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Tuesday, 4th August 2020
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Morrogh ruling risks Ireland's pro-business reputation being damaged Back  
Last year’s ruling on the Morrogh Stockbrokers case may damage Ireland’s investment management, custody and funds administration businesses, and as such Sean Hawkshaw writes that there is a strong view within the industry that something needs to be done to clarify the situation and preferably reinstate the ringfence around assets held by custodians.
AAnybody who has been following this case will know that there are complicated legal issues involved and not all the information is in the public domain.

To recap on the background, A&L Morrogh was a Cork based stockbroker which ceased trading in 2001. There was a fraud within the firm ‑ we needn’t be concerned with the details here ‑ but the net result was a shortfall of €12 million which greatly exceeded the assets of the firm.

The receiver was called in and as there were not sufficient assets to meet his costs he looked for recourse to client monies as he was entitled to under Section 52 of the Investment Intermediaries Act, subject to application to the High Court.

The client assets were held in a nominee company controlled by W&R Morrogh. This was all in accordance with the prevailing client money rules ‑ there was nothing wrong with holding investment instruments in an in house nominee account.

The High Court decided that the receiver was entitled to be paid and that client assets could be accessed. In doing so Justice Murphy did not distinguish between the assets of W&R Morrogh and the clients’ assets.

It’s very unfortunate that investors with Morrogh lost substantial amounts of capital and the whole affair raises questions about the way in which financial intermediaries, especially stockbrokers, were regulated in the past.

Whilst acknowledging that it’s very difficult to prevent a problem arising where there’s determined effort to commit fraud it should be recognised that certain categories of financial institutions carry inherently higher risks than others and a ‘one size fits all’ is not appropriate when it comes to regulation.

The Irish Association of Investment Managers (IAIM) has lobbied for some time for a risk based approach too regulation and it is most encouraging to see that IFSRA have embodied this principle in their recently issued strategic plan.

Hopefully this will help foster an environment for safe and sound financial institutions and we won’t have any more cases like Morrogh in the future.

There is another substantive issue arising out of the Morrogh case and the subsequent High Court judgement.

Until now trustees of pension funds felt secure in the understanding that stocks held with custodians were completely ringfenced.

One of the legacies of the High Court ruling on Morrogh is that this understanding is now challenged.

The judgement delivered in September 2003 confirmed that in exceptional circumstances ‘client assets of the firm’ could be used to pay expenses and most significantly it was determined that shares held in trust for clients through a nominee account by Morrogh could accessed.

IFSRA’s definition of client assets as per the the draft new client money requirements is money and investment instruments which, ‘in the course of carrying on investment business, a firm receives, holds, controls or pays out for, or on behalf of clients’

It is clear that the manager does control the assets in this way even if they are held in the client’s name with the custodian or in a nominee account.

I do not believe it matters if the assets are held in electronic format or in physical certificates or indeed if the beneficial owners can clearly trace the specific securities to which they are entitled.

The High Court said in the Morrogh ruling:
‘the beneficial owners of electronically held stock held by the firm on behalf of clients are entitled to be treated in the same manner as the holders of certified stock’

In fact there is a precedent for a receiver having recourse to assets controlled by a company even though it is clear that the assets are beneficially owned by third parties.

In the Berkely and Applegate case in 1988 the English High Court determined that the liquidator was entitled to proper expenses and remuneration out of trust assets if non trust assets were insufficient.

There is some logic to this if you accept that the investors in the company received benefit from the work done by the liquidator in the realisation and distribution of the assets.

However there is a problem and there’s a strong view within the industry that something needs to be done to clarify the situation and preferably reinstate the ringfence around assets held by custodians.

Changing current practices for holding securities would have both direct and indirect costs for pension funds and even if the securities are held in physical certificates in the name of the pension fund there may be no guarantee that this is secure once the investment manager has control and can issue instructions regarding the assets.

Since this issue came to the surface all interested parties are working to bring it to a resolution. The IAIM has been proactive in lobbying government and the early indications are that they accept there is a serious issue which needs to be addressed urgently.

To this end, a working party is being set up involving IFSRA, Department of Finance and the Investor Compensation Board. Not surprisingly, the custodians are also lobbying Minister Mc Creevy.

As of now, there is no move to appeal the Morrogh ruling in the Supreme Court. The reality is that resolving this issue through the courts could prove costly and drawn out. A much more pragmatic approach would be to introduce legislative change to provide the necessary safeguards. Hopefully we will get a sensible resolution. In the interim is there anything trustees should be doing?

First and foremost we shouldn’t panic ‑ remember the precedent was established in the UK in 1988 and the investment management and custody industry has continued to thrive since then. There hasn’t been any evidence of ‘regulatory arbitrage’ as a result of the Berkely and Appelgate decision.

The most obvious advice for trustees is that they should make sure they are doing business with reputable service providers with strong balance sheets.

In the Morrogh case the extent of the fraud within the company was very significant relative to the asset base. Remember it’s only when all other assets are depleted that the receiver could have access to the client assets.

Consequently, if trustees are dealing with an investment manager or indeed a custodian which is a local subsidiary of a larger entity then they should check the level of parental guarantees and professional indemnity insurance in respect of the local service provider.

In circumstances where investment management services and custody is being provided by one integrated service provider it would be good practice to look for clear separation of duties between the various parties and arms length contractual arrangements.

Trustees should also seek comfort by asking to see the criteria used by investment managers in appointing and monitoring stockbrokers and custodians if this responsibility is delegated to the manager.

All of these suggestions are normal good practice and there’s a lot of evidence that Irish pension funds have solid arrangements in place regarding investment management and custody.

Of course it’s usually the exceptions to the norm where problems arise and the Morrogh arrangements were most unusual where there was one corporate entity which did not have a strong asset base providing stockbroking, investment management and custody services and in retrospect it would appear that the controls and reconciliations between the various functions were less than optimal.

The Irish Association of Pension Funds will shortly be issuing comprehensive guidelines for trustees on all matters relating to custodianship of assets and this should prove to be a helpful reference document.

There are also issues from an industry perspective. At the risk of being accused of ‘sexing up’ the Morrogh dossier I think it’s no exaggeration to say that if the situation remains as it is, there is potential for damage to the investment management, custody and funds administration business in Dublin which employs thousands of people and generates very substantial revenues for service providers and the exchequer.

Only in recent weeks have we read about plans by Merrill Lynch to employ a further 400 people in Sandyford as they move their back office operations to Dublin. Decisions like this are to a considerable extent influenced by the pro-business and pro-financial services attitude on the part of government and regulators in Ireland and they are not helped by the unintended consequences of the Morrogh case.

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