Lehman Brothers and client money - further developments



The Court of Appeal released its judgment in Lehman Brothers International (Europe) (In Administration) v CRC Credit Fund Limited & Ors [2009] EWHC 3228 (Ch) on 2 August 2010.

The original case was based on an application by the administrators of Lehman Brothers International (Europe) (“LBIE”) for directions on various aspects of the Financial Services Authority’s client money rules. The aim of these directions was to determine certain issues arising out of the intended distribution of client money held by LBIE prior to administration.

It was expected that appeals would be made by both the administrators and CRC from the original judgments. The Court of Appeal has taken the step of overturning key parts of the first instance decision.

This briefing note sets out the background to the client money issues raised in the Lehmans case and the impact that the latest ruling is likely to have on the client of investment firms and insolvency practitioners.


Since the collapse of Lehman Brothers and the entry into administration of LBIE in September 2008, the protection of client money held by LBIE and the correct application of the Client Asset Rules has been a matter of some controversy.

The regulatory regime for client money centres on chapter 7 of the Client Asset Sourcebook of the FSA Handbook, known as CASS 7.


CASS 7 was originally introduced in early 2004. At that time, compliance was not a mandatory requirement for firms dealing with professional clients since an “opt-out” was available. With the implementation of the Markets in Financial Instruments Directive (“MiFID”) in November 2007 the scope of protection for client money was significantly extended and the opt-out removed.

CASS 7 contains a number of fundamental rules with which investment firms must comply. In the context of the Lehmans case, the most important requirement is for firms to keep client money separate from their own money.

In order to achieve this separation, CASS 7.1.4R requires firms to credit client funds to a separately designated client account. The primary intention is to prevent firms from using client monies for their own purposes, and to safeguard clients against the insolvency of a regulated firm.

The default segregation requirement is for firms to pay all client money directly into segregated accounts (the “normal approach”). CASS 7.4.16 does, however, include a concession for larger investment firms for whom the normal approach would be unduly burdensome.

Under the terms of the “alternative approach” monies received from clients are paid into the firm’s own accounts prior to being segregated each day according to reconciliations of client monies conducted as at the close of business on the preceding day. The main benefit of this approach is a firm’s ability to net out clients’ positive and negative balances as appropriate.

Client money is defined in CASS 7.2.1R as “any money that a firm receives from or holds for, or on behalf of, a client in the course of, or in connection with its MiFID business”.

Under CASS 7.7.2R, a firm receives and holds client money as a trustee for the purposes of the client money rules. Again, the creation of the statutory trust is part of the legal structure designed to protect clients from the insolvency of a regulated firm

CASS 7.6.9R also aims to facilitate the “timely return” of client money if the firm fails, through the triggering of a ‘primary pooling event” whereby client money in each client money account of the firm is treated as pooled.

It is the interpretation of these central aspects of CASS 7 that formed the basis of the original application of the administrators of LBIE and the subsequent appeal.

First instance decision

The first instance decision on the application by the administrators was handed down in two separate judgments in December 2009 and January 2010.

The administrators had approached the court for guidance on their ability to distribute client money held by LBIE to those of its clients who benefitted from the statutory trust created by CASS 7.7.2R. Exactly how this distribution was to be made was unclear due to (i) certain difficulties in the interpretation of CASS and (ii) the manner in which LBIE had been dealing with client money in the run up to its administration.

LBIE, as the main UK trading subsidiary of Lehman Brothers Holdings Inc., held a considerable amount of money for and on behalf of its clients. On the appointment of administrators on 15 September 2008, a “primary pooling event” occurred.

The central problem arose from the fact that LBIE operated the alternative approach to segregation of client monies. The last reconciliation before the primary pooling event was done on the morning of 12 September which meant that considerable sums of client money remained in LBIE’s own account when the pooling took place. This was compounded by errors and discrepancies in the segregation exercise which LBIE had carried out.

The first instance judgment closely analysed the client money rules, together with relevant aspects of the general law, and came to the following conclusions: 

a.       CASS 7 imposed a statutory trust on client monies as soon as they were received by LBIE;

b.      The rules provided for the pooling of client monies but only those which had been credited to segregated accounts;

c.       The only persons entitled to share in the client money pool were those clients whose funds had been placed in segregated accounts; and

d.      Those clients with funds in LBIE’s own accounts had to pursue remedies open to them under the general law, such as tracing.

Under the terms of the first instance ruling, the pooling of client monies provided a higher level of protection but this was only available to client to the extent that a firm actually effected segregation of client money. This was the case even though all client money is expressed to be subject to the statutory trust. Where a firm had weak financial controls and client money was not segregated, clients would be at risk on the insolvency of the firm. Not only would client money in a firm’s general account not be pooled but clients with segregated accounts would not be required to share the available funds with those clients for whom segregation did not take place.

Court of Appeal rulings

Given the significant amounts of money involved in this case, it was widely expected that the decision would be appealed.

The appeals addressed important issues concerning the ownership of client monies held by LBIE at the date of its entry into administration.

The Court of Appeal identified a variety of issues which required decision, namely, (1) did the statutory trust come into effect when LBIE received client money, or only when it segregated those funds? (2) Does CASS 7 pool identifiable client money wherever found or only segregated client money? (3) Do clients participate in the pool if they have claims to client money or only if they have contributed to the pool? and (4) When does money which the firm owes to client become client money?

Issue 1 – Did the statutory trust come into effect when LBIE received client money, or only when it segregated those funds?

It was common ground at the appeal that, under CASS 7.7, client money in a segregated account is held on trust. The question to be determined by the court was whether the trust took effect immediately upon receipt or only upon segregation of that money.

