On 1 May 2009, the administrators of Lehman Brothers International (Europe) ("LBIE") applied to the English High Court for directions on certain issues relating to "Client Money" (as defined in the UK Financial Services Authority's Client Assets Rules, the "CASS Rules") held by LBIE. LBIE was regulated by the FSA and was required to comply with the CASS Rules. Details of the application and the list of issues involved can be accessed by clicking on the links above.  

Judgment

Mr Justice Briggs gave judgment on the administrators' application on 15 December 2009. The key points of the judgment are:

  1. The pool of pre-administration Client Money (the “Client Money Pool” or "CMP") consists of those bank accounts and transaction accounts used by LBIE in order to segregate Client Money, the balances of which at the time of LBIE’s administration (15 September 2008) totalled approximately USD2.1 billion. The LBIE administrators have indicated that they might not recover the whole of that amount however.
  2. LBIE is not required to top up or adjust the CMP, whether:
  • for clients for whom no or insufficient money was segregated at the time of administration;
  • for movements between the time of last segregation (being the morning of 12 September 2008, based on figures at as close of business on 11 September 2008) and the time of administration; or
  • to make good any credit loss shortfall including, for example, the shortfall arising by reason of the insolvency of Lehman Brothers Bankhaus AG (with which LBIE had deposited USD1 billion of Client Money on 12 September for repayment on 15 September 2008).
  1. The CMP is to be distributed to those clients for whom LBIE had segregated Client Money as at 15 September 2008. These will generally be those clients who have already received information from the LBIE administrators advising them how much Client Money was segregated for them at that date, according to LBIE's books and records. According to the administrators, if a client had not received any such information, it is likely LBIE did not segregate any Client Money for that client at the time of administration and it would not have a claim against the CMP.
  2. Clients’ Client Money entitlements are to be calculated at the time of administration by reference to what was segregated by LBIE for them at that time. For many clients, this will be the same as that which was segregated for them at the time when LBIE last conducted its reconciliation and segregation of Client Money on the morning of 12 September 2008 (which it did using data as at close of business on 11 September 2008). However, for some futures clients, the amount segregated for them in respect of certain of their futures’ positions was adjusted between close of business on 11 September 2008 and the time of administration to reflect fluctuations in the value of those futures’ positions. Those clients’ Client Money entitlements will therefore reflect that adjustment. The judgment does not however address whether clients for whom LBIE segregated sums in respect of depot breaks or unapplied credits have a Client Money entitlement in respect of those amounts. That issue is expected to be dealt with by way of a short addendum to the judgment.
  3. Clients will be required to give credit for Client Money paid to them by LBIE (or its affiliates on LBIE’s behalf) prior to the time of administration. Where LBIE segregated money for clients in respect of fails and those clients have subsequently received the relevant securities, clients will also be required to give credit.
  4. In the absence of an agreement to the contrary, LBIE may not exercise any right of set-off or retention against clients’ distributions from the CMP in respect of debts owed by those clients to LBIE.
  5. The judgment was an affirmation of Re Global Trader Europe Ltd (in liquidation) [2009] in that Client Money in non-segregated accounts used by LBIE may nonetheless be identified by the application of the established principles of tracing.

See our briefing on the Global Trader decision at: http://www.herbertsmith.com/NR/rdonlyres/E26F98E7-FAF2-461D-BCE3-EA313BA542C1/0/GlobalTraderBriefingJune2009.pdf

The judgment does not decide whether particular clients may or may not be able to bring claims against the general estate in relation to pre-administration Client Money, whether as unsecured creditors or for the return of identifiable Client Money held by LBIE outside the CMP.

Six respondents to the application have sought and been granted permission to appeal the judgment. Those respondents are Lehman Brothers Inc. (the US broker-dealer); Lehman Brothers Holdings Inc. (the ultimate holding company of the Lehman group); Lehman Brothers Finance AG; CRC Credit Fund, Limited; Goldman Sachs GSIP Master Company (Ireland) Limited; and Paragon Capital Management Fund Limited. If any or all of these respondents decide to appeal, they are required to file their appeal notice on or before 15 January 2010.

Any appeal may affect the progress of the LBIE administrators in distributing Client Money.

CASS Rules

What is clear from the judgment is that the Client Money Rules in Chapter 7 of the CASS Rules ("CASS 7") are inadequate and require review. The facts of the case have illustrated a series of fundamental problems in the interpretation and application of the rules in CASS 7. The "alternative approach" sanctioned by CASS 7 and adopted by many large firms (such as LBIE) as the preferred method of segregation has also aggravated the problems. Under the "alternative approach", Client Money is both received from and paid out to clients from the firm’s house accounts. Internal reconciliations are carried out every business day in order to top up or reduce the sums held in segregated accounts, so as to ensure that the amounts held in the segregated accounts match the amounts required to be held in segregated accounts. Client Money is then inevitably mixed with “house” money in the period between its receipt and later segregation, on a day-to-day basis.

LBIE did not generally segregate any money as Client Money for its affiliates as it did not believe it was required to do so by the CASS Rules or otherwise. The judgment confirmed that LBIE was incorrect to take this approach and that it was obliged under the CASS 7 to treat money held in the course of or in connection with business for affiliates covered by the Markets in Financial Instruments Directive ("MiFID") as Client Money. The confusion as to the treatment of affiliates' money post-MiFID arose due to inconsistencies in the FSA's Policy Statement (PS 07/2). This judgment will be relevant to other FSA authorised firms relying on the position as described in that Policy Statement with regard to the treatment of its affiliates' money.

The FSA is due to conduct a wholesale review of the CASS Rules early next year.

The UK Treasury has also recently published "Establishing resolution arrangements for investment banks" which outlines a package of more than 30 policy initiatives designed to mitigate the impact of the failure of an investment firm. In particular, Chapter 4 sets out proposals to improve the protections for investment firm clients at a pre-insolvency stage, including measures such as mandating product warnings in contractual agreements, clearly setting out the implications of allowing rehypothecation and use of client omnibus accounts, increasing disclosure to the FSA around the holding of client money and assets, and limiting the ability of investment firms to transfer client money to affiliate entities and jurisdictions incompatible with the protections in the CASS Rules. The Consultation Paper can be accessed here.

We will be preparing a more detailed briefing on the LBIE Client Money judgment in January 2010 analysing its potential regulatory implications.