In light of the recent Chapter 11 bankruptcy filing by Lehman Brothers Holdings Inc. and the subsequent determination of the Securities Investor Protection Corporation (SIPC) to commence a proceeding placing Lehman Brothers Inc. (LBI) in liquidation under the Securities Investor Protection Act (SIPA), we are circulating this brief summary of certain key provisions of United States law affecting customers of insolvent broker-dealers and counterparties of broker-dealers and other financial institutions that become debtors under the United States Bankruptcy Code (the “Bankruptcy Code”).This summary addresses both the SIPA broker-dealer insolvency proceedings as well as Bankruptcy Code provisions affecting counterparties to forward contracts, swaps, securities contracts and other contractual arrangements with entities in bankruptcy.


U.S. registered broker-dealers must comply with Securities and Exchange Commission (SEC) Rule 15c3-3 under the Securities and Exchange Act of 1934 - commonly referred to as the “Customer Protection Rule.”

The Customer Protection Rule requires that broker-dealers take steps to protect the credit balances and securities held for customers. This requires broker-dealers (i) to segregate customer funds, and (ii) to maintain control of fully paid and excess margin securities carried for customers.

If a broker-dealer becomes insolvent, it may voluntarily commence a liquidation proceeding or creditors may force it into an involuntary liquidation, both under Chapter 7 of the Bankruptcy Code (a “Bankruptcy Liquidation”). Broker-dealers are not eligible to reorganize under Chapter 11 of the Bankruptcy Code.

Alternatively, SIPC, which insures customers’ securities accounts, may, as it has done with LBI, commence a liquidation proceeding against an insolvent broker-dealer under SIPA (a “SIPA Proceeding”). This is the action taken against LBI.

A SIPA Proceeding may be commenced only if SIPC determines that the broker-dealer has failed, or is in danger of failing, to meet its obligations to customers and (i) the broker-dealer is insolvent; (ii) there is already a pending proceeding against the broker-dealer and a receiver, trustee or liquidator has been appointed; (iii) the broker-dealer is not in compliance with certain applicable rules; or (iv) the broker-dealer is not able to compute whether it is in compliance with certain financial or securities hypothecation rules. In either a Bankruptcy Liquidation or a SIPA Proceeding, a trustee is appointed to take control of all of the broker-dealer’s assets, including customer cash and securities. In either proceeding, a stay goes into effect, freezing customer accounts and making cash and securities in those accounts inaccessible for an uncertain period of time.

If the broker-dealer has complied with the Customer Protection Rule, the trustee in either a Bankruptcy Liquidation or a SIPA Proceeding should be able to transfer customer accounts to a financially stable broker-dealer. This process is not immediate. Until the transfer is complete, customers will not have access to cash and securities in their accounts.

However, customer accounts may not be capable of being transferred to another broker-dealer (for example, because the failed broker-dealer did not comply with the Customer Protection Rule). Under those circumstances, there are different distribution schemes (discussed below) for cash, securities and other property in customer accounts in a SIPA Proceeding and a Bankruptcy Liquidation.

If customer accounts are not transferred to another broker-dealer, the main difference for customers between a SIPA Proceeding and a Bankruptcy Liquidation is that, in a bankruptcy, the trustee is required to convert securities, other than customer name securities, into cash as quickly as possible and distribute such cash proceeds to customers in satisfaction of their claims. In contrast, a trustee in a SIPA Proceeding is required to distribute such securities to customers, to the greatest extent possible.

SIPA Proceeding

  • Customer Name Securities – Assuming that the customer is not indebted to the brokerdealer (based on an outstanding margin loan, for example) the trustee is required to delivercustomer name securities” to the customer. If the customer is indebted to the broker-dealer, the customer may, with the approval of the trustee, reclaim customer name securities upon payment of the indebtedness within a period determined by the trustee. The term “customer name securities” is defined under SIPA as “securities which were held for the account of a customer on the filing date by or on behalf of the debtor and which on the filing date were registered in the name of the customer, or were in the process of being so registered pursuant to instructions from the debtor, but does not include securities registered in the name of the customer which, by endorsement or otherwise, were in negotiable form.” Thus, customer name securities do not include securities which are in negotiable form or held in “street name.” 
  • Distributions to Customers – To the extent that a customer’s account consists of cash and/or securities other than customer name securities (e.g., securities held in “street name”), such cash and/or securities will not necessarily be returned to the customer. Rather, the customer will have a “net equity”1 claim on account of such cash and/or securities against the total pool of customer property (comprised of all cash and securities, other than customer name securities, in all customer accounts and other property recovered by the trustee) on a pro rata basis with other customers.
  • To the extent possible, the trustee is required to satisfy net equity claims by providing customers with securities identical to the securities that they owned immediately prior to commencement of the SIPA proceeding. 
  • SIPC provides insurance protection to customers of failed broker-dealers up to $500,000 per customer (of which up to $100,000 may be for cash claims). If customer property and SIPC insurance are not sufficient to satisfy customers’ net equity claims in full, customers are entitled to receive distributions from the pool of any non-customer property of the broker-dealer on a pro-rata basis with holders of general unsecured claims.

