The latest Court judgment arising from the MF Global UK Ltd ("MF Global") insolvency provides further clarity on how client money entitlements under the FCA's client money rules ("CASS") should be assessed, but is potentially superseded by a key proposal in the FCA's July 2013 Consultation Paper. In MF Global UK Ltd (No 4) (in special administration); Heis and others v Attestor Value Master Fund LP and another  EWHC 2556 the Court was asked to determine to what extent, and in what circumstances, MF Global clients with client money claims are also entitled to share in the general assets of MF Global as unsecured creditors in the insolvency.
1. Why did the issues arise?
The questions that the Court was asked to determine arose for two main reasons: first, a significant shortfall was identified in the firm's protected client money account ("CMA") so that clients did not have the full value of their funds returned to them from the CMA (the "CMA Shortfall"). Secondly, the Court in an earlier MF Global judgment ( EWHC 92 (Ch)) set out a different calculation for valuing clients' open positions than that applied in insolvency, which raised the question of what, if any, amount clients would be entitled to claim under their contractual rights in the insolvency.
How the Court determined the issues arising in this case is therefore of significance both to clients with client money protection, and for those unsecured creditors whose share in the general insolvency pot would be reduced to the extent that other claims are permitted.
2. Different calculations for valuing claims
In the earlier MF Global judgment the Court held that the correct date for assessing the value of claims to the Client Money Pool ("CMP Entitlement"), arising from clients' net open positions, was different to that which would be applied in an ordinary insolvency valuation for an unsecured creditor's claim. Whereas insolvency rules would apply the "hindsight" principle, so that net open positions would be calculated at the actual post-insolvency settlement value, the client money valuation for open positions was held to be the value of those positions as at the date of the Primary Pooling Event ("PPE"). The judge's reasoning, in part, was that the PPE date valuation is the basis on which the firm should have been calculating its client money reconciliation and the sum it should have set aside at the end of each day (the "PPE Value"). That first judgment created a potential difference in the value of claims, with the value of a breach of trust claim relating to the CMP Entitlement potentially greater or lower than a regular contractual claim for proof of debt in the insolvency (the "Contractual Claim"), depending on whether the net open position in question in fact settled at a value higher or lower than its PPE Value.
3. The Claim
This application for directions was brought by MF Global's joint administrators, and two different groups of investors as respondents. The first group, represented by Attestor Value Master Fund LP, all had net open positions at the PPE which later settled at a lower value than the PPE Value. The second group, represented by Solid Financial Services Limited, had net open positions at the PPE which later closed higher than the PPE Value. In short, the first group wanted to be able to claim the CMA Shortfall up to the PPE Value, from the insolvency, whilst the second group wanted to claim the total of the CMA Shortfall and the (higher) "hindsight" Contractual Claim over and above their PPE Value.
All parties accepted that a client who has a contractual claim against MF Global for money owed is entitled to prove for that claim in the liquidation even if it also has a claim to client money from the CMP. There were, however, three issues arising from this premise that the parties did not agree on, and which the Court was asked to determine.
4. Issue 1 – whether the amount claimed in the insolvency is reduced by amounts distributed from the CMA
Whilst all parties agreed there could be no recovery of both the full amount of the Contractual Claim in the insolvency and the CMP Entitlement, they disagreed over whether the CMP Entitlement reduced the amount that could be claimed in the insolvency.
On this issue, the judge held that the occurrence of the PPE does not mark the start of a new trust but provides a mechanism for giving effect to the existing client money trust, and that it does not alter the purpose of CASS 7 and 7A to provide protection for clients' contractual rights. This is not affected by the fact that some clients will be entitled to a larger distribution from the CMP than they would from the general estate because of the PPE Value. He therefore held that a distribution from the CMP will "reduce a client's contractual claim, and hence the amount for which it may prove, just as a payment from the client money account before a PPE reduced or discharged the client's contractual claim." The judge held that it would be contrary to the purpose of the client money trust not to take into account payments made from the CMP after the submission of claims against the general estate in deciding the amount that could be proved.
5. Issue 2 – whether the CMA Shortfall can be claimed in the insolvency
The judge was asked to consider whether a client may prove for a contractual claim in the insolvency the difference between its CMP Entitlement and the amount the client was able to recover from the CMA – i.e., whether it could claim the CMA Shortfall in the insolvency. The rule against double proof applies where more than one proof is admitted in respect of the same liability. David Richards J. noted that the authorities show that the test is whether two competing claims are, in substance, claims for payment of the same debt twice over. He held that since a client's Contractual Claim and the amount for which it may prove is reduced by payments from the CMP, the two liabilities must in substance be the same. Therefore, a Contractual Claim in the insolvency for the difference between the PPE Value and the value of open positions under the "hindsight" principle amounts to a "double proof" and cannot be claimed. The judge held that "the client cannot prove for both the CMP Shortfall and the balance of the Contractual Claim." By contrast, he held that it would not be a double proof for a client to claim the CMP Shortfall from the insolvency, including the PPE Value, since in such circumstances the client is seeking to prove once for one liability.
6. Issue 3 – quantum of insolvency claim where PPE Value is greater than contractual entitlement
This issue addresses the maximum amount of a shortfall claim in equitable compensation for breach of trust, including the reverse situation to that considered above: i.e., where the full CMP entitlement is higher than the full Contractual Claim, because the value of certain open positions at the date of insolvency – the PPE Value - was higher than the value at the date that transaction later settled.
The judge held that the purpose of the daily CMA reconciliation was to ensure that sufficient funds to meet the client money requirement were segregated at the end of each day, and the PPE process is an integral feature of the client money protection offered by CASS. As a result, clients should not be prohibited from receiving their share of the CMP entitlement purely because the firm has defaulted on its obligation to properly segregate all those funds. Therefore clients with higher PPE Values than their Contractual Claim could claim up to the entire PPE Value in the insolvency. The logic of the judgment suggests that those with higher Contractual Claims would not be able to claim the balance of the subsequent settlement value of their open positions, but this was not explicitly addressed in issue 3.
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This case further highlights the extent to which the post-insolvency impact of the CASS Rules may not have been fully envisaged by the regulators when the CASS rules were drafted and implemented, and the need for judges to fill the gaps between the CASS and insolvency rules. The effect of this decision is that a client's remedy is set at the PPE Value even where it is less than their contractual entitlement arising from the settlement date valuation. Furthermore, since the settlement value in fact recovered will be different to the client's entitlement under the PPE Value, that difference impacts on the funds available to all clients entitled to the CMP, because of the pooling principle. It is far from clear whether the intention of the CASS rules was to reduce the value of the client's legal entitlement from what it would otherwise have been absent insolvency, and/or absent client money protection.
That the FCA may view this outcome as a "loophole" is indicated by Consultation Paper 13/5, issued at the end of July 2013, which consults on proposed wide-ranging changes to the CASS rules. In respect of the "hindsight" principle, the FCA recognises the inconsistencies which can arise from some open positions. The Consultation Paper specifically proposes to end the use of the PPE Value for transactions cleared through central counterparties "so that clients' margined transactions that are open at PPE…are valued at the amount at which they are liquidated to determine client money entitlements to the CMP. That is, hindsight should be applied." (see paragraph 2.48 on page 18). The FCA has asked for responses to this section of the Consultation Paper by 11 October 2013.
Should this proposal be adopted, it will help to resolve this particular tension between the CASS regime and the insolvency rules. In the meantime, for clients holding open positions with any firm providing services protected by CASS, this case reinforces the importance of conducting due diligence on the CASS systems and institutional stability of that provider.