The Supreme Court, which delivered its judgment by a majority of three judges (Lords Clarke, Dyson and Collins) to two (Lords Hope and Walker dissenting on two of the three issues considered) effectively upheld the conclusions of the Court of Appeal, by holding that:
(1) a statutory trust under CASS arises upon receipt by a firm of client money, rather than upon segregation of client money;
(2) the notional client money pool which is available for distribution includes all identifiable client money, including client money which a firm holds on house accounts; and
(3) a client is entitled to participate in the notional client money pool where that client has a contractual entitlement to client money, irrespective of whether the client money has been segregated.
As well as confirming the conclusions of the Court of Appeal, the three majority judges of the Supreme Court reached their conclusions using largely the same methodology as the Court of Appeal. Their reasoning is premised on a purposive interpretation of the relevant provisions in both CASS and MiFID (i.e. the Markets in Financial Instruments Directive and its Implementing Directive, which CASS partially implements at a UK level) and seeks to give effect to the overarching aim of protecting investors, including in particular those whose client money has not been segregated in accordance with CASS. The majority opinions contrast with those of the two dissenting judges, who favoured a textual interpretation of CASS and MiFID that would safeguard the rights of those clients whose client money had been appropriately segregated in accordance with the requirements of CASS prior to the failure of the firm, and that would facilitate a workable scheme for the timely distribution of client money and avoid the complexities involved in identifying unsegregated client money.
1. What were the conclusions of the Supreme Court?
The Supreme Court based its three conclusions on the following reasoning:
a) The client money trust arises on receipt of any client money by a firm
All five judges were in agreement on this point, which is also in line with the Court of Appeal and High Court judgments. It means that a firm owes trustee duties to a client from the time at which the firm begins to hold such money on behalf of the client (which, in the case of payments from the client or a third party, will be the time of receipt), before there is segregation of client money and whether or not there has been segregation. Lords Clarke and Collins emphasised that if the trust did not arise until segregation, then whether or not clients are protected by CASS would become arbitrary and dependent upon the firm’s own practices.
This outcome is significant in the context of the FSA’s ‘alternative approach’ to client money segregation. The alternative approach allows firms to receive client money into their own house accounts, and make appropriate adjustments (no later than the close of the next business day) to reconcile the difference between the amount that is in the client money bank accounts and the amount that it should have been segregating at the close of the previous business day. There is, therefore, an inherent intra-day risk that the firm may, contrary to its trustee requirements, dissipate the received client money before the relevant reconciliation takes place. The Court of Appeal judgment advocated the use of ‘prudential buffers’ to address this risk – a suggestion which the Supreme Court did not elaborate on. A prudential buffer is a surplus amount that a firm maintains, either in its house account or client money account, to ensure at all times that it holds, as a trustee, the entire amount of client money that it is required to hold. The buffer is funded from the firm’s own capital. At the moment, the use of any buffer is subject to a consultation process with the firm’s auditors and the FSA. In future, if the alternative approach survives, the requirement to maintain a prudential buffer is likely to be codified.
A similar risk also arises where a firm goes into administration in between the point of receipt of client money and the firm’s next scheduled reconciliation (which does not take place because of the commencement of the administration process). If the money that was not segregated proves to be untraceable, the claim for that money will effectively rank as an unsecured creditor claim (and not a proprietary one). Lord Walker’s dissenting judgment suggests that this risk be addressed by requiring the administrator to give effect to a final outstanding reconciliation following failure of the firm, limited to taking account of events between the firm’s point of last segregation and its administration (the “gap period”). This approach was opposed persuasively by Lord Clarke, on the basis that the last segregation may not have been carried out correctly, that there is no reason to give preferential treatment to those clients who deposit client money with the firm in the gap period, and that all clients with unsegregated client money entitlements should be treated in the same way, irrespective of when they have deposited monies with the firm.
