Download The Untangling of Client Assets at Lehman: A Year`s Progress

The Untangling
of Client Assets
at Lehman:
A Year’s Progress
By Joanne Morrison
More than a year after the collapse of Lehman Brothers, many of its
institutional customers are still waiting to recover their cash and
other assets from accounts at Lehman Brothers International
Europe, the firm’s U.K. subsidiary. But now there is light at the end
of the tunnel, thanks to two important developments in December.
O
n Dec. 29, PricewaterhouseCoopers,
the firm appointed by the U.K. government to administer the LBIE bankruptcy,
announced broad support for a “claim resolution agreement” that establishes a process for
returning $11 billion in client assets that
were clearly segregated from LBIE’s house
accounts. PWC said it expects to begin distributions under this agreement shortly after
March 19, when the deadline comes due for
the filing of all claims to the money.
“The claim resolution agreement now
provides an agreed basis on which to systematically settle clients’ claims and reunite
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them with their assets,” Steven Pearson, a
partner at PWC and joint administrator of
LBIE, said in a Dec. 29 statement.
Second, a court decision in midDecember provided PWC with guidelines for
the return of more than $2 billion in client
money also held in segregated accounts.
Although many of LBIE’s customers were not
pleased by the outcome because it excluded
their claims, PWC hailed the ruling as an
important step forward.
“There has been a significant uncertainty
over who is entitled to claim the client money
which LBIE is holding,” Andrew Clark, a
partner at PWC who is leading the team managing client money matters, said in a Dec. 15
statement. “This decision provides clarity and
enables us to confirm client entitlements.”
The latter development is especially
important for hedge funds and other institutional investors that traded futures and options
through LBIE. When Lehman Brothers collapsed in September 2008, the two clearinghouses that handled the bulk of LBIE’s listed
derivatives business—LCH.Clearnet and
Eurex—were able to transfer client positions
into accounts at other futures and options brokers in a matter of days (see “The Lessons of
Lehman” in the January/February 2009 issue of
Futures Industry).
Consequently, none of those positions
were tangled up in the administration. But
the cash and other collateral used to margin
those positions had to be transferred to
LBIE’s administrators, and up to now most of
that collateral has not been released.
On the other hand, neither development
addresses the large number of LBIE customers whose assets and monies were not
segregated. “An awful lot of clients opted out
of client money protection,” Pearson said in
an interview with Futures Industry. As a
result their claims will go into the same pool
as all other unsecured creditors.
Claim Resolution Agreement
Under the agreement, PWC will divide
client claims to the segregated asset pool into
four categories and apply varying formulas to
determine the value of claims and the distribution of the assets. The agreement is similar
to the “scheme of arrangement” that PWC
proposed in July 2009 but abandoned in late
2009 after it failed to receive the necessary
backing in the U.K. courts.
One potential problem with the claim
resolution agreement is that it is not binding on all clients with segregated asset
claims. Although more than 90% of the
clients with claims to the segregated asset
pool gave their support to the agreement,
the handful who did not could challenge
the distribution in court.
Another critical factor in determining
the size of the distribution is the administrators’ effort to recover client assets from
LBIE affiliates. PWC has identified $7.2 billion held by Lehman affiliates in other
countries. In December, PWC succeeded in
recovering $1 billion from Lehman Brothers
Japan, but $5.9 billion is tied up in Lehman
Brothers Inc., the firm’s main operating
entity in the U.S., and there is no timeline
for that return.
“They [LBI] have yet to return any assets
to LBIE,” said Pearson. “We have a very constructive working relationship with LBI, but
the complexities of the U.S. process and the
lack of certainty of treatment of various claims
means that they have been unable to return
any of these assets to us at this stage,” he said.
Even in the best case scenario, clients will
not recover 100% of their assets due to shortfalls in LBIE’s segregated asset pool, the difficulties of recovering assets from other Lehman
affiliates, and the costs of the PWC administration. PWC’s fees so far have reached £154
million ($249 million), equivalent to roughly
0.7% of the total amount of client assets held
by LBIE when it went bankrupt. PWC is also
seeking a 1% fee on all assets distributed under
the claim resolution agreement.
