The English High Court has approved a distribution plan proposed by the Administrators of WealthTek LLP under the Investment Bank Special Administration Regulations regime (“IBSAR regime”) which, for the first time, does not strictly follow some of the creditors’ rights in the underlying assets.

In this case there was a significant shortfall in the assets and money held by WealthTek for its clients when it went into special administration, and the FCA intervened on the grounds of suspected criminal activity and acting outside the investment bank’s regulatory permissions. The Administrators found that the books and records of WealthTek were unreliable, with significant discrepancies and mismatches.

The judgment considers the matters that will concern the Court on an application by Administrators seeking approval for a distribution plan in circumstances where it is not practically possible to return unencumbered client assets in accordance with the clients’ strict legal rights. It is a useful judgment on the boundaries of what a distribution plan can do, and highlights the need for Administrators to provide as much information as possible to the clients and the Court, particularly where there is not separate representation for clients’ interests in Court.  It also makes clear that the Court will want to satisfy itself that the distribution plan is fair and reasonable, and, as when sanctioning a scheme of arrangement or restructuring plan, the role of the Court is not merely to act as a rubber stamp.

In a further judgment from a subsequent consequentials hearing, the Court found that where the FSCS had compensated clients and subrogated to their claims, it was for the FSCS to pursue and bear the costs of any litigation rather than the administrators, and further rejected  a potential litigation reserve.

Background

Objective 1 of the IBSAR regime requires the Administrators to return client assets as soon as is reasonably practicable, and to prepare a distribution plan setting out what assets are to be returned, to whom and when, and what retention is to be made for costs. In this case, the client assets were held in a bare trust, and the plan returned stocks, shares and other assets to WealthTek’s retail clients (with client money being returned in accordance with the rules of the FCA’s Client Asset Sourcebook).  Most of WealthTek’s clients were eligible for compensation from the FSCS up to the £85000 cap.  The costs of returning the assets were to be borne per capita, making maximum use of the FSCS compensation available to meet client shortfalls, but 21% of clients would face a shortfall in their return after FSCS compensation.

Due to the complexity in identifying the ownership of WealthTek’s client assets and the costs involved in asking the Court to determine how to treat individual claims, the Administrators undertook a reconciliation of the accounts, adopting a “robust and commercial approach” to establish the rights of the clients in the assets.  They received legal advice on this process, including a joint counsel’s opinion, developed the plan in consultation with the FCA and the FSCS, and received creditors’ committee approval.  The Administrators appreciated that where contrary positions were arguable, there would be winners and losers in taking this approach.  Notably:

• the distribution plan had no procedure to refer disputes between the Administrators and the clients over the reconciliation exercise to the Court: the Administrators maintained allowing challenge would render the distribution plan unworkable;
• the Administrators treated their legal advice, including the legal opinion, as privileged and refused requests by WealthTek’s clients to see it, and it was not produced to the Court;
• the Administrators invited the Court not to consider the correctness of their proposed approach to the reconciliation exercise, and instead accept that they considered, and the creditors’ committee (including the FSCS) agreed, that the approach proposed was in the interests of the clients generally.

The plan included a cost reserve to be borne per capita (resulting in each client bearing a share of the costs), which included an element for potential litigation costs.  Significantly: 

• the FSCS had an interest in the costs being minimised and the Court took comfort in them monitoring the non-litigation costs;
• 40% of the proposed cost reserve related to potential litigation against third parties, although the form of litigation, if to be pursued, had not been determined;
• the Administrators did not provide details of the potential claims to the Court for confidentiality reasons and to avoid prejudicing any future actions against third parties;
• the clients suffering a shortfall were not consulted, even though they would suffer a greater shortfall if the potential litigation reserve was created; and
• the potential litigation reserve was to be held indefinitely, with no timetable given for reporting to clients or the Court or obtaining the periodic consent of the clients financially affected by the continued retention of their funds or compensation. 

In his judgment, Mr Justice Rajah approved the distribution plan, finding it fair and reasonable in meeting Objective 1, but refused to approve the proposed litigation reserve.