b) The client money pool to be distributed on insolvency includes all traceable client money, including in house accounts
The three majority judges in the Supreme Court, like the Court of Appeal, were at variance with the High Court judgment on this point. The High Court judgment stated that the client money pool only included the client money that was held as such at the time of administration (subject to a few permitted adjustments). The High Court judge was persuaded by the symmetry in requiring the firm to identify and segregate client money whilst in business, and then distribute the same amounts on failure. This position was also taken by the two minority judges in the Supreme Court, in whose opinion clients should not be taken to implicitly accept the risk that, upon the failure of the firm, their segregated funds should be shared with unsegregated clients. Clients whose client money was not properly segregated would still have a proprietary claim to the extent that their client money could be traced within LBIE’s house accounts.
The majority judges in the Supreme Court, like the Court of Appeal judges, found this approach to be flawed. They were more persuaded by the argument that since there was only one single trust, the distribution in relation to that trust should include all the money within it, under one single pooling.
This outcome creates forensic issues for the administrators in terms of ascertaining the amount in the client money pool. Under the High Court judgment they would have only needed to include those amounts that were in LBIE’s client money bank accounts, and in transaction accounts held with brokers and clearing houses (subject to some adjustments). Now under the Supreme Court judgment they are potentially required not only to scour each and every account in which LBIE ever held client money (even momentarily) for any trace of this client money, but also to pursue all payments from those accounts (whether to other accounts or to third parties) to see how far the trail can be usefully followed. As Lord Walker points out in his dissenting judgment, “a trust without segregation is a very precarious form of protection because of the risk – or rather, in this context, the strong probability – that the element of trust property in unsegregated funds will rapidly become untraceable”.
Trust law may lend a small hand in simplifying the tracing process: to the extent that an account balance falls below the client money amount that it is meant to contain (or becomes overdrawn), there is no traceable client money interest in that difference (or none at all in the account), since a trust can only attach to identifiable property (and not to an overdraft). LBIE’s own liquidity management process, in which surplus cash balances were constantly swept up to its parent company and paid back down to LBIE only as and when required, could also serve to destroy the trail. Nevertheless, such a process could be time-consuming, costly, and potentially make no net difference to the overall size of the client money pool. The
Court of Appeal judges had alluded to the fact that a tracing exercise carried out on a collective (as opposed to individual) entitlement basis might be more fruitful.
c) Any client who has a contractual entitlement to client money can participate in the distribution (pro rata)
On this point, the majority Supreme Court judgment, like the Court of Appeal judgment, was again at odds with the High Court, which was naturally aligned to the issue of what was included in the client money pool.
Under the High Court judgment, the clients entitled to a share in the pool were only those clients who had actually contributed to it (i.e. those that had some traceable proprietary claim to the money in the pool).
Under the Supreme Court judgment, clients who did not necessarily have any proprietary claim to the client money pool could nevertheless potentially have a share in that pool based on a contractual claim. In other words, if LBIE was required as a matter of contract to segregate client money for them, then they could participate in the pool, even if their client money entitlement could not be traced to money that was actually within the pool. In reaching this conclusion, the three majority Supreme Court judges adopted a purposive construction of the term ‘client money entitlement’ (which is not defined in CASS).
In upholding the position taken by the Court of Appeal, the Supreme Court judgment confirms that all clients are ‘in it together’ as regards the distribution of client money, irrespective of whether LBIE treated them as it should have done (by segregating their money) or did not. The value of the entitlements of clients whose money had been segregated is effectively diluted, as compared to the value of those entitlements under the High Court judgment (where the non-segregated clients could not participate in the client money pool). The ‘pari passu’ type arrangement that the CASS 7 distribution provisions purport to provide for is effectively guaranteed, and so the FSA may well feel vindicated. However, there are some important consequences of this outcome, which may not be so pleasing in terms of investor protection.
First, it means that any efforts made by an individual client to ensure that his client money is being dealt with in a compliant way could potentially be (for the most part) wasted energy if the firm fails to treat all its other clients in the same compliant way. In a previous article (see here) we suggested some sensible steps that a client might take, including due diligence and increased vigilance over statements. These would have helped under the High Court judgment, but are arguably of limited use here with a non-compliant firm. A client who is diligent and proactive may end up being no better off than the client who does nothing.
