UNITEDSTATESBANKRUPTCYCOURTSOUTHERNDISTRICTOFNEWYORK

x InreLEHMANBROTHERSHOLDINGSINC.,etal., Debtors.

:::::::

Chapter11CaseNo.0813555(JMP)(JointlyAdministered)

x

REPORTOFANTONR.VALUKAS,EXAMINER

March11,2010

Jenner&BlockLLP353N.ClarkStreetChicago,IL6065434563122229350919ThirdAvenue37thFloorNewYork,NY1002239082128911600CounseltotheExaminer

VOLUME4OF9

Section III.A.5: Secured Lenders

Section III.A.6: Government

i

EXAMINERSREPORT

TABLEOFCONTENTS

(SHORTFORM)

VOLUME1

Introduction,SectionsI&II:ExecutiveSummary&ProceduralBackground

Introduction...................................................................................................................................2

I. ExecutiveSummaryoftheExaminersConclusions ......................................................15

A. WhyDidLehmanFail?AreThereColorableCausesofActionThatAriseFromItsFinancialConditionandFailure?.....................................................15

B. AreThereAdministrativeClaimsorColorableClaimsForPreferencesorVoidableTransfers?......................................................................................................24

C. DoColorableClaimsAriseFromTransfersofLBHIAffiliateAssetsToBarclays,orFromtheLehmanALITransaction? ....................................................26

II. ProceduralBackgroundandNatureoftheExamination ..............................................28

A. TheExaminersAuthority ...........................................................................................28

B. DocumentCollectionandReview..............................................................................30

C. SystemsAccess..............................................................................................................33

D. WitnessInterviewProcess...........................................................................................35

E. CooperationandCoordinationWiththeGovernmentandParties ......................37

SectionIII.A.1:Risk

III. ExaminersConclusions......................................................................................................43

A. WhyDidLehmanFail?AreThereColorableCausesofActionThatAriseFromItsFinancialConditionandFailure?.....................................................43

1. BusinessandRiskManagement..........................................................................43

a) ExecutiveSummary .......................................................................................43

ii

b) Facts..................................................................................................................58

c) Analysis .........................................................................................................163

VOLUME2

SectionIII.A.2:Valuation

2. Valuation ..............................................................................................................203

a) ExecutiveSummary .....................................................................................203

b) OverviewofValuationofLehmansCommercialRealEstatePortfolio .........................................................................................................215

c) SeniorManagementsInvolvementinValuation....................................241

d) ExaminersAnalysisoftheValuationofLehmansCommercialBook................................................................................................................266

e) ExaminersAnalysisoftheValuationofLehmansPrincipalTransactionsGroup......................................................................................285

f) ExaminersAnalysisoftheValuationofLehmansArchstonePositions.........................................................................................................356

g) ExaminersAnalysisoftheValuationofLehmansResidentialWholeLoansPortfolio .................................................................................494

h) ExaminersAnalysisoftheValuationofLehmansRMBSPortfolio .........................................................................................................527

i) ExaminersAnalysisoftheValuationofLehmansCDOs ....................538

j) ExaminersAnalysisoftheValuationofLehmansDerivativesPositions.........................................................................................................568

k) ExaminersAnalysisoftheValuationofLehmansCorporateDebtPositions ...............................................................................................583

l) ExaminersAnalysisoftheValuationofLehmansCorporateEquitiesPositions .........................................................................................594

iii

SectionIII.A.3:Survival

3. LehmansSurvivalStrategiesandEfforts........................................................609

a) IntroductiontoLehmansSurvivalStrategiesandEfforts.....................609

b) LehmansActionsin2008PriortotheNearCollapseofBearStearns............................................................................................................622

c) ActionsandEffortsFollowingtheNearCollapseofBearStearns .......631

VOLUME3

SectionIII.A.4:Repo105

4. Repo105................................................................................................................732

a) Repo105ExecutiveSummary.................................................................732

b) Introduction ..................................................................................................750

c) WhytheExaminerInvestigatedLehmansUseofRepo105Transactions ..................................................................................................764

d) ATypicalRepo105Transaction ................................................................765

e) ManagingBalanceSheetandLeverage ....................................................800

f) ThePurposeofLehmansRepo105ProgramWastoReverseEngineerPubliclyReportedFinancialResults.........................................853

g) TheMaterialityofLehmansRepo105Practice ......................................884

h) KnowledgeofLehmansRepo105ProgramattheHighestLevelsoftheFirm .....................................................................................................914

i) Ernst&YoungsKnowledgeofLehmansRepo105Program..............948

j) TheExaminersConclusions ......................................................................962

iv

VOLUME4

SectionIII.A.5:SecuredLenders

5. PotentialClaimsAgainstLehmansSecuredLenders .................................1066

a) IntroductionandExecutiveSummary....................................................1066

b) LehmansDealingsWithJPMorgan ........................................................1084

c) LehmansDealingsWithCitigroup.........................................................1224

d) LehmansDealingsWithHSBC ...............................................................1303

e) LehmansDealingsWithBankofAmerica ............................................1375

f) LehmansDealingsWithBankofNewYorkMellon............................1376

g) LehmansDealingsWithStandardBank................................................1382

h) LehmansDealingsWiththeFederalReserveBankofNewYork .....1385

i) LehmansLiquidityPool...........................................................................1401

SectionIII.A.6:Government

6. TheInteractionBetweenLehmanandtheGovernment..............................1482

a) Introduction ................................................................................................1482

b) TheSECsOversightofLehman ..............................................................1484

c) TheFRBNYsOversightofLehman ........................................................1494

d) TheFederalReservesOversightofLehman .........................................1502

e) TheTreasuryDepartmentsOversightofLehman ...............................1505

f) TheRelationshipoftheSECandFRBNYinMonitoringLehmansLiquidity....................................................................................1507

g) TheGovernmentsPreparationfortheLehmanWeekendMeetingsattheFRBNY .............................................................................1516

v

h) OntheEveningofFriday,September12,2008,theGovernmentConvenedaMeetingoftheMajorWallStreetFirmsinanAttempttoFacilitatetheRescueofLehman ..........................................1523

i) LehmansBankruptcyFiling ....................................................................1535

VOLUME5

SectionIII.B:AvoidanceActions

B. AreThereAdministrativeClaimsorColorableClaimsforPreferencesorVoidableTransfers....................................................................................................1544

1. ExecutiveSummary ..........................................................................................1544

2. ExaminersInvestigationofPossibleAdministrativeClaimsAgainstLBHI(FirstBullet) .............................................................................................1546

3. ExaminersInvestigationofPossibleAvoidanceActions(Third,FourthandEighthBullets)...............................................................................1570

4. ExaminersInvestigationofPossibleBreachesofFiduciaryDutybyLBHIAffiliateDirectorsandOfficers(FifthBullet) .....................................1894

5. ExaminersAnalysisofLehmansForeignExchangeTransactions(SecondBullet) ...................................................................................................1912

6. ExaminersReviewofIntercompanyTransactionsWithinThirtyDaysofLBHIsBankruptcyFiling(SeventhBullet).....................................1938

7. ExaminersAnalysisofLehmansDebttoFreddieMac..............................1951

SectionIII.C:BarclaysTransaction

C. DoColorableClaimsAriseFromTransfersofLBHIAffiliateAssetstoBarclays,orFromtheLehmanALITransaction? ................................................1961

1. ExecutiveSummary ..........................................................................................1961

2. Facts .....................................................................................................................1965

3. WhetherAssetsofLBHIAffiliatesWereTransferredtoBarclays .............1997

4. LehmanALITransaction..................................................................................2055

vi

5. Conclusions ........................................................................................................2063

6. BarclaysTransaction .........................................................................................2103

UNITEDSTATESBANKRUPTCYCOURTSOUTHERNDISTRICTOFNEWYORK

x InreLEHMANBROTHERSHOLDINGSINC.,etal., Debtors.

:::::::

Chapter11CaseNo.0813555(JMP)(JointlyAdministered)

x

REPORTOFEXAMINERANTONR.VALUKAS

SectionIII.A.5:SecuredLenders

1054

TABLEOFCONTENTS

5. PotentialClaimsAgainstLehmansSecuredLenders .................................1066 a) IntroductionandExecutiveSummary....................................................1066

(1) JPMorgan..............................................................................................1068 (2) Citibank ................................................................................................1073 (3) HSBC.....................................................................................................1077 (4) OtherLenders......................................................................................1080 (5) TheFederalReserveBankofNewYork..........................................1081 (6) LehmansLiquidityPool....................................................................1082

b) LehmansDealingsWithJPMorgan ........................................................1084 (1) Facts.......................................................................................................1084

(a) OverviewofJPMorganLehmanRelationship ....................... 1084 (b) TripartyRepoPriorto2008 ....................................................... 1089 (c) JPMorganRestructuresItsApproachtoTripartyRisk ......... 1094 (d) LehmanBeginsPostingAdditionalCollateral ....................... 1101 (e) JPMorganConcernOverLehmanCollateralinAugust

2008 ............................................................................................... 1105 (f) TheAugustAgreements ............................................................ 1113 (g) BackgroundtotheSeptember9CollateralRequestand

SeptemberAgreements.............................................................. 1125 (h) September9CallsBetweenStevenBlackandRichard

Fuld ............................................................................................... 1138 (i) SeptemberAgreements.............................................................. 1143 (j) DailyLiquidityPoolUpdatesFromLehmanto

JPMorgan ..................................................................................... 1156 (k) September11CollateralRequestPursuanttothe

SeptemberAgreements.............................................................. 1158 (l) AdditionalValuationAnalysesbyJPMorganBeginning

September11 ............................................................................... 1165 (m) LehmanRequestsforReturnofCollateral.............................. 1168

(2) AnalysisofPotentialClaims .............................................................1172 (a) TheEvidenceDoesNotSupportaColorableClaim

AgainstJPMorganforEconomicDuress................................. 1173 (i) LegalBackground:EconomicDuress............................. 1173

1055

(ii) ThereIsNoAvailableEvidenceofanExpressUnlawfulThreatMadebyJPMorganinConnectionWiththeFormationoftheSeptemberAgreements ..... 1174

(iii) TheAvailableEvidenceSuggestsJPMorganDidNotHaveanImproperPurpose...................................... 1178

(iv) ThereWasaDegreeofNegotiationOvertheTermsoftheSeptemberAgreements ......................................... 1181

(b) ThereIsInsufficientEvidencetoSupportaColorableClaimThattheSeptemberAgreementsAreInvalidforLackofConsideration ................................................................ 1183

