-
UNITEDSTATESBANKRUPTCYCOURTSOUTHERNDISTRICTOFNEWYORK
x InreLEHMANBROTHERSHOLDINGSINC.,etal., Debtors.
:::::::
Chapter11CaseNo.0813555(JMP)(JointlyAdministered)
x
REPORTOFANTONR.VALUKAS,EXAMINER
March11,2010
Jenner&BlockLLP353N.ClarkStreetChicago,IL6065434563122229350919ThirdAvenue37thFloorNewYork,NY1002239082128911600CounseltotheExaminer
VOLUME4OF9
Section III.A.5: Secured Lenders
Section III.A.6: Government
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i
EXAMINERSREPORT
TABLEOFCONTENTS
(SHORTFORM)
VOLUME1
Introduction,SectionsI&II:ExecutiveSummary&ProceduralBackground
Introduction...................................................................................................................................2
I. ExecutiveSummaryoftheExaminersConclusions
......................................................15
A.
WhyDidLehmanFail?AreThereColorableCausesofActionThatAriseFromItsFinancialConditionandFailure?.....................................................15
B.
AreThereAdministrativeClaimsorColorableClaimsForPreferencesorVoidableTransfers?......................................................................................................24
C.
DoColorableClaimsAriseFromTransfersofLBHIAffiliateAssetsToBarclays,orFromtheLehmanALITransaction?
....................................................26
II. ProceduralBackgroundandNatureoftheExamination
..............................................28
A. TheExaminersAuthority
...........................................................................................28
B.
DocumentCollectionandReview..............................................................................30
C.
SystemsAccess..............................................................................................................33
D.
WitnessInterviewProcess...........................................................................................35
E. CooperationandCoordinationWiththeGovernmentandParties
......................37
SectionIII.A.1:Risk
III.
ExaminersConclusions......................................................................................................43
A.
WhyDidLehmanFail?AreThereColorableCausesofActionThatAriseFromItsFinancialConditionandFailure?.....................................................43
1.
BusinessandRiskManagement..........................................................................43
a) ExecutiveSummary
.......................................................................................43
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ii
b)
Facts..................................................................................................................58
c) Analysis
.........................................................................................................163
VOLUME2
SectionIII.A.2:Valuation
2. Valuation
..............................................................................................................203
a) ExecutiveSummary
.....................................................................................203
b) OverviewofValuationofLehmansCommercialRealEstatePortfolio
.........................................................................................................215
c)
SeniorManagementsInvolvementinValuation....................................241
d)
ExaminersAnalysisoftheValuationofLehmansCommercialBook................................................................................................................266
e)
ExaminersAnalysisoftheValuationofLehmansPrincipalTransactionsGroup......................................................................................285
f)
ExaminersAnalysisoftheValuationofLehmansArchstonePositions.........................................................................................................356
g)
ExaminersAnalysisoftheValuationofLehmansResidentialWholeLoansPortfolio
.................................................................................494
h) ExaminersAnalysisoftheValuationofLehmansRMBSPortfolio
.........................................................................................................527
i) ExaminersAnalysisoftheValuationofLehmansCDOs
....................538
j)
ExaminersAnalysisoftheValuationofLehmansDerivativesPositions.........................................................................................................568
k)
ExaminersAnalysisoftheValuationofLehmansCorporateDebtPositions
...............................................................................................583
l)
ExaminersAnalysisoftheValuationofLehmansCorporateEquitiesPositions
.........................................................................................594
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iii
SectionIII.A.3:Survival
3.
LehmansSurvivalStrategiesandEfforts........................................................609
a)
IntroductiontoLehmansSurvivalStrategiesandEfforts.....................609
b)
LehmansActionsin2008PriortotheNearCollapseofBearStearns............................................................................................................622
c) ActionsandEffortsFollowingtheNearCollapseofBearStearns
.......631
VOLUME3
SectionIII.A.4:Repo105
4.
Repo105................................................................................................................732
a)
Repo105ExecutiveSummary.................................................................732
b) Introduction
..................................................................................................750
c) WhytheExaminerInvestigatedLehmansUseofRepo105Transactions
..................................................................................................764
d) ATypicalRepo105Transaction
................................................................765
e) ManagingBalanceSheetandLeverage
....................................................800
f)
ThePurposeofLehmansRepo105ProgramWastoReverseEngineerPubliclyReportedFinancialResults.........................................853
g) TheMaterialityofLehmansRepo105Practice
......................................884
h) KnowledgeofLehmansRepo105ProgramattheHighestLevelsoftheFirm
.....................................................................................................914
i)
Ernst&YoungsKnowledgeofLehmansRepo105Program..............948
j) TheExaminersConclusions
......................................................................962
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iv
VOLUME4
SectionIII.A.5:SecuredLenders
5. PotentialClaimsAgainstLehmansSecuredLenders
.................................1066
a)
IntroductionandExecutiveSummary....................................................1066
b) LehmansDealingsWithJPMorgan
........................................................1084
c)
LehmansDealingsWithCitigroup.........................................................1224
d) LehmansDealingsWithHSBC
...............................................................1303
e) LehmansDealingsWithBankofAmerica
............................................1375
f)
LehmansDealingsWithBankofNewYorkMellon............................1376
g)
LehmansDealingsWithStandardBank................................................1382
h) LehmansDealingsWiththeFederalReserveBankofNewYork
.....1385
i)
LehmansLiquidityPool...........................................................................1401
SectionIII.A.6:Government
6.
TheInteractionBetweenLehmanandtheGovernment..............................1482
a) Introduction
................................................................................................1482
b) TheSECsOversightofLehman
..............................................................1484
c) TheFRBNYsOversightofLehman
........................................................1494
d) TheFederalReservesOversightofLehman
.........................................1502
e) TheTreasuryDepartmentsOversightofLehman
...............................1505
f)
TheRelationshipoftheSECandFRBNYinMonitoringLehmansLiquidity....................................................................................1507
g)
TheGovernmentsPreparationfortheLehmanWeekendMeetingsattheFRBNY
.............................................................................1516
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v
h)
OntheEveningofFriday,September12,2008,theGovernmentConvenedaMeetingoftheMajorWallStreetFirmsinanAttempttoFacilitatetheRescueofLehman
..........................................1523
i) LehmansBankruptcyFiling
....................................................................1535
VOLUME5
SectionIII.B:AvoidanceActions
B.
AreThereAdministrativeClaimsorColorableClaimsforPreferencesorVoidableTransfers....................................................................................................1544
1. ExecutiveSummary
..........................................................................................1544
2.
ExaminersInvestigationofPossibleAdministrativeClaimsAgainstLBHI(FirstBullet)
.............................................................................................1546
3.
ExaminersInvestigationofPossibleAvoidanceActions(Third,FourthandEighthBullets)...............................................................................1570
4.
ExaminersInvestigationofPossibleBreachesofFiduciaryDutybyLBHIAffiliateDirectorsandOfficers(FifthBullet)
.....................................1894
5.
ExaminersAnalysisofLehmansForeignExchangeTransactions(SecondBullet)
...................................................................................................1912
6.
ExaminersReviewofIntercompanyTransactionsWithinThirtyDaysofLBHIsBankruptcyFiling(SeventhBullet).....................................1938
7.
ExaminersAnalysisofLehmansDebttoFreddieMac..............................1951
SectionIII.C:BarclaysTransaction
C.
DoColorableClaimsAriseFromTransfersofLBHIAffiliateAssetstoBarclays,orFromtheLehmanALITransaction?
................................................1961
1. ExecutiveSummary
..........................................................................................1961
2. Facts
.....................................................................................................................1965
3. WhetherAssetsofLBHIAffiliatesWereTransferredtoBarclays
.............1997
4.
LehmanALITransaction..................................................................................2055
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vi
5. Conclusions
........................................................................................................2063
6. BarclaysTransaction
.........................................................................................2103
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UNITEDSTATESBANKRUPTCYCOURTSOUTHERNDISTRICTOFNEWYORK
x InreLEHMANBROTHERSHOLDINGSINC.,etal., Debtors.
:::::::
Chapter11CaseNo.0813555(JMP)(JointlyAdministered)
x
REPORTOFEXAMINERANTONR.VALUKAS
SectionIII.A.5:SecuredLenders
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1054
TABLEOFCONTENTS
5. PotentialClaimsAgainstLehmansSecuredLenders
.................................1066 a)
IntroductionandExecutiveSummary....................................................1066
(1)
JPMorgan..............................................................................................1068
(2) Citibank
................................................................................................1073
(3)
HSBC.....................................................................................................1077
(4)
OtherLenders......................................................................................1080
(5)
TheFederalReserveBankofNewYork..........................................1081
(6)
LehmansLiquidityPool....................................................................1082
b) LehmansDealingsWithJPMorgan
........................................................1084 (1)
Facts.......................................................................................................1084
(a) OverviewofJPMorganLehmanRelationship .......................
1084 (b) TripartyRepoPriorto2008
....................................................... 1089 (c)
JPMorganRestructuresItsApproachtoTripartyRisk ......... 1094 (d)
LehmanBeginsPostingAdditionalCollateral .......................
1101 (e) JPMorganConcernOverLehmanCollateralinAugust
2008
...............................................................................................
1105 (f) TheAugustAgreements
............................................................ 1113
(g) BackgroundtotheSeptember9CollateralRequestand
SeptemberAgreements..............................................................
1125 (h) September9CallsBetweenStevenBlackandRichard
Fuld
...............................................................................................
1138 (i)
SeptemberAgreements..............................................................
1143 (j) DailyLiquidityPoolUpdatesFromLehmanto
JPMorgan
.....................................................................................
1156 (k) September11CollateralRequestPursuanttothe
SeptemberAgreements..............................................................
1158 (l) AdditionalValuationAnalysesbyJPMorganBeginning
September11
...............................................................................
1165 (m)
LehmanRequestsforReturnofCollateral..............................
1168
(2) AnalysisofPotentialClaims
.............................................................1172
(a) TheEvidenceDoesNotSupportaColorableClaim
AgainstJPMorganforEconomicDuress.................................
1173 (i)
LegalBackground:EconomicDuress.............................
1173
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1055
(ii)
ThereIsNoAvailableEvidenceofanExpressUnlawfulThreatMadebyJPMorganinConnectionWiththeFormationoftheSeptemberAgreements
..... 1174
(iii)
TheAvailableEvidenceSuggestsJPMorganDidNotHaveanImproperPurpose......................................
1178
(iv)
ThereWasaDegreeofNegotiationOvertheTermsoftheSeptemberAgreements
......................................... 1181
(b)
ThereIsInsufficientEvidencetoSupportaColorableClaimThattheSeptemberAgreementsAreInvalidforLackofConsideration
................................................................
1183
(c)
ThereisSufficientEvidencetoSupporttheExistenceofaTechnical,ButNotColorable,ClaimThattheSeptemberAgreementsAreInvalidforLackofAuthority......................
