In this article, Patrick Buckingham, a partner in Herbert Smith's Financial Services Regulatory Group, and Sophia Reeves, an associate in the same group, consider the implications of the decision of the High Court in Re Global Trader Europe Limited (In Liquidation)  EWHC 602 (CH) regarding the application of the FSA's client money rules.
The High Court (Court) has ruled (www.practicallaw.com/3-422-4896) on several issues arising in relation to the application of the client money rules of the Financial Services Authority (FSA) in the context of insolvency proceedings relating to Global Trader Europe Limited (Company). The client money rules of the FSA (Client Money Rules) are set out in its Client assets sourcebook (CASS) and are intended to safeguard client funds held by an FSA regulated firm, particularly where the firm becomes subject to insolvency proceedings. The Client Money Rules do not apply where the FSA regulated firm is a credit institution, the logic being that cash deposits are held by it as banker on the basis of a debtor-creditor relationship. This means that the Client Money Rules are primarily relevant where client funds are held by other types of FSA regulated firm, notably those with investment firm status under the Markets in Financial Instruments Directive (2004/39/EC) (MiFID).
The judgment (which will not be appealed) raises wider questions about the impact of the insolvency of an FSA regulated firm on the application of FSA rules to the insolvent firm's ongoing regulated business. It also has obvious relevance to the conduct of the administration proceedings relating to Lehman Brothers International (Europe) (LBIE) and it therefore comes as no surprise that the LBIE administrators have applied for directions from the Court to clarify its precise impact on the funds held by LBIE.
Broadly, client money is money that an FSA regulated firm receives from or holds for, or on behalf of, a client in the course of its investment business. At the time the Company became subject to insolvency proceedings, the Client Money Rules were split between the rules that applied to business covered by MiFID (set out in Chapter 7 of CASS) and the rules that applied to other types of investment business falling outside the scope of MiFID (set out in Chapter 4 of CASS). On 1 January 2009, the Client Money Rules for both types of business were merged into a consolidated Chapter 7, with Chapter 4 of CASS being deleted. The judgment in relation to the Company is based on the Client Money Rules that applied before 1 January 2009.
The Company was an FSA regulated derivatives broker that entered into contracts for differences and spread bet transactions with its clients. When entering into a transaction with a client, the Company would hedge its exposure by entering into a matching transaction with one of its prime brokers. Thus, for every transaction concluded with a client, there would be two separate transactions entered into by the Company as principal, one with its client and one with a prime broker. Clients were required to pay cash margin to the Company as security for any losses they might owe to the Company upon the closing of their trading positions. Money paid to the Company by clients would be held in one of two ways:
in a general bank account of the Company (a non-segregated account) where the money was treated by the Company as falling outside the scope of the Client Money Rules, the assumption being that money credited to this account belonged to the Company; or
in a segregated client bank account of the Company (a segregated account) where the money was treated by the Company as client money subject to the requirements of the Client Money Rules.
The Company's practice, prior to the implementation of the MiFID on 1 November 2007, was to treat money belonging to those of its clients who were categorised as intermediate customers under pre-MiFID rules as falling outside the scope of the Client Money Rules so that it could be credited to a non-segregated account. This opt-out of intermediate customers was something that the Company was allowed to do under the Client Money Rules in force at the time, albeit subject to conditions (the opt-out was dependent on the Company obtaining a prescribed form of written acknowledgement from each intermediate customer). Money belonging to those of the Company's clients who were categorised as private customers under pre-MiFID rules was treated by the Company as being subject to the requirements of the Client Money Rules and was credited to a segregated account.
The implementation of MiFID on 1 November 2007 resulted in a change of client categorisations under FSA rules, with existing intermediate customers of the Company being transitioned across to a new professional client category and existing private customers of the Company being transitioned across to a new retail client category. This transitioning of client categorisations is generally referred to as "grandfathering". MiFID also brought about a number of changes to the Client Money Rules relating to MiFID business (which includes contracts for differences and spread bet transactions). The impact of these changes meant that the Company had to find another way to opt out its professional clients from the requirements of the Client Money Rules. The method chosen by the Company was to adopt a title transfer collateral arrangement (a TTC arrangement) under which the Company treated funds credited to the client's trading account as being its own property available for use in the course of its business for the purpose of securing obligations owed by the client. TTC arrangements are expressly recognised as a way of disapplying the Client Money Rules under the rules relating to MiFID business in force from 1 November 2007.
