XCHRX Re C.A. PACIFIC FINANCE LTD. (in Liquidation)

HCCW 36/98, 37/98

HEADNOTES

(1) Cash clients (meaning exclusive CAP Securities clients) were different from margin clients (meaning clients who were also CAP Finance clients).

Cash clients' agreements with CAP Securities stated that CAP Securities shall not, without the prior written consent of the clients, deposit any of their shares as security for loans, or lend or otherwise part with possession of their shares for any purpose.

Margin clients' agreements with CAP Finance stated that they consented to CAP Finance pledging their shares for loans made by CAP Finance's lenders to it, and CAP Securities was authorized to deliver shares to CAP Finance for that purpose. The extent of CAP Finance's pledge to its lenders was not expressly restricted to any amount owing by the margin clients to CAP Finance.

This contrast between cash clients and margin clients was respected and implemented in practice. The two categories of clients were identified differently in CAP's record system. Shares of margin clients only were considered by CAP Finance for transfer to the Lenders, until the last few trading days when due to the sale of shares by CAP Finance's lenders and their retention of surplus shares, CAP Securities drew on available shares in CCASS to meet settlement obligations including shares attributable to cash clients.

(2) Where shares now available completely matched clients' claims, the shares should be delivered to the clients, subject to payment of costs and expenses and any lien of CAP Securities, and subject to the SFC's statutory subrogation to the extent decided in Re Forluxe Securities. Where there is any dispute between margin clients and CAP Finance's Liquidators as to any indebtedness, the Liquidators of CAP Securities should interplead.

(3) Where there is a shortfall of shares now available, the rule in Clayton's case ("first in, first out") was in the present case, unjust, inapplicable and impractical.

(4) In the light of the difference between the cash clients and the margin clients, and the practice that had been implemented by CAP Securities until the last trading days, since CAP Securities as trustee could have lawfully delivered shares attributable to margin clients to CAP Finance's Lenders, but could not have lawfully delivered shares attributable to cash clients, it must be presumed to have done the lawful thing first, i.e. to have first exhausted shares attributable to margin clients before drawing on shares attributable to cash clients. The consequence is that what remains in each line of stock must be attributable first to cash clients.

(5) The most just and fairest solution was therefore to give priority to the remaining shares in each line of stock to cash clients who had acquired that stock (subject to any sale effected by CAP Securities under clause 4 of the Client Agreement), the balance of the shares in each line to be allocated to margin clients who had acquired that stock, with clients in the same class sharing pari passu in the event of deficiency.

(6) Directions as to classification of clients and objections to classification given.

HCCW 36/98, 37/98

IN THE HIGH COURT OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

COURT OF FIRST INSTANCE

COMPANIES (WINDING-UP) ACTIONS NO. 36 AND 37 OF 1998

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DECISION

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1. This is an application by the Liquidators of C.A. Pacific Securities Ltd and CAP Finance Ltd for directions as to the distribution, or allocation, of shares to clients of CAP Securities.

2. This application is consequential upon my decision in December 1998 (Re C.A. Pacific (No.1) [1999] 2 HKC 632) that the company's clients had a proprietary interest in shares as individual beneficiaries notwithstanding the fact that the shares were unnumbered and "immobilized" under the Central Clearing and Settlement System ("CCASS") operated by the Hong Kong Securities Clearing Co. Ltd. In view of the time that has elapsed since that decision, it is imperative that a decision on the allocation of shares be made as soon as possible.

3. The hearing of the application, whilst in chambers, was open to all clients and was attended by a number of them. Whilst representation of different classes of clients would have been ideal, that would have taken more time and costs. The Liquidators have discussed this application with the Committee of Inspection and their counsel has endeavoured to present different views to the Court.

4. It may be helpful to summarize the factual background first.

CAP Securities

5. CAP Securities started business in Hong Kong as a broker or dealer in shares in 1986. It was a member of the Hong Kong Stock Exchange and was a broker participant in CCASS. In the 12 years up to 1998, it had grown to become one of the largest local stockbrokers with a large client base.

