September 15, 2008

This Could Get Ugly: Lehman’s Bankruptcy and Systemic Risk

Late last night, Lehman Brothers announced that it intends to file for Chapter 11 bankruptcy protection of the parent company, Lehman Brothers Holdings, capping off a tumultuous weekend of negotiations to sell the bank, which ultimately failed when the government decided that it would not back-stop any deal. Apparently, the concept of “too big to fail” has its limits. It seemed only a matter of time for the government bailouts to reach an end, and unfortunately for one of the most storied investment banks on Wall Street, that time is now. If Lehman is liquidated as many seem to expect, it is truly a tragic end for an institution known for being capable of surviving many ups and downs over its 158-year history.

As noted in this WSJ article, the two leading contenders to save Lehman, Barclays and Bank of America, walked away when the government refused to provide financial support to any potential buyers. Bank of America didn’t walk away empty-handed though, picking up Merrill Lynch along the way for $50 billion – apparently Merrill Lynch saw the handwriting on the wall that it could be next. Meanwhile, AIG is struggling to raise capital as it faces a possible downgrade of its credit rating, taking the unprecedented step of trying to convince the Federal Reserve to lend it some of the $40 billion that it needs to survive.

Lehman’s imminent bankruptcy filing looked relatively certain by Sunday afternoon as no willing buyers emerged. The firm’s huge exposure in the credit derivatives market and in other derivatives led the ISDA to announce a “netting trading session” between 2 p.m. and 6 p.m. on Sunday. Under the protocol for the session, firms could seek other counterparties to take Lehman’s place on outstanding contracts as a means of beginning to unwind Lehman’s positions. But it appears that few contracts were offset through this process, and trades were conditioned on Lehman filing for bankruptcy before 11:59 pm New York time on Sunday. The SEC put out a statement last night, just a few hours before Lehman’s announcement, noting that it was taking steps to protect customers of Lehman’s broker-dealer subsidiaries. And the Federal Reserve announced some initiatives designed to increase liquidity, including allowing lower-rated collateral to be pledged to the Fed for borrowings.

While Lehman’s failure will certainly have an effect on the already jittery equity markets, I think that the big concern will be the extent to which the Lehman bankruptcy will damage the credit and derivatives markets, where Lehman’s exposures were huge. Presumably those same reasons that drove the government to push Bear Stearns into its shotgun wedding with JP Morgan are present with Lehman, including the potential for a shock to the credit default swap market of unprecedented proportions, as traders seek to unwind trades with Lehman in an environment where pricing may be difficult and where few counterparties may be willing (or able) to participate. Further, a back-to-back failure of AIG or another massive financial institution may have become more likely, now that it has been made abundantly clear that the government is not going to stand behind every deal. With many other Wall Street firms, commercial banks and presumably hedge funds facing capital crunches of their own, the large-scale orderly unwinding of Lehman’s positions that the Federal Reserve and Treasury appear to expect may prove difficult to pull off, raising the level of systemic risk in the financial system to what I think are unprecedented heights.

Now Effective: Changes to Form D

The amendments to Form D that the SEC adopted earlier this year are now effective, although electronic filing will remain optional until March 16, 2009. On Friday, the Corp Fin Staff put out a Small Business Compliance Guide on filing and amending a Form D, highlighting in particular the specific circumstances for when an amendment to Form D is – and is not – necessary. Under revised Rule 503 and the Form D instructions effective today, amendments to the Form D notice are required in the following three instances only:

(1) to correct a material mistake of fact or error in the previously filed notice (as soon as practicable after discovery of the mistake or error);

(2) to reflect a change in the information provided in a previously filed notice (as soon as practicable after the change), except that no amendment is required to reflect a change that occurs after the offering terminates or a change that occurs solely in the following information:

– the address or relationship to the issuer of a related person identified in response to Item 3 of Form D;
– an issuer’s revenues or aggregate net asset value;
– the minimum investment amount, if the change is an increase, or if the change, together with all other changes in that amount since the previously filed notice, does not result in a decrease of more than 10%;
– any address or state(s) of solicitation for a person receiving sales compensation;
– the total offering amount, if the change is a decrease, or if the change, together with all other changes in that amount since the previously filed notice, does not result in an increase of more than 10%;
– the amount of securities sold in the offering or the amount remaining to be sold;
– the number of non-accredited investors who have invested in the offering, as long as the change does not increase the number to more than 35;
– the total number of investors who have invested in the offering;
– the amount of sales commissions, finders’ fees or use of proceeds for payments to executive officers, directors or promoters, if the change is a decrease, or if the change, together with all other changes in that amount since the previously filed notice, does not result in an increase of more than 10%; and

(3) beginning March 16, 2009, annually, on or before the first anniversary of the filing of the Form D or the filing of the most recent amendment, if the offering is continuing at that time.

If you wish to try your hand at electronic filing over the next six months, it is necessary to first obtain a CIK and CCC number (otherwise known as a log in and password) in order to access the EDGAR system. If you choose to file in paper until electronic filing is mandatory, you can either use the old Form D, which has been revised slightly and is called “Temporary Form D,” or you can use the new Form D that contains all of changes to the information requirements adopted earlier this year.

The Staff has also provided this additional guidance on the Form D filing process.

– Dave Lynn