meet claims, a claimant would need to pursue the firm itself or its administrators. The compensation limit for investment firms that have failed after 1 April 2019 is £85,000 per eligible complainant, per firm.

Any client of a failed investment firm may be an ‘eligible claimant’ if they are not specifically excluded.[7]  Individual persons are generally classed as eligible complaints although directors/partners of the defaulted firm will be excluded in most cases.   

For clients that are companies, the company must qualify as a ‘small company’ under Companies Act 2006[8] to be eligible. There are three criteria in the test - annual turnover, balance sheet and number of employees - and the firm must meet two of the three criteria to qualify as ‘small’.

 Phoenixing

“Phoenixing” is a common term used to describe the practice of closing a firm and that firm re-appearing under a new guise to avoid liabilities arising from the old firm. Each time this happens, the insolvent company’s assets, but not its debts, are transferred to a new, similar “phoenix” company.

As part of the FCA’s ongoing supervision of firms and of individuals controlling firms, the FCA actively looks out for and acts on, situations where a firm or individual is seeking to avoid their liabilities.

Where it finds individuals have deliberately avoided their responsibilities, the FCA will question the fitness and propriety of these individuals and take necessary steps against them so that they don’t cause further harm to consumers.

[1] Banking Act 2009 (legislation.gov.uk)

[2] The Investment Bank Special Administration Regulations 2011 (legislation.gov.uk)

[3] The Investment Bank Special Administration (England and Wales) Rules 2011 (legislation.gov.uk)

[4] The Investment Bank (Amendment of Definition) and Special Administration (Amendment) Regulations 2017 (legislation.gov.uk)

[5] Insolvency Act 1986 (legislation.gov.uk)

[6] FCA Handbook - FCA Handbook

[7] COMP 4 - FCA Handbook

[8] Companies Act 2006 (legislation.gov.uk)