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Part II United Kingdom, 9 Lessons of LBIE: Reuse and Rehypothecation

Joanna Benjamin

From: Bank Failure: Lessons from Lehman Brothers

Edited By: Dennis Faber, Niels Vermunt

From: Oxford Legal Research Library (http://olrl.ouplaw.com). (c) Oxford University Press, 2023. All Rights Reserved. Subscriber: null; date: 07 June 2023

Shadow banking — Bank resolution and insolvency — Issue and trading of securities — Securities settlement system — Financial collateral — Regulated activities

(p. 171) Lessons of LBIE

Reuse and Rehypothecation

I.  Introduction

9.01  Two particular traumas followed the failure of Lehman Brothers on 15 September 2008.1 One was the catastrophic delevering that affected wholesale financial institutions in 2009, as the post-LBIE markets went into freefall. The other was the very long delays in the return of client assets held in the UK by Lehman Brothers International (Europe) (‘LBIE’). The systemic failure has been associated with the reuse of securities collateral in general. Some have argued that the client asset delays were associated with a category of reuse, known as rehypothecation, in particular. Regulatory reforms have been introduced with a view to addressing both. However, it will be argued in this chapter that the true lesson of both failures is not yet fully reflected in regulation. This is the profound impact of shadow banking, and the reuse of securities collateral within it, upon client asset protection and systemic risk management alike.

9.02  This discussion is based on law and practice in London as it is understood by the author at the time of writing.

II.  Nature of Reuse of Securities Collateral

9.03  The economic and legal natures of reuse will be considered in turn.

(p. 172) A.  Economic nature

9.04  The economic nature of the reuse of securities collateral is simple enough. Reuse occurs where collateral assets are received by one person as collateral taker, and then delivered by that same person, as collateral giver and acting otherwise than for the account of the original collateral giver, to a third party collateral taker, as shown in Figure 9.1.

9.05  For example, a hedge fund, or ‘alternative investment fund’ (AIF) grants a security interest, together with rehypothecation rights, to its prime broker, over the securities portfolio held in custody by the prime broker for the AIF. The AIF does this in exchange for cheap credit. Thereafter, the prime broker exercises its rehypothecation rights to deliver securities from the custody portfolio, firstly to itself and then to a third party bank under a repurchase transaction ‘repo’, in which it acts as principal (again in exchange for cheap credit).

Figure 9.1  Reuse

9.06  The reuse of collateral securities has the result that one piece of collateral supports more than one piece of credit, as shown in Figure 9.2.

Figure 9.2  Reuse and multiple credits

9.07  Thus, the first point about reuse, including rehypothecation, is that it multiplies the credit within the financial system.

B.  Legal nature and terminology

9.08  The legal nature of reuse is a little more complex, because collateral may be delivered and reused by one of two legal means. The first is by security interests combined (p. 173) with a contractual right of rehypothecation. The second is by title transfer collateral arrangements (‘TTCA’).

1.  Security interest plus rehypothecation

9.09  The traditional legal method of delivering collateral is under a security interest, such as a mortgage or a charge. The granting of a security interest involves both the delivery and the reservation of property rights. A security interest is a limited property right, falling short of outright ownership. If the collateral giver defaults during the term of the loan, the collateral taker is entitled to enforce its rights, typically by selling the collateral assets, applying the proceeds of sale to discharge the debt, and passing any surplus to the collateral giver.

9.10  However, if the loan is serviced and repaid without default, the collateral giver is entitled to the discharge of the collateral asset, ie to the assets without the security interest. This right is known as ‘the equity of redemption’. Like the security interest, the equity of redemption is a property interest attaching to the collateral assets. Thus, during the currency of the secured obligation, the collateral is subject to two concurrent property interests, namely the security and the equity of redemption, as shown in Figure 9.3.

Figure 9.3  Security interest and equity of redemption

9.11  A property right cannot survive the absence of the assets to which it relates.2 It follows that the equity of redemption is generally3 incompatible with the reuse of the collateral assets. But a security interest may be combined with a contractual right of rehypothecation. If this right is both enforceable and enforced, the equity of redemption drops away.

(p. 174) 2.  Title transfer collateral arrangement

9.12  In recent decades, the predominant legal method of collateral delivery in wholesale market transactions has been TTCA. The effect of a TTCA transaction is immediately to confer on the collateral taker absolute title to the collateral assets. TTCA is functionally equal to the combination of a security interest and a right of rehypothecation.

(a)  Outright transfer

9.13  Thus, under TTCA, full title to the collateral assets is transferred to the collateral taker (CT)4 when the transaction is opened and the credit extended. The collateral giver retains no equity of redemption or other residual property rights.

(b)  Equivalent redelivery

9.14  In the absence of default, when the transaction is closed and the credit is repaid, outright title to assets equivalent to the original collateral is delivered to the collateral giver (CG). For this purpose, ‘equivalent’ means securities of the same type and number, but not necessarily the same ones.

9.15  The essential legal difference between security interests and TTCA relates to the presence or absence of the equity of redemption, as shown in Figure 9.4.

Figure 9.4  Comparison of security interest (SI) and TTCA

(c)  Close-out on default

9.16  In the event that either party defaults before close, the cross claims are valued, converted (if necessary) to cash in the contractually specified base currency, aggregated and setoff, so that only a net sum is payable by one party to the other.

(d)  Facilitates reuse

9.17  TTCA facilitates reuse, as the original collateral taker is free to reuse the collateral asset immediately upon receipt.

(p. 175) (e)  Recognition

9.18  TTCA have long been recognized in English law,5 but are less familiar to the traditional domestic law of civilian jurisdictions. However, as discussed below,6 within the EU the Financial Collateral Directive (FCAD)7 provides in article 6(1) that ‘Member States shall ensure that a title transfer financial collateral arrangement can take effect in accordance with its terms.’

3.  Terminology

9.19  In the present discussion, ‘reuse’ is taken to be the generic category, namely the use of particular assets to collateralize more than one extension of credit (irrespective of the legal nature of the original collateral delivery). In contrast, ‘rehypothecation’ is taken to be a sub-set of reuse (where the original collateral delivery is under a security interest).8 This terminology is shown in Table 9.1.

Table 9.1  Terminology

Legal method of original collateral delivery

Name of subsequent disposal of collateral



Security interest



However, this field is bedevilled by inconsistent terminology, and ‘[r]e-hypothecation’ and ‘re-use’ are terms that are often used interchangeably’.9

III.  Prime Broker Rehypothecation

9.20  Prime brokerage is a bundle of services typically provided by investment banks to hedge funds to enable the latter to pursue their trading strategies on a scale greatly exceeding their capital base. The overall effect of prime brokerage is the loan of resources of all kinds from the investment bank to the hedge fund. Prime broker services include custody, or the safekeeping of the client securities portfolio, and also the provision of credit in a range of forms.

(p. 176) A.  Overview

9.21  The practice of rehypothecation is particularly associated with prime brokerage, and has become (rightly or wrongly) notorious following the collapse of the UK prime broker, Lehman Brothers International (Europe) (LBIE). (In contrast, rehypothecation is not a typical feature of ‘plain vanilla’ global custody.)

9.22  Rehypothecation is central to the prime brokerage business model. The hedge fund client is granted extremely cheap credit10 in exchange for permitting the prime broker to treat the hedge fund’s portfolio as a collateral pool.

B.  The deal and hypo limits

9.23  It is provided in the prime brokerage agreement that the prime broker may elect from time to time to use particular client securities for own account.

9.24  A limit is placed on the right of the prime broker to rehypothecate client assets, typically expressed as a percentage of the client’s obligations. The extent from time to time to which further rehypothecation is permitted within the agreed limit is known commercially as ‘headroom’.

9.25  In the US, two particular aspects of prime brokerage practice were implicated in the asset bubble that led to the Wall Street Crash of 1929. One was margin trading.11 The other was rehypothecation. As part of the official response to the Crash and the Great Depression that followed in the 1930s, regulatory legislation—the ability of US prime brokers to rehypothecate client assets—was limited in effect to 140 per cent of the net credit extended to the client.12

9.26  In contrast, UK prime brokers are not subject to any such regulatory rehypothecation or ‘hypo’ limit. Regulatory arbitrage drove much prime brokerage (and associated hedge fund) business to London. After the failure of LBIE, the FSA considered whether to impose hypo limits. However, the applicable limit was and remains at the time of writing a question of contract. At the time of writing, the question is being considered by the Financial Stability Board (FSB).13 Prior to the financial crisis, hypo limits of up to 200 per cent were routinely sought by prime brokers, and not infrequently accepted.

9.27  However, market practice changed after the commencement of the LBIE administration. The typical negotiated hypo limit is now understood to be 140 per cent, coinciding with the US regulatory maximum.

(p. 177) C.  Legal position

9.28  The respective rights and obligations of the prime broker and the client are as follows.

1.  Prior to rehypothecation

9.29  It is important to distinguish the contractual right of rehypothecation, granted in the prime brokerage agreement, and the exercise of that right from time to time by the prime broker in respect of particular client assets.

9.30  Prior to the exercise of the right of rehypothecation, the position is as follows.

  1. (i)  Legal title to client securities is held or controlled14 by the prime broker.

  2. (ii)  It is agreed that client securities are held by the prime broker on trust for the client.15

  3. (iii)  This agreed trust status is compatible with the right of rehypothecation16 (although not with the exercise of that right).17

  4. (iv)  The client charges the balance of the client securities account to the prime broker in order to secure its obligations. The effect of this is to charge the beneficial interest of the client to the prime broker.18

  5. (v)  Thus, as shown in Figure 9.5, the client has property rights under the custody trust, and the prime broker has a charge over the trust interest.

Figure 9.5  Respective rights of parties before use

2.  Upon rehypothecation

9.31  Post-LBIE case law19 refers to a debate as to when title moves from the client in rehypothecation.20 However, the position seems entirely clear (to the author) under market standard documentation. The right of rehypothecation is exercised by the prime broker debiting the client account and crediting the house account. The effect of this is that the prime broker becomes absolutely entitled to the rehypothecated securities, and free to dispose of them as it wishes. The client ceases to have any property rights in respect of the rehypothecated securities. Instead, it has only a contractual and personal right against the prime broker to have equivalent securities delivered to it upon its call to close the rehypothecation.

(p. 178) 3.  Closing the rehypothecation

9.32  It is provided in the prime brokerage agreement that the client may call at any time for the delivery to it, or to its order, of securities equivalent to the rehypothecated securities. As indicated briefly above, in this context, ‘equivalent’ means securities of the same type21 and number. On receipt of such a call, the prime broker must deliver equivalent securities within the settlement cycle for the securities in question; in the EU this is typically two business days. However, if the prime broker is unable to deliver equivalent securities on the due date, it may instead pay their current market value to the client.22 Case law has confirmed that this right to cash out the equivalent delivery obligation is compatible with the prime broker being the trustee of the client in respect of unrehypothecated client securities.23

9.33  In practice, if and when the prime broker receives an instruction from the client to settle a sale to a third party which relates to securities that have been rehypothecated, the prime broker will typically check whether it can deliver equivalent securities from its own inventory.24 If it cannot, it may either purchase the securities in the market, or alternatively borrow25 equivalent securities to ensure timely settlement of the client’s trade, and then use a subsequent market purchase to close the securities loan. It is understood to be fairly unusual to have to cash out the equivalent delivery obligation.

9.34  Once equivalent securities have been delivered to the client account or according to the client’s instructions, the rehypothecation is closed. Equivalent securities credited to the client account are subject to the same custody trust as unrehypothecated client securities.

(p. 179) 4.  Impact on prime broker’s charge

9.35  It was indicated above that the prime broker takes a charge over the balance of the client securities account.

(a)  Charged asset during rehypothecation

9.36  Property rights cannot survive the absence of the assets to which they relate.26 It follows that rehypothecation takes the securities in question outside the scope of the prime broker’s charge. A well-drafted charge will include the client’s equivalent delivery rights within its scope.

9.37  Note however that equivalent delivery rights may not fall within the statutory definition of ‘financial collateral’ under the Financial Collateral Directive.

(b)  The charged asset after rehypothecation closed

9.38  What is the position when the rehypothecation is closed by the delivery to the client of equivalent securities? The prime broker’s charge will define the charged assets to include securities credited to client’s securities balance from time to time, so these securities will automatically fall within its scope. But even if it did not, the position is the same by virtue of the first provision of regulation 16(3) of the Financial Collateral Arrangements (No 2) Regulations27 (‘FCAR’). This provides:

The equivalent financial collateral which is transferred in discharge of an [equivalent delivery obligation], shall be subject to the same terms of the security financial collateral arrangement as the original financial collateral was subject to…28

9.39  Thus, the equivalent securities are charged to the prime broker, but on what basis? The second provision of FCAR regulation 16(3) is relevant here. It provides,

… and shall be treated as having been provided under the security financial collateral arrangement at the same time as the original financial collateral was first provided.

9.40  This is a deeming provision, which has the effect of legally backdating the time at which the equivalent securities are treated as having come within the scope of the charge. This may assist the prime broker as collateral taker in relation to potential timing sensitivities relating to double dealing priorities and insolvency displacement rules.

D.  Operational aspects of rehypothecation

9.41  Operational practice varies between prime brokers and changes over time. However, as a broad generalization, the legal aspects of rehypothecation are typically supported by the followisng operational steps.

(p. 180) 9.42  Historically, some prime brokers have automatically swept client assets into house account, or settled client trades into house account, so as to exhaust headroom at all times. However, this may no longer reflects best practice, and will be restricted under MiFID II.29

1.  Credit house

9.43  In the house account, securities are outside the custody trust and available to be transferred by the prime broker to third parties. Typically, prime brokers deliver rehypothecated assets to cash-rich institutions such as banks and money market funds, as securities finance collateral to raise short term credit. Thereafter the assets may be reused again and again in other transactions, as discussed below.30

2.  Omni account

9.44  It is customary for prime brokers (and other custodians) to hold most client securities, not in individually designated client accounts, but in omnibus (‘omni’) client accounts, whereby the like securities of all clients are pooled. Increasingly, the prime broker (or other custodian) is obliged by EU legislation to offer the client the choice of individual and omni accounts. However, the practice is, and is expected to remain, for most client assets to be held in omni accounts, because of the operational efficiencies and lower costs associated with such pooling.

9.45  Where an omni account is used, debiting that account has the result that the sum of client securities is reduced. However, it is not of itself effective to allocate the rehypothecation to a particular client.31

3.  Allocation to client

9.46  The prime broker typically rehypothecates a quantity of particular securities in circumstance where the omnibus client account contains a larger quantity of security, held for different clients and available for use within the aggregate headroom. In such circumstances, there will be a choice as to how the rehypothecation should be attributed amongst the relevant clients. The allocation procedure will be determined by an electronic algorithm. It may be retrospective and discontinuous.32 In some cases it may not always take place, so that allocation is ascertainable but not ascertained. It is understood that it is not customary for the allocation procedure to be agreed with or disclosed to clients.