6. CAP Securities acted only as a stockbroker, not as a financier, of its clients.

7. Its clients could be classified into 3 categories :-

(1) those clients who had opened accounts with CAP Securities only and who bought shares with their own resources. These clients have been referred to as "cash clients". They could also be described as "exclusive CAP Securities clients";

(2) those clients who had also opened accounts with C.A. Pacific Finance Ltd., a finance company which provided margin facilities for buying shares. These clients have been referred to as "margin clients" although a more accurate description would have been "CAP Finance clients" as some had margin facilities but had not drawn upon them or had not actively used them;

(3) those clients who were also clients of a company called Pui Hang Enterprises Ltd which was operated by persons related to the persons who operated CAP Securities and CAP Finance respectively. Pui Hang (which is still operating) carried on the business of trading in shares. Whilst Pui Hang was itself a client of CAP Securities, some of its clients also opened their own accounts with CAP Securities. However, this is of no relevance for present purposes. Shares attributable to Pui Hang's clients were capable of being transferred to lenders to Pui Hang, but as Pui Hang did not suffer the same fate as CAP Finance, nothing turns on this for present purposes.

8. Cash clients signed a Client Agreement. Under this Agreement, the client's shares were held for and on behalf of the client, and it was provided that CAP Securities shall not, without the prior written consent of the client, deposit any of the client's shares as security for loans or advances or lend or otherwise part with possession of any such shares for any purpose (clause 11).

9. The Client Agreement restricted the client's rights to the shares that he had bought in only two instances. First, it would only be where a cash client fails by settlement date (Transaction + 2 days) to pay for his shares that CAP Securities would be authorized to transfer or sell his shares in satisfaction of his payment obligation (clause 4). Secondly, there was a general lien whereby all the client's shares were subject to a general lien for the discharge of his obligation to it arising from the business of dealing in shares (clause 6).

CAP Finance

10. CAP Finance carried on business as a finance company offering margin facilities to persons wishing to buy shares.

11. On opening an account with CAP Finance, margin clients would be required to sign, amongst other documents, a Memorandum of Deposit. Under Clause 28 of the memorandum, the margin client consented to CAP Finance mortgaging, charging, pledging or creating any security interest in or over any or all of his shares by way of security for loans or advances of any amount made or to be made to CAP Finance for the discharge of obligations of any kind and amount undertaken or to be undertaken by CAP Finance. The extent of the charge or pledge by CAP Finance to its lenders was not expressly restricted to the amount owing by the margin client to CAP Finance.

12. Clause 28 was implemented in practice by CAP Finance causing CAP Securities to deliver shares acquired for margin clients to various financial institutions ("the Lenders") as security for loans made to CAP Finance by the Lenders. Margin clients had also signed a Letter of Authorization to transfer funds or properties among intergroup or related companies, including CAP Securities and CAP Finance, enabling shares to be withdrawn from any one of them.

Comparison between margin clients and cash clients

13. There is thus a clear contrast between the cash client's position and the margin client's position.

14. As far as the cash client was concerned, his stockbroker CAP Securities would only be entitled to deal with shares acquired for him if he failed to pay for the shares by T+2. Apart from that situation, CAP Securities was obliged to always retain enough shares for delivery to the cash client, though it need not deliver the very shares that it had acquired from the selling broker in that particular trade (Solloway v McLaughlin [1938] AC 247).

15. As far as the margin client was concerned however, he had authorized his stockbroker CAP Securities to deliver shares to CAP Finance for pledging with the latter's own lenders. In exchange for having margin facilities made available to him by CAP Finance, he was in effect risking his shares to finance CAP Finance's private commercial operations.

16. This contrast between cash clients and margin clients was respected and implemented in practice. The Liquidators' investigations have revealed that the two categories of clients were identified differently in CAP's record system known as Financial Investment System or "FIS", a record system which the Liquidators have ascertained was kept accurately.

17. Cash clients had a 4-digit client number, whereas margin clients had a 6-digit client number or a 4-digit number starting with a letter other than "M".

18. On a daily basis, CAP Finance staff would check the FIS, and the shares of margin clients only would be considered for transfer to the Lenders, until at the last stages of the companies before collapse.

Matters regarding margin clients

19. With reference to the distinction between cash clients and margin clients, I should mention two matters that had previously been drawn to my attention by the Liquidators although they did not feature prominently in their present submissions. In my view, for present purposes, neither matter impacts on the issue of the recovery of shares.

20. First, some margin clients have, after the liquidation of CAP Securities and CAP Finance, claimed that misrepresentations had been made to them by CAP Finance staff on the effect of the documentation prior to their execution.

21. Secondly, the Liquidators have also, in another context, previously drawn the Court's attention to a possible question over the CAP Finance documentation regarding formalities set out in the Money Lenders Ordinance.

