The collapse of Lehman Brothers International in 2008 was an event now frozen in infamy. Henry Davis York's Braydon Heape looks at why Australia should examine its own regime to determine whether it remains appropriate.
And it may hold significant lessons for Australian regulators.
The case concerns the consequences of the Lehman Brothers International (Europe) (LBIE) administration, for clients who had paid money to the company in connection with its investment services business.
LBIE was based in the United Kingdom. As the main trading company of the Lehman Brothers group within Europe, it provided a variety of services typical of a global investment bank, including prime brokerage, corporate advice, equity and fixed income trading and investment management.
On 15 September 2008 - a date now notorious in the history of modern finance - it went into administration. It was regulated under the Financial Services and Markets Act 2000 (UK) by the Financial Services Authority (FSA).
Client monies paid to LBIE enjoyed some protection under a statutory trust, through the rules provided for in the FSA Handbook. In Australia, similar provisions are found in the Corporations Act 2001 (Cth) and Corporations Regulations 2001.
The issues in the case concerned the scope of the protection afforded by the statutory trust.
In the case, the English Court of Appeal closely scrutinised the UK's regime for distribution of client money on failure of a financial services business. The rather vague definitions of the terms of the statutory trust created fertile ground for dispute about the entitlements of different classes of clients. The main contest was between those whose client monies had been segregated in a client account and those whose monies were simply mixed in house accounts with LBIE's own money.
Given the time and expense it would take for the "unsegregated" clients to pursue their claims individually, and the poor prospects for recovery in any event, there was a powerful incentive for these clients (represented by CRC Credit Fund Limited) to seek to extend their entitlement under the statutory trust to money held in the client account.
Equally, given the impact this would have on the claims of segregated clients already facing a diminished pool of segregated money, there were strong reasons for segregated clients (represented by GLG Investments Plc) to resist these claims.
While the Australian law has not yet been put to such a test, the case presents a strong argument for re-examining the Australian regime to determine whether the outcomes produced by it remain appropriate.
The English court decision reveals two potential flaws in the Australian regime.
The first is that Australian clients whose investment monies have not been placed in the required trust account by the investment firm - whether through permissible delay, negligence or fraud - will likely be forced to bring expensive and lengthy legal proceedings to recover their trust monies in the event of failure of the investment firm. In contrast, clients whose money has been held in a trust account will benefit from the rules in place to streamline distribution of these monies.
Section 981H of the Corporations Act 2001 provides that client money is taken to be held in trust by the licensee for the benefit of the client. Section 981F of the Act governs the event of the licensee's insolvency. Critically, the section applies only in respect of money in a segregated client account. The section, with its related regulations, has nothing to say about unsegregated client monies.
"The rather vague definitions of the terms of the statutory trust created fertile ground for dispute about the entitlements of different classes of clients."
Braydon Heape, senior associate, Henry Davis York
The second is that the financial services firm benefits from residual trust account monies, instead of clients whose money has not been set apart in the trust account. This is because under the current rules, the firm is entitled to any residue remaining after trust account clients' claims have been met.
The "waterfall" provision at regulation 7.8.03(6) of the Corporations Regulations provides (at paragraph (b) and (c)) for the distribution of the trust monies to segregated clients. Following any such distribution, the residue is to be paid to the licensee (under para (e)). No provision is made for any distribution to clients with unsegregated client monies. Thus the licensee itself will participate in the distribution of client money, in all likelihood well before the claims of unsegregated clients will have been satisfied. Those whose trust money has been wrongfully dissipated by the firm may only compete for the residue of the trust account - pooled with other assets of the firm - along with other unsecured creditors.
Ironically, consideration of these consequences proved important in shaping the English Court of Appeal's decision. The Court concluded that these consequences could not have been intended in the UK regime, which led it to favour an interpretation of the relevant rules that did not produce such an unfair outcome.
By contrast, the unfair consequences appear to be intentionally present in the Australian regime.
The reasoning in the British case suggests that a review of the regime is warranted in Australia. It is appropriate to consider whether these outcomes remain appropriate in light of international experience.
The striking differences in treatment of the different classes of clients suggests that the issue of unfairness can be expected to arise upon failure of an Australian investment firm with significant numbers of clients whose money has not been segregated in a client trust account. Regardless of the decision of the UK's Supreme Court in the final appeal in the Lehman case, the issue is likely to remain significant as a matter of Australian financial services regulation and policy in the future.
The global financial crisis and the collapse of Lehman Brothers has led to a number of interesting legal disputes. Henry Davis York advised Perpetual Limited in relation to recovery action since Lehman Brothers filed for bankruptcy and assisted Perpetual negotiate a settlement with Lehman Brothers in November last year following a complex cross-border insolvency priority dispute.
Details of an out-of-court settlement with Lehman Brothers were released in May. This related to $125 million of credit-linked notes (CLNs) issued by an Australian Company, Mahogany Capital, backed by other CLNs issued from the Lehman Brothers sponsored "Dante" note program.
Approximately 1,000 retail investors who bough the Mahogany notes will recover around $100 million from their $125 million investment
The dispute was hard fought and involved complex priority, conflict of laws and cross-border insolvency issues. It ran for nearly two years with proceedings across three jurisdictions of the UK, the US and in Australia.
Braydon Heape is a senior associate with Henry Davis York.