1186 (i) TonucciMayHaveActedWithApparent
Authority
............................................................................
1190 (ii) ThereIsSubstantialEvidenceThatLehman
RatifiedtheSeptemberAgreements...............................
1193 (d) ThereIsInsufficientEvidencetoSupportaColorable
ClaimThatJPMorganFraudulentlyInducedtheSeptemberAgreements..............................................................
1198
(e)
ThereIsInsufficientEvidencetoSupportaColorableClaimforBreachofContractoftheSeptemberAgreementsBasedonJPMorgansRefusaltoReturnCollateral
......................................................................................
1200 (i) LegalBackground:ContractualObligationsUnder
SeptemberAgreements
.................................................... 1200 (ii)
ThereWasNoWrittenNoticeforCollateralReturn ... 1208
(f)
ThereIsEvidencetoSupportaColorable,ButNotStrong,ClaimThatJPMorganBreachedtheImpliedCovenantofGoodFaithandFairDealingbyDemandingExcessiveCollateralinSeptember2008...................................
1210 (i) LegalStandardsGoverningImpliedCovenantof
GoodFaithandFairDealing
........................................... 1211 (ii)
ThereIsSufficientEvidenceToSupporta
Colorable,ButNotaStrong,ClaimThatJPMorganViolatedtheImpliedCovenantbyDemandingExcessiveCollateral
.......................................................... 1214
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1056
(iii)
ATrierofFactWillLikelyHavetoResolveaWaiverDefense..................................................................
1220
c)
LehmansDealingsWithCitigroup.........................................................1224
(1)
Facts.......................................................................................................1224
(a)
CitigroupProvidedContinuousLinkedSettlementServiceandOtherClearingandSettlementOperationstoLehman.........................................................................................
1224 (i) BackgroundInformationontheContinuous
LinkedSettlementServiceCitiProvidedtoLehman... 1224 (ii)
OtherClearingandSettlementServicesThatCiti
ProvidedtoLehman
......................................................... 1227
(iii) CitisClearingandSettlementExposureto
Lehman,Generally............................................................
1229 (iv) TheTermsofLehmansCLSAgreementwithCiti ...... 1231
(b)
LehmanProvideda$2BillionCashDepositwithCitionJune12,2008ToSupportitsClearingNeeds..........................
1233 (i) TheMarketEnvironmentandOtherCircumstances
SurroundingCitisRequestforthe$2BillionCashDepositonJune12
............................................................
1235
(ii)
ThePartiesDidNotSharetheSameUnderstandingoftheTermsofthe$2BillionCashDeposit
.................. 1242 a. WhatLehmanUnderstoodtheTermsofthe
DepositToBe..............................................................
1243 b. WhatCitiUnderstoodtheTermsoftheDeposit
ToBe.............................................................................
1245 c. TheExactTermsoftheComfortDepositAre
UnknownBecausetheTermsWereNotReducedtoWriting....................................................
1250
(iii)
CitiKnewtheComfortDepositwasIncludedinLehmansLiquidityPool..................................................
1250
(c)
CollateralPledgeDiscussionsBetweenLehmanandCitiBeganinJune2008andContinuedUntilSeptember2008
... 1251 (i) TheUnexecutedPledgeAgreement:theParties
AgreedtoNegotiatetheTermsbutNotExecutetheAgreementUntilItWasNeeded.....................................
1251
-
1057
(ii)
CitiHadDifficultyPricingtheCollateralOfferedbyLehmanasaSubstitutefortheCashDeposit
.......... 1254
(iii) TheGuarantyAmendmentWasSignedinaFireDrillonSeptember9,2008
............................................. 1261 a.
EventsPriortotheSigningoftheSeptember9
GuarantyAmendmentfromCitisPerspective ..... 1263 b.
EventsPriortotheSigningoftheSeptember9
GuarantyAmendmentfromLehmansPerspective
..................................................................
1265
c.
NegotiationsBetweenLehmanandCitiPersonnelRegardingWhichLehmanEntitiesWereToBeAddedtotheParentGuarantybytheSeptember9GuarantyAmendment.................
1268
(iv)
September12,2008:ALehmanCollateralAccountatCitiwasActivatedAfterTwoMonthsofDiscussion,andLehmanSignedanAmendmenttotheDirectCustodialServicesAgreement......................
1273
(d)
LehmansClearingEnvironmentatCitiDuringtheWeekofSeptember8,2008........................................................
1276 (i) CitiRequiredLehmanToOperateUnderLower
DaylightOverdraftLimits
............................................... 1276 (ii)
LehmanDepositedAmountsinExcessofthe$2
BillionDepositatVariousTimesin2008WithCiti...... 1279 (iii)
CitiEndeavoredToHelpLehmaninSeptember
2008,PriortotheBankruptcyFiling...............................
1281 (iv) LehmansAccountsatCitiClosedonFriday
September12WithFundsinExcessofthe$2BillionDeposit
...................................................................
1284
(e) CitisParticipationinLehmanWeekendEvents................ 1285
(f) CitisActionsTowardLehmanAfterLehmanFiledfor
BankruptcyProtection
...............................................................
1287 (i) CitiContinuedtoProvideCLSServicesfor
Lehman,ButNotinanEntirelyUninterruptedManner................................................................................
1287
(ii)
PriortoLehmansBankruptcyFiling,CitiSetOffaPortionoftheCashDeposit.............................................
1290
(2) AnalysisofPotentialColorableClaims
...........................................1291
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1058
(a) ValidityoftheSeptember9GuarantyAmendment.............. 1291
(i)
EconomicDuress...............................................................
1291
a. LegalFramework
....................................................... 1292 b.
TheEvidenceDoesNotSupporttheExistence
ofaColorableClaimAgainstCitiforEconomicDuress
..........................................................................
1293
(ii)
TheFailureofConsideration...........................................
1297 a. LegalFramework
....................................................... 1298 b.
TheEvidenceDoesNotSupporttheExistence
ofaColorableClaimAgainstCitiforFailureofConsideration
.............................................................
1298
(b)
BreachoftheDutyofGoodFaithandFairDealinginConnectionWiththeCLSServicesAgreement
...................... 1300 (i)
TheEvidenceDoesNotSupporttheExistenceofa
ColorableClaimAgainstCitiforBreachoftheDutyofGoodFaithandFairDealinginConnectionWiththeCLSServicesAgreement..................................
1301
d) LehmansDealingsWithHSBC
...............................................................1303
(1) OverviewofHSBCsRelationshipWithLehman
..........................1305
(a) HSBCProvidedCRESTClearingandSettlementServicestoLehman
....................................................................................
1306
(b) OverviewoftheOperativeAgreements
................................. 1309 (2)
TheExaminersInvestigationofParticularTransactions
.............1311
(a) HSBCCancelleda$1BillionIntradayCreditFacility ...........
1311 (b) LehmanMaintaineda$1BillionSegregatedDeposit
withHSBC
...................................................................................
1312 (c) LehmanDeposited$750MillionwithHSBConJune24 ...... 1314 (d)
LehmanCommitted$25MilliononAugust15toHSBCs
SyndicatedLendingFacility......................................................
1315 (e) LehmanPledged$6MilliontoHSBCasCollateralfor
LettersofCredit
..........................................................................
1317 (f)
OtherSignificantExposures......................................................
1318
(3)
HSBCRequiredLehmantoProvideApproximately$1BillioninCollateralWhileQuietlyEndingTheirRelationship
.........................................................................................1319
(a) HSBCDeterminedtoEndItsRelationshipwithLehman .... 1319
-
1059
(b) HSBCDemandedCollateralforIntradayCredit ...................
1322 (c) HSBCAgreedToAccommodateLehmanatQuarterEnd... 1325 (d)
LehmanDepositedtheCashCollateralWithHSBC ............. 1326 (e)
LehmanNegotiatedNewTermsandExecutedtheCash
Deeds
............................................................................................
1327 (i) LehmanSecuredConcessionsintheU.K.Cash
Deeds...................................................................................
1327 (ii) LehmanExecutedtheHongKongCashDeedLate
onSeptember12
................................................................
1329 (f) HSBCandLBHIStipulatedToSetOffandReturnSome
oftheFundsCoveredbytheU.K.CashDeeds ...................... 1332
(4)
OtherIssuesStemmingfromHSBCsCollateralDemand............1333
(a)
LehmanIncludedtheDepositsCoveredbytheCashDeedsinItsReportedLiquidityPool
...................................... 1333
(b)
HSBCConsideredWithholdingPaymentsorRequiringPrefundingofTradesintheAsiaPacificRegionPriortoLehmansBankruptcy
................................................................
1336
(5)
TheEvidenceDoesNotSupporttheExistenceofColorableClaimsArisingFromHSBCsDemandThatLehmanProvideCashCollateralandExecuteCashDeedsinOrderforHSBCtoContinueProvidingClearingandSettlementServices.............1336
(a) TheParametersoftheExaminersAnalysis ...........................
1336 (b) TheFactsProvideLittletoNoSupportforInvalidating
theU.K.CashDeeds...................................................................
1339 (i)
AnalyticalFramework......................................................
1339
a. EnglishLawGovernsContractClaimsArisingfromtheU.K.CashDeeds
........................................ 1339
b.
EnglishContractLawTreatsDeedsDifferentlyfromOtherContracts.................................................
1340
(ii)
TheEvidenceDoesNotSupporttheExistenceofaColorableClaimThattheU.K.CashDeedsAreInvalidforWantofConsideration..................................
1341
(iii)
TheEvidenceDoesNotSupporttheExistenceofaColorableClaimforEconomicDuressBecausetheCRESTAgreementAllowedHSBCToCeaseClearingandSettlementatItsAbsoluteDiscretion
..... 1343
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1060
a. ElementsofEconomicDuress..................................
1343 b. ApplicationtoLehmanFacts
................................... 1344 c.
OtherTransactionsDoNotGiveRiseto
EconomicDuressClaims ..........................................
1346 (iv) TheEvidenceDoesNotSupporttheExistenceofa
ColorableClaimthatHSBCViolatedaDutyofGoodFaithandFairDealingbyDemandingCashCollateral
............................................................................
1348 a. EnglishLawDoesNotRecognizeaPrincipleof
GoodFaithandFairDealingofGeneralApplication..................................................................
1349
b. ApplicationtoLehmanFacts ...................................
1349 (v) TheEvidenceDoesNotSupporttheExistenceofa
ColorableClaimthatHSBCViolatedtheNoticeProvisionoftheCRESTAgreement
............................... 1352 a.
ConstructionofTerms...............................................
1352 b. ApplicationtoLehmanFacts
................................... 1353
(vi)
TheCashDeedsWereNotContractsofAdhesionorStandardFormContracts
............................................ 1355 a.