9.47  However, under MiFID II, ‘The records of the investment firm shall include details of the client on whose instructions the use of the financial instruments has been (p. 181) effected, as well as the number of financial instruments used belonging to each client who has given his consent, so as to enable the correct allocation of any loss.’33

4.  Client account and client securities balances

9.48  The term ‘client account’ refers to the accounts maintained in the name of the prime broker (or its nominee) with the designation of ‘client account’, by, and in the books of, a settlement system, sub-custodian, or issuer through whom the prime broker asserts title to the client securities. As mentioned above, these are typically pooled, and record the assets held by the prime broker for its clients generally. A second set of accounts are maintained by, and in the books of, the prime broker, to record the entitlements of particular clients. This second set of accounts is called ‘client securities balances’.

9.49  As indicated above, rehypothecation involves debiting the client account. Where the client account is an omni account, the allocation of the rehypothecation to a particular client requires a further operational step.

5.  Notice to client

9.50  Prior to the implementation of MiFID I, it is understood that the client was typically not informed when the right of rehypothecation was exercised. Instead, a general disclosure relating to rehypothecation appeared on client statements. Following the implementation of MiFID I, the FSA (now the FCA) conduct of business rules have required client statements to include information on the extent to which client financial instruments have been the subject of securities financing transactions.34 Since the failure of LBIE, further requirements have been introduced.35

6.  Client balance not amended

9.51  Rehypothecation is notified to the client, as indicated above, and also noted on the client balance. However, it is not understood to be current practice to debit rehypothecated securities from the client balance. At the time of writing, the norm is for client securities balances to reflect the clients’ economic position, ie how long they are in particular securities. The balance does not differentiate between that part of the long position that comprises property rights in client assets held by the prime broker, and that part that comprises contractual equivalent delivery rights in respect of rehypothecated assets. In order to ascertain the true legal position, the client balance must be read together with the daily notices.

(p. 182) 9.52  In the interests of transparency, it would be desirable for practice to change, and for the client balance to be split into separate parts, so as to distinguish rehypothecated from unrehypothecated client securities.

E.  Inadvertent rehypothecation

9.53  Rehypothecation typically takes place deliberately, in accordance with contractual rights granted by the clients in question. But not all rehypothecation is deliberate.

1.  Intraday settlement related shortfalls

9.54  Inadvertent rehypothecation may arise in pooled accounts intraday, in relation to settlement practice. A benefit to settlement of pooling is a phenomenon that used (unfortunately) to be called pilfering, and is more properly termed intraday securities borrowing. This is best explained by example.

9.55  Suppose pooled client A has sold 1 million Y shares to a third party for settlement on Wednesday. Suppose also that at 12.00 a.m. on Wednesday client A has not pre-positioned 1 million Y shares with the custodian, but the custodian has received 1 million Y shares on the settlement of a purchase by pooled client B. As an operational matter, the custodian is able at 12.00 a.m. to settle A’s sale. In most cases, A would deliver 1 million Y shares to the custodian before close of business on Wednesday, say at 4.00 p.m.

9.56  The operational effect of this is that settlement occurs earlier in the day, facilitating further settlements dependent on the receipt by the third party of the 1 million Y shares. The arrangement serves to eliminate interdependent settlement ‘circles’, and prevents settlements being concentrated at the end of the day. Legally the effect is securities borrowing by the custodian as agent for X of Z’s 1 million Y securities between 12.00 a.m. and 4.00 p.m. This is in order where Z has consented to the arrangement.

9.57  Historically, custodians took such consent to be implied in the client’s consent to the use of a pooled account, as a necessary implication of the latter. More recently, the need for separate express consent to intraday securities lending has been appreciated, and will be expressly required under MiFID II.36 Up to date and well drafted custody agreements include it in the discussion of pooling. Alternatively, authority could be taken as part of a securities lending mandate.

9.58  In April 2014, the FCA imposed a record fine37 on BNY Mellon entities for client asset protection failures in their custody operations.38 This was because BNY (p. 183) Mellon had not obtained the consent of all pooled clients, and was unable to establish which pooled clients had consented.39

9.59  Note however that under MiFID II the standard appears to be less exacting. In the detailed obligations to avoid use and avoiding shortfalls,40 reference is to the settlement date, as opposed to at any intra day point on that date.41

2.  Settlement into house

9.60  Where a delivery of securities to the prime broker (or other custodian) is flagged by the counterparty as the settlement of a client trade, the prime broker will typically receive the delivery into the client account. However, where deliveries that settle client trades are not so flagged, the practice would be to receive the delivery into the house account. The securities would only be transferred to the client account later, when the client nature of the delivery is identified. The arrangement is arguably akin to the alternative method of segregating client money. But between receipt and transfer to the client account, a client shortfall arises. Arguably, it amounts to use. But because it is inadvertent and caused by counterparty default, it is hard to think of a remedy, other than requiring the firm to identify and deal with client trades not settling into the client account as early as possible.

3.  Contractual settlement and failed settlement

9.61  Inadvertent use may also arise due to failed settlements affecting omnibus client accounts, where contractual settlement (see below) is practised. The term ‘failed settlement’ is used to apply to a trade that is not credited to the settlement system’s account on the due date, in accordance with the terms of the trade.

(a)  Practice of contractual settlement

9.62  Failed settlement alone would not give rise to a shortfall, but in combination with the practice of contractual settlement, it may. Contractual settlement is a service customarily offered by global custodians and prime brokers to managed fund clients for presentational purposes, in order to assist fund managers compete in industry league tables. Under contractual settlement, where the client has for example purchased securities, the custodian credits those securities to the client securities balance on the date specified for settlement under the terms of that trade (contractual settlement date), whether or not settlement has actually taken place on that date.

(b)  Status of contractual settlement credit

9.63  Contractual settlement credits are typically provisional credits, pending actual settlement, which the custodian may reverse at any time prior to actual settlement. Typically, such credits are designated on the account as provisional, and do not entitle the client to dispose of (p. 184) the securities. Nevertheless, they have the result that the sum of client securities balances exceed the balance of the client securities account.

4.  Inadvertent breach of hypo limit: sudden deleveraging

9.64  One context in which unauthorized use may inadvertently arise is the sudden deleveraging of a hedge fund client, eg where it rapidly sells securities and pays the proceeds to the prime broker in order to exit a falling market. Because rehypothecation limits are typically defined as a percentage of the net exposure of the prime broker to the client, sudden reduction by the client of that net exposure may have the result that use that was originally done within available headroom, subsequently and suddenly exceeds permitted limits. In these circumstances, the prime broker should restore securities to the client account (either from house account or through a market buy-in) as quickly as possible, and ideally within the normal settlement cycle for the securities in question, in order to rectify the position.

9.65  If it does so, it is highly arguable that the prime broker has not been in breach of contract.

IV.  Rehypothecation and the Failure of LBIE

A.  The failure

1.  LBIE

9.66  Lehman Brothers International (Europe) (LBIE) was a prime broker operating in London and part of the US-based Lehman group.42 LBIE went into administration on 15 September 2008. The Lehmans failure triggered free fall in the international financial markets, considerable litigation, and a wide-ranging regulatory debate.

9.67  One poignant aspect of the administration was the experience of clients awaiting the return of their assets. LBIE held client securities and client money for some 900 prime brokerage clients of the Lehman’s group.

2.  Delays in the return of client assets

9.68  There were very considerable delays in the return of client assets held by LBIE. At the time of writing, more than seven years after the commencement of administration, the process is not complete. It took over five years for very significant (p. 185) client securities to be returned to clients (following the resolution of a dispute with Lehman Brothers Inc (‘LBI’),43 which was one of LBIE’s sub-custodians, and over seven years for a final distribution of the client securities recovered from LBI.44 Lingering snags continue to affect other client securities.45 As for client money, at the time of writing, ‘[t]he uncertain status of [US litigation] continues to block the final resolution of the pre-Administration Client Money estate.’46

9.69  The long delays and uncertainty caused particular concerns for the hedge funds that made up the bulk of the client base, some of whom were open ended,47 and needed urgently to sell custody assets in order to fund redemptions. The Financial Services Authority (‘FSA’, now succeeded by the Financial Conduct Authority, ‘FCA’) noted the potentially systemic impact of delays in the return of client assets to wholesale market clients.48 In another context, the FSA wrote,49 ‘Following the insolvency of LBIE and the resultant market instability, it became clear that confidence in the UK [client asset protection] regime had been damaged.’ In its client asset review, the FSA stated that one of its primary objectives was to ‘improve the speed of return of client assets following the insolvency of an investment firm’.50

B.  Doctrine: the role of property rights

9.70  The fundamental technique for protecting client assets in the insolvency of a firm is the assertion and protection of property rights. Clearly there is an element of conceptual circularity here: the term ‘client assets’ means, very broadly, assets belonging to clients and held by a firm. The regulatory obligation to protect client assets ‘…especially in the event of the investment firm’s insolvency…’,51 is elaborated primarily in terms of operational measures52 facilitating the identification of client assets and (therefore of the property rights of clients in relation to them).

1.  Property rights in insolvency

9.71  The point of this is the general principle that assets held by an insolvent and subject to third party property rights are not available to the creditors of the insolvent, do not form part of the insolvent estate subject to the rules of insolvency distribution, and are returnable by the insolvency official to the proprietors, to the extent of their (p. 186) property rights.53 Thus, property rights survive intermediary insolvency, and hence the regulatory client asset protection regime.

2.  Reliance on trust

9.72  The type of property right on which English law client asset protections relies is the trust.54 The firm is the trustee of the client assets it holds for client beneficiaries.

9.73  In the case of client money, the trust asset comprises the firm’s debt claim against the client money bank where it has deposited the client money.

9.74  In the case of client securities positions,55 the trust asset comprises the securities (or, more likely, the indirectly-held interests in securities) held by the firm for clients.

9.75  Whereas the client money trust arises under statute,56 the custody trust has no statutory basis.57 It arises under the law of equity, in accordance with the agreement of the parties. It is not customary for English law custody documentation to use the word ‘trust’.58 But such use is not required, provided there is certainty of intention that the client should beneficially own the assets.

9.76  Certain operational and contractual arrangements that are customary among custodians generally, and others that are customary among prime brokers in particular, attracted concerns. It had been argued by some that these arrangements were so at odds with the trustee’s traditional equitable duties, as to be incompatible with the existence of a trust. But these concerns were put to rest, as discussed in the following section.

3.  Official recognition of custody trust

9.77  In LBIE’s administration, the proposition that client assets were held on trust by the insolvent firm was not officially disputed.

(a)  Joint administrators’ reports

9.78  The reports of the Joint Administrators that were issued every six months reassuringly reported on client assets under the reassuring heading, ‘trust estate’.59 The administrators took seriously their duty to seek to return these trust assets to the clients in accordance with their entitlements,60 and to do so urgently.61

(p. 187) (i)  Trust property order

9.79  The administrators obtained a court order dated 7 October 2008 setting out guidelines to clarify their obligations in managing the trust estate.

(b)  Most unusual type of trust

9.80  The existence of a custody trust was disputed in court. It was argued in Lomas v RAB Market Cycles (Master) Fund Limited (2009)62 (‘MCF litigation’) that the following features of the LBIE prime brokerage arrangements, which reflect the industry norm, were nonetheless incompatible with a trust:63 the pooling of client assets;64 the use of sub-custodians;65 equivalent rather than in specie delivery rights;66 the option to cash out the equivalent delivery obligation;67 the right of rehypothecation; settlement blocking rights;68 and close-out on default.

These are cogent submissions, and amply sufficient to demonstrate that if any trust is created by the [prime brokerage agreement], it is a most unusual type of trust. Nonetheless, I have not been persuaded by Mr Peacock’s conclusion that the effect of the Agreement in relation to securities is that it creates no trust known to English law.69

9.81  Mr Justice Briggs (as he then was) found a clear intention to create a trust.70 He went on to hold that the following features were compatible with trust: pooling, provided client assets were segregated from house;71 the use of sub-custodians, the consequences of which were practical rather than legal;72 equivalent delivery, on the basis of co-ownership,73 even if the delivered securities are not fungible with those originally deposited;74 the option to cash out the close of rehypothecation, on the basis that it amounted to client protection;75 close-out on default, notwithstanding prima facie incompatibility with trust,76 and further notwithstanding that it may operate in the default of the client;77 because it is optional in the default of the prime broker;78 settlement blocking rights.79

(p. 188) 9.82  Even though the right of rehypothecation is prima facie inconsistent with a trust,80 it was analysed as a right to substitute trust assets.81 On this basis the right of rehypothecation, and the credit exposure of the client when it is exercised, was held to be compatible with a trust, again because of the clear intention to create a trust.82

9.83  Thus, Mr Justice Briggs concludes that custody securities were held by LBIE on trust for clients.83 This is an extraordinary example of English judicial commitment to freedom of contract, and the associated willingness to treat doctrine as extremely elastic.

4.  Custody cash protected

9.84  As indicated above, the basis of the finding of a custody trust was contractual interpretation.84 The judgment went further, and found that the trust extended to the proceeds of client securities. Curiously enough, this extension was found notwithstanding the express terms of the Agreement.

9.85  In order to avoid client money obligations, clause 5.2 of the prime brokerage agreement provided that full title to cash held by LBIE for the client was delivered to LBIE as collateral, so that the client was an unsecured creditor outside the protection of the client money regime. Because of delays in the return of custody assets, all the custody securities had been redeemed.85 The issue was whether the client must prove for the redemption proceeds as unsecured creditor under clause 5.2, or whether the redemption proceeds were held on the same trusts as the custody assets from which they derived. The administrators sought directions from the Court.

9.86  It was held that the redemption proceeds were held on trust. Even though the express provisions of clause 5.2 extended to all cash held for the client,86 a term was implied that the carve-out in clause 5.2 did not apply to sums received after the failure of LBIE.87 The interests of client asset protection88 and justice89 were invoked.

5.  Theory and practice (first catch your rabbit)

9.87  If the English courts were zealous to defend the custody trust, and if at law the trust is effective to protect assets in insolvency, then what went wrong? The answer to this question illustrates the painful difference between theory and practice. Before assets could be delivered up to any client, the administrators had to identify those (p. 189) assets, in many cases obtain control of them, and ascertain the extent of the client’s entitlement.90 This last point proved particularly difficult, because of the complexity of the encumbrance affecting client assets. As Mrs Beaton is apocryphally said to have begun her recipe for rabbit pie, ‘First catch your rabbit.’

C.  Process

9.88  The gap between legal doctrine and practical reality was nowhere clearer than in the process of client asset recovery. Insolvency is a collective procedure that may take many years to conclude. In theory, property rights against the insolvent can be enforced outside the insolvency process, neatly sidestepping its complexities and delays. It has traditionally been argued that in English law, legal rights are remedies.91 The historic purpose of asserting property rights was to obtain the remedy of vindication, or a court order for the return of assets to the owner out of possession. But, when LBIE failed, clients found that they were not able to recover their custody securities, either from the administrators or through the courts.

