On 29 February 2012, the UK Supreme Court handed down its judgment concerning the treatment of client money in the long-running administration of Lehman Brothers International (Europe) (“LBIE”).
The uncertainties as to which funds had the benefit of the protection of the Financial Services Authority’s (the “FSA’s”) client money rules and which funds did not have such protection, has been one of the main reasons for the length of time it has taken to resolve the LBIE administration. This distinction has had a great significance for LBIE’s clients because where LBIE held their funds under the FSA’s client money rules, they should, at least in theory, be entitled to the return of their money, in full. On the other hand, those clients who were not afforded these protections would merely rank as general creditors in the estate of LBIE, and so would achieve a much lower recovery.
There were three issues before the Supreme Court: (i) the point at which client money became subject to a statutory trust and therefore “belonged” to the client and not Lehman; (ii) did the client money pool available to be distributed include both segregated and unsegregated accounts; and (iii) was a client’s right to participate in the client money pool dependent on whether their money was actually segregated.
The Court agreed unanimously that the statutory trust that protects client money arises on receipt of the money from the client, rather than when (or if) such money is actually segregated from the investment firm’s own funds.
The second and third interrelated issues were only decided by a 3:2 majority. On the second issue, the Supreme Court held that the client money pool available for distribution on insolvency comprises all funds identifiable as client money, whether or not those funds were actually segregated by the firm from its own money.
On the third issue, the Court held that all clients with a contractual entitlement to have their money segregated should be entitled to participate in the distribution from the client money pool, irrespective of whether their funds were actually segregated.
Given that the text of the FSA’s client money rules are ambiguous, the Court chose the interpretation, which best promoted the purpose of the client money rules as a whole, namely to provide a high level of protection for client money (or money which should have been treated as client money). The majority held that to exclude identifiable client money in house accounts from the funds available for distribution would run counter to this policy, because it would provide different levels of client protection according to whether or not the firm had, for whatever reason, actually segregated the money.
The consequence of this decision is that investors do not have to enquire as to how money is actually held by an FSA authorised investment firm in order to rely on these protections. The judgment means that clients who go to the effort of checking with an investment firm that their funds have been properly segregated may nevertheless find that their funds are diluted on insolvency by the claims of those clients who have been less diligent and who have not performed such checks and whose money has not been segregated by the firm (in breach of the rules). Whilst the Court’s decision was good news for many LBIE clients, it was bad news both for LBIE clients whose money was actually segregated who will now receive a lower entitlement to the funds in the client money pool, and for the administrators who now have to face the task of identifying which of the accounts held by LBIE contained client money, and which clients were entitled to client money protections. The judgment therefore means that the length of time it will take to complete the LBIE administration – which has already been progressing for three and a half years – will now be even longer.
The Court’s ruling also has implications for the administrators in the MF Global UK administration, who face similar problems in identifying which funds constitute the client money pool and who is entitled to a share of that pool. Until these matters are finalised, it will not be possible to ascertain the residue left for distribution to general creditors. The judgment will therefore delay final distributions in the MF Global UK administration.
All these difficulties and the uncertainties surrounding the FSA client money rules have resulted in widespread criticism of the UK client funds regime. The position in the UK has been compared unfavourably to that in other jurisdictions, where, in the Lehman and MF Global insolvencies, there has been a much swifter return of client funds. It is probable that the FSA will re-write their client money rules to address these criticisms and to take account of the Supreme Court’s judgment.