Read literally, the definition of client money in CASS 7.2.1 supports the conclusion reached at first instance to the effect that the statutory trust operates from receipt. The Appeal Court judges looked at the requirements of the MiFID directives on which much of CASS 7 is based and, while they understandably found no specific reference to a trust, their reading of Article 13(8) of MiIFD required CASS 7 to provide for a trust of client monies with effect from the time of actual receipt. The trust was not “deferred” until segregation was completed.

The appeal was dismissed on this issue and it was decided that the statutory trust arose on receipt of funds from or for the account of the client.

Issue 2 - Does CASS 7 pool identifiable client money wherever found or only segregated client money?

This question depended on the true meaning of CASS 7.9.6R which states that “client money held in each client money account of the firm is treated as pooled”.  More specifically, the Court focused on the definition of the term “client money account”.

The term “client money account” is not defined for the purposes of the client money rules, and this expression accordingly required independent interpretation. At first instance, the court had come to the conclusion that this referred to the segregated accounts only, and on this basis, only funds which had actually been credited to the segregated accounts were to be pooled.

While the High Court acknowledged that this reasoning would leave clients with client money in LBIE’s own account in a legal black hole, he justified the result by reference to the fact that the pooling and distribution of non-segregated funds to clients would involve costs and delay and that such clients would in any event have tracing rights to recover their money.

This point was also raised by the administrators who – perhaps understandably - were not seen to “…evince great enthusiasm for the task of distributing a pool comprising both monies in segregated accounts and identifiable monies found elsewhere.”

The administrators expressed anxiety over the amount of work the potential outcome of the appeal would create for them and argued that it shouldn’t be incumbent on them to identify client money outside segregated accounts unless they were put on enquiry, whether by the firm’s records or a sufficiently supported claim.

Had the first instance decision in this matter been correct, then CASS 7 would fail to protect clients who pay money to a firm that operates the alternative approach on its last day of trading because a primary pooling event would inevitably occur before any reconciliation could take place. This risk is endemic in the use of the alternative approach to segregation and the Court was of the opinion that this was not the regulatory intention.

However, the Court of Appeal disagreed with this approach and decided that the pool arising under CASS 7.9.6R on the primary pooling event includes not only segregated monies in segregated accounts but also all identifiable client money in the firm’s house accounts.

The Court of Appeal accepted that this may cause practical difficulties for the administrators, in that they could not confine their inquiries and obligations to the segregated accounts for those purposes. Equally, however, it would not be fair to leave non-segregated clients to the uncertainties and difficulties involved in the pursuit of claims under the general law. In such a complex situation, the value of remedies such as tracing was highly uncertain and unlikely to be of much use. No evidence was provided to support the assertion that distribution of segregated client money alone would be more timely, and there was thus no real basis for supporting the more narrow approach put forward by the administrators and endorsed at first instance.

It was felt that the administrators were in the best position to decide how to pursue other identifiable client money but the Court refused to give guidance on these matters to the administrators, stating the need for directions to be sought in the Companies Court.

Issue 3 - Do clients participate in the pool if they have claims to client money or only if they have contributed to the pool?

The answer to this issue is necessarily closely linked to the outcome of the second issue considered by the Court.

The Court of Appeal saw this question as a contest between two different means of distribution; the “claims basis”, under which the pool would be shared by reference to the amount of client money which should have been segregated, and the “contributions basis” pursuant to which the pool would be shared out pro rata to amounts of clients’ money actually segregated.

The High Court had decided this issue in favour of “fully segregated” client but, in the opinion of the Court of Appeal it was “…implicit in safeguarding the assets of clients that the clients should all share in the remaining assets.

This aspect of the appeal was allowed on this basis and it was held that the client money pool should be distributed to all clients according to the amount which ought to have been segregated for each client, rather than the amount which was in fact segregated.

Issue 4 - When does money which the firm owes to clients become client money?

If the firm owes money to a client, at what point should the relevant funds become “client money” and hence subject to the statutory trust?

At first instance it was held that client money could be those funds (a) received by a client, (b) those received by a third party for a client or (c) funds of the firm appropriated to the client but that monies which the firm simply owes to the client would not constitute client money.

To illustrate this type of situation, the Court gave the example of manufactured dividends in stock lending transactions which would not constitute client money and would consequently not be pooled on a primary pooling event.

The appeal against the original judgment was dismissed. “Client money” did not include sums due and payable by the firm to its clients but not yet specifically appropriated for that purpose.


The decision of the Court of Appeal to overturn the original judgments on the make up and distribution of LBIE’s client money pool has significant consequences for both LBIE’s clients and for the administrators.

The scope and extent of pre-administration client money that has to be pooled has been broadened significantly, as has the number of clients that are entitled to claim for a distribution from the pool.

This will inevitably lead to a greatly increased burden on insolvency practitioners in dealing with client money in these situations and increases the potential for lengthy delays in the distribution of funds to clients of insolvent investment firms.

The Court has shifted the emphasis of the CASS rules in relation to the making of distributions. At first instance, the court had considered that the primary objective of the client money rules was to ensure a “timely” distribution of funds and that this justified the different treatment of clients with segregated and non-segregated client money. While the Appeal Court judges acknowledged that the purpose of pooling under CASS was to speed up the process of distribution, they placed far greater emphasis on achieving a fair outcome for all clients with identifiable client money. The Court of Appeal has thus preferred a wider concept of fairness over speed and convenience.

If you would like to discuss any matters arising from this Briefing, please contact Charles Proctor or Oliver Irons on +44 (0)20 7415 6000.