Lessons to be learnt from Lehman Brothers client money judgment


NB The High Court Judgment to which this article relates has since been revisited by the Court of Appeal, and to some extent overturned. Please see here for our analysis of the Court of Appeal Judgment and its consequences

Client money is money that belongs to a client but is held for safekeeping by an investment firm on behalf of the client under a statutory trust, for example in order to enable the provision of brokerage, trading or portfolio management services by the firm. Unlike banks, investment firms are generally required to segregate client money separate from their own money in order to protect their clients’ proprietary interests.

The recent High Court judgment relating to the distribution of over US$2 billion of client money held by Lehman Brothers International (Europe) (“LBIE”) (click here for the full judgment) has served to highlight that the general law and rules around how firms must treat client money are difficult to apply in the context of the insolvency of a firm such as LBIE. Bearing in mind that, given the current environment, it is possible that other investment firms holding client money will face insolvency, we will summarise the findings of the court, and identify some important practical points for clients and firms that arise from those findings.


LBIE was the primary trading company of the Lehman Group in Europe, and is regulated by the Financial Services Authority (the “FSA”) in the UK. Its client activities included prime brokerage, investment banking and advisory services, fixed income and equities dealing and investment management. LBIE held money belonging to a range of clients (including affiliates within the Lehman Group) and was therefore subject to the rules about client money in Chapter 7 of the FSA’s Client Assets Sourcebook (“CASS 7”). CASS 7 implements various organisational requirements prescribed by MiFID (the European Markets in Financial Instruments Directive) and also creates a trustee/beneficiary relationship between firms and clients in relation to client money.

At 07.56 am on 15 September 2008, LBIE went into administration, an event which, in accordance with CASS 7A (formerly CASS 7.9), triggered the pooling of all client money that had been properly segregated by LBIE. The total value of the client money pool, in an ideal world, should have been sufficient to return the client money to the relevant clients in full (less costs of distribution). Instead, as was soon discovered, LBIE had consistently failed to keep client money segregated from its own house funds (as it was required to do so by CASS 7 as trustee), resulting in the client money pool being insufficient to satisfy all claims. Furthermore, one of the banks with which LBIE held US$1bn of client money for safekeeping, Lehman Brothers Bankhaus AG, also became insolvent, instantly creating a further reduction in the pooled amount that would have been available to clients whose client money had been properly segregated.

The Administrators of LBIE, on the one hand faced with a host of claims from clients (some of which are Lehman Brothers affiliates also in administration) asserting rights under a wide array of contracts and business arrangements to the client money pool, and on the other hand faced with further claims from general creditors of LBIE (who did not have client money claims, but were otherwise owed money), sought assistance from the court with the complex task of applying CASS 7 and UK property and insolvency law to the client money claims in order to establish the correct legal basis for any entitlement in the client money pool. The analysis and reasoning of the court is lengthy and highly technical, but is extremely valuable, not
least because CASS 7 has been shown to include some glaring errors and gaping holes, not all of which were apparent from a previous case concerning the insolvency of a UK investment firm, Global Trader Europe Limited (click here for that judgment).

What were the conclusions of the court?

i) Entitlements

The court generally found in favour of clients whose client money is handled in accordance with CASS 7 prior to the administration of the firm. Clients of a firm that is in administration will therefore only have an entitlement to the client money pool constituted at the time of administration if their client money (having been segregated properly by the firm) actually forms part of that pool.

This may seem unfair to clients of firms who have failed to comply with CASS 7, and in respect of which the FSA has not taken enforcement measures prior to administration. If client money becomes subject to a trust the moment it is received by the firm (as was held by the court), it could be argued that it should be returned to clients on administration of the firm. However, according to the court this apparent unfairness is mitigated by the fact that if any client money was not segregated by the firm as at the time of administration, it can still be the subject of a proprietary claim that ranks above other creditors of
the firm. The court did, however, acknowledge that any successful proprietary claim is likely to involve ‘formidable evidential hurdles’. This is especially the case where the client needs to use a process known as ‘tracing’ to track his specific entitlement in money through the course of various dealings in that money by the firm. In brief, client money outside of the client money pool can be reclaimed by clients if it can be successfully identified as theirs.

ii) Distribution

Where there is a shortfall in the amount of client money that has been segregated (as is likely to be the case with most insolvent firms), the client money pool is required to be distributed on a pari passu basis. The court held that client entitlements to the client money pool are to be calculated with reference to the proportion of the pool that represents money belonging to each client at the time of administration (rather than on the basis of how much money should have been segregated for each client). In addition, the entitlement of each client is measured on the basis of the value of the pool as at the time of administration and not, for example, the value at the time the distribution is made. This means that clients must share in the fortunes and misfortunes of other clients whose entitlements rise or fall in value between the date of administration and eventual distribution (e.g. due to currency fluctuations, or market movements on open trades), again on a pari passu basis.

iii) Other findings

In addition to the main findings explained above, there were several other determinations made by the court to help LBIE’s administrators deal with the particular facts in hand. For example, the court clarified the distinction between client money received by the firm from a client (or a third party for the benefit of a client), which becomes subject to the trust at the moment of receipt, and money that the firm owes a client as a debt (for example if that client profits from a trade entered into with the firm), which only falls within the statutory trust once the firm actually segregates an amount of its own representing that debt. The court also identified certain circumstances where entitlements in the client money may be legitimately adjusted, for example to prevent double counting.

