Almost a decade after the global financial crisis, the fate of another $2 billion from the wreckage of Lehman Brothers Holdings Inc. is about to be determined.

The failed New York investment bank is seeking to recoup the cash from one of its old derivatives trading partners, Citigroup Inc. In a trial that started this week in Manhattan bankruptcy court, Lehman alleges Citigroup created “phantom transaction costs” in order to justify a bankruptcy claim that would allow it to keep $2 billion in cash Lehman had deposited on the trades.

Citigroup contends it did nothing wrong and used reasonable practices.

The trial opens a rare window into the frenzied weekend before Lehman’s bankruptcy filing on Sept. 15, 2008. Banks were supposed to use a Sunday trading session to mitigate damage to the financial system by reducing their exposure to the bank. Lehman, which first sued over the $2 billion in 2012, claims that Citigroup efficiently hedged its risks, but went on to inflate its claim by marking its books to its benefit.

The proceeding is being closely watched by the derivatives industry, which has been overhauling the way it manages counterparty risk. There are unresolved questions about whether the market’s shift to using central clearinghouses is effective, said Peter Niculescu, a partner at Capital Market Risk Advisors. The firm advises financial institutions and law firms on issues including the termination of derivatives agreements, and has represented around 15 parties with regards to their Lehman exposure, but not Citigroup.

Seeking Clarity

“Most banks are of the opinion that the non-defaulting counterparty is entitled to the replacement cost, whether or not they do in fact replace the position” Niculescu said, adding that there is hope the Lehman and Citigroup trial will provide clarity on that point.

Proceedings that began Tuesday, arising from the 2012 lawsuit, will decide whether Citigroup has to return any of the money. Lawyers and witnesses will delve into how the two financial behemoths behaved on the eve of a bankruptcy that helped throw the global financial system into disarray.

At the time of the bankruptcy, it and Citigroup had entered into more than 30,000 derivatives trades tied to an estimated $1.18 trillion of wagers on everything from interest rates to corporate and sovereign debt. Lehman’s bankruptcy gave Citigroup the right to terminate the agreements and determine its damages.


Lehman claims that in the days, and even months after its bankruptcy, Citigroup concocted an inflated claim, which it eventually filed in September 2009. Lawyers for Lehman said in court Wednesday that traders at Citigroup were instructed to stray from convention in valuing their positions. Instead of pricing trades at the mid-point of bid and offer prices, the bank marked the trades on one side or the other, depending on which was to their advantage.

“Citi cherry-picked the valuation curve,” said Andrew Rossman, a lawyer for Lehman, while showing a crowded courtroom slide after slide of charts and Citigroup derivatives trades.

Danielle Romero, a Citigroup spokeswoman, said Thursday that the bank “has always acted appropriately.”

“Citi will continue to vigorously pursue its right to recover the substantial damages it is owed as a result of Lehman’s breach of contract and will vigorously defend against Lehman’s attempts to limit those rights,” she said by email.

Testimony from some of Citigroup’s top bankers, including Carey Lathrop and Brian Archer, will shed the first light on the unwinding of Lehman trades and the management of such counterparty risk. Around a dozen other banks, including JPMorgan Chase & Co., have settled similar issues, leaving only a dispute over a $1 billion claim with Credit Suisse Group AG remaining.

One Night

Marc Pagano, who ran Citigroup’s emerging-markets business at the time and was involved in closing out some of his group’s trades, was asked in a phone conversation — a recording of which was played in court Wednesday — whether traders were supposed to mark their books under a different methodology than usual.

“Yeah, one night. One night only,” Pagano said in the call. “We only deviated one night.”

Pagano didn’t return a message seeking comment.

Citigroup says it used its best professional judgment to determine close-out amounts on the trades. The contracts, the bank said, were governed by International Swaps & Derivatives Association master agreements, which give the non-defaulting party — in this case Citigroup — the right to assess the close-out costs as long as it uses commercially reasonable procedures.

Citigroup disputes Lehman’s allegation that it replaced the trades quickly and efficiently. Instead, it “adopted a triage approach and executed blunt, first-order hedges” that usually only addressed part of its risk, according to Citigroup’s filings in the case.

The trial, before U.S. bankruptcy Judge Shelley Chapman, is expected to run until May 17, according to court papers. Lathrop is expected to testify Monday.

The adversary suit is Lehman Brothers Holdings Inc., et al v. Citibank N.A., 12-01044, U.S. Bankruptcy Court, Southern District of New York.