The United Kingdom Supreme Court recently decided the appeal in the important case In the Matter of Lehman Brothers International (Europe) (LBIE) (In Administration) and In the matter of the Insolvency Act 1986  UK (the Case).
In summary, the Case is about which claims can be treated as claims for client money. This turns on interpreting the rules of the UK’s Financial Services Authority’s (FSA) Client Assets Sourcebook (CASS) in chapter 7 of CASS. These FSA rules stem from the Markets in Financial Instruments Directive (MiFID).
The Case dealt with three issues on how to interpret CASS:
- When does the statutory trust under CASS 7 arise?
- Does the client money need to be segregated for the client to share in the client money pool?
- Is client money in house accounts part of the client money pool?
CASS 7 provided for two alternative approaches to client money:
- the “normal” approach; and
- the “alternative” approach
to performing an FSA-regulated firm’s client money segregation requirements. LBIE used the alternative approach.
The alternative approach means, in summary:
- a firm receives client money into and pays it out of its own bank account/s;
- a firm segregates the relevant balance of client money, after reconciliations, daily into the client account from the house account;
- under CASS 7.7.2R “a firm receives and holds client money as trustee …”.
A failure of a firm is a “primary pooling event”. If this happens:
- “client money held in each client money account of the firm is treated as pooled” (CASS 7.9.6(1)R); and
- “the firm must distribute that client money … so that each client receives a sum which is rateable to the client money entitlement …” (CASS 7.9.6(2)R) (calculated under CASS rules).
Central to the Case is that LBIE failed to identify sums as client money and therefore then failed to segregate the client money.
At the hearing in the High Court of Justice, Chancery Division, before Mr Justice David Richards, on 3 February 2012, in the matter of MF Global UK Limited (MF Global), the issues of what is the client money pool and segregating client money were raised. They are relevant to the MF Global administration. In particular these issues apply to claimants asserting their claim is for client money, although the CASS rules on client money were not complied with. The outcome of the Case is therefore pivotal to the MF Global administration.
Outcome of the appeal
The Supreme Court dismissed the appeal and upheld the Court of Appeal’s decision on the three appealed issues.
The Supreme Court held by a 3-2 majority that:
- the statutory trust under CASS 7 arises on receiving client money;
- the primary pooling arrangements apply to client money in house accounts; and
- participation in the pool is not dependent on segregation of client money.
Points to support the reasoning
When does the statutory trust arise under CASS 7.7.2R?
The alternatives the Supreme Court considered were whether:
- the statutory trust under CASS 7 arises on receiving client money; or
- the statutory trust arises on segregation of funds.
- The Supreme Court unanimously supports the former. The judges’ main reason for this finding focused on client protection. The Supreme Court said it would be unnatural for money to stop being the client’s property on receipt by a firm – and then to become client property again, on segregation. An immediate statutory trust of identifiable client money (i.e. on receipt) would achieve the objectives outlined in MiFID which the CASS principles reflect.
Distribution and primary pooling arrangements
The Supreme Court said there were two possible interpretations of CASS 7, either:
- CASS 7.9.6(1)R requires all identifiable client money; or
- only client money that is held in segregated client accounts
to be treated as pooled.
- The majority held the rules need not be interpreted following English trust law principles and the correct approach is the one that gives the best protection for all clients.
- The majority held that to exclude identifiable client money in house accounts from the distribution regime would run counter to this policy.
Participation in the client money pool is not dependent on segregating client money
- The majority stated this did not depend on considering any general principles of trust law. The scheme to be analysed is in CASS 7. They approved of the claims theory adopted by the Court of Appeal and rejected the contributions theory adopted by Mr Justice Briggs in the court of first instance.
- The majority held the general scheme of CASS 7 is that all client money is subject to a trust that arises on receiving the money. The rules are to protect client money before any primary pooling event whether or not the money was segregated.
- The majority also confirmed that, where there is a choice of possible interpretations of CASS 7, they will adopt the one which affords a higher degree of protection for all clients. They recognised the interpretation meant ignoring the words “in client accounts” in CASS 7.9.6. The court held that not just client money in client accounts but also client money in house accounts is to be pooled.
- The court held the claims basis outlined above better promotes the purpose of CASS 7.
Commenting on the Supreme Court’s decision, Richard Heiss, a special administrator, pointed out that while the decision brings a degree of clarity it also means doubts remain about who may share in the client money pool, which may need to be decided by the court. Additionally, he said: “While this is good news for some claimants, who are more likely to receive better returns because of an entitlement to share in the client money pool, we expect to receive a very negative response from clients with written confirmation of segregated status.”
The Supreme Court’s decision in the Case is helpful to those claimants who would because of "happenstance" – the failure of the particular firm to segregate money which should have been segregated – not otherwise have had a claim. But many funds and other market participants pay for client money protection, and it is not clear why they should suffer mutualisation with those who either did not pay for it or whose money was not treated as client money.
Also it is likely there will be several fact patterns which may result in yet further litigation. The Case does not deal with the situation where money was previously commingled, and the firm then subsequently agrees to segregate it and treat it as client money. Query whether insolvency officers will take the view the money became client money on that agreement or whether they will seek further directions from court. But we do know now that any failure subsequently to segregate it will not, of itself, defeat a claim to share in the client money pool.
Because of the lessons learnt from the Case and the MF Global special administration, our view is that it is excessively high risk, and inappropriate, to hold any client money, even temporarily, in house accounts. The majority relied on the fact that the alternative approach is conceptually inconsistent with a common law trust arising on receiving money to move away from the idea the client money trust has to be on all fours with a common law trust.
Most large institutions still adopt the alternative approach to segregation. We expect the FSA will review its client money rules carefully because of the Case and the MF Global special administration, and the alternative approach might be excised from CASS 7 with huge costs implications.
The Case is unlikely to speed up a return of client money in either the Case or the MF Global case. The court stressed at the MF Global hearing on 3 February 2012 that KPMG, the MF Global special administrators, will need to have time to digest the result of the Case before they can extrapolate and apply relevant principles. Therefore we do not expect that application of the principles and any resulting distribution to happen soon.
It is, in theory, possible the Supreme Court’s decision in the Case could be appealed to the European Court.