Lehman Decision Transmutes Structured Finance Investors into General Unsecured Creditors

Recently, in a case of first impression, the Honorable Judge Shelley Chapman, U.S. Bankruptcy Judge for the Southern District of New York, ruled that Lehman Brothers Holdings Inc. (“LBHI” and together with its affiliated debtors, the “Debtors”) cannot subordinate securities fraud claims filed by holders of mortgage-backed securities (“MBS”) under Bankruptcy Code Section 510(b) even though an LBHI affiliate and co-debtor, Structured Asset Securities Corporation (“SASCO”) was the depositor of, and considered the issuer for securities law purposes of, the MBS.

The ruling is very significant and, as discussed below, problematic. MBS represents just one type of structured finance vehicle. Diversified financial conglomerates issue enormous volumes of those and many other types as well, e.g., credit card receivables, auto loans, student loans, etc. The essence of a structured finance vehicle is that the sponsor engages in a “true sale” of financial assets to a special purpose vehicle, typically a trust, which acquires the financial assets and in exchange transfers to the sponsor certificates evidencing ownership interest in the trusts assets. The sponsor then sells the securities in the capital markets either through a public offering or private placement. The structure has clearly delineated characteristics on which all parties rely:

• the investors in the structured finance vehicle (“certificate holders”) have exclusive rights to the financial assets in the vehicle, to the exclusion of creditors of the sponsor and the sponsor’s affiliates;
• certificate holders have no recourse to the sponsor, the sponsor’s affiliate or any of their assets; with limited exceptions their recourse is to the financial assets in the pool. These limited exceptions involve breach of contract claims for breaches of representations and warranties as to the characteristics of the financial assets contributed to the pool. The proceeds of such claims would go directly into the pool and represent another type of financial asset available for distribution to certificate holders; and
• creditors of the sponsor and the sponsor’s affiliates have no recourse to assets in the pool, such assets having been sold.

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