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In re Lehman Brothers Holdings Inc.

United States District Court, S.D. New York

December 18, 2014

BARCLAYS CAPITAL INC., Defendant-Appellee In re LEHMAN BROTHERS INC., Debtor. FIRSTBANK PUERTO RICO, Plaintiff-Appellant,

As Corrected December 29, 2014.

Page 482

Chapter 11. Case No. 08-13555 (SCC). Jointly Administered. SIPA. Case No. 08-01420 (SCC). Adv. Proc. No. 10-04103 (SCC).

For Firstbank Puerto Rico, Appellant: Jeffrey A. Mitchell, Judith Rita Cohen, Dickstein Shapiro LLP (NYC), New York, NY.

For Barclays Capital, Inc., Appellee: Boaz S. Morag, Lindsee P. Granfield, Cleary Gottlieb, New York, NY; Mark Edward McDonald, Cleary Gottlieb Steen & Hamilton LLP, New York, NY.

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This appeal arises from the insolvency proceedings of Lehman Brothers Holdings Inc. and its subsidiaries (collectively, " Lehman" ).

Long before Lehman filed for bankruptcy, plaintiff-appellant FirstBank Puerto Rico (" FirstBank" ) gave bonds to a Lehman entity as collateral for derivative transactions between FirstBank and Lehman. FirstBank's contract gave that counterparty license to sell those bonds free of FirstBank's interest. Once FirstBank's counterparty took advantage of that provision and sold all of FirstBank's collateral (as it happened, to a different Lehman entity), FirstBank retained nothing more than a contractual claim against its counterparty for return of the bonds at a later date. FirstBank, then, has no right to re-claim the collateral from the collateral's subsequent purchaser, Barclays Capital Inc. (" Barclays" ), which bought the collateral at a bankruptcy sale. Therefore, we affirm the judgment of the United States Bankruptcy Court for the Southern District of New York (the " Bankruptcy Court" ) granting summary judgment to Barclays.

At the time of the bankruptcy sale, the Bankruptcy Court enjoined suits against Barclays related to assets that Barclays purchased from Lehman in bankruptcy. Because the Bankruptcy Court did not

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abuse its discretion in holding that FirstBank's suit violated this anti-suit injunction, we also affirm the Bankruptcy Court's sanctions against FirstBank.



Because this appeal requires us to discuss sophisticated transactions among the parties and various Lehman entities, we offer an overview of the securities, derivatives, and financing tools involved in this case.

A. Swaps

1. Definition of a Swap

A swap is, generically, an over-the-counter transaction in which two parties agree to exchange the returns of two cash flows.

Perhaps the most simple example is an interest-rate swap.[1] See generally Frank J. Fabozzi et al., Interest-Rate Swaps and Swaptions, in Handbook of Fixed Income Securities 1445, 1445-46 (Frank J. Fabozzi ed. 2012). One party agrees to pay a fixed rate of interest (say, 4%), while the other party pays a floating rate of interest based on some published rate that varies over time (say, " U.S.-dollar 3-month LIBOR, plus 1%" ), with both interest payments calculated against the same notional amount of principal. At set intervals, one of the parties calculates the difference between the fixed-rate interest and the floating-rate interest, and the party that owes more interest pays the difference to the party that owes less interest. Thus, if interest rates rise during the term of the swap, then the payer of the floating-rate leg will make a net payment; if interest rates fall, then the payer of the floating-rate leg will receive a net payment.

An interest-rate swap allows a party to gain or reduce exposure to interest rates. See id. at 1445. For example, suppose that a bank has loaned money to its customers at fixed interest rates, but that the bank borrows money at short-term rates that fluctuate. Then the bank faces a risk that its own borrowing costs will increase from rising interest rates, while the bank's income, from its fixed-rate loans, will remain constant. In such a circumstance, the bank can avoid this risk by entering into an interest rate swap with a swap dealer. The bank will deliver fixed payments to the dealer, and will receive floating payments in return. This effectively allows the bank to convert its fixed income into an income stream whose fluctuations will match the bank's borrowing costs.

2. Counterparty Risk

Because swaps are traded directly between counterparties (rather than through an exchange), each party faces the risk that the other party will be unable to pay its net losses under the swap agreement. See id. at 1446-47, 1474-75; Christian J. Johnson, Derivatives & Rehypothecation Failure: It's 3:00 P.M., Do You Know Where Your Collateral Is?, 39 Ariz.L.Rev. 949, 958-59 (Fall 1997). Turning back to the example of an interest-rate swap, suppose prevailing interest rates fall, so that the bank (as the payer of a fixed rate and receiver of a floating rate) will expect to owe the swap dealer payments throughout the term of the swap. Until the bank successfully makes each payment, the swap dealer faces the risk that the bank will become unable to pay. Conversely, if prevailing interest rates rise, then the swap dealer will expect to owe the bank payments throughout the term of the

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swap. Until the swap dealer successfully makes each payment, the bank faces the risk that the swap dealer will become unable to pay.

One partial solution to this credit risk is for one party (called the " pledgor" ) to give the other party (the " secured party" ) safe assets to hold as collateral. The pledgor retains the economic interest in its collateral. That is, when the pledged bonds pay interest, the secured party must deliver the interest to the pledgor, and the pledgor may re-claim and sell the pledged bonds upon proper notice (although the pledgor must then post other acceptable collateral in its place). See Jon Gregory, Counterparty Credit Risk 70-71 (2010).

