Vol 11 (2014) - Issue 3

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Lessons from Lehman: Persistent Problems for Secured Lenders

Five years after the Lehman Brothers collapse, it is instructive to consider how our legal rules coped with the pressure. The Lehman collapse remains the largest bankruptcy in history. But what made this insolvency different was not just its size, but the unavoidable ripples which extended well beyond the Lehman group itself, and indeed well beyond its many contracting counterparties. Hundreds of hedge funds used Lehman Brothers as their prime broker and relied on the firm for financing. Their positions were frozen when Lehman Brothers entities went into Chapter 11 proceedings in the US and into administration in the UK. This in turn created systemic risk, resulting in a decline of almost USD 737 billion in collateral outstanding in the securities lending market. And even beyond that, there was an awareness that many of the contracts being litigated in the Lehman insolvency were standard form contracts used by thousands of parties internationally. Decisions of the courts would thus inevitably have wide-ranging consequences.
Crises often provide the impetus for change. That is as true in the legal arena as elsewhere. The law, if it is to work well, must keep pace with social and market developments. Incremental change is inevitably slow, often too slow, and a good crisis can prove vital in delivering the necessary catch up. But a crisis can also prompt responses which seem apt at the time, but which will not serve well in the future. Thus the aphorism that hard cases make bad law. The pragmatic solution which deals well with the crisis may not serve so well as a long term generic precedent.
So the important question is, did the English courts do the right things? There is no unquestionably right answer. Most obviously, some matters were dealt with in one way in the UK and in another in the US. Comparisons are thus inevitable. In the UK there is clearly much to be complimented, but across the broad sweep, history may not judge us quite so well.
English courts may have leant too far in favour of market expediency and pragmatism, and paid insufficient regard to principle and future practice. Hence the title – persistent problems for secured lenders – referring not to those intractable problems from the past which remain annoyingly unresolved, but rather to new problems which have emerged from this crisis and which may remain to haunt us well beyond the heat of the battleground.
But how is that to be judged? How is legal performance to be evaluated? An analogy may prove helpful. After a serious train crash, we typically look at whether the railway systems and the rolling stock are fit for purpose, and then make changes accordingly. We know this will not eliminate every subsequent train crash, just as we know there will be more financial crises, but good and useful changes may reduce the frequency and severity of subsequent crashes.
In the context of financial crises, the greatest focus is typically on regulatory rules. To pursue the analogy, this is rather like looking at whether the train signals worked, whether the speed limits were appropriate, whether the train-drivers were adequately trained, and so on. That is not the focus here, although even a cursory reading of the literature would suggest that assessments differ widely.
But the other matter which deserves attention is the trains themselves: are they are fit for purpose, could they be better designed to meet current needs while still delivering passengers safely to their intended destinations. The 'train', in the financial markets context, is our private law and its rules on contracting and division of property rights in assets. It is the state of the trains, or the state of our private law, and its proper development, which are of particular interest here.