On July 28, 2014, in a matter of first impression, the US Bankruptcy Court for the Southern District of New York, in In re Lehman Brothers Holdings Inc., held that certain residential mortgage-backed securities (RMBS) that were arranged and sold by the Lehman debtors were not securities "of the debtor" under section 510(b) of the Bankruptcy Code (No. 08-13555, (Bankr. S.D.N.Y. July 28, 2014)). Therefore, claims for damages arising from their sale could not be subordinated to other unsecured creditors in bankruptcy. The ruling provides judicial reinforcement for some of the basic underpinnings of US securitization transaction structure.

Lehman Brothers Holdings Inc. (Lehman) and Structured Asset Securities Corporation (SASCO) (collectively, the debtors) packaged, marketed and sold RMBS to various investors, including Federal Home Loan Bank of Pittsburgh (FHLB) in a securitization transaction. As in a typical RMBS transaction, the securitized asset pool consisted of mortgages that Lehman, as arranger and sponsor of the transaction, pooled and then transferred to SASCO, which acted as depositor for the transaction. SASCO set up various special purpose entity (SPE) trusts, which individually had no reporting obligations, employees, officers or directors, but which held the mortgages for purposes of the transaction. RMBS certificates were distributed by the trusts to investors, entitling them to the stream of payments on the underlying pool of securitized mortgages. A Lehman affiliate acted as underwriter of the transaction. (For a diagram of a basic securitization like this one, see Diagram: Basic Structure of a US Securitization.)

From May 2006 to November 2007, FHLB purchased RMBS issued by six of the trusts, which were all AAA-rated at the time. FHLB subsequently incurred significant losses on the securities.

On September 19, 2009, FHLB filed two claims in the debtors' US bankruptcy proceedings, one against Lehman and one against SASCO, for unspecified damages. The claims alleged securities laws violations for material misrepresentations and omissions in the registration statements, prospectuses, prospectus supplements and related offering documents prepared and distributed by the debtors in connection with the marketing of the RMBS. Under US securities laws, due to the absence of directors or employees at the trusts, SASCO was considered the issuer of the RMBS.

The debtors' plan administrator sought to subordinate the FHLB claims under section 510(b) of the Bankruptcy Code, which states that "a claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor for damages arising from the purchase or sale of such a security ... shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security." The parties disagreed only on whether the RMBS in question were securities "of the debtor or an affiliate of the debtor."

The debtors argued that:

FHLB responded that because the RMBS did not represent an interest in any of the debtors, they could not be considered securities "of the debtor," and therefore should fall outside of the subordination requirement of section 510(b) of the Bankruptcy Code.

The Lehman Court agreed with FHLB, holding that FHLB's claims should not be subordinated under section 510(b) of the Bankruptcy Code because the purchased RMBS were not securities "of" the debtors, or any affiliate of the debtors.

The Court noted that John Slain and Homer Kripke authored the article that prompted section 510 of the Bankruptcy Code to be enacted. According to the Court, that article stated that:

(The Interface Between Securities Regulation and Bankruptcy - Allocating the Risk of Illegal Securities Issuance Between Securityholders and the Issuer's Creditors, 48 N.Y.U.L. Rev. 261 (1973) ("Slain & Kripke")).

Subsequently, congress enacted section 510(b) of the Bankruptcy Code, which placed the risk of illegality in the issuance of stock in an issuer bankruptcy on the shareholders as opposed to creditors. As a result, when an investor purchases securities "of a debtor," it assumes the risks tied to the financial performance of a debtor and may not leapfrog other creditors that have not assumed those same risks.

In this case, the court noted that, as is typical in a securitization:

The Court noted further that the RMBS were unlike traditional equity securities of a debtor due to their unique characteristics and lack of relationship to the debtors' capital structure. Since FHLB never took any interest in the capital structure of the debtors and never assumed the risks of the debtors' financial performance (because the RMBS that had no relation to the debtors' own financial health, but rather to that of the securitized mortgage pool), subordination under section 510(b) of the Bankruptcy Code was not appropriate. Regardless of whether the RMBS were "issued by" the debtors or their affiliates, the RMBS were not "of" the debtor because the RMBS lacked the requisite relationship to the debtors' capital structure.

Moreover, the Court held, since FHLB's claims for the mis-selling of the RMBS were more akin to a traditional breach of contract or tort claim arising from the sale of faulty products (rather than a claim to recover an interest in the issuer's capital structure), unsecured creditors had assumed the risk that they would be required to recover from the same creditor pool as these claimants.

The recognition by the nation's leading bankruptcy court of the separateness of the SPE issuer trusts and the revenue streams generated by the securitized asset pool as distinct from the capital structure of the transaction's arranger, depositor and sponsor (the Lehman debtors) provides judicial reinforcement for the key underpinnings of basic US securitization transaction structure and seems likely to make its way into ABS nonconsolidation opinion analyses (see Practice Note, Securitization: The SPV: Substantive Consolidation).

The fact that the Lehman Court refused to even characterize the RMBS as securities of affiliates of the debtor under 510(b) is perhaps even more noteworthy, as the issuer trusts were technically affiliates of the debtor. The ruling provides further support for the legal independence of securitized asset pools, and the revenue they generate, from their sponsors, arrangers and other affiliates.

It is important to note that in another recent Lehman adversary proceeding (In re Lehman Brothers Inc., 503 B.R. 778 (Bankr. S.D.N.Y. 2014)), the same court reached the opposite result, subordinating claims under bonds issued by an affiliate of a Lehman debtor. The Lehman Court held that the situation fit "squarely within the statutory framework of section 510(b)[.]" The two cases are distinguished, however, because in the latter, the debt securities were attached to the capital structure of a Lehman debtor or an affiliate, and therefore properly subordinated under section 510(b).

When read together, these two decisions underscore the legal distinction between debt securities that were issued as part of a debtor's capital structure and ABS, which generate revenue from a ringfenced asset pool that is not associated with the capital structure of the sponsor or arranger of the ABS transaction.

For details on the parties to a securitization transaction such as the one discussed in this case, see Practice Note, Securitization: US Transaction Parties and Documents.

For information on the mechanics of a typical securitization such as the one discussed in this case, see Practice Note Securitization: US Overview.

For more on substantive consolidation in bankruptcy, SPEs/SPVs and ringfencing securitized assets, see the following Practice Notes: