One of the reasons that Bear Stearns unraveled so quickly was that hedge fund customers and trading counterparties started reducing their exposures out of fear that their funds would become subject to a bankruptcy proceeding, leaving them unable to trade them. Worse, as some hedge funds are learning, customer agreements permitted Lehman (as most other prime brokerage agreements do) to use prime brokerage collateral as assets for their own repos, which has the effect of co-mingling them and thus making them subject to creditor claims.
Bear admittedly unravelled quickly, before the Fed’s new facilities came into effect. But even with the new programs in place, Lehman was deteriorating for months. It is thus surprising to read that some major firms got caught.
The Bloomberg story does a nice job of discussing the mechanics:
Lehman Brothers Holdings Inc. will take “considerable time” before returning assets stranded by the world’s largest bankruptcy to hundreds of hedge fund clients, according to PricewaterhouseCoopers….
GLG Partners Inc., which oversees $24 billion, CQS U.K. LLP and Bay Harbour Management LC are among the hedge funds that used Lehman as a prime broker for borrowing stock and clearing trades. Funds with assets at Lehman probably will have to write them down when they report net asset values, according to Laven Partners LLP, a London-based hedge fund consultant.
“If your hedge fund assets have been included with Lehman’s, you’re in the back of a queue that’s quite long,” said Laven Partners founder Jerome Lussan. “What’s the market value of, say, $100 million that’s owed to you by Lehman? I’d say it’s not that great, and it’s going to have to be written down.”
Bay Harbour said in a Sept. 19 court filing that money it deposited with the New York-based bank “appears to have been siphoned from London to the U.S. as part of an $8 billion asset transfer and then “trapped” by the midnight bankruptcy filing. This happened “despite repeated assurances of the integrity of the cash,” according to Bay Harbour’s objection.
Lehman was entitled to use prime-brokerage clients’ securities as collateral for money it borrowed through so-called repurchase agreements, PwC said. Securities used for these purposes were mingled with Lehman’s, PwC said.
“The assets, once `used,’ were no longer held for the client on a segregated basis, and as a result the client may cease to have any proprietary interest in them,” PwC said in the statement.
Using securities pledged as collateral, a practice known as rehypothecation, is common, said Richard Frase, an attorney at Dechert LLP who represents hedge funds in London.
“Most investors aren’t used to waking up and not knowing where their assets are,” Frase said. “There are several basic questions: are the assets there or not, what value do you place on them and what do you say to investors.”
Determining which assets are Lehman’s and which are clients’ is “exceptionally complex,” Steven Pearson, a partner at PwC, said in an Internet presentation last week…..
GLG, founded as a unit of Lehman 13 years ago, filed a suit in New York last week to protect assets that “may have been misappropriated” in Lehman’s sale of its U.S. investment bank to Barclays Plc.
GLG said it “holds significant claims” against Lehman, according to an objection filed Sept. 18 in U.S. bankruptcy court. GLG said last week it had some “residual” trades with Lehman that didn’t clear before it filed for bankruptcy…
Because many hedge funds pulled accounts before Lehman’s collapse, their losses may be limited. Gottex Fund Management Holdings Ltd., a Swiss-based manager with about $16 billion invested in hedge funds, is among those who last week said the exposure to trapped assets at Lehman was “minimal.”
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Matthew Dubuque
This is absolutely HORRIFIC lawyering by those who represented the hedge funds.
As one of Lehman’s biggest sources of revenue, they had a right to have their funds segregated and they should have negotiated that, at least in the last few months when it was obvious Lehman was in truly desperate straits.
These hedge funds and their incompetent lawyers deserve what they get. This is a very basic mistake and it’s their own fault they can’t think past the end of their nose.
Their shortsightedness will come to bite them in a very big way.
Matthew Dubuque
If you hold any shares try asking for issue of certificates in your name to find out if the broker/bank segregates your trading account. Good luck.
Matthew,
You actually think the legal counsel at hedge funds were hired to think? They were window-dressing. They might as well have walked around with the words “legal compliance” scrawled on their foreheads. They are mid-level law firm associates who thought they were worth something. Now they are all going to be teaching 6th Grade English if they are lucky.
LEH hastily seizes $8 billion of overseas client funds right before it files for BK?
