What to do if your product provider goes bust

Investors in fund manager Keydata have been chewing their nails. The firm was placed into administration last Monday after the Financial Services Authority declared it insolvent. The trigger was the firm's inability to fund a £5m tax payment to HM Revenue & Customs after it was accused of failing to offer individual savings accounts (ISAs) that complied with the tax rules. Whilst it now looks as though funds held with Keydata are safe - the business may be sold on as a going concern - questions remain over the tax status of up to 24 of its funds.

But the firm's woes throw up a key issue for investors what happens if a product provider goes bust?

A warning from the Lehman collapse

Until the credit crunch many investors had assumed their hard-earned cash was safe provided it was parked in a product backed by a blue-chip provider. In a worst case, surely the Financial Services Compensation Scheme would bail out anyone who lost money? The sudden collapse of US bank Lehman Brothers revealed that both assumptions were built on sand. Not only could a major bank fail, but also if it had acted as the counterparty backing structured products offered by another firm (such as Legal and General), investors could not rely on the FSCS for compensation. Indeed investors who put money into products guaranteed by Lehman Brothers are still in limbo, unsure as to whether they will see a penny of their cash again.

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So, given that you can't easily predict which financial services firms might go bust, it's worth knowing what to do should the worst happen.

The FSCS who can claim?

Regulators never seem to stop at one rule when three will do instead. So the FSCS is divided into three different schemes all offering different payout levels (see below).

Before diving into these rules, be aware of some major FSCS caveats. First off, the scheme is intended to pay out compensation as a last resort. If, for example, an administrator has been appointed to run an insolvent firm, you may not have a valid FSCS claim until that process has been completed. If your claim can be paid out of the remaining assets of the firm then that is what will happen eventually - and you should not need the FSCS.

Next, watch out for unauthorised firms hedge funds for example. The FSCS only pays out in the event that an FSA-authorised firm goes bust. Note that "unauthorised" does not equal "illegal" it's just that some firms need FSA permission to operate in the UK and others don't. If in doubt about a firm's status, you can check whether it's on the authorised list before investing or phone 0845 606 1234).

Lastly, if a UK firm is still trading but you have a complaint against it, you should deal with that firm or seek help from the Financial Ombudsman Service. The FSCS also offers guidance on claims. Finally, note that it can take up to six months to process claims.

The 'ring-fencing' rules

The FSCS covers a wide range of "investment firms" including brokers, fund managers and banks. However, as the Lehmans collapse illustrated, claims are only covered if your capital is held by that firm and not by a third party guarantor. That's pretty tough on structured product investors.

But here's some good news. Under FSA rules, authorised firms such as fund managers operating unit trusts and OEICs, are required to segregate funds and assets held on behalf of clients. That means your money is electronically "ring fenced" and separated from the firm's own capital.

The same principle applies to brokers who may hold your cash before it is used to buy shares, or even the shares themselves. For example, as Liz Coleman points out in the Sunday Times, Killik and Co's client deposits are spread across accounts at Lloyds, HSBC and Barclays.

This rule even extends to professionals such as solicitors who might temporarily hold say your deposit for a house purchase. What this means is should a firm go bust, client money and assets should be safe. However this does all presuppose that your firm follows the rules. If it doesn't and subsequently collapses, you'll need the FSCS.

Claiming for lost investments

The range of investments covered is pretty wide and extends not just to shares but also unit trusts, derivatives, personal pension plans and endowment plans.

The first step is to complete an application form. You need to get hold of the right one check at fscs.org.uk or by phoning 0207 892 7300.

Assuming your claim is successful the scheme can only pay out a maximum of £48,000 regardless of the size of your loss. The exact amount is calculated as 100% of the first £30,000 plus 90% of the remainder up to that limit. So, for example, a claim for £35,000 could receive a maximum payout of £34,500 (£30,000 + 90% of £5,000).

Claiming for lost deposits

A separate part of the scheme kicks in if a bank or building society fails. This part of the scheme can get fiddly because it not only covers UK banks but also those that operate with an authorisation granted by a regulator within the European Economic Area (EEA) with a branch here. Further it also applies to non-EEA firms with branches in the UK - but it's worth noting that deposit-takers in the Channel Islands and the Isle of Man are not covered.

If a UK authorised bank or building society goes bust you can claim a maximum of £50,000. This works on a per person basis so a joint account payout could reach £100,000.

The position regarding foreign banks is muddier. Savers with Dutch bank ING and Irish banks Anglo-Irish and Bank of Ireland for example recently lost their FSCS protection. That's because, under EU law, if a local scheme offers more compensation than the FSCS, a bank must opt out of our compensation scheme. The Dutch underwrite the first €100,000 in ING accounts while the Irish government claims to guarantee 100% of savings. Ireland suffered its second S&P credit rating downgrade recently though, so savers could be forgiven for wondering whether this guarantee is cast-iron.

Savers with most other foreign EEA banks meanwhile face a split compensation system. For example, those who bank with Swedish bank Handelsbanken would apply to Sweden for the first €20,000 of any claim and to the FSCS for the rest under its "top up" arrangement. In other words the FSCS is committed to ensuring that you are still covered for up to £50,000 in total, but you may have to apply to two places to get it all.

For a tabular summary see moneysavingexpert.com/savings/safe-savings#foreign.

Some insurance claims are covered too

The final part of the scheme deals with claims relating to insurance products. So for example you might face a situation where you have an outstanding claim with an insurer that has gone bust. If the original insurance was "compulsory" third party for example the scheme will cover it in full. Otherwise it pays out the first £2,000 in full and 90% of the remainder. This also applies to those who have bought annuities (an annual income) from an insurer on retirement having cashed in a money purchase, or defined contribution, pension plan. Be warned though, that pre-retirement money purchase plans are covered up to the £48,000 investment limit, but only if the client money rules fail to protect your investments.