Investor compensation: seeing the wood for the trees

What is the purpose of investor compensation schemes? When, to what extent, and to whom should compensation be paid? Peter Andrews, Oxera Senior Adviser, and Jonathan Haynes, finance expert and Oxera alumnus, consider a complex case in the High Court of Ireland following the failure of investment firm Custom House Capital. They look at the policy issues and ask how economic analysis can help courts to determine which interpretations of statute best reflect the intentions of the legislators.

Oxera Chair and Partner, Dr Luis Correia Da Silva, acted as expert witness in this case.

One main objective of an investor compensation scheme is to maintain market confidence, which could be eroded if retail investors are not compensated in the event of a failed investment firm being unable to return their money or financial instruments.

Market confidence is fragile in investment markets due to the high levels of information asymmetry between investors and investment firms. Investors have no easy means of observing whether an investment firm is misappropriating or losing their assets. This is a serious problem because of the length of time over which investment typically occurs.

If retail investors lose their investments and are not compensated when investment firms fail, this is likely to have a chilling effect on investment with other firms. In other words, there are negative externalities (or spillover effects) associated with adverse events in one investment firm on other investment firms. For example, retail investors as a whole could lose confidence in the market and withdraw investments from investment firms.¹

Investors suffer an economic cost when they lack the confidence to follow their true preference in making investments. This is costly for investees, the wider economy, and also investment firms. It follows that investment firms themselves benefit materially from the existence of investor compensation schemes that maintain market confidence, and firms can pass the costs of compensation schemes on to investors through the prices that they set.

Investor compensation schemes exist as a last resort when a firm fails despite all other forms of protection. These other forms of protection include ongoing supervision by regulators of the activities of the investment firm, and the underpinning regulatory requirements around authorisation, capital adequacy and firm conduct.²

Requirements and discretion under EU law

Since 1997, the EU Investor Compensation Schemes Directive (ICD) has required all member states to set up investor compensation schemes.³ All firms supplying investment services in the EU must belong to such a scheme.

The ICD ensures that, where an investment firm cannot for financial reasons meet its obligations to investors, cover shall be provided for investors’ claims relating to money or instruments held, administered or managed by the investment firm.

The ICD stipulates the following.

• Investor compensation schemes must ensure a minimum level of compensation per investor of €20,000—Article 4(1).
• Schemes must be in a position to pay an investor’s claim as soon as possible and no later than three months following the establishment of the eligibility and amount of the claim, although an extension of up to three months is available on application to the competent authorities—Article 9(2).
• Those schemes that make payments in order to compensate investors must have the right of subrogation to the rights of those investors in liquidation proceedings for amounts equal to their payments—Article 12.⁴

The ICD allows member states to tailor national compensation schemes to their local preferences in some important areas. For example, member states may offer greater or more comprehensive coverage and limit the percentage of a claim that will be paid. A limit creates an incentive for investor due diligence. The percentage of the claim covered must, however, be 90% or more, provided that the amount payable under the scheme is below €20,000.

For example, Ireland and the Netherlands use the minimum permitted compensation level of €20,000, while (during the UK’s EU membership) the UK scheme allowed compensation of up to £85,000. The Netherlands allows compensation of up to €40,000 for those who have invested in a joint account.

Ireland has not elaborated greatly on the provisions of the Directive, whereas the UK has 12 chapters of detailed rules setting out the terms on which compensation may be paid.⁵

Implementation in practice

Investor compensation may sound like a straightforward concept: an investor suffers a loss when an investment firm cannot, for financial reasons, return client money or assets; they make a claim on their national compensation scheme; and they are paid compensation for their loss, subject to an element of co-insurance and an overall limit.

In fact, however, there is little detail given in the ICD, and practical issues can arise, especially when national implementation laws are also specified at a high level.

Suppose that the failed firm is able to return some but not all classes of client money and assets, and that these are mixed in common accounts across different classes of investor. Suppose also that the firm’s liquidator struggles for months or years to locate and recover some of the client money and assets, and that the firm itself has negative net assets. Three questions arise regarding this case.

