As investors we’re often reminded that our investments can go down as well as up, but not that our brokers can go bust. Yet figures provided by the Financial Services Compensation Scheme (FSCS) reveal this is not uncommon. In the past five years alone more than 400 investment firms have gone belly up. What happens in this situation and what can you do to protect yourself?
Existing safeguards
Rules set out by the Financial Conduct Authority (FCA) mean brokers are supposed to protect client money by keeping client assets in ring-fenced accounts segregated from the broker’s assets. In the event of the firm’s insolvency, its creditors should only have a claim against the assets held in the broker’s name, not the assets registered in client accounts. This means, even if the firm fails, your money should be safe.
Nevertheless despite this safeguard there are two main hazards to be aware of that you won’t find promoted in brokers’ glossy brochures or websites – the difficulties of untangling pooled nominee accounts and the risk of broker fraud or mismanagement.
Nominee account downsides
Most broker firms rely on nominee accounts. Around 95 per cent of all UK share purchases are conducted electronically via a nominee account and all individual savings accounts (Isas) and Self-invested pension plans (Sipps) are run this way. But what exactly is a nominee account and why have they become so widely used?
A nominee account is a type of account in which stockbrokers hold assets on behalf of investors, typically through a designated nominee company. Rather than investors being individually registered as shareholders on Company Share Registers, their shares are registered in the name of the broker. This means the nominee company that a broker uses to hold its clients’ investments is the recorded legal owner of the shares.
Investors are considered ‘beneficial owners’ and have rights over the use of the shares and the proceeds from them. Crucially, your shares remain your property and cannot be claimed by a bust firm’s creditors.
Brokers will usually pool the assets of all their clients into a single client account. A pooled account makes it quicker, cheaper and easier for brokers to deal on their clients’ behalf as it cuts the administration of dealing with numerous accounts. Brokers will then keep their own records as to which clients own which stocks.
However, herein lies the potential problem. Firms that go bust can be disorganised so client records are often out of date and sometimes assets may have been misplaced. It may take the broker’s administrator several months to work out which shares belong to which client. This can quickly turn into a bureaucratic nightmare for clients who are unable to trade their shares and also bear the cost of the administrator’s fees.
In the case of two recent failures – Fyshe Horton Finney and Pritchard Stockbrokers – clients have been waiting two and three years respectively to get their money back. One person Investors Chronicle heard from – a former client of Hartmann Capital, which went bust last year – said: “Dealing with administrations is an experience you can liken to pulling teeth.”
Holding shares under your own name via personal membership of the Crest settlement system offers some protection against this problem. However, the number of brokers offering Crest membership is shrinking.
Roger Lawson, deputy chairman of the UK Individual Shareholders Society (ShareSoc), said about nominee accounts: “The danger is that if your broker goes bust you have no proof of ownership. You are not on the register of the company – you don’t legally own the shares, the broker does. Now what brokers will say to you is that these shares are held by a separate trustee company; that they are demarcated.
“But the problem in practice is when brokers go bust there have been several cases where the broker’s records of what they own and what the clients own have been muddled. So there is no clear proof that you own the shares, and this is the difficulty.”
He added: “It’s not just small brokers – Lehman Brothers was a classic case of a big company that muddled up its client shareholdings with its own holdings. Barclays was penalised recently for the same confusion.”
When client and company assets have not been separated, shortfalls in client money can occur. This may be due to fraud, negligence or mismanagement. In these circumstances investors are typically unable to get all their money back from the firm and therefore may be eligible to receive compensation from the FSCS.
FSCS to the rescue?
The FSCS is a Treasury-backed but industry-funded body that runs a compensation scheme of last resort for customers who suffer losses as a result of bad advice, fraud, misrepresentation or investment mismanagement by authorised financial services firms.
Compensation is only possible once a firm has been declared ‘in default’, that is “unable, or likely to be unable, to pay claims against it”. By definition then, the FSCS only deals with those firms that pose the most serious difficulties to their unfortunate customers. In the past five years 411 investment firms have been declared in default by the FSCS.