(c) ThereisSufficientEvidencetoSupporttheExistenceofaTechnical,ButNotColorable,ClaimThattheSeptemberAgreementsAreInvalidforLackofAuthority...................... 1186 (i) TonucciMayHaveActedWithApparent

Authority ............................................................................ 1190 (ii) ThereIsSubstantialEvidenceThatLehman

RatifiedtheSeptemberAgreements............................... 1193 (d) ThereIsInsufficientEvidencetoSupportaColorable

ClaimThatJPMorganFraudulentlyInducedtheSeptemberAgreements.............................................................. 1198

(e) ThereIsInsufficientEvidencetoSupportaColorableClaimforBreachofContractoftheSeptemberAgreementsBasedonJPMorgansRefusaltoReturnCollateral ...................................................................................... 1200 (i) LegalBackground:ContractualObligationsUnder

SeptemberAgreements .................................................... 1200 (ii) ThereWasNoWrittenNoticeforCollateralReturn ... 1208

(f) ThereIsEvidencetoSupportaColorable,ButNotStrong,ClaimThatJPMorganBreachedtheImpliedCovenantofGoodFaithandFairDealingbyDemandingExcessiveCollateralinSeptember2008................................... 1210 (i) LegalStandardsGoverningImpliedCovenantof

GoodFaithandFairDealing ........................................... 1211 (ii) ThereIsSufficientEvidenceToSupporta

Colorable,ButNotaStrong,ClaimThatJPMorganViolatedtheImpliedCovenantbyDemandingExcessiveCollateral .......................................................... 1214

1056

(iii) ATrierofFactWillLikelyHavetoResolveaWaiverDefense.................................................................. 1220

c) LehmansDealingsWithCitigroup.........................................................1224 (1) Facts.......................................................................................................1224

(a) CitigroupProvidedContinuousLinkedSettlementServiceandOtherClearingandSettlementOperationstoLehman......................................................................................... 1224 (i) BackgroundInformationontheContinuous

LinkedSettlementServiceCitiProvidedtoLehman... 1224 (ii) OtherClearingandSettlementServicesThatCiti

ProvidedtoLehman ......................................................... 1227 (iii) CitisClearingandSettlementExposureto

Lehman,Generally............................................................ 1229 (iv) TheTermsofLehmansCLSAgreementwithCiti ...... 1231

(b) LehmanProvideda$2BillionCashDepositwithCitionJune12,2008ToSupportitsClearingNeeds.......................... 1233 (i) TheMarketEnvironmentandOtherCircumstances

SurroundingCitisRequestforthe$2BillionCashDepositonJune12 ............................................................ 1235

(ii) ThePartiesDidNotSharetheSameUnderstandingoftheTermsofthe$2BillionCashDeposit .................. 1242 a. WhatLehmanUnderstoodtheTermsofthe

DepositToBe.............................................................. 1243 b. WhatCitiUnderstoodtheTermsoftheDeposit

ToBe............................................................................. 1245 c. TheExactTermsoftheComfortDepositAre

UnknownBecausetheTermsWereNotReducedtoWriting.................................................... 1250

(iii) CitiKnewtheComfortDepositwasIncludedinLehmansLiquidityPool.................................................. 1250

(c) CollateralPledgeDiscussionsBetweenLehmanandCitiBeganinJune2008andContinuedUntilSeptember2008 ... 1251 (i) TheUnexecutedPledgeAgreement:theParties

AgreedtoNegotiatetheTermsbutNotExecutetheAgreementUntilItWasNeeded..................................... 1251

1057

(ii) CitiHadDifficultyPricingtheCollateralOfferedbyLehmanasaSubstitutefortheCashDeposit .......... 1254

(iii) TheGuarantyAmendmentWasSignedinaFireDrillonSeptember9,2008 ............................................. 1261 a. EventsPriortotheSigningoftheSeptember9

GuarantyAmendmentfromCitisPerspective ..... 1263 b. EventsPriortotheSigningoftheSeptember9

GuarantyAmendmentfromLehmansPerspective .................................................................. 1265

c. NegotiationsBetweenLehmanandCitiPersonnelRegardingWhichLehmanEntitiesWereToBeAddedtotheParentGuarantybytheSeptember9GuarantyAmendment................. 1268

(iv) September12,2008:ALehmanCollateralAccountatCitiwasActivatedAfterTwoMonthsofDiscussion,andLehmanSignedanAmendmenttotheDirectCustodialServicesAgreement...................... 1273

(d) LehmansClearingEnvironmentatCitiDuringtheWeekofSeptember8,2008........................................................ 1276 (i) CitiRequiredLehmanToOperateUnderLower

DaylightOverdraftLimits ............................................... 1276 (ii) LehmanDepositedAmountsinExcessofthe$2

BillionDepositatVariousTimesin2008WithCiti...... 1279 (iii) CitiEndeavoredToHelpLehmaninSeptember

2008,PriortotheBankruptcyFiling............................... 1281 (iv) LehmansAccountsatCitiClosedonFriday

September12WithFundsinExcessofthe$2BillionDeposit ................................................................... 1284

(e) CitisParticipationinLehmanWeekendEvents................ 1285 (f) CitisActionsTowardLehmanAfterLehmanFiledfor

BankruptcyProtection ............................................................... 1287 (i) CitiContinuedtoProvideCLSServicesfor

Lehman,ButNotinanEntirelyUninterruptedManner................................................................................ 1287

(ii) PriortoLehmansBankruptcyFiling,CitiSetOffaPortionoftheCashDeposit............................................. 1290

(2) AnalysisofPotentialColorableClaims ...........................................1291

1058

(a) ValidityoftheSeptember9GuarantyAmendment.............. 1291 (i) EconomicDuress............................................................... 1291

a. LegalFramework ....................................................... 1292 b. TheEvidenceDoesNotSupporttheExistence

ofaColorableClaimAgainstCitiforEconomicDuress .......................................................................... 1293

(ii) TheFailureofConsideration........................................... 1297 a. LegalFramework ....................................................... 1298 b. TheEvidenceDoesNotSupporttheExistence

ofaColorableClaimAgainstCitiforFailureofConsideration ............................................................. 1298

(b) BreachoftheDutyofGoodFaithandFairDealinginConnectionWiththeCLSServicesAgreement ...................... 1300 (i) TheEvidenceDoesNotSupporttheExistenceofa

ColorableClaimAgainstCitiforBreachoftheDutyofGoodFaithandFairDealinginConnectionWiththeCLSServicesAgreement.................................. 1301

d) LehmansDealingsWithHSBC ...............................................................1303 (1) OverviewofHSBCsRelationshipWithLehman ..........................1305

(a) HSBCProvidedCRESTClearingandSettlementServicestoLehman .................................................................................... 1306

(b) OverviewoftheOperativeAgreements ................................. 1309 (2) TheExaminersInvestigationofParticularTransactions .............1311

(a) HSBCCancelleda$1BillionIntradayCreditFacility ........... 1311 (b) LehmanMaintaineda$1BillionSegregatedDeposit

withHSBC ................................................................................... 1312 (c) LehmanDeposited$750MillionwithHSBConJune24 ...... 1314 (d) LehmanCommitted$25MilliononAugust15toHSBCs

SyndicatedLendingFacility...................................................... 1315 (e) LehmanPledged$6MilliontoHSBCasCollateralfor

LettersofCredit .......................................................................... 1317 (f) OtherSignificantExposures...................................................... 1318

(3) HSBCRequiredLehmantoProvideApproximately$1BillioninCollateralWhileQuietlyEndingTheirRelationship .........................................................................................1319 (a) HSBCDeterminedtoEndItsRelationshipwithLehman .... 1319

1059

(b) HSBCDemandedCollateralforIntradayCredit ................... 1322 (c) HSBCAgreedToAccommodateLehmanatQuarterEnd... 1325 (d) LehmanDepositedtheCashCollateralWithHSBC ............. 1326 (e) LehmanNegotiatedNewTermsandExecutedtheCash

Deeds ............................................................................................ 1327 (i) LehmanSecuredConcessionsintheU.K.Cash

Deeds................................................................................... 1327 (ii) LehmanExecutedtheHongKongCashDeedLate

onSeptember12 ................................................................ 1329 (f) HSBCandLBHIStipulatedToSetOffandReturnSome

oftheFundsCoveredbytheU.K.CashDeeds ...................... 1332 (4) OtherIssuesStemmingfromHSBCsCollateralDemand............1333

(a) LehmanIncludedtheDepositsCoveredbytheCashDeedsinItsReportedLiquidityPool ...................................... 1333

(b) HSBCConsideredWithholdingPaymentsorRequiringPrefundingofTradesintheAsiaPacificRegionPriortoLehmansBankruptcy ................................................................ 1336

(5) TheEvidenceDoesNotSupporttheExistenceofColorableClaimsArisingFromHSBCsDemandThatLehmanProvideCashCollateralandExecuteCashDeedsinOrderforHSBCtoContinueProvidingClearingandSettlementServices.............1336 (a) TheParametersoftheExaminersAnalysis ........................... 1336 (b) TheFactsProvideLittletoNoSupportforInvalidating

theU.K.CashDeeds................................................................... 1339 (i) AnalyticalFramework...................................................... 1339

a. EnglishLawGovernsContractClaimsArisingfromtheU.K.CashDeeds ........................................ 1339

b. EnglishContractLawTreatsDeedsDifferentlyfromOtherContracts................................................. 1340

(ii) TheEvidenceDoesNotSupporttheExistenceofaColorableClaimThattheU.K.CashDeedsAreInvalidforWantofConsideration.................................. 1341

(iii) TheEvidenceDoesNotSupporttheExistenceofaColorableClaimforEconomicDuressBecausetheCRESTAgreementAllowedHSBCToCeaseClearingandSettlementatItsAbsoluteDiscretion ..... 1343

1060

a. ElementsofEconomicDuress.................................. 1343 b. ApplicationtoLehmanFacts ................................... 1344 c. OtherTransactionsDoNotGiveRiseto

EconomicDuressClaims .......................................... 1346 (iv) TheEvidenceDoesNotSupporttheExistenceofa

ColorableClaimthatHSBCViolatedaDutyofGoodFaithandFairDealingbyDemandingCashCollateral ............................................................................ 1348 a. EnglishLawDoesNotRecognizeaPrincipleof

GoodFaithandFairDealingofGeneralApplication.................................................................. 1349

b. ApplicationtoLehmanFacts ................................... 1349 (v) TheEvidenceDoesNotSupporttheExistenceofa

ColorableClaimthatHSBCViolatedtheNoticeProvisionoftheCRESTAgreement ............................... 1352 a. ConstructionofTerms............................................... 1352 b. ApplicationtoLehmanFacts ................................... 1353

