T he LBIE Client Money Judgment on the appeal from the Court of Appeal has been eagerly awaited by creditors and secondary claims trading market participants in order to give clarity to the funds available for the client money pool and to determine which clients will have the benefit of those funds.

The decision has implications for creditors of MF Global UK Limited and all clients of UK financial firms.

BACKGROUND

Lehman Brothers International (Europe) (“LBIE”) was the principal European trading company in the Lehman group and was put into administration in England on 15 September 2008.

The LBIE Client Money Judgment decision of the Supreme Court (the final court of appeal in the UK) relates to key provisions of the FSA’s Client Assets Sourcebook governing Client Money (“CASS 7”), made under the Financial Services and Markets Act 2000.

CASS 7.7.2R provides that: “a firm receives and holds client money as trustee… for the purposes of and on the terms of the client money rules and the client money (MiFID business) distribution rules.”

The FSA guidance to the client money rules states that a primary pooling event (i.e. failure of a firm) (a “PPE”) triggers a notional pooling of all the client money, in every type of client money account, and the obligation to distribute it. If the firm becomes insolvent, and there is (for whatever reason) a shortfall in money held for a client compared with that client’s entitlements, the available funds will be distributed in accordance with the client money (MiFID business) distribution rules.  

Two approaches that a firm can adopt in discharging its obligations under the MiFID client money segregation requirements are (i) the “normal approach” and (ii) the “alternative approach”.

Under the “normal approach” a regulated trading company is required to pay client money promptly (no later than the next business day) into a client bank account – the company has no freedom to deal with the client monies. The “alternative approach” was introduced in 1995 and originally required consent from the statutory regulator, but this requirement was replaced by the procedure in CASS 7.4.15R whereby a firm which does not adopt the normal approach must first send written confirmation to the FSA from the firm’s auditor that the firm has in place systems and controls which are adequate to enable it to operate another approach effectively. The CASS guidance states that the alternative approach would be appropriate for a firm that operates in a multi-product, multi-currency environment for which adopting the normal approach would be unduly burdensome.  

LBIE adopted the “alternative approach” to client money, meaning that it received client money into and paid out of the firm’s own bank accounts. Under the alternative approach, LBIE was obligated to segregate client money on a daily basis after performing a reconciliation of client bank accounts and transactions accounts to determine the client money requirement as of the previous business day. In theory, if the CASS 7 rules are correctly administered under either the normal or alternative approaches, then upon a firm’s insolvency client money claimants will receive their money back in full, free from claims of other creditors.  

However, LBIE client money claimants face a shortfall in available funds due largely to two reasons (i) LBIE failed to properly identify client money (and therefore failed to segregate it) and (ii) LBIE had deposited at least US$1 billion of segregated client money with Lehman Bankhaus AG, which also became insolvent.

JUDGMENT

The judgment addresses three main questions:

  • When does the statutory trust arise?
  • Do the primary pooling arrangements apply to client money held in a firm’s own accounts? and 
  • Is a client’s participation in the notional client money pool dependent on actual segregation of client money?

The majority (Lords Clarke, Dyson and Collins), led by Lord Dyson, dismissed the appeal and held that:

  • All client money is subject to a statutory trust upon receipt of client money by the firm, not at the point of segregation, irrespective of whether the firm adopted the “normal approach” or the “alternative approach” to client money;
  • Upon insolvency of a firm, all identifiable client money, irrespective of the account in which the money has been received, is pooled for distribution (i.e. the client money pool includes the firm’s own accounts); and
  • Participation in the notional client money pool is not dependent on segregation and the pool will be distributed to all clients in accordance with each client's contractual entitlement to claim, irrespective of whether or not segregation occurred.

IMPLICATIONS OF THE DECISION

Clients with segregated client money accounts will now be pooled with the clients whose accounts were not segregated by LBIE and will share rateably in the shortfall. Determining the final size of the client money pool will be difficult, since it is necessary to identify client money held in non-segregated accounts and potentially to trace other assets acquired with client money that would be subject to the statutory trust.

The decision impacts the MF Global UK Limited administration, future UK financial firm insolvencies as well as current practice for clients of UK financial firms. Client money claimants can no longer be certain their money will be returned in full on the basis of money being held as client money and an account being segregated, as any shortfall will impact all client money claims. Such shortfall must then be claimed as a (typically less valuable) general unsecured claim against the estate.  

