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Lehman and the hedge funds: a scheme too far?
Practical Law UK Articles 1-500-3173 (Approx. 4 pages)
Lehman and the hedge funds: a scheme too far?
by Mark Bardell, Herbert Smith LLP
| Published on 01 Oct 2009 |
The High Court has recently considered the extent of the meaning of "a compromise or arrangement" within the scope of Part 26 of the Companies Act 2006 and the court's jurisdiction to sanction such a scheme of arrangement so as to bind a dissenting minority. The facts in this case, and the terms of the proposed scheme, provide an interesting illustration of the limits of this versatile statutory mechanism.
The High Court has recently considered the extent of the meaning of "a compromise or arrangement" within the scope of Part 26 of the Companies Act 2006 (Part 26) and the court’s jurisdiction to sanction such a scheme of arrangement (a scheme) so as to bind a dissenting minority (In the matter of Lehman Brothers International (Europe) (in administration) (No 2) [2009] EWHC 2141).
The facts in this case, and the terms of the proposed scheme, provide an interesting illustration of the limits of this versatile statutory mechanism (see box “Schemes of arrangement”).
Scheme workaround
Before the collapse of Lehman Brothers in the US, Lehman Brothers International (Europe)’s (LBIE) institutional clients (mainly hedge funds) actively traded in securities and derivatives, often requiring stock borrowing and financing facilities and foreign exchange services, all of which LBIE provided. Accordingly, the clients held proprietary interests in assets held on trust by LBIE through depositories, exchanges, clearing systems and sub-custodians under a variety of contractual arrangements.
As a result of LBIE entering into administration in September 2008, LBIE’s administrators need to determine what the net financial position is between LBIE and each client at the date that LBIE went into administration and the extent to which LBIE is entitled to have recourse to a client’s assets to satisfy LBIE’s monetary claims against the client.
The administrators also face many difficulties associated with any attempt to return clients’ assets because any purported distribution of assets would potentially give rise to claims for breach of trust and related claims against the administrators, as well as the complexities of competing proprietary claims between the clients in the context of shortfalls in particular asset classes.
In an innovative attempt to provide the certainty and finality sought, and after creating a consultative working group drawn from the clients concerned, the administrators promoted a scheme between LBIE and its clients (the scheme creditors) that was intended to address the difficulties associated with the return of client assets and the various related claims. The scheme provided that the scheme creditors release all claims against LBIE, the administrators and other creditors in exchange for each scheme creditor receiving:
- A final determination of its net contractual position on the basis set out in the scheme and a claim against LBIE for that amount.
- Those client assets available for distribution under the scheme allocated to it on the pooled basis set out in the scheme, or appropriated by LBIE in or towards discharge of that scheme creditor’s liabilities to LBIE.
This would effectively replace the scheme creditors’ old rights with new rights, with the result, the administrators argued, of vindicating the scheme creditors’ proprietary rights. However, it is important to note that the scheme provided for a cut-off date for the submission of claims relating to the assets in question. While this was clearly desirable from the administrators’ perspective to provide certainty and finality, it could have the effect of depriving a former client of its proprietary rights in the event that it missed the cut-off date.
The scheme was presented to the court by the administrators as a practical necessity and as a demonstration of the ability of the insolvency process to respond to the challenges presented by the particularly complex administration of LBIE.
The administrators accepted that the scheme would interfere with the proprietary rights of the scheme creditors but argued that the scheme fell within Part 26 and the court’s jurisdiction because each scheme creditor had a pecuniary claim in the form of a claim for damages in the event of a shortfall in the class of assets available to meet that scheme creditor’s proprietary claim for return of those assets.
To support this argument, the proposed scheme expressly excluded former clients who had decided to forego any pecuniary claim and only sought to enforce their proprietary rights. The administrators drew on a line of authority where the courts had been willing to sanction creditors’ schemes involving a variation to scheme creditors’ security over assets of the company in question, and which therefore interfered with scheme creditors’ proprietary rights as secured creditors.
The decision
The court recognised the difficulties that the administrators faced and described the objectives behind the scheme, the early return of client assets to scheme creditors and the certainty it would provide, as admirable. However, this was ultimately considered to be irrelevant to the key question of whether the scheme constituted "a compromise or arrangement" within the scope of Part 26. The scheme purported to vary and, in some cases, deprive the clients of their proprietary rights; those rights arose independently from any rights they had against LBIE as creditors of that company.
The meaning of the phrase "a compromise or arrangement" goes to the very heart of what a scheme is and may be used for and, although it is clear that the phrase is to be given a wide construction, neither Parliament nor the courts have been willing to provide a precise definition.
The court found that, whatever the precise meaning of the phrase, the "compromise or arrangement" must be made with the creditors, or shareholders as the case may be, in their capacity as such. The requirement in Part 26 that a compromise or arrangement be between a company and its creditors should not enable the court to sanction substantive interference with the rights of persons who happen to be creditors but where the rights in question are held in a different capacity.
Avoiding a dangerous precedent
The decision is a timely reminder of the limits of a scheme and, despite the obvious merits of the objective of this particular scheme, had the decision gone in favour of the administrators it would have represented a clear precedent for the coercion of, and expropriation from, a dissenting minority in almost unlimited circumstances.
It does not, however, affect the ability of a company to propose a scheme with its secured creditors, which may involve a variation of the security and those proprietary rights that form part of the security package.
Mark Bardell is a partner at Herbert Smith LLP.
Schemes of arrangement
Schemes of arrangement under Part 26 of the Companies Act 2006 (and previously under section 425 of the Companies Act 1985) have become increasingly popular in recent years because of their versatility. They can be used as an alternative to a standard contractual takeover offer as a means of acquiring a UK public limited company and also for many other matters, including reorganising companies’ share capital, reducing the size of a company’s share register, effecting de-mergers and restructuring a company’s debt (see feature article “The scheme: a most convenient and modern arrangement”, www.practicallaw.com/5-380-7686).
A scheme is a compromise or other arrangement between a company and its creditors or shareholders (or any defined class or classes of its creditors or shareholders). A majority in number representing 75% in value of the creditors or a class of creditors (or shareholders, as the case may be) can enforce its will against the dissenting minority subject only to the correct identification of the relevant class and obtaining the court’s sanction to the arrangement which the majority has approved.