To Lose One Investment Bank is Unfortunate, to Lose Two Would Be Careless: Addressing Investment Bank Insolvency, Contributed by Joe Bannister and Alexander Wood, Hogan Lovells LLP
After a period of intense speculation, on 15 September 2008 Lehman Brothers International Europe (LBIE) and certain other English companies within the Lehman Brothers Group went into administration in the UK. They were followed later that day by Lehman Brothers Holdings, Inc. which filed for Chapter 11 protection. In the subsequent days and weeks, various other Lehman entities worldwide filed for insolvency in their relevant jurisdictions. The fall of the investment banking giant that had been the Lehman Group was complete. More than three years later, the relevant insolvency officials, including the English administrators, are still trying to resolve the issues and complexities caused by the insolvency and in so doing, to return funds to the companies’ creditors.
Many of these complexities arose as a consequence of the way in which client monies and client assets had been held by the various Lehman group companies. Reports indicate that in the UK, Lehman’s counterparties were unclear as to whether over 840,000 trades would go on to settle, while clients had more than $35 billion in cash and assets tied up in the insolvent estate.1 There have been delays in identifying and returning those assets to clients, resulting in further disruption to the financial markets. In some cases, the delay in returning assets to the counterparties has caused those counterparties to find themselves in financial difficulties.
So what has been done to try to avoid similar issues should an investment bank fail in the future?
The Banking Act 2009
The Banking Act 2009 (Banking Act) established a permanent special resolution regime, providing the Financial Services Authority (FSA), the Bank of England (BoE) and HM Treasury (together, the Authorities) with tools to deal with banks that get into financial difficulties. A “bank” is defined as “a UK institution which has permission under Part IV of the Financial Services and Markets Act 2000 (FSMA) to carry on the regulated activity of accepting deposits (within the meaning of section 22 of that Act, taken with Schedule 2 and any order under section 22).”
The Banking Act provides for:
- Three stabilisation options available to the Authorities;
- A bank insolvency procedure, which provides for the liquidation of the bank and the transfer of all the bank’s deposit-taking business to a purchaser or a bridge bank; and
- A bank administration procedure, which provides for the appointment of an administrator to support the partial transfer of a bank’s business to a purchaser or bridge bank, and the ongoing running of the residual bank, either as a going concern or as part of an orderly winding up process for use where there has been a partial transfer of business from a failing bank.
The Investment Bank Special Administration Regulations 2011
To the extent they fall outside the definition, investment banks are excluded from the processes introduced by the Banking Act. However, it was acknowledged that changes had to be made to the UK insolvency regime to provide expressly for investment banks. Although the UK insolvency regime proved itself more flexible than some, the unforeseen complexities in resolving a failed investment bank through the English administration process were seen as having major implications for confidence in the UK financial markets and the attractiveness of the UK as a place to conduct prime brokerage business.
Acknowledging the need to make further provision for the insolvency of investment banks, but not wishing to implement new provisions without full discussion with the relevant bodies, the Banking Act therefore provided that HM Treasury could make regulations modifying insolvency law as it applies to investment banks, or alternatively, set up a new insolvency scheme. After a long period of consultation and review (and shortly before the expiry of its powers to make such regulations), HM Treasury put forward the Investment Bank Special Administration Regulations 2011 (SI 2011/245) (Regulations). These came into force on 8 February 2011.
As with the Insolvency Act 1986 (IA 1986), much of the detail of the mechanics of the special administration regime for investment banks (SAR) (e.g., the holding of creditors’ meetings and the submission of claims) are set out in the Investment Bank Special Administration Rules (England and Wales) (Rules) 2011 (SI 2011/1301), which came into force on 30 June 2011.
What is an “Investment Bank”?
For the purposes of the Regulations, a firm is an “investment bank” if it satisfies three conditions:
- It is incorporated in or formed under the laws of any part of the UK – so the legislation covers not only companies but also partnerships and limited liability partnerships.
- It has permission under Part IV FSMA to carry on at least one of the following regulated activities: 1) safeguarding and administering investments; 2) dealing in investments as principal; or, 3) dealing in investments as agent.
- It holds client assets. “Client assets” are defined as assets – including client money – which an institution has undertaken to hold for a client. However, there is an exception for firms which hold client money relating to insurance mediation activities that are not part of investment activities.
The New Procedure for Investment Banks
The Regulations introduce a SAR for investment banks. Perhaps unfortunately, it is not a single process that applies to all investment banks. The processes introduced by the Regulations can be broken down as follows:
- Special administration – available to all investment banks save where the investment bank is a deposit-taking bank with eligible depositors;
- Special administration (bank insolvency) – available to investment banks that are deposit-taking banks with eligible depositors; and
- Special administration (bank administration) – available to all investment banks that are deposit-taking banks.
This article will focus on the SAR and will consider only briefly special administration (bank administration) and special administration (bank insolvency).
