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On February 29, 2012, the UK’s highest court (the “Supreme Court”) issued its judgment on the client money issues that arose during the administration of Lehman Brothers International (Europe) (“LBIE”). The litigation focused on the correct interpretation of the UK Financial Services Authority’s (“FSA”) client money rules found in Chapter 7 of the Client Assets Sourcebook (“CASS 7”).
Summary
CASS 7 provides that UK investment firms must hold their clients’ money under a statutory trust, subject to certain exceptions. Client money should be segregated from an investment firm’s own funds. LBIE used the “alternative approach” to client money segregation, which CASS 7 permitted. This meant that client money was received into, and paid out of, LBIE’s house account and then paid over to a segregated client bank account.
The Supreme Court considered three issues that had been appealed from an August 2010 Court of Appeal decision:
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at what point does client money received by a UK-regulated firm become subject to a statutory trust?
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do the primary pooling arrangements, which are used in the event of a regulated firm’s failure, apply to client money held in house accounts as opposed to client accounts?
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is a client’s right to participate in a notional client money pool dependent on the actual segregation of its client money?
The Supreme Court upheld the Court of Appeal’s August 2010 decision and ruled that:
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client money becomes subject to a statutory trust immediately upon receipt by a UK regulated firm;
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the primary pooling arrangements apply to all client money whether held in house accounts or in client bank accounts; and
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all clients with a client money claim are entitled to participate in the notional client money pool regardless of whether or not their client money actually was segregated.
Comment
The Supreme Court’s decision deals with one of the main issues arising from the LBIE administration, namely what money does the statutory trust cover? However, it has taken more than three years to obtain clarity on this issue. This contrasts with the relative speed of the bankruptcy process in the U.S. where, last week, Lehman Brothers emerged from the largest-ever corporate bankruptcy, announcing that it will begin making payments to clients.
In addition, the joint administrators now will need further time to calculate the amounts owing to all creditors with a client money claim, not just those whose money had been segregated. The joint administrators may need to seek further directions and there may be further litigation to identify which unsegregated funds should be added to the client money pool. The Court recognised that this is likely to be a lengthy and complex exercise.
The FSA has said that it will review the client money rules in CASS to ensure that they are consistent with the Supreme Court decision. This will supplement the FSA’s significant post-Lehman work to strengthen client asset protection through rule changes and more direct supervisory and enforcement intervention. This focus will continue right through to the formal creation of the new Financial Conduct Authority. UK regulators appear determined to ensure that the failures that have come to light are not repeated.
It is almost certain that clients whose money had been segregated ultimately will receive less than they had previously been led to believe (on the basis of the original court order in December 2009). This is because other clients who had a contractual entitlement to have their unsegregated funds treated as client money will be able to claim against the client money pool. This is not a good outcome for certain creditors of LBIE. This is unfortunate, but there is logic in the court’s decision, which interprets the rules in the light of the underlying policy aim to provide a high level of protection for client money. The alternative would be an arbitrary approach where a client could become a general unsecured creditor simply because operational failings beyond the client’s control and oversight led to money not being segregated. However, the judgment alone will not protect clients. Therefore, UK regulators should revise CASS and ensure that those responsible for holding client money do so to a high standard.
Detail
LBIE was the principal European trading company in the Lehman Brothers group with its head office in London. It was authorised and regulated by the FSA. On September 15, 2008, LBIE was put into administration by the English High Court following the Chapter 11 bankruptcy of Lehman Brothers Holdings Inc., LBIE’s ultimate parent. Following this, the joint administrators encountered numerous difficulties and applied to the court for directions on a number of matters.
The Supreme Court was asked to interpret how CASS 7 treated client money that had been paid to LBIE before it entered administration. CASS 7 appears to provide a straightforward method for the safeguarding of client money by FSA regulated firms. Regulated firms must identify client money and promptly pay it into segregated accounts. Client money must be held by regulated firms on trust for the clients for whom it is received and held. In the event of the regulated firm’s failure, the segregated client money that is held on trust would be pooled for distribution to those entitled to it under that trust. This should ensure that client money will not be used by the firm and, upon the firm’s insolvency, clients would receive their money back in full (subject to deduction of the proper costs of distribution).
In LBIE’s case the rules plainly did not achieve the desired regulatory result. LBIE failed to properly identify and segregate vast amounts of client money belonging to both external LBIE clients and LBIE affiliates. Affiliates advanced client money claims against LBIE that exceed US$3 billion. To make matters worse there is also the potential shortfall arising from the insolvency of Lehman Brothers Bankhaus AG where LBIE had deposited at least US$1 billion of segregated client money. In all there has been a huge shortfall in the amount of client money available to meet client money claims. This has pointed to a series of fundamental problems in interpreting CASS 7 rules.
There were three issues for the Supreme Court to consider following the Court of Appeal’s August 2010 judgment.
1. At what point does client money received by a UK-regulated firm become subject to a statutory trust?
CASS 7 states that an FSA regulated firm receives and holds client money on trust on the terms of the client money rules and for the clients for whom that money is held. The first question before the Supreme Court was to determine the point in time that this trust arose. Was it when money was received from a client or third party, or was it when the money was segregated?
The Supreme Court unanimously upheld the Court of Appeal’s decision that the trust arose on receipt of the money by an FSA regulated firm. The Court pointed out that if the trust did not arise until the point of segregation, then the protection afforded by CASS 7 would be arbitrary and depend entirely on the regulated firm’s own practices. The Court felt this would be “unnatural”: the greater the level of a regulated firm’s incompetence or misconduct, the less protection for the firm’s clients.
2. Do the primary pooling arrangements, which are used in the event of a regulated firm’s failure, apply to client money held in house accounts as opposed to client accounts?
Under CASS 7, a regulated firm’s insolvency, administration or similar will be a “primary pooling event.” If there is a primary pooling event, then the “client money held in each client money account of the firm is treated as pooled” and available for distribution to clients. The second issue before the Supreme Court was whether this pooling should apply to all money that is identifiable as client money or whether it only applies to money that is in segregated client accounts.
On this question, and the third question, the Supreme Court reached a 3-2 majority decision. The Court ruled that the interpretation of the rules must be the one that best promotes the purpose of CASS 7, namely to provide a high level of protection for client money. Therefore, the primary pooling arrangements should apply to all money identifiable as client money.
The dissenting judges argued that only claimants whose money had actually been segregated should be entitled to money from the client money pool and, consequently, only money that had actually been segregated should be pooled in the first place.
3. Is a client’s right to participate in a notional client money pool dependent on the actual segregation of its client money?
This question was very closely linked to the second question. Who should be entitled to the distributions that will be made from the client money pool in accordance with CASS 7? The CASS 7 rules require the distribution of pooled client money in accordance with the trust discussed above, so that each client receives a sum that is rateable to his client money entitlement. The Court decided that the general scheme of CASS 7 is that all client money is subject to a trust that arises on receipt by the regulated firm of that client money.
Again, this is in line with the purpose of providing a high level of protection for client money. It follows, therefore, that any client with a claim for client money should be entitled to participate in the notional client money pool, regardless of whether or not its client money was in fact segregated.
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