• When claims are lodged with the compensation scheme, should an investor be compensated for the amount not received at the time when the claim is determined, even if the liquidator is confident of recovering all of the investor’s property?
• If an investor is entitled to be compensated for the amount not received at the time when their claim is determined, should the compensation scheme be required to pay out immediately? Alternatively, if the liquidator is confident that recovery will take place within, say, six months, should the scheme be allowed to delay payment so that any appropriate offsets can be made?
• If the liquidator recovers an investor’s property after compensation is paid, should the compensation scheme be entitled to this property up to the compensation amount even if recovery is not full and the investor is left out of pocket?

In practice, compensation schemes also need to consider several other issues, such as whether investors’ entitlement to recovered assets depends on the assets being in a class for which compensation was paid, or on the assets being owned solely by investors who claimed compensation.

The case of Custom House Capital

The case in Ireland, on which Oxera provided expert evidence, concerned compensation payments for investors (many of them pensioners) who suffered losses through misappropriation of their funds in the failure of investment firm Custom House Capital (CHC) in 2011.⁶

The liquidator identified that €66m of client assets had been improperly managed by CHC. For example, some pensioners who thought their money was in savings accounts later found that it had been invested in property assets within special purpose investment vehicles across the EU.⁷

In such circumstances, the Irish investor compensation scheme (the ICCL) is required by law to compensate retail investors for 90% of their loss, up to €20,000.⁸ But in practice this begs many questions, and the High Court of Ireland was asked to interpret the ICA to determine:

• the definition of investors’ net loss for compensation purposes;
• the extent of the ICCL’s right of subrogation (its right to pursue investors’ claims to reimburse itself).

Specifically, the ICCL claimed that its right of subrogation extended to investors’ claims against certain client assets as well as their claims against the company’s assets. On the definition of net loss, the ICCL claimed that, for compensation purposes, net losses must take into account actual and expected recoveries of misappropriated client assets.

The judgment concluded that (i) the ICCL’s right to subrogation is restricted to the assets of the company, and does not extend to client assets; and (ii) the calculation of net losses must not take into account actual and expected recoveries of misappropriated client assets between the date of determination of an investor’s claim and the final certification of the investor’s net loss.⁹ The rationale for this is discussed below.

An important point about the value of economic evidence is that the judge was receptive to the idea that losses are not just cash flows, but may also include economic costs such as opportunity costs and the time value of money.

How economic analysis helped the High Court

The High Court’s challenge was that neither the ICA nor legal precedents gave clear answers to the questions that it faced. In line with the Marleasing principle of interpretation,¹⁰ the Court therefore considered which legally feasible interpretations of the ICA were most aligned with the purposes of the ICD and ICA. To determine this, the Court needed to know the effects of the different interpretations on the relevant markets and stakeholders. Oxera’s analysis, which could be viewed as a cost–benefit analysis of one interpretation versus another, provided this insight, and materially informing the judge’s decisions.

In the CHC case it was difficult for the liquidator to establish what had been lost and what might be recovered. This, and the legal disputes between the liquidator and the ICCL, had already caused several years of delays in the payment of compensation, while the total compensation bill facing firms was low relative to equivalent bills in the UK even after adjusting for the different sizes of the Irish and British financial industries. These considerations, the references to speed in the ICA and ICD, and the importance of cash flows to retail consumers, supported an interpretation of the ICA as requiring rapid compensation to be paid to investors without anticipating recoveries, while limiting the subrogation rights of the ICCL. This would be likely to further the legislators’ goals of building and maintaining market confidence.

This case shows how sound economic analysis can help to resolve complex regulatory disputes and inform court judgments in delivering a beneficial outcome for society: compensation schemes add costs to the system, but firms and investors both benefit from it in terms of market confidence—and investment is critical for economic growth.

Policy considerations

The design of compensation schemes needs to satisfy social demands for fairness, command the support of those who fund them, and ensure that moral hazard¹¹ does not undermine market discipline in the markets to which they relate.

So, what lessons have we learned from the CHC case?

First, speed of payment matters for investor confidence. A slow payout exposes directly affected retail investors to liquidity risks such as costly borrowing, and may undermine retirement funding. It also signals to other retail investors that the risks associated with their delegated investments are higher than they might otherwise have thought. Thus, if a compensation scheme is to be a success in terms of market confidence, it must pay compensation quickly.

Second, while compensation claims may be simple, complex situations can easily arise in which it is less clear which is the best course to follow. If these situations are not clarified within the rulebook or case precedent, this can lead to uncertainties that threaten investor confidence.

