Yet again there is plenty to write about on regulatory developments but it is worth spending a bit of time on the Lehman client money judgement.
The Supreme Court judgement on Lehman Brothers has reached a sensible result for protecting client assets.
Lord Hope described the basic position in English law where “segregation of money into separate bank accounts is not sufficient to establish a proprietary interest in those funds in anyone other than the account holder. A declaration of trust over the balances standing to the credit of the segregated accounts is needed to protect those funds in the event of the firm’s insolvency. Segregation on its own is not enough to provide that protection. Nor is a declaration of trust, in a case where the client’s money has been so mixed in with the firm’s money that it cannot be traced. So segregation is a necessary part of the system. When both elements are present they work together to give the complete protection against the risk of the firm’s insolvency that the client requires.”
These principles were adopted in CASS 7 of the FSA rules creating a statutory trust over client money and providing for segregation of the client money.
The Lehman insolvency gave rise to three questions over the operation of the client money rules:
- When does the statutory trust arise
- Where a firm fails, is client money that is identifiable in the firm’s house account to be treated as client money or only money that is in the segregated client accounts
- Where a firm fails, who has a right to participate in the client money pool i.e. should it be only those clients whose money was held in the segregated client money accounts or should it be all clients who ought to have had their money held in segregated accounts but which may have been in house accounts at the time of failure.
The treatment of client money can potentially give rise to huge problems because there is a reliance on the financial services firm to recognise the funds as client money and then to treat it appropriately. If it does not take the two steps to segregate and declare the funds as client money, then the client is exposed at a time when it needs most protecting in the event of a firm’s failure.
On the first question the Supreme Court found that the statutory trust arose upon receipt of the money. They drew on the Scottish law principles of fiduciary duties owed by an agent rather than on the law of trusts in reaching their conclusion. They determined on the second issue that all money received as client money was client money regardless of whether it was held in house accounts or in client money accounts. On the third issue which was closely related to the second and which a number of the judges considered before reaching their conclusions on the second issue – it was held that distribution of the client money pool should be on a claims basis and not a contributory basis. i.e. all clients that were entitled to have their money segregated were entitled to participate in the client money pool rather than restricting it to those clients whose money had been placed in the segregated client money accounts.
Although there is complex legal reasoning in reaching these conclusions the practical effect of the judgements is a sensible one for clients. Clients are not in a position to assess whether a financial services firm has properly segregated client money that is to be treated as such and a failure on the part of the financial services firm not to segregate the client money should not result in a misfortune for the client.
The judgement means that clients no longer need to take steps to verify that their funds have been properly segregated where a regulated firm is applying the CASS rules to funds held on their behalf as client money. (Something that Jaitly LLP has advised clients in the past to do in order to protect their interests – even though the process of doing so practically was quite difficult.)
The Supreme Court recognised that this was likely to mean a more complex process for the administrators of the Lehman Administration in distributing the client money pool but it means that clients are not faced with an additional burden of verifying that an authorised financial services firm has carried out its obligation to segregate and place money in a client account. A process which was difficult even for sophisticated institutional clients.
A sensible result for protecting and preserving assets that belong to clients.
©Jaitly LLP