22. Neither of these matters has been brought before the courts for decision. However in my view, neither should have any influence upon the Court's determination of the present application for directions on the allocation of shares.

23. To determine which clients should receive the remaining shares, the shortfall being due largely to the sale by the Lenders of shares delivered to them under CAP Finance's pledge, it is relevant to consider whether in 1998, CAP Securities would have been likely to have delivered shares attributable to cash clients, or shares attributable to margin clients. This involves the ascertaining of CAP Securities' intention at the time of delivery of the shares in 1998.

24. Any alleged misrepresentation or failure of compliance with the money-lending legislation could not have affected CAP Securities' intention in 1998 when it delivered shares to the Lenders. Even if one assumes that the CAP Finance contracts signed by the margin clients were to be now declared unenforceable, the fact is that CAP Securities had historically acted on those clients' authority to deliver shares to CAP Finance's lenders. In considering whose shares had been so delivered (i.e. whether the cash clients' or the margin clients'), CAP Securities' intention in 1998 is a historical fact that cannot be reconstructed.

25. The delivery of shares by CAP Securities as stockbroker is not enforcement of the CAP Finance contract. Where shares are to be delivered to margin clients who are indebted to CAP Finance, the latter's liquidators may well claim a charge over the shares to the extent of the debt. If the margin clients were to dispute that charge, the Liquidators of CAP Securities would be in the position of interpleaders vis-a-vis the shares, and to avoid any conflict of interests (as the same persons have been appointed liquidators of both companies) I expect they would have to seek directions from the court as to how to deal with the shares pending resolution of any disputes between the clients and CAP Finance. A provision to this effect will be included in my order.

Cause of shortfall of shares

26. As stated above, it would appear from the Liquidators' investigations that even as late as 3 days before the collapse of CAP Securities and CAP Finance, the holdings of shares by CAP Securities and CAP Finance were still "whole", meaning that there were enough shares to be delivered to all clients.

27. However, when CAP Finance's lenders sold some of the pledged shares and retained surplus shares, CAP Securities drew on available shares in CCASS to meet settlement obligations without distinguishing between those shares attributable to cash clients and those attributable to margin clients. It is the Liquidators' view that these transfers would probably not have been the result of deliberate decisions to directly transfer shares between the companies, but an indirect consequence of an automatic drawing on available shares in CCASS to meet settlement obligations without distinguishing shares attributable to cash clients.

Liquidations

28. On 4 June 1998, both CAP Securities and CAP Finance were wound up, CAP Finance on a petition presented on the basis of its inability to pay an inter-company loan, and CAP Securities on a petition presented by the Securities and Futures Commission ("SFC") on the grounds that it was insolvent and that it was just and equitable, and in the public interest, for it to be wound-up.

Title application - CAP Securities trustee of clients' shares

29. In view of the CCASS procedures and a shortfall in some of the shares, the Liquidators brought an application to the Court ("the title application") for determination of the question whether CAP Securities' clients had any proprietary interest in shares which they had instructed that company to acquire. The question arose because under CCASS, unnumbered share certificates were immobilised and deposited with a central shares depositary, and there was therefore no `earmarking' of specific shares to individual clients.

30. The postulation adopted at the title application was of cash clients who had paid for shares from their own resources and on whose instructions CAP Securities had purchased shares settled through CCASS.

31. On 17 December 1998 I found that notwithstanding the CCASS procedures, CAP Securities' clients had a proprietary interest in shares as beneficiaries under individual trusts.

32. I noted however that a finding of individual proprietary interests may pose difficult or cumbersome administrative problems which would take substantial time and money to unravel. That was due to a shortfall in some lines of shares claimed by CAP Securities' clients.

Allocation of shares

33. That shortfall has led to the present application being brought by the Liquidators for directions on allocation of the shares, a term which is preferable to distribution of shares as it is important to bear in mind that it is the clients' own shares which are being recovered by them.

34. In the present application, as in Re Forluxe Securities (HCCW 310/98) heard one day after this hearing, the Court has been taken to very full materials presented by the Liquidators, and at the Forluxe hearing, the Court has also been referred to Canadian, Australian and New Zealand cases to assist in the determination of the fairest and most just solution in the circumstances.

35. In the present case, there are two situations:- where there is no shortfall in shares; and where there is a shortfall.