Application for Special Administration
The special administration process is commenced through a court application made by one or more of any of the directors of the investment bank, one or more of its creditors, the FSA or the Secretary of State. An application by anyone other than the Secretary of State must state either that the investment bank is or is likely to become unable to pay its debts (Ground A) or that it would be fair to put the investment bank into special administration (Ground B). An application by the Secretary of State has to show both Ground B and that it is expedient in the public interest to put the investment bank into special administration (Ground C).
However, before an investment bank that is not a deposit-taking bank can go into administration (or, indeed, liquidation), certain conditions have to be met. These conditions include the giving of notice of the intended process to the FSA and either waiting for a period of two weeks or obtaining the consent of the FSA to the process. Upon receipt of the notice, the FSA also has the option of commencing the proposed or an alternative insolvency process.
There are three special administration objectives (Objectives):
- Objective 1 – to ensure the return of client assets as soon as is reasonably practicable;
- Objective 2 – to ensure timely engagement with market infrastructure bodies and the Authorities; and
- Objective 3 – either to rescue the investment bank as a going concern, or wind it up in the best interests of the creditors.
The administrator can prioritise the Objectives in whatever order he sees fit so as to achieve the best result overall for clients and creditors, but whatever the priority decided upon, he must work to achieve each objective as quickly and efficiently as is reasonably practicable.
If the FSA considers it necessary to do so to maintain public confidence in the stability of the financial markets, it can – after consultation with the other Authorities – direct the administrator to prioritise one or more of the objectives (a Direction). Where the FSA has given a Direction, the administrator’s statement of proposals must set out how the objectives are to be achieved in accordance with the Direction, and that statement must be agreed with the FSA, not the creditors’ committee. Where a different statement of proposals has already been approved by the creditors, the statement agreed with the FSA will take precedence. In addition, where a Direction has been given, no challenge to the administrator’s conduct can be raised under paragraph 74 of Schedule B1 of the IA 1986 if such a challenge would impede or prevent compliance with that direction – so perhaps alleviating an administrator’s concern that having to comply with a Direction might leave the administrator open to personal liability.
— Objective 1 – Return of Client Assets
The powers given to the administrator to achieve the first objective seek to address some of the issues which have confounded the LBIE administrators in their attempts to return client assets. The powers are summarised below.
Distribution of Client Assets
No distinction is made between a distribution of segregated and unsegregated client assets. The administrator has the power to deal with both in the same way – no priority is given to one over the other. It is thought that the ability to make distributions in this way of both segregated and unsegregated client assets will speed up the return of assets to clients.
The explanatory memorandum to the Regulations states that it is “hard for an administrator to start returning client assets until they have complete information on all claims to the assets. Not having a cut-off date after which the administrator can start reconciling claims can cause a severe delay in the return of client assets.”
Reflecting this, the Regulations provide that, if he feels it is necessary in order to expedite the return of client assets, the administrator can set a bar date for the submission of claims to the ownership of, or a security interest in, the client assets. Certain protections are built into the bar date process under both the Regulations and Rules, including rules on timing, notification, publicity and late claimants. Once the bar date has been set, no distribution can be made without the approval of the creditors’ committee (if one exists) and the court.
One significant improvement for administrators looking to make a distribution of client assets is that where a claimant becomes known about after a distribution has been made, that late claimant cannot overturn the distribution or look to claw back from the recipient any amount paid to the recipient unless the payment was made by the administrator in bad faith or the claim made by the recipient was false.
If the administrator becomes aware that there is a shortfall in the amount available for distribution of securities of a particular description held by the investment bank as client assets in a client omnibus account, the administrator must make sure that when making the distribution the shortfalls are borne pro rata by all clients for whom those securities are held. The shortfall is then treated as an unsecured claim in the insolvency of the investment bank.
In the event of a dispute as to who is owed what proportion of the distribution, the administrator is given the option of either making the distribution in accordance with an agreement between the disputing parties, or lodging the securities which are the subject of the dispute in court (presumably until the dispute is resolved). In this way the administrator does not have to wait for the dispute to be resolved before completing the distribution – again, speeding up the return of client assets.
The difficulties faced by administrators trying to return client assets without the powers that are now set out in the Regulations are best exemplified by the attempts by the administrators of LBIE to solve some of the issues by proposing a scheme of arrangement under Part 26 of the Companies Act 2006. The administrators had difficulties in establishing the identity of LBIE’s trust clients who had proprietary claims to certain trust funds, and the value of the claims to those funds, making it virtually impossible for them to make a distribution. They therefore tried to put in place a scheme of arrangement that would compromise the claims of all trust clients. The Court of Appeal held that a scheme of arrangement could not be used to compromise proprietary claims and so the scheme failed.2
— Objective 2 – Engaging with Market Infrastructure Bodies & the Authorities
The second Objective requires the administrator to work with market infrastructure bodies to facilitate the settlement or cancellation of outstanding market contracts or unsettled settlement instructions. It attempts to minimise the disruption caused by counterparties not having certainty as regards unsettled trades and settlement instructions by requiring the administrator to provide information and access to the relevant market infrastructure bodies and the Authorities as quickly as possible. However, this Objective pre-supposes the administrators themselves have access to such information – one of the problems faced by the Lehman administrators was getting accurate and complete information, and it is difficult to see how this Objective resolves that underlying fundamental issue.
