Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Winding up Lehman Europe

While much has been made about the difficulty of winding up large
and complex financial institutions, it appears that it is the simplest
of structures that are the hardest to wind up. Giving some of
one’s things to another for temporary safe keeping on
“trust” is probably older than lending money (debt markets)
or selling equity interests in assets (stock markets) – it is
probably older than money itself. Yet it is the simple trust structure
that is proving so difficult with Lehman Brothers International Europe
(LBIE) in London.

The UK High Court has ruled that the normal scheme of arrangements
in bankruptcy do not apply to trust property:

51. On analysis Part 26 is concerned with the general estate of a
company. It cannot override ordinary trust principles. In the case of
creditors, whether actual, prospective or contingent, it deals with
persons who have claims which they can bring against the pool of
assets which comprises the general estate of the company. A
creditor’s claim ranks pari passu with other creditors’
claims against that general estate. It is perfectly comprehensible,
therefore, that Part 26 should provide that if those creditors wish to
rearrange or compromise their rights against the company, they should
be able to do so, by the requisite majorities, because, at the end of
the day, they all look to the company’s assets for satisfaction
of their pecuniary rights.

52. By contrast with that is the person who has placed his assets
with a trustee. There the position is totally different: the essential
feature of so doing is that the owner knows that he can have his
property, which remains his throughout, dealt with by the trustee in
accordance with the terms of the trust. The property is not vulnerable
to interference merely because the trustee becomes insolvent: the
trust remains. The fact that the trustee is a corporate trustee is
likewise immaterial to the integrity of the trust; no less immaterial
is that the trustee happens to be a company liable to be wound up
under the Insolvency Act 1986 (or the equivalent provision in Northern
Ireland), these being the types of company to which the court’s
jurisdiction under Part 26 applies where a compromise or arrangement
is proposed between a company and its creditors or any class of them:
see section 895(2)(b).

53. The fact that the proposed scheme is confined to persons who
have a pecuniary claim, however prospective or contingent that claim
may be (for example a claim for damages or compensation for the delay
in returning that person’s property), does not assist the
administrators. While the existence of that claim may provide the
basis for a scheme of arrangement directed to that and other pecuniary
claims against LBIE, it does not justify interference with the
underlying property rights of the property owner. Aside from the fact
that the property owner’s remedy (as beneficiary under the
trust) for breach of trust is principally directed to securing
performance of the trust, rather than to the recovery of compensation
or damages, the existence of the pecuniary claims does not affect, and
is certainly not the origin of, the owner’s property rights. To
suggest otherwise and to ground the intention of the scheme to
interfere with the owner’s property rights merely because that
owner also has a pecuniary claim against LBIE in view of the
possibility that LBIE has acted (or may yet act) in breach of trust is
to invert the position. Indeed, the scheme, if it is allowed to
proceed, risks turning the position of the beneficial owner on its
head: this is because under a trust it is for the trustee to justify
and account for his dealings with the trust estate whereas under the
scheme the onus will be on the owner to come forward, as a
dissentient, to explain and justify why that owner’s property
rights should not be dealt with and varied under the scheme.

What I found most amusing was the idea that when a hedge fund gives
collateral to a prime broker with unlimited right to rehypothecate,
“the owner knows that he can have his property, which remains
his throughout.” But then I am not a lawyer.

The court of course thinks that the absence of a scheme of
arrangement does not matter. The court has enough powers to sort
things out. By that argument, one does not need a scheme of
arrangement for creditors either – the courts can sort that out

77. Establishing what client assets of any given client LBIE holds
or controls, what competing claims there may be to those assets by
other clients or by LBIE (or others) and how LBIE and the
administrators are to discharge their duties in respect of those
assets with a view to their due distribution to those entitled to them
are all matters where the court has, in the exercise of its trust
jurisdiction, well-developed processes to assist the accountable
trustee or other fiduciary. For example, the court is well used to
authorising a trustee to make distribution of a fund where there can
be no certainty that all of the claimants to it have been identified
and the trustee desires the protection of a court order in the event
that a further claimant should subsequently appear or matters
subsequently come to light which question the basis on which the
distribution is made. In one sense, dealing with the matter by
recourse to the court’s assistance in this way can be simpler
(and less costly) than the often complex processes involved in the
promotion of a scheme under Part 26.

78. At the risk of appearing glib, I do not consider that a
structured approach of this broad kind is beyond practical achievement
in the exceptionally difficult circumstances of LBIE’s

In short, it appears that the legal system in the foremost
financial centre in the world does not have a practical way of dealing
with the simplest and oldest financial contract – property held
under trust.


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