Late in December last year Lehman Brothers International Europe (LBIE) announced that it had received sufficient acceptances to its Claim Resolution Agreement to return up to £7 billion ($11 billion) of assets to creditors trapped in the bank since its collapse in September 2008. But over a year since the company went into Administration, why does £13.3 billion ($21.7 billion) remain tied up in LBIE?

Trusts present a special issue for financial company insolvency in the UK, in an era weighted by a fund-heavy financial sphere and it is an issue not present over in the U.S. custodian trust accounts are a common feature of hedge funds and prime brokers in the UK and they create trust relationships between bank and client. These same trusts mean that much of a financial services company’s funds will fall outside of the normal insolvency process on liquidation. The same is not true in the U.S. where broker rules and regulations prevent trust issues from arising. The recent decision by the Court of Appeal not to extend Schemes of Arrangement to proprietary rights will mean that trust relationships will be an ongoing problem for many administrators.

Trust Law

Trust law was developed during the Crusades of the 12th and 13th centuries as method to reconcile legal ownership disputes in feudal property. A body of law was developed by the Lord Chancellor to give just and equitable treatment to those who returned from the Crusades to discover that they had lost legal title to their lands. It is those same equitable concepts and rules that govern trust relationships today including those trusts in sophisticated financial products.

In the context of the Crusades equitable claims would have involved disputes over estates of maybe a few acres of land. Something that is in stark contrast to the modern reality when you consider that on its insolvency Lehman Brothers International Europe had pooled assets of $35 billion consisting in over 28,000 different types of financial security.

The Lord Chancellor also did not have to deal with the problem that modern banks operate huge pools of complex financial instruments that are moved between numerous investors, often on a loan basis, making it difficult to establish a proprietary interest in any particular asset.

The Saga

The Administration of LBIE is a rapidly unfolding drama that will hold its place in UK insolvency history. Administrators have struggled to ascertain ownership of the various different and complicated financial instruments held by LBIE on behalf of hedge funds and their inability to use a court approved Scheme of Arrangement means that this saga has some time left to run.

The Administrators have suffered a plethora of problems in returning assets to clients in the administration of LBIE: from the inability to rely on LBIE’s books and records; to the failure of custodians, depositaries and affiliates and the impact of trust interests on a proposed scheme of arrangement. It has been dogged and slow progress. The Claim Resolution Agreement is the latest attempt by the Administrators to achieve a timely and efficient return of client assets but it represents a more costly and uncertain alternative to the Administrators’ earlier failed Scheme of Arrangement proposal.

In a bit of background to the case, Lehman Brothers International Europe entered administration on 15 September 2008. At its height, the Lehman Brothers Group had revenues of $19.2 billion and $800 million in pre-tax income. It was one of the world’s leading global financial-services firms which conducted business in investment banking, research and trading, private equity and private banking.

The primary business of Lehman Brothers International Europe, the European arm of the Lehman Brothers Group, lay in the provision of what have been described as “prime services to various institutional clients”. The majority of those services involved providing hedge funds with execution, clearing and settlement securities and derivative trades and the custody and valuation of the clients’ portfolio.

Hedge funds do not have substantial back office functions of their own. They therefore require a third party to deal with the trades themselves and thereafter to provide custodial and reporting services. As part of these transaction arrangements, prime brokers such as LBIE lent cash and securities to hedge funds and provided foreign exchange services.

These services were provided under standard form agreements of four principal kinds: International Prime Brokerage Agreements, Master Custody Agreements, Margin Leading Agreements and the Credit Support Annex of the Margin Lending Agreement.

A key feature of these agreements was that the client, in most cases a hedge fund, acquired proprietary interests in the assets held by or on behalf of LBIE. These assets were then held through various depositories, exchanges, clearing systems and sub-custodians depending on the type of asset. But these arrangements did not materially change the underlying beneficial ownership of the assets.

A major difficulty facing the Administrators is ascertaining who is entitled to the trust property in their hands, where an asset may have changed hands numerous times. The Administrators have faced the prospect that if they return trust property to beneficiaries then they may face litigation later down the line from beneficiaries who later come to light as entitled to the trust property. To make matters worse, some creditors have threatened to take legal action against the Administrators for failure in their fiduciary duties if they fail to return assets in a timely manner. So damned if they do or damned if they don’t? Or are they?

The solution, it seemed, to the Administrators was to apply to court for a Scheme of Arrangement under section 899 of the Companies Act 2006. A Scheme of Arrangement empowers the court to sanction a compromise or arrangement proposed between a company and its creditors or any class of creditors when it has previously been agreed to in class meetings by a majority in number representing 75 percent in value of the creditors or class of creditors in question.

