On 29 February 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 for the distribution of client money and the entitlement to share in the client money pool upon the insolvency of a firm operating the “alternative approach”.
The appeal concerned the interpretation of Client Money Rules contained in the Chapter 7 of the Client Assets Sourcebook (“CASS 7”). As permitted under the Client Money Rules, Lehman Brothers International (Europe) (“LBIE”) – like all large investment firms – adopted the alternative approach. Under the alternative approach 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: firstly LBIE failed to identify and segregate large sums of client money; and secondly, LBIE’s affiliate, Lehman Brothers Bankhaus AG, failed at a point in time when it was holding at least US$1 billion of client money. The appellants, GLG Investment PLC, raised three issues:
(1) When does the statutory trust with respect of client money received by the firm arise? (2) Do the arrangements for pooling of client money, in the event of a primary pooling event, apply to client money held in house accounts? (3) Is participation in the notional client money pool dependant 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 3:2 majority (Lord Hope and Lord Walker dissenting) dismissed the appeal on second and third issues.
Issue 1 – Client money in house accounts
The court unanimously ruled that a trust arises upon the receipt of client funds, irrespective of whether the normal or alternative approach to segregation of client money was adopted. The court considered it would be both contrary to the primary purpose of client protection and contrary to the CASS rules for the trust to arise upon segregation. It was reasoned that any other decision would fail to achieve the client protection purposes of the MiFID directive.
The implications of this are far from clear. Indeed, there appears to be a lack of clarity between how investment firms can use trust money in house accounts. Notably, important questions arise when considering a scenario where there is a shortfall in the house account (i.e. because the client money is paid into an overdrawn house account, or because the investment firm has used client money for other purposes).
In this judgment, 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”. While this may provide some comfort, it does not address the situation where there is a shortfall of the house account. It would seem that in such a situation clients, in a practical sense, have ‘daylight exposure’ until segregation.
Issues 2 and 3 – What money forms the client money pool and how should that money be distributed?
By a 3:2 majority, it was held the correct interpretation was the approach which 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.
Again by majority, the court ruled that all clients were entitled to share in the distribution of the client money pool irrespective of whether actual segregation had occurred. For clients of the failed firm, this could be either advantageous or detrimental to their claim to get their money back. Clients who would have otherwise 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 evenly share the shortfall as unsecure creditors because distribution of the pool will be on a pro rata basis.
This raises important questions as to the due diligence a client can undertake to ensure their money is best protected. Previously, a client could request a statement and rest easy if the money had been ring-fenced. But now, following the Supreme Court’s judgment, there appears little a client can do to prevent their entitlement from being diluted, even after proper enquiries.
The Supreme Court’s decision will undoubtedly cause further delay to creditors awaiting their money. Perhaps worryingly, it seems likely the uncertainties caused by the decision will result in further litigation. It remains to be seen, however, whether the operation of the alternative approach will be affected in practice by the court’s decision.