Observations on the Globalization of Finance and the Bankruptcy Process of Lehman Brothers Finance of Switzerland Robert J.

Shapiro March 2, 2012 The bankruptcy proceedings for Lehman Brothers Finance, AG (LBF), a Swiss subsidiary of Lehman Brothers Holdings, Incorporated (LBHI) and part of the Lehman Brothers Group (LBG), remain unresolved more than three years after the bankruptcy of LBHI and its subsidiaries. The bankruptcy process for LBF is by the Swiss Financial Market Supervisory Authority (FINMA), which thus far has been unable to expedite its resolution. In contrast to most corporate bankruptcy proceedings, this case involves the subsidiary of a global financial institution with affiliated companies and subsidiaries in many countries. The globalization of financial markets can increase the costs of untoward delay in resolving the bankruptcy of a subsidiary of a global financial services corporation. This essay examines some of those costs for the parties involved and for the Swiss economy. Globalization has altered many of the dynamics of national and international capital markets and investment. The growth of global financial institutions with separate operating subsidiaries or affiliates in scores of countries, established through foreign direct investment (FDI), lies at the heart of these developments. Every day, global financial institutions transact tens of billions of dollars in investments with third parties and among their own subsidiaries in various countries. The efficiency and stability of the international financial system depends on the routine operations of these global institutions, and therefore on their foreign direct investments. The security of the FDI of global financial institutions is also an important factor in both the international integration of advanced economies. Small advanced economies such as Switzerland can benefit substantially from the transfers of advanced financial service operations, technologies and business methods through the FDI of global financial institutions. The presence of these subsidiary companies intensifies competition in those economies and thereby promotes innovation and new efficiencies in the operations of their own financial and nonfinancial enterprises. In this respect, the ability of a small advanced economy to attract FDI in financial services is a factor in both the international competitiveness of that nations companies and its ability to attract FDI in other areas. Global financial service companies do not have unlimited resources for their foreign direct investments, and therefore pick and choose where to establish new operations. Economists have studied these decisions and identified criteria which determine where these multinationals locate their subsidiaries. Many of these criteria are traditional economic matters such as the size of the domestic market, its access to other neighboring markets, the quality and wage costs of the domestic labor force, the quality and extent of the countrys infrastructure, the extent of regulation, and national tax burdens. Researchers also have identified other political factors which influence where multinational financial service firms locate their FDI. The reliability of the rule of law, the enforcement of contracts, the protection of property rights, and the fair settlement of business disputes are threshold issues for multinationals contemplating new FDI commitments, in the financial service sector and others. In this context, the legal and

regulatory requirements for establishing, operating and closing down a failed business can matter greatly. The recent and ongoing volatility and disruptions of worldwide financial markets, including the U.S. financial crisis of 2008-2009 and the current threat of financial chaos in the Eurozone, has raised new concerns about the possible failures of global financial enterprises. In this context, these enterprises and their global investors must now give greater weight to the terms and quality of the bankruptcy regimes of the advanced in which they locate their FDI. As the U.S. Government recently advised U.S. multinationals, the manner in which creditors and debtors are treated under a particular insolvency law can also influence the perceptions of investors (and) the quality of the Bankruptcy Law (and its enforcement) may influence the extent to which parties are willing to extend credit to businesses. In particular, a nations bankruptcy regime should be seen to allow for the prompt and efficient reallocation of the debtors resources, and in a manner consistent with the bankruptcy regimes of the advanced nations where those multinational institutions are based. The large multinational financial and other enterprises which account for major FDI in advanced (and developing) economies may limit or avoid investments in nations which fail to establish and enforce consistent, predictable and efficient bankruptcy regimes for the subsidiaries of those multinationals. In this economic environment, the bankruptcy proceedings of the international network of Lehman Brothers companies, has assumed new importance. Lehman Brothers Holdings, Inc. (LBHI), the holding company for Lehman Brothers operations in scores of countries, failed in September 2008 in the largest financial bankruptcy in history. This failure also produced what are likely the complex bankruptcy proceedings in history. By press accounts, the Lehman bankruptcy exposed two leading British banks (Royal Bank of Scotland and Barclays) to losses of $3.6 billion (2.7 billion), Deutsche Bank in Germany to losses of $2.5 billion (1.9 billion), major Spanish banks to losses of $1.7 billion (1.3 billion), and large Italian institutions to losses of $1.3 billion (1 billion). Over the last three years, the bankruptcy systems in many countries have successfully settled the claims and counterclaims among Lehman Brothers subsidiaries, between those subsidiaries and LBHI, and between outside investors and LBHI and its subsidiaries. The most outstanding exception to this record is LBHIs Swiss subsidiary, Lehman Brothers Finance AG (LBF). For three years, LBF has been in discussions with third-party investors and other Lehman Brothers subsidiaries. Yet, under the oversight of the Swiss Financial Market Supervisory Authority (FINMA), LBF apparently has rejected virtually every proposed settlement. In March 2011, the Fourth Report from PricewaterhouseCoopers, AG, Zurich, the appointed liquidators for LBF, noted significant progress in establishing, reconciling, analyzing and valuing the claimed filed by third parties against LBF. These included claims by LBF against 22 Lehman Brothers Group (LBG) companies totaling CHF 87.6 billion and claims by 25 LBG companies against LBF totaling CHF 66 billion. One year later, these claims have still not been resolved. In January of this year, the chief judge in the U.S. bankruptcy process, Judge James Peck, noted the impact of LBFs singular failure to resolve its issues in the global bankruptcy. On January 26, 2012, he said, LBF is the outlier here relative to the other foreign affiliates, and that one could conclude, LBF is not acting reasonably under the circumstances. Until LBF resolves these claims, which are now among the largest disputed claims still asserted against 2

