The UK Supreme Court's decision in Re Lehman Brothers International (Europe) (In Administration) caps the extensive litigation which developed in the aftermath of the collapse of Lehman Brothers International (Europe) (Lehman Brothers) almost four years ago.
It all began on 15 September 2008 when Lehman Brothers went into administration following what the Courts have referred to as its performance failures on 'a truly spectacular scale', foremost of which was the failure to protect its clients' monies.
As part of its business of providing a wide range of investment banking services and in common with other financial services institutions (firms), Lehman Brothers held a considerable amount of funds on behalf of its clients (Client Money). The Financial Services Authority (FSA), as the regulator of the UK financial services industry, implemented strict rules (FSA Rules) for the protection of Client Money with a view to ensuring that firms are prevented from using Client Money as their own working capital and also that, in an insolvency, Client Money would be protected from any claims by the creditors of the insolvent firm. Therefore, firms are obliged to hold Client Money, not as their own property but in a fiduciary capacity on behalf of their clients.
The key principle underpinning an effective fiduciary arrangement is that of segregation of Client Money. Segregation is a cornerstone of the FSA Rules - it requires firms to segregate Client Money from the firm's money (Firm Money) so that the former is held separately from the latter and, therefore, is readily identifiable. The FSA Rules allow two ways of achieving segregation of Client Money:
- the firm immediately pays any Client Money into a separate Client Money Account - this is known as the 'normal approach'; or
- the firm may initially pay any Client Money into its own bank account (Firm Account) but if it does so, the firm would have to promptly thereafter - and on a daily basis - segregate Client Money into a separate Client Money Account - this is known as the 'alternative approach'.
The alternative approach allows firms the flexibility needed when dealing with complex investment services (eg those involving multiple investment products and multiple currencies) in which the normal approach would be unduly burdensome; however, this approach is subject to authorisation by auditors which must be provided to the FSA and the overriding consideration remains the protection of Client Money held by the firm. It is clear that, under the alternative approach, there is a period of time during which Client Money will be mixed with Firm Money in the Firm Account.
Prior to going into Administration, Lehman Brothers was handling money in more than 50 currencies on behalf of more than 1,500 clients in different time zones. Therefore, it perhaps comes as no surprise that Lehman Brothers chose the alternative approach. However, what was surprising was the level of its failure to segregate vast sums received from or on behalf of a significant number of its clients - the Courts described this as a 'shocking underperformance'. This inevitably caused considerable difficulty to the Administrators in identifying funds for distribution to the clients.
The Administrators made several applications to the Courts for guidance on how to deal with the Client Money held by Lehman Brothers. The litigation commenced in the High Court, progressed to the Court of Appeal and ultimately reached the Supreme Court amidst sharply different views being expressed by the Judges. In view of the wide-ranging implications of any Court rulings in the matter, sufficient numbers of Lehman Brothers' clients were joined in a representative capacity to ensure that the voices of affected clients would be heard and the FSA also participated in the litigation.
The 3 principal elements of the Supreme Court's decision are as follows:
- Client Money is held on trust for the client from the time of receipt by the firm;
- in an insolvency, identifiable yet un-segregated Client Money in the Firm Account will be included in the funds for distribution to clients of the firm (separately from the general creditors of the firm) (Client Money Pool);
- clients can participate in the Client Money Pool distribution on the basis of the amount of Client Money which should have been segregated at the date of insolvency (and not on the amount which had actually been segregated on that date).
Client Money is held on trust from the time of receipt
Under the UK's insolvency laws, mere segregation of Client Money, without the imposition of a trust, would not give adequate protection in the event of a firm's failure. Therefore, the FSA Rules provide that a firm receives and holds Client Money as trustee on behalf of the client.
The Supreme Court held that the trust on Client Money arises upon receipt of the money by the firm, not upon segregation. Otherwise, it could mean that the greater the level of performance failure in a firm (eg the Lehman Brothers' failure to segregate Client Money), the lesser the protection for their clients which would clearly be an unsatisfactory result.
Client Money pool includes identifiable, un-segregated funds in firm account
This issue involved the interpretation of specific FSA Rules which provide that in the event of an insolvency, Client Money held by a firm is treated as pooled (to form the Client Money Pool) for distribution to clients.
The Supreme Court held that the Client Money Pool consists of not only the Client Money segregated in the insolvent firm's Client Money Account, but also any identifiable Client Money in the Firm Account. Given that their purpose is to provide a high level of protection to all clients, it would defeat the objective of the FSA Rules if clients of firms adopting the alternative approach (such as Lehman Brothers) stand to receive lesser protection on the arbitrary basis of whether the firm had in fact segregated their funds into the Client Money Account.
Participation in the Client Money Pool distribution is based on segregation which should have occurred
The Supreme Court was asked to decide whether participation in the Client Money Pool distribution is based on the amount of Client Money which had actually been segregated at the date of insolvency ('the contributions basis') or the amount which should have been segregated at that date ('the claims basis').
Echoing the other two elements of its decision, the Supreme Court held that the 'claims basis' was the correct mode of participation in the Client Money Pool distribution. Given that the starting point is that all Client Money is held on trust from the time of receipt by the firm (irrespective of segregation) and the purpose of the FSA Rules is to provide a high degree of protection to all clients whose funds are held by the firm, it is axiomatic that the Client Money Pool distribution should be based on the amount which should have been segregated at the date of insolvency.
In practical terms, this means that clients whose funds had actually been segregated stand to receive a lesser return in the light of the Client Money Pool being widened to include those whose funds had not, in fact, been segregated. However, in the Supreme Court's view, 'there is nothing unrealistic in a scheme [in] which...all clients share in the common misfortune of the [firm's] failure'.
The failure of Lehman Brothers triggered a global recession, the effects of which continue to be felt today. Notwithstanding the staggering figures involved - the affiliates of the Lehman Brothers Group (of companies) alone advanced Client Money claims exceeding US$3 billion in aggregate - and the inevitable result that there will now be further delays in making a distribution to clients of Lehman Brothers, the Supreme Court's decision leaves no room for doubt that safeguarding the funds of, and thus protecting, all clients of a firm is of paramount importance
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