Prior to the global financial crisis, most savers had never considered the idea that their money might not be safe in a bank. That might also apply to brokerage accounts, where the system of using nominee accounts should leave client assets untouched in the event of a broker failure. However, some recent broker failures have called this protection into question.
Broker failures are rare, but happen at a rate of one or two each year. In October, discretionary fund management group Reyker Securities was placed in ‘special administration’ after it fell into financial difficulties. And there have been a number of other notable casualties in recent years: SVS, Beaufort Securities, Fyshe Horton Finney and Pritchard – enough, potentially, to trouble those holding investments with brokerage groups.
Those with assets tied up in a failed broker face a tense few months without access to their assets while administrators disentangle their portfolios. Broker failures often come out of the blue and investors will often only become aware of the problem after their assets have been frozen.
For clients, the biggest question is whether they will get their money back. Certainly, there are plenty of protections in place. Danny Cox, chartered financial planner at Hargreaves Lansdown, says that all assets held with a broker or platform have to be held within a nominee account: “All client money and assets held with a nominee service is held on trust and is segregated from the platform’s own funds in accordance with the Financial Conduct Authority’s (FCA) client money rules and guidance. Therefore, no creditors have a legal right to client money or assets and these cannot be used to cover any of the stockbroker's or platform’s obligations.”
So far, so good. The client’s only risk appears to be that their capital is tied up in an administration process for a period of time. Richard Stone, chief executive of the Share Centre, says: “At any broker, provided those customer assets are properly segregated and reconciled, then even if the firm goes bust those assets should still be there for the clients. It may take a little while for them to get access to those assets as any insolvency practitioner works through the process, but they should get them back.”
However, there is a wrinkle in the system. Mr Cox says: “If the administrator can’t recover fees from company assets, it’s legally allowed to do so from client assets instead.” In theory, the administrators can use client assets to pay their fees. Administration is a costly process with each stage of the process needing to be approved by the courts. Previous broker administrations have seen bills run into tens of millions, which can come out of investors' pension pots.
This is controversial. In the case of Beaufort Securities, investors were angered when they found that the administrator’s costs (in this case PwC) – estimated to be around £100m – would be paid for with their supposedly ring-fenced savings. Lord Lee of Trafford became involved, tabling a number of questions in the House of Lords about the practice. Costs were ultimately revised lower and capped at £10,000 per person.
There are a number of ways this isn’t quite as bad as it seems. Brokers have capital requirements placed on them by the regulator. These are designed to cover administration costs if they stop trading. Hargreaves Lansdown, for example, has net cash of £394m according to its last set of accounts.
It is possible that the capital held by the broker isn’t sufficient to cover the costs of administration. The Financial Conduct Authority is monitoring capital held by brokers all the time, but in cases of fraud and financial malpractice clients’ assets could be put at risk once again. However, should this happen, investors will be able to claim under the Financial Services Compensation Scheme (FSCS), which can pay up to £85,000 to each investor.
The system therefore offers three layers of protection: one, the client’s assets are held separately; two, the broker holds enough capital to cover its administration costs; and three, the FSCS will step in to pay the difference.
But is it still possible to lose money? FSCS compensation applies where individuals have contracted directly with the broker. The broker will need to be UK-authorised and covered by the scheme, which should be clear from its literature. It gets more complex if the client has the relationship through an intermediary, such as a self-invested personal pension (Sipp) provider. The FSCS may well be able to ‘look through’, but it will depend on the circumstances of the individual case.
Equally, the FSCS should be triggered automatically, and investors should be told how to apply. Alex Kuczynski, chief corporate affairs officer at FSCS, says: “FSCS protection is triggered by the insolvency of the firm, such as the special administration regime – which the recent broker failures have been. FSCS protection is automatic and need not wait for any payout from the firm.” That said, the FSCS does have to identify and quantify the shortfall – that will depend on the administrator reconciling the accounts to check the cash and assets are there and can take time.