Although the decision may be helpful to those with nonsegregated accounts and to increase the pool of client money available for distribution, in current financial firm insolvencies, the decision will cause further delay in distribution of client monies as it will take longer to determine the client money pool.

THE COURT’S REASONING

Trust on Receipt Versus Segregation

The judges were unanimous in their conclusion that the trust arises “on receipt” of client money rather than on segregation. The point considered by the Supreme Court concerned money received from clients and/or third parties where the firm operated the “alternative” approach (it was generally accepted that the trust arises on receipt in relation to the normal approach since the firm has no ability to deal with the funds).  

“Segregation without a trust would not achieve MiFID’s objective. Under the alternative approach an immediate trust of identifiable client money does provide protection, though mixed funds are subject to a variety of risks.” Lord Walker, summarising Briggs J at the Court of Appeal.  

Client Money Pool

The majority (Lords Clarke, Dyson and Collins) held that the pool extended to all client money in whatever account and whenever received by the firm. The minority (Lords Hope and Walker) considered that the distributable pool should consist of the aggregate of the segregated funds holding client monies immediately before the PPE and supported a limited reconciliation upon pooling to identify client money received since the last point of segregation before LBIE’s failure (the “final reconciliation theory”).  

The majority decision is helpful to those for whom money was not segregated, but for segregated account holders such as GLG Investments plc, the words of Lord Walker (dissenting) will strike a chord:

“Lord Dyson and the others in the majority evidently regard it as realistic to suppose that those segregated clients accepted the risk of having the bulk of their beneficial interested divested in order to compensate other non-segregated clients who, immediately before the PPE, had no beneficial interest in any identifiable trust property (and of whom, and of whose affairs, the segregated clients knew nothing). The majority’s decision makes investment banking more of a lottery than even its fiercest critics have supposed.”

Distribution: Claims Basis Versus Contributions Basis

The final key issue was whether the client money pool should be distributed on a “claims” basis or a “contributions” basis.  

“Claims basis” requires distributions to be made relative to clients’ contractual entitlements as at the date of the PPE, i.e the amount which ought to have been segregated, whether or not money had been actually segregated for any given client. Whereas the “contributions” basis is dependent upon what had actually been segregated and contributed for a client and which remained identifiable as at the date of pooling.  

Lord Clarke, agreeing with the majority stated: “... the distribution rules, namely CASS 7.9.6R and 7.9.7R, make it clear that the quantum of a participant’s share depends not upon the size of their contribution to the pool but upon the size of their contractual entitlement vis-à-vis the firm.”

The majority approved the claims basis of distribution taking the view that the distribution rules are intended to protect all the clients’ money in the event of a PPE, all client money is subject to a statutory trust and where there is a choice of possible interpretations, the court should adopt the one which affords a high degree of protection for all clients.  

SUMMARY AND IMPACT FOR MF GLOBAL UK LIMITED

The majority and minority judges were sharply divided on the issues regarding distribution and the constitution of the client money pool having regard to the wider implications. While the aim of the judgment is stated to be to provide all clients with a high degree of protection, Lord Walker notes at para. 83 “the solution means that no client of LBIE is provided with a high degree of protection, even those whose funds were (at all times down to the PPE) meticulously segregated and accounted for in accordance with CASS 7.”

The Joint Special Administrators of MF Global UK Limited issued a publication via the KPMG website1 which noted that following the decision, they will need to conduct a detailed and thorough regulatory and legal analysis of each client’s position to establish if they may have a contractual entitlement to client money and should have a segregated client money claim. This is likely to increase the number of claimants to the client money pool.  

In addition, a forensic analysis of MF Global UK’s own bank accounts, and potentially other assets acquired by the firm using funds from those accounts, will be conducted and may increase the size of the client money pool, which in turn may decrease the size of the general pool available to the unsecured creditors.  

Given the additional work involved since the LBIE Supreme Court decision, distributions of MF Global UK Limited client money and of general assets are likely to be delayed, but the 26% distribution announced by the Joint Special Administrators on 3 February 2012 will be unaffected.