The court also reconsidered one particular aspect of the Global Trader case, which had previously allowed administrators to ‘top up’ the client money pool in respect of shortfalls that were actually caused by the firm going into administration (as opposed to other failures). The court considered whether a top up could be made in any circumstances, including to give effect to a final reconciliation between a firm’s house account and client money account, which would have happened in the course of business as usual had the firm not gone into administration. The conclusion reached was that no top ups whatsoever can be made.

Why did the court reach those conclusions?

The court was mindful of the fact that LBIE’s circumstances were both unique and extraordinary, and therefore was reluctant to set new legal precedents. Instead the court sought to apply CASS 7 in the spirit of MiFID, and in the context of general law, in particular property law and insolvency law. In doing so, the court acknowledged that MiFID created no legal safety net for clients whose funds were misappropriated by firms. Instead, it imposed harmonized organisational requirements on firms that may assist in achieving investor protection but would not guarantee it. The legal remedies against firms who misappropriated client money were, instead, to be found in general local law in each member state. Indeed, when transposing MiFID into UK rules, the FSA was only required to create additional rules where UK law would have failed to provide investor protection. It did this, for example, through the concept of the statutory trust. Unhelpfully, however, CASS 7 is silent on the consequences of the trust being operated incorrectly, and the drafting of CASS 7 is far from perfect, as is shown at several points in the judgment.

The court was therefore required to apply existing general law to circumstances for which CASS 7 is silent or unclear. In doing so the court was very careful not to make inroads into the existing UK insolvency regime. This is, for example, one reason as to why top-ups to the client money pool were ruled out. However, the court also acknowledged that some circumstances have no legally perfect solution, in which case the most just solution is the best. This is shown for example inthe sharing of all clients, pari passu, of fluctuations in the value of the client money pool between administration and distribution, even where those fluctuations are only strictly attributable to some clients.

The significance of this approach is that CASS 7 does not paint a full picture of the UK client money regime. A wider understanding of UK law is required to appreciate the extent of proprietary rights to client money in certain circumstances, including failure of the firm or bank at which the money is held, and how best to protect those rights up front.

Practical points for clients of firms

i) Understand the dangers

If you are a client considering using a firm for the provision of services that will involve the firm holding (at some point) money that belongs to you, the starting point is to recognise that both CASS 7 rules and UK law have limitations in the degree of protection they can provide.

Even if your money is held under a statutory trust, this may be of little use if the firm fails altogether to discharge its trustee duties and obligations (as was the case with money belonging to LBIE’s affiliates). If the firm has not segregated your money, and mixed it up with its own money in its house accounts or, worse, spent the money as if it belonged to the firm itself, and the FSA has not managed to spot and rectify such a breach before the firm goes into administration, there are likely to be significant problems in recovering your money. You may need to use equitable remedies (tracing) to assert your proprietary claim, since you will not have any entitlement in the client money pool under CASS 7. However, equitable remedies can fail. For example, if the balance on the relevant house accounts in which the client money was mixed has been reduced to zero or overdrawn, since that would extinguish any proprietary rights to it. The onus will be on you to identify any property left in the house accounts as your own. If, under such circumstances, equitable remedies prove to be useless you will probably be left in the same position as an unsecured creditor and will, most likely, receive only a portion of your entitlement, if at all.

Ideally, clients should be able to conduct checks on whether a firm to whom they entrust their money is operating correctly. However, practically, it is difficult to conduct these checks as it requires open access to the firm’s records and would require accounting expertise and resources. Many firms would resist such enquiries and only the larger client may be able to persuade them otherwise. There are, nevertheless, some actions that can be taken to highlight and potentially avoid some of the risks.

ii) Know your contractual rights

You should ensure that you fully understand what your contractual rights are in relation to (i) money that you pay to the firm (or that the firm receives from third parties) and (ii) money that the firm comes to owe to you in the course of providing services.

Banker/depositor or trustee/beneficiary relationship? If a firm offers investment services but is also a licensed bank, it may be the case that you have no client money protection whatsoever, and your money is treated as a deposit (i.e. a debt as opposed to money under a trust) falling outside of CASS 7.

