The issues currently being debated in the context of the Lehman insolvency should be of concern to hedge funds. Client money and client asset issues arise in the context of a broad range of relationships between hedge funds and their service providers including prime brokerage relationships, margin trading agreements, master institutional futures customer agreements, master repurchase agreements or any other arrangement involving the transfer of money or assets. In the context of these types of relationship hedge funds may be both segregated clients whose assets and cash are held separately from those of the firm, and also unsecured creditors where the firm has not agreed to provide client money or client asset protections.
In recent Court proceedings relating to the administration of Lehman Brothers International (Europe) (LBIE) and client money issues (the Client Money Application) the Court referred to Lehman’s “shocking underperformance” resulting in the firm’s failure to segregate “vast” sums of clients’ money. When administrators were appointed to LBIE last year the firm held some US$2.16 billion in segregated client funds. Around $1billion of this was held with an affiliate of LBIE which also went into insolvency proceedings. The segregated funds were also subject to competing claims from clients and affiliates who have claimed that they too should have been treated as segregated clients. The result has been the diminution and potential dilution of the segregated funds so that even clients whose money was or should have been segregated from the firm’s own money, are almost certain to suffer a substantial loss on the return of their funds.
The complexity of the position and potential prejudice to clients occurs in spite of detailed legal and regulatory rules providing for the protection of client money and assets by their segregation from the firm’s money and assets. In theory at least, the proper segregation of money and assets should protect clients on the basis that they will not form part of the estate of the insolvent firm. On this basis the money and assets will not be available to the firm’s general creditors, should be easy to identify and accordingly straightforward to return to clients. In practice, the failure by firms to properly implement segregation and reconciliation requirements,weaknesses in regulatory rules and a firm’s own internal procedures for dealing with client money will mean that there will rarely be sufficient funds to fully repay to clients what is due to them. Recent decisions of the English Court have shown that where there is a shortfall in available funds, Courts are unlikely to order the topping up of the shortfall by ordering the transfer of the firm’s own house funds into the client account for the purpose of meeting segregated client claims.
From a client’s perspective securing protection depends upon making sure that the right things happen in practice and not just in theory. If in fact a client’s assets and cash have not been segregated from those of the firm, the client will suffer a loss irrespective of whether the firm has acted in breach of regulatory or other requirements by failing to provide the adequate degree of protection. A client can address its risk by ensuring that its terms of business with the firm provide for the segregation of its money and assets and by insisting on reporting and monitoring provisions in order to ensure that it understands where and with whom its cash and assets are being held and that they are in fact segregated from the firm’s own cash and assets. Issues arising from Lehman’s failure have also highlighted the risks of assets and cash all being held with a single group. LBIE, for example, used Lehman Brothers Inc. as its sub-custodian and Lehman Brothers Bankhaus AG to hold client money. Clients’ assets may be trapped in Lehman Brothers Inc. and the failure of Bankhaus is likely to be a major contributor to the shortfall in the client monies held by LBIE. Diversification out of the Lehman’s Group by the appointment of third party custodians and the holding of client money with a third party bank, would have mitigated risks for clients.
Under the UK’s regulatory system the rules relating to the holding and distribution of assets and cash for clients are contained in the FSA’s Client Asset Sourcebook (CASS). While in each case the rules provide for the segregation of client money and assets, the detailed rules differ. The rules relating to client money are contained in Chapter 7 of CASS and the rules relating to assets in Chapter 6 of CASS. Deficiencies in the FSA’s CASS rules have added to the complexities in dealing with claims to the repayment of client money. The Judge dealing with Client Money Application commented that the rules in Chapter 7 of CASS were patently inconsistent and flawed in significant respects.
The attempts by the Administrators of LBIE to resolve issues relating to the return of trust assets (i.e., securities and not cash) under a court approved scheme have been reported on in previous editions [The Hedge Fund Journal Issue 49 and 52]. The focus of this article is on issues relating to client money, the Client Money Application brought by LBIE’s Administrators for directions on how to pay out money and HM Treasury’s very recently published proposals for providing investors with greater protection for their money and assets in the event of a firm’s failure.
European and UK Legal Framework
The regulatory obligations on firms to segregate and protect client money and assets are derived at a European level from the Markets in Financial Instruments Directive (MiFID) and its implementing directive.
Broadly, MiFID requires that firms, in order to protect an investor’s ownership rights in respect of securities and funds entrusted to the firm, keep those securities and funds distinct from the firm’s own securities and funds. Adequate arrangements must be made to safeguard clients’ rights and detailed organisational requirements are imposed. The obligation to segregate is not absolute and carve outs are provided for. Where a client transfers funds or assets to a firm (for example, as financial collateral) on terms that ownership is transferred for the purpose of securing or otherwise covering present or future, actual or contingent or prospective obligations of a client towards to the firm, the funds or assets transferred do not need to be segregated.
The judgment of the Court on the Client Money Application has considered the meaning and effect of the provisions in MiFID dealing with client money protection. The Court found that MiFID does not provide any safety net to investors. It merely requires that firms follow various organisational requirements in order to protect investors. If, however, those requirements are not followed, or there is a shortfall in money or assets for some other reason, MiFID does not require the loss to be made good. The Investor Compensation Scheme Directive and Deposit Guarantee Schemes Directive provide for compensation to be paid to investors who have suffered a loss on the failure of a regulated firm. However, institutional investors such as hedge funds are unlikely to be eligible to claim compensation and in any event the amount of compensation available is likely to be negligible when compared with the investor’s exposure to the firm.