Client Money Shortfall
While progress is being made on the
return of client assets, a separate process is
under way for returning client money,
including cash held as collateral for
A further complication is that roughly $1
billion in client money, some of which is
exchange margin, was deposited at Lehman’s
German affiliate, Lehman Brothers Bankhaus.
These funds are now frozen in bankruptcy proceedings in Germany. Even though these funds
belong to Lehman’s customers, under German
bankruptcy law they are considered a claim by
a Lehman affiliate and therefore will not be
considered ahead of other creditor claims
lodged with the German affiliate. PWC has
said that there is a possibility that none of this
money will be recovered, leading to a $1 billion deficit in the client money pool.
A further complication is that roughly $1 billion in
client money, some of which is exchange margin,
was deposited at Lehman’s German affiliate,
Lehman Brothers Bankhaus. These funds are now
frozen in bankruptcy proceedings in Germany.
exchange-traded futures and options contracts. PWC estimates that LBIE was holding
more than $2 billion in segregated client
money when it went into administration.
On Dec. 15, a U.K. justice issued a ruling
that clarified several key issues affecting
claims on this money. In particular, the justice ruled that customers whose money was
not segregated do not have claims on the segregated client money pool, even though
there was a “massive failure” to properly
identify and segregate client money.
“LBIE failed to identify as client money
and therefore also failed to segregate vast
sums received from or on behalf of a significant number of its clients,” the justice wrote
in the Dec. 15 ruling. These clients include
various Lehman affiliates, which have
advanced claims against LBIE in excess of $3
billion, well beyond the $2.16 billion actually held by LBIE in segregated accounts.
Several clients, including Goldman Sachs
GSIP Master Co. (Ireland) and Paragon
Capital Management, have indicated that
they plan to appeal this decision, according to
PWC. Also planning to appeal are LBIE affiliates such as Lehman Brothers Inc. and
Lehman Brothers Holdings. Those appeals
will have to be submitted by mid-January.
“The combination of a massive failure to
identify and segregate client money, coupled
with the credit loss shortfall attributable to
the Bankhaus failure, has thrown up a series
of fundamental problems,” the justice wrote
in his Dec. 15 ruling.
Proposed Reforms
Meanwhile, U.K. policymakers are taking
steps to address the weaknesses in U.K. customer protections that were exposed by the
collapse of Lehman Brothers. In a consultation
paper released on Dec. 16, the U.K. Treasury
issued a package of market, regulatory and legislative policy proposals aimed at improving
the management of investment bank failures.
Among other things, the Treasury proposed creating a client assets agency within
the Financial Services Authority to oversee
the segregation and protection of client
money. The Treasury also proposed appointing a client assets trustee separately from the
bankruptcy administrator to ensure that
client assets and money are returned as
quickly as possible when an investment bank
runs into financial difficulties.
Other proposed recommendations include the following:
January 2010
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• Increase clarity over the allocation of
shortfalls in an omnibus account by making the allocation pro rata.
• Mandate product warnings in contractual
agreements by clearly setting out the implications of allowing rehypothecation and use
of client omnibus accounts at custodians.
• Encourage clarity in contractual agreements by encouraging investment firms
to be transparent over any risks to client
money and assets protection.
Services Authority is able to ensure that
the people in charge of directing client
assets are fully qualified and capable of
executing their duties.
• Support the establishment of bankruptcyremote special purpose vehicles for client
assets to ensure that the return of client
assets is not affected by the insolvency
proceedings of the investment firm.
• Place an absolute ban or heavy limitations on the ability of investment firms to
One result of the Lehman bankruptcy is that more
customers have opted for segregated treatment
for their assets even if it means more cost.
• Increase reporting and record-keeping
requirements by requiring investment
firms to develop capacity for daily reconciliation of client positions and
exposures.
