How did firms deal with assets held at Lehman?

When Lehman Brothers collapsed in September 2008, many hedge funds were caught in a bankruptcy that has shaken the foundations of the prime services industry. Funds that thought assets were safely ring-fenced from the bank found they were unable to retrieve much needed assets. The ensuing legal procedure to get these assets back has severely hampered many funds, with around $50 billion or more stuck in the bankruptcy. The aftermath has led to the adoption of multi prime brokers, a more careful look at custodians and a complete examination of re-hypothecation practices.

At Deloitte in London, Stuart McLaren takes a philosophical approach to the debacle. “Funds that had assets custodied at Lehman obtained confirmation from the liquidators that the assets would be returned in the future, albeit at an unspecified date, and marked them to market. Funds that had direct Lehman exposures marked them to market values, which was often nil,” he says.

Colin Hanson at PricewaterhouseCoopers in the Cayman Islands takes a slightly different tack. He says it is important to remember that “valuation is the responsibility of management. The Lehman situation was very complex.” He says the fate of assets will generally by case-by-case and facts/circumstances-specific. “The key was the determination of the legal basis by which the assets where held,” he says, “complicated by whether or not certain positive/negative balances could be offset. This required a careful review of agreements and consideration of publicly available information,” he concludes.

The KPMG team says responses varied depending on the relative materiality and nature of the assets involved and also with which Lehman entity the fund transacted. Where relevant, audit firms devised alternative audit procedures to obtain independent third-party confirmation as the appointed administrator stated at the outset it would not provide audit confirmations. In terms of financial reporting, KPMG saw numerous narrative disclosures and/or provisions in relation to contingent assets and/or liabilities; these are likely to remain and will be updated on December 31, 2009.

At KPMG in Dublin, Barry Winters and Garrett O’Neill believe the key issues relating to assets held at Lehman centred on ownership and valuation. In many cases, they say, audit confirmation of the ownership of assets could no longer be sourced from the relevant Lehman entities. As a result the focus was placed on reviewing legal advice obtained in relation to the suite of contracts and master agreements, which could include (among others) prime brokerage agreements, futures agreements, stock lending agreements, ISDA master agreements, cross-margining and netting agreements.

These were often individually modified by agreement or side letter. Some agreements were subject to New York law and some were subject to English law.

As a result Winters and O’Neill say complex legal issues arose, as did significant practical issues in identifying and reviewing contracts and understanding all relevant terms. In particular, the extent of any security lending or re-hypothecation needed to be verified and checked, and additional issues arose in these areas.

The resultant losses, complexity and limitation of audit scope resulted in modified audit opinions and extensive additional disclosures in some financial statements, they conclude.