The requirements of MiFID are also subject to local insolvency and property laws which are not harmonised at European Union level. In order for a client to properly assess and mitigate the risks it faces in holding cash and assets across Europe, it must accordingly have an understanding of the local property and insolvency laws in the jurisdictions in which its cash and assets are held.
The requirements of MiFID are implemented in different ways across Europe. In most European jurisdictions MiFID’s client money protections have been implemented purely through segregation backed by the imposition of reconciliation requirements. While straightforward, if funds are not in fact segregated, a client will rank as a mere unsecured creditor, even though the firm should have provided protections through segregation.
In the UK MiFID requirements have been implemented through a statutory trust, so that a firm receives and holds client money as trustee. In order to comply with its obligation as trustee, a firm will hold client money in a client account separate from its house accounts in which it holds its own funds. The failure of a firm (i.e, its insolvency) will constitute a pooling event under Chapter 7 of CASS so that the funds held in all of the firm’s client accounts will be pooled and distributed to clients according to their client money entitlements. To the extent that there is a shortfall on available pooled funds, payments to clients will be pro rated.
Problems with the UK framework
At a superficial level the UK framework seems straightforward. However, there are various complexities and uncertainties with the way in which the UK’s rules operate. The position with Lehman illustrates the fact the complexities and uncertainties are likely to take a long time to resolve and thereby materially delay the repayment of funds to clients.
The use of the statutory trust as opposed to a simple segregation requirement gives rise to uncertainty as to the meaning and effect of the trust and what particular funds the trust applies to. These uncertainties mean that clients whose funds have not in fact been segregated can seek to assert a claim to segregated funds or to extend the trust to non-segregated funds held in the firm’s house accounts.
The UK’s rules also provide firms with two options in how they comply with their obligations to protect client money, the “normal approach” and the “alternative approach”. Under the normal approach a firm is required to pay client money promptly, and in any event no later than the next business day after receipt, into a client bank account. Under the alternative approach client money is received by a firm into its house account. A reconciliation may be performed on the next business day with funds required to top up the client bank account being transferred from the house account. Accordingly, segregation under the alternative approach takes place on a net basis rather than separately in relation to each amount of the client money received. A client whose funds are paid into the firm’s house account under the alternative approach assumes the credit risk of the firm pending transfer of the funds into the client account.
The Lehman Client Money Application
In the Client Money Application, LBIE’s Administrators applied to the Court for directions on a number of complex issues that they needed to have resolved before being able to repay money to clients. In broad terms, these issues related to identifying what money constituted client money, to what money the statutory trust should apply and who was able to share in the distribution of client money. Certain clients of LBIE claimed that they should be treated as segregated clients when LBIE had failed to segregate money for them, and issues arose as to whether the shortfall on LBIE’s client money should be topped up with LBIE’s own funds so that the segregated clients would receive back a full or near full return to the detriment of the unsegregated clients and LBIE’s general estate.
Clients of LBIE suffered what the Judge described as a “triple whammy”. One aspect of this was LBIE’s insolvency itself. The other aspects were:
• LBIE’s failure to properly segregate client money.
• The failure of Lehman Brothers Bankhaus AG, which held approximately US$1 billion in client money for LBIE’s clients.
LBIE’s failure to properly segregate client money had several causes. For example, LBIE did not segregate money for its affiliates and routinely treated as its own sums deriving from OTC derivatives transactions with its clients, regardless of the terms of business agreed with those clients.
LBIE also used the “alternative approach” and so received client money into its house accounts, which were subject to the Lehman Group’s liquidity management process, whereby funds were swept from LBIE’s house accounts to its parent company in the United States on a daily basis. The sweeping of funds out of the house accounts would likely defeat any proprietary claim to those funds by the clients from whom those funds were received.
The Court found that whilst the trust attached to all client money from its receipt by LBIE, regardless of whether the money was properly segregated, nevertheless, where clients’ money was not properly segregated, the money did not form part of the pool to be distributed to clients. Whilst LBIE’s failure to segregate effectively meant that there was a huge shortfall in the client money pool, the Court found that, nonetheless, there was no obligation, either under the CASS rules or otherwise, to “top up” the client money pool from LBIE’s own funds or from identifiable client money held in LBIE’s house accounts.
The Treasury’s Proposals
The Treasury’s proposals, contained in its consultation paper “Establishing resolution arrangements for investment banks”, are designed to facilitate the managed wind down of an investment firm. Key aspects of the proposals address practical issues with returning client money and assets. The Treasury proposes the creation of a Client Assets Agency whose function would be the pre-insolvency supervision of client money and assets and the post-insolvency appointment of a client assets trustee to handle the identification and distribution of client money and assets.
The Treasury’s other proposals include:
• Mandating product warnings to explain the implications of rehypothecation and risks relating to omnibus accounts;
• Requiring firms to offer clients designated named accounts at custodians;
• Increasing reporting and record keeping requirements, including requiring firms to develop the capacity for daily reconciliation of client positions and exposures;
• Increasing audited disclosures by firms around client money and assets;
• Supporting the establishment of bankruptcy remote SPVs for client assets so that the return of client assets is not affected by the insolvency of a firm;
• Limiting the ability of firms to transfer client money, including limits on the transfer of assets to affiliates;
• Requiring firms to have the ability to divide client money into different pools, according to the types of risk or investments involved.
At first sight some aspects of the Treasury’s proposals appear to involve the duplication of the existing insolvency regime and do not address the full complexities of real life. However, the interest of government in enhancing investor protections in a proportionate manner is to be welcomed, particularly a year after the failure of Lehmans when large amounts of investors’ cash and assets remain trapped.
Baker & McKenzie acted for Hong Leong Bank, the representative of LBIE’s general estate in the recent Client Money Application