In such circumstances, there is an increased importance on the firm’s overall compliance with CASS 7, and therefore the FSA’s adequate oversight of such compliance. As the increasing number of client money enforcement cases shows, an investor may well be justified in feeling nervous, despite the FSA’s strict approach to CASS 7 compliance.
Secondly, the Supreme Court judgment allows clients of LBIE who were Lehman group affiliates (many of which are also in administration) to participate in the client money pool. Because LBIE carried out a significant amount of intra-group business, but failed to segregate any client money belonging to its affiliates, this will bring about a heavy dilution of the value of the entitlements of any non-affiliate clients. If those affiliates were dealing in their own capacity with LBIE, then on distribution of the LBIE client money pool those affiliates would receive an injection of cash assets, which would be available to satisfy any (non-client money) claims against them. Therefore, indirectly, the Supreme Court judgment could potentially increase the amount of money available to unsecured creditors of the Lehman Brothers group as a whole, to the detriment of LBIE’s non-affiliate clients.
Thirdly, the administrators are given another forensic issue to deal with – how to identify the universe of clients that have a valid contractual entitlement that gives rise to a share in the client money pool, and how to value each of those individual entitlements to work out the size of each share in the pool.
The starting-point for any contractual entitlement is, naturally, the terms of the contract. In the case of LBIE (and no doubt many other investment firms offering prime brokerage and trading services), the contracts in use are often unclear and ambiguous. Particular types of problematic clause may include title transfer collateral provisions, where money that would otherwise be client money is entirely transferred to the firm on the basis that it is collateral, and ‘rights to use’ provisions, where the firm has an option to use client money in the context of rehypothecation.
Aside from the construction of the contract, whether or not the performance of the contract gives rise to an entitlement to client money is a separate matter that relates, for example, to what exactly the transactions were, how big they were, and when they were settled. In the context of LBIE’s administration this adds an additional layer of complexity.
2. Where to go from here?
The administrators of LBIE now need to assess the implications of the Supreme Court judgment for the likely timing and level of any distribution, both in respect of client money and unsecured creditors. They may seek further directions from the courts as to what might be a workable solution in respect of the two forensic activities identified above, given that there is no limitation period under UK trust law (valid claims for breach of trust can be brought at any time after a distribution is made).
Against the backdrop of the Supreme Court judgment, the FSA’s ongoing drive to make firms accountable to their client money breaches will continue. To the extent that a firm has breached CASS 7 (however flawed it may be) the FSA will show zero tolerance. The FSA may now also seek to rectify or improve the rules in CASS, which may include incorporating the prudential buffer suggested by the Court of Appeal as a requirement for firms using the alternative approach.
Finally, clients may be left in the unenviable position of needing to place their faith in the firms which they deal with, and in the FSA (and as of 2013, the Financial Conduct Authority) for monitoring those firms’ compliance with CASS 7. On the one hand, the overall effect of the Supreme Court judgment is that the net of protection can be cast wider. Clients’ rights under trust law will protect their interests within the operation of the CASS 7 distribution rules, so they do not need to carry out the tracing exercise themselves – subject, of course, to the extent that there remains identifiable property to which those rights can attach. On the other hand, the dilution of claims of clients whose client money had been properly segregated (as compared to the value of their claims under the High Court judgment, as supported by the two dissenting Supreme Court judges) will seem unfair, particularly to those clients who go to extra lengths to obtain assurances through due diligence, or preferential contract terms to protect their client money, in circumstances where the firm in question is non-compliant in respect of all its other clients. It remains to be seen as to whether or not this judgment will have a net positive effect on investor confidence.
Please see here for the full text of the Supreme Court judgment. If you would like to discuss the judgment in more detail, or have some concerns in relation to client money, please feel free to get in touch with your usual CMS contact.
The client assets RegZone page contains more useful information relevant to this topic.