By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)
In this two part paper, the issues regarding settlement of complex derivatives arrangement revealed by the failure of Lehman Brothers is outlined. Many of the failures affect new regulatory proposals such as the rapid resolution regimes under consideration. The First Part dealt with terminating and settling derivative contracts. The Second Part deals with effects of the bankruptcy on structured products and collateral.
Lehman’s bankruptcy filing also affected structured products. Typically, these products are notes, bonds or deposits that use derivative technology to provide investors with higher interest rates than traditional instruments or “bespoke” structured returns on equity, currency, credit or commodity assets.
Exposure to Lehman derives from multiple sources. Lehman itself was the basis of the underlying commercial bet in some transactions. Lehman issued the notes in some cases. Lehman was the derivative counterparty in other transactions.
Structured products involving Lehman were frequently “white labelled”; that is, packaged and sold by unrelated banks and brokers as their own. This form of “own brand products”, common in financial markets, creates multiple problems, especially where sold to retail investors in non-English speaking jurisdictions. The level of disclosure of details of the structure and risk is variable. Words like “loss” and “risk” do not appear to exist in many emerging market languages. In addition, the direct exposure to Lehman, the product manufacturer, may not be obvious or even disclosed. Following the demise of Lehman, many investors in Europe and Asia were surprised to discover indirect and hitherto unknown exposure to the collapsed investment bank.
Lehman was a common reference entity in the CDS market. When the firm filed for bankruptcy protection, losses were triggered in CDS contracts but also a variety of structured credit products, such as Collateralised Debt Obligations (“CDOs”) and credit linked notes.
Where Lehman had issued or guaranteed the structured product, the investor was directly exposed to the investment bank. Upon the bankruptcy, the investors suffered losses.
The most complex exposure was where Lehman was the counterparty to derivative transactions incorporated within a structured product. One example is the Lehman’s Minibond product sold to Asian retail investors.
The Minbonds entailed investors purchasing a bond or note issued by a special purpose vehicle (“SPV”) located in the balmy Cayman Islands or British Virgin Islands. The funds were then placed in highly rated (AAA) securities (“the collateral”). The SPV then entered into a credit derivative contract known as a first-to-default (“FTD”) swap. The SPV received fees in return for insuring the risk that no entity within a basket of 7-8 firms defaults during the life of the contract.
As the product evolved, the investor’s money was increasingly invested in more risky collateral such as complex structured securities, including asset backed securities (“ABS”), CDOs and CDO2s. In addition, many structures involved layers of other derivative contracts, such as interest rate swaps and currency swaps, to allow the notes to be denominated in the required currency or pay fixed or variable coupon.
The investor received an interest rate, higher than on normal deposits of bonds of a comparable maturity. This enhanced return was the combination of the interest on the AAA collateral and the fees on the FTD swap.
The investor took the risk that one of the insured entities may default resulting in the investor losing all or part of its principal. This risk was frequently highlighted in the marketing material as the “primary” risk. The investor also took less obvious risks, which could be equally damaging to the investor’s wealth. The most important additional risk was to the potential default of the counterparty to the derivative contracts, the role played by Lehman in the Minibonds.
Consistent with the procedure described, when the investment bank filed for bankruptcy, the derivative contract between the SPV and Lehman terminated necessitating determination and payment of a settlement amount. If this amount was payable to Lehman then the entire structure had to be unwound. The collateral had to be sold and the cash released distributed to the derivative counterparty and the investors in accordance with a nominated hierarchy.
This process exposed the investor to a potentially toxic combination of credit, market and liquidity risk. The Lehman filing triggered a significant rise in credit margins and volatility, which resulted in significant mark-to-market losses on the FTD swaps and also the underlying collateral. This meant there was a large amount owing to Lehman upon termination of the derivative contract. It also meant that the value of the collateral was lower than face value. The investor lost when the SPV realised its collateral. It then further lost under the FTD swap.
The investor’s losses were especially egregious as they were triggered by Lehman’s collapse, rather than the risks that the investor assumed that they had taken. In many cases, if the Minibond been held through to maturity, then the investor would not have suffered any losses. There had been no defaults by any of the entities that the investor had insured under the FTD swap. The underlying collateral, which is generally matched to maturity of the notes, would have matured, at face value.
