Quinn Emanuel Urquhart & Sullivan, LLP

Ten years ago, Lehman Brothers filed for bankruptcy. The collapse of the legendary bank — a fixture of the U.S. financial system dating to the 1850s — reverberated around the world, unleashing a financial crisis of a magnitude not seen since 1929. Credit markets froze, global trade choked, asset values evaporated and jobs vanished.

The firm has spent nearly 10 years since then fighting in court for the rights of Lehman’s creditors, leading the charge against the so-called “big bank” counterparties. This arduous legal journey, wending through tens of millions of documents, hundreds of depositions, and one of the longest trials in the history of the U.S. Bankruptcy Court for the Southern District of New York has allowed Lehman’s estate to recover more than $6 billion. It has also yielded insights into weaknesses in our financial system and bankruptcy laws that could allow such catastrophic losses to happen again.

The immediate cause of Lehman’s death was a rapid loss of liquidity capped by extraordinary demands for cash collateral by other banks. As Bryan Marsal, the restructuring expert who oversaw Lehman post-bankruptcy, explained, Lehman “was solvent. It just ran out of liquidity.” Despite being the fourth largest investment bank in the world, Lehman’s life literally depended on the mercy of its clearing banks, the conduits of short-term liquidity. None more so than JPMorgan, which controlled Lehman’s tri-party repo, the repurchase agreements akin to collateralized loans essential to broker-dealers’ financing their inventory of securities.

The run on Lehman came in various forms, including money market funds scaling back their overnight repo investments and hedge funds transferring out their prime brokerage balances. Some of the big banks sought to improve their position vis-a-vis Lehman on the eve of bankruptcy by obtaining additional collateral, but the players’ varying degrees of success were a direct function of their relative leverage. Citibank, for example, used its essential role in clearing Lehman’s foreign exchange transactions to extract a $2 billion cash deposit in June 2008. Firms who were merely Lehman’s trading counterparties enjoyed more limited success. During the week of Sept. 8, 2008, as rumors swirled that counterparties were reluctant to trade with Lehman, Lehman provided $285 million to Goldman Sachs and $200 million to Deutsche Bank as extra collateral for their derivatives trades. No such luck for Lehman bondholders and other Main Street investors.

The largest single drain on Lehman’s liquidity came ultimately from JPMorgan itself. In the week prior to Lehman’s bankruptcy, JPMorgan used the explicit threat of ceasing to clear Lehman’s tri-party repo to extract $8.6 billion in cash from Lehman. This left Lehman’s European broker-dealer with a projected cash shortfall of $4.5 billion, forcing Lehman to file for bankruptcy in the early morning hours of Sept. 15, 2008.

Rather than step in as lender of last resort, the Federal Reserve pronounced Lehman just small enough to fail, offering a lesson in moral hazard that lasted 24 hours until the Fed found it had $85 billion with which to bail out AIG.

To halt the run, the market needed assurance from the Fed that JPMorgan and Lehman’s tri-party repo investors would not pull the plug on Lehman’s financing. The Fed had begun participating in the tri-party repo market in March 2008. At first, the Fed accepted only the most liquid and easily valued types of securities. But on Sunday, Sept. 14, 2008, it offered expanded repo financing to every dealer except one — Lehman. Not only did the Fed have the authority and ability to extend this liquidity to Lehman using its emergency lending authority under Section 13(3) of the Federal Reserve Act, but it actually did so immediately after Lehman’s bankruptcy, which allowed Lehman’s broker-dealer business to continue operating long enough to be purchased by Barclays.

Had the Fed offered Lehman this liquidity lifeline just one day earlier, Lehman would have survived long enough to be rescued when the real Wall Street bailout came in the form of programs like the Troubled Asset Relief Program, or TARP, which Congress passed three weeks later. Instead, Lehman plunged into a bankruptcy freefall that destroyed billions of dollars in value — value that belonged to Main Street creditors and shareholders — and turned a credit crisis into a global conflagration.

For Lehman’s creditors, a sudden unplanned bankruptcy filing proved extremely costly. Untold value was lost in translation as the once-integrated global enterprise was Balkanized into multiple insolvency proceedings in different jurisdictions and once valuable assets were broken apart and sold at fire-sale prices. Bankruptcy fees, expenses and interest alone reached into the billions. Lehman’s U.S. broker-dealer business was sold to Barclays in such a mad rush that an extra $5 billion of securities were mistakenly conveyed as margin to cover overnight loans, a loss to the estate that the bankruptcy judge chalked up to the “fog of Lehman.” Lehman suffered a deluge of inflated bankruptcy claims, particularly for derivatives trades where counterparties tried to claim losses bearing no resemblance to the actual value of their trades.

Bankers and regulators were not the lone culprits. Exacerbating the crisis was a legal regime that rewarded the base instincts of fear and greed. The Bankruptcy Code provides a “safe harbor” for securities transactions, emboldening firms to make collateral grabs and, perversely, hasten the collapse of a firm like Lehman. Ordinarily in a bankruptcy, if the debtor pays off a debt on the eve of filing, that preferential payment can be clawed back. But Bankruptcy Code Section 546(e) exempts securities transactions from preference liability, giving financial institutions an incentive to demand that a failing borrower repay its loans prior to a bankruptcy filing. As former Bankruptcy Judge James Peck explained in a later case, 546(e) protects transactions “that the law generally would seek to discourage (ganging up on a vulnerable borrower to obtain clearly preferential treatment in the months leading up to a bankruptcy).” Consequently, once there’s a hint of trouble, financial institutions have every incentive to accelerate the downfall by ceasing to lend and demanding payment — precisely what happened to Lehman.

Post-bankruptcy, the legal regime allowed for further abuse of the Lehman estate. The ISDA (International Swaps and Derivatives Association) master agreement gives counterparties the chance to inflate claims and force the bankrupt party to pursue them in court. As one Wall Street trader preyed on a bankrupt Lehman, he quipped, “let them come sue us.” With 6,000 counterparties asserting claims arising from over 1 million derivative trades, Lehman was forced to expend vast amounts of time and resources pursuing lawsuits, mediations and settlements to resolve inflated derivatives claims. As long as faulty rules like these persist, and as long as a handful of colossal firms serving many different functions dominate our financial system, the law of the jungle that toppled Lehman will surely govern the next financial crisis.

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