The failure of Lehman Brothers of course highlights the risk to client assets and money when the firm holding them becomes insolvent. It is now well recognised that clients who have entered into title transfer or right of use terms (where the right has been exercised) will rank as unsecured creditors and are almost certain to suffer a substantial loss. The risks to clients are, however, much broader than that. Even where clients believe that their assets and money have been appropriately protected by segregation from the firm’s own assets and money, the Lehman insolvency shows that there is a substantial risk of a shortfall in funds to repay clients.

The issues currently being debated in the context of the Lehman insolvency should be of concern to hedge funds. Client money and client asset issues arise in the context of a broad range of relationships between hedge funds and their service providers including prime brokerage relationships, margin trading agreements, master institutional futures customer agreements, master repurchase agreements or any other arrangement involving the transfer of money or assets. In the context of these types of relationship hedge funds may be both segregated clients whose assets and cash are held separately from those of the firm, and also unsecured creditors where the firm has not agreed to provide client money or client asset protections.

In recent Court proceedings relating to the administration of Lehman Brothers International (Europe) (LBIE) and client money issues (the Client Money Application) the Court referred to Lehman’s “shocking underperformance” resulting in the firm’s failure to segregate “vast” sums of clients’ money. When administrators were appointed to LBIE last year the firm held some US$2.16 billion in segregated client funds. Around $1billion of this was held with an affiliate of LBIE which also went into insolvency proceedings. The segregated funds were also subject to competing claims from clients and affiliates who have claimed that they too should have been treated as segregated clients. The result has been the diminution and potential dilution of the segregated funds so that even clients whose money was or should have been segregated from the firm’s own money, are almost certain to suffer a substantial loss on the return of their funds.

The complexity of the position and potential prejudice to clients occurs in spite of detailed legal and regulatory rules providing for the protection of client money and assets by their segregation from the firm’s money and assets. In theory at least, the proper segregation of money and assets should protect clients on the basis that they will not form part of the estate of the insolvent firm. On this basis the money and assets will not be available to the firm’s general creditors, should be easy to identify and accordingly straightforward to return to clients. In practice, the failure by firms to properly implement segregation and reconciliation requirements, weaknesses in regulatory rules and a firm’s own internal procedures for dealing with client money will mean that there will rarely be sufficient funds to fully repay to clients what is due to them. Recent decisions of the English Court have shown that where there is a shortfall in available funds, Courts are unlikely to order the topping up of the shortfall by ordering the transfer of the firm’s own house funds into the client account for the purpose of meeting segregated client claims.

From a client’s perspective securing protection depends upon making sure that the right things happen in practice and not just in theory. If in fact a client’s assets and cash have not been segregated from those of the firm, the client will suffer a loss irrespective of whether the firm has acted in breach of regulatory or other requirements by failing to provide the adequate degree of protection. A client can address its risk by ensuring that its terms of business with the firm provide for the segregation of its money and assets and by insisting on reporting and monitoring provisions in order to ensure that it understands where and with whom its cash and assets are being held and that they are in fact segregated from the firm’s own cash and assets. Issues arising from Lehman’s failure have also highlighted the risks of assets and cash all being held with a single group. LBIE, for example, used Lehman Brothers Inc. as its sub-custodian and Lehman Brothers Bankhaus AG to hold client money. Clients’ assets may be trapped in Lehman Brothers Inc. and the failure of Bankhaus is likely to be a major contributor to the shortfall in the client monies held by LBIE. Diversification out of the Lehman’s Group by the appointment of third party custodians and the holding of client money with a third party bank, would have mitigated risks for clients.