Exploring the relationship between client money claims and creditor claims

Restructuring & Insolvency analysis: Does a distribution of client money reduce the amount a creditor can claim? Can a shortfall in a client money claim constitute a provable debt?       

Original news: Heis (as joint administrators) of MF Global UK Ltd v Attestor Value Master Fund LP (as representatives) Re MF Global UK Ltd (in special administration) [2013] EWHC 2556 (Ch), [2013] All ER (D) 152 (Aug)

The Companies Court decided that, among other things, following the insolvency of an investment firm, distribution from the client money pool would reduce a client’s contractual claim, and hence the amount for which it might prove, just as a payment from client money before a primary pooling event (PPE) reduced or discharged the client’s contractual claim.

What are the key points of this case?

This latest case arising from the special administration of MF Global looks at the relationship between a client’s claim to client money and its claim as creditor. The main issues were:

• does a distribution of client money reduce the amount a creditor can claim?

• can a shortfall in a client money claim constitute a provable debt?

• if so, what principles govern the amount and does the rule against double proof apply?

Richards J decided that:

• in principle, one client can have parallel claims (ie a client money claim and a claim as creditor), but distributions from a client money pool (CMP) will reduce the contractual claim

• the claimant can claim for a shortfall in client money, but only if that shortfall was due to the debtor’s fault (as here)

• the rule against double proof doesn’t apply here

Why is the difference between client money and creditor claims important?

The same transaction may create both a:

• proprietary claim (as beneficiaries of a trust) to client money, and

• personal claim (as a creditor) to a firm’s assets after filing a proof of debt

Clients were invited by the administrators to submit a single document containing a claim against the CMP and against the general estate. A successful proprietary claim means the assets in question never form part of the assets of the debtor (see Proprietary claims). Usually this is preferable to a personal claim as creditor (which just ranks as an unsecured claim fairly low down in the waterfall of payments). However, in this case, the anticipated recoveries (or dividends) for unsecured creditors was unusually high:

• unsecured creditors: 93%–100% expected dividend

• client money claimants: 62%–86% expected dividend

The different classification of claims was also important as different valuation rules applied for open contracts depending on whether they were:

• client money claims—contracts closed out at the commencement of liquidation/administration (ie the trigger date for client money distribution rules)

• creditors’ claims—notionally valued at the commencement of liquidation/administration, but then subject to the hindsight rule to take account of the actual subsequent close out value (see Entitlement and the ‘hindsight principle’)

Therefore the same transaction may give rise to different amounts claimed as client money or creditor, depending on price movements.

When are the client money distribution rules triggered under the Financial Services Authority’s (FSA) Client Assets Sourcebook 7 and 7A (CASS)?

Because of the timing of the events, the former FSA Client Asset Rules are the relevant provisions. The client money distribution rules contained in FSA CASS 7 and 7A are triggered on certain events (eg administration/liquidation) and constitute a primary pooling event (PPE). At this point, all client money held in each individual client money account is pooled to create a CMP. These moneys are then distributed according to the claimant’s individual client money entitlement (see Lehmans—client money issues) on the basis of the amount the firm should have segregated rather than it actually segregated.

Richards J decided the CMP and the firm’s general estate were two separate estates which would be distributed on entirely separate bases. The nature of interests was fundamentally different:

• a vested beneficial interest in the CMP assets, and

• simply a right to have the estate administered in accordance with the statutory scheme on insolvency as regards the general estate

The pooling of client money leads to a change of beneficial interests:

• prior to a PPE—client money is held in the amounts shown in the firm’s records

• after a PPE—client money is held for all clients in proportion to their client money entitlements (ie the amounts which ought to have been segregated)

However, there’s no reason why pooling and modification of the basis on which client money is held should prevent payments of client money from reducing client’s claims. For example, if (prior to a PPE) the firm:

• pays on maturity of a contract the whole/part of the amount due to the client from funds held as client money, the contractual liability is reduced/discharged and there is no obligation on the firm to reimburse the client money trust for that sum

• pays the sum due to the client from its own resources, the amount required to be held as client money will be correspondingly reduced

• receives the proceeds of sale of a security to the account of a client and holds those proceeds as client money, and there’s also a contractual obligation on the firm to pay the proceeds to the client, a payment from the client money account to the client would reduce/discharge the corresponding contractual obligation

FSA CASS 7 and 7A create a single trust of client money. The trust is sui generis (unique) and while the firm is a going concern, the client money arrangements are not analogous to security given by a debtor or provision of a third party guarantee. A PPE doesn’t create a new trust, but is a mechanism to give effect to the trust.

What did the case decide?

Richards J decided that:

• a distribution from the CMP would reduce a client’s contractual claim and hence the amount for which it might prove (just as a payment from client money before a PPE would do) and it would be contrary to the nature and purpose of the client money trust to find otherwise

• if a client’s contractual claim and the amount for which it might prove was reduced by payments from the CMP, it had to follow that the client could not prove for both the shortfall claim and the balance of its contractual claim—a payment in respect of the shortfall claim would, to that extent reduce the contractual claim as they were in substance, though not in form, claims in respect of the same liability

• excess shortfall could be claimed on the basis of equitable compensation—MF Global had defaulted in its obligation to maintain the client money at the required level causing the beneficiaries actual loss by MF Global’s breach of trust

• the rule against double proof is a test of substance, not form—it doesn’t apply here as the client is not proving twice for the same liability, but is proving once for one liability (the shortfall claim)

What are the practical consequences?

Richards J noted that it would be undesirable for administrators to delay distributions to creditors to ensure that they claimed against (and fully exhausted) the CMP first. This decision strikes a sensible balance between recognising the two potential elements of a client’s claim and avoiding unwarranted windfalls to clients.

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