Lehman Brothers International (Europe) [2012] UKSC 6

Following Lehman Brothers International (Europe)'s collapse in 2008, the Supreme Court considered how client money under FSA's CASS 7 rules should be protected and distributed. The court held the statutory trust arises on receipt, and by majority that pooling and distribution extends to all client money on a claims basis.

Facts

Lehman Brothers International (Europe) (‘LBIE’) was placed into administration on 15 September 2008. As a MiFID-authorised firm, it was required to comply with Chapter 7 of the FSA’s Client Assets Sourcebook (‘CASS 7’), which imposes a statutory trust over client money and prescribes segregation, reconciliation and distribution rules. LBIE operated the ‘alternative approach’ permitted under CASS 7.4.16G, receiving client money into its own house accounts and segregating it on a next-business-day basis following internal reconciliation.

On the assumed facts, LBIE had failed to segregate client money on what Briggs J described as ‘a truly spectacular scale’. Affiliates alone had advanced claims exceeding US$3 billion, against only approximately US$2.16 billion actually held in segregated accounts. In addition, US$1 billion of segregated client money had been deposited with Lehman Brothers Bankhaus AG, which itself failed (a secondary pooling event).

Issues

Three issues arose on the construction of CASS 7:

(1) When does the statutory trust under CASS 7.7.2R arise — on receipt of client money, or only on segregation?

(2) Do the primary pooling arrangements apply only to money in segregated client accounts, or also to identifiable client money in the firm’s house accounts?

(3) Is participation in the client money pool (‘CMP’) dependent on actual segregation (the ‘contributions basis’), or extended to all clients with a contractual entitlement to have money segregated (the ‘claims basis’)?

Arguments

Appellant (GLG, representing fully-segregated clients)

GLG argued that the trust arose only on segregation, particularly under the alternative approach where money was lawfully paid into house accounts. It contended the CMP comprised only segregated funds and that distribution should follow the contributions basis, preserving the proprietary entitlements of segregated clients. To hold otherwise would, it submitted, effectively use segregated funds as a compensation pool for unsegregated clients.

Respondents (CRC, LB affiliates, Administrators, FSA)

The respondents argued that the statutory trust arose on receipt, that pooling extended to identifiable client money in house accounts, and that distribution should be on the claims basis to give effect to the high level of protection mandated by MiFID and the Implementing Directive 2006/73/EC. They emphasised that ‘client money entitlement’ in CASS 7.9.6R(2), calculated by reference to CASS 7.9.7R, indicated a contractual rather than proprietary measure.

Judgment

Issue 1 — Time of arising of the trust

The Supreme Court was unanimous in holding that the statutory trust arises on receipt of client money, not on segregation. The opening words of CASS 7.7.2R (‘A firm receives and holds client money as trustee’) make this plain. The conclusion is reinforced by article 13(8) of MiFID, which obliges firms holding client funds to prevent their use for the firm’s own account, and by article 16 of the Implementing Directive. Lord Hope considered the position in Scots law, where section 139(3) of FSMA 2000 substitutes agency for trust, drawing on Jopp v Johnston’s Trustee (1904) 6 F 1028 and Council of the Law Society of Scotland v McKinnie 1991 SC 355, concluding that the fiduciary relationship attaches throughout the period the money is held.

Issues 2 and 3 — Pooling and distribution (majority)

By majority (Lord Clarke, Lord Dyson and Lord Collins; Lord Hope and Lord Walker dissenting), the court held that the primary pooling arrangements under CASS 7.9.6R(1) apply to all identifiable client money held in any account of the firm, including house accounts, and that distribution proceeds on the claims basis.

Lord Dyson reasoned that all client money is subject to the statutory trust from receipt (CASS 7.2.1R; CASS 7.7.2R), and that CASS 7.9.6R(2) requires distribution ‘so that each client receives a sum which is rateable to the client money entitlement calculated in accordance with CASS 7.9.7R’. The reference to CASS 7.9.7R, which calculates entitlement by reference to ‘individual client balance’ and ‘client equity balance’ (objective contractual measures), strongly supports the claims basis. The ‘formidable textual argument’ identified by Briggs J was accepted.

The majority considered that a purposive interpretation, reflecting the MiFID objective of providing ‘a high level of protection’ (recital 2; article 13(7) and (8)), required all clients with contractual entitlements to share in the pool, not merely those whose money happened to have been segregated. A bifurcated scheme drawing arbitrary distinctions based on whether the firm had complied with its segregation duty would frustrate the protective purpose of CASS 7.

Lord Clarke emphasised that limiting pooling to segregated funds would produce anomalous results, particularly given that the unsegregated clients could include those whose money was received after the point of last segregation (‘PLS’).

Dissent

Lord Walker (with whom Lord Hope agreed) would have held that the CMP comprises only segregated funds (subject to a final reconciliation covering the gap period between PLS and the primary pooling event (‘PPE’)), and that distribution should be on the contributions basis. He regarded the majority’s approach as producing ‘a cataclysmic shift of beneficial interest on the PPE’, using segregated clients’ funds as ‘a strange form of compensation fund’ for unsegregated clients. He considered that CASS 7 was erected on the foundation of the general law of trusts, and that fully-segregated clients had identifiable equitable interests immediately before the PPE which should not be disturbed.

Implications

The decision establishes three propositions of importance to firms regulated by the FSA (now FCA) and their clients:

First, the statutory trust under CASS 7.7.2R attaches to client money from the moment of receipt, not from segregation. This protects clients during the interval between receipt and segregation under the alternative approach, and also where the firm wrongly fails to segregate at all.

Second, on a primary pooling event, the client money pool comprises all identifiable client money in any account of the firm, including house accounts, not merely money in segregated client accounts.

Third, participation in the pool is on the claims basis: each client with a contractual entitlement to have money segregated shares rateably in the pool, regardless of whether segregation in fact occurred.

The practical consequence is that clients whose money should have been segregated but was not nevertheless share in the pool alongside those whose money was duly segregated. The majority considered this consistent with the high level of investor protection required by MiFID. The dissenters warned that this approach may delay and complicate distributions and may dilute the protection that segregating clients reasonably expected.

The decision is significant for insolvency practitioners administering failed investment firms, for compliance officers designing client money systems, and for clients of regulated firms seeking to understand the level of protection afforded by CASS. It also illustrates the interaction between EU regulatory directives and domestic trust and insolvency law, and the limits of using ordinary trust principles to construe a statutory regulatory scheme.

Verdict: Appeal dismissed. The Supreme Court held unanimously that the statutory trust under CASS 7.7.2R arises on receipt of client money. By majority (Lord Clarke, Lord Dyson and Lord Collins; Lord Hope and Lord Walker dissenting), the court further held that the primary pooling arrangements apply to all identifiable client money including that held in house accounts, and that participation in the client money pool is on the claims basis rather than the contributions basis.

Source: Lehman Brothers International (Europe) [2012] UKSC 6