Supreme Court decision
On February 29 2012 the Supreme Court released its judgment in the Lehman Brothers client money litigation. In a somewhat divided analysis, the court outlined the correct approach to the distribution of client money and the entitlement to share in the client money pool on the insolvency of a firm that operates what is termed the 'alternative approach'.
The appeal concerned the interpretation of client money rules in Chapter 7 of the Client Assets Sourcebook (CASS 7). As permitted under the rules, Lehman Brothers International (Europe) - like all large investment firms - adopted the 'alternative approach', whereby firms may receive client money into their house accounts, but are required to segregate that money into ring-fenced client accounts on a daily basis.
On insolvency, the application of CASS 7 will ideally result in all clients receiving their money back in full and free from creditors. However, two problems arose in this case. First, Lehman Brothers International (Europe) failed to identify and segregate large sums of client money. Second, its affiliate, Lehman Brothers Bankhaus AG, failed at a time when it was holding at least $1 billion of client money.
The appellant, GLG Investment plc, raised three issues:
- When does the statutory trust arise in respect of client money received by the firm?
- Do the arrangements for the pooling of client money, in the event of a primary pooling event, apply to client money held in house accounts?
- Is participation in the notional client money pool dependent on actual segregation of client money?
The Supreme Court unanimously dismissed the appeal from the Court of Appeal on the first issue and, by a three-to-two majority, dismissed the appeal on the second and third issues.
Client money in house accounts
The court unanimously ruled that a trust arises on the receipt of client funds, irrespective of whether the normal or alternative approach to segregation of client money is adopted. The court considered that it would be contrary to the primary purpose of client protection and to the CASS rules for the trust to arise upon segregation. It reasoned that any other decision would fail to achieve the client protection purposes of the EU Markets in Financial Instruments Directive (2004/39/EC) (MiFID).
The implications of this are unclear. In particular, uncertainty remains on the issue of how investment firms can use trust money in house accounts. Notably, questions will arise where there is a shortfall in the house account (ie, because the client money is paid into an overdrawn house account or because the investment firm has used client money for other purposes).
Lord Walker stated:
"Client money held temporarily in a house account does not, in the eyes of trust law, 'swill around' but sinks to the bottom in the sense that when the firm is using money for its own purposes it is treated as withdrawing its own money from a mixed fund before it touches trust money."
Although this may provide some comfort, it does not address the situation where there is a shortfall in the house account. It appears that in such a situation, clients - in a practical sense - have 'daylight exposure' until segregation.
Identifying and distributing the client money pool
A majority held that the correct interpretation is the approach that best promotes the protection of client money, as required by MiFID. To exclude client money held in house accounts from distribution would run counter to that purpose and afford different levels of protection on the basis of the money being segregated. As a result, all identifiable money held in house accounts will form part of the client money pool.
The court ruled that all clients are entitled to share in the distribution of the client money pool, irrespective of whether actual segregation has occurred. For clients of a failed firm, this may be either advantageous or detrimental to their claim to recover their money. Clients that would otherwise have ranked as unsecured creditors may now share in the client money pool; however, clients whose money was properly segregated will have their entitlement diluted. As such, all clients will share the shortfall evenly as unsecure creditors because distribution of the pool will be on a pro rata basis.
This raises important questions about the due diligence that a client can undertake to ensure that its money is best protected. Previously, a client could request a statement and rest easy if the money had been ring-fenced. Following the Supreme Court's judgment, there appears to be little that a client can do to prevent its entitlement from being diluted, even after proper enquiries.
The Supreme Court decision will undoubtedly cause further delay to creditors awaiting their money. It seems likely that the uncertainties caused by the decision will result in further litigation. However, it remains to be seen whether the operation of the alternative approach will be affected in practice.
For further information on this topic please contact Louise Verrill, Sonya Van de Graaff or Patrick Elliot at Brown Rudnick LLP by telephone (+44 20 7851 6000), fax (+44 20 7851 6100) or email ([email protected], [email protected] or [email protected]).