No shortfall in shares

36. The 13th Affidavit of Mr Jan Blaauw, one of the Liquidators, reveals that for some 250 lines of stock, the shares now available to the Liquidators match the claims made by all the clients who had bought that stock.

37. In relation to these lines of stocks, there is no difficulty in delivering the shares. In the title application, I had found that as between a stockbroker (CAP Securities) and each of its clients, there was an individual trust relationship under which the stockbroker was obliged to deliver to its client an equivalent quantity of the shares which it had bought on behalf of the client. The Privy Council had held in Solloway v McLaughlin (cited above) that the broker need not deliver the very shares that the selling broker had transferred to it in that specific transaction, but it has to have an equivalent quantity of those shares to satisfy the client's proprietary interest.

38. Accordingly, where there are sufficient shares in a particular line of stock available now to meet the claim of each client who had bought that stock, each such client should be entitled to the recovery of his trust property, being the equivalent quantity of the shares which he had instructed CAP Securities to buy for him.

Conditions

39. This recovery should however be subject to 2 conditions. First, the payment of proper and reasonable costs, fees and expenses of the Liquidators in relation to this aspect of their work

40. I had held in Re C.A. Pacific (No.2) [1999] 2 HKC 652 that as far as the incidence of costs of the title application was concerned, it would only be right for those costs to be borne by the trust assets, and not by the free assets as that would place an unfair burden of costs on unsecured creditors (applying Re Berkeley Applegate (Investments Consultants) Ltd (in liquidation) [1989] Ch 32).

41. The present application being part of the execution of the decision in the title application, it follows that delivery of the shares should be subject to payment by the recipient clients of a proper proportion of the Liquidators' proper and reasonable costs, fees and expenses attributable to (i) determination of the entitlement to such delivery, (ii) management of that portfolio of shares prior to delivery and (iii) carrying out the actual work of delivering the shares.

42. As far as (i) legal costs and (ii) expenses for the management of that portfolio of shares are concerned, Mr Moss QC has suggested, and I agree, that it would be fair to apportion these costs and expenses by reference to the value of the shares in proportion to the value of the total portfolio of shares the subject-matter of this application. As for (iii) the administrative expenses of withdrawing the shares from CCASS and then transferring them to the individual clients, these expenses should be borne by those clients themselves.

43. The 2nd condition is payment of any indebtedness to CAP Securities. In the case of any amount owed by a client to CAP Securities, delivery of the shares to him should be subject to CAP Securities' general lien under clause 6 of the Client Agreement.

44. As for any amount owed by a margin client to CAP Finance, I have referred above to the interpleader position that I would expect would be adopted by the Liquidators of CAP Securities in the event that a margin client disputes his liability to repay any amount to CAP Finance.

SFC's claim to statutory subrogation

45. Apart from the above, I should record that at the Re Forluxe Securities hearing, the liquidators there sought directions on the SFC's claim (under s.118 of the Securities Ordinance cap.333) to a statutory right of subrogation to shares where compensation had been paid to any clients out of the Unified Exchange Compensation Fund. A similar right has been asserted by the SFC against clients of CAP Securities, although the Liquidators here have not issued a summons for directions in this respect.

46. My decision in Re Forluxe Securities is being delivered immediately after the delivery of my decision in the present case. In allocating the shares here, the Liquidators will no doubt also consider the decision in that case, although they would of course be free to return to Court for any further directions that may be needed.

Physical scrip held for individual clients

47. I have dealt above with the situation where shares available matched claims made. It would further appear that in a small number of cases, CAP Securities actually held physical scrip for particular individual clients. Presumably this arose from specific instructions given by those clients for shares they had acquired to be withdrawn from CCASS.

48. In the light of my finding of a proprietary interest of the clients in the shares under individual trusts, it is clear that these scrip should be delivered to the particular clients, subject to the same conditions set out above.

49. There is a further variation on this situation disclosed in Mr Blaauw's 14th affirmation. It would appear that there were further stock which were similarly withdrawn by CAP Securities from CCASS on the instructions of particular individual clients. However, for reasons of administrative convenience, the Liquidators then returned the stock to CCASS.

50. Since these stock would have remained held as physical scrip for those particular clients had it not been for their return to CCASS by the Liquidators for purely administrative reasons, it is clear that these scrip should similarly be delivered to the particular clients, subject to the same conditions set out above.

Shortfall

51. The more difficult part of the application lies in finding the solution in cases of shortfall in particular lines of stock. In arriving at the decision in this case, I have also drawn on the submissions of law made by counsel for the liquidators in Re Forluxe Securities, who was also junior counsel for the Liquidators in the present case.