Where the Client Money Rules applied, the Company held the money of its clients on the terms of a statutory trust imposed under the Financial Services and Markets Act 2000 (FSMA) and the Client Money Rules. The effect of this statutory trust is to create a fiduciary relationship between the Company and each client under which the client money of that client is in the legal ownership of the Company but remains in the beneficial (equitable) ownership of the relevant client. The existence of this trust was reflected in the fact that the Company held client money in segregated accounts on the basis that this money could not be mixed with its own funds.
The Company went into administration on 15 February 2008 and later into liquidation. On the day it went into administration, the Company had instructed its bank to transfer a sum of money out of its own account into a segregated account to correct a payment mistakenly made out of this account. The bank did not act upon the Company's instructions, which resulted in a shortfall in the segregated account. A number of client trading positions were open when the administration of the Company commenced on 15 February 2008, the majority of which were subsequently closed out.
The first respondent (CB) represented a class of clients whose funds were held in segregated accounts. The second and third respondents (R and S) represented classes of clients whose funds were not held in segregated accounts on the assumption that they were not subject to the requirements of the Client Money Rules.
R and S submitted that both in respect of money paid to the Company and where they were in profit on a closed trading position, they were trust creditors entitled to a proprietary interest in funds of the Company held outside of the segregated accounts and that an amount up to the aggregate of their claims should be segregated and held on trust for them. R and S further submitted that they should at least be treated as trust beneficiaries of the segregated accounts.
CB argued that the Company's unsuccessful attempt to make the bank transfer had created a trust of that money in favour of CB, alternatively that the Court should order the liquidators to transfer the money from the Company's general funds. In relation to client trading positions that were open on 15 February 2008, CB submitted that profits arising to segregated clients of the Company on the subsequent closing out of these positions should be treated as client money and amounts equal to those profits paid into new segregated accounts opened by the liquidators and held on trust for the relevant clients.
The Court held that money paid to the Company by R and S before the implementation of MiFID on 1 November 2007 was client money as a result of R and S (and other similar clients) not having been validly opted out of the Client Money Rules. This money should have been paid by the Company into a segregated account. However, the Company had mistakenly (but honestly) believed that it was not client money and had paid the money into a non-segregated account and used it for its own purposes. While it was not necessary for the money to be paid into a segregated account for it to be subject to the statutory trust, it had to remain identifiable for the trust to have any effect. In this case, the money had clearly lost its identity with the result that it would have been very difficult indeed to substantiate a proprietary claim on the basis of the trust. The Court also held that the fact that the Company had failed to perform its obligation to treat money paid by R and S before 1 November 2007 as client money, together with the fact that this money had ceased to be identifiable, did not cause a trust to attach to the Company's own money. (The decisions in MacJordan Construction Ltd v Brookmount Erostin Ltd (1992) BCLC 350 CA (Civ Div) and Various Customers of BA Peters PLC v Moriaty (2008) EWCA Civ 1604, Times, January 14, 2009 were applied by the judge).
The position was the same for money paid to the Company on or after 1 November 2007. The situation was complicated by the fact that some clients of the Company formerly categorised as intermediate customers had received an email from the Company purporting to effect a TTC arrangement in the period leading up to the implementation of MiFID. The judge held that there was an effective TTC arrangement in relation to clients who had:
received the email;
paid money to the Company in the post-1 November 2007 period; and
accepted the contents of the email by entering into at least one new transaction with the Company.
This meant that the Client Money Rules did not apply to money paid to the Company by these clients in the post-1 November 2007 period. However, even where there was no valid TTC arrangement (it is worth noting that many former intermediate customers of the Company appear not to have received the email purporting to effect the TTC arrangement), the position would have been the same in relation to post-1 November 2007 money paid by the clients to the Company for the reasons explained above.
The Client Money Rules provide for a pooling of all of the Company's segregated accounts where an administrator is appointed and for the client money credited to those accounts to be distributed to the clients for whom that money is held according to their respective interests. The effect of the judgment is that R, S and other clients of the Company falling within the same classes of client as R and S would not be clients whose interests should be taken into account for the purposes of this distribution of client money. Put simply, they ranked as unsecured creditors of the Company to the extent of their claims against it.
In relation to the failed bank transfer, the Court held that where the bank failed to act upon the Company's instruction to make a transfer of money from its own account to a segregated account, there was no basis on which that could be regarded as the Company having made a declaration of trust in relation to the money in question. Ordering the liquidators to transfer the Company's funds to a segregated account to make up the shortfall would be contrary to the distribution arrangements under the Client Money Rules and would involve some unsecured creditors being preferred over the remaining unsecured creditors.
