By: Richard S. Miller, Robert T. Honeywell, Jeffrey N. Rich
The Lehman Brothers bankruptcy sometimes seems to have exhausted the list of “biggest ever” superlatives: Biggest ever bankruptcy filing in the United States ($639 billion in assets). “By far the largest securities broker-dealer liquidation ever attempted,” according to the trustee overseeing the liquidation of Lehman’s U.S. broker-dealer. His British counterpart, overseeing the insolvency of Lehman’s London operations, told the press, “Enron and BCCI were large and complex but not on this scale.” The Lehman collapse has been tied to the fall of the investment banking model, to continuing uncertainty in financial markets, and to the current turmoil in the global economy itself.
A less-discussed theme of the Lehman bankruptcy is the strain it is revealing between the efficiencies of global corporate cash management and the legal regimes governing creditor claims. When the cash literally stops flowing, creditors and investors naturally ask, “Where’s my money?” The Lehman insolvency has revealed, like many of the largest corporate bankruptcies in recent years, that this can be an extremely difficult question to answer.
Part of the problem is that most corporate cash management systems involve one corporate entity moving cash on behalf of its affiliates, but reflecting their interests primarily through intercompany claims. This has obvious operational efficiencies, but when “the music stops” upon a bankruptcy filing, the cash is held by the entity with legal title to it (i.e., in its accounts). Creditors of the entity holding the cash have an immediate enforcement advantage – the money is there – while creditors of its affiliates have to chase it down, possibly across jurisdictional boundaries. The Lehman bankruptcy is the latest example.
Like most large companies, Lehman operated a centralized cash management system that had one entity – in this case the holding company – operate as the “central banker” for the numerous Lehman entities. According to court filings, the holding company generally swept excess cash into its own U.S. and foreign operating accounts and used it to fund expenses of subsidiaries. The degree to which subsidiaries were integrated into the system varied. For example, unregulated subsidiaries had their excess cash swept on a daily basis to the holding company’s operating accounts, while regulated subsidiaries (generally broker-dealers) transferred cash to the holding company less frequently, to pay down intercompany loans for prior advances. Some subsidiaries managed their own cash and disbursements independently (e.g., Lehman Brothers Commercial Bank). Others had some of their collections deposited into the accounts of other subsidiaries. For example, the regulated U.S. broker-dealer (Lehman Brothers Inc. (“LBI”)) received collections from some derivatives, futures and foreign exchange transactions of Lehman Brothers Commercial Corporation, Lehman Brothers Special Financing Inc., and Lehman Brothers International (Europe) (“LBIE”). As to disbursements for expenses, the holding company acted as “paymaster” for most of Lehman’s European operations, while the regulated U.S. broker-dealer (LBI) acted as “paymaster” for most U.S. operations.
A centralized cash management system such as Lehman’s may make utter sense pre-bankruptcy, but can produce legal nightmares afterward. For one, the sheer number of transactions can make untangling intercompany claims based on those transactions a herculean task. Lehman reported that the portion of its business related to the sale of derivatives alone involved approximately 1,500,000 transactions with approximately 8,000 counterparties. It is now faced, in the post-bankruptcy setting, with sorting these out with a radically reduced staff, going from more than 13,000 employees to about 140. Lehman’s London office recently lost over half of its legal staff. Its current U.S. management, led by an outside restructuring firm, is reportedly focused on preserving its information systems and retaining employees, and estimates being able to respond to creditor inquiries in 45-60 days. Impatient creditors in the U.S. case have filed motions for their own investigations and for the appointment of an examiner and for an independent trustee to replace Lehman’s remaining officers and directors. Its UK insolvency administrators reported difficulty determining the UK companies’ assets, partly due to difficulties getting information from other asset custodians around the world, and that “it will take many years to finally resolve the inter-company and third-party claims.”
