A Shortfall at Lehman Brothers Inc.: The SIPA Trustee's Property Allocation Motion

On October 5, 2009, the trustee (“Trustee”) overseeing the liquidation of Lehman Brothers Inc. (“LBI”), the U.S. broker-dealer, asked the court to approve his proposed allocation of LBI property (the “Motion”).¹ The Motion reveals a $4.9 billion shortfall in assets that should have been segregated or reserved to satisfy customer property claims, i.e., claims for fully paid and excess margin securities carried for the accounts of customers and cash in the accounts held with a view to trading.

As a broker-dealer, LBI was subject to a number of different regulations designed to protect its customers, most notably Rule 15c3-3 under the Securities Exchange Act of 1934, known as the “Customer Protection Rule.” This rule requires a broker-dealer to have possession or “control” of all customer property. In addition, Rule 15c3-3 requires a broker-dealer to maintain a reserve account in an amount equal to the net amount owed by the broker-dealer to its customers on customer property and to settle customer transactions.²

As described in the Motion, the shortfall is largely attributable to errors in the calculation of the amount of property required to be set aside against customer property claims. These errors occurred primarily during the period between the commencement of bankruptcy proceedings by Lehman Brothers Holdings Inc. (“LBHI”) and commencement of LBI’s liquidation proceedings. 

The $4.9 billion shortfall has important implications for the LBI liquidation proceedings and LBI claimants, some of which we outline below. It also will continue the ongoing discussion in the market concerning protection of customer assets.

I. Overview of the LBI Motion

LBI customers with allowed claims share ratably in customer property based on each customer’s “net equity” as of commencement of LBI’s liquidation proceedings. The Trustee determines the allowable customer property claims and the customer property available to satisfy them. The Motion is intended to determine what property will be available to satisfy customer property claims in priority to the claims of non-customer general unsecured creditors of LBI.

The Trustee requests that the court approve his determination that certain assets are “customer property.” This includes assets held in segregated accounts for customers, proceeds of the sale of customer assets and other core customer property. The Trustee also requests that any property of LBI up to the amount that should have been maintained as reserves under Rule 15c3-3 (but was not) should be treated as customer property and distributed to allowed customer property claimants. Neither the amount of allowed customer property claims nor the amount of assets in the estate has yet been determined. It is possible that the combination of core customer property and the reserve shortfall may equal, or even exceed, the full value of LBI’s assets, leaving nothing for non-customer property general unsecured claimants.

The Trustee also seeks authorization to make interim distributions of customer property to satisfy allowed net equity claims of customers of LBI, subject to reserves in his discretion for open issues.

II. Proposed Allocation Scheme: Potential Effect of Trustee’s Motion on LBI Claims

An order granting the motion would permit the Trustee to use not only segregated customer property but also certain general assets of LBI’s estate, to the extent necessary, to pay all allowed customer property claims in full. Due to the shortfalls in LBI’s customer assets reserve fund, it appears that assets worth at least $4.9 billion, and possibly much more, will have to be taken out of the general estate and applied to allowed customer property claims. The Trustee believes that there may be sufficient assets in LBI’s estate to pay all allowed customer property claims in full. If he is correct, all allowed customer property claims will be paid in full. Whether any shortfall in customer property will be covered by recourse to other estate property will depend upon, among other things, the final determination of the amount of the shortfall, the value of other assets of LBI, including proceeds of avoidance actions and other recoveries by LBI against third parties, and the amount of customer property claims ultimately allowed against LBI.

Recovery on allowed non-customer general unsecured claims would be substantially impaired by the use of billions of dollars from the general assets of LBI’s estate to pay customer property claims. While customer property claims have priority over non-customer general unsecured claims in any Securities Investor Protection Act (“SIPA”) proceeding, a multibillion-dollar shortfall in the segregated customer property and reserves available to pay customer property claims was not generally anticipated in the LBI proceeding.

III. LBI’s Purported Non-Compliance With Customer Protection Rule

The Trustee points to what appear to be lapses in LBI’s compliance with the Customer Protection Rule, particularly between the commencement of LBHI’s bankruptcy case and the commencement of LBI’s SIPA proceedings. The Trustee asserts that these lapses, which resulted in a reduction of customer property in an amount not less than $4.9 billion, included:

• Errors in coding accounts as customer or non-customer accounts, which included coding of certain LBI affiliates as though they had agreed to subordination, which they had not done;

• A large unreconciled accounting break relating to $2.3 billion payable to Lehman Brothers International (Europe), which should have been treated as a customer asset;

• Failure to obtain agreements from banks and custodians not to assert liens over customer property; and

• Compliance systems that were unable to cope with large stock record and general ledger breaks and other changes in the week leading up to LBI’s filing.

In addition, various items are still under investigation by the Trustee that may increase LBI’s reserve account obligation.

IV. Conclusion

The Trustee states in the Motion his belief that his proposed allocation of customer property will rectify the $4.9 billion shortfall in assets that should have been segregated for customers, leaving holders of non-customer general unsecured claims to bear the cost of the shortfall. But the Trustee cautions that upon further investigation the amount of the shortfall may increase. The amount of the shortfall is noteworthy, as are the reasons it arose. These developments in the LBI liquidation proceedings will have a significant impact on LBI claimants and will certainly continue the ongoing discussion in the market concerning protection of customer assets.

ENDNOTES

¹ See In re Lehman Brothers Inc., Case No. 08-01420 (JMP) (SIPA) (Bankr. S.D.N.Y.), docket no. 1866.

² See 17 C.F.R. § 240.15c3-3.