Lehman, AIG, Merrill Lynch, HBOS and, we are told, more to come. The recent acceleration of turmoil in international financial markets is a familiar, yet no less unsettling headline by now. Less reported, however, are the potential strains on insolvency systems around the world.
The US bankruptcy filing of Lehman Brothers Holdings and the UK administration of Lehman Brothers International Europe could set the stage for difficult cross-border issues. At the same time, these events could create opportunities for unprecedented cross-border coordination and novel solutions.
By way of qualification, we at Kirkland and Ellis do not represent Lehman, and I personally have almost no visibility into Lehman’s particular situation. However, based on experience, Lehman’s profile could indicate the cross-border issues that could emerge.
In its US bankruptcy petition, Lehman reported $639bn in unconsolidated assets and $613bn in consolidated liabilities (both as of May 31, 2008).
Lehman listed its largest unsecured creditors (Citibank, as indenture trustee) as holding $138bn in senior note claims. Lehman’s capital structure no doubt consists of additional layers of public and private debt issuances. Indeed, Lehman Holdings’ next largest creditors, also indenture trustees, hold $12bn and $5bn in unsecured bond debt.
At the same time, as emphasized in the affidavit of its Chief Financial Officer, filed with its US bankruptcy petition, Lehman’s sprawling operations span the world. These facts suggest potentially difficult cross-border questions faced in the insolvency proceedings, many of which could spring from old fashioned jockeying for position among creditors.
For starters, in its bankruptcy petition, Lehman reports its assets and liabilities on a consolidated basis. It is unclear to what extent assets, and hence value, reside at the holding company level or are dispersed throughout its direct and indirect subsidiaries.
Creditors with direct claims against Lehman’s subsidiaries, including through guarantees, may have claims that are ‘structurally superior’ to creditors with claims against other entities in the Lehman group, including the holding company that filed for US bankruptcy protection.
Structural superiority results from the fact that generally debt gets paid before equity in insolvency proceedings. Therefore, creditors with claims only against a parent of a bankrupt or insolvent subsidiary would have to rely on distributions made on account of the parent’s equity interests in the subsidiary only after distributions are made to creditors of the subsidiary (assuming any value is left for them).
Faced with structural subordination, debtors and creditors can employ various strategies (some potentially novel) to try to tap value at subsidiaries, such as asserting intercompany debt claims, or what’s known in the US as “substantive consolidation”, whereby the assets and liabilities of the entire group in effect can be pooled so that all creditors in the group share pro rata from that same assets.
In a US bankruptcy case, these issues can generate intense litigation. Lehman’s collapse suggests the contest may unfold on a global stage.
Already, and purely hypothetically, competing claims by the creditors in the US bankruptcy and the UK administration could raise difficult issues. Which law – US or UK – would govern an intercompany claim by Lehman Holdings against Lehman Brothers International Europe? Should a US or UK court preside and decide the matter? Could a US bankruptcy proceeding be filed for Lehman Brothers International Europe, or a UK proceeding for Lehman Holdings? How would such proceedings be coordinated? Should the US court respect the UK proceedings and UK law and vice-versa?
The difficulty of these questions may be amplified by uncertainty around where assets such as cash or securities, which often appear as data on a computer screen, actually reside.
The foregoing issues may be just a sampling of the potential complexities. By comparison to the specter of coordination and resolution across multiple jurisdictions in the US, Europe, Asia, the Middle East, and elsewhere, the foregoing US/UK example is greatly simplified. Faced with this challenge, insolvency practitioners not only must prepare for international travel, but also to delve into foreign legal systems.
In addition to understanding the nuances of different statutory designs, this includes appreciating how practitioners in different locales practice their craft. While it may sound trite, experience has taught a simple lesson: mutual understanding of competing concerns and priorities goes a long way towards crafting solutions and compromises, particularly in the cross-border arena.
David Agay is a restructuring partner at Kirkland & Ellis.