Lehman Brothers Europe Wins "Rascals" Appeal
Shortly before Christmas, the Court of Appeal in London handed down judgement in favour of the administrators of Lehman Brothers International Europe (LBIE) in what is known as the “Rascals” case.1 In so doing the Court, whose judgement was given by Lord Justice Lloyd, upheld Mr Justice Briggs’ finding at first instance2 resolving an intra-group dispute over the beneficial ownership of securities worth in excess of $1.5 billion.3
The outcome is of immediate interest to creditors of LBIE and the unsuccessful appellant, Lehman Brothers Finance S.A. (LBF), a Swiss subsidiary also subject to insolvency procedures. Two other appellants settled with the company’s administrators prior to the appeal. While Lloyd LJ upheld the judge’s decision in most respects, he differed in certain key matters in his reasoning. The decision is also of note because of the Court’s approach to Lehman’s global settlement practice for securities acquired in the market (or the “street” as referred to in the judgment), and the effect of recurring back-to-back repos and stock loans.
The securities in dispute were purchased through Lehman Brothers’ global settlements practice. This meant that in each region there was a “hub” company; for Europe this was LBIE, through which all securities acquired by Lehman subsidiaries in the region were settled and transferred on sale. The securities comprised both fixed income and equities, most of which were held in a dematerialised form with a clearing house or depository. It was LBIE’s policy to use the securities for the economic benefit of the group. In this regard, it would lend them to the market and retain the fees earned although it accounted to the subsidiary for dividends and any capital gain on eventual resale.
In the early 1990s concerns were raised about the global settlements practice. These centred on capital adequacy requirements and the application of regulatory capital charges that differed depending on the nature of an entity’s capital. For instance, if LBIE paid for securities on behalf of a subsidiary but in return had only an unsecured debt, it would be exposed, potentially, to a high capital charge than if it enjoyed a secured debt. Another issue was the need to ensure that LBIE could give good legal title when lending the stock out.
To tackle these issues, a process known as Rascals4 was introduced from 1996. This sought to replace an unsecured obligation by the subsidiary to repay LBIE the purchase price with a secured obligation to pay for equivalent securities under the Rascals process by the use of repo agreements.5 LBIE would also be left to economically exploit the securities in the market with good legal title.
There were two versions of the Rascals process: electronic daily transactions between LBIE and Lehman subsidiaries, called “automatic” Rascals, and “manual” Rascals carried out by staff. Rascals operated as follows:
- LBIE acquired and paid for securities on behalf of a Lehman subsidiary;
- LBIE and the subsidiary then entered into a repo agreement to sell the securities to LBIE for its value that day, the “on-leg,” and for its sale back the day after for the same price plus a fee, the “off-leg;” and
- A further identical repo would then be entered into except that the price was marked to market, and this process would be carried out on a daily basis until the securities were sold back to the market.6
On the collapse of Lehman Brothers in 2008, what was an intra-group agreement was transformed into a dispute between competing groups of creditors over which company, LBF or LBIE, was entitled to the beneficial interest. At first instance, Briggs J having reviewed the Rascals process and English trust law, including LBIE v RAB Market Cycles  EWHC 2545 (Ch), found in favour of the administrators. This was despite both parties ironically having argued that the Rascals process was ineffective in transferring beneficial ownership to LBIE.7
The Court of Appeal, while arriving at the same overall conclusion, differed in its reasoning in some respects. This included the effect of the Inter-Company Repurchase Agreement (ICRA) which governed the making of repos between LBIE and LBF. Clause 1 provided: “For the avoidance of doubt, any loans under this agreement are provided from [Lehman Brothers Holdings Incorporated] to LBF and at no time will LBIE be regarded as lending to LBF.” Briggs J considered that clause 1, which suggested that the Lehman Brothers’ parent funded the acquisition of securities, rather than LBIE, did not apply because the acquisition was self-funded by LBIE using LBF’s unsecured obligation to pay. Unsurprisingly, Lloyd LJ was unable to follow the judge’s reasoning as the purchase from the market must have required the exchange of funds sourced from somewhere.8 The terms of the ICRA appeared to mean that LBIE could not be a lender to LBF under the Rascals process.
Having reached this conclusion, contrary to that at first instance, the Court of Appeal observed that the ICRA clause had not affected the manner in which LBIE and LBF had recorded the repo transactions. Evidence at trial on the group’s accounts and ledgers showed LBIE’s purchase of securities to have been funded by its parent, but on its purchase of securities for LBF, an intra company debt was recorded between LBIE and LBF. The evidence further showed that the parties had acted on the basis that those records were correct.9 On this basis, the appeal court held that while this would be insufficient to vary or waive the ICRA clause, LBF was estopped by common assumption or convention from disputing that it owed LBIE this sum.10
This resolved the first element of the Rascals process in the administrators’ favour, but it was also necessary to show payment by LBIE for the “on-leg” of the repo in order for ownership to transfer. At first instance, the answer was said to be an “offset” of LBF’s debt for the acquisition of the securities by LBIE.11 The Court of Appeal did not accept this analysis – the legal significance of the term “offset” being unclear – but it did agree with Briggs J’s reliance, in the alternative, on estoppel by convention where he had cited HMRC v Benchdollar Ltd  EWHC 1310 (Ch) in respect of the relevant principles.12 Lloyd LJ considered that such a finding was merited when one took into account the purpose of the Rascals process, which was shared by all members of the Lehman Brothers group.13
Giving Effect to Rascals
On this basis, therefore, dismissing the appeal (and incidentally the administrators’ cross appeal), LBIE was held to be the beneficial owner of the securities, albeit on the basis of giving effect to the contemporaneous intention of the parties with respect to the Rascals process by means of estoppel. Potentially, given the sums at stake, an appeal may be heard by the UK Supreme Court.
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