Free Fall: Lehman Enters Chapter 11

(9/16/08 Update Here)

In most endeavors, it's important to start off on the right foot.  I don't think you'd call the Lehman bankruptcy filing today one such start.  A well-planned bankruptcy case is orchestrated so that the early days of the case represent a seamless flow between the pre- and post-bankruptcy world.   Calpine's "first-day pleadings" (discussed at length here) reflected the kind of significant planning that would avoid a financial meltdown of the firm.

By contrast, Lehman Brothers Holdings, Inc.'s chapter 11 filing early this morning (docket here / petition here) shows that Lehman's executives must have hired Weil Gotshal as late as possible to avoid any hint to its employees or the market that bankruptcy was possible.  It played chicken, and lost.  Lehman filed only three motions to open the case, and none are substantive: 

  • this motion asks the Court to enforce the automatic stay provisions of Code Section 362 (and is in itself a curious motion since the law in the 2nd Circuit is that all actions in violation of the automatic stay are void, not voidable);
  • this motion asks the Court to extend the time to file required lists and schedules; and
  • this motion asks the Court to waive the requirement that a filing include a list of creditors. 

Like Drexel before it, only the holding company filed, so it will be "business as usual" for all of Lehman Holdings' subsidiaries, none of whose activities are directly subject to the protections of the automatic stay or the Bankruptcy Code and Court generally (SIPC confirmation here).

Maybe, in the end, preparation of a well-executed contingency plan wouldn't have mattered much since, in BAPCPA, Congress (as discussed at length here) amended or added various provisions to the Bankruptcy Code that enabled a nondebtor party–without limitation–to terminate, liquidate or accelerate its securities contracts, commodity contracts, forward contracts, repurchase agreements, swap agreements or master netting agreements with the debtor.  As noted in my previous post on BAPCPA's effectively excluding Wall Street's financial firms from the benefits of bankruptcy, Columbia Law professor Edward Morrison, with Columbia GSB economics legend Franklin Edwards, argued in a Winter 2005 article entitled Derivatives and the Bankruptcy Code: Why the Special Treatment? that BAPCPA's extension of the Code's protections for the financial services industry "to include a broader array of financial contracts, all in the name of reducing systemic risk ... is a mistake."  They argued that "[a] better, efficiency-based reason for treating derivatives contracts differently arises naturally from the economic theory underlying the automatic stay [i.e., derivative contracts are rarely needed to preserve a firm's going-concern surplus]."  Still, they warn (at pp.1, 4-5):

Equally important, the amendments limit judicial discretion to assess the economic substance of financial transactions, even those that resemble ordinary loans or that retire a debtor's outstanding debt or equity.  The reforms of 2005 direct judges to apply a formalistic inquiry based on industry custom: a financial transaction is a "swap," "repurchase transaction," or other protected transaction if it is treated as such in the relevant financial market.... 

Indeed, if anything is clear from the new Code, it is that judges are strongly discouraged from engaging in functional analysis of financial contracts.  The Code's protections encompass contracts or combinations of contracts that differ little in substance from unprotected transactions, such as secured loans.  They are protected because they are recognized in financial markets as financial contracts.  Any judicial effort to distinguish protected and unprotected contracts based on their "substance" is doomed to failure and can only generate significant uncertainty in the very markets the Code seeks to protect.  By relying on broad market definitions, the Act gets judges out of the (largely futile) business of second-guessing financial contracts.  Absent evidence of intent to defraud a debtor's creditors, which remains ground for denying protection to payments under a financial contract, the new role of judges is to apply industry custom to financial contracts in much the same way that they would apply custom to interpret a contract under the Uniform Commercial Code.

There are, however, downsides to treating derivatives contracts differently (creditors, for example, would like to disguise loans as derivatives contracts).  These downsides are probably not signficant, but they highlight the fragility of the Code's treatment of derivatives contracts, which should worry members of Congress as they consider arguments to expand the Code's exemptions for derivatives contracts.

Tensions in the financial markets on this morning are greater than I have ever seen in nearly 25 years of practice.  Guess we'll find out soon just how much of a mistake BAPCPA's changes were for the financial world. 

Good luck to all!

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The "free fall" image is taken from the "Free Fall" album by Lish, an Israeli band that, according to this reviewer, "has been focusing on extra polishing their unique blend of powerful, sweet and emotional progressive beats, which make wonders on the dance floor."  In other words, Disco 2.0 remains alive and well in Israel, in case you were worried.

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© Steve Jakubowski 2008

Written By:jake On September 15, 2008 10:12 AM

What's the possible rationale for not including the subs in the bankruptcy?

Written By:Lance On September 15, 2008 11:08 AM

I had the same question as Jake - why leave the subs out? Does the holding company actually have any assets besides the value of each of the subs (besides some possible office furniture if its not leased)?

Written By:Steve Jakubowski On September 15, 2008 2:45 PM

A simplistic answer is that Lehman Holdings is a company in the business of holding other companies. The liquidity crisis compelled it to file bankruptcy to prevent a "run on its subsidiaries" (who likely were pledged in one form or another to support various collateralized debt obligations). By filing at the holding company level, all actions to foreclose on Lehman's equity interests in these subsidiaries are stayed. Whether a local subsidiary needs to file will be tackled on a case-by-case basis down the road, but absent an emergency, why subject a going concern operation (like a brokerage, investment banking house, or mutual fund) to the whiplash of a bankruptcy, particularly given the draconian rules that allow non-debtor parties to close out derivative and forward contracts as soon as the company files? Meanwhile, the bankruptcy gives Holdings time to auction off its subsidiaries to the highest bidder in an orderly manner. The fact that those sales can be cleansed through the bankruptcy and be sold "free and clear" of claims and interests should maximize their already distressed values. Hope that helps.

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