A whole new world

The regulatory focus on insolvency since the Lehman Brothers collapse is beginning to affect other cases, such as that of MF Global in the UK. By Joanne Harris

Corzi Abelow
Corzi Abelow

Three years on from the collapse of Lehman Brothers the repercussions continue to reverberate around the financial services industry. There have been a large number of court cases in several countries concerning insolvency as creditors seek to ­recover lost assets.

Lehman’s collapse has also guided regulators in bringing into force new rules that apply in the case of the ­insolvency of a financial institution. In the UK, provisions in the 2009 Banking Act finally came into effect on 8 February last year. These provisions are supplemented by the ­Investment Bank Special Administration (England and Wales) Rules 2011, known as the SAR rules.

The SAR rules have been invoked by the FSA for the first time in the MF Global case. On 31 October 2011 KPMG’s Richard Fleming, Richard Heis and Mike Pink were appointed joint special administrators of MF Global UK.

The SAR rules apply only to UK ­investment banks and not non-UK affiliates so, in the case of MF Global, it is only the UK arm that is affected.

As Schulte Roth & Zabel associate Ron Feldman and partner Lawrence Gelber put it in a note to clients, the purpose of the new rules is to help clarify issues including: ascertaining which assets are client assets and which firm assets; interpreting the ­effect of, and the inter-relationship between, various contracts and ­master agreements such as prime brokerage agreements, futures agreements, stock lending agreements and International Swaps and Derivatives Association (ISDA) master agreements; establishing the extent of any right of use; and determining and ­allocating any shortfalls in client ­omnibus ­accounts.

Administrators under the new regime have three main objectives, say Feldman and Gelber. They must: ensure the return of client money or assets as soon as is reasonably practicable; ensure timely engagement with market infrastructure bodies and authorities such as the Bank of England, HM Treasury and the FSA; and either rescue the investment bank as a going concern or wind it up in the best interest of the creditors.

As the Schulte Roth briefing stated: “This essentially might be said to codify existing best practice. While the administrator has the power to determine the priority of these objectives the FSA can, in certain circumstances, direct the administrator to prioritise one or more of the objectives if it is necessary to do so in order to maintain public confidence in the stability of the financial markets in the UK.”

Berwin Leighton Paisner partners Jacob Ghanty and Ben Larkin add: “The administrator has the flexibility to prioritise the SAR objectives as ­appropriate so, for example, the ­administrator would not be required to return all client assets before ­addressing unsecured creditors.”

The rules give the special administrator the power to set a ’bar date’ for the submission of claims over client assets held by the insolvent bank. This bar date is designed to address situations in which claimants are trying to recover assets that the administrators have already distributed.

Regulation 11 of the SAR rules states that the special administrators have to publicise the bar date widely, including giving notice to all clients who may have a security interest over the assets held by the insolvent institution. The rules also give instructions for the special administrators on dealing with a shortfall in client assets held in a client omnibus ­account.

“In the event of a shortfall, the special administrator shall ensure that it is borne pro rata by all clients for whom the investment bank holds securities of that particular description in the same account, in proportion to their beneficial interest in those ­securities,” states a Cadwalader Wickersham & Taft client note.

One of the principal issues that has reared its head since the Lehman ­insolvency is the question of segregation of assets. In the UK this issue has gone all the way to the Supreme Court, where Lords Hope, Walker, Clarke, Dyson and Collins heard ­arguments at the end of October. Judgment is awaited.

In theory, existing guidelines, set down in the FSA’s Client Asset Sourcebook (Cass), should help clients regain lost assets.

“If a firm complies with the client money and asset rules in Cass, clients should receive a full return,” point out Baker & McKenzie partners Arun Srivastava and Louise Webb and ­associate Georgia Chrysikopoulou. “However, in the real world these rules do not operate flawlessly. In the Lehman case the judge found that there had been a ’shocking underperformance’ by Lehman in its compliance with these rules.”

There are a number of reasons why clients might lose money in the case of insolvency. As well as a failure to segregate, Bakers also highlights the use of an alternative approach to client money protections and the credit risk of banks at which a firm holds client money.

The SAR rules do not deal explicitly with segregation issues, but the increased efficiencies involved in the new regime ought to help avoid a ­repeat of the Lehman controversies.

The process so far in MF Global UK seems to be working fairly well. The special administrators have a timeline in place for the return of client assets. On 28 November 2011 they ­announced that clients with a claim against funds in the client money pool, or with claims against client ­assets, had from 8 December to 30 March to submit a claim form. ­Although the SAR rules allow the ­administrators to set a bar date they have chosen not to do so in this ­instance.

In a statement, Heis said: “Putting a timeline in place creates an important framework for the return of client assets and client money. This helps to create certainty around the number and size of claims with the intention of allowing a return of a proportion of client funds before 30 March 2012.”

In the statement, he added that the proportion of the client money pool to be distributed initially would depend on the return of sufficient funds from third-party institutions and the ability of the joint special administrators to make adequate provision for all possible claims in respect of client money.

Liquidated assets

Over in the US, the Securities Investor Protection Corporation (SIPC) initiated liquidation proceedings on 31 October and appointed Hughes Hubbard & Reed partner James Giddens as the trustee for the liquidation. Significantly, Giddens has also overseen the liquidation of Lehman.

Giddens has made a number of ­filings to recover assets, including transferring segregated commodity positions to other institutions. By the end of November transfers had been made enabling the retail customers of MF Global Inc to recover all or most of the equity in their accounts. This process is part of the US commodities insolvency regime.

But, as Morgan Lewis pointed out shortly after the MF Global insolvency, the regime is “dependent on an FCM [futures commodities merchant] maintaining sufficient assets in accounts segregated for customer property to cover all of its customer obligations. Assuming that the FCM properly calculated the amount of ­assets that it needed to maintain in the segregated accounts, the ­accounts generally would be transferred to a solvent FCM.” However, according to a statement made by Giddens, in the MF Global case there could still be a shortfall of $1.2bn (£770m) or more in funds that should have been segregated and were not.

As in the UK the SIPC process is ­affected by the ongoing impact of the Lehman affair. Proceedings in the US will affectthe status of counterparties. In particular, Morgan Lewis notes, to-be-announced (TBA) securities counterparties will have to file claims to recover liquidated trades. In the Lehman proceedings, the trustee has challenged the status of TBA counterparties, questioning whether they can be treated as Lehman customers or creditors. If US courts decide that TBA counterparties are creditors, their claims will be dealt with after those of customers and may only recover minimal funds.
MF Global subsidiaries are also in insolvency proceedings in Australia, Hong Kong and Singapore. The scale of the collapse is significant, and the success or otherwise of changes made since Lehman are likely to be closely scrutinised by lawyers as proceedings around the world continue.

Creditor as predator

The collapse of brokerage firm MF Global was the biggest insolvency of a financial institution since the Lehman Brothers bankruptcy in 2008. Now lessons learnt from Lehman, and rules changed since that September day, are being applied as creditors fight for their cash from MF Global’s administrators.