Various methods of allocation

52. In considering the proper solution in cases of shortfall, I have been referred to the following methods of allocation of the remaining shares:-

(1) adopting the rule in Clayton's case, whether by way of "First In First Out", or "Last In Last Out";

(2) adopting what has been called the "pari passu ex post facto" approach, and its variations:-

(i) the "North American" or "rolling charge" basis;

(ii) the "weighted pro rata" basis suggested by the Liquidators.

53. I have also considered a third solution, namely -

(3) a method whereby for each line of stock, priority would be given to cash clients as a class before margin clients, with clients in each class as between themselves sharing pari passu.

(1) Rule in Clayton's case

54. The usual "first port of call" in situations where beneficiaries are competing for distribution in case of deficiency is the rule in Clayton's case, where it is presumed that the first amount paid into a bank account would be the first amount taken out. The same result can be achieved by considering the facts backwards, i.e. by assuming that the last amount paid in would be the last amount taken out.

55. When one considers that Clayton's case itself was concerned with appropriation of payments credited to a running account, that rule accords with presumed intention and is fair and just. In the present case however, such a method of allocation is unattractive and is in any event inapplicable and impractical.

Injustice of applying the rule

56. I am not the first judge, nor I expect will I be the last, to echo with respect the words of Learned Hand, J. in Re Walter J Schmidt & Co., ex p Feuerbach (1923) 298 F 314:

"When the law adopts a fiction, it is, or at least, it should be, for some purpose of justice. To adopt [the fiction of first in, first out] is to apportion a common misfortune through a test which has no relation whatever to the justice of the case."

57. Nonetheless, the Court of Appeal in Barlow Clowes (International) Ltd (in liq) v Vaughan [1992] 4 All ER 22 has recognised it to be a long-established general practice that the rule in Clayton's case is to be applied when several beneficiaries' moneys have been blended in one bank account and there is a deficiency. In Barlow Clowes however, the rule was not applied because there was evidence that the parties intended to participate in a collective investment scheme.

58. In the title application, I have found that the clients here were beneficiaries in individual trusts, not in a collective scheme. Therefore the Barlow Clowes method of distinguishing the rule in Clayton's case is not applicable.

59. However, the rule in Clayton's case was based on presumed intention. In the present case, there are no facts which can support any presumed intention that CAP Securities would have first withdrawn for delivery to the Lenders the shares which had been deposited with them first. None of the documentation signed by either the cash clients or the margin clients supports the presumption of such an intention, nor did any past course of dealings between CAP Securities and any of its clients. To apply the "first in, first out" rule in Clayton's case here would be contrary to the parties' intentions and would work arbitrary and unjust results.

Inapplicability

In any event, given the circumstances in which the rule in Clayton's case evolved and has been developed, it can be restricted to situations where beneficiaries are competing only for funds in an account into which different trust moneys have been paid and from which amounts have been withdrawn so as to result in a deficiency. The Court of Appeal in Re Diplock's Estate [1948] Ch 465 said (at p.555) that they saw no justification for extending the rule beyond the case of a banking account. In the present case, the trust is of shares, so that strictly speaking, the rule in Clayton's case does not apply.

Impracticality

61. Even if it did apply on the basis that there is no real distinction between moneys in a bank account and shares in CCASS, it would be impractical to apply that rule in the present case. The Liquidators have estimated that a detailed Clayton's case type tracing process would cost $187 million and would take 5 years to complete. The cost and time required for this method of allocation render it unacceptable. It could not possibly be in the interests of any of the clients for them to have to spend so much and to wait so long, for a potentially unjust result not intended by any of them.

(2) "Pari passu ex post facto" approach and variations

62. As an alternative to the rule in Clayton's case, the "pari passu ex post facto" approach was adopted in Barlow Clowes. As explained in that case (at p.36)

"this involves establishing the total quantum of the assets available and sharing them on a proportionate basis among all the investors who could be said to have contributed to the acquisition of those assets, ignoring the dates on which they made their investment. ... It has the virtue of relative simplicity and therefore relative economy and also the virtue of being in this case more just than the first solution [the rule in Clayton's case]. It would have the effect of sharing the pool of assets available proportionately among the thousands of investors in a way which reflected the fact that they were all the victims of a `common misfortune'".

