On 29 February 2012, the Supreme Court of the United Kingdom handed down its judgment In the matter of Lehman Brothers International (Europe) (In Administration), more commonly known as the 'Lehmans client money case'. The case related to client money issues arising out of the insolvency and administration of the Lehman Brothers group of companies. The Supreme Court upheld the decision of the Court of Appeal on all points of appeal, agreeing that all clients are entitled to share in the distribution of the client money pool, irrespective of whether their money was segregated in practice. This briefing examines the background to the proceedings, the judgment of the Supreme Court and the consequences of the judgment for client money issues.
Background to the proceedings
The appeal before the Supreme Court arose from the insolvency and administration of Lehman Brothers International Europe ("LBIE"), Lehman Brothers' principal trading company in Europe. LBIE, which was authorised and regulated by the Financial Services Authority ("FSA"), went into administration on 15 September 2008. Prior to entering administration, LBIE provided a wide range of investment banking services to a large number of international clients. As part of this business, LBIE held considerable amounts of money and assets on behalf of its clients through a number of third parties. When it entered administration, LBIE was holding some $2.1 billion in its core segregated client bank accounts. Of this, it had placed $1 billion in an affiliated bank, Lehman Brothers Bankhaus AG, which is currently in insolvency proceedings in Germany. In addition to its core client bank accounts, LBIE operated several hundred other bank accounts, some of which were substantially in credit at the time of LBIE's insolvency. These accounts were used for processing both house and client money.
The collapse of LBIE has posed significant difficulties for LBIE's administrators in identifying, reconciling, recovering and returning client assets promptly. A large number of LBIE's clients have asserted trust or proprietary claims over assets held by LBIE and in order to attempt to settle these claims, the administrators have turned to the English courts for guidance.
The administrator's application before the Supreme Court related to the FSA provisions governing client money, namely chapter 7 of the Clients' Assets Sourcebook ("CASS 7"). CASS 7 creates a statutory trust over client assets which is designed to ensure that such assets remain the property of clients notwithstanding the insolvency of the firm. CASS 7 also provides for both a 'normal approach' and an 'alternative approach' to discharging a firm's client money segregation requirements. LBIE took advantage of the 'alternative approach'. This enabled LBIE to receive client money into its house account and then adjust the amount of money segregated for clients during the course of the next business day. As such, when LBIE entered administration on the morning of Monday 15 September 2008, the last adjustment to the amount LBIE had segregated as client money had taken place on Friday 12 September by reference to the closing balances on Thursday 11 September. Accordingly, there was a significant disparity between the amount of client money actually held in segregated accounts when LBIE entered administration and the total amount of client money held by LBIE at that time. This issue was compounded in LBIE's case because LBIE did not normally segregate client money for its affiliates, erroneously believing that it was not required to do so.
The administrators' application to the Court for directions covered a series of questions concerned with the application of CASS 7 to the extensive and complicated circumstances of LBIE's insolvency, including (i) what money constitutes the client money pool (the "CMP") for distribution purposes and (ii) which clients of LBIE are entitled to distributions from this pool.
Judgments of the lower courts
In the first instance, the High Court delivered a judgment that, in summary, would have required the administrators to include within the CMP for distribution purposes only those amounts which had been segregated into client money accounts by LBIE, and to distribute the CMP amongst only the clients whose client money was actually contained within the pool (i.e. those clients whose money had actually been segregated). This meant that clients would have no claim against the CMP if LBIE had failed to segregate their assets as required by CASS 7.
The first instance judgment was successfully appealed to the Court of Appeal, which held that, on the failure of a firm, all client money held by a firm, whether segregated or not, is to be pooled for distribution, and, furthermore, that any client who has a contractual entitlement to client money (whether segregated or not) can participate in the distribution on a pro rata basis.
The Court of Appeal's decision was appealed by the administrators of LBIE along with certain of its hedge fund clients.
Decision of the Supreme Court
By the time the case reached the Supreme Court, several questions relating to the true construction of CASS 7 were subject to appeal, namely:
- when does the statutory trust created by CASS 7.7.2R arise;
- do the primary pooling arrangements apply to client money held in house accounts; and
- is participation in the notional CMP dependant on actual segregation of client money?
The Supreme Court's findings in relation to each of these questions are considered in turn.
- When does the statutory trust created by CASS 7.7.2R arise?
CASS 7.7.2R provides that "A firm receives and holds client money as trustee (or in Scotland as agent)…". A statutory trust is thus created whereby the firm holds the client's money as trustee for the benefit of the client. The question before the Supreme Court was whether the statutory trust arises at the time of actual receipt of the client money or at the time of segregation into a client account. The Supreme Court unanimously affirmed the conclusion of the Court of Appeal that the trust arises on receipt. The Supreme Court was of the view that the alternative interpretation, whereby the statutory trust would arise at the time of segregation, was contrary to the natural meaning of the language of CASS 7.7.2R and was also contrary to CASS 7's primary purpose of client protection, as it would lead to clients receiving less protection simply because a firm had failed to reconcile its accounts properly.