• Increase audited disclosures by firms
around client money and assets.
• Make client asset officers directly
accountable so that the Financial
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transfer client money to affiliate entities
and jurisdictions where there potentially
are interoperability issues with U.K.
client protections.
• Change the regime regarding custodians’
right of lien over client assets so that
firms would be required to obtain letters
in respect of client assets that state that
the custodian has no lien or right of
retention over the account and that it
will not seek to combine, net, or set off
the account against the debts or obligations of the firm.
• Require firms to have the ability to divide
client money into different pools according to the type of investment involved.
• Create a statutory scheme with fixed
terms under which client claims have to
be received and dispersals commenced.
Comments on the consultation paper—
developed in collaboration with the Bank
of England and the Financial Services
Authority—are due by March 16, and the
Treasury expects to issue a final report later
this year with concrete proposals and a
timetable for action.
“The collapse of Lehman Brothers …
had a major impact on financial centers
across the world,” U.K. Treasury Financial
Services Secretary Paul Myners said in
December when the consultation was
issued. “It is important that the government
acts to ensure that any future failure of an
investment bank does not cause the same
degree of damage to markets or investors.”
Another important recommendation is
to make sure that certain key personnel
are retained after a firm goes bankrupt so
that essential functions continue and
administrators have access to critical
books and records. This was one of the
major challenges in the immediate aftermath of the Lehman bankruptcy, according to LCH.Clearnet Chief Executive
Roger Liddell.
At a December meeting hosted by the
Commodity Futures Trading Commission’s
Global Markets Advisory Committee,
Liddell explained that it was difficult to
obtain critical information about Lehman
trades and customer accounts from PWC.
“We realized we needed this information from Lehman Brothers,” Liddell said.
“The administrators were very nervous
about giving information away,” he added,
noting that under U.K. law the bankruptcy
administrators working for PWC are individually liable for the decisions they take
and the distributions they make.
Liddell explained that LCH.Clearnet
had to send people on site to Lehman to
gain access to trade information and settle
out Lehman trades. “We sent people down
physically to get it and we started to sit at
the terminals,” he said.
Another important proposal is to
require investment banks to establish a
“living will,” i.e., a detailed plan to unwind
in the event of a bankruptcy. PWC’s
Pearson noted that when his firm was
appointed as administrator there were no
funds to keep LBIE running. “We didn’t
even have any funds to keep the lights on
and had to borrow $100 million in the first
two days,” he said. This was because all of
the funds used to operate LBIE had been
funneled back to its parent in the U.S.
Pearson suggested creating a longer settlement window in the U.K. for completing
trades that a bankrupt firm has entered into
and making liquidity available to allow
these trades to settle. “It would certainly
reduce the enormous reconciliation task we
had to deal with on LBIE.”
Changes in Behavior
One result of the Lehman bankruptcy is
that more customers have opted for segregated treatment for their assets even if it
means more cost.
“In the new structures being set up, hedge
fund clients are increasingly demanding segregated accounts,” said Edmond Parker, who
runs the derivatives practice at the law firm
of Mayer Brown in London. “It’s a clash
between protecting your assets against a
future Lehman-style event and the commercial costs of doing so.”
Another example of changing practices is
at LCH.Clearnet. As it expands its SwapClear interest rate swap clearing service to
buy-side customers, the U.K. clearinghouse
has introduced a “deed of assignment” to protect customer margin from being shifted
under a bankruptcy administrator’s control.
(See “LCH.Clearnet Takes the Lead in
Clearing Interest Rate Swaps” in this issue of
Futures Industry.)
With years of restructuring work under
his belt, PWC’s Pearson said simplifying
organizational structure is critical. “I think
the biggest policy changes are the simplification of investment firms and the de-risking of institutions too-big-to-fail. I do a lot
of restructuring work and the first thing
we look to do is simplify the organization,”
he said.
Joanne Morrison is deputy editor of Futures
Industry.
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