63. One can easily see the attraction of applying that approach in a situation where the contractual positions of all clients were identical.

64. In the present case, however, the contractual positions of the clients were not identical. Although all clients of CAP Securities were individual beneficiaries vis-a-vis CAP Securities, only the margin clients had separately authorised CAP Securities to transfer their shares to CAP Finance to enable the latter to pledge those shares as security for loans made to it (CAP Finance) by the Lenders. As noted above, this was a distinction which was respected and implemented in practice.

65. In light of the above facts, whilst all clients have suffered a misfortune arising from the collapse of the CAP companies, it is only fair to recognise that the cash clients were the victims of a greater misfortune, because shares attributable to them had been transferred for the benefit of CAP Finance when (a) they had never signed any documentation authorizing any such transfer and (b) CAP Securities had respected and implemented their instructions in practice, never having drawn on shares attributable to cash clients until the last few trading days when a deficiency in shares attributable to margin clients led to the transfer of shares attributable to cash clients.

66. This is a distinction between the two types of clients which renders the equal treatment of all, under the "pari passu ex post facto" approach, unjust and unfair to the cash clients. Equal treatment would only be just and fair if the equities were equal.

(i) The "North American" or "rolling charge" variation

67. I have also been referred to a number of cases decided in the Canadian courts where the "North American" or "rolling charge" basis has been considered. This is a refinement which also recognises that a broad-brush equal treatment of all may lead to injustice.

68. This involves treating credits to a bank account at different times as a blend, with the result that when a withdrawal is made from that account, it is treated as a withdrawal in the same proportions as the different interests in the account bear to one another just before the withdrawal.

69. This is a refinement in the time element which makes the "pari passu ex post facto" approach fairer. Assuming that at some stage, the account was completely depleted, contributors before that date would not be able to share in any balance in that account at a subsequent date. For that reason, this basis has been said to be subject to a "lowest intermediate balance" restriction.

70. Whatever the improvement effected by this variation to the pari passu ex post facto approach, it does not address the distinction between the two types of clients in the present case, where the distinction is not one of time of contribution, but one of authorisation.

(ii) The weighted pro rata variation

71. The method recommended by the Liquidators in the present case has been called the "weighted pro rata" approach. This involves a 2-pool approach: the 1st being the shares which were held at CCASS or otherwise under CAP Securities' control prior to liquidation, and the 2nd pool being shares under the control of the Lenders.

72. As I understand it, the suggestion briefly, is that the proportions of each stock in each pool be calculated as between cash clients, margin clients and Pui Hang clients, and those proportions would be applied to the shares remaining in each pool available for allocation now.

73. Whilst this approach attempts to crystallize the position at a moment in time prior to the collapse of CAP Securities and CAP Finance, again it does not address the distinction referred to above, that of the lack of authorization from the cash clients for any transfer of shares to CAP Finance's lenders.

(3) Priority to cash clients, clients in same class sharing pari passu

74. This distinction is reflected in the method of allocation which I believe would be the most just in the circumstances:- under this method, priority to the remaining shares in each line of stock is given to cash clients who had acquired that stock (subject to any sale effected by CAP Securities under clause 4 of the Client Agreement to which I will refer later), the balance of the shares in each line to be allocated to margin clients who had acquired that stock, with clients in the same class sharing pari passu in the event of deficiency.

75. In my view, this would reflect the presumed intention of all parties. I have referred above to the differences in the documentation between cash clients and margin clients. The Liquidators have also found that the actual practice of the companies was that it was generally not the policy to pledge shares attributable to cash clients to CAP Finance's Lenders, and it could therefore be assumed that shares attributable to cash clients remained, as far as possible, at CCASS or otherwise under the control of CAP Securities.

76. In Re Hallett's Estate, Knatchbull v Hallett (1880 ) 13 Ch D 696, it was held by the majority of the Court of Appeal that where a trustee had blended moneys held by him for a beneficiary and for certain other trustees with his own moneys in a bank account which he operated for his own purposes, he must be deemed to have drawn on his own moneys first, rather than trust moneys, in paying expenses for his own purposes.

77. The principle behind that decision was that where a person can do an act lawfully, it would not be assumed that he had intentionally done the act wrongfully (at p.727). The position is clear where a trustee has mixed his own money with that of a beneficiary, and has spent some of the mixed money for his own purposes. He would be presumed to have used his own money first because that would be the lawful thing to do.