Continuity of Supply
One of the key features of the Regulations is the requirement that once the investment bank is in special administration “suppliers” can only terminate a supply in certain circumstances. The provision is similar in scope to the provisions set out in IA 1986 regarding utilities.
The provisions cover the supply of:
- Computer hardware or software or other hardware used by the investment bank in connection with the trading of securities or derivatives;
- Financial data;
- Infrastructure permitting electronic communication services;
- Data processing;
- Secure data networks provided by an accredited network provider; or
- Access to a relevant system by a sponsoring system participant.
Continuation of these services is seen as key to the effective administration of the investment bank by the administrator.
Supply can only be withdrawn if, once the administrator has been appointed, charges for the supply remain unpaid for more than 28 days, or if the administrator or the court consent to the termination. In addition, suppliers cannot make it a condition of continued supply that unpaid amounts that were incurred by the investment bank before the commencement of the special administration be paid.
Variations where the Investment Bank is a Deposit-taking Institution
Where the investment bank is also a deposit-taking institution, it may not always be obvious on a cursory glance as to which procedure is to take precedence – bank insolvency or bank administration under the Banking Act, or special administration, special administration (bank insolvency) or special administration (bank administration) under the Regulations? Not only is the terminology very similar, but there are substantial similarities between the procedures themselves.
The Regulations themselves try to clarify the position, as follows:
- An investment bank which is a deposit-taking bank with eligible depositors can go through any of the procedures open to it under the Banking Act. In addition, on application by either the FSA or the BoE, the investment bank can be put into either special administration (bank insolvency) or special administration (bank administration).
- An investment bank which is a deposit-taking bank with no eligible depositors can go through: 1) any of the procedures open to it under the Banking Act; 2) special administration; or, 3) on the application of the BoE, special administration (bank administration).
A special administration (bank insolvency) is intended to be used as an alternative to the bank insolvency process set out in Part 2 of the Banking Act. The process is similar in many ways to a special administration order. However, one key difference is that there is an overriding objective, which is to work with the financial services compensation scheme (FSCS) to ensure that eligible depositors either receive payments, or have their accounts moved to another financial institution. This objective has to be prioritised by the administrator until a full payment resolution is passed. A Direction from the FSA that prioritises any other objective has to be ignored by the administrator.
A special administration (bank administration) is to be used as an alternative to the bank administration process set out in Part 3 of the Banking Act where part of the business of the deposit-taking bank is sold to a commercial purchaser or transferred to a bridge bank. As with special administration (bank insolvency) there is an overriding objective which must be promoted by the administrator, and that is to provide support for a private sector purchaser or bridge bank.
Will it Work?
It is to be hoped that we do not experience another “Lehmans,” with the tidal wave of financial issues which followed that collapse, many of which are still reverberating around the market three years later. However, such a hope may be viewed – even by the most optimistic – as unrealistic given the prevailing economic conditions. Each collapse brings with it its own peculiar set of circumstances and issues – there is no such thing as a “by the book” insolvency, particularly where the insolvent entity is a major financial institution with complex, inter-related dealings across the world markets.
In addressing some of the most intractable legal issues raised by the Lehmans’ collapse, the Regulations and accompanying Rules should at least provide a useful framework for the conduct of investment bank insolvencies. The absence of such a framework was a major contributing factor to the loss of market confidence which followed the Lehman bankruptcies in 2008.
On 31 October 2011, the broker-dealer MF Global Holdings USA Inc., filed for Chapter 11 bankruptcy protection after disclosing a quarterly loss the previous week. Later the same day, the UK arm, MF Global UK Limited and MF Global UK Services Limited, became the first investment bank to enter special administration under the Regulations. Messrs Fleming, Heis and Pink, all of KPMG LLP, have been appointed as joint special administrators. Although a smaller corporate group than Lehman, and so – in theory at least – more easily resolved, it will be interesting to see whether the Regulations do indeed assist the special administrators in returning funds and generally avoiding some of the issues which have made life interesting for the UK Lehman administrators.
Joe Bannister is a partner in the London business restructuring and insolvency team of Hogan Lovells International LLP. Joe specialises in all aspects of corporate restructuring and insolvency. He has particular experience in cross-border and financial services insolvencies, especially banks, insurance companies, Lloyd’s members agencies and pools. Joe is admitted as a solicitor in London and Hong Kong where he worked between 1998 and 2002 as the partner in charge of the firm’s business restructuring and insolvency practice in Hong Kong and China. Telephone: +44 (0) 20 7296 2900; E-mail: email@example.com.
Alexander Wood is a partner in the London business restructuring and insolvency team of Hogan Lovells International LLP. Alexander is experienced in all aspects of business restructuring and insolvency, focusing on complex insolvency work and financial services (including insurance) insolvency and restructuring. He has particular expertise in the design and implementation of complex schemes of arrangement, cross-border restructurings and formal insolvency procedures. Telephone: +44 (0) 20 7296 5762; E-mail: firstname.lastname@example.org.
© 2011 Hogan Lovells International LLP
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