Lehman lawyers think insolvency regime too weak

Arun Srivastava
THE high profile failure of MF Global has once again highlighted the intractable problems that arise when an investment firm fails. The latest reports suggest that the shortfall on client funds may be as much as $1.2bn (£0.7bn). Staggeringly, that represents a quarter of all the funds that the firm was supposed to be holding.

What is also becoming clear now is that, despite the major legal and regulatory reforms that were implemented following the collapse of Lehman Brothers in 2008, few advances have been made when it comes to safeguarding investor funds.

While it might be wishful thinking to expect segregated clients to get all their money and assets back in such a situation; the failure of MF Global shows that investors are still not being adequately protected.

In the UK, MF Global’s insolvency marks the first use of the Investment Bank Special Administration Regime (SAR), which was implemented by the UK government to address failings on Lehman. The collapse of Lehman had a disastrous effect on its UK clients. At the time of its collapse Lehman’s UK arm held $35bn in cash and assets and was party to some 840,000 open transactions. Unable to access their cash and assets, many of it customers suffered substantial losses and some went out of business.

The idea behind the SAR was to stop this happening again by giving priority to the identification and return of client money and assets. It is still early days, but MF Global suggests that this approach is overly simplistic. Once again, it appears that clients will suffer major delays and significant losses.

The problem is that the SAR acts to shut the barn door after the horse has bolted. If funds have not been segregated before the insolvency, as they should have been, then no amount of priority after the event will put clients in a better position.

UK laws protect client assets through the application of a trust. But legal wrangling in the Lehman administration demonstrated that trust laws cannot be used to make good on losses incurred when a firm inadvertently fails to segregate client funds or uses client monies for its own account.

Another problem with the SAR is that clients are liable to bear, proportionately, the costs of collecting and returning client monies and assets. This matters because funds will sometimes be held with third parties such as clearing houses, exchanges and third-party banks, which will be unable to return funds until they have reconciled their positions. This can take considerable time and further increases the cost to the client.

In order to better protect investors there needs to be increased regulatory oversight to ensure that firms comply with segregation rules while they are still trading. This is especially true during times of financial turbulence when the risk of client funds and assets being used by a firm is more acute. And, ultimately, the only way to improve the position of clients in an insolvency would be to establish a mechanism for making good client losses. The US does more in this regard. It is time the UK considered following suit.

Arun Srivastava is partner at Baker & McKenzie. Georgia Chrysikopoulou, associate at Baker & McKenzie also contributed to this article. Baker & McKenzie represented the general estate of Lehman Brothers International (Europe) in the client money proceedings before the English High Court and Court of Appeal.