CharacteristicsofStandardFormContractsor
ContractsofAdhesion...............................................
1355 b. ApplicationtoLehmanFacts
................................... 1355
(c)
OtherPotentialTheoriesofLiability........................................
1357 (i) EnglishLawGovernstheRemainingPotential
ClaimsEvenThoughTheyAreNotCoveredbytheChoiceofLawProvisionoftheCashDeeds.................
1357 a.
AnalyticalFramework...............................................
1357 b. ApplicationtoRemainingPotentialClaims........... 1359
(ii)
TheEvidenceDoesNotSupportTheExistenceOfaColorableClaimForUnjustEnrichmentBecauseLehmanConveyedaBenefitonHSBCPursuanttoLehmansValidContractualObligations
...................... 1360 a. ElementsofUnjustEnrichment
............................... 1361 b. ApplicationtoLehmanFacts
................................... 1362
(iii)
TheEvidenceDoesNotSupportaColorableClaimThatHSBCBreachedaFiduciaryDutytoLehman
-
1061
BecauseHSBCandLehmanWereSophisticatedPartiesinaRelationshipGovernedbyanAgreementThatLimitedHSBCsObligations..............
1363 a. ElementsofBreachofFiduciaryDutyand
Misappropriation
....................................................... 1364 b.
ApplicationtoLehmanFacts ...................................
1365
(iv)
TheEvidenceDoesNotSupportaColorableClaimthatHSBCsDemandforCollateralTortiouslyInterferedWithLehmansOtherBusinessorContractsBecauseHSBCWasActingToProtectItsOwnEconomicInterests
.................................................. 1367 a.
ElementsofTortiousInterference ........................... 1368 b.
ApplicationtoLehmanFacts ...................................
1369
(v)
TheEvidenceDoesNotSupportaFindingthatHSBCFraudulentlyorNegligentlyMisrepresentedItsPlantoWithdraw.........................................................
1371 a. ElementsofFraudandMisrepresentation ............. 1371 b.
ApplicationtoLehmanFacts ...................................
1373
e) LehmansDealingsWithBankofAmerica
............................................1375 f)
LehmansDealingsWithBankofNewYorkMellon............................1376
(1) BNYMDemandsandReceivesaCollateralDeposit
.....................1377 (2)
TheDepositIsSignificantBecauseofInternalLehman
ConcernsAboutIncludingItinItsPool
..........................................1379 g)
LehmansDealingsWithStandardBank................................................1382
h) LehmansDealingsWiththeFederalReserveBankofNewYork .....1385
(1)
TheFRBNYSupervisesDepositTakingInstitutionsandAssistsinManagingMonetaryPolicy,butLacksAuthorityToRegulateInvestmentBankHoldingCompanies
......................1385
(2)
InResponsetotheBearStearnsNearCollapse,theFRBNYCreatedaVarietyofFacilitiesToBackstoptheLiquidityofBrokerDealers;Lehman,InTurn,DrewonTheseFacilities........1387
(a) ThePrimaryDealerCreditFacility
.......................................... 1387 (b)
TheMarketGreetedtheCreationofthePDCFasa
PositiveStepTowardBackstoppingBrokerDealerLiquidity,andasShoringUpLehmansLiquidity
................ 1390
-
1062
(c)
InAdditiontoaLiquidityBackstop,LehmanViewedthePDCFasanOutletforItsIlliquidPositions............................
1392
(d)
LehmanWasReluctanttoDrawonthePDCFBecauseofaPerceivedStigmaAttachedtoBorrowingfromtheFacility
..........................................................................................
1396
(e)
LehmanAccessedthePDCFTenTimesin2008;LehmansUseofthePDCFWasConcentratedinPeriodsImmediatelyAftertheBearStearnsNearCollapse,andImmediatelyAfterLBHIFiledforBankruptcy
...................... 1398
(3)
OtherFRBNYLiquidityFacilities.....................................................1400
(a) TheTermSecuredLendingFacility
......................................... 1400 (b)
OpenMarketsOperations
......................................................... 1401
i)
LehmansLiquidityPool...........................................................................1401
(1)
IntroductionandExecutiveSummary.............................................1401
(2) TheImportanceofLiquiditytoBrokerDealersand
InvestmentBankHoldingCompaniesGenerally
..........................1406 (3)
LehmansLiquidityPool....................................................................1408
(a) ThePurposeandCompositionofLehmansLiquidityPool
...............................................................................................
1408
(b)
LehmanTestedItsLiquidityPoolandSharedtheResultsofTheseTestswithRatingAgencies
....................................... 1413
(c)
MarketParticipantsFormedFavorableOpinionsofLehmansLiquidityontheBasisofLehmansRepresentationsAboutItsLiquidityPool...............................
1415
(4)
LehmansClearingBanksSoughtCollateralPledgesandCashDepositsToSecureIntradayCreditRisk;LehmanIncludedThisCollateralinItsLiquidityPool
................................1417 (a)
LehmanPledgedCLOsandOtherSecuritiesto
JPMorganThroughouttheSummerof2008toMeetTripartyRepoMarginRequirements
...................................... 1417
(b)
TheSecuritiesPostedtoMeetJPMorgansMarginRequirementsWereIncludedinLehmansLiquidityPool
...............................................................................................
1422
(c)
OnJune12,2008,LehmanTransferred$2BilliontoCitiasComfortforContinuingCLSSettlement
........................ 1424
-
1063
(d)
TheCitiComfortDepositWasIncludedinLehmansLiquidityPool..............................................................................
1430
(e)
OnAugust25,2008,LehmanExecutedaSecurityAgreementwithBankofAmerica,GrantingtheBankaSecurityInterestina$500MillionDeposit
............................. 1433
(f)
LBHIandJPMorganExecutedanAmendmenttotheJune2000ClearanceAgreement,aSecurityAgreementandaHoldingCompanyGuaranty,allDatedAugust26,2008
...............................................................................................
1436
(g)
LehmanAssetsSubjecttotheAugustSecurityAgreementWereIncludedinLehmansLiquidityPool
....... 1439
(h)
September2,2008:LehmanTransferredJustUnder$1BilliontoHSBCtoContinueClearingOperations,andEncumberedThiswithCashDeedsExecutedonSeptember9andSeptember12.................................................
1441
(i)
TheHSBCDepositWasRepresentedasLiquidandWasIncludedinLBHIsLiquidityPool
.................................. 1446
(j)
LehmanandJPMorganExecutedAnotherRoundofSecurityDocumentationDatedSeptember9,2008;LehmanMade$3.6Billionand$5BillionPledgestoJPMorganSubjecttotheTermsofTheseAgreements
.......... 1446
(k)
LehmanMadeaDeposittoBankofNewYorkMellontoCoverIntradayExposure,andIncludedThatDepositinItsLiquidityPool
........................................................................
1448
(l)
TheCumulativeImpactofLehmansInclusionofClearingBankCollateralandDepositsinItsLiquidityPool
...............................................................................................
1450
(5)
DisclosuresConcerningtheInclusionofClearingBankCollateralinLehmansLiquidityPool.............................................1454
(a) LehmanDidNotDiscloseonItsJune16,2008Second
QuarterEarningsCallThatItWasIncludingthe$2BillionCitiComfortDepositinItsLiquidityPool
............. 1454
(b)
LehmanDidNotDiscloseinItsSecondQuarter200810Q,FiledJuly10,2008,ThatItWasIncludingBoththe$2BillionCitibankComfortDepositandApproximately$5.5BillionofSecuritiesCollateralPledgedtoJPMorganinItsLiquidityPool
....................................................................
1455
-
1064
(c)
LehmanDidNotDiscloseOnItsSeptember10,2008EarningsCallThataSubstantialPortionofItsLiquidityPoolWasEncumberedbyClearingBankPledges
................ 1457
(d)
SeniorExecutivesDidNotDisclosetotheBoardofDirectorsattheSeptember9,2008FinanceCommitteeMeetingtheFactThataSubstantialPortionofItsLiquidityPoolWasEncumberedbyClearingBankPledges..........................................................................................
1460
(e)
LehmanOfficersDidNotDisclosetotheBoardofDirectorsThatItsLiquidityPositionWasSubstantiallyImpairedbyCollateralHeldatClearingBanksUntiltheEveningofSeptember14,2008
................................................. 1464
(f)
LowittsViewsonIncludingClearingBankCollateralintheLiquidityPool
.......................................................................
1466
(6)
RatingAgenciesWereUnawareThatLehmanWasIncludingClearingBankCollateralinItsLiquidityPool
.............1467 (a)
Fitch...............................................................................................
1467 (b)
Standard&Poors.......................................................................
1468 (c)
Moodys........................................................................................
1469
(7)
TheFRBNYDidNotViewtheClearingBankCollateralintheLiquidityPoolasUnencumbered
..........................................1469
(8)
TheSEC,LehmansPrimaryRegulator,WasUnawareoftheExtenttoWhichLehmanWasIncludingClearingBankCollateralinItsLiquidityPool;totheExtentItWasAware,theSECDidNotViewThisPracticeasProper
..............................1472
(9)
CertainLehmanCounselWereAwareThatAgreementswithItsClearingBanksWereStructuredtoIncludeClearingBankCollateralinItsLiquidityPool,butDisclaimedKnowledgeConcerningWhatAssetsWereAppropriateorInappropriatefortheLiquidityPool
....................1476
(10)
LehmansAuditorsMonitoredLehmansLiquidityPool,butViewedtheCompositionofthePoolasaRegulatoryIssue.........1478
(11)
ThereIsInsufficientEvidenceToSupportaDeterminationThatAnyOfficerorDirectorBreachedaFiduciaryDutyinConnectionWiththePublicDisclosureofLehmansLiquidityPool
......................................................................................1479
-
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PAGEINTENTIONALLYLEFTBLANK
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5. PotentialClaimsAgainstLehmansSecuredLenders
a) IntroductionandExecutiveSummary
Pursuanttotheeighthbulletofparagraph2oftheExaminerOrder,thisSection
oftheReportexaminestransactionsandtransfersamongthedebtorsandpreChapter
11 thirdparty lenders. The Examiner has consulted with the
parties in interest,
reviewedissuesidentifiedbythoseparties,conductedhisownindependentreviewand
examinationand exercisedhisdiscretionas towhich issues to
include in theReport.
This Section of the Report covers potential common law claims
against Lehmans
lenders.SectionIII.Bcoverspotentialavoidanceandpreferenceactions.
Throughout 2008, and up to the date that Lehman filed for
bankruptcy,
Lehmans clearing banks demanded collateral to secure risks they
assumed in
connectionwithclearingandsettlingLehmanstripartyandcurrencytrades,andother
extensions of credit. This Section of the Report examines the
circumstances
surroundingLehmansprovisionofapproximately$15to$21billionincollateral(both
in cashand securities) to its clearingbanks,andLehmans
simultaneous inclusionof
thosefundsinitsreportedliquiditypool.