Lehman Brothers enterprises, the LBHI bankruptcy proceedings in many other countries cannot be fully resolved. The failure of FINMA and LBF to resolve LBFs debts and claims, virtually alone among LBHI subsidiaries in advanced countries, has become a subject of concern and debate in Switzerland and in financial and legal circles around the world. In Switzerland, this debate has focused largely on the shortcomings of the current Swiss bankruptcy regime. In particular, commentators such as Prof. Dr. Urs W. Birchler of the Institute for Banking and Finance at the University of Zurich and others, have drawn attention to revisions of the Swiss Banking Act in 2003 and 2011. These revisions expanded depositor protections and strengthened measures to head off de facto government bailouts. In addition, the revisions expanded FINMAs authority and discretion in insolvencies and bankruptcies of financial institutions in Switzerland. Much of this discussion has focused on whether these revisions have effectively increased the likelihood of state bailouts. Criticism has been leveled in particular at the 2011 revision which omitted FINMAs long-standing statutory responsibility to guarantee, to the extent possible, the property of all parties. The 2003 revisions directed FINMA to conduct the bankruptcy and liquidation process to protect creditor and owner interests to the extent possible and account for creditor priority with precedence over that of owners and also account for precedence priority among creditors. (Art 31(d) BankG (2003). The 2011 revisions, however, omitted the provision stipulating that the process be conducted in a manner which would maximize the assets owned by beneficiaries overall, and protect them to the extent possible. This revision lessens the legal security of creditors in financial bankruptcies. Moreover, when the interests of creditors, depositors and the debtor conflict, the decision to expand FINMAs powers and discretion without providing a statutory goal to maximize and protect the assets of beneficiaries has had the perverse effect of extending the process, in the way criticized recently by U.S. Bankruptcy Judge Peck. These revisions also may leave the proceedings more exposed to political pressures. If such political pressures are seen to prevail, the overall credibility of Swiss bankruptcy law in global financial circles and markets will be damaged. With the claims and counterclaims arising out of the LBHI bankruptcy resolved in most other countries, continued delay by FINMA and LBF in resolving the issues arising out of LBFs bankruptcy may entail substantial unnecessary costs for the Swiss economy as well as for LBHI and LBG creditors. Avoiding such unnecessary costs is widely seen as a critical of the reliability of a national bankruptcy regime in addressing the failure of a global financial service company. If Switzerland remains the outlier in this global process, that nations reputation will suffer among financial institutions. This may result in lower FDI to Switzerland in this area. Moreover, this failure may raise larger questions of the reliability of Swiss law to settle disputes, potentially affecting future FDI in other areas as well. The Eurozones ongoing financial crisis further increases the potential costs of FINMAs continuing delay in resolving the LBF bankruptcy. A sovereign debt default by a major Eurozone country would threaten a number of large European financial institutions with global networks as extensive and diverse as that of Lehman Brothers. If FINMA and LBF cannot resolve LBFs issues promptly, and the possibility of a Eurozone sovereign debt default persists 3

or increases, prudent worst-case planning may dictate that those European financial institutions draw down or otherwise limit the operations of their Swiss subsidiaries. It is difficult to overstate the critical importance of finance to the Swiss economy. Banking and financial services account for nearly 6 percent of Swiss employment and more than 11 percent of Switzerlands GDP. Moreover, the international reputation of Swiss banking and financial services has suffered in recent years, mainly over issues in which Swiss banking law and practices have been at odds with the law and practices of other advanced nations. In this context, continued delay by FINMA and LBF to resolve their part of the Lehman Brothers bankruptcy could undermine Switzerlands unique brand in global finance. Such damage would be felt by Swiss workers and affect Swiss GDP. By every available measure and precedent, it is imperative that FINMA and LBF promptly resolve their issues in the Lehman Brothers bankruptcy.

Robert J. Shapiro is the chairman and co-founder of Sonecon, LLC, a private firm that advises U.S. and foreign businesses, governments and non-profit organizations on market conditions and economic policy. He is also advisor to the International Monetary Fund, Senior Fellow of the McDonough School of Business at Georgetown University, director of the Globalization Initiative at NDN, chair of the U.S. Climate Task Force, and co-chair of the America Task Force Argentina. From 1997 to 2001, Dr. Shapiro was the U.S. Under Secretary of Commerce for Economic Affairs. In that post, he directed economic policy for the U.S. Commerce Department and oversaw the major statistical agencies of the U.S. Government. Prior to that, he was co-founder and Vice President of the Progressive Policy Institute and Legislative Director for U.S. Senator Daniel P. Moynihan. Dr. Shapiro also served as the principal economic advisor to Governor Bill Clinton in his 1991-1992 U.S. presidential campaign, and senior economic advisor to Senator Barack Obama, Vice President Albert Gore, Jr. and Senator John Kerry in their U.S. presidential campaigns. Dr. Shapiro has been a Fellow of Harvard University, the Brookings Institution, and the National Bureau of Economic Research. He holds a Ph.D. and M.A. from Harvard University, a M.Sc. from the London School of Economics, and an A.B. from the University of Chicago.