In its recent decision in Lehman Brothers International (Europe) (in administration)1 the Supreme Court resolves the uncertainty where a regulated firm does not properly segregate client monies. The decision has a number of practical implications, not only for the administration of Lehman Brothers International (Europe) (LBIE) but also for the way client monies are held by institutions.
The client money rules in Chapter 7 of the Clients Assets Sourcebook (CASS 7) of the Financial Services Authority (FSA) create a statutory trust under which firms hold client money on behalf of clients. This client money is then usually used for trades/investments. The central feature of the rules is the requirement imposed on regulated firms to segregate money that they receive from or hold on behalf of their clients in the course of business by placing it into a client money account in order to keep it separate from the firm's own money.
In the event of a regulated firm going into administration, one role of the administrators is to identify the size and value of the pool of client money available for distribution, the "client money pool" (CMP), and the number of claimants to the CMP.
The LBIE litigation
LBIE, the Lehman Brothers' principal European trading subsidiary, provided investment banking services to clients across the globe and held considerable amounts of money and assets on behalf of its clients. When LBIE went into administration, the administrators applied to the court for directions on how to deal with these client assets under CASS 7.
At first instance the High Court held that where a regulated firm becomes insolvent, clients whose money was not segregated in accordance with CASS 7 would be unable to share in the CMP, effectively meaning that the client would have to claim as an unsecured creditor (and therefore potentially get a much reduced recovery).
Subsequently the Court of Appeal overturned the High Court's decision, holding that the CMP includes all traceable client money and that the class of creditors entitled to participate in distributions of the CMP includes not only clients who can trace their funds into the client money account but all creditors contractually entitled to client money, even where this money is not held in a separate account and is held in the firm's own account.
The administrators appealed to the Supreme Court.
The decision of the Supreme Court
The Supreme Court upheld the decision of the Court of Appeal, holding that:
- The statutory trust over client money arises upon receipt of the funds by the firm, not when the money is segregated from the firm's own assets.
- The CMP available for distribution includes all identifiable client money, including both segregated client money and client money held in the firm's own accounts.
- All creditors with a contractual entitlement to client money have a right to share in the CMP, irrespective of whether their client money was in fact segregated.
Implications for creditors and administrators
- Potential increase in the size and value of the CMP. The decision that the CMP includes all identifiable client money means that there is likely to be an increase in the size of the CMP as the administrators can utilise client money held in the firm's accounts. This will lead to a corresponding decrease in the size of the general asset pool available for ordinary unsecured creditors.
- Increase in the number of claimants to the CMP and corresponding dilution of distribution to CMP claimants. All creditors with a contractual entitlement to client money now have a right to share in the CMP and therefore, despite the likely increase in the size of the CMP, distribution to those claimants is expected to be diluted. Administrators will need to conduct a thorough regulatory and legal analysis of each client's position in an administration in order to establish whether they have an entitlement to client money and are therefore entitled to participate in the CMP.
- Short term delays in the repayment of creditors. Administrators will need to undertake a complex and time-consuming tracing exercise to identify all client monies regardless of which accounts they are being held in. It is expected that administrators will apply to the court for further directions on how client money should be traced which will further prolong the process.
- Eventual reduction in the time it takes for creditors to be repaid. The judgment has resolved much of the previous uncertainty surrounding CASS 7 and accordingly, once directions on tracing have been given by the court, it is expected that the time it takes for creditors to recover money will be reduced (although clearly not in the case of LBIE).
- Conduct enhanced due diligence. Clients are advised to enhance their due diligence of firms' client money procedures and protections. Clients should check that the firm has reviewed its procedures in light of the judgment in order to ensure that their money is properly safeguarded.
Implications for regulated firms holding client money
- Heightened focus by the FSA on client money systems and controls. Firms should expect a more thorough assessment by the FSA of the handling of client money and are advised to review their relevant procedures and processes to ensure that they will withstand not only close regulatory scrutiny but also the scrutiny of potential clients.
- Potential reformulation of the CASS rules. It is likely that the CASS rules will be subject to some consideration by the FSA, with some commentators expecting a comprehensive reformulation of the rules. Regulated firms should ensure that they keep up to date with any regulatory response to the judgment.