Federation Investors’ Patience Vindicated

In October 2008, the now infamous Federation SCDO arranged by Lehman Brothers Holdings Inc in the USA (Lehman) and distributed locally in Australia, redeemed early providing a full return to holders. Despite the investment being based on the performance of US sub-prime mortgages, there was no loss of principal or interest to those holding the bonds at the time of redemption.

Lehman disputed the Trustee’s actions in redeeming the bonds and subsequently sued the trustee, the custodians and Federation investors. However a recent court decision helps vindicate Amicus’ advice to its clients and many other Federation bondholders not to pay monies to Lehman to settle the legal disputes out of court.

A secondary benefit of the recent court decision is that it may now mean Lehman drops its current lawsuit against Lehman Brothers Australia (LBA) for acting as custodian for former Federation bondholders.  If this were to occur, it will allow the liquidator to increase the size of the next dividend from the LBA estate; not having to hold back monies against the chances of an adverse legal judgement however remote.

The original Federation redemption was based on clauses in the documentation that allowed the Trustee, BNY Mellon New York Branch, to liquidate all the collateral held to pay back full principal and interest to investors giving them priority over Lehman as the swap counter-party. Lehman disputed the redemption across the broad class of SCDOs, of which Federation was just one of many, claiming it had a right to be paid the swap mark to market ahead of any payments to bondholders.   

Lehman argued the bond documentation was invalid under “ipso facto” (Latin meaning “by that very fact”) clauses in US Chapter 11 legislation.  The over-arching purpose of Chapter 11 legislation is to protect US companies from their creditors while they reorganise themselves; hence a clause in a contract that specifically disadvantages a company simply because of its bankruptcy (which was the case for Lehman with Federation as its bankruptcy denied Lehman the value) was invalid under the legislation.  Lehman’s argument was supported by a 2009 ruling on similarly structured SCDOs by Judge Peck of the US bankruptcy court.

Lehman used the original ruling by Judge Peck as leverage against former Federation holders to “negotiate” (or some may argue “extort”) out of court settlements by writing to former holders with claims for large amounts of monies.  Some holders who were poorly advised or received no advice at all acquiesced to Lehman’s pressures and returned over 50% of their original principal to avoid the potential lawsuits and additional penalty interest Lehman was claiming.

Amicus consistently advised its clients not to participate in settlements as we believed Lehman’s case was without merit and we were aware other bondholders in similar SCDOs were challenging it.

Despite the case being “stayed” for over four years (by Lehman so they could extract out of court settlements from affected bondholders), bondholders were ultimately successful in 2016 when Judge Shelley Chapman of the US Bankruptcy Court ruled all the SCDOs (including Federation) fell under Section 560 “safe harbour” provisions of the bankruptcy code which protects the settlement of the derivative contracts that were embedded in the SCDO from the Chapter 11 “ipso facto” clauses.  Lehman’s case was dismissed.

However, shortly before Judge Chapman’s ruling was published, a large group of smaller Federation bondholders were encouraged by their custodian ANZ (who was also being sued by Lehman and was also threatening bondholders) to settle with Lehman, returning an estimated 35% of their principal amount. 

Lehman unsuccessfully appealed Judge Chapman’s ruling to the District Court in early 2017 which upheld the Bankruptcy Court’s original decision.  Lehman then appealed the District Court’s decision to the Second Circuit Court. The Second Circuit Court rejected Lehman’s appeal in early August 2020 vindicating many former Federation bondholder’s decision not to succumb to Lehman’s tactics and settle out of court.

Lehman has repeatedly appealed the judgements against it simply to keep the issue ongoing in the court process for the purpose of continuing to force settlements from investors who rightly received full return of their monies when Lehman defaulted under the legal terms of their bonds.

Amicus understands Lehman has one possible appeal left to the US Supreme Court, but it is unclear whether this appeal will be allowed or Lehman will actually appeal given the judgements against it so far have been both comprehensive and emphatic. If any investors would like to know more about any of their former SCDO or structured product investments and any claims or legal actions pertaining to them either past or potential, please feel free to contact Amicus.

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