There is no formal time frame for returning money to investors. Mr Kuczynski says: “Each case will be different due to the variety of reasons for which firms fail. A firm with properly segregated assets and good records is likely to be quicker than a firm where there has been a fraud or some other poor behaviour. The quality and availability of the failed firm’s systems and key people are also likely to have a significant impact. As an example, Beaufort failed in March 2018 and the first transfer took place at the end of September 2018.”
Mr Kuczynski is clear that there shouldn’t be a situation where an individual client dealing with a UK-authorised financial services broker has uncompensated losses for a broker failure. The only circumstances in which it might happen is when a client has a very large portfolio and their allocation of the administration costs – which are charged as a percentage of the fund held – exceeds the £85,000 limit.
It is important to note that this hasn’t happened with recent broker failures and is only likely to happen in very specific cases where the administration is lengthy and expensive. The process will cost more where assets are invested in ‘exotic’ investments – individual smaller company shares, shares in emerging markets – rather than, say, collective funds. Equally, it will cost more if record-keeping has been poor. Administrators charge by the hour, so the longer and more complex the process, the more it will cost and the greater the risk of loss to investors.
Another potential route to losses is that the FSCS won’t compensate for investment losses except when clients have been victims of mis-selling (such as assets being put in high-risk illiquid areas when clients had requested a low-risk portfolio). In all other cases, while their assets are tied up in administration, the stock market could slide and they wouldn’t be able to take action. Of course, the opposite could happen as well, but investors lose agency over their assets. This can be a particular problem with smaller companies or other illiquid investments. In Beaufort’s case, there was also a problem with the valuation of some of the assets, so some investors saw apparent losses from a revaluation.
Most investors would rather avoid bad brokers altogether. It goes without saying that investors should ensure that a broker is regulated by the FCA, covered by the FSCS and operates through nominee accounts. However, this applies in the majority of broker failures, so is not protective in itself.
Beyond that, it is not easy to generalise about the reasons for broker failure: in Beaufort’s case it fell under investigation by the US Department of Justice, prompting the FCA to declare it insolvent. The US agency accused six individuals of “deceit and manipulative stock trading” and then laundering the fraudulent proceeds through offshore bank accounts and the art world. For SVS, the regulator found it had “questionable commission arrangements” and had promoted high-risk bonds to retail investors. In the case of Reyker and Fyshe Horton Finney, financial difficulties led to the closure.
That said, Richard Stone believes there are certain factors that should flash red for investors: “One of the key issues that has led to failures is where companies' business models result in potential conflicts, in particular where firms act as both agent and principal – trading on behalf of clients and trading on their own account. Personal investors should be wary of firms where this is the case and focus on those firms that only ever act as an agent for its clients. In this case, it is always therefore acting in its clients’ interests and not placing itself in a position where those interests may be conflicted with the trading interests of the firm.”
He believes personal investors should also look at the business model of the broker – is it sustainable, how does it make its money, is it profitable? In the case of Fyshe Horton Finney, the firm had been in financial difficulties for some time, with its final year of trading showing losses of £565,701. It can be easier to find this information for larger companies. Listed brokers need to publish audited accounts, which can provide greater transparency on their financial situation.
Spreading assets across multiple brokers may bring complexity and may not make a significant difference. Given that the risk is around the £85,000 compensation limit, that broker failures are rare and that no-one can know the administration costs ahead of time, it may be worth finding the right broker rather than trying to manage multiple accounts.
A final note would be that the failure of a broker often prompts a raft of scammers and claims management companies to appear offering to help investors receive compensation. Investors can end up losing twice. It is highly unlikely that a third-party claims organisation would be able to get money out of an administration process any faster and they may charge a vast fee for the attempt.
Investors can rest assured that in most cases the system works well and they should receive their money back in full in the event of broker failure. The FSCS will even pay for the assets to be transferred to a new scheme. Even so, it's worth checking a broker’s strength before investing.