Assetforthinmoredetailbelow,theimportanceofliquiditytoinvestmentbank
holdingcompaniescannotbeoverstated.
Brokerdealersaredependentonshortterm
financing to fund their daily operations, and a robust liquidity
pool is critical to a
brokerdealers access to such financing. The Examiner has found
that the size of
-
1067
Lehmans liquidity pool provided comfort to market participants
and observers,
including rating agencies. The size of Lehmans liquidity pool
encouraged
counterpartiestocontinueprovidingessentialshorttermfinancingandintradaycredit
to Lehman. In addition, the size of Lehmans liquidity pool
provided assurance to
investors that if certain sources of shortterm financing were to
disappear, Lehman
couldstillsurvive.
Critically, thecollateralpostedbyLehmanwith
itsvariousclearingbankswas
initially structured in a manner that enabled Lehman to claim
the collateral as
nominallylienfree(atleastovernight),andcontinuetocountitinitsreportedliquidity
pool. However,bySeptember2008,muchofLehmansreported liquiditywas
locked
upwithitsclearingbanks,andyetthisfactremainedundisclosedtothemarketpriorto
Lehmansbankruptcy.
What follows is a review of the demands for added credit
protection by
JPMorgan,Citi,HSBC,BankofAmerica,BankofNewYorkMellonandStandardBank,
followed by a brief synopsis of the Examiners legal conclusions.
The Examiner
concludesthattheremaybeacolorableclaimagainstoneclearingbankJPMorgan
arising from thesecollateraldemands in2008. Then,
thisSectiondiscussesLehmans
publicstatementsaboutitsliquiditypool.
-
1068
(1) JPMorgan
JPMorgan acted as LBIs principal clearing bank pursuant to a
Clearance
AgreementbetweenJPMorganandLBI.ThemostsignificantcomponentofJPMorgans
clearing services was triparty repo clearing. Although
tripartyrepo investors
typically required a brokerdealer such as LBI to post margin
(that is, additional
collateral)overnighttoaccountfor
investorrisk,before2008,JPMorgandidnotretain
thatmarginintraday.
In February 2008, JPMorgan informed Lehman that JPMorgan would
begin
retaining the samemargin intraday that triparty investors
required overnight. This
change JPMorgans retention of tripartyinvestor margin was
implemented
graduallyin20percentincrementsoverthecourseofapproximatelyfivemonths.
JPMorganalsodeterminedthat
itsriskvisvisbrokerdealerssuchasLBIwas
greater than the risk facedbyovernight investors. JPMorgan
therefore instituted an
additionalmarginrequirement,whichitcalledriskbasedmargin,andincrementally
imposed that margin on brokerdealers as well. Lehman initially
responded to
JPMorgans riskbased margin requirement by posting approximately
$5 billion in
securities in June 2008. Lehman continued topost additional
collateral at JPMorgan
throughoutthesummerinresponsetoJPMorgansmarginrequirements.
In August 2008, JPMorgan raised concerns about collateral that
Lehman had
posted. In particular, Lehman had posted illiquid and
difficulttoprice CDOs that
-
1069
Lehmanhad selfpriced. JPMorganwasalso concernedbecauseLCPI
(notLBIor its
holding company) had posted collateral to cover JPMorgans
riskbased margin.
Lehman transferred much of this collateral from LCPI to LBHI in
early August to
alleviateJPMorgansconcern.
At the end of August, after significant negotiation, Lehman and
JPMorgan
enteredintothreeagreements:anAmendmenttotheClearanceAgreement,aGuaranty
and a Security Agreement. The Amendment to the Clearance
Agreement added
additional Lehman parties to theClearanceAgreement. Under
theGuaranty, LBHI
guaranteed the Lehman parties obligations under the Clearance
Agreement. The
SecurityAgreementsecuredLBHIsGuaranty,grantingJPMorganasecurityinterestin
a Cash Account, Securities Account and certain related accounts.
The Security
AgreementalsoprovidedforanOvernightAccount
intowhichLBHIcouldtransfer
cashorsecuritiesovernightifnoobligationsremainedoutstandingundertheClearance
Agreementattheendoftheday.Thoseassets,however,generallyhadtobereturned
toLehmans lienedaccountsbymorning inorder for JPMorgan
tocontinueclearance
operations. Lehman understood the August Agreements as
documenting existing
practice,notfundamentallyalteringitsrelationshipwithJPMorgan.
BylateAugustandearlySeptember,Lehmansdeterioratingfinancialcondition
became increasingly apparent. On September 4, 2008, Lehman and
JPMorgan
executives met to discuss Lehmans third quarter earnings and
survival strategies.
-
1070
JPMorganemergedconcernedwithLehmansplans.JPMorganalsoreviewedadraftof
Lehmansplannedpresentation to ratingagencies,and
JPMorganexpressed concerns
about that presentation as well. The following day (September
5), JPMorgans
InvestmentBankRiskCommitteemet todiscuss the InvestmentBanks
exposures to
various brokerdealers, and expressed particular concerns about
Lehman. Then, on
September 9, 2008, reports surfaced that acquisition
talksbetweenLehman andKDB
hadfallenthrough,andLehmansstockplummeted.
Inresponse,Lehmandecidedto
preannounceitsthirdquarterearningsthefollowingmorning,September10.
Alsoon
September 9, JPMorgan requested $5 billion of additional
collateral to cover all of
JPMorgans exposures to Lehman, not limited to tripartyrepo
clearing exposure.
Lehmanagreed topost$3billion immediately,andposted the$3billion
in cashand
moneymarketfundsbythenextday.
JPMorgan furtherdetermined that
itwantedanewmastermasteragreement
withLehman tocover itsentire relationshipacrossallLehman
liabilitiesandentities.
For thecollateral that JPMorganrequestedonSeptember9
tocoverallof JPMorgans
exposures toallLehmanentities,newdocumentationhad tobeexecuted.
JPMorgan
insisted that an Amendment to the Clearance Agreement, Security
Agreement and
Guarantybe inplacebeforeLehmans earnings call thenextmorning.
The evidence
doesnotsuggest,however, that JPMorgan threatened toceaseclearing
forLehman if
theagreementswerenotexecutedbythen.
-
1071
JPMorgans and Lehmans legal teams negotiated the documents
through the
night. Lehmansattorneysreceivedvirtuallyno
inputfromLehmansseniorfinancial
officers or other business personnel, who were immersed in
preparations for the
upcoming earnings call. Indeed, neither Lehmans Treasurer nor
itsChief Financial
Officer reviewed the terms of the agreements or even a summary
of the key terms
beforetheagreementsweresigned.
TheseagreementssignificantlyextendedJPMorgansrightstorequestandretain
collateralbyexpandingtheLehmanaccountsoverwhichJPMorganhadalienandthe
obligationsthatitsliensecured.TheSeptemberSecurityAgreementandGuarantyalso
requiredthreedayswrittennoticeforLBHItoattempttoretrieveanyofitscollateral.
On September 11, JPMorgan executives met to discuss significant
valuation
problems with securities that Lehman had posted as collateral
over the summer.
JPMorgan concluded that the collateral was not worth nearly what
Lehman had
claimeditwasworth,anddecidedtorequestanadditional$5billionincashcollateral
fromLehman thatday. The requestwas communicated in an
executivelevelphone
call, and Lehman posted $5 billion in cash to JPMorgan by the
afternoon of Friday,
September 12. Around the same time, JPMorgan learned that a
security known as
Fenway,whichLehmanhadposted to JPMorgan at a statedvalueof
$3billion,was
actually assetbacked commercial paper creditenhanced by Lehman
(that is, it was
Lehman, rather than a third party, that effectively guaranteed
principal and interest
-
1072
payments). JPMorgan concluded that Fenway was worth practically
nothing as
collateral.
NotwithstandingJPMorgansconcernswiththequantityandqualityofcollateral
postedbyLehman,LehmanbelievedthatJPMorganwasovercollateralized.Thereisno
evidence, however, that Lehman requested in writing the return
of the billions of
dollars of collateral ithadposted in September. Lehmandid
informally request the
return of at least some of its collateral, and JPMorgan returned
some securities to
Lehman on September 12. JPMorgan did not, however, release any
of the cash
collateral thatLehmanhadposted in response to
theSeptember9andSeptember11
requests.
TheExaminerhasanalyzedanumberofpotential common law
claimsagainst
JPMorganinconnectionwiththeSeptemberAgreementsandcollateraldemands.The
Examinerconcludes:
The evidence does not support the existence of a colorable claim
againstJPMorgan foreconomicduressprincipallybecause theExaminerhas
foundnoevidenceofanexpressunlawfulthreatbyJPMorgan.
The evidence does not support the existence of a colorable claim
that theSeptemberAgreementsare invalid for
lackofconsiderationbecause (i) theSeptemberAmendment to
theClearanceAgreementwasamodificationofanexistingcontractand,therefore,requirednoadditionalconsideration,and
-
1073
(ii) the September Security Agreement and Guaranty were
supported byJPMorganscontinuedextensionofcredittoLehman.3952
Theremaybea technicalclaim that theSeptemberAgreementsare
invalidfor lack of authority, but there are substantial defenses to
such a claim,including thatLehmanratified theagreementswhen
itpostedcollateralonSeptember12.
Accordingly,theExaminerconcludesthattheevidencedoesnotsupporttheexistenceofacolorableclaim.
The evidence does not support the existence of a colorable claim
thatJPMorgan fraudulently induced the September Agreements even
ifJPMorgancounsel toldLehmancounsel thatanagreement
inprinciplehadalready been reached by Lehmans and JPMorgans senior
management.There isconflictingevidenceastowhether
therewassuchanagreement inprinciple. Nonetheless,regardlessof
theoutcomeof thatdisputed issueoffact, it does not appear that
Lehman counsel in fact relied on
therepresentationorreasonablycouldhaverelieduponit.
The Examiner also concludes that the evidence does not support
theexistence of a colorable claim that JPMorgan breached the
SeptemberAgreementsbyrefusing toreturncollateral toLehman.
JPMorganwasnotlegally required to do so principally because Lehman
failed to provideJPMorganwithwrittennotice
forreturnofcollateralasrequiredunder theSeptemberAgreements.
Finally,theExaminerconcludesthattheevidencemaysupporttheexistenceofacolorableclaimbutnotastrongclaim
that JPMorganbreached theimplied covenant of good faith and fair
dealing by making
excessivecollateralrequeststoLehmaninSeptember2008.Atrieroffactwouldhaveto
consider evidence that the collateral requestswere reasonable and
thatLehmanwaivedanyclaimsbycomplyingwiththerequests.
(2) Citibank
Citibank was Lehmans designated settlement member on the
Continuous
Linked Settlement (CLS) system, a trading platform operated by a
consortium of
3952 See infra Section III.B.3.g.5.a for a discussion ofclaims
to avoid the September Guaranty underapplicable fraudulent transfer
law where a different standard applies for assessing
reasonablyequivalentvalue.
