HFW’s Will Reddie, Bob Haken and Ali Mynott examine how M&A-hungry brokers can better avoid the regulatory headaches they see cropping up in deals in the sector, particularly those around the handling of client money.
On paper, the client money rules seem a matter of process and procedure. However, we regularly see client money issues arising on M&A deals which can derail even well-run transactions. This article explores some of the issues that we commonly see, along with how to deal with them.
Regulatory landscape
Insurance intermediaries must comply with the Financial Conduct Authority (FCA)'s Client Assets Sourcebook (CASS) when handling client money, which includes premiums, refunds and claims payments.
The CASS rules seek to safeguard client money in the event of a firm's insolvency, aligning with Principle 10 of the FCA's Principles for Business: "A firm must arrange adequate protection for clients' assets when it is responsible for them."
Failure by insurance intermediaries to manage client money properly puts clients, typically policyholders, at risk. The regulators take a tough stance on compliance with the CASS rules, and we have seen the FCA levy substantial financial penalties for failures to protect client assets.
When dealing with client money, there are two approaches that firms can adopt.
One approach that firms can take is to consider risk transfer, whereby intermediaries act as an agent of insurers when receiving client money. Amounts which a policyholder pays to an intermediary are deemed to have been received by the insurer upon receipt by the intermediary. Accordingly, the policyholder is protected by the insurer carrying the risk should the intermediary misappropriate the amounts, or fail to transfer them to the insurer. The insurer is not permitted to ask the policyholder to pay those amounts again.
The alternative approach firms can take is segregation. This sees client money held in a client bank account under either a statutory trust or non-statutory trust. By clearly separating client monies from firm funds, client monies will not be available to the firm's creditors upon insolvency.
While firms can employ either approach, or a combination, they cannot adopt both approaches for funds in the same account. If a firm wants to combine risk transfer and segregated client money, all funds must be treated as client money, adhering to the segregation approach and CASS rules. To commingle monies, firms need a written agreement from each relevant insurer, confirming the subordination of their interests to those of the firm's other clients.
Issues arising during M&A deals
Common areas of concern around client money handling that arise on M&A deals include incorrect implementation of risk transfer, confusion regarding fund handling (such as accounting errors) and inadequate policies and procedures.
A buyer should consider carefully the costs involved in rectifying issues, the regulatory risks, and the potential for reputational damage as a result of regulatory investigation and enforcement.
Sellers should also ensure that vendor due diligence recognises and deals with any potential problems, to avoid any risk of a buyer misunderstanding or misinterpreting them, rather than waiting for issues to be identified by the buyer's advisers.
In practice, we see buyers approach client money issues in a number of ways. Pre-acquisition, a buyer might require the seller to take remediation actions and may decline to proceed with the transaction until issues have been dealt with to the buyer's satisfaction.
A buyer can also seek to protect itself from any financial impact post acquisition by negotiating contractual protections (such as indemnities) in the sale and purchase agreement (SPA) and/or negotiating a reduction of the purchase price. These steps are often taken where pre-acquisition remediation is undesirable for timing, commercial, and/or cost reasons.
Pre-acquisition remediation actions might involve compliance audits or requiring the seller to implement new policies or staff training.
We have experienced this situation in practice, where we identified client money issues when undertaking due diligence for a buyer client. We worked with the seller and its advisers to implement improved client money procedures and clear documents. This also involved negotiating robust indemnities in the SPA.
By undertaking these pre-acquisition actions, our client could proceed with the transaction in the knowledge that it was buying a compliant entity and had protections in the SPA.
Will Reddie and Bob Haken are partners in the insurance and reinsurance global group at HFW. Ali Mynott is an associate in the practice.