INSURANCE

Since the implementation of the client money rules contained in the Client Assets Sourcebook (CASS), there has been debate about the way an officeholder deals with the distribution of client monies on the insolvency of an entity regulated by the Financial Services Authority (FSA). In particular, there has been on-going debate whether client trust claims can be the subject of a scheme of arrangement or whether distribution of those monies can only be effected under the CASS rules. The issue has become the subject of a High Court decision in the administration of Lehman Brothers International (Europe) ("Lehman") in which the administrators proposed a scheme of arrangement under Part 26 of the Companies Act 2006 ("the 2006 Act"), to address in part the proprietary interests of various claimants.

The debate is complicated because of the potential conflict between the regulatory and insolvency regimes and the application of trust law. Trust property does not form part of a company's estate and trust assets held or controlled by the relevant company/entity are held as custodian or trustee. This means as a result, a company is restricted in its dealings with trust assets whilst it is solvent. It renders it virtually impossible for a company to deal with those assets when the company is insolvent, because of the risk of potential breaches of trust/duty. Insolvency practitioners usually seek an appropriate order from the Court to enable them to deal with trust assets, but identifying how trust funds should be distributed has remained an issue. Poor filing and poor record keeping by an insolvent entity prevent officeholders clearly from identifying which monies have been received on trust or for whom those sums are held. What can the officeholder do?

Some officeholders take a robust view and argue that a proprietary claim is capable of compromise under the 2006 Act and therefore can be the subject of a scheme of arrangement in the same way as one might propose a scheme of arrangement in respect of normal creditor claims. The advantage of a scheme of arrangement, of course, is that it only requires a 75% majority by value and simple majority in number in favour of it to bind all creditors, including dissenters. This enables the company to distribute the funds that are held by it and compromise all claims, releasing the scheme company from any relevant liabilities.

The restrictive view is that the company acts as a trustee and holds the monies, not on a debtor-creditor relationship but, on the basis of a trustee-beneficiary relationship. It therefore has to abide by the terms of the relevant trust. The moot point therefore is whether a trust claim (being a proprietary claim) against monies, being a claim in rem (thing/property), as opposed to a claim in personam (person), is in fact a claim that is capable of being schemed.

In the case of Lehman, the administrators made an application to establish whether a scheme of arrangement under the 2006 Act, which they wished to promote, was one that the court had jurisdiction to sanction. As is common knowledge now, Lehman went into administration in September 2008 and for an element of its business it acted as broker to various institutional clients. It held monies for those clients subject to the governing rules in CASS. By virtue of contractual relationships the monies were to be held for the clients (on trust) with them retaining a proprietary interest. The administrators were concerned to return assets to the company’s clients/creditors but were faced with various difficulties. Not only were there proprietary interests, but also the need to overcome the practicalities of the lack of responses from all clients and the inaccuracy of Lehman’s books and records. There was also insufficient information about the assets of which Lehman was meant to be custodian to be able to arrive at a view as to how those monies should be distributed. It may be said therefore that the proposed scheme was a sensible approach to find a quick solution to deal with a difficult problem. It would enable the return of monies in what otherwise will be a complicated, time consuming and ultimately expensive exercise of reconciling balances and identifying closing positions.

It was common ground between the parties that appeared on the application that there were shortfalls between the amounts due and the sums claimed and that had to be addressed. Submissions by creditor representative bodies argued that the approach to replace proprietary rights with rights under the scheme was not a compromise or arrangement under the 2006 Act.

The Court was not persuaded that it was possible that a scheme (as contemplated) can bind the clients to whom Lehman owed obligations for the holding or control of client (trust) property, and in particular, that a scheme of arrangement could be used to return that property to the relevant clients for whom it was held. This was the case where the clients may have "mixed rights", not only being proprietary rights but also rights as creditors. The Court thought it immaterial that the ascertainment of clients' net contractual positions might be intimately linked with their claims as property owners. Consequently, the Court ruled that the proposed scheme was outside the scope of the 2006 Act.

The Court considered that any clients’ claims against the assets held were enjoyed quite independently of any creditors claims. This was in effect a different situation to one where an entity may have secured creditors or where it was concerned with its own assets. In this instance, the Court considered that the scheme sought to vary or in some cases extinguish the proprietary rights of clients and that there was no jurisdiction to enable that to be done so as to bind dissenters, which otherwise normally would be bound in a scheme.

Despite what appears to have been an attempt to mix creditor claims and claims of beneficiaries/claimants, the Court’s reasoning is not difficult to follow in light of the way it is intended that trusts operate. However, where a party has sought to constitute a trust (in accordance with the regulator’s requirements, or otherwise) and indeed where that trust is subject of specific rules relating to the failure of the regulated entity, and the distribution of assets, then a scheme is not the appropriate mechanism to effect a distribution. There remains a sharp distinction between the ambit of the scheme legislation and trust claims generally. However, it is not clear whether the ruling in Lehman seeks in some way to preserve the integrity of the regulatory regime for the distribution of assets under CASS, notwithstanding the recognised difficulties in this instance relating to record keeping. It seems that this is an area that still may be tested, and indeed the interesting point perhaps is - what happens if the trust in question has not been properly constituted?

It is not surprising that this judgment will be the subject of an appeal, particularly in view of the sums involved and the knock-on consequences that the judgment will have on other estates. This judgment for example will impact on certain estates/businesses where a scheme of arrangement has been promulgated as a means by which they are able to dispose of unreconciled balances of client monies attributable to legacy business in the insurance sector. The same issue in Lehman will arise again in those cases. No doubt there will be immense political pressure that a solution be found to expedite the distribution of funds in this high profile insolvency. However, the fact that the FSA created rules providing that client monies be held on trust and a trustee/custodian-beneficiary relationship be created between Lehman and its clients would necessitate the Court of Appeal making some nimble-footed reasoning to find that trust claims should be treated other than in accordance with the FSA’s rules and trust law. This case highlights the increasing interplay and potential conflicts between regulatory regimes, trust law and insolvency/company law.

Tim Goodger

Source: Elbornes.com