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.

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

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).

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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.

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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.

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’).

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.

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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.

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.

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.

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.

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Figure 9.4  Comparison of security interest (SI) and TTCA

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.

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

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.’

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.

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

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.

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.

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.

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

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.

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Figure 9.5  Respective rights of parties before use

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.

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.

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

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.

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:

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,

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.

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

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

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

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

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.

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

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.

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

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

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.

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.

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.

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.

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.

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.

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

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).

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.

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.

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

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

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

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.

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.

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.

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.’

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.

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

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

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

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.

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

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.

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

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

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.

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

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.

9.105  The Supreme Court judgment in Re LBIE¹¹⁸ concluded three years of complex litigation¹¹⁹ on the interpretation of the FSA’s (p. 193) Client Money Rules and Client Money Distribution Rules. The central question was how to deal with under-segregation.

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’).

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.

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.

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.

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.

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

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.

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.

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.

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.

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

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.

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.

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.

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

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.

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.

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.

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

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

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.

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

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

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.

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.

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.

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.

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.

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.

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

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

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.

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.

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

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).

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

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

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

9.174  MiFID II places severe restrictions on rehypothecation.

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

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

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.

9.189  The CSDR²⁶⁹ prohibits a CSD from using for its own account any securities that do not belong to it, except with the consent of the affected participant, and must require that participant to obtain client consent where relevant.²⁷⁰

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.

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

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.

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.

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.

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.

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

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.

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Figure 9.6  Securities lending

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

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

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

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.

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.

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.