In relation to client trading positions that were open on 15 February 2008, the Court held that any profits that had subsequently arisen as a result of their close out should not be treated as client money referable to CB and other clients of the Company falling within the same class of client. The logic applied by the Court is that the distribution arrangements set out in the Client Money Rules required positions that were open on 15 February 2008 to be valued as at that date (this issue was the subject of a decision by Richards J at an earlier stage of the proceedings), with this date operating as a cut-off point for the trust protection afforded to money in the segregated account. While affected clients were entitled to the benefit of this trust protection as regards any increase in the value of their positions that took place before this cut-off point, they would have no entitlement to any increase in value that occurred at any subsequent point in time.
The judge's decision was reinforced by his interpretation of the definition of client money under the Client Money Rules. For money to be client money, it has to be money that the Company receives from or holds for, or on behalf of, a client. Where an open position of a client had been closed out at a profit to the client, a contractual debt was owed by the Company to the client in the amount of the profit but it was not the case that a corresponding amount became client money in the sense of being money which the Company held for, or on behalf of, the relevant client.
This position was held to be equally true of profits arising on client positions that were closed out before 15 February 2008. However, the interesting point to note is that the contractual debt represented by the profit could result in the creation of client money by the Company paying an amount equal to the profit into a segregated account. According to the judge, this could not happen after 15 February 2008, reflecting the fact that the Client Money Rules do not allow for client money held in a segregated account to be increased or for the relative entitlements of client beneficiaries to be changed by reference to events occurring after that date. This meant that CB and other clients in the same class of client were entitled to the protection of the Client Money Rules only in relation to the value of the profit attributable to their open trading positions as at 15 February 2008.
We think that the judgment of the Court is sound in many respects. That said, we do have reservations regarding the part of the judgment addressing the treatment of client trading positions that were open on 15 February 2008. In particular, this part of the judgment raises questions about the precise impact of the insolvency of an FSA regulated firm on the application of FSA rules to the insolvent firm's ongoing regulated business. This is particularly relevant where the firm is in administration as it is clearly within the realms of possibility that it will continue to undertake business in one form or another for some time to come. While it seems clear that the administration or liquidation of an FSA regulated firm must be conducted in accordance with UK insolvency law, the judge appeared to be suggesting that the onset of administration in relation to the Company meant that the wider requirements of the Client Money Rules ceased to apply.
This part of the judgment is difficult to reconcile with what we understand to be the view of the FSA, namely that an FSA regulated firm in insolvency continues to be subject to the provisions of FSA rules (including the Client Money Rules) in relation to its ongoing activities. We do think it would be a very unfortunate (and unintended) outcome if this judgment resulted in the insolvency officers of an insolvent FSA regulated firm concluding that they were no longer subject to some or all of the requirements of the Client Money Rules in relation to the conduct of the firm's ongoing business.
The judgment represents the first affirmation by the English courts of the efficacy of TTC arrangements as a way of disapplying the Client Money Rules in relation to MiFID business. It also provides a useful clarification of the circumstances in which client funds held by an FSA regulated firm will become client money (as opposed to being merely a contractual debt owed by the firm to its client).
What is very apparent from the judgment is that clients entitled to the protections afforded under the Client Money Rules are dependent on the FSA regulated firm to deal with their funds in accordance with the requirements of the Client Money Rules, notably the requirement to segregate those funds from its own funds. Where these requirements have not been observed by the FSA regulated firm and it becomes insolvent, there is a significant risk that the Client Money Rules will not provide any protection in practice, leaving them as unsecured creditors of the firm to the extent of their claims against it. While the clients in question may be able to assert claims against the insolvent FSA regulated firm under section 150 of the FSMA or for breach of trust, they would be unsecured creditors in relation to any resulting claim for damages. As a result, the assertion of such a claim is unlikely to be an attractive option in practice.
It remains to be seen how the English courts will approach the judgment when considering the application for directions made by the LBIE administrators. What does seem clear is that there will be a heightened degree of scrutiny of what the judge says and does, there being much wider issues at stake in relation to the ongoing conduct of the LBIE administration. In addition, it seems clear that the FSA will undertake a potentially wide ranging review of the current arrangements under the Client Money Rules, most likely towards the end of this year (publication of an FSA consultation was mentioned in a recently published HM Treasury consultation document entitled "Developing effective resolution arrangements for investment banks"). Any such review would give the FSA an opportunity to address any particular concerns arising as a result of the judgment as well as other perceived problems with the Client Money Rules, notably as regards the way in which TTC arrangements have been used following the implementation of MiFID. It is also within the realms of possibility that there will be future insolvency law changes to address specific issues arising in relation to the insolvency of investment firms.
For more information on the Client Money Rules that applied before 1 January 2009, see Practice note, Historic client assets practice notes (www.practicallaw.com/0-385-1083).