Frequently, the swap parties will agree that, at certain intervals, the party with a net unrealized loss will deliver collateral to cover the unrealized loss. See id. at 60. If collateral is exchanged frequently enough, this exchange will prevent either side's counterparty credit exposure from becoming intolerably great.

The swap parties may also agree that one party (typically the party with weaker credit) will post some amount of collateral for each swap, called an " independent amount" or " initial margin," regardless of profit or loss on the swap. This decreases the secured party's risk; if the pledgor defaults before the pledgor has an opportunity to post collateral against a sudden loss, the secured party will (it hopes) have enough initial margin to cover the pledgor's loss. See id. at 67. Conversely, the use of initial margin increases the pledgor's counterparty risk; if the secured party defaults, then the pledgor will not be able to offset the loss of its initial margin against any payments owed to the secured party.

3. Documentation and Rehypothecation

A swap dealer does not re-negotiate the terms of its relationship with a customer each time the customer executes a swap. Instead, a customer negotiates a single master agreement with a swap dealer, usually based on standard agreements published by the International Swaps and Derivatives Association, Inc. (ISDA). This master agreement will include terms regarding the overall credit relationship between the parties--representations and warranties, events of default, termination procedures, procedures for offsetting debts between different trades, and so forth. Once a master agreement is in place, each trade requires only a short confirmation to record essential details of the particular transaction, such as the notional principal, the fixed rate, the definition of the floating rate, and the term of the swap. See generally Harding, supra, at 9-16; Johnson, supra, at 957-58.

The standard ISDA Agreements do not govern the exchange of collateral. Instead, parties who wish to collateralize their swap agreement will agree to collateralization terms in a separate document, such as a " Credit Support Annex" or a " Credit Support Deed."

In particular, some credit support documents allow the secured party to use or dispose of the collateral. This is known as rehypothecation. See generally Johnson, supra, passim.

Just as the pledgor retains the economic interest in bonds that are posted as collateral, see supra at 5, the pledgor continues to retain that economic interest after the secured party has rehypothecated the bonds. This is because the secured party must still deliver any interest payments to the pledgor as though the secured party still held the collateral, and the pledgor may still re-claim and sell the pledged bonds upon proper notice. See Paul C. Harding & Christian A. Johnson,

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Mastering the ISDA® Collateral Documents 279 (2d ed., 2012).

The main advantage of rehypothecation is to allow the secured party to finance its own operations; in exchange, the secured party offers the pledgor cheaper funding, or, at the margin, the secured party offers a swap line to a customer who would not otherwise qualify. Before 2007, at least some commentators believed that rehypothecation was " critical to the entire financial system." Gregory, supra, at 71 (citing M. Segoviano Basurto & M. Singh, Counterparty Risk in the Over-the-counter Derivatives Market 1-19, IMF Working Papers (2008), available at

The main disadvantage (at least to the pledgor) is that, as in this case, " the secured party could become insolvent and therefore be unable to return the posted collateral . . . ." Harding & Johnson, supra, at 66. This risk is especially great when the pledgor has posted collateral whose value exceeds the pledgor's unrealized losses (for example, when the pledgor posts an " independent amount" ), because then the pledgor cannot set off the whole value of its collateral against its own unrealized losses. See id. at 67; ISDA, Independent Amounts 6-7 (release 2.0, Mar. 1, 2010), available at Because of this risk to the pledgor, " [r]ehypothecation rights are often heavily negotiated." Harding & Johnson, supra, at 279; cf. Credit Support Annex between FirstBank and Bank of Montreal, Mar. 15, 2004, J.A. 1810-27 at ¶ 13(g)(ii) (forbidding rehypothecation).

B. Repurchase Agreements (Repos)

A repurchase agreement (or repo) is, legally, a pair of bond sales: A seller sells a bond to a buyer, and the parties agree that the buyer will re-sell the bond back to the seller at a later date for a slightly higher price.[2] Frank J. Fabozzi & Steven V. Mann, Financing Positions in the Bond Market, in Handbook of Fixed Income Securities 1355, 1355-56 (Frank J. Fabozzi ed. 2012) In a " bilateral" repo--the kind that pertains to this case--the first sale transfers legal title to the purchaser-reseller, and the second sale transfers legal title back to the seller-repurchaser. See In re Lehman Bros. Inc., 506 B.R. 346, 349 (S.D.N.Y. 2014).

Although a repo is structured as a pair of sales, the economic substance is that the " seller" borrows money from the " buyer" and provides the bond as collateral. See Fabozzi & Mann, Financing Positions, supra, at 1357. A repo resembles a secured loan in that the borrower (or seller and repurchaser) retains the economic interest in the bonds. When the bonds pay interest, the lender of cash must deliver the interest to the borrower. See Frank J. Fabozzi & Steven V. Mann, Repurchase & Reverse Repurchase Agreements, in Securities Finance: Securities Lending & Repurchase Agreements 221, 237 (Frank J. Fabozzi & Steven V. Mann eds. 2005) (contrasting a repo to a " buy/sell back" transaction, in which the lender of cash obtains beneficial ownership of the bond).

The most important use of a repo is to secure financing. Suppose a bullish trader wants to have economic exposure to $300 of bonds, but has only $100 of cash. See Fabozzi & Mann, Financing Positions, supra, at 1356. The ...

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