Insolvency

Administration - Client funds - Company providing services for clients wishing to invest in securities

Re Lehman Brothers International (Europe) (in administration): Supreme Court (Lords Hope DP, Walker, Clarke, Dyson and Collins): 29 February 2012

Section 139 of the Financial Services and Markets Act 2000 expressly permitted rules to make provision which resulted in clients' money being held on trust in accordance with the rules. Chapter 7 (Client money: MiFID business) of the Client Assets sourcebook issued by the Financial Services Authority was commonly referred to as CASS 7. MiFID was an abbreviation for the Markets in Financial Instruments Directive (EC) 2004/39. CASS 7 had evolved from earlier regulatory instruments to transpose MiFID and its implementing Directive, Commission Directive (EC) 2006/73. CASS 7 provided for the segregation of client money and created a statutory trust over client money to support and reinforce the purposes of segregation.

CASS 7.4.14G dealt with payment of money into a client business account and set out two approaches that a firm could adopt in discharging its obligations under the MiFID client money segregation requirements, namely (a) the normal approach; or the (b) the alternative approach. Under the normal approach a firm that received client money should either pay it promptly into a client bank account or pay it out in accordance with the rule regarding the discharge of a firm's fiduciary duty to the client.

Under the alternative approach, a firm that received client money should: (a) pay any money to or on behalf of its clients out of its own account; and (b) perform a reconcilaition of records and accounts required under CASS 7.6.2R. CASS 7.7.2R set out the terms on which a firm held and received client money as trustee and CASS 7.9.4R stated that a 'primary pooling event' (PPE) occurred, inter alia, on the failure of the firm.

The glossary to CASS 7 defined a 'secondary pooling event' as an event which 'occurs on the failure of a third party to which client money held by the firm has been transferred' under the relevant provisions. CASS 7.9.6R stated that if a pooling event occurred: '(1) client money held in each client money account of the firm is treated as pooled; and (2) the firm must distribute that client money in accordance with CASS 7.7.2R, so that each client receives a sum which is rateable to the client money entitlement calculated in accordance with CASS 7.9.7R.'

When first read, CASS 7 appeared to provide a relatively straightforward and intelligible code for the safeguarding of client money by regulated firms. In an ideal world, the flawless operation of the scheme created by the CASS 7 rules would ensure first, that the clients’ money could not be used by the firm for its own account and secondly, that upon the firm’s insolvency, the clients would receive back their money in full, (subject only to the proper costs of its distribution) free from the claims of the firm’s creditors under the statutory insolvency scheme. The rules would achieve those twin objectives by ensuring that, promptly upon receipt, client money was held by a firm as trustee, separately and distinctly from the firm’s own money and other assets, and therefore out of the reach both of the firm (for the conduct of its business) and of the firm’s administrator or liquidator upon its insolvency (for distribution among its creditors).

Lehman Brothers International (Europe) (LBIE) was incorporated as an unlimited company with its head office in London. It was the principal European trading company in the Lehman Brothers group. It was authorised and regulated by the FSA. LBIE was not a licensed deposit-taker, but was authorised to hold clients' money. Its ultimate holding company was Lehman Brothers Holdings Inc, a company incorporated in Delaware which was put into administration on 15 September 2008. The difficulties that had arisen in the administration had led to several applications to the Companies Court for directions pursuant to paragraph 63 of schedule B1 to the Insolvency Act 1986.

Probably the most contentious and difficult of those applications was the client money application. The combination of a massive failure to identify and segregate client money, coupled with the credit loss shortfall attributed to the failure of another LBIE affiliate, Lehman Brothers Bankhaus AG (Bankhaus), had thrown up a series of fundamental problems in the interpretation and application of the rules in CASS 7 to LBIE's business and insolvency. In the case of LBIE, there had been a secondary pooling event, namely the failure of Bankhaus, as well as a primary pooling event, namely the failure of LBIE.

In December 2009, the High Court made an order giving directions on a range of issues concerned with client money (see [2010] All ER (D) 143 (Jan)). Four general issues emanating from that application were made the subject of an appeal to the Court of Appeal. Those issues were closely connected and depended upon the application of CASS 7. The Court of Appeal allowed the appeal on two of the four issues. Permission to appeal or cross-appeal to the Supreme Court in respect of three of those issues was granted to GLG, a representative of LBIE's fully-segregated clients.

The issues were: (i) when did the statutory trust created by CASS 7.7.2R arise; (ii) whether participation in the notional client money pool (CMP) was dependent on actual segregation of client money; and (iii) whether the primary pooling arrangements applied to client money held in house accounts (the client money account issue). The appeal would be dismissed.

(1) Where money was received from a client, or from a third party on behalf of a client, it would be unnatural, and contrary to the primary purpose of client protection, for the money to cease to be the client’s property on receipt, and for it (or its substitute) to become his property again on segregation. It would also be contrary to the natural meaning of the comprehensive language of CASS 7.7.2R. Segregation without a trust would not achieve MiFID’s objective.

Under the alternative approach, an immediate trust of identifiable client money did provide protection, though mixed funds are subject to a variety of risks. The absence of express restrictions, under the alternative approach, on use of clients’ money while held in a house account did not mean that the firm was free to use it for its own purposes. Its obligation was to segregate it promptly, and both CASS 7.3 and the general law of trusts would prevent use of clients’ money for proprietary purposes.