Bankruptcy Liquidation 

  •  Customer Name Securities – As is the case in a SIPA Proceeding, a trustee in a Bankruptcy Liquidation of a broker-dealer is required to deliver any “customer name securities” to the customers for whose accounts they are held, unless those customers have negative net equity.2 With the approval of the trustee, a customer with negative net equity may reclaim customer name securities after satisfying the negative net equity obligation. For purposes of a Bankruptcy Liquidation the term “customer name security” is defined to mean: “security--(A) held for the account of a customer on the date of the filing of the petition by or on behalf of the debtor; (B) registered in such customer's name on such date or in the process of being so registered under instructions from the debtor; and (C) not in a form transferable by delivery on such date.” 
  • Distributions to Customers – The trustee in a Bankruptcy Liquidation is required to liquidate customer property as soon as practical after the date the petition is filed. Thus, the trustee in a Bankruptcy Liquidation has no authority to distribute to customers any securities other than customer name securities. The net proceeds realized from the liquidation are required to be distributed in cash on a pro rata basis to customers to the extent of such customers’ allowed net equity claims and in priority to all other claims of creditors, except certain claims attributable specifically to the administration of such customer property.


General Bankruptcy Provisions

The Bankruptcy Code provisions summarized below apply (except as otherwise described) in bankruptcy proceedings generally, regardless of the identity of the debtor. Thus, they affect both Bankruptcy Liquidations of broker-dealers and Chapter 7 and Chapter 11 proceedings involving entities other than broker-dealers. 

  • The Automatic Stay. Upon the commencement of any bankruptcy case an automatic stay, pursuant to section 362 of the Bankruptcy Code, goes into immediate effect. Subject to the “safe harbor” provisions discussed below, the stay precludes, among other things, any actions taken by a non-debtor to collect payment from or otherwise to enforce contractual rights against the debtor. The non-debtor party may, by filing a motion with the bankruptcy court, seek relief from the stay to enforce its rights. Relief may be granted if the non-debtor party can establish “cause” to lift the stay. Particularly if the contract in question is an “executory contract” (discussed below), the non-debtor party will often find that obtaining stay relief without the debtor’s consent is a slow and costly process. 
  • Rights and Obligations Regarding Executory Contracts. As generally defined by bankruptcy courts, the term “executory contract” means a contract under which, as of the date the bankruptcy case is commenced, each party has material unperformed obligations such that one party’s failure to perform would relieve the other party from its obligation to perform. Section 365 of the Bankruptcy Code generally affords debtors the right to assume executory contracts (in which case they become enforceable against the debtor, and its obligations have administrative priority) or to reject them (in which case they normally cannot be enforced against the debtor, except that a counterparty to a rejected contract can assert an unsecured claim for damages for breach of contract). If it assumes an executory contract, a debtor generally can also assign it to another party that is in position to perform. A debtor generally is under little or no time pressure to assume or reject its executory contracts, and until it does so the contracts are, in effect, in limbo: unenforceable against the debtor and enforceable, at least in part, against the counterparty. This includes funding obligations of a debtor under a contract. Absent assumption by the debtor of such contract, such funding obligations will not be enforceable against the debtor. Forward contracts, swaps, repurchase agreements and other financial contracts to which a debtor is party typically will qualify as executory contracts. But for application of the “safe harbor” rules described below, disposition of such contracts would generally be governed by Section 365. 
  • Setoff. Although it recognizes the rights of debtors and non-debtors to set off their mutual obligations, the Bankruptcy Code generally restricts the rights of non-debtor parties to exercise setoff rights. Here again, the safe harbor provisions make an exception.
  • Avoidance of Preferential Transfers. Subject to the “safe harbor” provisions discussed below, certain payments and other transfers of property made to or for the benefit of a creditor on account of antecedent debts within ninety (90) days (or one year if such creditor is an “insider” of the debtor) prior to the commencement of the bankruptcy case are subject to avoidance for the benefit of the debtor’s creditors. An avoidable transfer must have been made while the debtor was insolvent (but there is a statutory presumption of insolvency during the 90 days before bankruptcy), and must have enabled the creditor to receive more than it would receive in a Bankruptcy Liquidation of the debtor. Some categories of routine transactions can be insulated from preference avoidance based on defenses prescribed in Section 547(c) of the Bankruptcy Code.

“Safe Harbor” Provisions 

  •  The Bankruptcy Code includes “safe harbor” provisions designed to shield certain categories of common financial transactions from the disruptions to which they would otherwise be subject, following one party’s bankruptcy, as a consequence of the automatic stay and application of normal bankruptcy rules governing executory contracts, setoffs and preferences. 
  • Protected contracts include “securities contracts,” “commodities contracts,” “forward contracts,” “repurchase agreements,” “swap agreements” and “master netting agreements,” each of which is defined under the Bankruptcy Code. 
  • The “safe harbor” provisions allow the non-debtor party to exercise certain contractual rights including the rights to terminate, liquidate and accelerate such contracts, based upon the commencement of the bankruptcy case or the insolvency of the debtor, without regard to the automatic stay
  • The “safe harbor” provisions also allow the non-debtor party to exercise setoff rights without first seeking court approval including rights to set off obligations under Master Netting Agreements.
  • The “safe harbor” provisions also protect the non-debtor party from avoidance actions (including preference actions) with respect to payments made under the protected contract prior to the commencement of the bankruptcy case. 
  • The “safe harbor” provisions do not create any termination, acceleration, setoff or liquidation rights. They simply enable the non-debtor party to enforce pre-existing existing rights set forth in the protected contract.