Lehman Brothers International (Europe) (in administration) - Unsettled OTC trades - Update

Background

Further to the statement issued on 24 September 2008 concerning the possibility of cancelling unsettled OTC trades, the joint administrators (the "Administrators") wish to propose a possible approach which would deal with the legal and operational uncertainties caused by the large number of unsettled transactions to which LBIE is a party.

Contracts - default rules

LBIE was party to a large number of transactions with a large number of counterparties, which were entered into prior to the date of LBIE going into Administration (15 September 2008) and which were due to settle some time after that date, but which remain unsettled today. Many of those transactions are subject to a legally binding default process that will govern how those unsettled obligations will be valued and determined. Examples of those processes are the default rules of a central counterparty (such as LCH.Clearnet, which apply to contracts registered with the LCH), the default rules of an Exchange (such as the LSE) which apply (broadly) to other on-exchange LSE trades, and bilateral master agreements (such as ISDA) entered into by many counterparties and LBIE. In most instances, that will result in a process being undertaken to convert the respective obligations of LBIE and the counterparty into a single net cash sum in respect of all of the contracts subject to the default process in question.

OTC contracts - no default rules

Other transactions between LBIE and counterparties fall outside any such default arrangement - referred to here as "OTC contracts", though that term excludes in this context contracts executed off exchange but subject to a binding master agreement with default arrangements as described above. That therefore could cover pure cash equities trades, or fixed income trades, executed off exchange and subject only to standard terms of business. As a result, there is considerable uncertainty as to the legal obligations, and possible rights and liabilities, associated with those contracts. The Administrators believe it would be beneficial for a process to be established which would facilitate the removal of that uncertainty.

Match deletion of settlement instructions on CREST

The Administrators are also aware that uncertainty has been caused by the existence of matched settlement instructions on CREST in respect of a large number of such OTC contracts. EUI has today directed all market counterparties with outstanding settlement instructions of all types involving LBIE to input instructions in the CREST system to match delete those instructions. For clarification, this instruction will not, however, cancel the underlying contractual obligations between the parties in relation to the relevant transactions.

Proposal for bilateral agreed net settlement on OTC contracts

In order to deal with the contractual rights and liabilities associated with OTC contracts, the general approach which the Administrators propose would be for LBIE and each counterparty to agree bilaterally that their respective liabilities under their OTC contracts would be cancelled and replaced by a determination of a net position between LBIE and the counterparty. The net position would be calculated in a manner analogous to the approach applied under the LSE default rules - namely that each contract would be valued by comparing the trade price and its close-out price as at an agreed valuation date. Note that, as the purpose of adopting this approach is to provide legal certainty, and a single net position in respect of all relevant liabilities, it will be a condition of the approach that all relevant OTC contracts be included in the arrangements, and not only some.

For OTC contracts that were to be settled through a clearing or settlement system any cancellation will normally need to be subject to the relevant matched settlement instructions first being duly deleted in accordance with the rules of that system. For contracts which were to be settled through CREST, this will be achieved consequent on the directions published by EUI earlier today, as referred to above.

Valuation date

The valuation date would ideally be the date which most accurately reflects the date that a court would use to value a party's loss on the relevant trade. In practice, it would be operationally onerous to have multiple, different valuation dates, and accordingly the Administrators propose that a single valuation date be adopted for the relevant trades. One option would be for the parties to adopt a value equivalent to the LSE's "hammer price" approach in its default rule. It is possible other valuation dates would need to be adopted, but in principle the Administrators are open to prioritising operational simplicity in this regard.

Payment of the net sum

Where the calculated net position is an amount due to LBIE, this would be payable in cash by the counterparty, subject to the pre-existing rights of the counterparty. Where the calculated net position is an amount due from LBIE, it will represent a claim on the LBIE estate and the counterparty will rank as an unsecured creditor. The Administrators wish to make clear that under no circumstances will a net position payable by LBIE rank as an expense of LBIE's administration.

Operational costs

In order to justify adopting this approach, which will involve a prioritisation of LBIE's resources to calculate the relevant net sum, the Administrators need to be able to recover the costs from counterparties adopting this approach. LBIE would therefore propose to charge a fee equal to 10  basis points multiplied by the notional value of the cancelled trades with the counterparty in question, which they believe to be a reasonable proxy for the operational costs in question.

Indemnity

The Administrators will ask counterparties to indemnify them from the risk that this approach is subsequently held to be invalid, or involves the giving of a preference to any creditors. That indemnity will be in a standard form.

Legal terms and process

Any counterparty which is interested in adopting this approach should make contact in the manner described below. They will be then provided with a copy of a standard form legal agreement which will govern the arrangement and a request for further details of the positions and contracts affected. Assuming the parties can agree in principle to the approach, arrangements will then need to be agreed by which the relevant OTC trades are identified, reconciled and valued.

Process management framework and prioritisation

The Administrators intend to prioritise each counterparty in accordance with the order in which they agree to the above terms.

Next steps

The Administrators confirm that the principles contained in the update issued on 24 September 2008 continue to apply, but wish to extend the proposal as described in this update. For further details please contact: enquiries.lehmanbrothers@uk.pwc.com ensuring that the subject field is entitled OTC UNSETTLED TRADES.

Further details relating to the administration are included on the PwC website www.pwc.co.uk

Notes to Editors:

AV Lomas, SA Pearson, DY Schwarzmann and MJA Jervis were appointed as Joint Administrators of Lehman Brothers International (Europe) on 15 September 2008 to manage its affairs, business and property as agents without personal liability. AV Lomas, SA Pearson, DY Schwarzmann and MJA Jervis are licensed to act as insolvency practitioners by the Institute of Chartered Accountants in England and Wales.