Whilst the Alpari Group’s other companies around the world continue trading unaffected, and the initial view of the Special Administrators appointed for Alpari UK on 19 January 20151 is that client monies remain intact, clients were not so fortunate following the high-profile collapse of broker MF Global in 2011. MF Global’s bankruptcy was the largest Wall Street collapse since Lehman Brothers in 2008, and when the fallout of the administration of its UK subsidiary MF Global UK Ltd (MFGUK) reached the English courts, it was the first major case to illustrate the implications of the leading Supreme Court decision on CASS, which arose from the Lehman litigation, Lehman Bros International (Europe) v CRC Credit Fund Ltd  UKSC 6.
CASS 7 requires that client money received by a regulated firm should be segregated from the firm’s own funds and held on statutory trust for the clients. Failure of a firm is designated as a “primary pooling event” which causes all client money in a client bank or transaction account to be treated as a single notional pool of client money held for the beneficiaries of the pool, who have proprietary claims to a rateable share in the pool.
In the case of MFGUK, however, a significant proportion of client monies was found to have been mixed with money held beneficially on MFGUK’s own accounts. This left clients affected by the shortfall with the option either of seeking to identify client money in MFGUK’s house accounts in order to establish proprietary claims, or of pursuing personal claims for breaches of trust. The difficulties involved in establishing these claims led, instead of litigation, to a creative compromise agreement, which is discussed below.
There are very real questions as to whether complex client money claims involving unsegregated money will ever be capable of proportionate litigation following the Supreme Court’s decision in the Lehman case, a problem of which the administrators of MFGUK were acutely aware.
The peculiarities of brokerage business models raise particularly interesting issues in relation to client money should a firm fail, albeit the fundamental principles are the same as for any firm. For example, what happens if the client alleges that before a primary pooling event the broker negligently failed to open a position it was instructed to? Or if the broker opened a position without the client’s consent and the client incurred losses?
Brokers occupy an unusual position in relation to client money because of the different forms of broking activity. Interdealer brokers play a crucial role in providing banks and other institutions with liquidity, particularly in over-the-counter (OTC) wholesale financial markets including in cash deposits, derivatives, securities, commodities, equities and credit. Ordinarily transactions proceed on a non-advised basis. There are three main models of broking:
- Name passing/name give-up (the traditional model): the broker arranges a transaction between two counterparties whose identities are not disclosed. Once the terms are agreed, the counterparties’ names are disclosed, the broker drops out of the transaction and a bilateral contract is entered into between the counterparties which they settle mutually. The broker is paid by way of commission and will not ordinarily be in receipt of client money.
- Matched principal: the broker enters into simultaneous or near-simultaneous matched transactions as counterparty of both buyer and seller. The broker acts as principal in each transaction, but only on client orders rather than speculatively for its clients or for its own account. Matched principal broking preserves anonymity for the clients, but exposes the broker to a level of risk while it holds positions. The clients settle with the broker within a specified time period, and the broker will be holding client money while there are outstanding settlements.
- Exchange give-up: the broker places an order on a derivative exchange such as LIFFE, Eurex and ICE Futures on the instructions of the client, either in the broker’s own name (if it is a member of the exchange) or via a third party. The executed transaction is then given up to the client, usually by the end of the day. The broker generally has intraday exposure until the position is settled by the client.
Proprietary trading by brokers for their own account is far less common than it once was, given the liquidity and other risks involved (as illustrated by high-profile collapses such as that of MF Global), as well as strengthened capital adequacy requirements.
CASS client money rules
The key client money provisions in CASS are divided into two parts: CASS 7 setting out rules as to how client money is to be treated, and CASS 7A setting out client money distribution rules. As noted above, CASS 7 requires firms to segregate client money in a client bank account or qualifying money market fund, and to hold the money as statutory trustee (7.7.2R).2
There are two approaches for the segregation of client money. Under the “normal approach”, client money must be paid promptly (and no later than the next business day after receipt) into a client bank account (7.4.17G). Under the “alternative approach”, which is appropriate where a client’s transactions are “complex, numerous, closely related to the firm’s proprietary business and/or involve a number of currencies and time zones”, client money is received into and paid out of a firm’s own bank account and an internal client money reconciliation must be undertaken on each business day (7.4.17AG). If a firm uses the alternative approach, it must pay a sufficient amount of its own money (which is treated as client money) into its client bank account in order to protect client money against the risk of a shortfall (7.4.18BR).
Under CASS 7A, where a primary pooling event occurs (such as the firm entering into liquidation or administration) (7A.2.2R), the general pool and each discrete sub-pool of client money is treated as a single notional Client Money Pool (CMP). The CMP is distributed so that each client receives a sum rateable to their client money entitlement (7A.2.4R).