(vi) TheCashDeedsWereNotContractsofAdhesionorStandardFormContracts ............................................ 1355 a. CharacteristicsofStandardFormContractsor

ContractsofAdhesion............................................... 1355 b. ApplicationtoLehmanFacts ................................... 1355

(c) OtherPotentialTheoriesofLiability........................................ 1357 (i) EnglishLawGovernstheRemainingPotential

ClaimsEvenThoughTheyAreNotCoveredbytheChoiceofLawProvisionoftheCashDeeds................. 1357 a. AnalyticalFramework............................................... 1357 b. ApplicationtoRemainingPotentialClaims........... 1359

(ii) TheEvidenceDoesNotSupportTheExistenceOfaColorableClaimForUnjustEnrichmentBecauseLehmanConveyedaBenefitonHSBCPursuanttoLehmansValidContractualObligations ...................... 1360 a. ElementsofUnjustEnrichment ............................... 1361 b. ApplicationtoLehmanFacts ................................... 1362

(iii) TheEvidenceDoesNotSupportaColorableClaimThatHSBCBreachedaFiduciaryDutytoLehman

1061

BecauseHSBCandLehmanWereSophisticatedPartiesinaRelationshipGovernedbyanAgreementThatLimitedHSBCsObligations.............. 1363 a. ElementsofBreachofFiduciaryDutyand

Misappropriation ....................................................... 1364 b. ApplicationtoLehmanFacts ................................... 1365

(iv) TheEvidenceDoesNotSupportaColorableClaimthatHSBCsDemandforCollateralTortiouslyInterferedWithLehmansOtherBusinessorContractsBecauseHSBCWasActingToProtectItsOwnEconomicInterests .................................................. 1367 a. ElementsofTortiousInterference ........................... 1368 b. ApplicationtoLehmanFacts ................................... 1369

(v) TheEvidenceDoesNotSupportaFindingthatHSBCFraudulentlyorNegligentlyMisrepresentedItsPlantoWithdraw......................................................... 1371 a. ElementsofFraudandMisrepresentation ............. 1371 b. ApplicationtoLehmanFacts ................................... 1373

e) LehmansDealingsWithBankofAmerica ............................................1375 f) LehmansDealingsWithBankofNewYorkMellon............................1376

(1) BNYMDemandsandReceivesaCollateralDeposit .....................1377 (2) TheDepositIsSignificantBecauseofInternalLehman

ConcernsAboutIncludingItinItsPool ..........................................1379 g) LehmansDealingsWithStandardBank................................................1382 h) LehmansDealingsWiththeFederalReserveBankofNewYork .....1385

(1) TheFRBNYSupervisesDepositTakingInstitutionsandAssistsinManagingMonetaryPolicy,butLacksAuthorityToRegulateInvestmentBankHoldingCompanies ......................1385

(2) InResponsetotheBearStearnsNearCollapse,theFRBNYCreatedaVarietyofFacilitiesToBackstoptheLiquidityofBrokerDealers;Lehman,InTurn,DrewonTheseFacilities........1387 (a) ThePrimaryDealerCreditFacility .......................................... 1387 (b) TheMarketGreetedtheCreationofthePDCFasa

PositiveStepTowardBackstoppingBrokerDealerLiquidity,andasShoringUpLehmansLiquidity ................ 1390

1062

(c) InAdditiontoaLiquidityBackstop,LehmanViewedthePDCFasanOutletforItsIlliquidPositions............................ 1392

(d) LehmanWasReluctanttoDrawonthePDCFBecauseofaPerceivedStigmaAttachedtoBorrowingfromtheFacility .......................................................................................... 1396

(e) LehmanAccessedthePDCFTenTimesin2008;LehmansUseofthePDCFWasConcentratedinPeriodsImmediatelyAftertheBearStearnsNearCollapse,andImmediatelyAfterLBHIFiledforBankruptcy ...................... 1398

(3) OtherFRBNYLiquidityFacilities.....................................................1400 (a) TheTermSecuredLendingFacility ......................................... 1400 (b) OpenMarketsOperations ......................................................... 1401

i) LehmansLiquidityPool...........................................................................1401 (1) IntroductionandExecutiveSummary.............................................1401 (2) TheImportanceofLiquiditytoBrokerDealersand

InvestmentBankHoldingCompaniesGenerally ..........................1406 (3) LehmansLiquidityPool....................................................................1408

(a) ThePurposeandCompositionofLehmansLiquidityPool ............................................................................................... 1408

(b) LehmanTestedItsLiquidityPoolandSharedtheResultsofTheseTestswithRatingAgencies ....................................... 1413

(c) MarketParticipantsFormedFavorableOpinionsofLehmansLiquidityontheBasisofLehmansRepresentationsAboutItsLiquidityPool............................... 1415

(4) LehmansClearingBanksSoughtCollateralPledgesandCashDepositsToSecureIntradayCreditRisk;LehmanIncludedThisCollateralinItsLiquidityPool ................................1417 (a) LehmanPledgedCLOsandOtherSecuritiesto

JPMorganThroughouttheSummerof2008toMeetTripartyRepoMarginRequirements ...................................... 1417

(b) TheSecuritiesPostedtoMeetJPMorgansMarginRequirementsWereIncludedinLehmansLiquidityPool ............................................................................................... 1422

(c) OnJune12,2008,LehmanTransferred$2BilliontoCitiasComfortforContinuingCLSSettlement ........................ 1424

1063

(d) TheCitiComfortDepositWasIncludedinLehmansLiquidityPool.............................................................................. 1430

(e) OnAugust25,2008,LehmanExecutedaSecurityAgreementwithBankofAmerica,GrantingtheBankaSecurityInterestina$500MillionDeposit ............................. 1433

(f) LBHIandJPMorganExecutedanAmendmenttotheJune2000ClearanceAgreement,aSecurityAgreementandaHoldingCompanyGuaranty,allDatedAugust26,2008 ............................................................................................... 1436

(g) LehmanAssetsSubjecttotheAugustSecurityAgreementWereIncludedinLehmansLiquidityPool ....... 1439

(h) September2,2008:LehmanTransferredJustUnder$1BilliontoHSBCtoContinueClearingOperations,andEncumberedThiswithCashDeedsExecutedonSeptember9andSeptember12................................................. 1441

(i) TheHSBCDepositWasRepresentedasLiquidandWasIncludedinLBHIsLiquidityPool .................................. 1446

(j) LehmanandJPMorganExecutedAnotherRoundofSecurityDocumentationDatedSeptember9,2008;LehmanMade$3.6Billionand$5BillionPledgestoJPMorganSubjecttotheTermsofTheseAgreements .......... 1446

(k) LehmanMadeaDeposittoBankofNewYorkMellontoCoverIntradayExposure,andIncludedThatDepositinItsLiquidityPool ........................................................................ 1448

(l) TheCumulativeImpactofLehmansInclusionofClearingBankCollateralandDepositsinItsLiquidityPool ............................................................................................... 1450

(5) DisclosuresConcerningtheInclusionofClearingBankCollateralinLehmansLiquidityPool.............................................1454 (a) LehmanDidNotDiscloseonItsJune16,2008Second

QuarterEarningsCallThatItWasIncludingthe$2BillionCitiComfortDepositinItsLiquidityPool ............. 1454

(b) LehmanDidNotDiscloseinItsSecondQuarter200810Q,FiledJuly10,2008,ThatItWasIncludingBoththe$2BillionCitibankComfortDepositandApproximately$5.5BillionofSecuritiesCollateralPledgedtoJPMorganinItsLiquidityPool .................................................................... 1455

1064

(c) LehmanDidNotDiscloseOnItsSeptember10,2008EarningsCallThataSubstantialPortionofItsLiquidityPoolWasEncumberedbyClearingBankPledges ................ 1457

(d) SeniorExecutivesDidNotDisclosetotheBoardofDirectorsattheSeptember9,2008FinanceCommitteeMeetingtheFactThataSubstantialPortionofItsLiquidityPoolWasEncumberedbyClearingBankPledges.......................................................................................... 1460

(e) LehmanOfficersDidNotDisclosetotheBoardofDirectorsThatItsLiquidityPositionWasSubstantiallyImpairedbyCollateralHeldatClearingBanksUntiltheEveningofSeptember14,2008 ................................................. 1464

(f) LowittsViewsonIncludingClearingBankCollateralintheLiquidityPool ....................................................................... 1466

(6) RatingAgenciesWereUnawareThatLehmanWasIncludingClearingBankCollateralinItsLiquidityPool .............1467 (a) Fitch............................................................................................... 1467 (b) Standard&Poors....................................................................... 1468 (c) Moodys........................................................................................ 1469

(7) TheFRBNYDidNotViewtheClearingBankCollateralintheLiquidityPoolasUnencumbered ..........................................1469

(8) TheSEC,LehmansPrimaryRegulator,WasUnawareoftheExtenttoWhichLehmanWasIncludingClearingBankCollateralinItsLiquidityPool;totheExtentItWasAware,theSECDidNotViewThisPracticeasProper ..............................1472

(9) CertainLehmanCounselWereAwareThatAgreementswithItsClearingBanksWereStructuredtoIncludeClearingBankCollateralinItsLiquidityPool,butDisclaimedKnowledgeConcerningWhatAssetsWereAppropriateorInappropriatefortheLiquidityPool ....................1476

(10) LehmansAuditorsMonitoredLehmansLiquidityPool,butViewedtheCompositionofthePoolasaRegulatoryIssue.........1478

(11) ThereIsInsufficientEvidenceToSupportaDeterminationThatAnyOfficerorDirectorBreachedaFiduciaryDutyinConnectionWiththePublicDisclosureofLehmansLiquidityPool ......................................................................................1479

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1066

5. PotentialClaimsAgainstLehmansSecuredLenders

a) IntroductionandExecutiveSummary

Pursuanttotheeighthbulletofparagraph2oftheExaminerOrder,thisSection

oftheReportexaminestransactionsandtransfersamongthedebtorsandpreChapter

11 thirdparty lenders. The Examiner has consulted with the parties in interest,

reviewedissuesidentifiedbythoseparties,conductedhisownindependentreviewand

examinationand exercisedhisdiscretionas towhich issues to include in theReport.

This Section of the Report covers potential common law claims against Lehmans

lenders.SectionIII.Bcoverspotentialavoidanceandpreferenceactions.

Throughout 2008, and up to the date that Lehman filed for bankruptcy,

Lehmans clearing banks demanded collateral to secure risks they assumed in

connectionwithclearingandsettlingLehmanstripartyandcurrencytrades,andother

extensions of credit. This Section of the Report examines the circumstances

surroundingLehmansprovisionofapproximately$15to$21billionincollateral(both

in cashand securities) to its clearingbanks,andLehmans simultaneous inclusionof

thosefundsinitsreportedliquiditypool.