1.  Inability to recover assets through courts

9.89  In the MCF litigation (2009),92 Mr Justice Briggs referred to ‘… up to 900 Counterparties, many of whom demanded the return of their securities shortly after LBIE went into administration, but were refused’.93 The administrators’ basis for the refusal was practical rather than doctrinal: ‘… they have nonetheless thus far resisted their delivery to Counterparties on demand, because to have done so would have been contrary to the efficient conduct of the administration’.94 Thus, ‘[d]emands by numerous Counterparties for the transfer of their securities portfolios to replacement prime brokers, or for their delivery up (whether or not by way [of] redemption) were routinely declined and, … no Counterparty obtained the permission of the court to bring proceedings to enforce a delivery up of securities.’95

(a)  RAB Capital v LBIE (2009)

9.90  In the case of RAB Capital (2009),96 a hedge fund client, whose proprietary claims to the custody assets were not disputed,97 sought an order to expedite a hearing for the return of its assets. This was on the familiar basis that, to the extent of third party property rights, assets held by the company do not form part of the pool subject to insolvency proceedings.

(p. 190) 9.91  Those of us who had cherished the trust as the instrument for ring-fencing custody assets from custodian insolvency were shaken to read that the claim was rejected. It was rejected principally on the grounds that an order would open the floodgates for individual applications; this in turn would disrupt the orderly collective distribution which was the role of the administrators, not the court.98 (The other point was that an English court order would be futile where assets were out of the jurisdiction, with LBI acting as sub-custodian in New York.)99

2.  Role of administrators

(a)  LBIE

9.92  In the event, LBIE the trust estate was handled by the administrators as an inseparable part of the administration. With hindsight, inseparability of the trust estate from the house estate appeared to turn principally on the complexity of the encumbrance to which the trust estate was subject. As discussed below,100 trust assets were subject to complex security arrangements. Their complexity had two key aspects. Firstly, the secured liabilities of clients were complex in themselves, as they related to elaborate portfolios of financial transactions including hard-to-value derivatives positions. Secondly, the secured liabilities were owed, not only to LBIE, but also to its affiliates under the famous ‘extended lien’101 included in standard prime brokerage documentation. The extended lien generated disputes and litigation between LBIE and its affiliates.102 Since these affiliates also acted as sub-custodians of client assets, the disputes significantly delayed their return to clients.

9.93  Again with hindsight, this should have been predictable. The essence of prime brokerage is for the well-resourced investment bank to lend its resources to enable the thinly-capitalized hedge fund to pursue its complex trading strategy on a scale greatly exceeding its capital base. It does this by sophisticated collateral structures that squeeze every last drop of credit protection from an already complex portfolio. The hope that trust estate assets would be readily separable from the cross-claims the subject of the administration proceedings, was always forlorn. The client asset protection pinch point was not in the administration, but in the combination of the prime brokerage business model, and the basis of UK client asset protection in trust law. The latter necessarily implies asset recovery, as opposed to the market based solution to counterparty default, namely close-out.103

(p. 191) (b)  Potential conflicts

9.94  Assets controlled by the insolvent may be allocated to the trust estate, or to the house estate, but not to both. This raises the potential for conflicts of interest.

(c)  SAR objectives

9.95  In the event, potential conflicts between trust and house estate were sought to be addressed for the future in another way. A new insolvency procedure for investment banks, known as special administration, was introduced following LBIE.104 Under this procedure the administrator has three special administration objectives,105 one of which is ‘to ensure the return of client assets as soon as reasonably practicable’.106

3.  Consensual collective solutions

(a)  Complexity and uncertainty

9.96  There has been much comment on the complexity of the arrangements handled in the LBIE administration and also the novelty of the issues arising. Because of this, it was often difficult for the administrators to establish the best way of dealing with client assets, agreeing the same with clients, and/or ensuring that they were not exposed to potential liability.

(b)  Lack of statutory scheme

9.97  In this respect administrators were disadvantaged by the lack of a mandatory scheme for custody securities. The administrators sought to create such a scheme for custody securities under Part 26 of the Companies Act 2006,107 but the proposed Client Asset Scheme was rejected both in the High Court108 and also the Court of Appeal.109 This rejection was on the basis that the framework for such statutory schemes related to the rights of creditors in their capacity as such, and not to property rights.110

(c)  Contractual schemes

9.98  The administrators then offered to clients a contractual scheme in like form to their proposed mandatory scheme that had been rejected,111 the Claim Resolution Agreement (CRA) in respect of custody claims against LBIE. Many clients accepted its terms. Those that did not had to be dealt with painstakingly on a case by case basis.

9.99  Some judicial assistance was given when the bar date for client asset claims proposed by the administrators was approved by the High Court.112

(p. 192) 9.100  When in June 2013 the dispute between LBI and LBIE was resolved and significant client assets released by LBI to LBIE, the administrators formulated another consensual collective solution to deal with the released assets, namely Consensual Proposal effective the same month.

9.101  In respect of client money, ‘A Client Money settlement offer was made in February 2014 to settle those counterparties at 100% of their CME113… in exchange for an assignment of their CME to LBIE’s nominee. 54 of the 55 counterparties accepted the settlement offer and payment was made on 10 April 2014.’114

(d)  SAR pro-ration

9.102  After LBIE, under the SAR procedure, any client asset shortfalls are to be pro-rated.115 But SAR falls short of a full statutory scheme of distribution.

(e)  Collective loss bearing

9.103  The collective loss bearing of client asset shortfalls under SAR, and under the consensual collective solutions negotiated in LBIE’s administration, are nothing new. It is of course consistent with the pari passu principle in the handling of ordinary unsecured claims in insolvency. It is also consistent with the treatment of property claims within a fund that suffers shortfalls, whether under the Client Asset Distribution Rules,116 or in case law where the separate ascertainment of individual entitlements under the tracing rules is impracticable, due to the complexity of the arrangements.117

D.  Property remedies rejected as impracticable

9.104  Thus, the traditional model of individual property rights can find no traction on the pooled and sub-custodied securities, subject to rehypothecation, close-out, and elaborate encumbrance, held by LBIE and its associates. Just as the traditional proprietary remedy of the return of the assets was not available through the courts, (in relation to client’s application for the early return of their securities), so common law tracing was rejected by the administrators (in relation to client money), as discussed in the next section.

1.  Client money

(a)  LBIE CM litigation and treatment of under-segregation

(i)  Overview of litigation

9.106  LBIE was authorized to hold client money. It took the alternative approach to segregation,120 and accordingly all client money receipts were paid initially into the house account, and segregated the next business day following reconciliation. LBIE’s administration was a primary pooling event,121 triggering the client money distribution rules. LBIE had massively under-segregated client money. Most unsegregated client money (c $3 billion) had been received for associate companies.122 Further, an associate company acting as client money bank, Lehman Brothers Bankhaus AG (LBB) became insolvent (‘a secondary pooling event’)123 taking down with it124 c $1 billion segregated client money (memorably described by Briggs J as ‘the double whammy’).

Key issues and decisions

9.107  In this discussion, clients whose client money should have been, and was, segregated are called ‘segregated clients’. Clients whose client money should have been, but was not segregated are called ‘unsegregated clients’.

9.108  Litigation amongst LBIE’s administrators, affiliate companies, and clients raised many complex arguments, and the following is a considerable simplification. The essential dispute was between segregated clients (who wanted to claim the whole of the recovered client money) and unsegregated affiliates (who wanted to share it). The three key issues considered in all three hearings, and the decisions relating to them, were as follows.

When client money trust arises

9.109  The courts had to determine at what point client money receipts by the firm are impressed with the statutory trust. The specific question was whether the client money trust arose (i) when money is received by the firm, or (ii) later when it is segregated. Alternative (i) helps unsegregated clients.125 Alternative (ii) helps segregated clients.126

9.110  Every judge at every hearing agreed with (i). Thus, the statutory trust arises upon receipt of client money, and not later upon segregation.

(p. 194) The rights of unsegregated clients to distributions

9.111  The courts considered whether unsegregated clients were entitled to distributions from the client money pool. Two possible bases for distribution were considered: (a) Distribution amongst segregated clients only (the ‘contributions basis’); and (b) distribution amongst segregated and unsegregated clients alike (the ‘entitlements basis’).

9.112  The first instance decision was for the contributions basis. Briggs J (as he then was) found that the client money regime assumed total compliance by the firm, and provided no remedy for non-compliance.127 The only recourse for unsegregated clients was to look to the law of tracing.

9.113  This was overturned in the Court of Appeal, which found that the assumption of total compliance was unreal,128 and the contributions basis was unfair. Moreover the contributions basis better served MiFID client asset protection objectives.

9.114  The majority in the Supreme Court favoured the entitlements basis, again citing unreality of assuming total compliance, fairness, and MiFID client asset objectives. (A minority, Lords Walker and Hope, chose the contributions, raising concerns about delays associated with the entitlements basis.)

9.115  Thus on the firm’s failure, if under-segregation has occurred, unsegregated clients are entitled to share in the CM pool.

Components of CM pool

9.116  The third issue, which is closely related to the second, is to identify the components of the client money pool. Does the CM pool comprise (1) only segregated CM, or (2) also CM that should have been segregated but was not?

9.117  Option (1) benefits the general creditors of the insolvent firm; option (2) benefits its clients.

9.118  First instance held in favour of alternative (1). This was overturned in the Court of Appeal, which held that the client money pool includes money that should have been segregated but was not, provided it can be identified (in accordance with alternative (2)).

9.119  Alternative (2) was upheld by a majority in the Supreme Court. The minority favoured alternative (1) (consistently with their findings on the second issue).

9.120  Thus, on the firm’s failure, the CM pool comprises (i) segregated CM, and (ii) identifiable CM held in house accounts.

Key implications

9.121  The case has a number of interesting implications, going beyond the administration of LBIE.

(p. 195) Client due diligence inconclusive

9.122  In relation to a solvent firm, no due diligence can assure a particular client that their money is safely segregated. This is because, even if that client’s money is fully segregated, they would share in any shortfalls in the client money pool due to the firm’s failure to segregate other clients’ money.

Alternative approach and fiduciary duty

9.123  The next point relates to client money credited to the house account pending segregation under the alternative approach.129 The firm’s duty to treat the house account as a mixed fund in these circumstances is not new. But the case law now clarifies that such duty is fiduciary as well as regulatory. This may increase the firm’s legal exposure if it debits its house account so as to dip into the client element. In turn, this emphasises the importance of maintaining a prudential balance.

Recourse for unsegregated clients

9.124  The impact of the decision for the unsegregated clients of failed firms is more procedural than substantive, but crucial nonetheless. They are not obliged to bring a separate tracing action to seek to recover unsegregated client money. But the requirement for identifiability under the Supreme Court decision functionally equates to the requirement for a continuing fund under equitable tracing rules. The result is in effect to incorporate the equitable tracing rules into the client money distribution rules. This is unlikely to serve the regulatory objective of quick distribution.

(b)  Administrators reject tracing

9.125  The (well advised) administrators did not embrace the Supreme Court’s equitable offering with enthusiasm. As late as September 2013, they reported that the basis of client money distribution was still unclear.130 They decided not to trace, on the basis that it was impracticable.131

9.126  Thus, the proprietary remedy offered by the courts was judged to be ineffective by the administrators.

(c)  Clients release CME

9.127  Nor did client money clients show enthusiasm for property rights. As indicated above,132 the handling of the house estate proceeded largely through consensual collective solutions. The administrators settled remaining client money entitlement (CME) claims by in effect offering to buy them out.133 Clients chose for the most part to release CME, either to offset liabilities to the house account (in effect, to bring client money into set off) or simply in order to prove as general creditors.134,135

(p. 196) 9.128  Litigation following the failure of another firm, MF Global, supported the position that contractual claims may prove more valuable than beneficial property claims. Heis v Attestor Value Master Fund LP and Schneider Trading Associates Ltd.136 concerned client open positions that had appreciated in value since the failure of LBIE. It was argued that the hindsight principle of insolvency should apply, so that the client money entitlement was calculated as at the failure of the firm, but on the basis of the subsequent liquidation value. This was rejected, and Richards J held that no hindsight principle applied within the client money regime. It followed that beneficial claims and debt claims will diverge in moving markets, and debt claims will prove more valuable in rising markets.137

(d)  Use of credit derivatives

9.129  Following LBIE, professional clients of other firms have in practice preferred not to place their funds with those firms subject to client money protection, but rather to take their credit risk, and manage it through a credit derivative from a third party protection seller. Again, contract is king and property rights of less use.

2.  Client securities

9.130  As with client money, so with client securities. As indicated above, there was a very high uptake of the contractual collective scheme proposed by administrators. Further, assets that were recovered from LBI were liquidated before distribution to clients.138 None of this is characteristic of traditional property remedies.

E.  Practical problems

9.131  Thus, property rights proved an inadequate remedy in the insolvency of a complex financial institution. The author had believed that client property rights would be an invulnerable aegis in insolvency, sweeping all before it and simply lifting the claimant above the misery of the collective insolvency procedure. Now, sadder and wiser, she must admit that the exquisitely developed doctrine of property rights and remedies in English law simply did not work on this occasion. The reasons for this were practical and not doctrinal.

1.  Complexity and scale of exercise

9.132  The client asset pool comprised vast numbers of different assets,139 much of it out of LBIE’s control in the hands of (it is understood) some eighty international (p. 197) sub-custodians, with whom communications were imperfect and relations sometimes litigious. The composition of the pool fluctuated through post insolvency settlements140 and redemptions.141 Valuation was challenging.142 Very large numbers of clients made claims, sometimes competing,143 on these assets.144 The extent to which their claims were valid depended inter alia upon rehypothecation practice, and also (as discussed below) upon complex security and netting arrangements under the terms of the prime brokerage agreements. Under these, client entitlements varied with changing values of open derivative positions145 and assets. Some derivatives positions proved difficult or impossible to close.146 As well as much of the relevant assets, much of the relevant data was outside the administrators’ control. The quality of data that was available was sometimes poor.147 As understated by the administrators, ‘The identification, securing, reconciliation and return of Trust Property are complex and highly technical areas.’148

2.  Affiliate disputes and assets out of the jurisdiction

9.133  There was continued litigation with overseas affiliates, and this included those holding client assets, most notably Lehman Brothers International, Lehman Brothers Hong Kong and Lehman Brothers Bankhaus AG.

(a)  Recovery from sub-custodians (title disputes)

9.134  A key challenge for the administrators was recovering client assets, or at times even receiving information, from insolvent149 affiliates acting as sub-custodians.150 The chief of these was Lehman Brothers International151 in New York (LBI),152 which held client securities for some 300 LBIE clients,153 and which was subject to proceedings under Securities Investor Protection Act 1970 (SIPA). The process of establishing what client assets were returnable to LBIE was complicated by many factors. The two entities used different definitions of client assets.154 The client asset (p. 198) records of LBIE and LBI differed significantly and had to be reconciled,155 and methodologies for handling client asset claims had to be agreed.156 Litigation was commenced.157 Pending trades158 and open positions159 complicated the figures. The client asset pool held by LBI fell short160 of the competing claims upon it,161 including claims from LBI itself.162 Communications between the two entities were far from perfect.163

9.135  As indicated above, the fact that the assets were out of the jurisdiction and therefore not immediately recoverable by order of the High Court was cited as a reason for withholding an order for their return to the client in the RAB case.

