“But as the collapse of Lehman Brothers showed, the Bankruptcy Code is not an effective tool for resolving the failure of a global financial services firm in times of severe economic stress.”
Treasury Secretary Timothy Geithner, Oct. 29, 2009
Since its origins as a response to debtors’ prisons, U.S. bankruptcy law has constantly evolved. The once-narrow system that was originally designed to primarily help merchants and businessmen (and women) has developed into today’s comprehensive legal system, which addresses issues from how a family car is to be valued to the sale of a multi-billion dollar company less than two months after filing for bankruptcy.
However, with the increasing complexity and riskiness of the business activities of large nonbank financial institutions (financial debtors), a new class of über-debtors[1] is now straining the Bankruptcy Code’s legal framework. With the problems highlighted by Secretary Geithner and exposed in the Lehman Brothers’ chapter 11 case, the time for new legislation to address the unusual and highly-contentious legal issues spawned by financial debtors is now. While Geithner has expressed concern over the current Code’s ability to address the wide range of legal, political and economic problems caused by the Lehman Brothers bankruptcy, he also clearly indicated in the same speech that bankruptcy would remain the dominant tool for addressing financial debtor failures.
This article does not propose any specific legislation to remedy a particular problem posed by financial-debtor bankruptcies. Instead, it discusses two areas where legislation could be beneficial in resolving difficulties that would likely arise in future Lehman-like cases.
The Automatic Stay? Avoidance Actions? What Are They?
As noted in two excellent overviews[2] of the special nature of a variety of complex financial contracts previously published in the ABI Journal, many of the most important financial transactions of financial debtors are not subject to any meaningful form of scrutiny by either the Bankruptcy Code or bankruptcy courts. Contracts such as securities contracts, commodities contracts, forward contracts, repurchase agreements, swap agreements and master netting agreements[3] (collectively, the protected contracts) have been exempted by Congress from normal bankruptcy procedures in order to prevent the ripple or domino effect that a financial debtor’s bankruptcy could have on the credit and capital markets.
However, while the protection of the world’s overall economy is a critical goal given both the ever-expanding reach of protected contracts into general business transactions and the increased presence of the financial debtors in the business world, a review of the current broad exemptions granted by Congress to protect these entities and contracts is in order. Such a legislative review should seek to enact a comprehensive revision of bankruptcy and related laws with the objective of increasing the efficiency, effectiveness and fairness of the Bankruptcy Code in dealing with complex financial debtors in the current economic climate.
Haste Makes (Something a Lot Worse than Waste) in the Lehman Brothers Holdings Inc. Sale
As noted by Prof. Stephen Lubben in his leading article[4] on the Lehman Brothers Holdings Inc. (LB) sale of its brokerage assets to Barclay’s Capital Inc., the Sept. 20, 2008, hearing on the approval of the Barclay’s sale motion was the single most important hearing in bankruptcy history. Indeed, the fate of the United States’ and the world’s financial, credit and stock markets depended on its outcome. The proposed sale to Barclay’s was ultimately approved by a court order, and the immediate crisis was averted (sale order).
However, less than one year later, on Sept. 15, 2009, LB filed a motion under Rule 60(b) of the Federal Rules of Civil Procedure (the Rule 60 motion) to modify the sale order, arguing that there was either (1) a horrible[5] series of mistakes, (2) a deliberate or accidental misrepresentation of facts to the court, (3) fraud in the court and/or (4) some combination of the above factors that was sufficient to permit the modification of the sale order to return several billion dollars to the LB bankruptcy estate.
The single largest identifiable transaction at issue in the Rule 60 motion involved the purported manipulation of the termination and liquidation of a repurchase agreement between Barclays and LB that allegedly resulted in a “$5 billion haircut”[6] to LB’s bankruptcy estate. While it is possible that this issue was merely one of many that could have slipped through the cracks due to the confusion and turmoil of the early days of the LB bankruptcy leading up to the approval of the Barclay’s sale, the fact that the Bankruptcy Code allowed parties under a repo agreement to engage in postpetition transactions with debtor assets greatly contributed to the extremely serious issues now being litigated in connection with the Rule 60 motion.
Conclusion
Experts such as Geithner and litigation such as the Rule 60(b) motion has identified the shortcomings of the Bankruptcy Code in dealing with financial debtors and protected contracts. A full review, by Congress and key financial regulators, of the treatment of both the financial debtors and protected contract is critical to addressing these problems and making sure that companies that are “too big to fail” will be able to comfortably “fit” into the confines of the Code for the final resolution of their problems.
Editor's note
On July 23, 2009, Congressman Spencer Bachus, the Ranking Republican on the House Financial Services Committee, and House Judiciary Committee ranking Republican Lamar Smith introduced legislation (H.R. 3310) to create a new chapter of the bankruptcy code to make it more efficient and better suited for resolving large non-bank financial institutions. The new chapter would facilitate coordination between regulators and the courts to ensure technical and specialized expertise is applied when dealing with these complex institutions. Bankruptcy judges would also have the power to stay claims by creditors and counterparties to prevent runs on troubled institutions. Any articles concerning this pending legislation, or any other bankruptcy-related legislation can be directed to Editor Jon Lieberman at jjl@lsrlaw.com.
1. As noted in bloomberg.com, the professional fees paid in the Lehman Brothers European bankruptcy totally approximates $363 million in the first year of the case, while the professional fees in the U.S. part of the bankruptcy proceeding headed more than $417 million in the same period.
2. White & Elwood, “Are You Sailing In Safe Harbors? An Overview of Various Bankruptcy Code Safe Harbor Protections,” 26 ABIJ 44 (December/January 2008); Redd, “Treatment of Securities and Derivatives Transactions in Bankruptcy, Part I,” 24 ABIJ 36 (August 2005).
3. See 11 U.S.C. §§101, 741 and 761.
4. Lubben, “The Sale of the Century and its Impact on Asset Securitization, Lehman Brothers,” 27 ABIJ 1 (December/January 2009)
5. The actual arguments raised by the debtor are something of a mystery, as the entire statement of facts of the Rule 60 motion is redacted. Except for the outline and certain arguments made in the argument section of the Rule 60 motion, there is no direct statement of the LB’s factual basis for this motion.
6. Rule 60(b) motion at p. 70.