No such thing as a simple administration

THE SUPREME COURT’S decision in the Lehman Brothers International Europe (LBIE) litigation brings to an end the long running saga of how client money should be defined and distributed to creditors when a financial institution becomes insolvent. Administrators must now tackle the practical difficulties of implementing the decision, which, when a large financial institution (such as LBIE) fails, might be far from straightforward.

The decision has brought clarity to chapter 7 of the Financial Services Authority rules on client money (CASS 7), will mean that all clients, whose monies were either segregated or should have been segregated, will have a claim against the client money pot irrespective of whether the company segregated their funds.

Three main points could affect administrators undertaking future financial institutional insolvencies, with MF Global and Pritchard Stockbrokers the most recent cases in point.

Firstly what the business does with the client funds on receipt of them will have no bearing on whether or not it must be paid back out of a designated client pool in the event of an administration. It is not dependent on the company actually segregating the money into a designated client account.

It was previously thought any client which invested money into a company and those funds were segregated would receive their funds back in full. However, now those funds will be divided between all companies that should have had their money segregated, meaning clients are unlikely to receive payment in full.

The client money pool, available for distribution on insolvency, is comprised of all funds identified as client money – irrespective of which account the money is sitting in or was received by. This meant any identifiable client money which LBIE failed to segregate (such as funds sitting in LBIE’s house accounts at the time of administration, rather than a segregated account) would form part of the client money pool available to creditors.

The client money pool is to be distributed among all clients having an entitlement, and that clients’ entitlements are to be dependent on their respective contractual claims – all clients whose monies either were segregated, or should have been segregated, will have a claim against the client money pool based on its “actual and objective entitlement”, rather than how much of its funds were segregated.

This decision will have a substantial impact on the administrators of Lehmans. The pool should increase in value over time as assets held in non-segregated accounts are identified, although the process by which administrators will easily be able to identify such client money mixed in the house accounts is far from clear.

It must be noted that clients with claims against the client money pool are likely to face a shortfall upon their eventual recovery, and one practical outcome is that creditors may look to other targets for recovering that shortfall.

The administrators must now embark on the process of identifying the client funds held in non-segregated accounts. This is likely to cause yet further delay to the distribution of client money at LBIE. However, as the administrators were aware that this was a potential outcome following the Court of Appeal’s August 2010 decision, it would be surprising if the tracing exercise is not already underway.

Although the uncertainty in the interpretation of CASS 7 (which should be of assistance to the administrators of MF Global), the manner in which this interpretation should be put into practice is not yet clear. Certainly all firms operating within the CASS 7 framework will need to review their procedures to ensure compliance with the judgment.

For example, will an administrator need to undertake a complete client money reconciliation (including a complete review of the relevant agreements) as soon they are appointed? How will client money in house accounts be quickly identified? These queries could lead to delays in the distribution of client money upon the collapse of a large financial institution – delays which CASS 7 and the introduction of special administrations was specifically designed to avoid. As a result a review of CASS 7 may well be required.

Some commentators are already arguing that the certainty which CASS 7 was supposed to provide to investors has all but evaporated.

Rather than protecting investors who have ensured that their funds are placed in a segregated client account, CASS 7 appears to have imposed upon administrators an obligation to undertake a root and branch review of the firm’s arrangements in respect of client monies to determine the pool, and in many cases to recognise client money claims where in fact the funds are not segregated.

Shane Gleghorn is a partner and head up the financial dispute at international law firm Taylor Wessing