In some transactions, the losses were exacerbated by the use of highly structured securities as collateral. These securities lacked liquidity and attempts to realise them to unwind the arrangements as required sharply increased investor losses.
Perversely, the structure of the transactions allowed Lehman to benefit from its own bankruptcy in relation to these specific transactions. Living up to their names, the MiniBonds provided mini returns and maximum losses. Investors shared American author Bill Watterson’s lament: “I know the world isn’t fair, but why isn’t it ever unfair in my favor?”
There were documentary problems as largely untested legal arrangements failed to work as intended. In most structured notes such as the Minibonds, the documentation sets out a system of priority of claims against the underlying collateral.
Normally, the derivative counterparty, such as Lehman, has first claim over the collateral to meet amount owed to it. Where the derivative counterparty itself is in default, as when Lehman filed for bankruptcy protection, the priority reverses with the innocent investor having the first claim on the collateral. Such arrangements – known as the “flip” clause – are commonplace. They are a feature of many structured finance arrangements, buttressed by appropriate “legal opinions” from “learned” counsel.
When Lehman filed for Chapter 11 protection triggering termination of derivative contracts with SPVs in structured products, the operation of the flip clause should have ensured the change in priority for payment under the swap in favour of Lehman’s swap counterparties. On 25 November 2008, Weil, Gotshal & Manges, Lehman Brothers’ legal counsel, notified all swap counterparties that, in their opinion, the flip clause breached several provisions of the US Bankruptcy Code. This was despite the fact that many of the relevant transactions were governed by English law.
The argument was that the change in priority deprived Lehman of an asset (being the priority to amounts owed under the swap) because of its bankruptcy. Section 365(e)(1) of US Bankruptcy Code provides that an “executory” contract may not be terminated or modified solely as a result of debtor filing for bankruptcy. Lehman also argued the application of the basic English law proposition that the property of a person cannot be taken away on insolvency.
The operation of the flip clause became the subject of complex and expensive litigation between a trustee (Perpetual Trustee Co Ltd) and Lehman Brothers Special Financing (“LBSF”). Perpetual is acting as the trustee of Mahogany Capital, an Australian SPV, which issued A$125 million (US$120 million equivalent) credit-linked notes to retail investors. The money received from the retail investors was invested in CDOs issued by Saphir Finance Ltd (a SPV associated with Lehman). The financial arrangements and collateral for Mahogany Capital are similar to the arrangement described above for structured products generally, such as the Minibonds.
Perpetual initiated legal proceedings in the UK claiming priority over LBSF to the underlying collateral (Noteholder Priority). Perpetual took action in the UK Court to order the custodian (Bank of New York Mellon (“BNY”)) to release the underlying collateral to Perpetual. In proceedings before the UK High Court from 7 to 9 July 2009 and Court of Appeal from 13 to 15 October 2009, Perpetual’s position was upheld. The UK court ruled that Perpetual had priority over LBSF to the collateral under the English Law, that is upheld the Noteholder Priority). Upon appeal, the UK Supreme Court confirmed that Perpetual had priority over LBSF.
Parallel to the progress of the Perpetual case in UK, LBSF commenced a separate legal action against BNY in the US Bankruptcy Court on 20 May 2009 by filing a two-count complaint. The US Bankruptcy Court on 25 January 2010 ruled in favour of LBSF. The court decided that the provisions in the swap agreements that seek to modify LBSF’s payment priority upon an event of default constitute unenforceable ipso facto clauses that violate Bankruptcy Code. It also ruled that any action to enforce such provisions as a result of LBSF’s bankruptcy filing violates the automatic stay under US Bankruptcy Code. The later makes it difficult for counterparties to prosecute their right or deal with assets.
The conflicting position creates significant uncertainty for all parties seeking to settle terminated transactions. Judge Peck in his judgement which was at odds with the UK Courts noted that: “This decision places BNY in a difficult position in light of the contrary determination of the English Courts confirming that Noteholder Priority applies to claims made against it in English by Perpetual. This is a situation that calls for the parties, this Court and the English Courts to work in a coordinated and cooperative way to identify means to reconcile the conflicting judgments.”
