Restructuring Failed Financial Firms in Bankruptcy: Selling Lehman’s Derivatives Portfolio

By Mark J. Roe, Harvard Law School, and Stephen D. Adams, Ropes & Gray LLP

adams-stephen-200 Roe 124Lehman Brothers’ failure and bankruptcy led to the deepest part of the 2008 financial crisis. Yet, while Congress reformed financial regulation in hopes of avoiding another crisis, bankruptcy rules, such as those that governed Lehman’s failure, have persisted unchanged. When Lehman failed, it lost perhaps tens of billions of dollars of further value when its contracting counterparties terminated their financial contracts with Lehman.

Bankruptcy must be able to market salable parts of the failed institution’s financial contracts portfolio at other-than-fire-sale prices. Current law prevents this marketing, however. It allows only two polar choices: sell the entire portfolio intact (currently impossible in bankruptcy and only narrowly viable under Dodd-Frank) or allow for the liquidation of each contract, one-by-one (which worked poorly in Lehman). Bankruptcy needs authority, first, to preserve the failed firm’s overall portfolio value, and, second, to break up and sell along product lines a very large portfolio that is too large to sell intact.

Congress and the regulators favor bankruptcy for financial resolution. Yet, bankruptcy law has neither been fixed nor even updated here since the financial crisis. We here outline one critically needed fix: authorizing bankruptcy to break up a large derivatives portfolio by selling its constituent product lines, one-by-one, instead of a Lehman-style close-out of each contract, one-by-one.

This article is forthcoming in 32 Yale Journal on Regulation. A full draft of the article can be found here.

For related pieces discussing safe harbors, see here and here.