But with a limit of £50,000 compensation available per firm per person, the FSCS scheme is not completely comprehensive. People with investments of more than £50,000 held with a bust broker would not necessarily get all their money back (although the FSCS does attempt to recover the full amount by passing on any money extracted from the firm’s liquidation which may materialise further down the line).
Furthermore the scheme only covers firms authorised by the FCA and the Prudential Regulation Authority (PRA). It does not cover firms domiciled outside the UK (including the Channel Islands or The Isle of Man). It’s also important to realise that the FSCS does not compensate losses arising from investment performance.
The FSCS will only consider claims if they cannot be paid by anyone else. Therefore they will not consider claims until you have tried and been unable to recover your assets via the failed firm or its administrators and this can mean the process can take a long time. To speed things up the broker’s administrators may choose to notify the FSCS at the outset of a full liquidation that the firm’s clients are unlikely to be repaid, but until they do your claim will not be processed.
BROKEN BROKERS:
Wills and Co.
Set up in 1883 Wills and Co. was one of the City’s oldest stockbroking firms. However in 2007 the firm was fined £49,000 by the Financial Services Authority (FSA) for failing to outline the risks attached to penny shares it was selling. Despite the fine, the broker failed to clean up its act. In February 2010 it was censured again by the regulator for poor sales practices and not monitoring its advisers properly and finally banned from giving investment advice. An FSA fine of £1.5m would have been imposed had the broker not been in the process of winding down its business, dragged under by the large amount of customer redress it owed.
Wills and Co. was declared in default by the FSCS in June 2010. The FSCS received 6,430 claims from the company’s clients and paid out £56m in compensation. However this wasn’t the end of the road for the 19,000 unfortunate clients who were transferred to Pritchard Stockbrokers, a firm that also went bust (see below).
Lesson 1: longevity is no guarantee
Pritchard Stockbrokers
In February 2010, Bournemouth-based firm Pritchard Stockbrokers acquired the accounts of 19,000 clients from failed broker Wills and Co. However, almost exactly two years later in February 2012, Pritchard was also banned from trading by the FSA and had its cash assets frozen. In the supervisory notice it issued, the FSA said the broker had “used client money to meet its own expenses, thereby putting client money at risk”.
Had it not been for the firm’s distressed financial position, the FSA would have imposed a fine of £4.9m. As it was, a month later the firm was officially declared in default by the FSCS. The administrators confirmed a £3.1m shortfall in client money. In October 2014, two former directors of Pritchard Stockbrokers were fined and banned by the revamped regulator, the FCA, for recklessly failing to protect client money. But three-and-a-half years after the broker went bust many of Pritchard’s clients are still waiting to receive their money back in full, while the costs of the administration have climbed to £5m. As the FSCS does not pay compensation on administrator fees, clients are the ones who must cough up, based on size of their asset holdings. By September 2015, 8,383 of 11,211 clients had received just half their money back – totalling £12.5m – with no clear timeframe as to when they can expect the remainder. The FSCS has also paid out £9m to former Pritchard clients so far.
Lesson 2: Lightning can strike twice
Lesson 3: Lengthy waits = higher costs
Hartmann Capital
Hartmann Capital offered a range of investment services, including a brokerage that dealt in equities, CFDs, futures and options. The company had around 1,200 clients and £39.7m in custody assets, mainly stocks and shares. However in December 2013 the firm informed the FCA of a shortfall in client money – estimated at £1.5m. It also disclosed it was trading with a £1.2m shortfall in regulatory requirement capital. Despite the shortfall in client money, the regulator was alarmed that the firm planned to “use client money to fund further expenses of the firm”. On Christmas Eve 2013, the FCA banned Hartmann Capital from dealing with or releasing client money and carrying out any regulated business. In January 2014 the company entered special administration and was declared in default by the FSCS.
From January 2015 the FSCS started paying compensation to Hartmann’s clients and has so far paid out more than £2.5m after receiving 405 claims. However as there was a shortfall in client money, pooled nominee account holders had to bear the costs of reconciling accounts and were charged a fee of 2.4 per cent of the value of their assets to transfer their assets out of the failed broker.
Lesson 4: Nominee accountholders share the pain