BNY subsequently appealed the decision. The appeal process was made difficult by Judge Peck’s refusal to seal his orders, normally a key step in allowing appeals and judicial reviews of a lower court decision. After much legal manoeuvring, BNY received leave to appeal Judge Peck’s decision.
In giving leave for BNY to appeal the decision contradicting the UK Court ruling, the appellate Judge (McMahon J.) referred to a number of articles cited by BNY questioning the correctness of Judge Peck’s decision and comments that “LBSF meekly responds, citing a single article, that the commentary on the Bankruptcy Court’s decision has, in fact, been “mixed”.” Judge McMahon was critical of Lehman and the bankruptcy court’s conduct: “it is not difficult to see LBSF’s arguments for what they are: an attempt to use the English proceedings to insulate Judge Peck’s decision from appellate review for as long as possible … LBSF’s efforts to shield Judge Peck’s unprecedented and – for LBSF – extremely favourable decision from review are, of course, not surprising; indeed, LBSF does not deny that, since the decision was handed down, it has used it as leverage in settlement negotiations concerning billions of dollars worth of similar transactions.”
In December 2010, Judge Peck approved a settlement between Lehman and BNY and Perpetual. A condition of the settlement was that the US and UK lawsuits involving Lehman, BNY and Perpetual would be dismissed and the parties would release their claims against one another. Under the settlement, Lehman paid £280,320 ($440,000) to cover Perpetual’s cost costs in the English case. The settlement may have been motivated by Lehman’s desire to enable the bankrupt firm to continue to use the uncertainty as leverage in it settlement negotiations.
Losses for investors in structured products will sharply increase if the flip clause is not upheld. This would rub further salt into fresh and extremely raw wounds given that investor losses were largely the result of Lehman’s default under its contract.
A&M and Lehman’s comments about “bankruptcy opportunism” are self serving. When it has suited them as in the case of the flip clause, A&M and Lehman have been quick to indulge in opportunism of their own. As French playwright Moliere noted: “Hypocrisy is a fashionable vice, and all fashionable vices pass for virtue.”
In Life and In Death…
The Lehman’s matter highlights the weakness and complexities of derivative contracts and related transactions, such as the use of collateral. For the most part, regulators, industry bodies and policy makers have failed to acknowledge, understand and deal with these issues. Like John Cash (Of IdSoftware fame), regulators have taken the view: “I want to move to theory. Everything works in theory.”
There have been attempts to address some issues in relation to collateral. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act provides for the segregation of margin. The legislation requires dealers to notify counterparties of their right to require “segregation of the funds or other property supplied to margin, guarantee, or secure the obligations of the counterparty”. It is unclear whether segregation of collateral is likely to become widespread as it will increase the costs to dealers which, in turn, will be passed on to clients.
Many documentary problems of derivatives, especially around the termination and calculation of settlement amounts, remain. In addition, there are equity issues where counterparties and investors in structured products suffered large losses as a result of the operation of the termination provisions. The opportunity for Lehman to benefit from its own default in many transactions has also not attracted attention.
The complex legal proceedings around the enforceability of the flip clause have significant implications for securitisation. In the short, run it creates uncertainty that will make it difficult for policy makers to resuscitate the moribund market.
If the flip clause was to be ruled unenforceable, it could have consequences for other financial contracts, including provisions within the ISDA Master Agreement itself. For example, there could be challenges to various contracts where provisions purport to modify rights following the insolvency of one party to the contract. In the extreme case, some lawyers have suggested that it could call into question the efficacy of bankruptcy proof SPV, central to most structured finance.
A key problem has been the financing of legal actions. In many structured transactions where the ultimate investors are individuals, Trustees have been reluctant to initiate and continue legal proceedings because of the lack of available funding to finance such actions. The problem has been exacerbated by actions of Lehman/ A&M to initiate and prosecute expensive, lengthy legal proceedings aggressively. While perfectly legal, these strategies take advantage of the inadequate financial resources of counterparties, forcing early settlements that may be favourable to Lehman and unfavourable to the investors.
It is only in rare cases that Trustees have been able to take the necessary legal steps to clarify the legal issues. In Hong Kong, the Trustee of the MiniBonds was provided with the ability to (if necessary) initiate legal action by a funding arrangement, established under the supervision of Hong Kong regulators. Under the arrangements, the banks, which distributed the Minibonds, were forced to buy back the Minbonds sold to retail investors at an agreed price. The banks were also forced to disgorge commissions earned on the transactions to effectively create a pool of funds to finance potential litigation against Lehman to recover amount owed.