Schemes of Arrangement have become a regular feature in takeovers and administrations in the UK over the past few years. They provide a clean and relatively straightforward method by which new credit arrangements or share ownership can be imposed on a company, by effectively severing existing creditor and shareholder relationships and creating an entirely new corporate structure. Recent examples include First Quantum Minerals recommended offer for Kiwara, a mineral exploration company, and Resolution’s recommended acquisition of Friends Provident Group, a UK-based life and pension company.

The Administrators’ proposal was that the existing creditors release their proprietary and pecuniary claims and be attributed New Claims under the Scheme of Arrangement. These New Claims would give a creditor a right to receive, on a pooled basis, securities or other assets of the type claimed and would leave a counterparty to recover as an unsecured creditor the value of any shortfall as an unsecured creditor.

The proposal had a number of benefits in its favour: it removed the danger of the administrators or creditors facing future proprietary claims from disenfranchised beneficiaries and it only required the consent of 75 percent of the creditors to be binding on all creditors.

In March 2009, the administrators obtained the High Court’s permission to explore the use of a Scheme of Arrangement under section 899 of the Companies Act 2006. The first instance hearing, however, raised an interesting if esoteric point – was a beneficiary’s rights under a trust capable of being modified by a Scheme of Arrangement?

The Inviolability of Trusts

What may seem like an esoteric point under UK law, actually affects the very heart of the protection provided to trusts. Under a trust, a beneficiary’s right to his assets is inviolable and is separate from the status of the trustee. This right is not affected by the insolvency of the trustee.

In insolvency, as in life, things are rarely that simple, however. There is no statutory definition of “creditor”, “compromise” or “arrangement” for a Scheme of Arrangement and the courts have interpreted these provisions widely. In Re Midland Coal, Coke & Iron Company [1895] 1 Ch 267 it was accepted that a person with a contingent claim against the company qualified as a creditor and in Webb v Stenton [1883] 11 QBD 518 a beneficiary under the trust was treated as a creditor of the trustee.

To further complicate matters; in addition to having proprietary claims, many of the hedge funds, are ipso facto creditors of the LBIE, as they had separate cash accounts with LBIE prior its Administration.

In light of the uncertainty about the remit of Schemes of Arrangement, the Administrators sought a determination by the court under paragraphs 63 and 68(2) of Schedule B1 to the Insolvency Act 1986 that a Scheme of Arrangement extended to a beneficiary’s proprietary rights.

This application was opposed by London Investment Banking Association (LIBA), a trade association for firms in the investment banking and securities industry, who claimed that if such a scheme was possible, it would allow a majority of beneficial owners of property to impose on the minority a compromise of their rights to their own trust property.

Court of Appeal

The case made it to the Court of Appeal, where the court held unanimously that a Scheme of Arrangement was not capable of varying a beneficiary’s proprietary rights under a trust.

Longmore LJ expressed some sympathy with the Administrators attempt to expeditiously return assets to beneficiaries but commented that “it seems most unlikely that the legislature would have intended the beneficiaries’ rights to be capable of being altered by a scheme if the trustee was a company, when there is no such possibility if the trustee was an individual.”

Longmore LJ applied short shrift to the notion that the hedge funds status as creditor in respect of Cash Accounts could mean that this creditor status extends to trust property stating “the practical consequences of [this] would also be startling. Why should the mere fact that a beneficiary happens also to be a creditor of the company entitle the company, or its liquidators or administrators, to include his property in a scheme, when they could not otherwise do so?”

Lehman Brothers Holdings Inc

Across the pond in the U.S., the bankruptcy of Lehman Brothers Holdings, Inc (LBH) unfolded in an altogether different manner. Although LBH also owned numerous and valuable broker-dealer subsidiaries, stockbrokers and commodity brokers, which held securities for clients, Rule 15c3-3 of the Securities Exchange Act of 1934 meant that clients’ fully paid securities were segregated from other accounts and the owner was clearly identified. These securities were then liquidated (sold) under the Securities Investor Protection act of 1970 (SIPA) on bankruptcy and the funds were used to satisfy customer claims.

This segregation of assets meant that LBH was able to ascertain the nature and extent of a beneficiary’s proprietary interests and there was no need to resort to a Scheme of Arrangement style reorganisation. For additional information on the structure of Lehman’s bankruptcy, please see the previous Westlaw Business Currents article Lehman Bankruptcy: Dancing on the Head of a Pin, available in the Related Resources panel.

