Tag: Lehman

Money Market Fund Reform Makes My Head Hurt

100 hundred dollar bill

One of the critical moments of the 2008 financial crisis was caused by Lehman Brothers and its effect on the Reserve Fund, a money market fund. The fund had a significant amount of short-term debt issued by Lehman. Enough that the fund had to ‘break the buck.’ Now even “cash” was not a safe place to invest capital.

The Securities and Exchange Commission has been looking at this problem for years and issued final rules yesterday in an attempt to fix the problem.

The first fix is removing the fiction that a money market fund has a share price of $1. Money market funds had an exemption from valuation and could keep a stable net asset value. To appease retail investors, the change only affects institutional class funds.

Second, the SEC granted money market funds the right to impose redemption restrictions. The fund can charge a liquidity fee or suspend redemptions if the fund encounters liquidity problems. The SEC wants to stop any potential bank run like events on money market funds.

I have to admit that I have not finished reading the rule. It’s an 869 page behemoth of a regulatory release.

I’m trying to figure out the implications for cash management operations. A company needs to hold onto a stockpile of cash to help fund future operations. Bank deposits are only insured up to $250,000. Any stockpile bigger than $250,000 was a risk if the bank failed. We have been in a period where bank failure was at the forefront of everyone’s mind.

Dodd-Frank alleviated that concern by granting unlimited protection for non-interest bearing checking accounts. That’s any easy choice. Interest rates are excruciating low for cash deposits. (Fantastically low if you are borrowing.)

That unlimited protection expired at the end of 2012. It was easy to get diversification and reduce exposure to bank failure by putting the cash in a money market fund. There is little interest earned, but the diversification reduces risk.

There are other alternatives to money market funds, but they take more resources to manage, cost more, or carry more risk. In this low interest rate environment there is little gain in trying to more actively manage the cash. Any interest rate gains will be chewed up by transaction costs.

The SEC has made the lives of corporate treasury groups more difficult. I don’t think they feel any safer and I don’t think the financial markets are any safer.

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Revoking a Subscription Agreement

Private equity funds investors sign a subscription agreement, promising to deliver cash when the fund makes a capital call. In a recent Delaware case, investors sought to revoke their subscription agreements and recover their capital contribution. They were investors in a Lehman Brothers sponsored investment fund.

In 2007 the three plaintiffs became limited partners in Lehman Brothers Merchant Banking Partners IV L.P. After Lehman declared bankruptcy, the the Fund’s management team bought out Lehman, took over the Fund’s general partner and investment advisor, and changed the Fund’s name to Trilantic Capital Partners IV, L.P.

Among the other investors in the fund was Lehman Brothers itself. The company had made a $250 million capital commitment. The fund itself was not part of the Lehman bankruptcy estate, but the general partner’s interest, the investment advisor and the $250 capital commitment were involved.

The plaintiffs told the fund they would not make any capital calls after they heard of the Lehman bankruptcy. That was probably a sensible position to take initially.

But the fund emerged from the Lehman bankruptcy proceedings. The existing fund management team would stay in place. A third party capital source funded their purchase of Lehman’s general partner interest and investment adviser. The investor also agreed to assume the unfunded and uncommitted portion of the Lehman’s capital commitment. The management team offered all the limited partners a chance to reduce their capital commitments. Ultimately, the fund reduced in size from $3.3 billion to $2.6 billion.

These three plaintiffs sought a rescission based on three counts: supervening frustration, mutual mistake and violations of the Texas Securities Act.

Supervening frustration

“The doctrine of supervening frustration can be invoked ‘[w]here, after a contract is made, a party’s principal purpose is substantially frustrated without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made.’ … The doctrine does not apply if the supervening events were “reasonably foreseeable, and could (and should) have been anticipated by the parties” at the time of contracting.”

The limited partnership agreement contemplated that Lehman might transfer its general partnership interest and the fund would continue to operate. The LP Agreement also contemplated the potential bankruptcy of Lehman.

This claim did not even come close to working.

Mutual mistake

“Under this doctrine, a party can rescind an agreement if (i) both parties were mistaken as to a basic assumption underlying the agreement; (ii) the mistake materially affects the agreed-upon exchange of performances; and (iii) the party adversely affected did not assume the risk of the mistake.”

The plaintiffs claimed they were mistaken about Lehman’s financial condition and the continued presence of Lehman was one of their basic assumptions. The LP agreement contemplated the removal of Lehman. The private placement memorandum made not representations about Lehman’s financial health. The subscription agreement stated that the investors were not relying on any other representations.

This claim did not even come close to working.

Texas Securities Act

“This statute prohibits the soliciting of an investment ‘by means of an untrue statement of a material fact or an omission to state a material fact necessary in order to make the statements made, in the light of the circumstances in which they are made, not misleading.’”

The plaintiffs claimed that Lehman failed to disclose its financial instability. Given this instability, its unlikely Lehman could continue its sponsorship of the fund.

But the false statements were in Lehman’s public filings, not the fund documents. They failed to show that the subscription agreement, the limited partnership agreement or the PPM contained any representation about Lehman’s financial health. They merely pointed to general statements in the PPM about how the fund would benefit in the future from its affiliation with Lehman.

The plaintiffs also failed to allege that the fund knew its representations about Lehman were “false when made.” It failed the scienter requirement under the Texas Securities Act.

It’s tough for a fund to get in a fight with its investors. Here, it was the investors who filed suit. it was probably sensible to resist making capital calls when Lehman filed bankruptcy. Once the fund survived and was spun out with the existing management team, the investors should have re-thought their position.

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What Went Wrong at Lehman?

DeMuro

Complinet interviewed David DeMuro, head of compliance at Lehman Brothers during its last days in 2008. It should come as no surprise that the warning signs were there for everyone to see but in the midst of a bubble, employees were too scared to raise their hand because there was still money to be made.

DeMuro did not blame the regulators, saying they were looking closely at the working of the investment bank. He did lay some blame on the Federal Reserve Bank: “The role of the Fed is to take away the punch bowl just as the party gets going. However, in recent times the Fed has chosen to add just a few more shots of vodka to the punch bowl to keep the party going.”

He did peg lots of blame on an over-reliance on financial risk models. There was also an “almost religious belief” in the veracity of the models.

See the webcast yourself (13 minutes): Complinet Interviews David Demuro

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