According to some conspiracy theories, bad blood with Goldman Sachs (NYSE:GS) prevented Lehman Brothers from being bailed out during the financial crisis. Ironically, a small group of Goldman Sachs bondholders is now facing onerous claims from the bankrupt estate of Lehman Brothers. JBK is a small NYSE traded bond trust that holds Goldman Sachs bonds and passes through the bond interest as dividends. Unfortunately, JBK shareholders have good reason to fear these attacks from the corpse of Lehman Brothers.
What is JBK?
Before the financial crisis, Lehman Brothers was once a great investment bank. Lehman Asset Backed Securities was one of their many successful business units. Lehman ABS created what are known as structured products. Back in 2004, many investors were concerned with the threat of rising interest rates. To meet this demand, JBK was created as a variable interest rate issue.
JBK is a par $25 issue that holds Goldman Sachs debt and passes through the interest to JBK shareholders as dividend payments. Variable rate quarterly dividends were initially paid at a rate of LIBOR plus 0.75% subject to a 3.5% floor. See Quantumonline.com or prospectus for additional details. Note that Lehman ABS is now a unit of Barclay's PLC (NYSE:BCS). Therefore, Barclay's is now the trustee for JBK.
How was fixed interest rate debt used to create an adjustable rate issue?
JBK holds the Goldman Sachs Cap I 6.345% trust preferred debt issue (CUSIP 38143VAA7) maturing on 2/15/2034. How did this fixed interest rate debt with semi-annual interest payments become a variable rate issue that paid dividends quarterly? This was accomplished through the magic of derivatives. Lehman Brothers and the trust agreed to exchange the fixed rate interest payments from the 6.345% Goldman Sachs trust preferred debt for variable rate quarterly payments.
How did JBK become a fixed rate issue?
As shown by the Yahoo Finance dividend history, JBK paid quarterly adjustable rate dividends from 5/12/2004 through 8/12/2008. On 2/11/2009, JBK began paying fixed semi-annual dividends of 79.3 cents. When Lehman Brothers went bankrupt, the JBK trustee declared that the variable rate swap agreement was now void. The trust began passing through the fixed rate semi-annual Goldman Sachs interest payments as fixed semi-annual dividend payments.
JBK dividends were higher as a fixed rate issue
The conversion of JBK from an adjustable rate issue to a fixed rate issue was extremely favorable for JBK shareholders. LIBOR interest rates have been at historical lows since the financial crisis. JBK shareholders were fortunate to receive fixed 6.345% dividends rather than 3.5% dividends (minimum allowed when LIBOR plus 0.75% falls below 3.5%). Over the last 7 years, the excess dividends received by JBK holders as a fixed rate issue have been:
$25 * (6.345% - 3.5% ) * 7 years = $4.98 per share
Lehman Brothers seeks damages
As noted above, JBK holders received an extra $4.98/share over the last 7 years due to the apparent termination of the swap agreement with Lehman Brothers. As summarized in JBK's 6/2/2016 SEC filing, Lehman Brothers does not agree that the swap agreement was properly terminated. They want to claw the money back and are taking legal action. Lehman seeks past damages as well as future payments under the swap agreement. As stated in JBK's 2/26/2016 SEC filing:
"On November 30, 2015, the Trustee sent a notice (the "Notice") to holders of Trust Certificates stating that LBHI, as Plan administrator on behalf of Lehman Brothers Special Financing Inc. ("LBSF"), initiated a mediation proceeding with the Trust pursuant to an order of the Bankruptcy Court. The mediation is related to a complaint filed by LBSF against the Trust on September 18, 2015 arising out of a swap transaction between LBSF and the Trust (the "Swap Transaction"). The Notice states that the complaint "seeks a determination, among other things, that LBSF is entitled to a Termination Payment [as defined in the Series Supplement] with respect to any Termination of the Swap Transaction, or alternatively that it is entitled to the Fixed Payments it alleges are due by the Trust." In the event that an Early Termination Payment or judgment is payable by the Trust to LBSF, the payment may need to be satisfied by the distribution to LBSF of a portion of the underlying securities or the proceeds thereof".
How might these damages impact JBK?
There are $1 million shares of JBK outstanding. Suppose that JBK was awarded $5/share in damages ($5 million) based on the swap payments they missed over the last 7 years. The JBK trustee would be forced to sell $5 million in collateral (approximately 1/5th of the GS bonds held in trust) to pay this claim. Instead of being a par $25 issue, JBK would effectively become a par $20 issue. The dividend payments and payment at maturity would be reduced accordingly.
JBK must sell trust assets or reduce the dividend to pay legal fees
Barclay's is unwilling to spend any of its own money to defend JBK shareholders from these attacks by Lehman Brothers. The trustee wants to sell assets (some of the Goldman Sachs debt held in the trust) to pay the legal bills. This is noted in the 6/2/2016 SEC filing:
"The Petition requests that the Minnesota Court authorize the Trustee to use Trust assets to A. pay all fees and expenses including, without limitation, attorneys' fees, incurred by the Trustee to date in connection with an adversary proceeding filed by Lehman Brothers Special Financing Inc."
This author is not a lawyer and does not know how much these legal bills might amount to or how the case might be settled. JBK holds $25 million of bonds in trust. To take a wild guess, let's suppose that the legal bills amounted to $2.5 million. In that scenario, the par $25 trust would become a par $22.50 trust. Even if JBK won the case outright (no damages or future swap payments due to Lehman Brothers), JBK holders could still take a 10% hit to principal and dividends from the legal fees alone. Alternately, dividends (including the expected 8/15/2016 payment) could be reduced or eliminated by the trust to cover legal expenses.
Could JBK dividends be slashed going forward?
Suppose that the swap agreement with Lehman is reinstated going forward. The coupon of JBK would drop from the current 6.345% to the greater of 3.5% or (LIBOR + 0.75%). Note that this significant reduction in the dividend (unless LIBOR spikes higher) could be in addition to legal fees and past damages estimated above.
My Panick Value Research Report is focused on high yield preferred stocks and exchange-traded debt issues. I provide members with continued coverage of all of the high yield issues I write about here. I started out researching JBK hoping to write a positive article. Instead, I uncovered a legal horror story. This illustrates why reading SEC filings is an important part of the due diligence process. JBK faces risks from legal fees, damage claims and a possible dividend cut. Most income investors would rather face a zombie apocalypse than expose their portfolio to such ghoulish attacks. The 7.2% JBK dividend yield does not provide much protection against these potential nightmare scenarios. I expect the August dividend to be reduced or eliminated just to cover legal fees.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.