A review of Lehman’s cash management system also shows that numerous legal and regulatory regimes are now at play that may affect intercompany claims and, as a result, creditors’ ultimate recoveries. The holding company that acted as the “central bank” is now subject to the U.S. Chapter 11 case, along with 16 subsidiaries; LBI is subject to a separate liquidation proceeding supervised by the Securities Investor Protection Corporation; LBIE and three other British entities are in a UK administration proceeding; other foreign subsidiaries are subject to insolvency proceedings in their own jurisdictions (for example, in Hong Kong, Australia, Singapore, Japan, The Netherlands, France and Germany); and various Lehman entities and funds are still “non-debtors,” not having yet filed a formal insolvency proceeding and thus continuing to be subject to whatever laws govern the entities and their various contracts.
From an insolvency perspective, this means that a creditor or investor evaluating its recovery prospects must:
- first determine which entity or entities it did business with, both directly and through guaranties, cross-collateralization, setoff and netting rights; then
- determine which assets (including collateral) are available for recovery and which courts and regulators may have jurisdiction over those assets (including a possible stay or injunction prohibiting enforcement or foreclosure); then
- file claims in the relevant insolvency proceedings prior to the applicable deadlines (subject to considering the risks of submitting to jurisdiction), exercise any voting and participation rights available to creditors (for example, attending creditors’ meetings and voting on a plan of reorganization), and possibly take other enforcement action (for example, a motion to modify any stay against foreclosure or other litigation); then
- monitor the relevant insolvency proceedings, to determine the timing and amount of creditor recoveries.
The multiplicity of bankruptcy regimes now governing Lehman means that each Lehman entity is now considered a separate “bankruptcy estate” – i.e., a separate group of assets and creditors – and each is now vying with the other bankruptcy estates for a piece of the Lehman group’s remaining assets. Intercompany claims are often the main vehicle through which these separate bankruptcy estates try to recover assets for themselves. Anyone who has lived through other large corporate bankruptcies (e.g., Adelphia, Global Crossing, Refco) knows that intercompany litigation can be the most complex, intractable and even unresolvable feature of the insolvency proceeding. Some cases feature creditors attempting to “substantively consolidate” all of the companies by collapsing all of the different bankruptcy estates into one, eliminating intercompany claims in the process, but other creditors naturally, and fiercely, resist. Some creditors will of course benefit from corporate separateness by preserving their respective debtor-companies’ assets for themselves.
Creditors and investors of the “asset-weak” companies try to reach through corporate boundaries by any and all means. If they are unsuccessful, their recoveries can be much lower than their counterpart creditors at other entities in the corporate tree, in what is ostensibly the “same company.” A typical pattern is that lenders and investors at one level (for example, stockholders and bondholders of the holding company) assert that they financed the operations of the subsidiaries and should recover accordingly; conversely, creditors of the subsidiaries assert that holding company creditors were aware of their “structural subordination” and have to live with the consequences.
Hence, the (often furious) litigation that attends many complex corporate bankruptcies and is now gathering steam in the Lehman cases. In addition to the multiple insolvency proceedings around the world, there are now securities class actions and criminal investigations, all of which will presumably take years to resolve. One of the well-publicized complaints is from creditors of Lehman’s UK entities, who claim that several billion dollars was swept into Lehman’s U.S. accounts on the eve of its Chapter 11 filing. These creditors are now faced with trying to claw back cash that once flowed easily within “Lehman Brothers” and is suddenly beyond their reach due to legal boundaries that became very real, and difficult to pierce, upon Lehman’s bankruptcy filing.
This is one of the difficult lessons that is learned repeatedly in corporate bankruptcies but is especially potent for companies with global operations. At a court hearing, one of Lehman’s lawyers explained its cash management system as “cash moves around with great velocity.” This can be profitable for creditors in good times yet very dangerous in others. Creditors should be aware of the benefits and risks of centralized cash management – specifically, of exactly which entities they have claims against, and where those entities’ cash and other assets are – so that they can understand and be prepared for the consequences in the event, “the music stops.”