Assetforthinmoredetailbelow,theimportanceofliquiditytoinvestmentbank

holdingcompaniescannotbeoverstated. Brokerdealersaredependentonshortterm

financing to fund their daily operations, and a robust liquidity pool is critical to a

brokerdealers access to such financing. The Examiner has found that the size of

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Lehmans liquidity pool provided comfort to market participants and observers,

including rating agencies. The size of Lehmans liquidity pool encouraged

counterpartiestocontinueprovidingessentialshorttermfinancingandintradaycredit

to Lehman. In addition, the size of Lehmans liquidity pool provided assurance to

investors that if certain sources of shortterm financing were to disappear, Lehman

couldstillsurvive.

Critically, thecollateralpostedbyLehmanwith itsvariousclearingbankswas

initially structured in a manner that enabled Lehman to claim the collateral as

nominallylienfree(atleastovernight),andcontinuetocountitinitsreportedliquidity

pool. However,bySeptember2008,muchofLehmansreported liquiditywas locked

upwithitsclearingbanks,andyetthisfactremainedundisclosedtothemarketpriorto

Lehmansbankruptcy.

What follows is a review of the demands for added credit protection by

JPMorgan,Citi,HSBC,BankofAmerica,BankofNewYorkMellonandStandardBank,

followed by a brief synopsis of the Examiners legal conclusions. The Examiner

concludesthattheremaybeacolorableclaimagainstoneclearingbankJPMorgan

arising from thesecollateraldemands in2008. Then, thisSectiondiscussesLehmans

publicstatementsaboutitsliquiditypool.

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(1) JPMorgan

JPMorgan acted as LBIs principal clearing bank pursuant to a Clearance

AgreementbetweenJPMorganandLBI.ThemostsignificantcomponentofJPMorgans

clearing services was triparty repo clearing. Although tripartyrepo investors

typically required a brokerdealer such as LBI to post margin (that is, additional

collateral)overnighttoaccountfor investorrisk,before2008,JPMorgandidnotretain

thatmarginintraday.

In February 2008, JPMorgan informed Lehman that JPMorgan would begin

retaining the samemargin intraday that triparty investors required overnight. This

change JPMorgans retention of tripartyinvestor margin was implemented

graduallyin20percentincrementsoverthecourseofapproximatelyfivemonths.

JPMorganalsodeterminedthat itsriskvisvisbrokerdealerssuchasLBIwas

greater than the risk facedbyovernight investors. JPMorgan therefore instituted an

additionalmarginrequirement,whichitcalledriskbasedmargin,andincrementally

imposed that margin on brokerdealers as well. Lehman initially responded to

JPMorgans riskbased margin requirement by posting approximately $5 billion in

securities in June 2008. Lehman continued topost additional collateral at JPMorgan

throughoutthesummerinresponsetoJPMorgansmarginrequirements.

In August 2008, JPMorgan raised concerns about collateral that Lehman had

posted. In particular, Lehman had posted illiquid and difficulttoprice CDOs that

1069

Lehmanhad selfpriced. JPMorganwasalso concernedbecauseLCPI (notLBIor its

holding company) had posted collateral to cover JPMorgans riskbased margin.

Lehman transferred much of this collateral from LCPI to LBHI in early August to

alleviateJPMorgansconcern.

At the end of August, after significant negotiation, Lehman and JPMorgan

enteredintothreeagreements:anAmendmenttotheClearanceAgreement,aGuaranty

and a Security Agreement. The Amendment to the Clearance Agreement added

additional Lehman parties to theClearanceAgreement. Under theGuaranty, LBHI

guaranteed the Lehman parties obligations under the Clearance Agreement. The

SecurityAgreementsecuredLBHIsGuaranty,grantingJPMorganasecurityinterestin

a Cash Account, Securities Account and certain related accounts. The Security

AgreementalsoprovidedforanOvernightAccount intowhichLBHIcouldtransfer

cashorsecuritiesovernightifnoobligationsremainedoutstandingundertheClearance

Agreementattheendoftheday.Thoseassets,however,generallyhadtobereturned

toLehmans lienedaccountsbymorning inorder for JPMorgan tocontinueclearance

operations. Lehman understood the August Agreements as documenting existing

practice,notfundamentallyalteringitsrelationshipwithJPMorgan.

BylateAugustandearlySeptember,Lehmansdeterioratingfinancialcondition

became increasingly apparent. On September 4, 2008, Lehman and JPMorgan

executives met to discuss Lehmans third quarter earnings and survival strategies.

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JPMorganemergedconcernedwithLehmansplans.JPMorganalsoreviewedadraftof

Lehmansplannedpresentation to ratingagencies,and JPMorganexpressed concerns

about that presentation as well. The following day (September 5), JPMorgans

InvestmentBankRiskCommitteemet todiscuss the InvestmentBanks exposures to

various brokerdealers, and expressed particular concerns about Lehman. Then, on

September 9, 2008, reports surfaced that acquisition talksbetweenLehman andKDB

hadfallenthrough,andLehmansstockplummeted. Inresponse,Lehmandecidedto

preannounceitsthirdquarterearningsthefollowingmorning,September10. Alsoon

September 9, JPMorgan requested $5 billion of additional collateral to cover all of

JPMorgans exposures to Lehman, not limited to tripartyrepo clearing exposure.

Lehmanagreed topost$3billion immediately,andposted the$3billion in cashand

moneymarketfundsbythenextday.

JPMorgan furtherdetermined that itwantedanewmastermasteragreement

withLehman tocover itsentire relationshipacrossallLehman liabilitiesandentities.

For thecollateral that JPMorganrequestedonSeptember9 tocoverallof JPMorgans

exposures toallLehmanentities,newdocumentationhad tobeexecuted. JPMorgan

insisted that an Amendment to the Clearance Agreement, Security Agreement and

Guarantybe inplacebeforeLehmans earnings call thenextmorning. The evidence

doesnotsuggest,however, that JPMorgan threatened toceaseclearing forLehman if

theagreementswerenotexecutedbythen.

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JPMorgans and Lehmans legal teams negotiated the documents through the

night. Lehmansattorneysreceivedvirtuallyno inputfromLehmansseniorfinancial

officers or other business personnel, who were immersed in preparations for the

upcoming earnings call. Indeed, neither Lehmans Treasurer nor itsChief Financial

Officer reviewed the terms of the agreements or even a summary of the key terms

beforetheagreementsweresigned.

TheseagreementssignificantlyextendedJPMorgansrightstorequestandretain

collateralbyexpandingtheLehmanaccountsoverwhichJPMorganhadalienandthe

obligationsthatitsliensecured.TheSeptemberSecurityAgreementandGuarantyalso

requiredthreedayswrittennoticeforLBHItoattempttoretrieveanyofitscollateral.

On September 11, JPMorgan executives met to discuss significant valuation

problems with securities that Lehman had posted as collateral over the summer.

JPMorgan concluded that the collateral was not worth nearly what Lehman had

claimeditwasworth,anddecidedtorequestanadditional$5billionincashcollateral

fromLehman thatday. The requestwas communicated in an executivelevelphone

call, and Lehman posted $5 billion in cash to JPMorgan by the afternoon of Friday,

September 12. Around the same time, JPMorgan learned that a security known as

Fenway,whichLehmanhadposted to JPMorgan at a statedvalueof $3billion,was

actually assetbacked commercial paper creditenhanced by Lehman (that is, it was

Lehman, rather than a third party, that effectively guaranteed principal and interest

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payments). JPMorgan concluded that Fenway was worth practically nothing as

collateral.

NotwithstandingJPMorgansconcernswiththequantityandqualityofcollateral

postedbyLehman,LehmanbelievedthatJPMorganwasovercollateralized.Thereisno

evidence, however, that Lehman requested in writing the return of the billions of

dollars of collateral ithadposted in September. Lehmandid informally request the

return of at least some of its collateral, and JPMorgan returned some securities to

Lehman on September 12. JPMorgan did not, however, release any of the cash

collateral thatLehmanhadposted in response to theSeptember9andSeptember11

requests.

TheExaminerhasanalyzedanumberofpotential common law claimsagainst

JPMorganinconnectionwiththeSeptemberAgreementsandcollateraldemands.The

Examinerconcludes:

The evidence does not support the existence of a colorable claim againstJPMorgan foreconomicduressprincipallybecause theExaminerhas foundnoevidenceofanexpressunlawfulthreatbyJPMorgan.

The evidence does not support the existence of a colorable claim that theSeptemberAgreementsare invalid for lackofconsiderationbecause (i) theSeptemberAmendment to theClearanceAgreementwasamodificationofanexistingcontractand,therefore,requirednoadditionalconsideration,and

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(ii) the September Security Agreement and Guaranty were supported byJPMorganscontinuedextensionofcredittoLehman.3952

Theremaybea technicalclaim that theSeptemberAgreementsare invalidfor lack of authority, but there are substantial defenses to such a claim,including thatLehmanratified theagreementswhen itpostedcollateralonSeptember12. Accordingly,theExaminerconcludesthattheevidencedoesnotsupporttheexistenceofacolorableclaim.

The evidence does not support the existence of a colorable claim thatJPMorgan fraudulently induced the September Agreements even ifJPMorgancounsel toldLehmancounsel thatanagreement inprinciplehadalready been reached by Lehmans and JPMorgans senior management.There isconflictingevidenceastowhether therewassuchanagreement inprinciple. Nonetheless,regardlessof theoutcomeof thatdisputed issueoffact, it does not appear that Lehman counsel in fact relied on therepresentationorreasonablycouldhaverelieduponit.

The Examiner also concludes that the evidence does not support theexistence of a colorable claim that JPMorgan breached the SeptemberAgreementsbyrefusing toreturncollateral toLehman. JPMorganwasnotlegally required to do so principally because Lehman failed to provideJPMorganwithwrittennotice forreturnofcollateralasrequiredunder theSeptemberAgreements.

Finally,theExaminerconcludesthattheevidencemaysupporttheexistenceofacolorableclaimbutnotastrongclaim that JPMorganbreached theimplied covenant of good faith and fair dealing by making excessivecollateralrequeststoLehmaninSeptember2008.Atrieroffactwouldhaveto consider evidence that the collateral requestswere reasonable and thatLehmanwaivedanyclaimsbycomplyingwiththerequests.

(2) Citibank

Citibank was Lehmans designated settlement member on the Continuous

Linked Settlement (CLS) system, a trading platform operated by a consortium of

3952 See infra Section III.B.3.g.5.a for a discussion ofclaims to avoid the September Guaranty underapplicable fraudulent transfer law where a different standard applies for assessing reasonablyequivalentvalue.