-
1074
banksfortheclearanceandsettlementofforeignexchange(FX)trades.Inexecuting
trades forLehmanon theCLSsystem,CitiacceptedLehmansCLS
trades,submitted
them to theCLSBank,and extended intraday credit toLehman,
therebyassuminga
certain amount of intraday credit risk. Citi provided the
clearing and settlement
servicesonCLSundertheaegisofaCLSSettlementServicesAgreementforCLSUser
Members, originally entered into by Lehman and Citi in December
2003, and later
amended inOctober 2004. Notably, thisAgreement provided that any
extension of
creditbyCitiwaswithinCitissolediscretion.
Citi provided Lehmanwith additional financial services, such
asmaintaining
cashdepositandcustodialaccounts,providingcreditfacilities,andsomecustodyand
clearingservicesinemergingmarketsandintheUnitedStates.
After the markets negative reaction to Lehmans second quarter
earnings
announcement and Lehmans announced personnel changes on June 12,
2008, Citi
sought to reduce its intraday risk exposure toLehman.
Consequently,on that same
day,Citiobtaineda$2billioncomfortdepositfromLehman,tobemaintainedatCiti
inanovernightcallaccount.Althoughthe$2billiondepositwasnotformallypledged,
Citi believed that it had a general right of setoff. In
addition, according to Citi
personnel,hadLehmanwithdrawnthedeposit,Lehmanwouldhavehadtoprefundits
transactionsinorderforCititocontinueclearingandsettlingLehmanstrades.The$2
billiondepositwasincludedinLehmansreportedliquiditypool.
-
1075
Further,beginninginJuly,thepartiesnegotiatedwithoutsuccessthetermsof
aformalpledgeagreementontheunderstandingthatLehmanwouldpledgesecurities
to collateralizeCitis clearing and settlement lines, in lieu of
the cash deposit. Citi
proposed several versions of a collateral pledge agreement, and
Lehman proposed
differentportfolios of assets topost as collateral. Citideclined
to accept any of the
securitiesproposedbyLehmanascollateral;Citihaddifficultypricing
theassetsand
questionedwhethertherewasareadymarketforthem.
Thenegotiations betweenCiti andLehman over thepledge agreement
ceased
when,betweenSeptember9and12,LehmanandCitiamendedtwocriticalagreements
instead of executing the pledge agreement. By early September,
Citi had become
acutelyconcernedaboutitsclaimonthe$2billiondeposit.Then,onSeptember9,the
reportedfailureoftheKDBdeal,coupledwithLehmansannouncementthatitwould
accelerate its thirdquarterearningsannouncement
toSeptember10,promptedCiti to
requestthatLehman
immediatelyamendtheparentGuarantyAmendmenttoexpand
thescopeoftheholdingcompanyGuaranty(toincludeobligationsowedtoCitiunder
any custodial agreement with Citi in addition to extensions of
credit by Citi) and
ultimatelyadded10additionalLehmansubsidiariestotheguaranty(Citihadoriginally
requested that 17be added). On September 12, theparties also
amended theDirect
CustodialServicesAgreement(DCSA),whichprovidedCitiwithabroadandexplicit
securityinterestovercash,securitiesorotherassetsheldbyCitionbehalfofLehman.
-
1076
Citi continued thereafter to provide clearing and trade
settlement services for
Lehman, albeit under reduced clearing limits, until Lehman filed
for bankruptcy on
September 15. Ultimately, Citi cleared for Lehman through CLS
until Friday,
September19.
TheExaminerhas identifiedpotential common law claims againstCiti
arising
outofthesetransactions,buthasnotfoundanyofthemtobecolorable.
The evidence does not support the existence of a colorable claim
foreconomic duress surrounding Citis demand that Lehman execute
theSeptember 9 amendment to the Guaranty because, inter alia, there
is
noevidenceofanexpressunlawfulthreatbyCititoinduceLehmantoagreetoitsterms.
Indeed,Lehmansuccessfullynegotiatedcertaintermsinitsfavorpriortosigningtheamendment.
Likewise,theevidencedoesnotsupporttheexistenceofacolorableclaimforfailureofconsideration:CitiextendedcredittoLehmanatitssolediscretion,and
the September 9 amendment induced Citi to continue
providingintraday credit to Lehman subsidiaries. Given the rapidly
deterioratingmarket conditions, itwasnotunreasonable forCiti to
seekadded securityfromLehman.3953
TheevidencedoesnotsupporttheexistenceofacolorableclaimagainstCitiforbreachof
thedutyofgood faithand fairdealing inconnectionwith
itsCLSagreementwithLehman. TheExaminer foundnoevidence
tosuggestanyobligationbyCititoprovideclearingandsettlementservicestoLehman,and
given the increased riskCiti faced visvis Lehman on September
9,there is no colorable claim that Citi acted unreasonably,
irrationally,arbitrarily, or in bad faith by exercising or
threatening to exercise itscontractualright
toceaseextendingclearingadvancesand
toceaseservingasLehmansCLSsettlementmemberbank.
3953 See infra Section III.B.3.g.5.b for a discussion ofclaims
to avoid the Guaranty under
applicablefraudulenttransferlawwhereadifferentstandardappliesforassessingreasonablyequivalentvalue.
-
1077
(3) HSBC
HSBC principally provided Lehmanwith clearing and settlement
services for
sterlingdenominated trades in CREST, a clearing and settlement
system for certain
securities.SterlingdenominatedtradesinCRESTaresettledinrealtime;consequently,
asLehmanssettlementbank,HSBCextendedLehman intradaycredit to
facilitate the
settlementofitsCRESTtrades.ThegoverningagreementbetweenLehmanandHSBC
(theCRESTagreement)provided thatHSBChadabsolutediscretion to
terminate
itsresponsibilitiesasLehmansCRESTsettlementbank (which
includedextensionsof
intraday credit associated with settling Lehmans trades). The
CREST agreement
furtherprovidedthatHSBCcouldterminatethecontractwithoutnotice,onlyrequiring
30daysnoticetotheextentthatHSBCconsider[ed]itpracticableandappropriate.
HSBCprovidedmyriadotherbanking services toLehman,
includingactingas
Lehmans trustee for special purpose vehicles in the Cayman
Islands, as Lehmans
counterpartyinderivativestradesandothertransactions,andprovidingvariousother
creditproductstoLehman.HSBCsmostsignificantcreditexposure,however,derived
fromHSBCsroleasLehmansCRESTsettlementbank.
Beginning inmid2006,HSBC took steps to reduce its credit
exposure to the
financial sector generally, and, in 2007, it reduced its lines
of uncommitted credit
available to the investment banks. HSBC accelerated
thesemeasures after the near
collapseofBearStearns inearly2008. ViewingLehmanas
thenextmostvulnerable
-
1078
investment bank, HSBC further reduced various lines of credit it
had extended to
Lehman. Initially, HSBC implemented these measures quietly,
undetected by both
Lehmanandthemarketplace.However,onAugust18,2008,HSBCadvisedLehmanof
its intention to withdraw from its business relationship with
Lehman entirely. In
addition,overthenextseveraldays,HSBCdemandedthatLehmandeposit
justunder
$1billionintoaccountsintheU.K.andinHongKong,ultimatelytobesecuredbythree
cashdeeds.HSBCintendedtheU.K.deposittocoveritsexposurearisingfromCREST
clearing and settling. The smallerHongKongdepositwas intended to
collateralize
variouslinesofcreditHSBCprovidedtoLehmansubsidiariesintheAsianmarket.
Lehman understood that HSBC would cease clearing and settling
trades in
CRESTforLehman ifLehmandidnotpost thiscollateral. Lehman
initiallydeposited
theequivalentofapproximately$800millionwithHSBConAugust28.Laterthatsame
day,HSBCpermittedLehman toretrieve thatdeposit toassistLehman
inmeeting its
thirdquarterbalancesheet targets. Lehmansubsequentlyredeposited
theequivalent
ofapproximately$800millionwithHSBConSeptember1.
OnSeptember2,Lehman
depositedapproximately$180millioninanHSBCHongKongaccount.
Negotiations over the terms of the cash deeds ensued, and Lehman
secured
favorableconcessionsduringthatprocess.Twocashdeedswereexecutedtocoverthe
U.K.depositonSeptember9(theU.K.CashDeeds),andthepartiesexecutedathird
cashdeedonSeptember12related to theHongKongdeposit
(theHongKongCash
-
1079
Deed).EnglishlawgovernedthetermsoftheU.K.CashDeeds,whileHongKonglaw
governedthetermsoftheHongKongCashDeed.Notably,thedeedslimitedLehmans
abilitytoaccessthecollateralunlesstherewerenodebts
incertain,specifiedaccounts
(andnocontingentliabilities),andHSBCretainedgeneralrightsofsetoffinallevents.
TheExaminerhas identifiedseveralpotentialclaimsunderEnglish
lawagainst
HSBC arising out of these transactions involving
theU.K.CashDeeds, but has not
foundanyofthemtobecolorable.
The evidence does not support the existence of a colorable claim
that
theU.K.CashDeedsareinvalidforlackofconsideration.Englishlawdoesnotrequireconsideration
toenforceanagreementcontained inadeed. Inanyevent, because the
CREST agreement gave HSBC absolute discretion inprovidingLehmanwith
settlementand clearing services,Lehman receivedconsideration in
HSBCs agreement to continue providing those
services.Lehmanmayhavealsoreceivedconsideration in the formof the
interest itreceivedonthecollateralitposted.
Likewise,theevidencedoesnotsupporttheexistenceofacolorableclaimforeconomicduressbecause
theoperativeCRESTagreement (andothercreditagreements)permittedHSBC
to terminate its services at itsdiscretion.
Inanyevent,theExaminerfoundnoevidenceofduress,inparticulargiventhatLehmannegotiatedmore
favorable terms for itself in theprovisionsof thedeeds.
Theevidencedoesnotsupporttheexistenceofacolorableclaimforbreachofthedutyofgoodfaithandfairdealing.
HSBCsabsolutediscretionoverofferingCRESTservicesandextensionsofcredittoLehmanisnotsubjecttosuchanobligationunderEnglish
law,andeven if
itwas,HSBCsdemandsweregroundedinlegitimatecommercialconcernsaboutLehmansviability.
HSBCdidnotbreachthenoticeprovisionoftheCRESTagreement.HSBCsdetermination
not to provide more advanced notice of its decision
toterminateserviceswasnotarbitrary,capricious,unreasonableorinbadfaith;instead,itwaslegitimatelygroundedinitscommercialinterest.
-
1080
TheevidencedoesnotsupporttheexistenceofacolorableclaimthattheU.KCashDeedswerecontractsofadhesionor
standard formcontracts.
