When it was placed into administration on the morning of 15 September 2008, Lehman Brothers International (Europe) (in administration) ("LBIE") could account for approximately $2.16 billion of money in its segregated client accounts. This amount fell far short (by several billion dollars) of the amount which would later come to be claimed by the firm’s clients. Although some of the shortfall was made up of money that had been passed to another subsidiary, LBIE was exposed as having manifestly failed to comply with client money regulations requiring the full segregation of client money.

This failure led to a series of litigation culminating in February 2012 when the Supreme Court ruled on principles for the designation and distribution of client money held by LBIE, bringing closure on a long running saga to determine how the money should be returned.

The outcome of the client money litigation was very important, not only for the parties involved who stood to gain or lose millions, but also for the financial services industry in the UK as a whole. The case did much to highlight weaknesses in the existing client money rules and spurred regulatory change in the area, a process which is still being carried out now with the updating of the Client Assets sourcebook rules ("CASS").

BACKGROUND

What is client money?

Along with the majority of relevant regulations in this case, the technical definition of client money is contained in chapter 7 of CASS ("CASS 7") – but for the purposes of this note client money can be understood to be money held by a firm regulated by the Financial Conduct Authority ("FCA") on behalf of a client, specifically for the purposes of investment business¹. Examples of client money include money:

a) held pending investment;

b) held in the course of settlement; or

c) derived from client assets held in custody.

CASS 7 – statutory trust, segregation and pooling

Under CASS 7, firms are required to segregate money received from clients in special accounts designed for that purpose, to make adequate arrangements to safeguard clients’ rights over that money and not to use client money for its own purposes.

At the heart of the operation of CASS is the concept of a "statutory trust" under which all client money is held. The creation of a statutory trust means that client money is not a firm’s property, rather it is held in a fiduciary capacity or by a firm as agent on behalf of the client.

Firms are permitted to deal with incoming client money using one of two approaches. Under the first, the "normal approach", firms must pay client money into trust status client bank accounts by the following business day. Under the second, the "alternative approach", client money may be paid into a firm’s own accounts providing that a daily reconciliation of records and accounts is performed and an equivalent amount of money is deposited into segregated client bank accounts. LBIE purported, but demonstrably failed, to be following the alternative approach.

The general purpose of CASS 7 is to protect client money not only from misuse but also failure of firms. If a firm enters into an insolvency process whilst holding client money the intention of CASS 7 is to facilitate timely repayment. The failure of a firm is designated a primary pooling event under CASS 7.  If this happens, client money is to be pooled (in what is termed the client money pool ("CMP")) and paid back to clients.

ISSUES

Segregation

After LBIE's collapse, accountants discovered there had been - in the words of the Supreme Court - "regulatory non-compliance on a truly spectacular scale" amounting to a "shocking underperformance".

In addition to the aforementioned undisclosed amount of unsegregated client money belonging to independent clients, approximately $3 billion of client money was owed to other Lehman entities, which according to CASS 7 was to be treated as if it had come from any other client of the firm. Matters were complicated further by the fact that LBIE deposited approximately $1 billion of segregated client money with a German affiliate – Lehman Brothers Bankhaus AG – which had also become insolvent and subject to a moratorium. Altogether, client money claims exceeded the money actually held in the segregated client money accounts by a very big margin.

Deficient Regulation

A second issue conspired with the first to trigger the litigation. The drafters of CASS had entirely failed to contemplate the possibility that their rules would not be followed and that a substantial difference between the amount of client money which should have been segregated and the amount which was actually segregated would arise. The lack of provision for such a circumstance meant that the Courts were asked to fill in the gaps.

A broad range of questions was dealt with at first instance and in the Court of Appeal but only the following three issues reached the Supreme Court:

a) When does a statutory trust arise – when money has been placed in a segregated client account or as soon as it is received by a firm?

b) Is client money not in segregated client accounts to be included in the CMP (for redistribution to clients)?

c) Do all clients have a right to participate in the distribution of the CMP, or only those whose money was properly segregated?

Because of the interrelation between issues b) and c), they are dealt with together below (as they were in many of the judgments).

SUPREME COURT JUDGMENT

Statutory Trust

The Court found, unanimously, that the statutory trust arises immediately on receipt of client money by a firm.

It reasoned that only this analysis is consistent with the wording of CASS 7.7.2R: "A firm receives and holds client money as trustee".  No point of transition after the point of receipt is mentioned in CASS and at no stage does the money cease to belong to the client and become the property of the firm. It follows logically therefore that the statutory trust must arise as soon as the firm receives the money. Importantly, it also follows that the fiduciary duties imposed by CASS 7 are owed by a firm before segregation, whether or not segregation actually occurs.