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banksfortheclearanceandsettlementofforeignexchange(FX)trades.Inexecuting

trades forLehmanon theCLSsystem,CitiacceptedLehmansCLS trades,submitted

them to theCLSBank,and extended intraday credit toLehman, therebyassuminga

certain amount of intraday credit risk. Citi provided the clearing and settlement

servicesonCLSundertheaegisofaCLSSettlementServicesAgreementforCLSUser

Members, originally entered into by Lehman and Citi in December 2003, and later

amended inOctober 2004. Notably, thisAgreement provided that any extension of

creditbyCitiwaswithinCitissolediscretion.

Citi provided Lehmanwith additional financial services, such asmaintaining

cashdepositandcustodialaccounts,providingcreditfacilities,andsomecustodyand

clearingservicesinemergingmarketsandintheUnitedStates.

After the markets negative reaction to Lehmans second quarter earnings

announcement and Lehmans announced personnel changes on June 12, 2008, Citi

sought to reduce its intraday risk exposure toLehman. Consequently,on that same

day,Citiobtaineda$2billioncomfortdepositfromLehman,tobemaintainedatCiti

inanovernightcallaccount.Althoughthe$2billiondepositwasnotformallypledged,

Citi believed that it had a general right of setoff. In addition, according to Citi

personnel,hadLehmanwithdrawnthedeposit,Lehmanwouldhavehadtoprefundits

transactionsinorderforCititocontinueclearingandsettlingLehmanstrades.The$2

billiondepositwasincludedinLehmansreportedliquiditypool.

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Further,beginninginJuly,thepartiesnegotiatedwithoutsuccessthetermsof

aformalpledgeagreementontheunderstandingthatLehmanwouldpledgesecurities

to collateralizeCitis clearing and settlement lines, in lieu of the cash deposit. Citi

proposed several versions of a collateral pledge agreement, and Lehman proposed

differentportfolios of assets topost as collateral. Citideclined to accept any of the

securitiesproposedbyLehmanascollateral;Citihaddifficultypricing theassetsand

questionedwhethertherewasareadymarketforthem.

Thenegotiations betweenCiti andLehman over thepledge agreement ceased

when,betweenSeptember9and12,LehmanandCitiamendedtwocriticalagreements

instead of executing the pledge agreement. By early September, Citi had become

acutelyconcernedaboutitsclaimonthe$2billiondeposit.Then,onSeptember9,the

reportedfailureoftheKDBdeal,coupledwithLehmansannouncementthatitwould

accelerate its thirdquarterearningsannouncement toSeptember10,promptedCiti to

requestthatLehman immediatelyamendtheparentGuarantyAmendmenttoexpand

thescopeoftheholdingcompanyGuaranty(toincludeobligationsowedtoCitiunder

any custodial agreement with Citi in addition to extensions of credit by Citi) and

ultimatelyadded10additionalLehmansubsidiariestotheguaranty(Citihadoriginally

requested that 17be added). On September 12, theparties also amended theDirect

CustodialServicesAgreement(DCSA),whichprovidedCitiwithabroadandexplicit

securityinterestovercash,securitiesorotherassetsheldbyCitionbehalfofLehman.

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Citi continued thereafter to provide clearing and trade settlement services for

Lehman, albeit under reduced clearing limits, until Lehman filed for bankruptcy on

September 15. Ultimately, Citi cleared for Lehman through CLS until Friday,

September19.

TheExaminerhas identifiedpotential common law claims againstCiti arising

outofthesetransactions,buthasnotfoundanyofthemtobecolorable.

The evidence does not support the existence of a colorable claim foreconomic duress surrounding Citis demand that Lehman execute theSeptember 9 amendment to the Guaranty because, inter alia, there is noevidenceofanexpressunlawfulthreatbyCititoinduceLehmantoagreetoitsterms. Indeed,Lehmansuccessfullynegotiatedcertaintermsinitsfavorpriortosigningtheamendment.

Likewise,theevidencedoesnotsupporttheexistenceofacolorableclaimforfailureofconsideration:CitiextendedcredittoLehmanatitssolediscretion,and the September 9 amendment induced Citi to continue providingintraday credit to Lehman subsidiaries. Given the rapidly deterioratingmarket conditions, itwasnotunreasonable forCiti to seekadded securityfromLehman.3953

TheevidencedoesnotsupporttheexistenceofacolorableclaimagainstCitiforbreachof thedutyofgood faithand fairdealing inconnectionwith itsCLSagreementwithLehman. TheExaminer foundnoevidence tosuggestanyobligationbyCititoprovideclearingandsettlementservicestoLehman,and given the increased riskCiti faced visvis Lehman on September 9,there is no colorable claim that Citi acted unreasonably, irrationally,arbitrarily, or in bad faith by exercising or threatening to exercise itscontractualright toceaseextendingclearingadvancesand toceaseservingasLehmansCLSsettlementmemberbank.

3953 See infra Section III.B.3.g.5.b for a discussion ofclaims to avoid the Guaranty under applicablefraudulenttransferlawwhereadifferentstandardappliesforassessingreasonablyequivalentvalue.

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(3) HSBC

HSBC principally provided Lehmanwith clearing and settlement services for

sterlingdenominated trades in CREST, a clearing and settlement system for certain

securities.SterlingdenominatedtradesinCRESTaresettledinrealtime;consequently,

asLehmanssettlementbank,HSBCextendedLehman intradaycredit to facilitate the

settlementofitsCRESTtrades.ThegoverningagreementbetweenLehmanandHSBC

(theCRESTagreement)provided thatHSBChadabsolutediscretion to terminate

itsresponsibilitiesasLehmansCRESTsettlementbank (which includedextensionsof

intraday credit associated with settling Lehmans trades). The CREST agreement

furtherprovidedthatHSBCcouldterminatethecontractwithoutnotice,onlyrequiring

30daysnoticetotheextentthatHSBCconsider[ed]itpracticableandappropriate.

HSBCprovidedmyriadotherbanking services toLehman, includingactingas

Lehmans trustee for special purpose vehicles in the Cayman Islands, as Lehmans

counterpartyinderivativestradesandothertransactions,andprovidingvariousother

creditproductstoLehman.HSBCsmostsignificantcreditexposure,however,derived

fromHSBCsroleasLehmansCRESTsettlementbank.

Beginning inmid2006,HSBC took steps to reduce its credit exposure to the

financial sector generally, and, in 2007, it reduced its lines of uncommitted credit

available to the investment banks. HSBC accelerated thesemeasures after the near

collapseofBearStearns inearly2008. ViewingLehmanas thenextmostvulnerable

1078

investment bank, HSBC further reduced various lines of credit it had extended to

Lehman. Initially, HSBC implemented these measures quietly, undetected by both

Lehmanandthemarketplace.However,onAugust18,2008,HSBCadvisedLehmanof

its intention to withdraw from its business relationship with Lehman entirely. In

addition,overthenextseveraldays,HSBCdemandedthatLehmandeposit justunder

$1billionintoaccountsintheU.K.andinHongKong,ultimatelytobesecuredbythree

cashdeeds.HSBCintendedtheU.K.deposittocoveritsexposurearisingfromCREST

clearing and settling. The smallerHongKongdepositwas intended to collateralize

variouslinesofcreditHSBCprovidedtoLehmansubsidiariesintheAsianmarket.

Lehman understood that HSBC would cease clearing and settling trades in

CRESTforLehman ifLehmandidnotpost thiscollateral. Lehman initiallydeposited

theequivalentofapproximately$800millionwithHSBConAugust28.Laterthatsame

day,HSBCpermittedLehman toretrieve thatdeposit toassistLehman inmeeting its

thirdquarterbalancesheet targets. Lehmansubsequentlyredeposited theequivalent

ofapproximately$800millionwithHSBConSeptember1. OnSeptember2,Lehman

depositedapproximately$180millioninanHSBCHongKongaccount.

Negotiations over the terms of the cash deeds ensued, and Lehman secured

favorableconcessionsduringthatprocess.Twocashdeedswereexecutedtocoverthe

U.K.depositonSeptember9(theU.K.CashDeeds),andthepartiesexecutedathird

cashdeedonSeptember12related to theHongKongdeposit (theHongKongCash

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Deed).EnglishlawgovernedthetermsoftheU.K.CashDeeds,whileHongKonglaw

governedthetermsoftheHongKongCashDeed.Notably,thedeedslimitedLehmans

abilitytoaccessthecollateralunlesstherewerenodebts incertain,specifiedaccounts

(andnocontingentliabilities),andHSBCretainedgeneralrightsofsetoffinallevents.

TheExaminerhas identifiedseveralpotentialclaimsunderEnglish lawagainst

HSBC arising out of these transactions involving theU.K.CashDeeds, but has not

foundanyofthemtobecolorable.

The evidence does not support the existence of a colorable claim that theU.K.CashDeedsareinvalidforlackofconsideration.Englishlawdoesnotrequireconsideration toenforceanagreementcontained inadeed. Inanyevent, because the CREST agreement gave HSBC absolute discretion inprovidingLehmanwith settlementand clearing services,Lehman receivedconsideration in HSBCs agreement to continue providing those services.Lehmanmayhavealsoreceivedconsideration in the formof the interest itreceivedonthecollateralitposted.

Likewise,theevidencedoesnotsupporttheexistenceofacolorableclaimforeconomicduressbecause theoperativeCRESTagreement (andothercreditagreements)permittedHSBC to terminate its services at itsdiscretion. Inanyevent,theExaminerfoundnoevidenceofduress,inparticulargiventhatLehmannegotiatedmore favorable terms for itself in theprovisionsof thedeeds.

Theevidencedoesnotsupporttheexistenceofacolorableclaimforbreachofthedutyofgoodfaithandfairdealing. HSBCsabsolutediscretionoverofferingCRESTservicesandextensionsofcredittoLehmanisnotsubjecttosuchanobligationunderEnglish law,andeven if itwas,HSBCsdemandsweregroundedinlegitimatecommercialconcernsaboutLehmansviability.

HSBCdidnotbreachthenoticeprovisionoftheCRESTagreement.HSBCsdetermination not to provide more advanced notice of its decision toterminateserviceswasnotarbitrary,capricious,unreasonableorinbadfaith;instead,itwaslegitimatelygroundedinitscommercialinterest.

1080

TheevidencedoesnotsupporttheexistenceofacolorableclaimthattheU.KCashDeedswerecontractsofadhesionor standard formcontracts. HSBCandLehmanweresophisticatedpartiestoagreementsthatwereextensivelynegotiated(ultimatelyresultinginchangesthatfavoredLehman).

