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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 34 www.futuresindustry.com 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 35 Thank You Sponsors! FIA Futures Services Division Angelo Laspina Golf Outing ’09 • BMO Capital Markets • Millenia Imaging • Brown Brothers Harriman • NASDAQ OMX • CME Group • Newedge USA • Credit Suisse Securities (USA) • National Futures Association • Dennis Murray Consulting • The Options Clearing Corporation • Federated Investors Inc. • Prudential Bache Commodities • FTEN • R.J. O’Brien & Associates • HSBC Securities USA • SunGard • Katten Muchin Rosenman • Tellefsen and Company • Michael Kaczmarski Consulting • 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 36 www.futuresindustry.com 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. Be part of the event! Registration for IOSCO 2010 in full swing! AMF AMF is is proud proud to to host host the the Annual ual Conference 35th Ann International of the In ternational Organization Organization Securities of Secur ities Commissions Commissions (IOSCO) (IOSCO) June 6 – 10, 2010 Montréal, Montréal, Québec, Canada Canada www.lautorite.qc.ca www.lautorite.qc.ca www.iosco2010.com www.iosco2010.com January 2010 37