The CHC case was an important test case for Ireland—a jurisdiction with limited previous case experience. The judgment clarifies the practical operation of the compensation scheme, helping the firms that fund compensation awards to plan financially, and sets a clear precedent for speedy compensation of retail investors when investment firms fail. This should increase investor confidence and certainty around the compensation backstop, thereby attracting more investment in Ireland to the benefit of investment firms.

While the court’s decision has resolved some uncertainties in Ireland, these persist in other EU member states with limited case experience and detail in their national implementation of the ICD. It is also worth noting that the minimum compensation limit of €20k per investor is much lower than in other financial centres. For example, the limits per investor are up to €33k in Singapore,¹² €58k in Hong Kong,¹³ €101k in the UK, and €450k in the USA.¹⁴

The European Commission did propose amendments to the ICD in 2010. These included an increase in the compensation amount to €50k, a minimum funding requirement, and faster payouts. However, the proposal was withdrawn in 2015 following a failure to reach agreement with the European Parliament and the Council of the European Union.

Given that EU policymakers wish to develop capital markets and attract investment into the EU, they might reconsider updating the ICD to further develop investor confidence. For example, it might be helpful to level the playing field between capital market investments (covered by the ICD, which compensates investors by up to €20k) and bank deposits (covered by the EU Deposit Guarantee Scheme Directive, which compensates investors by up to €100k).

¹ See, for example, Giannetti, M. and Wang, T. (2016), ‘Corporate Scandals and Household Stock Market Participation’, Journal of Finance, 71:6, February, pp. 2591–636; and Gurun, U., Stoffman, N. and Yonker, S. (2018), ‘Trust Busting: The Effect of Fraud on Investor Behavior’, Review of Financial Studies, 31:4, April, pp. 1341–76.

² Investors could also seek damages via private litigation against the defunct firm. However, the defunct firm might not have the resources to pay successful claims, and litigation is likely to be risky and lengthy, as well as unaffordable for many households affected. Tracing the assets and client assets of insolvent firms typically takes years, not months, and for all but the wealthiest households cash flow is very important.

³ Directive 97/9/EC of the European Parliament and of the Council of 3 March 1997 on investor-compensation schemes.

⁴ ‘Subrogation’ refers to the practice of substituting one party for another in a legal setting.

⁵ See the COMP section of the FCA Handbook; and Oxera (2005), ‘Description and assessment of the national investor compensation schemes established in accordance with Directive 97/9/EC’, report prepared for the European Commission, January.

⁶ In 2011 it was estimated that CHC in Ireland had client assets in excess of €1.1bn under management, more than 1,500 clients, and some €24m held in designated client accounts. Inspectors appointed by the High Court of Ireland estimated that significant client funds and assets had been misappropriated and, as a consequence, an order to wind up CHC was made on 21 October 2021.

⁷ Special purpose vehicles are corporations set up with their own assets and liabilities to isolate their financial risk from the risk in related institutions.

⁸ In Ireland, the 1998 Investor Compensation Act (ICA) gives effect to the EU ICD requirements for investor compensation and the Investor Company DAC (ICCL) has been established to operate an investor compensation scheme.

⁹ Hight Court of Ireland (2021), ‘Custom House Capital Limited (in liquidation) and The Companies Acts 1963 – 2012 on the application of the Investor Compensation Company DAC’, Judgment of Mr. Justice Heslin, 13 October, [2021] IEHC 842, para. 312.

¹⁰ Under the Marleasing principle, or ‘principle of conforming interpretation’, the domestic court of an EU member state must interpret its national law as far as possible in the light of the wording and purpose of the Directive in question.

¹¹ If investors were covered up to the full amount of their exposure without qualification, they might be expected to take little care in their choice of intermediaries. Accordingly, calibrating the extent to which investors remain at risk so that market discipline is retained is an important element of compensation scheme design.

¹² See Singapore Exchange Limited (2022), ‘Investor Protection’.

¹³ See Investor Compensation Company Limited (2004), ‘Compensation Limits’.

¹⁴ See Securities Investor Protection Corporation (2022), ‘What SIPC Protects’. The amounts in local currencies are up to S$50,000 in Singapore, HK$500,000 in Hong Kong, £85,000 in the UK and US$500,000 in the USA. The conversion to euros was based on the exchange rates as of 17 March 2022.