This case study illustrates the race against time to salvage as much of the firm’s franchise as possible and how circumstances overcame Lehman’s plans to restructure the business resulting in the biggest bankruptcy in U.S. history

Excerpted from Mergers, Acquisitions, and Other Restructuring Activities. 5th edition, 2009, by Donald M. DePamphilis. For more information or to buy online, click here.

     The credit crisis of 2008, which saw global banks write down more than $300 billion in assets and caused the hurried sales of Bear Stearns, Merrill Lynch, Wachovia, and Washington Mutual, also forced investment-banking behemoth Lehman Brothers to seek protection from its creditors.      Lehman Brothers had a plan in place to restructure operations, reduce the overall cost structure, and improve performance. Top executives intended to sell a majority of the firm’s investment management business, which included money manager Neuberger Berman, and spin off its troubled real estate loans into a publicly traded unit. The firm also had explored the sale of its broker-dealer operations (i.e. a broker network and securities trading business). However, plans take time to implement and, with the loss of confidence in the capital markets in general and Lehman in particular, the firm simply ran out of time and options.

      Reflecting the intensity of the 2008 credit crisis that shook Wall Street to its core, Lehman Brothers Holdings, Inc. (LBHI), a holding company, on September 15, 2008, announced that it had filed a petition under Chapter 11 of the U.S. bankruptcy code. Lehman’s board of directors decided to opt for court protection after attempts to find a buyer for the entire firm collapsed. With assets of $639 billion and liabilities of $613 billion, Lehman is the largest bankruptcy in history in terms of assets. The next biggest bankruptcies were WorldCom and Enron with $126 billion and $81 billion in assets, respectively.

     None of the holding company’s subsidiaries was included in the filing, enabling customers of Lehman’s brokerage, Neuberger Berman Holdings, to continue to use their accounts to trade. Furthermore, by excluding its units from the bankruptcy filing, customers of its broker–dealer operations would not be subject to claims by LBHI’s more than 100,000 creditors in the bankruptcy case.

     When a financial services firm goes bankrupt, counterparties have a right to cancel contracts. Lehman would normally hedge or protect its investments by taking opposite positions to minimize potential losses in its derivatives portfolios. Derivatives are financial instruments whose value changes in response to the value of the underlying assets over a specific period. For example, if the firm purchased a contract to buy oil at a specific price at some point in the future, it would also sell a contract at a somewhat lower price to another party (called a counterparty ) to minimize losses if the price of oil dropped. Thus, filing for Chapter 11 reorganization left Lehman’s investment positions unprotected.

     On September 20, 2008, Barclays PLC. a major U.K. bank, acquired Lehman’s broker–dealer operations for $250 million and paid an additional $1.5 billion for the firm’s New York headquarters building and two New Jersey–based data centers. Coming just five days after Lehman filed for bankruptcy, the deal reflected the urgency to find buyers for those businesses whose value consisted primarily of their employees. Barclays did not buy any of Lehman’s commercial real estate assets or private equity and hedge fund investments. However, Barclays did agree to take $47.4 billion in securities and assume $45.5 billion in trading liabilities. On September 24, 2008, Japanese brokerage Nomura Securities acquired Lehman’s Japanese and Australian operation for $250 million. Lehman’s investment management group, Neuberger Berman, was sold in late December 2008 to a Neuberger management group for $922 million. Under the deal, Neuberger’s management would own 51 percent of the firm and Lehman’s creditors would control the remainder. Other Lehman assets, consisting primarily of complex derivatives ranging from oil price futures to insuring corporate debt (i.e. credit default swaps) to options on stock indices, with more than 8,000 counterparties, were expected to take years to identify, value, and liquidate. The firm also could expect to face numerous lawsuits.

T     he October 18, 2008 auction of $400 billion of Lehman’s debt issues was valued at 8.5 cents on the dollar. Because such debt was backed by only the firm’s creditworthiness, the buyers of the Lehman debt had purchased insurance from other financial institutions to mitigate the risk of a Lehman default. The existence of these credit default swap arrangements meant that the insurers were required to pay Lehman bondholders $366 billion (i.e. 915 times $400 billion). Purchasers of this debt at the auction were betting that, following Lehman’s eventual liquidation, holders of this debt would receive more than 8.5 cents on the dollar and the insurers would be able to satisfy their obligations.

Hedge funds also were affected significantly by the Lehman bankruptcy. Hedge funds borrowed heavily from Lehman (a so-called prime broker), putting up certain assets as collateral for the loans. While legal, Lehman was using this collateral to borrow from other firms. By using its customers’ collateral, as its own collateral, Lehman and other firms could borrow more money, using the proceeds to make additional investments. When Lehman filed for bankruptcy, the court took control of such assets until who was entitled to the assets could be determined. Moreover, while derivative agreements are designed to terminate whenever a party declares bankruptcy and be settled outside of court, Lehman’s general creditors may lay claim to any collateral whose value exceeds the value of the derivative agreements.

     Despite what appeared to be aggressive efforts to save the firm, the poor decisions made by senior management in previous years could not be reversed amid the chaos in the capital markets at that time. Investors and lenders saw the collapse of the iconic firm as a harbinger of the bankruptcy of other financial services firms. Increasingly negative investor and lender sentiment further exacerbated the worst global economic downturn since the Great Depression.