HSBCandLehmanweresophisticatedpartiestoagreementsthatwereextensivelynegotiated(ultimatelyresultinginchangesthatfavoredLehman).
Likewise, the evidencedoesnot support the existenceofa colorable
claimthat HSBC was unjustly enriched through the U.K. Cash Deeds.
TheExaminer concludes that the U.K. Cash Deeds are valid contracts,
underwhichLehmanhadadutytoconveyabenefittoHSBC,forwhichLehmanreceivedabenefit.
TheevidencedoesnotsupporttheexistenceofacolorableclaimthatHSBCbreacheda
fiduciaryduty toLehman. HSBCdidnotoweLehmanadutyindependent of its
narrowly defined role as Lehmans CREST
settlementbank,andtheCRESTagreementimposednoobligationonHSBCtocontinueprovidingservicestoLehman.
Even if HSBCs collateral demands were to have factored
materially
inLehmansdecisiontofileforbankruptcy,theevidencedoesnotsupporttheexistenceofa
colorable claim thatHSBCsdemand for collateral
tortiouslyinterferedwithLehmanscontractswithotherparties.
HSBCwasacting toprotectitsowncommercialinterests.
Finally,theevidencedoesnotsupporttheexistenceofacolorableclaimthatHSBC
fraudulently or negligently represented its plans to terminate
itscommercialrelationshipwithLehman.Tothecontrary,HSBCwasforthrightaboutitsintentionstoreduceitsexposuretoLehmanandultimatelytoceasedoingbusinesswithLehman.
(4) OtherLenders
Several banks, in addition to JPMorgan,Citi andHSBC, demanded
increased
security fromLehman in theweekspreceding thepetitiondate. While
theExaminer
did not investigate whether or not there were colorable claims
arising from these
transactions,theExaminersetsforthfactualfindingsastheyarerelevanttotheanalysis
ofLehmansreportedliquiditypool.
-
1081
Bank of America (BofA). BofA provided clearing and other
financialservicestoLehman.Inconnectionwithitsclearingservices,BofAprovidedunsecured,
intraday credit to coveroverdrafts. OnAugust 14,
2008,BofAdemandedadepositfromLehmaninorderforLehmantoretainitsoverdraftcredit.
In addition, BofA required Lehman to sign a
SecurityAgreement(executedonAugust25),inwhichLehmanagreedtomaintain$500millionincollateralwithBofA,andgrantedBofAasecurityinterestinthatcollateral.The
Security Agreement permitted Lehman to remove assets from
thedepositaccountwithadvancenoticeofthreedays.
Bank of New York Mellon (BNYM). BNYM provided Lehman withcredit
related to commercialpaper andmedium termnoteprograms. OnAugust 20,
BNYM requested that Lehman prefund its transactions withBNYM. After
a series of discussions, Lehman and BNYM agreed onSeptember8,2008,
thatLehmanwouldopenamoneymarketaccountwithBNYMandmaintainasufficientdeposit
there tocoverBNYMs forecastedintraday exposure to Lehman.
Thereafter, on September 11, Lehman
andBNYMexecutedaCollateralDepositAgreement,requiringLehmaninitiallytodeposit$125millionintradayandmaintainacollateralaccountofatleast$50million.
Standard Bank. Standard Bank provided Lehman with clearing
andsettlementservicesinSouthAfrica.OnAugust18,StandardBankrequestedthat
Lehman begin prefunding its trades. Discussions ensued, and
onSeptember 4, 2008, StandardBankdemanded $200million in collateral
bySeptember 9, or it would cease settling Lehmans trades.
Consequently,Lehmanprovided$200millionincollateraltoStandardBankonSeptember9,andexecutedapledgeagreement
tocover thedepositonSeptember11.The Examiners financial advisors
have not been able to identify a
U.S.debtorasthesourceofthesefunds.
(5) TheFederalReserveBankofNewYork
TheFRBNYwas one ofLehmansmajor creditors,particularly in thewake
of
BearStearnsnear collapse inMarch2008,and in theweeks subsequent
toLehmans
bankruptcy.
-
1082
Duringthetimeperiodsurrounding thenearcollapseofBearStearns
inMarch
2008, the FRBNY established the Primary Dealer Credit Facility,
or PDCF, through
which the FRBNY offered shortterm, collateralized loans to
brokerdealers at its
discountwindow,ineffectactingasarepocounterpartyoflastresort.Additionally,
theFRBNYcreated
theTermSecuritiesLendingFacility,orTSLF,underwhich,every
28 days, brokerdealers could engage in a competitive auction and
could swap
mortgagebackedsecuritiesandothersecuritiesforTreasuries.TheExaminerfindsthe
evidence does not support the existence of colorable claims in
connection with the
lendingtransactionsbetweentheFRBNYandLehman.
(6) LehmansLiquidityPool
Lehman represented in regulatory filings and in public
disclosures that it
maintaineda liquiditypool thatwas intended
tocoverexpectedcashoutflows for12
months in a stressed liquidity environment andwas available
tomitigate the lossof
securedfundingcapacity.AftertheBearStearnscrisisinMarch2008,itbecameacutely
apparenttoLehmanthatanydisruptioninliquiditycouldbecatastrophic;Lehmanthus
paidcarefulattentiontoitsliquiditypoolandhowitwasdescribedtothemarket.
Lehman reported the sizeof its liquiditypoolas$34billionat the
endof first
quarter2008,$45billionattheendofsecondquarter,and$42billionattheendofthe
thirdquarter. Lehmanrepresented that its
liquiditypoolwasunencumbered that it
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was composed of assets that could be monetized at short notice
in all market
environments.
TheExaminers investigationofLehmans transferofcollateral to its
lenders in
thesummerof2008revealedacriticalconnectionbetweenthebillionsofdollarsincash
and assetsprovided as collateral andLehmans reported liquidity.
At first,Lehman
carefullystructuredcertainofitscollateralpledgessothattheassetswouldcontinueto
appear tobereadilyavailable (i.e., theOvernightAccountat
JPMorgan, the$2billion
comfort deposit to Citi, and the threeday notice provision with
BofA). Witness
interviewsanddocumentsconfirmthatLehmansclearingbanksrequiredthiscollateral
and without it would have ceased providing clearing and
settlement services to
Lehmanor,attheveryleast,wouldhaverequiredLehmantoprefunditstrades.
The
market impactofeitherof thoseoutcomes couldhavebeen catastrophic
forLehman.
Lehman also included formally encumbered collateral in its
liquiditypool. Lehman
includedthealmost$1billionpostedtoHSBCandsecuredbytheU.K.CashDeedsin
its liquiditypool;Lehman included the$500million incollateral
formallypledged to
BofA;Lehman includedanadditional$8billion incollateralposted to
JPMorganand
securedbytheSeptemberAgreements;andLehmancontinuedtoincludethe$2billion
atCiti,evenaftertheGuarantyandDCSAamendments.
BythesecondweekofSeptember2008,Lehmanfounditselfinaliquiditycrisis;
itno longerhad sufficient liquidity to fund its survival. Thus,
anunderstanding of
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1084
Lehmanscollateraltransfers,andLehmansattendantlossofreadilyavailableliquidity,
isessentialtoacompleteunderstandingofwhyLehmanultimatelyfailed.
b) LehmansDealingsWithJPMorgan
ThisSectionoftheReportdiscussescollateralpostedbyLehmanentitiesduring
2008 inresponse torequestsmadeby JPMorganChase
(JPMorgan)andagreements
betweenLehmanand JPMorgan relating to clearingoperations,
credit,and collateral.
Inadditiontothemanywitnessinterviewsconductedanddocumentsreviewedbythe
Examiner,theExaminerhasinformallysoughtandobtainedinformationfromAlvarez
&Marsal,counselfortheDebtors,counselforJPMorganandcounselfortheCreditors
CommitteerelatingtotheissuesdiscussedinthisSectionoftheReport.
(1) Facts
(a) OverviewofJPMorganLehmanRelationship
JPMorgan acted as LBIs (LBHIs U.S. brokerdealer subsidiary)
principal
clearingbankforsecuritiestradingandtripartyrepurchase(repo)agreements.3954In
thatrole,JPMorganassistedintheclearanceandsettlementofsecuritiestradedbyLBI
and LBI funding through triparty repos. Clearing banks
facilitate security trades
between buyers and sellers and secured loans between borrowers
and lenders by
3954JPMorganengagedinotherroleswithLehman,includingasacounterpartytoderivativetransactions,counterpartytopurchasesandsalesofsecuritiesandotherfinancialinstruments,lenderonbothsecuredand
unsecured terms, investment banker to assistwith the issuance of
loans, bonds and equity,
andcounterpartytosecuritieslendingtransactions.TonuccidescribedLehmansdealingswithJPMorganasLehmansmostimportantrelationship.ExaminersInterviewofPaoloR.Tonucci,Sept.16,2009,atp.4.
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1085
providing services such as valuing the collateralposted by
borrowers, applying and
enforcing specific rules regarding collateralization and moving
cash and collateral
betweenaccounts.3955 JPMorganwasoneofonly twobanks in
theUnitedStates that
providedthevastmajorityofclearingservicestobrokerdealerentitiessuchasLBI;the
otherwasTheBankofNewYork.3956
JPMorgansclearingservicesforbrokerdealerssuchasLBIconsistedprincipally
oftripartyrepoclearingandclearingforothertypesofsecuritiestransactions.Triparty
reposareaprincipalsourceoffundingforbrokerdealers3957andrepresentedthelargest
intraday risk to JPMorgan of the clearing activities it carried
out forLehman.3958 As
implied by its name, triparty repo involves three parties: an
investor (typically a
pension fund, money market mutual fund or bank), a borrower
(such as a broker
dealer) and a clearing bank.3959 In a triparty repo, a triparty
clearing bank such as
3955See, e.g.,TobiasAdrian, et
al.,TheFederalReservesPrimaryDealerCreditFacility,CURRENT ISSUES
INECON. & FIN.,Aug. 2009, at p. 6, available at
http://www.newyorkfed.org/research/current_issues/ci154.pdf
[hereinafter Current Issues: PDCF]; Lehman,RepoManual (Nov. 8,
2005), at p. 11 [LBEXLL1175483][hereinafterRepoManual].3956Current
Issues:PDCF,atp.6;WorkingGrouponGovernmentSecuritiesClearanceandSettlement,ReporttotheFederalReserveBoard(Dec.2003),atp.10,availableathttp://www.federalreserve.gov/boarddocs/press/Other/2004/20040107/attachment.pdf[hereinafterWorkingGroupReport].3957CounterpartyRiskManagementPolicyGroupIII,ContainingSystemicRisk:TheRoadtoReform(Aug.6,2008),atp.113,availableathttp://www.crmpolicygroup.org/docs/CRMPGIII.pdf[hereinafterCRMPGIIIReport].