Likewise, the evidencedoesnot support the existenceofa colorable claimthat HSBC was unjustly enriched through the U.K. Cash Deeds. TheExaminer concludes that the U.K. Cash Deeds are valid contracts, underwhichLehmanhadadutytoconveyabenefittoHSBC,forwhichLehmanreceivedabenefit.

TheevidencedoesnotsupporttheexistenceofacolorableclaimthatHSBCbreacheda fiduciaryduty toLehman. HSBCdidnotoweLehmanadutyindependent of its narrowly defined role as Lehmans CREST settlementbank,andtheCRESTagreementimposednoobligationonHSBCtocontinueprovidingservicestoLehman.

Even if HSBCs collateral demands were to have factored materially inLehmansdecisiontofileforbankruptcy,theevidencedoesnotsupporttheexistenceofa colorable claim thatHSBCsdemand for collateral tortiouslyinterferedwithLehmanscontractswithotherparties. HSBCwasacting toprotectitsowncommercialinterests.

Finally,theevidencedoesnotsupporttheexistenceofacolorableclaimthatHSBC fraudulently or negligently represented its plans to terminate itscommercialrelationshipwithLehman.Tothecontrary,HSBCwasforthrightaboutitsintentionstoreduceitsexposuretoLehmanandultimatelytoceasedoingbusinesswithLehman.

(4) OtherLenders

Several banks, in addition to JPMorgan,Citi andHSBC, demanded increased

security fromLehman in theweekspreceding thepetitiondate. While theExaminer

did not investigate whether or not there were colorable claims arising from these

transactions,theExaminersetsforthfactualfindingsastheyarerelevanttotheanalysis

ofLehmansreportedliquiditypool.

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Bank of America (BofA). BofA provided clearing and other financialservicestoLehman.Inconnectionwithitsclearingservices,BofAprovidedunsecured, intraday credit to coveroverdrafts. OnAugust 14, 2008,BofAdemandedadepositfromLehmaninorderforLehmantoretainitsoverdraftcredit. In addition, BofA required Lehman to sign a SecurityAgreement(executedonAugust25),inwhichLehmanagreedtomaintain$500millionincollateralwithBofA,andgrantedBofAasecurityinterestinthatcollateral.The Security Agreement permitted Lehman to remove assets from thedepositaccountwithadvancenoticeofthreedays.

Bank of New York Mellon (BNYM). BNYM provided Lehman withcredit related to commercialpaper andmedium termnoteprograms. OnAugust 20, BNYM requested that Lehman prefund its transactions withBNYM. After a series of discussions, Lehman and BNYM agreed onSeptember8,2008, thatLehmanwouldopenamoneymarketaccountwithBNYMandmaintainasufficientdeposit there tocoverBNYMs forecastedintraday exposure to Lehman. Thereafter, on September 11, Lehman andBNYMexecutedaCollateralDepositAgreement,requiringLehmaninitiallytodeposit$125millionintradayandmaintainacollateralaccountofatleast$50million.

Standard Bank. Standard Bank provided Lehman with clearing andsettlementservicesinSouthAfrica.OnAugust18,StandardBankrequestedthat Lehman begin prefunding its trades. Discussions ensued, and onSeptember 4, 2008, StandardBankdemanded $200million in collateral bySeptember 9, or it would cease settling Lehmans trades. Consequently,Lehmanprovided$200millionincollateraltoStandardBankonSeptember9,andexecutedapledgeagreement tocover thedepositonSeptember11.The Examiners financial advisors have not been able to identify a U.S.debtorasthesourceofthesefunds.

(5) TheFederalReserveBankofNewYork

TheFRBNYwas one ofLehmansmajor creditors,particularly in thewake of

BearStearnsnear collapse inMarch2008,and in theweeks subsequent toLehmans

bankruptcy.

1082

Duringthetimeperiodsurrounding thenearcollapseofBearStearns inMarch

2008, the FRBNY established the Primary Dealer Credit Facility, or PDCF, through

which the FRBNY offered shortterm, collateralized loans to brokerdealers at its

discountwindow,ineffectactingasarepocounterpartyoflastresort.Additionally,

theFRBNYcreated theTermSecuritiesLendingFacility,orTSLF,underwhich,every

28 days, brokerdealers could engage in a competitive auction and could swap

mortgagebackedsecuritiesandothersecuritiesforTreasuries.TheExaminerfindsthe

evidence does not support the existence of colorable claims in connection with the

lendingtransactionsbetweentheFRBNYandLehman.

(6) LehmansLiquidityPool

Lehman represented in regulatory filings and in public disclosures that it

maintaineda liquiditypool thatwas intended tocoverexpectedcashoutflows for12

months in a stressed liquidity environment andwas available tomitigate the lossof

securedfundingcapacity.AftertheBearStearnscrisisinMarch2008,itbecameacutely

apparenttoLehmanthatanydisruptioninliquiditycouldbecatastrophic;Lehmanthus

paidcarefulattentiontoitsliquiditypoolandhowitwasdescribedtothemarket.

Lehman reported the sizeof its liquiditypoolas$34billionat the endof first

quarter2008,$45billionattheendofsecondquarter,and$42billionattheendofthe

thirdquarter. Lehmanrepresented that its liquiditypoolwasunencumbered that it

1083

was composed of assets that could be monetized at short notice in all market

environments.

TheExaminers investigationofLehmans transferofcollateral to its lenders in

thesummerof2008revealedacriticalconnectionbetweenthebillionsofdollarsincash

and assetsprovided as collateral andLehmans reported liquidity. At first,Lehman

carefullystructuredcertainofitscollateralpledgessothattheassetswouldcontinueto

appear tobereadilyavailable (i.e., theOvernightAccountat JPMorgan, the$2billion

comfort deposit to Citi, and the threeday notice provision with BofA). Witness

interviewsanddocumentsconfirmthatLehmansclearingbanksrequiredthiscollateral

and without it would have ceased providing clearing and settlement services to

Lehmanor,attheveryleast,wouldhaverequiredLehmantoprefunditstrades. The

market impactofeitherof thoseoutcomes couldhavebeen catastrophic forLehman.

Lehman also included formally encumbered collateral in its liquiditypool. Lehman

includedthealmost$1billionpostedtoHSBCandsecuredbytheU.K.CashDeedsin

its liquiditypool;Lehman included the$500million incollateral formallypledged to

BofA;Lehman includedanadditional$8billion incollateralposted to JPMorganand

securedbytheSeptemberAgreements;andLehmancontinuedtoincludethe$2billion

atCiti,evenaftertheGuarantyandDCSAamendments.

BythesecondweekofSeptember2008,Lehmanfounditselfinaliquiditycrisis;

itno longerhad sufficient liquidity to fund its survival. Thus, anunderstanding of

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Lehmanscollateraltransfers,andLehmansattendantlossofreadilyavailableliquidity,

isessentialtoacompleteunderstandingofwhyLehmanultimatelyfailed.

b) LehmansDealingsWithJPMorgan

ThisSectionoftheReportdiscussescollateralpostedbyLehmanentitiesduring

2008 inresponse torequestsmadeby JPMorganChase (JPMorgan)andagreements

betweenLehmanand JPMorgan relating to clearingoperations, credit,and collateral.

Inadditiontothemanywitnessinterviewsconductedanddocumentsreviewedbythe

Examiner,theExaminerhasinformallysoughtandobtainedinformationfromAlvarez

&Marsal,counselfortheDebtors,counselforJPMorganandcounselfortheCreditors

CommitteerelatingtotheissuesdiscussedinthisSectionoftheReport.

(1) Facts

(a) OverviewofJPMorganLehmanRelationship

JPMorgan acted as LBIs (LBHIs U.S. brokerdealer subsidiary) principal

clearingbankforsecuritiestradingandtripartyrepurchase(repo)agreements.3954In

thatrole,JPMorganassistedintheclearanceandsettlementofsecuritiestradedbyLBI

and LBI funding through triparty repos. Clearing banks facilitate security trades

between buyers and sellers and secured loans between borrowers and lenders by

3954JPMorganengagedinotherroleswithLehman,includingasacounterpartytoderivativetransactions,counterpartytopurchasesandsalesofsecuritiesandotherfinancialinstruments,lenderonbothsecuredand unsecured terms, investment banker to assistwith the issuance of loans, bonds and equity, andcounterpartytosecuritieslendingtransactions.TonuccidescribedLehmansdealingswithJPMorganasLehmansmostimportantrelationship.ExaminersInterviewofPaoloR.Tonucci,Sept.16,2009,atp.4.

1085

providing services such as valuing the collateralposted by borrowers, applying and

enforcing specific rules regarding collateralization and moving cash and collateral

betweenaccounts.3955 JPMorganwasoneofonly twobanks in theUnitedStates that

providedthevastmajorityofclearingservicestobrokerdealerentitiessuchasLBI;the

otherwasTheBankofNewYork.3956

JPMorgansclearingservicesforbrokerdealerssuchasLBIconsistedprincipally

oftripartyrepoclearingandclearingforothertypesofsecuritiestransactions.Triparty

reposareaprincipalsourceoffundingforbrokerdealers3957andrepresentedthelargest

intraday risk to JPMorgan of the clearing activities it carried out forLehman.3958 As

implied by its name, triparty repo involves three parties: an investor (typically a

pension fund, money market mutual fund or bank), a borrower (such as a broker

dealer) and a clearing bank.3959 In a triparty repo, a triparty clearing bank such as

3955See, e.g.,TobiasAdrian, et al.,TheFederalReservesPrimaryDealerCreditFacility,CURRENT ISSUES INECON. & FIN.,Aug. 2009, at p. 6, available at http://www.newyorkfed.org/research/current_issues/ci154.pdf [hereinafter Current Issues: PDCF]; Lehman,RepoManual (Nov. 8, 2005), at p. 11 [LBEXLL1175483][hereinafterRepoManual].3956Current Issues:PDCF,atp.6;WorkingGrouponGovernmentSecuritiesClearanceandSettlement,ReporttotheFederalReserveBoard(Dec.2003),atp.10,availableathttp://www.federalreserve.gov/boarddocs/press/Other/2004/20040107/attachment.pdf[hereinafterWorkingGroupReport].3957CounterpartyRiskManagementPolicyGroupIII,ContainingSystemicRisk:TheRoadtoReform(Aug.6,2008),atp.113,availableathttp://www.crmpolicygroup.org/docs/CRMPGIII.pdf[hereinafterCRMPGIIIReport]. AdocumentdraftedbyJPMorgan,BestPracticesIntradayandOvernightTripartyDealerFinancing,formedabasisforwhatwasultimatelypublishedbytheCRMPG. ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atp.7;JPMorgan,BestPracticesIntradayandOvernightTriPartyDealerFinancing[JPMEXAMINER00006026];ExaminersInterviewofPaoloR.Tonucci,Sept.16,2009,atp.4(explainingthatLehmanwasveryreliantontripartyrepoandthattripartyrepoisthelifebloodofaninvestmentbank).3958ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atp.5.3959CurrentIssues:PDCF,atpp.2,6.