78. Similarly here, where CAP Securities as trustee could have lawfully delivered shares attributable to margin clients to CAP Finance's Lenders, but could not have lawfully delivered shares attributable to cash clients, it must or must be presumed to have done the lawful thing first, i.e. to have first exhausted shares attributable to margin clients before drawing on shares attributable to cash clients. The consequence is that what remains in each line of stock must be attributable first to cash clients.

79. This method of allocation does not seem to have been adopted in any of the cases referred to me, where different facts prevailed. In any event, this method of allocation does not appear to be inconsistent with any decisions.

80. In Re Bryant, Isard & Co, ex parte Turner [1925] 7 CBR 44, a case referred to by counsel in Forluxe, a customer (T) of a stockbroker had deposited shares with him with instructions to sell those shares. Other customers (E and B) had deposited their shares with him as collateral for their trading accounts. The stockbroker pledged all the shares to a third party and then became bankrupt. The stockbroker's pledgee sold all the shares and returned surplus proceeds to the stockbroker's trustee in bankruptcy. Customer T sought an order that he should rank in priority to the other customers E and B.

81. The Appellate Division of the Supreme Court of Ontario held that the pledging by the stockbroker of all the shares was wrongful because the stockbroker there had no right to pledge E and B's shares for any sum in excess of their respective debts, and in fact their indebtedness had been eliminated by other collaterals.

82. Not surprisingly in those circumstances, no distinction was made between T of the one part, and E and B of the other. The act of pledging was unlawful in both cases.

83. As a matter of completeness, I would note that the method of allocation to be adopted in the present case was alluded to obiter in the decision of the Registrar in Re Carroll & Wright, ex p Bain quoted by Urquhart J. in Re Nakashidze (No.2) [1948] 2 DLR 522, 531-2.

84. The registrar in Carroll & Wright had referred to customers whose securities were wrongfully pledged as having priority over those whose securities had been rightfully pledged. That statement although obiter was accepted by Urquhart, J. in Nakashidze when he remarked that where there was both a lawful and an unlawful pledging of shares, the equities would not be equal.

85. As for the practicalities of this method of allocation, I have been informed by the Liquidators that they would have no difficulties implementing it.

86. As a distinction has to be drawn between cash clients and margin clients, any clients who had not signed any Memorandum of Deposit in favour of CAP Finance would be treated as cash clients, and any clients who had signed a Memorandum of Deposit would be treated in the first instance as margin clients.

87. Should any client object to being classified as a margin client notwithstanding his execution of the Memorandum of Deposit, he should lodge his objection (together with reasons and supporting documentation) within 28 days of his being notified by the Liquidators of his classification as a margin client. However, as has been decided above, since any misrepresentation by CAP Finance staff would not have affected CAP Securities' perception of the client as a margin client when shares attributable to him were delivered to CAP Finance's Lenders in 1998, no purpose would be served in permitting objections to classification based on any alleged misrepresentation. In those circumstances, the client would have to pursue his remedies against CAP Finance.

Order

88. In conclusion therefore, there is therefore nothing in logic, case law or practicalities that detracts from the fair and just solution of giving priority to the cash clients in each line of stock, save for any cash clients who had fallen foul of Clause 4 of the Client Agreement by having failed to make payment for the shares. Should there be any such clients, it should be assumed that CAP Securities would have sold the shares acquired to satisfy the defaulting clients' obligations to it.

89. In relation to any shares which had not been paid for by a cash client by T+2, but which had nevertheless been attributed to that client in the FIS after T+2, the conclusion that should be derived from those facts would be that CAP Securities did not intend to sell those shares, but only intended the general lien under Clause 6 of the Client Agreement to apply. The Client Agreement gave no power of sale of shares covered by the lien.

90. After the recovery of shares in each line of stock by cash clients who had acquired that stock, the balance of shares in each line should be recovered by margin clients, subject to any charge in favour of CAP Finance for any indebtedness, and in the event of any dispute between the liquidators of CAP Finance and the margin clients in relation to such indebtedness, the liquidators of CAP Securities should apply for directions by way of interpleader.

91. In the event that there should be a deficiency within either class, the shares should be allocated pari passu amongst the members of that class.

92. In either case, the allocation of shares is subject to the right of the SFC to statutory subrogation to the extent set out in the decision that I am about to deliver in Re Forluxe Securities Ltd.

93. In the light of my decision above, I would ask that counsel for the Liquidators prepare a draft of the proposed order for my consideration and approval.