(b)  Recovery from CM banks (recognition failure)

9.136  In relation to Lehman Brothers Bankhaus AG (‘LBB’), which acted as a client money bank for LBIE, the German courts did not initially recognize the priority of CM claimants over general creditors.164 The recovery of client money from LBB in Germany was delayed by litigation.

3.  Tax

9.137  When client assets were finally recovered following settlement between LBIE and LBI, further delays were introduced by uncertainties as to the US tax treatment of the recovered assets. The administrators were obliged to make reserves pending agreement with the IRS. Final agreement with the IRS was a (long-delayed) breakthrough.165 (UK tax was less problematic.)166

4.  Disputed title to client money entitlements (BarCap)

9.138  A major delaying factor affecting client money distribution was the LBI/BarCap dispute.167 ‘BarCap has asserted that it acquired LBI’s CME in accordance with the terms of a sale and purchase agreement entered into in September 2008…. LBIE does not currently anticipate that this issue will be resolved before the related US-based litigation between LBI and BarCap is concluded.’168

(p. 199) F.  Central issue: complexity of encumbrance key factor in delays

9.139  It is hard and possibly unwise to make generalizations about such complex events. Nevertheless, if one looks at the experience in functional terms, a central issue emerges as the key factor in the delays in the release of client assets. This is the complexity of encumbrance.

1.  Security and close-out

9.140  Prime brokers extend credit to their hedge fund clients, and secure the associated exposures by taking security over the clients’ portfolio assets, including their custody securities. It followed that, even where LBIE itself originally controlled custody assets or had been able to recover them from sub-custodians, its administrators were unwilling to return such assets to a client until that client’s liabilities were discharged.169 The pattern of trades under which such liabilities arose, and thus the quantification of the liabilities, was complex, particularly in relation to open and hard-to-value positions.170

2.  Set-off

9.141  A further delaying factor was that shortfalls in the return of client asset conferred on affected clients unsecured claims against LBIE. These in turn would offset and so reduce the liabilities secured on their custody assets. This meant in effect that delays in recovering assets and ascertaining shortfalls from sub-custodians in turn affected the return of assets controlled by LBIE.171 This circularity did not expedite matters.

9.142  For their part, clients were unwilling to pay their debts to LBIE pending the return of client assets to them, creating a stand-off.172

3.  Client liabilities

9.143  Even in the absence of client default, provisions were typically included in standard form prime brokerage agreements relieving the prime broker of its obligation to comply with instructions to release inter alia custody assets at any time when any secured liability is outstanding. The administrators appropriated assets from client to house to discharge client liabilities. Thus, as well as ascertaining client asset entitlements and recovering assets, it was necessary to go on to ascertain sums due from client asset claimant debtors.

9.144  Further, the secured liabilities are typically defined to include an indemnity given by the client. In turn, the indemnity is drafted to include contingent and future obligations of the client. These may include medium or long term obligations, and the client may not be entitled to recover its long positions until they have matured.

(p. 200) 9.145  This problem would be addressed by two-way events of default, whereby in the default of the prime broker, the client was entitled to close out the cross claims. Future and contingent liabilities would be accelerated, valued, and brought into account. See section IV.I below.

4.  Extended lien

9.146  The picture was complicated yet further by the fact that the secured liabilities were not limited to those owed to LBIE, but included those owed to its affiliates.173 Under the terms of its standard prime brokerage agreement, LBIE contracted, and took the benefit of the security interest, both for itself and as agent and trustee of its affiliates.174

9.147  The extended lien involved LBIE in fiduciary duties to affiliates, and it followed that the administrators were unwilling to release client assets while secured claims against clients were being asserted by affiliates.175 The administrators required that any dispute about such claims be taken up by the client directly with the affiliate.176 Unsurprisingly, this further delayed the return of client securities.177 Disputes between LBIE and LBI, and also LBIE and LBHK, were a considerable delaying factor.178,179 Resolution of these disputes was a breakthrough in the release of client assets.180,181

9.148  Thus, LBIE was for a long period not able to release assets in its control because of the uncertainty of liabilities to affiliates under extended lien; and further not able to recover assets from sub-custodian affiliates, particularly LBI and LBHK, again because of disputes about affiliate liabilities secured by extended lien.

9.149  The terms of the security interest contained in LBIE’s prime brokerage agreement were typical in the industry. The commercial intention behind the drafting was to confer the greatest possible credit protection on the prime broker in the default of the client. This is done by defining secured liabilities very widely,182 to include those owed to affiliates, and also those arising only after a final reckoning of the mutual dealings between the parties. This latter point is included because, on the default of the client, the most effective form of credit risk management is the close-out netting of underlying master agreements for market transactions; the security interest protects any excess exposure remaining after close-out netting has taken effect. But (p. 201) in the default of the prime broker, such drafting was another delaying factor. This is because it made the release of client assets dependent on so many other operationally difficult procedures. As already indicated, these included the final determination of client asset shortfalls, the valuation and netting of complex portfolios of positions, and the agreement and discharge of affiliate liabilities.

9.150  Thus, in effect, the drafting of the security interest necessarily postponed the release of client assets to the completion of much of the insolvency procedure.

9.151  The usual warning given by lawyers prior to LBIE’s failure, that the magical effect of property rights was subject to the terms of any security, and possible insolvency-related delays and expenses, proved to be a considerable understatement.

G.  Impact of rehypothecation

9.152  The LBIE client asset delays have sometimes been treated as a cautionary tale about rehypothecation. But as discussed below, rehypothecation appears to have been a considerably simpler issue to resolve than the extended lien.

1.  Not major delaying factor

9.153  The legal effect of rehypothecation in the EU is clear and well understood, at least by lawyers.183 It is clarified by legislation across the EU,184 and has never been in serious dispute. The client’s rights in respect of unrehypothecated custody assets are proprietary; in respect of rehypothecated assets they are contractual.185 On this basis, that part of the custody securities balance that has not been rehypothecated is returnable to the client by the insolvency official; that part of the securities balance that has been rehypothecated is not, and the client must rely on any netting rights, or prove as an unsecured creditor.

9.154  The administrators of LBIE nevertheless faced client asset claims for rehypothecated assets,186 giving rise to significant187 ‘over-claims’.188 ‘Pending resolution, these Over-Claims delay the release of the impacted assets to valid claimants.’189 Such over-claims were a category mistake, and conceptually190 straightforward for (p. 202) the administrators to resolve.191 They were a misunderstanding of a legally simple situation.

9.155  However, an important operational point arises. It is not current practice to show the extent of rehypothecation in the securities balances maintained by prime brokers in favour of their clients. These currently show client long positions; the extent to which these long positions comprise trust assets, and the extent to which they comprise contractual rights of equivalent delivery, must be ascertained by reading securities balances together with the latest daily client rehypothecation notice. Reforms that show the extent of rehypothecation on the securities balance would greatly assist the insolvency official.

2.  Rehypo credit exposure not material disadvantage

9.156  This credit exposure of the rehypothecated client under English law may have been underappreciated by those used to New York prime brokerage, who may have assumed that the position in the prime broker’s insolvency would be as it was under SIPA.192Regulatory concerns about the credit exposure involved in rehypothecation have resulted in both restrictions on the use of rehypothecation, and transparency where it is permitted. But it appears that, in the LBIE administration, rehypothecated clients were not materially disadvantaged relative to unrehypothecated clients, for the following reasons.

(a)  Shortfalls resolved

9.157  Client asset shortfalls193 were soon identified during the administration,194 but these were greatly reduced by the settlement with LBI, and the associated Consensual Proposal for distributing LBI recoveries (including compromising shortfall claims).195 A key issue was that English trust law (unlike SIPA in the US) did not permit surpluses in one type of client securities to offset shortfalls in another.196 It is understood that following collective agreement with clients, there was no significant ultimate shortfall in securities on either house197 or trust estate (at least in relation to clients who were not associates of LBIE).198 (p. 203) Indeed, surpluses were identified in both trust199 and house200 estates, and over-segregation was identified in some securities.

(b)  Timing not extent of recovery

9.158  Thus, the issue was not so much the extent of the recovery, but its timing. It is possible that, by proving as general creditors, rehypothecated clients would have recovered sooner than client asset claimants. Certainly, such a position for client securities would have been consistent with the choice, discussed above,201 of client money claimants to convert their proprietary claim into an unsecured claim under the client money settlement

H.  Compare US experience

9.159  Because of the very long delays in the UK,202 the experience of custody clients in the UK administration of LBIE203 compared unfavourably to that of custody clients in the US liquidation of LBI under the Securities Investor Protection Act (SIPA).204 It is understood that private asset management accounts, and related client assets, were seamlessly transferred to Barclays under an asset purchase agreement;205 and that the SIPA trustee established a voluntary scheme to transferring prime brokerage client accounts, together with associated client assets, under a Prime Brokerage Protocol.206 ‘All told, in less than one year following commencement of the LBI case, the Trustee transferred more than 110,000 customer accounts representing (p. 204) assets of more than US$92 billion. The definitive settlement [agreement was] approved by the Bankruptcy Court…’.207

9.160  The lesson that account transfer is preferable in such cases was not lost. Significant legislation, particularly the regimes relating to resolution, and (in relation to client assets taking the form of margin posted to CCPs) under EMIR, have facilitated the transfer of client assets, together with associated positions, from failing firms to successor service providers.208

I.  Key role of securities finance in failure

9.161  The key lesson from LBIE for client asset protection is the role of securities finance in the delayed return of client assets. It was about prime brokerage, in which the client portfolio serves as a collateral base for significant leverage. It was not about plain vanilla custody, in which the firm holds, settles, and administers the portfolio, and takes security principally only for costs and settlement-related exposures. Prime brokerage and plain vanilla custody are radically different services. While prime brokerage includes a custody element, the lessons of LBIE lie outside that, in the complex financing and collateral arrangements that defeated a speedy return of client assets. LBIE held no lessons for plain vanilla custody.

9.162  But the impact of securities finance on the custody aspects of prime brokerage has been underappreciated, despite the very considerable regulatory reforms that have sought to address client asset protection after LBIE. It has been argued here that the impact of securities finance was to render property rights unfit for the purpose in protecting client assets in the administration of LBIE.

9.163  One size no longer fits all; two separate client asset protection regimes are recommended for plain vanilla custody, and prime brokerage (or other custody services associated with securities finance of significant complexity). The former can continue to be based on property rights. The latter should be based on close-out, with two way events of default. Particular regulatory attention should be (p. 205) given the firm’s discretion in valuing collateral, both for margining and haircut purposes.

9.164  While this was proposed by the author following the failure of LBIE,209 the idea was not taken up. The best hope must be that, when the next LBIE fails, existing reforms are sufficient to ensure a better outcome.

1.  Legitimacy

9.165  The key lesson of LBIE for rehypothecation is operational: the importance of clarity of entitlement and also of mandate. There is scope for reform in this area. Subject to that, it is argued that rehypothecation is a legitimate exercise of freedom of contract within a specialized and sophisticated market sector (hedge funds and their prime brokers). It is essential to the business model of prime brokerage, and is the foundation of the credit granted to hedge funds that in turn enables them to provide market liquidity.

2.  Market responses

9.166  The inability of hedge funds promptly to recover their assets in the administration of LBIE caused a significant change in market practice from the buy side.210 Contractual hypo limits tightened. Some funds began to appoint multiple prime brokers, thereby avoiding having all their eggs in one basket (but by the same token foregoing the efficiency of portfolio consolidation). Where multiple prime brokers were appointed by a fund that fund typically became reluctant to over-collateralize, ie to place significantly more assets with a particular prime broker subject to the prime broker’s security interest than was required to collateralize liabilities. In some cases third party custodian arrangements have been established. Although this raised operational challenges, it also became a general requirement under AIFMD.211

V.  Post-Crisis Client Asset Measures

9.167  Rehypothecation reforms have been introduced in the UK, internationally and in the EU.


9.168  After LBIE, new transparency and operational requirements were imposed on prime brokers in relation to rehypothecation by the FSA (now the FCA).

(p. 206) 1.  Daily reports

9.169  Daily reports212 must be made to clients on their assets and positions,213 including ‘where the firm has exercised a right of use in respect of that client’s safe custody assets’.214

2.  Disclosure annex

9.170  Also, the prime brokerage agreement is required to include a disclosure annex,215 setting out key contractual provisions relating to rehypothecation,216 including: hypo limits;217 related definitions;218 numbered references to contractual provisions;219 and a statement of key risks including in the firm’s insolvency.220 The disclosure must be updated to reflect relevant changes to the prime brokerage agreement.221

3.  Systems and controls

9.171  A prime broker must not rehypothecate unless (very broadly) the responsible individuals within the organisation are satisfied that it has adequate systems and controls.222


9.172  Internationally, the Financial Stability Board (‘FSB’) has made recommendation for rehypothecation, as part of its work on shadow banking risks in securities lending and repos.223

9.173  The FSB’s recommendations for restricting rehypothecation are designed to address client asset protection, as well as systemic risks. The recommendations relate to: client disclosures;224 purpose tests (client financing only, which reflects (p. 207) existing best practice);225 liquidity regulation;226 and cash collateral reinvestment.227 A client asset protection expert group should consider harmonization of re-hypothecation.228 ‘Such harmonised rules could set a limit on re-hypothecation in relation to client indebtedness. The FSB thinks client asset regimes are technically and legally complex and further work in this area will need to be taken forward by expert groups.’229


1.  Restrictions on use of client financial instruments

9.175  Article 16(8) of Level 1 requires firms holding to make adequate arrangements inter alia to prevent the use of a client’s financial instruments on own account except with the client’s express consent.

9.176  Article 5 of Level 2230 imposes further restrictions. Use (in including securities finance transactions) of client securities is only permitted with the client’s prior, express, written, and affirmative, and signed consent;231 and in accordance with the terms of that consent.232

9.177  Securities finance transactions using financial instruments held in omni accounts are not permitted unless, in addition, either each client participating in the omni account gives prior express consent;233 or the firm has systems and controls restricting such use to the financial instruments of consenting clients.234

9.178  Firms must take appropriate measures to prevent unauthorized use,235 such as (broadly) securities lending or unwinding in the event of failure to pre-position for (p. 208) settlement;236 close monitoring of ability to deliver on settlement day, and remedial measures if necessary;237 and close monitoring and prompt call of undelivered securities.238

2.  Inappropriate use of title transfer collateral arrangements

9.179  Note also the restrictions on the use of title transfer collateral arrangements.

9.180  Article 16(10) of Level 1 bans TTCA with retail clients.239

9.181  Article 6 of Level 2240 bans its ‘inappropriate use’ with non-retail clients, very broadly as follows. Firms must (in effect) be able to demonstrate that they have considered the relationship between a client’s assets subject to TTCA and the client’s obligations to the firm.241 In order to show that TTCA is appropriate it must take into account: the strength of the connection between the client’s obligation and the assets subject to TTCA;242 excessive margin;243 and whether client assets are subject to title transfer collateral arrangements, irrespective of the client’s obligations.244 Risk warnings must be given.245


9.182  Under the AIFMD,246 rights of rehypothecation must be defined by contract and comply with fund rules.247 Further, the manager must set rehypothecation limits for each fund as part of risk management.

