By Andrew Scurria
Citigroup Inc. will hand over $1.74 billion to walk away from
disputes with now-defunct Lehman Brothers Holdings Inc., a deal
that cuts short an autopsy of the banks' crisis-era
derivative-trading practices.
A deal announced Friday concludes several outstanding disputes
between Citi and a team of Lehman Brothers bankruptcy
administrators, most notably a $2 billion lawsuit over the cost of
replacing derivatives trades terminated upon Lehman's bankruptcy on
Sept. 15, 2008.
Since April, U.S. Bankruptcy Judge Shelley Chapman has heard 42
days of evidence and testimony in the case, in which 170 people
gave depositions and 30 witnesses wrote expert reports seeking
either to justify or discredit Citi's calculation of what it was
owed.
Pending approval of the deal, the judge won't have to decide the
critical question of how banks should determine their damages when
the institution on the other side of its derivatives positions
shuts its doors.
Lehman had derivatives trades with roughly 6,700 counterparties
when it entered bankruptcy. With Citi's deal, only one holdout
counterparty, Credit Suisse, hasn't settled with the bankruptcy
estate.
A Citi spokeswoman said the settlement "furthers management's
goals of resolving legacy matters stemming from the financial
crisis and focusing on Citi's strategic business objectives."
Citi had more than 30,000 derivatives trades on its books facing
Lehman. The trial was supposed to determine Citi's proper
compensation for having to replace the economic terms of those
positions. It shed new light on the frantic weekend before Lehman
went under, and the immediate aftermath, when traders allegedly
used chaos in the marketplace to justify running up huge
transaction fees that Lehman said were disconnected from actual
replacement costs.
A standard promulgated by the International Swaps and
Derivatives Association, the self-governing body for derivatives
markets, days before Lehman's collapse says only that participants
should act in a commercially reasonable manner when determining
their damages, known as closeout amounts.
The dispute raised "the factual question of how closely your
calculation of a closeout with a bankrupt counterparty tracks your
normal course of business," said Joshua Dorchak, a lawyer with
Morgan Lewis & Bockius LLP who has advised other institutions
caught up in Lehman's collapse. "And the legal question of whether
those difference are so substantial that your closeout was
commercially unreasonable or in bad faith."
The judge heard recorded phone calls from the head of Citi's
emerging-markets trading group, Mark Pagano, including one
instructing a colleague calculating a closeout amount to "pretend
they weren't a dealer, they were a real-money, slow-moving deer
account."
The "slow-moving deer" reference, Lehman's attorneys argued,
showed that Citi ignored the lower transaction costs available to
market-making dealers such as itself and based its claim on what
ordinary participants would have paid. Citi argued that all
derivatives counterparties should recoup the same amounts following
a bankruptcy whether they are dealers or ordinary market
participants.
Derivatives are used by corporations, financial services firms
and other institutions to mitigate their exposures to fluctuations
in interest rates, currencies and commodities and to hedge credit
risks on corporate borrowers. Trades can overlap, or offset, each
other, meaning the notional amount outstanding doesn't reflect an
institution's true exposure. Citi took the position that it could
charge Lehman for the cost of replacing its 30,000 contracts
individually, without "netting out" the offsetting contracts.
The bank also said it was entitled to recoup transaction costs,
including the difference, or "spread," between the bid price and
the offer price, despite the usual accounting practice of valuing
trades at a midmarket price. Two days after Lehman's bankruptcy,
Mr. Pagano was asked by a colleague whether traders should continue
marking their books using bid-ask spreads.
"That was one night," he said, according to a recorded call that
was played at trial. "One night only."
Lehman offered its largest derivatives counterparties, dubbed
the "big-bank counterparties," the chance in 2011 to settle their
claims under a stipulated valuation method, in exchange for not
seeking to reduce those claims further in what would undoubtedly be
lengthy, expensive litigation. About 30 large financial
institutions filed $22 billion in derivatives claims against Lehman
and its derivatives subsidiary. Under the settlement framework,
Lehman estimated those claims would total around $10 billion. Citi,
which rejected the offer, now stands to keep $350 million out of
$2.1 billion in cash that Lehman had on deposit before the
bankruptcy. Judge Chapman conferred with the banks during
negotiations, according to the settlement.
Some Lehman counterparties knew they were "pushing the envelope"
with their closeout calculations, "and some tried to get everything
precisely right," said Mr. Dorchak, the Morgan Lewis & Bockius
lawyer.
Losses from terminated derivatives trades cost Lehman's
bankruptcy estate at least $50 billion in value, according to a
2008 report by restructuring adviser Alvarez & Marsal. The
over-the-counter derivatives market that has emerged since 2008 has
been reformed by Dodd-Frank regulations and central clearinghouses
to try to avoid a repeat.
The size of the OTC derivatives market has shrunk since the
financial crisis, according to the Bank for International
Settlements. The reduction in size is in part because of trade
compression, whereby banks replace offsetting derivatives contracts
with a new trade containing the same net exposure. But it "hasn't
been acid-tested yet," said Peter Bible, chief risk officer of
accounting firm EisnerAmper LLP, because it hasn't had to absorb a
default of a large financial institution. Investors had $484
trillion of contracts outstanding in the second half of 2016, down
20% from 2008. Settlements of derivatives claims have been a
significant source of cash for hedge funds that snapped up
unsecured claims against Lehman in the last nine years. It has been
a fruitful bet. Lehman said last week it would hand out another
$2.4 billion to creditors, bringing the total payout from the
chapter 11 proceedings to about $119 billion. Senior unsecured
creditors, bondholders who were estimated to receive about 21 cents
on the dollar, will have recovered more than double that amount
when the next distribution is completed.
(END) Dow Jones Newswires
October 02, 2017 20:33 ET (00:33 GMT)
Copyright (c) 2017 Dow Jones & Company, Inc.
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