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JPMorgan acts as an agent, facilitating cash transactions from investors to broker

dealers,which,inturn,postsecuritiesascollateral.3960Thebrokerdealersandinvestors

negotiatetheirownterms;JPMorganactsonlyasanagent.3961Tripartyrepostypically

mature overnight, although investors and brokerdealers can also enter into term

repos(reposthatmatureatalatertime)oropenrepos(reposwithoutasetmaturity

datethatpermittheagreementtobeterminatedonanyday).3962

Eachnightcollateral isallocated to investors (intodesignationscalledtriparty

shells),eithermanuallybythebrokerdealeror,moretypically,throughanautomated

process in JPMorgansBrokerDealerAutomationSystem (BDAS).3963 The investors,

inturn,provideovernightorlongertermfundingtothebrokerdealer. Thefollowing

morning, JPMorgan unwinds the triparty repos, returning cash to the triparty

investors and retrieving the securities posted the night before by the brokerdealer.

3960CRMPGIIIReport,atp.114;RepoManual,atp.7[LBEXLL1175483].Tripartyreposaresimilartoloans inwhich collateral is posted to secure the loan. SeeCurrent Issues:PDCF, at p. 2 (In a repotransaction, theholderof a securityobtains fundsby selling that security to another financialmarketparticipantunder an agreement to repurchase the security at a fixedpriceon apredetermined futuredate.Inessence,thesellerisborrowingfundsagainstthesecurity,typicallyasameansoffinancingtheoriginalpurchaseofthesecurity.).3961E.g.,ExaminersInterviewofBarryL.Zubrow,Sept.16,2009,atp.3.3962SeeCRMPGIIIReport,atpp.11415;CommitteeonPaymentandSettlementSystemsoftheCentralBanksoftheGroupofTenCountries,CrossBorderSecuritiesSettlements(Mar.1995),atp.42,availableathttp://www.bis.org/publ/cpss12.pdf.3963JPMorgansResponses toExaminersFirst SetofQuestions reLehman/JPMAccounts&CollateraldatedSeptember3,2009 (Oct.23,2009),atpp.1,19 [hereinafterJPMorganFirstWrittenResponses];Examiners Interviewof JohnN.Palchynsky,May11,2009,atp.4. BDAS isamainframesystem thatJPMorganusestomanage itsclearanceactivities. ExaminersInterviewofRicardoS.Chiavenato,Sept.21, 2009, at p. 12; JPMorgan, U.S. Clearance, http://www.jpm.com/tss/General/U_S_Clearance/1114735376505 (lastvisitedDec.17,2009). BDAShandles tensof thousandsof tradesettlementsdaily.JPMorgan,U.S. Clearance, http://www.jpm.com/tss/General/U_S_Clearance/1114735376505 (last visitedDec.17,2009).

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These securities then serve as collateral against the risk created by JPMorgans cash

advance to investors.3964 During thebusinessday,brokerdealersarrange the funding

thattheywillneedatthecloseofbusinessthroughnewtripartyrepoagreements.This

newfundingmustrepaythecashthatJPMorganadvancedduringthebusinessday,as

wellasanyothernonJPMorgancashneeds.Thus,throughouttheday,brokerdealers

send instructions into JPMorganssystem to indicate thedetailsofnew tripartyrepos

(e.g.,collateralamountand type) thatwillcloseat theendof theday.3965 Theprocess

thenrepeatsitself.

JPMorganalso facilitates thesettlementofbrokerdealersalesandpurchasesof

securities.3966Forexample,abrokerdealerclientmaywishtopurchaseabondfor$10

million. At time of settlement, the deliveryversuspayment (DVP) convention

entails thesimultaneousexchangeofcash for thesecurity. JPMorganwouldadvance

the$10millioncashforthebenefitofthebrokerdealer.Thecashwouldgooutwhile

thesecuritycame intoanaccountoverwhichJPMorganheldasecurity interest. The

brokerdealerwouldeffectivelyreceivea$10millionloanfromJPMorgancollateralized

bythesecurity. Thebrokerdealerwill inmostcasesrepaythis loanatendofdayby

borrowing the$10million froma tripartyrepo investor. The risks to JPMorganafter

advancingthecashandpriortorepaymentarethatthejustpurchasedsecuritywillfall

3964SeeCRMPGIIIReport,atpp.11415.3965Examiners Interview of John N. Palchynsky, May 11, 2009, at pp. 34; JPMorgan First WrittenResponses,atp.19.3966SeeCRMPGIIIReport,atp.113;ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atp.4.

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in value below the $10million cash advance or the brokerdealerwilldefault on its

repaymentobligation.

The JPMorganLBI clearing relationship was governed by a Clearance

Agreement between LBI and JPMorgans predecessor, The Chase Manhattan Bank,

executed in June 2000.3967 JPMorgan agreed to act as LBIs nonexclusive clearance

agentforsecuritiestransactionsandtoopenandmaintainaclearanceaccount.3968

TheClearanceAgreement also provided for the extension of credit to LBI by

JPMorgan,butatJPMorganssolediscretion.JPMorgancouldsolelyat[its]discretion,

permit [LBI] to use funds credited to the Account prior to final payment . . . or

otherwise advance funds to [LBI] prior to final payment.3969 Further,

[n]otwithstanding the fact that [JPMorgan]may from time to timemakeadvancesor

loans . . . or otherwise extend credit to [LBI],whether or not as a regular pattern,

[JPMorgan]mayatany timedecline toextend suchcreditat [JPMorgans]discretion,

withnotice.3970

InconsiderationofanyadvancesorloansJPMorganextendedtoLBIpursuantto

theClearanceAgreement,LBIgrantedJPMorganacontinuingsecurityinterestin,lien

upon and right of setoff as to certain LBI assets (explicitly excluding certain

3967ClearanceAgreement(June15,2000),atp.20[JPM20040031786]. Foreaseofreference,TheChaseManhattanBankisreferredtohereinafteraspartofJPMorgan.3968Id.atp.1.Theclearanceaccountisactuallyasetofaccounts:ClearingAccounts,CustodyAccountsandSegregatedAccounts.Id.3969Id.atp.4.3970Id.

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segregatedcustomeraccounts).3971 Inotherwords,dailycreditextendedbyJPMorgan

wassecuredbyalienoncertainLBIaccountsmaintainedatJPMorgan.

Initially, theClearanceAgreementwas to expire onOctober 7, 2002, atwhich

time if the parties had not entered into a written extension, the agreement would

automaticallyrenewforaoneyearperiod.3972TheExaminerisunawareofanywritten

extension of the agreement during that time. The parties, however, continued to

operate pursuant to the terms of the Clearance Agreement, as evidenced by their

amendingtheagreementonMay30,2008.3973

(b) TripartyRepoPriorto2008

TheSeptember11,2001terroristattackssignificantlydisruptedtheoperationsof

the clearing banks (in particular the Bank ofNewYork, due to its proximity to the

WorldTradeCenter),exacerbatingpolicyconcernsabouttheconcentrationofclearing

banks and risk of disruptions to financialmarkets.3974 In the attacks aftermath, the

Federal Reserve, the SEC and the Treasury Department initiated discussions with

3971Id. atpp. 1213. In theClearanceAgreement, thisprovisionwas in tensionwith thedefinitionofClearingAccountsandCustodyAccounts,whichJPMorganagreedtoholdas[LBIs]custodian,freeof[JPMorgans]lien,claimorinterest.Id.atp.1.InMay2008,theClearanceAgreementwasamendedto delete this lienfree language in the definition of Clearing Accounts and Custody Accounts.AmendmenttoClearanceAgreement(May30,2008),atp.1[JPM20040085662].3972ClearanceAgreement(June15,2000),atp.17[JPM20040031786].3973TheMayAmendmenttotheClearanceAgreementaddedLehmanCommercialPaperInc.(LCPI)asapartytotheClearanceAgreement.AmendmenttoClearanceAgreement(May30,2008),atp.1[JPM2004 0085662]. Furthermore, JPMorgan and Lehman entered into agreements after the ClearanceAgreement that secured Lehmans obligations arising from JPMorgans provision of specific clearingservicestoLehman.See,e.g.,CashCollateralAgreement(Oct.3,2005)[JPM20040085509].3974WorkingGroupReport,atp.11;ExaminersInterviewofChristopherJ.McCurdy,Aug.26,2009,atp.2.

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market participants to explore the risks of having only two clearing banks.3975 The

FederalReserveconsidered theoptionofcreating itsownclearingbankof last resort

calledNewBank. It lookedatways to transferpositionsquickly fromone clearing

banktoNewBankintheeventthatcustomerslostconfidenceinaclearingbankorin

the event that a clearing bank was incapacitated by some catastrophic event.

Ultimately,therewasnoeasysolutiontotheseproblems,andtheNewBankproject

was held in abeyance.3976 The Federal Reserve and the clearing banks continued,

however,todiscussabroadrangeofriskstoclearingbanks, includingrisksposedby

failureofabrokerdealer.3977

Inevaluatingtripartyrepoclearingrisks in2008,JPMorganrecognizedthatthe

tripartyrepomarkethadrecentlyexpanded,bothintermsofvolumeandthetypesof

3975WorkingGroupReport,atp.11.3976Examiners Interview ofChristopher J.McCurdy,Aug. 26, 2009, at p. 2; see alsoWorkingGroupReport, atpp. 2837;WorkingGrouponNewBank Implementation,Report to theFederalReserveBoard(Dec. 2005), available athttp://www.federalreserve.gov/boarddocs/Press/Other/2005/20051215/attachment.pdf [hereinafterNewBankWorkingGroupReport].3977See,e.g.,emailfromJanetBirney,Lehman,toDanielJ.Fleming,Lehman,etal.(Feb.26,2008)[LBEXDOCID280175](TherecentmarketturmoilhaspromptedtheFedtoquestionJPMContheviabilityofTripartyfinancingintheeventofbrokerdealerdefault.);emailfromJanetBirney,Lehman,toDanielJ.Fleming,Lehman,etal.(May5,2008)[LBEXDOCID065656];emailfromLucindaM.Brickler,FRBNY,toTimothyF.Geithner,FRBNY,etal.(July16,2008)[FRBNYtoExam.034046](attachingtalkingpointstheFRBNYdevelopedforaJuly17,2008meetingwithDimonandKellyregardingneartermmeasuresto enhance the stabilityof the triparty repomarket);FRBNY,TalkingPoints,NeartermMeasures toEnhancetheStabilityoftheTripartyRepoMarket[Draft](July16,2008),atp.1[FRBNYtoExam.034047](talkingpointsnoting,[i]ntheeventofthedefaultofalargeborrower,thepotentialforsystemicrisktomaterializeco[u]ldbereduced).