(p. 209) 9.183  The manager is required to set rehypothecation limits for each fund as part of its risk management,248 taking account of a number of factors including the need to limit exposure to any single counterparty.249 (This requirement reflects market practice following the failure of LBIE.)

9.184  Under article 91 the AIFMD level 2 Regulation250 the prime broker must make statements available to the depositary containing, inter alia, the value of all rehypothecated assets.251 If this same statement is also made available to clients, CASS daily statement requirements are treated as satisfied.252


9.185  Article 22(7) of the Level 1 UCITS V directive253 restricts the reuse of the custody assets of a UCITS fund. Reuse is defined extremely widely.254 There is a general prohibition on reuse.255 By way of derogation from this, reuse is permitted where it satisfies each of a series of criteria.256 These are, very broadly, that the reuse is: (a) for the account of the UCITS;257 (b) on the instructions of the manager;258 (c) for the benefit of the UCITS;259 and (d) well collateralized.260 Further, a haircut must be taken.261


9.186  In respect of non-centrally cleared OTC derivatives contracts, EMIR262 requires financial counterparties to practice the segregated exchange of collateral.263

(p. 210) 9.187  The final draft Regulatory Technical Standards on Uncleared Margining264 prohibit the rehypothecation of initial margin.265

1.  CCP

9.188  The CCP may have a right of use relating to margins or default fund contributions collected under a security interest, provided that this is provided for in its operating rules and clearing members confirm acceptance in writing, and the CCP publicly discloses this right.266 Reuse must be exercised in accordance with the CCP’s investment policy.267 This requires rehypothecated financial instruments to be deposited in securities settlement systems where available, or other highly secure arrangements with authorized financial institutions.268 The effect of this is likely to be the warehousing of securities collateral in CCP’s custody accounts, putting a stop to the practice of collateral reuse as long as it is posted to the CCP. This has possible implications for liquidity in the shadow, and therefore in the regulated sector. We may anticipate pressure in the medium term for CCPs to become collateral intermediaries.


1.  Definition of reuse

9.190  Reuse is defined271 as, broadly, the use by a collateral taker, on its own account or on the account of another counterparty, of financial instruments272 received as collateral under a TTCA, or under a security interest plus right of use. Liquidation on default is not reuse.273

(p. 211) 9.191  Because agency securities lending is undertaken by custodians for the account of the client, this is not caught by the definition, even though the client portfolio is subject to the custodian’s charge.

2.  Right of reuse

9.192  As to the right of reuse, there are four separate requirements,274 as follows.

9.193  Any right of a counterparty to reuse financial instruments received as collateral is expressed to be conditional on:

  1. (i)  the provision of written risk warnings to the providing counterparty (collateral giver);275 including upon the default of the collateral taker,276 and

  2. (ii)  The prior, express and signed consent of the collateral giver to the terms of the reuse.277

3.  Exercise of the right of use

9.194  The exercise of a right of use is in turn conditional on:278

  1. (iii)  compliance with the terms of the collateral arrangement;279 and

  2. (iv)  the transfer of the reused financial instruments from the account of the collateral giver.280

9.195  These requirements are without prejudice to stricter rules under UCITs and AIFMD or elsewhere.281

9.196  It has been argued that the imposition of reuse consent requirements on collateral received under TTCA is inconsistent with the essential nature of TTCA.

9.197  Satisfaction of these requirements is expressed to be a condition of the right of reuse. This raises the question of the status of reuse where the requirements are not satisfied. Is third party title affected? It is provided282 that these requirements shall not affect national law concerning the validity or effect of a transaction. Similar (p. 212) issues arose prior to the protection of rehypothecation under the FCAD under the ‘once a mortgage, always a mortgage’ rule.283 The legal certainty introduced by the FCAD may have been undermined by the SFTR, if the saving in article 15(4) for national law is taken to exclude the FCAD as implemented. But the correct view must be that the FCAR, which implement the FCAD in the UK, are clearly part of national law, so that no recharacterisation risk arises.

I.  Conclusions

9.198  Thus, two points arise on rehypothecation and client asset protection. Firstly, the issue was not a major problem in the administration of LBIE. Secondly, the issue generated a formidable regulatory response.

9.199  It will be argued below that the converse was true of rehypothecation and systemic risk.

VI.  Securities Finance and the Reuse of Securities Collateral

9.200  Having provided the legal and commercial context and considered the client asset protection aspects of rehypothecation, this discussion now turns to the systemic aspects of the practice. This brings us to the securities finance markets.

9.201  Since the financial crisis beginning in 2007, there has been much discussion of securities finance, or shadow banking. Shadow banking is the discharge of bank-like functions outside the traditional banking sector, ie by entities that are not regulated as deposit taking institutions. Securities finance is such an important component of shadow banking that the terms are widely used interchangeably. In securities finance, cheap credit is provided against securities collateral. A distinctive feature of securities finance is the reuse of collateral. Reuse permits both liquidity and a low cost of credit.

9.202  The ‘pull’ factor driving reuse in general, and rehypothecation in particular, is the shadow banking system. This system provides cheap credit for its customers, and handsome profits for its service providers, through securities finance transactions (SFTs). The raw materials of production of this particular industry are the investment grade securities that serve as collateral in SFTs. The shadow’s appetite for high quality securities is vast, notwithstanding reuse.

9.203  Sufficiently vast reserves of such securities can be found in only one place, namely the institutional asset base. Pension funds, insurance companies, and managed funds whether wholesale (in the EU, AIFs) or retail (in the EU, UCITs) comprise (p. 213) the major institutional investors. They are under increasing economic,284 regulatory,285 and commercial286 pressures to enhance their returns to investors. These pressures are increased by the current low interest rate/dividend environment. One solution is to allow their assets to be introduced into, or (to use a term borrowed from securitization) ‘originated’ into the shadow.

9.204  The use of securities collateral in the shadow banking sector involves complex flows of collateral securities amongst financial institutions. The following is a considerable simplification.287

9.205  The systemic importance of rehypothecation is that it forms part of the flow of institutional assets into the shadow.

A.  Origination transactions: reuse into the shadow

9.206  The securities that serve as collateral in shadow banking also enter these markets principally from two additional sources, namely agency securities lending and collateral swaps.

1.  Agency securities lending

(a)  Overview

(i)  Institutional investors as securities lenders

9.207  Institutional investors such as insurance companies, mutual managed funds, and pension funds typically grant securities lending mandates to their global custodians. The mandates permit and require the global custodians to lend the institutional investors’ securities to third parties, acting as agent. These loans are collateralized with cash or other securities, and the fees they generate serve to enhance portfolio returns to the institutional investors.288

(ii)  Broker dealers and hedge funds as securities borrowers

9.208  The chief function of securities borrowing is to cover short positions.289 Typical securities borrowers include broker dealers with short positions arising from their trading and market making (p. 214) activities; and also AIFs with short positions arising as part of a long/short290 or bear trading strategy.291 See Figure 9.6.

Figure 9.6  Securities lending

9.209  A practical aspect of securities lending is that liquid assets flow from the institutional asset base.

(b)  Cash collateral reinvestment

9.210  Cash collateral reinvestment for securities lenders is a relatively new development.

(i)  Collateral

9.211  A securities lender faces the risk of the securities borrower defaulting in its obligation to return equivalent securities to close the loan. This risk is managed by taking collateral, typically in the form of securities292 or cash. As part of their agency securities lending service, global custodians call, receive, hold, and manage collateral on behalf of their securities lending clients.293

(c)  Cash collateral

9.212  Historically, cash collateral was simply placed on deposit. More recently, however, the trend has been for cash collateral to be reinvested by the global custodian on behalf of its securities lending clients in money market instruments.294 This practice is a source of profit for the securities lender, as the assets into which the cash collateral is reinvested typically generate higher returns than the securities lender’s portfolio of investments.

(p. 215) (d)  Asset risk

9.213  Cash collateral reinvestment is also a source of asset risk, as higher returns are associated with poorer credit quality. Further, asset risk may be highly correlated with the credit risk of the custodian, where reinvestment assets are issued by vehicles within the custodian’s group.295 Institutional investors participating in these arrangements suffered significant losses in the financial crisis and regulatory reforms have been proposed to manage such asset risk.

9.214  A practical aspect of securities lending combined with cash collateral reinvestment is a reduction in the credit quality of institutional holdings.

2.  Collateral swaps

9.215  A second category of transaction whereby securities flow from institutional investors into the shadow is under collateral swaps. Collateral swaps were developed by investment banks as a technique for exploiting the high quality portfolios of insurance companies, in order both to enhance returns to insurers and to raise liquidity for themselves.

9.216  It is important to note that a collateral swap is not a swap296 at all, but rather an adaptation of the securities loan.

9.217  A typical transaction involves a securities loan followed by a repo, as follows. (1) The insurer loans high quality, low return securities such as Treasuries to the investment bank, against (2) high return, low quality collateral. (3) The insurer also receives fee income which, together with income from the collateral, improves its portfolio returns. (4) The investment bank then repos the high quality securities to a cash-rich entity such as (for example) a money market fund, in order (5) to raise liquidity for its own operations.

9.218  Under a collateral swap, high quality assets flow from institutional investors into the shadow banking sector.297

9.219  Incidentally, the same technique of providing of high credit quality securities in exchange for lower credit quality securities, so that the counterparty can make use of high quality securities to raise liquidity, is used both in collateral swaps between insurance companies and investment banks, and also in emergency liquidity provided by central banks to participating banks.

(p. 216) 3.  Systemic concern: safe, liquid assets drawn into shadow

9.220  Legal and regulatory gatekeepers failed to see the financial crisis coming. Lawyers focused on particular transactions, and wrote clean opinions on them. Regulators focused on particular institutions, and found them to have adequate capital. These established techniques of private and public risk management missed the build-up of the systemic risks that subsequently materialized and engulfed the global financial markets. The key lesson is that risk analysis should be, not merely transactional or institutional, but also systemic.298

9.221  A systemic point that may be underappreciated is that the securities finance markets serve to erode the institutional asset base. While the subject high quality assets remain on the institutions’ balance sheets, they are not be in their possession or operational control. This might prove significant should the music stop again.

B.  Market transactions: Reuse within the shadow

9.222  The previous section considered reuse into the shadow, or origination. This section considers reuse within the shadow.

1.  Reuse in practice

9.223  The same financial institutions that act as collateral taker in certain wholesale market transactions, also act as collateral taker in others.299 In practice, collateral is delivered from person to person under chains of back to back wholesale market transactions.

9.224  It was estimated that the collateral reuse or ‘churn’ factor immediately prior to the financial market crisis beginning 2007 was four.300

9.225  For example, treasury securities might be (i) rehypothecated from a hedge fund to a prime broker; (ii) delivered by the prime broker to a corporate301 under a repo; (iii) delivered by the corporate to a commercial bank as collateral for a bilaterally cleared swap; and (iv) delivered by the commercial bank to a clearing house as margin for a centrally cleared swap. See Figure 9.7.(p. 217)

Figure 9.7  Reuse of securities collateral

2.  Repo and reuse

(a)  Repo finance

9.226  The repo transaction is a technique for raising cheap short term credit. A transaction which is called a repo for the party raising cash, is called a reverse repo for the party providing it.

9.227  Reverse repos are also used by central banks to advance short term collateralized credit to commercial banks, both in routine open market operations, and also in quantitative easing, emergency lender of last resort operations.

9.228  In turn, commercial banks use reverse repos to provide liquidity to broker–dealers. Reverse repos are also used as an alternative to bank deposits by mutual funds, corporate treasury functions, and other cash-rich financial institutions such as money market funds. Their typical counterparties are broker–dealers. In turn again, broker–dealers provide repo finance to their clients, including hedge funds in their capacity as prime brokers (Figure 9.8). Prior to the crisis, CDO securitization vehicles also used repos to finance the purchase of their portfolios.

Figure 9.8  Repo finance

9.229  Note that all shadow banks are reliant on repos for liquidity.

(i)  Collateralizing repo finance

9.230  Repo credit is collateralized with securities. Broker dealers may collateralize their repos with the securities rehypothecated (p. 218) from the hedge fund client of their prime brokerage operations. Under MiFID II this must be in order to facilitate client transactions.302

9.231  Commercial banks normally collateralize their repo finance from central banks using treasuries, although emergency central bank funding may be collateralized by a wider range of assets.303

9.232  Thus, collateral reuse is the medium for the flow of cash liquidity through shadow system.

(ii)  Use of repo finance to fund long securities positions

9.233  One use of repo finance by broker dealers and hedge funds is to finance their long positions in corporate and government securities.304 As indicated above, prior to the financial crisis, holdings of a type of asset backed securities known as CDOs, were also widely funded in this way.

(p. 219) 9.234  The use of repos to finance long positions also serves an important role in the infrastructure.305

9.235  Thus, collateral reuse through repos is the basis of capital market liquidity.

9.236  The use of short term money to fund large long positions in securities, which may be difficult to liquidate short term, is a source of maturity transformation, raising potential liquidity risk.

3.  Securities lending and reuse

9.237  Collateral deliveries under securities loans take the form of TTCA, which facilitates the reuse of collateral.

4.  Swaps collateral/margin and reuse

9.238  Securities collateral for non-centrally cleared swaps,306 and margin for centrally cleared swaps,307 may be delivered either under a security interest or under TTCA. But in recent decades the preponderance has been delivered under TTCA, which again facilitates reuse. (New provisions under EMIR may cut across this, as mentioned above.)308

5.  Flows of cash and securities

9.239  The combined effect of these five stages is a complex pattern of cross flows of financial assets between wholesale market participants.

9.240  The volumes traded are vast, rivalling the commercial banking asset base. However, contractual obligations are netted under standard documentation. Settlement of cross obligations is also netted, so that actual flows and gross exposures are considerably smaller than contractual values.

9.241  It should be remembered that the arrows in the figures represent only the opening of the trades; for their closing, the arrows are reversed. Many trades are typically short term, but in practice are often rolled over, so that many settlements are not reversed on a short term basis. Also, the charts do not show margin adjustments. Although the chart is radically simplified, it nevertheless shows the density of interconnections, and the liquidity interdependence of institutions participating in securities finance.