And it’s short sellers who are undermining confidence in the American financial system?
YOU CANNOT PULL THESE THINGS BEFORE DECLARING BANKRUPTCY.
They may try but the courts are likely to undo any transaction in the last few hours if it looks preferental.
http://www.legalhelpmate.com/legal-dictionary-term.aspx?legal=preference
PREFERENCE
n. in bankruptcy, the payment of a debt to one creditor rather than dividing the assets equally among all those to whom he/she/it owes money, often by making a payment to a favored creditor just before filing a petition to be declared bankrupt.
Oops, cut off part II
Such a preference is prohibited by law, and the favored creditor must pay the money to the bankruptcy Trustee. However, the bankruptcy court may give secured creditors (with a judgment, lien, deed of trust, mortgage or collateralized loan) a Legal preference over “general” creditors in distributing available funds or assets.See also: bankruptcy.
These hedge funds probably tried to save money by *not* using lawyers for these transactions. Lawyers make a lot of mistakes all of the time, but encouraging their clients to take on additional risk is rarely one of them.
Posters are trying to be securities lawyers online. It is complex as hell. These last minute moves could just as easily be considered legal as illegal. For example, the courts could state that the last minute actions were not intended to favor one creditor, but rather were intended to protect the correct claimants prior to the filing.
At a minimum, this $8B currently is not cash, and is at risk.
Poor hedge funds. Poor Wall Street.
Something like this happened recently in Australia where retail customers of Opes Prime borrowed money against their stock. They thought they had signed standard margin agreements but instead had signed Securities Lending agreements. They lent their stock to Opes who onlent it to ANZ Bank and Merrill who lent it to short sellers. In exchange they got cash that they used to buy more of the same stock. Many of these customers were company directors and used the money borrowed against the stock to exercise stock options. Under the securities lending agreement absolute title to the securities passes to the borrower who can pass title to another borrower. When Opes collapsed ANZ and Merrill seized the “onlent” stock and sold it. The clients were, for the most part, wiped out.
Securities Lending agreements are the commercial contracts between hedge funds and prime brokers that underly the borrowing and shorting of securities.
The judge, Ray Finkelstein, ruled against the clients. His decision is online here: http://www.austlii.edu.au/au/cases/cth/FCA/2008/594.html
From Jubak’s Friday column:
And maybe the Fed and Treasury hadn’t remembered that Congress amended the bankruptcy code in 2005 to carve out special rules that applied to swaps, repurchase agreements and the other derivatives that have proved so toxic to Lehman.
In most bankruptcy proceedings, all of a debtor’s assets are frozen. The bankrupt company can’t even pay a bill without permission of the bankruptcy court once the bankruptcy petition is filed. The point of this rule is to create an orderly distribution of the company’s assets to the company’s creditors. The creditors, ranging from the company’s employees to its coffee service to its landlord to the big investors who own its bonds, all get in line by seniority. The bankruptcy court then doles out the liquidated assets of the bankrupt company until there are no more.
The 2005 exception threw that process out the window for the derivatives that Lehman owns. The counterparties in those deals are free to sell those deals on the market, if anyone wants them. They’re free to take the collateral they’d given to Lehman as part of one of these derivative deals. Lehman took out hedges in the derivatives market to protect against a deal going bad or the value of a security (or another derivative) falling. The financial companies that were the counterparties to those hedges can now just rip them up, taking away critical protection for the company’s portfolio just when creditors need it most.
And because the derivative market is so lightly regulated, it’s likely that no one will even know if an asset walks out the door at Lehman in this way before it could be liquidated and distributed to creditors. In essence, the companies that were parties to derivative deals with Lehman are free to strike the best deals they can without having to clear them with the bankruptcy court or inform other creditors. Creditors’ claims against Lehman come to $613 billion, according to bankruptcy court filings.
Does intermingling invalidate Jubak’s point on the possibility of preferential settlements outside bankruptcy proceedings?
This article refers to clients of the London Subsidiary of Lehman. The US based clients seemed to have had an entirely different experience: http://sipc.org/media/release20Sept08.cfm
Bay Harbor is both a client of the London subsidiary and US based. I guess SIPC does not not have jurisdiction overseas.