LandAmerica

The issue of trust ownership in corporate bankruptcy did raise its ugly head in the U.S. in the landmark bankruptcy of LandAmerica, as LandAmerica was safekeeping escrow funds for real estate investors.With LandAmerica the dispute arose out of whether the funds belonged to the bankrupt estate and not the customers.

In LandAmerica, the creditors were unintentionally joined, and there was no clear document outlining their inter-creditor rights and rankings. Enter the proposal of the creditor committee, which attempted to superimpose creditor rankings and structure, using choice of escrow clause as a proxy for strength of creditor rights.

Three “classes” are formed by this analysis, each with quite different recovery levels. The most senior “class” rested on the notion of “qualified escrow account” with a stated escrow agent and segregated client proceeds…and a 97 percent recovery level. The more junior classes were diminished by increasingly weak protections. The “mezzanine class”, awarded a 70 percent recovery level, at least required a separately identified account. The most junior class left LandAmerica Exchange Services (LES) with dominion and control over client’s funds, and merely stated the bank at which they’d be held.

In essence, the weakest classes lacked the separately identified accounts and any reference to a third party escrow administrator outside LES. Further, in dicta, the bankruptcy court indicated that the mezzanine class-member’s position would be stronger if the member had withdrawal rights. These would be found to exist where LES’s client had either co-signatory powers for release of proceeds at the bank level or a provisional contract right to move the proceeds if the custodian faced financial trouble. For additional information on Escrow Risks in the U.S. please the previous Westlaw Business Currents article titled Escrow Risks: It's 10 PM...Do You Know Where the SPAC Funds Are?.

Claim Resolution Agreement

The failure of the Administrators of LBIE in the UK to achieve a court sanctioned reorganisation has led the Administrators to seek a contractual non-court alternative in the form of a Claim Resolution Agreement (CRA).

The CRA, which was circulated in November last year, seeks to provide an agreed contractual mechanism by which creditors will receive payment. It also provides that each signatory releases all other signatories for all asset claims to Trust Assets and obviates the need for complex cross party indemnities.

A contractual remedy as opposed to a court sanctioned Scheme of Arrangement contains a number of deficits. Unlike a Scheme of Arrangement, which will bind all creditors (provided it receives 75% approval), the CRA only binds those creditors that agree to sign up to the CRA. A real danger for the CRA was, therefore, that a significant number of creditors would fail to sign up to the CRA and would maintain their rights to asset claims.

As a consequence of this danger, the CRA was drafted to be conditional on acceptance by 90% of the creditors with proprietary interests together with receiving representations and warranties from the creditors that they have not transferred their entitlement to another person (something that is permitted prior to the acceptance date).

The CRA also contains a “Bar Date” concept that will limit the amount of information that Administrators will have to regard in determining a creditors claim. Under the agreement, a Bar Date of 26 February 2010 means that the Administrators will not have to review any new submissions for Asset Claims received after 26 February 2010 but instead will determine a creditor’s entitlement on the information received up to the Bar Date.

Conclusion

The Claim Resolution Agreement represents an admirable attempt by the Administrators to bring this prolonged administration to a conclusion and it has received favourable uptake from many creditors.

It is as comprehensive as it is complex, but it suffers a number of deficiencies when compared to a Scheme of Arrangement. Its failure to impose conditions on all creditors means that it must run the risk of potential claims from up to 10 percent of creditors by value. Its 90% acceptance level makes it a time consuming and rather longer and more complex process than a Scheme of Arrangement, as greater creditor participation is required. It also lacks the certainty of a Scheme of Arrangement, with no court sanction and a reliance on complex mechanisms for determining asset entitlements.

The insolvency of the Lehman Brothers Group marks a fundamental difference between the UK and the U.S. in the insolvency of financial services companies. In the U.S the Securities Exchange Act of 1934 ensures that a beneficiary’s property in a financial services company is identifiable at all times, whereas the same cannot be said to be true in the UK. This lack of segregation poses an uphill struggle for UK administrators where financial services companies are involved, as it makes it difficult to identify a beneficiary’s entitlement to trust property. This is exacerbated by the fact that administrators are unable to use Scheme of Arrangements where trusts are involved, as they inevitably will be in the case of a Financial Services Company.

The Court of Appeal’s recent decision not to extend Scheme of Arrangement to a beneficiary’s proprietary interests will be welcomed by some as it will preserve the inviolable rights of a trust. Nonetheless, others may well feel that the Court of Appeal have missed an opportunity to recognise that Schemes of Arrangement have a place in the complicated insolvency proceedings of financial service companies.