VII.  Repo Run

9.242  The experience of the financial crisis for the securities finance markets was traumatic. The first wave of analysis diagnosed a number of important regulatory (p. 220) lessons, particularly the need for more capital, liquidity regulation, better incentives, and the separation of utility and investment banking. But as the crisis continued to unfold, such measures seemed necessary but insufficient. An explanation was still required as to why financial distress continued to spread from the bursting of the sub-prime bubble, through the securitization markets and across the wider financial system, so as to overwhelm so many firms and EU sovereign debtors thereafter. Financial bubbles had been forming and bursting for hundreds of years,309 but rarely affected the whole financial system. What was the virus this time?

9.243  The virus310 has been pinpointed311 in specific transactional practices in the securities finance markets. Accordingly the crisis has been characterized as both a ‘collateral crunch’ and a ‘repo run’. Prior to the onset of the crisis in 2007, haircuts had been extremely low, leading to very high levels of leverage. Asset backed securities based on sub-prime portfolios served as a major collateral category. The collapse of the sub-prime markets caused collateral values to spiral. Securities finance borrowers faced ever more severe haircuts or ‘marks’, reflecting both falling collateral prices and the panic of collateral takers with discretionary marking powers. They were forced into fire sales of assets, in order to roll over trades, and/or to meet margin calls. Fire sales in turn caused price spirals in other asset classes. Borrowers unable to roll over their short term credit faced immediate illiquidity. Those that failed to meet margin calls faced default, cross default312 and insolvency. Thus, the transmission mechanism of financial distress was the hardening of securities finance market practice, particularly tougher haircuts.

9.244  Further, the origination of collateral was interrupted. The failure of LBIE exposed hedge fund clients to significant delays in the return of assets, and as a result, other prime brokers found their rehypothecation rights severely reduced.

9.245  An additional blow to the origination of collateral was the move by institutional investors to restrict the agency securities lending mandates of their global custodians. This was due partly to losses associated with the reinvestment of cash collateral from securities lending; and party due to general risk aversion in turbulent market conditions.

9.246  Together, the severe reduction in rehypothecation and agency securities lending have been termed ‘collateral hoarding’. Securities finance is typically short term, (p. 221) and transactions must be continually rolled over in order to maintain the supply of credit. Such maintenance was important for many ‘shadow banks’ that used this short term money to fund medium or long securities positions (a form of ‘maturity transformation’). However, collateral hoarding (on top of higher haircuts) prevented roll over, and the long positions so funded were in turn subject to fire sales. It will be remembered that securities finance collateral was being reused up to four times. It followed that, for every piece of collateral that was withdrawn from the market, four pieces of credit collapsed. This explains the sudden deleveraging experienced in the period after the failure of LBIE.

9.247  Thus, the systemic propagation of financial distress has been attributed to specific transactional features of securities finance practice, particularly leverage (with excessively low haircuts in rising markets) and maturity transformation (where reuse is not matched with effective liquidity regulation). Regulatory reforms targeting these are discussed in the next section.

VIII.  Post-Crisis Systemic Measures

9.248  Important post-crisis measures have been taken to address systemic risks associated with reuse.


9.249  The FSB’s recommendations to address client asset risks in rehypothecation were mentioned above.313 Its recommendations to address systemic risk314 comprise the following:

  1. (1)  Authorities to collect more granular data on securities finance exposures among large financial institutions;315

  2. (2)  Trade data to be collected through trade repositories and regulatory reporting;316

  3. (3)  FSB to aggregate national date to identify global trends;317

  4. (4)  Enhanced Disclosure Task Force to work to improve firm’s public disclosures;318

  5. (5)  Only entities subject to adequate liquidity regulation to engage in rehypothecation;319

  6. (p. 222) (6)  Collateral valuation and management to be subject to minimum standards;320 and

  7. (7)  Wider use of CCPs to be evaluated.321

9.250  Insolvency law reforms were considered but not proposed.322 Earlier proposals for minimum haircuts were not included.323


9.251  EU implementation of the FSB recommendations in the SFTR was discussed above.324 The requirements are light touch, and primarily confined to transparency.

C.  Generally

9.252  The repo run that followed the failure of Lehmans raised legitimate concerns about system leverage. It must be remembered that, in the EU, reuse is facilitated by the Financial Collateral Regime, and the post-LBIE push-back in relation to securities finance is at this stage primarily confined to transparency.

IX.  Transactional Integrity

9.253  A fundamental requirement of all markets is that the delivery of title (whether under sale and purchase or collateral transactions) should be certain. There should be no general requirement to investigate title. Defects in title should not affect the good faith purchaser. In securities finance, it is also necessary to establish that certainty of title is not compromised by the reuse of collateral.

A.  Once a mortgage

9.254  Contractual rights of rehypothecation may, at general law, be subject to possible legal risk. A body of pre-modern debtor protection rules of equity325 protected the equity of redemption against such contractual waiver in certain circumstances. Where applicable, these rules avoided contractual rights of rehypothecation, and raised possible uncertainty of title for third parties to which the collateral assets were rehypothecated.

(p. 223) B.  FCAD protection of right of use

9.255  However, this legal risk was eliminated by the Financial Collateral Arrangements Directive326 (‘FCD’), which protects contractual rights of rehypothecation.327

C.  Recognition of TTCA

9.256  As mentioned previously, TTCA have long been recognized in English law,328 but are less familiar to the traditional domestic law of civilian jurisdictions. However, the FCD provides329 that ‘Member States shall ensure that a title transfer financial collateral arrangement can take effect in accordance with its terms.’

D.  Recharacterization risk

9.257  Where title disputes arise, these may relate to uncertain characterization. TTCA status may be contractually asserted for a transaction under which the rights and duties of the parties are doctrinally incompatible with that categorization. Alleged TTCA status may be disputed where, for example, assets are blocked in the hands of the collateral taker in a manner suggestive of an equity of redemption. This is called ‘recharacterization risk’, and relates to the misuse, rather than the use, of the available legal structures.330

E.  Position v title

9.258  With reuse, it is important to distinguish the economic position in securities from the legal title to them. While title moves outright the original collateral giver and down the chain of collateral takers, the economic position long remains with the original collateral giver. The equivalent delivery rights of the collateral giver on the close of the reuse is to the same type and same number of securities, not the same value. Thus, the original collateral giver takes any capital gain or loss affecting the securities during reuse. Equally, the original collateral giver is entitled (under market standard documentation) to sums equal to any income generated by the collateral. If A delivers US treasuries to B as collateral, A remains (and B does not thereby become) long US treasuries. This accords with the neutral accounting treatment of collateral transactions.331 The transaction is reflected in notes to the accounts, but (p. 224) the collateral asset remains on the balance sheet of the collateral giver, and does not go on the balance sheet of the collateral taker.

9.259  This separation of legal title and economic position should not be confused with so-called ‘securities inflation’,332 which denotes the duplication (as opposed to transfer) of title. Securities inflation was a miasma that has now fortunately been dispersed, and is not reflected in the SFTR.

F.  Credit protection

9.260  As well as certainty of title, reuse is compatible with effective credit protection.

9.261  Reuse means that one piece of collateral supports up to four pieces of credit. Non lawyers may be alarmed by this, and take it to be a kind of Ponzi scheme or cup trick, where the available assets are a mere fraction of the claims upon them. But this fear is unreal when one looks at the legal structure of the transactions.

9.262  The protection of each collateral taker in the insolvency of its collateral giver is not property (requiring an asset to back each obligation), but the cross claims that arise during a trade. The collateral taker’s right to have its credit repaid is balanced by its obligation to redeliver equivalent collateral. In the event of default, the closing obligations of the parties are accelerated, valued and set-off against each other, so that the collateral taker is paid in full.

9.263  The point is that the collateral takers rely, not on property rights to protect themselves in counterparty insolvency, but insolvency set off, in the context of close-out netting rights.

X.  Conclusions

9.264  A number of conclusions may be drawn.

A.  Costs of rehypothecation and reuse

9.265  Reuse and rehypothecation undoubtedly have a number of costs.

(p. 225) 1.  Client asset protection

9.266  Rehypothecation is not the servant of client asset protection. It exposes the client to the credit risk of the prime broker. Further, it intensifies the potential conflicts of interest between the client and the prime broker.333

9.267  There has been a considerable regulatory response to these issues. But it was argued above that rehypothecation was not a major issue in the client asset delays following the failure of LBIE. It was argued that the key delaying factor was the complexity of encumbrance, together with the basis of the current client asset regime in property rights. A different approach to client asset protection for prime brokerage was recommended, based on close-out netting. Property rights are no longer apt to protect client positions when these are involved in securities finance.

2.  Erosion of institutional asset base

9.268  Rehypothecation, together with other origination transactions such as agency securities lending and collateral swaps, serves to reduce the quality of the assets held by or for institutions investors. This means, held in fact, under the control of the client, and in law, so that the assets are beneficially owned by the client, as opposed to held on the balance sheet. All the origination transactions are balance sheet neutral, and serve to cause the factual and legal position, and the balance sheet, to diverge.

9.269  Institutions investments of record circulate off balance sheet in the shadow. While the obligation to return them to the institution is collateralized, this is not the same as holding the asset, when title and control are elsewhere. The difference became painfully clear in the financial crisis, when closing obligations were not honoured, and collateral values spiralled.

9.270  This problem may be widely underappreciated.

3.  Systemic costs

9.271  Other costs are systemic. As discussed above, reuse multiplies the sum of credit in the financial system, leading to system leverage. As well as leverage, it typically involves maturity transformation, and pro-cyclicality. All of these factors increase systemic risk, as demonstrated in the repo run following the Lehmans failure.

9.272  The current regulatory emphasis on transparency may represent an under-reaction. Given the systemic importance of reuse within the securities finance markets, there may be a case for the mandatory use of central counterparties (CCPs) for securities finance transaction as there currently is for OTC derivatives under EMIR. In this (p. 226) context, the CCP would fulfil a ‘lender of last resort’ function akin to that of central banks in traditional bank lending. While recommended for consideration by the FSB, this is not required under the SFTR.

B.  Value of rehypothecation and reuse

9.273  Yet rehypothecation and reuse also have value as a source of wholesale market liquidity and cheap credit. The transactional integrity of reuse transactions was one of the very few good news stories of the financial crisis. Without it, the crisis would have propagated absolute insolvency, and not merely illiquidity, from institution to institution, and recovery would have been much harder.

9.274  The reuse of financial collateral is a powerful technique, with considerable potential for both good and ill. Other legal inventions that have transformed financial life, from the floating charge to the swap, have proved too effective to be laid aside.

9.275  The extent of market reliance on the reuse of financial collateral should not be underestimated. As ICMA famously stated, ‘Collateral is the new cash.’334 To continue the cash analogy, in its multiplying effect, reuse is comparable to the reuse of money in fractional reserve banking.335 While the reuse of securities collateral may have its costs, no one seriously argues that banks should bury their deposits in the ground.


1  The author is grateful to Ferdisha Snagg of Freshfields Bruckhaus Deringer for her invaluable help with this chapter. When finalizing this chapter the author had sight of chapters in this volume on ‘The Management and Distribution of Client Assets in the LBIE Administration’ by D Ereira OBE; K Caputo, W Giddens, and C Kiplok ‘The Liquidation of Lehman Brothers Inc, the New York Brokerage of the Lehman Global Enterprise’, and H Anderson, ‘Extended Liens’. These have provided invaluable insights for which the author is grateful, and enabled her to correct a number of errors. Any remaining errors are of course her own.

2  Re Hallett’s Estate [1874–80] All ER Rep 793.

3  It would be compatible with a subordinate security interest.

4  More accurately, the entirety of the title of the collateral giver. If this is equitable title, the collateral taker will acquire equitable title. The key is that the collateral taker retains no residual property right.

5  eg Beckett v Lower Assets Co Ltd (1891), British Railway Traffic v Kahn (1921), and Chow Yoong Hong (1961). More recently see the recognition of elaborate TTCA structures in Pearson v Lehman Brothers Finance SA [2010] EWHC 2914 (Ch), AC [2011] EWCA Civ 1544 (RASCALS).

6  See section IX.C on the recognition of TTCA.

7  Directive 2002/47/EC of the European Parliament and of the Council of 6 June 2002 on financial collateral arrangements (OJ L 168/43).

8  See for example the Securities Financing Transactions Regulation, EU Regulation No 548/2012, article 3(12).

9  FSB, ‘Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos’, 29 August 2013, <http://www.financialstabilityboard.org/publications/r_130829b.pdf> p. 15.

10  Typically sub-LIBOR.

11  This involves the purchase of securities for the client with money loaned by the prime broker.

12  SEC rule 15c3-3.

13  FSB, ‘Strengthening Oversight and Regulation of Shadow Banking; Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos’, 29 August 2013, <http://www.financialstabilityboard.org/publications/r_130829b.pdf> p 15.

14  Typically, legal title is held through a nominee or sub-custodian.

15  No formalities are required to establish a trust (not over land), provided there is certainty of intention, asset, and beneficiary. Knight v Knight (1840) 3 Beav 148; 49 ER 58.

16  In re LBIE [2009] EWHC 2545 (‘MCF litigation’).

17  See below section III.C.2.

18  There is no merger of interests, as the beneficiary’s interest under a trust is not the same as the debt of the trustee. See also Re BCCI (No 8) [1994] 3 All ER 565, [1996] 2 All ER 121 (no merger of interests in charge back).

19  In re LBIE [2009] EWHC 2545 (‘MCF litigation’).

20  ibid, para 39. See also para 64.

21  Having the same International Securities Identification number (ISIN).

22  In re LBIE [2009] EWHC 2545 (‘MCF litigation’) per Briggs J, para, 38.

23  ibid.

24  ie from its own house account.

25  Usually from another client who has granted an agency securities lending mandate to the prime broker.

26  Re Hallett’s Estate (1880); Re Diplock [1948] Ch. 465 at 566.

27  SI 2003/3226.

28  FCAR 16(3), first provision.

29  Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU (‘MiFID II’), OJ L 173/349; see section V.C.

30  See section VI.B.1.

31  Unless, unusually, only one client holds the relevant type of securities.

32  ie undertaken on a batch basis.

33  Commission Delegated Directive (EU) C(2016) 2031 final of 7.4.2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to safeguarding of financial instruments and funds belonging to clients, product governance obligations and the rules applicable to the provision or reception of fees, commissions or any monetary or non-monetary benefits (‘MiFID II Delegated Directive’) art 5(2).

34  FSA, Reforming Conduct of Business Regulation, 16.4.2(2), implementing MiFID I Level 2 Directive 2006/73/EC art 43(2)(b).

35  As discussed in section V below.

36  MiFID II Delegated Directive of 7.4.16 on safeguarding client assets, product governance and fees and commissions, art 5(2).

37  £126 million, reduced by 30 per cent as the firms agreed to settle early.

38  FCA, ‘Final Notice to The Bank of New York Mellon’, 14 April 2015, <http://www.fca.org.uk/static/documents/final-notices/bank-of-new-york-mellon-london-international.pdf>. See p 17 for a note of failings.