AdocumentdraftedbyJPMorgan,BestPracticesIntradayandOvernightTripartyDealerFinancing,formedabasisforwhatwasultimatelypublishedbytheCRMPG.
ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atp.7;JPMorgan,BestPracticesIntradayandOvernightTriPartyDealerFinancing[JPMEXAMINER00006026];ExaminersInterviewofPaoloR.Tonucci,Sept.16,2009,atp.4(explainingthatLehmanwasveryreliantontripartyrepoandthattripartyrepoisthelifebloodofaninvestmentbank).3958ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atp.5.3959CurrentIssues:PDCF,atpp.2,6.
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JPMorgan acts as an agent, facilitating cash transactions from
investors to broker
dealers,which,inturn,postsecuritiesascollateral.3960Thebrokerdealersandinvestors
negotiatetheirownterms;JPMorganactsonlyasanagent.3961Tripartyrepostypically
mature overnight, although investors and brokerdealers can also
enter into term
repos(reposthatmatureatalatertime)oropenrepos(reposwithoutasetmaturity
datethatpermittheagreementtobeterminatedonanyday).3962
Eachnightcollateral isallocated to investors
(intodesignationscalledtriparty
shells),eithermanuallybythebrokerdealeror,moretypically,throughanautomated
process in JPMorgansBrokerDealerAutomationSystem (BDAS).3963 The
investors,
inturn,provideovernightorlongertermfundingtothebrokerdealer.
Thefollowing
morning, JPMorgan unwinds the triparty repos, returning cash to
the triparty
investors and retrieving the securities posted the night before
by the brokerdealer.
3960CRMPGIIIReport,atp.114;RepoManual,atp.7[LBEXLL1175483].Tripartyreposaresimilartoloans
inwhich collateral is posted to secure the loan. SeeCurrent
Issues:PDCF, at p. 2 (In a repotransaction, theholderof a
securityobtains fundsby selling that security to another
financialmarketparticipantunder an agreement to repurchase the
security at a fixedpriceon apredetermined
futuredate.Inessence,thesellerisborrowingfundsagainstthesecurity,typicallyasameansoffinancingtheoriginalpurchaseofthesecurity.).3961E.g.,ExaminersInterviewofBarryL.Zubrow,Sept.16,2009,atp.3.3962SeeCRMPGIIIReport,atpp.11415;CommitteeonPaymentandSettlementSystemsoftheCentralBanksoftheGroupofTenCountries,CrossBorderSecuritiesSettlements(Mar.1995),atp.42,availableathttp://www.bis.org/publ/cpss12.pdf.3963JPMorgansResponses
toExaminersFirst SetofQuestions
reLehman/JPMAccounts&CollateraldatedSeptember3,2009
(Oct.23,2009),atpp.1,19
[hereinafterJPMorganFirstWrittenResponses];Examiners Interviewof
JohnN.Palchynsky,May11,2009,atp.4. BDAS isamainframesystem
thatJPMorganusestomanage itsclearanceactivities.
ExaminersInterviewofRicardoS.Chiavenato,Sept.21, 2009, at p. 12;
JPMorgan, U.S. Clearance,
http://www.jpm.com/tss/General/U_S_Clearance/1114735376505
(lastvisitedDec.17,2009). BDAShandles tensof thousandsof
tradesettlementsdaily.JPMorgan,U.S. Clearance,
http://www.jpm.com/tss/General/U_S_Clearance/1114735376505 (last
visitedDec.17,2009).
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1087
These securities then serve as collateral against the risk
created by JPMorgans cash
advance to investors.3964 During
thebusinessday,brokerdealersarrange the funding
thattheywillneedatthecloseofbusinessthroughnewtripartyrepoagreements.This
newfundingmustrepaythecashthatJPMorganadvancedduringthebusinessday,as
wellasanyothernonJPMorgancashneeds.Thus,throughouttheday,brokerdealers
send instructions into JPMorganssystem to indicate
thedetailsofnew tripartyrepos
(e.g.,collateralamountand type) thatwillcloseat theendof
theday.3965 Theprocess
thenrepeatsitself.
JPMorganalso facilitates
thesettlementofbrokerdealersalesandpurchasesof
securities.3966Forexample,abrokerdealerclientmaywishtopurchaseabondfor$10
million. At time of settlement, the deliveryversuspayment (DVP)
convention
entails thesimultaneousexchangeofcash for thesecurity.
JPMorganwouldadvance
the$10millioncashforthebenefitofthebrokerdealer.Thecashwouldgooutwhile
thesecuritycame intoanaccountoverwhichJPMorganheldasecurity
interest. The
brokerdealerwouldeffectivelyreceivea$10millionloanfromJPMorgancollateralized
bythesecurity. Thebrokerdealerwill inmostcasesrepaythis
loanatendofdayby
borrowing the$10million froma tripartyrepo investor. The risks
to JPMorganafter
advancingthecashandpriortorepaymentarethatthejustpurchasedsecuritywillfall
3964SeeCRMPGIIIReport,atpp.11415.3965Examiners Interview of John
N. Palchynsky, May 11, 2009, at pp. 34; JPMorgan First
WrittenResponses,atp.19.3966SeeCRMPGIIIReport,atp.113;ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atp.4.
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1088
in value below the $10million cash advance or the
brokerdealerwilldefault on its
repaymentobligation.
The JPMorganLBI clearing relationship was governed by a
Clearance
Agreement between LBI and JPMorgans predecessor, The Chase
Manhattan Bank,
executed in June 2000.3967 JPMorgan agreed to act as LBIs
nonexclusive clearance
agentforsecuritiestransactionsandtoopenandmaintainaclearanceaccount.3968
TheClearanceAgreement also provided for the extension of credit
to LBI by
JPMorgan,butatJPMorganssolediscretion.JPMorgancouldsolelyat[its]discretion,
permit [LBI] to use funds credited to the Account prior to final
payment . . . or
otherwise advance funds to [LBI] prior to final payment.3969
Further,
[n]otwithstanding the fact that [JPMorgan]may from time to
timemakeadvancesor
loans . . . or otherwise extend credit to [LBI],whether or not
as a regular pattern,
[JPMorgan]mayatany timedecline toextend suchcreditat
[JPMorgans]discretion,
withnotice.3970
InconsiderationofanyadvancesorloansJPMorganextendedtoLBIpursuantto
theClearanceAgreement,LBIgrantedJPMorganacontinuingsecurityinterestin,lien
upon and right of setoff as to certain LBI assets (explicitly
excluding certain
3967ClearanceAgreement(June15,2000),atp.20[JPM20040031786].
Foreaseofreference,TheChaseManhattanBankisreferredtohereinafteraspartofJPMorgan.3968Id.atp.1.Theclearanceaccountisactuallyasetofaccounts:ClearingAccounts,CustodyAccountsandSegregatedAccounts.Id.3969Id.atp.4.3970Id.
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segregatedcustomeraccounts).3971
Inotherwords,dailycreditextendedbyJPMorgan
wassecuredbyalienoncertainLBIaccountsmaintainedatJPMorgan.
Initially, theClearanceAgreementwas to expire onOctober 7, 2002,
atwhich
time if the parties had not entered into a written extension,
the agreement would
automaticallyrenewforaoneyearperiod.3972TheExaminerisunawareofanywritten
extension of the agreement during that time. The parties,
however, continued to
operate pursuant to the terms of the Clearance Agreement, as
evidenced by their
amendingtheagreementonMay30,2008.3973
(b) TripartyRepoPriorto2008
TheSeptember11,2001terroristattackssignificantlydisruptedtheoperationsof
the clearing banks (in particular the Bank ofNewYork, due to its
proximity to the
WorldTradeCenter),exacerbatingpolicyconcernsabouttheconcentrationofclearing
banks and risk of disruptions to financialmarkets.3974 In the
attacks aftermath, the
Federal Reserve, the SEC and the Treasury Department initiated
discussions with
3971Id. atpp. 1213. In theClearanceAgreement, thisprovisionwas
in tensionwith
thedefinitionofClearingAccountsandCustodyAccounts,whichJPMorganagreedtoholdas[LBIs]custodian,freeof[JPMorgans]lien,claimorinterest.Id.atp.1.InMay2008,theClearanceAgreementwasamendedto
delete this lienfree language in the definition of Clearing
Accounts and Custody
Accounts.AmendmenttoClearanceAgreement(May30,2008),atp.1[JPM20040085662].3972ClearanceAgreement(June15,2000),atp.17[JPM20040031786].3973TheMayAmendmenttotheClearanceAgreementaddedLehmanCommercialPaperInc.(LCPI)asapartytotheClearanceAgreement.AmendmenttoClearanceAgreement(May30,2008),atp.1[JPM2004
0085662]. Furthermore, JPMorgan and Lehman entered into agreements
after the ClearanceAgreement that secured Lehmans obligations
arising from JPMorgans provision of specific
clearingservicestoLehman.See,e.g.,CashCollateralAgreement(Oct.3,2005)[JPM20040085509].3974WorkingGroupReport,atp.11;ExaminersInterviewofChristopherJ.McCurdy,Aug.26,2009,atp.2.
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1090
market participants to explore the risks of having only two
clearing banks.3975 The
FederalReserveconsidered theoptionofcreating
itsownclearingbankof last resort
calledNewBank. It lookedatways to transferpositionsquickly
fromone clearing
banktoNewBankintheeventthatcustomerslostconfidenceinaclearingbankorin
the event that a clearing bank was incapacitated by some
catastrophic event.
Ultimately,therewasnoeasysolutiontotheseproblems,andtheNewBankproject
was held in abeyance.3976 The Federal Reserve and the clearing
banks continued,
however,todiscussabroadrangeofriskstoclearingbanks,
includingrisksposedby
failureofabrokerdealer.3977
Inevaluatingtripartyrepoclearingrisks
in2008,JPMorganrecognizedthatthe
tripartyrepomarkethadrecentlyexpanded,bothintermsofvolumeandthetypesof
3975WorkingGroupReport,atp.11.3976Examiners Interview
ofChristopher J.McCurdy,Aug. 26, 2009, at p. 2; see
alsoWorkingGroupReport, atpp. 2837;WorkingGrouponNewBank
Implementation,Report to theFederalReserveBoard(Dec. 2005),
available
athttp://www.federalreserve.gov/boarddocs/Press/Other/2005/20051215/attachment.pdf
[hereinafterNewBankWorkingGroupReport].3977See,e.g.,emailfromJanetBirney,Lehman,toDanielJ.Fleming,Lehman,etal.(Feb.26,2008)[LBEXDOCID280175](TherecentmarketturmoilhaspromptedtheFedtoquestionJPMContheviabilityofTripartyfinancingintheeventofbrokerdealerdefault.);emailfromJanetBirney,Lehman,toDanielJ.Fleming,Lehman,etal.(May5,2008)[LBEXDOCID065656];emailfromLucindaM.Brickler,FRBNY,toTimothyF.Geithner,FRBNY,etal.(July16,2008)[FRBNYtoExam.034046](attachingtalkingpointstheFRBNYdevelopedforaJuly17,2008meetingwithDimonandKellyregardingneartermmeasuresto
enhance the stabilityof the triparty
repomarket);FRBNY,TalkingPoints,NeartermMeasures
toEnhancetheStabilityoftheTripartyRepoMarket[Draft](July16,2008),atp.1[FRBNYtoExam.034047](talkingpointsnoting,[i]ntheeventofthedefaultofalargeborrower,thepotentialforsystemicrisktomaterializeco[u]ldbereduced).
