The Supreme Court decides how client moneys are to be allocated in the Lehman estate, which has far-reaching implications for distributions in other financial collapses.
The Supreme Court has recently handed down a decision in a contentious and difficult application in the Lehman administration, a decision which fundamentally affects the allocation of client moneys in the Lehman estate.
Lehman Brothers International (Europe) (LBIE) was put into administration in September 2008. A number of applications have been made by the LBIE administrators to the court for directions, and it is the outcome of one such application, the so-called “client money” application, that we are concerned with here.
The background to the application was the client money held by LBIE. The FSA Client Assets Sourcebook (CASS) provides for client money to be identified and promptly paid into segregated accounts, segregated that is from the firm’s house accounts. The client money would be held on trust by the firm as trustee, in substance for the clients for whom it is received and held. In the event of the firm’s insolvency, the client money would thus be out of reach of the firm’s administrator or liquidator; instead, it would be pooled and distributed to those entitled to it under the trust, pari passu in the event of a shortfall.
However, it appears that in LBIE this did not happen. Apparently LBIE failed to identify all client money, and therefore failed to segregate, vast sums received from or on behalf of a significant number of its clients, including moneys received from its own affiliates and independent clients. Further, another LBIE affiliate, Lehman Brothers Bankhaus AG, with which LBIE had deposited US$1 billion of segregated client money, is also insolvent, and the administrators are not able to even guess how much, if any, client money may be recovered.
The question being considered in this application was whether those clients for whom LBIE should have been holding their money as a trustee should receive distributions from the moneys held on trust generally, not just such of those moneys actually held on trust for that client. As such, the Supreme Court decision turned on the correct construction of the relevant CASS rules, against the background of the general law of trusts. The Supreme Court concluded as follows:
- The statutory trust arises on the receipt of the moneys by the trustee, not upon segregation
- Client moneys are to be distributed on a claims and not a contribution basis, i.e. the money treated as pooled at the primary pooling event should be distributed to clients in accordance with their respective client money entitlements
- Participation in the notional client money pool is based on the amount that ought to have been segregated at the date of the primary pooling event, not on the amount that was in fact segregated for that client, i.e., it is not dependent on actual segregation of that client’s money.
This application was described by the court as the most “contentious and difficult” application of all those made by the LBIE administrators, and it is easy to see why. LBIE was the principal European trading company in the group, and the application required an analysis of LBIE’s many and varied trading activities, including futures, margins, currency transactions and stock loans, which it conducted for clients and on its own account. It regularly and on a daily basis handled money in more than 50 currencies on behalf of more than 1,500 clients in different time zones. Furthermore, the application required close review and consideration of complex and interconnected rules, where there was a choice of possible interpretations.
In essence, the correct interpretation was held to be the one that best promoted the purpose of CASS as a whole, which was found to be to provide a high level of protection for client money received by financial services firms. Accordingly, the general scheme of CASS rule is that all client money is subject to a trust that arises upon receipt, and the client money rules are therefore intended to protect all clients’ money received prior to a primary pooling event. Given that, it was held that that purpose would be frustrated if clients were afforded different levels of protection on the basis that, although the firm held their money as a trustee, their money was held in the firm’s house account rather than a segregated client account. However, the decision was not unanimous, with two members of the five-strong panel dissenting strongly on the second and third issues.
This decision has a fundamental effect on creditors’ entitlements, not only for those Lehman creditors who can demonstrate a trustee/beneficiary relationship with LBIE, but across the board generally. For example, the liquidators of the failed financial services firm MF Global have had to recast the basis upon which their distributions were to be made, and no doubt many other administrators and liquidators will have been considering this decision and doing likewise. At a time when there are more and more financial institutions in financial difficulties, such decisions take on an increasing significance.