Lehman Brothers International (Europe) v CRC Credit Fund Ltd & Ors

The court determined a wide range of issues of construction and application of the Financial Services Authority's Client Assets Sourcebook (CASS7) in the administration of Lehman Brothers International (Europe) (“LBIE”). Key legal principles established include: (i) CASS7 creates a statutory trust in favour of clients in respect of identifiable client money received or otherwise appropriated as such; (ii) for the purposes of the client-money distribution regime the Client Money Pool (CMP) consists of client money held in segregated client bank accounts and client transaction accounts as at the primary pooling event (PPE), not all client money potentially identifiable in a firm’s house accounts; (iii) proprietary recovery outside the CMP requires conventional equitable tracing and following (with the usual limits such as the lowest intermediate balance rule); (iv) there is no general obligation on the firm or its administrators to ‘top up’ the CMP from the firm’s general assets to meet shortfalls caused by prior under-segregation; (v) the correct basis of sharing in the CMP is the contributions basis (the amounts actually segregated for clients, subject to specified adjustments including CASS7.9.7R), not a claims basis based on amounts which ought to have been segregated; and (vi) the PPE is the appropriate date for calculating and valuing clients’ shares in the CMP. The rules in CASS7 and the general law (trust and insolvency principles) were applied together, and the court rejected arguments that CASS7 should be read as permitting a wide floating trust or equitable charge over the firm’s general estate to protect un‑segregated clients.

This was an application by LBIE’s administrators under paragraph 63 of Schedule B1 to the Insolvency Act 1986 for directions on the interpretation and application of CASS7 (client money rules and the MiFID business distribution rules) arising from LBIE’s administration on 15 September 2008. The administrators sought directions to permit the orderly identification and distribution of the Client Money Pool (CMP) to clients with beneficial interests under the statutory trust created by CASS7.

Background and facts:

• LBIE operated the CASS7 alternative approach to segregation. Its last internal reconciliation prior to administration related to close of business on 11 September 2008 (the Point of Last Segregation, PLS), with the segregation carried out on 12 September 2008.
• Between the PLS and the Primary Pooling Event (PPE, the Time of Appointment on 15 September 2008) LBIE continued business without further reconciliation, producing material inflows and outflows of client money.
• On the assumed facts used for this application LBIE had very substantial under‑segregation: affiliates’ claims exceeded US$3 billion while segregated balances were circa US$2.16 billion; additionally LBIE had deposited US$1 billion of segregated money with Lehman Brothers Bankhaus AG (Bankhaus), which itself subsequently failed, creating a significant credit shortfall in the CMP.
• The Administrators compiled an agreed Statement of Assumed Facts (SAF) for the court to resolve legal issues on that factual platform.

Parties and procedural posture:

• The Administrators applied for directions and joined representative client respondents (segregated, un‑segregated and partially segregated clients), a number of Lehman affiliates, LBIE’s unsecured creditors’ representatives and the FSA as respondent to assist the court.
• The hearing was at first instance before Briggs J over several weeks; the court decided issues of law arising under CASS7, MiFID-derived obligations and their interaction with the general law of trusts and insolvency.

Nature of the application and relief sought:

1. (i) The Administrators sought directions under Schedule B1 para 63 as to how to identify the CMP, which clients are entitled to share in it, the correct basis of sharing (claims or contributions), the date for valuing claims, and how post-PLS and post‑PPE events should be treated.

Issues framed and decided by the court:

• (ii) The court framed and decided the principal issues: whether the statutory trust under CASS7 arises on receipt or only on segregation; what can lawfully be done with client money mixed in house accounts pending segregation under the alternative approach; the contents of the CMP; whether shortfalls may be topped up from other client money or general assets; whether sharing is claims‑based or contributions‑based; the correct valuation date (PPE or distribution); the operation of CASS7.9.7R adjustments; tracing/proprietary remedies outside the CMP; and whether set‑off/retention by the firm is available against CMP distributions.

Court’s reasoning (concise):

• (iii) The court interpreted CASS7 in the light of MiFID and domestic law. It concluded the statutory trust attaches on receipt (or when money becomes identifiable as client money by appropriation) and that firms using the alternative approach are nonetheless under obligations (by CASS7 and the general law) to protect clients’ rights while funds are mixed, for example by appropriate prudential buffers or segregated top‑ups, but this did not imply unfettered authority to use mixed funds for the firm’s own purposes.
• The CMP was held to comprise client money in segregated client bank accounts and client transaction accounts as at the PPE. Client money outside those segregated accounts is not part of the CMP; recovery of such sums depends on conventional equitable tracing/following (subject to established limits such as lowest intermediate balance); courts will not read CASS7 as creating a broad floating charge or statutory equitable charge over a firm’s general assets to protect un‑segregated clients.
• The court rejected a general top‑up obligation (either from the firm’s assets or from non‑pooled client money) because the client money rules are replaced by the distribution rules on a PPE and because the insolvency scheme prevents prioritising unsecured creditors unless a proprietary right is established. CASS7.9.7R operates as a reducing mechanism against certain entitlements (linked to Annex 1 options) and the contributions basis (amounts actually segregated) governs sharing in the CMP. The PPE is the proper date for calculating and valuing client entitlements for rateable distribution'

Practical implications: The judgment resolves numerous technical disputes on CASS7 implementation in a large, multi-currency, complex failure. It emphasises the interplay between regulatory rules and established trust/insolvency law and leaves certain factual tracing disputes and contractual questions to be litigated or otherwise resolved in subsequent processes of the administration.

The court made comprehensive directions and determinations on the interpretation and application of CASS7. The key holdings were: (i) the statutory trust created by CASS7 attaches on receipt (or on appropriation making money identifiable as client money), (ii) the Client Money Pool (CMP) comprises client money held in segregated client bank accounts and client transaction accounts as at the primary pooling event, (iii) proprietary claims outside the CMP require conventional equitable tracing and are subject to established limits, (iv) there is no general obligation to ‘top up’ the CMP from the firm’s general assets, (v) the correct basis of sharing in the CMP is the contributions basis (amounts actually segregated, subject to limited adjustments including CASS7.9.7R), (vi) the PPE is the valuation date for clients’ shares, and (vii) set-off and retention against CMP distributions are generally not available. The court gave detailed reasons grounded in CASS7, the MiFID implementing directives and established trust and insolvency principles.