39  ibid p 14.

40  MiFID II Delegated Directive of 7.4.16 on safeguarding client assets, product governance and fees and commissions, art 5.

41  See art 5(3).

43  See Tenth Joint Administrators’ Report, p 6.

44  Fourteenth Joint Administrators’ Report, p 8 (Omnibus Trust and other client assets).

45  Thirteenth Joint Administrators’ Report, p 25.

46  Fifteenth Joint Administrators’ Report, p 8.

47  An open-ended fund has redeemable units.

48  See FSA, Client Assets Regime: EMIR, Multiple Pools and the Wider Review, CP 12/22, 4.23 and 4.29.

49  PS 10/16.

51  MiFID II Level 1 (Directive 2014/65/EC) art 16(8).

52  Such as segregation, reconciliations, and records.

53  Provided the transaction whereby the property interest was acquired is not voidable under the insolvency regime, eg as a transaction at an undervalue, and provided also that there is no shortfall in the assets held.

54  Lomas v RAB Market Cycles (Master) Fund Limited [2009] EWHC 2545 (Ch), per Briggs J, para 67.

55  To be precise, long client securities positions, ie holdings.

56  Financial Services and Markets Act 2000 s 137B(1) and CASS 5.3.2.

57  To the consternation of US lawyers.

58  This is understood to be partly due to US regulatory sensitivities concerning fiduciaries.

59  Trust estate is discussed in 3 sections in later reports: Omnibus Trust (recovered from LBI), other client assets and client money estate.

60  Administrators’ First Progress Report, p 34.

61  Administrators’ Third Report, p 30.

62  EWHC 2545 (Ch).

63  ibid paras 50, 51.

64  ibid ie the holding of the like securities of different clients in a single pool.

65  ibid para 56.

66  ibid. Clients are entitled to the return of securities of the same type and number as those originally placed with the prime broker, but not the same ones.

67  ibid para 61. The prime broker has the option of returning the market value of the rehypothecated securities.

68  ibid. The prime broker is not obliged to implement the client’s delivery instructions.

69  ibid. Per Briggs J at para 52.

70  ibid para 53.

71  ibid para 54.

72  ibid para 72.

73  ibid para 56.

74  ibid para 57.

75  ibid para 61.

76  ibid paras 65, 66.

77  ibid para 69.

78  ibid para 67.

79  ibid para 59.

80  ibid para 60.

81  ibid para 62.

82  ibid para 63; see also para 64.

83  ibid para 72.

84  ibid para 5.

85  ibid para 83.

86  ibid para 73.

87  ibid para 86.

88  ibid para 93.

89  ibid paras 108, 109.

90  First Administrators’ Progress Report, p 31. See also generally Chapter 8.

91  F W Maitland, The Forms of Action at Common Law, (ed.) A H Chaytor and W J Whittaker (Cambridge University Press 1997). (First published 1909).

92  Lomas v RAB Market Cycles (Master) Fund Limited [2009] EWHC 2545 (Ch).

93  ibid para 102.

94  ibid para 109.

95  In re LBIE [2009] EWHC 2545 (‘MCF litigation’) per Briggs J, para, 15.

96  RAB Capital Plc v Lehman Brothers International (Europe), [2008] EWHC 2335.

97  ibid per Morgan J, para 4.

98  ibid paras 4, 5.

99  ibid para 6.

100  See section IV.F.

101  Under the ‘extended lien’, client assets secured the claims of associates of the prime broker as well as those of the prime broker. See generally Chapter 7.

102  Particularly Lehman Brothers Inc in New York and Lehman Brothers Hong Kong in Hong Kong.

103  Section IV.I.

104  By The Investment Bank Special Administration Regulations 2011, SI 2011/245.

105  ibid Regulation 10(1).

106  ibid Regulation 10(1)(a).

107  This provides, very broadly, that a proposed arrangement between an insolvent company and its creditors, which is approved by 75 per cent in value of creditors may be sanctioned by the Court, and if so will be binding on all creditors: s 899.

108  In re LBIE [2009] EWHC 2141 (Ch).

109  Re LBIE (no 2) [2009] EWCA Civ 1161. The Client Asset Scheme was also rejected in Hong Kong: Administrators’ second report, p 28.

110  The argument that the status of clients as both creditors and trust beneficiaries brought client assets within the scope of the regime, was rejected. Accordingly the Court lacked jurisdiction to approve the proposal.

111  Administrators’ Second Progress Report, p 21.

112  See Administrators’ Third Report, p 46.

113  Client money entitlement.

114  Twelfth Joint Administrators’ Report, p 24. See also See also Eleventh Joint Administrators’ Report, p 6.

115  Regulation 12.

116  See CASS 7A.3R.

117  Barlow Clowes International Ltd (in liq) v Vaughan [1992] BCLC 910.

118  Re LBIE Supreme Court [2012] UKSC 6.

119  First instance: Re LBIE (Briggs Judgment) [2009] EWHC 3228; Appeal Court: CRC Credit Fund Ltd & ORs v GLG Investments [2010] EWCA Civ 917.

120  CASS 7.13.54G–7.13.69G. Very broadly, client money is received into the house account, and then segregated the next business day following reconciliation.

121  Very broadly, the failure of the firm. CASS 7A.2.

122  Ninth Joint Administrators’ Report, p 28.

123  Very broadly, the failure of an entity holding client money for the firm, such as a client money bank. CASS 7A.3.

124  Client money segregation protects clients of the firm in the firm’s insolvency, but not in the insolvency of the client money bank.

125  Whether money received in respect of them is held in the house account pending segregation under the alternative approach, or whether the practice is never to segregate their money, as with LBIE affiliates.

126  Who would not be obliged to share the client money pool with unsegregated clients.

127  Para 37.

128  Para 62.

129  Note however the post-LBIE restrictions on the use of the alternative approach.

130  Tenth Joint Administrators’ Report, p 6.

131  Eleventh Joint Administrators’ Report, p 28.

132  Section IV.C.3.

133  Eleventh Joint Administrators’ Report, p 27.

134  Twelfth Joint Administrators’ Report, p 24.

135  Joint Administrators’ Fifteenth Progress Report, p 10.

136  [2013] EWHC 92.

137  But see the later case of Heis v Attestor Value Master Fund LP and Solid Financial Services Ltd [2013] EWHC 2556, which confirmed that a contractual claim ran in parallel to the beneficial claim. But while a client could prove as a creditor for a client money distribution shortfall (para 69), they could not claim for a higher close-out sum (para 85).

138  Tenth Joint Administrators’ Report, p 26.

139  ‘There are … more than 12,500 lines of stock owned by one or more claimants …’ Joint Administrators’ Third Progress Report, p 48.

140  Or failed settlement: see Joint Administrators’ First Progress Report, p 34.

141  See Lomas v RAB Market Cycles (Master) Fund Limited [2009] EWHC 2545 (Ch).

142  ‘Valuing Client Assets is a complex task, both operationally and legally. There is significant variation in valuation dates which affect clients’ rights to Client Assets…’ see Joint Administrators’ First Progress Report, p 34.

143  See Joint Administrators’ First Progress Report, p 34.

144  ‘There are 570 Client Asset claimants… This is a volume-intensive exercise’ Joint Administrators’ Third Progress Report, p 48.

145  See Joint Administrators’ First Progress Report, p 34. Also, ‘The effects of termination are not legally clear in all cases.’ Ibid.

146  Lomas v JFB Firth Rixson, Inc [2010] EWHC 3372 (Ch).

147  FSA, ‘Client Assets Regime: EMIR, Multiple Pools and the Wider Review’, CP 12/22, 4.14.

148  Joint Administrators’ First Progress Report, p 31.

149  Joint Administrators’ Fourth Progress Report, p 36.

150  Joint Administrators’ Second Report, p 26.

151  Joint Administrators’ Seventh Progress Report, p 27.

152  Joint Administrators’ Third Report, p 47. See also Fourth Report, p 39.

153  Joint Administrators’ Eighth Progress Report, p 26.

154  Joint Administrators’ Third Report, p 47.

155  Joint Administrators’ Fourth Progress Report, p 38.

156  Joint Administrators’ Fourth Report, p 38.

157  See Joint Administrators’ Seventh Progress Report, p 24.

158  See eg Joint Administrators’ Fifth Report, p 23.

159  Joint Administrators’ Sixth Progress Report, p 24.

160  Joint Administrators’ Second Report, p 27.

161  Joint Administrators’ Third Report, p 47.

162  Joint Administrators’ Sixth Progress Report, p 22. This claim was subsequently withdrawn: see Joint Administrators’ Seventh Report, p 24.

163  Joint Administrators’ Fifth Report, p 21.

164  Ninth Joint Administrators’ Report, p 29. This was later resolved.

165  See Thirteenth Joint Administrators’ Report, p 24.

166  Twelfth Joint Administrators’ Report, p 22.

167  Eleventh Joint Administrators’ Report, p 8.

168  ibid p 28.

169  Joint Administrators’ Seventh Progress Report, p 26.

170  Joint Administrators’ Sixth Report, p 24.

171  Joint Administrators’ Fifth Progress Report, p 23.

172  Joint Administrators’ Sixth Progress Report, p 22.

173  See Joint Administrators’ Third Progress Report, p 48.

174  See generally Chapter 7.

175  Joint Administrators’ Fourth Progress Report, p. 37.

176  ibid; see also Joint Administrators’ Third Progress Report, p 48.

177  See Joint Administrators’ Fifth Progress Report, p 23.

178  Ninth Joint Administrators’ Report, p 26.

179  Twelfth Joint Administrators’ Report, p 23.

180  Ninth Joint Administrators’ Report, p 13.

181  Twelfth Joint Administrators’ Report, p 6. See also Eleventh Joint Administrators’ Report, p 5.

182  And also assets, although the wide definition of secured assets does not seem to have been a major problem in the administration.

183  Some hedge funds clients are understood to have claimed that they did not understand this. Subsequent regulatory reforms require very clear disclosures.

184  Under the Financial Collateral regime.

185  More specifically, the client’s rights in relation to the securities is reduced from a property interest (under a custody trust) to a personal right of equivalent delivery against the prime broker.

186  ‘… the vast majority of Over-Claims appear to be for amounts already provided for by LBIE, albeit as unsecured claims and typically for rehypothecated assets.’ Joint Administrators’ Sixth Progress Report, p 22.

187  ‘These over-claims total c. £7.3bn…’ Joint Administrators’ Fourth Progress Report, p 37.

188  ibid. See also Fifth Progress Report, p 22.

189  Joint Administrators’ Sixth Progress Report, p 22.

190  Anecdotally, certain clients sought to withdraw rehypothecation rights as LBIE slid towards administration, and it became unclear what rights of rehypothecation remained at the relevant time.

191  Joint Administrators’ Fourth Progress Report, p 37. All overclaims were finally resolved by March 2015 (Thirteenth Joint Administrators’ Report, p 7.) and late overclaims did not relate to rehypothecation: Twelfth Joint Administrators’ Report, p 23.

192  It is understood that under SIPA a client’s net equity claim includes rights in respect of rehypothecated securities.

193  Joint Administrators’ Third Report, p 48. See also the Joint Administrators’ Eighth Progress Report p 29.

194  These were estimated as at 14 September 2013 to be between $0.24 billion and $0.08 billion. See eg Tenth Joint Administrators’ Report p 39.

195  Ninth Joint Administrators’ Report p 26.

196  See Chapter 8.

197  ‘The vast majority of [ordinary unsecured] creditors have been repaid their unsecured claims in full…’ Joint Administrators’ Fifteenth Progress Report, p 5.

198  ‘The Surplus will be generated after payment in full of [ordinary unsecured creditor claims…and after return in full of Client Assets and post-Administration Client money…’ Fourteenth Joint Administrators’ Report, p 5.

199  In relation to the Omnibus Trust, as at 14 September 2014: ‘…106% of Best Claim values has now been paid to Omnibus Trust beneficiaries…’. Twelfth Joint Administrators’ Report, p 5. As at 14 March 2016, a client money surplus was anticipated, to be transferred to house estate, of between $830 million and $1.020 billion. Joint Administrators’ Fifteenth Progress Report, p 10.

200  A surplus between c £6.57 billion and c £7.79 billion is anticipated after payment of ordinary unsecured creditors: Joint Administrators’ Fifteenth Progress Report, p 5.

201  Section IV.D.1.

202  The author is grateful to Professor Charles Mooney for this point.

203  And also that of MF Global clients: ‘Following the introduction of the SAR and the developments in the client assets regime there was an expectation of significantly improved speed of return of client assets. However, in the case of MF Global Ltd the UK regime has at times, rightly or wrongly, been compared unfavourably to the US regime where, for example, nearly all securities customers of MF Global Inc. received 60% or more of their account value within a month of the firm’s insolvency.’ FSA, ‘Client Assets Regime: EMIR, Multiple Pools and the Wider Review, CP 12/22, 4.15.

204  See generally Chapter 2.

205  ‘Early in the LBI case the Trustee began to pursue the transfer of many of its customer accounts to other broker-dealers. …LBHI (as debtor in possession), LBI, as Seller, and Barclays Capital Inc., as Purchaser, entered into an Asset Purchase agreement pursuant to which LBI would sell, and Barclays would buy, most of the assets that formed LBI’s investment banking and capital market business. …As the Trustee reported: “Seamlessly, as far as virtually all PIM [Private Asset Management] customers were concerned, the LBI account holders became Barclays account holders, and all assets from their PIM accounts appeared on their Barclays accounts statements.” …eight months after the liquidation case was commenced…98% of the securities related to the PIM accounts had been transferred to Barclays.’ C. Mooney and G. Morton, ‘Harmonizing Insolvency Law for Intermediated Securities: Principles for an Ideal Regime’, in T Keijser (ed), Transnational Securities Law (Oxford University Press, 2014) para 8.62.

206  ‘… the PB Protocol provided … a voluntary process for the transfer of portions of the PBA assets to operating broker-dealers. Sorting out the accounts that could be transferred was a complex procedure inasmuch as, for example, some PBA assets were subject to liens and potential claims of other Lehman entities. Under the PB Protocol… the Trustee transferred approximately 300 PBAs valued at more than US$3.4 billion as of the filing date. The transfers were subject to letter agreements allowing the Trustee a clawback right if assets were transferred to which the transferee was not entitled or which were subject to another entity’s superior claim.’ C. Mooney and G. Morton, ‘Harmonizing Insolvency Law for Intermediated Securities: Principles for an Ideal Regime’, in T Keijser (ed), Transnational Securities Law (Oxford University Press, 2014) para 8.65.

207  ibid, 8.66.

208  See also HMT proposed reforms to the special administration regime to facilitate the transfer of client portfolios, available at: <https://www.gov.uk/government/consultations/reforms-to-the-investment-bank-special-administration-regime>, and the letter from the Financial Markets Law Committee of 22 June 2016, available at: <http://www.fmlc.org/letter-to-hmt-about-investment-bank-sar.html>.

