On Wednesday, the UK’s Supreme Court handed down judgment in the high profile directions application brought by the administrators of Lehman Brothers International (Europe) (in Administration) (“LBIE”) concerning client monies.  The case addressed the meaning and application of the “client money rules” and the “client money distribution rules” contained in Chapter 7 of the Client Assets Sourcebook (“CASS”).  CASS sets forth the rules promulgated by the Financial Services Authority (“FSA”), the regulator of the financial services industry in the UK, and implements a European Union Directive (Markets in Financial Instruments Directive (“MIFID”) 2004/39/EC) into English law.  Its principal purpose is to provide rules regarding the safeguarding and distribution of client assets and funds held by regulated financial institutions in the UK.
Background to the Application
LBIE was the principal European trading company in the Lehman group, and it went into administration in the UK on Monday, September 15, 2008, immediately following the chapter 11 filing of its U.S. parent.  Its administrators, tasked with the role of getting in and distributing its assets following a proving procedure, sought directions on certain key issues concerning the construction and interpretation of the CASS rules as a result of LBIE’s undisputed failure to segregate and identify as “client money” large sums it had received from a large number of clients, including its affiliates.  Faced with a substantial shortfall, the administrators sought court directions as to whether these clients could nevertheless share in the pool of “client monies.”
The CASS rules are extensive and complex.  CASS 7 requires MIFID firms to segregate money they receive on behalf of their clients by keeping it in a client account apart from the firm’s own money.  CASS provides for two different approaches to discharging a firm’s client money segregation requirements:  the normal approach and the alternative approach.  LBIE adopted the alternative approach.   Under the alternative approach, client money is received into the firm’s house account and also paid out to clients from the house account.  The CASS rules require client money to be segregated from the house account into a client bank account on a daily basis, after a reconciliation of records determining the position as at the previous business day.  CASS 7.7.2R imposes a statutory trust pursuant to which client money is in the legal ownership of the firm but remains in the beneficial ownership of the client.
The First Issue
The first issue to be determined was whether the statutory trust created by CASS7.72R took effect upon receipt of client money or only upon the actual segregation of client money from LBIE’s house accounts.   The issue was important as, aside from any failures or errors in segregation that may have occurred at earlier dates, LBIE had last undertaken a reconciliation and segregation on the morning of Friday, September 12 on the basis of the close of business position September 11.  Accordingly, monies received from September 12 to the 15th had not been segregated.
The Law Lords unanimously held that the statutory trust arose as soon as the money was received by LBIE, and not at the point of actual segregation (and irrespective of whether it had been segregated).
The Second and Third Issues
The Law Lords, however, were divided on the second and third issues on appeal, which concerned further aspects relating to distribution.  CASS also contains the Client Money (MIFID business) Distribution Rules, which seek to facilitate the timely return of client money to a client if the firm or a third party at which the firm holds client money fails.  Failure of the firm triggers a “primary pooling event.”  Upon the occurrence of a primary pooling event, CASS Rule 7.9.6R  requires that “(1) client money held in each client money account of the firm is treated as pooled; and (2) the firm must distribute that client money in accordance with CASS 7.7.2R so that each client receives a sum which is rateable to the client money entitlement calculated in accordance with CASS 7.9.7R.”  LBIE’s failure was a primary pooling event.  The failure of another firm to which LBIE had transferred client money, Lehman Brothers Bankhaus AG, triggered a “secondary pooling event.”  CASS 7.9.7R also applies in the case of a secondary pooling event.
The second and third issues which arose to be determined were as follows:

• Whether the primary pooling arrangements applied to client money in house accounts
• Whether participation in the pool was dependent upon actual segregation.

The majority of the 5-person Supreme Court panel considered that the questions raised by the issues in the appeal depended upon the construction of the relevant provisions of CASS 7 rather than upon the ordinary law of trusts.  Because all of the judges had concluded that the statutory trust arose when LBIE received the client monies, Lord Clarke considered that it followed that the fiduciary duties imposed by CASS were owed by LBIE before segregation of the client money and whether or not segregation actually occurred.  The majority held that, if the trust did not arise until segregation occurred, then whether or not clients are protected by CASS 7 would become arbitrary and dependent on the firm’s own practices.  In other words, the greater the level of incompetence or misconduct on the part of a firm, the less protection its clients would have.  Lord Dyson, with whom Lords Clarke and Collins agreed, emphasized the following:
where there is a choice of possible interpretations, the court should adopt the one which affords a high degree of protection for all clients who have client money with the firm and to safeguard their interests, thereby furthering the purposes of the Directives.  It is not the purpose of the Directives to provide a level of protection only for those clients who are recorded in the firm’s ledger as clients with client money entitlements when the firm calculated the net amount to segregate at the last reconciliation.
In conclusion the majority held that

• the primary pooling arrangements and pool composition applied to all client money identifiable in whatever account of the firm into which it had been received, and
• the money treated as pooled at the time of the primary pooling event should be distributed to clients in accordance with their respective client money entitlements and irrespective of whether the money had in fact been segregated or recorded by the firm as having been so segregated.