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securities funded.3978 That is, more tripartyrepo transactions were occurring and

tripartyrepo parties were using lessliquid and often hardertoprice securities.3979

Liquidityandeaseofpricingarebothcriticalfactorsaffectingriskstotripartyinvestors

andclearingbanks.Thepremiseofatripartyrepoisthatitconstitutessecuredfunding

inwhich the lender (investor) has the opportunity to sell the collateral immediately

uponabrokerdealers (borrowers) failure topaymaturingprincipal. U.S.Treasury

securitiesaretheoptimalcollateralforU.S.dollartransactionssincelargeblockscanbe

soldreadilywithinonetradingdayandthewidelyquotedpricesofsuchsecuritiesare

highlyreliable.Stateddifferently,ifatripartyinvestorhas,forexample,avalueofpar

onits$100millionofTreasurysecuritycollateralandneedstosellitquicklybecausea

borrowerfailedtorepayitsloaninthemorning,theinvestorwouldalmostcertainlybe

abletosellthecollateralduringthesamebusinessdayatavalueveryclosetopar.

To guard against the possibility of the investor realizing less than the loan

amount ina liquidationscenario, theborrowermustpledgeadditionalmargin (i.e.,

additionalcollateral)tothelender3980forexample,$100millionofTreasurysecurities

inexchangefor$98millionincash.This2percenthaircut(i.e.,discount)istypicalfor

3978ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atp.4;seealsoCurrentIssues:PDCF,atp.2.3979CRMPGIIIReport,atpp.11314;CurrentIssues:PDCF,atp.2.3980RepoManual,atp.14[LBEXLL1175483].

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U.S.Treasurycollateral.3981Eveniftheborrowerdefaults,thelenderwillsuffernoloss

ifitcansellthe$100millionofTreasurysecuritiesfor$98millionormore.

Asnotedabove, theriskof investor lossdependsupon the investorsability to

sell collateral quickly and on the accuracy of the quoted price. Illiquid collateral

requires longer timeperiods for saleatmoreuncertainprices,with timeperiodsand

pricesdependentonthetypeofcollateral,theamountofcollateraltosellandprevailing

marketconditions.3982

Due to thesalvagevalueuncertaintyassociatedwith illiquidcollateral, triparty

investorsdemandhigherhaircutsasperceivedcollateral illiquidity increases. Equally

important,haircutsgenerallyincreaseasmarketvolatilityincreases.Forexample,some

lenders increased haircuts on assetbacked securities by 10 percent or more during

times of market turmoil.3983 Larger haircuts directly reduce the amount of funding

3981See,e.g.,NewBankWorkingGroupReport,atp.10.3982As one example, consider a brokerdealer that owns $10million of a tripleB rated residentialmortgagebackedsecurity(RMBS). Assumetheentireissuanceofthisparticularbondis$20million,sothebrokerdealerownshalfof thebond issue. Typically therewouldbezeroorvery fewobservabletradesof thisspecificbondduring theprecedingmonth. Hence, there isnoway toknowbeforehandhowthemarketwillreactintermsofliquidationtimeandpricetoatripartyrepoinvestor(aslenderto thebrokerdealer securedby theRMBS collateral)who seeks to sell $10millionof theRMBSbondquickly (uponadefaultof thebrokerdealer). Themarketmay treat this tripleBbondas ithasothersimilarlyratedRMBSbondsinthepriormonth,butassumptionsofthistypeadduncertainty.Eventhequotedprice inadvanceofanyattempt tosell thebond isanestimatebasedonmodelsand therecentperformance of theprevailing residentialhousingmarket rather than a representation of recent tradeactivity.Inshort,themoreilliquidthecollateral,thegreatertheuncertaintyofthesalvageablevalueofsuchcollateraltothetripartylender.3983See,e.g.,email fromLauraM.Vecchio,Lehman, toLoriBettinger,SEC,etal. (May7,2008) [LBEXWGM012803] (showingDresdner increasinghaircutonABS from110 to120duringstressperiod);seealsoemail fromAmberishRatanghayra,Lehman, to JohnFeraca,Lehman,etal. (Mar.24,2008) [LBEXDOCID 046250] (Danske has requested an increase in haircut to 15%.). CraigDelany, amanaging

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available toabrokerdealer,whichmay force thebrokerdealer to sell collateral, find

otherfundingarrangements(suchasissuanceofunsecureddebt),oracceptareduction

inexcessliquidity.

Astripartyrepoagenttobrokerdealers,JPMorganwaseffectivelytheirintraday

tripartylender.WhenJPMorganpaidcashtothetripartyinvestorsinthemorningand

receivedcollateralintobrokerdealeraccounts(whichsecureditscashadvance),itbore

asimilarriskforthedurationofthebusinessdaythattripartylendersboreovernight.

IfabrokerdealersuchasLBIdefaultedduring theday, JPMorganwouldhave tosell

thesecuritiesitwasholdingascollateraltorecoupitsmorningcashadvance.

JPMorgan used a measurement for triparty and all other clearing exposure

knownasNetFreeEquity(NFE).Initssimplestform,NFEwasthemarketvalueof

Lehman securities pledged to JPMorgan plus any unsecured credit line JPMorgan

extendedtoLehmanminuscashadvancedbyJPMorgantoLehman.3984AnNFEvalue

greater than zero indicated that Lehman had not depleted its available credit with

JPMorgan. The NFE methodology also enabled JPMorgan to monitor its exposure

positionatalltimesduringthetradingdayandtherebyevaluatecollateralsubstitutions

directoratJPMorgansInvestmentBank,however,statedthat,intripartyrepos,typicallyinvestorslookto the counterparty (i.e.,brokerdealer) first and the collateral secondwhen settinghaircuts. Inotherwords,ahaircutmaynotbesufficientforaninvestorifithasseriousconcernsabouttheviabilityofitscounterparty.ExaminersInterviewofCraigM.Delany,Sept.9,2009,atp.13.3984ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atp.5.

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byLehman thatmightproduceundesired credit exposures.3985 If a tradewouldput

LehmansNFE below zero, the tradewould not bepermitted.3986 Through February

2008, JPMorgan gave full value to the securities pledged by Lehman in the NFE

calculation and did not require a haircut for its effective intraday triparty lending.

Consequently,throughFebruary2008,JPMorgandidnotrequirethatLehmanpostthe

marginrequiredbyinvestorsovernighttoJPMorganduringtheday.3987

DanFleming,LehmanGlobalHeadforCashandCollateralManagement,stated

thatLehmanobjectedtotheopaquenatureofJPMorgansNFEformulaandthatthere

oftenwasdisagreementbetweenLehmanand JPMorgan regardingNFE figures,with

Lehman struggling to find causal connections between drops inNFE and Lehmans

actions.3988 InFebruary 2008,Lehman requested that JPMorganprovide adailyNFE

snapshotinordertoallowLehmantoobtainbetterestimatesofitsposition.3989

(c) JPMorganRestructuresItsApproachtoTripartyRisk

In early 2008, the Federal Reserve Bank of New York (FRBNY) urged

JPMorgan to focuson therisksassociatedwith its intradayexposure tobrokerdealer

3985Id.atp.6.3986Id.atp.5;ExaminersInterviewofDanielJ.Fleming,Apr.22,2009,atp.3.3987ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atp.4.3988Examiners InterviewofDaniel J.Fleming,Apr.22,2009,atp.4;Examiners InterviewofCraigL.Jones,Sept.28,2009,atp.5.TonuccidescribedNFEasnotatransparentthing.ExaminersInterviewofPaoloR.Tonucci,Sept.16,2009,atp.6.3989Email fromCraig L. Jones, Lehman, toDaniel J. Fleming, Lehman (Feb. 26, 2008) [LBEXDOCID280175].

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clients.3990 In February 2008, JPMorgans Ricardo Chiavenato, a risk manager at

JPMorgan,wastaskedwithreviewingJPMorganstripartybusiness.3991Afteranalyzing

the market and increasing risks faced by clearing banks handling triparty repo

transactions,ChiavenatorecommendedthatJPMorganretaintripartyinvestormargin

the samemargin triparty investors required.3992 JPMorgandecided to implement the

marginrequirementsgradually.3993

JPMorgan incorporated itsnewmargin requirements into theNFE calculation.

Under itsnewapproach, JPMorgan reduced thevalue itassigned tosecurities itheld

commensuratewiththemarginrequirementsofthetripartyinvestors.3994Forexample,

ifLehmanhadborrowed$19million inanovernighttripartyrepofromaninvestor,it

mighthavepledged $20million (marketvalue)of corporatebondsas collateral (ata

haircut of 5percent). Before February 2008, JPMorgan required no tripartyinvestor

margin,soJPMorganspaymentof$19millioncashinthemorningtorepaythelender

(acashadvanceforthebenefitofLehman)inconcertwiththereceiptofthe$20million

3990See email from JanetBirney,Lehman, toDaniel J. Fleming,Lehman, et al. (Feb. 26, 2008) [LBEXDOCID280175].3991ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atpp.3,5.3992Id.atp.5.ThisrecommendationthatclearingbanksretainmarginagainstcashadvancesisconsistentwithaDecember2005reportofaworkinggroupcommissionedbytheFederalReserveBoardtostudyNewBank feasibility. A portion of this report dealt with prudent riskmanagement practices andincludedtherequirementthatclientspostmargintocollateralizetheclearingbanksriskexposure. SeeNewBankWorkingGroupReport,atp.17.3993EmailfromJanetBirney,Lehman,toDanielJ.Fleming,Lehman,etal.(Feb.26,2008)[LBEXDOCID280175].3994Id.;ExaminersInterviewofRicardoS.Chiavenato,Sept.21,2009,atp.6.

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ofsecuritieswouldgiveLehmananimmediate$1millionsurplusofNFE.3995Lehman

could thenuse this surplus bywithdrawing cash or securities or by executing other

tradesthatmightdrawdownthesurplus.

UponfullimplementationofJPMorgansplantoretaintripartyinvestormargin,

the change to theNFE calculationwould be to treat the $20millionmarketvalue of