On December 21 2011 the Court of Appeal handed down judgment in Pearson v Lehman Brothers Finance SA.(1) The case highlights the complexity of legal issues that may arise on the collapse of an investment banking group and the unwinding of intra-group structures that were established with the aim of benefiting the group in terms of efficiency and economy. Although the court upheld the first instance decision, it did so on slightly different grounds.

The economic climate remains worrying, with financial commentators coining the phrase 'zombie banks' for banks within the Eurozone that are borrowing from the European Central Bank overnight. It is important that investment banks and creditors alike understand that when the music stops, it may be difficult to establish which entity within an investment bank holds the legal and beneficial title to various securities.


The dispute between Lehman Brothers International (Europe) (in administration) (LBIE) and Lehman Brothers Finance SA (LBF) related to the beneficial ownership of securities which LBIE had acquired from 'the street' (ie, from third parties) for the account of LBF.

Since the 1990s the Lehman Brothers worldwide group had operated a global settlements practice whereby all securities were settled on acquisition into one group company in each main time zone. This was termed the 'hub company', which acted on its own behalf and on behalf of its affiliates, and from which securities were transferred on sale back to the street. The hub company - LBIE in Europe - accounted to the relevant affiliate for any capital benefit or income received on resale to the street, but not for any benefit obtained through short-term use of the securities.

This practice of using hub companies had many benefits for the Lehman Brothers group in terms of efficiency and economy. However, the scale and nature of the practice also presented possible problems, most notably in relation to capital adequacy requirements. The hub company would face a much higher regulatory capital charge if it did not hold the beneficial as well as the legal title to the securities.

Accordingly, a Lehman Brothers working group known as Regulation and Administration of Safe Custody and Global Settlement (nicknamed 'Rascals') established the 'Rascals' processes, which were intended to address these perceived problems.

When LBIE acquired a security from the street on behalf of an affiliate, the effect was to confer beneficial title on the affiliate. A primary purpose of the Rascals processes was to ensure that the beneficial title then passed from the affiliate back to LBIE. This was intended to be achieved by way of a stream of daily repos (ie, sale and repurchase contracts) or by way of an open-ended stock loan. However, payment for the first repo (or collateral for the stock loan) was effected not by way of cash settlement but by a book entry, coupled with offset against the affiliate's unsecured debt to LBIE for the original acquisition price of the security from the street. Subsequent purchases and repurchases under the 'on' and 'off' legs of the repos were similarly intended to be achieved by a series of successive offsets.

The issue in the proceedings was whether LBIE or LBF held beneficial title to the securities when Lehman Brothers collapsed on September 15 2008. LBIE and LBF - which is a Swiss company - each have different creditors, and on Lehman Brothers' insolvency this became a highly significant issue.

Beneficial title
LBIE argued that even if beneficial title moved to the affiliate upon acquisition, contrary to its primary contention, it came back to LBIE under the first repo and stayed with LBIE continuously until resale to the street. For its part, LBF claimed beneficial title to all such securities, as they were acquired for its account.

The Court of Appeal agreed with the judge's conclusion at first instance that upon acquisition, LBIE held the rights on trust and a beneficial title passed to the affiliate. The next issue was whether LBIE reacquired beneficial title to the securities under the 'on' leg of the repo. Under the terms of the repo contract, title passed on payment, so that LBIE had to show that it paid the price.

At first instance, the judge held that LBIE had paid the price under the repo contract by way of offsets of the debt owed by LBF in respect of the acquisition price. However, the Court of Appeal held that these were not true the offsets (as the ledgers did not show any set-off of a credit against a debit), and that an offset is not enough to evidence payment.

The Court of Appeal therefore held that the on-leg repos were ineffective to transfer the beneficial title to the securities to LBIE from LBF on the basis of payment by offset.

Estoppel by convention
A summary of the principles relevant to establishing an estoppel by convention is set out in HMRC v Benchdollar Ltd:(2)

"i) It is not enough that the common assumption upon which the estoppel is based is merely understood by the parties in the same way. It must be expressly shared between them.

ii) The expression of the common assumption by the party alleged to be estopped must be such that he may properly be said to have assumed some element of responsibility for it, in the sense of conveying to the other party an understanding that he expected the other party to rely upon it.

iii) The person alleging the estoppel must in fact have relied upon the common assumption, to a sufficient extent, rather than merely upon his own independent view of the matter.

iv) That reliance must have occurred in connection with some subsequent mutual dealing between the parties.

v) Some detriment must thereby have been suffered by the person alleging the estoppel, or benefit thereby have been conferred upon the person alleged to be estopped, sufficient to make it unjust or unconscionable for the latter to assert the true legal (or factual) position."


Applying the above principles, the Court of Appeal held that LBF was estopped by convention from contending that LBIE did not satisfy its liability to LBF for the price of the 'on' leg.

For many years LBF had obtained the benefit of LBIE's acquiring securities from the street for its book without paying cash upfront, on the assumption that under the Rascals process the beneficial title was with LBIE. It was held that it would be unconscionable for LBF to resile from that convention, which was sufficiently shared between LBIE and LBF and without which LBIE would have been unable to meet its capital adequacy and regulatory obligations.


During opening submissions at first instance, the judge was told that he would have to make the best sense of what was, in some respects, a mess. The Court of Appeal was also clearly unimpressed by the structure that Lehman Brothers had put in place.

Indeed, the Court of Appeal considered that the capital adequacy problem could have been solved in a much simpler way if Lehman Brothers had adopted a different approach under which the common objective intention, supported by the relevant paperwork, was that LBIE retained the absolute title to all relevant securities throughout, accounting to affiliates only in contract for the relevant economic benefits, and leaving the affiliates with no beneficial entitlement to the securities at any stage.

Given the current market turmoil, it is not unthinkable that another investment bank may collapse. It is unlikely that Lehman Brothers was alone in having less than perfect settlement processes in place. Investment banks should revisit their settlement processes in light of this decision, and investors would do well to ensure that they identify their counterparty exactly.

For further information on this topic please contact Andy McGregor at RPC by telephone (+44 20 3060 6000), fax (+44 20 3060 7000) or email ([email protected]).


(1) [2011] EWHC Civ 1544, Lord Justices Lloyd, Patten and Tomlinson.

(2) [2009] EWHC 1310 (Ch).