As such, immediately upon receipt of a client's money, a firm's fiduciary obligations to that client are triggered and a statutory trust is created, even if this is prior to the actual segregation of the money.
- Do the primary pooling arrangements apply to client money held in house accounts?
The failure of a regulated firm constitutes a 'primary pooling event'. On the appointment of administrators on 15 September 2008, a primary pooling event thus occurred in respect of LBIE. CASS 7.9.6R (as in force at the time of the insolvency) provided that "If a primary pooling event occurs: (1) client money held in each client money account of the firm is treated as pooled; and (2) the firm must distribute that client money in accordance with CASS 7.7.2R, so that each client receives a sum that is rateable to the client money entitlement calculated in accordance with CASS 7.9.7R". The client money which is treated as pooled as a result of the primary pooling event constitutes the CMP for distribution purposes. Broadly, the question before the Supreme Court was whether the CMP includes only the client money that was held as such in LBIE's segregated client money accounts at the time of administration or, alternatively, whether it also includes identifiable client money held in LBIE's house accounts.
The Supreme Court, by split decision, affirmed the finding of the Court of Appeal, holding that primary pooling arrangements apply to all client money held by a firm, including money held in house accounts. All client money is thus included in the CMP for distribution purposes. Since an examination of CASS 7.9.6R shows that there are two possible interpretations as to what constitutes a 'client money account of the firm' (being (i) an account which contains exclusively client money or (ii) an account which contains some client money, even if it also contains non-client money), the Supreme Court held that the correct interpretation is the one which best promotes the purpose of CASS 7 as a whole, namely to provide a high level of protection for client money received by financial services firms.
This conclusion will clearly create significant forensic difficulties for LBIE's administrators in relation to the ascertainment of the amount of the CMP and the specific assets which should form part of it. The administrators are potentially required to work through each and every account in which LBIE held client money looking for any trace of client money and also pursue all payments from those accounts to see how far the trail can be usefully followed. This will undoubtedly be a time-consuming and costly process.
- Is participation in the CMP dependant on actual segregation of client money?
This question was naturally aligned with the identification of those monies required to be included in the CMP. The Supreme Court had to decide whether only those clients whose money had been segregated by LBIE could participate in the CMP (the so-called 'contributions basis' for participation) or, alternatively, whether all clients whose money was subject to a statutory trust (i.e. all clients for whom LBIE held client money) were entitled to participate in the CMP (the so-called 'claims basis' for participation).
The Supreme Court, again by split decision, affirmed the conclusion of the Court of Appeal, holding that participation in the CMP is not dependant on actual segregation of client money. The Supreme Court held that the client money rules are intended to protect all clients' money. Accordingly, the Court held that each client of LBIE should receive a rateable proportion of the aggregate of all the client money; in other words that all clients should share in the common misfortune of LBIE's failure. The Court again sided with the interpretation of CASS 7 which best promoted its overarching purpose, namely, to afford a high degree of protection for all clients who have client money with the firm.
Clients of LBIE for whom money was not segregated will clearly welcome the decision of the Supreme Court. Undoubtedly, the converse is true for clients of LBIE whose money was properly segregated, as their entitlements to the CMP will effectively be diluted as compared to the value of those entitlements under the 'contributions basis' for participation. That said, it should be noted that, while the number of clients having a claim against the CMP will increase substantially, its size should increase in value as money held in non-segregated accounts is identified and allocated to the CMP.
Unfortunately, the decision is likely to lead to further delay in distributions by the administrators as they seek to trace client monies in, and having passed through, LBIE's house accounts, as well as establishing those clients who have valid contractual claims against the CMP. The scale and complexity of the task facing the administrators of LBIE means that it is likely to be some time before clients of LBIE receive their entitlements. Nevertheless, the Supreme Court's decision does unblock a major impediment to distributions to both clients and creditors of LBIE alike. The judgment also provides some much needed clarity in respect of client money issues where a financial services firm fails, including, notably, in the case of MF Global UK Limited (in special administration).
Against the backdrop of the case, it should be noted that the regime for the protection of client money and assets has become a regulatory priority for the FSA. There has already been a marked emphasis on both reforming the requirements of CASS to ensure greater protection of client money, and also on ensuring compliance by regulated firms with these requirements. This new approach has been evidenced in a number of FSA publications, amendments to CASS, the creation of a specialist CASS supervisory team and, notably, several high-profile enforcement actions, one of which resulted in the FSA's highest ever fine of over £33 million. In its 2011/12 business plan, the FSA stated that it would continue to monitor the appeal to the Supreme Court in the Lehman client money case and consider its regulatory response in light of the decision. The FSA has yet to comment on the decision of the Supreme Court but, clearly, regulated firms will need to keep abreast of these developments.