Key points in the judgment are as follows:

The Administrators’ approach to the application

• The Administrators’ approach in not providing the joint legal opinion to clients on the grounds it was privileged was questionable in circumstances where the advice was to determine each beneficiary’s interest in the trust assets, was being paid for by the trust funds and was arguably a trust document. 
• The Court’s approval of a distribution plan is a key safeguard of client interests under the IBSAR regime and it must satisfy itself that a proposed plan is fair and reasonable, although it will have appropriate regard to the views of the Administrators and the creditors’ committee.
• The application was adjourned for a review of the reconciliation exercise by independent counsel on behalf of the beneficiaries and for further submissions by the Administrators on whether the Court had jurisdiction to, and should, approve the plan. Independent counsel was instructed by the Administrators on the basis that his primary and overriding duty was to the Court and to consider the distribution plan from the perspective of the beneficiaries. The Judge’s preference however, would have been for the independent counsel to have been instructed by a representative client or the committee, albeit on the basis that the costs of the exercise would be paid by the Administrators as part of the costs of the application.

Jurisdiction to approve a plan which does not conform with the strict rights of clients in and to the client assets

• The IBSAR regime was introduced following the Lehman administration to deal with specific issues arising in investment bank insolvencies that are not capable of being dealt with as a matter of trust law, scheme of arrangement, or the ordinary administration process in Sch B1 of the Insolvency Act 1986. It is intended, in appropriate cases, to override proprietary rights to permit the Administrators to fulfil Objective 1, for example in situations where the investment bank’s records do not identify who the assets belonged to, or there are shortfalls in total assets and it is not clear how the assets should be distributed. If the Court were to treat proprietary rights as sacrosanct, the IBSAR’s fitness for purpose would be undermined.
• The Court has an unfettered discretion whether to approve a distribution plan or make some other order, and will take into account whether the distribution plan assists in achieving Objective 1 and whether it is satisfied that the plan provides a fair and reasonable means of effecting the distribution. A plan which rides roughshod over client’s rights without good reason would not be fair or reasonable. 
• In this case, the Judge found that the distribution plan was as fair an approximation of each client’s interest in the client assets as could be practically achieved if there was to be a speedy return of assets. The independent counsel had concluded that although there were winners and losers, to the extent that the provisions of the distribution plan interfered with the strict legal rights of beneficiaries it did so in a rational and sensible way.  It did so by taking the available path of least interference or least prejudice possible; by avoiding alternative approaches with a greater risk of prejudice; by avoiding the incurring of significant levels of costs which would be borne by all beneficiaries to their obvious detriment; and by promoting Objective 1 and the requirement for speed therein.
• The Administrators’ approach on the potential litigation reserve however, was not fair and reasonable:
  • The lack of information provided to the Court or the potentially affected clients (and the lack of ongoing reporting requirements) regarding the potential litigation made it impossible to determine if the claims should be brought by the Administrators rather than the clients.
  • Where the litigation was to recover missing trust assets, that chose in action was itself an asset of the beneficiary and in a bare trust, the client has the right to pursue the claim itself or abandon it to avoid costs. There may be compelling legal or procedural reasons for the Administrators to bring the litigation but none were provided to the Court in this instance to justify overriding the clients’ rights and retaining clients’ funds for that purpose, and in this case the retention was not necessary to achieve Objective 1.
  • In these circumstances the potential litigation reserve could not be allocated to the clients on the basis of the interests of clients as a whole. As the interests of the minority did not give way to the interests of the creditors as a whole, the approval of the committee carried less weight on this issue.

Findings from the consequentials hearing:

• It was found at the consequentials hearing that the FSCS had paid compensation to WealthTek’s clients and was subrogated to the clients’ rights against the defaulting firm and third parties in respect of the clients’ loss. The scheme for recoveries by the FSCS in accordance with the rules in the Compensation Sourcebook within the FCA Handbook in COMP 7 therefore applied and on that basis alone, there was no entitlement to a litigation reserve. This had not been brought to the Court’s attention at the previous hearing.
• The FSCS had a duty to bring appropriate proceedings to pursue recoveries for itself and the clients if it considered the recoveries were likely to be both reasonably possible and cost effective to pursue (the “COMP 7.4 threshold”)), to be brought at its own risk and expense. If the COMP 7.4 threshold was not met the FSCS must assign back the subrogated rights to the relevant client if requested.
• The FSCS compensation scheme should have been taken into account in the formulation of the distribution plan and should have been brought to the attention of the Court when it was asked to approve the distribution plan as fair and reasonable.