209  J Benjamin, ‘The Law and Regulation of Custody Securities; Cutting the Gordian Knot’, Capital Markets Law Journal (2014) 9(3): 208–326.

210  ie from the fund clients as opposed to the sell side, or custodian/prime broker service provider.

211  Directive 2011/61/EU, article 21(4)(b) (prime broker not to act as depositary, unless functional and hierarchical separation of functions and management of conflicts).

212  No later than close on the next business day to which it relates: CASS9.2R(2).

213  CASS9.2.1R(1).

214  ibid (3)(c).

215  CASS9.3R(1).

216  ibid R(2).

217  ibid (2)(a).

218  ibid (2)(b).

219  ibid (2)(c).

220  ibid (2)(d).

221  ibid (3).

222  ibid (2)G.

223  FSB, ‘Strengthening Oversight and Regulation of Shadow Banking; Policy Framework for Addressing Shadow Banking risks in Securities Lending and Repos’, 29.8.13, <http://www.financialstabilityboard.org/publications/r_130829b.pdf>. For other FSB work on shadow banking see FSB shadow banking material generally: <www.fsb.org/publications/?policy_area%5B%5D=14>.

224  ‘Financial Intermediaries should provide sufficient disclosure to clients in relation to re-hypothecation of assets so that clients can understand their exposures in the event of a failure of the intermediary.’, Recommendation 7, first paragraph, p 16. See also p 15: ‘This could include, daily, the cash value of: the maximum amount of assets that can be re-hypothecated, the assets that have been re-hypothecated and assets that cannot be re-hypothecated, …’ Note the additional recommendation concerning reporting requirements for fund manages to end-users (Recommendation 5).

225  ‘In jurisdiction where client assets may be re-hypothecated for the purpose of financing client long positions and covering short positions, they should not be re-hypothecated for the purpose of financing the own-account activities of the intermediary; …’ Recommendation 7, second paragraph, p 16.

226  ‘Only entities subject to adequate regulation of liquidity risk should be allowed to engage in the re-hypothecation of client assets.’ Recommendation 7, third paragraph, p 16.

227  Recommendation 6. See the discussion of cash collateral reinvestment in section VI.A.14 below.

228  ‘An appropriate expert group on client asset protection should examine possible harmonisation of client asset rules with respect to re-hypothecation, taking account of the systemic risk implications of the legal, operational, and economic character of re-hypothecation. Recommendation 8, p 16.

229  ibid p 15.

230  MiFID II Delegated Directive of 7.4.16 on safeguarding client assets, product governance and fees and commissions <ec.europa.eu/finance/securities/docs/isd/mifid/160407-delegated-directive_en.pdf>.

231  ibid art 5(1)(a).

232  ibid art 5(1)(b).

233  ibid art 5(2)(a).

234  ibid art 5(2)(b).

235  ibid art 5(3).

236  ibid art 5(3)(a).

237  ibid art 5(3)(b).

238  ibid art 5(3)(c).

239  ibid art 16(10): ‘An investment firm shall not conclude title transfer financial collateral arrangements with retail clients for the purpose of securing or covering present or future, actual or contingent or prospective obligations of clients.’

240  MiFID Delegated Directive of 7.4.16 on safeguarding client assets, product governance and fees and commissions. <ec.europa.eu/finance/securities/docs/isd/mifid/160407-delegated-directive_en.pdf>.

241  ibid art 6(1).

242  ibid art 6(2)(a): ‘whether there is only a very weak connection between the client’s obligation to the firm and the use of title transfer collateral arrangements, including whether the likelihood of a clients’ liability to the firm is low or negligible’.

243  ibid art 6(2)(b): ‘whether the amount of client funds or financial instruments subject to title transfer collateral arrangements far exceeds the client’s obligation, or is even unlimited if the client has any obligation at all to the firm’. Note that in the aftermath of LBIE, clients became reluctant to over-collateralize.

244  ibid art 6(2)(c): ‘whether all clients’ financial instruments or funds are made subject to title transfer collateral arrangements, without consideration of what obligation each client has to the firm’.

245  ibid art 6(3).

246  Directive 2011/61/EU on Alternative Investment Fund Managers.

247  ibid art 14.3: ‘Where the AIFM on behalf of an AIF uses the services of a prime broker, …any possibility of transfer and reuse of AIF assets shall be provided for in [the contract with the prime broker] and shall comply with the AIF rules or instrument of incorporation.’

248  ibid art 15(4).

249  ibid art 15(4)(e).

250  Regulation (EU) No. 231/2013.

251  Art 91(3)(c).

252  CASS 9.2.

253  Directive 2014/91/EU amending Directive 2009/65/EC.

254  ‘Reuse comprises any transaction of assets held in custody including, but not limited to, transferring, pledging, selling and lending.’ ibid art 22(7), first paragraph, second sentence.

255  ‘The assets held in custody by the depositary shall not be reused by the depositary, or by any third party to which the custody function has been delegated, for their own account.’ ibid art 22(7), first paragraph, first sentence.

256  ‘The assets held in custody by the depositary are allowed to be reused only where’ ibid art 22(7), second paragraph.

257  ‘the reuse of the assets is executed for the account of the UCITS’. ibid art 22(7)(a).

258  ‘the depositary is carrying out the instructions of the management company on behalf of the UCITS’. ibid art 22(7)(b).

259  ‘the reuse is for the benefit of the UCITS and in the interest of the unit holders’. ibid art 22(7)(c).

260  ‘the transaction is covered by high-quality and liquid collateral received by the UCITS under a title transfer arrangement.’ ibid art 22(7)(d).

261  ‘The market value of the collateral shall, at all time, amount to at least the market value of the reused assets plus a premium.’ ibid art 22(7), final paragraph. The term ‘market value’ is not defined in the UCITS Directive as amended.

262  Regulation No 648/2012/EU on OTC derivatives, central counterparties and trade repositories.

263  ibid art 11(3).

264  Final Draft Regulatory Technical Standards on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP, 8.3.16.

265  ‘The collecting counterparty shall not re-hypothecate, re-pledge nor otherwise re-use the collateral collected as initial margin.’ ibid art 34(1). Reinvestment in cash is however permitted: ibid art 34(2).

266  Level 1, ibid art 39(8).

267  ibid arts 39(8) and 47.

268  ibid art 47(3).

269  EU Regulation 2014/909 on securities settlement.

270  ibid art 38(7).

271  In ibid art 3(12).

272  ibid. The definition of reuse, and therefore the reuse requirements, apply only to financial instruments, and not commodities (unlike the SFTR definition and associated reporting requirements).

273  ibid art 3(12) final paragraph.

274  ibid art 15(1).

275  ibid art 15(1)(a). This relates to risks and consequences of either a FCAD right of use coupled with a security collateral arrangement or of a TTCA.

276  ibid art 15(1) final paragraph.

277  ibid art 15(1)(b).

278  ibid art 15(2).

279  ibid art 15(2)(a).

280  ibid art 15(2)(b). Or, in the case of third country counterparties, by either transfer from the account of the collateral giver or by appropriate means. See also Explanatory Memorandum, p 7: Further, hypothecation ‘should be appropriately reflected in the securities accounts. The counterparty receiving financial instruments as collateral will be allowed to rehypothecate them only … after having them transferred to its own account.’

281  ibid art 15(3).

282  ibid art (4).

283  See section IX.C below.

284  These include demographic pressures of an ageing population for pension funds and life insurers.

285  These include tougher prudential regulation for insurers.

286  These include competitive short term pressure on funds managers.

287  For example, the discussion omits important transaction categories, including the use of securities lending and repos by settlement systems to provide securities and cash lending to and the involvement of securitization vehicles as issuers of repo collateral, and also as repo borrowers in CDO squared structures (although such markets have been much less active since the crisis).

288  See also the discussion of returns on cash collateralized securities below in this section.

289  A short position is (broadly) the contractual obligation to deliver assets that one does not hold at the time the obligation is assumed.

290  A long/short fund hedges its exposures to market movements by holding pairs of correlated positions, one short and one long, so that it can profit in both rising and falling markets.

291  A bear trader goes short in order to profit from anticipated falling prices.

292  Of a type other than the loaned securities.

293  Collateral management includes marking to market, substitution, and handling manufactured income.

294  These are highly liquid short term debt instruments, also known as near cash.

295  This was the experience of LBIE clients whose cash collateral was invested in the shares of associated money market funds.

296  Swaps are the dominant category of derivatives transaction in the international financial markets.

297  See (relaxed) FSA guidance in 2011, available at: <http://www.fca.org.uk/static/pubs/guidance/fg12-06.pdf>.

298  FSA, ‘The Turner Review’, 2009, available at: <http://www.fca.org.uk/static/pubs/guidance/fg12-06.pdf> p 53: ‘Because of these specific characteristics many of the most important challenges in banking regulation are systemic rather than idiosyncratic. One of the key deficiencies problems of the past approach, not only in the UK but in many other countries, was that it did not reflect this reality. There was inadequate focus on the analysis of systemic risk and of the sustainability of whole business models: and a failure to design regulatory tools to respond to emerging systemic risks.’

299  In the case of a collateralized swap, it may act as both, as its swap position moves in and out of the money.

300  M Singh and J Aitken, The (Sizable) Role of Rehypothecation in the Shadow Banking System’, IMF Working Paper WP/10/172, <http://www.imf.org/external/pubs/ft/wp/2010/wp10172.pdf>.

301  The term ‘corporate’ is used in the financial markets to mean a commercial company that is not a financial institution.

302  See above section V.C.

303  eg the US Troubled Asset Relief Program that formed part of the bailout.

304  See Credit Suisse First Boston (Europe) Ltd v MLC (Bermuda) Ltd [1999] 1 All ER (Comm) 237, a hedge raised a large part of the purchase price of Russian debt by repoing the purchased securities to an affiliate of its prime broker. Sadly, the arrangements unravelled five months later when the Russian default rendered the bonds worthless, the hedge fund failed to meet a repo margin call, and then failed to pay the repurchase price (which was presumably payable because the counterparty declined to roll the trade in the circumstances). On default, the value of the bonds fell short of the purchase price, and complex international litigation ensued.

305  In the UK settlement system CREST, under DBV arrangements, a repo of purchased securities collateralizes the purchase price provided by settlement banks.

306  Under the ISDA Credit Support Annex (CSA) and Credit Support Deed (CSD) respectively.

307  Depending on clearing house rules.

308  Final Draft Regulatory Technical Standards on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP, 8.3.16.

309  See generally C Kindleberger, Manias, Panics, and Crashes. A History of Financial Crises, (4th edn, Wiley 2000).

310  Or pro-cyclicality.

311  Gary Gorton, ‘Questions and Answers about the Financial Crisis’, 2010, available at: <http://online.wsj.com/public/resources/documents/crisisqa0210.pdf>; M Singh and J Aitken, ‘The (Sizable) Role of Rehypothecation in the Shadow Banking System’, <IMF Working Paper WP/10/172, http://www.imf.org/external/pubs/ft/wp/2010/wp10172.pdf>. See also T Adrian and A Ashcraft, ‘Shadow Banking Regulation’ (2012) Federal Reserve Bank of New York Staff Reports, no 559, p 4.

312  Certain master agreements include default under other agreements or financial obligations as an event of default.

313  Section V. B.

314  See generally FSB, ‘Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos’, 29 August 2013, available at: <http://www.financialstabilityboard.org/publications/r_130829b.pdf>.

315  ibid Recommendation 1.

316  ibid Recommendation 2.

317  ibid Recommendation 3.

318  ibid Recommendation 4.

319  ibid Recommendation 7, point 3. This requirement applies to the rehypothecation of client assets, but also has a systemic element.

320  ibid Recommendation 9.

321  ibid Recommendation 10.

322  ibid Recommendation 11.

323  ibid. However, minimum haircuts are applicable for derivatives under EMIR.

324  Section V.B.

325  Known as the ‘once a mortgage, always a mortgage rules’. Noakes v Rice [1902] AC 24 per Lord Davey at 32.

326  2002/47/EC as amended.

327  Article 5 of the FCAD that protects contractual rights of use, in respect of financial collateral provided under security interest within the scope of the Directive. Equivalent provisions are contained in regulation 16 of the FCAR.

328  Existing position under English law, law recognized outright collateral transfers (eg Beckett v Lower Assets Co Ltd (1891), British Railway Traffic v Kahn (1921), and Chow Yoong Hong (1961). More recently see AC Pearson v Lehman Brothers Finance SA [2010] EWHC 2914 (Ch), [2011] EWCA Civ 1544 (RASCALS).

329  In article 6(1). There is no equivalent in the UK FCAR, because none was needed.

330  For the courts’ approach to recharacterization see In re Spectrum Plus Ltd (in liquidation) [2005] 2 AC 710 per Lord Walker at 725, 726.

331  Whether taking the form of security interests or title transfer collateral arrangements.

332  French Authorities Answer to European Commission’s Green Paper on Shadow Banking (2012), <http://ec.europa.eu/internal_market/consultations/2012/shadow/public-authorities/france_en.pdf>.

See, on Commission shadow banking material generally: <http://ec.europa.eu/internal_market/finances/shadow-banking/index_en.htm#maincontentSec2>. See also European Commission, ‘Communication from the Commission to the Council and the European Parliament: Shadow Banking – Addressing New Sources of Risk to the Financial Sector’, 4 September 2013, COM(2013) 614, p 11, para 2: ‘The reuse or rehypothecation of securities generated dynamic collateral chains in which the same security is lent several times, often involving actors from the shadow banking system. …the lack of transparency of these markets makes it difficult to identify property rights (who owns what?).’ Available at: <http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52013DC0614>.

333  Contrast the duty of the SIPA trustee to act in the interests of clients. Potential conflicts of interest are required to be managed by the AIFMD. See Madeleine Yates, ‘Custody, Prime Brokerage and Right of Use: A Problematic Coalition?’ (2010) 7 Journal of International Banking and Financial Law 397, for a discussion of the importance of client understanding the exact terms and implications of any right of rehypothecation.

334  Andy Hill, ‘Collateral is the New Cash, Systemic Risks Inhibiting Collateral Fluidity’, ICMA, April 2014: available at: <www.icmagroup.org/assets/documents/Regulatory/Repo/COLLATERAL-IS-THE-NEW-CASH-THE-SYSTEMIC-RISKS-OF-INHIBITING---4-April-2014.pdf>.

335  ‘Subject only but crucially to confidence in their soundness, banks extend credit by simply increasing the borrowing customer’s current account, which can be paid away to wherever the borrower wants by the bank writing a cheque on itself ’. This “money creation” process is [10] constrained by their need to manage the liquidity risk… to which it exposes them.’ (Paul Tucker, Executive Director and Member of the Monetary Policy Committee of the Bank of England, ‘Money and Credit – Banking and the Macroeconomy’ (Speech at the Monetary Policy and the Markets Conference, London, 13 December 2007), 9–10, available at: <http://www.bis.org/review/r071217f.pdf>).