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1091
securities funded.3978 That is, more tripartyrepo transactions
were occurring and
tripartyrepo parties were using lessliquid and often
hardertoprice securities.3979
Liquidityandeaseofpricingarebothcriticalfactorsaffectingriskstotripartyinvestors
andclearingbanks.Thepremiseofatripartyrepoisthatitconstitutessecuredfunding
inwhich the lender (investor) has the opportunity to sell the
collateral immediately
uponabrokerdealers (borrowers) failure topaymaturingprincipal.
U.S.Treasury
securitiesaretheoptimalcollateralforU.S.dollartransactionssincelargeblockscanbe
soldreadilywithinonetradingdayandthewidelyquotedpricesofsuchsecuritiesare
highlyreliable.Stateddifferently,ifatripartyinvestorhas,forexample,avalueofpar
onits$100millionofTreasurysecuritycollateralandneedstosellitquicklybecausea
borrowerfailedtorepayitsloaninthemorning,theinvestorwouldalmostcertainlybe
abletosellthecollateralduringthesamebusinessdayatavalueveryclosetopar.
To guard against the possibility of the investor realizing less
than the loan
amount ina liquidationscenario,
theborrowermustpledgeadditionalmargin (i.e.,
additionalcollateral)tothelender3980forexample,$100millionofTreasurysecurities
inexchangefor$98millionincash.This2percenthaircut(i.e.,discount)istypicalfor
3978ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atp.4;seealsoCurrentIssues:PDCF,atp.2.3979CRMPGIIIReport,atpp.11314;CurrentIssues:PDCF,atp.2.3980RepoManual,atp.14[LBEXLL1175483].
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U.S.Treasurycollateral.3981Eveniftheborrowerdefaults,thelenderwillsuffernoloss
ifitcansellthe$100millionofTreasurysecuritiesfor$98millionormore.
Asnotedabove, theriskof investor lossdependsupon the
investorsability to
sell collateral quickly and on the accuracy of the quoted price.
Illiquid collateral
requires longer timeperiods for saleatmoreuncertainprices,with
timeperiodsand
pricesdependentonthetypeofcollateral,theamountofcollateraltosellandprevailing
marketconditions.3982
Due to thesalvagevalueuncertaintyassociatedwith
illiquidcollateral, triparty
investorsdemandhigherhaircutsasperceivedcollateral illiquidity
increases. Equally
important,haircutsgenerallyincreaseasmarketvolatilityincreases.Forexample,some
lenders increased haircuts on assetbacked securities by 10
percent or more during
times of market turmoil.3983 Larger haircuts directly reduce the
amount of funding
3981See,e.g.,NewBankWorkingGroupReport,atp.10.3982As one
example, consider a brokerdealer that owns $10million of a tripleB
rated residentialmortgagebackedsecurity(RMBS).
Assumetheentireissuanceofthisparticularbondis$20million,sothebrokerdealerownshalfof
thebond issue. Typically therewouldbezeroorvery
fewobservabletradesof thisspecificbondduring theprecedingmonth.
Hence, there isnoway
toknowbeforehandhowthemarketwillreactintermsofliquidationtimeandpricetoatripartyrepoinvestor(aslenderto
thebrokerdealer securedby theRMBS collateral)who seeks to sell
$10millionof theRMBSbondquickly (uponadefaultof thebrokerdealer).
Themarketmay treat this tripleBbondas
ithasothersimilarlyratedRMBSbondsinthepriormonth,butassumptionsofthistypeadduncertainty.Eventhequotedprice
inadvanceofanyattempt tosell thebond isanestimatebasedonmodelsand
therecentperformance of theprevailing residentialhousingmarket
rather than a representation of recent
tradeactivity.Inshort,themoreilliquidthecollateral,thegreatertheuncertaintyofthesalvageablevalueofsuchcollateraltothetripartylender.3983See,e.g.,email
fromLauraM.Vecchio,Lehman, toLoriBettinger,SEC,etal. (May7,2008)
[LBEXWGM012803] (showingDresdner increasinghaircutonABS from110
to120duringstressperiod);seealsoemail
fromAmberishRatanghayra,Lehman, to JohnFeraca,Lehman,etal.
(Mar.24,2008) [LBEXDOCID 046250] (Danske has requested an increase
in haircut to 15%.). CraigDelany, amanaging
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1093
available toabrokerdealer,whichmay force thebrokerdealer to sell
collateral, find
otherfundingarrangements(suchasissuanceofunsecureddebt),oracceptareduction
inexcessliquidity.
Astripartyrepoagenttobrokerdealers,JPMorganwaseffectivelytheirintraday
tripartylender.WhenJPMorganpaidcashtothetripartyinvestorsinthemorningand
receivedcollateralintobrokerdealeraccounts(whichsecureditscashadvance),itbore
asimilarriskforthedurationofthebusinessdaythattripartylendersboreovernight.
IfabrokerdealersuchasLBIdefaultedduring theday,
JPMorganwouldhave tosell
thesecuritiesitwasholdingascollateraltorecoupitsmorningcashadvance.
JPMorgan used a measurement for triparty and all other clearing
exposure
knownasNetFreeEquity(NFE).Initssimplestform,NFEwasthemarketvalueof
Lehman securities pledged to JPMorgan plus any unsecured credit
line JPMorgan
extendedtoLehmanminuscashadvancedbyJPMorgantoLehman.3984AnNFEvalue
greater than zero indicated that Lehman had not depleted its
available credit with
JPMorgan. The NFE methodology also enabled JPMorgan to monitor
its exposure
positionatalltimesduringthetradingdayandtherebyevaluatecollateralsubstitutions
directoratJPMorgansInvestmentBank,however,statedthat,intripartyrepos,typicallyinvestorslookto
the counterparty (i.e.,brokerdealer) first and the collateral
secondwhen settinghaircuts.
Inotherwords,ahaircutmaynotbesufficientforaninvestorifithasseriousconcernsabouttheviabilityofitscounterparty.ExaminersInterviewofCraigM.Delany,Sept.9,2009,atp.13.3984ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atp.5.
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byLehman thatmightproduceundesired credit exposures.3985 If a
tradewouldput
LehmansNFE below zero, the tradewould not bepermitted.3986
Through February
2008, JPMorgan gave full value to the securities pledged by
Lehman in the NFE
calculation and did not require a haircut for its effective
intraday triparty lending.
Consequently,throughFebruary2008,JPMorgandidnotrequirethatLehmanpostthe
marginrequiredbyinvestorsovernighttoJPMorganduringtheday.3987
DanFleming,LehmanGlobalHeadforCashandCollateralManagement,stated
thatLehmanobjectedtotheopaquenatureofJPMorgansNFEformulaandthatthere
oftenwasdisagreementbetweenLehmanand JPMorgan regardingNFE
figures,with
Lehman struggling to find causal connections between drops inNFE
and Lehmans
actions.3988 InFebruary 2008,Lehman requested that
JPMorganprovide adailyNFE
snapshotinordertoallowLehmantoobtainbetterestimatesofitsposition.3989
(c) JPMorganRestructuresItsApproachtoTripartyRisk
In early 2008, the Federal Reserve Bank of New York (FRBNY)
urged
JPMorgan to focuson therisksassociatedwith its intradayexposure
tobrokerdealer
3985Id.atp.6.3986Id.atp.5;ExaminersInterviewofDanielJ.Fleming,Apr.22,2009,atp.3.3987ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atp.4.3988Examiners
InterviewofDaniel J.Fleming,Apr.22,2009,atp.4;Examiners
InterviewofCraigL.Jones,Sept.28,2009,atp.5.TonuccidescribedNFEasnotatransparentthing.ExaminersInterviewofPaoloR.Tonucci,Sept.16,2009,atp.6.3989Email
fromCraig L. Jones, Lehman, toDaniel J. Fleming, Lehman (Feb. 26,
2008) [LBEXDOCID280175].
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1095
clients.3990 In February 2008, JPMorgans Ricardo Chiavenato, a
risk manager at
JPMorgan,wastaskedwithreviewingJPMorganstripartybusiness.3991Afteranalyzing
the market and increasing risks faced by clearing banks handling
triparty repo
transactions,ChiavenatorecommendedthatJPMorganretaintripartyinvestormargin
the samemargin triparty investors required.3992 JPMorgandecided
to implement the
marginrequirementsgradually.3993
JPMorgan incorporated itsnewmargin requirements into theNFE
calculation.
Under itsnewapproach, JPMorgan reduced thevalue itassigned
tosecurities itheld
commensuratewiththemarginrequirementsofthetripartyinvestors.3994Forexample,
ifLehmanhadborrowed$19million
inanovernighttripartyrepofromaninvestor,it
mighthavepledged $20million (marketvalue)of corporatebondsas
collateral (ata
haircut of 5percent). Before February 2008, JPMorgan required no
tripartyinvestor
margin,soJPMorganspaymentof$19millioncashinthemorningtorepaythelender
(acashadvanceforthebenefitofLehman)inconcertwiththereceiptofthe$20million
3990See email from JanetBirney,Lehman, toDaniel J.
Fleming,Lehman, et al. (Feb. 26, 2008)
[LBEXDOCID280175].3991ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atpp.3,5.3992Id.atp.5.ThisrecommendationthatclearingbanksretainmarginagainstcashadvancesisconsistentwithaDecember2005reportofaworkinggroupcommissionedbytheFederalReserveBoardtostudyNewBank
feasibility. A portion of this report dealt with prudent
riskmanagement practices
andincludedtherequirementthatclientspostmargintocollateralizetheclearingbanksriskexposure.
SeeNewBankWorkingGroupReport,atp.17.3993EmailfromJanetBirney,Lehman,toDanielJ.Fleming,Lehman,etal.(Feb.26,2008)[LBEXDOCID280175].3994Id.;ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atp.6.
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1096
ofsecuritieswouldgiveLehmananimmediate$1millionsurplusofNFE.3995Lehman
could thenuse this surplus bywithdrawing cash or securities or
by executing other
tradesthatmightdrawdownthesurplus.
UponfullimplementationofJPMorgansplantoretaintripartyinvestormargin,
the change to theNFE calculationwould be to treat the
$20millionmarketvalue of