For the foreseeable future, lawyers for the Lehman estate and acting for counterparties in transactions with the collapsed investment bank are likely to test contractual provisions and bankruptcy laws in many jurisdictions as they attempt to gain access to collateral, valued at billions of dollars. Who said there were no winners in the Lehman’s collapse?
The problems identified have significant implications for a key element of proposed new financial regulations– the rapid resolution plan, christened the “living will” or “financial death plans”. In essence, systematically important financial institutions (“SIFIs”) would be required to file a plan for dismantling the institution in case of serious financial distress.
The concept is driven by fear of widespread systemic failure following the failure of a SIFI. In reality, it is also a “soft option” avoiding the need to deal with the real issue – the size, scope and complexity, especially the network effects of trading, of large “too big to fail” financial institutions. Promoted by regulators and academics with little or no practical familiarity with the complexity of derivative trading or dealing with failed or bankrupt financial institutions, the concept may be in the words of The Economist “a little fantastical”.
One institution promoting the idea is the US Federal Deposit Insurance Corporation (“FDIC”) which already has powers to wind down some banks. However, the FDIC procedures are not suited to large complex financial institutions.
While the FDIC’s procedures may work for smaller institutions with little of no derivative exposures operating primarily in America, it is difficult to see similar approaches being successful for larger institutions with more complex, cross border operations. For example, Lehman Brothers had 2,985 legal entities operating in around 50 countries. In hindsight, it is also abundantly clear that neither Lehman nor its counterparties had a thorough grasp of its credit exposures under derivative contracts, credit enhancement used or the required process to terminate the contracts.
No resolution process will be effective unless the fundamental issues relating to termination of derivative contracts are clarified and resolved. Similarly, no resolution process will be effective unless the procedures around the use of collateral and other forms of credit enhancement are strengthened. The imposition of a central counter party (“CCP”) will not be effective without resolution of these issues.
A key problem that will remain is the application of different laws and regulations in different jurisdictions. “International” when solvent, complex financial institutions quickly become “national” in distress. As was evident in the case of Lehman, when a firm collapses, it quickly fragments into its individual legal entities that must be dealt with separately around the world. There is no current effective system for dealing with this fragmentation.
The proceedings around the flip clause are instructive. If the US court ruled in favour of Lehman but failed in the UK courts, then one option for the estate would be to invoke measures in the United Nations Commission on International Trade Law (Uncitral) Model Law of Insolvency. This would entail requesting the English courts to apply provisions of the US Bankruptcy Code.
To date, the UK courts have not indicated whether this would be possible. It seems likely that the UK courts would recognise the insolvency, but only insofar as it is consistent with English law. It is unlikely that the English courts would adopt US bankruptcy law where there are conflicts with English law, for example, in the case of the flip clause.
If the US Court decides for and the UK Courts against Lehman, then there would be a stalemate. The trustee and custodians would be in the unenviable position of having to reconcile the diverging rulings. They would probably refuse to release assets or meet claims without full indemnities, further extending the delay.
The reality is that any functioning global resolution regime is “light years” away as international agreement on critical issues and a coordinated approach is unlikely.
In fact, under the law of unintended consequences, the resolution regime may perversely make matters worse. For a large international institution which is active globally, local regulators may correctly decide to insist on “ring fencing” local operations to protect local creditors and the integrity of national financial markets. In effect, deposits and contracts with a local operation would have to be segregated from cross border dealings, enabling local regulators to have surety of access to assets to meet local claims. This would have the effect of vastly complicating bankruptcy and also dealing with derivative risk and unwinding positions.
The Hippocratic oath specifies “do no harm”. It would be more sensible to focus on addressing the clear problems in derivative documentation, termination and credit enhancement processes. Unfortunately, regulators and policy makers have embarked on a reformation process without understanding key aspects of the problem or even the appropriate framework of reference.
In a celebrated exchange between two technologists, Trygve Reenskaug says: “In theory, practice is simple.” Alexandre Boily asks: “But, is it simple to practice theory?” The matter of Lehman raises precisely this question.