The recent failure of Lehman Brothers Inc. (LBI) has provided, and continues to provide, valuable insight into how large-scale insolvency proceedings of broker-dealers are administered. Insolvent broker-dealers cannot reorganize under the US Bankruptcy Code. Instead, they must usually liquidate under the Securities Investor Protection Act of 1970, as amended (SIPA) (see box, Insolvency proceedings for broker-dealers).

Although broker-dealer liquidations under SIPA have taken place in the past, no prior case had even remotely resembled the magnitude of the LBI SIPA proceeding, nor had any attracted as much public scrutiny. As a result, many professionals and advisors with no prior experience of broker-dealer insolvencies were forced to familiarize themselves quickly with SIPA.

Although a SIPA proceeding resembles in many ways a liquidation under Chapter 7 of the US Bankruptcy Code, one aspect of the LBI case that caught many by surprise was the temporary restriction against the ability to foreclose on securities collateral. On the commencement of a SIPA proceeding, creditors with claims against the debtor broker-dealer generally are stayed from taking any direct actions against it that might negatively impact the value of the its estate, such as exercising any setoff or foreclosure rights.

This general restriction is subject to a safe harbor provision permitting creditors to both:

The stay under SIPA, as well as this financial contracts exception, closely resemble the automatic stay and the safe harbor provisions contained in the US Bankruptcy Code. The safe harbor under SIPA, however, contains one significant caveat that the Bankruptcy Code does not: the ability of counterparties to financial contracts to foreclose on any securities collateral posted by the debtor broker-dealer (whether under a securities lending arrangement or a repurchase agreement) can be prohibited for a period of time, effectively, at the Securities Investor Protection Corporation's (SIPC) (see box, Insolvency proceedings for broker-dealers) discretion.

Indeed, the order that was entered commencing the LBI SIPA proceeding prohibited the foreclosure on any securities collateral posted by LBI for a period of 21 days following the date of the order (see box, Duration of the SIPC's prohibition on counterparty foreclosure on securities collateral).

This 21-day prohibition was not anticipated by many of LBI's counterparties who had intended to foreclose on LBI's securities collateral immediately on the commencement of LBI's SIPA case. As a result, those counterparties in many cases were exposed to an additional 21 days of market risk in relation to those securities.

By contrast, those who were aware, in advance, of this temporary prohibition were able to substantially limit this exposure by taking advantage of an option that the SIPC historically has offered up. In response to various concerns expressed by market participants, the SIPC in the past has indicated that it expects to consent to the lifting of the temporary prohibition with respect to the applicant if a secured counterparty submits within the restricted period a "good faith affidavit" attesting both that:

Many of the counterparties who were aware of this option had prepared "good faith affidavits" in advance of LBI's SIPA case and submitted them to SIPC promptly after the commencement of the proceeding. In response, the SIPC in many instances promptly lifted the stay to permit the foreclosure of securities. In fact, certain clients of Shearman & Sterling LLP had the stay lifted within three days of the commencement of the SIPA case.

Based on this experience, practitioners would be well-advised in the future to prepare for any apparently imminent broker-dealer liquidation proceeding by compiling, before the case commences, good faith affidavits with respect to any securities collateral their clients may hold in respect of any qualifying financial contracts with the broker-dealer, so that they may be submitted shortly after the SIPA case commences. The time which it takes to prepare such materials may be short, but such efforts are likely to prove worthwhile.