There were at least two methods, one contemplated by CASS 7.4.21R, of ensuring the protection of clients’ money temporarily held in a house account. The most formidable argument in favour of segregation (premised on the view that the provision of the distribution rules in CASS 7.9.6R(1) applied only to segregated funds) was that there was under the alternative approach potentially a 'black hole' into which clients’ money might vanish, so as not to be caught by the distribution rules. That was a point of substance, but it did not outweigh the opposing arguments.

To allow a limited defect of the alternative approach to dictate the interpretation of the essential provisions of CASS 7.2 would be to let 'the tail wag the dog'. Further, the alternative method was available not for the convenience of the firm, but as a better means of securing client protection. Both the normal approach and the alternative approach were intended to achieve a high degree of client protection, either by immediate segregation or by very prompt segregation. Moreover, when the firm was using money for its own purposes, it was treated as withdrawing its own money from a mixed fund before it touched trust money (see [63], [65] of the judgment).

(2) CASS 7.9.6R(2) should be read as a whole, including the words which followed the comma after 'in accordance with CASS 7.7.2R'. So read, the better interpretation was that the right to share in a distribution was given to 'each client' of the firm, so that all clients with a 'client money entitlement' were entitled to share. That was what CASS 7.9.6R(2) stated. The reason for referring back to CASS 7.7.2R was not to identify the client money that was to be distributed (that was done in CASS 7.9.6R(1) and (2)). It was to introduce the order of priorities referred to in CASS 7.7.2R. Accordingly, for example, the incorporation of CASS 7.7.2R(2) threw the costs properly attributable to the distribution of client money on to the client money (rather than on to the general assets of the firm). The costs of distribution would have to come from the trust before division to clients (see [158] of the judgment).

The general scheme of CASS 7 was that all client money was subject to a trust that arose upon receipt of the money by the firm. That included money received from the firm’s affiliated companies. The client money rules were, therefore, intended to protect all the clients’ money received prior to a PPE. The distribution rules were intended to protect all the clients’ money in the event of a PPE. There was nothing surprising in the notion that, once a PPE occurred, the treatment of client money was subject to a different regime from that to which it had been subject before It was not inherently unlikely that the draftsman intended that clients with established proprietary interests in segregated funds should have those interests disturbed by the distribution rules in the event of a PPE.

There was no a priori reason why the draftsman would not have intended to produce a scheme pursuant to which the protection afforded to clients was modified in the event of a PPE. There was nothing unrealistic in a scheme which provided that, in the event of the failure of a firm, the beneficial interests in the client money were adjusted so as to provide that each client received a rateable proportion of the aggregate of all the client money; in other words that all clients share in the common misfortune of the failure. Accordingly, the distribution model underlying the CASS 7 trust differed from that of private law (see [144], [146] of the judgment).

Participation in the CMP was not dependent on actual segregation at the time of the PPE. Such a purposive interpretation supported the claims basis for participation and better reflected the fact that all client money was subject to the statutory trust and that CASS 7 was intended to give effect to the Directives whose overriding purpose was to safeguard the assets of all clients and to to provide all clients with a high degree of protection (see [159], [160] of the judgment) (Lord Hope and Lord Walker dissenting).

(3) As a matter of ordinary language, the phrase 'client money account' was capable of meaning: (i) an account which contained or was intended to contain exclusively client money or (ii) an account of the firm which contained client money. Even where a firm was fully compliant, CASS 7 contemplated that client money would be held in the firm’s own account.

Accordingly, where the 'alternative approach' of payment of client money into a client bank account was adopted under CASS 7.4.16G, 7.4.18G and 7.4.19G, the firm might receive client money into its own bank account before (on the next business day) paying it out to or on behalf of the client. The question of whether a house account in which client money is held was a 'client money account of the firm' arose, therefore, both in relation to money held by the firm where it adopted the alternative approach and where it wrongly retained client money in its own account. Since that examination of the text showed that there were two possible interpretations of the phrase 'each client account of the firm', the correct interpretation should be the one that best promoted the purpose of CASS 7 as a whole (see [163], [164] of the judgment).

The fundamental purpose of CASS 7 was to provide a high level of protection for client money received by financial services firms. That was why all client money received from or held for or on behalf of a client in the course of, or in connection with its MiFID business (CASS 7.2.2R) was held on trust upon receipt and why the other client money rules in CASS 7.1 to 7.8 were expressed as they were; and that was the policy underlying the distribution rules. To exclude identifiable client money in house accounts from the distribution regime would run counter to that policy (see [164], [165] of the judgment).

The pooling at the PPE included all client money identifiable in any account of LBIE into which client money had been received and was not limited to client money in the firm's segregated accounts. That conclusion was consistent with and reinforced the conclusion reached on the client money account issue (see [167], [169] of the judgment) (Lord Hope and Lord Walker dissenting). Decision of Court of Appeal [2010] All ER (D) 15 (Aug) affirmed.

Antony Zacaroli QC, David Allison and Adam Al-Attar (instructed by Allen & Overy LLP) for GLG; Jonathan Crow QC, Jonathan Russen QC and Richard Brent (instructed by Field Fisher Waterhouse LLP) for Lehman Brothers Finance AG; Jonathan Crow QC, Jonathan Russen QC and Richard Brent (instructed by Norton Rose LLP) for Lehman Brothers Inc; Robert Miles QC and Richard Hill (instructed by Simmons & Simmons) for CRC Credit Fund Ltd; Iain Milligan QC, Rebecca Stubbs and Richard Fisher (instructed by Linklaters LLP) for the administrators; David Mabb QC and Stephen Horan (instructed by the FSA) for the FSA.