The immediate statutory trust analysis also applies when a firm uses the alternative approach. Lord Walker suggested that if it were not so, client money would effectively be being put into a "black hole into which [it] may vanish, so as not to be caught by the distribution rules". To counter arguments raised that client money mixed with other money in a firm’s house accounts could not be the subject of a trust, Lord Walker stated that client money does not mix but "sinks to the bottom"; if the firm draws on that account for its own uses, it is treated as drawing on its own money first.

CMP

The second two issues considered by the Supreme Court relate to the CMP. In coming to its decision, the justices weighed up two differing analyses adopted at different points in earlier hearings. Under the first analysis, dubbed the "contributions theory", a CMP should include only that client money which has been segregated and over which a proprietary entitlement can be staked. The second analysis was labelled the "claims theory" and following this approach a CMP would include segregated and non-segregated client money, including non-specific funds over which only a contractual (i.e. not a proprietary) entitlement could be established.

Following 20 days of argument in the courts over the nature of the statutory trust, CMP and the precise wording of individual sections of CASS 7 (which did not stand up well to such close scrutiny as many drafting inconsistencies were revealed), a sharp division of opinion arose between the justices and the final ruling was made on a majority of 3:2.

The majority ruled in favour of the claims theory, thereby including unsegregated client money in the CMP. This analysis was argued predominantly on a certain textual reading of CASS, but also on the basis that it gave better effect to the underlying purpose of the client money regime (and MiFID, which CASS was drafted to implement), that is, to protect clients’ money equally and not expose them to the randomness of reliance on firms’ adherence to the rules.

In preferring the claims theory with regard to the issue of constitution of the CMP, the answer to the third question before the Supreme Court followed logically. The justices found, again on a majority judgment of 3:2, that all clients whose money should have been treated as client money (i.e. segregated) had a claim against the CMP, regardless of whether their money was ever segregated. Although somewhat in contradiction to English trust law which states that those with a proprietary interest in money will be protected only if both a trust is declared and the money is in fact properly segregated, the majority justices insisted that it was CASS, not English trust law, that was at issue here.

The ruling generated winners and losers. The winners being those clients (including Lehman affiliates) whose money had not been segregated but who now could claim against the CMP, and the losers being those whose money had been properly segregated but who now faced a lower return because of the increased liability of the CMP. Generally however, the judgment was well received by commentators, and indeed the regulator, because it made for the most equitable outcome; equal treatment was afforded to all clients, regardless of whether their money had been segregated.  

REGULATORY FALLOUT

The Lehman client money case raised a largely unforeseen issue with the UK’s client money regime; namely that the draftsmen had not sought to include provision to cover the possibility of non-compliance with the rules. This immediately became apparent when LBIE’s malpractice was exposed and its administrators were consequently at a loss as to how to distribute client funds, a task which in comparison to the rest of the extraordinarily complex winding up of the Lehman business should have been straightforward. Similar shortcomings also became apparent in the administration of MF Global UK Ltd, a UK company in the MF Global inter broker-deal group which entered into insolvency proceedings in 2011.

One of the purposes of the CASS rules is to "facilitate the timely return of client money… in the event of the failure of a firm." Given that the client money judgment was made in 2012 and client money distributions are still being made this year (most recently on 27 June 2014), CASS has proved to be lamentably ineffective. Only a portion of the blame for this delay can be attributed to LBIE's non-compliance; the other part must be borne by the legislators.

To counteract these failures, the FCA undertook a comprehensive review of CASS and launched a consultation of market participants. New rules covering the entire operation of CASS have been proposed, which will be phased in throughout the rest of 2014, with the final deadline for implementation being 1 June 2015. The particular subject of this case, CASS 7, is due to receive special attention and will include relevant provisions on immediate segregation (except when using the alternative approach) and diversification of third parties with which firms place client money. A full summary guide to the changes is available here.

Notwithstanding the new CASS rules, the whole client asset regulatory structure is still in a state of flux. A review by HM Treasury of the special administration regime - designed post-crisis to ensure there is minimum disruption to financial markets in the event of the failure of an investment firm – was completed in January 2014. HM Treasury's report, the text of which is available here, overlaps with CASS and the FCA has stated that it will conduct a further review of the client money distribution rules in line with the report, and publish a further consultation later this year.

In addition to being the catalyst for revision of the law, the LBIE client money case has also brought the focus of the FCA onto the enforcement of CASS 7. This was highlighted as recently as 22 September by the imposition of a record £38 million fine on Barclays for failure to segregate billions of pounds of client money between 2007 and 2012. JPMorgan Chase received a similar fine of £33 million in 2010 for a comparable offence.

¹Client money held on deposit by firms for investment business should not be confused with deposits in the conventional sense (i.e. money held in bank accounts, certain of which may have the benefit of a state-backed guarantee).  Moreover, it is likely that client money deposits are actually excluded from the "traditional" definition of deposits in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001: article 8 of that order excludes sums received by authorised or exempt persons for the purposes of various regulated investment activities.