Title transfer collateral arrangements: In some standard form agreements both types of money will be expressly excluded from having trust status if they fall under a ‘title transfer collateral arrangement’. These are commonplace where the services provided by firms include the execution of margined transactions (whether on your behalf as agent or as riskless principal under a back-to-back arrangement). They are essentially a carve-out from the statutory trust under CASS 7: the money would be deemed as held by the firm as collateral to secure the performance of your contractual obligations towards the firm. Title transfer collateral arrangements go further than legal charges in the sense that full title to the money actually passes to the firm – the money is no longer yours, and you are a creditor to the firm in respect of it (and rank amongst other creditors on administration). In some circumstances, and depending on the nature of the services being provided, a firm may be satisfied with a ‘right to use’ your client money under a charge, rather than a full title transfer from the time of receipt – it is therefore worth raising this possibility with the firm.

Treatment of money owed to you by the firm: If the service you are using envisages that the firm will owe you money as a debt (for example, profits from a cash-settled transaction entered into with the firm, such as a contract for differences), you should confirm how quickly the firm will discharge any such debt to you. Although the safest option is to require immediate payment you may wish the firm to retain the money for future services, in which case the firm should ideally be required to appropriate the correct amount from its own funds and segregate these for you into a client money account (thereby placing them within the trust) as soon as possible. The other advantage of this, as shown by the LBIE judgment, is that once those debts owing to you are converted into money held under trust, they cannot be used by the firm to set-off against debts that you owe to the firm.

iii) Do your due diligence

You should appreciate that firms have a degree of flexibility in deciding how to operate their client money processes in several respects. In a perfect world none of the permitted alternatives should jeopardize investor protection. In practice they may create additional risk under certain circumstances. It is therefore worth finding out how the firm complies with its obligations under CASS 7, to identifying potential risks.

Does the firm use the normal or alternative approach? Under the FSA’s ‘normal approach’ for handling client money, firms are expected to receive and pay client money directly from a client money bank account (i.e. directly from the trust), and to regularly clear the account of any money that is their own (for example, as a result of a mixed remittance). However, firms such as LBIE that operate in a multi-currency and multi-product environment may elect to use the FSA’s ‘alternative approach’ for client money segregation. This involves receiving and paying client money directly from the firm’s own house accounts, but segregating an amount equal to the value of client money into a client account through a reconciliation process that takes place once a day. The alternative approach therefore allows for client money to be mixed with the firm’s own money in a house account, at least until the time at which the next reconciliation and segregation process takes place.

Does the firm operate a liquidity management process? Operating the alternative approach is riskier in the sense that long running undetected failures to reconcile and segregate (as in the case of LBIE) may significantly harm the chances of success of recovering your money through the equitable remedy of tracing, if necessary. This may be particularly relevant where a firm operates a liquidity management process, whereby banked cash surpluses are swept up into one centralised location (to benefit from economies of scale and ease of management) on a short or medium term basis until they are identified as being required in their original source.

Does the firm maintain a client money buffer? Some firms operating the alternative approach will mitigate the risk of failing to segregate the correct amount of client money by operating a ‘client money buffer’. This is a fixed amount that is segregated on a daily basis into the client account, calculated on the basis of a historical average of the amount of client money required to be segregated. LBIE maintained such a buffer with the blessing of the FSA, in recognition of the fact that it was not always possible for LBIE to determine immediately whether a credit to a house account represented client money or not. In theory this would have been a prudent measure and would reduce the risk to clients. In the event the size of the buffer did little to compensate the overall shortfall.

Where does the firm keep client money? Firms are permitted to hold client money in a number of different locations. Firms placing client money with a bank (or in a money market fund) are required under CASS 7 to exercise all due skill, care and diligence in the selection, appointment and periodic review of that bank. As shown in the case of LBIE, the choice of an institution outside of the firm’s group (and therefore one that was less prone to fail simultaneously with other group companies) may serve to reduce the risk of a huge funding shortfall in the client money pool. Firms that provide trading services, for example by dealing in financial instruments as agent for a client or as principal in a back to back arrangement, are also permitted to transfer client money to ‘client transaction’ accounts held by the firm with an intermediate broker or clearing house for the benefit of the client. This money is usually required to fund the margin requirements for such transactions. In the case of LBIE, where the brokers and clearing houses agreed they would not exercise rights of set-off relating to LBIE’s proprietary positions against the client monies in those transaction accounts, the court viewed those accounts as ‘choses in action’ between LBIE and the market counterparty, under a trust for the benefit of the client. Helpfully to the clients, those accounts could therefore be included in the client money pool for distribution.

iv) Be vigilant

Ultimately, even where you have a carefully negotiated contract, and have done full due diligence, your chances of recovering client money from the client money pool will be affected by whether or not your client money has in fact been segregated by the firm and is therefore part of the pool at the time of administration. You should therefore take care to check any statements provided to you by the firm and perform your own reconciliations, confirming that they match your understanding of what should be happening with your money under any contracts.

