Download - Lehman Examiner's Report, Vol. 4
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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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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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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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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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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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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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5. Conclusions ........................................................................................................2063
6. BarclaysTransaction .........................................................................................2103
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UNITEDSTATESBANKRUPTCYCOURTSOUTHERNDISTRICTOFNEWYORK
x InreLEHMANBROTHERSHOLDINGSINC.,etal., Debtors.
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Chapter11CaseNo.0813555(JMP)(JointlyAdministered)
x
REPORTOFEXAMINERANTONR.VALUKAS
SectionIII.A.5:SecuredLenders
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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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(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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(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
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(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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(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
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(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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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
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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
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(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
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(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
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(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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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
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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.
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(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
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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.
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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.
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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
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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
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(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.
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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.
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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.
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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.
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(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
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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
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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.
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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.
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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.
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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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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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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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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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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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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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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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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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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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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