Lehman Bankruptcy Gets Ugly

The Lehman Brothers bankruptcy is quickly becoming one giant mess.

Scores of hedge funds that had hundreds of millions in cash and other securities parked with Lehman’s prime brokerage operation in London have had their accounts frozen. A number of these hedge funds have filed formal objections with the bankruptcy court and at least one fund, New York-based Bay Harbour Management, is mounting a legal challenge to the court’s hastily-approved sale of Lehman’s brokerage arm to Barclays Capital.

Now a new and even more troubling scenario is arising: legal disputes stemming from the estimated $1 trillion in derivatives transactions that Lehman had entered into on behalf of itself and some of its customers. Already, at least three lawsuits have been filed, alleging that nearly $600 million in collateral posted by some of Lehman’s trading partners in derivatives transactions hasn’t been returned and is in jeopardy of disappearing as the bankruptcy process unfolds.

To date, the most aggrieved of Lehman’s trading partners is Bank of America, which at onetime was considering buying Lehman as the investment firm was lurching towards bankruptcy. The Charlotte, NC based lender is seeking to recover nearly $500 million the bank “posted as collateral to “support derivative transactions between BofA and the respective Lehman Entities,’’ according to a lawsuit filed in New York State Supreme Court.

The lawsuit alleges the accounts at Lehman that held the collateral were “frozen,’’ when the investment house filed for bankruptcy on Sept. 15. The complaint describes numerous attempts by BofA to persuade Lehman officials to unfreeze the funds, but each time the bank was rebuffed. In one email exchange, a Lehman employee says: “All activity has been suspended until further notice. Since everything is frozen, we cannot return the remaining collateral at this time.’’

BofA contends that Lehman “has wrongfully refused’’ to return the collateral and is violation of its agreement as a trading partner. The dispute could be the first of many since it’s not uncommon for derivative transaction to be part of tangled web, in which on trading partner is on the hook to make payments to other trading partners. A derivative is a sophisticated contractual agreement that is dependent on the performance of an underlying security, such as a bond, a stock or a commodity.

The dispute between BofA and Lehman appears to stem from the fateful decision by Lehman officials in New York to transfer $8 billion in cash from the firm’s London offices on the eve of the bankruptcy filing. The $8 billion cash and securities sweep left Lehman’s London offices with no money to pay employees or to provide cash to hedge funds that made use of the firm’s overseas prime brokerage operations.

The list of hedge funds entangled in the Lehman bankruptcy keeps growing by the day. Besides Bay Harbour, the list of hedge funds caught-up in the great $8 billion cash transfer include, GLG Partners, Newport Global Opportunities Fund, Amber Capital and Harbinger Capital Partners. Texas-based Newport Global, a nearly $700 million fund with close ties to private equity giant Providence Equity Partners, got squeezed when Lehman officials apparently failed to comply with the funds’ request to move all its assets to Credit Suisse. Newport, which used Lehman as a prime broker, notified Lehman on Sept. 10 to “transfer assets held by “Lehman’s London affiliate to Credit Suisse. Newport executives had believed the transfer was completed and were shocked to learn that the assets were never moved before Lehman filed for bankruptcy.

Now Newport’s assets are frozen in the wake of the $8 billion transfer. In court papers, Newport says, “if these assets are not located and recovered immediately, there is the very real specter of serious and irreparable harm to not only the funds, but also to their respective investors.’’

The trouble is there are now a lot of questions about what happened to that $8 billion. It does not appear that $8 billion in cash and securities was ever part of the deal that enabled Barclays to buy Lehman’s New York operation. Trading partners like BofA and hedge funds like Newport that had money parked with Lehman, are now worrying they may never get their assets back. There’s growing concern that some hedge funds may be forced to shut-down if they can’t get their funds unfrozen soon.

It’s looking like Lehman, contrary to the conventional wisdom, may have been too big to fail after all. And the fallout from the bankruptcy may further undermine investors’ confidence in the financial system.

with David Henry