Significantly, client money claims are valued on the basis that open contracts were closed out on the date of the primary pooling event. By contrast, for claims from the general estate in an insolvency, hindsight is applied to open contracts: the price at which they in fact close out subsequent to the commencement of the liquidation or administration will determine the amount for which clients may prove (In re MF Global UK Ltd (No 2)  Bus LR 1030). A client’s entitlement to client money will therefore often be different in amount from its claim as a creditor (In re MF Global (No 4)  EWHC 2556 (Ch) at ).
Lehman Brothers case: the question of unsegregated client money
After Lehman Brothers Holding Inc filed for Chapter 11 bankruptcy in the US, its UK subsidiary Lehman Brothers International (Europe) (LBIE) was placed into administration on 15 September 2008. The administrators found that hundreds of millions of dollars of client funds had been placed without segregation in LBIE’s house accounts, partly owing to it having operated the alternative approach and partly because of widespread failures to comply with CASS.
The first important issue that the Supreme Court had to decide when the case came before it was the time at which the statutory trust in CASS 7 arose. The court unanimously held that the trust arises on receipt of the money by the firm, not on segregation of the money.
More controversially, by a majority of 3:2 the Supreme Court held that the statutory trust applied to all client money that should have been segregated, whether or not it had in fact been segregated, including identifiable client money in house accounts. Unsegregated clients could therefore share in the CMP with segregated clients, rather than having to resort unsecured claims in LBIE’s general estate. Clients would share in the CMP on the “claims basis’ rather than the “contributions basis”, ie based on the sums that clients were contractually entitled to have had segregated for them. Lord Dyson (with whom Lords Clarke and Collins agreed) said that this result gave effect to the aims of the Markets in Financial Instruments Directive 2004/39/EC (MiFID) and the Implementing Directive 2006/73/EC, including the key aim to afford a high level of protection for all clients. All clients, to use Lord Neuberger MR’s expression in the Court of Appeal, were to be considered “in it together” when a primary pooling event occurred .
Lord Walker, in a strong dissenting opinion alongside Lord Hope, disagreed. He said that the majority’s decision failed to have proper regard to the general law of trusts, which requires segregation in addition to continuing beneficial ownership, and would unfairly prejudice the clients whose funds had been segregated. Lord Walker’s view was that the majority’s decision would make “investment banking more of a lottery than even its fiercest critics have supposed” , creating an unworkable scheme for distributions which
would lead to “delay, uncertainty and expense” .
Application to interdealer brokers and the MF Global case
The nature of brokerage business, as outlined above, means that brokers will maintain a certain amount of their own funds in order to provide liquidity, as well as holding client funds subject to CASS.
Ordinarily, a broker will hold client money in a client bank account with an account bank in the name of the firm and/or a client transaction account maintained by the firm itself. Where the client money has been segregated, should the firm fail there is generally no problem for the client in bringing a proprietary claim for a pro rata share in the pool of client money. Where an account bank is used there is normally only a debtor-creditor relationship between the broker and the bank, so there is a credit risk of the insolvency of the account bank, but this is usually very low provided a reputable bank is used.
If the client’s claim is not covered by the statutory trust under CASS, however, the client will be left with a personal claim to be proved among the other creditors in the liquidation or administration. For example, a client may have a personal claim in the case of a breach of trust or contract by the broker, such as if the broker opened a position on the client’s behalf without its instructions.
A client is also entitled to equitable compensation if there is a shortfall in the client money subject to the statutory trust because the firm has, in breach of trust, failed to maintain it at the required level (so-called “shortfall claims”) (In re MF Global (No 4)  EWHC 2556 (Ch)).
It is also clear from the Supreme Court’s decision in the Lehman case that the statutory trust under CASS applies only to client monies received by the firm, so if funds do not reach the broker as a result of negligence, the client is left with a personal claim against the person responsible for failing to transfer the funds.
However far greater difficulties arise if client money subject to the statutory trust has not been segregated by the firm, as was encountered in the MF Global case.
MF Global may have been just the horror that Lord Walker prophesied when he said that the majority decision in Lehman would lead only to “delay, uncertainty and expense”, preventing timely distribution of segregated client money funds. There was a significant shortfall in the approximately $1bn CMP of MFGUK, as a result of wrongful failure to treat a number of clients as being entitled to the protection of
It was accepted that these were breaches of trust giving rise to two possible claims on behalf of clients: firstly, a proprietary claim to any client money received by MFGUK which remained identifiable in its house accounts or in the traceable proceeds of the money, applying the decision in Lehman; secondly, personal claims for breach of trust.
