Report: Lehman losses reflect poor planning, complexity; recovery 28%

By Caroline Salls

Pittsburgh, April 4 - The difficulties associated with Lehman Brothers Holdings Inc.'s Chapter 11 bankruptcy resolution resulted in part from the company's lack of bankruptcy planning and in part from the inherent complexity of its business and organizational structure, according to a report from Michael Fleming and Asani Sarkar.

Fleming is a vice president in the Federal Reserve Bank of New York's Research and Statistics Group, and Sarkar is an assistant vice president in that group. However, the opinions in the report are those of the authors and not the bank.

Given that the bankruptcy of Lehman-type firms is rare outside of a crisis, Fleming and Sarkar said it would be challenging for the bankruptcy court to quickly build the expertise required to deal with such cases effectively.

The report said Title II of the Dodd-Frank Act gives regulators the option of replacing Chapter 11 with an alternative mechanism, known as the Orderly Liquidation Authority, for resolving large, complex organizations, but complete details of this alternative are still in the works.

The Orderly Liquidation Authority expands the reach of the Federal Deposit Insurance Corp. in resolving the cases of large, non-bank financial institutions like Lehman.

Creditor recoveries

According to the report, the bankruptcy of Lehman and its 209 registered subsidiaries involved more than $1 trillion of creditor claims in the United States alone, four bodies of applicable U.S. laws and insolvency proceedings that involved more than 80 international legal jurisdictions.

Fleming and Sarkar estimated the payout ratio to Lehman's creditors so far to be about 28% on estimated allowable claims of more than $300 billion, implying a loss to creditors and counterparties of more than $200 billion.

The report said the recovery for Lehman Brothers Holdings creditors has been below average so far, coming in at about 27% versus more than 55% historically, even after accounting for prevailing economic conditions likely to result in a recovery rate lower than the historical average for firms comparable to Lehman.

The Lehman estate is scheduled to make further distributions to creditors, but Fleming and Sarkar said it remains to be seen how much further recovery rates can improve.

Fleming and Sarkar said the payout ratio to Lehman's creditors was initially estimated to be about 21% on estimated allowable claims of $362 billion, implying a loss to creditors and counterparties of roughly $286 billion.

Actual distributions so far appear to have exceeded initial estimates, although the report said some of the amount distributed has gone to other Lehman creditors rather than third-party creditors.

In addition, the report said there was substantial variation in recovery rates even for similar creditor groups.

For example, of Lehman's derivative subsidiaries, creditors of three subsidiaries received full recovery on their claims, but those of the largest subsidiary, Lehman Brothers Special Financing, suffered substantial losses.

Fleming and Sarkar said the variation in the recovery rate depended on what was negotiated between creditors who had claims against the holding company and derivative creditors who had claims against the subsidiaries, whether the holding company guaranteed the debt of the subsidiary, whether the securities were centrally or bilaterally cleared and how the court interpreted various provisions of the Bankruptcy Code.

Loss factors

Fleming and Sarkar said some of the losses borne by Lehman investors stemmed from the manner in which Lehman failed, and they might have been avoided in a more orderly liquidation process.

For example, the authors of the report said because Lehman filed for bankruptcy abruptly, the value of its estate might have been reduced through the loss of derivative receivables that could otherwise have been unwound and by the lack of bankruptcy planning, a factor that contributed to creditor litigation.

Specifically, Fleming and Sarkar said the abruptness of Lehman's filing is reported to have reduced the value of its estate by as much as $75 billion, and 70% of derivatives receivables worth $48 billion were lost that could otherwise have been unwound.

In addition, Fleming and Sarkar said creditor losses would have been more substantial without Lehman Brothers Inc.'s ability to finance positions through the Federal Reserve's liquidity facilities. The authors said this financing was critical to Lehman Brothers Inc. remaining a going concern pending the finalization of its sale to Barclays.

The Dodd-Frank Wall Street Reform and Consumer Protection Act has since circumscribed the Federal Reserve's ability to act as lender of last resort to the same extent that it did during the recent financial crisis, the report said.

Derivative claims settlement

Fleming and Sarkar said their study focused on the settlement of claims related to Lehman's over-the-counter (OTC) derivative positions, as much of the complexity in resolving Lehman's bankruptcy case was tied to these settlement procedures.

According to the report, derivatives receive special treatment under Chapter 11 through exemptions or "safe harbor" from several provisions of the Bankruptcy Code, although questions have been raised regarding the desirability of providing these exceptions.

Fleming and Sarkar said the effectiveness of the derivative settlement procedures were assessed based on their speed, predictability and transparency.

In Lehman's case, Fleming and Sarkar said the speed of resolution varied across claimant groups. Many Lehman OTC derivative counterparties terminated their contracts within weeks of the holding company's bankruptcy filing, as was allowed under the safe harbor provisions, while some derivative contracts of large, institutional counterparties took much longer to terminate.

Even in cases where termination happened quickly, Fleming and Sarkar said final settlement was a long, drawn-out process, which is still ongoing.

The authors said the settlement process was long because the Lehman estate was obligated to do due diligence on numerous complex claims on an individual basis, and its determination of claims was frequently litigated.

Organizational complexity

Fleming and Sarkar said Lehman's organizational complexity also prompted delays. For example, in some instances, the report said Lehman and its counterparties were not sure of the identity of the specific Lehman subsidiary against which creditors had claims.

Lehman's "interconnectedness" also led to delays as creditors of the holding company argued in court that they were entitled to a portion of recovery from subsidiary assets because the holding company had guaranteed some of the subsidiaries' debt, according to the report.

"The predictability of the outcome of claims settlement in the Lehman resolution was hindered by the novelty of its financial structure (in the context of bankruptcy cases)." Fleming and Sarkar said.

"While existing case law provided a useful starting point for Lehman's resolution, the court provided new interpretations of provisions in the Bankruptcy Code."

Fleming and Sarkar said this was in part because Lehman held many complex financial securities that were subject to litigation during the bankruptcy proceedings. The court had to analyze these securities for the first time and sometimes made surprising rulings.

New York-based Lehman Brothers Holdings Inc. was the fourth-largest investment bank in the United States. The company emerged from bankruptcy on March 6, 2012.

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