Practical points for firms

Comply with your trustee duties: One of the most significant outcomes of the judgment for firms using the ‘alternative approach’ is confirmation that firms have certain duties as trustees that are not expressly recognised in CASS 7. In particular, where client money is mixed with house money (however temporarily), the mixed fund must be handled with care, since there is a duty to deal with that fund in such a way that the portion of it that represents client money is not put at risk pending the next reconciliation and segregation process. This duty applies to the firm at the point at which the trust is constituted – that is, at the moment of receipt of client money from the client or a third party, or the moment of the appropriation of identifiable property (by segregating an amount) to discharge a debt owed by the firm to the client. The mixed fund can never be used entirely for the firm’s own purposes. Whilst it is not for the court to determine any organisational requirements (in addition to those provided for in MiFID and the FSA) that a firm should adopt to ensure it does not fail in this duty (this is more a task for the firms themselves, their auditors, or the FSA), the court did suggest as a possible solution the concept of maintaining a ‘prudential buffer’ that is based on historical averages of the amount of clientmoney typically held in a house account, either in the form of a minimum account balance maintained in the house account, or as a segregated amount maintained in the client money bank account.

Be aware of the complexity of CASS 7: The judgment is also useful in providing very detailed guidance on some of the more complicated provisions in CASS 7, particularly in relation to the alternative approach. For example, there is considerable discussion as to the precise purpose of CASS 7A.2.5R (formerly CASS 7.9.7R). The court confirmed that this provision is simply a reducing mechanism to be used only on final distribution of the client money pool in circumstances where the firm did not, prior to administration, use the ‘reduced client money requirement option’ in its daily client money reconciliations. This option allows firms to offset client money cash balances against client money used for margined transactions, thereby reducing the overall amount needed to be segregated. Firms have the option to use this complicated offsetting process, which will be applied to the client money pool on administration if they have not opted to use it. CASS 7A.2.5R is therefore not (as was argued) evidence in support of an argument that entitlements in the client money pool should be based on the amounts that should have been segregated (as opposed to the exact amounts that were).

Be aware of the shortcomings of CASS 7: Firms should also be aware, when interpreting CASS 7, that as well as gaps in explaining what happens to client money entitlements under unfortunate circumstances, the drafting of CASS 7 itself is far from imperfect. Some of these issues have been resolved in the version of CASS 7 that followed LBIE’s administration (which came in to effect on January 1 2009), but many others remain. For example, CASS 7 is inconsistent in its use of the defined term ‘money’. In some cases ‘money’ appears to refer to a monetary obligation or entitlement (for example in CASS 7.2.9R and 7.2.13G), and in others ‘money’ appears to relate cash as a species of property (for example in CASS 7.2.15R). These inconsistencies can create conflicting interpretations, for example, in relation to the question of exactly when money ceases to be client money if a debt is owed by a client to a firm. The court found in that case that money ceases to be client money at the point of payment to the firm (rather than the point at which the debt becomes owed by the client). There is also a significant error in CASS 7.8.9G, which states that clients who have suffered a shortfall in the client money pool only have a claim in respect of that shortfall as an unsecured creditor (rather than as a beneficiary of a trust who has a proprietary claim). This is clearly untrue - a proprietary claim cannot be extinguished so easily, although it may be harder to pursue given the evidential hurdles mentioned above.

Keep your eye on the regulatory reforms: It seems likely that the FSA will, at some point in the future, consult on amendments to CASS 7 to take into account the findings of the court, if only to correct the mistakes that were highlighted. In addition, the UK Treasury (“HMT”), in its consultation paper on resolution arrangements (known commonly as ‘living wills’) for investment banks, has also highlighted the need to ensure client property (both money and assets) can be identified and returned to clients in the event of insolvency (the consultation paper can be found here). HMT has proposed a range of new
measures aimed at increasing protection of client property and reducing confusion (both of clients and firms). The proposed measures include changes to documentation (such as enhanced product warnings of risks to client money, and clarity in contracts on client money issues); increased transparency to the regulators (reporting, record-keeping, and auditing of client property operations); allocating staff responsibilities for client money within firms; limitations on what firms are able to do with client property (including liquidity management operations); and further segregation of client property into different risk pools.


In conclusion, there is much in the LBIE judgment for firms and their clients to consider. Firms should work closely with their legal advisors and auditors to confirm that their systems and controls are compliant and being run in accordance with the rules in respect of all clients (which may include affiliate companies). Clients may want to review their existing investment arrangements with a view to ensuring maximum protection for their money under the legal and regulatory framework.

If you would like to discuss the judgment in more detail, or have some concerns in relation client money, please feel free to contact your usual CMS contact.