However the practical difficulties of pursuing the proprietary claims were such that, following court-directed negotiations, the court (David Richards J) approved a settlement agreement compromising all claims between the trustee of the client money trust and the general estate of MFGUK (Re MF Global  EWHC 2222 (Ch)). It was accepted by the court that the proprietary claims would have required an immense amount of investigatory work in order to identify payments in MFGUK’s house accounts: the court noted that in the 11 days before the commencement of the administration there were approximately 10,000 receipts and payment instructions in respect of 259 house accounts with an aggregate value of over £30bn. There would also be complex legal issues about tracing into mixed funds, inevitably leading to appeals. The settlement saved substantial legal costs, benefitting both clients and creditors, who in some cases were in a position to net or set-off their claims against debts to MFGUK.
Conclusions from the case law
Whether intended or unintended, it is clear from MF Global that a consequence of the Lehman case is to steer parties in a client money dispute towards negotiation rather than litigation. The majority decision in Lehman prioritised the aim of ensuring an equally high level of protection for all creditors over considerations of speed and efficiency in making distributions. This reflects the approach of MiFID, but makes litigation unattractive in situations where there are:
- large sums of unsegregated client money; and
- prospects of a reasonably high percentage distribution both to clients as beneficiaries of the trust and to creditors from the general estate.
Ultimately, a negotiated settlement sanctioned by the court may be the way that most substantial client money claims involving unsegregated funds are dealt with in the future.
This necessitates an active approach on the part of the courts. Such an approach was taken in MF Global, in which David Richards J was willing to approve a Client Money Distribution Procedure to be followed by the trustee, dealing among other things with how disputed and unknown claims should be assessed (since CASS itself did not set out a procedure for client money claims to be made and adjudicated) (In re MF Global (No 3)  1655 (Ch)).
The court’s proactivity in that case is to be welcomed, and will hopefully be repeated in future cases. Without it, the current state of the law means that recovery of client money where there is a CMP shortfall is likely to be time-consuming and expensive. This will trouble many of those, such as hedge fund managers and others, who are concerned to a significant degree about immediate liquidity just as much as the ultimate percentage distribution. Where a failed firm is highly insolvent and distributions are expected to be low, a drawn-out process may be unavoidable.
New CASS rules
In 2013 the FCA consulted on strengthened client asset and client money rules, in response (among other things) to the Lehman and MF Global collapses. On 10 June 2014 it published Policy Statement PS 14/9, setting out significant modifications to CASS. The rules were designed to come into effect in three stages: the initial changes came into force on 1 July 2014 and 1 December 2014, and the final set of changes is to follow on 1 June 2015.
Specific rules have already been introduced in relation to firms operating the alternative approach to segregating client money and/or a non-standard method of internal client money reconciliation (although some firms have been allowed until 1 June 2015
- Many of the most onerous requirements will come into effect on 1 June 2015, including:
- Immediate segregation of client money into a client bank account, where the normal approach to segregation is used;
- A requirement to ensure that cleared funds are used for client transactions;
- More detailed recordkeeping, record checking and reconciliation requirements;
- Enhanced due diligence to be carried out on account banks, together with periodic reviews of whether the third parties used to place client money are appropriately diversified.
Further clarification of certain aspects of the rule changes has been proposed in a quarterly consultation paper, CP15/8, which was published by the FCA on 6 March 2015.
Significantly for the purposes of client money distribution, following the 2013 consultation the FCA decided not to introduce its so-called “speed proposal”. This would have made changes to CASS 7A to increase the speed at which client money is returned after a primary pooling event, including by requiring an initial distribution of client money shortly after a firm’s failure, solely on the basis of the
This met with widespread concern in the industry and was not pursued in PS14/9. Although the FCA stated it would publish a further consultation paper later in 2014 addressing this, changes to CASS 7A are yet to be finalised and the speed proposal appears to have been side-lined pending reform of the Special Administration Regime for Investment Banks.
In light of the tension identified above between the need for speed and accuracy in client money distributions following failure of a firm, reform to CASS 7A is an area that merits the FCA’s urgent attention. The changes introduced to CASS 7 have improved controls on the handling of client money, and the FCA’s Client Asset Unit is expected to crack down further on non-compliant firms, particularly following
the final deadline for the changes on 1 June 2015. This has already been seen in the £126m fine handed out on 14 April 2015 to BNY Mellon (the world’s largest global custody bank) for CASS breaches including failing to prevent commingling of safe custody assets with firm assets in proprietary accounts and to keep entity-specific records and accounts. This has already been seen in the £126m fine handed out on 14 April 2015 to BNY Mellon (the world’s largest global custody bank) for CASS breaches including failing to prevent commingling of safe custody assets with firm assets in proprietary accounts and to keep entity-specific records and accounts. However past experience suggests that client protection cannot be guaranteed through the client money rules alone, and that having an effective distribution regime is at least as important.
James Potts is a barrister at Thirty Nine Essex Chambers specialising in financial services and commercial law.
Email: firstname.lastname@example.org / www.39essex.com